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Kass: Housing Red Ink Could Spell Recession

Doug Kass

My article Monday offered a sober view of the U.S. economy, documented the government's illusion of low inflation and healthy job growth, and discussed why stagflation will continue to serve as the functional equivalent of a huge tax increase on the middle class.

From my perch, the odds favoring a housing-induced recession are now increasing. My bearish preoccupation with the health of the housing markets appears to be justified by history.

The slow-motion drop in consumption seen in the last 12 months will likely accelerate, aided by growing evidence of a second housing downturn this year and possibly another downswing next year, which will be exacerbated by ever-increasing supplies of unsold homes served up, in part, by mortgage resets in 2007 and 2008.

The bullish crowd contends that there is no evidence that the real economy has been affected by the housing market and subprime collapse, rising energy prices or geopolitical threats. Nor -- according to them -- has the economy been affected by a host of other varied microeconomic and macroeconomic issues.

Today, the term liquidity is a catch-all phrase in support of continued economic growth and stock market appreciation, just at a time that collateral and interest rate terms in private-equity deals have begun to tighten.

The same things were said in the late 1980s.

During that period, unprecedented land and housing speculation followed the erosion in lending standards that were a byproduct of the deregulation of the savings and loan industry and the liquidity introduced by Michael Milken's Drexel Burnham, which brought an unprecedented increase in takeover activity.

Ultimately, the economic progress of the early- and mid-1980s gave way to an implosion in the high-yield debt markets, an economic downturn and a horrific housing depression -- and the loss of the previous decade's liquidity. In the early 1990s, the economic contraction was severe in both magnitude and duration (continuing for three years), even though the federal funds rate was reduced by 500 basis points to 3% and stayed there for over 20 months.

(As an result of the recession's severity, several money-center banks, such as Citigroup(C Quote - Cramer on C - Stock Picks) and Bank of Boston, were almost insolvent and had to be saved by the Tisch family.)

Fast-forward to the present.

In 2007, the economy is nearly two-thirds larger than it was 16 years ago, a period in which the downturn in real estate produced nearly $300 billion in losses. But not only is the residential mortgage market much larger now, so are subprime delinquencies and the ultimate losses they will deliver.

Moreover, home mortgage borrowing, home ownership (69% of families vs. only 64% in 1991) and the impact of housing on aggregate economic activity have never been higher. Equally important, household debt as a percentage of GDP is dramatically higher, and home equity as a percentage of home market values has never been lower.

Once again, as in the late 1980s, llax lending standards have become the mainstay of our markets and now are a contributor to the real estate and subprime mess. Also, liquidity is the most often quoted term to explain the market's buoyancy, takeover activity and rising stock prices.

Given the extraordinary creation of wealth -- in part because of the ongoing strength of the equity markets and, until recently, the large price appreciation in home prices and breathtaking mortgage equity withdrawals -- one should not be surprised by a delayed or slow-motion response, particularly by consumers.

Nevertheless, there is an obvious chain of real estate-related jobs -- mortgage brokers, landscapers, title searchers, real estate lawyers, mortgage bankers, realtors, contractors, etc. -- that will suddenly be lost at breakneck speed over the near term.

The worst is yet to come -- the housing's multiplier effect is starting to kick in.

The consumer has never been more levered, homeownership as a percentage of household net worth has never been higher, the issue of home affordability has yet to be resolved, the inventory of unsold homes is at record levels, homeowner vacancy rates are at an all-time high (2.8% vs. 1.2% in the early 1990s), foreclosures and delinquencies are skyrocketing, and mortgage interest resets are just beginning to further pressure household incomes.

The damage associated with the housing problems will be long-lasting -- and, as in the early 1990s, lower interest rates will not readily jump-start growth and rescue the economy.