Best Financial Markets Analysis Article House prices are collapsing, which means that homeowners' equity in their houses is plunging. According to Federal Reserve flow-of-funds data, homeowners' equity dropped by $399 billion quarter-to-quarter in Q1:2008 and $880 billion year-over-year - both record absolute declines (see Chart 1). The drop in homeowners' equity contributed significantly to the $1.7 trillion decline in household net worth in the first quarter (see Chart 2).

Chart 1

Chart 2

Economists refer to something called the "wealth" effect. It is hypothesized that households tend to spend relatively more of their income when their wealth is increasing and vice versa. Mind you, households do not have any more cash in hand to spend when the value of their stock portfolios or houses go up. They are just wealthier "on paper."

In this past cycle, it had become very easy for households to turn their increased "paper" housing wealth into actual cash by borrowing against their increased home equity. This borrowing is called mortgage equity withdrawal, or MEW. Active MEW can be defined as mortgage equity withdrawal consisting of refinancing and home equity borrowing. In contrast, inactive MEW consists of turnover. At an annualized rate, active MEW peaked at $576 billion in the second quarter of 2006. Active Mew has slowed to only $114 billion in the first quarter of this year - the smallest amount since the fourth quarter of 1999 (see Chart 3).

There is no doubt in my mind that active MEW, which actually puts additional cash into the hands of households, played an important role in boosting consumer spending in this past expansion. And there is no doubt in my mind that the recent and likely continued decline in active MEW will play an important role in retarding consumer spending in this recession. Because it has been easier to borrow against the increased wealth in one's house than in one's stock portfolio, dollar-for-dollar, falling house prices will have a more important negative effect on household spending that will falling stock prices.

Chart 3

By Paul L. Kasriel
The Northern Trust Company
Economic Research Department - Daily Global Commentary

Copyright © 2007 Paul Kasriel
Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

Paul L. Kasriel Archive

Comments

B.L.
24 Jun 08, 11:12

Credit Crisis Mess

It took aproximately ten years for the credit crisis to happen. It will take another ten years for the economy to absorb and digest what has happened.

hmmm
14 Sep 08, 13:14

brick value of housing stock

how many upside down buyers know the value of a new home?

drywall costs 3.50 a board, bricks are cheap, dirt is cheap, dead wood is not expensive, paint still costs 10-14 bucks a gallon, when people realize thier OVERPAID FOR ...INFLATED..OVERTAXED..ERRORFULLY ASSESSED 200,000 dollar home is only worth 50,000 land and brick value, buyers will be educated. When condo owners realize thier 180,000 dollar shared wall/shared bugs, condo was only worth 43,000 new and with depreciation is now only worth 20,000, the buyers will then be educated.

Gougers INFLATED the market and now the same gougers are buying everything for 10 cents on the dollar.

Too bad the bloated wasteful school systems do not teach kids the value of a dollar. I vote all kids be home schooled on a computer 3 days a week with 2 days a week socialization. THAT will cut the fat and waste of the BLOATED inefficient wasteful school systems. And kids will learn via computer the value of a dollar AND SUCH SCAMS AS THE LENDERS AND REALTORS AND APPRAISERS RAN WILL NO LONGER OCCUR WITH A COMPUTER EDUCATED POPULATION.

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