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Seeing signs of strength.


Since the beginning of the 1990-1991 recession in July 1990, Fannie Mae's economics department has consistently said it expected the recession to be somewhat milder than normal. Offsetting this relatively optimistic outlook, however, was our expectation that the recovery would be much less robust than usual.

It appears that the national recession ended last spring, although the weakness of the recovery has left the precise ending date of the recession in doubt. Additional signs of sluggish economic growth - and even decline - have led many analysts to conclude either that the recession, in fact, did not end last spring, or that the economy is headed for a "double dip" recession.

The problem, as we see it, is that the U.S. economy has never experienced an economic recovery this far below average. Expansions in the United States typically occur in one of two ways: strong or very strong. This recovery is clearly neither of those.

An anemic recovery

During even an average recovery, in which overall economic growth increases at about a 5 percent annual rate, there is sufficient forward momentum to pull virtually all sectors and geographic regions of the economy up. In the current environment - with economic growth at less than half its usual pace for the first year of an expansion - we find that many sectors and many regions remain underwater. This is certainly the case for certain sectors of the economy that include financial services, construction and state and local governments, as well as the Northeast, Middle Atlantic and California econ- omies regionally. This weakness is countered by expansion in non-auto manufacturing and services, especially in health care, and in the Southeast, Southwest, Middle West and Mountain states.

During the coming year, we expect continued below-average economic growth, although the economy should pick up some additional steam by midyear. Certain key elements of recovery are in place: lower interest rates, increased liquidity, lower inflation and a high degree of competitiveness in international markets. Unfortunately, factors that have slowed the expansion thus far remain impediments: low consumer confidence, high levels of consumer, business and government debt and rising state and local tax burdens. The net result of these conflicting factors should be faster economic growth in the coming year - about 2.3 percent real GNP by our estimate - but still well below average. (See Table 1.)

Table : TABLE 1 Fannie Mae Economic Forecast for 1992
 1990 1991 1992
Real GNP Growth 1.0% -0.5% 2.3%

Components of GNP:
 Personal Consumption 0.9% 0.4% 2.3%
 Nonres. Business Investment 1.8% -2.3% 5.1%
 Residential Investment -5.5% -11.2% 11.8%
 Change in Business Inventories -$3.6b -$20.8b $1.8b
 Net Exports -$33.8b -$19.3b -$41.5b
 Government Purchases 2.1% 0.5% -1.4%
GNP Deflator Growth 4.1% 3.8% 3.1%

The anemic pace of economic growth, and the fears that growth might again turn negative, have caused the Federal Reserve (the Fed) to ease monetary policy fairly aggressively since August. The federal funds rate has been cut from 5.75 percent to 4.75 percent in early December (on top of a 225 basis point decline from July 1990 to July 1991), while the discount rate has fallen by 100 basis points to 4.5 percent. This easing has brought short-term interest rates down in the market, with the three-month Treasury bill also down by about a percentage point in the past four months. We expect additional easing by the Fed during the next few months - until the danger of slipping back into recession has passed - with both the discount and federal funds rates falling to 4 percent.

Interest rates

Long-term rates have been somewhat stickier, however, as a result of continued long-term inflation fears, record borrowing demands by the U.S. Treasury and reduced demand for U.S.-dollar denominated assets by foreign purchasers. This caused the yield curve to steepen to record levels as of late November. Because we do not expect any of the elements that have kept long-term rates from falling to dissipate in the next few months, long-term rates are likely to remain near current levels - causing the yield curve to steepen even more.

If the pace of economic growth picks up in 1992, as we expect, then the Fed will likely refrain from further easing sometime in the first half of the year. Faster economic growth during the second half of the year (averaging about 3 percent at annual rates) will probably even cause the Fed to tighten policy modestly by late summer. We expect short-term rates to move up by more than long-term rates, however, as the Fed's willingness to change policy should be looked upon positively by the bond market. As a result, long-term rates should move up only slightly over the second half of next year, resulting in some flattening of the yield curve.

As noted in Chart 1, mortgage rates have moved to the lowest levels since early 1977 for fixed-rate mortgages, and the lowest levels in history for adjustable-rate mortgages. This decline in rates has come in part from the general decline in market rates, and in part from a tightening of mortgage-Treasury spreads.

The steepness of the yield curve has made the issuance of collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs) extremely profitable, and so the demand for mortgages as collateral has increased sharply - driving up their price and driving down their yields relative to Treasuries. Additional steepening of the yield curve should increase the demand for mortgage derivative products, although this may be offset by increasing prepayments as the rush to refinance continues. (See Table 2.)

Table : TABLE 2 Fannie Mae Interest Rate Forecast for 1992
 1990 1991 1992
3-Month Treasury Bill 7.49% 5.42% 5.04%
30-Year Treasury Bond 8.61% 8.13% 8.10%
1-Year T-Bill ARM 8.36% 7.12% 6.49%
30-Year Fixed-Rate Mortgage 10.13% 9.27% 9.18%
Consumer Price Index 5.4% 4.2% 3.4%

Housing: the economy's

stalled engine

The housing market is typically one of the first sectors of the economy to recover at the end of a recession - usually with a rebound that allows it to be accurately characterized as one of the primary engines of growth for the economy in the first year of a recovery. In the current recovery, housing certainly turned upward before the rest of the economy, with gains in both sales and starts beginning in the spring (see Chart 2). Just as the overall economy has seen only a very modest improvement, however, so has the housing market gained only slowly during the past several months. The case easily can be made that it is the weak recovery in housing that has held down growth in the economy as a whole.

While we expect the housing market to continue to improve, it is likely to remain a subpar recovery into 1992. (See Table 3.) Lower mortgage rates have resulted in the highest levels of affordability in nearly 20 years, but the problems in housing during the past couple of years - and certainly during the last recession - have had less to do with mortgage rates and more to do with lack of pent-up demand, high levels of consumer debt and a less-favorable demographic picture.

Table : TABLE 3 Fannie Mae Housing Forecast for 1992
 1990 1991 1992
Housing Starts, Total (millions) 1.19 1.01 1.17
 Single-family 0.90 0.84 0.95
 2-4 Units 0.04 0.04 0.05
 5+ Units 0.26 0.14 0.17
New Home Sales (thousands) 534 491 575
Existing Home Sales (millions) 3.30 3.27 3.45
Growth in Median New Home Price 2.4% 3.1% 5.9%
Growth in Median Exist. Home Price 2.6% 4.3% 4.0%

As a result, lower mortgage rates can only go so far in spurring housing demand. Every bit helps, however, and so we do see a stronger housing market for 1992 than 1991 - but until people are willing to increase their debt levels, or income rises appreciably, it will be difficult for home sales and starts to improve as they have in prior recoveries.

Origination flurries

The mortgage market has experienced a rush of activity since the spring with the modest improvement in sales, a flurry of refinancings in the spring, and a surge in refinancings in the fall. Taken together, the volume of single-family mortgage originations in 1991 should be at record levels - surpassing the previous peak of $507.2 billion in 1987 by about 3.5 percent. The modest declines in home sales in 1991 should be roughly offset by equally modest price hikes - resulting in little change in the total dollar volume of purchase originations. Virtually all of the increase in mortgage originations for 1991 will come from refinancing activity, with the refinance share of single-family originations rising from 16 percent in 1990 to more than 26 percent.

We expect a further improvement in origination volume for 1992, but the source of demand will change somewhat. A pickup in home sales, along with slightly faster home price appreciation (see Chart 3), should result in a modest increase in purchase originations. With mortgage rates first flattening out and then rising slightly during the second half of the year, refinancing activity should taper off during the first half of 1992 - with the refinance share of originations falling from more than one-third at the beginning of the year to about one-fifth by mid-year - before falling to more normal levels by year-end. On balance, single-family mortgage originations should rise by 8.4 percent to a record level of about $570 billion in 1992. (See Chart 4.)

Multifamily demand down

Reflecting the weakness in multifamily construction, originations for multi-family structures should increase only slightly in 1992. We expect a drop of nearly 30 percent in multifamily originations in 1991, as starts in five-plus units should decline by about 45 percent to a record-low 143,000 units. The weakness is only partially cyclically related - as recessions typically reduce the rate of household formations, and thus the demand for rental units. Most of the problem derives from tax-induced overbuilding in the early-to mid-1980s.

An improving economy in 1992 should increase the pace of household formations, resulting in a slowly declining vacancy rate and a slight increase in multifamily construction activity. This should yield an 8.7 percent increase in multifamily originations in 1992 - to a still-low $25 billion total. (See Table 4.)

Table : TABLE 4 Fannie Mae Mortgage Origination Forecast for 1992
 1990 1991 1992
Single-family, Total (billions) 458.4 525.0 569.0
 Conventional 376.7 450.0 489.0
 FHA/VA 81.7 75.0 80.0
Multifamily, Total (billions) 32.5 23.0 25.0
Refinance Share of Originations 16.0% 26.4% 22.2%
ARM Share of Originations 28% 23% 33%

Interest rate trends

The spread between rates on fixed-rate mortgages and adjustable-rate mortgages (ARMs) widened over the second half of 1991, primarily because of the steeper yield curve. We expect this trend to continue through next year even after the yield curve begins to flatten. In large part, this is because depository institutions tend to price ARMs - even Treasury ARMs - according to their own cost of funds, with two important implications.

First, ARM rates typically lag movements in short-term Treasury rates because the cost of funds to banks and thrifts are blends of both short-term and intermediate-term liabilities (primarily certificate of deposits [CDs]). Thus, as Treasury rates fell during the summer and fall, the cost of funds to banks and thrifts fell more slowly because the old CDs had not yet been rolled over at the lower rates. Likewise, we expect that short-term Treasury rates will begin to rise in the first half of 1992, but CD rates - and hence ARM rates - will begin increasing only later.

Second, some deposit rates (such as those for savings accounts) tend to be fairly rigid. Just as depositories tend to keep rates on these accounts stable in rising-rate environments, they are reluctant to lower them in falling-rate environments. This puts a "floor" on one element of costs, keeping ARM rates from declining as much as short-term Treasury rates. Similarly, as short-term Treasury rates begin rising in 1992, this element of depository institutions' costs will bump up against a "ceiling."

With ARM rates slow to adjust, or "sticky," the spread between short-term Treasuries and ARMs should narrow during the next six to twelve months. Because fixed-rate mortgages adjust more quickly to movements in Treasury yields, rates on fixed-rate mortgages should rise more quickly in 1992 than rates on ARMs. As a result, the fixed-ARM spread should widen - by about 50 basis points - leading to an increase in the ARM share of originations. Even so, with fixed-rate-mortgage rates expected to remain well under 10 percent in 1992, the ARM share should rise only to about one-third of all originations, considerably below the levels of the late 1980s.

David W. Berson is vice president and chief economist in the economics department at Fannie Mae, Washington, D.C.
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Title Annotation:improving economy in 1992
Author:Berson, David W.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jan 1, 1992
Previous Article:Housing's modest recovery: down but not out.
Next Article:A view of the California market.

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