The National Association of Realtors recently reported that prices of single-family homes fell by 1.8% in 2007 – the first decrease since the inception of record keeping in 1968 and, likely, the first drop since the Great Depression.

1.8% doesn’t seem like much of a decline, given recent commentary about housing prices approaching free-fall. For example, recall that Merrill Lynch recently forecast a 15% drop in housing prices in 2008 and a further 10% drop in 2009. Such a prognosis appears highly extreme in light of the 1.8% drop in 2007 housing prices.

But there is a catch, in effect. The median can be very different from the mean. The National Association of Realtors was referring to a median housing price decline of 1.8%. Merrill Lynch, in its outlook, was referring to the mean – or average – price decline of single-family homes.

As a reminder, the median is the halfway point. If prices of single-family homes declined by 1.8% in 2007, then half the homes declined by less than 1.8% and half the homes declined by more than 1.8%. If all homes that declined by more than 1.8% dropped in price by 20%, for example, it would not affect the median. The median would remain at a negative 1.8%. In fact, the National Association of Realtors also estimated that the mean, or average, annual decline in single-family home prices in 2007 was 5.3%.

It can all be very confusing. Keep in mind, too, that declines and advances may refer to single-family homes as well as single-family homes and condominiums. The median price for single-family homes and condominiums fell 1.4% in 2007, slightly less than the drop in the median price for single-family homes only.

And to add further confusion, there are periodic reports about new home sales. The Commerce Department reported recently that new home sales fell by 26% in 2007, which was the steepest drop since 1963, also the first year in which records were kept on new home sales.

If there is a bottom line to this array of housing statistics in their various guises, it may well be that the housing industry is suffering a severe correction with no necessary end in sight.

The recently announced $150 billion stimulus package is not yet a done deal. It requires Senate concurrence, which the Senate may or may not readily provide. The amount seems robust enough, but it is unclear if the money will get into the hands of those who will spend it and spend it immediately.

Apart from this rather critical issue, there is the issue of timing and execution. Given language in the proposed legislation, rebates and money flows from the U.S. Treasury would begin 60 days after the legislation is signed into law. Depending on the time it takes to reach Congressional agreement and submit a stimulus package to the President, the earliest money could reach the consumer appears to be late April.

Then there is the problem of implementing the stimulus package and issuing the checks. The Congressional Committee on Joint Taxation recently commented that the I.R.S. and its computer systems are presently “…fully engaged in processing 2007 tax returns…as a result, it is not practical to contemplate distributing cash rebates until the peak filing season is completed, which in past years has been the very end of May…”

Further, the I.R.S. must adjust and modify software systems to establish rebate eligibility, once the provisions of the stimulus package are established – no small task under any circumstances and even more pressing in the midst of tax season.

June, perhaps, when the money begins to flow? If so, the stimulus package will be far too late to help restrain the U.S. economy from slipping into recession. Its primary role may be that of mitigating the impact of a recession rather than helping to prevent the recession itself.

It worked! The Federal Reserve dropped the Fed Funds rate by 75 basis points to 3.50%, along with decreasing the discount rate, just for good measure, by an equal amount to 4.00%. On the day it happened, the stock market was skeptical – stunned disbelief, perhaps – but a day later the Dow Jones surged robustly upward by almost 300 points. Further, every national and local news station is now chock full of stories about the magic of rate cuts potentially putting hundreds of dollars a month into the pocket of the average consumer. No more gray skies and oppressive thoughts.

But, then, there are three nagging issues that we can’t quite disregard.

• The massive recent losses suffered by the banking community impact bank capital and lending capacity. Citigroup and Merrill Lynch recently scrambled for additional capital in the wake of horrendous fourth quarter write-offs and losses. Bank of America just reported anemic fourth quarter earnings of $268 million – down from $5.26 billion a year earlier – which reflected a further $5.28 billion write-off of collateralized debt obligations. It announced, further, that it would be in the market to raise approximately $2 billion to shore up its capital base.
  
  
• Lenders now find themselves compelled to originate and hold the loans they generate in view of the collapse in demand for mortgage-backed securities – or for any investment asset not totally transparent. That means the risk stays with the originator, which can only force lenders to apply far more stringent credit standards. In other words, the market for “liar” loans has dried up – at least for the moment.
  
  
• With the continuing debacle in the housing market and the increase in household debt from 80% of disposable income two decades ago to 130% of disposable income today, the consumer has become an increasingly risky client base. As housing prices fall, the consumer borrowing base falls in lock step. Add an uncertain job market and employment outlook, and the reasons explaining lender caution become painfully obvious. As the CEO of Bank of America recently remarked “…we have tightened standards across the board…but, to the extent people do meet our standards, we are open for business…”

Perhaps these are minor considerations in the wake of more liquidity and the return to better times. After all, if Wall Street is pleased, won’t Main Street soon be happy?

(For more on the topic of rate cuts and economic activity, please see our most recent Credit Refresher on The Magic of Rate Cuts.)

In a recent New York Times article, Floyd Norris offered several interesting observations based on research conducted by the National Bureau of Economic Research. On nine occasions since 1950, unemployment increased by 13% or more above the number of unemployed a year earlier. On eight of those occasions, the economy was already in recession at the time the 13% year-over-year increase occurred. On the other occasion, the 13% increase happened prior to the actual onset of a recession three months later.

Moral of the story? If unemployment increases by 13% or more from the unemployment level a year earlier, the U.S. economy is either in a recession or shortly will be. There were nine such 13% year-over-year unemployment increases between 1950 and 2007. There were nine recessions between 1950 and 2007.

Interestingly, the December 2007 unemployment level represents the tenth time since 1950 that unemployment has increased 13% or more above the number of unemployed a year earlier. Unemployment in December 2007 was 7,655,000 – 13.2% greater than unemployment of 6,760,000 in December 2006.

If history is any guide, it is the change in unemployment that matters and not the unemployment level or unemployment rate. Of the nine recessions since 1950, five began with the unemployment rate less than 5%, which is the present U.S. unemployment rate. In fact, the 2001 recession began with an unemployment rate less than 5%. All of this implies that the U.S. economy is in, or near, a recession. Opinion may be split on this issue at the moment, but we’ll find out soon enough if a 13% or more year-over-year increase in unemployment correctly signals a recession for a tenth time since 1950.

The conventional wisdom seems in agreement on several points about the U.S. economy.

• Further cuts in the Fed Funds rate may do little to stimulate the economy, certainly in the short run.
  
• A fiscal policy stimulus package is vital, perhaps in the form of income tax rebates and expanded unemployment benefits.
  
• A stimulus package must provide at least $100 billion to middle and low income workers and families and, further, must be enacted very quickly.
  
• Even if enacted quickly, a $100 billion stimulus package may be too late to avoid a recession.

There is one other consideration. Every dollar of new spending injected into the economy via a tax rebate, for example, has a ripple effect. It represents additional spending power for the recipient of that one dollar, who in turn spends some portion of it. There is some evidence to suggest that tax rebates and expanded unemployment benefits, which find their way into the spending stream immediately, have a multiplier of roughly 1.8. That means that a $100 billion stimulus package will result in $180 billion of additional spending.

Given the size of the U.S. economy, what does $180 billion of additional spending really mean? Gross Domestic Product (GDP) in 2007 will likely be around $13.5 trillion when all the numbers are in. Therefore, if a $100 billion stimulus package does have a $180 billion spending impact on the economy, it will account for roughly 1.3% of 2007 GDP.

So the question is whether a GDP stimulus of 1.3% is sufficient to offset the negative forces at work as the economy slows and hovers near recession. On that point, we can all likely agree that we simply don’t know.

The Federal Reserve announced recently that the amount of revolving consumer credit – credit card debt, in effect – was $937.5 billion at the end of November 2007. That’s an increase of 7.4% over the amount outstanding a year earlier. In fact, the annual growth rate for revolving consumer credit has now been above 7% for three consecutive months – the first such string of months since 2001 when an economy in recession was largely driving the increase in credit card debt.

There are some interesting dynamics currently at play.  As housing prices decrease, consumers have less equity in their residential mortgages to support additional borrowing.  Given a weakening economy and increasing unemployment, the beleaguered consumer now appears compelled to rely on additional credit card debt to make ends meet.  

There may be another explanation.  Robust consumer spending during the past holiday season, which began the last week in November, could explain some or all of the recent increase in credit card debt.  However, consumer spending during the holidays was disappointingly weak.  The consumer did not embark on a holiday spending binge. 

The implications for the economy are rather ominous if, in fact, consumer credit card debt has been increasing rapidly to allow the hard-pressed consumer to pay his or her bills.  Whether we slip into – or avoid – a recession depends overwhelmingly on consumer spending, at least according to the conventional wisdom.  Consumers concerned primarily with making ends meet are hardly a dependable driving force for the additional spending necessary to revitalize a slowing economy.

And there are other ominous signs about consumer credit quality and, by implication, consumer spending.  American Express recently announced that delinquencies increased from 2.9% in the third quarter to 3.2% in the fourth quarter of 2007.  Further, American Express will take a $440 million charge to earnings in the fourth quarter to provide for these rising delinquencies.  Fitch Ratings, in turn, recently reported that it foresees an increase in credit card delinquencies during 2008.

Will a further drop in the Fed Funds rate cure our ills?  Hardly.  Even if the banking community enjoys cheaper access to funds and correspondingly greater liquidity, why re-open the credit spigots when most indicators point to alarming increases in borrower risk?

By all accounts, Wall Street is becoming quite vocal about Mr. Bernanke’s lack of resolve to aggressively cut the fed funds rate, thereby putting an end to economic sluggishness and an end to stagnating stock prices. Prevailing Wall Street opinion seems to suggest that the appropriate fed funds rate is somewhere around 3.00%, 125 basis points below the present fed funds rate of 4.25%. At that point, the magic of lower interest rates will kick in. Banks, flush with liquid resources, will happily lend to hungry borrowers – particularly consumers who will continue to spend relentlessly. Relentless consumer spending will trigger more aggressive business borrowing and spending, and this rising tide of economic activity will overcome the woes of the housing industry, restore faith in the U.S. economy and, above all, stimulate stock prices and, ultimately, Wall Street bonuses.

It all sounds so simple. Could there possibly be a counterargument?

There is.  It focuses on the banking industry’s willingness to lend, regardless of its liquidity position and access to low cost funds.  For starters, the consumer is woefully over-borrowed.  Credit card debt relative to disposable income is at an historic level – and the prospects for an up tick in disposable income darken by the day.  The housing price bailout has stopped.  As housing prices fall, consumer collateral and borrowing power fall in lock step.  And as housing prices fall, the woes of the housing industry increase, spilling over into a range of related and not-so-related industries.

But the greatest impediment to the magic of lower interest rates and revitalized lending may be lenders’ inability to routinely sell toxic loans they originate to unsuspecting investors far removed from the origination process.  The sub-prime meltdown is too recent and still too painful to be fully discarded in the rush to higher investment returns.

Even if Mr. Bernanke caves in to Wall Street pressure, there is little assurance progressively lower fed funds rates will fix a range of basic economic problems.  We may be stuck with the sins of the past for many months to come.