How Citi's Fortunes are Tied to Housing's

Jobs, spending, and banks' balance sheets will continue to deteriorate until the housing market stands on solid ground

Another one bites the dust—almost. This time it was struggling giant Citigroup (C) that needed a government rescue as growing worries about the sinking U.S. and global economies fueled angst about the health of financial institutions. Citi's troubles are just the latest illustration of how the U.S. is caught in something economists had feared earlier this year: a "negative feedback loop," as they call it, between banks and the real economy. Simply, it's a vicious cycle in which sharply tighter financial conditions weaken the economy, which further erodes the health of financial markets, depressing economic activity even more. If not arrested, it's a recipe for a deflationary spiral much like what happened in the 1930s.

For the next several months, the economy is going to be trapped in the vortex. There is little hope for any good news on business activity anytime soon. The declines in jobs, consumer spending, business outlays, and factory output are getting larger. Most October reports suggest the economy is contracting by about a 4% annual rate this quarter. That would follow a revised 0.5% shrinkage in real gross domestic product last quarter, and it would be the sharpest drop since the severe 1981-82 recession. Economists widely expect further contraction in the first half of 2009.

The hope is that policymakers can shore up the financial markets, kick-start spending by consumers and businesses, and stop the spinning. Policy efforts, which took on a new urgency after the bankruptcy of Lehman Brothers, are now ramping up even higher. The incoming Administration is considering fiscal stimulus of $500 billion to $700 billion.

And on Nov. 25, the Fed announced two new facilities that will purchase up to $600 billion in mortgage-backed securities from Fannie Mae, Freddie Mac, and the Federal Home Loan Banks and up to $200 billion in other securities backed by consumer loans. The programs are aimed at reducing household borrowing costs.

These policy efforts, however, often lose sight of a key point: Housing started this vicious cycle, and it remains the critical link between economic and financial health, via the impact of falling home prices on the value of all those mortgage-related securities sitting on and off bank balance sheets. The problem: As the economy tanks and unemployment rises, fewer potential home buyers can qualify for a mortgage, even as credit conditions continue to tighten. As a result, the decline in housing activity is accelerating again.

Builder surveys already show a further sharp deterioration in the market. Housing starts tumbled in October, and permits to begin construction on single-family homes plunged 14.5%, the largest monthly drop since 1984. Although new construction has plunged in past years, its decline has yet to catch up with the fall in sales, resulting in little shrinkage in new-home inventories relative to demand—and more downward pressure on prices.

Sales of existing homes, down 3.1% in October, appear to have stabilized this year, but that's mostly an illusion. The National Association of Realtors says sales of homes in foreclosure and short sales now account for 45% of all purchases. Sales in Arizona, California, and Nevada are up 49%, 58%, and 76%, respectively, over the past year, while demand everywhere else is down 14%. The jump in distressed sales, many at rummage-sale prices, only puts more downward pressure on home values. Progress on reducing the glut of unsold homes, also a continuing negative for prices, is further limited as new foreclosures throw more homes on the market.

The rescue plans for Citi and other massive policy efforts make it clear the Fed and Congress are committed to avoiding the worst result of this increasingly corrosive cycle. However, it's also clear that financial market healing, and thus any economic recovery, cannot begin until ever-lower home prices stop eroding the value of banks' mortgage-related assets. That's going to take months—well into 2009.

    Before it's here, it's on the Bloomberg Terminal.