Highlights include D.R. Horton, Inc. (DHI), Whirlpool Corp. (WHR) and Fortune Brands, Inc. (FO).

A recent academic paper by Atif Mian and Amir Sufi, both of the University of Chicago and the NBER, took a very close look at the effect of mortgage equity withdrawal on the overall economy during the housing bubble. “Mortgage equity withdrawal” is the more technical name for the housing ATM.

It was very actively pushed by the banks during the housing bubble, with ads showing money hidden in people’s houses that they were not taking advantage of. I knew it was significant, but this paper indicates that it was even more important than I thought it was. Here is an abstract from the paper:

“Using individual-level data on homeowner debt and defaults from 1997 to 2008, we show that borrowing against the increase in home equity by existing homeowners is responsible for a significant fraction of both the sharp rise in U.S. household leverage from 2002 to 2006 and the increase in defaults from 2006 to 2008.

“Employing land topology-based housing supply elasticity as an instrument for house price growth, we estimate that the average homeowner extracts 25 to 30 cents for every dollar increase in home equity. Money extracted from increased home equity is not used to purchase new real estate or pay down high credit card debt, which suggests that consumption is a likely use of borrowed funds.

“Home equity-based borrowing is stronger for younger households, households with low credit scores, and households with high initial credit card utilization rates. Homeowners in high house price appreciation areas experience a relative decline in default rates from 2002 to 2006 as they borrow heavily against their home equity, but experience very high default rates from 2006 to 2008.

“Our estimates suggest that home equity-based borrowing is equal to 2.3% of GDP every year from 2002 to 2006, and accounts for over 20% of new defaults in the last two years.”

This is a much higher flow-through from the wealth effect of rising home values than is normally assumed, with most economists having modeled it at less than $0.10 on the dollar rather than over $0.25. It is not surprising that when house prices are rising quickly that default rates fall — after all, if the borrower gets in trouble, he can always just sell the house.

The 2.3% of GDP each year is stunning, since it accounts for nearly all of the economic growth the country experienced from 2002 through 2006 (real GDP growth averaged 2.68% in those years, inclusive). Put another way, if we didn’t have growth due to the housing bubble, we would have hardly had any growth at all.

This data does seem to correspond to the data showing no increase in median income over the period. It also explains why it is not just people who bought their houses near the top who are in trouble right now.

Historically, Residential Investment (RI) has been the primary driver to lead the economy out of a recession. A housing recovery obviously helps homebuilders like D.R. Horton (DHI) and those that supply it like Whirlpool (WHR) and Fortune Brands (FO).

The equity extraction helped support just about every part of the consumer based economy. With foreclosures still on the rise and a huge inventory of houses (both new and used) still out there, it is hard to see RI lifting the economy this time around. RI has already shrunk to its smallest percentage of GDP on record (after being at near record highs just a few years ago), so it might not fall that much further.

While it is true that an absence of a negative is a positive, it will not provide very much power for the economy. Right now, the most likely scenario is that the economy stops falling, but then bumps along the bottom for a very long time. This will not be a V shaped recovery, at best it will be a very broad-bottomed U. Zombie banks could turn it into an L, otherwise known as “turning Japanese” (not to be confused with the new-wave pop song).

This, then, implies a lower long-run growth rate of corporate profits coming out of the recession. That is something that would argue for lower P/E multiples for the market as a whole (although the currently very low interest rates argue for higher P/E multiples).

The “end of the world” scenarios have, for the most part, been pulled off the table by very aggressive policy responses on both the fiscal (stimulus package, very large budget deficits) and monetary side (Fed funds near zero, printing presses working overtime). However, the most fundamental rule in all of economics is that there is no free lunch (except if you work on the buy side, and with the possible exception of improvements in efficiency).

These responses have prevented the current economy from turning into an absolute disaster (the second Great Depression), but will come with a cost down the road. The debt we have taken on will have to be serviced and eventually repaid. This implies either higher taxes or lower government services, especially if economic growth is anemic.

The huge expansion of the Federal Reserve’s balance sheet substantially raises the risk of out-of-control inflation as the economy recovers (not happening now, but could be a huge 2011 or 2012 story).

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Last 5 posts by Dirk Van Dijk

• Durable Goods Orders Drop - Analyst Blog - November 25th, 2009
• New Home Sales Rise! - Analyst Blog - November 25th, 2009
• Spending Up, Savings Rates Down - Analyst Blog - November 25th, 2009
• Initial Jobless Claims Plunge - Analyst Blog - November 25th, 2009
• Fed Gives Clear Message - Analyst Blog - November 25th, 2009