Recovery Shirt

Jerome Powell thinks there are three major reasons to be optimistic about the U.S. economic recovery. Yet we've watched the S&P 500 fall almost 5% from its peak over the past month, only to recover slightly. Is he just plain wrong?

Powell, a Federal Reserve governor, during a speech in June at the Bipartisan Policy Center in Washington D.C. cited the reasons for optimism: an improving housing market, a better-capitalized financial system, and gains in household and business spending. Let's see whether the data from those three areas gives us reasons for optimism or not.

The housing market
The housing market bubble and accompanying collapse was one of the biggest factors contributing to the recession we all endured. Now, the housing industry is slowly clawing its way back to health, as seen in the chart below:

Chart

Source: Census Bureau.

Housing starts represent new home construction. While we're still well below the levels we saw 15 years ago, housing starts in July 2013 were 87% above April 2009's low. That represents an annual growth rate of over 15.5%, even including the minor dip seen in the second quarter of this year.

With home construction up -- and projected to keep rising, according to the National Association of Home Builders -- Fools should monitor builders like Toll Brothers (NYSE:TOL) and D.R. Horton (NYSE:DHI), whose prices generally follow the same trend of housing starts.

Yet the housing market does not consist only of new homes being built. It also involves new mortgages to finance the purchase of both new and existing homes:

Quarter

Mortgage Originations (in billions)

Q1 2012

$373

Q2 2012

$395

Q3 2012

$471

Q4 2012

$511

Q1 2013

$482

Q2 2013

$494

Q3 2013 (Proj.)

$369

Q4 2013 (Proj.)

$247

Q1 2014 (Proj.)

$251

Q2 2014 (Proj.)

$283

Q3 2014 (Proj.)

$290

Q4 2014 (Proj.)

$267

Source: Mortgage Bankers Association.

The picture there certainly looks much less rosy. The coming months' projections remain well below the 20-year average of $466 billion in originations per quarter. In addition, mortgage rates are rising, which almost always leads to fewer originations.

However, it is vitally important to note that mortgage originations encompass both those made for purchasing and those made for refinancing. And when you see the mortgage business broken out into its different segments, you get a much better idea of where things have been -- and where they're going.

Chart

Source: St. Louis Federal Reserve and Mortgage Bankers Association.

As interest rates rise -- that's the red line -- fewer people are refinancing existing mortgages on their current homes -- the green columns. Those refinancings previously drove a lot of the gains in the mortgage business. But even as they fall off, more people are getting brand-new mortgages to buy homes -- the light blue columns. That kind of demand depends far less on interest rate changes than refinancings do. If anything, the actual housing market (when considering homes being bought and sold) looks much better than we would have previously believed.

This will assuredly hurt banks like Wells Fargo (NYSE:WFC). The company announced two weeks ago that as a result of the expected decline in refinancing, it would lay off some 2,300 employees in its mortgage origination business, which wrote over $112 billion in mortgages last quarter.

While Wells Fargo and other banks like it rode the refinancing boom for quite some time, rising rates have caused that industry to come to an expected standstill. However this does not discredit Fed Gov. Powell's suggestion that the recovering housing market will help the U.S. economy.

Homes purchased and homes built both have greater economic impacts than those refinanced. For example, last year, Freddie Mac estimated that a borrower would save just $2,900 a year after they refinanced their mortgage. But the National Association of Home Builders estimated that for every 100 homes built, the local economy around those homes gains $21.1 million -- an economic impact more than 70 times larger than the same amount of refinancings.

Better capitalized financial system
During the financial crisis, too many banks didn't have enough capital to insulate themselves from the various losses the meltdown triggered. Banks typically lend out more money than the cash they have on hand. In good economic times, this isn't a problem, since they still have enough hard cash on hand to meet their daily needs. But when an economy sours, and the loans the banks make start to go bad, they need more cash to cover those losses. If the ratio of what they've lent to what they actually have is too big, the banks risk going belly-up.

While Powell stated that the financial system had improved the capital cushion that protects it from such losses, we also need to see how that improvement has trended:

Chart

Source: New York Federal Reserve.

As you can see in the chart above, Powell was absolutely correct. Banks have done a great job of reducing their risky assets in relation to their total assets, while boosting their capital to defend against any losses that may still occur. We have seen a spike in risk-weighted assets and a decline in capital at the beginning of this year, which will be important to monitor in the future. But banks nonetheless now sport capital ratios 50% higher than their lows of 2007.

Surprisingly, the Tier 1 capital ratios of the four largest commercial banks in the United States have also dipped from the peaks they reached last year:

Company

Q2 2013

Q1 2013

Q4 2012

Q3 2012

Q2 2012

Bank of America (NYSE:BAC)

12.2%

12.2%

12.9%

13.6%

13.8%

Citigroup (NYSE:C)

13.3%

13.1%

14.1%

13.9%

14.5%

JPMorgan Chase

11.6%

11.6%

12.6%

11.9%

11.3%

Wells Fargo (NYSE:WFC)

12.1%

11.8%

11.8%

11.5%

11.7%

Source: Company Earnings Reports.

Bank of America and Citi have higher Tier 1 ratios than their more highly regarded peers JPMorgan and Wells Fargo . But B of A and Citi's ratios have fallen since last year, while JPMorgan and Wells Fargo's have risen. It's clear the banks are better capitalized than they once were; however, their trend of lower ratios certainly bears watching.

That said, the banks remain well above the baseline 6% that regulators require. And generally, the more capital banks hold, the less in returns they can generate. Thus, diligent investors should keep a close eye on lower capital ratios to make sure banks strike the right balance between maximum profitability and safety.

Gains in household and business spending
Lastly, Powell noted the improvements in both household (personal) and business spending as the final reasons for optimism in the economy. While their growth has slowed down since the immediate recovery from the recession, both personal consumption and business sales (trade sales and shipments) are now 6% above their Q2 2007 levels.

Chart

Source: Bureau of Economic Analysis and US Census Bureau.

Patrick Morris owns shares of Bank of America. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.