The U.S. economy could fall into recession in early 2013 if Congress fails to stop a looming fiscal cliff made up of automatic spending cuts and tax hikes.
The negative scenario also would stifle gains made in the mortgage finance and housing sectors with the market likely "to react negatively," forcing home buyer confidence and prices down, said Bose George and Jade Rahmani, analysts with Keefe, Bruyette & Woods.
KBW analysts made these solemn calls Wednesday in a report that forecasts unemployment as high as 9.2% by the third quarter of 2013 and gross domestic product of -1.5% in 1Q if the fiscal crisis is not averted by Congress.
On the other hand, KBW believes the U.S. could see unemployment drop to a rate of 7.3% by the end of 2013 as long as Congress avoids the automatic tax increases and spending cuts scheduled for Jan. 1. Under this more positive scenario, GDP would rise as much as 2.2% by the end of next year, the research firm said.
But with Congress facing a tough election season and a gridlocked legislature, the economy is heading into a dark period even if the crisis is averted, economists suggest.
"I think that scenario (if the fiscal cliff is averted) is on the optimistic side," said Dr. Roger Meiners, an economist with the University of Texas at Arlington. "Markets have already taken into account the fiscal cliff and a lot of their concerns are already reflected in stock and equity prices, as well as decisions that businesses are making today."
On the mortgage front, Meiners says QE3 as announced by the Federal Reserve already shows an attempt "to stimulate the housing market a bit." But the effectiveness of it long-term is highly uncertain.
"The idea is to offer mortgage money and make it even cheaper. But the problem is people can resist the money," Meiners added. He points to Japan which kept interest rates low for 20 years without experiencing a full recovery or a surge in buyer activity.
George and Rahmani with KBW are even more explicit about how a fiscal-cliff scenario would impact housing and mortgage finance.
Falling off the cliff would push the 10-year Treasury below 1%, a situation that would "endanger a large mortgage refi wave," the research team said.
The team suggests a fiscal cliff also would cause declines in agency MBS REIT earnings and drive down the operating fundamantals of non-agency MBS REITS.
"We would expect a decline in the value of non-agency MBS prices given the credit sensitivity of those assets," George and Rahmani wrote. "Partly offsetting these negatives, we believe the decline in non-agency MBS prices could lead to increased investment opportunities in some cases."
A shock to the market from tax hikes and spending cuts also could create headwind risk for global banks such as Goldman Sachs ($157.41 0%), Morgan Stanley ($24.25 0%), Bank of America ($13.14 -0.07%) and Citi ($50.53 0%).
The scenario facing the banks looks remniscent of the 2011 minor market meltdown when Congress failed to address debt ceiling talks on time and S&P downgraded U.S. debt.
"In our view, the fiscal cliff would freeze up the markets, shutting down trading volumes and investment banking activity at a level worse than 4Q10 and the first half of 2011," KBW analysts wrote. "Trust banks — The Bank of New York Mellon ($29.38 -0.26%) State Street ($63.81 -0.79%) and Northern Trust Corp. ($57.11 0%) — would also be under pressure from reduced capital market activity and low interest rates."
KBW says a recessionary period caused by the fiscal cliff also would impact financial stocks that are tightly tied to capital markets, banks and life insurance.
The impact would be particularly harsh on asset managers and companies with mortgage servicing rights that have not hedged their bets.
"For companies like PHH Corp. ($20.24 0%) that do not hedge their MSRs, this would be a significant negative," the KBW analysts said. "For most companies that hedge their MSRs, the net impact would be neutral. For non-prime and subprime mortgage servicers, we believe the impact is likely to be neutral to potentially positive"
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