Zeitgeist

On April 30, 2008 the Federal Open Market Commission is scheduled to meet and review current direction of our economy. The FOMC primary goals are to foster growth and job creation and restrain inflationary pressure, controls two short terms rates; the Fed-Funds Target and Discount Rates. With these rates currently at 2.25% and 2.50% respectively, the general consensus is that the Feds will drop the aggregate rate sby 0.25 to 0.50 basis points and most everyone agrees this reduction is already baked into the cake.

Eight months into the Fed's most recent rate-cutting spree, the evidence is overwhelming that it has been a major policy mistake. Aggressive rate cutting – taking the fed funds rate to 2.25% from 5.25% last September – has had little effect on the banking crisis it was supposed to ease.

The Fed’s decision to open the general monetary spigots come principally from the discount window innovations, especially its lending to investment banks in the wake of Bear Stearns rescue. This decision to open the discount window came on March 17, 2008 almost ten years too late after the repeal of the Glass-Steagall Act of 1999.

The opening of these monetary spigots came at a price; this has inspired a global commodity boom unlike any since the 1970s. Oil has climbed to nearly $119 a barrel today from $70 in late August, a 70% increase. Farm and other commodities have seen a similar surge, with corresponding increases in food prices leading to shortages and riots in Egypt and other places, and to rice hoarding even in Southern California. 

The popular media explanation is that this price surge is a result of rising global demand, greedy speculators and human profligacy. All of a sudden, without warning, the world is said to be running out of food. After 30 years in intellectual hibernation, Thomas Malthus and the Age of Scarcity are back in style.

In Business Week April 7, 2008 edition, is an article by Chris Farrell; “The Age of Scarcity?” The tag lines are: Rising Population. Skyrocketing commodity prices. Strains on natural resources. Is this a Malthusian moment?

The spiraling cost of all commodities continues to place pressures on the flooring manufacturer’s margins. Crude oil and natural gas prices are escalating at a rate that it is very difficult to pass these costs along to customers.

Like oil, world trading in most commodities is denominated in dollars. When the dollar declines, especially as fast as it has since September, commodity prices surge and speculators gamble on even further declines. Since 2003 the dollar price of oil has climbed far more rapidly than has the euro price – 273% in dollars, compared to 146% in euros. Oil spiked in dollars since the second half of last year. This reflects the European Central Bank's sounder monetary management. And it means that had the dollar merely retained the same purchasing power as the euro, today's price of oil would be below $70 a barrel.

The practical impact has been to send energy and food prices soaring. This is a direct tax on both the world's poor and America's middle class. Just when the U.S. economy needs a resilient consumer given the fall in housing prices, these price increases have eviscerated consumer pocketbooks. In its attempt to help Wall Street and the financial system, Fed policy is punishing average Americans. The public is frustrated and angry with these price increases, and it has a right to be. Inflation is the thief of the thrifty middle class.

 

The benchmark metric that most economists utilize to measure a housing bottom is new housing construction. When we review the past seven cycles since 1959, housing starts (seasonally adjusted) have fallen on average, 50.7% from peak-to-trough.

Over these past seven cycles the peak has averaged 1.963 million housing starts (Seasonally Adjusted Annual Rate) and the trough has averaged 0.922 million. Within these seven cycles there is a high peak of 2.494 million during January 1971 through January 1975 and there are low of the trough of 0.798 million during the February 1984 to January 1991.  

March housing starts and permits data were released on April 16 and both reached a 17 year low. The numbers for housing starts 0.947 million (-11.9%) and permits 0.927million (-5.8%).

A far larger than expected -11.9% plunge; single family fell -5.7%, multifamily fell -25% also a new 17 year low. Housing starts have declined 58% since the January 2006 peak and with tighter mortgage lending and huge unsold inventories are also lengthening the wait for stability in starts.

The housing starts reported for March is rivaling the SAAR’s average trough over these seven cycles of 0.922 million. In the first quarter of 2008 the housing starts has averaged 1.079 million suggesting there is more room ror decline, another -14.6% before the markets reaches historical levels.

On Tuesday, April 22 existing-home sales were reported and falling during March after making a surprising climb in February.

Home resales fell to a 4.93 million annual rate, a 2.0% decrease from February's unrevised 5.03 million annual pace, the National Association of Realtors said Tuesday. Resales fell 19% from March 2007's 6.11 million rate.

Lenders have tightened their standards on home loans, contributing to the credit crunch that is restraining the U.S. economy. Those tighter standards have priced marginal buyers out of the market and made purchasing more difficult and costly for prime borrowers.

The March resales level was right in line with Wall Street expectations of 4.93 million sales rate for previously owned homes. The average 30-year mortgage rate was 5.97% in March, up from 5.92% in February, according to Freddie Mac.

Inventories of homes increased 1.0% at the end of March to 4.06 million available for sale, which represented a 9.9-month supply at the current sales pace. There was a 9.6-month supply at the end of February.

There is no sign of the fundamentals (housing demand) needed to turn the direction over the intermediate term.  The plunge has been a large drag on economic growth as further risk surrounds the defaults/foreclosures that come as a result of falling home prices and high loan to value ratios.  The upturn in new construction could be a long way off in 2009.   The correction for the inflated housing market was expected (and needed) but with a more moderate decline as the poor quality mortgage lending has added strongly to the downturn.  Stability will have to wait for new home sales to tick higher and unsold inventory to significantly thin.  Continued mortgage lending to low risk borrowers is needed just to get the declines to decelerate. 

New home sales numbers are scheduled for release on April 24; forecast is 0.580 million with the prior February number at 0.590 million.

The Subprime mortgage crisis has been redefined as the Sub-slime market and warrants a closer review. This ongoing economic problem manifesting itself through liquidity issues in the banking system owning to foreclosures which accelerated in late 2006 and triggered a global financial crisis during 2007 and 2008. The crisis began with the bursting of the US housing bubble and high defaults rates on “subprime” and other adjustable rate mortgage (ARM) made to higher risk borrowers with lower income or lesser credit history than “prime” borrowers. Loan incentives and long-term trend of rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favorable terms later. However, once housing prices started to drop moderately in 2006-2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as ARM interest rates reset higher. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006. Some estimates place the subprime defaults would reach a level from U.S. $300-$500 billion. Currently there is a bill before Congress and the Senate began debate on Thursday, April 3, 2008 on a $15 billion bipartisan housing relief package that could get a final vote by next week.

The proposed measures include funding to help borrowers refinance unaffordable loans and help boost activity in neighborhoods with properties in foreclosure. Also in the bill is a tax break for homebuilders, as well as a new tax credit and deduction for homeowners and home buyers. The package also contains measures to make loans that are insured by the Federal Housing Administration - which helps borrowers with weak credit or little or no cash for a down payment - more accessible.

The Democrats allowed two provisions they've been pushing for to be excluded from the package: a measure that would let bankruptcy judges reduce residential mortgage debts, and a measure that would let the Federal Housing Administration insure up to $400 billion in troubled loans if lenders agree to write them down to affordable levels for borrowers.

The Senate package reflects concessions from both sides of the aisle. But it will be subject to amendments, which the Senate started voting on Thursday night. In addition, the House - led by Financial Services Committee Barney Frank, D-Mass. - will have its say next week.

"It's not the end of the road, but it's a very strong beginning," said Senate Banking Committee Chairman Christopher Dodd, D-Conn., in a press briefing Wednesday evening.

 

The February housing numbers released on March 18, 2008 reflect a continued weakness in housing starts and permits. Historically, when the seasonally adjusted annual rate (SAAR) for housing starts has reached 1.0 million, this level has been perceived as the bottom of the trough. 

Meanwhile, home construction dipped in February, reflecting a sharp drop in the Northeast, while permits for future groundbreakings plunged to the lowest level in 16 years. However, January growth was revised upward boosting the pace of construction.

A historical review from a paper published by Dr. Nouriel Roubini, who is the Professor of Economics and International Business Stern School of Business, NYU and Chairman of Roubini Global Economics (RGE) Monitor. This paper “The US Housing Recession is Still Far from Bottoming Out” was published in March 2007. Professor Roubini was one of the first to call the sub-prime market fiasco and has been a frequent guest on Kudlow and Company stating the problems in the sub-prime market would bubble up to prime and secondary markets.

In his published work, Professor Roubini reviews the last seven recessions that occurred from 1959-1991 and the impact on housing. He has established the peak to trough of housing starts for each recession. From this paper he chronicles the housing cycles for each recession, not only from peak to trough; but also the percent change in housing starts and the duration of each recession. The average for the peak is 1.963 million and the trough was .922 million, percent change (51%) and the duration averaged 32 months.[1]

Professor Roubini presents an excellent analysis of long term trends in housing, demand and inventory to assess when and at which level the housing sector will bottom out in the current housing environment

To begin his analysis he estimates the long-run demand for housing units. He emphasizes the long-run level of housing starts and completions, is a function of the housing units needed. The requirement for new housing units is dictated by population dynamics and household formation, as well as loss and destruction of already existing units.

By establishing the year 2000 as the base year, he then establishes units per person (total existing housing units/total population) in 2000 were 0.4119.[2] The assumption is made that a constant value of 0.4119 units per person, population growth calls for an average of 1.104 million new units per year between 2001 and 2010. Housing units lost each year to fire, natural disasters, demolition and other reasons average 0.596 million, and Professor Roubini estimates that the average yearly need for units between 2001 and 2010 amounts to about 1.700 million.

After establishing the forecasted 1.700 million housing starts, Professor Roubini sets up five different scenarios[3] that reflect how the housing industry must absorb the overhang.

Additionally the assumption is made that the overbuilding between 2001 and 2006 which produced a sharp increase in inventories relative respect to its long-term average. The average long-term inventory of hew homes for sale between 1963 and 2001 was 0.310 million; in December 2006 the inventory of new homes for sale peaked at 0.537 million, producing an excess of relative long-term average of 0.227 million.

These five different scenarios makes the assumption that the overbuilding will be reabsorbed over the next four years (57 thousand per year), then between 2007 and 2010 total completions should average 1.643 million per year to bring back the inventories to their historical average level by 2010.

 

 

 

 

 

 

 

On Tuesday March 11, 2008, Fed Chairman Ben Bernanke (text of speech) announced an expansion of its securities lending program. Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential mortgage backed securities (MBS), and non agency AAA/Aaa rated private label residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus foster the functioning of financial markets generally. As in the case with the current securities lending program, securities will be made available through an auction process. Auctions will be held on a weekly basis, beginning on March 27, 2008.

The centerpiece of the Fed's latest initiative is the TSLF, under which the Fed will lend its primary dealers as much as $200 billion of Treasury securities from its own $713 billion portfolio of those securities. These unconventional steps are a series of steps the Feds have taken to return liquidity back in the market and ease concerns regarding credit risks. Previous proactive steps taken have been; $100 billion to loans to banks via Term Auction facility, $100 billion for 28-day money-market loans to dealers, $36 billion swap lines to European central banks and $200 billion loans of Treasurys with mortgage backed  as securities as collateral. 

This action was described as a shot in the arm to stressed financial markets by offering to take a large portion of the difficult to trade securities, temporarily out of circulation. I am not certain if this is a shot in the arm of cortisone or a slow intravenous drip of Prozac. 

The offer is a surgical strike at the more recent and worrisome new developments in the global credit crunch. There has been a surge of investor selling off mortgage linked securities. This heavy selling is driving up mortgage interest rates, dealing a hard blow to the fledging housing market, and threatening the U.S. economy by making credit more difficult to come by. It does not matter that if you can obtain a 4% home mortgage loan compared to a 6%, if you are unable to meet the credit criteria. So cutting rates is only one piece of the puzzle, lmore iquidity in the market place is one of the main drivers.

By taking some of these securities on its own books, the Fed is seeking to make its primary dealers -- the network of 20 Wall Street firms with which it typically does securities business -- more comfortable buying them from their own clients. It hopes this could lead to higher prices and thus lower yields on the mortgage-linked debt. A decline in those yields could help banks offer lower interest rates to prospective homebuyers.

Still, the Fed's efforts won't eliminate the root cause of the economy's problems: falling home prices and a mounting wave of mortgage defaults.

The Fed’s Monetary policy remains a key tool for the fed to use ,but with weak employment numbers released last Friday, March 7, 2008 this report led futures markets to anticipate the Fed will cut its target for the federal-funds rate, charged on overnight loans between banks, by 0.7 basis point from its current 3% when it meets on March 18.

But Fed officials at present are unconvinced such drastic action is needed or wise. Their economic forecast has deteriorated, so they agree some monetary easing is called for. But they also believe their 2.25 percentage points in cuts to date, including 1.25 percentage points in January alone, are already a lot. Some feel an overly aggressive follow-up this month could look panicked, while weakening the dollar and aggravating inflation concerns. That suggests they'd much prefer a half-point cut. A quarter-point cut may be on the table, but the Fed would hesitate to disappoint the markets that much given their current fragility.

A 0.75 percentage-point cut "is likely to pull the dollar down and push expected inflation and ultimately actual inflation up," said Doug Elmendorf, a former senior Fed staffer now at the Brookings Institution. A half-point is sufficient given "they've put a lot of stimulus into the pipeline already and they have other tools they're using to focus on the short-term funding market problems."

 

 

 

The current credit contagion has been defined as the worst credit crunch and financial crunch since the Great Depression. The past has caught up with us, and there will not be much of a future until we work those problems out.

 The single largest asset class of people’s wealth is their homes which is >$20 trillion and as I alluded to in my February 28, 2008 blog, a 10% decline in house prices equates to cutting household wealth by $2 trillion and this eventually reduces annual consumer spending by 5% or $100 billion. Falling house prices also discourage home building, with housing starts down 38% for 2007.

 We are having a bad hangover from easy money. Thanks to low interest rates and an expanding money supply, people and companies borrowed more than they could “reasonably” pay back. The average debt-to-income ratio for the middle class in America has climbed to 141%, twice what it was in 1983. In the U.S. as a whole, the ratio of all debt to GDP rose to 342% at the end of September 2007, more than double what it was in 1975. It grew rapidly after 2000, in what could be describe only as a bubble. Banks were willing to lend more and more to purchasers to bid more and more for a house, causing some prices to rise and giving the banks and other buyers even more confidence that of prices would increase, justifying even or more lending. This also spurned other asset prices. Banks set up off-balance-sheet subsidiaries that piled up debt; leveraged-buyout groups borrowed many billions to take companies private; hedge funds borrowed to invest in assets.

 The greatest area of concern, though, is falling prices in the biggest asset category in the U.S. economy-homes. The consumption binge of the last decade was, to some extent, a reflection of the housing market bubble that made it possible for homeowners to refinance their homes and free up a trillion dollars. Estimates are that this decline will continue in 2008 and 2009 by as much as 10% each year. The derivatives markets are predicting further declines of about 20% in home prices, which would wipe out about $5 trillion from the net worth of Americans households.

 If prices decrease by as much as 20% in 2008 and 2009, as Merrill Lynch estimates, this may mean that over 10 million American home-owners will have no equity left. No one knows what effect this will have on the national economy. The potential tidal wave of home foreclosures will throw many families into the streets, erode home values of other properties, and damage neighborhoods. There are some estimates that more than 2 million foreclosures could take place over the next two years.

 

 

 

 

 

 

 

 

U.S. manufacturing activity declined last month to a five-year low, as slowing demand and rising prices continued to damp factory output.

The Institute for Supply Management said its index of manufacturing activity, based on a survey of supply executives, dropped to 48.3 in February from 50.7 in January. Figures below 50 indicate a contraction. The December reading was 48.4.

Meanwhile, the Commerce Department said the nation's construction spending fell in January by the biggest margin in 14 years -- to a seasonally adjusted annual rate of $1.121 trillion.

The weakness that had been concentrated in housing is spreading to nonresidential construction. Spending on private nonresidential construction slumped by 1.2% in January -- the biggest drop in more than two years -- as evidence mounts that the housing-market downturn and credit crunch are crimping nonresidential projects.

The components of the ISM survey point to a weakening economy. New orders and employment continued to decline, while prices rose for the 14th month in a row. Growth in exports -- which have been keeping American manufacturers afloat as the economy slows -- continued, though at a slower rate.

Still, January's manufacturing index was stronger than the readings typically associated with recessions. In 2001, during the last recession, the index remained below 45 for nine months, said Bank of America senior economist Peter Kretzmer. During the 1990-91 recession, the index dipped below 40 for two months.

January's drop in construction spending was the largest since 1994. Spending on residential construction fell 2.9% from December and 19.4% from a year earlier.

Spending on private nonresidential construction slumped for the second month in a row. Lodging, transportation, communication and commercial-construction spending have all declined in recent months after surging earlier last year. Tighter credit conditions and falling property values could spell trouble for nonresidential-construction projects this year and next.

The WSJ in the past few days has conjured up memories of eras that harkens back to the 1970s. In Wednesday’s, Feb. 20, 2008 edition Professor Martin Feldstein had an op-ed piece entitled “Our Economic Dilemma.” As you read through Dr. Feldstein’s article, I would call your attention to his reference in falling house prices that is reducing household wealth and therefore consumer spending.

Dr. Feldstein states that house prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion and this eventually reduces annual consumer spending about $100 billion. No one can forecast the extent to which the coming fall in house prices will lead to defaults (see previous post) and foreclosures driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.

There are concerns today regarding the paralysis of the credit markets. Credit has always been the key to the expansion of our economy. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds.

From Professor Mark Perry’s blog Carpe Diem, presents a counter argument to Dr. Feldstein’s op-ed piece. From Dr. Perry’s blog he states; “According to quarterly banking data released yesterday by the Federal Reserve on "end of period levels" through the end of 2007 for all banks, bank credit/loan volume is at an all-time record for all types of credit (business, consumer, real estate)! If there is some paralysis/collapse of the U.S. credit markets, how can bank loan volume be at all-time historical record high levels?”

In Thursday’s edition, Feb. 21 of the WSJ, Greg Ip’s tag line for his article begins by stating; “The U.S. faces an unwelcome combination of looming recession and persistent inflation that is reviving angst about stagflation, a condition not seen since the 1970s.” Stagflation is defined as a portmanteau of the words stagnation and inflation is a macroeconomic term used to describe a period of inflation combined with stagnation in economic growth and rising unemployment, possibly including recession.[1]

In this article the suggestion is made the Labor Department release reflects that consumer prices in the U.S. jumped 0.4% in January and are up 4.3% over the past 12 months, near a 16-year high. Even when you strip out sharply rising food and energy costs, prices rose 0.3% in January, driven by education, medical care, clothing and hotels. They are up by 2.5% from the previous year, a 10-monty high. When you review the last 10 years, the average of our PCE is 2.5% which is the FOMC’s preferred inflation measure.

The same day brought a reminder of possible recession. The Federal Reserve disclosed that its policy makers lowered their forecast for economic growth this year to between 1.3% and 2%, half a percentage point below the level of their previous forecast, in October. They blamed a further slowdown on the slump in housing prices, tighter lending standards and higher oil prices. They warned the economy's performance could fall short of even that lowered outlook.

 

Today, Tuesday, February 12, 2008 Secretary of Treasurer Hank Paulson announced six major mortgage lenders unveiled their latest response to the continuing turmoil in the housing market, offering to “pause” the foreclosure process for the seriously troubled homeowners.

 The announcement of “Project Lifeline” was couched in tones of optimism; officials cautioned that it is only an incremental step that would not guarantee help for every homeowner facing the loss of their home.

This new project involves a promise by top lenders to proactively contact homeowners who are 90 days or more late on their mortgage payments. Those borrowers would be sent a letter giving them a step-by-step approach that "may enable them to "pause" their foreclosure for 30 days while potential loan modification is evaluated," according to plan overview documents.

Those six mortgage lenders are Bank of America Corp., Citigroup Inc., Countrywide Financial Corp., JPMorgan Chase & Co., Washington Mutual Inc. and Wells Fargo & Co. The same banks are part of the administration’s Hope Now Alliance

The sub-prime quagmire continues to develop into an abyss, pulling more and more homes into foreclosure. The number of foreclosures soared to 2.2 million in 2007 with 450,000 households losing their homes. Total foreclosure filings soared 97% in December along compared with December of 2006, according to RealtyTrac.[1] For the year, total filing-which includes default notices, auction sale notices and bank repossessions-grew 75%. A foreclosure map provides a much better view and understanding of what states and areas of the states that are impacted.

The cover story in Business Week’s Feb. 11 edition is an article entitled; “Housing Meltdown” written by Peter Coy. This article suggests home prices could sink an additional 25% over the next two or three years, returning values to their 2000 levels in inflation-adjusted terms. That's even with the Federal Reserve's half-percentage-point rate cut on Jan. 30.

The article cites the Mankiw’s paper that was written in 1989, long before Professor Mankiw worked in the White House as chief economic adviser or writing his best-selling textbook, “Principles of Economics.” Harvard University economist N. Gregory Mankiw co-wrote a paper that was startlingly negative on housing. He and David N. Weil predicted that home prices would decline by 47% after inflation over the next 20 years, based on a shrinking pool of potential first-time buyers and an expectation that baby boomers as a group would spend less on housing as they grew older.