The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

William C. Dunkelberg is Professor of Economics in the College of Literature and Arts , Temple University, and is chairman of the NFIB.

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If you listen to Washington and New Yorkers working for bailed out institutions or in offices 100 floors above Wall Street, the recovery is weak because banks, and now small banks in particular, wont lend money to small businesses. There has been plenty of evidence to the contrary (demand is weak rather than banks are hoarding money), but facts don’t play well in Washington.

First of all, we should stop “benchmarking” to 2006 and 2007, a period of credit excesses enabled by an apparent “weakening” of credit standards in many parts of the economy. This is not a period we should aspire to return to. Of course credit is “harder” to get than it was prior to the recession. And of course the press can find someone who thinks they deserve credit but can’t get it. These “Man Who” statistics (“I know a man who…………) quoted in the press and in hearings are not helpful and highly misleading. Nobody did the investigatory work to see if any of these alleged cases of unfair credit rationing were really bankable. In the best of times, 5% of small business owners say their credit needs weren’t met – it was 8% in May (NFIB). Banks aren’t venture capitalists, they have no ability to recognize the next “great idea” and don’t make loans to fund such projects. Lending is about capacity to repay – tomorrow, not yesterday.

The “message” from Washington and some New York pundits is that the banks “owe it’ to the U.S. to make more loans (it’s “unpatriotic” not to!) because they were “bailed out”. Well, most small banks were not bailed out, but they sure are paying through the nose to cover the “bad actors” with FDIC premiums 700% higher. The implication is that banks are not making good loans when the opportunity arises, an unlikely situation. Large banks lost a ton of bucks, and did restrict their lending. But the “small banks” for the most part did not engage in risk-taking like the larger institutions and have money to lend. Surely the administration is not suggesting that banks go back to making bad loans to create jobs.

NFIB (which surveys a sample of its 300,000 or so members each month) finds that only 3% of its members report financing as their top business problem (as high as 37% pre-1983). A third cites “weak sales” as their top problem. 92% report all of their credit needs met (or having no desire to borrow). Thirteen percent of regular borrows report credit “harder to get” than their last attempt which now dates into the post crash period – of course it is harder!! (but not as high as pre-1983 survey readings).

Loans to small business are down primarily because huge amounts of private credit demand are on the sidelines:

a. Housing starts are 1,000,000 below normal needs, normally built by

thousands of small construction firms financed by thousands of community banks. At, say, $200,000 per construction loan, that’s a huge gap in private credit demand. In the first year after the more modest 1991 recession, 100,000 new construction jobs were credit by a housing recovery. Missing today.

b. Auto purchases are 5 million units below normal

c.. For 6 million employer firms, actual capital outlays are at 35 year low levels,

purchases that are normally financed at banks.

d. For two years, firms have been liquidating inventory, not adding, an activity

usually supported by bank loans.

e. Consumers have been actively paying down their indebtedness.

In short, there are far fewer firms looking for credit these days, there is money to be lent, but a shortage of eligible borrowers. A special NFIB study of D&B firms with under 100 employees in December, 2009 indicated that the purpose of most borrowers (over 70%) was to supplement cash flow, not expanding their businesses or hiring. In addition to too many houses, we also built too many strip malls, retail outlets and restaurants and accumulated too much inventory to keep up with a non-saving consumer. Now, all these firms must share a reduced level of consumer spending to support them. Not all will succeed unless, of course, consumers return to their old spending ways. In the meantime, the Treasury found it a lot easier to finance our trillion dollar deficit. But when the private sector begins to expand and private credit demands explode, “crowding out” will provide a strong headwind to private sector growth.

Assets, whether human capital or physical assets must “earn their keep”. Workers don’t get hired unless they have high odds of generating enough sales to pay for the cost of hiring them. Equipment isn’t purchased unless it can be productively used to pay for itself. You can give owners interest free loans and they will not spend the money because they have to repay the loan and in this environment the assets are unable to earn their keep. Business tax cuts wont be spent on endeavors that have a low probability of paying off. Anyway, $30 billion isn’t much to throw at the problem if the Administration really believes that small bank reticence to lend is the problem. One firm with a handful of employees got twice that amount (and will not pay that back to taxpayers with all likelihood because it was a loan that rational private sector lenders wouldn’t make for that reason).

So, lending to small business is down because credit demands are down. In this recovery, inventory rebuilding (manufacturing) and exporting have led, not housing and the consumer. This has favored large firms (and the stock market), not small businesses which are usually the first to see the turnaround in the economy. Yes, credit standards are higher than they used to be, using 2007 as a benchmark! But making bad loans is not the key to stimulating the economy. Government has done this, sadly, but the private sector is more careful with the funds entrusted to its lending institutions by savers, especially small banks. Small business produces half of private sector GDP in normal times. Perhaps the reason GDP growth is rather anemic (and inventory driven) is that the small business sector of the economy is not participating. Certainly developments in Washington offer little encouragement for small business owners and the consumer is less than exuberant. But all of this is not a result of unwillingness on the part of small banks to lend and make good loans.

Our story so far:

Following the 2,000 Dot Com crash, then Fed Chair Alan Greenspan brought Fed Funds rates down to ultra-low levels. Under 2% for 3 years, and 1% for more than a year.

Rates this low — and for that long — were simply unprecedented. They wreaked havoc with the traditional fixed income market. Bond managers scrambled for yield, and found it in investment grade, triple A rated residential mortgage-backed securities (RMBS). This better interest rate was created by securitizing mortgages with an unhealthy slug of higher yielding, riskier, sub-prime mortgages.

The demand for RMBS paper was nearly insatiable. Wall Street sucked up as much sub-prime paper as could be legitimately, then illegitimately produced. Lend-to-securitize-nonbank mortgage writers responded to the demand by abdicating traditional lending standards. 30 year mortgages were given to people who in no conceivable way could afford them. The hope was a non-default over the warranty period of the mortgage, typically 90 or 180 days.

The Greenspan Fed, in charge of supervising financial lending institutions, looked the other way.

The net result of this was a credit bubble and a housing boom. (A true housing bubble formed only in a handful of places). The credit bubble allowed 10s of millions of Americans to become, albeit temporarily, home owners.

In 1992, some 4 million homes per year were being purchased. A decade later, that number had risen 25% to 5 million. A mere 3 years later, annual sales were 7 million units — a 40% increase. From 2002 to 2007, the abdication of lending standards — who cares about credit scores, incomes, debt load, assets, even job! — created millions of new homeowners. And thanks to the ultra low rates, prices had exploded. The combination of brand new, unsophisticated buyers and rapidly rising prices was a dangerous combination.

Buyers of limited financial means who en masse overpaid for their houses at ultra low rates was a recipe for disaster. The Fed began its cyclical tightening, price appreciation slowed, then reversed. Sales plummeted, and prices fell. Five million of those buyers were foreclosed upon, with another 5 million likely to come.

Which more or less brings you up to date.

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Today, residential real estate confronts numerous headwinds: Credit, once given to anyone who could fog a mirror, is now tight. Hence, demand is far below what it was during the past decade. Home prices are still unwinding from artificially high levels, and remained over-priced. Inventory is elevated. Unemployment remains high. A huge supply of shadow inventory is out there: Speculators and flippers who overpaid but have held onto their properties await modestly higher prices to sell. Bank owned real estate (REOs) continues to increase. We are barely halfway through a decade long foreclosure surge.

This is known, or at least should be by those who have looked at the data. I cannot explain why some economists still have not figured this out.

In my analysis, price stands out as being the prime mover of the next leg down. High unemployment, and a decade of flat wages aren’t helping to create any new housing demand. And the millions in homes they cannot afford will eventually add more pressure to inventory and prices.

But the bottom line is Home prices remain too high: There can be no doubt that home prices have moved way down from the 2005-06 peaks. How did I reach the conclusion that, even after a 33% decrease in prices?

By using traditional metrics. Whether we are looking at US housing stock as a percentage of GDP or Median income vs home prices or even ownership vs renting costs, prices remain elevated. Indeed, we see prices remain above historic mean.

Consider price relative to income. From 1977 to 2010, the median US home price was 4.1 times median household income. But as the chart below shows, Home prices are still above that mean. Oh, and that mean is artificially elevated due to the 2002-07 boom. Same with home prices relative to rentals, or housing value as percentage of GDP.

Further, we should not assume that prices will merely mean revert back to historic levels. In most markets, a near 3 standard deviation price move is resolved not by reverting to the mean, but by by careening far below it.

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New Home Prices vs Median Income

Home vs Rent

Charts courtesy of Ned Davis Research.

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We can look at numerous other factors. Employment, inventory, REOs, credit, another wave of foreclosures. etc. But the bottom line remains that prices must revert to a sustainable level, and we simply aren’t there — yet.

Yes, government policies temporarily stopped prices from finding their natural levels. Now that the tax credit has ended, and most mortgage mods are failing, the prior downtrend in price will now resume.

Neither the Bush nor the Obama White House seemed to truly understand this. The assumption has been that if we can modify mortgages or voluntarily refrain from foreclosures, the RRE market will stabilize. Through a combination of mortgage mods and buyers tax credits, the government has managed to — temporarily– create artificial demand and keep more supply off of the markets.

But as we have seen, that fix was at best temporary.

One of the things that Markets are best at is price discovery — the determination of a price for a specific item through basic supply and demand factors. Without the heavy hand of the government intervening, the residential real estate market is about to experience what price discovery is all about . . .

I am S O – B O R E D of all the Fed chatter. Its become meaningless blather, as we now know they are not going to tighten til around 2020 or so.

So instead of focusing on that nonsense, here are some unrelated, non-Fed readings that are well worth your while.

• Inside the Dire Financial State of the States (Time)
• Asia’s wealthy surpass Europe’s for first time  (AP/Yahoo)
• Fannie Mae Increases Penalties for Strategic Defaulters — Borrowers Who Walk Away (Fannie Mae)
• Victor Niederhoffer on Being Wrong (Slate)
• Contemptible Advocates of Debt Default (Capital Gains and Games)
• A Colossal Fracking Mess (Vanity Fair)
• The most comprehensive iPhone 4 review you are likely to see (Engadget)
• Why Amazon’s Kindle Will Eventually Win the e-Book Wars (gigaom)
• How a Four-Year-Old Plays Grand Theft Auto — very differently from an adult (Bitmob)
• Giant time suck: Ragdoll Cannon (Game)

What are you reading?

To put today’s 10 yr note yield of 3.11% into perspective and its huge relevance, taking out the sharp drop in interest rates in late ’08, early ’09 due to the obvious financial collapse fear flight to safety trade, the last time the 10 yr bond yield closed at 3.11% was on June 13th, 2003, almost two weeks before Greenspan cut rates to 1% due to the Fed’s deflation fears. The closing low on that date at the time was a record low dating back to at least 1962 and was only first breached in Nov ’08. The level also came 7 months after Bernanke gave his famous “Deflation: Making sure ‘it’ Doesn’t Happen Here” speech where he talked about dropping money from a helicopter if need be.

Just when one thought the FOMC couldn’t get more dovish, they get more dovish, specifically on inflation. They toned down the outlook by saying the “economic recovery is proceeding” vs “economic activity has continued to strengthen” in Apr. They referred to the improvement in the labor market as gradual. They took out “housing starts have edged up” out of the statement as they should and they also implicitly referred to Europe by saying “financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad.” On inflation, they referred to the drop in energy and other commodities as helping to lower the trend of inflation. Of course in Apr when copper was at $3.65 and oil was at $90, the FOMC didn’t mention the upside risks to inflation, thus the very dovish commentary. Rates will stay “exceptionally low” for a very, very, very, very long time.

Markets have gone green in reaction to a dovish FOMC Statement, highlighting the softening economic factors:

“The economic recovery is proceeding and that the labor market is improving gradually. Household spending is increasing but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit . . . Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad. Bank lending has continued to contract in recent months. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be moderate for a time.

That is Fed speak for “No change in rates for a good long time . . .”

FedSidebySide.

Bundle.com looks at the total Auto & Gas expenses in the US:

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click for interactive graphic

hat tip Flowing Data

Read the rest of this entry »

Alternative title: Economic catastrophes are hard . . .

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We have been hearing lots of noise lately about state and sovereign deficits, especially from the newly minted deficit hawks in the US. So I took special notice of the Washington Post’s Ezra Klein recent discussions regarding the various States fiscal crises (here and here).

Klein cites Wharton prof Robert Inman, who identifies Unemployment as the single biggest factor impacting States fiscal crises: “The good news from this analysis is that the states’ fiscal crises of 2009 do not appear to be linked to any obvious structural or institutional failures in state finances. It’s the economy.”

Klein distinguished between States’ policies and economic conditions:

“A set of policies that were balancing state budgets in 2004 and 2005 and 2006 and could’ve survived a mild recession but weren’t able to hold the line against a once-in-a-generation economic storm aren’t bad or profligate policies: It’s just hard to endure economic catastrophes, and you wouldn’t necessarily want to orient your economic policy around long-tail events. A pension program that was started in the early 1900s and that’s worked pretty well but will run a temporary deficit when an uncommonly large generation retires isn’t a poorly designed pension program.”

There is additional evidence to back this up: An IMF report analyzing sovereign deficits, and an NBER Working Paper titled  States in Fiscal Distress.

The bottom line is that deficits reflect both government policy AND economic conditions. You cannot intelligently analyze or criticism one without recognizing the impact of the other . . .

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Sources:
Unemployment, not budget practices, to blame for state woes
Ezra Klein
Washington Post, June 22, 2010
http://voices.washingtonpost.com/ezra-klein/2010/06/unemployment_not_budget_practi.html

States in Fiscal Distress
Robert P. Inman
NBER Working Paper No. 16086
June 2010
http://papers.nber.org/papers/w16086

Budget deficits reflect economic conditions, not just government policy
Ezra Klein
Washington Post, June 22, 2010
http://voices.washingtonpost.com/ezra-klein/2010/06/budget_deficits_reflect_econom.html

Navigating the Fiscal Challenges Ahead
Fiscal Affairs Department, IMF, MAY 14, 2010
http://www.imf.org/external/pubs/ft/fm/2010/fm1001.pdf

Capturing the post home buying tax credit world, May New Home Sales, a measure of contract signings of new homes, was a disaster at 300k annualized, 27% below estimates and April, which included the credit, was revised down by 58k. The May sales level of 300k is the lowest since at least 1963. The drop sent months supply to 8.5 from 5.8 in April, the highest since June ’09. The area with the biggest foreclosure rate and thus greatest competition to the home builders, the West, saw sales fall 53% m/o/m. The median home price fell 9.6% y/o/y and 1% sequentially. Bottom line, we knew there would be a large post tax credit drop in sales but the degree is obviously big. The question though for the industry is not this data but what happens after the hangover runs its course. Either way, the distortion of steroid shots into the marketplace has only made long term planning and thus efficiently allocated capital that much more difficult to coordinate.

Sales of new homes fell 33% in May 2010.

With the expiration of the artificial government demand created by the tax cut left little doubt that new home construction is in for a challenging few quarters.

The caveat: This data series is notoriously noisy, and you are must better off using a 3 month moving average than read too much into any single month.

Highlights:

• Sales fell 32.7% below the April 2010 and were off 18.3% below the May 2009.

• Median sales price decreased 9.6% from May 2009 to $200,900.

• Purchases dropped in all four U.S. regions last month.

• A record 53% sales drop occurred in the West.

• Supply of homes jumped to 8.5 month’s worth, up from 5.8 months in April.

Note that May is usually an improved month versus April.

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New Home Sales May 2010, NSA

Chart courtesy of Calculated Risk

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Previously:
New Home Sales Data: Don’t rely On It Either (November 30th, 2005)
http://www.ritholtz.com/blog/2005/11/new-home-sales-data-dont-rely-on-it-either/

Home Builders Sell Signals (June 21, 2010)
http://www.ritholtz.com/blog/2010/06/home-builders-sell-signals/

Source:
NEW RESIDENTIAL SALES IN MAY 2010
Department of Commerce, Manufacturing and Construction Division
http://www.census.gov/const/newressales.pdf