by Calculated Risk on 8/17/2010 02:15:00 PM

From Minneapolis Fed President Narayana Kocherlakota: Inside the FOMC

The FOMC’s decision has had a larger impact on financial markets than I would have anticipated. My own interpretation is that the FOMC action led investors to believe that the economic situation in the United States was worse than they, the investors, had imagined. In my view, this reaction is unwarranted. The FOMC’s decisions were largely predicated on publicly available data about real GDP, its various components, unemployment, and inflation. I would say that there is no new information about the current state of the economy to be learned from the FOMC’s actions or its statement.

Kocherlakota points out that the Fed's balance sheet was falling quicker than anticipated because of the high level of refinancing as mortgage rates have declined.

But Kocherlakota fails to note that the mortgage rates have declined because of the weaker economy - and the Fed appears to be behind the curve in adjusting their views lower.

Kocherlakota is forecasting that real GDP growth in the 2nd half of 2010 will be about the same as in the first half:

Based on estimates from our Minneapolis forecasting model, I expect GDP growth to be around 2.5 percent in the second half of 2010 and close to 3.0 percent in 2011. There is a recovery under way in the United States, and I expect it to continue.

Although Kocherlakota forecast is possible - and is a weak recovery - I think the economy will slow in the 2nd half.

And I think the growing view isn't that the economy is worse than investors had imagined, but that the Fed is once again behind the curve on the economic outlook.

by Calculated Risk on 8/17/2010 11:49:00 AM

This morning the Census Bureau released the "Quarterly Starts and Completions by Purpose and Design" report for Q2 2010.

Click on graph for larger image in new window.

This graph shows the NSA quarterly starts intent for four categories since 1975: single family built for sale, owner built (includes contractor built for owner), starts built for rent, and condos built for sale.

Condo starts in Q2 were just above the all time record low (4,000 vs 3,000 in Q4 2009).

Units built for rent set an all time record low in Q1 (19,000 units in Q1 2010) and rebounded to 31,000 units in Q2. Some of this increase is seasonal, but it does appear that many large apartment owners think the vacancy rate has peaked - and some builders and owners are starting to build new apartments (probably for delivery in 2011).

Starts for owner built units increased too. In Q2, there were 44,000 owner built units started - up from 38,000 in Q2 2009.

And the largest category - starts of single family units, built for sale - increased to 93,000 in Q2 from 86,000 in Q1. Some of this was seasonal, and some was related to the tax credit (although most of the tax credit starts were probably in Q1).

Of course single family starts, built for sale, will decline sharply in Q3.

Comparing Housing Starts and New Home Sales

Monthly housing starts (even single family starts) cannot be compared directly to new home sales, because the monthly housing starts report from the Census Bureau includes apartments, owner built units and condos that are not included in the new home sales report.

However it is possible to compare "Single Family Starts, Built for Sale" to New Home sales on a quarterly basis. This is not perfect because of reporting differences and changes in cancellation rate - but it is close. The quarterly report shows that there were 93,000 single family starts, built for sale, in Q2 2010, and that is just below the 97,000 new homes sold for the same period. This data is Not Seasonally Adjusted (NSA).

This suggests that home builders are starting about the same number of homes that they are selling (unlike in 2005 and 2006 when builders built far too many spec homes).

by Calculated Risk on 8/17/2010 09:15:00 AM

From the Fed: Industrial production and Capacity Utilization

Industrial production rose 1.0 percent in July after having edged down 0.1 percent in June, and manufacturing output moved up 1.1 percent in July after having fallen 0.5 percent in June. A large contributor to the jump in manufacturing output in July was an increase of nearly 10 percent in the production of motor vehicles and parts; even so, manufacturing production excluding motor vehicles and parts advanced 0.6 percent. The output of mines rose 0.9 percent, and the output of utilities increased 0.1 percent. At 93.4 percent of its 2007 average, total industrial production in July was 7.7 percent above its year-earlier level. The capacity utilization rate for total industry moved up to 74.8 percent, a rate 5.7 percentage points above the rate from a year earlier but 5.8 percentage points below its average from 1972 to 2009.

Click on graph for larger image in new window.

This graph shows Capacity Utilization. This series is up 9.8% from the record low set in June 2009 (the series starts in 1967).

Capacity utilization at 74.8% is still far below normal - and well below the the pre-recession levels of 81.2% in November 2007.

Note: y-axis doesn't start at zero to better show the change.

The second graph shows industrial production since 1967.

This is the highest level for industrial production since Oct 2008, but production is still 7.3% below the pre-recession levels at the end of 2007.

The increase in July was above the consensus of a 0.5% increase in Industrial Production, and an increase to 74.5% for Capacity Utilization.

by Calculated Risk on 8/17/2010 08:30:00 AM

Click on graph for larger image in new window.

Total housing starts were at 546 thousand (SAAR) in July, up 1.7% from the revised June rate of 537 thousand (revised down from 549 thousand), and up 14% from the all time record low in April 2009 of 477 thousand (the lowest level since the Census Bureau began tracking housing starts in 1959).

Single-family starts declined 4.2% to 432 thousand in July. This is 20% above the record low in January 2009 (360 thousand).

The second graph shows total and single unit starts since 1968. This shows the huge collapse following the housing bubble, and that housing starts have mostly been moving sideways for over a year - with a slight up and down over the last several months due to the home buyer tax credit.

Here is the Census Bureau report on housing Permits, Starts and Completions.

Housing Starts:
Privately-owned housing starts in July were at a seasonally adjusted annual rate of 546,000. This is 1.7 percent (±9.7%)* above the 9.7%) revised June estimate of 537,000, but is 7.0 percent (±7.5%)* below the July 2009 rate of 587,000.

Single-family housing starts in July were at a rate of 432,000; this is 4.2 percent (±8.7%)* below the revised June figure of 451,000.

Building Permits:
Privately-owned housing units authorized by building permits in July were at a seasonally adjusted annual rate of 565,000. This is 3.1 percent (±2.0%) below the revised June rate of 583,000 and is 3.7 percent (±2.2%) below the July 2009 estimate of 587,000.

Single-family authorizations in July were at a rate of 416,000; this is 1.2 percent (±1.2%)* below the revised June figure of 421,000.

This was below expectations of 565 thousand, and is good news for the housing market longer term (there are too many housing units already), but bad news for the economy and employment short term.

by Calculated Risk on 8/16/2010 06:44:00 PM

First on housing ...

When the July existing home sales data is released, will we see 12 months of supply? Double-digits supply is a given. The high for this cycle was 11.2 months back in 2008, and based on preliminary reports, I think a new high is very likely and 12 months of supply is a reasonable possibility.

CoreLogic reported house prices were flat in June (this is a 3 month weighted average of April, May and June).

Altos Research compiles a price index for 10 cities that shows prices falling in July. They report

"The Composite, which was reasonably flat in June, showed a marked decrease in July, falling more than half a percentage point (0.63%)."

RadarLogic CEO Michael Feder writes: Beware the "Fall" of 2010

Moody’s housing economist Celia Chen has released a forecast of housing that is pretty dire. If the U.S. enters a doubledip recession, writes Chen, home prices could fall another 20% before stabilizing in early 2012. That compares to a baseline forecast that calls for another 5% decline in home prices and a bottom early next year. Chen puts the odds of a near‐term double‐dip at one in four. As observers of the actual housing market, while we cannot say these numbers are right, we certainly support Chen’s concern. However, we think the order of events will be reversed: it is our belief that housing prices will decrease in the autumn, perhaps precipitously, and that may cause a second dip in the U.S. economy.

The NAHB showed builder confidence declined in August and is now at the lowest level since March 2009.

Other reports of interest ...

Another installment on Sovereign Debt from "Some Investor Guy" Part 5D: European Banks, What if Things Go Really Badly?

NY Fed: Manufacturing Conditions improve "modestly" in August

Weekly Schedule for week of August 15th

Weekly Summary for week ending Aug 15th.

A post on Saturday about the coming Negative News Flow

Also from Saturday about why I expect the unemployment rate to increase.

On a lighter note, a new song from Merle Hazard Double Dippin'

by Calculated Risk on 8/16/2010 03:28:00 PM

CR Note: This series is from reader "some investor guy".

Part 5D. What if Things Go Really Badly? More Than Half of Europe’s Banks Would Need Capital. A quarter would be insolvent. This part was moved a bit later to allow a more thorough analysis of the European Bank Stress Tests.

There are two questions I’ve been asked repeatedly since the European stress tests were announced.

Q1. Was there much sovereign stress in the European bank stress tests?

NO. The most glaring oversight, in the opinion of the author and many other analysts, is assuming there would be no sovereign defaults, and thus not showing any losses on the bank’s long term holdings (in the banking category vs the “trading book”). According to the Committee of European Banking Supervisors, the sovereign stress scenario results in “39 billion euro associated with valuation losses of sovereign exposures in the trading book “.

“The haircuts are applied to the trading book portfolios only, as no default assumption was considered, which would be required to apply haircuts to the held to maturity sovereign debt in the banking book.”

Yes, as you may have seen in other reports, the “sovereign stress scenario” contained no sovereign defaults. Why on earth would this be the stress case? “The setting up of the European Financial Stability Facility (EFSF) and the related commitment of all participating member States provides reassurance that the default of a member State will not occur, which implies that impairment losses on sovereign exposures in the available for sale and held-to-maturity in the banking book cannot be factored into the exercise.” (source).

For there to be no sovereign defaults: the EFSF and IMF plans would have to be big enough to subsidize a lot of sovereign problems, they would have to stay in place for a long time, member countries would have to continue to subsidize them for a long time, and (the worst vulnerability) countries like Hungary and Greece have to accept the conditions which come with the offers of support.

Plenty of countries have turned down potential IMF support over the years. Hungary turned down additional support from the IMF and the EU, the week before the stress test results were released, (source). Hungary continues to say “no”, and “Hungary's defiance could conceivably spread to other governments currently being squeezed by the IMF and European authorities.” (source).

At least four forms of defiance might lead to default. First, a country might say that they can’t or won’t do the requested steps like austerity. They would rather just default. Second, a country might claim or actually believe they don’t need help. Then if markets freeze up due to problems elsewhere, they might not be able to roll over their debt, and they could default. Third, a country with a lot over the counter derivatives might come up with a reason not to pay them (see Part 5C for some examples of how sovereigns might try to get out of commitments). That’s a big potential problem for some European banks that don’t have collateral from sovereigns on their interest rate and currency swaps. Fourth, someone already receiving considerable help from the EU or IMF might not repay it. For example, a new government might be elected (as happened in Hungary).

Here is a list of the 30 countries whose sovereign debt was included in the stress tests. Six of them already are receiving help from the IMF. Note that most of the IMF support agreements end before the end of the Stress Test period, 12/31/2011. Most of the amounts outstanding are due to be repaid to the IMF quarterly installments 3-5 years later.

European Stress Test Participants and Existing IMF Support Agreements
As of August 5 2010, In Millions, source
				Amount	Undrawn
	Type	Effective	Expires	Agreed	Balance	Outstanding
Austria
Belgium
Bulgaria
Cyprus
Czech Republic
Denmark
Estonia
Finland
France
Germany
Greece	Standby	5/9/2010	5/8/2013	26,433	21,627	4,806
Hungary	Standby	11/6/2008	10/5/2010	10,538	2,901	7,637
Iceland	Standby	11/19/2008	8/31/2011	1,400	630	770
Ireland
Italy
Latvia	Standby	12/23/2008	12/22/2011	1,522	629	892
Liechtenstein
Lithuania
Luxembourg
Malta
Netherlands
Norway
Poland	Credit Line	7/2/2010	7/1/2011	13,690	13,690	0
Portugal
Romania	Standby	5/4/2009	5/3/2011	11,443	2,412	9,031
Slovakia
Slovenia
Spain
Sweden
United Kingdom
Count	6		Totals	65,026	41,889	23,136

Official Opinion. Jean-Claude Trichet, President of the European Central Bank, claims that the stress tests were “an important step forward in restoring market confidence.” (August 5, NY Times: Trichet Sees Reasons for Optimism in Europe). OK. Let’s see what the bond and CDS markets have done since July 23rd when the results were released.

What the market thinks. The CDS market believes that stress test member governments have about half a trillion dollars of expected default losses, about one third of the worldwide total. Big difference. And the CDS and bond markets didn’t move much since the announcement of the stress test results. Greece’s CDS prices for Greece show a 50% chance of default within 5 years. Before the stress test, it was 53%. In other words, the people with real money riding on these outcomes were not impressed. If everyone in the CDS market believed the assumptions used in the stress tests, that pricing should be near zero.

Click on graph for larger image in new window.

CR Note: This graph of European bond spreads is from the Atlanta Fed weekly Financial Highlights (line added for stress tests).

Bond spreads would also have gotten much smaller, with debt from Greece, Spain, Portugal, and Italy having yields much closer to German debt. As can be seen from this CR chart from August 12, that isn’t occurring.

However, there some useful results of the stress tests. There is plenty of published data which is reasonably comparable from one bank to another. The regulators also put in general economic stresses like unemployment and slow growth, which caused a lot of losses to banks: 473 billion euros of impairment losses (source). That’s where the great majority of the losses in the stress tests arose.


Q2. How many European banks would fail a real sovereign stress test, or would fail in the Really Bad Scenario?

There are four sets of tests I would like to discuss:

1. The official European bank stress tests, from the Committee of European Banking Supervisors, where only 7 of 91 banks “failed” the tests, and would need more capital. Much of that data is here. As mentioned above, the official test doesn’t even match the expected level of sovereign losses, much less a real stress test.

2. Citi did a reanalysis if all of the banks’ sovereign bonds were marked to market and concluded that 24 of 91 banks would fail the Tier 1 capital test from the European regulators, on exactly the same economic assumptions as the regulators. In other words, about a quarter of the banks would need more capital to be considered solvent, according to Citi’s analysis.

3. Using a rather different method, and current credit default swap pricing, Some Investor Guy came to an almost identical conclusion as Citi, with an almost identical list of banks needing capital. Citi’s test can be regarded as a reasonable baseline.

Why is Citi’s scenario using the regulators’ haircuts and interest rate assumptions so close to Some Investor Guy’s scenario based on credit default swap data? Part of the reason is that both sets of losses were calculated from the same sovereign bond holdings for each bank.

I speculate that something else might also be occurring. Faced with political and public relations difficulties of having sovereign defaults of European countries despite a one trillion euro commitment that is supposed to prevent them, analysts at the central banks may have calibrated their sovereign stress assumptions to provide similar overall market value losses to what the CDS market currently expects. If so, the exact details are obscured by the stress tests using changes in ratings and yields (and multiple languages and currencies). If this is really what happened, I’m proud of the analyst(s) at CEBS who figured out how to set the sovereign assumptions and data collection so that someone like Citi or Some Investor Guy could easily do a real, expected value stress test. They keep their jobs, other people willing to wade through thousands of numbers get to do their own scenarios. Everybody’s happy.

4. In the Really Bad Scenario, the results are much worse for banks. 57 of 91 major European banks would need capital, and 23 of them would have their Tier 1 capital go below zero. In other words, they would be technically insolvent.

In the Really Bad scenario, defaulted sovereigns include Belgium, Bulgaria, Cypress, Estonia, Greece, Hungary, Iceland, Ireland, Italy, Latvia, Lithuania, Malta, Poland, Portugal, Romania, and Spain. About $4 trillion of European sovereign debt would be in default, and losses to the European banking system would be about $568 billion, doubling the losses in the official stress tests. When added to the rest of the losses in the stress tests, losses to banks go to 1.041 trillion euros.

In this scenario, there is a strong correlation between where a bank is based, and whether it needs capital. Banks tend to hold a very disproportionate amount of their sovereign bonds from their home country. Thus, banks from Greece, Hungary, Ireland, Italy, Poland, Portugal, Romania, and Spain encounter a disproportionate amount of the damage in this scenario. The portion of outstanding bonds held by banks varies a lot. More than half of Greek debt is held by banks, but only about 15% of Belgian and Italian debt is at banks.

Please note that for the Really Bad scenario, the exact same baseline numbers were used for everything except sovereign losses. Same unemployment, GDP growth, private sector losses, etc. With widespread sovereign default, in the short run there would probably be more unemployment and lower GDP growth.

In Banking Crises, an Equal Opportunity Menace, Reinhart and Rogoff show that the cost of banking crises are greater than has been commonly assumed. “Banking crises dramatically weaken fiscal positions…with government revenues invariably contracting, and fiscal expenditures often expanding sharply. Three years after a financial crisis central government debt increases, on average, by about 86 percent. Thus the fiscal burden of banking crisis extends far beyond the commonly cited cost of the bailouts.”

Given the typical timing of banking and sovereign crises, it would take about 1-2 years for the crisis to reach its peak, and about 3 more years for recovery.

Chart source: page 40.

Full Disclosure: Some Investor Guy lives in the US and owns no sovereign debt from outside the US. He owns bonds from one of the banks involved in the stress tests. To his relief, that bank is solvent even in the Really Bad scenario. Since he didn’t name specific banks, it would be pointless to have modified the Really Bad scenario in any way to help that bank or the value of its bonds. This article is not an offer to buy or sell anything, but after all of the work assembling the data and doing calculations, Some Investor Guy might be persuaded to share the underlying analysis.

CR Note: This series is from "Some investor guy"

Series:
• Part 1: How Large is the Outstanding Value of Sovereign Bonds?

• Part 2. How Often Have Sovereign Countries Defaulted in the Past?

• Part 2B: More on Historic Sovereign Default Research

• Part 3. What are the Market Estimates of the Probabilities of Default?

• Part 4. What are Total Estimated Losses on Sovereign Bonds Due to Default?

• Part 5A. What Happens If Things Go Really Badly? $15 Trillion of Sovereign Debt in Default

• Part 5B. Part 5B. What Happens If Things Go Really Badly? More Things Can Go Badly: Credit Default Swaps, Interest Swaps and Options, Foreign Exchange

• Part 5C. Some Policy Options, Good and Bad

• Part 5D. European Banks, What if Things Go Really Badly?