by Calculated Risk on 10/05/2007 08:15:00 PM

First, what is normal economic growth? To answer that question, look at this graph of the distribution of four quarter real GDP growth since 1956 (the last 50 years).

Note: this graph uses each moving four quarter period as a data point. Each quarter will eventually be in four different events (they are not all independent).

Click on graph for larger image.

The bars represent the number of times the four quarter real GDP growth was within a certain range. As an example, the ">1%" range is for a four quarter growth rate of 1% to 2% real GDP.

In general, the probability of real GDP growth is a bell curve distribution centered around 3% to 4% real GDP growth.

Most forecasts start with trend GDP growth and then try to decide why growth in the next period will be higher or lower than trend. Instead of trying to forecast a specific number for GDP growth, I usually try to forecast in one of the four circles market on the graph. These are arbitrary definitions that I use: Booming Growth, Trend Growth, Sluggish Growth / mild Recession, and Severe Recession.

For 2007 my forecast was for Sluggish Growth / mild Recession, and I've tried to break it down a little further by saying it is pretty much a coin flip between a mild recession and sluggish growth, but I lean towards a recession. Although there is a bright line between a recession and no recession, the economic difference between sluggish growth and a mild recession is pretty minor.

What is a Recession?

In the U.S., recessions are identified by the National Bureau of Economic Research (NBER), a private, nonprofit, nonpartisan research organization. Here is the NBER’s Recession Dating Procedure. Here are some excerpts:

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.
...
Q: The financial press often states the definition of a recession as two consecutive quarters of decline in real GDP. How does that relate to the NBER's recession dating procedure?

A: Most of the recessions identified by our procedures do consist of two or more quarters of declining real GDP, but not all of them. According to current data for 2001, the present recession falls into the general pattern, with three consecutive quarters of decline. Our procedure differs from the two-quarter rule in a number of ways. First, we consider the depth as well as the duration of the decline in economic activity. Recall that our definition includes the phrase, "a significant decline in economic activity." Second, we use a broader array of indicators than just real GDP. One reason for this is that the GDP data are subject to considerable revision. Third, we use monthly indicators to arrive at a monthly chronology.

For the four quarter period ending in Q2 2007, real GDP growth was 1.9% (for the Q1 ending period, four quarter GDP growth was 1.5%). So the U.S. economy is currently in the Sluggish Growth / mild Recession category.

If we go back to the graph, 5 out of the 19 events with 1% to 2% growth happened during a NBER defined recession. For the 0% to 1% category, 9 out of 11 events happened during a recession. This suggests that the U.S. economy is skating just above a recession, and if the four quarter real growth rate falls below 1%, there is a good chance the NBER will declare a recession.

So do Recessions matter?

What matters is what happens when the economy slows. With a slow economy, the unemployment rate will rise as is currently happening in the U.S. If the economy slides into a recession, then employment will actually decline month after month.

Another key impact is profit growth slows - or profits even decline - as the economy slows. We are already seeing declining profits in housing related sectors, and we will probably see declining profits for the financials too. Note: many analysts are arguing S&P earnings will still be strong, even if the U.S. economy slows, because so many earnings are from strong overseas economies. This is part of the "decoupling" debate.

Also, during an economic slowdown, many problems that were hidden during the previous expansion will be exposed. As an example, sales growth will slow at many companies exposing various structural problems - especially in highly leveraged companies. Some of these companies will go bankrupt making investors more cautious, increasing the spread between high and low quality debt. The recent bank failures are an example of a slowing economy exposing problems.

So recessions do matter in that economic activity slows down, but the key point here is that there is very little difference between sluggish growth and a mild recession (my current forecast). There is a significant difference between the current economic environment and either booming growth or a severe recession; however I think both of those scenarios are unlikely in the near future. Even trend growth seems unlikely over the next year.

by Calculated Risk on 10/05/2007 04:37:00 PM

From Jon Lansner at the O.C. Register on Orange County: Late-Sept. home prices at April ‘05 level

DataQuick’s latest sales update reveals a serious disruption to the O.C. housing market created by the mid-summer credit crunch. These new stats — for the 22 business days through Sept. 21 — show an O.C. median selling price of $590,000. If that held for the full month, that would be the lowest since April ‘05. ...

The sales activity news is no better with house buying through Sept. 21 off 36% vs. the ‘06 pace. If that pattern holds for the full month, September will be the slowest selling month since Jan. 1995 (and the second slowest in DataQuick’s 20-year record.)

I think this is how prices will be tracked - comparing the current prices to an earlier date.

Click on graph for larger image.

If we use the OFHEO house price index for Orange County, it would take a drop of 18% from the peak to reach Q2 2005 house prices. The OFHEO index probably excludes most transactions in Orange County because OFHEO only uses repeat transaction below the conforming limit.

DataQuick probably provides a better measure of house prices in Orange County.

by Calculated Risk on 10/05/2007 03:18:00 PM

From MarketWatch: U.S. consumer credit rises in August

Outstanding U.S. consumer debt rose at an annual rate of 5.9% in August, pushed higher mostly by a hefty gain in credit-card debt, the Federal Reserve reported Friday.
...
Revolving debt such as credit cards was the biggest driver behind the overall rise in August, the data show. That debt climbed by 8.1% in August, or by $6.1 billion. In July, credit-card debt rose by a revised 7.4%

by Calculated Risk on 10/05/2007 01:29:00 PM

From Fed Vice Chairman Donald L. Kohn: Economic Outlook. A few excerpts (video of speech at bottom of post).

... Our policy action will not be able to avert all of the weakness in the economy that may be in train for the next several months. Monetary policy works with a lag, and the effects of our easing action will have their maximum effect only after several quarters. In particular, housing markets are likely to remain depressed in coming months as housing demand is restrained by the difficulty in obtaining mortgages and perhaps also by spreading expectations on the part of buyers that house prices will fall, as they already have in a number of markets. And, although builders have reduced housing starts sharply, they have made very little progress in reducing the number of unsold new homes on the market. As a result, even absent a further deterioration in sales, residential construction would probably decline further in the months ahead, imparting a significant drag on overall growth in real gross domestic product.

Beyond housing, it is too early to tell what effect financial market turmoil is having on household and business spending, though very preliminary and partial information suggest that thus far the effects seem to be limited. Moreover, the available data indicate that the economy entered this period still expanding at a moderate pace. For example, consumption held up well this summer supported by solid growth in real incomes. And, the recent data on orders and shipments of capital goods and on nonresidential construction indicated further growth in capital outlays in August. That said, credit availability is likely to be tighter than before, consumer confidence is down, and businesses will probably be a little more cautious for a while, suggesting that these components of aggregate demand could become more subdued in coming months.

... To be sure, households are likely to start to save more out of their current incomes as they come to realize that they cannot count on a rise in the value of their real estate to build their retirement nest eggs. However, households have been surprisingly resilient to recent economic shocks, and any rise in the saving rate probably would be gradual. More generally, consumer spending should continue to be supported by ongoing growth in employment and income. In the business sector, balance sheets are in good shape, and most firms are not likely to face an appreciable tightening of credit availability. As a result, I anticipate that they will expand their investment spending to keep pace with rising household demands and with strength in export markets. In sum, once we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment.

But you should view these forecasts even more skeptically than usual. The FOMC emphasized the considerable uncertainty in the outlook.

... Of course, we would not have eased policy if the outlook for inflation had not been favorable. The recent data on consumer price inflation have been encouraging. ... And, it will be critical for inflation expectations to remain well contained.

That said, I do not want to minimize the upside risks to inflation either. Rates of resource utilization are still relatively high, and the slower rates of productivity growth over the past two years, coupled with a pickup in compensation growth, have led to a noticeable acceleration in unit labor costs. Moreover, the decline in the exchange value of the dollar has put upward pressure on prices of imported goods, which have both direct and indirect effects on overall consumer prices.

Click image for video.

Kohn Says Fed Must Be `Nimble' in Setting Interest Rates: Video October 5 (Bloomberg) -- Federal Reserve Board Vice Chairman Donald Kohn speaks at the Greater Philadelphia Chamber of Commerce Annual Meeting in Philadelphia about the Fed's half-point reduction in the benchmark lending rate to 4.75 percent last month, the outlook for the U.S. economy and the need for policy makers to be "nimble" in setting interest rates. (Source: Bloomberg)

by Calculated Risk on 10/05/2007 12:37:00 PM

From Bloomberg: Homebuilders Liquidate Assets as Threat to Survival Spurs Sales (hat tip Jim)

``It's desperation time and some companies may not make it,'' said Alex Barron, an industry analyst at Agency Trading Group Inc. in Wayzata, Minnesota. ``At this point in the housing cycle, if you have too much debt, it's hard to get out from under it.''
...
``They are all losing money,'' [John Burns, president of John Burns Real Estate Consulting] said.
...
The 15 largest homebuilders are saddled with $7.75 billion in debt due to be repaid through 2009 and the companies' bonds trade as if they were junk ...

The five biggest homebuilders by revenue -- Lennar, D.R. Horton, Pulte, Centex and KB Home -- wrote off a combined $3.3 billion in the third quarter on land they own and will not build on or options to buy land they are choosing not to exercise.

We could make fun of the analysts that claimed the homebuilders would have strong cash flow during a downturn (due to less investment in land and improvements) and that the homebuilders were "land banks". Those investment ideas were Dumb and Dumber!

But the more important point is that the homebuilders struggle to survive shows why the builders are still overbuilding. Building homes, and selling at a deep discount, is the only way they can liquidate land to raise cash and pay down their debts in the current environment. This is why housing starts are still too high and will likely fall further over the next few quarters.

by Calculated Risk on 10/05/2007 09:08:00 AM

From Bloomberg: Washington Mutual Says Third-Quarter Profit Fell 75%

Washington Mutual Inc., the biggest U.S. savings and loan, said third-quarter net income fell about 75 percent because of "a weakening housing market and disruptions in the secondary market."

Loan loss provisions total about $975 million and losses and writedowns on mortgage loans and securities amount to $410 million, the Seattle-based company said in a statement today.

Added: Merrill Lynch Says Credit Market Conditions to Adversely Impact Third Quarter 2007 Results

Merrill Lynch & Co., Inc. today announced that challenging credit market conditions will have an adverse impact on its net earnings for the third quarter. The company expects to report a net loss per diluted share ... resulting from significant negative mark-to-market adjustments to its positions in two specific asset classes: collateralized debt obligations (CDOs) and sub-prime mortgages; and leveraged finance commitments.
...
The primary drivers of the FICC net losses in the third quarter were as follows:

* Write-downs of an estimated $4.5 billion, net of hedges, related to incremental third quarter market impact on the value of CDOs and sub-prime mortgages. These valuation adjustments reflect in part significant dislocations in the highest-rated tranches of these securities which were affected by an unprecedented move in credit spreads and a lack of market liquidity in these securities, which intensified during the third quarter. During the quarter, the company significantly reduced its overall exposure to these asset classes.

* Write-downs of an estimated $967 million on a gross basis, and $463 million net of related underwriting fees, related to all corporate and financial sponsor, non-investment grade lending commitments, regardless of the expected timing of funding or closing. These commitments totaled $31 billion at the end of the third quarter of 2007, a net reduction of 42% from $53 billion at the end of the second quarter. The net losses related to these commitments were limited through aggressive and effective risk management, including disciplined and selective underwriting and exposure reductions through syndication, sales and transaction restructurings.

There appears to be a line at the confessional, also from Bloomberg: JPMorgan, Bank of America May Write Down Buyout Loans

JPMorgan Chase & Co. and Bank of America Corp., the biggest arrangers of U.S. leveraged loans, may have combined markdowns of $3 billion in the third quarter ...

These possible writedowns are because of LBO related pier loans.

by Calculated Risk on 10/05/2007 08:46:00 AM

From MarketWatch: Job growth rebounds to 110,000 in September

Nonfarm payrolls rose by 110,000 in September, including 73,000 in the private sector, very close to expectations of 113,000 total payrolls.

Payroll growth in July and August was revised higher by 118,000, the government said. Instead of falling by 4,000 in August, payrolls rose 89,000 after revisions. The unemployment rate ticked up to 4.7%, the highest in a year. ...

The annual benchmark revision will lower the level of employment by an estimated 297,000 as of March 2007. ... The actual revision occurs in February, but a preliminary estimate is given in October.

Here is the BLS report. Note that the decline in employment in August has been revised away. The unemployment rate increased slightly again and is now at 4.7%.

Click on graph for larger image.

This graph shows the year-over-year change in nonfarm employment. This shows the weak - but not recessionary - job growth over the last year.



Residential construction employment declined 20,000 in September, and including downward revisions to previous months, is down 191.5 thousand, or about 5.6%, from the peak in March 2006. (compare to housing starts off 30%+).

Note the scale doesn't start from zero: this is to better show the change in employment.

The initial benchmark revision shows the loss of an additional 8,000 construction jobs, but the initial report doesn't breakout residential construction.

Overall this is a stronger than expected report. Even the projected downward revision (that will be included in the January report) is smaller than expected.

by Anonymous on 10/05/2007 08:45:00 AM

Because we really needed to know that 47% of you think a professional opinion about cycling vs. jogging or miniblinds vs. drapes or mary janes vs. t-straps is of more value to you than a professional opinion about stocks vs. bonds.

According to the Securities Industry and Financial Markets Association:

Washington, D.C., October 3, 2007 – A majority of adults (53%) would choose to receive financial advice over that of a personal trainer, interior designer or fashion consultant if given the opportunity, according to the findings of a recent survey conducted on behalf of the Securities Industry and Financial Markets Association (SIFMA).

Should you for some reason really care, the question was "If you could have a free consultation session with an expert, which would you choose?" The responses were:

Financial Advisor: 53%
Personal Trainer: 23%
Interior Designer: 9%
Fashion/Style Consultant: 6%
Don't Know: 8%

We have certainly managed successfully to redefine the term "expert." I for one see great opportunities for financial advisors who also offer personal training services. If you could discuss portfolio allocation while teaching yoga--good morning, CR!--you could make a fortune. (I, whose interior design has been described as "presence of the usual items of furniture" and whose fashion has been described as "clothed and shod" and whose major form of aerobic exercise is typing, am angling for the "don't know" crowd.)

by Calculated Risk on 10/05/2007 12:00:00 AM

From the Chicago Tribune: Here's a new one: Being too broke to sell

A survey of mortgage brokers suggests that one in three consumers who recently signed purchase contracts canceled in August -- up from just 4 percent three years ago, according to the research firm that conducted the survey for Inside Mortgage Finance, a trade journal.

The cancellation rate undoubtedly was fed by two scenarios playing out: Many buyers couldn't get mortgage approval because lending suddenly tightened; or, financially strained lenders yanked funding from their borrowers at the last minute.

But another factor was at work: Sellers -- not buyers -- were in trouble as their closing dates neared.

"Our office had four sales in one week that failed to close because the seller didn't have the cash," said the real estate agent, who declined to be identified because she feared office repercussions.

Actually this isn't "new"; if the seller is making the payments - and can afford the payments - the lender won't do a short sale. The only way out is for the seller to bring cash to the closing. I wrote about this in March: Escrow to Seller: "Bring Money". Tanta called this "making your downpayment after the fact."

by Anonymous on 10/04/2007 05:50:00 PM

As a follow-up to CR's post below, here's a chart from the Moody's report, "Subprime Mortgage Market Update: September 2007," released yesterday.

Note that this chart calculates delinquencies as a percent of the original security balance, so these numbers may not match other delinquency measures you have seen reported that are based on current security balances.

And what seems to be driving 2006 and 2007 delinquencies?

The data show that, as we have noted in previous communications, loan performance for the 2006 subprime vintage seems to be driven primarily by the proportions of stated documentation loans and high CLTV loans backing the transactions as well as the proportion of loans that combine (or "layer") these risk characteristics. (Stated documentation loans are those loans for which the borrower's income and assets are not verified by documentation during the loan approval process and therefore are more likely to be overstated.) Interestingly, FICO scores and LTV ratios do not vary significantly between the strongest and weakest performing transactions and on average transaction performance does not appear to have been influenced by these characteristics.