by Calculated Risk on 4/17/2008 10:12:00 AM

The typical investment pattern is for residential investment to lead the economy into a recession, and then for non-residential investment to slump as the recession starts. The Philly Fed survey this month provides more evidence that the cycle is following the typical pattern (see the special question on capital spending at the bottom of this post).

Here is the Philadelphia Fed Index released today: Business Outlook Survey.

Click on graph for larger image.

This graph shows the Philly index vs. recessions for the last 40 years. There are a number of times the index was below zero without a recession - so the reading today doesn't mean the economy is in recession. However it is very likely that the economy is already in recession.

From the release, weaker conditions and higher prices and lower capital spending:

Indexes Reflect Weaker Activity

The survey’s broadest measure of manufacturing conditions, the diffusion index of current activity, deteriorated from -17.4 in March to -24.9 this month (see Chart). The index has remained negative for five consecutive months
...
Firms Report Higher Prices

A sizable share of the firms continued to report higher prices, both for inputs and for their own products. Fifty-five percent of manufacturers reported higher input prices this month, although the prices paid index edged slightly lower, from 54.4 in March to 51.6..
...
Six-Month Outlook Improves But Remains Cautious

The future general activity index rebounded from a reading of -0.5 in March, rising to 13.7, its highest level in five months.

Special Question on Capital Spending Plans

With regard to capital spending, the percentage of firms indicating that they had decreased their capital spending plans (27 percent) was greater than the percentage indicating they had increased them (19 percent) since January. Moreover, since January, 10 percent of the firms indicated that they had either delayed planned capital spending until later in the year or postponed it indefinitely.

by Calculated Risk on 4/17/2008 09:56:00 AM

From Fed Vice Chairman Donald L. Kohn: The Changing Business of Banking: Implications for Financial Stability and Lessons from Recent Market Turmoil

Setting aside the 100 largest banks, the share of commercial real estate loans in bank loan portfolios nearly doubled over the past 10 years and is approaching 50 percent. The portfolio share at these banks of residential mortgage and other consumer loans, which are more readily securitized, fell by 20 percentage points over the same period.

This is a key point that we've discussed before - the small to mid-sized institutions were not overexposed to the housing bubble because those loans were mostly securitized. Therefore the housing bust led directly to only a few small bank failures over the last couple of years.

However, these same banks have a heavy concentration in commercial real estate (CRE) loans, and also in construction & development (C&D) loans. Now that CRE is weakening - and the C&D loans are coming due - there will probably be a sharp increase in bank failures over the next couple of years.

Concentration risk is another familiar risk that is appearing in a new form. Banks have always had to worry about lending too much to one borrower, one industry, or one geographic region. But as smaller banks hold more of their balance sheet in types of loans that are difficult to securitize, concentration risks can develop. Concentrations of commercial real estate exposures are currently quite high at some smaller banks. This has the potential to make the banking sector much more sensitive to a downturn in the commercial real estate market.

by Calculated Risk on 4/17/2008 09:25:00 AM

From the WSJ: Merrill Lynch Swings to a Loss, Plans to Cut Another 4,000 Jobs

Merrill Lynch & Co. posted ... $6.6 billion in write-downs related to mortgages, complex securities called collateralized debt obligations, and loans made to junk-rated companies. Merrill wrote down another $3.1 billion in mortgage-related securities held at its U.S. banks...

Merrill CEO John Thain, speaking on a conference call with analysts, said the period was "as difficult a quarter as I've seen in my 30 years on Wall Street" and said the next half-year will continue to be difficult.

Merrill makes another visit to the confessional.

by Calculated Risk on 4/16/2008 09:02:00 PM

From MarketWatch: J.C. Penney scales back growth plans

Pointing to a tough economic environment that is clouding its outlook for the year, J. C. Penney Co. said it will open and renovate fewer stores ...

Penney plans to open 36 new stores this year, compared with 50 last year, a reduction that'll save $200 million in capital spending this year ... Total capital spending will drop by about a fifth to $1 billion this year from $1.24 billion...

"I've been in business in 39 years," [Chief Executive Mike Ullman] said. "I don't think I've seen anything as unpredictable. Our entire business is soft because of lack of traffic. We can't give much guidance because there's no visibility."

Company after company has announced scaled back capital spending plans. This will lead to more layoffs - especially in non-residential construction - and further weaken the economy. This is the typical pattern as the economy enters recession.

by Calculated Risk on 4/16/2008 07:19:00 PM

From The Times: Bank close to agreeing plan to end drought in funding for mortgages

It is understood that the Treasury is close to finalising a scheme under which the Bank would allow lenders to swap their mortgage-backed assets for government bonds rather than cash. Lenders would be able to use the gilts as collateral for loans from other banks. It is hoped that the move will ease the seizure in the credit markets and lead to a drop in mortgage rates for homeowners.

by Calculated Risk on 4/16/2008 02:05:00 PM

From the Fed's Beige Book:

Consumer spending was characterized as softening across most of the country, with some Districts reporting year-over-year declines in retail and/or auto sales.
...
Reports on real estate and construction were generally anemic for the residential sector; activity in the commercial sector has slowed.

On Real Estate and Construction:

Housing markets and home construction remained sluggish throughout most of the nation, though there were few signs of any quickening in the pace of deterioration. Ongoing weakness in housing markets, in general, was reported in almost all Districts. ... New residential construction was reported to have remained at depressed levels, and none of the Districts reported any pickup since the last report.

Declines or downward pressures in selling prices were specifically reported in the Boston, New York, Philadelphia, Richmond, Atlanta, Chicago, Minneapolis, Kansas City, and San Francisco Districts. In particular, New York and San Francisco noted some incipient price declines in areas that had previously shown resilience ...

Commercial real estate markets were generally reported to be steady or softening in most areas. ... sales of commercial properties were generally indicated to be sluggish, while prices were said to be under downward pressure. The Boston, Philadelphia, Minneapolis, Kansas City, Dallas, and San Francisco Districts all reported weakness in commercial real estate sales and prices.

Consumer spending and commercial real estate were two of the key areas that helped keep the U.S. economy out of recession for most of 2007. Now that these areas are weakening, this is more evidence that the U.S. economy is now in recession.

by Calculated Risk on 4/16/2008 12:53:00 PM

From the Q&A: (hat tip Brian)

No stabilization in home equity portfolio:

Analyst Question: Just a question on whether you're seeing anything that would give you some signs of stabilization of the loss and delinquency rates in the home equity portfolio?

JPM: No, it's exactly what we saw, higher, more houses are going negative equity, roll rates are high, home prices we expect to still go down. We have not seen it.

And on the deteriorating prime mortgage portfolio:

Analyst: You talked a little bit about prime mortgage and that it's definitely getting worse. But I look at a 48 basis point charge-off ratio on and say that's pretty bad. From that as a base, how much worse do you envision it getting or could it get?

JPM: You know, first of all, the risk factors in prime mortgage are exactly the same as in elsewhere, which is negative home prices, high LTV, things like that, and you know, I think it will probably get a little bit worse and we probably owe you a better answer on that. We did not -- but it's hard in almost all these mortgage areas to say exactly what's going to happen to behavior. You can guess as well as we can what's going to happen to home prices. We expect it will go down another 7, 8, 9% in '08.

And on Credit Card losses:

“Outlook, 4.5 to 5% full year losses trending higher as we get through the rest of the year and probably a little bit of an effect of slowing card spend which is what we've seen in the past couple of weeks.”
all emphasis added

How many companies - from GE to JPM - have said they saw a slowdown in March?

by Calculated Risk on 4/16/2008 11:50:00 AM

San Francisco Fed President Janet Yellen repeated an earlier speech today: The Economy: Where Are We and What Will Happen Next?.

This section is worth repeating:

[R]esearch ... reveals that the single best predictor of subprime delinquency rates is the pace of house price changes. ...

The link between house prices and delinquency rates is not surprising. When house prices have been stagnant or declining, a borrower with a recent mortgage secured with a very small or no down payment has little, if any, equity in the house and, therefore, can’t rely on it to help weather income and wealth stresses like job loss, illness, or divorce. Moreover, though some borrowers may be able to afford their loans, they may decide just to walk away, if, for example, their house is worth less than their mortgage.

I should also note that, while default rates for prime loans are lower than for subprime loans, delinquency rates among all categories are highly correlated with house price declines across the country, whether borrowers are prime or nonprime, or whether loans have fixed or variable rates.
emphasis added

Now that house prices are falling rapidly in many areas, delinquency rates can be expected to increase sharply for all loan categories; prime or subprime, fixed or variable.

by Calculated Risk on 4/16/2008 11:00:00 AM

There is an article this morning in the WSJ suggesting that the LIBOR rate might be too low, possibly because banks don't want to reveal their actual borrowing costs. See: Bankers Cast Doubt On Key Rate Amid Crisis

Here is a description of the LIBOR from the BBA:

Libor stands for the London Interbank Offered Rate and is the rate of interest at which banks borrow funds from each other, in marketable size, in the London interbank market.

The WSJ article suggests that banks are actually borrowing at a slightly higher rate (one estimate is 0.3% higher), but reporting a lower rate to the BBA. This doesn't make much sense to me, since understating their borrowing costs would reduce the banks net interest margin.

The article offers two possible explanations for a manipulated rate: reputation to the bank (banks reporting higher borrowing costs might see a bank run), and banks might be earning more profits from derivatives transactions. Neither seems convincing, but it is possible.

Other measures of the liquidity crisis are definitely showing the third wave is not over.

The TED Spread from Bloomberg: The TED spread has increased to 1.62%.

Note: the TED spread is the difference between the three month T-bill and the LIBOR interest rate. Usually the TED spread is less than 0.5%. The higher the spread, the greater the perceived credit risks (compared to "risk free" treasuries).

by Calculated Risk on 4/16/2008 08:44:00 AM

The Census Bureau reports on housing Permits, Starts and Completions.

Some key points:

Housing permits in March fell sharply to 927 thousand at a seasonally adjusted annual rate (SAAR). This is the lowest since 1991.

Single family housing starts were at 680 thousand SAAR. This is also the lowest since Jan 1991.

Completions are still very high. Privately-owned housing completions in March were at 1.216 million (SAAR). Completions will probably fall to the level of starts - and this will impact construction employment.

Click on graph for larger image.

Here is a long term graph of starts and completions. Completions follow starts by about 6 to 7 months.

Privately-owned housing starts in March were at a seasonally adjusted annual rate of 947,000. This is 11.9 percent below
the revised February estimate of 1,075,000 and is 36.5 percent below the revised March 2007 rate of 1,491,000.

Single-family housing starts in March were at a rate of 680,000; this is 5.7 percent below the February figure of 721,000.

The second graph shows Single family housing starts vs. New Home sales. Single family starts also include homes built directly by owners, in addition to homes built for sale (and some other minor differences).

This graph indicates the difference between single family starts and new home sales has narrowed recently, possibly indicating: 1) that fewer homes are being built by owners, and 2) that single family starts are now low enough to begin to reduce the inventory of new homes for sales.

Another very weak report.