by Calculated Risk on 9/14/2009 05:28:00 PM

This is a long excerpt, but worth reading ...

From San Francisco Fed President Janet Yellen: The Outlook for Recovery in the U.S. Economy

I am hugely relieved that our financial system appears to have survived this near-death experience. And, as painful as this recession has been, I believe that we succeeded in avoiding the second Great Depression that seemed to be a real possibility. Much of the recent economic data suggest that the economy has bottomed out and that the worst risks are behind us. The economy seems to be brushing itself off and beginning its climb out of the deep hole it’s been in.

That’s the good news. But I regret to say that I expect the recovery to be tepid. What’s more, the gradual expansion gathering steam will remain vulnerable to shocks. The financial system has improved but is not yet back to normal. It still holds hazards that could derail a fragile recovery. Even if the economy grows as I expect, things won’t feel very good for some time to come. In particular, the unemployment rate will remain elevated for a few more years, meaning hardship for millions of workers. Moreover, the slack in the economy, demonstrated by high unemployment and low utilization of industrial capacity, threatens to push inflation lower at a time when it is already below the level that, in the view of most members of the Federal Open Market Committee (FOMC) best promotes the Fed’s dual mandate for full employment and price stability. ...

I’m happy to report that the downturn has probably now run its course. This summer likely marked the end of the recession and the economy should expand in the second half of this year. A wide array of data supports this view. However, payrolls are still shrinking at a rapid pace, even though the momentum of job losses has slowed in the past few months. The housing sector finally seems to be improving. Home sales and starts are once again rising from very low levels, and home prices appear to be stabilizing, even rising in recent months according to some national measures. Meanwhile, manufacturing is also beginning to show signs of life, helped particularly by a rebound in motor vehicle production. Importantly, consumer spending finally is bottoming out.

A particularly hopeful sign is that inventories, which have been shrinking rapidly, now seem to be in better alignment with sales. That’s occurred because firms slashed production rapidly and dramatically in the face of slumping sales. Recent data suggest that this correction may be near an end and firms are now poised to step up production to match sales. In fact, I expect the biggest source of expansion in the second half of this year to come from a diminished pace of inventory liquidation by manufacturers, wholesalers, and retailers. Such a pattern is typical of business cycles. Inventory investment often is the catalyst for economic recoveries. True, the boost is usually fairly short-lived, but it can be quite important in getting things going. ...

The normal dynamics of the business cycle have also turned more favorable. Some economic sectors are growing again simply because they sank so low. The inventory adjustment I just discussed is one factor, although the biggest part of those benefits usually is only felt for a few quarters. But other business cycle patterns can be longer lasting. Demand for houses, durable goods such as autos, and business equipment is beginning to revive as households and firms replace or upgrade needed equipment and structures.
...
This time though rapid growth does not seem to be in store. My own forecast envisions a far less robust recovery, one that would look more like the letter U than V. ... A large body of evidence supports this guarded outlook. It is consistent with experiences around the world following recessions caused by financial crises. That seems to be because it takes quite a while for financial systems to heal to the point that normal credit flows are restored. That is what I expect this time. ...

Unfortunately, more credit losses are in store even as the economy improves and overall financial conditions ease. Certainly, households remain stressed. In the face of high and rising unemployment, delinquencies and foreclosures are showing no sign of turning around. The delinquency rate on adjustable-rate mortgages is now up to about 18 percent, and, on fixed-rate loans, it’s about 6 percent. Delinquencies on both types of loans have increased sharply over the past year and are still rising. ...

The chances are slim for a robust rebound in consumer spending, which represents around 70 percent of economic activity. Of course, consumers are getting a boost from the fiscal stimulus package. But this program is temporary. Over the long term, consumers face daunting issues of their own. In fact, it’s easy to draw a comparison between the financial state of households and that of financial institutions. For years prior to the recession, households went on a spending spree. This occurred during a period that economists call the “Great Moderation,” about two decades when recessions were infrequent and mild, and inflation was low and stable. Credit became ever easier to get and consumers took advantage of this to borrow and buy. Stock and home prices rose year after year, giving households additional wherewithal to keep spending. In this culture of consumption, the personal saving rate fell from around 10 percent in the mid-1980s to 1½ percent or lower in recent years. At the same time, households took on larger proportions of debt. From 1960 to the mid-1980s, debt represented a manageable 65 percent of disposable income. Since then, it has risen steadily, with a notable acceleration in the last economic expansion. By 2008, it had doubled to about 130 percent of income.

It may well be that we are witnessing the start of a new era for consumers following the traumatic financial blows they have endured. The destruction of their nest eggs caused by falling house and stock prices is prompting them to rebuild savings. The personal saving rate is finally on the rise, averaging almost 4½ percent so far this year. While certainly sensible from the standpoint of individual households, this retreat from debt-fueled consumption could reduce the growth rate of consumer spending for years. An increase in saving should ultimately support the economy’s capacity to produce and grow by channeling resources from consumption to investment. And higher investment is the key to greater productivity and faster growth in living standards. But the transition could be painful if subpar growth in consumer spending holds back the pace of economic recovery.

Weakness in the labor market is another factor that may keep the recovery in low gear for a while. ... While the August employment report offered more evidence that the pace of the decline has slowed, unemployment now stands at its highest level since 1983. My business contacts indicate that they will be very reluctant to hire again until they see clear evidence of a sustained recovery, and that suggests we could see another so-called jobless recovery in which employment growth lags the improvement in overall output. What’s more, wage growth has slowed sharply. Over the first half of this year, the employment cost index for private-industry workers has risen by a meager three-quarters of one percent. Unemployment, job insecurity, and low growth in incomes will undoubtedly take a toll on consumption. When the array of problems facing consumers is considered, it is hard to see how we can avoid sluggish spending growth.

Putting the whole puzzle together, the main impetus to growth in the second half of this year will be inventory investment. The boost it provides will be a big help for a while, but we will need to look to other sectors to sustain growth. The fact that the largest sector of the economy—consumer spending—is likely to be lackluster implies a less-than-robust expansion. Even the gradual recovery we expect will be vulnerable to shocks, especially from the financial sector. As I said, financial conditions are better, but not back to normal. And the likelihood of continuing losses by financial institutions will add new fuel to the credit crunch. In particular, small and medium-size banks could experience damaging losses on commercial real estate loans. Thus far, the largest losses have been on loans for construction and land development. Going forward, however, rising loan losses on other commercial real estate lending is likely because property values are falling, office vacancy rates are rising, and credit remains tight or nonexistent for those many property owners that will need to refinance mortgages over the next few years. Financial contagion from this sector is one of the most important threats to recovery.

The slow recovery I expect means that it could still take several years to return to full employment. The same is true for capacity utilization in manufacturing. It will take a long time before these human and capital resources are put to full use.

by Calculated Risk on 9/14/2009 03:35:00 PM

From CNBC: BofA Execs to Face Charges from NY's Cuomo: Source

Attorney General Andrew Cuomo's office is likely to file civil charges against the executives over their role in failing to alert shareholders to mounting losses as well as accelerated bonus payments at Merrill ...

Earlie today, from Bloomberg: Bank of America Settlement With SEC Over Merrill Bonuses Rejected by Judge

Bank of America Corp.’s $33 million settlement with the U.S. Securities and Exchange Commission over Merrill Lynch & Co. bonuses was rejected by a judge, who said the deal appeared to be a “contrivance” and ordered the case to trial on Feb. 1.
...
“The SEC gets to claim that it is exposing wrongdoing on the part of the Bank of America in a high-profile merger,” [U.S. District Judge Jed Rakoff] wrote. “The bank’s management gets to claim that they have been coerced into an onerous settlement by overzealous regulators. And all this is done at the expense not only of the shareholders, but also of the truth.”
...
“The parties’ submissions, when carefully read, leave the distinct impression that the proposed consent judgment was a contrivance designed to provide the SEC with the façade of enforcement and the management of the bank with a quick resolution of an embarrassing inquiry.”

Ouch. Bad day for BofA - but note that the NY charges will be civil, not criminal.

by Calculated Risk on 9/14/2009 01:36:00 PM

From Shahien Nasiripour at the HuffPost: Unable To Sell Their Houses, Millions Of Homeowners Are Turning Into Landlordsmaybe

Since 2007 about 2.5 million homes have been converted into rentals, according to an analysis performed for The Huffington Post by Foresight Analytics, a real estate market research firm based in Oakland, Calif. The conversions account for about 85 percent of the increase in rental homes.

The numbers are probably higher. As I noted in The Surge in Rental Units

Since Q2 2004, there have been over 4.3 million units added to the rental inventory.
...
Where did these approximately 4.3 million rental units come from?

The Census Bureau's Housing Units Completed, by Intent and Design shows 1.1 million units completed as 'built for rent' since Q2 2004. This means that another 3.2 million or so rental units came mostly from conversions from ownership to rentals.

These could be investors buying REOs for cash flow, condo "reconversions", builders changing the intent of new construction (started as condos but became rentals), flippers becoming landlords, or homeowners renting their previous homes instead of selling.

Note: I've been writing (and joking) about accidental landlords for several years.

From Nasiripour on a prominent accidental landlord:

[A] growing number of homeowners ... have become landlords, often reluctantly, as they struggle to sell during one of the worst housing markets in recent memory. The most prominent example may be U.S. Treasury Secretary Timothy Geithner, who after failing to sell his $1.6 million home in a New York City suburb found tenants instead.

I guess Geithner is holding on for a better market!

by Calculated Risk on 9/14/2009 10:53:00 AM

From the WaPo: Region's Office Space Vacancies Soaring

... property managers for the 1.4 million-square-foot [Constitution Center in Southwest Washington], which is scheduled to be completed in November, have yet to land any tenants ... Constitution Center is just one of several dozen existing, newly constructed or soon-to-be-completed office buildings in the Washington region that had vacancy rates in the 80 to 100 percent range as of midyear.

... In June ... the amount of vacant space in the region soared nearly 24 percent, to 47 million square feet from 38 million during the same month a year earlier.
...
Throughout the region, gleaming new office towers have sprouted, but with few or no tenants: a 275,000-square-foot building at 55 M Street SE in the emerging Capitol Riverfront area of the District; the 230,700-square-foot Piedmont Pointe II and 208,000 Redlands projects in Montgomery County; and the 215,000-square-foot Parkridge Center 6 and 178,000-square-foot Dulles View North in Fairfax County. Many other projects have been put on hold.
...
With many commercial real estate loans coming due soon, some foresee trouble for the region's properties. "We may see the commercial version of the subprime situation," said Steve Silverman, director of the Montgomery County Department of Economic Development.

This is happening all across the country: falling demand and still more office supply coming available as large commercial real estate projects are completed. This means falling rents and property values. And as the construction loans come due, there will be more and more losses for lenders.

And investment in non-residential structures will probably be a drag on GDP (and construction employment) at least through 2010 as projects are completed.

The only good news for the economy is that CRE is a trailing sector (See Business Cycle: Temporal Order).

by Calculated Risk on 9/14/2009 08:44:00 AM

Fed Governor Elizabeth Duke presented some thoughts today on possible accounting changes: Regulatory Perspectives on the Changing Accounting Landscape

... I feel it is crucial that an accounting regime directly link reported financial condition and performance with the business model and economic purpose of the firm. It is difficult for me to comprehend the value of an accounting regime that doesn't make that link.

As a regulator, I focus on the viability of individual financial institutions and the financial system as a whole. To be frank, it has been frustrating to try to assess that viability when the value of an asset is based on the nature of its acquisition rather than the way in which it is managed or the way in which its economic value is likely to be realized.
...
If the business model is predicated on the trading of financial instruments for the realization of value, or other strategies that essentially focus on short-term price movements, then fair value has relevance. In the trading business model, reporting fair value focuses risk management on short-term price movements and in most cases incentivizes management to define the organization's risk appetite and to mitigate risk through hedging or other means. Fair value also incentivizes the entity to raise and maintain capital at a level sufficient to cover the price volatility of its assets. For example, if the business model is an originate-to-distribute model, then fair value has relevance.

In contrast, if the business model is predicated on the realization of value through the return of principal and yield over the life of the financial instrument, then fair value is less relevant. Consider, for example, a bank that finances the operations of a commercial enterprise. The realization of value will come from the repayment of cash flows. Risk management is based on an assessment of the borrower's creditworthiness and the entity's ability to fund the loan to maturity. In this case, the accounting should incentivize the entity to maintain sufficient funding to hold the instrument to maturity and to hold a sufficient amount of capital to cover potential credit losses through the credit cycle, preferably in a designated reserve. Indeed, the use of fair value could create disincentives for lending to smaller businesses whose credit characteristics are not easily evaluated by the marketplace.

Admittedly, some have used the business model argument to manipulate accounting results. But the actions of those entities do not diminish the relevance of the business model to the measurement principle. Indeed, over time if the valuation model is not relevant to the business model, the business model itself is likely to change. Rather, the lesson to be learned from such manipulation is that we--preparers, users and auditors of financial statements--need to be vigilant in evaluating actual business practice, and restrict the use of particular measurement principles to the relevant business models.

To this end, safeguards should be implemented to eliminate a firm's ability to overstate gains or understate losses by switching back and forth between business models or by reclassifying assets from one business segment to another. For example, from a regulatory perspective, assets in a financial institution's liquidity reserve, by their nature, imply utility through sale and, therefore, should be valued at market price.

Take a mortgage loan. If the business model is to hold the loan to maturity, Duke believes the loan should be valued based on future cash flow (considering the creditworthiness and capacity of the borrower). However if the business model is based on trading mortgage loans, then she believes the loan should be valued based on fair market prices.

Duke goes on an discusses the Stress Test accounting and current FASB and IASB discussions.

by Calculated Risk on 9/13/2009 11:22:00 PM

Stephen Mihm at the Boston Globe looks at Hyman Minsky: Why capitalism fails

Amid the hand-wringing ... a few ... commentators started to speak about the arrival of a “Minsky moment,” ... shorthand for Hyman Minsky, a hitherto obscure macroeconomist who died over a decade ago.
...
In recent months Minsky’s star has only risen. Nobel Prize-winning economists talk about incorporating his insights, and copies of his books are back in print and selling well. He’s gone from being a nearly forgotten figure to a key player in the debate over how to fix the financial system.

But if Minsky was as right as he seems to have been, the news is not exactly encouraging. He believed in capitalism, but also believed it had almost a genetic weakness. Modern finance, he argued, was far from the stabilizing force that mainstream economics portrayed: rather, it was a system that created the illusion of stability while simultaneously creating the conditions for an inevitable and dramatic collapse.

In other words, the one person who foresaw the crisis also believed that our whole financial system contains the seeds of its own destruction. “Instability,” he wrote, “is an inherent and inescapable flaw of capitalism.”

Minsky’s vision might have been dark, but he was not a fatalist; he believed it was possible to craft policies that could blunt the collateral damage caused by financial crises. But with a growing number of economists eager to declare the recession over, and the crisis itself apparently behind us, these policies may prove as discomforting as the theories that prompted them in the first place. Indeed, as economists re-embrace Minsky’s prophetic insights, it is far from clear that they’re ready to reckon with the full implications of what he saw.

An interesting overview of Minsky. And this sure sounds like the recent credit bubble:

As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers - what [Minsky] called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further. As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit.

And since the failure of many economists to see the coming crisis is being widely discussed, here is a quote from Minsky on macroeconomics:

“There is nothing wrong with macroeconomics that another depression [won’t] cure."

by Calculated Risk on 9/13/2009 06:49:00 PM

From Bloomberg: Stiglitz Says Banking Problems Are Now Bigger Than Pre-Lehman (ht Ron Wallstreetpit)

... “In the U.S. and many other countries, the too-big-to-fail banks have become even bigger,” [Joseph] Stiglitz said in an interview today in Paris. “The problems are worse than they were in 2007 before the crisis.”
...
“It’s an outrage,” especially “in the U.S. where we poured so much money into the banks,” Stiglitz said. “The administration seems very reluctant to do what is necessary. Yes they’ll do something, the question is: Will they do as much as required?”

And on the economy:

"We’re going into an extended period of weak economy, of economic malaise,” Stiglitz said. The U.S. will “grow but not enough to offset the increase in the population,” he said, adding that “if workers do not have income, it’s very hard to see how the U.S. will generate the demand that the world economy needs.”

The Federal Reserve faces a “quandary” in ending its monetary stimulus programs because doing so may drive up the cost of borrowing for the U.S. government, he said.

“The question then is who is going to finance the U.S. government,” Stiglitz said.

Stiglitz also wrote a comment in the Financial Times: Towards a better measure of well-being and I think this comment is very important:

Too often, we confuse ends with means. ... a financial sector is a means to a more productive economy, not an end in itself.
excerpted with permission

by Calculated Risk on 9/13/2009 01:11:00 PM

Kenneth Harney discusses the credit impact of various mortgage choices: Mortgage problems are walloping Americans' credit scores

For example, loan modifications that roll late payments and penalties into the principal debt owed on the house can actually increase borrowers' scores modestly. Refinancings of underwater, negative-equity mortgages ... may have little or no negative effect on scores ...

However:

... short sales can trigger big drops in credit scores. ... strategic defaults [lead to even larger credit hits] "plus negative marks on their credit bureau files for as long as seven years." ... People who file for bankruptcy protection covering all their debts (mortgage, credit cards, auto loans, etc.) will get hit [the hardest]. Bankruptcies remain on borrowers' credit bureau files for 10 years.

Harney has some data on the sharp overall decline in credit scores.

Most of these changes -- fewer people with excellent credit, more people in the lowest brackets -- have been caused by late payments on home mortgages, serious delinquencies, short sales and foreclosures ...

One of the tragedies of the housing / credit bubble was that many people bought homes before they were financially ready - or bought homes they could not afford. Now many of these people will be soured on the home buying experience, and their credit scarred for years.

And there will also be another group of people who make their payments, and keep their "excellent" credit scores, but will be stuck with their underwater homes for years.

by Calculated Risk on 9/13/2009 10:30:00 AM

The "everyone was doing it" excuse ...

“Yes, we spent too much money. Of course we made mistakes. We made the same mistakes that everyone else has made across the country,’’
Roland Fahnbulleh Jr., [a Pequot tribal member].

From the Boston Globe: The wonder, and the fall (ht Lisa)

... casinos rode the wave of easy credit to success in the years leading up to the recession, and Foxwoods was no exception. The Pequots, who had to go to Malaysia to fund the initial $60 million casino because no one else would lend to them, soon had banks lining up with loan offers as Foxwoods raked in customers - and their cash. The tribe quickly expanded the resort, adding hotels, restaurants, and shops to the complex, which now stands at 4.7 million square feet, nearly 20 times its original size. The Pequots also spent big to acquire nearby businesses and invest in other industries, such as shipbuilding -an expensive effort that later flopped.
...
But by the time the MGM Grand at Foxwoods debuted in May 2008, the recession was well underway, and gambling receipts were dipping sharply nationwide. ... Now, the shimmering tower stands as a symbol of excess, with unbooked rooms, empty stores, and a sparsely populated gaming floor.

This has some interesting twists because many of the employees are members of the tribe and have lost their jobs. Plus there are payouts to the tribe members ... but the rapid expansion, with too much debt, are common stories.

by Calculated Risk on 9/12/2009 10:56:00 PM

From Bloomberg: Fed Failed to Curb Flawed Bank Lending, Inspector General Says (ht Stephen, others)

Federal Reserve examiners failed to rein in practices that led to losses from excessive real estate lending at two banks in California and Florida that later closed, the central bank’s inspector general said.

Riverside Bank of the Gulf Coast in Cape Coral, Florida, “warranted more immediate supervisory attention” by the Atlanta district bank, Fed Inspector General Elizabeth Coleman said in a report to the central bank’s board. In overseeing County Bank in Merced, California, the San Francisco Fed should have taken a “more aggressive supervisory” approach, Coleman said in another report, also dated Sept. 9.

Riverside Bank was closed in February 2009 by the Florida Office of Financial Regulation. The FDIC DIF is estimated to have lost $201.5 million from the failure of Riverside, or about 38.5% of assets (not an unusually high loss percentage in this cycle, see this sortable table).

Here is the report from the Inspector General: Material Loss Review of Riverside Bank of the Gulf Coast

Inspector General Coleman suggested that there should have been "more immediate supervisory attention" in 2007.

Based on our analysis of Riverside-Gulf Coast’s supervision, we believe that emerging problems observed during a 2007 visitation provided FRB Atlanta with an opportunity for a more aggressive supervisory response. Specifically, FRB Atlanta noted a significant decline in the local residential housing market and observed that new appraisals indicated that the value of certain collateral, particularly developed lots ready for construction, declined by as much as 70 percent. In addition, examiners observed that Riverside-Gulf Coast could no longer sell mortgages in the secondary market and, therefore, would be required to hold and service these loans.

"Emerging problems" in 2007? I strongly believe that action should have been taken much sooner - at least by 2005 - because of 1) concerns about the housing market, and 2) the concentration of loans in residential real estate. From the report:

Historically, Riverside-Gulf Coast focused on growth through real estate lending in its local service area, a business strategy that created concentrations in both the type of loans and the geographic location. In general, local real estate concentrations increase a financial institution’s vulnerability to cyclical changes in the local market place and may elevate a bank’s safety and soundness risk. Examiners noted that Riverside-Gulf Coast experienced rapid growth during its first six years when the bank’s total assets grew approximately 40 percent annually, to $275 million as of December 31, 2003.
...
Riverside-Gulf Coast’s concentration in real estate loans ranged between 92 and 98 percent of total loans during 2003 to 2008. The bank’s real estate portfolio included traditional one-to-four family mortgages and home equity lines of credit. In addition, a substantial number of Riverside-Gulf Coast’s real estate loans, such as those for residential construction, were categorized as CRE because repayment was dependent on the rental income, sale, or refinancing of the underlying collateral.
emphasis added

The signs of excessive risk were apparent in 2003 to 2005. The Fed is aware of the risks, especially of a high growth strategy with a high loan type concentration. If the regulator was unable to step in sooner and evaluate the risk, then the regulatory process is flawed - and the regulator has already failed. It was too late by 2007.

The inability of the Federal Reserve and the Inspector General to recognize the need for tighter supervision in 2005 or earlier is a serious oversight failure.