by Calculated Risk on 10/06/2007 05:56:00 PM

From BusinessWeek: Housing: That Sinking Feeling (hat tip seminole83). This article asks if the recent significant price cuts by home builders will shorten the duration of the slump. Here are a few excerpts:

For the first time, big builders are offering massive, often six-figure, price cuts in overbuilt developments nationwide, giving the industry a kind of shock treatment designed to move inventory off the books fast. It remains to be seen whether these radical measures will revive the market or deepen the slump, but it's certainly having an impact on the local communities.
...
The real question is whether the drastic price-cutting will short-circuit the usual long, painful downturn builders seem destined to undergo in this economically sensitive business. ... If by doing so the builders can force the market to accept the reality that housing values have fallen--and accept it fast--there's at least the possibility of emerging from the current bust sooner than in earlier down cycles.
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When builders cut their prices in one fell swoop, rather than letting them drift slowly downward, they in essence force sellers of existing homes to do the same. At the very least, that can be a severe psychological blow that in earlier slumps was absorbed over a period of time rather than all at once. For some homeowners, it's a catastrophic financial blow as well. With new, clearly established market prices, troubled homeowners who paid peak prices will have a harder time refinancing. ... As painful as such situations are, however, the excesses must be wrung out of the market before the sector or the broader economy can recover.
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Homeowners are almost always slower than builders to bite the bullet and cut their asking prices. That's why prices on sales for existing homes haven't dropped as precipitously as prices for new homes. ... The resale market will eventually have to realign--meaning homeowners will have to cut their prices--before the slump can end.
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The current housing downturn and the damage it's inflicting on the overall economy are far from over. With a slew of risky, adjustable-rate mortgages still to reset next year, foreclosure rates could climb even higher. ... "Builders definitely responded more quickly this time, and that's a good thing," says Banc of America Securities analyst Daniel Oppenheim. "But the inventory overhang is so great, it's going to take a long time to work through this. They still have a ways to go before there's a recovery."

Reducing prices is a necessary first step towards a recovery, but the builders are in a trap of their own making: so many builders bought into the "land bank" fallacy during the boom, and those builders now find themselves having to keep building too many homes - and sell them at a loss - just to liquidate land to make their debt payments. This means the builders are still starting far too many homes to make a dent in the current huge inventory overhang.

And the new price realities will put even more existing homeowners upside down in their homes, either trapping them in their homes for years or forcing more distressed property on the market. This will undoubtedly keep pressure on home prices, probably for years.

by Anonymous on 10/06/2007 02:05:00 PM

Advice for all you UberNerds: if your PC is already acting squirrelly, and your dsl connection is slower than usual, it is not a good time to decide to download a giant MIRS dataset from the Federal Housing Finance Board, because three hours later after you've finally restored your system and rebooted in normal mode and retrieved the fragments of your damaged spreadsheet, you will have forgotten what the hell you needed that data for.

This isn't the tune I had planned for today, but under the circumstances it will do.

by Calculated Risk on 10/06/2007 12:34:00 AM

From the WSJ: Merrill's $5 Billion Bath Bares Deeper Divide. This article is mostly about internal issues at Merrill Lynch. A few excerpts:

Merrill Lynch & Co.'s announcement Friday that it would take a $5.5 billion hit to third-quarter earnings is exposing the weak oversight exercised by top Merrill executives as it became a big force in the mortgage-securities business.
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In July, before the market worsened, Merrill's chief financial officer, Jeff Edwards, said in a conference call with investors that the firm's exposure to subprime mortgages was "limited, contained and appropriate."
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Credit-rating agencies maintained Merrill Lynch's current credit ratings but revised the outlook to negative. Standard & Poor's said Friday's announcement "raises concerns over Merrill Lynch's risk-management practices in allowing such a large exposure to build."
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The write-down means Merrill will report a loss of about $450 million, or 50 cents a share, for the third quarter, after showing quarterly operating profits averaging over $2.1 billion for the past four quarters.

Are the problems now behind Merrill and the other banks?

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.
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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.