by Calculated Risk on 10/11/2009 04:45:00 PM

From Paul Krugman: When should the Fed raise rates? (even more wonkish)

Let me start with a rounded version of the Rudebusch version of the Taylor rule:

Fed funds target = 2 + 1.5 x inflation - 2 x excess unemployment

where inflation is measured by the change in the core PCE deflator over the past four quarters (currently 1.6), and excess unemployment is the different between the CBO estimate of the NAIRU (currently 4.8) and the actual unemployment rate (currently 9.8).

Right now, this rule says that the Fed funds rate should be -5.6%. So we’re hard up against the zero bound.

Suppose that core inflation stays at 1.6% (although in fact it’s almost sure to go lower.) Then we can back out the unemployment rate at which the target would cross zero, suggesting that tightening should begin: it’s an excess unemployment rate of 2.2, implying an actual rate of 7 percent. That’s a long way from here. ...

This is all back-of-the-envelope stuff - and maybe NAIRU or core inflation will be a little higher (although I think core inflation might be lower next year because of declining owners' equivalent rent).

If we use Krugman's analysis, and the recent CBO projections for the average annual unemployment rate (10.2% in 2010, 9.1% in 2011, and 7.2% in 2012), the Fed would not raise rates until some time in 2012.

Last month I wrote:

Click on graph for larger image in new window.

This graph shows the effective Fed Funds rate (Source: Federal Reserve) and the unemployment rate (source: BLS)

In the early '90s, the Fed waited more than a 1 1/2 years after the unemployment rate peaked before raising rates. The unemployment rate had fallen from 7.8% to 6.6% before the Fed raised rates.

Following the peak unemployment rate in 2003 of 6.3%, the Fed waited a year to raise rates. The unemployment rate had fallen to 5.6% in June 2004 before the Fed raised rates.

Although there are other considerations, since the unemployment rate will probably continue to increase into 2010, I don't expect the Fed to raise rates until late in 2010 at the earliest - and more likely sometime in 2011.

Maybe 2011. Or maybe 2012. But talk of a rate hike in early 2010 seems crazy ...

by Calculated Risk on 10/11/2009 12:41:00 PM

Edward Robinson wrote a recent article for Bloomberg on the rise of independent research: ‘Sell’ for Research Renegades Becomes Business Off Wall Street (ht Eyal)

One of the analysts featured in the article is Ivy Zelman, formerly at Credit Suisse, and now at Zelman & Associates. Ms. Zelman became an internet favorite when she asked Toll Brothers CEO Bob Toll "Which Kool-aid are you drinking?" on the Q4 2006 Toll Brothers conference call.

On Zelman's current view:

Many of her clients are clamoring to know whether the market has hit bottom. In terms of prices, she says probably not: One out of three owners has a mortgage worth more than the value of the home, and mounting foreclosures and distressed properties are slated to account for 53 percent of home sales in 2010 compared with 40 percent in 2008, according to Moody’s.

“When that inventory hits the market, it’s going to undermine prices,” she says.

Although I think prices might have bottomed in some low end bubble areas at the end of 2008, or early 2009 - because of the flood of foreclosures at that time - some of these areas have seen prices increase 10% to 15% since then (according to local reports). This is because of a combination of a buying frenzy associated with the first time home buyer tax credit, and the lack of inventory because of foreclosure delays associated with the trial modifications. It is not unusual for homes in these areas to receive 20, 30 or 50 bids.

Even if the first time home buyer tax credit is extended, I think the interest will wane. Meanwhile the banks are preparing to start foreclosing again. The WSJ recently quoted a Bank of America Corp. spokeswoman: "We are going to see a spike from now to the end of the year in foreclosures as we take people out of the running" [for a loan modification].

So I expect prices in the low end areas to decline again (even if the bottom is in). I also expect further price declines in the mid-to-high end bubble areas. Note: this isn't like in 2005 when I thought large price declines were inevitable. House prices are much closer to the bottom now, and the U.S. government is trying to support house prices, or at least slow the rate of price declines.

by Calculated Risk on 10/11/2009 09:45:00 AM

“I don’t think it’s a bad thing that the bad loans occurred. It was an effort to keep prices from falling too fast. That’s a policy.”
Barney Frank, chairman of the House Financial Services Committee on recent FHA lending, quoted Oct 9th, 2009 in the NY Times.

"I believe the intent of the FTHB [first time home buyer] credit (and any extensions) is to raise the floor on home prices to delay (and sometimes prevent) defaults, reducing the shock to the financial system."
reader picosec in email, Oct 2nd, 2009

And a couple more quotes from an article by Alan Heavens in Philadelphia Inquirer: Skeptics question housing recovery :

"Government intervention to date has been extremely helpful in preventing an even more dramatic decline in home prices."
John Burns, real estate industry consultant

The housing market "is showing improvement only because it is on government life support."
Mark Zandi, Economy.com

As Representative Frank notes, the policy of the U.S. appears to be to support asset prices at almost any cost. This includes:

The FHA insuring "bad loans" for buyers with a high probability of default.

The first-time home buyer tax credit (the FTHB makes no sense from any other economic perspective).

Delaying foreclosures, first with moratoriums and then with "trial modifications".

We could probably include the Fed buying GSE MBS to lower mortgage rates, and other policies like increasing the "conforming loan" limit to $729,750 in high cost states.

Intentionally encouraging loans with high default rates (insured at taxpayer expense), and the FTHB tax credit (especially allowing buyers to use the credit as a down payment) have stimulated demand. And delaying foreclosures has restricted supply.

This has had the desired effect of pushing up asset prices, especially at the low end.

It is "a policy", but is it a good policy?

by Calculated Risk on 10/10/2009 10:35:00 PM

From David Cho at the WaPo: Steep Losses Pose Crisis for Pensions

The financial crisis has blown a hole in the rosy forecasts of pension funds that cover teachers, police officers and other government employees, casting into doubt as never before whether these public systems will be able to keep their promises to future generations of retirees.
...
Within 15 years, public systems on average will have less half the money they need to pay pension benefits, according to an analysis by Pricewaterhouse Coopers. Other analysts say funding levels could hit that low within a decade.

After losing about $1 trillion in the markets, state and local governments are facing a devil's choice: Either slash retirement benefits or pursue high-return investments that come with high risk.
...
Some pension experts say the funding gap has become so great that no investment strategy can close it and that taxpayers will have to cover the massive bill.

The problem isn't limited to public pension funds; many corporate pension funds have lost so much ground that they are also pursuing riskier investments. And they, too, could end up a taxpayer burden if they cannot meet their obligations and are taken over by the federal Pension Benefit Guarantee Corp.
...
In Ohio, for instance, the teachers pension system reported that it would take 41 years for its investments to catch up with the costs of meeting its obligations to retirees. That was before the worst of the financial crisis.

During the last fiscal year, Ohio's fund lost 31 percent. Its most recent annual report detailed how long it would now take for its investments to put the fund back on track. Officials simply said: "Infinity."

Infinity!

Also check out the Time magazine cover story: Why It's Time to Retire the 401(k).

... at the end of 2007, the average 401(k) of a near retiree [55-to-64-year-old] held just $78,000 — and that was before the market meltdown.

by Calculated Risk on 10/10/2009 05:45:00 PM

From Eric Dash at the NY Times: Small Banks Failure Rate Grows, Straining F.D.I.C.

A few numbers from the article:

... About $870 billion, or roughly half of the industry’s $1.8 trillion of commercial real estate loans, now sit on the balance sheets of small and medium-size banks like these, according to an analysis by Foresight Analytics, a research firm. ... And as a group, small banks have written off only a tiny percentage of the losses that analysts expect them to incur.

In fact, applying only the commercial real estate loss assumptions that federal regulators used during the stress tests for the big banks last spring, Foresight analysts estimated that as many as 581 small banks were at risk of collapse by 2011.

By contrast, commercial real estate losses put none of the nation’s 19 biggest banks, and only about 5 of the next 100 largest lenders, in jeopardy.
....
[Gerard Cassidy, a veteran banking analyst] projects that as many as 1,000 small banks will close over the next few years and that their losses will be more severe. “It’s a repeat [of savings and loan crisis] on steroids,” he said.

This gives us a ballpark feel for the coming CRE losses. Local and regional banks are exposed to about $870 billion in CRE loans. Not all of the loans will go bad, and the loss severity will be far less than 100%. So the losses may be in the $100 to $200 billion range; small compared to the residential mortgage losses, but still very significant.