by Calculated Risk on 9/07/2007 12:07:00 AM

From MarketWatch: Turmoil could take months to resolve, Paulson says

"There have been real strains in the capital markets and across some of the credit markets," Paulson told the Nightly Business Report on PBS. "And I think this will take a while to play out, and almost certainly over time this will have an impact on our economy."

"It's certainly going to be into the weeks, maybe a number of months," he said. .... Paulson said the economy would pay a "penalty," but insisted that the U.S. and global economies were "very strong."

Paulson said estimates of 2 million foreclosures are exaggerated.

by Calculated Risk on 9/06/2007 01:11:00 PM

Look at the economic data today: weekly unemployment claims were mild, the ISM non-manufacturing index was a solid 55.8 (see Bloomberg: Services Expand More Than Forecast), retail was decent (see the WSJ Retailers Post Generally Strong Sales), and auto sales rebounded in August (see Econbrowser: August auto sales).

What's going on?

Let's take a step back and look at residential investment, what Professor Leamer (IMO correctly) calls the best and most important leading indicator for the economy. Note: I take a slightly different approach than Dr. Leamer, see the graphs in his paper for more: Housing and the Business Cycle

Click on graph for larger image.

The first graph shows the YoY change in real residential investment (RI) since 1948. The general rule is that RI is falling before a recession, usually by more than 10% YoY in real terms.

There are two glaring false positives on the chart, with RI falling significantly but no recession. OK, three false positives if the U.S. economy doesn't slide into recession soon!

In the early '50s, with RI falling, the economy didn't slide into recession because of the buildup for the Korean War. And, in the mid '60s, it was the buildup for the Vietnam war that offset the decline in RI.

There are also two glaring false negatives with the economy entering recession without RI leading the way: the first in the mid '50s that was related to reduced Korean War DoD spending, and the '01 recession that was related to the stock market and business investment bust.

These false positives and false negatives show that we can't blindly rely on this chart. As an example, some people ask about the RI mini slump in the mid '90s. At that time, in late '94, I didn't consider the RI slump significant. The following graph shows why:

In late '94, RI was just coming out of a slump and was already very low as a percent of GDP.

Compare the level of RI as a percent of GDP in '94 vs. the level today. Even though RI has fallen significantly, RI as a percent of GDP is still well above the median of the last 50 years, and far above the normal cycle lows.

With falling RI, what will keep the economy out of recession this time? Hopefully not a serious buildup in defense spending. Professor Leamer suggests that a recession will be avoided because the manufacturing sector will not see a serious slump - mostly because manufacturing never recovered from the '01 recession.

My view is that there are two factors keeping the U.S. economy out of recession right now: 1) strong consumer spending (or personal consumption expenditures "PCE") and 2) strong non-residential investment in structures.

I believe the strong PCE numbers are related to homeowners extracting significant amounts of equity from their homes in recent years. The following graph (based on data from Dr. James Kennedy at the Fed) show mortgage equity withdrawal (MEW) since 1991 through Q1 2007 (Q2 data will be available soon).

Note: this data is based on the mortgage system presented in "Estimates of Home Mortgage Originations, Repayments, and Debt On One-to-Four-Family Residences," Alan Greenspan and James Kennedy, Federal Reserve Board FEDS working paper no. 2005-41.

This graph shows the MEW results, both in billions of dollars quarterly (not annual rate), and as a percent of personal disposable income.

Although MEW has been declining over the last few quarters, research suggests that MEW is spent over several quarters following extraction. So the impact on PCE from declining MEW should start soon.

Professor John N. Muellbauer presented a paper at the Jackson Hole Symposium on the impact of the housing wealth effect, and the availability of easy credit, on consumer spending: Housing, Credit and Consumer Expenditure. Muellbauer argues that the empirical evidence suggests that declining home prices and less home equity extraction will significantly impact consumer spending.

With the credit crunch, MEW will probably decline sharply in Q3 (after rebounding in Q2). This will impact PCE over the next several quarters.

And the other key driver of the U.S. economy has been non-residential investment, especially investment in structures. This is the typical pattern: first a boom in residential investment, followed by a boom in non-residential structures. But unfortunately, a bust in residential is usually followed by a bust in non-residential structures (with a lag of 5 or so quarters).

The final graph shows non-residential investment in structures as a percent of GDP. In earlier periods ('60s and '70s) a larger portion of GDP was spent on non-residential structures. In the '80s, there was a boom in investment as part of the S&L debacle (loose lending standards led to over investment in non-residential structures).

There is an argument that the over investment in the '80s led to an extended period of underinvestment in structures in the '90s. These structures are non-perishable, so over investment in one period can definitely lead to underinvestment in another period. There was another slump following the stock market bust, and, according to this argument, investment in non-residential structures has just returned to normal levels.

Although the above argument has some merit, I think there was an investment shift in the late '80s and early '90s, with certain structures being built overseas, and also less of a need for other structures because of improved communications. With non-residential investment, as a percent of GDP, now above the peak of the business boom in the '90s, I expect a slowdown in non-RI structure investment.

Because of MEW (and related strong PCE) and strong investment in non-RI structures, the slowdown in residential investment has not, as yet, led to a recession. With RI taking another significant downturn, MEW declining and non-RI slowing, the next several quarters are probably the most vulnerable to an economic recession.

by Tanta on 9/06/2007 10:23:00 AM

Via Marketwatch:

CHICAGO (MarketWatch) -- The number of mortgage loans entering the foreclosure process in the second quarter set another record, according to the latest data from the Mortgage Bankers Association.

According to the group's quarterly delinquency survey, a seasonally adjusted 0.65% of loans on one- to four-unit residential properties entered the foreclosure process during the period, the highest level in the survey's 55-year history. In the first quarter, when the previous record was set, 0.58% of loans entered the process; a year ago, 0.43% entered the process. . . .

According to the survey, 1.40% of all outstanding loans were somewhere in the foreclosure process during the second quarter, up from 1.28% in the first quarter and 0.99% a year ago.

The delinquency rate for mortgages on one- to four-unit proprieties was 5.12% in the second quarter, up from 4.84% in the first quarter and 4.39% a year ago.

by Tanta on 9/06/2007 09:29:00 AM

From USA Today:

Until recently, many Americans, like Chou, took advantage of their homes' value to lighten their credit card debt. Since 2001, more than $350 billion in card debt has been shifted into home-equity loans or into mortgages refinanced by homeowners, says Robert Manning, a finance professor at Rochester Institute of Technology. . . .

From 2000 to 2006, the average card debt carried by Americans grew from $7,842 to $9,659, according to CardTrack.com. That totals $850 billion in credit card debt for 88 million Americans, it says.

So credit card outstanding balances grew by ~20% at the same time that ~40% of it was rolling into the home equity book?

by Tanta on 9/06/2007 07:43:00 AM

This CPDO thing is a great test of whether media reports make any sense, because they have nothing to do with mortgages or any other form of consumer debt or any gems of Western Literature or seventies rock classics. Therefore I know nothing about them except what I read in the papers.

According to Bloomberg,

Constant proportion debt obligations use credit-default swaps to speculate that a group of companies with investment- grade ratings will be able to repay their debt. A wave of credit rating downgrades for investment-grade companies may cause losses that CPDOs would struggle to recoup, CreditSights said in a report entitled ``Distressed CPDOs: We're Doomed!''

``If you assume defaults and downgrades come in bunches rather than being evenly spaced out, CPDOs' default rates are more what you would expect for low junk ratings than for triple- A,'' David Watts, a CreditSights analyst in London, said in a telephone interview yesterday. . . .

CPDOs were first created last year by banks ranging from Amsterdam-based ABN Amro Holding NV, the largest Dutch lender, to New York-based Lehman Brothers Holdings Inc. . . .

The securities earn an income by selling credit-default swaps, a type of insurance contract that pays a buyer face value if the borrower can't meet payments on its debt. CPDOs typically provide debt insurance on a basket of 250 investment-grade companies by using the benchmark CDX North America Investment- Grade Index and the iTraxx index in Europe. The indexes rise when credit quality deteriorates.

OK, that all more or less makes sense, I guess. It's a big world, so there would have to be some people who would take the other side of a bet on whether investment-grade companies will pay their debts. But then:

Moody's and S&P assign their top credit ratings to CPDOs because of rules designed to ensure they never have to pay a debt insurance claim.

Ooooh Kaaaay. Can someone help me with the economic purpose of a form of insurance that involves rules that insure that claims never have to be paid? Of course we all love a good risk-free investment, but, um, who buys this "insurance"? Why? Have we just stumbled onto a major problem with our finance-based economy, or should I just go back to bed?

by Calculated Risk on 9/06/2007 12:22:00 AM

This is a story (sorry no link) that is of interest because the economists at Bear Stearns have been among the most bullish on Wall Street.

Bear Stearns economists have lowered their forecast for U.S. growth, and are now forecasting U.S. real GDP growth at 1.5% in Q4 2007, and 1.25% in the first half of 2008, with a 35% chance of recession. As a comparison, here is an excerpt from their June forecast:

"We're maintaining our forecasts for ... more [than 3% real GDP growth] in the second half of 2007, a decline in the unemployment rate, one or two Fed hikes in the second half, and a somewhat stronger dollar as the Fed shift toward hikes becomes apparent."

Now they are forecasting unemployment to "rise above 5%" in 2008. They also expect "incremental weakness" in consumption and commercial construction. They must be reading this blog!

Imagine what the more bearish economists are thinking.

by Calculated Risk on 9/05/2007 08:32:00 PM

From the WSJ: Countrywide Cuts 900 More Jobs

Countrywide Financial Corp. announced another 900 job cuts as the company slashes costs in the face of a drop in lending volumes and rising defaults.
...
On Wednesday, Countrywide said the 900 layoffs were mainly in its mortgage-production divisions. ...

The company's work force totals around 60,000.

Every rumor I heard seemed to increase the number of job cuts. Nine hundred is still a large number, especially if you are 1 of the 900.

by Calculated Risk on 9/05/2007 07:02:00 PM

NOTE: This graph is from ADP and shows total private employment based on ADP and BLS reports (in thousands). Both reports are currently showing around 115.5 million employed (SA). Ignore the "change" label on the side of the ADP graph.

The following graphs compares the ADP vs. the BLS reports.

Click on graph for larger image.

ADP August Employment Report

Nonfarm private employment grew 38,000 from July to August of 2007 on a seasonally adjusted basis, according to the ADP National Employment ReportTM.

This month’s ADP National Employment Report suggests that a deceleration of employment may be underway. The August increase of 38,000 was the smallest since June of 2003 and the second consecutive weak monthly reading.

Last month ADP wasn't close to the BLS data for private sector employment. Still, this is the second consecutive month with the ADP report showing weak employment gains for the private sector. Last month the ADP report showed private sector employment increased by 48,000; the BLS report showed the private sector increased 120,000.

Perhaps the BLS is missing the turning point.

by Calculated Risk on 9/05/2007 02:45:00 PM

From the Fed's Beige Book:

Reports from the Federal Reserve Districts indicate that economic activity has continued to expand.
...
Most Banks reported that the recent developments in financial markets had led to tighter lending standards for residential mortgages, which was having a noticeable effect on housing activity, and several noted that the reduction in credit availability added to uncertainty about when the housing market might turn around. While several Banks noted that commercial real estate markets had also experienced somewhat tighter credit conditions, a number commented that credit availability and credit quality remained good for most consumer and business borrowers. Outside of real estate, reports that the turmoil in financial markets had affected economic activity during the survey period were limited.
emphasis added.

And on Real Estate and Construction:

Residential real estate and construction weakened further in most Districts while the commercial market remained steady. Most Districts reported weak or declining residential sales and declining or stable prices. Markets in a few Districts did show some strength. Both sales and prices have been increasing in the Massachusetts housing market; the New York City apartment market remains tight as rents rise; and home sales rose in Louisville. Inventories of unsold homes are generally reported to be high. Moreover, contacts in Philadelphia, Cleveland, Richmond, Atlanta, Chicago, Kansas City, and Dallas believe softness in the market will continue in the near future, with potential for further declines.

Commercial real estate and construction markets were generally stable to expanding across the Districts. Philadelphia, Minneapolis, and San Francisco indicated continued expansion in nonresidential construction and commercial real estate. Dallas described the level of nonresidential activity as high, and St. Louis said commercial construction remained strong. New York, Cleveland, Richmond, Atlanta, Chicago, and Kansas City indicated commercial construction and real estate markets were steady or stable. Vacancy rates are reported to be low or declining in most Districts, and rents are rising modestly in many. Boston, New York, Richmond, Chicago, Kansas City, and Dallas noted some tightening of credit in the commercial real estate market.

by Calculated Risk on 9/05/2007 12:23:00 PM

From Bloomberg: Commercial Real Estate in U.S. Poised for Price Drop (hat tip Brian, Ryan)

U.S. commercial real estate prices may fall as much as 15 percent over the next year in the broadest decline since the 2001 recession as rising borrowing costs force property owners to accept less or postpone sales.

``People aren't willing to do deals right now,'' said Howard Michaels, the New York-based chairman of Carlton Advisory Services Inc., ... ``The expectation is that prices will come down.''

Investors in July bought the fewest commercial properties since August 2006 and apartment building acquisitions were down 50 percent from June, data compiled by industry consultants at New York-based Real Capital Analytics Inc. show. ...

``There are so many deals falling apart,'' said David Lichtenstein, chief executive officer of Lakewood, New Jersey- based Lightstone Group, an owner of more than 20,000 apartments and 30 million square feet of office and retail space. ``People who can get out are getting out.''

More hints of an impending slump in CRE.