State of the Economy Part II
From The Daily Capitalist
This is Part II of my three part series on the state of the economy going into 2010. Part I appeared yesterday, and Part III will appear tomorrow. This weekend I will combine the three parts into one downloadable PDF.
The Importance of Debt
The Fed, the Obama Administration, and a Democrat-controlled Congress are doing everything they can to prevent a recovery by delaying or preventing the liquidation of debt on the books of financial institutions.
In a credit-induced business cycle, such as this one where the Fed pumped vast amount of money into the economy (1.0% Fed Funds rates), some asset goes crazy. This time it was real estate, residential first and then commercial real estate. It led to an unprecedented explosion of debt--worldwide. This fake money expansion directed capital into bad investments as we've sadly learned.
There is a reason banks have tightened credit: they are worried about their capital base because they have too much bad debt on their books related to real estate. If they lend the money out, they worry that they might need it to cover their existing bad debt if things get even worse, so why take the risk and lend, they reason.
The Administration is doing everything they can to prevent debt write-downs because they fear the ongoing debacle in commercial real estate and its impact on the banking system. Last year they approved new FASB Rule 115, a de facto suspension of-mark-to-market accounting for loan portfolios which artificially inflates a bank's Tier 1 capital base. Banks are undercapitalized; ignore the (not so stressful) stress tests.
Recently the FDIC adopted new "extend and pretend" rules that say if the lender believes that the borrower can still pay the loan, regardless of the value of the asset relative to the amount of the loan, they can ignore valuations and not have to reserve for the loan. This gives lenders no incentive to write loans off, so they remain on their books. Ever optimistic real estate investor-borrowers are happy to extend in order to avoid huge income tax hits as a result of debt relief.
The Big Freeze
The Fed has tried to induce liquidity by buying GSE residential mortgage backed securities, a $1.25 trillion program that will end in April. The net effect was to take about $1.55 trillion of RMBS out of the market. In essence, private debt was off-loaded to the public. A side effect is that they have monetized Treasury debt yet they have not improved the credit markets. At some point the Fed will have to sell them back to the market in order to tighten credit (a part of the so-called "exit strategy").
None of these programs have loosened bank credit. The vast majority of small(er) business banking in America is not done by the giants, but rather by regional banks. And the regional banks are the ones holding most of the bad commercial real estate loans. They are facing massive write-offs, a deteriorating capital base, and so they hold their capital close.
The point here is that banks will restrict lending until their loan portfolios and balance sheets are cured. The cure will be to raise more capital in order to improve their Tier 1 capital ratios and write down debt.
This explains why banks are sitting on large "excess" reserves and why we don't have inflation.
This is the Monetary Base/M1 conundrum: the Fed has opened the monetary sluice gates (Monetary Base) to combat the credit crunch, yetmoney supply (M1) is declining. Why? Because there isnothing "excess" about these reserves: they are held by banks for business reasons--as a reserve against future problems. The result is that banks aren't lending and credit is not reaching the economy and money supply is declining. This is aninternational phenomenon.
This won't change until banks deleverage.
Deleveraging
In a recent report by McKinsey Global Insight, "Debt and Deleveraging: The global credit bubble and its economic consequences," they conclude that deleveraging will start about now in the U.S. In their study of 32 world financial crises since the Great Depression, the average period of deleveraging lasts about 6 to 7 years. The biggest GDP slowdowns are in the first two or three years of develeraging and the average hit to GDP is 25%. (See chart and more, below.)
What this means is that without deleveraging, we will catch the "Japanese Disease": economic stagnation.
Banks are now realizing that commercial real estate is not getting better. I don't believe lenders will wait too much longer in spite of the government's effort to prevent it. We need to carefully watch bank balance sheets, credit conditions, and money supply.
Commercial Real Estate and Liquidity
Commercial real estate is killing regional banks.
Unpaid loans on malls, hotels, apartments and home developments stood at a 16-year high of 3.4 percent in the third quarter and may reach 5.3 percent in two years, according to Real Estate Econometrics LLC, a property research firm in New York. That’s a bigger threat to regional banks, which are almost four times more concentrated in commercial property loans than the nation’s biggest lenders, according to data compiled by Bloomberg on bailout recipients.
“Community and regional banks basically became real estate banks in the past 25 years, and now real estate is on its back,” said Jeff Davis, an analyst at FTN Equity Capital Markets Corp. in Nashville, Tennessee. “The largest banks have other areas where they can make money, be it consumer lending, capital markets and asset management.”
A new report by Standard & Poor said:
Even though most highly exposed banks with weaker balance sheets are already rated below investment grade, more downgrades are possible; indeed, approximately 75% of the rated banks with the largest exposure to CRE carry negative outlooks ... We see no reason to believe the impact of this credit cycle in CRE will be less severe in terms of losses banks incur than that of the 1990s. ...
About 40% of rated banks' CRE loans are made for construction, acquisition, and development purposes, of which 22% (or 8% of total CRE loans) are for residential construction ... nonperforming loans in the homebuilding sector to rise to 18% as of Sept. 30, 2009. Homebuilder-related net charge-offs rose steeply to an annualized run rate of 4.8% for third-quarter 2009.
Non-residential commercial construction loans have gone sour as the fundamentals in those markets deteriorated ... office vacancies reached 17.3% as of third-quarter 2009, and C.B. Richard Ellis (CBRE) estimates they will go to 19.5% in 2010, higher than the peak of 18.9% in 1991. Likewise, retail vacancies, currently at 12.3%, are headed to 12.9% per CBRE estimates, versus 11.3% in 1991. Multifamily vacancies are at 7.4%, versus 7.0% in 1991. Nationally, rents for offices are down substantially more than in 1991--by 15.7% versus 9.4%. This time around, a particular trouble spot is the hotel sector, especially the casino hotel sector, where overbuilding has been a factor. The occupancy rate for this asset class is a low 60.9%, a level last seen after Sept. 11, 2001. Nationally, rents for offices are down substantially more than in 1991--by 15.7% versus 9.4%.
And,
A whopping $585 million of CMBS loans were liquidated in December, the largest monthly volume of liquidations ever. Special servicers, facing growing workloads, have become far more active in disposing of the loans they're handling. Meanwhile, CMBS delinquencies continued to climb, hitting a rate of 5.22 percent.
And,
The FDIC recovered $497.3 million, or [only] 29.6% of the face value of commercial real estate loans it sold during the third quarter. ... That's the lowest recovery rate the agency has had since its whole-loan sales program got into high gear late last year ... In contrast, the agency's recovery rate was 54.7% for the 2,487 loans sold in the second quarter, according to FDIC data.
I don't mean to beat this issue to death, but from a report prepared by Property and Portfolio Research (PPR):
"Due to government intervention, the concept of distressed selling and buying did not materialize anywhere in North America [in 2009]," said Mark E. Rose, chairman and CEO of Avison Young in Chicago. "The U.S. government put money into the major banks, which in turn extended every loan they could to avoid realizing losses. The Securities and Exchange Commission watched from the sidelines and allowed the impacted lenders to postpone the inevitable."
PPR predicts that by Q2 2010 lenders will more aggressively write off "distressed" CRE loans. That will attract lots of deal capital waiting on the sidelines. If so, then deleveraging will have begun.
Residential Real Estate
Residential real estate gets the award for "Most Bubbly Asset of the Great Recession!" This is where the river of Fed credit flowed, aided by loose lending standards encouraged and institutionalized by Congress, Fannie, Freddie, and the FHA. Wall Street, using faulty risk models, wrapped it up and sold it worldwide. They fooled themselves for years until they realized they couldn't spin dross into gold.
Rising prices fed the bubble, debt skyrocketed, homeowners pulled cash out and went on a spending spree. This spawned the boom in retail which spawned the boom in shopping centers. Which has collapsed. The boom was fake; hundreds of thousands of residences built were a huge malinvestment of capital. This is when the damage was done. The bust is the cure.
The residential real estate market is still deleveraging, price deflation goes on, and sales are up: "For all of 2009, there were 5.16 million home sales, up 4.9% from 4.91 million in 2008. It was the first annual sales gain since 2005." Much of that increase was due to the first-time buyers' tax credit which some say was responsible for 400,000 of sales. Starting in November, sales have tanked (down 16.7% in November for previously owned homes).
Regardless of sales, prices keep falling. People may be motivated by tax credits, but mostly I believe they are driven to the market by falling prices. Political reports say that the tax credit will not be extended. The most recent Case-Shiller 20 cities report showed prices declining 5.3%. Some areas are stabilizing (Dallas, Denver, San Diego and San Francisco) but Las Vegas was down 25% taking the average down.
I believe bargain hunting will continue to occur and sales will continue to rise. Here in California, housing supply has shrunk to a 5-year low (3.8 months). The GSE's and the FHA are providing massive amounts of credit to the mortgage market and I don't see this stopping anytime soon.
What will prevent a new bubble, and cap prices, for at least this year is the shadow inventory--potential foreclosures. About 1 in 4 homeowners are underwater:
The proportion of U.S. homeowners who owe more on their mortgages than the properties are worth has swelled to about 23%, threatening prospects for a sustained housing recover. ... Nearly 10.7 million households had negative equity in their homes in the third quarter, according to First American CoreLogic, a real-estate information company based in Santa Ana, Calif. Home prices have fallen so far that 5.3 million U.S. households are tied to mortgages that are at least 20% higher than their home's value, the First American report said.
There could be 3 million foreclosures this year, up from last year's 2.8 million.
Here are a few more points to consider:
US 2009 foreclosures shatter record despite aid
More Homeowners Struggling As Option ARMs Reset Higher
'Shot in the Arm' or Shot in the ARM?
US Prime Jumbo RMBS Delinquencies Nearly Triple to 9%; CA Drives Trend
This is threatening the financial integrity of the FHA:
In last year's third quarter, the FHA insured 25% of mortgages, according to Inside Mortgage Finance, a trade publication…. FHA-insured mortgages made in 2007 and 2008 are largely responsible for the agency's precarious position, with default rates approaching 24%. ...
The government's plans to help beleaguered homeowners is falling flat because they aren't requiring lenders to write down mortgage principal, or require a renegotiation of secondary home equity mortgages. It takes homeowners about 3 seconds to figure out that even with lower payments, there is no point paying for a home when the value is less than the amount of the loan.
If there were 5.16 million home sales in 2009, without the boost from a tax credit and with a substantial shadow market, expect prices continue to fall moderately. Sales will continue to increase as people search for bargains. The FHA and the GSE's will provide ample credit for the mortgage market. The government announced in December they were giving Fannie and Freddie unlimited guarantees for the next three years; they have thus nationalized them.
There is one more factor to consider about residential real estate: homeownership rates are declining (Megatrend No. 5). At the end of 2009 the homeownership rate fell to 67.3% from the high of 69%. "Between 2007 to 2009, nearly four million homes were lost to foreclosure. And home ownership rates are now moving closer to the level that was common in the 1990s."
A recent study from the NY Fed concluded, "This [negative equity] situation is likely to put downward pressure on future homeownership rates, and has potentially important implications for the maintenance of the housing stock, the stability of neighborhoods, and future household saving behavior.
The residential real estate market is deleveraging and the government can do nothing to prevent it.
See Part III tomorrow
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