Wednesday, October 22, 2008


More details of what has become a worldwide ‘bailout’ of financial institutions are emerging. Are we seeing the return of Roosevelt’s New Deal for the U.S. version, at least? Governments are actually taking ownership of many of the troubled financial entities that caused the subprime debacle. The European Union and United Kingdom recently announced that their governments would not only guarantee bank deposits and interbank lending between banks, but offer unlimited amounts of dollars to commercial banks as well!

As if to reinforce this perception, this year’s Nobel Prize in economics was just awarded to Paul Krugman, not only a ‘liberal” (his words) economist, but author of “The Great Unraveling”, which documented the attempt by conservatives to dismantle the New Deal, including privatization of social security.

The New Deal was based on a new economics of that time, formulated by Britain’s Lord Keynes, a British economist and expert on financial markets. He postulated that governments should intervene not only during wartime, but bad economic times to prime the economic pump. It should cut spending during good times, on the other hand, so that inflation and excess consumption would not take place. His most famous work was “The General Theory of Employment, Interest and Money” published in 1936.

“…there will be no means of escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidize new investment,” said Keynes. “Formerly there was no expenditure out of the proceeds of borrowing that it was thought proper for the State to incur except for war. In the past therefore, we have not infrequently had to wait for a war to terminate a major depression. I hope that in the future we shall not adhere to this purist financial attitude, and that we shall be ready to spend on the enterprises of peace what the financial maxims of the past would only allow us to spend on the devastations of war.”

Since the Roosevelt Administration governed during the worst of times—the Great Depression and World War II—it created massive government programs to support the economy, as well as modern financial regulation, the FDIC, housing programs and social security. More than 6,000 banks were re-capitalized with government funds at that time, according to historians. It was as much as is being spent today, in real terms.

Today, we find that history is repeating itself. The U.S. government is having to push back against the excesses created by too little government, as in the 1930s—especially too little regulation of financial markets. But no one thinks we will return to the monolithic measures of the New Deal, when there were fewer private institutions to spur economic growth.

Modern economic theory reflects this mix of private and public enterprise. We now know that so-called ‘free’ markets don’t work without regulations, for instance. Financial institutions do not regulate themselves, as Alan Greenspan and other classical economists believed. But private capital markets—such as bank deposits, pension and insurance funds—are now the best providers of jobs, not governments.

We also know why the markets collapsed after the subprime and housing meltdowns. Banks and consumers took out too much debt. But few will talk about the why. Fareed Zakaria,. Newsweek’s International Editor in chief, tells us that governments wouldn’t or couldn’t raise taxes to cover their increased spending. That is why the federal government now owes $10.2 trillion, whereas it owed just $3 trillion in 1990.

And consumers continued to spend, even though ‘real’ (after inflation) household incomes have been falling for decades. Household debt ballooned from $680 billion in 1974 to $14 trillion today. The average household now has 13 credit cards, and 40 percent of these carry a balance, up from 6 percent in 1970. In fact, consumers spent $800 billion more than they earned just in 2007.

The current financial dilemma is therefore a wakeup call for both government and consumers to spend within their means.

© Harlan Green 2008


“The U.S. Federal Reserve and other major central banks moved in concert to slash key interest rates as part of an ongoing effort to quell financial turmoil that has threatened to flatten the international economy”, was the headline event last week.

Why such an unusual move, and will the rate cuts continue? "Incoming economic data suggest that the pace of economic activity has slowed markedly in recent months," the Fed said in its statement. "Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit."

European banks were also worrying about their balance sheets. The Bank of England as well as EU, Swiss, Swedish, and Canadian Central Banks also cut their rates one-half percent. Rates were cut simultaneously to protect their currencies, since individual countries cannot lower interest rates without devaluing their currencies internationally.

The U.S. Fed lowered their overnight rate to 1.5 percent to stimulate consumer spending for the holiday season. One reason for the Fed’s action was that consumer credit had shrunk in August for the first time since January 1998, while retailers have been making gloomy predictions for the rest of the year.

What this might do for housing is still in question. But the Pending Home Sales Index, a forward-looking indicator based on contracts signed in August, rose 7.4 percent to 93.4 from an upwardly revised reading of 87.0 in July. The index is now at the highest level since June 2007, which might augur an improvement in existing-home sales.

Lawrence Yun, NAR chief economist, said home buyers were responding to improved affordability. “What we’re seeing is the momentum of people taking advantage of low home prices, with pending home sales up strongly in California, Nevada, Arizona, Florida, Rhode Island and the Washington, D.C., region,” he said. "It’s unclear how much contract activity may be impacted by the credit disruptions on Wall Street, but we’re hopeful most of the increase will translate into closed existing-home sales.”

Builders are also beginning to build smaller homes in order to increase affordability, for the first time in this writer’s memory. Los Angeles-based KB Homes had shrunk its homes from 3,400 square feet, selling for $450,000, to 2,400 square feet selling for $300,000 to appeal to buyers. Now, it's shrinking its homes yet again--1,230 square feet priced at about $200,000.

Other builders, including Warmington Homes and John Laing Homes, have taken similar approaches. “We're getting back to more the way things were historically, kind of undoing the excesses, not just from a price perspective but home size and (fewer amenities)," says Nishu Sood, a Deutsche Bank analyst.

The new KB Homes aren’t just smaller, they are more efficiently designed, says Steve Ruffner, president of KB Home's Southern California Coastal Division. "You could have a three-bedroom, 2,500 square-foot single-story home and all you had was wide hallways and bigger rooms. It wasn't really giving [buyers] the utility," Ruffner says.

The Federal Reserve has to print more money for as long as it takes to get banks lending again. Though the unemployment rate remained at 6.1 percent in September, jobs were lost in all sectors of the economy. That means extending unemployment insurance benefits for at least another 13 weeks.

U. S. and European governments are in effect nationalizing their banking systems to keep them solvent. We are seeing a return to Roosevelt’s New Deal. This also means we taxpayers will now have an ownership share in the banks that have been rescued, in order to guarantee repayment of those $ billions in government loans.

© Harlan Green 2008


What is the economic definition of a recession, and does it really matter? Pundits tell us that by the time it becomes a headline, the recession is almost over. There is some truth to that, as most of the indicators used by the National Bureau of Economic Research (NBER) Business Cycle Dating Committee to determine recessions are somewhat esoteric and not in the public eye.

One of the four indicators used by the NBER does get public notice, however—the unemployment rate. The current decline in employment began in January, and the other 3 indicators—real personal incomes, industrial production, and real manufacturing and sales—began their declines in October to December. In past recessions the jobless rate has been the last to decline, because businesses are usually reluctant to cut jobs until they are sure the decline is prolonged. So one can say that the national recession began in January.

What does that mean regionally? In fact, parts of the rust belt—Indiana, Michigan, and Ohio for starters—have been in a recession for years. Michael Moore’s films have highlighted the blight of Flint, Michigan in particular, his home town. But manufacturing jobs have been moving overseas for years and those states’ economic growth has been shrinking concurrently.

In a recent Santa Barbara News-Press business Roundtable, the consensus was that Santa Barbara and the south coast are weathering this downturn well. This is in part because Santa Barbara is such a desirable place in which to work and live (if one can afford to live here). And local jobs are predominately in the service sector of the economy—in tourism, education and healthcare—which have been the fastest growing segments of the economy in this decade.

There is now general agreement that we are either already in a national recession, or entering one. The question is for how long? The $700 billion ‘mortgage rescue package”, as I call it, will be a big step in arresting the real estate downturn, and hence the banks’ credit crunch that is beginning to affect small businesses who have most of the jobs.

But that is only if the U.S. Treasury verifies there is clear title to the mortgages it is buying. Lenders will attempt to offload the worst of them to the taxpayers, of course. It is the slicing and dicing of the subprime mortgages in particular, in an attempt to make them look better than they are, that is partly responsible for the current troubles. It is causing more foreclosures and delaying so-called ‘workouts’, since borrowers many times cannot find the real owner of their mortgage to negotiate with!

No one knows the value of the distressed mortgages at present or the ultimate cost of the mortgage rescue, as I said in last week’s column. The S&L bailout cost taxpayers $125 billion, after the RTC had disposed of all its assets. The amount of distressed mortgage debt could total $1 trillion this time, out of a total $9 trillion in outstanding mortgage debt.

But real estate has historically been the first sector to lead us out of a recession, according to UCLA Anderson School economist Ed Leamer. So curing the mortgage debt problem is a big first step towards a recovery.

© Harlan Green 2008


Regardless of the politics, why is Treasury Secretary Paulson (with the support of Fed Chairman Bernanke) in a hurry to buy up $700 billion in “distressed” debt? Paulson maintained in congressional testimony that it was to take bad loans off banks’ ledgers so that they would be able to lend again. But there is a much more serious reason, and it springs from the “Japanese lesson” of the 1990s.

It was Bernanke—in a little-noticed aside during his testimony—who said we didn’t want to repeat the “Japanese” experience. For those who don’t remember the 1990s, Japan experienced a 10-year deflationary spiral because their real estate and stock market bubbles burst almost simultaneously.

During that period, the interest rates on their cost of funds actually became negative. And that also happened in the past week with the U.S. Treasury’s 1-month bills, raising fears of a “liquidity trap”. This is the specter haunting the U.S. Treasury and Federal Reserve. When interest rates go to 0, it means all lending has ground to a halt, in a word. Investors have decided to park their monies in U.S. Treasury securities instead, the ultimate safe haven.

When this happened in Japan in the 1990s, it resulted not only in lost business and investor profits, but even reduced wages for Japanese workers that brought consumer spending to a screeching halt. And their 10 years of basically no growth made Japan no longer the feared economic competitor it had been in the 1980s.

Secretary Paulson’s rescue package will be helpful if structured correctly. It all depends on the ultimate cost to the Treasury, of course. Bernanke maintained that although $700 billion might be needed to purchase the bad debts—and might include all manner of consumer loans, as well as mortgages—they could hold the debts to maturity and thus be able to sell them for much more.

No one knows the value of the distressed mortgages at present, in part because the values of the underlying homes haven’t stabilized. Also, the amount of distressed mortgage debt could total $1 trillion, out of a total $9 trillion in outstanding mortgage debt. That means a lot more foreclosures could happen. But home prices should still remain above 2000 levels, according to most projections, which means a majority of homeowners might retain some of their equity.

It was because of the Japanese deflation that the Federal Reserve under Alan Greenspan advocated the record low interest rates of 2001-03 that brought us out of the 2001 recession. He (and Bernanke who was Fed Vice Chairman at the time) continually cited the Japanese reluctance to act quickly in writing off bad debts and closing down bankrupt entities.

There were other reasons for the Japanese deflation. The interlocking ownerships of banks-owning real estate-owning stocks made them reluctant to write off bad loans and close down insolvent institutions. They kept putting good money after bad money, in other words, which crowded out credit and capital needed for healthy businesses to grow.

That is the real danger we have now, in the eyes of Paulson and Bernanke. Hence the need for urgency in solving our credit crunch. The collapse of AIG, Lehman Brothers, Bear Stearns, combined with the failures of several banks, has left the government with few other options than to print as much money as is necessary to prevent the D words, the depression and deflation that might surely follow.

© Harlan Green 2008


What was behind the government bailout of Fannie Mae and Freddie Mac? It wasn’t because they were too big to fail. It was because they were too important to fail, which many pundits do not like to recognize. In fact, how quickly they begin to show a profit again, after approximately $40 billion in losses to date, will determine when real estate recovers as well.

Fannie Mae was established during the Great Depression—Freddie Mac in the 1960s—to keep the housing market afloat, just as they are doing today. They have bundled and sold approximately $4 trillion in mortgages to investors while holding $1 trillion in their own portfolio. Because of their stricter underwriting standards, their default rate is less than 2 percent, where it is more than 4 percent for all conventional loans.

Why did they grow so big? Because banks are inconstant lenders, as I highlighted in an earlier column of the same name. Banks will lend during the good times, but not when they are in trouble as now with the subprime debacle. This has always been so, beginning in the 1930s, but also in the early 1980s when interest rates rose so fast that many banks and S&Ls stopped originating mortgages altogether.

Banks today are in trouble because of their short-term memories, for one. A recent New York Times article pointed out how quickly banks and regulators forgot the lessons learned from the Long Term Capital Management (LTCM) bailout on 1998 that cost banks and taxpayers billions of dollars.

LTCM failed because of their reliance on credit derivatives, in a word. The Nobel prize-winners who set up its trading model had not programmed into their computers how hedging mechanisms such as derivatives could bring down whole markets, in part because they were unregulated. This is while Fed Chairman Greenspan went on record as opposing their regulation.

Fannie/Freddie’s business model—that of a Government Sponsored Enterprise (GSE)—is what got them into trouble, especially with conservatives. They are a private stock corporation with some preferred tax treatments in order to keep their cost of funds low. The preferred treatment (banks had tax benefits in holding their debt, for instance) was passed on to the mortgage holders with lower interest rates—usually one-quarter percent below jumbo rates.

But the fact that they also had stockholders and so had to show a profit irritated conservatives who believe in privatizing even essential government services. That jumbo rates have soared more than one percent above conforming rates is a testament to the success of the GSE model, and the broken jumbo mortgage market.

© Harlan Green 2008

Friday, October 3, 2008


The S&P/Case-Shiller composite index of 20 metropolitan areas slipped 0.5 percent in June from May, bringing the measure down 15.9 percent from June 2007. But the June price index was actually an improvement.Why? The 0.5 percent month-over-month drop in the 20-city index was the smallest since July 2007. And in June, nine of the 20 cities tracked showed home price increases compared with seven in May, and just two in April, S&P/Case-Shiller said.

The California Association of Realtors (CAR) also reported that home sales soared 43 percent in July, year-over-year. This was in part because median existing-home prices had fallen 40 percent, and 30 percent plus of sales were either REOs or short sales. Buyers are flooding back into the market. And the "C.A.R.’s Unsold Inventory Index for existing, single-family detached homes in July 2008 was 6.7 months, compared with 10 months (revised) for the same period a year ago," said the CAR.

While this does not signal an end to the housing recession, it does show that home prices are back to affordable levels. Nationally, existing-home sales rose 3 percent in July, though the 11-month inventory of homes on the market wasn’t reduced. This means that there is still a tremendous backlog of surplus homes on the market waiting to sell in places like Arizona and Florida, including bank-owned properties and short-sales.

New-home sales also showed a slight improvement, up 2.4 percent in July. New-home inventories improved, falling slightly from 10.7 to a 10.1-month supply. The reason is fairly simple. Builders are offering more incentives, including money to buy down the interest rates. The median-sales price is now down 6.3 percent to $230,700 from July 2007, according to the Commerce Dept.

Existing-home sales – including single-family, townhomes, condominiums and co-ops – increased 3.1 percent to a seasonally adjusted annual rate of 5.00 million units in July from a downwardly revised level of 4.85 million in June, but are still 13.2 percent lower than the 5.76 million-unit pace in July 2007.

And the national median existing-home price for all housing types was $212,400 in July, down 7.1 percent from a year ago when the median was $228,600. So the price bottom may not have been yet reached. Economists are saying that only a continuation of sales’ increases will cause prices to stop falling—maybe by the end of the year.

© Harlan Green 2008


The recent plunge in crude oil price futures—at $108 per light sweet barrel at this writing—will help us in many ways. It is one of the main causes of the economic slowdown, since it has taken so much out of consujmers’ pocketbooks as it boosted inflation to double-digit levels, the highest levels since the early 1980s, according to CBS Marketwatch economist Irwin Fellner.

Why are oil prices falling? The U.S. dollar is rising in value—especially against the euro and English pound. And since most oil producers are paid in dollars, a higher dollar value viz other currencies means lower dollar prices for foreigner’s oil.

The dollar is rising in value because other economies are slowing down, which makes the U.S. economy look better. Growth in Germany, Japan and Great Britain has turned negative, while U.S. second quarter economic GDP (domestic) growth was just revised upward from 1.9 percent to 3.3 percent—close to the 75-year growth average.

So this is a chain reaction of sorts that will benefit consumers and real estate as well. A strengthening dollar and lower inflation will keep the Federal Reserve from raising interest rates anytime soon, for one thing, as some inflation hawks have been calling for.

This also strengthens the balance sheets of our ailing banks, because it keeps their cost of funds low. And as banks’ profits increase, they will be able to originate more mortgages again. Real estate lending is down more than 50 percent, according to the Mortgage Bankers Association from its high point in 2005.

Where is our economy at present? We are probably bumping along at the bottom of this recession. Yes, it will officially be called a recession that begun around last November; probably sometime next year after the turnaround has begun. The end of the 2001 recession in November (yes, one month after 9/11) wasn’t called under 11 months later.

This means real estate sales are beginning to stabilize as well. The S&P Case/Shiller index of 20 metro areas is the broadest indicator of regional prices. The number of metro areas with home prices beginning to increase has increased steadily for the past 3 months, as we have said. This hasn’t yet put a dent in inventories, however.

But the wild card is the mortgage industry. Fannie Mae and Freddie Mac are about to be taken over by the Federal government, with details yet to be revealed. The scuttlebutt is that it will make mortgages cheaper. This should give a big boost to real estate, needless to say, since they now buy and package for investors more than 70 percent of all mortgages. And when the new $625,500 loan limit for a single unit kicks in in January, we presume 2-4 unit loan limits will also rise.

I believe we can look to 2009 with some optimism. Mortgage rates have been trending down of late with oil prices. The conforming 30-year fixed rate had briefly dipped to 5.875 percent last week, and the ‘jumbo-conforming’ amount (to $729,750) was just 6.125 percent—both with a 1 point origination fee. They should continue downward once the Fannie/Freddie rescue package is in place. This will bring many more home buyers into the market that has home prices already down some 16 percent, along with oil prices and inflation, of course.

© Harlan Green 2008