U.S. Economic Outlook Update, Is the Downturn Finally Over, if not, When it will end?
Economics / US Economy Aug 10, 2010 - 08:37 AM GMTBy: Matthew_Ehrlich
Living in Asia for most of the past ten years and having spent another twenty traveling between Wall Street and Asia, I am constantly being asked if the US economic downturn is finally over and if not, when it will end. Not an easy question and if you are going to even attempt to understand my answer, you have to look at some of the MECHANICS of how it started, how it grew, how we got to where we are now and the possible paths to bring about an end.
My short answer to that question has been the same since mid 2008 (in fact, I wrote an article on September 10, 2007, one month before the market peaked explaining what was to come. I would be happy to send it to you if you have not seen it). The key to the question of a recovery, watch the spread between new home and used home (now better know as Bank Foreclosed home) prices, and when that starts to narrow enough for a sane person to by new construction, the beginning of the end will be in sight. Now, let’s look at the mechanics.
The Beginning-
You have to start with the Presidential election of 1992 to fully understand the events that have led up to the Sub Prime crash of 2007 and what needs to happen before we can see a real recovery begin. From 1980 to 1992 the United States experienced relatively good times, the stock market was generally trending up, interest rates were trending down, and unemployment was low. We were coming out 12 years of Republican administrations ( 8 years of Ronald Reagan followed by 4 years of George Bush Sr.) and the voting population were generally satisfied with the way things were going. This satisfaction, was of course bad news for the Democrats, quite simply because there were more registered Republicans than registered Democrats and under this “satisfied” scenario there was no reason for voters to switch parties (like we saw with the anti Bush Jr. vote in 2008). The only chance the Democrats had to get their dynamic candidate, Bill Clinton into the White House was to “find” new voters and of course, get them to vote Democrat. By far, the largest block of eligible voters who were not exercising their right to vote were the minorities and these primarily were concentrated in the inner city black populations. Coming into the 1992 election, an all out effort was undertaken by the Democrats to get these potential voters registered and into the voting booth. This effort was aided by the inherent ideology that it was time these minorities should have more of a say in government. Logically, as a unified voice some change for greater equality and social betterment could be effected. Owing to this combined motivation there were several voter registration projects targeting this specific potential voter segment. Coincidently and as a good example, one of the most effective and aggressive of these minority voter registration drives was in Illinois. As highlighted by an article in the January 1993 issue of Chicago Magazine ‘The number of new voter registrations before the election hit an all time high. And the majority of those new voters were black’. Interestingly, the article goes on to say, ‘None of this, of course, was accidental. The most effective minority voter registration drive in memory was the result of careful handiwork by Project Vote!, the local chapter of a not-for-profit national organization. “It was the most efficient campaign I have seen in my 20 years in politics,” says Sam Burrnell, alderman of the west side’s 29th Ward and a veteran of many registration drives.
At the head of this effort was a little-known 31-year-old African-American lawyer, community organizer, and writer: Barack Obama. The son of a black Kenyan political activist and a white American anthropologist, Obama was born in Hawaii, received a degree in political science and English literature from Columbia University, and, in 1990, became the first black editor of the Harvard Law Review.’ (http://www.chicagomag.com/Chicago-Magazine/January-1993/ )
This nationwide voter registration effort was indeed very effective and in fact was the major deciding factor in putting Bill Clinton in the White House. But, here is where the “Unintended Consequences” begin to take form. When these newly registered voters went to vote, it was for more than the President of the United States, there were also local, regional, State and CONGRESSIONAL candidates to be voted for. This newly empowered segment of the population now had the opportunity to install representatives who were aligned with their interests and desires. In fact, there was another article in 1993, this one in Black Enterprise Magazine in October of 1993, entitled ‘Who is the Black Caucus’ that drives home this very point. This article speaks of the dramatic 50% increase in the number of members of the Congressional Black Caucus as a result of the 1992 election. The article begins,
‘What is the Congressional Black Caucus (CBC)? Who are its members and what do they want? Over the past few months a flurry of mainstream organizations have attempted to analyze the CBC and the impact its 40 members are having on the nation. Publications as diverse as Business Week, the Wall Street Journal and the National Review seem intrigued by the CBC, its leaders, regional strength and bright, new members.
What drives this sudden interest? Speculation points several ways. One group of observers says the CBC’s growth from 26 to 40 members in the 1992 election unnerved whit politicians, political insiders and their constituents.’
While we could do an entire article or an entire book for that matter on the CBC’s ideology, impact and membership, for this article lets just look at the impact of their “affordable housing mission”. In Congressional hearings in September 2003, Congress woman and CBC member Maxine Waters, sums up what happened primarily as a result of the increased power of the Congressional Black Caucus since 1992 as follows,
“since the inception of goals from 1993 to 2002, loans to African-Americans increased 219 percent and loans to Hispanics increased 244 percent, while loans to non-minorities increased 62 percent. Additionally, in 2001, 43.1 percent of Fannie Mae's single-family business served low-and moderate-income borrowers…”
In fact by 1999 the boom in minority home ownership was staggering and the connection between the CBC and Fannie Mae was so intertwined that Fannie Mae actually gave a grant to the Congressional Black Caucus of $500,000.00 to support its 5 year effort to generate an additional one million new minority homeowners. An article in the September 1999 issue of Mortgage Banker reported ‘Fannie Mae's support of the CBCF is part of its Trillion Dollar Commitment to help finance more than 10 million homes for families and communities most in need through the end of the decade.’
That very same month, on September 30, 1999, the New York Times had an article entitled ‘Fannie Mae Eases Credit To Aid Mortgage Lending’ By Steven A. Holmes
( http://www.nytimes.com/1999/09/30/business/fannie-mae-eases-credit-to-aid-mortgage-lending.html )
This is a must read article that clearly lays out the changing qualification requirements and the explosion in Sub-Prime loans and gives a warning of what might happen. The article states, ‘Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.’
Another interesting quote from the article, ''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.''
And a word of caution that was completely ignored, ''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''
All this lays the ground work of how a well intended concept for the betterment and increased opportunities of minorities turned into a feeding frenzy for power hungry politicians and greedy profiteers.
Don’t get me wrong, the entire blame for the housing debacle is not at the feet of the CBC, they only set things in motion. Where there is money to be made and political power to be gained a crowd will gather. In fact in another Black Enterprise Magazine article in October 2002, Daniel R. Brown writes,
‘In an effort to gain the support of minority voters, President George W. Bush recently unveiled his new plan to grow home ownership for people of color. By the end of the decade, Bush hopes to increase minority home ownership--now at 13 million--by 5.5 million to close the gap between the number of minority and Caucasian home owners.”
In what I am sure will be a small but sad footnote in the subprime crisis. Beginning in 2003, the Congressional Black Caucus was promoting the Student Homeownership Opportunity Program (S.H.O.P.). Under the program, $1,000.00 vouchers, or grant letters, were provided by lenders participating in the program. In 2004, JPMorgan Chase, Countrywide, and Pinnacle Mortgage sponsored grants. In 2005, a Congressional Black Caucus Foundation’s initiative, cosponsored by State Farm, Freddie Mac, the National Association of Home Builders, and the ING Foundation, targeted Historically Black Colleges and Universities (HBCUs) and community colleges in CBC member districts. One can only imagine the situation these former students found themselves in a few short years later.
This was of course not the only explosive and uncontrolled area of risky real estate growth. The attractiveness of continually refinancing at lower rates, the ease of second or third homes with little or no money down as rental properties, excessive speculation in rising real estate values, All led to the frenzy of higher prices and more supply .
Housing bubbles come and go, it’s inevitable, almost, like death and taxes and we always recover within a few years. But this time it’s different. The sheer volume of newly created houses, homeowners and the percentage of foreclosures has not merely plummeted values, it has also destroyed employment and that will not allow the economy to rebound any time soon. As I said at the beginning, watch the spread between new home and used home prices.
(At this point I could do a whole book on the offshoots and impact of these programs and products such as CDO’s, MBS’s and the international impact of these products but as I said, this is the short version. Most of the collateral damage from those have already been factored in to the economy and this article is directed toward how and when this might end for the US economy in general)
Why this particular bubble is different
The size and scope of the housing market boom lead by these efforts to build and sell millions of homes to new buyers with reduced qualifications led to an upward shift in the entire housing market. As I wrote in my September 2007 letter, ‘Consider this, for the past several years while the mortgage companies have been fighting to give people money--not so they could be in the mortgage business -- but because they could be in the "derivatives" business of packaging and selling off the bundles of mortgages (regardless of what happens later) not only did it enable the "SUB PRIME" borrowers you see in the headlines every day to get a mortgage to buy their "dream house" but everyone looking for a house got bumped up by the realtor. If you were looking for a $400,000 house they showed you a $500,000 house which they could work out a "special" mortgage deal on so the payments would be about the same --- sure they convinced you that you could afford it with an adjustable mortgage, low payments for the first few years, and besides by the time the rates readjusted you would most likely have a raise or a promotion, and also think of the appreciation in the real estate market (in fact with everyone getting these easy deals prices were soaring and you wouldn't want to miss out on the big bucks would you?). And this was not just with low and medium priced houses it went all the way up’
The competition among buyers with this new purchasing power for the available homes drove prices higher and higher and supply scarcer and scarcer. As prices were bid up from the bottom of the market, existing homeowners whose home values were rising rapidly upgraded to bigger, newer and fancier homes. Mortgage rates were low and dropping, terms flexible and lenders (and mortgage brokers) were falling over each other to write them.
Here is the real heart of the issue. Lets say in 2006, a husband and wife decide to look for a home, they go to the realtor and explain they are a family with 2 children and looking for a 4 bedroom home, about 4,000 square feet, half acre of land. The realtor says great, I have 5 for you to look at all about $300,000. She takes you out and look at all 5, go back to her office and the wife or husband is shaking their head, “nothing I really liked-all a bit old fashioned-hated the kitchen-etc”. The realtor says, yes I understand what you wants. You want a new kitchen, modern bath and to pick your own paint colors. You want new construction. I have 3 I can show you but they are about 10 to 15 percent more expensive. So instead of $300,000 they will be $330,000 to $345,000. BUT, I can get you special ARM financing so the monthly payment will be about the same for the first three years. Done deal, everybody is happy. Now, fast forward to 2008 or 2009. Same scenario, You go to the realtor, looking for a 4 bedroom home, about 4,000 square feet, half acre of land. Now she says, no problem, I have 352 homes I can show you and almost all are bank foreclosures at a great price, about $145,000. By the second day and 80 houses into looking, the realtor sits you down and says, I can see what you want. You want a new kitchen, modern bath and to pick your own paint colors. You want new construction. I have 3 I can show you and the price is down quite a lot from last year, from $340,000 down to $290,000. The price of the new home, although down by about 20% or even 30% is now about double the price of a bank foreclosure of the same specs, lot size, square footage, bedrooms. It is impossible to justify spending double the price, impossible. That, is what makes this real estate bubble different, job destruction. At that point, the chain reaction is unemployment for: carpenters, electricians, roofers, HVAC guys, plumbers and on and on, the entire construction trade is out of work until that spread comes back within a reasonable limit and they can start building new homes again. But, in this economic crisis, as a result of the force fed housing boom of the 1990’s and early 2000’s the sheer quantity of foreclosures sitting on financial institution balance sheets has kept the spread from closing and unemployment high long enough for those same unemployed trades people to add their own non sub prime homes to the distressed real estate market. In addition, these core unemployed building trades people do not have the spending power to support community businesses which in turn have to reduce workers and the downward employment spiral begins. Bottom line, this recession can not end until the new/used home spread narrows enough for people to buy new homes and the currently unemployed building trades go back to work. Forget the idea of retraining, forget the stimulus plans, these people need to go back to work with a steady pay check for the economy to recover. And, the government can’t just throw a few Billion Dollars at the home building industry like they did the Automobile industry, it is too decentralized and there are simply too many cheap foreclosed houses on the market and unfortunately lots more to come.
Again, I can do a whole book on why the effect of unemployment is different this time around and the huge effect debt has on the continuation of this economic crisis. But remember, this is the short version.
(Actually, I have a idea that could dramatically speed up the process. I call it the “Ehrlich Hybrid Home Stimulus Plan” (that name could only fly in Maryland if Bob Ehrlich is reelected Governor, no relation I am aware of). Federal, State and Local governments should grant a tax abatement “stimulus” on the sale of existing homes that apply for and reconstruct a specific percentage of the sale price. In other words, lets say the Federal government sets a minimum reconstruction standard of 25% of the homes resale value to get a federal stimulus grant, then the local/state could set any amount greater than that for an additional tax relief, say keeping the old home tax assessment for 3 to 5 years if the reconstruction value of the remodeling or an added bedroom or new roof is 30% of the sale price. This would both take used home inventory off the market at the same time as getting the building trades back to work.)
Inflation vs Deflation, the other big mistake
Even while having the roadmap of Japan’s great blunder into long term economic disaster. The US went right down the same road (and continues to speed along). Japan has been stuck in the “5 year economic cycle” for the past 18 years. One of the main reasons for this has been the zero interest rate policy. This policy has gorged inventories and impeded their crucial domestic velocity of money. I have been doing business in Japan for over 30 years and I see the parallels between Japan’s mistakes and the current US interest rate policy.
For most businesses, the best returns on capitol are generated through the normal profit margins on sales. Excess cash is invested in various ways to provide some diversification and collateral for financing. In 2007 and 2008, during the initial stages of the economic crisis, most of these investments had disastrous results, stocks, real estate, funds, you name it. Safety for the investable cash reserves became of paramount importance. Unfortunately, with interest rates at near zero and predictions of huge inflation coming from all the money the government was printing deposits short or long term afforded no return. On the other hand, to achieve a traditional return of 7 to 9 percent would involve accepting huge risk, literally 6.5 to 8.5 above the risk free rate of return. So the dilemma is, with anticipated rampant inflation, where best to invest. Let’s say you are in the home products business and a good part of your sales are dishes, you sell one Million Dollars a year of dishes. You make a good margin on dish sales of let’s say 14% to be conservative. With the prospect of rampant inflation from all the money being printed and no other investment that could match the return, in part due to the near zero opportunity loss on the capitol, you call around to your manufacturers to see if you can get a good discount on a three to five Million Dollar order. That represents a three to five year supply of dishes with a potential internal return of 12 to 14 percent with very little loss if interest income and low storage rates. Best investment is into your own business but without the risk of major expansion and hiring and new locations. Simply obtain three to five years inventory instead of one. This is exactly what I have seen in Japan. Where there were storefront electronics shops, there are now full square block 8 story superstores with millions of dollars inventory. This is better than giving your cash to some bank for safekeeping and having to worry about the bank. In fact many stores in Japan pride themselves on not only carrying every model of every make product in their business line but also every spare part and accessory. It is the best use of money when you can not either invest due to risk or deposit due to lack of return.
Several subtle but insidious consequences occur in this scenario. First, it takes about a year into the financial crisis for companies to realize they should follow this route. About one year into the economic crisis, we start to see elation, green shoots, factory orders are way up. The economic crisis is over and happy days are here again. Stock market rallies and the mood is up beat. Confidence comes back and there is a concurrent increase in the ”velocity of money”. This increase in the velocity of money is exactly what the government is trying to achieve. 2007 and 2008 there was the destruction of about 14 Trillion Dollars of wealth between the stock market and real estate values. The government injected about two Trillion Dollars and through cheer leading by the President and confidence building by the treasury, bail outs and stimulus packages the increased velocity on the 2 Trillion might start to synthesize some of the 14 Trillion that evaporated (sounds like smoke and mirrors to me). Here’s where the problems come in. First, the 2 to 4 Million Dollars of dishes sitting in a warehouse stops the velocity on that money cold. Second, one year later, the business headlines read “Factory Orders Decline”. Of course they decline, there is a multi year supply sitting in the warehouse, and next two years the headlines will be about the less well financed manufacturers going bankrupt or being bought out due to no orders again. Add to that, our dish seller offering SALE prices in the weak economy (the hyper inflation never materialized) and you have a deflationary spiral creeping in.
Those of you who have attended my talks over the past two years have heard all of this before but now we are seeing it in the news every single day. More foreclosures, falling housing starts, rising unemployment, declining factory orders, rising inventories, decline in consumer confidence, faltering stock market. The key is employment and urgently getting the home building trades which are in every state, county, city and community of the country (not just Detroit) back to work. A $600 stimulus check does little more than pay for a new cell phone or computer, you can not buy a house with $600, you need a steady pay check.
So, to wrap it up, the short answer is, I believe we are in this economic morass for a long time to come and it will get worse before it gets better. Keep watching the new/used housing spread and interest rates. There are still lots of good investment opportunities out there, especially in Asia and with companies doing business in Asia but you must go much deeper into the evaluations and be a bit abstract in your thinking. China is more than a bit risky at this point. Yes, there is a potential bubble looming but the government’s real goal is to use the current export boom as a tax revenue source to support the acquisition of natural resources and strategic materials. This is a form of hedging for future generations, the current generation is to some degree expendable and if a domestic bubble bursts, so be it, ( I don’t think they would mind showing what capitalism can do without tight government control). It would affect primarily the “Nouveau riche” real estate speculators who have built literally millions of apartments. I would expect, once the point is made the recovery will be quite quick. Another point about China, they can not afford to see a collapse in the value of the Euro. They will find ways to subtly support the weakest of the Euro countries. The last thing they need is for internal Euro zone goods to be competitively priced with Chinese imports.
By Matthew Ehrlich
Email: mattehrlich@msn.com
Matthew Ehrlich is an Economist and financial services professional, with more than 30 years experience on both Wall Street and throughout Asia . Experienced in the full spectrum of investment products including Futures, Hedge Funds, Derivatives, Alternative Investments, Foreign Exchange and Direct Investments. Mr. Ehrlich advises clients throughout Asian, particularly in Japan and Singapore. Mr. Ehrlich has broad and deep relationships with institutions, Exchanges, Banks, Brokerage Houses, High Net Worth investors and Insurance companies throughout the world.
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