Tuesday, December 2, 2008

Will Millenium Generation Save Economy?

1 unit - $603,750 2 - $772,900 3 – $934,250 4 - $1,161,050

First, note the 2009 conforming loan limits for 1-4 residential owner and non-owner residences for Santa Barbara County. Los Angeles and Ventura Counties’ conforming limits are higher. Conforming interest rates are back to their 2003 lows, while jumbo rates are much higher because that secondary market is still frozen. I predict this boost in loan limits should give a tremendous boost to real estate sales and values next year.

And, it is now official. The National Bureau of Economic Research (NBER) has pronounced December 2007 as the start of this recession. It was an easy call that I made several columns ago, since most of their indicators began to decline in November 2007. But the NBER folk being overly cautious, waited until now to be sure it wasn’t a temporary decline in business activity.

When will it ‘officially’ end? The NBER’s Business Cycle Dating Committee probably won’t tell us for at least another year. My prediction is that we will see an uptick in business activity beginning in the New Year. That doesn’t mean we will feel it right away. Usually the last to pick up in a recovery is the job market. It took almost 2 years into the 2001 recovery for jobs to grow again.

There is more good news. A new generation is coming of age that could give a boost to economic growth over the next 5-10 years, and which could mitigate fears that baby boomers might bankrupt social security/Medicare when they begin to retire in 2010. They are being called the Millenium Generation, formerly the echo boomers or children of the baby boomers who were born from 1980 to 1996. And, get this, they number some 90 million!

At least 40 percent of them are now 18 or older, according to demographers, a group even bigger even than their baby boomer parents. And precisely because they haven’t lost 50 percent in the stock market meltdown, they will be the leading edge of an economic recovery, according to a recent CBS Marketwatch article.

“They’re educated, technologically savvy, inspired, driven to succeed personally but also concerned for the greater good,” said CBS Maketwatch’s Jonathan Burton. Also, they are part of the under-thirty cohort, more than two-thirds of which voted for President-elect Obama.

What will create their affluence? Job seekers can call their own shots in the next 4 years, according to demographers. More than 200,000 per month entered the job market during the baby boomers era, whereas just 73,000 per month are projected to enter the work force through 2012. And since job creation won’t slow during that time, it will mean a huge shortage of workers. Much of the labor shortfall will be made up with more efficient technology, increasing labor productivity, and so higher worker wages and benefits.

Hence the reason for the incoming Obama administration’s focus on job creation. Nobel laureate economist Joseph Stiglitz even believes that Obama’s 2.5 million job creation goal over two years is too small. Dr. Stiglitz would like to see a job creation goal of 5 million.

We have already lost approximately 1 million of the meager 5 million jobs created over the past 8 years, as we said in last week’s column. So this is a huge and worthwhile goal. Those who want to check the NBER data can look up the info on its website for themselves—www.nber.org.

© Harlan Green 2008

Monday, November 24, 2008


An astounding thing happened in October. Both retail and wholesale prices fell record amounts, after having risen record amounts in the preceding months. The why is both a testimony to the severity of this downturn and points the path to a recovery.

October’s retail Consumer Price Index fell 1 percent due an 8.6 percent plunge in energy prices, the steepest decline recorded by the Labor Dept. since records were kept in 1947, according to CBS Marketwatch. Wholesale Producer Prices plunged even further—2.8 percent—the most in 50 years.

All are signs of a deflation danger that happened to Japan in the 1990s. No one wants it. Deflation last happened during our Great Depression, which depressed wages as well as prices for several years. One month’s results do not necessarily mean it could happen in the U.S, of course. The main reason for the massive amounts of federal aid flooding the markets with money is to prevent it from happening here.

But the flood has not caused banks to begin to lend again—except for residential loans backed by Freddie Mac, Fannie Mae, FHA and VA, for all intents and purposes. There are still some super-jumbo programs available from the few savings and loan banks left with rates in the low 6 percent range (3 and 5-year fixed ARMs, that is), if they use the 1-yr MTA Treasury index.

And that is the problem. The 10-year benchmark Treasury Bond recently dove to 2.99 percent—something not seen since the 1950s. This is while the money supply has been growing in double digits—19 percent annualized just over the past 2 months. But the monies have been used to buy more Treasury bonds and bills in a flight to safety, which is like putting money under the mattress, rather than lent out to businesses and residences.

This is the big danger of deflation—money being hoarded rather than spent. In other words, the price drops were signs that consumers and manufacturers have cut back on their spending. Both retail sales and industrial production have declined 4.1 percent in a year, according to the Federal Reserve.

Nobel laureate Paul Krugman sounded the alarm once again in his New York Times column. We should not only worry about Japan’s 10-year malaise of deflation, but the similarities of the current malaise with our own Depression. It began during Herbert Hoover’s lame duck administration with the Roosevelt Administration not yet in power. We should not wait for a new administration to act when every day brings more bad news.

“The prospects for the economy look much grimmer now than they did as little as a week or two ago,” said Krugman. “Yet economic policy, rather than responding to the threat, seems to have gone on vacation…Japan’s ‘lost decade’ in the 1990s taught economists that it’s very hard to get the economy moving once expectations of inflation get too low.”

What should be done? Our government needs to get banks lending again, for starters, as Prime Minister Gordon Brown required of British banks who received government aid. Some of the $700 billion authorized by congress, for example, can subsidize lower mortgage interest rates. The historical, 30-year fixed rate should be at 4.5-5 percent when Treasury bond rates have fallen this low.

This translates to at least a 10 percent payment reduction, making mortgages much more affordable. It would get so many more home buyers into the market at a time of rising housing affordability and declining home prices.

© Harlan Green 2008

Saturday, November 22, 2008


The glimmer of light that we saw several columns ago amid the economic doom and gloom may be getting brighter. I don’t say this as a contrarian—those who sell when irrational exuberance reigns and buy when everyone is pessimistic—although contrarians can occasionally be right.

No, my pessimism is lifting because real estate in particular is beginning to recover. Not only because existing and new-home sales improved in September, but several states, including California, have recently seen a sharp drop in foreclosures, according to both RealtyTrac and the Mortgage Bankers Association (MBA)

MBA chief economist Jay Brinkman says that 8 states are now above the national delinquency rate of 6.41 percent. California and Florida continue to lead the way with 39 percent of all foreclosures started in the second quarter.
But RealtyTrac just reported a huge drop in new foreclosure filings in California for the second month, partly due to new legislation that requires a 30-day notice to the homeowner before a foreclosure auction can take place.

“We’ve seem sharp declines in new foreclosure filings after legislation mandating delays to the foreclosure process was signed into law in several states—most notably in California, where overall foreclosure activity was down by double-digit percentage points for the second straight month in October, and where default filings were 44 percent below October 2007 levels,” said RealtyTrac CEO James Saccacio.

California’s foreclosures decreased 18 percent in October, but even more remarkable was that the number of foreclosure filings are now down almost 50 percent from the peak reached just this August.

We should also see more improvements in financing when the new conforming loan limits take effect in January, as we said in last week’s column. It allows conforming loan amounts of $625,500 for a single unit up to $1,202,925 for 4 units (owner and non-owner, but with a maximum limit of 10 financed properties and 4 non-owner financed properties) in many California counties. You should call your favorite banker or broker for more details.

The National Association of Realtors’ affordability index has risen 7 percent since May, due to the lower housing prices and falling interest rates. And, last but not least, consumers may have begun spending again. This is after recent news that retail spending had actually decreased for two consecutive months.

September consumer credit increased 3.2 percent after decreasing 2.9 percent in August, with non-revolving loans (e.g., car loans) up 4.4 percent. This means fears that consumer spending had ground to a halt were unfounded. With gas prices below $3 per gallon, we might see a boost to consumer confidence and so a better Christmas than the doomsayers have predicted.

And lastly, the huge amount of fiscal stimulus by the federal government is beginning to take effect. Economist and now Nobel laureate Paul Krugman has stated that consumers need a $600 billion stimulus package to make up for the loss in economic growth to come out of this recession.

The House of Representatives is already considering an additional $300 billion on top of the $150 billion package of rebates given out earlier this year, while Treasury Secretary Paulson is diverting some $60 billion of his bailout plan to bolster consumer loans. That already adds up to $500 billion, which might do the trick.

© Harlan Green 2008


The effectiveness of any further stimulus package will depend on where the money is spent. With the unemployment rate rising to 6.5 percent and 240,000 payroll jobs lost in October, creating jobs will be the first priority, which is why President-elect Obama said more aid to Detroit automakers was a priority in his first press conference. Jobs were lost equally in the manufacturing and service-sectors. Health care was the only industry that added jobs.

Attention is also being focused on fixing the housing market, since most experts believe that housing has to show signs of a recovery to lead the economy out of this recession. As many as 20 percent of subprime and negatively amortized option ARMs are in default, so lenders are now working on several ways to stop the foreclosures.
Firstly, anyone behind in payments on their primary residence should contact the lender to work on lowering their interest rate and payment. And if eligible, they can petition FHA for a lower interest rate replacement loan if their current lender will accept a 10 percent reduction in principal.

We also discussed some proposals in last week’s column that called for the federal government stepping in to directly pay down either the loan amount if larger than the home’s value, or a direct subsidy to buy down current interest rates to more affordable levels.

The Federal Reserve has lowered its fed funds rate another one-half percent to 1 percent, the lowest rate since 2003. This brought more relief to short-term rates that determine adjustable mortgage rates including the Prime Rate, which is now 4 percent.

There was some good news. New and existing-home sales improved in September for the first time in a year, a sign that both prices and interest rates have fallen to more affordable levels. Conforming 30-year fixed rates are now in the 5 percent range, while the so-called jumbo-conforming 5 and 30-year fixed rates are hovering around 6 percent.

And new and improved conforming loan limits will take effect in January that will also boost housing sales and refinancing. It allows conforming loan amounts of $625,500 for a single unit up to $1,202,925 for 4 units. You should call your favorite banker or broker to get more details.

Housing affordability could continue to improve as housing prices continue to fall in many metropolitan areas, particularly in California and Florida. S&P’s Case-Shiller existing-home price index is down 20.3 percent from its June 2006 peak and homeowners have lost $4 trillion in equity. But values had risen more than 50 percent from 2003 to 2006, according to Case-Shiller, which means most homeowners still have substantial equity left.

The National Association of Realtors’ affordability index has risen significantly over the past 6 months. The index reached 135.2 September, which means a family with a median income of $60,350 can now afford a home 135 percent above the current median, existing single-family home price of $190,600. This is because the median price has fallen 13 percent from its high, while median income has risen a total of 9 percent over the past 3 years.

There is a growing consensus that the housing crisis is at least bottoming out, though no one knows when prices will begin to turn up. There is an incredible ‘overhang’ of 1 million excess housing units for sale that have to be absorbed before the supply of housing again equals demand. We will see that happening in two ways; sales will continue to pick up and the number of foreclosures and short-sales will shrink back to more normal levels.

© Harlan Green 2008


The U.S. Gross Domestic Product contracted at a 0.3% annualized rate in the third quarter, as consumer spending declined at the fastest rate in 28 years, the Commerce Department estimated Thursday. This is making an additional stimulus package even more urgent. The House of Representatives is now holding hearings on it, evaluating what economists and others are recommending.

Harvard economist Martin Feldstein wants government to stop the foreclosure hemorrhage by replacing 20 percent of mortgage debt with low interest government debt for the 12 million homeowners who have negative equity in their homes. The government’s debt would take precedence and so be paid off first in the event of any payoff.

“The president-elect should focus on developing a mechanism for identifying and funding spending initiatives that can occur quickly and that would otherwise not be done”, said Feldstein in a recent Washington Post editorial. “The increased government spending should include not only money for infrastructure such as bridges and roads but also for a wide range of equipment. Rebuilding some of the military capacity that has been depleted by the wars in Iraq and Afghanistan could be done relatively quickly and should be part of the overall package.”

An even more radical solution proposed at a recent 2-day Berkeley, California symposium on the mortgage meltdown by Glenn Hubbard and Christopher Mayer of the Columbia Business School is for the government to buy down interest rates. Under this plan, the government would take action to return mortgage rates to what they would otherwise be if the mortgage market were functioning normally (about 160 basis points above the 10-year Treasury rate). This means that 30-year fixed conforming rates should be around 5.5 percent, rather than the current 6.25 percent.

“The principal benefit of our plan is to reduce mortgage rates by nearly one percent, holding up house prices by 10 to 17 percent around the country relative to how much house prices would fall if the mortgage market remains dysfunctional,” says Hubbard and Mayer. “Lower mortgage rates would allow many homeowners to refinance their mortgages at more normal spreads and to improve affordability for potential new home buyers.”

The House stimulus package will probably include something for everyone. It is projected to cost about $300 billion, which corresponds to the drop in consumer spending over the past year. It is likely to include many of the same provisions that comprised a $61 billion stimulus measure that last month passed the House but died in the Senate, according to the Washington Post, including new money for roads and bridges, aid to cash-strapped state governments and extra funds for food stamps and unemployment insurance.

The decline in real (after inflation) gross domestic product was the largest since the end of the last recession in late 2001. The economy grew at a 2.8 percent pace in the second quarter. Final sales to domestic purchasers fell 1.8 percent, the largest decline in 17 years. Consumer spending dropped 3.1 percent, the first decline in 17 years and the biggest drop in 28 years, while business investment fell 1 percent. Investments in homes fell for the 11th straight quarter.

After getting a big boost from tax rebates in the second quarter, inflation-adjusted after-tax incomes fell 8.7 percent, the largest quarterly decline since U.S. record-keeping began in 1947. Though incomes fell much more in the Great Depression, when annual records were kept.

"The capitulation of the consumer is the primary catalyst behind what is clearly the first consumer-driven recession in three decades," wrote one economist about the GDP contraction. "Just about all sectors of the economy are in the process of a serious contraction." So it looks like anything that gives a boost to consumer spending could shorten this recession.

© Harlan Green 2008

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

Wednesday, September 3, 2008


A Univ. of Chicago economist and Harvard Law Professor, Richard Thaler and
Cass Sunstein (the last is advising Barack Obama), have just come out with a wonderfully common sense book entitled, “Nudge, Improving Decisions About Health, Wealth, and Happiness”, (Yale University Press) that may help us to make smarter financial decisions.

Their thesis is that no decision is made in a vacuum. Context helps determine how content is understood, whether in a supermarket line, saving with a 401(k), or buying stock. Their book is based on research that shows people frequently make bad decisions because they don’t take into account the context or circumstances that can influence their decisions.

It is therefore important to provide guidelines or regulations that support wise decision making. So investing in “free markets and open competition (i.e., without regulation) will tend to exacerbate rather than mitigate the effects of human frailty,” say the authors. Unregulated markets tend to benefit insiders, in other words, who tend to be the most strenuous objectors to market regulations.

A simple example of nudging is the supermarket displays. How food items are displayed in supermarkets helps determine which are purchased. Sales and Public Relations people know that presentation is a big factor in sales. Even “small and apparently insignificant details can have major impacts on people’s behavior,” say the authors.

The authors’ goal is to ‘nudge’ people toward healthier, safer, more prosperous lives, says one reviewer. I agree with their thesis because it reinforces Dr. Robert Shiller’s bestseller, “Irrational Exuberance”. He predicted the dot-com stock market bust, as well as the current housing downturn that I have mentioned in past columns. Dr. Shiller’s research found that most investors follow their emotions in making investments, rather than do real research.

Messrs. Thaler and Sunstein take this understanding to another level, by recommending ways to correct the ‘bias’ in order to make more intelligent decisions. The first priority is to set up policies—whether by government or an employer that enable smarter outcomes by clearly explaining the choices. They recommend buying health insurance with the largest deductible that is affordable, for instance, since studies have shown that overall costs tend to be lower. This is something that insurance companies will not tell their clients.

Much decision-making must take into account a basic human trait. It is called cutting corners, inertia, or mental laziness, if you will. However, I believe consumers also have a basic common sense that can protect them. If consumers are given all the facts, they will make smart decisions. But it will take a greater effort by policymakers who formulate the rules and regulations that govern commerce—and prevent the negative ‘nudging’ of those who try to influence what is not in the consumer’s best interest.

© Harlan Green 2008


A recent Business Week article highlighted the importance of our rising labor productivity, which is mitigating some of the pain of the current economic slowdown. In a word, it means higher profits for companies and higher wages for their workers. And it will help to push future inflation lower

This is likely to help future growth, rather than the current economy, what with alarums over the possibility that Fannie Mae and Freddie Mac might be nationalized. All that negative news is making so-called conforming and jumbo-conforming conventional mortgages that are insured by Freddie and Fannie more expensive, as investors grow leery over the possibility of their failure.

Mortgage rates should in fact be trending down to historic lows with the 10-year Treasury bond yield now around 3.8 percent. Conforming 30-year fixed rates were in the 5.25 to 5.50 percent range in 2003, the last time Treasury rates were this low, versus 6.25 percent today.

A drop in inflation will also lower interest rates, especially for bonds that are sensitive to inflation trends. The current inflation spike is due to many factors, including the Iraq War and devalued dollar. Higher labor productivity is part of the technology revolution that has transformed the U.S. economy and kept inflation lower than it was in the 1980s and 1990s.

Productivity, measured as output per hour worked in private nonfarm businesses, has increased 2.8 percent in the second quarter from one year ago, versus its 1.1 percent annual rate of the past 2 years. This is good news when we are in the midst of an economic slowdown.

In fact, the current consumer inflation rate of 5.8 percent could be much higher without the savings in labor efficiency, caused by businesses continuing to invest in high technology to cut costs. Fed Chairman Ben Bernanke was optimistic about inflation prospects at the Fed’s recent annual Jackson Hole Conference.

“In this regard, the recent decline in commodity prices, as well as the increased stability of the dollar, has been encouraging. If not reversed, these developments, together with a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year.”

What are the prospects for growth in this economy that is going to be “short of

potential for a time”? The Conference Board’s July Index of Leading Economic Indicators (LEI) showed “slow growth the rest of the year, and possibly an economy grinding to a halt,” said its press release. Seven of its ten indicators that help to predict future economic activity have been negative over the past 6 months.

But second quarter GDP economic growth may be revised to as high as 3 percent from its 1.9 percent initial estimate, due to higher exports than originally estimated. This second GDP “preliminary” revision will be released by the Commerce Dept. August 28. Q1 growth was just 0.9 percent.

What does that tell us? Some parts of the economy are still growing, including exports, some manufacturing sectors tied to exports, and health care. But the financial industry needs more capital to make up for its horrendous losses (and a recovery of its stock prices) before the rest of the economy (including housing) recovers.

© Harlan Green 2008

Friday, August 15, 2008


The debate over the housing bill and backstopping of Fannie Mae and Freddie Mac highlight a major fact. Commercial banks are inconstant lenders. This became evident in early 1980s when then Fed Chairman Paul Volcker hiked the fed funds rate to 19 percent in 1980-81. It caused many Savings & Loan Banks, who were the major mortgage lenders of that time, to stop originating mortgages altogether.

This was particularly true in California, where the biggest mortgage lenders of that time—such as Home Savings, Great Western Savings & Loan, Security Pacific Bank, United California Bank—found that their cost of funds exceeded the income from existing fixed rate mortgages.

And it was the secondary market for mortgages that stepped into the breach, of which Fannie and Freddie played a major part. So-called non-traditional investors, such as mutual funds, life insurance companies, and pension funds, funded 42 percent of the growth of mortgage lending during the 1990s, versus just 19 percent during the 1970s, according to a 1992 Fannie Mae report.

Today the share of mortgages insured by Fannie and Freddie has ballooned to more than 70 percent of total originations. This is because the mission of these Government Sponsored Enterprises (GSEs) has not changed; to supply liquidity to mortgage lenders when commercial banks would not, or could not, do so.

The Reagan Administration attempted to shore up the S&Ls’ balance sheets with the 1982 Garn-St. Germain bill that gave them broad latitude to make money by acting like commercial banks—making commercial loans, borrowing from the Federal Reserve discount window, issuing credit cards, and even investing in real estate—which in turn precipitated the S&L crisis of the late 1980s and the federal bailout of same.

The banks’ inconstancy is again an issue with the bursting of the real estate bubble. It is not the province of this paper to discuss its origins, but rather the fact that once again, damage to their balance sheets and capital base has caused the banks to pull back from their lending activities. In this case, it is almost any loan not guaranteed by Fannie Mae, Freddie Mac, the Veterans Administration (for Vets) and Federal Housing Administration (FHA).

Has dependence on the GSEs caused a severe strain on our financial system? Not according to a study by R Glenn Hubbard, George W. Bush’s first Chairman of his Council of Economic Advisors that was commissioned by Fannie Mae in 2005. Dr. Hubbard’s study found that in fact Fannie Mae had half the risk of insolvency of commercial banks—in large part because of a more conservative mix of loans. The GSEs do not buy or insure either credit card or installment loans, as well as riskier commercial mortgages (other than apartment loans) of commercial banks.

In fact, Hubbard’s report maintained that if Fannie Mae failed, its bondholders could expect to lose just 8.9 percent of its assets, whereas commercial banks stood to lose 22.3 percent of their assets.

Of course, critics of the GSEs, including Alan Greenspan, have maintained that because of a implicit government guarantee the GSEs would not be allowed to fail, and so could offer interest rates below comparable commercial bank loans. But what critics fail to take into account are the stricter government-mandated underwriting standards that require income and asset verification to determine a borrower’s ability to repay their mortgage.

This has resulted in default rates just one-quarter of those for all conventional mortgages. Freddie Mac’s CEO said in a recent press release that there is ample evidence that the GSEs have helped to keep a bad situation—i.e., the worst housing crisis since the Great Depression—from becoming even worse. And, they have managed to maintain their mission of improving housing affordability in the process.

© Harlan Green 2008

Thursday, August 14, 2008

Week of July 28, 2008--IS THE ECONOMY IMPROVING?

The first ‘advance’ estimate of second quarter economic growth was 1.9 percent while prior quarters’ growth estimates were reduced slightly. The fourth quarter 2007 actually showed a 0.2 percent contraction in growth. So does that mean that we are in fact coming out of a recession? Real estate seems to be bottoming out, at least in some regions of the country.

If so, it is because a tremendous amount of stimulus has been put into the economy, not only by the Federal Reserve. The federal budget deficit is also stimulative. In fact, next year’s projected deficit of $482 billion—due in part to the rebate checks being sent out—is the total annual Gross Domestic Product of Belgium, according to one commentator. This means the government is spending more than it is taking in receipts, hence it is putting more money into the economy.

And more money in circulation should lower interest rates and stimulate businesses. Too much money in circulation also stimulates inflation, however, hence the tightrope the Federal Reserve is walking between its twin mandates of maintaining long term growth with low inflation.

The increasing unemployment rate—it rose from 5.5 to 5.7 percent in July—may belie any relief, but that is because more workers were kept on the unemployment rolls. Congress extended unemployment benefits for another 13 weeks, which has caused consumer confidence to increase in both the Conference Board and University of Michigan surveys.

The new housing bill may also provide some relief, though housing only accounts for 7 percent of economic activity. The conforming limits for loans insured by Fannie Mae and Freddie Mac that were boosted to $729,750 for a single unit this year, but will be permanently reduced to $625,500 as of January 2008. A $7,500 temporary tax credit for first time homebuyers should also help, given the fact that first-timers now make up 40 percent of homebuyers, according to the National Association of Realtors.

And the housing sector is beginning to work off excess inventories with new-home inventories back down to a 10-month supply, even though prices continue to decline. The good news is that some regions are showing price increases, after falling a cumulative 15.8 percent since last fall, according to the latest S&P Case/Shiller price index. Its survey showed that existing-home prices had actually risen in seven major metropolitan areas—but none yet in California.

Even the higher unemployment rate held some good news. The past 2 months showed 26,000 more jobs were created than originally estimated. And a major reason for the jobless increase was the temporary flood of summer youth 16-25 years old into the job market, with fewer able to find work. So the jobless rate could stabilize in the fall. The real estate bust has caused problems with our financial institutions that had over expanded into residential loans. Financial sector activity in general—including the activities of hedge funds, pension funds and the like—had ballooned to more than 25 percent of domestic (GDP) economic activity. It is now shrinking back to a more sustainable size. This will take time.

© Harlan Green 2008

Tuesday, July 29, 2008

The Importance of Fannie Mae and Freddie Mac

Fannie Mae, the Federal National Mortgage Corporation, and Freddie Mac, the Federal Home Loan Mortgage Corporation, are the 2 largest guarantors of conventional mortgages. Their importance was highlighted by the government’s rescue package, should they not have enough capital to continue to package and sell homeowners’ mortgages to investors.

Both Fannie Mae and Freddie Mac were set up by Congress for precisely the current situation, when commercial banks and investors are unwilling or unable to originate mortgages to homeowners. Fannie Mae saved thousands of home mortgages during the Great Depression, for example, without costing the taxpayers any money. That is why they are two of four Government Sponsored Enterprises—the other two being the Federal Housing (FHA) and Veteran (VA) Administrations that make loans to entry-level homebuyers and veterans.

They were also given a special status, such as tax exempt privileges for their debt that enabled them to keep costs low, as well as lower capital requirements. This was because they carried less risk than commercial banks who originate a mix of consumer and commercial loans that require more capital and loss reserves. And so their mortgage rates are lower than for comparable jumbo mortgage amounts.

The question is can they continue to do business given the current panic-driven environment that threatens to cut off all credit, which is the lifeblood of any economy? The answer of course is that the government will make sure they can continue to operate, given that they now originate more than 70 percent of all home loans, with safer underwriting guidelines that keep their default rate at 1 percent, less than one-quarter of the default rate for all conventional mortgages.

Most pundits continue to say we are not yet in a recession, even though 438,000 payroll jobs have been lost through the first six months of 2008. The unemployment rate held at 5.5 percent in June, as a shrinking labor force cancelled out the job losses in the Labor Department’s Household survey.

So can we expect a recovery this year? The job situation is one indicator. The Conference Board’s Employment Trends Index, which attempts to signal future hiring trends, has fallen 8 percent since July 2007. “The steep decline of the employment trends index in recent months, and the fact that its weakness is spread throughout all of its components, does not leave much room for optimism,” said its senior economist.

Another key to predicting a recovery are the twin manufacturing and service sector surveys put out by the Institute for Supply Management (ISM). Employment in both sectors plunged. What is the culprit? It was surging costs, with prices paid for purchased materials and services increasing for the 61st consecutive month in the service sector. The rise in material prices from May to June was 7.5 percent.

Housing has historically been one of the first markets to recover after a slowdown or recession, according to UCLA economist Ed Leamer. But the backlog of unsold, vacant homes has to first decline. Harvard’s 2008 Joint Housing Task Force report estimates that there is an 800,000 “overhang” of vacant, for-sale units nationally that have first to be sold.

Fannie Mae and Freddie Mac will be in a position to help with a housing recovery. Their so-called ‘jumbo-conforming’ products with a maximum $729,750 loan amount now offer 30 and 15-year fixed rate programs, a 5-year fixed rate ARM with interest only option at just one-quarter percent higher than Fannie and Freddie’s conforming loan amounts. That could save the day for many California homeowners.

© Harlan Green 2008

Sunday, July 27, 2008

Week of July 21, 2008--Are Home Prices at the Bottom?

On the latest Barron’s Magazine cover was a catchy title—“Home Prices Are About to Bottom”. It startled me, what with all the doom and gloom of late. But Barron’s does have a point. Existing-home sales have leveled out at about 5 million annualized units since last fall, though new-home sales and construction have shrunk approximately 50 percent from their highs.

The core of Barron’s argument is that some housing markets are beginning to show price increases, a combination of greater affordability and declining inventories. The S&P Case/Shiller Index for April showed that values in 8 of its 20 survey cities increased, versus just 2 of 20 in March, for example. And the rate of delinquencies in some of the worst sub-prime securities has been declining for the past 6 to 8 months, per the subprime indexes that track them.

House prices are continuing to decline, of course, but that has increased affordability in those same cities that are seeing sales’ increases. Case-Shiller measures affordability with a ratio of sales price to per-capita income. In Boston, for example, the affordability ratio has returned to a more normal 9 times, from its peak of 12 times per-capita income. This means that a home that once sold for $480,000 at its peak (12 times a $40,000 per-capital income), now has come down to $360,000 (i.e., 9 times $40,000). This is a 25 percent savings, and perhaps signals a bottom for prices in the Boston metro area.

Many coastal areas in Florida and California have not yet settled back to historical averages. Los Angeles, whose affordability ratio peaked at 16 times per-capita income, has come down to 11. But its longer-term average is closer to 8 times. So Los Angeles area prices may have another 20 percent decline before leveling out. The variation in affordability ratios just confirms the maxim that all real estate is local.

Other evidence of a real estate recovery is included in Harvard’s 2008 Joint Housing Task Force study, which emphasizes the inventory “overhang” of approximately 1 million unsold and vacant single-family and apartment units that has to be worked off. But household growth over the next decade 2010-2020 should actually increase to 1.4 million households per year. That and other elements should create a demand for at least 1.8 million new-home completions per year over that time.

Lastly, any recovery is dependent on the availability of credit, of course. And mortgage lenders are hurting at present. The so-called quasi-governmental agencies Fannie Mae, Freddie Mac, and outright government-owned FHA/VA agencies have become lenders of last resort that now account for more than 70 percent of originations.

© Harlan Green 2008

Week of July 7, 2008--Will Jobs Market Improve?

Will the jobs market improve this year at all? This could well determine when overall economic activity recovers, not to speak of housing. Consumer spending, the main driver of growth, was up just 1.1 percent in the first quarter 2008, while retail inflation is running at 4.1 percent annually, meaning real spending contracted by more than 3 percent. So consumers have little left over after necessities.

Most pundits continue to say we are not yet in a recession, even though 438,000 payroll jobs have been lost through the first six months of 2008. The unemployment rate held at 5.5 percent in June, as a shrinking labor force cancelled out the job losses in the Labor Department’s Household survey.

Another business indicator is the Conference Board’s Employment Trends Index, which attempts to signal future hiring trends. It has fallen 8 percent since July 2007. “The steep decline of the employment trends index in recent months, and the fact that its weakness is spread throughout all of its components, does not leave much room for optimism,” said its senior economist.

But employment sometimes behaves differently from the more general economic activity as measured by the Gross Domestic Product, according to the Conference Board. But “it has accurately signaled every rise and fall in employment over the last 35 years”.

And that is the key. Economic activity can pick up before jobs. Though the last recession was over in November 2001—yes, that’s just after 9/11 attack—jobs didn’t begin to recover until the second quarter of 2003. This may be a small consolation to consumers, however.

Another key to predicting when the jobs market will improve are the twin manufacturing and service sector surveys put out by the Institute for Supply Management (ISM). Employment in both sectors plunged. What is the culprit? It was surging costs, with prices paid for purchased materials and services increasing for the 61st consecutive month in the service sector. The rise in prices just from May to June was 7.5 percent.

Housing employment has historically been one of the first job markets to recover after a slowdown, according to UCLA economist Ed Leamer. But the backlog of unsold, vacant homes has to first decline. Harvard’s 2008 Joint Housing Task Force report estimates that there is an 800,000 “overhang” of vacant, for-sale units nationally.

Historically, housing markets usually recover after an economic recession and a mix of falling mortgage rates and dropping home prices. That has been happening of course. But this housing downturn may take longer due to the high volume of foreclosures and the constraints in the credit markets, says the report.

© Harlan Green 2008

Week of June 23, 2008--Has the Recession Ended?

The Federal Reserve came out of its latest Open Market Committee meeting with interest rates unchanged. Its reasoning was convoluted, however, in that it believed the worst of the recession is behind us and that the economy is growing again. We therefore have now to worry about inflation, though it should moderate later this year, due to the current slowdown!

So which is it? We cannot have both. Either the credit and housing crunches—along with soaring energy prices—have seriously hurt consumers, which comprise two-thirds of economic activity. Or, the worst is over and consumers have enough spending power to continue to drive up prices—i.e., inflation.

The latest Q1 Gross Domestic Product revision tells us that consumer spending rose just 1.1 percent, half that of 2007’s last quarter, which means consumers are spending on basic necessities at discount prices, but nothing else. This will not drive inflation higher.

One glimmer of hope on the housing front was the 2 percent increase in existing-home sales, to 4.99 million annualized units. Sales have stabilized around a 5 million average since last August. The median-price is now down 6.3 percent in 12 months.

But Harvard’s 2008 Joint Center for Housing Studies report says that the “corrections” in housing starts, in new, and existing home sales rival the deepest slowdowns since World War II. Historically, housing markets usually recover after an economic recession that drives down interest rates and housing prices. But this recovery may take longer due to the high volume of foreclosures and shrinking of available credit, said the report.

May’s new-home sales seemed to confirm this prognosis, falling 2.5 percent with the median price down 5.7 percent in a year to $231,000. The current annual sales rate is 512,000, which is approximately 50 percent below the 1.05 million sold in 2006.

Another indication of weakening consumer demand was the plunge in the Conference Board’s Confidence Index to 50.4, from 58.1 in May. The Director of its Consumer Research Center said the Index was the fifth lowest ever, while its Expectations Index of future activity had reached a new all-time low. Consumers believe we are still in a recession, in other words.

So how do we know if we are in or out of a recession? Once last sign is the Conference Board’s Leading Economic Index (LEI), which rose 0.1 percent in May but is down -0.7 percent over the last 6 months. Its coincident index tracks the same 4 indicators used to determine a recession. And though those indicators also rose 0.1 percent in May after falling -0.1 percent in April., it was the first increase in seven months. The growth rate of the coincident index stands at -0.4 percent (a -0.7 percent annual rate) in the six-month period though May, down from 0.3 percent (a 0.6 percent annual rate) from July 2007 to January 2008, and the weaknesses among its components have remained widespread in recent months.

The predominance of evidence seems to be that we are still in a recession, with energy and food inflation wiping out most economic growth. But said inflation is driven by growth in the rest of the world—especially Asia, rather than domestic demand. So, paradoxically, we therefore must wait for the rest of the world to slow its growth before U.S. growth can resume, and housing has a chance to recover.

© Harlan Green 2008

Week of June 9, 2008--JOBS VS. OIL?

There was further evidence that jobs and oil don’t mix. It is not only the possibility of $5 per gallon gas, but food and most other commodities are also soaring, thanks largely to the fallen dollar. This is while May’s unemployment rate soared to 5.5 percent, as there were 861,000 new workers—mainly young 16-24 year olds—applying for jobs at the same time that there were 281,000 jobs lost, according to the Labor Department’s Household survey.

How high will oil prices rise? And how much will it affect the rest of the economy? That is the question for consumers who now have to spend more on basic necessities. The good news is that the 2 sectors most affected by the economic slowdown—auto and home sales—account for just 7 percent of economic activity and 3 percent of payrolls, according to Business Week.

In fact, it is the credit crunch and high oil prices, which are causing car and home sales to languish. But in line with increased housing affordability that we documented in last week’s column, there is evidence that home sales are already increasing in some parts of the country.

The National Association of Realtors’ Pending Home Sales Index (PHSI), a measure of existing home purchases under contract but not yet closed, surged 6.3 percent in April. It’s the highest index since last October, yet remains 13.1 percent lower than April 2007.

Lawrence Yun, NAR chief economist, said pending sales contracts have picked up notably in areas undergoing significant price drops. “Bargain hunters have entered the market en masse, especially in areas that have experienced double-digit price declines, but it’s unclear if they are investors or owner-occupants,” he said. “Sharp price reductions are leading to a quicker discovery of price equilibrium points. The West is already seeing year-over-year gains in pending contracts.”

In fact, without auto and housing, the U.S. economy grew 2.8 and 2.5 percent, respectively, over the last 2 quarters, close to the long-term average. It is being powered by the ever-growing service-sector, which now provides nearly 60 percent of GDP growth, according to Business Week. And export orders are at a 4-year high, according to the Institute for Supply Management’s May manufacturing survey.

But as oil prices continue to climb, Bernanke and the Fed are beginning to worry about inflation. This is why Fed officials have been hinting at a possible Federal Reserve rate hike in the fall. Such a rate hike would certainly damage any prospects of an economic recovery this year.

UNEMPLOYMENT—The May jobless rate of 5.5 percent was mainly due to students flooding the summer job market, according to some economists. But 49,000 additional payroll jobs were lost in the more dependable Establishment survey, bringing the total this year to 324,000 payroll jobs lost. We doubt the Fed will or can raise interest rates as long as jobs continue to be lost.

RETAIL SALES—Another indicator of consumer health was the 1 percent rise in May’s retail sales, which caused stocks to rally and interest rates to rise. But sales are unadjusted for inflation, which suggests that ‘real’ retail sales are falling when the 4 percent CPI inflation rate is taken into account.

Any hike in interest rates could harm a housing recovery, as we said, since default and foreclosure rates are still increasing, putting pressure on banks to lend less, which further exacerbates the problem.

The pending sales figures do give some hope that housing sales are in a recovery model. The PHSI in the West rose 8.3 percent to 98.8 in April and is 4.0 percent higher than April 2007. In the Midwest, the index jumped 13.0 percent to 83.7 in April but remains 13.1 percent below a year ago. The index in the South increased 4.6 percent to 88.8 but is 22.5 percent below April 2007. In the Northeast, the index declined 1.9 percent in April to 79.3 and is 12.2 percent below a year ago.

© Harlan Green 2008

Week of June 2, 2008--How Affordable is Housing?

Housing affordability has improved significantly due to the fall in both interest rates and home prices in the past year, which may be why home sales have stopped declining of late. Does this mean the housing market is beginning to recover? Yes, but only in regions where those prices conform to reasonable personal income or rent multiples.

As of the April stats, the typical existing home cost 3.4 times annual household incomes, while median new-home prices equaled almost 3.8 times family incomes. These are down from the peak of 4.2 times reached in the bubble year 2005, although they remain above the 2.8 figure that prevailed in the 1980s, when housing sold at a brisk pace.

Two housing price surveys highlight why some regions are recovering. The Case-Shiller index that tracks all same-home sales that include jumbo loans in 20 metropolitan areas has fallen 14 percent from Q1 2007 to Q1 2008, whereas the Office of Federal Housing Enterprise Oversight (OFHEO) saw it prices for homes with conforming loan amounts fall just 1.7 percent in Q1. These are homes that require a maximum $417,000 conforming loan amount, hence have lower prices.

The National Association of Realtors (NAR) has a Housing Affordability Index that corroborates this trend. It increased from April 2007 through this February, but has since reversed course as median existing-home prices have begun to rise again along with interest rates.

The index is still at 130, however, indicating that a household with a $60,185 median annual income can afford a home that is 130 percent of the median price, whereas a median household could afford one just 112 percent of the median price in April 2007.

There may be some improving economic factors buttressing the prospects of homebuyers as well, from higher factory orders (read exports), higher labor productivity that is also pushing up wages, and a service-sector in the expansion mode.

LABOR PRODUCTIVITY—So-called non-farm businesses’ productivity increased 2.6 percent in Q1 and is up a huge 3.3 percent in 4 quarters. This means workers are producing more at lower cost, but also making more money. Q1 hourly compensation was up 4.8 percent. Higher productivity raises the standard of living. Sustaining a productivity rate over 2.5 percent means a doubling of the standard of living every 25 years for a household.

ISM NON-MUFACTURING SURVEY—So-called service-sector activity increased almost 3 points in May, mainly due to a 5.5 point increase in new export orders. And this is with its financial services component (read ongoing credit crunch) weighing down the averages.

So given the enormous head winds generated by soaring food and energy prices, with banks cutting back on lending activities, we have to say that the ship of state is weathering this storm fairly well.

But banks’ profits are still hurting from all the credit losses, and new banking regulations are slowly wending their way through the congress. Until those issues are resolved it will still be a bifurcated real estate market, with some high-priced areas in Florida and California taking longer to recover.

As a footnote, it is generally agreed that sloppy underwriting and regulation led to the sub-prime debacle. A new NBER study highlights why. It was in fact those loans sold to so-called “unafilliated” entities that had the higher default rates—meaning hedge funds and so-called ‘shadow’ banking entities not regulated by the Federal Reserve and Treasury Department. So look for greater regulation of financial markets down the road.

© Harlan Green 2008

Week of May 26, 2008--Real Estate's Future

“The future ain’t what it used to be,” said Yogi Berra, famously. So how can we even hope to predict future housing activity? Certainly we know several factors that helped to inflate the real estate bubble—record low interest rates and deregulation of the financial markets that allowed for rampant manipulation of securitized mortgage credit ratings, among others.

And we know that regulators are now overreacting as property values continue to decline, so that higher credit scores and larger down payments are now required for most purchase and refinance transactions, even with verified incomes.

But we also know that both existing and new-home sales have stabilized somewhat. Annualized existing-home sales have been in the 5 million unit range for the past 6 months (4.89 million in April from 4.94 million in March), while new-home sales just jumped 3.3 percent in April.

One comparison is the last housing recession—which lasted from approximately 2001 to 2006, before prices returned to prior levels. But banks were dropping like flies then due to the S&L debacle, and the Federal Reserve wasn’t much help. In fact Alan Greenspan, et. al., began raising interest rates in 2004 without much warning, causing Orange County’s bankruptcy, for one.

The Fed is playing a different game this time, injecting all kinds of money into the system by holding as collateral many of those prime and subprime mortgage-backed securities that banks haven’t been able to unload.

The Fed has also lowered their over night rate 3.25 percentage points since last fall, bringing the Prime Rate down to 5 percent and the indexes that control adjustable rate mortgages much lower.

This has flooded the financial markets with money, raising fears of higher inflation down the road. Be that as it may, inflation has always helped property values. Also, Fed Governor Janet Yellen believes the Fed’s “liquidity-enhancing” actions “are having a beneficial effect on financial markets”.

Reinforcing Yellen’s optimism is that first quarter Gross Domestic Product growth was just revised upward to 0.9 percent from 0.6 percent, mainly because of higher export growth. Its so-called PCE inflation index that the Fed uses also was lower. In fact the core index without food and energy prices was up just 2.1 percent in Q1 and is up just 2 percent in a year.

But perhaps the best gauge of housing values is the so-called housing price-to-rent ratio. It is the ratio of a home’s value over annual gross rents. Its national average is currently 25 times annual rents, according to the San Francisco Federal Reserve Bank, meaning that a home that rents for $30,000 per year is now worth approximately $750,000. Its long-term average since 1970 is about 21.5, which means that average prices may decline another 14 percent. But values could fall even further, of course, since the price-to-rent curve is not a straight line, but fluctuates around its average value.

So what is the future for both housing sales and values? Sales of new and existing home will probably stay in the same narrow band this year, simply because for sale inventories are bloated by newly foreclosed homes replacing those that were sold.

And values will eventually return to the long-term 21.5 housing-to-rent ratio average. This ratio has taken 10 years to return to its historical ratio over each of the last 2 housing cycles—from 1980 to 1990 and 1990 to 2000. This is of course unless the future “ain’t what it used to be”!

© Harlan Green 2008