Revisiting Ground Zero & the Spreading Tentacles of a Recession
By Chris Puplava, July 16, 2008
There is a choice to be made: Either we regulate the Banks, or leave it to the vagaries of the free markets to punish those who trade with, or place their assets in the wrong institutions. But for God's sake, do not give us the worst of both worlds -- do not allow banks the freedom to make horrific but preventable mistakes (i.e., only lending money to those who can pay it back), but then expect the taxpayers to foot the trillion dollar bill.
That's not capitalism, its not socialism, its not regulation, and its sure as hell isn't what free markets are. Our language is insufficient to describe this hodge-podge system, other than to call it a random patchwork of quasi-capitalism, quadrennial-socialism, and politics as usual. Ideological idiocy is the only phrase I can muster that has any resonance with the daily insanity…
Books will be written about this period of time, and our descendants will wonder in awe as to how this was allowed to happen. Tulips got nothing on us! It’s not just the total dollar value of the losses that have exceeded all other global fits of financial madness combined, but rather, how so many warning signs were so blithely ignored by so many and for so long. What was wrong with these people, the authors and historians will wonder. Did the antibiotics in the food supply drive them mad? Did the High Fructose Corn Syrup compromise their ability to think? Some form of viral plague? Road rage? What else could have created such a mass delusion amongst not just the populace, but their leadership and institutions?
Barry Ritholtz Idiots Fiddle While Rome Burns, 07/16/2008
The situation described above came to a head with the topping of the greatest housing bubble ever in 2005 followed by a climatic top in the credit markets in the summer of 2007. As Mr. Ritholtz points out, what is truly amazing is how so many warning signs were so blithely ignored by so many for so long. Now millions are paying for a failure to grasp the second bubble to burst this decade as the housing downturn has wiped out trillions in wealth, not to mention a bear market in stocks to boot.
Financial institutional losses are mounting as mortgage portfolios are written down as home prices continue to decline and foreclosures continue to rise. Highlights from a Bloomberg article shown below illustrate the dire housing situation.
Foreclosures Rose 53% in June, Bank Seizures Tripled
U.S. foreclosure filings increased 53 percent in June from a year earlier and bank seizures rose the most on record as deteriorating property values and higher rates on adjustable mortgages forced more people to give up their homes…
Bank seizures rose 171 percent, the most since the Irvine, California-based company began tracking statistics on default notices, warnings of a scheduled auction and repossessions in January 2005.
"The foreclosure problem is getting worse and will stay with us well into the next decade," Mark Zandi, chief economist for Moody's Economy.com in West Chester, Pennsylvania, said in an interview…
Foreclosure activity is the highest since the Great Depression of the 1930s, said Rick Sharga, RealtyTrac's vice president of marketing…
"We'll have 1 million bank-owned properties by the end of the year," Sharga said in an interview. "That will represent between one-fourth and one-third of all home sales…"
About $3.5 trillion in homeowner equity has been wiped out since the spring of 2006, when housing prices were at their peak, Zandi said.
Adding fuel to the building recessionary fire first kindled by the bursting of residential real estate is non-residential real estate (say that ten times fast), the balancing force that helped limit the pain from residential real estate in 2007. For example, in 2007 real non-residential fixed investment grew by $97.9 billion while real residential fixed investment fell by $96.7 billion, more than offsetting the entire decline from the housing recession last year.
The rate of change in non-residential property prices have already fallen significantly from their momentum highs in 2005-2006, with apartment buildings now showing actual price declines. Supporting evidence of a peak in non-residential real estate are rising vacancy rates as is seen typically heading into a recession.
Figure 1
Source: Moody's
Figure 2
Source: CB Commercial
Delving deeper into areas of non-residential real estate shows that industries beholden to the almighty American consumer are not holding up so well. A few recent news articles illustrate this point:
- The next building bust, CNNMoney.com, 05/19/08
- Steve & Barry bankruptcy further pressures malls, MarketWatch, 07/09/08
- Slide by Marriott Signals Distress For Hotel Industry, Washington Post, 07/11/08
Multi-merchandise shopping mall investment peaked last year, and lodging investment also appears to be peaking. The stock market proved true as a discounting mechanism as the stocks related to these non-residential real estate areas peaked prior to the fundamentals and point to a greater decline in consumer-related non-residential real estate ahead.
Figure 3
Source: BEA
Figure 4
Source: Dow Jones & Company, Inc./BEA
Figure 5
Source: Dow Jones & Company, Inc./BEA
Non-residential real estate peaking is no small matter, particularly so as it helped offset the pain in residential real estate last year, which shows no signs of bottoming. With both shoes presently falling, financial losses will continue to plague an already battered stock market. The financial risk to various areas of the economy can be seen by looking at risk measures such as the five year credit default swap (CDS) spreads. CDS spreads were at their lowest point just prior to the credit crisis that began last summer as investors underpriced risk, which is clearly being priced in now as CDS spreads continue to remain elevated.
As seen below, the collective spike in CDS spreads recently may indicate an interim bottom as they did at the January and March lows. The industry CDS spreads are listed from highest to lowest financial risk. As is no surprise, the financial industry lies at the top with the financial guarantee industry leading the pack followed by the lending industry. Fallout from a weakening consumer can be seen looking at the leisure industry, which supports Figures 4 and 5 above. (Note: CDS spreads reached over 700 for Bear Sterns in March when it initially agreed to be sold for $2/share to JP Morgan)
Figure 6 - Financial Guarantee Insurance
Source: Bloomberg
Figure 7 - Lenders
Source: Bloomberg
Figure 8 - Leisure
Source: Bloomberg
Figure 9 - Retail
Source: Bloomberg
Figure 10 - Brokers
Source: Bloomberg
Figure 11 - Banks
Source: Bloomberg
The fallout from a weakening American consumer is not only showing up in the CDS spreads for the leisure industry, but also their stock prices. Since the October peak in the markets last year the leisure industry has witnessed a very nasty decline that has eroded 40% to 75% of shareholder value over the last nine months alone.
Figure 12
Source: StockCharts.com
The decline in the S&P 500 consumer discretionary sector has nearly dropped its weighting in the S&P 500 in half since the housing collapse began in 2005. Mortgage losses resulting from the housing fallout has brought the financial industry to its knees and so too its sector weighting in the S&P 500.
The pain experienced in the consumer discretionary and financial sectors is the energy sector’s gain as the S&P 500 energy sector’s weighting has more than tripled from the 4.93% weighting in January 1999 to 16.21% in June of 2008. Interestingly enough, one month after the low in the S&P 500 energy sector’s weight was the low in gasoline station sales as a percent of total retail sales, which bottomed at 6.5% in February 1999. Since then gasoline station sales now make up 12% of total retail sales and act as a major drag on consumer discretionary spending.
Figure 15
Source: Bureau of the Census
As long as the housing market is buffeted by continued real estate declines coupled with high energy prices, the U.S. economy will continue to weaken further as witnessed by falling individual and corporate income tax receipts. To-date the fiscal and monetary responses have been completely ineffective in turning the economy around, though they have undoubtedly helped soften the financial blow.
Figure 16
Source: U.S. Department of Treasury
Figure 17
Source: U.S. Department of Treasury
The process of unwinding the leverage built up over the last two decades will take time as the credit bubble of a generation bursts. The excesses of the past will not simply be swept under the rug overnight. Bank charge off rates are rising for all loan categories as shown below, indicating things are getting worse and the financial markets have not turned the corner.
Figure 18
Source: Federal Reserve Board
Figure 19
Source: Federal Reserve Board
Figure 20
Source: Federal Reserve Board
Fool me once, shame on you. Fool me twice, shame on me!
If indeed we have made an interim bottom as evidenced by the recent spikes in CDS spreads and today’s strong rally, expect the “ALL CLEAR” and “THE WORST IS BEHIND US” nonsense just like we witnessed after the March lows. Examples on how completely wrong the financial media and pundits can be are shown below.
The "R" Word (Source: Calculated Risk)
Since Chairman Bernanke allowed for the possibility of a recession in his testimony today - see NYTimes: Bernanke Nods at Possibility of a Recession - it might be fun to look back at a few Fed quotes from prior periods:
For the recession that began in July 1990:
- “In the very near term there’s little evidence that I can see to suggest the economy is tilting over [into recession].” Chairman Greenspan, July 1990
- “...those who argue that we are already in a recession I think are reasonably certain to be wrong.” Greenspan, August 1990
- “... the economy has not yet slipped into recession.” Greenspan, October 1990
- 10/27/2005 – Bernanke: There's No Housing Bubble to Go Bust
- 10/07/2006 – Greenspan sounds optimistic note on housing
Don Luskin (A favorite on the Larry Kudlow Show)
- 04/27/2007 - Once Again, Earnings Prove the Bears Cannot Get It Right
- 08/24/2007 - Stock Pullback Is Buying Opportunity, Not Meltdown
- 11/30/2007 - 11 Reasons to Buy Now
- 12/07/2007 - It's Time to Invest in Financials
- 03/21/2008 - The Worst Risks of the Credit Crisis Averted
- 05/02/2008 - Housing Prices Near or at Bottom?
- 02/26/2007 – Housing Boom! (Ken Fisher)
- 06/02/2008 – Barron’s Cover: BUY GM
A FEW YEARS AGO, AN ACQUAINTANCE SENT Wellesley College economist Karl "Chip" Case a T-shirt depicting a cartoon of a smiley-face house surrounded by soap bubbles, called "Mr. Housing Bubble." But it was the words captured in a comic-book cloud on the shirt that gave this otherwise goofy image its bite: "If I pop, you're screwed!"
The dark humor hardly was lost on Case, co-creator along with Yale economist Robert Shiller of the now-canonical S&P/Case-Shiller Home Price Indices. In pairing recent sale prices of U.S. homes with the prices those same homes fetched previously, the index is substantiating what every ...
Instead of listening to media nonsense, PLEASE, PLEASE don’t forget Newton’s first law of motion (Don't Forget Newton's First Law!).
Chris Puplava
© 2008 Chris Puplava
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