No Time for Alarm vs. The Great Unraveling

Defaults are soaring and stocks are tanking but BusinessWeek says it's no time for alarm.

On Mar. 13 the Mortgage Bankers Assn. reported a record percentage of mortgages entering foreclosure in the fourth quarter—news that sent the Standard & Poor's 500-stock index tumbling 2%.

Nonetheless, in the broadest sense, say economists, the economy should be able to withstand the downdraft in the mortgage market. "It's going to have limited impact."

The good news is that, although the subprime business has grown rapidly in recent years, it remains a small part of the overall mortgage market—14% of outstanding mortgage loans. And only some subprime loans are in trouble. About 13% were past due in the fourth quarter, the Mortgage Bankers Assn. said.

So the most serious damage is confined to a fraction of a sliver of the overall mortgage market. Christopher L. Cagan, chief economist at Santa Ana (Calif.)-based First American CoreLogic (FAF), projects mortgage defaults of about $300 billion through 2010, just a flea on the nation's $10 trillion housing elephant. And about two-thirds of the losses will be recovered when lenders repossess homes.

The overall economy is doing reasonably well, creating 97,000 jobs in February, according to the Bureau of Labor Statistics. The unemployment rate is just 4.5%. Subprime's woes aren't an indicator of deeper-seated problems.

David Rosenberg, chief North American economist at Merrill Lynch (MER), who is among the more bearish economists on Wall Street, wrote on Mar. 14 that "it is not inconceivable" that house prices will fall 10% this year, which he estimates would cause economic growth to slump to about 1.75% in 2007 from 3.3% in '06.

Wyss of S&P thinks the weakness in housing, compounded by subprime's problems, will slow economic growth to 2.4%, though he recently raised his estimate of the probability of a recession starting in the next 12 months to 30%, from 25%

Greg Jensen, co-chief investment officer at Bridgewater Associates, a large manager of institutional investments, wrote in a report to clients on Mar. 14: "Our guess is that the current bond rally will do more to fuel global growth than the subprime problems will do to slow it."

Greenspan: Spillover Unlikely

It is difficult to determine what the consensus is, or even if there is one because there certainly are numerous housing bears to be found, but I suspect the above article comes closer to representing a main stream view than not. One can even add Greenspan to the list when he said Subprime Spillover Unlikely.

"I think it's important to recognize that what we're dealing with ... is more an issue of house prices than it is mortgage credit. .... If home prices would go up 10 percent, the subprime mortgage problem would disappear."

It's hard to know where to even start rebutting nonsense of this sort. Let's just say that rot starts at the bottom. That rot exceeds far more than a "fraction of a sliver of the overall mortgage market". The USA Today is reporting Record foreclosures hit mortgage lenders.

The reason many mortgage lenders are in trouble became alarmingly clear Tuesday. The Mortgage Bankers Association said more than 2.1 million Americans with a home loan missed at least one payment at the end of last year — and the rate of new foreclosures hit a record.

The problem is most severe for borrowers with scuffed credit and adjustable-rate mortgages. More than 14% of them were behind on their payments. And the worst is yet to come, the MBA said.

2.1 million Americans are in jeopardy of losing their homes. That sounds more like a significant piece of the pie than a sliver of a slice. Ten states have delinquency rates that exceed 7%. Note that the big bubble states of Florida and California are not even in that list yet. (Click on the above link to see the full table).

And the big wave of ARMs resets has not even occurred yet. That will happen later this year. Most interesting is the viewpoint that anyone would stake a claim that "The overall economy is doing reasonably well" on the basis of an anemic 97,000 jobs in February, when 39,000 of those jobs were government jobs.

Hardly anyone is looking at the slowdown in consumer spending that is going to occur once cash out refis completely dry up in the face of tougher appraisals and tougher lending standards. A reduction in MEW (mortgage equity withdrawal) will impact spending and reduced spending will further impact jobs.

The downward spiral has barely begun and optimists think the "current bond rally will do more to fuel global growth than the subprime problems will do to slow it." No, the Fed is not going to be able to get this trainwreck back on track. After all, long term fixed rates have barely budged in the last few years. Teaser rates have however, in the face of 17 consecutive rate hikes. One or two rate cuts is not going to help the average borrower that much and meanwhile the rot is already spreading into Alt-A loans. That rot will eventually spread to prime loans. A prime loan is only going to remain a prime loan as long as the borrower has a job.

Manufacturing Indices

With little fanfare last week came the announcement Two factory gauges show little growth.

Empire State index plunges to 1.9, Philly Fed inches down to 0.2
The New York Fed's Empire State index fell sharply to 1.9 in March from 24.4 in February, putting the index at its lowest level since May 2005.

The size of the decline in the Empire State index surprised economists, who were expecting the index to slip to 19.0. Economists had expected the Philly Fed index to rebound to 4.2.

In both indexes, readings over zero indicate growth. The two gauges are of interest primarily because they are seen as clues to the Institute for Supply Management's national survey for March due out in two weeks. The ISM has been trending lower, but has averaged 50.7% over the past four months. Readings under 50% would indicate a contraction in the sector.

Philly Fed Index



Notes: The above chart was constructed by subtracting the percentage of respondents reporting a decrease from those reporting an increase. Constructed this way, numbers below 0 indicate contraction while the ISM goes negative at 50 (the percentage of respondents reporting an increase in activity drops below 50%). The Fed has never hiked with an ISM reading under 50 and I expect we are soon going to see a crossover in the ISM that gains no traction for quite some time.

Interestingly enough the Business Outlook Survey by the Philly Fed shows optimism looking six months ahead.

Overall activity in the region’s manufacturing sector was steady this month, and indicators for new orders, shipments, and employment improved only slightly from February. Firms continue to report higher prices for inputs and for their own manufactured goods, and the survey's price indexes edged higher this month. The manufacturers’ outlook remains generally optimistic: They expect a pickup in growth during the second quarter and improved conditions over the next six months.

In special questions this month, firms were asked about expected growth in production during the second quarter. Fifty-nine percent of the firms indicated that production would increase in the second quarter; only about one-third of these firms said the increase was due to seasonal factors. Twenty-three percent indicated that production would decrease, and a small percentage of these firms attributed the expected decrease to seasonal factors. The largest share of firms (43 percent) indicated that the growth expected represented “some acceleration” from the first quarter; 10 percent indicated that it represented a “significant acceleration.”

I am not sure where this optimism stems from but I am willing to take the other side of the bet. In fact, if you look at the above chart there has been an overabundance of optimism for nearly seven straight years.

Economists were surprised by the plunge from 24.4 to 1.9 in the New York region (chart not shown) and they are going to be surprised again at the rate of contraction in the second or third quarter. If for some reason there is not a contraction, then I look for inventories to skyrocket in the face of declining sales.

The Great Unraveling

Even as others are predicting containment, Stephen Roach is pondering The Great Unraveling.

From bubble to bubble – it’s a painfully familiar saga. First equities, now housing. First denial, then grudging acceptance. It’s the pattern and its repetitive character that is so striking. For the second time in seven years, asset-dependent America has gone to excess. And once again, twin bubbles in a particular asset class and the real economy are in the process of bursting – most likely with greater-than-expected consequences for the US economy, a US-centric global economy, and world financial markets.

Too much attention is being focused on the narrow story – the extent of any damage to housing and mortgage finance markets. There’s a much bigger story. Yes, the US housing market is currently in a serious recession – even the optimists concede that point. To me, the real debate is about “spillovers” – whether the housing downturn will spread to the rest of the economy.

The spillover mechanism is hardly complex. Asset-dependent economies go to excess because they generate a burst of domestic demand that outstrips the underlying support of income generation. In the absence of rapid asset appreciation and the wealth effects they spawn, the demand overhang needs to be marked to market. The spillover is a principal characteristic of such a post-bubble shakeout. Interestingly enough, in the current situation, spillovers have first become evident in business capital spending, as underscored by outright declines in shipments of nondefense capital goods in four of the past five months. The combination of the housing recession and a sharp slowdown in capex has pushed overall GDP growth down to a 2% annual rate over the past three quarters ending 1Q07 – well below the 3.7% average gains over the previous three years. Yet this slowdown has occurred in the face of ongoing resilience in consumer demand; real personal consumption growth is still averaging 3.2% over the three quarters ending 1Q07 – only a modest downshift from the astonishing 3.7% growth trend of the past decade.

Therein lies the risk. To the extent the US economy is now flirting with “growth recession” territory – a sub-2% GDP trajectory – while consumer demand remains brisk, a pullback in personal consumption could well be the proverbial straw that breaks this camel’s back. The case for a consumer spillover is compelling, in my view. A chronic shortfall of labor income generation sets the stage – real private compensation remains over $400 billion below the trajectory of the typical business cycle expansion.

Former Fed Chairman Alan Greenspan crossed the line, in my view, by encouraging reckless behavior in the midst of each of the last two asset bubbles. In early 2000, while NASDAQ was cresting toward 5000, he was unabashed in his enthusiastic endorsement of a once-in-a-generation increase in productivity growth that he argued justified seemingly lofty valuations of equity markets. This was tantamount to a green light for market speculators and legions of individual investors at just the point when the equity bubble was nearing its end. And then only four years later, he did it again – this time directing his counsel at the players of the property bubble. In early 2004, he urged homeowners to shift from fixed to floating rate mortgages, and in early 2005, he extolled the virtues of sub-prime borrowing – the extension of credit to unworthy borrowers. Far from the heartless central banker that is supposed to “take the punchbowl away just when the party is getting good,” Alan Greenspan turned into an unabashed cheerleader for the excesses of an increasingly asset-dependent US economy. I fear history will not judge the Maestro’s legacy kindly. And now he’s reinventing himself as a forecaster. Figure that!

Is the Great Unraveling finally at hand? It’s hard to tell. As bubble begets bubble, the asset-dependent character of the US economy has become more deeply entrenched. A similar self-reinforcing mechanism is at work in driving a still US-centric global economy. Lacking in autonomous support from private consumption, the rest of the world would be lost without the asset-dependent American consumer. All this takes us to a rather disturbing bi-modal endgame – the bursting of the proverbial Big Bubble that brings the whole house of cards down or the inflation of yet another bubble to buy more time.

Roach may be wondering whether or not the Great Unraveling is at hand, but not me. In quick order the spillover is going to hit both jobs and consumer spending. The Wall Street Journal is reporting Out of Space, Retailers Trim Growth Plans.

For years, investors rewarded those retailers with fast expansion rates. Now that some retailers have nearly tapped out their potential in the U.S., investors are punishing them for failing to slow down.

The result is that a number of major retailers are ratcheting back on the number of new stores they open each year and are diverting more of their spending to repurchasing shares and increasing dividends. Among those adopting this strategy are Sears Holdings Corp., Home Depot Inc. and AutoZone Inc.

The full article is subscription only.

I have talked about this before but corporate expansion is not going to be the savior where homebuilding left off. The goldilocks theorists simply refuse to believe that even as the WSJ is reporting that it is happening.

Corporate construction follows residential with a lag. We are saturated with stores. There will be a diminishing job hiring effect heading forward just as homebuilding is set for another wave down caused by foreclosures. Simply put, there is nothing that can remotely come close to filling the jobs needs of the US with a pullback in housing construction, commercial construction, manufacturing, and a consumer spending revolt against all kinds of discretionary things like eating out at restaurants. That is the downward spiral that has already started, and the only debate should be about the speed at which it continues as opposed to whether or not it is about to happen.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/