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The Start Signal for Recession
Yesterday’s 3%+ stock market plunge was not due to losses in the China stock market or computer glitches. Instead several data points showed a deteriorating economic climate in the U.S. and probably world wide.
After years of low central bank rates and easy credit availability the U.S. housing market last year went nuts. People could get mortgages of 100% of the inflated house value without down payments and many borrowers took out ARM’s, mortgages with adjustable rates. But as rates started to climb through inflationary pressure, the party suddenly, but not unexpectedly, stopped.
New home sales are down and last month they plunged. But builders still had and have lots of new houses in the pipeline and as these are finished those additionally come into the market. More house offered but less customers able to pay the now higher rates results in sinking house prices.
Those borrowers who were barely able to afford the initial payments for their ARMs on 100% of their house value now experience a double crunch. The real value of their houses go down and the amount of their loan may now be at 110% of the house value. At the same time the increased rates increase the monthly payments of the original loan. For many the result is bankruptcy. Their houses go into receivership and will add to the glut of offered homes.
With too many houses in the market and little sales, home builder companies are in trouble. New home sales plunge. Also affected are home improvement markets like Home Depot. Last year the construction industry had been a leading hiring sector. It may become the leading firing sector now.
The lenders who gave the sub-prime mortgages bundled the mortgages they issued, repacked those and sold them to institutions and individuals as Mortgage Backed Securities. Those securities promised a relatively high rate of return for the buyer, if the payments would actually come in. But with borrowers going under, lots of the involved mortgages default, and those who did buy the MBS bonds now will have negative returns, i.e. they are losing money.
Several lending companies have shut down. Some big institutions have already taken losses in the range of several billions. This of course will show in their balance sheets and take a toll on their share prices.
Now lending standards are tightened going back to the regular standards which demand down payments and an appropriate stable income. For those borrowers already in trouble, refinancing to stretch their loans will thereby become impossible. The result is more bankruptcy cases, more houses in the market, lower house prices, more bankruptcy cases… A downward spiral has started that will only stop after house prices, which have been high above historical norms, are well below those.
The side effects on the general economy will take a while to get visible. Manufacturing is already in trouble. Expect higher unemployment, lower stock markets and lack of lenders who, licking their wounds, will only loan for higher rates and to very secure borrowers. A credit crunch that will affect businesses, small and big, too.
All this points to general deteriorating economic conditions beyond isolated sectors that will be reflected in the stock markets. Yesterday’s drop may therefore only have been the start signal of a wider recessionary phase that could well take some years to find a bottom.
A recent sample of my sources with respect to the economy:
Mauldin 16 Feb 07 – Expect a Recession
Mortgage Equity Withdrawal (MEW) accounted for over 2% of last year’s GDP growth. Take away that and 1% for construction, and we would have been close to a recession. MEWs are going to be harder and harder to get, especially for sub-prime mortgages. A decade ago sub-prime mortgages were a mere $35 billion. Today they are one-fourth of all mortgages, about $665 billion. Somewhere in the neighborhood of $1 trillion in adjustable-rate mortgages is eligible to be reset in the next two years, sharply increasing payments and lowering the discretionary spending ability of those homeowners. But the real hit is going to be the inability of many to actually get loans. So, will there be a recession? I still think so, and I think the culprit is going to be the housing market, which is going to trigger a slowdown in consumer spending, the first such slowdown since 1991.
Briefing.com 22 Feb 07 – GDP Growth Revised Down
Q4 GDP revisions will be severe. Should leave growth near 2.5%. Advanced estimate showed 3.5% growth, final sales rose 4.2% — both the strongest since Q1. Revisions will leave 4 of the last 5 quarters below the 3% estimate for potential growth. Actual growth for the trade deficit and business inventories provide the majority of the revision. Business capital investment fell as structural investment was the weakest in five quarters. Another strong decline in residential investment as the housing effect lightens in late 2007. Fed looks for sub-3% potential growth in 2007 and 2008.
Economist 25 Feb 07 – Signs of a Market Top
As a proportion of market value, margin debt is now at its highest since the late 1920s and has jumped by $40bn in the past three months, a similar rate to early 2000, when the markets were in frenzy. The proportion of cash held in mutual funds has dropped to 3.9%, equal to its record low (although those lows were recorded only in 2005). The stockmarket has gone almost 950 trading days without a 10% correction, the third-longest period in history. If volatility rises, shares will look riskier. Hedge funds will be tempted to cut their borrowings, and investment banks their trading positions. This could cause a sharp correction, as investors all try to head for the exits at the same time. Until such an event occurs, the circle is virtuous. Low volatility props up markets, which keeps volatility low. So the bears are dependent on a satan ex machina – a huge corporate default, a geopolitical risk come true, or a bird-flu epidemicâ��to turn sentiment around.
Yardeni 26-Feb-07 – Bullish to the Max
The US economy deserves an Academy Award for its outstanding performance. Despite all its critics and naysayers, the economic expansion has lasted 63 months so far. The average of the previous 10 cycles since 1945 was 57 months. The previous two recessions lasted only 8 months each from July 1990 to March 1991 and from March 2001 to November 2001. In other words, since the November 1982 recession trough, there have been 275 months of economic expansion and only 16 months of contraction. The economy has grown 94.5% of the time, while the Alarmists seem to have been predicting a recession 100% of the time. I wouldn�t give the Fed the Academy Award for the Great Moderation. The other more deserving nominees include Globalization following the end of the Cold War, industrial deregulation in numerous countries around the world, and the Internet. The two big concerns at present are a credit crunch in the mortgage market triggered by the woes in the subprime market and a crunch in the oil market triggered by Iran�s uranium enrichment program. I still expect that both these issues will be resolved without any significant impact on the economy or the stock market.
Bill Gross at Pimco 27-Feb-07 – Rates will Fall, Risk will Rise
The Fed will cut rates later this year and their two key criteria will be employment and asset prices. With construction laborers about to hit the unemployment lines and the [unemployment] rate in jeopardy of rising more than the Fed feels comfortable with, an ease as soon as mid-year may be in the cards. I have a strong sense as well, that mortgage credit availability is in the midst of a cyclical squeeze due to subprime defaults and “��better late than never”�� moral suasion/congressional supervision of mortgage bankers. This should not only continue to floor the housing sector but dampen consumption, as the combined effect of layoffs and Mortgage Equity Withdrawal, “��withdrawal”�� produce a 2% or less real and a 4% or less nominal economy. Those numbers when extended for three or four quarters (which they now have been) are the stuff leading to output gaps, rising unemployment, declining inflation, and an easing in overnight Fed Funds rates. What the last six months have shown us is that the U.S. economy and its asset markets are sensitive to 5 1/4% overnight rates and that asset prices are going down -�� first for those categories most sensitive to negative carry.
There is always disagreement, because whatever concensus exists is already reflected in the market. A sports analogy – the issue is not which team will win the series, but which team will beat the current bookies’ spread…
Sorry about the lack of links, but these sources are sourced from email.
Posted by: PeeDee | Feb 28 2007 20:22 utc | 4
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