Tags: saving, Housing, economy, recession
The economy is in recession partly because the consumer is fearful. The consumer is afraid of the high level of debt as well as of falling networth (retirement, real / investment asset prices) and also afraid of job loss. The correct private response to these fears is to cut back spending to deleverage, boost assets/networth by fresh savings / investment and to build a short term savings buffer as unemployment self-insurance. The means of doing this is by cutting back on discretionary spending to generate or increase a cash flow surplus, and put that to work to achieve these private objectives. However, given that private debt is such a large part of income, it will take a long time to realign.
Suppose someone wants to build an additional savings buffer of 6-months of must-spend expenses… pretty reasonable, I’d say, and not something that would fundamentally improve their balance sheet, so they really need to do more… Take an average family with $50k household income. Given that they are probably taking home about 80% of their pay ($40k) after taxes, and spending about 95%+ of their take home, and assume that 75% of their expenses are non-discretionary ($30k), they would need to save $15k to achieve that 6-month goal. Since only 20-25% of their spending is discretionary, even if they cut that to zero (highly unrealistic) it would take 18 months to achieve this objective. Clearly, then, spending alone is not enough. But right now, raising incomes to meet this goal is just as unrealistic, on average!
This $15k savings goal for an average family translates to $1.7 trillion for all US households – $1.7 trillion of reduced consumer spending. I think the true savings goal to restore private fiscal health is way greater than this. So the stimulus is not enough. No way. Not even close.
The public impact of the collective private actions is this: Everyone is cutting back, and is willing to work longer hours / grow productivity just to keep their job. People are even willing to take pay cuts to avoid layoffs ( you kept the job, but your nominal debt is the same, real debt has increased because nominal and real wages went down). As a collective, that sucks because the economy needs to deleverage even more with a lower income base to do it – debt to income just went up a notch. That means demand for discretionary goods and services is way down, will stay down for a long time, and, when it begins to recover, the incremental demand will be met for a long time from existing employment, so this will be a jobless recovery when it recovers. In the meantime, note that the growth in unemployment is only about 5-6% points so far i.e. unemployment has not risen fast enough to account for higher productivity and the lower demand that has occurred and will continue to impact the economy. This means there is a lot of “dry powder” left in productivity gains for when the recovery does happen.
The economy is 65% consumer, and the rest is enterprise spending to create capacity to meet consumer demand. A lot of export markets are in worse shape than the US.
I think this is a false spring. We may not drop back into the depths of winter, but the real spring lies on the other side of a few bad cold spells – enough to wither the green shoots.
Stay cautious. Stay pessimistic.
Tags: retirement, real estate, economy, recession
Usually, in a recession, there are people who suffer – people who lose jobs or have their hours cut… Others see the value of their investments fall as well. However, for the majority of people, life goes on as usual. They may cut back a bit, may feel the impact of the markets on their portfolio, but most people don’t have too large a portfolio, especially outside of a 401(k) or IRA, so the impact isn’t immediate. Yes, the 401(k) is down, but it’ll recover by the time I need the money seems to be the mantra.
What may be unusual about this recession is that everybody is hurting. You cannot be complacent about a “safe” job when you have suffered anything from 30% (for those with no or almost paid-off mortgages) to 75% or even greater than 100% loss of equity in your greatest asset – your home.
This is not an event that has happened to some of your neighbors and you hope does not happen to you. You may still have your job, you may be years from retirement – but the recession has already hurt you – and me, and all of us.
Tags: credit, Housing, economy, recession
I’m back after a long break from writing. I’ve been thinking about how psychology plays into the recession – in fact, most of my direst predictions of the past three years have played out, often worse than I expected, mostly because I think I got consumer actions right.
My thesis can be summarized as follows: The US economy is 70% consumer spending. Much of business spending is in anticipation of future consumer spending ( or anticipation of other businesses anticipating consumer spending). With the savings rate near 0% and housing slowing down, there was no wealth effect or accumulated assets to drive spending, so any correction in house prices must necessarily slow down consumer spending and thus the economy as consumer’s try and fix their balance sheets and their income statements (expenses and savings % equivalent to net income margin for business). Businesses would respond accordingly, and, while exports could help, a lot of global income – especially emerging markets like China, is dependent directly or indirectly on US consumer demand. The bottom had to fall out of the market, and the banking system was going to be part of that because of housing and consumer exposure (Credit cards are yet another shoe waiting to drop). Oil prices didn’t help but were not central to the argument.
Tags: Paul Krugman
I gues this is a couple of days late – I’m still backpacking in Northeast India – but I must say I am really pleased Paul Krugman won the “Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel”.
Krugman is one of my favorite columnists at the NY Times, and I regularly read his blog. In particular, I think he has been spot on in terms of identifying the drivers of the current financial crisis. I also think he is absolutely right in claiming that the next president will have to boost government spending significantly.
I think that the choice is either a deep and lengthy recession – even, perhaps, a Second Depression – or a new New Deal – which may not work either.
Tags: economy, consumer spending
With Wall Street volatility increasing day by day, and -at the very least – delays to the bailout plan, I believe the consumer retrenchment we have seen so far this year will only deepen. Consumer spending has been under pressure from a variety of factors, from high gas prices to increasing food inflation to weakening job prospects.
Since about September 2007, I’ve been expecting consumer sentiment and spending to both weaken significantly. While the latest data points are weak, I still believe the bottom is still some way away – At the very least 2Q 2009 – with a very slow recovery after that, but I am increasingly inclined to believe that the bottom may be in 2010.
Tags: bailout, rescue, credit crisis
The housing and related market has several layers to it. There are a whole lot of individual mortgages. Many of these are sensible mortgages on affordable terms made to people who have been reasonably prudent. Some of them were risky, for a variety of reasons, including individuals who got greedy for more house than they could afford, or lenders / brokers who put buyers into unaffordably large mortgages or with onerous terms. Some of the risky mortgages have defaulted or are otherwise in trouble, and things will continue to worsen for some time.
Tightening credit norms are making it difficult for buyers to buy homes now, even as prices are slipping and inventory is rising, further causing prices to spiral downward.
Most of these individual mortgages were put together into pools of mortgages, and investors bought securities created out of these pools. The idea is that each mortgage-backed bond represents tiny fractions of thousands of mortgages, and so should be safe even if a few of those mortgages go bad. These securities are then broken up into tranches, with the worst tranches the first to absorb any losses from defaults, and the best tranches only taking a loss if the lower-ranked tranches were wiped out.
So far, so good. The value of these mortgage backed securities is similar to the value of the mortgages underlying these securities. But then, we add derivatives on these MBS’s. There is no real limit to the number or value or complexity of derivatives. We can bet that one security will be worth more than another, or that the defaults in one security will exceed (or be below) a certain level, or a host of other such bets. And we can then create securities that pay off based on the outcome of other bets. The size of the derivatives market has been estimated at nearly $700 trillion – A thousand times the size of the proposed bailout, and ten times the size of the global economy.
I guess thats a bit like horse racing – The amount of money that changes hands based on the outcome of a single race is many times the amount of money spent by the breeders, or the prize money they may win.
I think that if the bailout money was used to buy mortgages, the price support is more likely to buoy the prices of the derivatives, than if the attempt was to either support the derivatives directly, or to rescue the bank after the derivatives caused big losses. After all, with the money, one could buy up over 5% of mortgages, and thus support the value of derivatives that depend on the value of the underlying mortgage for their own value, or make the tiniest dent in the derivatives market. If the derivatives got support from underlying values, there wouldn’t need to be as much of a writedown.
Obviously, every trade has a counterparty. For everyone who bought a derivative, someone sold it. If the value of the derivative tanks, someone loses big, and someone makes a killing. Supporting the derivatives market via underlying mortgage action will reduce the change in the derivative value. People won’t lose as much, or make as much.
Clearly, this is distortionary – If the investors believed the government would rescue the derivatives, they would not have made the same trades. But I think that the only area where a rescue could work is at the underlying mortgage level – and if derivative investors see bets they called correctly going against them because of the rescue, I feel for them, but still think the economy is better off than if the bailout money was used to rescue the financial sector from the results of mortgage defaults.
Tags: bailout, rescue, credit crisis, Housing, workout, proposal, homeowner, tenancy
I’ve said all this before, but I’m collecting all my thoughts in one place with the following article.
The housing crisis has caused a series of writedowns, leaving the financial sector seriously undercapitalized and averse to further lending – even if their balance sheets permitted much lending. The resulting unwillingness or inability to lend money is threatening the entire economic system, as otherwise sound businesses find themselves unable to raise or refinance debt.
While a number of ad hoc actions have already been taken, with a major bailout plan proposed, they have tended to focus on supporting financial institutions while not tackling the real housing problem or the value of the actual mortgages underlying the mortgage backed securities and various related derivatives. However, as mortgage defaults increase, the value of these securities falls, often precipitously for some MBS tranches and for some derivatives.
I would like to propose an alternative workout that could simultaneously support the institutions while also providing some relief to Main Street.
I propose creating an agency empowered to buy near-foreclosure mortgages from the banks / debt holders, at a modest 3-5% discount to the outstanding principal balance, provided the homeowner agrees to a) transfer over the title of the property to the agency without a foreclosure and, b) continues to reside in the property as a tenant for at least a two year period at a reduced rental rate.
This would serve two purposes – First, by taking distressed mortgages off banks’ balance sheets at or near par value, this recapitalizes the banks and restores equity – basically by overpaying for the mortgages at taxpayer expense. You could prop up the prices of all mortgages, and thus restore the health of all balance sheets, as opposed to current policy of letting the value of mortgages slide, and then rescuing banks piecemeal, as they fail, without supporting underlying mortgage prices. Second, by keeping the erstwhile homeowner in the property, it reduces the supply of vacant homes -and the attendant security / vandalism problems for the neighborhood and unsold / auctioned / bank-owned home inventory, which eases the downward pressure on home prices, hopefully keeping more people in their homes.
How would this be structured, and how much would it cost? Here’s a back of the envelope calculation with some simplifications: Let’s say home ownership declines from near two-thirds of all households down to a 64% historical average level, which would translate into 3 million fewer home owners, with an average of $300,000 in outstanding debt (above the $203,100 median home price, to be conservative, as defaults are more likely in urban and suburban areas). At about a 5% discount, these mortgages could be purchased for $850 billion in capital ($900 billion face value). This money could support home prices and help keep other homeowners in their homes.
The homeowner must commit to a two-year rental on the property to be eligible for this scheme, with the rent set at a level that can recover the cost of capital for the agency. I assume a 4% cost of capital, the average tenant with a $300,000 loan would pay $12,000 a year towards capital cost. Assuming a $4000 annual property tax, the monthly rent could be set at just over $1300 for this average property – almost certainly more affordable than their current payment. If the tenant can make payments for two years, they avoid a foreclosure on their credit record. This brings the agency $36 billion in annual cash inflow, after paying $12 billion in property taxes (thus bolstering the local communities as well).
Some tenants will still be unable to make these rent payments on time, and will fall behind – Let us assume 20% of them fall behind, on average halfway through the two-year rental period. This would create a $10 billion shortfall in rental cash inflows over the two years. While these places can be rented to another tenant, let us assume they are sold at 25% below the debt value. Since the properties were bought at a 5% discount, the actual loss to the agency would average $60,000 per home, or $36 billion in capital.
Finally, if the remaining properties were sold after twoyears at a 15% loss to the debt value (10% loss to purchase price), the agency would lose a further $72 billion. In addition, the agency would incur various legal, administrative and property management expenses. Let us assume the annual cost to manage the entire process is 15% of the annual rent, above conventional propoerty management fees, considering the complicated transactions and higher default risk. This totals to about $10 billion. The total cost comes to $128 billion, or ~$56,000 per acquired house. Private sectors investors could be attracted to this scheme either in place of a federal agency, or in competition with it, by offering a $43,000 (14%) taxpayer-paid subsidy per average house, and acquiring it a 5% discount to outstanding principal. In fact, the government could auction the subsidy, granting the contracts to bidders who require the lowest percentage subsidy.
The government would need to create the legal framework, structure and guidelines to ease acquiring mortgages as well as to create a new “tenancy” alternative to foreclosure.
With a capital outlay of $850 billion, and a conservatively estimated cost of $128 billion to the taxpayer, this scheme can help homeowners in trouble, support housing prices and ease excess inventory, and support the mortgage backed securities’ and derivatives’ prices, restoring bank balance sheets. Hopefully, this could restore liquidity and some return to normalcy for the credit markets and the broader economy as well.
Tags: bailout, credit crisis, economy
While I am not a fan of the bailout proposal, and have blogged about an alternative plan that incorporates support for homeowners – both those in trouble and those who might benefit from a price / inventory stabilization – here, something certainly needs to be done.
The NY Times cover story says it all –
Defying President Bush and the leaders of both parties, rank-and-file lawmakers in the House on Monday rejected a $700 billion economic rescue plan in a revolt that rocked the Capitol, sent markets plunging and left top lawmakers groping for a resolution.
It seems clear to me that the US economy, and the financial sector is clearly undercapitalized and does not have the wherewithal to absorb the kind of massive losses we have seen and are likely to continue to see. Wall Street needs help, and it needs help soon.
Hi, we haven’t had internet access the past couple of days, and we may have only spotty access the next three weeks as we backpack across north eastern India. I will post when I can, and as often as I can.
Tags: rescue, credit crisis, Housing, foreclosure
Maybe we can have an agency or a fund that buys off foreclosed properties from banks, and allows the erstwhile owner to continue to occupy the place as a tenant (I’ve written about this here) . This would take the toxic mortgage off the bank’s balance sheet, and, by buying the mortgage at face value, or at a slight discount to face value, it would basically rescue the bank’s capital by overpaying for the debt. This, in turn, may support the mortgage market and the derivatives on these mortgages.
Knowing that the bad mortgages – those approaching foreclosure- can be sold at near-par (I suggest a 3-5% discount) would support prices of all mortgages.
In the meantime, the agency could convert the foreclosure process into a tenancy process – Ownership transfers to the agency, the previous owner now pays rent (at a rate somewhat lower than the mortgage payment, but one which covers the capital cost of the money the agency used to acquire the place), and, if s/he makes the rent payment regularly for a certain period of time (say two years – after all, plenty of renters lock themselves into a two year lease), they can then exit without a foreclosure on their credit record.
How much will this cost?
Lets try some round numbers to estimate this.
Two-thirds of about 110 million households own their homes, while the historical rate has been about 64%. The difference is about 3 million households, or about 4% of current homeowners. While the cycle could take homeownership even lower, I think rescuing homeowners would support the market to the point that perhaps prices and, more importantly, home ownership does not dip too far below this level.
The median home price in August 2008 was $203100, down from $224,400 in August 2007. However, we can assume that the median foreclosure may be above this amount for a couple of reasons – 1. Foreclosures are more likely in higher priced areas, and urban / suburban areas, and 2. The slowdown is worse in higher priced areas such as Southern California. Foreclosures started off in below-median-income households, but I think they are moving up the income ladder.
So lets assume the average mortgage on a foreclosed home is $300,000. This translates into about $850 billion in capital to purchase these foreclosed homes, at a 5% discount. Putting this money to work may help support pricing and keep other homeowners in their homes despite a decline in house prices.
I have previously estimated that the fall in home values could leave aggregate mortgage debt about $1.8 trillion above home values, so a real estate (RE) fund that buys up to $850 billion in property and converts them into rentals could make a serious dent in the problem. I wouldn’t worry too much about the derivatives market if we can bring some stability to the underlying real estate market – the derivative losses may be limited somewhat by the underlying stabilization, and anyway, I would rather use taxpayer money to support both Wall Street and Main Street, not just Wall Street.
Assuming a 4% cost of capital for the RE fund, and a $4000 median property tax, the median rental on these properties would be ~$1350 per month. We would have some people falling behind on the rent as well, so there would be losses on that as well, but I’m guessing that by stabilizing the market, and by charging rent that is probably considerably below what the tenant was previously paying in monthly installments, we might make it easier for the tenant to make these reduced payments.
So this fund would need $850B in capital, hopefully be able to largely produce returns that meet its cost of capital, and have assets that would eventually be sold to recover a fair amount of the principal, with a holding period of 2-5 years. Administratively, this would be a tough challenge to manage, but one could contract with property management agents to take care of some of these issues.
The ultimate cost to the tax payer may be a relatively small portion of the real estate fund. If we assume that about 20% of tenants fall behind on their payments (a conservatively high figure) during the two-year lease period (at a median of 1 year into the lease), that is just a $10 billion shortfall in lease collections. Lets say these 20% of properties are then sold (instead of being rented out to someone else) at a 20% loss. That is a 4% loss to the fund = $35 billion. Finally, assume the rest of the properties are eventually sold at a 10% loss. That would be $70 billion.
By my estimates, the total cost of a tenancy workout would be $115 billion, spread over several years. This is assuming the taxpayer-funded RE fund would actually purchase 3 million homes. But why not bring in private players who would get government backstop funding, based on these assumptions? Let them buy the properties at a 4% cost of capital, manage the process and the landlord -tenant relationship, and participate in the gain / loss relative to these back of the envelope calculations?
I would love to see a plan built around some such framework, and I would support the use of taxpayer money for this purpose.