The Good, Bad, and the Ugly

 

March 8, 2010

 

I thought it might be time to resurrect the old The Good, Bad, and Ugly title to describe conditions in key areas of jobs, housing, and credit markets.  A year ago the title would have been The Ugly.  Six months ago, the title would actually have been The Less Bad.  But I think it’s fair to say we can go back to the full title at this point.

 

Jobs – Finally running out of people to fire

 

The Good (?) – The latest Nonfarm Payroll report reported a job loss of 36,000.  I refuse to call that “good” when we need to be creating an average of at least 200,000 jobs per month to have any hope of getting the Unemployment Rate down appreciably over the next five years.  But given the potential weather distortions and other factors, the number at least qualifies as a neutral.  Looking back over the past four months, the average payroll monthly payroll loss was only 25,000.  A year ago one of my themes about the future of payrolls was that employers would eventually run out of people to fire, barring a depression.  We’ve achieved that at least.

 

We can also conclude employers have run out of people to fire by looking at the productivity numbers.  For the past three quarters, productivity (roughly a measure of the value of goods produced by workers) has risen by an average of 7.1% per quarter.  Since we’re not going through some radical technology-based efficiency breakthrough, this tells us that businesses have cut workers dramatically to the point at which we would expect hiring in the near future.  Of course this hinges on the economy maintaining some upward momentum. 

 

The Unemployment rate held steady at 9.7%.  Again, this is not good but better than the 10.1% rate in October.

 

A subcategory in The Good section would be the Potentially Good.  Not only do the productivity numbers argue for future payroll gains, so does the temporary worker payrolls.  The temporary worker category has gained for five straight months. Historically this has led to permanent jobs.  I do think that something might have changed however.  Businesses seem to be willing to rely longer on temporary workers than historical data would suggest.  This likely means that businesses are not that confident just yet.  Additionally, the cost of health insurance for permanent workers is an added negative to staffing up on permanent workers.  Still, a job is a job. 

 

The ink wasn’t even dry on the latest headlines on this payroll report before economists and pundits started looking toward next month.  We usually have at least a two or three week respite between numbers before the hype kicks in.  But economists were eager to look ahead.  Although the cold weather might not have been a serious negative factor in the latest report, it’s reasonable to assume whatever was lost will return in March.  To that positive, you can add census hiring.  The government only added 15,000 census workers in February.  The Census Bureau has said that well over 1,000,000 jobs will be added over the next four months.  While most of these will be short-term in nature and many part-time in hours, the jobs will be paying reasonable wages as long as they exist.  This will filter into sales and perhaps have some of those infamous trickle-down benefits.  Very early projections for March Nonfarm Payrolls are for a gain of 350,000 to 400,000 jobs.  Yes, the census hiring will distort those numbers beyond what permanent hiring growth is generated from the economic environment, but won’t those headlines look good after such a miserable two years?    

 

The Bad – Not all employment sectors are running out of people to fire.  State and local governments cut 25,000 workers.  That alone is not significant, but the likelihood is that this is only the beginning of a wave of job cuts in that sector.  While the State of California’s budget problems are massive and get a lot of ink, there are similar stories abounding from coast to coast and in governments from the smallest cities to the largest states.  Most government’s have yet to take significant action, but the deeper in the hole they get, the worse the cuts yet to come will be.  I do believe that, baring another wave of federal money, there will be 1,000,000 job cuts in this sector over the next eighteen months. That would represent only 5% of the workers in that sector.  Government payrolls will be playing catch-up to what has already happened in the private sector. (Maybe I should have put this in the ugly sector.)

 

 I had also expected the construction sector to run out of people to fire by this time but, alas, that is not the case.  Construction jobs fell by 64,000, which is no improvement at all over the past six months.  Any gain in residential construction jobs is being more than offset by declines in commercial construction.  I won’t even predict when this tide will turn. 

 

The subcategory in this section has to be The Skeptical.  Yes, the Unemployment Rate held steady at 9.7%, but I’m not certain all is as it appears on the surface.  The BLS slid another 140,000 workers from the “unemployed” category to the “discouraged workers” category, which takes them out of the unemployment rate calculation.  The BLS also “estimated” that based on the household survey there were roughly 400,000 jobs created in February by small businesses.  I don’t know about you, but all I have heard about from the small business sector are tales of continued sluggishness and problems.

 

The Ugly – A staggering employment problem still confronts the U.S.  Despite the supposed good news in this report, the true unemployment rate rose to 16.8%.  The BLS calls this the U6 rate.  This category includes discouraged workers, the marginally attached, and those forced into part-time jobs that need full-time work.  The 16.8% is marginally below the high reached a couple of months ago of 17.2%.  The “normal” U6 rate experienced in relatively good economic times ranges from 6-8%.  That to me is the definition of ugly.

 

Last month the number of workers involuntarily working part-time instead of full-time rose by 500,000 to a record of 8.8 million.  Part-time workers are considered employed by the BLS and does not count against the number regardless of circumstances.  But it gets worse.  In the BLS survey a worker only has to work one hour (ONE HOUR!) over a two-week period to be counted as employed.  As an example – you lose your $50,000 a year job but get paid $25 for mowing a neighbor’s lawn one week.  To the BLS you’re employed.  You might not feel like you’re employed, your mortgage lender might not view you as employed, but the BLS does.  We’re also seeing virtually no wage gains, and the average workweek remains stubbornly low. 

 

The BLS also reported that the number of long-term unemployed (27 weeks or longer) remained at the record high of 6.1 million workers. 

 

What ultimately matters to our economic health is not contained in the confusing cauldron of government calculations, but it is income.  The BLS can categorize and compartmentalize workers all it wants, but the bottom line is how much income gets into the pockets of consumers to pay mortgages and bills. 

 

Housing – Superficially Good  

 

 

The Good – In most areas, median home prices have finally turned positive, however slightly, on a year-over-year basis.  The most recent two months of sales has actually been very soft, but we can excuse some that as seasonal.  Additionally, a lot of demand in 2009 was pulled forward because of the expected November 30 expiration of the home tax credit.  Looking back at the entire year though, sales activity was strong. 

 

As mentioned above, the median home price comparison headlines have turned positive, and they are likely to get more positive for at least the next two months.  Most regions reported the bottom in the median prices in the first six months of 2009 when foreclosure activity (distressed sales) represented a near majority of all sales.  As foreclosed home sales have waned, the median has gravitated higher.  The median home price movement is further boosted by the increased activity in the higher end market as a percentage of all homes sold.  The caveat here though is that homes are beginning to move in that market because sellers are finally getting real and dropping prices.  Zillow has reported that asking prices for homes has dropped for the past three months.  Although prices in this sector are lower, the number of homes sold relative to sales in the low-end pulls the median price higher. While there is no convincing evidence of a general home price appreciation, the median price numbers should continue to look favorable for the next few months.  That’s a psychological boost to buyers.

 

While January home sales numbers were weak and February’s numbers will likely be no better, we should expect the numbers to escalate in March and April.  Unless again extended, the home tax credit will expire April 30.  The first home tax credit expiration expired at the end of November and that was based on closings.  The tax credit did not seem to be working until the surge in sales in August and September, as a sense of urgency struck buyers.  This time buyers have until April 30 to buy and close by June 30.  That would mean the surge is likely in March and April.  If I was thinking about selling my home (which is difficult given I don’t have one), I would put my home on the market now.  The next two months are likely to be the best ones of the year.  Buyers will be active and willing to negotiate prices less in order to get that golden ticket from the government.  After April 30, I would expect prices to drop.     

 

Mortgage rates have remained low.  Most mortgage experts felt that mortgage spreads would begin to widen in advance of the Fed’s cessation (March 31) of its mortgage backed securities purchase program.  But we have yet to see any signs of that.  Banks, especially, have escalated their purchases of agency MBS, and other buyers (mostly bond funds) have been very active. 

 

The Bad – The good story on mortgage rates will likely not last for long.  While buyers of mortgage backed securities (MBS) are active now, there is no certainty that will last.  Any signs of a stronger economic recovery will send buyers to the sidelines.  They will not want to risk buying MBS at such low rates and see the securities extend on them.  While spreads of mortgages vs. treasuries has remained at record low levels, there is really only one way for them to go - up.  Over the next six months we should see spreads widen by roughly 50 to 75 basis points on mortgages, which would return spreads closer to historical norms.

 

The U.S. remains a government-only mortgage market.  Agency mortgages currently account for 90% of mortgages made.  There is still absolutely no market for private-label mortgage securitization.  This limits any non-qualifying mortgages to the capacities of bank or credit union balance sheets.  This is not enough to sustain a healthy, diverse housing market.  The government is no further along in working toward a long-term solution for this problem than the first day they took over Fannie and Freddie.  In the meantime, buyers are perfectly willing to give up some yield for that government guarantee. 

 

The Ugly – The ugly story here is more potential for ugly than what is currently being experienced.  Delinquency numbers are not getting better.  There are fewer foreclosed homes on the market, but this is mostly due to efforts by banks to meet government demands for modification efforts as well as delay taking losses on final sales.  One shift we have seen in mortgage data analysis is that banks are beginning to get serious in working with sellers on short sales.  Through most of the housing debacle, banks were almost impossible to work with to accomplish a short sale.  The most recent data has shown, as foreclosure sales are declining, short-sales are rising rapidly.  But short sales are still not keeping up with the growing percentage of homeowners behind by sixty days or longer on house payments.  The data is also showing that homeowners falling into this category are far less likely to catch up and keep the home than any prior period.  Almost one in ten homeowners with mortgages is behind by sixty days or longer.  That is a staggering number.

 

Contributing to the ugly side of the ledger is the growing volume of “walk-aways” or, to use the new p.c. term, “strategic defaults.”  (People who can make the payments but choose not to).  At the beginning of the housing debacle, there was still an enormous negative feeling toward walking away.  You might still feel that way, but the tide has definitely shifted with or without you on board.  Over 1,000,000 of the homes lost to foreclosure last year were due to “strategic defaults.”  Articles appear regularly in a variety of papers depicting the lessening stigma of these defaults and arguments that in many cases it makes financial sense.  I’ve seen more than one article mention the economic benefits from those defaulting on payments.  The conclusion is those in default are spending more money on other things in addition to saving for an apartment and paying off bills.  One homeowner who opted to stop making payments was able to spend four months in France with his girlfriend with the money he save by pouring money down the drain in house payments.     

 

Strategic defaults are, of course, more likely and more prevalent in areas of greatest depreciation relative to mortgage values.  In Nevada, 70% of mortgagees are upside down on their homes.  In the high-priced state of California, 35% are underwater.  Florida and Arizona each stand at roughly 50%.  Given that the most of the troubled mortgages were taken out when home prices were peaking, the negative equity positions are huge.  It’s one thing to be upside down by $10,000 to even $50,000 on your mortgage.  It’s quite another to be down $250,000 or more.  The more sluggish the housing recovery is, the more hope will fade. 

 

No one knows how many foreclosures await us in the future, but the estimates derived from delinquency numbers argue that another wave is inevitable.  Last year there were roughly 2.5 million homes foreclosed.  Although the current delaying factors might have slowed the foreclosure pace at the beginning of this year, conservative estimates argue that 3.0 million homes are likely to hit foreclosure this year, slowing to 2 million in 2011.  Those are awfully big numbers for the housing market to absorb without further damage.

 

As far as the last argument for the Ugly side, please see Jobs.  Analysts can crank out chart after chart about improved affordability and low mortgage rates, but without a stable job market with improving prospects, the housing market will only come to life from time to time with shots of government-sponsored adrenalin.

 

Credit and the Credit Markets – Fuel Supplies Still Low

 

The Good – There are a few signs of thawing the credit markets, but the progress is mostly in the securitized debt markets.  Of course credit spreads on securities have collapsed from extraordinarily high levels.  Much of the improvement is due to passing of the wave of hysteria that gripped the markets during 2008 and 2009, when no entity was considered credit worthy.  We have also seen a resurgence in the issuance of non-mortgage consumer credit backed debt issues.  These have been mostly due to the Fed’s TALF program, set to expire this month.  But dealers are saying they are seeing a growing appetite of this product.  Spreads are still wide by historical measures and issuance is nowhere near previous levels, but it’s a step in the right direction. 

 

For those homes too expensive to qualify for any government mortgage, lending conditions are at least modestly better.  Most lenders have reduced the required down payment from 30% to 20%.  And instead of pricing the loans 1-1.5% higher than conventional, loans are somewhat widely available at spreads of roughly .75%.  Baby steps, but steps none the less.

 

A couple of months ago, the focus of credit problems shifted from the private sector to the sovereign debt sector.  This was kicked off by the Dubai concerns, then on the Greece deficits. Personally, I believe many we’ll have many more incidences of sovereign debt panics, but the immediate concerns have temporarily died down.  Greece was able to successfully issue a new 10-year note.  The success of that issue seemed to allay many fears that a contagion was developing. 

 

The Bad - The tightening of credit spreads and the success of that Greek bond offering tells us more about short-term borrowing rates than any judgment on credit worthiness.  I won’t repeat what I’ve written about so often in the past about how ultra-low short-term rates in the U.S. and Japan are fueling a credit bubble, but I believe this is a big risk that will be with us for a long time to come.  As long as the Fed insists on staying near 0%, highly leveraged funds will continue to pile into credits of lesser and lesser quality.  The returns are simply too tempting. 

 

The old saying goes something like “credit is what fuels the economy.”  If so, we got some bad gas the last time we filled up. Bank credit actually fell in the fourth quarter.  While banks claim they are no longer tightening lending standards, demand has clearly declined.  Banks have used the Fed provided liquidity to beef up securities portfolios, not beef up lending.  Further, although I cited the TALF program as a success, and we can have seen huge volume in mortgages, both of these are tied to government support. As these ties are severed, we simply don’t know how the markets will perform.

 

The Ugly – There is no escaping the fact that the commercial real estate lending shoe will drop this year.  Banks are pushing the envelope in a big way in not recognizing failed projects and taking losses.  Repayments are being pushed out and terms renegotiated, but the properties are still not filling up. A day of reckoning is inevitable.  The commercial property market does not represent as large of a problem as did residential, but there are roughly $1.5 trillion in commercial real state loans in question.

 

The sovereign debt issue will continue to rear its ugly head.  While there are sighs of relief all around regarding Greece, we still have no firm commitments from the EU to provided support as needed, nor do we have any reason for confidence that Greece will even live up to its bargain on deficits.  Greece has met the EU targets for deficits only once in ten years.  Yet, the EU has looked the other way.  They were likely caught up in the heady talk that the euro would eventually replace the dollar as the world’s reserve currency.  Now the truth, not only in Greece, but throughout the EU is slowly coming to light.  Spain is very likely to be in the crosshairs soon, and Spain represents a far more formidable challenge than Greece.     

 

I know I’ve been harping a lot over the past few months on the danger of a second credit meltdown stemming from the global re-leveraging play that has been fueled by low short term rates, but I fear this more than anything including sluggish job growth or falling home prices.  Another debt bubble bursting would be devastating.  The fact that nothing whatsoever has changed in the regulatory world to prevent or limit damage is what keeps me up at night.  Had global leaders made true progress on reforms, I would worry much less about this.  But this hasn’t happened, and it looks like an accident just waiting to happen.  Although Wall Street and our leaders such as Greenspan, Bernanke, and Paulson failed to foresee burgeoning risks in housing and mortgages, frankly the signs were there for anyone with some common sense to see.  I feel we’re almost looking at the same circumstances.  Nothing has changed on regulation or capital requirements.  No safeguards are in place.  And, our Fed and global central banks are all feeding the fire with ultra-low rates.  You think Toyota had braking problems?  They are nothing compared to the problems in the financial system. 

 

The Big Picture – Challenge Everything

 

This commentary has thrown a lot at you.  You might be taking away more confusion than clarity.  As most of you know, I expect more of the bad will ultimately outweigh the good.  I believe the economy will sink again in the second half of the year.  And, I worry a great deal that the ugly might get uglier, and we won’t be talking about just a mildly weaker economy.  But despite those feelings, I think we’re at a juncture where we should challenge all assumptions, whether good, bad, or ugly.  In the next commentary, I will address various interest rate scenarios.  Those could also be good, bad, or ugly.   

 

Dwight Johnston