Weekend Contemplation - Dr. Feldstein Says the Recovery Could be Long and Slow

Finally, some realistic comments about the condition of the US economy. Debate as much as you like but it looks like the recovery will be long and slow. The housing crisis is really causing major problems in the capital markets and at the banks. If Fannie and Freddie go through with the reduced mortgage purchases like they claim this will really slow down the the housing market. Throw into the mix a weak consumer and this could be tough. If you don't believe me go to the car lots and see the mark down in cars. Or go to the grocery store and ask them how business is. If you disagree, tell me what is going to turn the market around, I am dying to know. Text in bold is my emphasis. From Market Watch:

There is a palpable sense here at the Federal Reserve's exclusive retreat that the road to recovery will be a very long one for the U.S. economy.

A slowdown in the third and fourth quarter is widely expected, but many economists see a long stretch of stagnant conditions.

"I am worried," Martin Feldstein, a Harvard University professor, and leading economist, said in an interview.

"I think the downward spiral of house prices could be a very serious problem to the economy. There is no evidence that is going to stop," he said.

The danger is that this spiral becomes self-reinforcing -- with foreclosures leading to lower prices leading to more foreclosures, he said.

Although the Federal Reserve's latest forecast sees a rebound next year, Feldstein questioned what factors are behind the forecast.

"It is not clear where the lift will come from," Feldstein said.

Alan Sinai, chief global economist at Decision Economics Inc, forecast that the U.S. will soon slip into a recession lasting as long as any in the post-War history.

There were two recessions lasting roughly 16 months, one in the mid-1970s and another in the early 1980s.

"What is daunting now is that we've got a lot to go. We now have a weak consumer and after some amount of time, we'll have a weak business sector and a major global slowdown in growth. All of this will reverberate back into the economy," Sinai said.

"And the big wild card is how long does it take to deleverage, consolidate, squeeze down costs and then have some liveliness in the business of financial service,?" he added.

"That process time-wise, along with financial problem, could easily take a year," he said.
Feldstein said the market doesn't reflect this risky outlook because some sectors are still reporting healthy profits.

But it is also true that economists at major Wall Street firms are not as pessimistic as Feldstein or Sinai.

"I think the most likely scenario is by early next year things start to work themselves out," said Lewis Alexander, chief economist at Citigroup.

"I don't think we're likely to get a very robust recovery ... but I don't think a more disastrous scenario is the most likely case either," Alexander said.

Mickey Levy, chief economist at Bank of America, agreed.

"I think six months from now we will start to see the light at the end of the tunnel of the housing crisis," Levy said.

The declines in home construction will be near the end and "at that point, some of the uncertainty about how much home prices will fall will start to dissipate," he said.
Inflation

There was no consensus about the outlook for price pressure.

Levy said the Fed will soon begin to prepare markets for a rate hike by the end of the year, providing the Bush Administration completes a credible nationalization of Fannie Mae and Freddie Mac.

"That will open the door for the Fed hiking rates," Levy said.

Despite his weak growth outlook, Sinai said he would also support a small rate hike as a signal that the Fed is committed to stable prices.

Sinai said the Bush Administration and the Fed's response to the financial market turmoil over the past year is inherently inflationary.

For his part, Feldstein said he agreed with Fed chairman Ben Bernanke, who yesterday signaled that the central bank was prepared to be patient about hiking rates given the recent decline in oil prices.

The Worst Housing Market Since the 1930s

The following comments from Freddie Mac in the UK Guardian are at least forthright although you might not like the message. Interesting that these comments were not common in the US press. Text in bold is my empahsis.

The US mortgage finance empire Freddie Mac yesterday predicted the worst housing slump since the Great Depression as it set aside $2.5bn (£1.28bn) to cover credit liabilities caused by delinquent loans and foreclosures.

Two weeks after the US government hastily assembled a rescue package to support the business, Freddie revealed a second-quarter loss of $821m - a big jump in comparison with its first-quarter deficit of $151m.

Richard Syron, chief executive of Freddie Mac, said: "As we're all painfully aware, the housing correction has had a significant impact on the US economy." He admitted that the credit environment was deteriorating "even faster than we thought".

The government-sponsored company has a loan portfolio of more than $1.5tn. Along with its sister firm, Fannie Mae, it buys mortgages from lenders and securitises them on the financial markets in its mission to broaden access to home ownership.

Syron predicted yesterday that the American housing slump would be even deeper than anticipated. He said the company believed prices would drop by between 18% and 20% from their peak, exceeding its earlier forecast of 15%. In a statement, the company said it was "in the midst of the single largest decline in real estate values since the Great Depression".

Syron said: "Today's challenging economic environment suggests the housing market is far from stabilising. We now think we're about halfway through the peak-to-trough decline."

Alarm about the financial position of Fannie and Freddie has sent shares in the two companies plummeting by more than 80% this year. Freddie's loss, which was significantly greater than analysts had predicted, sent its stock down by 15% in early trading on Wall Street.

Freddie intends to raise $5.5bn of new capital to bolster its reserves and is slashing its dividend. The company insisted that its cash remained above regulatory targets - it has $37.1bn of core capital, which is $2.7bn more than the surplus required by the US government.

Congress recently nodded through a bill allowing the US treasury to lend money or buy shares in Freddie and Fannie to keep the businesses afloat. Economists fear that a collapse of one or both could have grave repercussions throughout the financial system. Between them, they back more than half of new US mortgages.

Syron said he did not believe such drastic taxpayer support would be needed: "While we do not expect to draw on any of the new backstops going forward, they provide important sources of reassurance and potential support in the event that the housing market declines even further than anticipated."

Analysts believe investors are likely to attach stringent terms to any fundraising by the company. Walter O'Haire, of the Boston financial consultancy Celent, said: "What will be interesting to see are the terms investors will demand in return for buying into Freddie Mac's proposed $5.5bn stock offering."

This Weekend's Contemplation - Are the Bank's Beginning to Sieze Up?

The real issue for me, the thing I worry most about is when the banks start refusing to lend. This past week was scary to me. The ultimate demand for housing is not the ratio of rent to house payment or the price of homes, it is the ability of a consumer to borrow the money for a home. Banks stop lending, the demand for homes decreases, so what is going to happen to the price of homes? The price of homes goes down, banks have to take additional charge-offs, so now they have less money to lend due to impairmants on capital, therefore, the banks stop lending. It is a vicious circle. Below are comments from 3 articles this week that may more strongly effect our respective futures than any other news this week.

From Yahoo News:

Fannie Mae on Friday posted a much larger-than-expected second-quarter loss and slashed its dividend more than 85 percent to preserve capital as home loan defaults accelerated in the bleakest U.S. housing market since the Great Depression. . . . .

. . . . . Fannie also said it will cease buying certain risky mortgages that accounted for nearly half of its credit losses in the quarter and set a year-end target for doing so.

The loss reversed a profit of $1.95 billion, excluding preferred dividend payments, from a year earlier. Excluding extraordinary items, the second-quarter loss equaled $2.51 per share, more than two-and-a-half times greater than the average estimate among Wall Street analysts of 98 cents per share, according to Reuters Estimates.

"The key for Fannie and Freddie both, and also for banks, is 'Do they have the capital to get through the next year or so?"' said David Dreman, chairman of Jersey City, New Jersey-based Dreman Value Management, LLC, a large holder of Fannie and Freddie Mac shares. . . . .

. . . . . By year's end, Fannie Mae will stop buying Alt-A mortgages, riskier mortgages that require less proof of borrower income. These loans made up about 11 percent of the company's total single-family mortgage credit business, but spurred about half of its credit losses in the second quarter.

Fannie said it has already reduced its holdings and purchases of Alt-A mortgages by 80 percent from peak levels. Far fewer such loans are being originated under tighter lending standards imposed as a result of the subprime lending crisis.

From Yahoo News:

Wachovia Corp, the fourth-largest U.S. bank, will stop making mortgage loans through its branch offices in 19 U.S. states, a published report said.

The bank will eliminate 125 jobs in connection with the cutback, but still plans to offer mortgages through branches in 18 other states, Bloomberg News reported on Friday.

The latest cuts extend the fallout from the Charlotte, North Carolina-based bank's failed $24.2 billion purchase in 2006 of California mortgage lender Golden West Financial Corp.

A surge in mortgage losses contributed to an overall $8.86 billion second-quarter loss at Wachovia. . . . . Wachovia is eliminating more than 10,700 jobs and plans to reduce expenses by $2 billion by the end of 2009. In July, it said it had already eliminated 2,000 retail mortgage jobs this year, and planned to cut 4,400 more over 12 months.

From Market Watch:

Freddie Mac's $821 million second-quarter loss makes it more likely that the government will have to bail out the mortgage giant, experts said on Wednesday.

In addition to reporting the loss, Freddie also slashed its dividend and set aside $2.5 billion in provisions to cover credit losses, more than twice as much as in the first quarter. The company reiterated a commitment to raise $5.5 billion in new capital and said that it may raise more than that if needed.

However, experts said after the results that the company may struggle to raise the capital it needs by selling new common stock and preferred securities in the private market. That may force the Treasury to lend more money to Freddie and buy equity in the company, they explained.

Freddie and rival Fannie Mae guarantee roughly half of all residential mortgages in the U.S. With home prices falling and foreclosures surging, they're suffering billions of dollars in losses and have been under pressure to raise new capital.