Popular Economics Weekly

The Labor Department’s employment report was much better than the headline, which showed 36,000 payroll jobs lost. This was mostly due to a drop in construction employment from the severe winter. But it also showed signs of an incipient spring thaw. Private service-producing jobs actually increased by 42,000, mainly in education and health care, and temporary help jobs continued to rise—up another 48,000.

Jobs are coming back, in other words, but unevenly. The unemployment rate seems to have topped out, and is at 9.7 percent for the second consecutive month.

The question is what are employers waiting for? Retail sales are showing a 2 percent growth rate month-to-month—and are up 4.7 percent in a year.  Consumers have increased overall spending, including for motor vehicles.

A big surprise was the rise in consumer debt, a sure sign of increased consumer purchases. Consumer credit broke a record cycle of decline in January, rising $5.0 billion and led by a $6.6 billion rise in non-revolving credit (car loans, mobile homes, education, boats, trailers, vacations). But revolving credit (credit cards) still declined, down $1.7 billion but much less than December’s $9.4 billion plunge. Today’s news is good but consumer reluctance and/or inability to borrow on their credit cards is still a sign of economic distress.

Housing is in the January blahs, with pending, new, and existing-home sales down due to seasonal factors. Sales are bound to improve with the spring sales season, however. Prices should also improve after a year-end slowdown. The Case-Shiller 20-City Home Price Index is actually increasing when seasonally adjusted.

The seasonally adjusted 20-city composite rose 0.3 percent in January, equaling the rise the month before.  This version of Case-Shiller has increased in six of the last seven months (September 2009 was flat).  But recent numbers are much softer than those seen during last summer when even seasonally adjusted prices were rising in the 1 percent vicinity. This is per Econoday.

Much of what happens in 2010 will depend on the consumer. Indeed, the consumer’s mood is still downbeat, reflecting a jobs market that is not improving and income growth that is stagnant.  The Conference Board’s consumer confidence index fell back sharply in February, dropping nearly 10 points to 46.0.  This is the lowest level since the 40.8 reading for April 2009 but is still above the recession low of 25.3 seen in February 2009. Expectations, the index’s leading component, fell more than 13 points last month to 63.8 reflecting a sweeping sentiment downturn in income, employment, and business conditions.  

The view for current conditions is even worse as this index dipped nearly 6 points to an abysmal 19.4 and the lowest reading since 17.5 set in February 1983. Weakness is clearly tied to pessimism over the jobs market. Only 6.2 percent of the survey sample describes job prospects as good. A miniscule 3.6 percent describes jobs as currently plentiful with 47.7 percent calling them as hard to get.

Yet consumer confidence is notoriously fickle. Barron’s Gene Epstein pointed out in a recent column that consumer confidence tanked during the earlier part of past recoveries. It fell 16 percent in the summer of 1992, for example, yet “We now know that in the third and fourth quarters of ‘92, real GDP growth accelerated to a healthy annual rate of 4.2 and 4.3 percent, respectively, accompanied by a steady rise in consumer spending and a steady fall in the unemployment rate..

So the February jobs report may actually be a sign of better things to come.

Harlan Green © 2010

Popular Economics Weekly

We are beginning to see a many-shaped recovery. That is, some sectors show a ‘V’ shaped recovery, such as manufacturing. Employment is becoming a ‘U’ shape, while real estate could very well take the longest to recover, and so look like a ‘W’. This means it will be uneven, for starters, so that some sector areas of the country will recover before others.

Let’s start with manufacturing, which is being powered by our less expensive exports thanks to the Dollar’s lower foreign exchange value.

It had a record plunge during the recession, which probably ended last fall. It is too early to tell, but those expecting a "V" shaped recovery would expect industrial production to be tracking at or above the "severe recessions" line (since this was the worst recession since the Depression).

In fact, manufacturers’ new orders, a leading indicator, is up eight of the last nine months. It increased $3.7 billion or 1.0 percent to $370.4 billion, reported the U.S. Census Bureau. This followed a 1.0 percent November increase.

An employment recovery is already taking a ‘U’ shape, with the jobless rate dropping to 9.7 percent in January.

The month-to-month percentage change in employment is more useful, especially when compared with past recessions. It is a very shallow ‘U’ shape, but could still recover sooner than the 2001 jobless recovery, which took 47 months to return to pre-recession levels.

The shape of a real estate recovery is more uncertain. That is because the vacancy rate of unoccupied homes is still rising, meaning a huge overhang of unsold housing inventory. And maybe 20 percent of all homeowners have no equity left or are ‘underwater’ in their properties, which could lead to more defaults. This has basically stopped new home construction. So though defaults have leveled off at present, they could increase again, driving down both sales and home prices further.

The latest Case-Shiller Home Price Index shows that prices in most metropolitan areas are still trending downward, but at a slower rate. Only Dallas, Denver, San Francisco, and San Diego prices have turned positive over the past year.

In fact, most of the economy has been expanding for at least 6 months, but net revenues have either been hoarded as reserves against future losses, or used to pay down debt. Consumers’ outstanding debt has been shrinking for an unprecedented 11 months. Only when consumer credit begins to expand again will consumer spending return to historical levels.

Harlan Green © 2010

Popular Economics Weekly

The Federal Reserve decided to raise their nominal discount rate by 0.25 percent—the rate they charge banks to borrow Fed money—to 0.75 percent last week. The reason is to get banks off the Fed’s dole. Banks had been borrowing from the Fed, because the money was so cheap. The Fed is now saying it is time for banks to look for funds in the private sector.

But it also signaled that this wasn’t the beginning of a sustained tightening. “"The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy."

This is a sign the Fed sees business activity increasing. We have already talked about the surge in manufacturing in what is looking like a ‘V’ shaped recovery.

Industrial production posted another strong gain for January-but this time the strength was real and not weather related. Industrial production in January advanced 0.9 percent, following a 0.7 percent jump in December. The January was marginally better than the market projection for a 0.8 percent gain.

The service sector is also on a sustained recovery. The headline composite rose 1.4 points to 50.1, a level indicating very little month-to-month change in overall activity for the bulk of the economy. New orders, the life blood of business, did show a month-to-month increase at 52.1, the slowest increase over the last four months. In a reflection of the prior gains in orders, the business activity component, which can roughly be described as a production reading, rose more than 4 points to 53.7.

Lastly, consumer spending has been expanding since April 2009. This was remarked upon by the Federal Reserve in its latest Beige Book report. “Ten Districts reported some increased activity or improvement in conditions, while the remaining two–Philadelphia and Richmond–reported mixed conditions. This was an improvement from the last Beige Book that reported eight Districts with increased activity or improving conditions and four Districts showing little change and/or mixed conditions.

And is why retail sales have been increasing since last fall.

The bottom line is that the Fed has decided to no longer subsidize the so-called ‘carry trade’, whereby banks were able to borrow monies at next to zero interest and lend or invest it at prevailing market returns. This is why profits of the largest banks have been surging. The release of minutes from the January FOMC hints at why the Fed has begun to tighten.

“Information received since the Federal Open Market Committee met in December suggests that economic activity has continued to strengthen and that the deterioration in the labor market is abating. Household spending is expanding at a moderate rate but remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software appears to be picking up, but investment in structures is still contracting and employers remain reluctant to add to payrolls.”

It remains to be seen how the markets will react to the first interest rate rise in more than 2 years.

Harlan Green © 2010

The Mortgage Corner

The Calculated Risk Blog highlighted some interesting data on short-sales in Las Vegas. Short sales averaged about 7 percent to 8 percent of Las Vegas existing-home closings in early 2009, but averaged 22 percent of the market by the end of the year and in early January. This is while foreclosure rates are declining.  Is there a connection?

And pending home sales for contracts signed in December rose, while home prices continue to improve.

“We have seen a decrease in foreclosure activity in Las Vegas, which was puzzling to us,” said Daren Bloomquist, marketing manager for California-based RealtyTrac, which monitors foreclosures in Nevada. “Maybe Las Vegas has become somewhat of a test ground for streamlining short sales. It sounds like it could have an impact in Las Vegas.”

In fact, the Treasury Department is now offering incentives on short sales by providing a $2,500 subsidy, $1,000 to the servicer and $1,500 to the seller for moving expenses. In addition, investors can get $1,000 by allowing subordinate lenders to get $3,000 in proceeds from the sale. The program is effective April 5, but servicers can implement it earlier.

This is better than “walking away” for the lender - the losses are less than for a foreclosure. And this is better for the homeowner too because Treasury requires that “the borrower will be released from all liability for repayment of the first mortgage debt”, although the borrower will still take a credit hit.

The November Case-Shiller headline composite 20-city index showed a 0.2 percent decline in November, following a 0.1 percent dip in October.  But the headline numbers still are not seasonally adjusted. The report detail showed a 0.2 percent rise in November, following a 0.3 percent boost the month before. On a seasonally adjusted basis, this index has risen for six consecutive months.

NAR chief economist Lawrence Yun said it’s important to recognize how the tax credit is skewing market data. “There are easily understood swings in contract activity as buyers respond to a tax credit that was expiring and was then extended and expanded,” he said. “These swings are masking the underlying trend, which is a broad improvement over year-ago levels. December activity was the fifth highest monthly tally in two years.”

The Pending Home Sales Index, a forward-looking indicator, showed activity picking up in 2010. It increased 1.0 percent to 96.6 from 95.6 in November. This should also continue to push up home prices as more repeat buyers enter the market for higher priced homes.

Home prices are already stabilizing or even firming. Existing home prices firmed in December with the median price up a sizable 4.9 percent to $178,300. The National Association of Realtors, which compiles the report, attributed the gain to a higher proportion of repeat buyers during the month.  That is, there were more buyers moving up in contrast to sales be dominated by first-time buyers recently enticed by special credits.

Harlan Green © 2010

Financial FAQs

How important is it to know how to negotiate? Particularly for real estate, which is a decision homebuyers may live with for years. We don’t think of it for everyday items or even in other areas of life. Americans don’t have the time for it, do we? Yet how is one to negotiate for the ‘big ticket’ items if we don’t become proficient at negotiating for the mundane? Psychologists will tell you that children tend to manipulate for what they want, while mature adults negotiate, hopefully.

A trait that makes it difficult to negotiate is imbedded in our culture. Americans tend to want to please others. We are a happy, fairly prosperous people, right? It is difficult to say no to someone, such as a salesperson, or to accept no—rejection in a word. Yet that is at the heart of learning how to negotiate. A trained negotiator will tell you to practice getting rejections, as strange as that may sound.

For instance, there is a trick to buying a car at the right price, if you aren’t a practiced negotiator. Negotiate for one you don’t want first, so there is a minimum of emotional attachment to the transaction. Or, is there a friend who is a good negotiator? Listen to him/her. They will ask more questions than give answers. Learning how to acquire important information is part of the process, but more on this later.

Learning how to negotiate is tough. It goes against many ingrained habits. One is thinking there has to be a winner—and loser. The competitive urge says it’s either ‘them’ or ‘us’, for instance. In fact, the most successful negotiations will achieve a win—win solution, so that both sides feel they have won something. If that basic principle is kept in mind then the negotiating process will not only be easier, but the outcome more successful. Also, if both parties feel they have accomplished something in the transaction, chances are better for repeat business.

This doesn’t mean hard work isn’t required. It is important, for instance, that the buyer knows not only their own ‘bottom line’ in costs and preferences, but must try to get as much information about the seller, as well. Does the real property seller have much time, for instance, or is a purchase waiting in the wings? Researching the history of the property is also important, to find out what the seller originally paid for it—and when. This is usually available in the public records.

Remember that the person who asks the questions and does the research gets the most valuable information. Much of the high profile negotiating we see in sports or politics is a jockeying for more information. The fact that they are adversarial doesn’t always help the process, of course.

What other information is important? One is the time element. It is not a good idea to let time rule a transaction. A rule of thumb is that the one who controls the clock has the advantage. If the seller knows you have to find a home by a certain date, then they have the edge. A seller’s foreclosure proceeding, on the other hand, is a classic example of a time constraint on the buyer’s side. A prospective buyer knows the property will sell for less because the clock is ticking, as does the lien holder in the foreclosure auction!

Wearing down the other side is another classic negotiating tactic. This is using time to your advantage. Act as if time is of no concern, for example. Walking away when there is an impasse, or putting pressure by setting deadlines are all examples of how valuable is time in any transaction.

But a good negotiator realizes that the other side has to win something, also. If the National Basketball Association’s season of several years’ ago had been completely cancelled nobody would have won. Salespersons realize that if they don’t sell the house or car, then nobody wins. And there might be return business if both sides feel good about the transaction, as we said.

There is much more to skillful negotiating, of course. In fact, studies have shown that it isn’t so much the skill level or knowledge of the negotiator as it is the desire that determines an outcome. An old saw is that they who want it the most usually succeed in getting what they want. So strong motivation will many times overcome a lack of negotiating skills. However one absolutely essential skill to cultivate is patience. For all good things will come in time, is another, very useful saw.

Next week: Art of Negotiation—Part II. Getting what is best for you.

Harlan Green © 2010

Popular Economics Weekly

What will economic growth be in 2010? Will it be enough to bring down the unemployment rate, for instance, or bring back the housing market? Does that mean we are really out of the Great Recession? Much of it may depend on how we feel about what has happened.

There is talk of a ‘new normal’ growth rate that will be slower than in recent years. Bill Gross, managing Director of giant bond fund PIMCO, says that a combination of deleveraging debt, re-regulation, and slower foreign growth means slower economic growth for all.

The largest drag will be the need to pay down both public and private debt to more historical levels. That means halving annual government budget deficits from 6 to 3 percent of GDP. That is projected to take 5-10 years—sooner if Congress will reinstate the Pay-as-you-Go rules mandating no additional government spending without the revenues to pay for it. This prevailed during the Clinton Administration that created a budget surplus by 2000.

Household debt is more difficult to determine; but it is rapidly declining, with overall balances back down to 2006 levels and household mortgage and credit card payments as a percentage of disposable household income the lowest since 2001.

The effects of re-regulation are something harder to measure. But if forceful, much confidence will be restored in the financial markets that have caused so much loss. Consumer confidence has stalled since the fall of 2008 when Lehman Brothers and Bear Stearns failed. Housing will also benefit if clearer rules for mortgage lenders are formulated that restores trust in banks. Former Fed Chairman Paul Volcker is leading the charge to take commercial banks out of high-risk investments, for instance.

Behavioral economist Robert Shiller has highlighted the importance of the loss of “hearts and minds” of workers that resulted from the horrendous financial losses incurred by the successive speculative booms. Shiller says “Solutions for the economy must address, not only the structural instability of our financial institutions, but also these problems in the hearts and minds of workers and investors—problems that may otherwise persist for many years.”

He is implying that restoring confidence in our financial system is only part of the problem. There is a system-wide malaise from a sense of injustice—that our modern economic system is not egalitarian, particularly today when Wall Street is being rescued by the victims of their greed—U.S. taxpayers.

Major indicators are giving the green light to better growth this year. Firstly, fourth quarter GDP growth surged 5.7 percent after 2.2 percent in Q3. But much of the growth was from replenishing depleted inventories, which is normal during a recovery. Businesses usually over react to downturns by cutting back on shelf-stocking, so have to play catch up when demand picks up.

Two other growth indicators put out by the Institute of Supply Management (ISM) show improving growth as well. The so-called non-manufacturing, service sector has been growing for the past 6 months, after shrinking for 10 months. Its new orders component shot up 2.7 points in January.

The pace of month-to-month growth in the manufacturing sector also rose sharply in January, driven by a red-hot pace of new orders that points to exceptional overall growth through the rest of the first quarter. The ISM’s manufacturing index jumped more than 3 points to 58.4 for its sixth straight indication of month-to-month growth over 50 percent.

Today’s report is very strong and points to a V-recovery for the manufacturing sector, a sector all through the second half of last year that was at the center of economic recovery. It has been rising since December 2008.

In fact, much of the current malaise is due to the high degree of uncertainty about what the future will bring. Start with housing—both the backlog of toxic mortgages weighing down banks, and home foreclosures waiting in the wings. Then we have the uncertainty of jobs growth, which depends in part on less than confident consumers. This uncertainty can only be allayed by a restoration of trust—in both our public and private institutions.

Harlan Green © 2010

Financial FAQs

We spoke recently of the possibility of returning to some form of the New Deal economics of Roosevelt and the Great Depression to help us out of this Great Recession. Those were very different times, of course. What made it the Great Depression was the lack of any social safety net at all. It was New Deal legislation that created Social Security, federal deposit insurance, unemployment insurance, and modern bank regulation which gave savers and the unemployed some sense of security. We didn’t get Medicare until the 1960s, and even today there is much resistance to universal health coverage.

Part of the problem is highlighted by Professor Robert Shiller in a recent Sunday New York Times Op-ed piece. He said that major recessions in particular mean a wholesale loss of confidence in institutions. And such losses came from too much emphasis on individual self interest as the prime mover of economic activity (rather than on institutions), hence the massive deregulation that was rationalized by an ideology that markets can best regulate themselves.

A more recent example of the effects of such confidence loss is the Japanese deflationary spiral that has now lasted almost twenty years, resulting is a massive devaluation of both income and assets. It was originally caused by real estate and stock market bubbles bursting in the early 1990s. This led to a massive rise in private saving by Japanese citizens, who were afraid to invest their monies in anything other than low yielding, (and more liquid) government securities.

Sound familiar? We highlighted the warning of Nomura Securities’ Richard Yoo that such could happen to the U.S. in a recent Barron’s article. That is, if government didn’t use some of those unused savings to invest in economic activity, then our economic growth could also remain stagnant.

So how to restore faith in institutions outside of ourselves when so many have lost their jobs and savings in this recession, “the most serious crisis in 75 years”, according to former Fed Chairman and Presidential advisor Paul Volcker? It may be a rational choice to save more and pay down one’s debts in such an environment, but an economy can’t grow unless some of those savings are re-invested, as we said. The first step should be restoring faith in the regulatory agencies that allowed the excesses of our financial sector, so that markets remain transparent and the wealthy few aren’t favored.

Paul Volcker himself has been the strongest advocate for again separating commercial from investment banks, similar to the depression-era Glass-Steagall act that was partially repealed in 1999. The core issue is that citizens’ depositary savings are federally insured in commercial banks, so commercial banks (as opposed to investment banks, hedge funds, and the like) should be restrained from too risky investments that might endanger those savings. When Glass-Steagall was repealed, banks were able invest for their own profit, which encouraged more risk taking.

Yet, “Apart from the risks inherent in these activities, they also present virtually insolvable conflicts of interest with customer relationships, conflicts that simply cannot be escaped by an elaboration of so-called Chinese walls between different divisions of an institution”, said Dr. Volcker.

Severe recessions are characterized by a loss of confidence in both government and private institutions. It was the private financial sector that almost failed this time around, after all. And memories of past disasters tend to dim over time.

“I’ve been there—as regulator, as central banker, as commercial bank official and director—for almost 60 years,” said Volcker. “I have observed how memories dim. Individuals change. Institutional and political pressures to “lay off” tough regulation will remain—most notably in the fair weather that inevitably precedes the storm.”

Effective financial reform has a better chance to succeed this time, in part because so many of our private institutions failed—or were proved inadequate to withstand the massive loss of credit, such as mortgage guarantors Freddie Mac and Fannie Mae. This recession has once again shown that we cannot rely solely in individual effort. Strengthening the institutions that support us–whether locally, or nationally, are just as important to maintaining financial health.

Harlan Green © 2009

Popular Economics Weekly

Fannie Mae’s rate of serious delinquencies - at least 90 days behind - for conventional loans in its single-family guarantee business increased to 5.29 percent in November, up from 4.98 percent in October - and up from 2.13 percent in November 2008. To put it in historical perspective, the delinquency rate for all conventional loans is now above 6 percent, up from 4 percent long term.

This is why there are efforts to ramp up the government’s Home Affordable Modification Program (HAMP) to include equity-line second Trust Deeds. The U.S. Treasury has outlined new guidelines aimed at streamlining requirements for mortgage relief under the administration’s Home Affordable Modification Program launched a year ago.

The guidelines specify that borrowers must provide three items to loan servicers, the companies that collect mortgage payments: a form requesting a loan modification, authorization for the servicer to seek tax information from the Internal Revenue Service and evidence of income, such as two recent pay stubs. Previously, some servicers have asked borrowers to fax in copies of their tax returns. Borrowers sometimes couldn’t find the needed tax forms or complained that servicers repeatedly lost material faxed to them.

Bank of America is the first large lender to sign on to the second lien program in an effort to speed up modifications. There are 3-4 million mortgage holders supposedly eligible for modifications. A 3 to 6 month trial period when payments must be kept up is to be followed by a more permanent 5-year fixed rate ARM. With market rates for both conforming and jumbo-conforming (with $729,750 maximum amount) 5-year fixed rates below 4 percent, this is an ideal time to push the modification effort.

Borrowers are eligible if their overall monthly mortgage payment including taxes, insurance and Condo Homeowner Association fee, exceeds 38 percent of their gross income on a loan taken out before January 1, 2009. Their lender has to first agree to bring their payment down to 38 percent, and the HAMP program will split the cost with the lender-servicer to bring it down to 31 percent of gross monthly income. To date more than 1 million have applied, but few have been converted to permanent status. This is in part because the rules have changed, and now income-verification is required.

The Fed’s $1.3 billion purchase of mortgage-backed-securities has kept down interest rates, but regulators are still pushing lenders to tighten their credit standards. The latest change is a maximum debt-to-income ratio limit of 45 percent of gross income. To date, this hasn’t helped to lower foreclosure rates, so defaults are still at record highs.

For those who are worried about mortgage rates after the Fed stops purchasing Mortgage Backed Securities in March, here is a Wall Street Journal opinion. The odds are highly in favor of the Fed keeping overnight rates where they are through June. In fact, an article in the Wall Street Journal yesterday points out that there is a growing belief among investors that when the Fed’s mortgage security purchase program ends at the end of March, mortgage rates won’t soar. "They argue that investors, searching for higher-yielding securities, will find government-backed mortgage-backed securities a bargain relative to other investments, like corporate debt, that have rallied for much of the past year."

The number of California homes entering the foreclosure process declined again during fourth quarter 2009 amid signs that the worst may be over in hard-hit entry-level markets, while slowly spreading to more expensive neighborhoods. There are mixed signals for 2010: It’s unclear how much of the drop in mortgage defaults is due to shifting market conditions, and how much is the result of changing foreclosure policies among lenders and loan servicers, a real estate information service reported.

Calculated Risk reported that Mid 2006 was clearly the worst of the ‘loans gone wild’ period and it’s taking a long time to work through them. We’re also watching foreclosure activity start to move into more established mid-level and high-end neighborhoods. Homeowners there were able to make their payments longer than homeowners in entry-level neighborhoods, but because of the recession and job losses, that’s changing. Foreclosure activity is a lagging indicator of distress," Walsh said.

Very good news was that fourth quarter advance estimate of gross domestic product rose more than expected at an annualized rate of 5.7 percent. This was the quickest growth rate in more than six years, up from Q3 growth of 2.2 percent.

And it was with very little inflation, what with wage costs having barely risen. The GDP’s so-called price deflator, the best indicator of inflation since it covers all sectors of the economy, is rising just 0.6 percent year-over-year.

Wage costs, which make up two-thirds of product costs, are directly tied to the employment rate. And since it could be another 3-5 years before employment returns to normal levels, there should be little inflationary pressure for years to come.

So the combination of low inflation and weak employment should keep interest rates low through 2010. This is already encouraging homebuyers to return to the housing market.

Harlan Green © 2010

Popular Economics Weekly

Much analysis has already been done on the causes of the housing bubble, but little done on helping to cure it. Nobel economist Professor Joseph Stiglitz’s just published FREEFALL is perhaps the most comprehensive analysis of what went wrong. He blames deregulation for allowing most of the excesses, since everyone—not just homeowners—over borrowed, and wants more stimulus spending that benefits Main Street jobs rather than Wall Street financiers.

Most of the stimulus spending to date has been either to prop up the financial system (TARP), and/or retain jobs, such as the $785 billion for ARRA, the American Recovery and Reinvestment Act.

The Fed’s $1.3 billion purchase of mortgage-backed-securities has kept down interest rates, but regulators are still pushing lenders to tighten their credit standards. The latest change is a maximum debt-to-income ratio limit of 45 percent of gross income. To date, this hasn’t helped to lower foreclosure rates, so defaults are still at record highs.

Part of the problem is there is still little agreement on the causes of the housing bubble. This is compounded by past and current Fed Chairmen saying they have little control over asset bubbles.

But in fact the cause of the housing bubble—and consequent recession when housing collapsed—was no different from that of any other bubble-caused recession. Too easy credit was extended that caused a huge oversupply of housing to be built and sold. Many more homes were built than could be justified by economic fundamentals, in other words.

And so when the Fed began to raise interest rates again in 2006, it popped the bubble of the subprime and Option ARMs as mortgage payments rose from their artificially low initial rates and borrowers began to default. Since banks had loaded up on these toxic loans, they could no longer service their normal business clients when those toxic assets were drastically devalued. That is, normal credit dried up and so business activity began to shrink.

How is real estate doing? New home sales fell 4 percent, but housing permits rose 10 percent; the second month of improvement, auguring higher residential construction next year.

Despite weakness in starts in the latest month, homebuilders are somewhat optimistic based on permits. Housing permits continued last month’s rebound rising 10.9 percent in December after a 6.9 percent comeback the month before. The December pace of 653,000 units annualized was up 15.8 percent from a year-ago. Both single-family and multifamily permits were up monthly in December.

But it is very unlikely that there will be a strong rebound in housing construction until the record number of vacant housing units is reduced. The vacancy rate has continued to climb even after housing starts fell off a cliff. Initially this was because of a significant number of completions. Also some hidden inventory (like some 2nd homes) have become available for sale or for rent, and lately some households have probably doubled up because of tough economic times, according to ECONODAY.

Then how can government help solve the housing crisis? Firstly, it is obvious from the high vacancy rate that there is still an oversupply of existing homes. And it is the record low interest rates plus the homebuyers’ tax credit—now extended through June—that is spurring home purchases. So the Fed should continue to hold down interest rates through 2010, at least.

There has also been talk of reducing principal loan balances for those millions of loans now underwater. But neither lenders nor the U.S. Treasury have been eager to embrace that option, according to the Wall Street Journal in a recent column, for fear it will precipitate more foreclosures:

“… Assistant Treasury Secretary Michael Barr … suggested that there would be a risk that such a [principal] program would change a lot of borrowers’ behavior. “Most people, most of the time, make their mortgage payments … even if they’re underwater,” Mr. Barr noted. “You have to be quite careful not to design a program that induces more people to walk away” …

Anyway, it is payment reductions that have been the most helpful to borrowers to date. But the reduced rates have to be fixed for at least 5 years, before any rate adjustment occurs. There should also be an interest-only option, and rates should be in line with current rates, which are 3.50 to 3.75 percent with a 5-year fixed rate conventional ARM for a 1 point origination fee.

Harlan Green © 2010

Financial FAQs

Are we returning to the New Deal economics of Roosevelt and the Great Depression? This would be an about face from the neo-classical, so-called trickle-down economic theories of recent decades that maintained government was inefficient and only the private sector should control markets and the fair distribution of wealth. If so, it will be much more like the European model that has prevailed since WWII.

Nobelist and New York Times columnist Paul Krugman said some interesting things of late comparing the U.S. economic system with Europe. His basic thrust is that even with a more comprehensive social safety net that allows universal health care, better unemployment benefits, and higher taxes, it hasn’t lowered their standard of living. In fact, Europeans have basically the same prosperity as do Americans—in terms of productivity, per capita GDP, and even technological innovation.

He makes an important point because Europeans are now living longer with fewer illnesses, have less severe recessions, lower crime rates and better environmental controls. Krugman is just quoting studies by historians, the UN, IMF, OECD and many other developmental organizations.

How did this happen? Basically, it is because we chose to keep a huge military and foreign aid establishment after WWII to defend our interests overseas, whereas Europe gave up its colonies, and so the overhead costs of maintaining them. They were able thereby to invest their revenues to better the lives of their citizens.

It is true that European countries have higher tax rates than the U.S., but that is made up by better infrastructure—such as a massive rapid transit system that makes auto ownership a luxury rather than necessity—and better social programs, as mentioned. This in turn protects the environment and makes businesses more competitive, since they no longer have to worry about their employees’ medical premiums.

U.S. personal taxes are some of the lowest in the world—in between that of Australia and Switzerland, while its corporate taxes are among the highest, according to Wikipedia.

Though tax rates have always been a bone of contention, they cannot be looked at without the attendant benefits. Europeans chose to invest in butter rather than guns in order to better their citizens in many ways. Paul Krugman gives France as an example of the tradeoffs. “The French family, without question, has lower disposable (i.e., after tax) income. This translates into lower personal consumption: a smaller car, a smaller house, less eating out.

“But there are compensations for this lower level of consumption. Because French schools are good across the country, the French family doesn’t have to worry as much about getting its children into a good school district. Nor does the French family, with guaranteed access to excellent health care, have to worry about losing health insurance or being driven into bankruptcy by medical bills.

“Perhaps even more important, however, the members of that French family are compensated for their lower income with much more time together. Fully employed French workers average about seven weeks of paid vacation a year. In America, that figure is less than four.”

So which society has made the better choice, Krugman asks, guns or butter?

“Europe is often held up as a cautionary tale”, he says, “a demonstration that if you try to make the economy less brutal, to take better care of your fellow citizens when they’re down on their luck, you end up killing economics progress. But what European experience actually demonstrates is the opposite: social justice and progress can go hand in hand.”

Harlan Green © 2009