News Column

Markets in Disarray...Fundamentals Still Strong?

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In the midst of the past March sell-off, we pointed out in our quarterly economic forecast that even if expectations were falling, fundamentals remained strong. After four months of tranquility, we are again in the middle of extreme market turbulence.

And while in March we were dealing with expectations, now we are dealing with reality. Unpleasant truths have been discovered, with potentially larger consequences, which are undermining the trust and stability of the financial system and the risk that lenders and investors are willing to take on.

In 2005, confident of ever-increasing home prices, some consumers took out excessive home loans with the help of mortgage brokers who were paid to make loans, not maintain them. In this environment, debt standards and due diligence procedures declined and the volume of questionable loans increased.

These dicey home loans were packaged together and sold as derivative financial products to buyers perceived to be knowledgeable investors, although these buyers with the blessings of credit-rating agencies also exhibited a lack of due diligence. The end result has been a snowballing transfer of unknown risk through the financial system.

There were plenty of alarming signs that few wanted to heed, citing those four most dangerous words on Wall Street: "This time is different."

No, it isn't. Even if economic laws are not as certain as physical laws, such as gravity, at the end of the day, excesses are brought back into balance and debts are to be paid or defaulted with a loss to someone.

The immediate impacts on the stock markets have been well reported. Let's focus here on what impact this credit and credibility crisis may have on future consumption, savings, economic growth, employment, and small-business financing.

From Credit Excess to Credit Crunch

For the first three weeks of August, outstanding commercial paper [IOUs issued by corporations to finance their operations] in the U.S. financial system has decreased by 11 percent, or $244 billion. The asset-backed segment, accounting for half of all the commercial paper, has decreased the most, representing $185 billion. As a result, companies financing their short-term cash needs with commercial paper have seen their cost of capital increase.

Asset-backed commercial paper, which up to the end of July carried a similar interest rate as commercial paper issued by financial and non-financial companies, has been adjusting upward its cost as a result of increasing risk of the underlying assets.

Thanks to this additional risk but insufficient additional reward, investors are opting to keep their money in cash instead, thus holding onto funds that usually would be buying financial products. Only exceptional borrowers in the commercial and real estate markets can still get loans. In addition to impacting the money market, a lack of financing a liquidity crunch can substantially undermine economic growth.

Smaller companies, which are more prone to finance their operations with either conventional bank credit or home equity, will feel more of the backlash. The U.S. Small Business Administration, through the guaranteed loan and other programs, can play a critical role in providing finance to small businesses in these circumstances.

Similarly, credit availability has been severely constrained in the mortgage markets, resulting in limited refinancing options for adjustable-rate mortgage borrowers. Plus, refinancings need to be "marked to market," reflecting the true price of the home. Refinancers must make a hard choice accept a suddenly higher mortgage payment or recognize a loss to refinance.

Federal Reserve: Preserving the Common Good (And the Credibility of the Financial System)

As the U.S. and indeed the world's financial community cried for help, all eyes turned to the U.S. Federal Reserve. While many called for the Fed to immediately decrease the target lending rate one TV host's tirade claiming the Fed was fiddling while Rome burned has become a much-viewed clip on the Fed has balanced its actions among the key objectives it lives by: liquidity to the system, yes, but also maintaining economic growth and keeping inflation at bay.

As the Fed's chairman, Ben Bernanke, said in August, "It is not the responsibility of the Federal Reserve nor would it be appropriate to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy."

The Federal Reserve's actions reflect having to keep its credibility intact. Fed actions during August 2007 have been measured, lowering one rate but not the Federal Open Market Committee target federal funds rate.

Consumers: Where is My Wealth Effect?

One area in which financial markets impact the real economy is through consumer spending. The resilience of U.S. consumption has been linked to employment growth and the "wealth effect" of people spending freely thanks to the increasing worth of their homes and investments. These bedrocks of consumer confidence have shown their fragility in the past six months. According to S&P/Case-Shiller Index, released on August 28, the National Home Price Index peaked in the second quarter of 2006. For 2007, the price index has decreased by 0.9 percent in the first quarter and 3.2 percent in the second. With the number of houses sitting unsold across the nation increasing to 9.8 months worth of inventory, don't expect home prices to gain strength soon.

The Mortgage Bankers Association in September reported an all-time high number of loans entering the foreclosure process, with delinquencies concentrated in adjustable-rate mortgages at both the subprime and prime ARM levels. Surprisingly, delinquency of subprime fixed-rate loans actually decreased for the past quarter.

In addition to real estate, consumers also hold savings and investments that are closely linked to returns on the stock market. Rising stock valuations had been providing steam to consumers who were smarting from falling home values. Now both sources of wealth are in negative sync, contributing key building blocks to a perfect storm.

More dark clouds come from the labor market.

According to recent data by the Bureau of Labor Statistics, the nation has seen no net job growth since March. No job creation, added to an increasing number of workers in the labor force, has produced a 5 percent increase in unemployment in the total U.S. and a 15 percent hike in unemployment of Hispanics just in the past five months. As a logical confirmation of these underlying consumer trends, the Conference Board reported on August 28 a sharp fall in consumer confidence, from 111.9 in July to 105.0 in August.

In mid-September, the Bureau of Labor Statistics reported a 4,000 loss in non-farm payroll for August, abruptly ending four years of monthly jobs gains.

Together with dismal existing conditions in the automotive and construction sectors, we should expect increasing softness in financial and retail employment resulting from the problems in the financial markets and expected reduction of consumer spending. There will be a few winners. Export-related industries and companies should fare well, due to the dollar's depreciation increasing competitiveness of U.S. exports.

Despite quietness in residential construction, business construction has been performing better, as well as public infrastructure construction. As the fatal collapse of the Interstate 35 bridge in St. Paul, Minnesota, made evident, the nation's public infrastructure is aging, and if local, state, and federal funds are forthcoming, we should expect a boom in civil engineering construction for years to come.

Other areas in which employment is increasing are health care, social assistance, food services, and business services.

What Lies Ahead?

Given the events explained above, prospects for continued economic growth are not bright. It seems inevitable that economic activity will be moderated during the fourth quarter of this year and the first half of 2008. Although GDP growth was revised upward to a 4 percent annual rate by the Commerce Department on August 30 due to improved trade balance and business investment, the effects of the events in July and August have yet to fully ripple across on the economy.

While consumer and business trends point downward, strength may come from growing overseas markets. Should the Fed reduce the target-lending rate on September 18 [after this issue goes to print], it might provide additional fuel to consumer and business spending.

Nonetheless, expect the entire mortgage market to be hurting for the next year or so, with borrowing requirements onerous for all but the most credit-worthy.

The impact throughout the economy can be severe. We will not regret having shouted loud enough, "This is the same" as it was in 1987, 1990, 1994, 1998, 2000, and 2002.

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