The Great Recession of the first decade of the 21st century is now morphing into new dimensions. Unemployment, which rose to over 10%, is still remaining high with the all-in unemployment rate at over 17%. Job creation continues to be anemic and the duration of unemployment lengthens and causes labor force drop outs. The labor force participation rate from the population at large is declining, thereby lowering per capita income despite transfer payments from the Federal government which amounts to 18% of Personal Income in the US.. With little improvement in the unemployment situation, a second stimulus bill, called the Jobs Bill, has been passed that extends the duration of unemployment insurance coverage that was expiring for many.
The residential real estate situation continues to deteriorate with the highest seriously delinquent home mortgage rate (90 days or more) of 9.5%, which is a stepping stone to foreclosure and further soft housing markets as the foreclosed properties are put on the market by the lender. The economic foundation of the economy continues to unravel as bank capital write-downs further restrict bank lending capacity and serve to neutralize any positive effects of a loose monetary policy.
While most of the attention thus far in the real estate market centered on residential housing, commercial real estate distress is now coming forward as the next major source of loan distress and bank capital deterioration. A just released Congressional Budget Office (CBO) study indicates that a “tidal wave” of commercial real estate loans will reach their term over the next four years, requiring a loan extension (Commercial Real Estate Losses and the Risk to Financial Stability, CBO Oversight Panel, Feb, 2010). The CBO estimates the exposure of commercial real estate to be 318% of bank regulatory capital mainly of the smaller and regional banks in the US. With commercial real estate prices running at approximately 60% of original appraisals of the 2006-2007 periods, this make a refinance or loan extension by banks problematic and indicates likely foreclosure. If that were to occur, there will be a serious erosion of bank capital sufficient that would cause 3,000 of the 8,000 commercial banks in the US to fail to meet their minimum regulatory capital. In turn, many of these banks are private and do not access public equity markets to facilitate a recapitalization. At this point in time, the FDIC troubled bank list is above 700 banks that have moved closer to the day of closure unless quickly recapitalized. With much of the repaid TARP funds now being used for other purposes, it is unlikely that these banks will be saved by a government bailout. This implies there will be a multiplier effect as bank dependent businesses and consumers are cut off from credit and the opportunity to expand and would also generate bankruptcies as borrowers are unable to roll over existing credit lines.
In addition to continuing real estate problems, every day in 2010 moves us closer to the ticking time bomb of Baby Boomer entitlements for Social Security, Medicare and Medicaid. In less than a year the first wave of the post WW II Baby Boomers reaches the entitlement age of 65. Thereafter for the next 18 years, we average 25,000 new entitles per day. The looming problem that was over the horizon for decades is now upon us and the unfunded costs of these entitlements have been estimated to be $55 Trillion as compared to current US income of $14.5 Trillion. This implies US budgetary short-falls from the current already record post WWII levels will continue for decades. Moreover the accumulated debt and associated debt service costs will rise disproportionately as market terms of finance tend to harden for a reckless, riskier borrower, as has occurred with Greece. That is the ominous conclusion the market is reaching. It is telling that the market yield on the debt of some firms like Berkshire Hathaway is now lower than comparable US Treasuries implying the market believes the Treasuries are no longer considered the riskless rate of return.
The events in Greece over the last month serve as a reminder of what we have in store for ourselves. Just as in Greece and the other “Olive Belt” countries of Europe, we will face the trade off of defaulting on debt or defaulting on entitlements. A reminder of the stress that follows is found daily in the front page news from Athens. One must consider those events to be a preview of coming events here. These same hard choices will be upon us in a matter of a few short years, except the US will not have a Germany, ECB, or IMF to turn to for a bailout as discussed in Reality Bites 2.3.
The forerunner of the concern for a country’s sovereign debt and the desire to hold the currency of a sovereign in distress played out in financial markets in 2009 when the dollar fell 15% against a basket of currencies and US Treasuries, aside from real estate finance, was the only asset class that declined in value. The financial markets turned on the US in 2009 in anticipation of these coming events, but in 2010, due to the Euro zone hitting the sovereign debt wall before the US, we became, in the short run, the beneficiary as European flight capital is temporarily being parked in the US while a search for an alternative reserve currency goes on. As an ominous backdrop to that concern in recent months, China and Japan the largest holders of US Treasuries have become net sellers of US Treasuries.
While still facing the combination of a Great Recession and sovereign risk problems in the US that should require monetary ease, the Fed has chosen this time to perform its promised “EXIT” from financial markets. How ironic that with the economy still facing serious unemployment, and after a year of headline deflation, one would not think it timely for the central bank to abandon its support of financial markets and economic activity. However, the motivation for the Fed EXIT was the inflation expectations generated by the Fed’s overwhelming expansion to backstop financial market pricing in 2008. Some seemingly responsible act by the central bank was necessary to placate market fears of a runaway central bank that was generating capital flight from the US Dollar. The exact form of the placebo that Fed offered the market will be subsequently addressed in the Great Recession Part 1.4. At the same time that monetary EXIT was forced on the Fed, the government is also being forced to raise taxes. Hence while the economic underpinnings are weak, some form of EXIT is being forced on both monetary and fiscal policy.
Given this plethora of unsettling news both long run and short run, I felt it was time for a financial market update not only covering the Great Recession but also how it was possible for the risk assets in global markets to be heading toward another asset bubble. This development largely explained by the Carry Trade through the Repo Market will be covered in the Great Recession in: Part 1. 5.