The utterly uglyemployment figures for August (a fall in jobs for the first time infour years, downward revisions to previous months’ data, a fall in thelabor participation rate, and an even weaker employment picture basedon the household survey compared to the establishments survey) confirmwhat few of us have been predicting since the beginning of 2007: theU.S. is headed towards a hard landing.
Theprobability of a US economic hard landing (either a likely outrightrecession and/or an almost certain “growth recession”) was alreadysignificant even before the severe turmoil and volatility in financialmarkets during this summer. But the recent financial turmoil - that hasmanifested itself as a severe liquidity and credit crunch - now makesthe likelihood of such a hard landing even greater. There is now avicious circle where a weakening US economy is making the financialmarkets’ crunch more severe and where the worsening financial marketsand tightening of credit conditions will further weaken the economy viafurther falls of residential investment and further slowdowns ofprivate consumption and of capital spending by the corporate sector.
TheUS economic slowdown was already serious since early 2007 and will getworse in the next few quarters for a variety of reasons. A massivehousing bubble - where home prices went to stratospheric levels becauseof a debt-driven asset bubble (a massive rise in mortgage debt ofhouseholds) - has now turned into the most severe housing recession inthe last 30 years and into a house price bust: for the first time sincethe Great Depression of the 1930s home prices are now falling on ayear-over-year basis. Home prices will fall much more in the next twoyears – by at least 15% - because of five factors that will make thehuge excess inventory of new and existing homes – already at historichighs – even larger: first production of new home is still excessive asdemand for new homes has fallen more than the now lower supply; thecredit crunch in mortgage markets will further reduce the demand fornew homes; millions of households will default on their mortgages andgo into foreclosure and once the creditor banks will repossess thesehomes they will dump them in the market adding to the excess supply;about $1 trillion of adjustable rate mortgages will be reset – at muchhigher interest rates – in the next 12 months: the households thatcannot refinance them and/or afford the higher interest rates will selltheir homes at distressed prices; and those who boughthomes for speculative reasons with little equity will now try to selltheir homes as prices are falling. So expect a much faster and deeperfall in home prices for the next two years.
Ahousing recession alone cannot lead to an economy-wide recession ashousing is only 5% of GDP. But now the housing slump is spreading toother parts of the economy: the auto sector is in a recession; themanufacturing sector is sharply slowing down; demand for housingrelated durable goods (furniture, home appliances) is falling.Moreover, US private consumption – that represents over 70% ofaggregate demand – is now under pressure. The US consumer is nowsaving-less, debt-burdened and buffeted by many negative forces. Aslong as home prices were rising it made sense for US households to usetheir homes as their ATM machines, borrow against their rising homeequity and spend more than their income (negative savings). But nowthat home prices are falling there is the beginning of a retrenchmentof consumption whose growth rate slowed down from a 4% average untilthe first quarter of 2007 to a weak 1.3% in the second quarter, evenbefore the summer financial market turmoil.
Thereare now many negative factors squeezing US consumers and forcing themto retrench spending: falling home values leading to a negative wealtheffect; sharply falling home equity withdrawal preventing householdsfrom overspending; a credit crunch in mortgages and consumer debtmarkets rising debt servicing costs for consumers; still high oil andgasoline prices; the beginning of a serious weakening of the labormarket – as signaled by today’s employment report and other data - thatwill significantly reduce income generation in the months ahead. Aslong as income generation and job generation was robust, one coulddismiss the risks of a hard landing; but the signal from today’semployment report is that the only force that was preventing a hardlanding (jobs and income generation) is now starting to falter.
Thus,in the next few months you can expect a further slowdown of consumptiongrowth from its already mediocre growth rate of 1.3% in the secondquarter. Indeed, after an ok July, retail sales were weak in August:based on the Redbook Johnson and the UBS Securities/ICSC data samestore retail sales in August actually fell relative to July; and inreal terms such retail sales in August were lower than in August 2006.Thus, the deceleration in consumption in Q3 is already clear in thedata.
And if consumption slows downthe build-up of inventories of unsold goods will force firms to slowdown production, employment and capital spending. Such investmentspending by the corporate sector was already weak in the last fewquarters in spite of the high corporate profitability. Now you canexpect further weakening of such real investment because of expectedlower consumption demand, higher credit spreads for the corporatesector, uncertainty about the future given the volatility in themarkets. The sharp re-pricing of risk that took place inthe summer – with higher credit spreads for a broad variety ofinstruments – implies much higher borrowing costs for consumers, buyersof homes, corporations and financial institutions. Thus, the slowdownof private consumption and capital spending in residential,non-residential and corporate investment will get more severe.
Ontop of a weakening of the real economy the current financial marketsturmoil will get worse – not better - in the next few months. This wasnever just a sub-prime problem as the same reckless and toxic lendingpractices in sub-prime – no down-payment, no verification of income andassets, interest rate only mortgages, negative amortization, teaserrates – were occurring in near prime mortgages, Alt-A loans, piggybackloans, home equity loans, and prime hybrid ARMs. About 50% of allmortgage origination in the last two years was made of this toxic wasteand utterly junk lending practices.
Andnow what started as a credit crunch in the sub-prime mortgage markethas spilled over to near prime and prime mortgages and to a variety ofother credit markets: money markets, interbank lending markets, assetbacked commercial paper, structured investment vehicles (SIVs) ofbanks, CDO markets, other securitization markets, andthe LBO market. All these markets are now literally frozen with adearth of liquidity, serious refinancing problems and severe creditproblems. The mess in the SIV products is particularly serious anddramatic as it is generating severe liquidity and capital problems forboth banking and non-banking institutions.
Andthis liquidity and credit crunch will get worse in the weeks ahead asthis financial markets crisis is much more severe than the liquiditycrisis of 1998 when LTCM – the largest US hedge fund – almostcollapsed. In 1998 you had only a liquidity problem as the economy wasstrong – growing at 4% plus - and we were still in the rising cycle ofthe internet boom. Today, in addition to severe liquidity problems inthe financial system (a near total freezing of the entire financialsystem liquidity plumbing), we have serious credit and insolvencyproblems too. The credit and solvency problems derive from a massivecredit boom that lead to excessive borrowing that, in turn fed for awhile rising asset prices that are now going bust, in a typical Minskycredit cycle. It is a insolvency problem as you have now millions of UShouseholds that are near insolvent and will default on their mortgages;dozens of sub-prime mortgage lenders who have already gone bankrupt;dozen of home building companies that are under distress; manyfinancial institutions in the US and abroad - such ashedge funds and other highly leveraged institutions – that have alreadygone belly up; and the rise in credit spreads will also lead soon to arise in corporate defaults that had been artificially low in the lastfew years given the excessively easy credit conditions. So we do notface only a most severe liquidity crisis; we are also observing aserious credit crisis and credit crunch. And you cannot resolve creditproblems – as opposed to liquidity problems – with liquidityinjections. That is why the forthcoming cuts in the Fed Funds rate bythe Fed will be ineffective in stemming the real and financial problemsof the economy.
Indeed,the forthcoming easing of monetary policy by the Fed will not rescuethe economy and financial markets from a hard landing as it will be toolittle too late. The Fed underestimated the severity of the housingrecession, its spillovers to other sectors, and the contagion of thesub-prime carnage to other mortgage markets and to the overallfinancial markets. Fed easing will not work for several reasons: theFed will cut rate too slowly as it is still worried about inflation andabout the moral hazard of perceptions of rescuing reckless investorsand lenders; we have a glut of housing, autos and consumer durables andthe demand for these goods becomes relatively interest rate insensitiveonce you have a glut that requires years to work out; serious creditproblems and insolvencies cannot be resolved by monetary policy alone;and the liquidity injections by the Fed are being stashed in excessreserves by the banks, not relent to the parts of the financial marketswhere the liquidity crunch is most severe and worsening. The Fedprovided liquidity to banking institutions but it cannot provide directliquidity to hedge funds, investment banks, other highly leveragedinstitutions and parts of the credit markets – such as asset backedcommercial paper – where the crunch is severe. Thus, the liquiditycrunch in most credit markets remains severe, even in the usually mostliquid interbank markets.
Unfortunately,financial globalization together with securitization and mushrooming ofcomplex credit instruments has lead to greater opacity and lesstransparency in the financial system. And this lack of transparencybreeds unmeasurable uncertainty rather than priceable risk. Risk can bepriced as you have a distribution of probabilities on various events.But unmeasurable uncertainty causes higher risk aversion underconditions of market distress. This generalized uncertainty is nowcoming from two sources: first, we do not know the size of the overalllosses in credit markets: sub-prime alone could lead to losses of $100billion or much higher depending on how much home prices will fall. Andother losses from other illiquid financial instruments remainunmeasured in a world where institutions were marking to model ratherthan marking to market and where credit rating agencies were mis-ratingcomplex credit instruments. Second, as securitizationimplies that financial risks have been spread out of banks and to thecorners of the global financial system we do not know which firms areholding the toxic waste and thus which firms will go belly up next. Itis like walking blind in a minefield where you have no idea of wherethe mines are. This uncertainty breeds large fear – after the massivegreed of the previous credit and asset bubble has now burst – and lackof trust of financial counterparties, even otherwiserespected ones: everyone want to hoard liquidity and hold the safestassets as even large financial institutions do not trust each other andare unwilling to lend to each other. This greater opacity of financialglobalization and securitization implies that the re-pricing of riskthat we have observed in the last few weeks is a permanent rather thana transitory phenomenon. And the sharp spike in the cost of credit willfurther weaken an already weakened economy. This is thus the first realcrisis of the new world of financial globalization and securitization.
