What a Difference a Month Makes
DKW; November 14, 2008
A month ago many economists, including me, were wondering whether, in fact, we would have a recession at all and, if so, how mild it would be. Today, we can confidently say we are in a recession, and we are worried about how severe it will be. So, what happened during the month of October? A lot.
Let’s go back a bit to the spring, Sunday, March 16, to be exact, when J.P. Morgan Chase agreed to absorb Bear Stearns, an investment bank founded in 1923, as long as the Federal Reserve Bank took responsibility for $30 billion of Stearns’s bad debt. The bad debt was mostly a result of failed revenue streams from home mortgage payments and the subsequent investments made based upon those mortgages, i.e., derivatives. Thirty billion was a huge number and opened the debate about whether or not the federal government should be bailing out private investment banks. Now fast forward to Sunday, September 14. The Fed and the U.S. Treasury decided not to rescue Lehman Brothers, another large Wall Street investment bank that had been around more than 150 years, founded by two cotton brokers in 1850. The feds didn’t want to make a habit of bailing out private firms (moral hazard). So Lehman failed.
That’s when the debacle began. Suddenly, banks stopped lending to each other. (Overnight bank lending is a standard daily practice that allows banks to square their balance sheets each day.) If Lehman could fail, then any bank could fail and you wouldn’t want to be holding a loan that wouldn’t be paid back. Because of the complex and often convoluted trading chains of investment derivative vehicles, most investment banks didn’t even know what their risk exposure was, much less another bank’s. So they went to ground until they could figure it out. Meanwhile, companies that insured the bad debt found themselves severely undercapitalized (without enough money to cover the claims) and were also facing liquidation. The largest of these was American International Group, Inc. (AIG).
In late September, the Fed and the Treasury had a change of heart. Essentially frightened into the prospect of having a genuine financial and economic meltdown on their hands, they devised a scheme to rescue the financial sector by pumping liquidity (money) into the markets to recapitalize (give money to) banks, trying to buy time for the system to sort itself out. With the help of Congress and passage of the Emergency Economic Stabilization Act of 2008, which set up the Troubled Asset Relief Program (TARP), the Treasury got $700 billion to shore up the financial markets. Treasury agreed to assume a mountain of debt from the banks to keep them solvent and even forced equity ownership on the major banks to allow them to keep operating and making loans.
Well, it isn’t working. Instead, the banks have just quit lending and credit markets seized up. The banks (by the way, at this point there are no longer any investment banks, they went commercial), are still uncertain about their risk exposure and the risk holdings of others, including foreign banks. Conjointly, there are no downstream investors willing to accept the debt pass-throughs (derivatives again), so the whole system is constipated.
Despite Fed and Treasury actions to inject hundreds of billions of dollars into the financial system, decrease interest rates, guarantee debt, liberalize debt obligation standards, and jawbone the markets, little credit extension has materialized.
In fact, much the opposite is happening. Banks are looking at acquisitions, paying increased dividends, and honoring pay packages. Moreover, other players are looking to get in on the TARP funds. For example, the credit arm of General Motors, GMAC, wants to restructure as a commercial financial organization so it can tap TARP. American Express has become a bank holding company. In addition, calls for bailouts are coming in from all quarters – student loans, credit cards, money market funds, the auto industry, more problems at AIG ($150 B) and Freddie Mac ($100 B) and Fannie Mae. Remember the moral hazard concept.
So, what does all this mean for near-term economic prospects? The economy was strained before the financial market collapse. The primary actors in the economy, consumers, were feeling the affects of higher gasoline and food prices along with falling equity in their homes. Now their investment portfolios may be worth forty percent less than it was a year ago. The two bastions of consumer wealth – home equity and retirement nest-eggs – have been compromised, shredding consumer confidence. Add on the prospects of job layoffs and it is no wonder consumers are retrenching. With less cash flow and fewer assets to borrow against, economic trade offs have been altered. Consumer spending dropped 3.1% in real terms in the third quarter of 2008. Personal savings rates have tripled. Outstanding consumer credit actually declined in August and since then has been increasing at about half the rate seen a year ago.
With decreased demand for goods and services, businesses are cutting back on labor, production, and capital spending. The U.S. lost 240,000 jobs in October and the unemployment rate shot up to 6.5%. October Wisconsin jobs fell by 27,300 year over year and the state’s seasonally adjusted unemployment rate rose to 5.1%. September U.S. industrial production fell 2.8%. Capacity utilization decreased to 76.4% (1972 – 2007 average is 81.0%). The October ISM manufacturing index dropped to 38.9 (less than 50 signifies contraction), the lowest level in twenty-six years. Spending on new equipment fell 5.5% in the third quarter. Exports had been supporting the economy the last couple of quarters, accounting for over 80% of GDP growth. The economic slow down has become global in nature and the U.S. dollar has appreciated against the Euro, knocking two supports out from under exports.
All in all, we expect things to get worse before they get better. Expect increased job losses, higher unemployment, and higher unemployment claims. The depth of the recession will be determined by the credit workouts, housing sales, and export markets. Estimated time frames for the turnaround are quite wide – from the third quarter of 2009 to as late as the second quarter of 2011. Suffice it to say that the economic slowdown will be neither short nor shallow.
That’s not to say that no companies are hiring. There are number of job openings posted on Job Center of Wisconsin and other sites. The most challenging issue is one of matching skills and location.
P.S. As we write this piece, Treasury announced that it will shift its rescue focus from buying toxic assets to buying equity and increasing the availability of consumer loans. They are still working out the details of the new tact. We have to wait to see how and if the new approach will work. Meanwhile, the list of players seeking rescue funds is snowballing.
Written by Dennis Winters, Chief Economist and OEA Administrator. November, 2008.