This week Bruce Norris is joined once again by Robert Kleinhenz. Robert is the Chief Economist of the Kyser Center for Economic Research, which conducts research on regional, state, and national economies. Dr. Kleinhenz has a Bachelor’s Degree from the University of Michigan, a Masters and Doctorate from USC, all in economics. Prior to joining LAEDC, he served as Deputy Chief Economist at the California Association of Realtors and taught economics for over 15 years, most recently at California State University Fullerton.
Bruce said he recently poked around at a refi and quoted a rate that he could barely understand. He said it was something like 3 7/8 for a 30-year mortgage. Bruce said going back 30 years when he became an investor and had refinanced his house at the time to get the money; it was perfect timing back in 1981 when he paid 17 ½ % fixed. Robert said there may have been a couple recessions in between, but what a difference two decades makes. Bruce wonders if when you are 22 and just starting out if you are thinking that it is in any way normal where you are only accustomed to seeing numbers that start with a 5 or a 4, and he wonders how different the future will be with the particular rate going forward. In this case you are comparing what happened back in the early 1980s to the interest rate situation today.
Robert said if he were to place a bet on what was likely to be more normal in the foreseeable future, he would look at the interest rate climate of today and not of the early 1980s. Back in that time we had high rates of inflation, and we had an economy that was in transition and stagnating in several sectors for several reasons. The main thing was we had a lot of inflation, partly driven by high oil prices. This in turn led to high interest rates and at the time the Paul Volcker of the Federal Reserve Bank of New York led efforts to bring the reign of inflation down. One of the ways it did that was by increasing rates by making it very difficult to borrow. This was a much different climate, and hopefully economists have learned a little bit about keeping inflation in check. Hopefully policymakers have listened to the economists who talk about it, and we are most likely going to stay in an environment over the next few years that either has low or moderate inflation and not double-digit inflation.
Bruce read a quote saying, “Experience is something that lets you recognize a mistake when you make it again.” What is interesting about not being concerned about the people that are in charge of policies is their opinion of how benign the housing problem was going to be. This bothered Bruce; and Robert reiterated saying policymakers are humans like us and sometimes don’t get the information right and sometimes still make poor judgments. We definitely have to be concerned about the fact that mistakes are made on the policy side just as mistakes were made on the business side of things. This gave rise to the situation we face today.
Bruce wondered if Robert was concerned about deflation if not inflation. He said it is not that he is not concerned about inflation, but he does not expect to see high levels of inflation over the foreseeable future, and that is predicated on policymakers and their ability to make the right decisions. It hinges on the ability of the Congress to come up with a credible plan to take care of these federal deficits over the long term. Somebody has to be interested in a bond that the risk-level seems appropriate with the return. What is interesting is the one-year T-Bill in Greece is paying 402% as of yesterday, which would probably give you an idea that you should not invest in it as you are not going to get your principle back.
The likelihood that the United States would find itself in the same position that Greece finds itself in is very low, so we should not be too alarmed. There is a very real possibility that we may face a debt situation, but there are several moving parts here. Fortunately, the ace in the hole that we have here in the United States is the fact that the U.S. dollar is the reserve currency, and our Treasuries tend to be the flight to safety for so many investors around the globe when things go awry elsewhere. Bruce did not know how profound an effect this would have because this is exactly what happened when you talk about a ten-year T-Bill. Most of us would have anticipated seeing something under 4% was pretty astonishing, and then it was under 2%. If someone has not already refinanced their house, you definitely need to be sitting up and taking a look at rates today because those rates are fundamentally driven by what is happening with the yield on the ten-year treasury, which nobody would have expected would fall below 3 or 4%, and here it has consistently been under 2% for quite some time. All of this is courtesy of something that is really outside of our borders. Part of this also stems from the Fed’s commitment to maintain low rates over the foreseeable future through the middle of 2013. There was this policy move and effort to insure that long rates stay low partly to help the housing market and to get investors to pay attention to the stock market where it would theoretically be better returns. There are a number of angles behind the Fed’s move, but this has served to also keep rates down.
To insure that something like what was aforementioned is in the Fed’s control, they would have a limited ability to do it. If the market moves in a big way, they may not be able to buck that trend. However, it does accomplish that end by buying or selling securities in such a way as to maintain rates at the levels that they are targeting at this time. We have a 0-fit fund rate and a mortgage rate under 4%. If we were to have an issue where the Euro zone went into a tough recession, Bruce wondered if there would be a domino effect here that could possibly kick us into a another recession. Robert said the cards we are looking at in 2012 include the situation happening in Europe. If their economy is weakened or there is some concern that we have already seen of economies tipping into recession; then that could jeopardize the situation here in the United States. We’re out of the recession and growing and now in the expansionary phase coming out of the recession, so that could tamper the growth or lead to a stall out in the economy here in the United States. This is economic linkage between the European economies and the U.S. economy.
The other linkage is the financial linkage. If the sovereign debt problem in Europe, not just in Greece but also Italy and possibly France, give rise to problems with banks not unlike what we had a few years ago at the height of the financial crisis, then that could stymie activity in the financial world once again. As a result of that, it could have a feedback effect on the real economy and either slow the growth pattern of the U.S. economy or tip it into recession. You have two things coming out of Europe that have the potential to either slow down or derail our current expansion. When the United States had defaults on the mortgages, mortgage-backed securities, and the CDOs, it had quite a direct effect on the people that invested in the banks.
Bruce wondered if the United States has as much of the investment there in Europe, or is it mostly contained inside of their own banking system. Robert answered that it was incestuous in a way in that there are flows capital that go across international boundaries through commercial banks; so if there is a problem that shows up over there, it may also show up on the balance sheets of banks over here. It is through this particular conduit or channel that we would see problems occur. Robert said he would be very surprised if we have something as calamitous as what we saw in 2008. To look at this situation in the financial sector, we have to recognize that so many financial decisions rest on some confidence of what is going to be occurring in the future. If you lack confidence in the future or just don’t know, then you are unlikely to make a decision or make a decision to do nothing. The problem with financial crises that we went through in 2008 is that they have long-lasting effects and wreak havoc on consumer and business confidence. They then leave businesses and households to sit on their hands until they get a sense that the coast is clear. That is one of the reasons this recession was so deep and continues to keep going as long as it has been. There is a real concern about the outlook, and it is reflected in consumer confidence and business confidence that has just not really shown marked improvement over the last couple years.
Bruce wondered if there is real concern about the oil world and if there is fear about aggressive actions such as the closing of the straight. Robert said if we take a step back to 2011 for a moment and think about all of the wild cards that played out in 2011, there are a lot and a number are still playable in 2012. There was earlier discussion on the European debt situation, which is a wild card that has been played several times over the past few years. The Greek debt crisis seems to be the one that is played most frequently. If you take a look at the Arab Spring, that gave rise to disruptions in the flow of oil and gave rise to higher oil prices. There is always the chance that something in the world of energy that triggers an increase in the price of energy, oil or otherwise, there is always the chance that this could slow down economic activity if not derail a growing economy. The other wild card that we have to contend with in 2012 that we also dealt with in 2011 was political. This year the big political wild card is what will happen in November with the election. It does appear as though we are going to continue to be stepping carefully through 2012, hoping that these wild cards do not wreak too much havoc on the economy. If they do, then they have an adverse impact on confidence. If there is an adverse impact on confidence, then the growth we anticipated is just not going to materialize.
In the employment sector, Bruce wondered how important construction is to the improvement of the unemployment. Robert said it is an important segment of the economy but is essentially flat on its back right now in California and elsewhere around the country. If you look at residential activity in the state of California, permits for example, they are just a fraction of what they were in years past. They have been at this very low level for just a fraction of any long-run numbers for the last few years, but it makes sense. If so many foreclosed or distressed properties are available for sale at a fraction of the cost of new construction, it is going to be sometime until after the backlog of distressed properties gets substantially moved before we see construction pick up in a noticeable way. There is a broad market for housing where distressed property values are probably way down on other properties. Things are also the same way with commercial construction. There are a lot of high vacancy rates for office buildings these days; less so for retail and certainly much less so for industrial. Industrial in Southern California is actually outperforming markets around the country. It has less than a 5% vacancy factor, so it is very much a mixed bag. However, construction is going to be recovering slowly, so meanwhile we should take a step back.
In a general sense, the labor market seems to be at a turning point where in order to produce more in 2012, it seems very likely that employers are actually going to have to add people, not just ask their existing labor force to work longer hours. There should be a general upturn in employment in 2012 compared to 2011. It is just a question of how much of an upturn there will be. We need somewhere around 300,000 jobs added per month across the nation in order to bring the unemployment down in a noticeable way in a reasonable amount of time.
The most recent report, the one for December, showed that we added 200,000 jobs, which was a great number based on the recent history. It is just not a high enough level of growth to bring the unemployment rate down. At 200,000 jobs per month, it could take 4 or 5 years for us to get back to a 6% unemployment rate nationally. At 300,000 jobs per month, it would only take a little less than two years, which is a huge difference. At the present time, we should be banking on the 200,000 jobs per month, barring any of these wild cards being played. If that happens for a few months time, then we might actually see the economy gain some ground.
The sector that is in the driver’s seat here is the consumer sector. Consumers are weighed down by uncertainty about their jobs and their economic outlook. The fact that are assets are not worth what they had been worth and the fact that they may have some credit constraints, access to credit may not be what it had been, especially with respect to buying homes. All those things are constraining growth and consumer spending, and that is really the main thing that we need to look for in terms of the driver behind the overall economy. If consumer spending picks up, then we are going to see job gains pick up as well.
In looking at a chart for mortgage equity withdrawal in 2002-2006, it was responsible for a lot of GDP growth. This driver has certainly been diminished if not eliminated from most people’s possibilities. As we go forward, it is certainly going to be the case that the American consumer is still going to have a place for the use of credit. They may not have access to the same amount of credit that was available when they were able to use their home equity in order to finance so many things. This is not a bad thing because it does seem to have created problems, especially problems that have spilled back into the housing sector. We do not want to go back this way, but we do expect to see that some loosening of credit access on the part of consumers would probable enable the consumer sector to get a little bit more steam and give a little bit more push to the overall economy.
Another issue is shadow inventory. Bruce wondered what Robert’s thoughts on what shadow inventory contains are. The definition of shadow inventory has changed over the last couple years, so Bruce wondered what Robert feels is the shadow inventory and what the best resolution for it is. Robert said it is useful for us to get a sense of how long we are going to be dealing with large numbers of distressed properties. If we use that as the definition and ask what things going to be like two years out, then the shadow inventory is the inventory that is on the books, such as MLS inventory for existing homes plus unsold new homes, and the unsold inventory for existing homes in the state of California, which is about 5 months inventory. Five months inventory is enough to actually sustain increases in prices and not decreases in prices because the average is about seven months, so we are at seven months if we are under five. By then we would go through the foreclosure pipeline, and the thing we would pick up would be the number of REO properties that are held by banks in inventory. This is equal to about another 2 ½ months of inventory. Now you are getting over seven months when you take the five mentioned earlier and add 2 ½ months, then there properties that are scheduled for auction and also another 2 ½ months inventory. However, the timeline for that is a much longer timeline.
For the REO properties, the point in time they go into inventory might be about 6 months or so before they are prepped and sold. The relevant shadow inventory number to use for current market conditions and understand what is happening in the current market is probably MLS based inventory plus new homes plus REOs in inventory. If we are asking the question about how long this is going to be with us, then we are going to go further up the foreclosure pipeline and pick up the properties that are in a pre-foreclosure state, such as an NOD or delinquent property. If this is the case, then you are looking at another 2 ½ months inventory. This is simply by taking the number of properties that are in pre-foreclosure state, which is roughly 100,000, and looking at that relative to total annual sales. You also have to look at the timeline. An NOD that is filed in January of 2012 is probably about 18 months away from going into the REO inventory. These numbers are roughly 100,000 in REO inventory and roughly 100,000 NODs plus delinquencies at the present time for the state of California. The timeframe is not anywhere close to normal as the statutory timeframe is about 6 months. Because of different kinds of policies and other factors, this timeline has been stretched out; and a number of lender and servicers have encountered a number of problems along the way.
The bottom line is as we are going further up the ladder and actually including more and more things in this notion of shadow inventory, we also have to figure out how long it is going to take to push all the properties through the foreclosure pipeline and out through the new home market. Therefore, we are looking all the way into 2014 before things get any closer to normal levels of distressed properties. The housing market is going to feel like it has recovered before that period of time, but we are going to have substantial numbers of distressed properties working through the housing market over the next three years. In Riverside, 62% of the sales are either short sales or foreclosures, which means when you sell 1,000 homes, only 380 buyers emerge. Everyone else is credit damage. This is going to take a while to heal.
If you want to learn more about Robert’s company, the Kaiser Foundation, go to LAEDC at www.laedc.org. Here, you can find out about the annual forecast event that will be happening this February 15th in downtown Los Angeles. This is a ticketed event.
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