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ALM First Financial Advisors
Fourth Quarter 2008 Economic Outlook
Prepared by: Lisa K. McDaniel, CFA
October 10, 2008
TOPICS COVERED
Third Quarter Review
What a difference three months can make. While the outlook at the beginning of the quarter was certainly less than rosy, no one could have predicted the catastrophic events we have witnessed recently. The financial crisis that began 13 months ago as a subprime mortgage crisis slowly evolved into a credit crisis that has since entered a new and far more serious phase. We now have a full-blown financial melt-down, the likes of which we have not seen since the Great Depression.
Mortgage-backed securities containing those infamous subprime loans were often coupled with credit default swaps, issued as a form of “insurance” against default; they could not be called insurance because they would then have been subject to regulation, including reserve provisions. The companies who sold these instruments (i.e. Bear Stearns, Lehman Brothers, and AIG to name a few) did not set aside reserves to pay out on these swaps when homeowners began to default on their loans; so not only did they not have enough cash to unwind these trades, but they found their lines of credit disappearing at a rapid pace.
This speaks to the psychological factor of fear that pervaded the markets as investors lost confidence in their ability to value debt and in the techniques that were used to create complex securitized structures. Lingering hopes that this damage could be contained to a handful of institutions that made bad bets on mortgages quickly evaporated.
The landscape of American finance has been radically changed. The independent investment bank - a quintessential Wall Street fortress that relied on high leverage and wholesale funding - is now all but extinct. Lehman Brothers went bust; Bear Stearns and Merrill Lynch have been swallowed by commercial banks; and Goldman Sachs and Morgan Stanley have become commercial banks themselves. The “shadow banking system” - the money-market funds, securities dealers, hedge funds and the other non-bank financial institutions that defined deregulated American finance will never again look the same.
Here is a timeline of events:
July 11: U.S. mortgage lender IndyMac collapses and is taken over by the FDIC. It was the second-biggest bank in U.S. history to fail.
July 14: The government steps in to assist America's two largest lenders, Fannie Mae and Freddie Mac. As owners or guarantors of nearly half of the outstanding mortgages in the U.S., they are crucial to the housing market and authorities agree they can not be allowed to fail. The previous week, there had been a panic amongst investors that they might collapse, causing their share prices to plummet.
September 8: Mortgage lenders Fannie Mae and Freddie Mac are placed in a government-operated conservatorship, which resulted in the departure of each agency’s chief executives and an elimination of their dividends. This action puts the liability of more than $5 trillion of mortgages onto the backs of U.S. taxpayers.
Treasury Secretary Henry Paulson said the two firms' debt levels posed a "systemic risk" to financial stability and that, without action, the situation would get worse. The Treasury also agreed to provide secured short-term funding to Fannie, Freddie and the 12 Federal Home Loan Banks and to purchase mortgage-backed debt in the open market. Treasury will receive $1 billion in senior preferred stock with warrants representing ownership of 79.9 percent of the two companies.
The financial pressures on the government sponsored enterprises (GSEs) that emerged in recent months stemmed from concerns about the losses they incurred and the extent to which they endangered their capital positions. Some of this stemmed from the observation of fair value accounting and how marking to market would cause capital levels to fall below minimum acceptable standards. It became increasingly difficult for the firms to raise new capital and led to a potential crisis of confidence among its debt and even mortgage-backed holders.
September 11: Lehman Brothers says it’s actively looking for a buyer. Its shares plunge 45 percent as traders feared it was having a difficult time finding a suitor.
September 14: Merrill Lynch, also stung by the credit crunch, agrees to be taken over by Bank of America for $50 billion, the latest twist in a dramatic turn of events on Wall Street.
After days of searching frantically for a buyer, Lehman Brothers files for Chapter 11 bankruptcy protection, becoming the first major investment bank to collapse since the start of the credit crisis. At $639 billion, this is the largest bankruptcy filing in U.S. history. After a weekend of feverish negotiations, potential buyers such as Bank of America and Barclays walk away, leaving Lehman and its CEO, Dick Fuld, with basically no other options.
Why did the Fed allow Lehman to fail after rescuing Bear Stearns? When the crisis erupted at Bear, the Fed feared a bankruptcy would devastate the financial system, since the markets were unprepared for the challenge of unwinding derivatives and funding contracts linked to Bear Stearns. However the Fed believed the system was better prepared for Lehman and wanted to make the point that it was not always going to prop up broker/dealers. Also, the magnitude of Lehman’s outstanding contracts was considerably less than that of Bear Stearns.
September 16: The Federal Reserve announces an $85 billion rescue package for AIG, the country's largest insurance company, to save it from bankruptcy. AIG gets the loan in return for an 80 percent public stake in the firm. The insurance group was again much bigger than Lehman, and furthermore, it had insured numerous banks against defaults on securities they held. Thus AIG’s collapse would have created further losses in the banking industry, which it could obviously ill afford.
September 17: Barclays makes a deal with Lehman to buy its North American banking division. The British bank, which had passed on buying Lehman before it filed for bankruptcy, picks up the failed firm's North American investment banking and trading operations for $250 million.
Meanwhile interbank lending markets were in crisis mode after the country’s oldest money market fund said it would break the buck. Demand for the three-month T-bill sent its yield down to 0.03 percent, its lowest level since 1941.
September 19: The Bush administration announces its “bailout plan” to confront the credit crisis. Congress is asked to give the administration new powers to execute a plan that could cost taxpayers billions to buy bad mortgages and other toxic debt. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Paulson hold meetings with lawmakers over weekend to convince them to approve the measures.
The Treasury Department says it will tap into a $50 billion fund created during the Depression and temporarily provide guarantees for money market funds. Under the program, the Treasury will guarantee the share price of any publicly offered eligible money market mutual fund that applies for and pays a fee to participate in the program. The program is designed to address temporary dislocations in credit markets. It will exist for an initial three-month term, after which the Secretary of the Treasury will review the need and terms for extending the program.
September 21: The Federal Reserve approves transformation of Morgan Stanley and Goldman Sachs into bank holding companies from investment banks in order to increase their oversight and allow them to access the Fed's discount window.
September 25: In the largest bank failure yet in the United States, Washington Mutual, the giant mortgage lender, which had assets valued at $307 billion, is closed down by regulators and sold to JPMorgan Chase. Analysts say much of its problems were caused by the company's 2006 purchase of mortgage lender Golden West for $25 billion at the height of the housing boom.
September 28: Lawmakers announce they have reached a bipartisan agreement on a rescue plan for the American financial system. The package, to be approved by Congress, allows the Treasury to spend up to $700 billion buying bad debts from ailing banks. It will be the biggest intervention in the markets since the Great Depression of the 1930s.
September 29: The FDIC helps broker a deal allowing Citigroup to buy the bulk of Wachovia's banking operations for $2.1 billion in stock. Wachovia, the fourth-largest U.S. bank, will be bought by its larger rival Citigroup in a deal where Citigroup will absorb up to $42 billion of Wachovia losses. Wells Fargo would later step in with its own offer (without federal aid) and after several days of legal wrangling seal a deal for $11.4 billion.
The House of Representatives rejects the $700 billion rescue plan for the U.S. financial system, sending shockwaves around the world. It opens up new uncertainties about how banks will deal with their exposure to toxic loans and how credit markets can begin to operate more normally. Wall Street shares plunge, with the Dow Jones Industrial Average slumping seven percent or 770 points, its largest one-day point drop in history.
October 1: The Senate approves an amended rescue plan by a vote of 74-25, putting pressure on the House to do the same.
October 3: The House of Representatives passes a $700 billion government plan to rescue the U.S. financial sector. The 263-171 vote was the second in a week, taking place after several revisions to the bill. President Bush immediately signs the bill into law as the Emergency Economic Stabilization Act. The core of the Act is a $700 billion fund that allows the government to buy troubled, so-called “toxic” assets from financial institutions. The program will initially be aimed at mortgage-backed securities and derivatives based on mortgages, but could be extended to other assets as necessary.
The program is intended to provide maximum flexibility for the government to buy troubled assets in an environment that is so uncertain that there are no known solutions. Nothing on this scale and level of complexity has ever been attempted before. The categories of troubled assets are more numerous, more complex, and less homogenous than in any previous financial crisis.
Also included in the bill were provisions to permit Treasury to amend the terms of mortgages that it acquires in order to prevent foreclosures. It contains provisions for greater oversight of financial institutions and rules controlling executive compensation for companies that participate in the purchase program. It allows Treasury to take equity warrants that would give it a share in any profitability that might arise from a recovery for these institutions.
Other unrelated provisions include a temporary increase in FDIC and NCUA insurance to $250,000, along with the usual provisions for pork that Congress can’t seem to do without.
October 5: In one of the most dramatic days the financial markets have ever seen (so far), the Dow falls as much as 800 points during the day; it ends the day down 370 points, below the 10,000 mark for the first time since 2004.
October 7: In a move design to unfreeze the commercial paper market, the Fed says it will lend directly to American corporations for the first time since the Great Depression. The Fed will set up a facility called a special-purpose vehicle that will purchase three-month top-rated commercial paper, which represents about $1.3 trillion of the market.
October 8: Several of the world’s major central banks lower their short-term rates in a coordinated and unprecedented effort to halt collapsing stock and credit markets. The Federal Reserve, ECB, Bank of England and the central banks of Canada and Sweden each reduce their primary lending rates by a half-percent.
Separately, the U.S. Treasury Department says it is considering ways to inject capital directly into banks, possibly by taking equity stakes.
October 10: Stocks fall for a seventh consecutive day and the Dow posts its worst week ever, falling a total of 1,874 points, or 18.2 percent. The Standard & Poor’s 500 index loses 15 percent of its value for the week.
Financial Market Performance
Needless to say third quarter performance was not a pretty picture. The Dow Jones index lost 4.4 percent during the quarter and was down 23 percent as of September 30 from its peak last October. Since then the decline extended to 40 percent on the one-year anniversary of that October peak. The S&P 500 index fell nine percent during the third quarter and 26 percent from its high.
On the surface, the third-quarter losses seemed like a continuation of the first half of the year, but underneath there were some notable differences. Despite bleak headlines about banks and brokerage firms in distress, financial stocks in the S&P index ended the quarter essentially flat from three months ago as some healthier banks and smaller institutions posted gains. Even with a worsening job market and the rising tide of mortgage delinquencies, consumer-discretionary stocks were also more buoyant than the broader market - falling just one percent - as oil prices declined and some investors began to think a recession was already built into share prices. The real damage was done to the stocks that had done well during the first half of 2008: energy and materials. These dropped as it became clear the global economy was slowing along with the U.S.
Credit markets nearly came to a standstill. Investors fled anything that seemed remotely risky and rushed into that last bastion, the U.S. Treasury market. Very short-dated Treasuries saw skyrocketing demand, sending their yields plummeting toward zero. Borrowing costs for companies soared, if they could borrow at all. Overnight and credit markets seized up as banks stopped lending, even to one another.
Monetary Policy
Only three months ago the market (as indicated by Fed funds futures) anticipated a 75 basis point increase in the Federal funds rate by year end, largely because inflation was heading higher. By early September, however, expectations for rate increases had evaporated and the market priced in a 25 basis point cut for the September FOMC meeting.
The FOMC defied market expectations at its September meeting, however, and held its benchmark rate steady at two percent. The language of the Fed’s statement was little changed, with threats to inflation and growth remaining balanced. The statement did note that financial market strains have “increased significantly,” whereas the last statement noted “markets remain under considerable stress.”
As noted above, the Fed did participate in a coordinated effort with other major central banks and lowered the Fed funds rate to 1.50 percent on October 8th.
Currency
The dollar recently began edging back up against key currencies, but it remains far below the levels it hit earlier in this decade, when a strong dollar was widely blamed for suppressing U.S. exports. The rally began in late July and early August as it became clear that the economic malaise wasn’t limited to the U.S. but was spreading globally, and particularly to Europe and the U.K. This coincided with a drop in oil prices, another positive for the dollar, as the two tend to trade in opposite directions.
By late September, the dollar was back under pressure although it managed to rise 11.8 percent over the Euro for the quarter.
Economic Indicators
Real GDP growth for the second quarter was revised from a preliminary reading of 3.3 percent to 2.8 percent largely due to a downward adjustment to consumption. One of the few bright spots in the U.S. economy was exports, which accounted for about 2.9 percent of growth, while the domestic economy contracted slightly. Export-driven growth marked a dramatic shift in an economy that has up to now relied heavily on consumer spending.
Over the past year, real-goods exports have increased $115 billion, or 12%, and are up across every major category. They now comprise nearly 13.5% of gross domestic product, the highest percentage since World War II. Key to this growth has been the weaker dollar, which made American goods more competitive in global markets and prompted many manufacturers to expand production inside the U.S. However, slower growth in the rest of the world will translate into slower growth in foreign demand of U. S. goods going forward.
The employment situation continued to deteriorate over the last quarter. Nonfarm payrolls fell 73,000 in August (revised), while the July report was revised to negative 67,000. In September, payrolls fell another 159,000, the largest drop in more than five years.
The unemployment rate continued to rise, spiking up to 6.1 percent in August (a five- year high) from 5.7 percent in July. It was unchanged in September.
The producer price index (PPI) fell 0.9 percent in August as energy prices fell 4.6 percent and food prices posted a moderate gain of 0.3 percent. The “core” PPI, excluding food and energy, moderated to 0.2 percent. On a year-over-year basis, PPI is still up 9.6 percent and the core is up 3.6 percent.
The consumer price index (CPI) dipped 0.1 percent in August for a 5.4 percent year-over-year increase that was also due to falling energy prices. Food prices continued to rise with a 0.6 percent gain. The “core” CPI rose 0.2 percent, in line with recent trends.
The ISM manufacturing index declined marginally in August to 49.9, holding very close to the breakeven level of 50 for the third straight month. The key components included orders, which rebounded but remained in negative territory (48.3), production growth, which moderated slightly, and employment, which fell to 49.7 from 51.9 in July. Lower prices were noted for a handful of energy, food and metal products for the first time in several months.
The ISM manufacturing index showed a steep decline in September, its largest drop in 25 years, as orders, production and payrolls all fell to levels not seen since 2001. The reading for September was 43.5, indicating recessionary levels. This level of manufacturing growth is consistent with GDP growth just above zero.
The ISM non-manufacturing index rose to 50.6 in August from 49.5 in July, moving just over the line into growth territory. Among its major components, the business activity index moved into positive territory (51.6 vs. 49.6), orders were improved but remained slightly negative and employment continued to deteriorate.
In September the non-manufacturing composite dropped to 50.2, a level consistent with stagflation. Business activity and orders showed small improvements but the employment component sank further.
Consumer confidence actually rose during the third quarter. The University of Michigan’s index of consumer sentiment surged 10 points in early September as respondents reacted positively to lower gasoline prices. Nine of ten respondents still believe the economy is in recession, but the drop in energy prices led more consumers to expect growth to improve rather than worsen over the next year for the first time in two years.
The Conference Board’s index of consumer confidence rose to 59.8 in September and the August reading was revised from 56.9 to 58.5. The gains here were also due to the expectations component, which offset a decline in the present situation component.
Retail sales fell 0.3 percent in August with downward revisions to gains in June and July. Some of the drop reflected a 2.5 percent decline at gas stations, but even excluding this, sales were generally weak.
Durable goods orders declined 4.5 percent in August, driven by a plunge in machinery orders. Core capital goods shipments were also soft, pointing to a substantial drop in business investment in the third quarter. Inventories became more bloated, rising 0.7 percent in August and lifting the inventory/sales ratio to a seven-year high.
Housing Market
Foreclosures accelerated to the fastest pace in three decades during the second quarter as interest rates increased and home values continued to fall. New foreclosures increased 1.2 percent, rising above one percent for the first time in the survey’s 29 years, according to the Mortgage Bankers Association. Prime ARMs accounted for 23 percent of new foreclosures and subprime ARMs were 36 percent.
The S&P/Case-Shiller home price index fell 16.3 percent in July from a year earlier and 10.1 percent (annualized) in one month. All 20 metropolitan areas in the survey are down from a year ago. The index has fallen every month since January 2007.
Housing starts plunged 6.2 percent in August to an annual rate of 895,000, the lowest point since January 1991. Multi-family starts fell 15 percent in August on top of a 27 percent decline in July, more than reversing a 42 percent rise in June. Single-family starts continued to fall, dropping 1.9 percent in August for a 65 percent declined since the January 2006 peak.
After rising 3.5 percent in July, existing home sales fell 2.2 percent in August to a 4.91 million annual rate, extending what has been a fairly stable trend for the year. Sales were mixed across the country, falling 6.6 percent in the Northeast and 5.3 percent in the West.
New home sales dropped 11.5 percent to 460,000 units annualized, the lowest number since 1991. This decline ended what had been a stabilizing trend. Weakness was again concentrated in the Northeast and the West, with sales in the West plummeting to a 27-year low. Homes available for sale fell 4.4 percent, but the supply of unsold homes rose to 10.9 months from 10.3 as sales continued to decline.
Fourth Quarter Outlook
At this point it is pretty clear that the economy is in a recession. The question is how long the contraction will be, and until the government’s plan goes into effect and some of the turmoil in the financial markets dissipates, it is difficult to guess.
Growth is expected to stall in the second half and not rebound until at least the second quarter of 2009. Most economists see contraction in the third and fourth quarters of this year, and some say it will extend into the first quarter of 2009.
More than a year of financial market distress is not surprisingly having a major effect on both consumer and business activity. Consumption, that lynchpin of economic growth, will continue to decline due to tighter credit, falling home values, rising unemployment and the fading tax rebate effect. Income growth is also fading as job losses continue to mount. Business spending is likely to be constrained as companies find it harder to secure financing, and layoffs are expected to mount.
Furthermore, foreign growth is slowing, as the financial turmoil spills over into Europe and elsewhere. This means the contribution of exports to U.S. GDP will decline.
Inflation should moderate due to the slow-down in growth. Commodity prices continue to fall and other disinflationary forces (such as unemployment) are building faster than expected.
What will it take to bring the economy back to health? Aside from a solution for the current financial market crisis, consumer spending is the key to economic growth – watch for this to turn around. Also we will have to reach a bottom in falling home prices.
Few financial crises have been sorted out in modern times without massive government intervention. If there was any doubt about the willingness of the Fed and the Treasury to do whatever it takes to counter threats to financial stability, the cumulative actions of the past several weeks should take care of them. This will more than likely be the primary focus of the next administration, regardless of who wins the presidential election. The new administration will have to get up to speed quickly on the largest government intervention since the Great Depression. The next president will have to decide, again quickly, whether to launch another economic stimulus package among other things.
There is no fast or easy way out of the current crisis. What began as a subprime crisis has been magnified exponentially by the use of leverage. Furthermore, the leverage wasn’t just in subprime, but also spread to commercial real estate and auto loans and even to short-term debt, which investment banks relied upon for funding. The problem is that there is simply not enough cash to absorb all the questionable or toxic assets that were bought using leverage.
At least three things need to happen to bring the current deleveraging process to an end. Financial institutions and others need to sell and/or write down the value of the distressed assets they purchased with borrowed money. Second, they need to pay off debt, and third, they need to rebuild their capital cushions, which have been eroded by massive write-downs and losses.
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