State and Local Governments and Real Estate: The Problems are Still There

“Moody’s Investors Service, the ratings agency, said in a report last week that many states ‘are increasingly pushing down their problems to their local governments.’ The Moody’s report warned that this would be “the toughest year for local governments since the economic downturn began.” (See “States Pass Budget Pain to Cities,” http://www.nytimes.com/2011/03/24/us/24cities.html?hp.)

“The state budget squeeze is fast becoming a city budget squeeze, as struggling states around the nation plan deep cuts in aid to cities and local governments that will almost certainly result in more service cuts, layoffs and local tax increases.”

Homes, over the last fifty years, served as the piggy-bank for the middle classes and the working classes as the rising price of houses during this time served as the major source for these people to increase their wealth. We are learning more and more that the inflated values of land and commercial real estate and the growing wealth of these classes also served as a piggy-bank for other sectors of the economy, such as state and local governments.

And, this piggy-bank was the source for increasing employment, rising wages, and other benefits in the public sectors of the economy.

Now the piggy-bank is broken and state and local governments are feeling the pain as have home owners, small commercial banks and small businesses over the past three years. (See my post http://seekingalpha.com/article/259867-banking-and-real-estate-the-problems-are-still-there.)

People are learning that those that “live” by inflation, “suffer” by deflation.

Ben Bernanke and the Federal Reserve are trying as hard as they can to create inflation once again so as to preserve the banking system, the housing market, and, now, state and local governments.

The economy, however, may not be responding as the Fed might want it to.

In a real sense there are two economies. There are the better off, those that benefitted from the credit inflation of the last fifty years, the people that learned how to use inflation and who have the resources to protect themselves against changes in prices. Then there are the others, those who can’t protect themselves from changing prices.

One result of this is that the income distribution in the United States is skewed more toward the wealthy than ever before in the history of the country.

The history: in the early 1960s, there were many intellectuals and policy makers who believed that inflation was beneficial to the worker because a little inflation was not a bad trade off for higher levels of employment. This trade off was captured in something called the Phillips Curve.
Although the Phillips Curve was intellectually contested by the end of the 1960s, the myth of the Phillips Curve lived on in many official circles and some still believe in it to this day.

Yet, the credit inflation that was supposed to be a ‘boon’ to the blue-collar worker and the middle class resulted in a withering of American manufacturing capability in steel, autos, and then other industries. It resulted in substantial amounts of under-employment for working age people. It decimated the housing industry. It has made many of the smaller commercial banks in the United States insolvent. And, it has now bankrupt the American system of local government.

We have had a bailout of the steel industry. We have had two bailouts of the auto industry. Labor unions in the manufacturing industries are so week that union leaders are now training people to go into other countries and build up labor unions there. We have had a bailout of the banking industry. We are now going through a workout and possible bailout of state and local governments.

Labor unions in the public sector, teachers unions, are now acting in much the same way as did the auto unions and the steel unions before them, as the economic base for their benefits have faded away.

People and organizations can only live beyond their means for so long and credit inflation can create the “good days” for only so long. And, when the good days are over, people must return to a more controlled and disciplined life style. The pain of the ‘return’ is not easy to bear.

The efforts by Mr. Bernanke and the Federal Reserve to create another round of credit inflation is, unfortunately, producing a further bifurcation of American society.

While the middle class and the blue collar workers continue to suffer and continue to restructure their budgets and balance sheets, those who have more are taking advantage of the Federal Reserve’s actions to further strengthen their position.

Large commercial banks are bigger than they were when they were “too big to fail” in 2008. Payrolls and bonuses at financial institutions are exceeding earlier years.

Large corporations are sitting on “tons” of cash and possess immense borrowing power at miniscule interest rates. And, we see one large merger taking place here and another large merger taking place there: AT&T and T-Mobile; Deutsche Bőrse and the NYSE Euronext; Warren Buffet and Lubrizol, and Caterpillar and Bucyrus. The projection is for more of this to take place in America...and in the world.

And, the wealthy? Consumer spending is picking up but the strength is not at the lower end of the value chain. Manufacturing is picking up but for higher end goods. Overall, the pickup is just modest because it is not supported throughout the income spectrum.

I raised the question earlier, in such an environment “Will the Financial Industry Dance Alone?” (http://seekingalpha.com/article/255748-will-the-financial-industry-dance-alone) The answer to this question seems to be “No, the financial industry will not dance alone. Big corporations will dance along too as will the wealthy.” There was concern in the 2000s that the benefits of the economic growth at that time were not spread evenly throughout the economy.
My feeling is that you haven’t seen anything yet.

The efforts by the Federal Reserve to inflate the economy are not going to be spread evenly throughout the economy. State and local governments are going to have to re-structure and downsize. The people in these bodies are going to have to lower their expectations as well as the people that have been served by them.

Similar to the situation with the smaller banks, one hopes to get through this adjustment period without major disturbances. That is, government officials and regulators are working overtime to keep a lid on things so that insolvencies and bankruptcies do not overwhelm the system. The efforts to contain these problems seem to be having some success. Ever Meredith Whitney, the financial analyst who predicted massive defaults in the municipal bond area still contends that there will be a large number of defaults although not as many as she first feared.

Still, things are changing and will my guess is that in many areas of the society we will not return to the “plush” years experienced in the last half of the twentieth century.

A Tipping Point?

Almost everyone is looking for a tipping point. At this time we are looking for signs that the decline in the economy and in the financial markets is lessening and that we might be somewhere near the bottom. If this is the case then can the turn to recovery be far behind?

It seems that every piece of information currently being released carries with it the claim that “this decline was less than expected” or ‘the decline was smaller than the last information released.” These are taken as signs of hope.

Even the results of the Treasury’s “stress tests” on the banks are accompanied by the assessment that the major banks that have just been examined are better off than was thought. Therefore, the banking system is not in as bad a condition as feared, and, stock prices can now continue moving upwards.

Fed Chairman Bernanke is still the leading spokesperson and “cheer-leader” in the administration and he stated this week that the economy will begin to expand later this year. So we must be at or near the bottom if the administration thinks so. Right?

We still have the nay-sayers out there claiming that things remain in terribly bad shape. Nicolas Taleb, of Black Swan fame, is saying that the economic situation is worse than it was in the 1930s because world markets are much more integrated now than it was then. And, Nouriel Roubini continues to sound alarms about how bad things could get. Part of his argument rests on the fact that the worst case scenario used in the Treasury’s “stress test” is out-of-date due to the recently released estimates issued by the International Monetary Fund that financial sector losses have doubled in the last six months. Yet are their claims sounding awfully shrill these days amidst the hope others are seeing?

Where are we?

To me, the uncertainties still outweigh any real sense of which direction the economy might take. I would tend to lean on the side that we have not seen the bottom yet, but what odds would I place on this possibility? Maybe I would give odds of 2-to-1 that the economy still will decline further. Maybe they should be 3-to-1. Maybe they should be 3-to-2. Somewhere in there.

First off, I am not convinced that the banks are coming out-of-the woods yet. Even if they are able to obtain more capital, I don’t see their lending picking up in any major way. Personal and business bankruptcies are still on the rise and there are still several major “black clouds” on the horizon that threaten that the storm that has hit bank balance sheets is not over. There are still large companies that are going out-of-business on a regular basis, in retail, in commercial real estate, in some areas of manufacturing, and we are waiting for the full ramifications of the collapses in the auto industry. Car dealerships are being closed, parts supply companies are on the edge, and the spread of these closures are affecting many other organizations and geographic regions. If unemployment is going to continue to rise, since it is a lagging economic indicator, then there still are houses that are going to need to be sold if not foreclosed upon and some credit card debt and auto loans that will need repayment.

And, speaking of cars. Last time I looked the price of a barrel of oil was approaching $60. Where is the price of oil going? And, the price of other commodities? The Financial Times has had several articles recently about why the price of commodities, including oil, might be going higher if a trough or bottom has been reached. What would higher commodity prices do to any recovery?

Then there is the level of interest rates. The government held an auction today for $14 billion of 30-year Treasury securities. The result? The yield of the new issue came out at 4.288% higher than the expected 4.192%. This caused a decline in bond prices with the 10-year Treasury note trading around 3.30% up from 3.14% late last week which was above the 3.00% level, reached earlier last week a level that had not been crossed since November 24, 2008.

How high are these interest rates going to go and what impact will these higher rates have on mortgage rates and corporate rates? We are already seeing spreads between Treasuries and corporates reach levels since last October and November. And the interest rate spreads on lesser credits have also been increasing. And, there is still much more Treasury debt to come.

Furthermore, the economic structure of the United States (and the world) has changed. The manufacturing base is going to be different in upcoming years and everything is going to be more connected technologically than before. And, what if the personal savings rate in the United States reverts back to 8% or so as it was before 1992? We are not going to be able to force employment, human or otherwise, back into the same industrial and financial structure with the same employment intensity as existed before this economic collapse.

I am not intentionally trying to stay on the “dark side”. It would be great if things were bottoming out and the economy were about to start on an upward path once again. But, there still seem to be too many “unknowns” out there, unknowns that relate to serious problems, for us to get our hopes up too high at this point. Managements must still re-focus their businesses and must deleverage their balance sheets. Boards of Directors still must make sure they have the right executives in the right places, and if the Boards don’t do this then the shareholders must become more aggressive. Many executives that managed in the pre-2007 period, I believe, are not the executives to lead our companies in the post-2009 period.

Are we at a tipping point? Are we at or near the bottom of the downturn?

The most important questions are still going unanswered: even with the results of the Treasury stress tests. Will a major bank fail? How many regional banks might fail? So far there have been 32 bank failures this year, up from 25 last year and 8 the year before. How will a General Motors bankruptcy impact the economy? What other possibilities are out there?

Other company failures? Bloomberg reports today "Moody’s is forecasting the default rate among high-yield companies globally to soar to 14.8 percent by year-end from 8.3percent in April as companies that financed a record amount of high-yield, high-risk debt leading up to the credit crisis struggle to refinance."

And, I haven’t mentioned the debt overload that exists throughout the country. The list goes on.

It seems to me that what we are seeing a lot of these days is wishful thinking. I really haven’t seen anything yet that one could argue was a “hard” fact pointing to a bottom of the downturn. I really don’t think we are going to see any “hard” facts in the near future, so the stock market and other areas of the economy will just to continue to live off of wishful thinking. This is a situation made for traders. Uncertainty creates volatility and traders feast off of volatility. I guess it is good to know that at least some people profit from this environment.