52 is Not a Pretty Number!

Reading an article in the Wall Street Journal this morning I was hit twice by the number 52. (For those that are looking for signs it can be noted that you can reverse today’s date and get 52 as well!)

The first sighting, Robert Taubman, chief executive of Taubman Centers, Inc. decided earlier this year to stop covering interest payments on it $135 million mortgage on the Pier Shops at Caesars in Atlantic City, N. J. “Taubman, which estimates the mall is now worth only $52 million, gave it back to its mortgage holder. (See http://professional.wsj.com/article/SB10001424052748703447004575449803607666216.html?mod=wsjproe_hps_TopMiddleNews.)

The second sighting: “Of the $1.4 trillion of commercial-real-estate debt coming due by the end of 2014, roughly 52% is attached to properties that are underwater, according to debt-analysis company Trepp LLC.”

The question raised in this article: is it a smart economic decision for commercial real estate firms to just stop making mortgage payments on properties whose values have fallen FAR BELOW the mortgage amounts?

This discussion parallels the discussions that took place many months ago about whether or not it was a smart economic decision for homeowners to just walk away from mortgages on properties whose values have fallen FAR BELOW the mortgage amounts.

The burning issue is between morality and economic incentives. And, what does the economist say about this? Well, everyone has a price. One of the rules I frequently hear is “Don’t say that you wouldn’t sell out for a particular price until you have actually been faced with the decision in real life and actually decided that you wouldn’t sell out for that price.” It’s easy NOT to walk away from a property if you have never been faced with the temptation!

This situation raises concerns relating to two major interpretations of the current economic situation.

First, debates are raging about whether or not we are in a deflationary period. For the last nine months the Consumer Price Index has shown a positive year-over-year rate of increase reaching about 3.0% during this time. For July the year-over-year growth rate was 1.3%.

Yet, the value of real properties seems to be going down and down.

But, isn’t this the same problem that existed in the early 2000s only on the other side of the coin? Then the Consumer Price Index was showing very little inflation, yet the value of real properties was increasing in the 10% to 15% range.

The problem was that the Consumer Price Index measured the price of “flow” goods and services and not the value of the “stock”, the value of the asset. Rent is what is measured in the Consumer Price Index and this is an “imputed” figure. Much concern was raised at the time about the validity of the estimates for rental prices used in the index. Perhaps the same issue should be raised now.

Second, this brings up the issue about whether or not we are in a period of debt deflation. This is the other side of the problem of the early 2000s when we had a credit inflation. In a period of credit inflation the problem is that there is too much credit chasing too few goods and services around. The credit keeps “the music playing” and as long as the music is playing, according to Chuck Prince, Chairman and CEO of Citigroup at the time, you have to keep dancing. A credit inflation is cumulative.

The problem with a debt deflation is that there is too much debt around. When there is too much debt around people have to de-leverage. And, de-leveraging takes a long time and is very, very painful.

One remedy to a debt deflation is for the government to re-flate the economy. This is what many economists, politicians, and pundits would like to see happen. If the government can cause prices to rise again the real value of the debt will go down and guess what? The music starts playing again.

The problem with this solution is that there are historical periods when the amount of debt outstanding becomes unsustainable. People have to accept the fact that “credit bubble” they lived in for so long, no longer exists. And, when this happens, people have to get their balance sheets back in order and live more practically within their means. In times like these, governments and others find it more and more difficult to push them back into profligate habits of spend, spend, spend.

The realization of this hit Europe earlier this year and the pain is evident.

Yet the fundamentalist ministers of “inflationary finance” like Paul Krugman, like many fundamentalist ministers when they are not being listened to, cry out that those who do not respond to their teachings are just members of a cult. These people that oppose them have been misled to a false teaching and are heretics.

The United States (and Europe and some other areas in the world) has a debt problem. And, a great deal of this debt is connected with real estate. And, a great deal of this debt rests on the balance sheets of depository institutions. (See my “Where is Banking Headed? Not up! http://seekingalpha.com/article/222005-where-is-banking-headed-not-up.)

What does a financial institution do when it is holding a mortgage for $135 million and the underlying property is given to them and the value of this underlying property is only $52 million? What does the banking system do knowing that 52% of the $1.4 trillion in commercial real estate debt coming due by the end of 2014 is underwater, and, by all we know, a lot of it is substantially underwater? What does the Federal Reserve and the FDIC and the Treasury Department do when they know that a very large number of the depository institutions in the United States have assets on their balance sheets that are substantially underwater?

This is what happens in a debt deflation. The economy, in a sense, implodes. But, it takes time for everything to happen because it is cumulative. First, there is the panic phase which we have gone through. Now, we are in the un-winding phase because a large number of people know what is happening, they are not surprised anymore, and are trying to work out the problems as smoothly as they can.

The best evidence I can give to support the idea that this implosion is happening is what I presented in the post cited above: on December 31, 2002 there were more than 7,888 commercial banks in the United States. As of March 31, 2010 there were only 6,772 commercial banks. In the next three to five years, many analysts expect this number to drop to 4,000 or so. Note that if the number of banks fell to 4,102 banks, this would be 52% of the number of banks that existed at the end of 2002.

Households Continue to Suffer

I’m trying to make sense out of the economic recovery. According to a growing number of people the Great Recession ended in July 2009 or, at least, somewhere in the third quarter. There continue to be “green shoots” that are popping up here and there.

Still, I am uncomfortable. I’m usually a pretty optimistic guy and I don’t like being considered as a “gloomy Gus”. But, some things in the economy continue to nag at me.

Households, at least how we used to know them, are having a difficult time. The major issue remains employment…or unemployment. However, another issue that can’t be ignored and that will impact employment patterns over the next five to ten years is the restructuring of industry and commerce. Restructuring often requires changes in skill sets and changes in geographic location.

In terms of employment we have just learned that companies in the United States cut an estimated 22,000 jobs in January, according to ADP Employer Services, the smallest decline in two years, and much lower than the recorded 61,000 decrease in December. The January result showed that 60,000 jobs were lost in the goods-producing area but in service industries 38,000 jobs were added to payrolls, the second consecutive increase. This was not a bad result, but employment is still declining. (http://www.bloomberg.com/apps/news?pid=20601087&sid=a01taizONkz8&pos=3.)

Most estimates for the unemployment rate in January remain in the 10% range. Very little improvement is expected in this measure in the first six months of this year. Furthermore, the projections of the unemployment rate used by the Obama administration in the budget proposals released this week are anything but encouraging.

These figures do not include numbers on discouraged workers who have left the labor force or those individuals that are working part-time but would like full-time employment. The rate of underemployment in the United States is in the neighborhood of 17% and is expected to remain around this level for the foreseeable future.

One of the reasons for underemployment to remain this high is the restructuring of industry and commerce that is going on in this country. As I have reported, capacity utilization in the manufacturing industries remains quite low and has not even come close to returning to 1960s levels in the past 40 years. (http://seekingalpha.com/article/185801-hearts-minds-and-recovery.)

The trend in United States manufacturing has been downward for a long time as industry has shifted from the heavy sectors to areas that produce higher-tech products. Some industries, like the auto makers, have had to decline due to diminished demand in the United States. Other industries, like chemicals, are relocating labor-intensive operations to other countries.

From December 2008 to December 2009 there have been large declines in capacity in the United States in areas such as textiles, printing, furniture, and plastics and rubber products. Industries where substantial increases in capacity have taken place are the producers of semiconductors, of communication equipment, and of computers. Shifts like these have major impacts on labor skills and the location of employees. (http://online.wsj.com/article/SB10001424052748703338504575041510998445620.html?mod=WSJ_hps_LEFTWhatsNews.)

It is important that these shifts take place. One of the problems with job stimulus packages sponsored by the federal government is that they tend to ‘force’ people back into the jobs that these unemployed have lost. This is not good because it reduces the incentives for industries to change even though it generates revenues for producers, like car manufacturers, and income for workers, like autoworkers. However, industries that need to change must change some time and postponing the change only exacerbates the magnitude and pain of adjustment. Need I mention the United States auto industry again?

This change is being reflected elsewhere and it has an influence on how political power is distributed in a country. The number of American workers that are in labor unions has been experiencing a downward trend that mirrors the decline in United States manufacturing. What is additionally interesting is the shift that has taken place within the overall union workforce: in 2009, public employees that are members of a union rose to more than 50% of total of all union workers. The decline in union membership connected to the manufacturing sector has been hidden because of the rapid growth in those connected with government employment. This is just another indication of the restructuring of the labor force. (http://online.wsj.com/article/SB10001424052748703837004575013424060649464.html.)

Added to this is the large shift that has taken place in home ownership in the United States. Home ownership peaked in the United States in 2004 when 69% of all Americans owned their own home. This peak was reached through the emphasis placed on home ownership in the United States, government programs to get people into their own homes, and low interest rates.
However, this rate has fallen to 67% at the end of 2009 and is expected to continue to decline as people lose their homes through foreclosure or bankruptcy. The rate of home ownership could fall into a range of 62% to 64% that was the case in the early 1990s. This represents a massive shift in the asset holdings of United States households for homes are still, by far, the largest asset held by households in America. (http://online.wsj.com/article/SB20001424052748704022804575041083721893188.html#mod=todays_us_page_one.)

This continued decline does not seem unreasonable given the hard facts facing many homeowners in the United States. In the third quarter of 2009, 4.5 million homeowners had seen the value of their homes drop below 75% of their mortgage balance. This figure is projected to hit 5.1 million, or 10% of all homeowners, by June. Research has indicated that this 75% figure is the level at which people really consider walking away from their home. (http://www.nytimes.com/2010/02/03/business/03walk.html?hp.)

These numbers make me feel uneasy…and that is an understatement. The basic reason for feeling uneasy is that I don’t see a “normal” economic recovery reversing these trends. The United States is restructuring from the excesses of the past, of “forcing” industry to not modernize, of “forcing” people to become homeowners, and so forth and so on. It is always the case that restructuring takes place: sooner or later. Now, seems to be OUR time!

The problem is that this restructuring has ramifications for other areas of the economy. Small- and medium-sized banks have lent money to these home owners and they are the ones that these households will walk away from if they leave. Commercial real estate developers will also walk away from the banks, maybe more easily, as we have seen, than the households themselves. Many businesses that are restructuring or downsizing will not be borrowing from the banks so business loan demand will stay low. And, one can think of many other areas in which repercussions may be felt.

I like to be optimistic about things, but I can’t get these “less-than-happy” conditions out of my mind.

The Problem with Debt

The economy is recovering. The areas that seem to show the most life are those sectors that have had sufficient debt relief so as to be able to move forward. The big banks are moving out in a very robust fashion, just how robust we will begin to hear this week. The auto industry seems to be moving ahead, albeit a little more slowly than the big banks. And, there are other areas that show signs of moving forward, the health industry and firms in the information technology industry.

The big cloud hanging over all of this is the debt that still is outstanding in many sectors of the economy. The problem with debt is that it just won’t go away. Regardless of any adjustments made to who owes what to whom, if there is debt outstanding, someone has to pay for it in some fashion.

The big banks were saved, but who picked up the tab for the bailout? The taxpayer did, or, at least the taxpayer has footed the bill pending a potential Obama tax on the banks to “recover” some of the bailout monies.

Who saved the auto industry and subsequently holds the IOU for the rescue? A large part of the financial restructuring came at the expense of those that had provided credit or equity funds to the car companies. And, the federal government also paid a share.

If homeowners got relief from their mortgage and consumer debt, who would pay the bill? Shareholders of the bank, holders of mortgage-backed securities, and the federal government. (You might check out this little piece by Peter Eavis in today’s Wall Street Journal: http://online.wsj.com/article/SB20001424052748704081704574652660161217386.html#mod=todays_us_money_and_investing.)

And, what about the debt that is related to commercial real estate lending? Shareholders of banks, holders of commercial mortgage vehicles, and the federal government.

Then we move to the financial problems of the states. Recent information points to the fact that 36 states in the United States are having financial problems and these could lead to deficits in the state budgets of around $350 billion this year and next. Where is the money going to come to pay for these shortfalls? States have already attempted to sell off properties, outsource functions to the private sector, and even turn some things over to the federal government.

Part of the problem here is that the tax base in most states has collapsed as unemployment and under-employment have risen, as property values have fallen, and as business earnings have collapsed. Rating agencies have begun to lower credit ratings on some states. The best guess is that ratings will drop on many other states before the year is over.

And, what about local and municipal governments? Same problems.

And, then, what about the federal government? Without totaling up the bill for the problems mentioned above, let alone the escalation of wars here and there all over the world, health care reform, and some kind of energy bill, many expect federal deficits over the next ten years to total $15 to $18 trillion!

Who is going to purchase all or almost all of this debt? China?

What I find scary is that our “friends” are voicing concern in different ways. For example, the Financial Times this morning carries the opinion piece of Gideon Rachman titled “Bankruptcy Could Be Good for America”: http://www.ft.com/cms/s/0/a8486284-fee9-11de-a677-00144feab49a.html. The point Rachman makes is that the Brics, Brazil, Russia, India, and China all went through economic reform before they “broke out” into their current ascendency. Brazil’s reform came in the 1990s, Russia defaulted in the late 1990s, India embraced economic reform in 1991, and China moved to a new mindset in the early 1990s. “Those much discussed emerging powers, the Brics, all needed a fiscal crisis to set them on the road to economic reform and national resurgence. America may one day be lucky enough to experience its very own national fiscal crisis.”

Even if we print money to pay for the federal debt, as the Federal Reserve has done over the last year or so, (the monetary base rose 23% from December 2008 to December 2009, and rose by 101% over the previous 12 months) someone, somewhere will pay this debt in terms of a reduction in purchasing power.

Need I mention that since January 1961 the purchasing power of one dollar has dropped to roughly $0.15. Inflating the United States government out of its debts has a long, post-World War II history.

Might this process of “printing money” continue?

Seems like a lot of people believe that it will. For one there is the problem of rising long term interest rates. More and more worry is being expressed about the expected increases. Why? Well most analysts believe that the Federal Reserve has helped to keep long term interest rates lower than they would have been in order to provide liquidity to the financial markets and to support the mortgage market. On January 6, 2010, the Fed held on their balance sheet $777 billion in U. S. Treasury securities, $160 billion in Federal Agency debt securities, and $909 billion in Mortgage-backed securities.

This totals $1.846 trillion in securities held by the central bank! The concern is that in the last week of August, 2008, the Fed had provided only $741 billion in funds to the banking system through some kind of market or auction based transaction.

How much affect these purchases have had on keeping long term interest rates lower than they would have been is currently being debated. What is not in question is that, sooner or later, interest rates are going to begin to rise, first because the Fed’s artificial support will be removed, but rates will rise as the economy begins to improve, further pressure will be put on rates as issuers of bonds race to place debt before the rise takes place (See “Rate Rise Fears Spark Rush to Issue Bonds: http://www.ft.com/cms/s/0/6f46f226-fef2-11de-a677-00144feab49a.html), and as inflationary expectations are incorporated into bond yields.

How fast will the Fed allow interest rates to rise because rising interest rates will slow down economic recovery. Also, the Fed has created another problem by keeping short term interest rates so low. Not only have these low rates created arbitrage possibilities for domestic investment, borrow short term money in the 35 to 65 basis point range and invest in 10-year government bonds at 3.50% to 3.80% but also for the international carry trade. It is argued that the Fed cannot allow rates to go up too fast or big financial institutions and other investors will get trapped in losses that will not help the economic recovery.

The point of all this discussion is that any “exit” strategy that the Fed is planning to reduce the securities held on its balance sheet from current levels to even a level of $1.0 trillion, let alone the $741 billion mentioned above, is already in jeopardy. And, many are arguing that in the face of such overwhelming future deficits, the Fed will be forced to print even more money than it has over the last 17 months.

The problem with debt is that debt, once issued, really does not go away. Someone has to pay for it!