Our Observations On The Economy: We Expect Inflation, More Foreclosures, And A Continued Rise Of China's Economic Power

Monday, January 17, 2011 08:13
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Our Observations On The Economy: We Expect Inflation, More Foreclosures, And A Continued Rise Of China's Economic Power

The U.S. Government went in the hole again in the fiscal year ended September 30, 2010, outspending its revenues by only $1.3 trillion, down from last year’s $1.4 trillion. 

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Unfortunately, due to the income tax bill passed in December, which in effect results in an income tax freeze for 2011 and 2012, the budget deficit appears to be on pace for similar deficits as occurred in the last two years. 

On the surface, the U.S. economy continues to improve ever so slowly, showing more of a limp “L” type recovery versus the usual “V."

Given the pathetic rate of improvement in some areas, especially unemployment and housing, that we’ve made over the past two years, it certainly does not seem to warrant that amount of spending. However, when looking below the surface, so to speak, it is likely we would be in a Depression--but not a Great Depression--were it not for the mammoth amount of Government spending since the Fall of 2008. 

In fact, to find a similar economic period in history, given the debt problems we currently have, you'd have to go back to the 1906 to 1914 period--although the debt this time as a percentage of Gross Domestic Product (GDP) is far larger this time (approximately 370.0% versus 260.0%).
During that nine-year period, there was a recession as well as three of what was then called depressions or panics. 

Notice we qualified that statement, although they may have actually been deep recessions. As a side note, recessions result in a decrease in GDP of 0% to 5.0%. What is often termed by the media as “The Great Recession” was actually a recession. A severe recession is a decrease in GDP of 5.0% to 10.0%, and a depression is defined as a decrease in GDP of 10.0% to 25.0%. A Great Depression is defined as a decrease in GDP of 25.0% or more. 

It's difficult to determine the severity of the economic downturn of  the early 1900s due to the fact that economic data was either not kept, or was not available to the degree it is today. However, we eventually emerged from that dire economic period due to the positive economic performance that was generated from World War I. 

 
During the early 1940s, we emerged from the Great Depression due to World War II. Today, it appears that given the enormous spending that we have incurred during the past two years, with so little improvement made, that we will experience a fate similar to that of Japan’s for the last 20 years assuming no wars occur. 
 
In other words, no strong and lasting economic growth can occur when every few years we re-enter a recession while piling on enormous amounts of additional debt—another $7.7 trillion by 2019 is projected, That’s the Obama Administration’s estimate—we all know Government estimates are almost always too low. By the way, that estimate was issued prior to the new tax act.
 
Our firm believes that the best case scenario for our future is much more of the same as the past two years, i.e. the 2008 to 2010 economic stagnation period. That means GDP growth of 2.0% or less over a five-year period with annual growth sometimes reaching as high as 4.0% but then dipping in a recession and perhaps a period of deflation as well for at least the next five, if not 10 years. 

At some point, consequently, we expect the U.S. Government will effectively give up and then reflate the economy.  Inflation makes GDP larger while debt does not inflate, thereby, making the debt amount smaller as a percentage of GDP. That can bring down our debt to a manageable level relative to the size of our economy. In order to accomplish this feat, we will need high single-digit inflation to occur for at least 10 to 12 years or a higher inflation rate over a shorter time period. 
 
Obviously, with high inflation, individuals who cannot keep pace with inflation and/or those that live on a fixed income will see large decreases in their purchasing power, and as a result, will eventually subsequently decrease their standard of living. All economic classes of people will suffer under this scenario, although the ultra-wealthy will not have their day-to-day standard of living impacted. 
 
As mentioned earlier, while the problems in housing are not the sole reason we are in a struggling economy, it is one of the primary reasons we are struggling to return to normal growth levels.
 
The first U.S. mortgage crisis began due to the Subprime loans issued in the middle of this past decade. For the most part, defaults on this group of loans have run their course and additional damage from such mortgages should be minimal. However, Subprime loans ate away at banks and other lenders’ capital, which is still shaky due to all of the home and commercial loans that have not yet been foreclosed upon by lenders. 
 
When lenders foreclose on a property, they need to write down the property’s value to current market prices or less depending upon what the house can be sold for. Historically, the value of a foreclosed home drops approximately 50.0%. This is an unattractive proposition from the bank’s standpoint given that the bank takes a hit to their capital.
 
Bankers and lenders now face a new threat—Alt A (low or no documentation loans) and Option ARM mortgage defaults. These are Adjustable Rate Mortgages where the borrower selects the amount of interest they want to pay. Any amount of interest not paid below the current rate is then added to the principal balance until the mortgage balance reaches 110.0% to 125.0% of the original mortgage amount depending upon the lending institution. Once the mortgage balance reaches these percentages, the loan becomes fully amortizing. In other words, principal and interest payments must be made by the borrower. This is an unlikely event given the borrower could not make partial interest payments in the first place. 

The Alt A and Option ARM mortgage problems peaked in late 2009, and mortgage defaults would normally occur six to nine months later. Well, to some degree we’ve arrived. To “some degree” means because the delinquencies (90 days or more overdue) have occurred at a rate of 13.0%, yet foreclosures are far behind that level at approximately 5.0%. 

Banks have, until this point, been reluctant to foreclose on homeowners for several reasons. Among them, the Government and the banks would like to avoid that scenario as much as possible due to the concerns about first, bank capital—when a bank forecloses on a home, the bank has to write down the mortgage to its true value, thereby, eating away at bank capital and perhaps jeopardizing the bank’s viability to continue its operations. Therefore, the banks often won’t foreclose—a banking strategy now known as extend and pretend. If the loan is not foreclosed upon the mortgage/home does not have to be written down. In effect, the bank pretends that it owns a fully amortizing mortgage.

The U.S. Government itself, of course, doesn’t want banks to foreclose due to the fact that the banking system could end up in jeopardy. Yet in calendar year 2010 there were approximately 2,900,000 foreclosure filings issued after 2,600,000 plus in 2009 were issued. 
 
Please note that not every home where a foreclosure notice is filed is repossessed. In 2010 more than 1,000,000 homes were repossessed far less than the 2,900,000 foreclosure filings. An additional 1,200,000 repossessions are expected to take place in 2011. 

To help minimize the impact delinquent home mortgage borrowers might have on the banking system, the Government’s Housing Affordability Mortgage Program (HAMP), which provides borrowers with the opportunity to modify the terms of the mortgage with regard to the principal and interest payments (and stay in their homes); in other words the Government subsidizes payments. 
 
The problem so far is that of the 1,200,000 individuals that have tried to qualify for the HAMP program, 700,000 either dropped out or were ineligible to continue under the plan because of the inability to pay as promised, or they did not qualify in the first place. Obviously, banks are then stuck with these non-performing loans.
 
Recently, to add more fuel to the fire, Government National Mortgage Association or GNMA (Ginnie Mae) and Federal National Mortgage Association or FNMA (Freddie Mac) have legally attempted to force banks (with some success – Bank of America paid them $3.4 billion for selling bad loans to them) to take back as much as $650 billion of mortgages that they claim they were mislead into buying from banks that had low underwriting standards. Some estimates though state that number could be as little as approximately $200 billion. In any event, this situation could cause large drawdowns in bank capital. Obviously, such losses will put at least a few banks into financial jeopardy.
 
In the end, what do more foreclosures mean?
 
  1. Poorer capitalized banks.
  2. Many homeowners with significantly lower credit ratings.
  3. Even lower housing prices nationwide.
  4. Increased Inventories of homes now over 3,000,000 [excluding what is called the shadow inventory (mortgages that are in or nearly in foreclosure but are not yet on the market) and getting worse] which causes new home construction to be depressed.
  5. More people will lose their homes.
On a more positive note, for the month ended November 30, 2010, approximately 600,000 new homes (seasonably adjusted) were built down from 2,300,000 in 2005.   The latest forecast is for us to again reach 1,000,000 new homes built by 2015—less than half of the 2005 peak but 10 years later.
 
The economy is getting better, but it is still a shell of its former self. Hard choices need to be made by the politicians. So far, neither political party has done much to improve our economy. 

Unfortunately, due to our debt load, little economic issues become big ones. In the long run the total debt, which is approximately 370.0% of Gross Domestic Product (GDP) has to decrease. 

If you don’t believe this, look at the Chinese. They have over $2.6 trillion in reserves, and it now appears that the Chinese make the economic rules and everyone else tries to get out of their way or work around them. After all, isn’t our government continually asking the Chinese to increase their currency value against the U.S. Dollar to minimize the Chinese imports to us and maximize our exports to them. Who is begging who?

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