real estate

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More Pale Green Shoots

I love the stock market’s constant urge to exaggerate any good news. Lately that has led us to some odd analysis. Even supposedly sober folks like those at the Financial Times fall prey to what we should now call Bernanke’s ‘Green Shoots Syndrome’ or simply BGSS.

Today’s example of this quickly spreading disease is the almost breathless reporting of the National Association of Homebuilders’ index of homebuilder sentiment. Under the heading of “US homebuilder confidence climbs” the FT solemnly reports that the sentiment index has shot up from a reading of 14 last month to … 16 this month.

Yes it shot up precisely 2 points.

The excitement overwhelms me.

That’s staggering.

A whole two points.

Wow.

Now consider this: at its high point in the balmy and heady days of never ending home price inflation and construction mania back in 2005 the index had a reading of 72. Yes that’s right: 72.

I realize that I am somewhat jaundiced, some have even called me a tad cynical, but there’s something that strikes me as odd about this picture. To characterize a meager 2 point gain in an index that seems to run from 0 to 100 as anything other than tiny seems to me to fall in the category of stock market hyperbole. Most tall tails have more substantial content. Think of that gigantic fish your favorite uncle claims to have caught whilst, unfortunately, no one was looking, and you get my drift.

Where, exactly is the news?

More to the point does this miniscule advance, and let’s acknowledge that it is progress, really justify the comment, made towards the end of the FT report, that: “A return of homebuilder confidence signals that housing starts could start to rebound”?

A “return of homebuilder confidence”?

Where?

Yes the index has doubled in the past few months. From a suicidally low 8 to a merely manically depressed 16.

But it used to be 72. And the blurb accompanying the index tells us that a level of 50+ is an expression of optimism or the that the sentiment is that ‘conditions are good’. So if 50+ means that things are good, I have to assume that 16 means that they are damned awful.

There is simply no return of confidence evidenced in these numbers. None. So why the breathlessness and eager reporting?

I haven’t a clue.

BGSS plays havoc with erstwhile sensible people’s ability to remain calm in the face of the slightest hint of green.

The implication that housing starts are about to recover or return to a more normal level, whatever that is nowadays in this glut-of-unsold-homes era, is a tiny bit ambitious.

The recovery, it appears to me, is not just around the corner. It is still lingering in a distant county.

I agree it’s nice to hope. And I think it very important to report data faithfully.

But this? Please.

BGSS. First Bernanke. And now the old FT.

Get back to me when the index hits 50. Then I’ll give a hoot. Until then: green shoots? Not in homebuilding.

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Understanding Bernanke

Every time I hear that Bernanke has offered up some hope of impending recovery I feel the need to scour through the data to find support for his statements. There is, after all, the idea that he sees something that the rest of us don’t. So his testimony today sent me back to the books. Here’s what I found:

  • He says that there are signs that consumer sentiment is turning. Well yes. Consumer confidence has ticked up. From extremely low levels to simply very low levels. This is an improvement. Whether we should read that as being the end of the slump I doubt. We need several more months of improvement before we can definitively call the corner. And with unemployment bound to get much worse through the summer last month’s movement could easily be reversed.
  • But: anecdotal information supports Bernanke. Wal-Mart recently told analysts that it was seeing a shift in the purchasing habits of its customers. After months of buying only essentials they were returning to the purchase of ‘discretionary items’. People don’t do tis unless they are beginning to think the worst is over.
  • Plus: the first quarter GDP data shows that consumption rose 2.2% January through March after having fallen by around 4% during the previous two quarters. If that holds up the recovery cannot be far away. Unfortunately the data also shows that pretty much all that gain was in January, and that by March consumption had turned down again.
  • The housing industry is starting to show some life after being trashed for the best part of eighteen months. Life that is if you think that a gentle slope down is much better than a precipitate collapse. Some areas of the country are now seeing a surge in home buying: Sacramento is being most often referenced as an example. The problem is that buyers are flocking to pick up bargains. The flood of foreclosed homes is finally attracting buyers who have cash or credit worthiness. With mortgage rates at extremely low levels this kind of activity will continue.
  • But: since the action is mostly bargain hunting, home prices continue to fall. They are now down about 30% on average from their peak and it looks as if we will see another 10% – 15% drop. That implies a further erosion of household wealth and consequently the threat of retrenchment in spending. That would offset the improvement in consumption I mentioned above.
  • The credit markets are improving steadily. A key measure of credit market confidence is the London Inter-Bank Offering Rate [‘LIBOR’] which is the rate banks in London lend to each other. It also is the rate used worldwide to set rates on things like mortgages. At the height of the crisis last September LIBOR shot up to record levels signaling that banks were afraid to lend to each other for fear of default. Since then the rate has bumped about as fears of banks failures and the AIG mess kept those fears high. Now, at last, LIBOR has fallen back. Not just to ‘normal’ levels, but to historically low levels. It is now down to less than 1%. In part this is due to the general level of rates being at historically low levels. But it also reflects a return of confidence that the worst of the banking crisis may be over. I don’t agree with that sentiment, but that’s another story.

So, taking all this together it is easy to see why Bernanke can say that things are improving. They are. What he means is that things are getting worse at a slower rate than before, which is a more accurate and more nuanced statement.

The problem is that we are still faced with fragility everywhere we look. Any one of these statistics could turn back and worsen just as easily as it could continue to improve.

As an example: the Federal Reserve Board reported this week that the major banks that it surveys regularly say that, overwhelmingly, they are tightening credit standards. That means they are renewing fewer loans and turning down more customer requests for new loans. This tells me that there are a lot of small businesses who are running short of cash. And there are consumers whose credit cards are getting more expensive. A consequence of this is that later this year we may well see surge in small business bankruptcies along with less consumer buying power. Either would spell the end of any improvement.

Which brings me the the last point: I have said repeatedly that the timing and shape of the recovery depends heavily on the banks being able and willing to fuel it with credit. The health of the banking system is now the critical element in the outlook.

And that’s not good.

Bernanke admitted as much in his testimony, so at least he is not fooled by the leaks from the Treasury Department that say while our banks need capital, they are fine anyway.

But let’s be hopeful: things are not getting worse as quickly as they were late last year.

Now doesn’t that feel better?

Addendum:

Here’s another upbeat note: David Leonhardt at the New York Times passes on this calculation from Larry Summers. US consumers need to buy about 14 million new cars a year to keep up with replacements of those that are worn out or obsolete. But actual car purchasing has now fallen to around 9 million a year. At some point the pressure to buy will outweigh the urge to save or the ability to extend the life of the old cars. So consumers will have to increase their buying. That will end the slump. This kind of calculation can be applied to many forms of goods or services. You can postpone some things only so long. The ‘pent up’ demand that this postponement implies eventually breaks and the economy recovers on the back of a surge in demand.

This is all well and good. It assumes that we are in a typical cycle. It is probably at least partially correct.

My concern remains the availability of credit to finance the car buying etc. Summers expects.

Having said that, the fact that we are even discussing stuff like pent up demand is a positive sign that the more dire fears we all had last year are dissipating.

The recession will end later this year.

Then the hard part begins: shaking out the imbalances that caused the crisis, and stripping the banks of their power.

I have been saying for a while now: the big question is not whether the recession will end, but what will the recovery be like?

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Gloomy Data: Whither Those Green Shoots?

The accumulated data releases over the past few days indicate that the economy remains deeply mired in recession. For every one of Bernanke’s ‘green’ shoots there seems to be a counterfactual.

Today we hear that durable goods orders sank dramatically during the first quarter. The drop in March was 0.8%, which caps off a fall of 27% for the first quarter as a whole when compared with the same quarter last year. Clearly that’s not good. Remember that durable goods are things with longer lives and generally higher prices: the kind of stuff you furnish a home with. The hit to manufacturing is enormous: production is fell at an annualized rate of 20% in the first quarter, the sharpest decline since the end of World War II.

One statistic I am watching carefully is the ratio between inventories and production. This ratio gives us an idea of the likelihood of future manufacturing trends Obviously if inventories are increasing rapidly businesses will tend to reduce output so as to avoid having to carry excess inventory. Conversely if inventories appear to be running low businesses will tend to step up output so as to avoid the loss of potential sales. There had been early signs that inventories were reducing, which is why I began to argue that we might see an ‘inventory led’ recovery later this year. Unfortunately that decrease reversed course slightly in March, putting off even further one possible reason for optimism.

To demonstrate how desperate we are for good news this morning’s release of the new home sales data, which under normal circumstances would have been treated as awful, brought a certain cheer to stock prices. The March decline of 0.6% was greeted as being a hopeful sign that the housing market may be reaching its nadir. I am a little skeptical. Yes there indeed signs of fairly strong home sales in regions that have been particularly hard hit by the collapse of home prices: California especially. But approximately half of those sales are of distressed properties whose prices are often 20% – 30% below the already severely depressed prices of other homes in the same neighborhood. So while houses are being bought and sold the pressure on prices is still downward which indicates even more trouble for the mortgage lenders as previously good loans gradually turn bad as whatever equity remaining in some homes is eroded away. Couple this erosion with rising unemployment and the outlook for recovery in real estate remains very weak.

So, overall, the economy is still shrinking. Some forecasters are now saying they expect GDP to have declined by an astonishing 6% annual rate in the first quarter. Such a decline pulls us even further from the potential of the economy and opens up the gap between our optimal utilization of our resources and where we actually are. Getting back to health just seems to get harder.

Clearly we still have a very big hole to dig out of. So while there may be a few, infrequent, ‘green shoots of spring’, I think it fair to say we remain stuck in the deep winter of this recession.

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Bernanke’s Green Shoots Wither

Ben Bernanke, in a fit of wild optimism, told us that he saw ‘green shoots’ of recovery springing up around the economy.

Not this morning I think.

If real estate is anything to go by we are still in full recessionary mode. Housing starts in March fell 10.8%, to a level that is the second worst since the middle of World War II, a time that home building presumably had a very low national focus. The worst month? January. It was the modest uptick in February that sparked so much of the ‘green shoots’ spotting that surged through the media in the past two weeks. To make matters worse, permits issued for new construction also fell to a record low – 513,000 – so there doesn’t seem to be any prospect of a real estate recovery any time soon.

Couple this with the bankruptcy of General Growth Properties, the nation’s second largest mall operator, and the outlook gets dimmer. General Growth is the owner and operator of such places as Faneuil Hall in Boston and South Street Seaport in Manhattan. Their failure is a sure sign that poor retail store sales and retrenchment by retailers will create a wave of distress amongst property owners. In fact we should all be on the look out for a surge in commercial property bankruptcies as real estate owners all reach the limits of their loan repayment forbearances and are unable to fund their debts any more. General Growth’s collapse is probably just the beginning of the commercial property sector’s problems.

Which is why I remain skeptical about all the bank earnings reports being published this week.

JP Morgan Chase attracted some good press this morning when it announced very healthy income, down 10% on last year, but still positive. If we are to believe these numbers are solid, then they along with similar shows of strength from Wells Fargo and Goldman Sachs could indicate the beginning of the end for the banking sector’s travails.

But.

Somehow I don’t think the banks are being upfront with us.

In particular their loan loss provisions – the amounts they set aside to cover future loan losses – appear inadequate. No other line in a bank’s income statement is subject to so much management discretion. Basically a banks’ executives can manipulate earnings by increasing or decreasing the provision, and they can always argue that whatever they do is the result of their ‘best estimates’ or ‘considered judgments’. Don’t believe a word of it. Those provisions should be very high right now. Not only are they all struggling with piles of toxic assets from before the recession, but now with commercial real estate tanking and rising unemployment sending credit card defaults through the roof, bank provisions should be approaching their high water mark.

Take two numbers from JP Morgan this morning. They tout their provision as being very solid at 4.53% of total assets. And they reveal that their credit card portfolio had a default rate of over 9% in the first quarter and seems to be getting worse rapidly. Given a deteriorating credit card portfolio, the imminent losses in commercial real estate, and the fact that the economy is still shrinking – in particular unemployment looks set to keep rising for a few more months – I would argue strongly that even at 4.53 % their provision is inadequate. Future earnings will more than likely be depressed by losses that the provision cannot cover.

Further: JP Morgan, like all the big banks has a ton of taxpayer cash to bolster its capital. That is low cost funding and should allow the banks to generate extra income so they can rebuild their own capital. Indeed giving the banks low cost funding in order to increase their earnings was one of the unwritten goals of TARP. Clearly TARP has succeeded in this respect. But, now the banks need to get themselves of of the taxpayers books. to do this they have to replace TARP money with private capital. And to attract private capital they need to show a strong and sustainable earnings recovery. Hence all that ‘judgement’ about provisions. JP Morgan Chase has a Tier 1 capital ratio – the capital that the regulators look at as the best sign of bank strength – of just over 11%. Take away TARP money and that ratio falls to around 9%. Since the regulators are likely to be looking for ratios higher than before when 10% was considered good, JP Morgan Chase has a way to go. It is not out of the woods by any means.

So, the real estate market belies Ben Bernanke’s ‘green shoot’ comment. And so does the banking sector, even with all these ‘good’ earnings reports.

We still have a long way to go.

The inventory turn around I expect in the fourth quarter is still our best bet to halt the decline. Until then it will stay bumpy.

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