Financial Crisis 101 - 10/29/08

November 12, 2008 2:38:49 PM PST
As expected, the Fed today slashed interest rates, cutting the target for the Fed Funds rate from 1.5% to 1.00%. The last time the Fed Funds rate was lower was during the Eisenhower Administration in 1958. The Fed lowered rates hoping to further loosen credit in an effort to revive economic activity. The Fed also left the door open for another interest rate cut at its December 16th meeting. The interest rate cut was expected, but also welcomed by the stock market. Ten minutes before the closing bell, the Dow Jones Industrial Average was up 265 points, and it looked like we were heading for a second consecutive day of big gains.

Then, in the last seconds, the bottom dropped out. The Dow lost 340 points real fast to close down 74.16 points for the day. The dictionary defines "volatile" as tending to fluctuate sharply and regularly. You think it fits? I like the definition of volatile as it relates to a chemical reaction better: evaporating rapidly; passing off rapidly in the form of vapor. Does that remind you of your 401k?

It would probably be a mistake to attach too much importance to this, but demand for new mortgages did bounce back a little for the week that ended October 24th. The Mortgage Bankers Association reports that requests for mortgage applications for both new purchases and for refinancing increased 16.8%. That doesn't do much more than make up for the previous week's decline of 16.6 per cent which put us at an 8 year low. But it might indicate that plunging home prices are beginning to find a level where potential buyers might be persuaded to make a move.

But we ought not to get too excited. The conventional wisdom has home prices going down another 10% before they stabilize. So why is this so important? Well first of all, if you own a home, you want to see the value of your home stop plummeting. You also want the value of your home to stay higher than what you owe on your mortgage. But seen in a larger picture, economists say a return to normalcy in the housing market is crucial to the prospects of an eventual economic recovery. In fact, housing is one of a basic group of indicators that economists are monitoring to see how bad and how long our economic downturn will be.

Here's a really good article from this morning's Wall Street Journal that explains how economists will be able to tell what's happening with the economy.

Economists struggling to gauge the depth of the U.S. downturn are turning to more forward-looking clues, such as home-vacancy rates and foreign stock markets.

The standard measures of gross domestic product and monthly payroll figures give snapshots of what has happened, but say less about what will happen next.

The current downturn is shaping up to be worse than the recessions of 1990-91 and 2001 and the prolonged downturn that ended in 1982. Banks are cutting back on lending, consumers are spending less, companies are shedding jobs amid sinking profits, and the housing bust that triggered the slide persists. Here are five areas economists are watching, and the indicators they are tracking.

Banks

The government's plan to inject $250 billion into financial institutions as well as its guarantees on loans between banks eased some of the stress ripping through credit markets.

In a sign that banks have become less wary of lending to one another, the London interbank offered rate, a benchmark interest rate for many dollar loans, has fallen sharply over the past two weeks. It still is historically high relative to the Federal Reserve's target rate, however. Continued declines in Libor will be an important sign that the credit crunch is easing.

While lower interbank rates are an important precondition for a recovery in lending markets, they won't automatically lead to a lending revival. "It doesn't matter whether a bank will lend to a bank," said Northern Trust economist Paul Kasriel. "It's whether a bank will lend to Joe the plumber."

Banks are cautious about lending, in part because they have been hurt badly in the housing downturn and financial-market turmoil, but also because lending is riskier during a downturn. In the Fed's July quarterly survey of senior loan officers, a large percentage of banks reported that they had tightened lending standards. One early sign the economy is on the road to recovery, according to Mr. Kasriel, will be when more banks are easing lending standards than tightening them.

Homes

The housing market will play a major role in any easing of lending standards. As long as home prices continue to fall, more homeowners will find themselves owing more on their mortgages than their homes are worth. That sets the stage for more mortgages going sour and continued caution among lenders. Through this year's second quarter, the S&P Case-Shiller national index of home prices was 18% below its 2006 peak; Goldman Sachs economists forecast another 15% fall.

The key to how much further home prices fall, Goldman Sachs economist Jan Hatzius said, is how fast the glut of empty homes is absorbed.

At the beginning of 2005, 1.8% of nonrental homes were empty and waiting to be sold. The Census Bureau reported Tuesday a 2008 third-quarter vacancy rate of 2.8% -- even with the second quarter and just shy of the first quarter's 2.9%. With many homes on the market, sellers are lowering prices to attract buyers.

"If you see excess supply coming down, Economics 101 says that house prices will eventually stabilize," Mr. Hatzius said.

Consumers

Worries about the economy have skittish consumers tightening their purse strings. Consumer spending represents more than two-thirds of U.S. GDP and hasn't declined on a quarterly basis since late 1991. That nearly two-decade spurt of spending growth likely ended during the July-through-September period, economists predict, dragging economic growth down with it.

A widely followed index of consumer expectations, part of the monthly consumer-sentiment report from Reuters and the University of Michigan, could offer clues to where spending is headed. After hitting its lowest level in nearly 30 years in June, the gauge had begun to improve as oil and gas prices fell from their record highs. But that improvement was wiped out this month as financial and economic conditions worsened.

One sign of improving attitudes among consumers will be their willingness to buy big-ticket items such as cars, furniture, appliances and electronics -- categories that have been hit hard in recent months as loan standards tighten and consumers shy away from making major purchases.

"It's a natural thing to postpone spending when you're uncertain about the world," said Barclays Capital economist Ethan Harris. "What we want to see are signs that those sales are starting to stabilize and improve. That would tell you people are starting to come out of their bunker and buy things that are longer-term commitments again."

Jobs

Americans probably won't be inclined to make such commitments until they see improvement in the labor market. The payroll figures and unemployment rate from the monthly employment report are lagging indicators, showing changes in the jobs environment long after the fact.

Many economists more closely monitor the Labor Department's weekly report on initial unemployment insurance claims, which measures the number of people filing for new unemployment benefits. A rule of thumb says that when claims stay above 400,000, the economy is slipping into recession. That started happening in July. The latest weekly claims figure is 478,000.

Stocks

Companies play the major role in the jobs outlook: If they are worried about losses, they are more likely to pare the work force than hire. The stock market, for all its imperfections, is one of the best indicators of corporate health. Millions of investors are devoted to figuring out where profits are headed, and their opinions get reflected in prices.

But at a time when companies' health is highly dependent on the global economic environment, watching the Dow Jones Industrial Average may not give the best reading. Instead, Merrill Lynch strategist Richard Bernstein tracks the Korea Composite Stock Price index, known as the Kospi. South Korean companies are export-oriented, which makes them highly sensitive to global profit growth. The Kospi topped out a year ago. Tuesday, it was 52% below that level.

If the boost in mortgage applications is good news, so is word that gasoline prices have sunk to a three year low. The average price of unleaded gasoline nationwide is now $2.589 a gallon after falling for the 42nd day in a row during which time gas prices have fallen 37%. Sure, this is good news for consumers who've been paying thru the nozzle for sky-high unleaded, but remember, the plunging price is also reflective of a world-wide economic slowdown which will bloody our nozzles in so many other ways.

Much of the discussion about the financial crisis has been about the idea of a second stimulus package as a way to kick start the economy. By way of background, we've already had one stimulus package passed last February by the Congress. The Government sent everybody rebate checks during the spring and early summer. The idea was that Americans would spend the extra cash, and get the money flowing through the economy. Maybe it worked, and maybe it didn't.

There are some economists who think that millions of people hoarded the cash and, perish the thought, actually saved it. That's a noble thing to do, but in this case, it didn't help achieve the goal of the stimulus package. So the Democrats in Congress are now talking about a second package, and the White House seems to be listening. The big question now is, what form would the package take, and how big would it be.

Well, there are all kinds of ideas floating around, including this proposal from House Republican leader, John Boehner: double the size of the child tax credit, reduce the corporate tax rate from 35% to 25%, and suspend the capital gains tax. A plan like that has as much chance of passing the Democratically controlled Congress as the Phillies have getting a do-over on the 6th inning Monday night when Tampa Bay scored the tying run.

Many Democrats are talking about a 150 billion dollar package that, for the first time, would invest in improvements to the nation's infrastructure. The theory goes that the country is in desperate need of repairing its roads, bridges, schools and that's just a start, and a massive investment would create jobs now, and have profound economic benefit long into the future. The argument against using stimulus money on infrastructure has always been that these are very long-term projects and that the whole point of a stimulus package is to provide a much needed boost now, or at least soon. Economy Writer Megan McArdle explains the argument against.

"I regret to report that the idea of using infrastructure spending as a stimulus is a complete fantasy. This is not your grandfather's stimulus spending. FDR could spend whacking great sums on dams and roads and rural electrification, and hope to have an immediate effect, because FDR was working on a multi-year depression, and in the pre-1960s regulatory environment.

Between the environmental impact statements, public review periods, and byzantine bidding process, the development cycle for anything more complicated than painting a bus station is now measured in decades, not years.

...

The reason we rely mostly on monetary policy and tax cuts for stimulus is that it is possible to rapidly implement whatever stimulus you decide on. With the exception of a few transfer programs such as food stamps and unemployment insurance, which are hard to funnel very large sums of money through, there is nothing on the spending side that matches tax cuts for speed. You could allocate the money, to be sure, but by the time it actually hit an agency and went through the bureaucratic procedures necessary to actually spend it, the window for effective stimulus would have passed."

But proponents of earmarking stimulus funds for infrastructure repair argue that if the recession is as long as many economists think it will be, then longer-than-normal-term projects will have time to have a positive influence on the economy. Plus, they say, states and localities have thousands of infrastructure proposals ready to go, on the shelf only because there's been no money to finance them.

There is no question that the state of America's infrastructure is deplorable. Pennsylvania needs about 10 Billion dollars just to repair its bridges. So the idea to use a second stimulus package to invest in America's long-term future while helping to ameliorate the country's shorter-term economic crisis seems to be gaining steam. There is talk of calling a lame duck session of the Congress to consider a stimulus package, but more likely, it'll happen early next year.

Will it help? Will the Phillies tonight? If you can answer one question, you can probably answer the second.

Jim Gardner


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