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Rose Colored Glasses?
Posted by: Dale Franks on Saturday, August 11, 2007

Perennial supply-side optimist Larry Kudlow isn't woried about housing prices. In fact, he's predicting that Main Street will bail out the nervous nellies on Wall Street.
While Wall Street was busy conjuring up high-yielding bond packages that were heavily invested in unsustainable sub-prime mortgages — and distributing these collateralized debt obligations to big institutional investors around the world — Main Street was focused on the real economics of our nation. To this day, the American labor force is going to work, running the millions of small owner-operated companies that provide the wellspring of our prosperity. And Main Street is benefiting from an unprecedented global boom that is stocking our stores with affordable goods and creating plentiful new jobs as U.S. firms service the rise of new export markets.

With a record 146 million men and women working, and the unemployment rate at a historically low 4.6 percent, the American labor force has increased its after-tax real income by a whopping $257 billion. Nominal wages for non-supervisory workers alone have sprouted by $296 billion over the past year, according to Wall Street economist David Malpass. Average compensation per hour has grown 5.2 percent...

The pattern is the same for American business. After-tax corporate profits have grown $578 billion to $1.1 trillion over the past five years, which is why jobs, the economy, and the stock market have performed so well. Very simply, profitable businesses are creating the jobs that are providing the incomes for families to spend. It’s an enduring story: Second-quarter profits for S&P 500 companies increased more than twice what Wall Street expected.

Meanwhile, the Federal Reserve reports that businesses don’t even need new loans. Corporate cash flow is so strong that firms are generating $987 billion in funds internally, which is actually more than the $973 billion they are investing in capital goods for new plants, equipment, and office buildings.

Bottom line: While the sub-prime mortgage virus has temporarily infected banks, hedge funds, insurance companies, and other institutions, most of Middle America is doing just fine, thank you very much.
Huh. Well, maybe. On the other hand...

The thing is that Ben Bernanke, the head honcho at the Fed, testified to Congress last week that the financial losses from sub-prime mortgage lending could be about $100 billion. That might be a little low, actually, considering that there's about $2.3 trillion in sub-prime loans outstanding. We'll be lucky if $100 billion is all that ends up as non-performing loans.

Oh, and all the rosy income figures—while nice—don't really address the consumer spending side. All those people who took those attractive ARMs a couple of years ago are now seeing rates above 9%, rather than below 5%. That eats up a lot of extra income. Sure, they can re-fi a fixed rate that's even higher. Not much of a solution,there.

Add to that those people who took out large seconds on their homes because they had so much equity—on paper—that is now dwindling away as housing prices decline. Those people are now upside-down on their mortgage, with no real way of alleviating that situation without diverting some of that nice income to paying down those seconds, or deciding to stay where they are indefinitely.

Oh, and if you want a loan for a new home...well, good luck with that. over the last 6 months, mortgage rates have jumped from 5.68% to 6.23%, and lenders have tightened their lending standards as well, both because falling housing prices make a mortage more risky, and the already significant amount of sub-prime lending that's already on the books.

So, here's the thing: it doesn't matter if households have more income, if their borrowing costs increase faster than their income rises. And it does matter if banks are unwilling to extend credit readily because the price of the collateral, the home, is falling steadily.

Consumer spending is 70% of the US economy. If consumers start deciding that the loss of housing values is a financial threat—which isn't an unreasonable reacxtion, since housing is the main component of household wealth—then they will start saving money instead of spending it. Which means that all those nice corporate cash flows—as well as earnings—will dry up as a result of consumers ceasing to buy the products that generate those earnings and cash flows.

Then, a lot of those people on Main Street won't have that nice income any more, because they won't have jobs as companies begin cost-cutting to stem the losses.

The Fed seems to think that we're starting a temporary credit squeeze—a correction, if you will—rather than a full-blown liquidity crisis. One notes, however, that both the Fed and he European Central bank started injecting cash into the financial system after Thursday's market wobbles. They may need to do more of that—a lot more—if credit continues to tighten.

One good sign—sort of—is that the 30-year mortgage has dropped from its high of 6.41% in the middle of June. It's significantly higher than it was 6 months ago, but it's climbed down off the most recent top. That doesn't mean the gradual decline will continue, however, especially if there is a looming credit crunch.

I really hope that Larry Kudlow is right. I fear he isn't, however.
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Previous Comments to this Post 

Kudlow is pretty much right. A credit contraction will have short term impacts on growth but the economy is in much better shape than in previous credit crunches and will be able to weather this storm, if the Fed doesn’t do anything stupid, like a lot of loud guys with investment shows are screaming for.

If the Fed can resist the political pressure to flood the street with money, the credit crunch, be reducing liquidity, will probably take care of the inflation problem that they have not been able to fix on their own.

The real threats to US economic growth are higher taxes and protectionism. Those issues are only on hold until January 2009.
Written By: DS
URL: http://
There are very few total losses on non-performing loans. A default causes a foreclosure and sale. Now the market is down, sales are weak, but buyouts including financing can still be arranged to other weak credit types and satisfy the Community Reinvestment Act, charge the current (discounted) loss to the in existent bond portfolio and package the new sub-prime loans in a new portfolio.

Yes, it is pyramiding, but what, having anything to do with government, isn’t? And yes, anything qualifying under the Community Reinvestment Act, is government.

Other sub-prime loans generated by overseas money looking for a killing leave me with only one sentiment. "Oops, you knew I was a snake when you picked me up."
Written By: RRRoark
A slight credit squeeze might be best for all...worldwide people have been noting the abundance of liquidity.
Written By: Harun
URL: http://
High public and private debt, combined with a credit squeeze, a weak dollar, and high energy prices could stymie consumer spending enough to create a major recession (how bad depends on a variety of factors). When you get to the point where people are saying ’the economy is so fundamentally strong nothing can really damage it’ that’s a sign of denial of reality. Conversely, back in 1992 when people were sayin "today’s young people will be the first generation not as well off as their parents," that was the reverse — a boom quickly followed.

Otherwise, I pretty much agree with DS that the fed should not flood the market with money, and that increased taxes and protectionism are a threat. But the fundamentals are weaker than one thinks given the possibility that consumer spending could weaken considerably.
Written By: Scott Erb
Dale—I think Kudlow is pointing out that the subprime mortgage mess is hurting lenders and Wall Street, but not Main Street. That’s accurate.

Rates for new mortgages are up slightly (10% or so) from six months ago, but still in the low 6% range, which is low by historical standards. For example, as recently as 2000, the average 30-year fixed mortgage was 8%. From the New York Times on August 11, 2000:

’...Freddie Mac, the mortgage company, reported today that fixed-rate loans dropped to 8.04 percent,...’

We also have very wise leadership at the Federal Reserve. The Fed has stepped in to provide liquidity to the system, but the Fed has rightly pointed out that the economy is sound. I covered this in more detail here:

Written By: Kurt Brouwer
When you get to the point where people are saying ’the economy is so fundamentally strong nothing can really damage it’ that’s a sign of denial of reality.
Wow Scott - after seeing you completely avoid a discussion of ’reality’ in two or three other posts this weekend, I’m surprised to see you call others out for ’denying’ it.
Written By: meagain
URL: http://
I have literally never seen Kudlow make a pessimistic statement about the U.S. economy. Not even one. He’s a crank, Dale. Your analysis is good. Not even pessimistic enough. It’s not just a liquidity crisis, it’s a debt crisis triggering event.

This is a very good link on the subject, comparing the difference to that between Mexico in 1998 and Russia in 1998.
Written By: glasnost
URL: http://
Rates for new mortgages are up slightly (10% or so) from six months ago, but still in the low 6% range, which is low by historical standards. For example, as recently as 2000, the average 30-year fixed mortgage was 8%. From the New York Times on August 11, 2000:

How high the rate is relative to historical standards is irrelevant because other variables in the consumer financial situation are not the same as then. For example, historically, the U.S. consumer didn’t have a negative personal savings rate. What matters is the rapidity of and size of the increase in rates, and that seems to me to be pretty significant, and headed for worse.
Written By: glasnost
URL: http://
My prediction is that the sub-prime crisis will cause millions to lose their homes and becomes renters again, but I don’t think this will cause a significant decline in property values because these people still need somewhere to live. The homes they lose will picked up by landlords and rented back to them (in the general sense, and sometimes literally). Rents will go up because of the influx of people into the rental market, and higher rents means higher valuations. In all, this will probably be a wash, except in a few places where people have gone loopy in what they were willing to pay for property... California and Florida come to mind.

The sad thing is the landlords will be able to borrow on the properties at rates that the current owners could afford, but the current owners will not get those rates because of the credit scores that put them in the sub-prime market market to begin with.

I understand the importance of being able to determine credit worthiness, but if I had my druthers, I’d like to see lenders look specifically at mortgage history and try to find a way to give these people a chance.

We still may dip into a recession because of the perception of crisis, and we can already see consumer spending on home improvements dipping. Ironically, a short recession may be a Godsend for the sub-prime mortgagees who could see their rates come back down as the Fed tries to stimulate the economy.

Written By: Captin Sarcastic
URL: http://
One cause of worry about the economy is reading bad news in the paper - affects confidence which affects the economy, etc. Another is the when markets overcompensate - oh no, we had some people default - better not lend to ANYONE.

The combination of these two issues MIGHT make this more than just a mild speedbump, but I doubt it. I do understand the feeling though that its seems the party has gone on just a bit too long.

Keep in mind, though, the rest of the world is now chugging along - German consumers are now spending, China/India, and all the rest are booming. That means a slight downturn in US consumer spending might not be the end of the world as we have now have additional engines of growth to keep the economy going.
Written By: Harun
URL: http://

You are beginning to sound like me, so I’ll throw in another factor. The mortgage equity withdrawal issue. In addition to the people who have actually suffered, a a large number of people have borrowed to spend. They are not upside down, they will not default, or any of that. However, they will not have large increases in equity available to tap for spending. This accounted for a large percentage of GDP growth over the last five years, probably it can explain more than half. Add that to all of the other issues and it is pretty hard to imagine we get by without a slowdown.

Nor are we anywhere close to a bottom. Prices have only begun to decline, and only by a small amount. If history is any guide we could easily see home prices decline by 20% or more. That isn’t a prediction, just what we have to consider a real possibility. Those declines will be concentrated in certain areas, thus the effect will be patchy, but it could still be quite large. This effect will be a drag for at least another year and a half, and quite likely longer.

Economic disaster? Probably not, but a recession is quite likely, and possibly, though unlikely, it will be severe. Of course, we Cassandra’s like to say I told you so, but given I just bought a house I can truly say I hope I am, and have been, too pessimistic.

The economy however will get by most likely with a mild recession, possibly just a slowdown similar to the last two recessions we have had. Asset prices in general however may have a much tougher time. Spreads will probably widen, thus making interest rates in general higher than any counteracting moves by the fed. So if the fed lowers by a percentage point, and most actual bonds and interest rates increase due to widening in risk spreads the fed may be less effective than they hope. Needless to say bond owners will suffer if that occurs, despite lower fed rates. That will truly stink for them, especially those investing, as a huge number are, with large amounts of leverage. It will also affect Main Streets bottom line as you point out.

Equities are pricing in pretty steep earnings assumptions (unprecedented growth, though not unprecedented assumptions) so anything which threatens record profit margins (unsustainable, but the market often needs an excuse to act upon that truth, credit concerns would be a fine excuse) and steady above average profit growth (when you have both of those factors, record high profits and high earnings growth the results moving forward have been truly and astoundingly bad) will likely lead to some real issues there as well. Throw in Real Estate owned as REITS still trade way above any historical valuation mean and financial assets look pretty darn scary.

Not a pretty picture overall, though I still suspect the damage will be more to financial assets and housings valuation than the real economy.
Written By: Lance
OK, OK, ’splain this to me... cause I’ve run the numbers, and what you’re saying doesn’t mesh.

According tow hat I’m seeing, some 96 odd pecent of the mortgage market is considered safe.

Let’s focus a little closer:

At the moment, we have along the lines of 44 to 45 million mortgages in the U.S.

Of those, less than 14% of them are in the subprime category. Of those, something on the order of a little over 10% are delinquent on payments, for 1/4% overall.

Of those, the majority are in the process of working payment problems and solutions through their local banks.

That works out to only around 6 tenths of a percentage point of the total mortgage market that is currently in foreclosure.

How much of a swing caused all this panic? Well, we were at around 5 tenths of one percent last year at this time, so in all, the answer is about one tenth of one percent.

Forgive me, but a swing of 1/10 of 1%, in the foreclosure rates of what are by definition, risky loans in the first place, is not cataclysmic... Or, even very surprising, given along expansion period we’ve just seen... (Especially given Kudlow’s points)... is it?

The press has been making a great deal, of late, about this sub-prime thing, and issuing dire warnings on the economy. Basically it looks to me like they are trying to create a panic. When someone blows something this far out of proportion , blowing something this small into a major panic, you can bet they have something to gain by that panic occurring. What might that gain be?

Well, wonder of wonders, we’re just going into one election year. An election year which finds the current occupant of the White House sitting on top of the longest positive streak in recent memory. As has already been pointed out unemployment and inflation at historicly low levels, interest rates while not at historic lows, are certainly far better than we have seen from say, Jimmy Carter. Do you suppose that some of this panic we are seeing, is being generated for the purpose of creating the perception that the economy is in the crapper?

The political angle on this takes an even steeper turn, when you consider that the democrats in Congress, who are now screaming for us to bail out such loans, get to project themselves as the saviors of "the poor" yet again. And why not? You can always blame GWB for the financial excesses involved with such bailouts.

Written By: Bithead
Dropped the final line in editing:

I say all of this because my read is that a lot of a predictions of a credit crunch... and the resulting price flux, is being driven by perception... which the current smoke about the Sub-Prime market is creating rather well.
Written By: Bithead

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