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Friday, February 02, 2007


recession forecasting

in an otherwise positive q4 employment report, the effect of the declining level of residential investment showed up in a contracting housing sector.

Residential construction employment decreased by 11,400 jobs in January and is down 112.2 thousand, or about 3.2%, from the peak in February. This is just the beginning of the loss of several hundred thousand residential construction jobs over the next year or so.

the spillover hasn't yet hit retail consumption, but some potential signs are developing -- see fig.4.

(Interestingly, non-oil imports tend to decline multiple quarters before recessions, so don't wish for too many quarters of real ex.-oil import decline...).

real import growth (ex-oil) peaked in 4q2003 and again in 1q2006 -- and elsewhere, retail employment may have peaked for this cycle in 1q2006. this timeframe -- first quarter 2006 -- perhaps notably follows the first fracture of the residential real estate bubble, which peaked in 3q2005.

is this the beginning of a more pervasive economic downturn? possibly. the treasury yield curve inverted in q42005 -- some 14 months ago -- and, as this tool can illustrate, the steepness of the inversion has since aggravated somewhat. a proper comparison can be made by running the tool from january 2000 to october 2000 -- the point of greatest inversion -- by which time recession had struck (though, typically, the fact was not recognized until later). the speed with which that inversion translated into recession, however, is not typical -- the event can precede the slowdown by years. the american stock markets (normally good leading economic indicators) have not yet faltered, and though the 10-year bond yield may have peaked in july 2006 the spread over corporates and emerging market debt instruments of like duration -- which are historically very narrow, indicating complacency -- have not widened appreciably. the conference board's leading economic indicator stands at 138.0, which is essentially flat from august 2005 -- but the consumer confidence differential (future less present) that i assign considerable weight to as an indicator of oncoming consumer-driven recession has deteriorated from zero in 2004 to (-20) in march 2005 to (-39.4) today.

most disquieting may be the aspect of a quite positive q4 gdp report which showed personal consumption expenditure declining for the first time in 45 years.

on balance, the curve inversion and consumer expectations continue to indicate that recession will not long be forestalled, though its imminence can be questioned. the housing deterioration, however, may be the leading edge. to be noted is the carnage now taking place among subprime lenders, the most exposed of all financial sectors, as default rates on low-quality loans start to spike and investors (who have been purchasing mortgage-backed securities from subprime lenders in search of yield) start exercizing their right to force the originator to repurchase bad loans on "warrants and representations" -- essentially, exposed lies concocted by the originator to make the loan to people who should never have been given them. as these subprime lenders have little capital on their balance sheet, forced repurchases of defaulting loans can quickly force them to bankruptcy -- which is now happening at the remarkable rate of several a day.

In any case, one is generally made to repurchase a loan at par (you might have to give back any actual premium paid if it’s an EPD [that is, 90 days late within the first year], depends on the contract). So passing it off to a junk dealer, in turn, at a bid in the 80s is a painful thing. Hanging on to it, if you’re as thinly capitalized as your average subprime mortgage banker, is out of the question. Hence the “bloodbath.”

If it hits an outfit like Fremont—which is an FDIC-insured thrift and can therefore hang onto this stuff a lot longer than a mortgage banker can—we’ll be out of “thinning the herd” and into “decimation.” One reason it’s so hard to tell at the moment how bad this might get is that it’s hard to tell how many more “pending” repurchases we have out there. The EPD garbage is just the first wave.

watching fremont general may be interesting -- they showed up on a list of particularly dangerous housing-related stocks i perused a couple years ago. this bit in the orange country register documents their plight.

Lenders made two mistakes, according to UBS and other analysts.

They didn't scrutinize borrowers' incomes, and they allowed subprime borrowers, who by definition have had past problems with their credit, to take on lots of risk.

Borrowers took advantage of "stated income" loan programs, where they simply tell lenders what they earn, said David Liu, director of UBS' mortgage strategy group.

And many first-time homebuyers made a small down payment or none at all. Often they took out simultaneous second mortgages to avoid paying mortgage insurance.

Borrowers gambled on rising home prices to bail them out of trouble, analysts said. Consumers thought home prices would keep climbing, which would enable them to sell or refinance if they got into a jam, analysts said.

But stalling or falling home prices last year changed all that, UBS' Liu said. Borrowers quickly began to miss payments.

"They lost the motivation or incentive to send in the checks," Liu said.

Because of the way loans are ultimately funded, it's very costly for lenders when a borrower misses one of the first payments on a loan.

Lenders package loans in big pools and sell them as bonds to investors. If a borrower misses the first payment, an investment bank putting the whole deal together can compel the lender to buy back the loan.

Lenders typically lose a lot of money when they must buy back delinquent loans. They lose transaction costs and may sell the loan again at a loss. Often when a borrower has defaulted, there is little or no equity in the home, so a foreclosure sale will not cover costs.

if damage in the banking sector starts to spread to fdic-insured outfits like fremont, one wonders if even the macro efficacy of the petrodollar put in holding down interest rates will be enough to stave off or just soften what must be seen as an overdue credit contraction and recession. this writer for one has been paranoid to the possibility since 2005, but it now seems real damage is underway.

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