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Consumer Confidence & Bank Lending Plunge

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
March 2, 2010

IN THIS ISSUE:

1.  Economy Continues to Recover, But Slowly

2.  ConsumerConfidenceFalls Off a Cliff

3.  Bank Lending Continues to Plunge

4.  More Really Bad News on the Housing Front

5.  Are “Option-ARMs” the Next Subprime Crisis?

6.  End of an Era for Coach Halbert

Introduction

Most economists and market analysts agree that the US economy has been through the worst of the recession.  The economy clearly rebounded in the 4Q of last year, as I will discuss in more detail below.  Some economic reports suggest that the economy will continue to strengthen through the balance of this year, such as the Index of Leading Economic Indicators which has risen for the last 10 consecutive months.

Unfortunately, two reports released last week were extremely negative.  First, consumer confidence unexpectedly plunged in January.  No analysts I read saw this large a drop coming.  Second, the Federal Deposit Insurance Corporation (FDIC) released its quarterly report which showed that lending by US banks plunged last year in the sharpest decline since 1942.  We also saw new unemployment claims spike higher for the week ended February 20.

It is widely agreed that consumer spending accounts for apprx. 70% of GDP.  With the Consumer Confidence Index unexpectedly plunging almost 20% in February alone, this raises serious doubts about economic growth going forward in 2010.  Likewise, spending by businesses is also a big part of GDP, but if bank lending to businesses remains hamstrung, this is not a good sign for the overall economy.

I have argued for some time that the nice rebound in the economy in the 4Q was largely due to inventory rebuilding.  I have likewise argued that inventory rebuilding would be only a relatively short-term boost to the economy, and that economic growth would be upward but disappointing in 2010.  I have also suggested that we could well be in for a double-dip recession in 2011, if not sooner.

The latest reports on consumer confidence and bank lending, along with continued high unemployment, virtually assure my arguments for disappointing growth in 2010 and support my suggestion of a possible double-dip recession in 2011.  We will discuss all this as we go along this week, plus another possible negative shock to come from the housing market.  Sorry to be so negative, but things are what they are. 

Economy Continues to Recover, But Slowly

Before I get to the discussion of plunging consumer confidence and bank lending, let’s first review the latest routine economic reports.  The US economy continues to struggle to dig out of the recession.  The Commerce Department’s second estimate on 4Q GDP came out last Friday, and it came in at 5.9% (annual rate), up from 5.7% in late January, and in-line with the pre-report consensus.

The Commerce Department again confirmed that inventory rebuilding accounted for much of the advance in GDP in the 4Q, followed by exports and consumer spending in third place.  Real personal consumption expenditures increased 1.7% in the 4Q quarter, compared with an increase of 2.8% in the 3Q.  

The Index of Leading Economic Indicators (LEI) registered its 10th consecutive monthly increase in January, rising 0.3%.  The continued rise in the LEI is a strong indication that the economy is in recovery; however, the January rise of 0.3% was far short of the December rise of 1.2%.  The tepid rise in January added fuel to the argument that GDP growth will be disappointing in 2010.

Retail sales rose a better than expected 0.5% in January following a loss of 0.1% in December.  On the manufacturing front, the ISM Index rose again in January to 58.4 from 54.9 in December.  Any reading above 50% in the ISM Index suggests that the economy is expanding, at least slowly in this case. 

Orders for durable goods (big-ticket items) rose a better than expected 3% in January, up from 1.9% in December.  Industrial production rose 0.9% in January, up from 0.7% in December.  And the factory operating rate (capacity utilization) rose modestly in January.  That’s about it for the good news of late.

The US unemployment rate fell from 10% to 9.7% in January, even as businesses cut another 20,000 jobs last month.  The drop in the headline unemployment rate occurred primarily because a large number of Americans gave up on looking for work late last year and in January and were therefore not counted in the official unemployment rate.  And as we learned last Thursday, the number of Americans filing for state jobless benefits is still increasing at the rate of almost 500,000 a week.

Consumer Confidence Falls Off a Cliff

The markets got a shock last Tuesday when the Conference Board announced that its widely followed Consumer Confidence Index basically fell off a cliff last month.  The Index plunged to 46.0 in February from January’s 56.5, a drop of apprx. 20%, following several months of increases.  This is the largest monthly plunge in consumer confidence in recent history, and was totally unexpected.

The non-partisan Conference Board said that consumers are still in a generally “sour mood,” due partly to continued pessimism about job prospects and income worries, and suggested that consumer spending could fall in the months ahead.  Remember that consumer spending accounts for apprx. 70% of GDP.

Lynn Franco, director of the Conference Board’s ConsumerResearchCenter, said in an interview following the report’s release: “This recovery has been driven more by business than by the consumer. The fact that we’re not adding jobs but are still shedding them is doing very little to comfort consumers. While other indicators are showing that the recession is over, to the consumer it still feels like we’re still mired in the recession.”

“Concerns about current business conditions and the job market pushed the Present Situation Index down to its lowest level in 27 years. Consumers’ short-term outlook also took a turn for the worse, with fewer consumers anticipating an improvement in business conditions and the job market over the next six months. Consumers also remain extremely pessimistic about their income prospects. This combination of earnings and job anxieties is likely to continue to curb spending.” 

There has been a great deal of discussion about the plunge in consumer confidence since last week’s surprising report.  Some of the reasons are obvious, as pointed out above by the Conference Board.  People are worried about their jobs, or lack thereof, and millions of Americans who are working are “under-employed” in jobs that pay a fraction of what they were used to making.  American consumers are quickly figuring out that this is a “jobless recovery,” and they are increasingly unhappy about it.

As I will detail below, credit remains very tight.  Small business owners can’t get loans to expand their operations.  Among those who can get access to credit, many are so concerned about the economy and a double-dip recession that they are reluctant to take on more debt, and some are even paying down their lines of credit.

At the risk of going political, I happen to believe that millions of Americans have recently turned negative because the “hope and change” that President Obama promised has not happened.  Instead, they see the government spending outrageous sums of money and running $1+ trillion deficits as far as the eye can see.  No wonder consumer confidence is in the tank.

Speaking of falling off a cliff, have you seen the latest polls on how the American public views the job Congress is doing?  The latest Rasmussen poll last week found that 71% of Americans believe that Congress is doing a “bad” job, while only 10% believe they are doing a “good” job.  This is the lowest approval rating ever recorded by Rasmussen and was up from 61% just one month earlier. 

Bank Lending Continues to Plunge

The FDIC reported last week that bank lending shrank at a record pace in 2009.  The lead article in the Wall Street Journal last Tuesday read: “Lending Falls at Epic Pace.”   How true, unfortunately.  Last year, US banks posted their sharpest decline in lending since 1942, suggesting that the industry’s continued slide is making it harder for the economy to recover.   

While top-tier banks are recovering at a faster clip, the rest of the industry is still suffering, according to a quarterly report from the Federal Deposit Insurance Corp (FDIC).  Banks fighting for survival, especially those plagued by losses on commercial real estate (as I have written about often recently), are less willing to extend loans, siphoning credit from businesses and consumers.

Besides registering their biggest full-year decline in total loans outstanding in 67 years, US banks set a number of other grim milestones last year.  According to the FDIC, the number of US banks at risk of failing hit a 16-year high at 702.  More than 5% of all loans were at least three months past due, the highest level recorded in the 26 years the data have been collected.  

Bad News For BusinessAnd the problems are expected to last at least through 2010.  FDIC Chairman Sheila Bair said that banks are “bumping along the bottom of the credit cycle,” and that the number of bank failures in 2010 will likely eclipse the 140 recorded last year.

The FDIC’s latest report revealed that asset-quality indicators for banks continued to deteriorate in the 4Q as borrowers continued to fall behind on their loans. Banks wrote down $53 billion in loans in the final three months of last year. The quarterly write-off rate was the highest ever recorded in the 26 years the FDIC has collected the data. A total of $391.3 billion of all loans and leases, or 5.4%, were at least three months past due at the end of 2009.

The fact that banks are not lending remains a problem for policy makers who are eager for banks to lend again.  Lawmakers on Capitol Hill and administration officials have pushed banks to lend, particularly in light of the billions in taxpayer aid injected into the financial industry over the past two years.  But banking groups and their members counter that they are under pressure from regulators to be more prudent in their lending practices, and that demand from struggling consumers and businesses isn’t there.

Initiatives such as the Obama administration’s $30 billion small-business lending program will rely on banks’ making loans at a time when many of those same firms are wrestling with a rising tide of commercial-real-estate problems (as I have chronicled previously), or they are being told to add to reserves by regulators.

The FDIC said that the decline in loan balances in the 4Q hit all major categories—from construction to commercial loans and residential mortgages.  Only credit-card loans increased in the 4Q.

It remains unclear whether the sharp decline in loans outstanding stems from banks’ tightening standards and a fear of lending or from weak demand from potential borrowers still spooked by the recession.  Frankly, it seems obvious it’s a combination of both.  FDIC Chief Economist Richard Brown recently noted: “Lending has been weak and spending by businesses and consumers has also been weak.”

A January survey by the Federal Reserve of senior loan officers showed banks have slowed their efforts to tighten lending standards, but have not backed off the more stringent loan terms they put in place over the past two years.  The same report, however, also showed that demand for loans from businesses and consumers continues to fall.  Bankers, on the other hand, say creditworthy borrowers are hard to come by.

The FDIC Chairman Sheila Bair said officials are eager for banks to make loans in their communities, putting the onus on the bigger institutions to do more small-business lending.  “The larger institutions I think need to step up to the plate here too,” Ms. Bair said, describing as “significant” the declines in their loan balances and credit lines over the last two years.

Lawmakers who are pushing banks to lend more are coming to realize the magnitude of troubled commercial-real-estate loans (you read it here first). The FDIC’s Mr. Brown said these loans take longer than residential mortgages to go bad, dragging out the hit to a bank’s balance sheet.

The FDIC’s Mr. Brown concluded: “While the economy is moving ahead, banking results tend to lag behind.  The problem loans and the earnings of the industry will improve somewhat after the economy improves.”

As the chart above illustrates, bank lending remains in freefall.  While the FDIC report suggests that most banks are no longer tightening their lending standards, there is little or no evidence that they will relax them anytime soon.  Likewise, it remains to be seen when, or if, demand for commercial loans will begin to rise among small and medium sized businesses.

None of this is good for the economy, and this is a big reason why I expect GDP growth to disappoint this year.  While the credit markets may not be frozen as they were in late 2008, they are still at least frosty.

More Really Bad News on the Housing Front

Let me begin with the only bit of positive news.  In January, housing starts rose 2.8%, the best pace in six months.  But that is where the good news ends and the really bad news begins.

New home sales in January plunged by 11.2% from December levels to a seasonally adjusted annual rate of 309,000 units, the Commerce Department said last Wednesday.  The decline brought sales to their lowest level since the government began tracking the numbers in 1963.  Sales were 6.1% lower than in January 2009.

The drop in sales in January triggered an increase in the backlog of unsold new homes on the market, pushing it up to the equivalent of what would normally be sold in 9.1 months versus eight months in December.  And the abundance of homes on the market continued to bring prices down.  The median sales price for new homes fell 2.4% to $203,500 in January, compared with a year ago.

Faltering demand in the housing market also led to a drop in mortgage applications for both new and existing homes. The Mortgage Bankers Association’s seasonally adjusted purchase index fell 7.3% for the week ended Feb. 19 from the prior week.  It is the index’s lowest level since 1997.

Existing home sales last month were also sharply lower, down 7.2%, well below expectations, to a seven-month low.  This was the second consecutive monthly decline in existing home sales.  And remember that this is happening at a time when there are tax rebates of $6,500-$8,000 for home purchasers.  What do you think will happen to home purchases when these tax breaks go away?

Much of this bad news is no doubt related to the plunge in consumer confidence last month and the continued tightness in the credit markets, as discussed above.   Unfortunately, weak home sales in January are not the industry’s only problem.

Are “Option-ARMs” the Next Subprime Crisis?

Some housing analysts believe that the option adjustable-rate mortgage market may be the next subprime disaster.  Recent analysis from Standard & Poor’s (S&P) anticipates that a full 37.5% of such loans, referred to as “option-ARMs,” that were written in 2007, at the height of lax lending, will eventually go bad.

The problem with option-ARMs begins with the fact that people who took out these loans were given the option to make ultra-low payments for the first few years, and many of them did exactly that.  Borrowers who took advantage of these ultra-low payments, mostly middle- and upper-class with good credit scores, were allowed to make payments that didn’t even cover the interest owed (let alone the principal), with the understanding that payments would go up later on to make up for the shortfall.

That allowed people to buy bigger, more expensive houses than they would have been able to qualify for otherwise.  Most of these families banked on a good economy and rising incomes by the time the resets took place five years later.  Likewise, many assumed they could just sell the house in five years in the unlikely event they couldn’t make the higher payments.  Thanks to the recession, the credit crisis and the housing crash, these people are now stuck in their ARMs.

Some option-ARMs have already reset (more on this below), but the bulk of these loans don’t reset until the last half of 2010 and the first half of 2011.  By the middle of next year, more than $10 billion worth of option-ARMs will reset higher each month, according to data from mortgage tracker Loan Performance.  That comes close to the figures we saw during the subprime crisis.

As noted above, some people with option-ARMs have already seen their payments spike, thanks to caps on “negative amortization” - that is, a loan balance that grows, instead of shrinks, over time.  Austin-based Amherst Securities, a big player in mortgage-backed securities, dissected one such loan, which was written in 2007 for $465,000 over 40 years.  A minimum monthly payment that started at $1,260 soon rose to $1,354 and then to $2,806, more than twice the original amount. The borrower quickly defaulted.

Even without negative amortization, many borrowers will see their monthly payments jump by 50% or more.  According to an S&P study of loans originated in 2005, borrowers who have undergone a higher reset are nearly three times as likely to default as those who haven’t. S&P managing director Diane Westerback warns, “Some of the damage has already been done but the loss projections are increasing.”

With the housing market as it is, borrowers will find few good alternatives for rescue should they run into trouble.  The traditional response of refinancing into a more affordable loan is off the table for many homeowners, considering that property prices have plummeted.  More than 85% of option-ARM holders owe more on their loan than their house is worth, a situation known as negative equity or being “underwater.”  Typically, a refinance is impossible without the borrower having at least 20% equity in a house.

The Obama administration’s big loan-modification effort, the Housing Affordability Modification Program (HAMP), does little to help such borrowers since in many cases lenders will recoup more by foreclosing (the test any loan modification must pass) than refinancing.  A recent Bank of America / Merrill Lynch study of loan modifications at IndyMac, which provided the template for broader modification efforts, found that only about 20% of subprime loans had been rewritten, while fewer than 8% of option ARMs were refinanced.

The good news, if you can call it that, is that these loans are very concentrated geographically.  About 75% of all option-ARMs were written in California, Florida, Arizona and Nevada, with the vast majority of those in California.  People living in Phoenix, Las Vegas and California’s Inland Empire, which have high concentrations of option ARMs, can expect to see renewed downward pressure on home prices.  Home prices in some of these areas are already down 30-40%.

Clearly, foreclosures are going to skyrocket again as the bulk of the option-ARM resets kick in later this year and next year.  The question is whether or not these will negatively affect home prices around the country, since most option-ARMs are concentrated in only four states.  Time will tell but this is not good news for the housing market or the credit markets.

End of an Era for Coach Halbert

Last Saturday, I was driving my daughter home from her last basketball game of the season which was played in San Antonio.  My daughter is a senior in high school and a point-guard on the team.  Her team won its District, Bi-District and Area championships this year.  My daughter, by the way, won a 1st-Team spot on the “All-District” team and the “All-State Academic” team. 

But as we were driving home, I realized that my days of coaching and driving to and from our kids’ sporting events were over, as my daughter is graduating in May.  Long-time clients and readers will recall that I have been very active in coaching youth sports since my oldest child was five years old.  I have coached football, basketball and baseball for the last almost 15 years.

In recent years, I have concentrated on coaching baseball for our high school, including last year when my son had graduated and gone on to college.  But it just wasn’t the same without a kid on the team, so for the first time in many years, I am no longer a coach.

I tell people that I was “abducted” into coaching almost 15 years ago when I took my son to his first tee-ball practice.  Since there was only one coach there, I stayed and helped out.  At the end of the practice, the coach motioned me over to his car, reached inside and handed me a cap and jersey and said (not asked), “You’ll be my assistant coach.”  He and I went on to coach baseball, football and basketball for years.

Coaching youth sports for so many years has given me some of the best memories of my life, brought me closer to my kids, and some of my best friends to this day are fellow coaches.  It still warms my heart when I’m on campus, and many of the kids still address me as “Coach Halbert.”

While it hasn’t been easy to retire from coaching, I have a bigger challenge coming up in August when my daughter goes away to college and Debi and I become empty-nesters.  I had a very rough time when our son left for college, but it will be much worse this time.  Fortunately, Debi is still my best friend (and business partner), so I’m sure we’ll get through it.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

Get Ready For The Double-Dip
http://www.businessinsider.com/america-just-declared-recovery-over-so-youd-better-get-ready-for-the-double-dip-2010-2

Bank lending plunges
http://www.cbsnews.com/blogs/2010/02/24/business/econwatch/entry6238210.shtml

Where the votes stand on healthcare reform
http://online.wsj.com/article/SB10001424052748704479404575087833312341178.html?mod=WSJ_Opinion_BelowLEFTSecond


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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