Businomics Blog

How Does This Recession Compare to Other?

The Minneapolis Fed has a nifty interactive web page that helps answer this question--for the recession so far, of course. (Hat tip to Alex at Marginal Revolution).

Banking Glass Half Empty with Red Ink

Last quarter was tough on banks.  All the details are in the FDIC's Quarterly Banking Profile.  Here are some highlights:

Loan loss provisions and goodwill write-downs were the problems.  Four institutions accounted for half of the total loss, though 32 percent of institutions had a loss.

Regulatory capital increased by a little.  The problem isn't so much that banks don't have capital anymore, it's that the front-line regulators want them to have even more capital (in contrast to what the muckety mucks in Washington say).  I've commented on this before.

Most banks are healthy, meeting the highest capital standards.  By "most" I mean 98.7% of them.

How bad are those loan problems?  Here's a look:

Note that I'm only showing commercial and industrial loans.  You can see the data for consumer and real estate loans at the Fed's web site.

For those of you who aren't bankers, here's what the terms mean:  "default" means that the borrower is not in compliance with all the terms of the loan.  The loan may be paid off, maybe even in full, but right now there's a payment late or a loan covenant broken.  "Charge off" means that the bank's financial statements assume a loss.  The charge off may be for some percentage of the loan amount, reflecting the bank's expected recovery.  (You charge off $30 on a $100 loan if you expect a 70% recovery.)  The charge off does not necessarily reduce earnings, because the bank may previously made a loan loss provision to reflect the possibility of the charge off.  Charge offs in excess of the related provision hurt earnings.  Last quarter, the provision exceeded the actual losses, meaning that banks are pessimistic about the future.

My conclusion: right now this is bad, but not terribly out of line with past bads.

Housing Prices and Wealth Loss

Home prices are down again.  The Case-Shiller home price numbers are pretty grim:

This leads naturally to wondering about the impact of such a massive loss of homeowner wealth.  But my friend Randy Pozdena, who blogs occassionally over at The Ornery Economist, offers these insights:

The Case-Schiller index is not the one I would use to measure wealth effects.  Although the indices attempt to crudely approximate a "same-home sales" protocol, in practice, they do not control for either within-region property location or distressed/thin market sale nature of current transactions.  I had the opportunity recently to work with a mass appraisal consultant (the folks who help assessors value properties for tax purposes) who showed me some GIS plots of recent vs. historical sales patterns.  It is clear that:

 

1.  The spatial pattern of sales is very different.  There are virtually no sales in the traditionally-high value subareas of large regions (e.g., Santa Monica within LA metro, or SF or Marin counties within the SF Bay Area). The transactions in these regions are dominated by foreclosure sales in places like Solano County, etc.

 

2.  The "market prices" being captured are not adjusted for illiquidity/thin market discounts. 

 

Thus it is very problematic to, in effect, mark-to-market a whole metro area's housing stock and then extrapolate from this to a one-to-one impact on wealth.  Doing so ignores the self-selectivity of sales and does not correct for illiquidity discounts.  To some degree, the problem is analogous to the one caused by the highly-flawed, FASB 157 mark-to-market rules as applied to business accounting in the current market.  Everyone recognizes that the poor language of this rule caused excessive mark-downs of assets that clearly would have higher value if trades could occur.  FASB at least recognizes it screwed up and has fast-tracked FASB 157-d to better value thin-market transactions.  (See the link below.)

 

But measuring the true trends in the market value of housing is further complicated by the legislation that was passed in 2008 that changed the "exercise price" of an owner's mortgage put option.  It did so by exempting 2006, 2007, and 2008 mortgages from the traditional IRS treatment of the abandoned loan value as "income".  This has caused a "bubble" of walk-aways and, in turn, greatly enlarged the dominance of lenders (as opposed to owners) as sellers of homes with "underwater" mortgages.  

 

This, in turn, enlarges the observed illiquidity discount and price depression.  As the Ong, Neo and Tu (2008) analysis of the so-called disposition aversion effect has shown, "lenders [selling foreclosed homes] may not act in the best interest of the foreclosed owners to get the best price possible [relative to owner-sales]."  

 

With FASB 157 breathing down their necks, banks have an even greater incentive to push for a transaction with less regard to price.

I would add that the Case-Shiller 20-city composite is just that: a composite of 20 cities.  The smaller cities and rural areas are not covered.  They had less boom, and now have less bust.

Consensus Economic Forecasts

A couple of folks have asked if my forecast, described here, is out in left field.  That prompts me to offer a comparison of my economic outlook to two survey averages.  The Wall Street Journal surveys (subscription required) 54 professional forecasters, mostly from financial institutions.  The National Association for Business Economics surveys its members, with 47 participating in the latest tabulation, from a somewhat more diverse group of companies.  Here's my forecast compared to the average of these two consensus forecast surveys:

Near term we're all pretty close, but I'm more optimistic about next year.

The most important point: recent press coverage would lead a person to think that no one was forecasting an end to the recession.  However, an economic recovery beginning later this year is the consensus forecast.

The Great Depression: A Good Summary

Lots of folks are asking if we're having another depression.  I very much think not.  But it's worth reviewing just what happened in the 1930s.  An excellent summary is the article in the Concise Encyclopedia of Economics.  That link takes you to the article, but here are some good passages for you skimmers:

Interestingly, given the importance of the Great Depression in the development of economic thinking and economic policy, economists do not completely agree on what caused it. Recent research by Peter Temin, Barry Eichengreen, David Glasner, Ben Bernanke, and others has led to an emerging consensus on why the contraction began in 1928 and 1929. There is less agreement on why the contraction phase was longer and more severe in some countries and why the depression lasted so long in some countries, particularly the United States.

...

In previous depressions, wage rates typically fell 9-10 percent during a one- to two-year contraction; these falling wages made it possible for more workers than otherwise to keep their jobs. However, in the Great Depression, manufacturing firms kept wage rates nearly constant into 1931, something commentators considered quite unusual. With falling prices and constant wage rates, real hourly wages rose sharply in 1930 and 1931. Though some spreading of work did occur, firms primarily laid off workers. As a result, unemployment began to soar amid plummeting production, particularly in the durable manufacturing sector, where production fell 36 percent between the end of 1929 and the end of 1930 and then fell another 36 percent between the end of 1930 and the end of 1931.

Why had wages not fallen as they had in previous contractions? One reason was that President Herbert Hoover prevented them from falling. He had been appalled by the wage rate cuts in the 1920-1921 depression and had preached a “high wage” policy throughout the 1920s. By the late 1920s, many business and labor leaders and academic economists believed that policies to keep wage rates high would maintain workers’ level of purchasing, providing the “steadier” markets necessary to thwart economic contractions. When President Hoover organized conferences in December 1929 to urge business, industrial, and labor leaders to hold the line on wage rates and dividends, he found a willing audience.

...

As the public increasingly held more currency and fewer deposits, and as banks built up their excess reserves, the money supply fell 30.9 percent from its 1929 level. Though the Federal Reserve System did increase bank reserves, the increases were far too small to stop the fall in the money supply.

...

President Roosevelt came into office proposing a New Deal for Americans, but his advisers believed, mistakenly, that excessive competition had led to overproduction, causing the depression. The centerpieces of the New Deal were the Agricultural Adjustment Act (AAA) and the National Recovery Administration (NRA), both of which were aimed at reducing production and raising wages and prices. Reduced production, of course, is what happens in depressions, and it never made sense to try to get the country out of depression by reduc ing production further. In its zeal, the administration apparently did not consider the elementary impossibility of raising all real wage rates and all real prices.

The entire article is quite readable.  Here's what I think:

Contraction of the money supply was the greatest problem in the Great Depression.

The various measures to prop up wages and prices contributed to the problem.  When economists create mathematical models of business cycles, they have to add some element that prevents wages and prices from falling.  Some are just ad hoc assumptions, other elements are theoretical based on monopolistic pricing.  However, we should remember that falling wages and prices are a natural adjustment mechanism.

The Smoot-Hawley tariff, along with other countries' movements toward protectionism, worsened the depression.

The many gyrations of policy lowered business investment.

Banking laws, which limited opportunities for geographic diversification, caused bank failures and much of the financial crisis.

My reading of America's post-World War II recessions indicates that multiple causation is common.  The economy is resilient enough to withstand a variety of shocks and policy errors.  Sometimes, though, the shocks and errors keep piling up. 

Another Great Depression?  Not while the Fed is aggressively easing.

Inventories Point to Worse Economic Forecast

I've lowered my economic forecast for 2009 based on inventory data which I've recently studied.  Here's the long-run picture:

That trendline (in red) would head even lower if it were calculated without the latest data.  It looks to me like we'll have a $200+ billion inventory correction this year, as companies try to get their inventory-sales ratios back to normal.  What would help?  Getting the sales level up quickly, of course, but that's unlikely to happen.

It's not the end of the world, but in my forecast GDP growth is lower in all four quarters of 2009.  That makes Q2 virtually flat (just a little positive, though, if you believe the decimal places).  I still have modest GDP growth in the second half of 2009.

Two Types of Bank Failure

There are two ways for a bank to fail.  That thought was prompted by a good explanation of economic research on banking crises by Charles W. Calomiris of Columbia University.  Read it here.

Here's the obvious way for a bank to go bankrupt: loan losses.

Assets			Liabilities
Loans, gross value	90		Deposits	90
- loan losses	-20
Loans, net value	70		Owners' equity	10
Cash	10
Total Assets	80		Total Liabilities	100

This bank has more debts (deposits are the bank's debt) than assets, because of its loan losses.  This is what we think of when a bank goes under.  But there's another way:

Assets			Liabilities
Loans, long-term	90		Demand deposits	90
Cash	10		Owner's equity	10
Total Assets	100		Total Liabilities	100

 

This bank is in fine shape.  The assets are greater than deposits, so it is solvent.  But now suppose that depositors get nervous and withdraw $15 of deposits.  The bank is supposed to provide cash immediately, but it only has $10 of cash.  Those long-term loans cannot be called in for payment; the borrowers have the right to pay according to the agreed-upon schedule.

In practice, those long-term loans might be marketable.  Our bank could try to sell them to another bank or investor.  But if financial markets are really nervous, that won't happen.  This bank becomes illiquid, which is not the same as insolvent.  Washington Mutual was closed for reason of illiquidity, and Bear Stearns had the same problem.  We may never know how their assets would have worked out if the companies had stayed in business.

The Calomiris article has a couple of good sections:

"The picture of small depositors lining up around the block to withdraw funds has received much attention, but perhaps the more important source of market discipline was the threat of an informed (often "silent") run by large depositors (often other banks). Banks maintained relationships with each other through inter-bank deposits and the clearing of public deposits, notes, and bankers' bills. Banks often belonged to clearinghouses that set regulations and monitored members' behavior. A bank that lost the trust of its fellow bankers could not long survive."

and

"Empirical research on the banking collapses of the last two decades of the twentieth century has produced a consensus that the greater the protection offered by a country's bank safety net, the greater the risk of a banking collapse."

Consensus Economic Forecast Down, But Not Catastrophic

I recently mentioned the value of consensus forecasts. We just got another survey, this one compiled by the Philadelphia Fed.  I like it because it's been running consistently for quite some time, and it's free, available here.

Here's what their panel of forecasters expects:

	Real GDP (%)		Unemployment Rate (%)		Payrolls (000s/month)
	Previous	New	Previous	New	Previous	New
Quarterly data:
2009:Q1	-1.1	-5.2	7.0	7.8	-218.8	-548.4
Q2	0.8	-1.8	7.4	8.3	-108.4	-311.2
Q3	0.9	1.0	7.6	8.7	-7.2	-202.1
Q4	2.3	1.8	7.7	8.9	19.8	-43.0
2010:Q1	N.A.	2.4	N.A.	9.0	N.A.	38.7
Annual average data:
2009	-0.2	-2.0	7.4	8.4	-130.1	-328.4
2010	N.A.	2.2	N.A.	8.8	N.A.	6.2

As I noted in my earlier post, I'm a bit more optimistic about next quarter, but I think this is a fine economic forecast input into a corporate planning process.

Your average man or woman on the street will think this is wildly optimistic, though.  It's hard to get away from the doom and gloom in the press.

Marketing in a Recession: Advice from John Quelch

How should your marketing change because of the recession?  Harvard professor John Quelch has eight tips for "Marketing Your Way Through a Recession."  (Hat tip to Steve Hughes.)  Let me add to his wise remarks my own thoughts:

The biggest changes in market share occur at economic turning points.

I don't have data to back up this claim, but I believe it.  A former client had to downsize his sales staff in the last recession.  The remaining sales people became order-takers, answering calls from repeat customers.  They had little time for outbound calls, and when they did call on new prospects or former customers, they had little success.  So they stopped trying.

At the same time, a competitor had some (probably young) sales people, too new or too stupid to realize that nobody buys in a recession.  They made the sales calls.  They followed up a month later.  They stayed in touch with their prospects and former customers.

When the economy turned around, guess who got the business?

Whose Economic Forecast Should You Use?

I like my own forecast.  Of course.

But no business owner or executive should bet the company on one economist's forecast.  It's impossible to avoid using a forecast.  The guy who scoffs at any forecast still has to come up with an idea of what his company's sales will be next quarter and next year.  The economy will figure into that, so claiming that you don't use an economic forecast simply means you don't want to acknowledge the true basis for your decisions--which is probably the seat of your pants.

So you need a forecast.  Should it be Bill Conerly's?  Two decades of forecasting has humbled me.  I like my forecast, I think it's right, but it may not be the best planning tool.  I like looking at consensus forecasts, the average of many professional forecasters.  The Wall Street Journal has recently released it's survey, and the results are not pretty--but they are much more upbeat than the newspaper headlines.  Here's the picture:

The key point is that the average forecast is for decline in the current quarter and next, with slow growth from mid-year on.  My own forecast has a slight gain in GDP second quarter, and mildly better growth in the second half of the year.

The idea that this recession is fundamentally different and will last for years--"this time it's different"--is not shared by my peers, nor by me, and I discussed in a recent post.

There's a lot to be said for managing your business as if the consensus forecast is the most likely path--unless you really think that I'm a better-than-average economist.  (In which case, thanks.)