Benchmarking the Financial Crisis

Here's a great source of information about past financial crises. Carmen Reinhart and Kenneth Rogoff, economics professors at Maryland and Harvard, respectively, have surveyed major post-war financial crises from around the world. Key findings are:

• Past financial crises have led to severe, prolonged recessions. The average fall in real per capita GDP was 9 percentage points, and the average period of falling output was 2 years. ('Ordinary' recessions generally last less than a year.) The NBER puts the beginning of the current recession at December, 2007. That suggests that the economy will continue contracting through the end of 2009.
  
• The average increase in unemployment was 7 percentage points, and the average period of rising unemployment was 5 years. (That's bad news for anyone who's looking for work.


• The average real (i.e., inflation-adjusted) stock price decline was 55%, and the average period of declining prices was 3.4 years.


• The average real home price decline was 35%, and the average period of declining prices was 6 years.

Reinhart and Rogoff point out that the 9 percentage point average contraction in GDP may be distorted by the inclusion of emerging market economies, which are subject to "abrupt reversals in the availability of foreign credit." Nonetheless, they maintain that the current crisis shares many of the same characteristics of the other crises in their study.

In other words, we shouldn't expect the current downturn to play out dramatically better than the numbers above would suggest.

The good news (if there is any) is that real home prices have already fallen almost 35% from the peak, which occurred in the summer of 2006. If the current crisis follows the historical script, prices might actually stabilize at their current levels and remain there until 2010 or 2011. Throw in declining mortgage rates and (with any luck) a relaxation of the current tough lending standards, and buyers may finally get a break. (Remember, however, that we're talking about the national housing market, not just San Francisco. Prices here have fallen only about 25%, in real terms. And of course, the survey statistics quoted above are historical averages, not laws of nature.)

By the way, the Reinhart-Rogoff paper is easily readable by anyone who isn't intimidated by ordinary bar charts. If you prefer something even lighter, however, you can try their recent Wall Street Journal article. Unfortunately, the Journal often restricts access to subscribers, so I can't promise how long the article will be accessible.

Good News for TIC Owners?

Gavin Newsom's office is floating a proposal that would allow TIC owners to skip the condo lottery in exchange for a special fee. It will need approval from the Board of Supervisors or the general electorate. In other words, it's a long shot. Cross your fingers, TIC owners. If it doesn't pass, it may be twenty years before you win the lottery and become eligible for condo conversion.

CBO Says Recession May Be Long and Deep

Here's what the director of the Congressional Budget Office has to say about the recession:

"The economy is currently weathering a recession that started more than a year ago, and absent a change in fiscal policy, CBO projects that the shortfall in the nation’s output relative to potential levels will be the largest – in duration and depth – since the Depression of the 1930s."

That's kind of scary, especially since the scale of fiscal stimulus that's currently being considered is modest compared to the expected decline in output.

How Good Are Current Mortgage Rates?

Mortgage rates are at record lows. And with the economy in a deep recession, they might stay there for the next few years. The economy will recover eventually, however, and at that point, rates are bound to increase. By how much? Take a look at the chart, below, which shows the recent history of 30-year mortgage rates.

Over the last twenty years, the average rate on 30-year mortgages has been about 7.5%. You could start by assuming that the future will look like the past, and that the average mortgage rate going forward will be 7.5%. The problem with that approach is that much of the historical variation in mortgage rates was driven by inflation, which arguably will be lower in the future. I've included a measure of inflation on the same chart. Although the correlation is far from perfect, it seems clear that mortgage rates have trended lower in response to lower inflation. That suggests that we should focus on the difference between mortgage rates and inflation, i.e., the so-called real mortgage rate.

Take a look at the chart, below, which shows the recent history of real mortgage rates. (It’s important to note that the real mortgage rate is an implied rate, which isn’t stated anywhere. I calculated it by subtracting the trailing one-year rate of inflation from the stated nominal mortgage rate.)

Unlike the stated nominal mortgage rate, the implied real rate has been fairly stable over time. (For most of the last twenty years, it remained in a band between 4% and 6%.) That's to be expected. Since it erodes the value of lenders’ capital, inflation should be regarded as a cost of doing business. Lenders will therefore subtract the inflation rate from the nominal interest rate in order to calculate the true return from lending money. In other words, lenders ultimately care more about real interest rates than nominal interest rates. Assuming that lenders' return expectations are stable over time, we'd therefore expect real mortgage rates to be stable as well, even when inflation fluctuates.

The average real mortgage rate over the last twenty years has been about 4.75%. Assuming that lender expectations are similar going forward, you can get a rough idea of where mortgage rates will be by adding an estimate for the expected inflation rate. Until recently at least, the Federal Reserve seems to have been comfortable with an inflation rate somewhere between 2% and 3%. If you split the difference and assume that inflation will run at 2.5%, that suggests a mortgage rate of around 7.25%. By way of comparison, mortgage rates are currently running at around 5.25%.

As I mentioned in an earlier blog entry, mortgage rates are likely to fall even further in the near term. In the long term, however, rates will probably go the other way. In fact, considering the massive amount of monetary and fiscal stimulus that is currently being provided, inflation and real interest rates are both likely to be higher than we've experienced in the last twenty years. But even if we're lucky enough to repeat the past, we're still in for a substantial increase in mortgage rates over the next five to ten years.

Borrowers with Adjustable-Rate Loans Have Some Breathing Room

A friend of mine told me today that she has a home equity loan, and said nervously that she hoped rates would remain low. I told her that she would probably be safe for awhile. But for how long? As luck would have it, Paul Krugman addressed this issue in his blog today, so he made my job easy. Take a look at the chart, below, which shows the history of the Fed Funds rate over the last twenty years.

The shaded regions indicate recessions, as defined by the National Bureau of Economic Research (the commonly accepted arbiter of recessions in the United States). According to the NBER, the 1990-91 recession began in July, 1990, and ended in March, 1991. The Fed didn't start raising short term interest rates until February, 1994, almost three years later. The 2001 recession began in March, 2001, and ended in November of the same year. The Fed didn't start raising rates until June, 2004, over two and a half years later.

Why did the Fed wait so long after the recessions had ended to start raising rates? The short answer is that while the economy had stopped deteriorating by the time the recessions ended, it was operating well below its potential. In other words, there was enough slack (read that, unemployment) in the economy that the Fed could continue providing monetary stimulus without fear of igniting inflation.

It seems reasonable to assume that the same thing will happen this time. In other words, the Fed Funds rate is likely to remain close to zero for at least two and a half years after the recession ends. When will that be? The consensus seems to be that the recession has at least another six months to run. Assuming that that's right, the Fed Funds rate will probably remain near zero through the end of 2011.

Most home equity loans are tied to LIBOR or the prime rate, which are in turn either directly tied to Fed Funds, or else are closely linked to it. If you have a home equity loan, my guess is that you'll be safe for at least another three years.

Technology Bellwethers Are Cutting Jobs

Microsoft has joined the list of major technology companies that have announced job cuts. On Thursday, they announced that they'll be reducing their workforce by about 5%. That's the first significant workforce reduction in the company's 34-year history.

Earlier in the week, Intel announced a 6% workforce reduction, following a 23% decline in fourth quarter revenue. AMD reported an even larger 33% decline in fourth quarter revenue, and announced a correspondingly larger 9% workforce reduction.

Perhaps more ominously for the Bay Area, Microsoft executives are suggesting that the slump in consumer and business spending is more than just a recession-related phenomenon. CEO Steven Ballmer said that it may take years for spending to return its former level. In keeping with that prediction, he indicated that Microsoft will scale back its acquisition activity, in the belief that corporate acquisition prices will decline still further.

Admittedly, there is more to the tech industry than Microsoft, Intel, and AMD. But these are bellwether companies, whose cost-cutting initiatives have effects that reach beyond their own doors. And cutbacks on a scale of 5%-9% are significant. To put them into perspective, a 5% increase in the national unemployment rate would amount to an economic disaster. (Worst-case predictions have the unemployment rate peaking at around 10%, compared to a current rate of around 7%.)

Those former Microsoft, Intel, and AMD employees are going to need jobs. Considering the plight of the stock market, venture funding will be way down in the near term. With Microsoft scaling back its acquisition plans, there will be even less money available to finance job creation in Silicon Valley. I don't see how the Bay Area can avoid a significant increase in unemployment.

Lembi Loses 1,500 Apartments to the Banking Crisis

The Lembi Group, San Francisco's largest residential landlord, has returned 51 buildings comprising 1,500 apartment units to its lender. That's according to Friday's edition of the San Francisco Business Times. The units in question represented only a portion of Lembi's portfolio, but that's still a remarkable turn of events. As recently as 2007, Lembi dominated the market for apartment acquisitions in San Francisco. Now they can't even get financing to hang onto what they've bought.

The short version of the story is that some of Lembi's loans matured in September. It's lender, UBS, declined to renew them. Unable to obtain replacement financing, Lembi simply handed over the keys. Now it appears that UBS may be stuck with Lembi's apartments until the banking crisis recedes, and investors are once again able to obtain commercial real estate loans on reasonable terms.

The San Francisco rental market has been strong (at least until recently), so it's not as if Lembi's apartments were fundamentally impaired. (Does anyone think that San Francisco apartments are a bad long term investment?) Instead, Lembi and UBS can blame their problems almost entirely on the banking crisis. In any other situation, Lembi would have refinanced its loans, or UBS would have sold the apartments to another buyer.

When banks refuse to renew loans on San Francisco aparments and choose instead to become landlords, real estate financing must be scarce indeed. That's not a good sign for homeowners, especially those who aren't eligible for Fannie Mae loans.