It is generally accepted and clear that the economic vitality of the US is based on jobs. Since its peak in late ’07, the US has lost between 6.8 and 7.0 million jobs (depending on which employment survey you consult). Despite record deficits, spending, various stimulus schemes, and money printing programs, jobs are not being created at a pace that results in a falling unemployment rate. Also, there is a lot of evidence that the official unemployment rate (the U3 series) seriously understates the issue. In his latest press conference, as QE2 is about to end, Fed Chairman Bernanke appears to be befuddled as to why the US economy is softening. The Obama Administration’s release of 30 million barrels of oil from the Strategic Petroleum Reserve (just over one day’s usage) with prices already retreating certainly appears to have an element of desperation in it, perhaps aimed at the 2012 election. For sure, after trying everything in the Keynesian playbook, no one with any policymaking power seems to have a clue about how jobs get created.
Demand, of course, is the key. If demand rises, employment will eventually follow. And it is not corporate America that is in need, as they stand around with record levels of cash looking for something to do with it. But it is middle America, the heart of the consumption machine, who is in trouble. We know that real wages have been stagnant since the late ‘90s and that the economic boom of the early part of the last decade was induced by debt and artificially low interest rates. But, besides stagnant wages, the biggest issue for Americans is their deteriorating balance sheets. Since the largest item in their asset base is their home, the relentless downward march of property values is simply debilitating to the net worth of a significant percentage of Americans, and this is likely the most significant factor in the stagnation of consumption despite the record level of stimulus. As an aside, the Fed’s QE2 program did raise the level of equity prices, but only a small segment of America benefitted. So, we’ve recently seen a rise in luxury retail sales, but little else. If we leave things as they are (unlikely in an approaching election year), because of the binge of Alt-A mortgage lending in ’06, 2011 is seeing the beginnings of another wave of defaults. Five years is the magic number written into those mortgage notes. At the end of five years, principle payments begin. For a property already underwater, a doubling of the monthly payment simply induces default. So, if nothing changes, the US has at least 18 more months of high foreclosure activity and declining property values.
Looking back at the employment data, in mid-’06, there were 7.7 million construction workers. Today, there are 5.5 million. Doing the math, of the 7 million lost jobs from the ’07 peak, 2.2 million (31%) are in construction. The fact is, US periods of economic expansion have always been accompanied by high employment in the construction trades. In addition, there is a multiplier effect both when jobs are created or lost as jobs in other ancillary industries (like home furnishings) are positively or negatively impacted to say nothing of jobs created simply as support (services etc.). After four years of the lowest level of construction activity on record, a level we know is below replacement and certainly below the needs of a rising population, with families moving in together and college graduates remaining in their parents’ homes, there has to be a huge pent-up demand for housing. But, no one will buy while prices are falling, and prices will continue to fall while foreclosures remain near record levels. One key to job creation, then, is stable or rising home values. That would result in rising sales and would stimulate construction employment with its attendant job multiplier.
Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff have completed several studies examining the aftermath of balance sheet recessions. In a recent interview with Investors Business Daily (“Slow Growth Normal For Post Fin’l Crisis Recoveries”, Norm Alster, 5/23/11), Vincent Reinhart said that in Japan, for example, “the banks were allowed to carry bad assets on their books at inflated values”. As a result, “property prices have declined for 20 years”. Reinhart concludes that “the government’s willingness to let banks carry bad debt rather than force them to take losses tends to stretch out the process of deleveraging. When you let banks carry their assets at high values relative to their market values, it freezes that market”. His prescription: “Recognize the losses … take the hit”.
We have a 20+ year example with Japan, 3+ years in the US, and now, Europe is about to embark on a similar path with the “extend and pretend” game with Greek debt.
Here is a 4 step prescription to stop the downward spiral in home prices, renew consumer confidence, increase consumption, and create jobs, all without additional spending.
1. All real estate notes held by Financial Institutions (“FI’s”) must be written down to appraised values (i.e., marked to market). Much of this has already taken place as regulators have examined the books of the FIs. Pools of mortgages trading in the secondary market have had their prices adjust to the reality of the market place. The larger FIs have already raised capital. To some extent, the plethora of short sales in which the FIs do not require deficiency payments is occurring because the assets have already been written down and the FI has already taken the hit.
2. The asset write-downs have been causing failures among those smaller FIs that have no access to the capital markets. This is costing the taxpayers in the form of fewer choices, and since the FDIC fund has been depleted and assessments on FIs have risen, consumers are paying higher prices for their financial services. The following was tried in the ‘90s during the S&L crisis, and mostly worked, failing only when government reneged. I am talking about the establishment of a special regulatory asset category into which the losses from the asset write-downs are placed. Such an asset (think of it as similar to goodwill) can be amortized over a fairly long period, say 10 or 15 years. Thus, from a regulatory perspective, the capital of the institution is not depleted immediately. Because liquidity is the most important part of an FI, GAAP insolvent institutions can operate and remain open indefinitely. We saw this in the 80s in the S&L debacle, and it is true today for many FIs (including, perhaps some in the SIFI {“Systemically Important financial Institutions”} category, and definitely some large European institutions) that don’t recognize the true value of their assets. Under this scenario, no taxpayer funds are expended. (Such a scenario can also play well with the SIFIs which are being pressured to have higher levels of capital since they pose systemic risks.)
3. With assets written down, in order to qualify for the special regulatory asset category, FIs must now reduce the balances owed by the mortgagors to appraised value and offer the residential borrower a 30 year fixed rate or a 5/1 ARM (borrower’s choice) at market rates. (Congress must also extend the provision that such debt forgiveness is not a taxable event.) I can even postulate a scenario in which the borrowers must share in any “profits” with the FI if the property sells for more than the written down mortgage note value. Some financial institutions, like JPM, have already done such note reductions with some of the loans they “bought” from Washington Mutual when they “purchased” WaMu in an FDIC assisted sale. [Having bought these assets at pennies on the dollar, accounting rules will not let them write the assets “up” to their true market values. So, last year, JPM reduced the mortgage notes to the borrower on some of the WaMu assets to an estimated market value still above the book value, while, at the same time, raising the interest rate. A win-win. The note holder could now sell the home at market value, and, if they didn’t, JPM got an enhanced interest return on the asset. Once sold, JPM gets to write-up the asset from its book value to the reduced mortgage note value.] The result of such a program would be a rapid fall in foreclosure activity. Properties could be sold without a short sale. Without foreclosure activity, prices would stabilize, even rise. With their balance sheets now stable to rising, consumers and small businesses would have more confidence, and the pent-up demand for homes and other properties would appear. New construction would occur. JOBS would be CREATED.
4. One more missing piece. When a home with an underwater mortgage note sells for appraised value, the selling homeowner has no equity with which to purchase another home, even with a good job, good credit scores, and acceptable expense ratios. In a recent article (Barron’s “The Next Mortgage Bombshell”, 6/25/11) author Jonathan Laing indicates that the big three private mortgage insurers, PMI, Radian, and MGIC, likely have insufficient capital to survive the current housing depression. Enter Fannie Mae, Freddie Mac or their successor(s). The original concept of Fannie and Freddie was to provide liquidity to the mortgage market, not to become the dominating forces. Becoming mortgage insurers would accomplish the original intent. And no taxpayer dollars would have to be expended if the mortgage insurance is properly underwritten. By insuring the top 10%-20% of new mortgages, those underwater homeowners who sell are now able to repurchase, and FIs can issue new loans with a 10%-20% equity cushion, just like in the old days.
Almost none of this is new. In the search for solutions to the jobs issue, at least this attacks the problem – the deterioration of middle America’s balance sheet. And it won’t cost the taxpayer a single dollar.
