Financial Armageddon

Less than Meets the Eye

2009-11-11T06:36:05-05:00

It's early in the trading day, but the bulls are already charged up by apparent good news out of China. According to Bloomberg,

production rose 16.1 percent from a year before, the most since March 2008, the statistics bureau said in Beijing today. Retail sales gained an annual 16.2 percent in October, it said. The trade surplus almost doubled from September, to $24 billion, as the slide in exports eased to the slowest pace this year.

On its face, the data gives cause for optimism. Yet like much of what we've lately been seeing and hearing from that part of the world, some things don't add up.

For example, although analysts have interpreted strong imports of industrial materials as a sign that China's factories are humming again, reports also note that there has been tremendous speculative stockpiling of copper and other metals by pig farmers, among others.

Moreover, when it comes to the supposedly recovering export sector, the following report from ChinaStakes.com, "China's Export Pickup Still Slow Due to Cautious Christmas Shopping Season," suggests there is less there than meets the eye.

CEO Willem van Walt Meijer of Mid Ocean Brands, a European high-end gift and business gift company, didn't lead his purchasing team to China this year until November, only a month away from Christmas.

Headquartered in the Apeldoorn Area of the Netherlands, Mid Ocean Brands is an international company with more than 40 years of experience in the industry, importing and wholesaling gifts and wares, supplying a product range of approximately 4,500 different promotional gift items mainly in Europe. It has purchasing offices in Hong Kong, Shanghai and Guangzhou.

Especially for the Christmas season, foreign buyers usually order at least three or four months, or even a year, in advance. Christmas commodities land on store shelves starting in October when Christmas spending starts. Meijer notes that the current situation, greatly affected by the financial crisis, is not much changed from that at the end of last year. Consumption in Europe is still in the doldrums, and businesses are anxiously awaiting a Christmas sales boom.

In October and November last year, the European market was in recession and didn't pick up until December. With people waiting until the last minute before making purchasing decisions, many retailers sold off inventory and stopped purchasing. The sales volume of Mid Ocean Brands, with 15,000 distributors, declined 20% and earnings dropped 30%.

Now Meijer says he and other buyers have adopted a procurement strategy of "transforming the whole to zero," greatly limiting one-time purchases and inclining towards frequent small-volume orders. At present, inventories are significantly lower than those of a year ago.

"The whole supply chain is changing and export volumes find it difficult to return to original levels," says Wu Zhenchang, chairman of Guangzhou ChuangXin Shoes Industry Co., Ltd. Earlier this year, the company's export orders, annually averaging over $100 million, decreased 30%-40%, and its workforce was reduced by 1/3. With Christmas orders now coming in, the factory is encountering a worker shortage, but unlike in previous years, Mr. Wu is in no hurry to recruit. "The annual shoe export volume of China is eight billion pairs. Five billion pairs are in circulation and the other three billion are in inventory warehousing," he says.

At the just-concluded 106th Canton Trade Fair, foreign buyers were very cautious. EU and the US purchasing volume picked up a bit, with export turnover increasing by 16.2% compared with the spring fair, but it was still down 3.4% compared with last autumn's fair.

According to Ministry of Commerce (MoC) research on this Canton Fair, orders under 3 months reached 59%, and 3-6 month orders were 33%. Short and medium-term orders accounted for over 90% of the total, indicating buyers' caution about the market outlook.

In this year's second half, China's export decline has narrowed. The MoC says China's current import/export situation is showing positive changes. The foreign trade decline may further slow or even slightly recover later this year. The decline of imports and exports is expected to drop to 20%, year-on-year. Still, compared with the V-shaped rebound of China's GDP, exports are experiencing quick decline and slow rebound.

The trade situation for GuangBo Import and Export, a stationery export company, improved at the latest Canton Fair. It received more than 70 orders, for about $20 million, 22% over the take from the last fair. Shu Yueping, the company's general manager, believes that there will be an export rebound in the fourth quarter, but it may be difficult to reverse of negative growth this year.

At a recent seminar on textile enterprises conducted by the MoC and China Textile Import and Export Chamber of Commerce it was said that most companies have yet to rise from the bottom and it still needs time.

Mid Ocean's Meijer says a European revival in consumer spending is not expected to come until the middle of next year and it is still a great test for buyers in the fourth quarter this year and in the first quarter next year. The current small-volume model means stricter requirements for Chinese firms and some Chinese suppliers are facing a restructuring of production patterns.

"After the financial crisis, buyers are more sensitive to price factors, but this is not the only factor, and they are also considering factors such as service, quality, safety, environmental protection, and design." Meijer says it is also critically important that suppliers deliver goods punctually.

Meijer and his team also began researching Vietnam, Indonesia, Myanmar and other Southeast Asian countries this year. In his view, although goods produced in these areas are cheaper than those in China, supply chains, quality, and delivery speed are not as good. "Dependency" is the word he uses to describe his company's relationship with China, as 99% of his company's products are purchased from China.

If foreign buyers continue the strategy of purchasing small amounts, however, the outlook for export enterprises accustomed to winning large orders is not optimistic. Many firms are trying to transform to deal directly with retailers to improve profitability through their own brands and creative ideas.

Dada, an Italian designer for NingBo Four Seasons Import & Export and the husband of the company's general manager, Bao Huihong, is leading a design team to assist the OEM-oriented firm to transform into a company with self design and proprietary brands, and has registered trademarks in Italy. At the Canton Fair, Bao Huihong brought new, own-brand products to sell. "An $18 coat is sold at $100. Although there is no growth in export volumes this year, profits are increasing," she says.

The strategy of GuangBo is to increase profit through the introduction of new products and stronger design. Shu Yueping says that Chinese company buyers are choosing Chinese suppliers now also. Although terminal retailers' purchase volumes are not large, profit margins are substantial. Before the crisis, the end customers of this firm accounted for 20% of sales. After the financial crisis, end customers increased to 40%, and profits increased by 15%.

Chen Deming, minister of Commerce, noted at the Canton Fair that the growth of trade volume needs to be maintained next year and the quality of exports should be attended to. The construction adjustment of imports and exports should be focused in the future and firms should rely on increasing value-added products to occupy international high-end markets.

'The Good News Is Still Less Bad News'

2009-11-10T20:29:12-05:00

Even though they create more than half of nonfarm private gross domestic product and employ half of all private sector employees, small businesses have borne a disproportionate share of the broad dropoff in demand and cutbacks in bank lending. Moreover, because these firms lack the influence-peddling resources of their bigger and better-connected brethren, they have been shut out of many of the "rescues" and stimulus boondoggles that have benefited firms like Goldman Sachs and JPMorgan. Under the circumstances, it's no surprise that, as the leading association representing small and independent businesses reveals in its latest survey, "Small Business Owners [Are] Skeptical of Economic Recovery":

The National Federation of Independent Business Index of Small Business Optimism gained 0.3 points in October, rising to 89.1 (1986=100), 8.1 points higher than the survey’s second lowest reading reached in March (the lowest reading was 80.1 in the second quarter of 1980). In the 1980-82 recession period, the Index was below 90 in only one quarter. In this recession, the Index has been below 90 for six quarters, indicative of the severity of this downturn.

“The October gain was minor, so the good news is still less bad news,” said William C. Dunkelberg, NFIB chief economist. Four of the ten Index components posted gains, two were unchanged, and four declined.

Employment
Eight percent (seasonally adjusted) reported unfilled job openings, unchanged from August and September. Over the next three months, 16 percent plan to reduce employment (unchanged), and 9 percent plan to create new jobs (up 2 points), yielding a seasonally adjusted net-negative 1 percent of owners planning to create new jobs, a 3 point improvement. In the last three months, 8 percent of the owners increased employment, but 19 percent reduced employment (seasonally adjusted), both statistics are better than September readings. However, the “job generating machine” is still in reverse.

Owners continued to reduce compensation at a record pace, with 11 percent reporting reduced worker compensation. Reports of increased compensation fell 3 points to 11 percent. Seasonally adjusted, a net 4 percent reported raising worker compensation, down 3 points from September and only 1 point above June’s record low reading.

Capital Spending
The frequency of reported capital outlays over the past six months rose 1 point to 45 percent of all firms, 1 point above the record low reading logged in September (data first collected in 1979). Capital spending, and the demand for credit to finance it, is on the sideline. Plans to make capital expenditures over the next few months fell 1 point to 17 percent, just 1 point above the record low last reached in August. Seven percent characterized the current period as a good time to expand facilities, down 2 points from September.

A net 11 percent expect business conditions to improve over the next six months, up 3 points from September but historically low. Consumer spending is weak, recent reports on consumer sentiment are discouraging, and there is nothing on the table in Washington to make owners more optimistic about the future, a recipe for depressed expectations and spending plans.

Inventories and Sales
The net percent of all owners (seasonally adjusted) reporting higher sales in the past three months remained low at negative 31 percent, down 5 points and only 3 points above the record low last set in July. Unadjusted, 17 percent of all owners reported higher sales (down 4 points), and 44 percent reported lower sales (up 3 points). Widespread price cutting continued to contribute to reports of lower nominal sales. After a 1 point drop in September, the net percent of owners expecting real sales gains improved 2 points to a negative 4 percent of all owners, still negative but 27 points better than the March record low level.

Small business owners continued to liquidate inventories, and weak sales trends gave little reason to order new stocks. A net-negative 26 percent of all owners reported gains in inventory stocks (more firms cut stocks than added to them, seasonally adjusted), 2 points worse than September, and only 1 point better than the record low of negative 27 recorded April through July. For all firms, a net-negative 3 percent (down 3 points) reported stocks too low. Plans to add to inventories improved 3 points to a negative 3 percent of all firms (seasonally adjusted).

Inflation
The weak economy continued to put downward pressure on prices. Ten percent of the owners reported raising average selling prices, but 30 percent reported price reductions. Seasonally adjusted, the net percent of owners raising prices was negative 17 percent, far more are cutting prices than raising them. Plans to raise prices fell 1 point to a seasonally adjusted net 5 percent of owners, 33 points below the July 2008 reading. On the cost or input side, the percent of owners citing inflation as their number one problem (e.g. costs coming in the “back door” of the business) fell 2 points to 2 percent and only 4 percent cited the cost of labor, so neither labor costs nor materials costs are seriously pressuring owners.

Earnings
Reports of positive profit trends were unchanged at a net-negative 40 percentage points. The persistence of this imbalance is bad news for the small business community and a contributor to the reported difficulties in obtaining credit. No doubt we are losing firms in this recession. For those reporting lower earnings compared to the previous three months (52 percent, up 2 points), 62 percent cited weaker sales, 4 percent each blamed rising labor costs and higher materials costs, 2 percent blamed higher insurance costs, and 8 percent blamed lower selling prices. Four percent blamed regulatory costs.

“Poor sales and price cuts are responsible for much of the weakness in profits,” said Dunkelberg.

Credit
For those who want to borrow, getting a loan continues to be difficult, with a net 14 percent reporting loans harder to get than in their last attempt. With very weak plans to make capital expenditures, add to inventory and expand operations, it would appear that many of those trying to borrow are having cash flow difficulties due to very weak sales (most frequently reported as the top business problem).

Thirty-three percent reported regular borrowing, unchanged from September. Overall, loan demand remains weak due to widespread postponement of investment in inventories and record low plans for capital spending. In addition, the continued poor earnings and sales performance has weakened the credit worthiness of many potential borrowers. This has resulted in tougher terms and higher loan rejection rates (even with no change in lending standards), and there is no rush to borrow money like that observed in the pre-1983 period when regular borrowers made up more than 50 percent of all owners (even with a 21 percent prime rate of interest).

Twenty-nine percent reported all their borrowing needs met (down 1 point) compared to 9 percent who reported problems obtaining desired financing (down 1 point, not seasonally adjusted).

“The recession is now 22 months old, straining the financial resources of more and more small firms. The economy may have turned, but it’s a slow turn so far,” said Dunkelberg.

In-Your-Face Influence Peddling

2009-11-09T22:55:01-05:00

Based on how slowly financial reform is going, how few people and firms have been punished for indiscretions that helped bring about the worst financial crisis this century, and, most of all, how much public money has been thrown its way, its clear that that the financial industry has done a phenomenal job as far as influence peddling is concerned.

That said, if it was just one industry throwing a bit of grease around, it might not be so bad. But the truth is that many of those who have been chosen to serve our interests have completely lost sight of why they were elected, and have instead become enamored with (and beholden to) myriad special interests with big wads of cash competing to win their affections (and their votes).

To make matters worse, the betrayal is often not very subtle -- it's right there in your face. If you read through the following report from the Omaha World-Herald, "What's Booming in a Recession? Lobbying in D.C.," paying particular attention to the bits I've highlighted in bold, you'll see just what I mean.

The recession has taken a toll on corporate bottom lines and public budgets, but lobbying the federal government continues to be a booming enterprise.

Midlands companies, universities, nonprofit organizations and local governments spend millions every year to lobby the federal government. While some have pared back recently, many have maintained their lobbying budgets or even increased them significantly.

The number of registered federal lobbyists was 14,808 in 2008, a year when overall lobbying expenditures reached a new height of $3.3 billion, according to the Center for Responsive Politics, a nonpartisan research group. Lobbying for 2009 is on pace to match that level or exceed it, fueled, not surprisingly, by substantial lobbying on matters related to health care.

For example, Wellmark Blue Cross Blue Shield, Iowa's largest health insurer, has spent $400,000 on lobbying so far in 2009.

Overall, Blue Cross has spent $16,727,065 on lobbying this year, making it the fifth-highest spender on lobbying so far this year, according to the Center for Responsive Politics, which tracks money in U.S. politics. The center reports that overall health sector lobbying for the year so far is $396 million.

Center spokesman David Levinthal said the fact that lobbyist spending has remained so robust in a recession surprises many people.

“But a lot of companies, despite the economy being what it was, sort of take the approach of ‘We need to invest money now in the hopes of potentially getting a windfall later from federal government assistance via friendly legislation,' ” Levinthal said. “If you're a company and you're trying to get something from the federal government, it oftentimes costs a good deal of money.”

Lobbyists in general have taken a beating in the public's perception, thanks to various scandals, but Iowans and Nebraskans involved in lobbying say it's important that lawmakers hear from those affected by federal policies. They said that's particularly true when sweeping legislation is considered in areas such as health care, energy and the environment, and financial regulation.

Des Moines-based MidAmerican Energy Holdings Co. has been a vocal opponent of legislation that would set a cap on greenhouse gas emissions and establish a trading system for pollution credits. MidAmerican typically spends a few hundred thousand dollars a year on its lobbying. So far this year, the company has spent $1.9 million.

The company says the caps are acceptable but that the proposed trading system would place undue burdens on coal-dependent Midwestern utilities such as MidAmerican and that those costs ultimately would be passed on to customers.

Nearly all of the increased spending has involved flying Chairman David Sokol and other MidAmerican executives to Washington for meetings with policymakers, said Jonathan Weisgall, the company's vice president for legislative and regulatory affairs. He said the company has not been paying any outside lobbyists.

“The purpose of our lobbying, there is absolutely nothing insidious about it,” Weisgall said. “On climate change, it is to say ‘Here is the impact on our customers, and we just don't think you're headed down the right road.' ”

Omaha-based Union Pacific Corp. also has been paying attention to energy and environmental legislation. Those measures could affect coal usage — and the railroad transports a lot of coal.

In addition, the company has been lobbying on issues specific to railroads, such as protecting the industry's antitrust exemptions. In all, the railroad has spent about $4.3 million on lobbying in 2009.

Levinthal also has looked at the growth of spending by state and local governments to lobby the federal government. He found that the nonfederal public sector has been increasing its lobbying expenditures every year, reaching more than $84.1 million in 2008.

That is reflected in the decision by the City of Omaha, under then-Mayor Mike Fahey, to hire a prominent Washington lobbying operation, Holland & Knight. The goal was expert guidance in seeking funds through the $787 billion economic stimulus package.

“You gotta grab the money if you can, and there's a lot there,” said Omaha City Attorney Paul Kratz.

Holland & Knight reported spending about $40,000 on the city's behalf. Kratz said the city signed two agreements with Holland & Knight, both of which fell under the $20,000 threshold that would require City Council approval.

Fahey's successor, Jim Suttle, chose to drop the outside firm. Suttle spokesman Ron Gerard said future efforts to land stimulus money could be handled by the city's grants department.

The City of Omaha directly has received about $14.4 million in federal stimulus money so far, but it's difficult to say how much of that can be attributed to the outside lobbyist.

Midlands universities also have been actively lobbying. The University of Nebraska has spent $150,000 in 2009, including payments to an outside lobbying firm. Creighton University has paid $120,000 to an outside firm.

All of NU's campuses have seen big increases in research funding over the past 10 years, and that stems partly from being more engaged with the federal government, said Matt Hammons, director of federal government relations for the University of Nebraska.

Fueled by grants for math education and science, the University of Nebraska-Lincoln set a record for research funding in the past fiscal year: $122 million, with nearly $84 million from federal sources such as the National Science Foundation, the National Institutes of Health and the Department of Energy.

Some other lobbying expenses by Midlands firms included:

Ÿ $440,000 by Lincoln-based student lender Nelnet Inc. The company's top concern has been college aid legislation, already passed by the House, that would eliminate federal subsidies to private student lenders. Nelnet and other lenders are fighting to preserve a role for the private sector, saying billions of dollars and potentially thousands of jobs are at stake.

Ÿ About $600,000 so far this year by Mutual of Omaha.

Ÿ About $180,000 by ConAgra Foods. The company has been keeping an eye on food safety legislation, as well as the cap and trade legislation, which it worries would have a negative impact on farmers and, therefore, food prices.

Not Music to Most People's Ears

2009-11-09T06:16:27-05:00

When it comes to pets, some creatures don't quite cut it. It's one thing to have a dog, a cat, a fish, a bird, or a hamster, because these animals are, for the most part, kind of cute and usually fun to be around. But for most people -- except, perhaps, "David Garrison" (played by actor Lee Montgomery), the character who befriends the leader of a vicious gang of rats in the 1972 cult classic, "Ben" -- rodents are a no-no. So no matter how soft and cuddly they might seem when (the late) Michael Jackson sings about them, the fact that they are poised to arrive in droves in a great many neighborhoods, as The Christian Science Monitor (via ABC News) suggests in "Bad Economy Puts Cities at Risk of Rat Invasion," is definitely not music to most people's ears:

New Study Says American Cities Are on the Verge of a Rat Invasion

While recession, foreclosure, and crumbling urban infrastructure grate on us humans, there's one pretty smart mammal who's living the life of Riley right now: the sewer rat.

American cities are on the verge of a rat invasion, warns small-mammal biologist and self-described "rat pack" member Dale Kaukeinen (in college "all the good animals were taken," he says) in a new study. And redemption, it turns out, is both personal and political.

"The problem of rats is just a symptom of a declining and weakening infrastructure, and it's one of the more visible symptoms of depressed cities struggling to face their problems," says Mr. Kaukeinen in an interview.

Partly to blame are politicians' budgetary choices, the economy, and, yes, even greenie environmentalists who propose wide-open green spaces that, it turns out, usually evolve into urban versions of a Sandals resort for rats.

In the second study of its kind (paid for by d-Con antipest products), New York once again topped the list of rats' favorite cities.

But 162-year-old Atlanta, the city too busy to hate anybody but rats, shot up the ranks to No. 2. A glimpse into why indicates that the plight of those yellow-toothed rodents are closely intertwined with the politics of the day.

The study took into account dozens of environmental, demographic, economic, and political factors, including budgetary priorities. Turns out that rat-friendly Atlanta has one of the highest poverty rates (20 percent) and highest foreclosure rates (five times the national average).

And Atlantans are paying attention. In its mayoral race, one frontrunner's main campaign promise is combatting foreclosure-related blight, which has increased as budgets have been gutted, city finances mismanaged, and building inspectors fired.

Sure, Hollywood likes rats. So do political commentators. Fox News' Glenn Beck recently described White House "regulatory czar" Cass Sunstein as "a man that believes that you should not be able to remove rats from your home if it causes them any pain. Rats could attack us in the sewer and court systems if all of Cass Sunstein's writings became law."

Rats Smarter Than Us?
Perhaps more worrying than Mr. Sunstein's concerns for rat welfare is news that scientists have found a way to make rats smarter. (The bumpersticker version: "My rat is smarter than YOU!") Read all about it here.
Even at their current levels of intelligence, rats deserve our respect, says Kaukeinen.

"He's not too big, not too tiny; he's got a good set of teeth and good eyes, good hearing, and he can live in very warm and very cold places," he says. "He's not afraid of people, eats almost anything. They're wild animals, but we don't have to go to the jungle to see them, but just into our own backyards."

Throughout civilized history, the rat has represented a mirror for urban existence, a gauge by which to judge the health, prosperity, and general welfare of cities.

Barring political response and better economic times, Kaukeinen sees a self-reliant counter-revolution to any future rat invasion.

"In an era of dwindling city resources, people are going to have to roll up their sleeves and [rat-proof their properties] on their own," he says.

Or just get a cat. Just not this one.

'The Least Bad of Many Bad Choices'

2009-11-07T21:19:14-05:00

It's not quite Kübler-Ross' five stages of grief -- in fact, it's more like two -- but it seems that at least some mainstream media types have stopped drinking the Keynesian Kool-Aid. They are beginning to accept that an exponential increase in our nation's debt load could bring us to the point where our nation is forced make the kinds of "choices" -- I use that term loosely -- that used to be reserved for banana republics and failed states (as it happens, that shouldn't be too much of a surprise to those who read one of my earlier posts on the subject). As Newsweek economics columnist Robert J. Samuelson notes in "Up Against a Wall of Debt, Part II," when you owe too much to others, your options suddenly become limited.

Are the United States, Japan, Great Britain, and other first-world nations in danger of defaulting on their debt?

In my latest NEWSWEEK column, I suggested that the unthinkable had become thinkable: some advanced society—say, the United States, Spain, Italy, Japan, or Great Britain—might someday default on its government debt. It wouldn't pay its creditors all they were owed or wouldn't pay them on time. Just a few days later, and completely coincidentally, the International Monetary Fund (IMF) issued a report that, without saying so, added credence to this unsettling hypothesis. (Click here to follow Robert J. Samuelson).

The report, done by IMF staff economists, comes with the forbidding title "The State of Public Finances Cross-Country Fiscal Monitor: November 2009." And it isn't much fun to read, because it's full of tables, charts, and various ratios. But the central conclusions, buttressed strongly by all the statistics, are simple enough: the economic and financial crisis has dramatically increased the deficits and debt of most countries, and many wealthy countries are in worse shape than major developing nations.

The economic crisis both increased spending—mainly through government "stimulus" packages and bailouts for the financial system—and devastated tax revenues. Of these, the falling taxes are the most important, the IMF said, because they may last much longer. The tax losses are especially large for the United States and Britain, because they stem heavily from "taxation of the financial sector and real-estate activities."

A look at the report's statistics reinforces the grim message. The table below shows government debt in relation to a country's gross domestic product (GDP), which is the output of its economy. The first column shows the debt-to-GDP ratio for 2007, the last pre-crisis year; the second column gives the IMF's projection for 2014. (Debt reflects government borrowing to cover annual budget deficits.) By this standard measure, many rapidly growing emerging-market countries are less indebted than wealthier nations.

(Connoisseurs of budget statistics will notice that the figures for the United States differ from those published by the Office of Management and Budget and the Congressional Budget Office. The reason is this: the OMB and CBO figures cover only the federal government; the IMF statistics cover "general government," which includes states and localities. For example, the OMB and CBO debt-to-GDP ratio for fiscal 2007 was 37 percent. But in both series, the big driver of higher debt-to-GDP ratios is rapidly rising federal debt.)

Just as sobering are estimates done by the IMF staff economists of so-called structural deficits—the hypothetical gaps between government spending and taxes, assuming that the economy has recovered from the crisis and that all crisis-related spending has ended. For the United States, this underlying deficit is 3.7 percent of GDP in 2010 and, in future years, would be driven higher by an aging society and increased spending on Medicare and Social Security. Some other countries' structural deficits for 2010 are even higher: 7.8 percent of GDP for Great Britain, 5.8 percent for Spain, 6.9 percent for Japan, and 8.2 percent for Ireland.

The political implications of these dry numbers are chilling. To prevent an unending upward spiral of debt would require huge spending cuts or tax increases. The IMF report doesn't suggest that those be made immediately, because doing so might cripple the fragile economic recovery. But the report does argue that without these adjustments, government debts could become unmanageable.

To show the size of needed changes, the IMF performed one final exercise. It estimated the spending cuts or tax increases needed over the next decade to return a country's debt-to-GDP ratio to 60 percent by 2030. For the United States, the changes would amount to 8.8 percent of GDP. In today's dollars, that's about $1.2 trillion and roughly a third of the existing federal budget. But again, some other countries would face even larger adjustments: 12.8 percent of GDP for Great Britain, 10.7 percent for Spain, 13.4 percent for Japan, 11.8 percent for Ireland, and 9 percent for Greece. For France and Germany, the required changes would total 6.1 percent and 3.4 percent of GDP, respectively.

No one can doubt that changes along these lines would be politically, economically, and socially wrenching. Government benefits, especially for the elderly, would have to be trimmed, and there would have to be large, broad-based tax increases. As a practical matter, the IMF doesn't think that governments can easily inflate away their debt, in part because much of it is short-term and has to be rolled over constantly. The report estimates that increasing inflation to 6 percent annually would on average eliminate less than a quarter of projected increases in debt-to-GDP ratios. At the same time, defaulting on the debt could trigger a broader financial and economic crisis: many financial institutions, businesses, and individuals hold large amounts of government debt; their wealth would drop, and their solvency might be threatened.

The simple and dispiriting point is that rapidly rising debt burdens confront most wealthy societies with deeply disturbing and damaging choices. My original column did not suggest that a debt default is imminent or that any country would eagerly go that route. The argument was that as debt rose and the ugly choices were clarified, some government—or governments—might decide that default was the least bad of many bad choices. If nothing else, the IMF report confirms that possibility.

A Tsunami of Red Ink

2009-11-06T21:48:30-05:00

Just over a week ago, Bloomberg revealed in "Geithner Says Commercial Real Estate Woes Won’t Spark Crisis," that the U.S. Treasury Secretary did not appear to be overly concerned about the threat posed by brewing problems in the commercial property sector:

U.S. Treasury Secretary Timothy Geithner said commercial real estate woes won’t set off a new banking crisis, in remarks to the Economic Club of Chicago.

“I don’t think so,” Geithner said, when asked whether commercial real estate could set off another banking meltdown. “That’s a problem the economy can manage through even though it’s going to be still exceptionally difficult.”

The global economy has accelerated since the worst of the recession and banking crisis last year, Geithner said, noting a U.S. Commerce Department report today showing the economy expanded 3.5 percent in the third quarter.

“You can say now with confidence that the financial system is stable, the economy is stabilized,” Geithner said. “You can see the first signs of growth here and around the world.”

Is he serious? All you have to do is spend about 15 minutes reading through just a few of the reports that were published recently and it quickly becomes apparent that a tsunami of red ink is forming in the sector, ready to come crashing down on the whole of the banking sector -- as well as the economy -- in the immediate period ahead:

"Why This Real Estate Bust Is Different" (BusinessWeek)

Unrealistic assumptions, layers of investors, sky-high prices, and possible fraud will make it hard to clean up the mess in commercial real estate

When Goldman Sachs (GS) sold complex bonds backed by the Arizona Grand Resort and other commercial properties in 2006, it suggested the returns would be strong. The 164-acre luxury Arizona Grand, set against the Sonoran Desert in Phoenix, boasted an award-winning golf course, deluxe spa, and several swank restaurants. The on-site water park was named one of the best in the country by the Travel Channel. With the resort's new owners planning to refurbish hotel rooms and common areas, Goldman told investors that the renovations would help boost cash flow.

As was so often the case during the real estate boom, the lofty projections didn't pan out. When the economy softened and business travel slumped, Arizona Grand's bookings slipped to 67%, from 80%. The resort defaulted on the $190 million underlying loan in 2009—a hit that alone could largely wipe out investors who bought the riskier pieces of the Goldman mortgage-backed securities deal.

"It's one of the largest losses we have forecasted for an individual loan," says Steve Kuritz, a senior vice-president at Realpoint, an independent credit-rating agency. The property, once valued at $246 million, is now worth just $93 million. A spokesman for Goldman says the pricing on the bonds was in line with market levels at the time and not above what investors could get on similar securities. Grossman Co. Properties, which owns Arizona Grand, didn't return calls for comment.

It would be easy to write off this blowup as just another casualty in the regular boom-and-bust cycle of the $6.4 trillion commercial real estate market. But the Goldman deal, with its unrealistic assumptions, multiple layers of investors, and stratospheric prices, helps illustrate why this downturn is more complicated than previous ones—and will turn out to be far costlier. Already, prices have plunged 41% from the peak in 2007, according to Moody's/REAL Commercial Property Price Index—worse than the 30.5% fall in the housing market from its 2006 apex. "We've never seen this extreme a correction as far back as the data go, which is the late 1960s," says Neal Elkin, president of Real Estate Analytics, the research firm that created the index. Adds billionaire investor Wilbur Ross: "Commercial real estate has gone from being highly liquid at sky-high prices to being extremely illiquid at distressed prices."

To appreciate why this bust is like no other, first consider the typical commercial real estate downturns that used to crop up every 5 or 10 years. The pattern was predictable: When prices for apartment complexes, office buildings, shopping malls, and other properties began to rise, developers sped up their projects to cash in on the bull market. Eventually, some of those developers, unable to fill all the new space, began to default on their loans, and lenders were stuck with the buildings they'd financed. The slump lasted no longer than the time it took for the property glut to be worked down.

TURNING A BLIND EYE
But overbuilding isn't the culprit in this bust. An oversupply of money is what pushed commercial real estate over the edge.

It turns out the same excesses that drove the housing market's crazy rise and fall were present in commercial real estate, too—but they have largely gone unnoticed until now. Bankers, in their haste to make more and bigger loans, blindly accepted borrowers' wildest growth assumptions and readily overlooked other shortcomings on loan applications. They did so in part because they could easily sell their dubious loans to investors in the form of commercial mortgage-backed securities. As the market overheated, it became a breeding ground for fraud: A flurry of new court cases reveals the disturbing extent to which commercial mortgage borrowers may have doctored loan documents.

While the housing crisis seems to be easing, the commercial storm is still gathering strength. Between now and 2012, more than $1.4 trillion worth of commercial real estate loans will come due, according to real estate investment firm ING Clarion Partners. Analysts at Deutsche Bank (DB) estimate that borrowers will have trouble rolling over as many as three-quarters of the loans they took out in 2007, the most toxic vintage.

For the banks and investors whose money fuels the economy, this presents major problems. Their losses will likely cast a shadow over lending—and, by extension, the overall economy—for years. The market won't fully recover until 2020, says Kenneth P. Riggs Jr., CEO of Real Estate Research, and in cases where "values were over the top...maybe never."

In the short term, toxic securities are creating a new problem weighing on the market: a tangle of interconnected investors fighting over the remains of the properties they own. In the past the damage was limited to a handful of lenders who invested directly in any given project. Now there can be dozens of groups of investors, each with its own agenda. The April bankruptcy of shopping mall owner General Growth, one of the largest real-estate-related bankruptcies ever, affected hundreds of parties—an unprecedented slicing and dicing of assets. These investors won't soon forget the bust and aren't likely to e back into the market as aggressively as they once did.

And yet the securities are only a secondary problem. The main driver of the commercial real estate bust is the underlying loans. How frothy did the market get? In one notable example, New York investment fund Sterling American Property and real estate company Hines paid $281 million in 2007 for the 42-floor office building at 333 Bush St. in San Francisco. That worked out to $518 a square foot, far higher than today's price, according to Real Capital Analytics, a research firm. Less than two years later, the building's primary tenant, law firm Heller Ehrman, filed for bankruptcy and stopped making rent payments. According to Real Capital Analytics, the building's owners did not make a recent loan payment, and the lender is expected to begin foreclosure proceedings. Says a spokesman for Sterling and Hines: "[We] continue to own and operate the property."

What's striking is how quickly some big commercial deals have gone south. In April 2007, Charney FPG, a New York real estate partnership, paid about $180 million to buy a 22-story office building in Manhattan's Times Square district. It borrowed $202 million to pay for the purchase, renovations, and incidentals—111% financing. Because the rental income didn't cover the debt payments, Comfort's lenders, Wachovia and RBS Greenwich Capital, required the firm to set aside $10 million in reserves to keep the project afloat until it got more paying tenants. Those occupants never materialized, and by July the owners had exhausted 95% of their reserves. The building is now in jeopardy of being seized by the bankers, says Real Capital Analytics' head of research, Dan Fasulo. "Everyone knows Judgment Day is coming." Says a Charney spokesman: "The owners are in the midst of restructuring the debt." Wachovia and RBS declined to comment.

Commercial lending mirrored mortgage lending in another way: Loans were made based on an unshakable belief that the market would never go down. An analysis by research firm REIS of mortgage securities created between 2005 and 2008 found that income projections for properties exceeded their historical performances by an average of 15%. "It was all based on assumption of cash flow," says Howard S. Landsberg of New York-based consultant Weiser Realty Advisors. "If you couldn't afford to pay the bank back now, in three years you could count on another $20 a square foot" in rent. When the numbers didn't add up, some lenders got imaginative. Says a banker at a large Wall Street firm: "If the cash flow wasn't there, you had to ignore it or find ways to create it."

"Gloomy Times for Commercial Real Estate" (San Francisco Chronicle)

Shopping centers, office buildings, industrial spaces, hotels and apartments can expect a period of "enveloping gloom" from the recession and credit crunch, according to a report released on Thursday.

Values will plunge, vacancies will rise and rents will decrease across all types of commercial property before the market hits bottom in 2010, according to the "Emerging Trends in Real Estate" forecast from the Urban Land Institute and PricewaterhouseCoopers LLP.

Based on interviews with 900 industry leaders, including investors, developers and financiers, the report was released at an Urban Land Institute conference for developers, planners and other real estate professionals taking place this week at San Francisco's Moscone Center.

No quick recovery is in store, the report said. "2010 looks like an unavoidable bloodbath for a multitude of 'zombie' borrowers, investors and lenders," it said. "The shake-out period may extend several years as even some conservative owners with well-underwritten loans from the early 2000s see their equity destroyed."

"$500 Billion Of Commercial Real Estate To Mature Soon" (The Atlantic Business Channel)

There was a Congressional subcommittee hearing today -- in Atlanta. The House Committee on Oversight and Government Reform's Domestic Policy Subcommittee addressed the residential and commercial real estate market in the Georgia metropolis. Sadly, the meeting was not on C-SPAN, but I managed to skim through some of the prepared remarks by more than a dozen witnesses from judges to economists to bankers. I was particularly interested to hear what those testifying had to say about commercial real estate, as I think that market will be one of the big business stories of 2010.

Atlanta has been gravely damaged by the housing bubble's pop. As a result, it sort of makes sense that only one witness appears to have spent much time addressing commercial real estate. Luckily, it was Jon Greenlee, Associate Director, ision of Banking Supervision and Regulation at the Federal Reserve. So it's pretty high quality testimony.

His analysis is also rather broad, not focusing on Atlanta's commercial real estate as much as the bigger picture. His prepared remarks make one thing utterly clear: the Fed is keeping a very close eye on commercial real estate (CRE). And it's worried. CRE is a big market to watch. Greenlee notes that at the end of the second quarter, commercial real estate debt was approximately $3.5 trillion.

And here comes the bad news:

Also at the end of the second quarter, about 9 percent of CRE loans in bank portfolios were considered delinquent, almost double the level of a year earlier. Loan performance problems were the most striking for construction and development loans, especially for those that financed residential development. More than 16 percent of all construction and development loans were considered delinquent at the end of the second quarter.

It should be a really, really worrying statistic that 9% of all CRE loans are delinquent -- because it isn't that hard for most of these loans to make monthly payments. Commercial mortgages are generally structured differently from fixed-rate residential mortgages. Many require relatively low monthly payments for the term of the loan, with a larger balloon payment due upon the loans' maturity. So if a large portion of commercial borrowers can't even make those relatively easier monthly payments, then we'll see some far more serious problems once those balloons come due.

And that storm is coming. Greenlee also says:

Of particular concern, almost $500 billion of CRE loans will mature during each of the next few years.

$500 billion isn't a small number by anyone's standards. Don't expect these loans to be rolled over very easily either. Banks are still keeping clenching their wallets tightly, and the commercial mortgage-backed securities market remains largely closed. Speaking of CMBS, banks have a lot of it, and those delinquencies are increasing as well, says Greenlee.

"Fitch Conference: Commercial Real Estate Decline & Negative Credit Effects; Muni Market Downturn" (BusinessWire)

Fitch Ratings will host its annual Morning Credit Brief Conference on Tuesday, Nov. 17, 2009 at the Grand Hyatt in midtown Manhattan with a focus on the broad credit implications for the collapsing commercial real estate market.

The performance metrics of commercial real estate (CRE), an area with a significant risk exposure for financial institutions and the structured finance market, continues to deteriorate at an unprecedented pace. While CRE loans, excluding the more problematic construction and development portfolios, represent more than 125% of total equity for the 20 largest banks rated by Fitch, the risk is even higher for banks with less than $20 billion in assets, as average CRE exposure represents more than 200% of total equity for these institutions. The negative credit implications of the declining CRE market are widespread, affecting not only large and regional financial institutions, but also CMBS entities, insurance companies and REITs whose investment portfolios are seeing a sharp decline in value due to their exposure to falling real estate prices.

"U.S. Shops and Apartments Head for Record Vacancies" (Bloomberg)

Stores, apartment buildings and warehouses in the U.S. will set new vacancy records before a recovery takes hold in the job and commercial property markets, according to a forecast by CB Richard Ellis Group Inc.

Vacancies at industrial properties will climb to almost 16 percent in 2011 and apartment vacancies will top out at 8.1 percent this quarter, CBRE chief economist Ray Torto said in a presentation at the Urban Land Institute convention in San Francisco. The proportion of empty space at shopping centers and malls will increase to about 13 percent in 2010, he said.

U.S. commercial real estate prices have plunged almost 41 percent since October 2007, the Moody’s/REAL Commercial Property Price Indices show. The highest unemployment since 1983 has lowered demand for office and retail space and reduced consumer confidence and spending. Job cuts are also prompting tenants to move out of apartments.

“We don’t have a sustainable recovery yet,” Kenneth Rosen, a University of California economist, said in a panel discussion with Torto. “The problem is not supply, but how we get demand back.”

U.S. office vacancies are forecast to reach 18.6 percent in the first quarter of 2011, just shy of 1991’s 19.1 percent record, Torto said.

“Increasingly, investors are viewing office as a kind of non-core investment, which is a concern,” said Jonathan D. Miller, author of PricewaterhouseCoopers’s “Emerging Trends in Real Estate” report, released today. “Tenants come and go, and with these cyclical swings, it can be a troublesome investment if you don’t time it right.”

"Commercial Property ‘Long Way’ From Rebound, GE’s Pressman Says" (Bloomberg)

The U.S. commercial property market is far from recovery and needs job growth, sustained low interest rates and further government support, said GE Capital Real Estate Chief Executive Officer Ronald Pressman.

“We’re a long way from where we’d like to be,” Pressman said at the Urban Land Institute’s annual meeting in San Francisco yesterday. “The stakes are very big here.”

Defaults and late payments on property loans sold as commercial mortgage-backed securities jumped more than fivefold to 4.52 percent of the total in the third quarter from a year earlier, New York-based real estate researcher Reis Inc. said. About $26.6 billion of CMBS loans were 60 days or more past due.

Commercial real estate won’t stop falling for 18 to 24 months after the economy bottoms out, as the full effect of the recession hits landlords, Pressman said in an interview at the San Francisco event. The unemployment rate needs to drop to 5 percent to 6 percent before the property market rebounds, according to his presentation. Joblessness rose to 9.8 percent in September, the highest since 1983.

About $22 billion worth of transactions will be completed this year, or 5 percent of the 2007 market peak, Roy March, CEO of commercial brokerage Eastdil Secured, said at the same event. Deals are down 74 percent from 2008 for offices, 72 percent for apartment buildings and 60 percent for retail properties, he said.

Stores, apartment buildings and warehouses in the U.S. will set vacancy records before a recovery takes hold, according to a forecast by CB Richard Ellis Group Inc. Office vacancies will fall just short of the record set in 1991, it said.

And to make matters worse, the agency that oversees much of the bank sector has decided, as the Dayton Business Journal reports in "FDIC Makes Statement on Commercial Real Estate Workouts," that the way to deal with the problem is to encourage lenders to rely on a dangerously flawed approach that is nonetheless all the rage nowadays: pretend and extend.

The Federal Deposit Insurance Corp. adopted a policy statement supporting prudent commercial real estate loan workouts, it reported Tuesday.

FDIC’s statement emphasizes performing loans, including those that have been renewed or restructured on reasonable modified terms, made to creditworthy borrowers will not be subject to adverse classification solely because the value of the underlying collateral declined.

The policy statement gives guidance to examiners and financial institutions that are working with commercial real estate borrowers who are experiencing diminished operating cash flows, depreciated collateral values, or prolonged delays in selling or renting commercial properties, the FDIC said.

Agencies of the Federal Financial Institutions Examination Council said prudent loan workouts are often in the best interest of both financial institutions and borrowers, particularly during difficult economic conditions. Financial institutions that implement prudent loan workout arrangements after performing comprehensive reviews of borrowers' financial conditions will not be subject to criticism for those efforts, even if the restructured loans have weaknesses that result in adverse credit classifications, the FDIC said.

Click here to read the full policy statement.

Media Appearance: Business News Network

2009-11-06T20:58:38-05:00

I was a guest on BNN's "SqueezePlay," with host Kim Parlee and guest host David Fleck. Here is a screen capture of the video (also available at Vimeo):

BNN Interview with Michael J. Panzner (Nov. 6, 2009) from Michael Panzner on Vimeo.

Linkfest for Treasury-Blogger Meet-Up - Part II

2009-11-06T11:27:17-05:00

On Wednesday, I highlighted links to posts about a "discussion" that took place earlier this week between senior Treasury Department officials and a group of economics and finance bloggers (including yours truly). For those who are interested, below are additional links to posts published since then by others who were at the meeting (in no particular order):

Across the Curve:
"A Face for the Radio"
"SqueezePlay: Geithner Summons the Blog Squad" (a video interview on Canada's BNN)

Marginal Revolution:
"Impressions from Treasury"

Kid Dynamite's World:
"A Sit Down With Senior Treasury Officials - Part II"

The Aleph Blog:
"My Visit to the US Treasury, Part 4"
"My Visit to the US Treasury, Part 3"

Interfluidity:
"Sympathy for the Treasury"

My Latest 'Market Observation'

2009-11-05T22:06:33-05:00

Once a month or so, I put together a "Market Observation" for Financial Sense. Below is a snippet from today's column, "Not as Good as Some Believe":

(Source: http://econompicdata.blogspot.com/2009/11/who-needs-workers-anyhow.html.)

The Labor Department today reported that nonfarm productivity rose 9.5% in the third quarter, the fastest pace in six years. Boosted by lower than expected labor costs, the bigger-than-expected jump was widely hailed as positive by economists and stock traders.

Huh? In a debt-challenged, consumer-dependent economy like ours, where a growing number of Americans are struggling to get by, the fact that businesses continue to benefit from squeezing wages and cutting jobs would seem to be the recipe for social unrest and revolution, not a return to economic good fortune.

Click here to read the rest.

Explaining the Discrepancy

2009-11-04T21:48:20-05:00

There is clear evidence that many consumers are cutting back on spending, either involuntarily or by choice. All you have to do, for instance, is look at the damage that has been done to the bottom -- and top -- lines of companies in industries that are dependent on discretionary spending (e.g., tourism and casual dining) to see that habits have changed from what they were, say, two years ago.

Yet as I noted last month in "More Dependent on the Consumer than Ever," the share of U.S. output accounted for by personal consumption is not far off its record highs. That is despite the fact that the savings rate has ticked up from the ridiculous low levels that were seen when euphoria was running rampant.

As it happens, The Atlantic Business Channel offers up an interesting explanation for the apparent discrepancy in "How Are Consumers Spending So Much?":

Could consumers be spending more than they should be? Such a possibility would go against an often heard complaint by economists that Americans aren't spending enough and consequently exacerbating the recession. This is the basis for the so-called "paradox of thrift," which says that when people save during a recession, it makes matters worse because their lack of spending hurts the economy. While I understand that logic, I've railed against the idea that consumers should be spending more, because they just don't have the money to responsibly spend more. University of Chicago economist Casey B. Mulligan presents a fascinating chart that implies that the common complaint I've noted might be misguided.

Here's that chart, from his blog post today on the New York Times Economix blog:

And here's Mulligan's explanation of how to read it:

Each series is displayed as an index, with its value at the start of the recession (December 2007) set to 100. Consumer spending normally trends up more than employment does, so I have adjusted for that by removing prior trends from consumer spending and work hours.
For example, a value of 95 for real consumer spending in September 2009 means that inflation-adjusted consumer spending in September 2009 was 5 percent below what it would have been had it continued its previous trend since December 2007.

This chart suggests that, although aggregate work hours (labor) are plummeting relative to the trend, spending hasn't followed over the past year. Since the fall of Lehman last year, Mulligan notes that spending has fallen by 2% on his chart, while labor has fallen by 10%. He concludes:

While it is conceivable that a few percentage points' decline in consumption could cause a many-fold reduction in work hours, it seems more likely that the reduced consumer spending was mainly a reaction to layoffs and hours cuts. The roots of this recession go a lot deeper than the paradox of thrift.

I think that's right. And it also raises a question: what's going on here? Reports show that personal saving is up. Also, labor is down. How hasn't spending followed -- where are consumers getting the money to continue to spend?

One potential explanation is credit: maybe consumers are borrowing in order to spend more than their labor implies they have. But everything we've been reading indicates that banks aren't lending as much. I constructed this chart below from Federal Reserve data on consumer credit outstanding, which supports the assertion that consumer credit has decreased in the past year:

All measures of credit have declined, but I find the blue line most notable. It represents revolving credit, like credit cards. That would be most responsible for everyday spending through credit. It's decreased by nearly 8% from September 2008 to August 2009.

A more plausible explanation is that unemployment benefits have bridged the gap. Frankly, I can't think of any other possibility. If credit is down and saving is up, something must be keeping spending going.

Since spending is precisely what unemployment benefits are for, I don't think it's quite right to say that spending is greater than it should be. I'd take away a different lesson. This suggests that as more unemployment benefits expire, the U.S. could face a situation where spending plummets further, and the economy finds it even harder to recover. This would be a sort of vicious cycle caused by prolonged unemployment.