Economic Outlook - September 2008

Government Takeover of Agency Lenders Amounts to Another Break for Economy – Significant Headwinds Remain

The government’s takeover of Fannie Mae and Freddie Mac, which combined back or hold $5.2 trillion of U.S. residential mortgage debt - or roughly one-half of the total – is a critical step in reducing financial market uncertainty. The Treasury Department’s seizure of the mortgage giants will result in losses for the companies’ shareholders and U.S. taxpayers in the near term, though it greatly reduces mortgage- and housing-related risks to the overall economy and the global financial system. The government’s actions will provide greater availability of mortgage debt, put downward pressure on residential mortgage rates and essentially elevate the status of securities issued by the governmentsponsored enterprises (GSEs) to U.S. Treasury debt.

The government will provide immediate liquidity to Fannie Mae and Freddie Mac to help offset mortgage-related losses and will purchase at least $5 billion of mortgage-backed securities issued by the companies. The initial plan places the firms under a conservatorship, which transfers control of the companies to the Federal Housing Finance Agency (FHFA).

Despite inflation concerns, the Fed held interest rates stable at its last two meetings, providing time for the economy to heal. The headline rate of inflation reached 0.8 percent in July, pushing the year-over-year increase to 5.6 percent, the highest figure since 1991; however, commodity prices declined considerably in August, which should translate into reduced consumer price growth. Furthermore, the Fed is betting that the weak employment market will continue to ease wage pressures and that the slowing economy will restrict consumer demand, taking additional pressure off inflation in the coming months.

The economy was weaker than thought in late 2007 but was propped up by stimuli in the first half of 2008. Annualized GDP growth came in at an estimated 3.3 percent in the second quarter, boosted by net exports, which contributed 3.1 percentage points to GDP growth – the greatest contribution since 1980. The dollar has firmed against major foreign currencies in recent weeks, and the slower global economy is expected to reduce demand for U.S. goods and services, ultimately limiting the impact of net exports on overall expansion in the latter part of this year. Personal consumption expenditures also contributed to growth, adding 1.2 percentage points to the second quarter figure, boosted by tax rebate checks, which were spent more quickly than many had anticipated. Business investment in structures also added modestly to economic expansion last quarter. The housing market, on the other hand, has yet to reach bottom, subtracting 0.6 percentage points from growth during the quarter, while reduced business inventories were a far greater drag, deducting 1.4 percentage points from the overall growth figure.

The recent plunge in oil prices was a much-needed break for the economy; prices should continue to trend down, albeit at a more moderate pace, assuming supply-shocks are avoided. The spike in oil prices earlier this year was attributable largely to the weak U.S. dollar and investor speculation. Domestic oil demand has slipped in recent years; however, global demand, particularly among emerging economies, remains at high levels, which could prevent prices from declining substantially.

Job losses are likely to continue but are still below trend, as companies remained cautious during the most recent period of expansion. U.S. employment has declined by 605,000 jobs to date in 2008, led by losses in trade, transportation and utilities, construction and manufacturing, while the unemployment rate has ticked up 110 basis points to 6.1 percent. There are some bright spots, however, including the educational and health services and government sectors. With high gas prices putting pressure on truck/SUV sales, domestic automakers will continue cutting back; however, manufacturing may get a boost from business spending later in the year, as companies take advantage of tax incentives offered as part of the stimulus package.

Housing and energy prices remain the economic wildcards. Existing single-family home sales increased in July due to transactions involving foreclosures; however, sales are still down 12.4 percent from 12 months ago, while condo sales have fallen almost 19 percent over the same period. For-sale inventory of houses and condos combined is at 11.2 months of supply, compared to 9.5 months one year ago, and 4.5 months of supply at the market’s peak. While energy prices have declined from peak levels, they remain elevated and will continue to act as a drag on household budgets and corporate profit margins. Adding to the economic headwinds is the fact that a large share of the $100 billion in economic stimulus checks has already been spent, minimizing the chances of any significant positive impact on consumer spending in the latter half of this year.

The U.S. housing market will continue to weigh down the economy in the near term. In addition to subtracting from GDP growth, housing market woes have also negatively affected household wealth, leading to deteriorating consumer confidence and reduced retail spending. During the first quarter, U.S. household wealth declined by $1.7 trillion, of which $400 billion was attributable to declining home equity. It is estimated that every $1 loss in household wealth translates to a $0.06 decline in consumer spending; therefore, the first quarter loss alone exceeds the total tax rebate checks issued as part of the economic stimulus package. Furthermore, an estimated 9 million households are currently upside-down on their mortgages. If otherwise financially able homeowners walk away from their loans en masse, home price corrections could continue over the next several quarters.

Bank failures are creating a new wave of uncertainty in the marketplace, spurring government action to shore up confidence. The Fed has extended its emergency lending facilities to ease tight credit conditions, but many institutions will remain hesitant to lend until they can better assess the damage to their balance sheets. Once lenders are able to stabilize their positions and confidence in the banking industry is restored, this negative feedback loop should be replaced by a mild self-sustaining recovery.

Credit remains tight as most banks are focused on regaining liquidity and addressing writedowns; however, several regional and local banks are stepping up to the plate. On average, balance-sheet lenders are pricing loans for office properties at 255 to 300 basis points over the 10-year Treasury, with maximum leverage of approximately 65 to 75 percent.