The U.S. Economy Faces Strong Headwinds in 2008

The U.S. Economy Faces Strong Headwinds in 2008 Commentary by Sondra Albert, Chief Economist AFL-CIO Housing Investment Trust February 15, 2008 The U.S. economy entered 2008 facing a significant risk of a recession due to problems in the credit and housing markets coupled with high oil prices and a decline in employment. The Federal Reserve cut interest rates twice in January, lowing rates by 125 basis points during the month. Lower interest rates will help some borrowers refinance their loans and lower the cost of capital to banks. The federal government has also enacted a fiscal stimulus package for the economy which will not take effect until later this year. Even with the monetary and fiscal stimulus, 2008 will be a difficult year for the economy. A significant amount of macroeconomic data is now pointing to a recession that likely began in the first quarter. Payroll growth turned negative in January and the Institute for Supply Management reported that its January non-manufacturing index slid to a reading of 41.9, from December s revised figure of 54.4. A reading below 50 indicates that industries are shrinking. In addition, in the last four decades, the U.S. economy has never endured such a deep and prolonged downturn in the housing sector without a spillover into the broad economy. Another indicator that has been forecasting a recession since last year is the U.S. Treasury yield curve, specifically the spread between the 10-year note and the Federal Funds Rate. The curve had been inverted for 18 months until the Federal Reserve s dramatic rate cut rates in January. Whenever this curve has been inverted for this amount of time, a recession usually follows with a year. This data, in conjunction with the declines in the equity market so far this year, appear to point to an economic recession. 4 3 2 1 0-1 10-Year U.S. Treasury minus the Federal Funds Rate (Percent) -2 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Haver Analytics/ Federal Reserve 1

Federal Reserve Cut Rates 225 Basis Points since September 2007 With the economy slowing and the financial sector suffering large losses from investments tied to the credit market, the Federal Reserve at an emergency meeting on January 22 lowered the Federal Funds target rate by 75 basis points, bringing the Federal Funds Rate to 3.5%; it then further cut the Funds rate at the scheduled meeting on January 29-30 to 3.0%. The intermeeting interest rate cut did not appear to be responding to any particular data released in the market, but it came the day after European and Asian stock markets plummeted, demonstrating a loss in confidence in the ability of the U.S. to stave off a recession as well as the increasingly global nature of all markets. It is clear from the Fed s most recent cut that Chairman Bernanke is attempting to lower short term rates quickly and substantially in order to assist the banking sector that is suffering large losses from the subprime market. Federal Reserve's Fed Funds Target Interest Rate (Percent) 7 6 5 4 3 2 1 0 20002001 2002 2003 2004 2005 20062007 2008 Source: Federal Reserve Lower interest rates affect the economy in two important ways. First, they lower the returns from safe investments, such as money-market accounts. That in most cases makes consumers more willing to spend, rather than save, and investors and lenders more willing to put money in risky ventures where they can get higher returns, such as start-ups. However, over the last five years, consumers have taken on considerable debt and, therefore, may not be willing, or able, to take on more debt. In addition, risky investments, such as subprime loans, have not been prudent investments for pension funds and other investors. These investors may have now become risk averse, favoring less risky investments. The Federal Reserve, by cutting the target Federal Funds Rate, is also lowering the cost of capital to borrowers. Lower rates encourage businesses to invest in new plants, equipment and workers. Together, increased spending and increased investment boost production and economic growth. This too may be difficult to achieve in the current market environment because many banks have suffered large losses. Paul Miller, an analyst at Friedman, Billings, Ramsey & Co., estimates that large U.S. banks could book $100 billion to $120 billion in provisions this year and next to ensure that their loan-loss reserves are strong enough, with the bulk of that expense occurring this year. 1 These losses have reduced banks ability to make loans, and because banks are now having difficulty selling nonagency backed mortgage-backed securities on the secondary market, they have significantly reduced their lending to that segment of the market. 1 Bank Shares Get a Reprieve But May Not Be in the Clear, by Peter Eavis and David Reilly, WSJ.com (1/23/2008). 2

The Federal Reserve is likely to continue lowering rates this year since the risks are now weighted towards economic growth rather then the possibility of inflationary pressures rising in the economy. The Fed indicated, in a statement released with the January 22 rate cut, that appreciable downside risks to growth remain, and it further stated that it will act in a timely manner as needed to address those risks. The Federal Reserve also said, Incoming information indicates a deepening of the housing contraction as well as some softening in labor markets. In the Federal Reserve s statement on January 30, it again took note of softening in the labor markets, which is consistent with January s disappointing fall in employment, with the economy losing 17,000 jobs. The Federal Reserve also left the door open to further cuts that will likely come at the next Federal Open Market Committee meeting scheduled for March 18. 380 Change in Nonfarm Payroll (Thousands) 330 280 230 180 130 80 30-20 2004 2005 2006 2007 Source: U.S. Department of Labor Slowdown in Secondary Market for Mortgages The secondary market for mortgage securities has seen a significant reduction in trading, reflecting investors decreased appetite for mortgage-backed securities following the losses in the subprime sector. That slowdown reduced the new capital available to mortgage lenders and also made them less willing to extend loans to home buyers. This has put further downward pressure on home prices. Meanwhile, banks are being forced to move onto their books tens of billions of dollars in housingrelated assets, once held in off-balance sheet vehicles. 2 Simultaneously banks are incurring massive 2 Structured investment vehicles (SIVs) are funds that basically engage in interest arbitrage. The funds raise money by issuing short-term debt securities called commercial paper, which have relatively low interest rates. Then they use the profits to buy long-term securities with high interest rates, such as mortgage-backed securities (including those with subprime exposure). The idea is that they d earn high interest while paying low interest, thus creating a neat profit. Banks structure these SIVs off their books so they can maintain a specific capital ratio to allow them to originate more loans. SIVs seemed brilliant before the housing bubble burst. Since real estate value was going up, subprime borrowers were able to refinance their mortgages. But once the bubble burst and real estate value dropped, people could no longer refinance and began defaulting on their mortgages. This destroyed the value of MBSs and SIVs that were backed by subprime mortgages. Banks are being forced to add 3

writedowns on these and other securities. For all the supposed benefit of securitized markets in distributing risk around the world, it appears that a large share of the ultimate risk remained with big U.S. commercial and investment banks. With banks facing balance sheet strains, some are being forced to reduce their lending both to consumers and to businesses outside the housing sector, creating a generalized credit crunch. 3 The U.S. banking sector has suffered large losses from investments in subprime loans. The largest writedowns came from Merrill Lynch and Citigroup. Investments from Asian and Middle Eastern government-controlled funds have offset a significant amount of Wall Street s losses. To date these offshore funds have poured over $90 billion into U.S. banks. This amount is close to the $109 billion in losses that these same banks have suffered through investments related to subprime mortgages. 4 Subprime Related Writedowns in Billions Merrill Lynch $22.4 Citigroup $19.9 UBS $16.4 Morgan Stanley $9.4 HSBC $7.5 Credit Agricole $3.6 Deutsche Bank $3.2 Bank of America $3.0 CIBC $3.0 Wachovia $2.7 AIG $2.7 Barclays $2.7 Royal Bank of Scotland $2.5 Credit Suisse $1.9 Bear Sterns $1.9 J. P. Morgan Chase $1.4 Countrywide $1.0 Others $4.6 Total $109.8 Source: The Wall Street Journal and Agaryshilling.com The crisis in the subprime market appears to be spreading to bond insurers that were once seen as a low-risk business. State and municipal bonds rarely defaulted, so the insurers who guaranteed their debt paid out few claims. In recent years the bond insurers have expanded their activities to guaranteeing debt related to subprime mortgages. Two large insurance companies, MBIA and Ambac, have guaranteed buyers against losses on more than $1 trillion of bonds backed by subprime loans, and these insurers might be unable to keep their promise to pay investors if borrowers default on their debt. That could cause the buyers of the bonds, which include many banks and pension funds, to suffer billions of dollars in losses, shaking confidence in the U.S. financial system. To avoid a possible crisis, insurance regulators met with representatives of about a dozen banks on January 23 to discuss ways to shore up the insurers by injecting fresh capital, much as Wall Street firms have recently turned to outside investors after suffering steep losses related to subprime these securities back to their balance sheets, which has raised their debt-to-capital ratios and reduced their ability to make new loans. 3 Danger Ahead: the prospect of a recession again confronts America, by Krishna Guha, FT.com (1/2/2008). 4 insight@agaryshilling.com (2/2008). 4

mortgages. While it is unclear what steps, if any, the banks and regulators may ultimately take, the talks focused on raising as much as $15 billion for the companies. 5 The problems in the credit markets also appear to be impacting loans for commercial property. U.S. property companies that took out large short-term loans to finance acquisitions in the past couple of years are now struggling to refinance this debt, as banks curb lending and commercial property prices fall. Recently, a New York developer, Harry Macklowe, failed to refinance $5.8 billion in short term loans used to buy seven Manhattan office buildings. Deutsche Bank, the loan provider, has taken control of the office buildings and is putting them up for sale. 6 Congress Approves and President Bush Signs a Stimulus Package On February 13, President Bush signed a $168 billion economic stimulus plan which includes tax rebates to Americans and incentives for business investment. Congress approved the bipartisan plan on February 7 after the Senate added low-income seniors and disabled veterans to the list of people who would receive money under a package previously approved by the House. The law will provide $600 payments for individuals, $1,200 for couples and $300 for each child younger than 17. It will begin to phase out eligibility at $75,000 in adjusted gross income for individuals and at $150,000 for couples. Workers who did not earn enough to pay income taxes but can show $3,000 in earned income last year will be eligible for payments of $300. The plan also includes $300 payments to seniors, disabled veterans and veterans widows who can show $3,000 in Social Security or veterans disability benefits last year. 7 This plan will have some impact on consumer spending, but some of the rebates will likely go towards paying down existing consumer debt that has increased substantially over the last ten years. The total debt-service ratio is near an all time high, and while the current interest rate environment is low, consumers are still likely to have increasing difficulty servicing their debt. The total debt-service ratio, which includes mortgages, credit cards and other consumer debt, is currently at 14.3%. 8 Consumers have taken on so much debt over the last ten years to finance the consumption and asset boom that, with these assets now deflating in value, interest payments are becoming a bigger drag today than they were when interest rates were higher. In 1982 when consumers began a 35 consecutive quarter expansion boom, their debt-service ratio was 10.5% and the savings rate was 10%. The next big boom came in 1992, after a period of balance sheet repair when debt service fell to below 11% and the saving rate was 8%. Those levels helped pave the way for 64 quarters of uninterrupted spending growth. Now, with consumers debt service burden at a near high of 14.3% and a savings rate close to zero, the government stimulus may offer some economic assistance, but it is difficult to imagine that the lower interest rates and new tax rebates will spur another consumption boom fueled by an increase in debt. 9 5 Next on the Worry List: Shaky Insurers of Bonds, by Vikas Vajaj and Janny Anderson, NYTimes.com (1/24/2008). 6 Risk of Property Defaults Growing, by Daniel Pimlott and Gillian Tett, FT.com (2/5/2008). 7 Congress Approves Stimulus Package, by Jonathan Weisman, Washingtonpost.com (2/8/08). 8 Federal Reserve. 9 Federal Reserve and Merrill Lynch. 5

15 Household Debt Burden (As a Percentage of Personal Disposable Income) 14 13 12 11 10 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Source: Federal Reserve Higher Loan Limits The new economic stimulus package will increase the loan limits for FHA, Fannie Mae and Freddie Mac so they can make larger home loans to aid the mortgage market. The package will raise mortgage limits that can be insured or purchased by these entities to as high as $729,750 in high-cost areas. Those are considerable boosts over the current FHA limit of $362,000 and the $417,000 cap for Fannie Mae and Freddie Mac loan purchases. Since the subprime problems became evident in the market, interest rates on jumbo mortgages have risen to over 100 basis points above conventional mortgages that are under the current $417,000 limits. 10 The stimulus package limits the new ceiling for Fannie and Freddie guarantees to mortgages originated between July 1, 2007, and December 31, 2008. The 2007 date is intended to allow banks that hold jumbo mortgages on their books to sell them into the securities markets, with the intention of increasing banks willingness to originate mortgages. Also assisting the market will be a new provision allowing Fannie Mae and Freddie Mac s ability to hold jumbo mortgages in their portfolio. But, Fannie Mae and Freddie Mac have also suffered losses under current market conditions and must adhere to minimum capital requirements; their capacity to purchase and guarantee loans is not unlimited. It takes three times as much capital to guarantee one $600,000 loan as it does one $200,000 loan. Therefore, it is unclear how much help Fannie Mae and Freddie Mac will be in adding liquidity to the market. Because the higher loan limits will be available only for loans originated in the six months starting July 1, the number of borrowers who can take advantage of the provision may be limited. 11 However, there is a chance that Congress and the President will extend the limit increase after the end of the year, so it is too early to tell if this will have a significant impact on increasing banks and mortgage companies willingness to make loans and decreasing the interest rates on larger mortgages. 10 Bush Hails Tax Rebate Plan as Robust msnbc.com (1/24/2008). 11 Will New Rules on Mortgages Help Borrowers, by Sara Murray and Jonathan Karp, WSJ.com (2/8/2008). 6

Fiscal and Monetary Stimulus May Not Be Enough to Stave off a Recession The fiscal and monetary stimulus may not be able to stave off a U.S. recession that may have begun in the first quarter of 2008. Currently many consumers are facing large debt burdens and instability in their jobs, so they are more likely to either pay down debt with the additional money or save it. A proposal to increase unemployment insurance and food stamps could have increased spending in the economy, but it was not included in the congressional bill. The unemployed and people on food stamps are in need of additional capital and therefore are extremely likely to spend any rebates they receive. Temporary aid to state and local governments would add some stimulus to the economy because most local taxes are procyclical, increasing in an expansion and falling in a contraction, but this was not included in the stimulus package despite support by the nonpartisan Congressional Budget Office. Therefore, the macroeconomic impact of the tax cuts on economic growth is not likely to be significant this year since the payments will not be targeted to people most likely to put the capital into the economy. Lower interest rates are likely to assist the economy, but banks are still holding a large amount of non-performing loans, which will continue to erode their balance sheets this year. Even with the monetary and fiscal stimulus, 2008 will be a difficult year for the U.S. economy. The AFL-CIO Housing Investment Trust has never invested in subprime or Alt-A mortgages and therefore has not suffered the significant losses experienced in these investments. Since the subprime crisis hit in the summer of 2007, there has been a flight to quality, which has led to Treasuries outperforming other fixed-income products. Spread products such as agency and nonagency MBS have seen a fall in demand which has caused spreads to widen considerably relative to Treasury bonds. Even high credit quality investments like agency mortgage-backed securities have experienced severe spread widening, causing market prices of these securities to fall relative to Treasuries. Investors in agency mortgage securities can now receive significant yield spreads over Treasuries with comparable average lives. The HIT overweights in agency-backed multifamily MBS, which over the long run have a record of outperforming other investments with similar average lives. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, especially during periods of downturn in the market. All current statistics are as of February 15, 2008, unless otherwise indicated. 7