Tuesday, June 23, 2009

The US economy: Getting worse before it gets worse

Well, here we are, having spent a couple of thousand billion to help the financial sector get back on it's feet. Regardless, it still looks like the wheels are still slowly falling off the economy, and we are at last about to see the financial tsunami arrive for real.

Tens of thousands of pages have been written about all this, most of it wild conjecture, driven by hope and people wearing Joo Janta 200 Super-Chromatic Peril Sensitive Sunglasses. Not familiar with them? They were an invention of Douglas Adams, in the Hitch Hiker's Guide to the Galaxy, and were worn by Zaphod Beeblebrox, the President of the Galaxy. At the first hint of danger, they would completely black out, so that the wearer would not be upset by the disaster that was about to befall him.

So take off your JJ200S-CPS sunglasses and listen up. Here is what is going to happen over the next two years, big picture. You can take this information and apply it to where you live, because there will be a lot of variance across the US. Once you understand what is happening, I will give you ideas on where to look for the real figures on your locale.

First, we need to dispose of the "little green shoots" fiction. Why are America's Leaders are all chorusing "litle green shoots" and other positive lyrics? Well, US politicians are all incompetent at the business of managing the country. It is too vastly complex for them to understand, and having a dumbass like GWB in the White House for eight years has made everybody else look like geniuses by comparison, so the average American did not notice how dreadful most of their politicians were.

But one simple thing these chorusing dumbasses all now understand is that consumer spending is 70% of the economy, and if people get really scared, they will stop spending. So they have to keep people ignorant of the facts, and keep them spending money or the economy will immediately implode, (called 'deflation'), with huge increases in unemployment, and more importantly, huge reductions in the Federal, State, County and City tax incomes.

In January 2009, in the political game, the Democrats got possession of the ball for the first time in years, and are doing everything they can to maintain consumer confidence, pumping money into the economy to try to keep it on life support. The Republicans, who lost the ball in the worst eight year play in American history on every front, are trying to torpedo the entire system under their new leader, Rush Limbaugh, who has announced to the world that his most fervent wish is to see America go down. Well, you can't say the Republicans haven't given it their best shot over the past 8 years! The aftermath of their destruction may yet ensure they get Rush's most fervent wish.

OK, so let's get down to business.

It is now late June, 2009. The economic indicators have been bouncing along the bottom of the chart for several months, and are not showing any real signs of life. Meanwhile, the various mechanisms that have slowed down the rate of decline have come to an end, and the real damage is about to kick in. Read on.

The Finance sector

The Government "rescue" programs have got the banking sector profitable again, by lending money to the banks at 1.5% , while the banks lend it out at 5.5%. The difference between what banks pay for money, and what they can lend it at, is called "spread". Historically, this has been 2%. Now, at 4% this spread is making the banks more than twice as profitable as they have ever been on their lending. So they are all going to report amazing profitability on their current loan activity, and by the end of year, these results should be rather spectacular. To the order of $200 billion or more. The funneling of this huge margin to the banks is yet another form of subsidy by taxpayers to the banks, because the discounted interest rates mean income the Government doesn't get, and has to make up in increased taxation. Not a problem. Just add it to the money the Government is currently printing.

But there is an 800 pound gorilla in the living room that is now demanding attention. Have a look at this graph.

Courtesy: T2 Partners LLC, published http://seekingalpha.com/article/144554-big-banks-in-trouble-huge-mortgage-write-downs-seem-inevitable?source=article_sb_popular

These are estimates by various organizations of the bank losses that are yet to come. There are January 2009 estimates from Goldman Sachs ($2,083 billion) and Nouriel Roubini ($3,552 billion), then a March 2009 estimate from T2 Partners ($3,778 billion), and an April estimate from the International Monetary Fund ($2,632 billion). I am inclined to plan for the worst of these estimates, because Goldman Sachs are part of the problem, and the IMF is politically driven to lowball their estimates.

Now look at the write-downs to date, of some $1,288 billion, and new capital raised of $1,103 billion. This means the banks are currently in a $185 billion dollar hole, the difference between the money they have raised and the costs to date. The assets of the entire banking sector are around $1,400 billion.

Now the IMF prediction of a further $2,632 billion of bad debts yet to hit the banks should put this all in perspective. There is no way that the banks can earn their way out of this hole, and it is impossible for them to raise that much new capital from investors. The banks are simply not worth that much! It would make more sense for investors to take over the assets of the banks and let the rest fail in the largest corporate default in world history.

And I am more inclined to believe Nouriel Roubini's and T2 Partner's range estimates of $3,500 billion. But what's $1,000 billion between friends? This makes the $700 billion TARP fund look like petty cash!

So what will be the consequences of all this?

First, we will see the financial markets dry up again, which is likely to bring about a further drop in real estate prices. This will further aggravate the banks' losses, because their foreclosure sales will net them much less than the current forecasts.

Here is a current analysis by T2 Partners LLC, published June 2nd, 2009. http://www.scribd.com/doc/16193713/T2-Partners-Presentation-on-the-Mortgage-Crisis

It is an excellent summary of the current state of affairs, with a detailed analysis of the Sacramento market starting around page 57, with a newspaper article from early May, 2009, about "little green shoots" in the 'improving' Sacramento market.

Alas, as the report goes on to show, those "little green shoots" were a mirage. On page 63, the predictions are dire. Currently, the market is at a false bottom, and an implosion of higher priced houses is about to happen, with a resumption of the downward price spiral. This spells D-O-O-M for the banks that hold these mortgages.

The awful truth may follow the model that has emerged in the Inland Empire in Southern California. In this article, prices are as low as 50% of the prices in 1989! http://www.latimes.com/business/la-fi-cheaphomes10-2009jun10,0,4802553.story

Maybe these kinds of price drops are going to make the Inland Empire a more attractive place to establish a business. But I doubt it. One of the huge overheads for any California company has been the large premiums employers have had to pay their staff for their cost of living, which was driven by real estate prices. But what kind of businesses could be established there?

It seems that the rest of California is going to follow this lead. In the higher priced areas (San Francisco, Danville, Venice Beach, etc) there will be a gradual implosion of prices of higher priced properties, driven by rising unemployment, which will be further aggravated by people walking away from their homes as the prices plummet well below the mortgage value.

For people with a good income, and the ability to limit their liability on their mortgage, this will present an attractive alternative. The stigma of simply walking away from a large mortgage is going to become more and more socially acceptable as more people do it, which will accelerate the problem.

In summary, the real estate market is about to resume it's downward plunge as we near the end of the high-transaction months of Spring and early Summer, with a lot more foreclosures hitting the market.

The Employment Market

Corporate income is going to continue to fall. As demand inexorably slows, competition will increase, which will squeeze profits. This will in turn push companies into doing more with less, which will result in continuing employment terminations to improve business survival.

Over the past 25 years, manufacturing has inexorably moved off-shore, and the main business of American business is product development and distribution, with the emphasis on getting the product made cheaper, which increases distribution profits. As a result, we have seen an explosion in retail business, with lots more commercial real estate development.

The distribution business is going to take a major hit. This will impact employment, but it will also contribute to further falls in the prices of commercial property, and accelerate loan defaults.

Every Government sector (Federal, State, County, City) has grown their payrolls enormously in the past 20 years, as they soaked up the extra tax windfalls that have landed in their hands, and put it to doubtful use. This is not only going to end, but a lot of the people employed in Government jobs will be terminated as their departments contract, are terminated, or are merged with other departments. The Government can't print money forever.

The work ethic in most Government departments is deplorable, according to contractors who work both industrial and Government sectors. One such example I am familiar with from the inside are the contractors that install high-tech energy-efficient commercial air conditioning systems. They comment on the difference between Government offices and industry. "Walk into a California high tech business, like Google or Electronic Arts, and people are busy, busy, busy. Walk into a Government building, and the staff are all standing around talking about their weekends, their kids, their neighbors, their boats. After a few hours, they are still all standing around chatting."

The problem for Government is there is great secrecy surrounding their administrative activities. Government departmental performance is unaudited, and they spend their appropriations without accountability to independent auditors. This would be regarded as reprehensible in a real business, but is par for the course for Government at every level in the US. In the past, most taxpayers didn't care. Until they do, and until we have some transparency, and performance expectations, nothing will change. Or maybe they will just run right out of money!

Which is about to happen to the State of California, unless the Feds decide they are going to give them a $34 billion dollar loan. OK, currently the State of California is predicting a $24 billion dollar shortfall. I think this will become $34 billion, as a result of plummetting tax revenues. And the Feds have sent a message from Mr. Geithner that they won't be getting any moneyuntil they clean up their wasteful ways.

In the past, the California State Government has blackmailed the people by threatening to pull social services and cut back on education. This time, this will not work, because the savings they can achieve will be around $2 billion, and the useless juggernaut that needs reforming is the State Government machinery, with mass firings.

So we will see what happens as July 31st, 2009 looms.

The New Enterprise Market

This ties in directly to future investment and employment opportunities.

Why is California so important? Because it has become the birthplace of American ingenuity. It has been attracting the best and the brightest of the new idea innovators for 40 years, and in the process, has built the wealth of the United States, with California becoming the eighth largest economy in the world in it's own right!

California is hated by the Republicans. For the most part, California is solidly Democrat. Our last President loathed California, and wanted to see the rest of the country take over the innovative lead of California.

Unfortunately, this approach has severely disabled the goose that was laying all those golden eggs. Combine the Federal neglect with Californian State taxes, and you have a combination that incents business to leave the State, and makes new business development incredibly expensive. In the process of this business departing, much of it also left the country!

How? By doing the research and development in the US, and moving the resulting product manufacturing offshore.

Since the 1980's, American manufacturers have been moving more and more sophisticated manufacturing off-shore. The biggest savings could be made by firing the most expensive employees, so the best paid jobs that were easiest to relocate went first. Since 2000, this has accelerated, and the companies that no longer manufacture their prodiucts are no longer capable of manufacturing their products. Manufacturing technology has moved on, and product manufacturing is not coming back to the United States. The expertise and technology is now all in Asia, along with a business mentality that actually wants to do the job!

In the past, new technologies have been a soak for unemployed employees displaced from other businesses. Over the past few years, US business has been increasingly about financial shennanigans, not about the business of creating business.

Here is a story from June 2008 that illustrates the problem. http://www.businessweek.com/magazine/content/08_26/b4090038429655.htm Boston-Power wanted to manufacture their batteries in the US, but were quoted huge up-front costs. In China, hundreds of companies lined up for the opportunity at lower costs and no up-front.

Since that article was written, both raw materials and the cost of shipping has fallen by two-thirds, and investment in new manufacturing plants in the US is almost non-existent.

This makes Asian manufacturing even more competitive, and further disincents investment in American manufacturing.

The future for industrial America

The auto industry has imploded. Rescued by Government, GM and Chrysler atre going to take a back seat to Asian manufacturers. The Chinese are getting into new battery technology for vehicles, and will likely pass up the rest of the world in the near future, if they haven't already.

Boeing is still competitive in the aircraft industry. However, with further delays to the Dreamliner, severe competition from Airbus, and both the Japanese and the Chinese vowing to get into passenger aircraft, the field will get more crowded in the near future. China is already pushing the envelope with a new twin-engine jet trainer, which is likely to morph into defense sales.

In computer technology, US companies own the architecture, but increasingly, Asian companies are doing the fabrication of the chips. It is only a matter of time before we see leading-edge chip design coming out of Asia to compete with Intel and other major US manufacturers, allied with open source (Linux) operating systems.

I would appreciate comments to this article to stick to investigated information. I don't want to hear what you believe. I want to hear about your investigations, and the things you have learned that will flesh out this article. This is only a first shot: I know there is a lot of ground I have not covered. Shoot me questions, and I will try to answer them.

But this isn't about what I Believe. It is about things I have Investigated.

As I promised earlier, I would give you suggestions to find out how bad things might be where you live.

Use Google. Search for the City in which you live, and the County, and link the word 'budget', 'deficit', 'unemployment', 'property prices', and anything else you can think of to your City name, then your County name. If you are a real enthusiast, you can do it for your State as well, but the higher you go, typically the less you can find out, because there is a veil of secrecy over Government reporting as you climb higher.

Then summarize it into a comment. Or ask questions.

We all need to investigate better. If we had all had out eyes open, maybe all this bad stuff would not have happened.