Recently in Economy Category

Lately, the economic news has been bad.  Initial jobless claims jumped back to the 500,000 level, a level no economist expected.  Housing sales dropped, but this was expected since the tax credit for first time buyers expired.  And Intel, just a few weeks after projecting strong sales and margins in the upcoming quarter, dialed down expectations.

Naturally, the markets reacted to the bad news.  Investors will be happy to close the books on the month of August.  For the month, the Dow dropped 4.3 percent.  The S&P also fell, declining by 4.7 percent.  And the Nasdaq made these declines seem tame by comparison, plunging by a painful 6.2 percent.

Even though the news was mostly bad, there are still silver linings in the clouds of economic data.  First, home prices rose in June, with the Case-Shiller index of 20 metropolitan areas climbing by one percent between May and June and increasing by 4.9 percent between June 2009 and June 2010.

But even here, economists warned that the relief could be short lived.  One at Capital Economics said that prices will likely fall five to ten percent when the effects of the tax credit are gone.  That, he warned, is likely to create a reverse wealth effect and "if households feel less wealthy, they will spend less."

This may mean that the higher than anticipated gains in consumer spending, which increased 0.4 percent in July, will fade.  The increase, which was the highest since March, was seen as evidence that the economy will continue to grow, although slowly.  After seeing the consumer spending numbers, the chief economist at Pierpoint Securities said "we'll see very slow growth, but it's a far cry from a double dip."  Added an economist at Scotia Capital, the increase in spending "is allaying near term double dip concerns.  It nonetheless showcases very lackluster growth in the U.S. economy."

The only good news from the plunge in stocks in the just closed month for us is that our options, which we were worried about being called away, are very likely to remain out of the money.  While we don't like the pain of seeing our positions decline in value, the pain is lessened by the premium income we collect.

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Deleveraging.  We keep hearing about this, and it's something that the pundits are pointing to as the reason why the economy's growing slowly.  With both consumers and companies not taking on more debt, we hear, spending's constrained.  Thus, the economy can't grow as rapidly as it did when individuals and companies were running up their debt and spending money.

It's a great theory, but it's not borne out by the facts.

A column by Gene Epstein in Barron's shows what's actually happening.  When businesses borrow money, they generally invest in plants and equipment with the proceeds.  So if businesses were not borrowing, then we'd see a big decline in the amount of money they spent on these investments. 

The opposite is actually what's happening.  According to Epstein, private sector plant and equipment increased by 7.8 percent in the first quarter.  In the second, investment surged by 17 percent, although it's likely that a revision will drop that number down to a still incredibly strong 15 percent.

While it's possible that companies are funding that investment with cash on hand -- the amount of cash on hand at S&P 500 component companies has soared -- it still means that they're investing in long term assets that require additional sales in order to be worthwhile.  And if the rest of the economy was growing at the same rate, we'd be talking about how miraculous the recovery we're seeing is and how the Fed is going to have to raise interest rates soon and how a half point increase in the discount rate was likely.

How about the consumer?  Have high unemployment rates and a weak housing market caused consumers to stop borrowing?  According to Epstein, the answer is no.  While it's true that the savings rate has jumped from negative numbers at the height of the bubble to 6.2 percent in the second quarter, that's lower than the 7.2 percent we saw back in the depths of the recession.

Of course, a big part of consumer credit is tapped when people buy homes.  And the housing market is still weak.  But other things that consumers buy on credit -- durable goods -- aren't showing the same weakness.  In fact, consumer spending on durable goods jumped by 8.8 percent in the first quarter of this year and 7.5 percent in the second.  Wouldn't it be nice to see that kind of growth in the rest of the economy?

What are consumers spending their money on, in addition to durable goods?  One thing is smartphones.  These are expected to account for 20 percent of all cell phones by the end of the year, and growth in sales of smartphones climbed by 15 percent in the second quarter of the year on the heels of a 21 percent growth rate in the first.

But be careful before jumping into investments in this market.  "Because everyone wants to be in smartphones, competition is predictably driving down profits," said an analyst at the ISI Group.  So instead of buying stock in companies like Research in Motion and HTC, it may be smarter to buy companies who make the chips or sell the handsets.

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As you know, one of the consequences of the implosion of the housing market was the nationalization (okay, they're calling it guardianship but it's really not) of mortgage giants Fannie Mae and Freddie Mac.  For decades, these two quasi public entities were boring companies that made their money by buying mortgages from lenders, aggregating those, and selling them to investors.  They benefited from an implicit guarantee from the government -- in other words, while their bonds weren't quite like Treasuries, they were pretty close.

One of the downsides of being a publicly traded company, though, is that shareholders are always demanding increases in both revenues and earnings.  And management constantly feels the pressure to increase those and to meet Wall Street expectations.

That caused Fannie and Freddie to branch out.  The boring -- and safe -- 30 year fixed mortgages weren't generating enough profits to make their shareholders happy.  So, what those companies did is put together what was essentially a government backed hedge fund.  They thought their expertise in the housing market would allow them to invest on much more risky assets without too many problems.  They were wrong.

In the end, that caused them to collapse.  They had to be nationalized and that implicit guarantee became an explicit one.  To date, the government has pumped $148 billion into the two companies.  This is painful, but it's necessary, because the companies hold around $5 trillion in mortgages.

Why not just let the two mortgage giants fail?  There are some who suggest that, such as representative Mike Pence.  "It is past time to rid the American taxpayer of the liabilities of these financial institutions," Pence said.

That's a nice soundbite from Pence, but keep in mind that Pence is screaming about the deficit but just as adamant about keeping the Bush tax cuts in place without any plans to pay for them.  So his credibility is just about nil.

Instead, we should listen to people who actually know what the hell they're talking about, such as Pimco's Bill Gross.  Gross was dismissive of comments by politicians by Pence, saying "to suggest that there's a large place for private financing in the future of housing finance is unrealistic.  It won't work."  His assertion is backed up by the current situation in the mortgage market.  Fannie and Freddie, along with the Federal Housing Administration, back up more than 90 percent of all new home loans.  So if you want to really see the housing market collapse and suffer the consequences, just do what politicians like Pence say.  They're good for soundbites, but not solutions.

One thing that everyone should be able to agree on is that Fannie and Freddie cannot be allowed to return to what they were before the housing bubble burst.  There can't be the perverse situation where private companies can be allowed to profit from their government guarantee.  As Treasury Secretary Timothy Geithner said, the Obama administration "will not support" a system where taxpayer funds are used to generate gains for private shareholders.

And as Gross said, the government can't get out of the mortgage market.  "Full nationalization" should be an option, Gross said.

One potential solution to the problem?  Fully nationalize parts of Fannie and Freddie, and allow the rest of the companies to be bought by private sector firms.  The mortgage securitization part of the companies is something that is in the national interest, especially when it comes to homes for the middle class.

The nationalized parts of Fannie and Freddie could service only conforming loans, where individuals put down at least ten percent of the value of the home and where the debt to income ratio is no more than the traditional 30 percent that's been used as a gauge for whether a payment is affordable.  And the value of loans would be no more than 150 percent of the median house price for the MSA where the house is located.

This would allow these parts of Fannie and Freddie to get back to doing what they did very well for decades -- buy mortgages from lenders, aggregate them, and sell them to investors -- for middle class home buyers.

The high end of the market and the speculative side of the businesses would be sold off to the private sector.  Here, the margins are likely to be higher, which would attract private capital.  And the government and the taxpayer wouldn't be on the hook for any potential losses.

I don't think that Geithner, Pence, or Barney Frank, who's called for Fannie and Freddie to be phased out, read this blog.  But instead of a poitical solution that rallies the base but is bad policy, this would be a good place to start.

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