The United States, and Virginia along with it, is entering a new era of budgetary constraints. The economic expansion we’re now entering will be weaker and frailer than in previous business cycles, with lamentable consequences for the productive, tax-paying economy of businesses and workers — and for the government that feeds off them.
Two weeks ago (See “The Ugly Ain’t Over, Not by a Longshot“), I made the point that the economy faces a wave of bad commercial real estate loans that will result in another round of crippling write-offs for commercial banks. But the magnitude of that problem is modest compared to the coming second wave of defaults in the residential mortgage business. Even that’s not the end of it. On top of real estate loans going bad, we soon will need to worry about the precarious state of the junk bond market.
While the Obama administration has supported the residential real estate sector with more than $1 trillion in TARP funds, Fannie Mae/Freddie Mac mortgage purchases, FHA mortgage underwriting and Federal Reserve purchases of mortgage-backed securities, it is not clear that housing prices have hit bottom. The housing sector has ridden out the wave of defaults on sub-prime loans and some “Alt-A” loans (lesser credit quality than prime loans but better than sub-primes), but it is bracing for a tsunami of bad Option ARM (Adjustable Rate Mortgage) loans. (See the T2 Partners presentation for details.)
During the peak of the housing bubble, financiers kept mortgages flowing by relying upon Option ARMs, which enticed buyers through ultra-low teaser rates and the ability to defer payments by adding to the mortgage balance. Typically, these loans reset after five years, at which point the payments can jump by 60% or more. Roughly $750 billion of these mortgages were written, and they are coming due. As Option ARM homeowners go into default, they will dump more houses into a sagging market, which will exert more downward pressure on housing prices. In a downward spiral, more homeowners will find themselves underwater, owing more on their mortgages than their houses are worth. If they walk away from the loans in large numbers, they will put even more pressure on housing prices and the financial institutions left holding the bag.
Indeed, there is little sign that the foreclosure crisis is abating. Monthly year-to-year comparisons between 2009 and 2010 show that mortgage foreclosures were still increasing. Realtytrac Inc. reported more than 308,000 default notices, scheduled auctions and bank repossessions in February, a six percent increase over the previous February. The silver lining was that, for the moment at least, the rate of increase was slowing.
Similarly discouraging is a recent report by Neil Barofsky, special inspector general for the Troubled Asset Relief Program (TARP), who concluded that the Obama administration’s $75 billion Home Affordable Modification Program (HAMP), which aimed at reducing the number of foreclosures by subsidizing the restructuring of troubled mortgages, was having little effect. Writes Barofsky in a recent report:
Absent a thorough review of HAMP and its goals, the program risks helping few [homeowners], and for the rest, merely spreading out the foreclosure crisis over the course of several years, at significant taxpayer expense and even at the expense of those borrowers who continued to struggle to make modified, but still unaffordable, mortgage payments for months before succumbing to foreclosure anyway.
Throughout the 2000s bacchanalia of borrowing, the non-finance business sector was restrained about taking on debt — thank goodness, or business bankruptcies would be far more widespread and unemployment even worse than it is now. But there were pockets of excess in residential and commercial real estate, and in the private equity sector. The growth of private-equity financial companies, which structure debt-heavy buyouts, led to a surge in highly leveraged acquisitions during the 2000s.
According to a recent McKinsey Global Institute study, companies acquired through such buyouts were 2.7 times as leveraged on average as publicly listed corporations. The use of leverage is a wonderful thing for investors if the companies prosper and pay off their debt — big fortunes can be made in a hurry. But if the economy stalls and companies have difficulty paying off their loans, investors and debt-holders can take a beating. By McKinsey’s estimate, roughly $434 billion of such loans in the U.S. are scheduled to come due between 2010 and 2014.
Add it all up, and the U.S. could experience another $1 trillion or more of write-offs over the next three or four years — and that’s just from the problems we know about. Banks, which have barely recovered from the sub-prime loan fiasco, will endure more rounds of massive write-offs. To avoid the prospect of more Wall Street-style bailouts, regulators are requiring banks to set aside more loan-loss reserves and strengthen their balance-sheet leverage, which leaves them no choice but to restrain lending. That they are doing by tightening their lending standards. No more sub-prime mortgages. No more liar’s loans. Lower lending limits on home equity loans. Fewer credit cards issued. More collateral demanded of small businesses.
Predictably, the politicians will rail at the banks for taking bailout money only to turn around and curtail their loan volume, but banks cannot simultaneously bullet-proof their balance sheets and ramp up lending. It is a financial impossibility that only a grand-standing congressman could fail to grasp.
The chart above shows the contraction in lending by which the banking industry shared its pain with consumers and small business in the past two years. Large, publicly traded corporations have alternatives to bank loans: They can issue stock and sell bonds. But small businesses, the job-creating locomotive of the U.S. economy, depend heavily upon banks. Obama’s plan to pump up small business lending by $30 billion may help, but it can’t make up for the $110 billion decline in bank lending to business last year alone. If the banks can’t lend, small businesses can’t hire, and the economy can’t grow.
No, the ugly ain’t over. And the politicians in Washington, D.C., and Richmond had better adjust their plans to that economic reality.
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