Last week’s news on housing and commercial real estate was all bad.  On the residential side, 

  • New home sales fell to an adjusted annual rate of 300,000, a new all-time record.
  • The builder confidence index declined sharply in June.
  • Existing home sales fell in May. 
  • 7.3 million mortgages are delinquent.
  • 11.2 million homeowners now have negative equity in their homes.

Those facts, coupled with an existing supply of 3.89 million homes for sale and a large shadow inventory of houses sitting on banks’ balance sheets that have been foreclosed on and not yet put back on the market, are strong evidence that the outlook for home prices is bleak, and will probably remain so into 2011 and maybe 2012.  This will also be a serious drag on the economy.

On the commercial side, AIA architecture billings declined in May.  This index is a leading indicator for commercial real estate construction and investment.  There is usually a lag time of approximately nine to twelve months between architecture billings and construction spending.  So it is fairly obvious that commercial construction is not going to increase this year and probably not next year either.  Then there is the existing supply of empty commercial real estate already on the market and the rising foreclosure rate for commercial mortgages which puts a stress on banks’ balance sheets that have a large number of commercial real estate mortgages on their books, and the greatest exposure to this risk is community banks which is where much of the small business lending is done.

This whole picture of all the components of the real estate and construction industries constitutes a major barrier to any economic recovery, and that barrier is going to be slow to come down because of the stubbornly high unemployment rate.  And the rising sentiment in Washington against stimulus and toward deficit reduction could hinder job growth to some extent which would then make it harder still to bring the unemployment rate down.  Like it or not, government stimulus has worked in some instances, and the housing market is an excellent example.  Before the $8,000 tax credit expired, home sales were doing well.  The credit has now expired and the bottom has dropped out of the housing market.

Physics 101: For every action there is an equal and opposite reaction.  Last month Louisiana governor Bobby Jindal was raising hell with the government and BP about the blowout and the chaos of the cleanup (rightfully, by the way).   So to try to show that it was on top of the situation, the government slapped a six-month moratorium on deepwater drilling in the gulf – the action.  This week, governor Jindal asked the U.S. to lift the moratorium, which has already been granted by a federal judge, because it could result in a loss of up to 20,000 new and existing jobs – the reaction.  Oops.  The hydrocarbon industry contributes 14 percent of the state’s budget.  It is estimated that oil and gas and its support businesses generate $70 billion and 320,000 jobs in the state.  It’s not just BP.  It is also Chevron, Shell and Exxon, and these are just the big players.  Oops.

Jobs, jobs, jobs.  We have an environmental disaster in the gulf, but we also have the worst recession anyone has ever lived through and the oil industry is the source of a lot of jobs, especially on the gulf coast.  There are not only the people that work on the rigs but the much larger number of people who work for the many companies that support the drilling operations.  Many jobs are already lost by the people on the gulf coast who make their living from the water.  The tourism industry in Louisiana and Alabama is suffering and the effects are moving around the coast into Florida where more tourism jobs will likely be lost as people cancel vacation plans.  No one knows what the cost in lost jobs is going to be there.  So we have an enormous conundrum with no good way out, but a result that is going to add something to the unemployment rate which we are having so much difficulty bringing down.

There is no argument that this is a huge disaster and that BP has major culpability and the U.S. government is right behind them because of the power of the oil industry lobby which has poured millions of dollars into Congress’s pockets, but also because of lack of government oversight and corruption in the Minerals Management Services office.  But the unpleasant fact overriding all of this is that the country needs oil, and lots of it, and the gulf is one of the largest and cheapest sources that we currently have.  But, surprise, surprise, in the latest New York Times/CBS news poll, a large majority of Americans think that we need a fundamental overhaul of our energy policies, but a majority is also unwilling to pay higher gasoline prices to develop alternative fuel sources.  So like it or not, we are going to keep drilling in the gulf, which supplies approximately 30 percent of the nation’s oil ad gas supply, not only because we have to have the oil but because we can’t afford to lose the jobs.

As bad as the economy is and even though the slow climb out of the recession is probably going to cause more small businesses to fail, one particular item that banks are still willing to finance is owner-occupied commercial real estate.  Most other types of credit for small businesses – working capital being a prime example – have become very difficult to get.  But for businesses that might be doing well enough to qualify for financing and are currently renting their space, this is one of the best times in a very long time to buy a building.

The commercial real estate crash, with overall commercial real estate prices down almost 40% below their peak in 2007, has created a large supply of buildings at prices lower than have been seen in recent memory.  To a bank, a building occupied by a business owner is about as good a risk as can be found in today’s economy.  Then add to that the fact that even though there may be a little more downside left in prices, there is much more upside potential as the economy continues to pull out of the recession.  So add together an unusually large supply of buildings, and banks aggressively competing for this type of business, and a business owner has a real opportunity at this time to acquire space to grow their business.

Making it even more attractive for banks that are comfortable with SBA lending is the fact that banks can get 75% of their loans guaranteed, so SBA loans become even more attractive as a means to accomplish a building purchase.  And for the potential business owner-borrower, the fact that SBA allows a 25-year amortization on commercial real estate usually means lower monthly payments on loans that also cannot be called.  So for small business owners needing expansion, this is a very unique opportunity in recent economic history.

It’s like a broken record: small businesses need more financing.  But it’s not going to happen any time soon, because since banks are where it comes from, and they are not going to do anything until they see a significantly improving economy that is dragging small businesses with it.  And any signs of a sustained recovery that is creating 300,000 to 400,000 new jobs a month is not in sight yet.   There are still too many bad things happening, and there is almost nothing that government can do to make any significant impact now with the political climate in Washington. 

The gulf oil spill is going to take a bite out of GDP, and at this point, I’m not sure anyone can even guess yet as to what it might be.  Problems in the housing market are ongoing, and without significant improvement in the housing market, any economic recovery is not going to have much steam.  According to the FDIC, more than 11 million homeowners are underwater – owing more than their houses are worth.  About 31/2 million mortgages were at least 60 days past due in May and 2.4 million were in foreclosure.  The number of mortgages currently in default or on their way is still rising.  More and more people are just walking away from their mortgages completely because of loss of jobs, and that trend is likely to continue.  And foreclosed real estate on banks’ balance sheets means losses which means curtailed lending of all kinds.  That problem is not subject to any kind of quick remedy (unless you believe in miracles).  Then there is the crisis in state governments, as I mentioned in my May 28 post, which is getting worse.  And though not often mentioned, municipal governments account for about 13 percent of GDP.  So when you look at that as a sector of the economy which is deteriorating rather than turning around, you see a major drag on any economic recovery.

But amid all these cheery scenarios, the overall economy is slowly improving.  All twelve Federal Reserve districts showed that overall economic activity for data created on or before May 28 improved.  So unless something drastic enough happens to throw us back into recession, there are going to be no major stimulants of any kind to the economy that will create a strong upsurge.  Fortunately or unfortunately, there is enough growth to give the government reason not to do anything dramatic, so the only thing that is going to work is just the work of the business cycle, which is now swinging back to positive.  That is the only thing that is going to really help small business.

Arguably, the comic strip character Pogo’s most famous quote was, “We have met the enemy, and he is us.”  That pretty well describes how we got into this mess and why it is going to be so difficult to get out of it.  There is plenty of blame to go around.  The home mortgage crisis was helped along by peoples’ fondness for “something for nothing” aided by a mortgage industry mostly interested in generating large fees, and being prodded along by a Congress who decreed that everyone should be able to own a home (whether they could afford it or not).  So to help achieve this dubious goal, the mortgage industry came up with a whole array of “cheap” mortgages – low down payments; no down payments; no documentation of income or anything else, and more.  It got to the point that it almost seemed like if you could breathe on a mirror and fog it up, you qualified for a mortgage.

Unemployment was low, business was strong, and incomes were high.  There was plenty of money to spend, home prices were going up, no need to save for the rainy day; so the savings rate dropped to near zero.  Then it started to rain, and it didn’t stop.  The stock market tanked, taking peoples’ retirements with it.  Loans began to go into default causing banks to get into trouble.  Credit dried up that businesses needed to stay in operation.  Businesses began to lose money and shed jobs.  Since the beginning of the recession, approximately eight million people have lost their jobs.

And now, the political winds in Washington are beginning to shift from stimulus to deficit reduction.  That we need to reduce the deficit is obvious.  But there is a little problem there in that to reduce deficits, you have to reduce spending.  But in an economy that is trying to recover from the worst recession since the Great Depression, less spending is only going to prolong the agony.  And remember, what finally got us out of the depression in the thirties was the advent of World War II.  We aren’t going to have that to help us this time.  So reducing the deficit is another example of doing the right thing for the long term while causing harm in the short term.  It is similar to what is happening to the consumer savings rate.  From near zero it has risen to about four percent.  This is good for everyone in the long run, but particularly bad in the short run because the consumer is saving money now that up to two years ago they were spending, and the economy desperately needs spending now..

Finally, I am going to re-phrase Pogo’s quote to read “We have met the enemy, and it is Congress.”  The almost visceral partisanship between the parties and lack of comity is making governing much more difficult at a time when, since it is the government and Congress in particular, that has the power to do anything major fast enough to help speed the recovery, instead, we have stalemate.  It is more important for them to “appeal to the base” so they can get re-elected than to make hard decisions that might not be what their base wants to hear.  The country be damned.  We are going to be in for a long and very unpleasant slog, and a lot of people are going to suffer.  In a speech this past Monday, Federal Reserve chairman Ben Bernanke pointed out that even if the economy grew at 3%, which normally would be considered good, it would not do much more than keep pace with the normal rate of growth in the work force.  Not a pretty picture.

41,000 is the number of new private-sector jobs added in May – far (very) below the estimates of most economists.  100,000 is the number of new jobs that need to be created every month just to handle new entrants into the job market, such as graduating students.  Approximately 200,000 jobs in addition to the 100,000 have to be added each month to begin to climb back to some semblance of full employment, generally considered to be in the 5 to 5.5% range.  I have seen many estimates of how long it might take to get there, ranging from three to five years.  Remember, there are approximately 15 million Americans currently looking for work.  Four or five years is probably more like it.

Prospects for job growth this slow do not bode well for many businesses, particularly smaller businesses that are currently healthy, but need financing either to stay healthy or to grow and create more jobs.  But in this kind of grinding, slow recovery, rebuilding balance sheets and improving sales and profits is going to be very slow, and these are the things that a bank uses to judge a company’s creditworthiness, and if it is slow going to improve sales and profits, financing is unlikely to be there any time soon.  The problem for banks was summed up succinctly by Tom Winfree, president and CEO of Village Bank, a community bank in Richmond, Virginia.  While talking about the pressure community banks are getting from the administration, Congress, the Federal Reserve, and anyone else who wants to join the party, he said “… Yet they send in regulators with very strict review of our loan portfolios and severe requirements for loan-loss reserves.  With pressure on our capital levels and the potential for even more problem loans, we are very reluctant to diminish our capital-to-asset ratio by growing our balance sheet by making more loans.”  That quote could probably come from hundreds of other community bank presidents around the country.  I have said this before as have many others, that even if the banks wanted to make more loans, they are under such strict scrutiny from regulators that they would just rather not make them than risk the wrath of the regulators.  So they find themselves in a damned-if-you-do and damned-if-you-don’t situation which doesn’t help them or their small business customers.

This is the lending environment that small business owners find themselves in today, and even though the economy is beginning to experience some solid growth, with the slow pace of new job creation, consumer spending is going to stay muted for the foreseeable future.  And without increased consumer spending, many businesses are just going to have to keep soldiering on with little or no help from the banks because they are having their own problems.  The economy has to improve for the banks as well so that they are strong enough to increase lending.

We hear the term unemployment all the time, underemployment less, and structural unemployment still less.  But it is structural unemployment that could create a drag on job growth as the economy improves, increasing the odds of what is often referred to a jobless recovery.  In the broadest terms, a jobless recovery generally occurs when gross domestic product (GDP) starts growing as the economy recovers, but job growth lags behind.  In recent months, the economy has enjoyed very strong growth in productivity which helps boost GDP.  Productivity growth generally stems from two things – improvements in technology and people working harder.  We know that new technologies have had a dramatic effect on productivity increases since the end of the last recession.  But is also appears that a lot of the increase has come from people working harder.  As the recession worsened, many companies made significant reductions in their workforces, reorganized workers and cut costs.  But even though the economy is now beginning to improve, it is not strong enough yet to convince employers to start hiring aggressively, and it has become apparent that in many large corporations workers who still have their jobs are working harder and longer hours to keep up with growing demand. 

One reason that structural unemployment may play a bigger role in this recovery than in recoveries from recent recessions is because certain aspects of the economy have undergone significant changes since the end of the last recession in 2001.  Technology has made a quantum leap and has enabled companies to produce more with the same or less employees.  Some industries, automotive manufacturing being a classic example, have shrunk dramatically, and many of those jobs will never come back.  For the foreseeable future, the same is true of the construction industry.

Another contributor to a more significant role for structural unemployment in this recovery is that because the recession has been so severe, and because there still remain some significant obstacles to a strong recovery, a lot of companies are being very cautious about bringing back laid-off workers.  In many cases they are using part-time workers who would prefer to be full-time, but who can also be laid off very quickly if demand changes.  The longer workers remain unemployed, the more their skills may begin to diminish, thus making it harder to work their way back into the labor force.  This is one of the major causes for structural unemployment. 

Also contributing to structural unemployment is that often when jobs disappear in one part of the country, they often reappear or new ones become available in another part of the country.  Historically worker mobility has always mitigated against the severity of job losses in one part of the country because people could pick up and move to where the new jobs were.  Not so this time.  The housing crisis has millions of people stuck in their homes that are now worth considerably less than what they paid for them and even perhaps, less than their mortgages.  So they choose not to or are unable to sell their houses to move to another part of the country where jobs are more plentiful.

In a June 3rd speech in Atlanta Dennis Lockhart, President and CEO of the Federal Reserve Bank of Atlanta, concluded that the pace of hiring as we come out of the recession is likely to be gradual (italics mine).  He said that there is still a great deal of uncertainty about the future business environment, government fiscal policies, and even the financial problems in Europe.  All of this is real, and all of this is telling small businesses to continue to run as conservatively as possible until the future course of the economy becomes clearer.  A high rate of structural unemployment in the labor force stretches out the time that it takes to get back to some semblance of full employment, which means continued barriers to increased consumer spending.

One of the who-knows-how-many battles currently going on in Washington is the battle between credit unions and banks.  Current law limits credit unions’ business lending to 12.5% of total assets.  The credit unions want that raised to 25%, and banks are fighting hard to defeat that request.  The reason that this is worth watching is that credit unions that are willing to make small business loans (and many are not) often lend to smaller businesses than banks like to deal with, or lend smaller amounts than banks are willing to lend and which have all but dried up in the recession.  According to government lending reports, loans to small business increased at credit unions but declined at community banks in 2009.

Looking at it from the banks’ perspective, they have a couple of good arguments on their side.  The best, and one that I would find hard to disagree with, is that credit unions are non-profit lending organizations that enjoy tax-free status.  It was because of that that Congress imposed the cap in 1998.  The banks argue, correctly, that they have to pay taxes, so the playing field is not level, and it should be.  The other argument on the banks’ side, although nowhere near as compelling as the tax issue, is that over the last two years, bank regulators have been beating up on banks to set aside more loan-loss reserves and strengthen their balance sheets.  While this is something that should be done, it has hit community banks much harder than larger banks because their capital base is usually smaller, and it is the amount of capital on a bank’s balance sheet that determines the amount of money it can lend.  When a loan is classified by a bank regulator, and thus a loan loss reserve set up, that loan loss reserve is against the bank’s capital even though the loan is not in default.

No matter how the battle turns out, I would argue that there is more than enough room for both to operate in the small business lending arena as long as the playing field is level.  There is seldom too much money available for small business owners, and because the recovery from this recession is going to be very slow, small businesses need all the help they can get now, and there is not enough coming from banks.  It is also a fact that there are not a lot of large, strong credit unions across the country competing head-to-head with banks for small business loans.  Plenty of credit unions don’t, and don’t want to, do business lending, and it would probably take only a few defaults on small business loans at a credit union to make them swear off small business lending permanently.  There are plenty of opportunities for both banks and credit unions.