More Pain For You And Me: The Economy's About To Stumble

It's semi-official: The economy is about to take the second leg down in a so-called W-shaped recession -- down, up, then down again -- and delicious as it may be to reflect that this disaster has its roots in the administration of George W. Bush, the result for you and me won't be much fun.

Warnings are popping up all over the place. But here's some of what Fed Chairman Ben Bernanke had to say November 16th to the Economics Club of New York:

  • "Significant economic challenges remain. The flow of credit remains constrained, economic activity weak and unemployment much too high. Future setbacks are possible."
  • "Banks' reluctance to lend will limit the ability of some businesses to expand and hire,"
  • "Jobs are likely to remain scarce for some time, keeping households cautious about spending,"
  • "The unemployment rate likely will decline only slowly if economic growth remains moderate, as I expect."
  • "The fallout for banks from commercial real estate could slow that progress, however."

Translation: Seventy-two percent of America's economy is consumer-based, and since a lot of people are out of work and not buying stuff, and banks aren't lending to businesses that want to hire, the economy will remain slow, unemployment will remain high, corporate earnings will remain weak, and the best we can hope for is that nothing bad will happen.

But good luck with that. People aren't buying stuff, so the companies that sell it don't need all the office space, warehouses, and glitzy mall stores they rented when times were good. This is making life hell for the owners of America's commercial real estate, and in fact, the most prestigious real estate trade group, the Urban Land Institute, predicts the sector is heading for a "bloodbath."

That is why Mr. Bernanke's last caveat about commercial real estate throws cold water over any hopes we'll muddle through; a recent report from CalPERS (the California Public Employees' Retirement System) says that about half -- some $750 billion -- of the nation's commercial mortgage debt will default over the next four years.

That debt, says the report, is already worth only fifty cents on the dollar and is simply not fully recoverable. But left out of that projection is that there's another $750 billion worth of credit default swaps associated with that debt; when the defaults kick in, separate, full-value payments -- over and above the mortgage debt -- will be made from one party to another. So the real losses are more like $1.5 trillion.

This amount is similar to the commercial real estate losses of the early 1990s, when like today, the defaults almost drove us off a cliff. The difference is that the 1990s property was financed with conventional, mortgage-based debt, so that when push came to shove, taking control -- and liquidating -- the property was a fairly straightforward matter.

Not today. Like the home loans that almost destroyed us last year, most of the commercial mortgages now facing default were sold off and turned into bonds. As a result, the liquidation of these debts will drag on for years.

There are all sorts of unpleasant reasons for that. For one thing, commercial real estate ain't beanbag; all the parties have plenty of lawyers, lots of money, and in negotiations, don't worry much about hurting somebody's feelings.

Even better: In a bankruptcy, any bondholder can derail any settlement, meaning the most unreasonable party has the whip hand.

To illustrate the problems, consider the $559 million mortgage bond issue connected to the redevelopment of New York's Drake Hotel, formerly one of the glories of Manhattan hospitality, but now a vacant lot on the corner of Park Avenue and 56th Street.

That mortgage was sliced into 21 separate pieces and sold to eight institutional investors. And in the bare-knuckle world of New York real estate Harry Macklowe, the developer, is not widely known for his sensitive, retiring nature; among the many lawsuits associated with the failed development are his allegations of fraud against the lender.

No serious observer would say that this cage fight has any prospects of a quick, tidy ending. But it should be considered that the country's other developers, lenders, and bondholders are as unlikely as Mr. Macklowe to fold at the first hard looks. Since banks typically hold onto some of the original debt instruments, the result will be prolonged wars that will drag down the earnings of the banks, big or small, connected to them.

That in turn will do nothing to encourage said banks to lend to businesses for, for instance, expanded payrolls. Already, big banks have cut back on their commercial lending--a trend that's accelerating; total loan originations in September at Bank of America fell 6 percent, or $53.6 billion, from a month earlier, according to a Treasury Department, while new loans at Wells Fargo & Co. dropped 14 percent to $47.4 billion. And this is a well-established trend.

In other words, business may live on credit, but so what? Banks aren't making loans. So businesses can't hire, the unemployment rate rises, and the consumer-driven economy falls.

Meanwhile, the Fed's most recent Senior Loan Officer's Survey indicates that what loans are being made are being made by smaller banks--the very ones that underwrote many of the commercial mortgages we've been talking about. These banks are, on the one hand, least able to withstand a sudden flood of bad loans, and on the other, are the least likely to be bailed out by the government if, in fact, the government -- or the public -- had any appetite for bailing them out. And it doesn't.

The obvious result will be a new spate of bank failures on Main Street. This has already been widely predicted, and estimated by some observers to eventually total another 400, or about 8 percent of America's banks. And it's these smaller banks that make loans to your local hardware store, since the top ten banks can't be bothered with that side of the business.

Even if this wonderful scenario was completely untrue, the fact remains that you and I are just not using our houses as ATMs anymore, need $300 jeans, or in general, expect our careers, the economy, or the stock market to rise forever. We accept now that the bubble burst; it was a real shock, but Americans have since grown up some and are acting more rationally than they did in 2006, when the Fed statistics said we were spending more than we had. The consumer economy, in other words, is a thing of the past.

But if the consumer economy is kaput, the American economy has to switch to a more solid and sensible model in order to stabilize for the long term. What that means exactly is for smarter people than I am to say; but it will obviously mean less whimsical spending, and, probably, selling more stuff to other countries instead of to ourselves. That will mean plenty of change in our daily lives, and even more dislocation in the jobs picture.

Since the likelihood of more federal stimulus packages is low -- unless they're called something like a "jobs bill" -- this will mean more pain and an even slower economy. Anybody waiting for things to get back to "normal" -- meaning 2005-2006 -- had better change to sweats and rent a bunch of movies; they've got a wait in their hands.