SPECIAL COMMENTARY March 2, 2009

The Evolution of the Economy, Credit & Economic Policy

John Silvia, Chief Economist
john.silvia@wachovia.com
704-374-7034

After more than a year of recession and a decline greater than forty percent in some
financial indices, are we making any progress to the upside? To identify progress we
first identify where we are now in the economy. 1 Second, we address the question of
whether we have reached a bottom, and which indicators we can use to gauge the
economy’s potential recovery. Finally, how can we measure progress in our policy
efforts to address both economic and credit issues and if there are signs of progress at
the regional level within the Sixth Federal Reserve District.
Our results suggest that we have made very little progress with the economy
remaining in a deep recession. Alternatively, we do see progress in selected credit
markets but only where the Federal Reserve appears to be directly involved.
Unfortunately, the regional story remains disappointing.
Where are we now?
Our most recent forecast shows a deeper and longer recession than we witnessed in
either 1990 or 2001, perhaps similar to our experience in 1973-75. In Figure 1 we
illustrate our baseline expectations for real GDP. Real final sales are expected to
remain negative throughout 2009. Inventory swings and declines in imports might
produce a positive GDP figure before then, but we now believe the recession will last
through the third quarter of this year while job losses and rising unemployment will
likely carry over into next year. Federal government spending makes a significant
positive contribution to our positive fourth quarter estimate for GDP.
Throughout this financial crisis there have been endless comparisons between
today’s environment and the 1930s. We feel a more apt comparison is the deep
1973-1975 recession, a period that also dealt with an oil price shock, a housing
collapse and a banking crisis (Figure 2). This more recent recession, and not the
Great Depression, provides a template for our outlook.
The current recession will take time to play out, and the economic stimulus package
and financial sector reform efforts will reflect the outside policy lags familiar to
policymakers. We have incorporated a very large stimulus effort into our baseline

1 As prepared for the Federal Reserve Bank of Atlanta, Debate & Confirm: 2009 Banking Industry Outlook.

February 19, 2009. The author would like to thank Sam Bullard, Azhar Iqbal, Gary Schlossberg, Kim
Whelan and Adam York.
The author also thanks to Carl Hudson and the Federal Reserve Bank of Atlanta for posing these starting
points to discuss.

This report is available on www.wachovia.com/economics and on Bloomberg at WBEC

 The Evolution of the Economy, Credit & Economic Policy
March 2, 2009 SPECIAL COMMENTARY

forecast. Our expectations are that the infrastructure spending and the tax cuts will
boost income growth and spending by the third quarter of this year. The bulk of the
impact from the stimulus package will not likely affect the economy until late this
year or next year.

Figure 1 Figure 2
Real GDP U.S. Business Cycles
Bars = Compound Annual Growth Rate Line = Yr/Yr Percent Change Real GDP, Peak Indexed to 100
8.0% 8.0% 108 108
Peak @ Q4-1973
Peak @ Q3-1981
6.0% 6.0% 106 106
Peak @ Q2-2008

4.0% Forecast 4.0%

104 104

2.0% 2.0%
102 102
0.0% 0.0%
100 100
-2.0% -2.0%

98 98
-4.0% -4.0%

96 96
-6.0% GDPR - CAGR: Q4 @ -6.2% -6.0%
GDPR - Yr/Yr Percent Change: Q4 @ -0.8% Quarters From Peak
-8.0% -8.0% 94 94
2000 2002 2004 2006 2008 2010 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10

Source: U.S. Department of Commerce and Wachovia

For bankers and regulators, the pattern of GDP does not suggest an easy way out this
year. First, in contrast to the historical pattern of housing, we expect housing starts
will not recover neatly in line with the economic cycle. Traditional economic
recoveries since WWII have been led by Federal Reserve policy easing that brought
down interest rates and thereby kick-started housing. In this cycle however, housing
continues to go through a long-term correction that reflects a fundamental
revaluation of the proper price and credit availability associated with home buying.
Second, in accordance with historical patterns, we expect that non-residential
construction will lag the business cycle due to the negative impact of lowered
economic expectations, energy prices and corporate profits.
Second Issue: A Bottom?—Consumer Spending & Real Final Sales
Has the economy reached a bottom? In addition, are there indicators that we can use
to gauge the economy’s potential recovery? Consumer spending (Figure 3) will
likely remain weak throughout 2009. We do expect some improvement during the
year as motor vehicle sales should gradually improve. On a long-term basis, this
pace is still well below the nearly 17 million unit pace averaged earlier in the decade.
This would suggest a challenge for bankers and regulators in terms of the financing
of auto inventories and the size and quality of associated asset-backed securities.
Consumer spending will also likely remain constrained for other goods and services,
particularly discretionary purchases such as leisure and travel, and big-ticket items
like furniture and home electronics.

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The Evolution of the Economy, Credit & Economic Policy
March 2, 2009 SPECIAL COMMENTARY

Figure 3 Figure 4
Real Personal Consumption Expenditures Real Final Sales to Domestic Purchasers
Bars = Compound Annual Growth Rate Line = Yr/Yr Percent Change Bars = Compound Annual Growth Rate Line = Yr/Yr Percent Change
8.0% 8.0% 8.0% 8.0%

6.0% 6.0% 6.0% 6.0%

Forecast Forecast
4.0% 4.0%
4.0% 4.0%

2.0% 2.0%
2.0% 2.0%
0.0% 0.0%
0.0% 0.0%
-2.0% -2.0%

-2.0% -2.0%
-4.0% -4.0%

-4.0% -4.0% -6.0% -6.0%

PCE - CAGR: Q4 @ -4.3% Real Final Sales to Dom. Purchasers - CAGR: Q4 @ -5.7%
PCE - Yr/Yr Percent Change: Q4 @ -1.5% Real Final Sales to Dom. Purchasers - Yr/Yr Percent Change: Q4 @ -1.7%
-6.0% -6.0% -8.0% -8.0%
2000 2002 2004 2006 2008 2010 2000 2002 2004 2006 2008 2010

Source: U.S. Department of Commerce and Wachovia

A second component of real domestic final sales, business fixed investment, also
tumbled during the fourth quarter of last year as firms struggled to realign
production capacity with dramatically weaker global economic growth. For 2009,
recent weakness in non-defense capital goods orders suggests continued weakness in
capital spending and thus domestic final sales (Figure 4). No bottom is apparent for
business equipment investment. In Figure 5, we use a mathematical technique, the
Hodrick-Prescott filter, to suggest a separation between trend and cycle components
of any time series. In this diagram we can see the rapid collapse in final sales relative
to trend in the current recession. There is no sign of a bottom here. Tighter credit
conditions are playing a role in reining in investment outlays, but the bigger problem
here is that businesses simply have too much idle capacity.
Figure 5

Decomposing Real Domestic Final Sales

Using H-P Filter, Year-over-Year Percent Change
5.0% 5.0%

4.0% 4.0%

3.0% 3.0%

2.0% 2.0%

1.0% 1.0%

0.0% 0.0%

-1.0% -1.0%
Log of Real Domestic Final Sales: Q4 @ -0.3%
Log of Real Domestic Final Sales, Trend Based on H-P Filter: Q4 @ 1.7%
-2.0% -2.0%
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Source: U.S. Department of Commerce and Wachovia

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 The Evolution of the Economy, Credit & Economic Policy
March 2, 2009 SPECIAL COMMENTARY

For bankers and regulators, the obvious implication of such weak spending would
suggest that credit-financed consumer purchases and thereby retail vacancy rates
will be under continued pressure. For example, we have already seen rising retail
vacancy rates, particularly for neighborhood centers tied to recent housing
developments. Bankruptcies at a long list of such easily recognized names as Circuit
City, KB Toys, Goody’s, Steve & Barry’s and Linen & Things have made the
consumer problems more visible.
The economy’s free-fall amid a severe credit squeeze and pressure to deleverage are
complicating efforts to pinpoint the depth of this recession and the timing and
strength of the next recovery. Consumer weakness has also driven the decline in
state/local sales tax revenues, which has aggravated municipal government deficits.
These deficits have already been hit by personal income and property tax revenue
declines. Deficit problems have led to credit quality issues (for example in
California) that have raised issues for both bankers and regulators.
Indicators of the Eventual Bottom and Recovery
We focus on four key, non-financial time series to provide an initial impression of the
state of the economy. First, the pattern of initial jobless claims in recent months
suggests that large significant job losses will continue and that there is no signal here
for a bottom in the economy. For bankers and regulators, continued job losses
suggest continued upward pressure on office and retail vacancy rates.
For a second indicator, we estimate employment losses in this recession will exceed
those of the recent recessions back to the 1957-1958 recession (Figure 6). These
estimates suggest continued pressure on consumer credit lines as well as retail
vacancy rates.

Figure 6 Figure 7
Employment Change in Recessions ISM Manufacturing Composite Index
Percentage Change Peak-to-Trough Diffusion Index
0% 0% 65 65

-1% -1% 60 60

-1.3%
-1.5% -1.5% 55 55
-2% -2%
-2.0%
-2.3%
50 50
-2.6%
-3% -2.8% -3%
-3.1%
-3.4% 45 45
-4% -4%
40 40
-4.4%
-5% -4.8% -5%
-5.2% 35 35
ISM Composite Index: Jan @ 35.6
-6% -6% 12-Month Moving Average: Jan @ 44.3
1948- 1953- 1957- 1960- 1969- 1973- 1980 1981- 1989- 2001 2007- Forec 30 30
1949 1954 1958 1961 1970 1975 Cycle 1982 1991 Cycle To- ast
Cycle Cycle Cycle Cycle Cycle Cycle Cycle Cycle Date 87 89 91 93 95 97 99 01 03 05 07

Source: Institute for Supply Management, U.S. Department of Labor and Wachovia

As a third indicator, the Institute for Supply Management (ISM) index illustrates the
rapid decline in the manufacturing sector’s fortunes in recent months (Figure 7).
This weakness is consistent with the recent weakness of industrial production
reported on February 18 and the sharp decline in exports also reported recently. For
bankers and regulators, the weakness in the manufacturing sector is consistent with
the rise in industrial vacancy rates since early 2007.
Finally, for business investment, we look to orders of non-defense capital goods,
ex-aircraft orders, as an indicator of recovery. Over the last three months these
orders are still down by double-digit percents, with no clear sign of a turn.

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The Evolution of the Economy, Credit & Economic Policy
March 2, 2009 SPECIAL COMMENTARY

So far we do not estimate a quick recovery in the economy. We use a probit model to
estimate the probability of a recession during the next two quarters. 2 Results from
our model are illustrated in Figure 8 and suggests the probability of a recession is
almost 100 percent for the first and second quarters of this year based upon data
available through the fourth quarter of last year.
Figure 8

Recession Probability Based on Probit Model

Two-Quarter Ahead Probability
100% 100%

80% 80%

60% 60%

40% 40%

20% 20%

Two-Quarter Ahead Recession Probability: Q4 @ 99.4%

0% 0%
80 84 88 92 96 00 04 08
Source: Wachovia

Measuring the Progress—or Lack of it—of Policy Efforts

Our third issue to address is how much, if any, progress we have made. Is the
economy improving? Are credit markets functioning any better since the Federal
Reserve opened up its credit facilities? In a traditional business cycle, Federal
Reserve policy easing on the scale of the last year would have elicited more of a
response in economic activity than what we have seen in this cycle. The culprit, we
would argue, has been the dramatic deterioration in both the availability and pricing
of credit.
Over the short run, as for the availability of credit, we have seen a rapid rise in the
net percentage of banks that have tightened credit according to the Federal Reserve’s
Senior Loan Officer Survey. As for pricing, we have also seen a rapid rise in bank
spreads in the same survey. In the private markets, for example the commercial
mortgage market, bank direct lending and securitization comprise some 75 percent of
all credit to the market. While we have already seen tighter bank credit, as for
securitization, commercial mortgage-backed securities were issued at a pace of

2JohnSilvia, Sam Bullard and Huiwen Lai, “Forecasting U.S. Recessions with Probit Stepwise Regression
Models,” Business Economics, January 2008.

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 The Evolution of the Economy, Credit & Economic Policy
March 2, 2009 SPECIAL COMMENTARY

$20-25 billion per month in 2007, while current issuance is now effectively zero. The
inability to finance commercial mortgages is a constraint on bank asset and fee
growth for the year ahead.
In the long run, increased federal deficit financing poses a threat to long-term interest
rates and financial stability, though less from increased inflation fears than one might
expect. Instead, the increased supply of Treasury securities and the same loss of
confidence in U.S. economic policy that helped destabilize the dollar and send U.S.
interest rates climbing in the 1970s are the greatest threats. This bond supply effect
over time is likely to offset the liquidity supply impact of Fed easing in the short-run.
Moreover, an unwinding of the “flight” capital, propelled by financial turmoil of the
past eighteen months, could complicate the outlook in this cycle. Treasury yields
could rise from unusually low levels sooner than they did during the two previous
weak economic recoveries, while, in contrast, yields on non-Treasury securities
(high-grade corporate bonds) could buck increases in government rates, as risk
premiums continue to diminish.
A Policeman on Every Corner
Policy progress does appear in the decline in the TED spread and other short-term
liquidity spreads such as the LIBOR to federal funds rate spread (Figure 9). As for
liquidity, we appear to be mirroring the pattern of police patrols. At each corner
where a policeman is stationed, we witness a decline in crime. In every market
where the Fed focuses its liquidity facilities, such as short-term instruments as well
as ABS and MBS, liquidity premiums decline. However, wherever the Fed is not
engaged (no market policeman), such as corporate bonds, spreads have not returned
to more normal levels (Figure 10). Fortunately investment grade bond issuance has
increased as investors are seeking yields in this market as long-term Treasury rates
offer very low historical yields. In contrast, high-yield issuance remains minimal
with wide yield spreads.

Figure 9 Figure 10
TED Spread Aaa and Baa Corporate Bond Spreads
Basis Points Over 10-Year Treasury, Basis Points
450 450 700 700
TED: Feb @ 93 bps Baa Spread: Jan @ 562 bps
400 400 600 Aaa Spread: Jan @ 253 bps 600

350 350
500 500
300 300
400 400
250 250
300 300
200 200
200 200
150 150
100 100
100 100

50 50 0 0

0 0 -100 -100
2004 2005 2006 2007 2008 2009 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Source: Federal Reserve Board and Wachovia

Financial fundamentals remain an issue for bankers and regulators. As illustrated in

Figure 11, there was a rapid rise in credit spreads for both 5-year and 10-year
AAA CMBS associated with the Bear Stearns collapse by mid-2008 and then a sharp
jump with the Lehman Brothers collapse in September of last year. For both policy
makers and bankers, the break in spreads during last year presents an interesting
problem. The break is significant in both size and duration, suggesting that the
market equilibrium spread is unlikely to return to levels common before the break.

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The Evolution of the Economy, Credit & Economic Policy
March 2, 2009 SPECIAL COMMENTARY

In this case, owners of paper issued between 2005 and mid-2007 would be
permanently at a loss. In economics we would consider the market equilibrium
pricing of the earlier period as unstable, made possible only by the perceptions of
low risk and high liquidity prevalent in the market at that time. With the destruction
of these perceptions the market equilibrium of the 2005 to mid-2007 ended, and is
unlikely to return. As of now, the CMBS market is searching for a new equilibrium
for pricing and issuance.
The current recession marks the end of the era of abundant and cheap credit, just as
the 1973-1975 recession marked the end of the era of abundant and cheap energy.
Bankers and policymakers are quickly adjusting to this new reality. With the
securitization market still largely frozen, banks will likely continue to closely
scrutinize anything they add to their balance sheets.

Figure 11 Figure 12
5-Year and 10-Year AAA CMBS Spreads Decomposing Corporate Profits Using H-P Filter
Basis Points 4-Quarter Moving Average, Year-over-Year Percent Change
1600 1600 32% 32%
5-Year AAA CMBS: Feb @ 1,400 bps Log of Corporate Profits: Q3 @ -5.3%
1400 10-Year AAA CMBS: Feb @ 1,100 bps 1400 Log of Corporate Profits, Trend Based on H-P Filter: Q3 @ 1.9%
24% 24%
1200 1200
16% 16%
1000 1000

800 800 8% 8%

600 600
0% 0%

400 400
-8% -8%
200 200

0 0 -16% -16%
2005 2006 2007 2008 2009 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: U.S. Department of Commerce, Wachovia Securities and Wachovia

The significant slide in profits remains in place (Figure 12). Profit growth has broken
far below its trend value in a pattern similar to the weakness in profits of the 2001
recession. Weaker profits are another issue for bankers and regulators. Weak profits
suggest weak business credit and thereby higher delinquencies and eventually
defaults. For the bond markets, weaker profits have historically been associated with
weaker high-yield bond performance. We believe risk premiums throughout the
bond market are attractive compared to the “rich” Treasury sector, despite their
decline from last fall’s peak. Sizable yield premiums on an array of higher quality
taxable and tax-exempt securities provide an alternative to Treasuries for many
investors.
Housing Market: Real-Side Correction? Continued Financial Deterioration
One positive sign for improvement in the housing market is the recent decline in the
outstanding inventory of existing homes for sale (Figure 13). In part, this decline
may represent the clearing out of some foreclosures. The bottom line, as we see it, is
still a decline in inventories and thereby a reduction in the downward pressure on
home prices.
However, financial deterioration continues as evidenced by the continued rise in
fixed-rate mortgage delinquency rates for both prime and subprime mortgages
(Figure 14). History here is not on our side. Delinquency rates tend to peak late in
the business cycle and in particular, actually peaked after the 2001 recession ended.
Our expectation is that delinquency rates will peak late, or even well after the
business cycle turns.

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 The Evolution of the Economy, Credit & Economic Policy
March 2, 2009 SPECIAL COMMENTARY

Figure 13 Figure 14
Inventory of Existing Homes for Sale Fixed-Rate Mortgage Delinquency
Existing Homes for Sale at End of Month, In Thousands Percent of Loans Past Due, Seasonally Adjusted
5,000 5,000 4.0% 20.0%
Prime FRM: Q3 @ 3.3% (Left Axis)
Subprime FRM: Q3 @ 18.0% (Right Axis)
4,500 4,500 3.5% 18.0%

4,000 4,000 3.0% 16.0%

3,500 3,500 2.5% 14.0%

3,000 3,000 2.0% 12.0%

2,500 2,500 1.5% 10.0%

2,000 2,000 1.0% 8.0%

Total Inventory: Jan @ 3,600,000

1,500 1,500 0.5% 6.0%
1999 2001 2003 2005 2007 2009 1998 2000 2002 2004 2006 2008

Source: National Association of Realtors, Mortgage Bankers Association and Wachovia

Commercial Vacancy Rates: Another Signal of Little Progress

Office vacancy rates are on the upswing, as would be expected in any recession
period in which job losses are so large and widespread (Figure 15). Unfortunately for
both bankers and regulators, office vacancy rates appear to peak long after the end of
the recession (note the 2001 experience). We would expect the recovery of 2010 to be
similar, with job gains initially being very limited and persistently high office
vacancy rates for a sustained period. This suggests weaker revenue on rents for bank
creditors and thereby a deterioration of credit quality at the margin.
Figure 15

Office Vacancy Rates

Percent Vacant
25% 25%
Metropolitan Office Vacancy Rate: Q4 @ 14.7%
Suburban Office Vacancy Rate: Q4 @ 16.3%
Downtown Office Vacancy Rate: Q4 @ 11.7%
20% 20%

15% 15%

10% 10%

5% 5%

0% 0%
1990 1994 1998 2002 2006
Source: CB Richard Ellis and Wachovia

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The Evolution of the Economy, Credit & Economic Policy
March 2, 2009 SPECIAL COMMENTARY

Regional Progress? Sixth District: Florida & Georgia – Not Much Progress
In the case of Florida, the upswing in housing permits and home prices during the
2003-2006 period was an overshooting on the upside relative to demographic
fundamentals, rather than the establishment of a new equilibrium. This is a
significant challenge to the banks and regulators in this state as home values
plummet and drive delinquencies and to a higher level, sustained for a longer time,
than experienced in recent recessions. In the Georgia case, the rapid gains in housing
starts during the 2003-2006 period was not as pronounced as in Florida but still
reached a much higher level than in the 1990s recovery.

Figure 16 Figure 17
Georgia Unemployment Rate Georgia Housing Permits
Seasonally Adjusted Seasonally Adjusted Annual Rate
10% 10% 125 125
Single-Family: Dec @ 9,936
Single-Family, 12-Month Moving Avg.: Dec @ 24,654
Multi-Family, 12-Month Moving Avg.: Dec @ 7,436
100 100
8% 8%

75 75

6% 6%

50 50

4% 4%
25 25

Unemployment Rate: Dec @ 8.1%

12-Month Moving Average: Dec @ 6.0%
2% 2% 0 0
80 83 86 89 92 95 98 01 04 07 90 92 94 96 98 00 02 04 06 08

Source: U.S. Department of Commerce, U.S. Department of Labor and Wachovia

What was especially distinctive in Georgia was the lack of a home price jump during
the 2004-2007 period. Unfortunately, home prices have dropped sharply in 2008, but
the extent of the decline may suggest less of a credit problem than Florida has
experienced.

Figure 18 Figure 19
Florida Unemployment Rate Florida Housing Permits
Seasonally Adjusted Thousands, Seasonally Adjusted Annual Rate
10% 10% 250 250
Single-Family: Dec @ 20,700
Single-Family, 12-Month Mov. Avg.: Dec @ 39,788
Multi-Family, 12-Month Mov. Avg.: Dec @ 22,855
200 200
8% 8%

150 150

6% 6%

100 100

4% 4%
50 50

Unemployment Rate: Dec @ 8.1%

12-Month Moving Average: Dec @ 5.9%
2% 2% 0 0
80 83 86 89 92 95 98 01 04 07 90 92 94 96 98 00 02 04 06 08

Source: U.S. Department of Commerce, U.S. Department of Labor and Wachovia

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Wachovia Economics Group

Diane Schumaker-Krieg Global Head of Research (704) 715-8437 diane.schumaker@wachovia.com

& Economics (212) 214-5070
John E. Silvia, Ph.D. Chief Economist (704) 374-7034 john.silvia@wachovia.com
Mark Vitner Senior Economist (704) 383-5635 mark.vitner@wachovia.com
Jay Bryson, Ph.D. Global Economist (704) 383-3518 jay.bryson@wachovia.com
Sam Bullard Economist (704) 383-7372 sam.bullard@wachovia.com
Anika Khan Economist (704) 715-0575 anika.khan@wachovia.com
Azhar Iqbal Econometrician (704) 383-6805 azhar.iqbal@wachovia.com
Adam G. York Economic Analyst (704) 715-9660 adam.york@wachovia.com
Tim Quinlan Economic Analyst (704) 374-4407 tim.quinlan@wachovia.com
Kim Whelan Economic Analyst (704) 715-8457 kim.whelan@wachovia.com
Yasmine Kamaruddin Economic Analyst (704) 374-2992 yasmine.kamaruddin@wachovia.com

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