Monetary policy.

The Federal Reserve is using all of its considerable resources to stabilize the financial system and the economy. The effective federal funds rate remains near zero, and policymakers have indicated that the funds rate will stay at zero for an "extended period." The Fed is also aggressively buying financial securities ranging from commercial paper to Treasury securities, guaranteeing troubled assets of key financial institutions, and extending credit to investors to facilitate their purchases of financial securities. The Fed's unprecedented actions appear to be working, with varying degrees of success. Efforts to revive the commercial paper market have been particularly effective as the private CP market is functioning well and Fed ownership of CP has been winding down since peaking late last year. The recent rise in long-term Treasury yields and fixed mortgage rates shows the limits of the Fed's actions, however, as investors have seemingly become more fearful of future inflation and heavy government borrowing. Inflation is, after all, a monetary phenomenon, and the Fed is printing trillions of dollars. Although inflation may very well get uncomfortably high at some point early in the next decade, it is unlikely to be the problem feared and is certainly not a reason for the Fed to hold back in its response to the current crisis. Money growth ignites inflation only if it first leads to more and less costly credit, which then fuels an economy so strong that labor markets get tight and utilization rates bump up against capacity constraints. Policymakers have time to respond before all of this transpires, as it could be years before credit flows freely again and the economy finds its way back to full employment. Also, most of the liquidity the Fed has provided so far to the financial system is very short term. The Fed is expected to begin normalizing interest rates by summer 2010. At that time, the financial crisis will have subsided and house prices and the broader economy will be stabilizing. The funds rate is expected to end 2009 at effectively zero and 2010 at closer to 1%.

Fiscal policy. The federal government's fiscal situation is rapidly deteriorating. The budget deficit, which was $475

billion in fiscal 2008, is expected to balloon to a whopping near $2 trillion in fiscal 2009 and total a cumulative $6 trillion over the next four fiscal years. This reflects the expected nearly $2.6 trillion price tag to taxpayers of the financial crisis. Of the $2.6 trillion in costs, $1.8 trillion represents the direct cost of the government response to the financial crisis. This includes nearly $800 billion for the economic stimulus package spent from fiscal 2009 to 2012, and $1 trillion for what the government is committing to support various institutions and markets less what the government will recoup in future asset sales. The commitments have quickly mounted and include such things as $700 billion for the Troubled Asset Relief Program, $400 billion for recapitalizing Fannie Mae and Freddie Mac, and over $2 trillion in Federal Reserve loans to various financial institutions. For context, the savings and loan crisis in the early 1990s directly cost taxpayers some $275 billion in today's dollars. The weaker economy, the resulting loss of tax revenues, and increased spending to support those losing their jobs and other income support programs will cost the Treasury another $800 billion. The budget outlook will remain extraordinarily daunting even after the financial crisis abates as the costs of Medicaid, Medicare and Social Security balloon. President Obama's first budget proposal does not significantly address the nation's long-term fiscal problems. The Congressional Budget Office projects that the nation's federal debt-to-GDP ratio will rise to over 80% a decade from now under the president's plan, about double the approximately 40% ratio that prevailed before the current financial crisis. This budget outlook is untenable, however, and policymakers will need to undertake various substantial changes to entitlement programs and taxes. U.S. dollar. The U.S. dollar has sagged a bit in recent weeks as the flight-to-quality bid for U.S. assets has faded with the better financial conditions and the moderating global recession. Despite the recent decline, the dollar is still up over 10% on a broad trade-weighted basis from its low about one year ago, rising most against the British pound and Canadian dollar.

The dollar is roughly appropriately valued against most of the world's major currencies, including the euro, Canadian dollar and Japanese yen. The dollar is somewhat overvalued against the British pound and significantly overvalued, by some 25%, against the Chinese yuan. Once the financial crisis subsides, the Chinese are expected to resume revaluation of their currency, eventually resulting in a freely floating yuan by the middle of the next decade. Energy prices . The price of a barrel of West Texas intermediate crude oil is trading near $70. Over the past year, prices have ranged from well below $50 per barrel at the start of 2009 to a record of almost $150 per barrel in summer 2008. Retail gasoline prices are near $2.50 per gallon, compared with an all-time high of close to $4. Natural gas prices have also fallen sharply, to well below $4 per million BTU. Global economic conditions and the subsequent impact on energy demand are driving energy prices. The recent firming in prices reflects growing expectations that the worst of the global downturn is over as the Chinese economy reaccelerates and the severity of the U.S. recession abates. Oil prices are not expected to rise above $ 75 for very long, at least not until the global recession is over late this year. However, prices are expected to move steadily higher in 2010 as global growth resumes and energy demand picks up in earnest. For all of 2009, oil prices are expected to average near $55 per barrel, and to average $75 per barrel in 2010. Early in the next decade, oil prices are expected to range between $75 and $100 per barrel, consistent with global demand and supply fundamentals and abstracting from the vagaries of the global business cycle. Natural gas prices will have trouble keeping up with oil prices over the next several years as a very substantial glut has developed. Demand has weakened sharply with the recession, and supply has increased substantially in response to previously very high prices. Natural gas prices are expected to average $4.5 per million BTU in 2009, $7 per million BTU in 2010, and closer to $9 per million BTU in the longer term. Martz Zanuli June 2009

Moody's Economy. com www.economy. com help @ economy.com Precis MACRO June 2

Fiscal stimulus . The policy response out of Washington will help end the recession late this year but could provide a boost more quickly than expected. The government's one-time payment to Social Security recipients occurred in May. This, combined with tax refunds and other fiscal stimulus, will add an estimated $22 billion, or $264 billion at an annualized rate, to household cash flow in May. The massive infrastructure spending could also kick in more quickly than expected, providing a big boost to the labor market and business investment. ' Fed policy. The Federal Reserve is fully engaged, and additional unconventional actions could stabilize financial markets, stimulate growth, and improve confidence more quickly than expected. The Fed is involved in almost all financial activities to promote the resumption of normal credit flows, and its actions may buy additional time for the economy to recover. Reduced stress in financial markets has led to a decline in demand for many of the Fed's credit facilities. This implies that banks are finding it easier to access other sources of credit, which lends some upside risk to the outlook. j. Bond market . A selloff of Treasury bonds is driving interest rates higher, threatening to unwind the improvement in financial conditions. Treasury yields have surged because of a renewed appetite for risk in an effort to find higher yields and concern that large budget deficits and expansionary monetary policy could lead to higher inflation. Treasury prices could fall further, pushing borrowing costs up, and higher mortgage rates could extend the downturn in housing. The 30-year fixed mortgage rate is expected to fall below 5% in the third quarter but unease in the bond market suggests that rates could move higher than expected. j Labor market . The forecast is for a peakto-trough decline in payroll employment of almost 8 million and for the unemployment rate to peak near 10%, but job losses could be even larger than expected. Forwardlooking labor market indicators are bad, with initial claims for unemployment insurance benefits still above 600,000. The strength of the recovery will determine how quickly the unemployment rate declines. In fact, the unemployment rate is not expected to return to its equilibrium rate of around 5% until 2013, and a weaker than expected recovery could delay this even further, creating drags on incomes and consumer spending.

j Wages. Although the pace of job losses moderated in May, the substantial deterioration in the labor market is weighing on wages more quickly than expected. The rapid rise in the unemployment rate is expected to unleash powerful disinflationary pressures over the coming quarters as a downshift in compensation causes core inflation to slow. Given a 0.7/o drop in aggregate hours worked in May, the payroll report's proxy for labor income is falling at a more than 6% annualized pace, a massive headwind for consumer spending. Businesses will need to cut far fewer jobs if labor income is to stabilize, a necessary condition for sustained economic growth as fiscal stimulus fades. ., Energy prices . Oil prices could increase more quickly than expected, putting upward pressure on headline inflation and reducing household purchasing power. The price of a barrel of West Texas intermediate crude has more than doubled since the end of 2008 and is expected to remain near $60 through the rest of 2009. However, further increases in energy prices would raise costs for gasoline and home heating oil, pulling down consumer spending on other items and weighing on sentiment. ,, Detroit 3. Disorderly bankruptcies at Chrysler and/or GM would lead to larger than expected job losses and declines in industrial production and vehicle sales. Chrysler appears to have avoided liquidation; a deal worked out with the Obama administration, Fiat, the UAW and creditors will allow the company to continue operations. In liquidation, Chrysler's factories and other operations would have closed and the company's assets sold off to pay creditors. The bankruptcies of Chrysler and GM could slow the recovery in manufacturing and add another hurdle for the labor market to overcome. .+. Lending standards . Lending standards remain extremely tight despite a massive infusion of capital from the government, which could slow the recovery in housing. Banks' unwillingness to lend except to borrowers with pristine credit is weighing on the recovery. With consumers' access to credit impaired, a significant rebound in home and auto sales is unlikely over the next few quarters. The economy will remain very vulnerable until credit flows more freely between banks and creditworthy borrowers. The forecast assumes a loosening in lending standards, but there is a possibility that this will not materialize, extending the housing downturn and recession.

j Inflation expectations . With the recession showing signs of abating, inflation expectations could increase more quickly than anticipated, complicating matters for the Fed. Market-based measures of inflation expectations have climbed steadily over the past few months, and concern is growing that the Fed's massive expansion of its balance sheet and enormous budget deficits will fuel future inflation. The increase in inflation expectations may be overdone because the sizeable output gap is expected to keep inflation low. Further increases in inflation expectations could force the Fed to tighten monetary policy with the expansion still uncertain. j Foreclosures . Rising foreclosures threaten to overwhelm the Obama administration's mortgage mitigation efforts and could delay the expansion. Without further government action, mortgage loan defaults-the first step in the foreclosure process-will reach 4 million this year, or nearly one in 12 first mortgages. The increase in foreclosures would add more inventory to an already-bloated housing market, driving prices even lower. From peak to trough, Moody's Economycom expects prices to fall almost 40%, based on the Case-Shiller Home Price Index, but surging foreclosures could magnify the decline. If house prices overshoot, falling below equilibrium levels, lenders would be forced to write down even more mortgages, and household wealth would decline further. 4. Investment . Businesses' access to credit remains impaired, which threatens to deepen the contraction in nonresidential fixed investment. The baseline forecasts calls for nonresidential fixed investment to decline into 2010, but deeper business pessimism could extend the contraction. Businesses are already slashing capital expenditure plans and liquidating inventories in an effort to better align them with final demand. j Fiscal conditions . Washington's eroding fiscal situation threatens long-term economic growth, and there is great risk that the budget deficit could be much larger than expected. The stimulus package passed earlier this year was necessary but will result in budget deficits of close to $2 trillion for the next two years. With costs for Medicare, Medicaid and Social Security set to increase substantially in coming years as the baby boomers retire, policymakers will have to make very difficult decisions about long run taxes and spending. Ryan Sweet June 2009
2009 5

Moody 's Economy . com www . economy. com help@economy. com Precis MACRO June

New-Home Inventories Are Back to Normal

600 550 500

Mortgage Refinancing Wave Is in Jeopardy

6.8 30-year fixed mortgage rpte, % (L) Source: Freddie Mac 6.4 t 6,000 5,000 8,000 7,000

450 4,000 400 3,000 350 300 250 00 01 02 03 04 05 06 07 08 09 2,000 4.8 r } 1,000 Mortgage refinancing applications, index, March 16, 1990=100 (R) Source: Mortgage Bankers Association 4.4 0 J'08 F M A M J J A S O N D J'09 F M A M J

The recession continues on, but the basis for an economic recovery is coming into place. Monetary and fiscal policies remain extraordinarily stimulatory, and progress is being made in correcting the excesses that are at the heart of the downturn. Households and businesses are rapidly deleveraging, as is the financial system. Retailers and manufacturers have been cutting inventories for the better part of the past two years. The sharp decline in house prices has restored housing affordability, and homebuilders have successfully reduced their inventories of unsold homes to where they were prior to the housing bubble. Not a V-Shaped Recovery

Even more policy action is likely necessary to ensure that the recession ends this year. Most notable is the need for more concerted action to stem surging foreclosures and shore up the still-weakening housing market. The Obama administration's foreclosure mitigation plan has yet to have a meaningful impact, and a bolder plan may be required. The Federal Reserve may also need to increase its commitment to purchasing Fannie Mae and Freddie Mac debt and the mortgages they insure and Treasury bonds. The recent rise in longterm rates is already short-circuiting the mortgage refinancing wave and threatens to undermine any housing recovery. Credit Will Not Flow Freely Any Time Soon
Net % of senior loan officers at large commercial banks willing to make a consumer loan

-80 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09

The severe recession is expected to end this year, with real GDP falling 3%, the largest annual decline since the Great Depression. The recovery expected in 2010 will be disappointingly weak, with real GDP advancing just over 1%. This stands in contrast to the much stronger recovery expected by the Obama administration's Office of Management and Budget and the Congressional Budget Office. History argues for a stronger recovery, but this is unlikely, given that the troubled housing and vehicle industries will not be able to drive growth as they have in times past. Weak credit growth due to the restructuring of the financial system will also impair recovery.

Key to the timing of the end of the recession and the character of the subsequent recovery will be how quickly credit begins to flow more normally again. The worst of the credit crunch is over, as the banking system has stabilized, credit spreads have narrowed, and some bond issuance has resumed. However, underwriting standards remain very tight across all types of lending, particularly for consumer and residential and commercial mortgage loans. When combined with weak credit demand, debt outstanding is falling sharply. A strong, self-sustaining economic expansion will not take hold until credit is expanding again.
7

Moody's Economycom www.economy.com help@economy.com Precis MACRO June 2009

Prospects are improving that the recession will be over by year's end. Real GDP which fell nearly 6% annualized in the first quarter, is on track to decline 3% in the second quarter and to see marginal gains in the second half of the year. Behind this upbeat outlook is evidence that the long-running downdraft in housing construction is winding down, consumer spending has stabilized, and government spending is picking up. All of this will be just enough to offset continued weak business investment and exports. Evidence indicating that housing starts are near bottom includes the recent firming in new-home sales and lower new-home inventories. A floor has formed under sales, as homebuilders are lowering prices more aggressively and mortgage credit is becoming a bit more ample. Tax credits in various states and a nationwide tax credit for first-time buyers included as part of the fiscal stimulus are also helping. Consumers are no longer panicked, in part because they are saving again. The personal saving rate, which was essentially zero one year ago, is now closer to 6% after accounting for various measurement issues. The saving rate will move higher, but only slowly, as lower-income households with very low saving rates are in no position to save much more in this tough economy. While this does not mean that consumer spending will ramp up any time soon given the difficult job market, it does suggest that the spending declines are over. The infrastructure outlays included as part of the fiscal stimulus will also begin to increase in earnest later this year. These dollars should more than offset the budget cuts that many state and local governments are being forced to make, at least for a while. Rate threat . The recent increase in long-term interest rates poses a new threat to optimism that the recession will be over soon. Yields on the 10-year Treasury have jumped 1 percentage point since mid-April to just below 4%, pushing the rate on a conforming 30-year fixed mortgage up to nearly 5.5%. If sustained for much longer, these higher rates would curtail the budding mortgage refinancing wave and undermine any revival in home sales. Heightened worries about future inflation and record government borrowing are driving rates up. Both concerns are over-

done, or at least premature. Given the excess capacity throughout the economy, deflation-not accelerating inflation-remains the predominant risk through this time next year. Not only is the unemployment rate approaching double digits, but office and retail space vacancy rates are rising, the capacity utilization rate in manufacturing is at a record low, rig counts in the Gulf of Mexico are off sharply, and the numbers of mothballed airplanes and cargo ships rise. Most businesses have little or no pricing power. Concerns that the massive liquidity the Federal Reserve is currently pumping into the financial system will eventually ignite runaway inflation are misplaced. Most of the Fed's credit facilities are short-term and designed to wind down as private credit markets revive. The commercial paper program policymakers established last year is a case in point. The Fed owned upward of $350 billion in commercial paper during the height of the financial panic late last year, but now owns only one-third of that, as the private commercial paper market is again operating well and rates are below what the Fed is charging. The nation does have very serious fiscal problems, but it seems premature for investors to be focused on that now. The government's unprecedented borrowing is occurring when private credit demands are extraordinarily low and personal saving has surged. As a result, global investors have not been called upon to increase their Treasury purchases. That may be the case if government borrowing does not abate when the broader economy improves and credit demands meaningfully increase, but this moment of truth is still some way off. Unless long-term rates soon give back some of their increases, the Federal Reserve will be under pressure to significantly increase its current commitment to purchase $300 billion in longer-term Treasury securities. Upping the ante to, say, $600 billion or even $1 trillion may not get yields back down, but it is worth the effort, given the threat that higher rates pose to the struggling economy. , V U or ...? Despite the threats, the end of the recession is close enough in view that it is reasonable to consider the character of the subsequent economic recovery. History would suggest a strong recovery is in the offing, as the one and only regularity of business

cycles is that strong recoveries (V-shaped) follow severe downturns and shallow recoveries (U-shaped) follow shallow downturns. Unfortunately, history is not expected to be a prologue, as this is likely to be a U-shaped recovery. V-shaped cycles have always been powered by the interest ratesensitive housing and vehicle industries. While homebuilding and vehicle sales will increase from their current record lows in coming months, the gains will be limited until most of the excess existing housing inventory is sold off and the ample amount of spent-up vehicle demand is worked off. The problems in the banking system and credit markets will also take time to resolve, suggesting that the credit crunch will lift only slowly. Given these headwinds, economic growth will not be in full swing until early in the next decade. While less likely, it is too early to rule out an L-shaped business cycle, in which the severe recession is followed by an extended period of halting growth, or even a W-shaped cycle, in which the economy slides back into recession after a brief recovery. A more prolonged financial crisis than anticipated could result in an L-shaped cycle, much like the one that plagued Japan in the 1990s after its banking debacle. A W-shaped cycle could occur if policymakers do not soon credibly address the nation's daunting long-term fiscal challenges, leading global investors to flee U.S. assets, sending the dollar crashing and inflation and interest rates soaring. Outlook . In the baseline, most likely, U-shaped economic outlook, real GDP is projected to decline 3% this year, increase by a disappointing 1.2% in 2010, and grow by 4.4% in 2011. Employment is expected to fall by 8 million jobs peak to trough, and the unemployment rate will peak near 10% in early 2010 . The economy does not return to full employment until late 2013. The risks to this baseline outlook have become more balanced in recent months but remain somewhat skewed to the downside. Given that the baseline outlook represents about 50% of the distribution of possible economic outcomes , there is a 30% probability that the outlook is measurably worse than the baseline (L- or W- shaped) and a 20% probability that it is better (V-shaped). Mark Zandi

June 2009

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Recent Performance . The good news is that with each passing month, evidence that the housing market is at or near bottom is strengthening. The bad news is that there is no sign that housing will turn around soon. Topline indicators of housing such as home sales and housing starts have been bouncing along a bottom since the end of last year The April data were no different, with sales of existing homes rising slightly, new-home sales flat, and housing starts-omitting the volatile multifamily sector-up slightly. On the policy side, a new HUD rule will mildly boost home sales; it allows first-time homebuyers to use their $8,000 tax credit to reduce their mortgage balance in excess of the required 3.5% down payment on an FHA loan. Homebuilders were hoping that the tax credit could be applied directly to the 3.5% down payment. Despite the hopeful signs, one key indicator of the health of the housing market-house prices-continues to descend, at least by the most reliable indicator, the Case-Shiller Home Price Index. Foreclosures are depressing house prices, and the foreclosure rate is up again, as Fannie Mae, Freddie Mac, and several large mortgage lenders ended their foreclosure moratoriums in the spring. Diverging prices . The three most often cited measures of house prices are diverging. The Federal Housing Finance Administration's purchase-only index and the Realtors' median existing single-family sale price have both been about flat since the end of last year, while the S&P/Case-Shiller 20-city index continues to decline. The rate of decline in the S&P/CS index is not worsening, but it remains substantial at about 2% per month, a pace it has maintained since last September. Since peaking in early 2006, the index has declined by 31%, compared with 11% for the FHFA index and 24% for the median price. Although the S&P/ CS 20-city index is based on a small sample of metro areas, its growth rate has closely matched that of the more geographically inclusive CaseShiller national index since that measure's peak in 2006. Thus, trends in the 20-city index should be comparable to the U.S. FHFA index and the median price. There are several reasons behind the widening gap between the S&P/CS index and the other two house price measures. The NAR median house price reflects only realtor sales, and currently, many foreclosure sales are accomplished without the aid of a real estate agent.
36 Moody's

RealtyTrac, for example, reports that 70% of real estate-owned properties in its database are not currently listed with a realtor. Nonrealtor sales are included in the S&P/CS index. Foreclosure sales typically are for lower prices than for normal home sales, thus omission of foreclosure sales would bias up the median price. Foreclosed homes often go for a low price because their holders, such as mortgage lenders, are eager to get these houses off their books and are therefore more likely to discount the sale price. Additionally, foreclosed homes are often ill-maintained or damaged, reducing their selling prices. Another reason for the gap between the S&P/CS index and the median price is a shift in the mix of homes sold. As mortgage credit problems infect the alt-A and prime mortgage markets, more owners of larger, more expensive homes are selling, thus skewing up the median price. While the FHFA index does not have the mix problem and includes foreclosure sales, it only includes foreclosed homes purchased with a government-sponsored enterprise owned or securitized mortgage. A number of foreclosed houses, particularly less expensive ones, are likely being purchased with cash. Furth er; the growing share of the GSEs in the mortgage market is probably muddling appreciation in the FHFA price index. Many homes now being purchased using conforming mortgages were previously bought at the height of the market with subprime, nonconforming mortgages. Because the FHFA index only includes homes bought with a conforming mortgage, it likely underestimated the runup in the price of homes during the first half of the decade and is now underestimating the more recent price decline. Foreclosures . Foreclosures also have a neighborhood effect on house prices that is evident in all of the price measures, as foreclosed properties drive down prices of nearby homes that are not distressed. Foreclosures add to the inventory of available homes, in turn depressing prices. Additionally, the'stigma of being next door to a foreclosed property will make a home less desirable. A recent study by the FHFA of California indicates that even when omitting foreclosed properties, the FHFA index has declined by a still-substantial 36% from the peak of the market to the first quarter of 2009, compared with a 41% decline when including foreclosed properties. The continued rise in foreclosures points to further declines in house prices, despite the firming in the FHFA and median prices. If the

housing market is to stabilize this year it is essential that loan modifications proceed at a faster pace to limit foreclosures. Falling home prices result in more households owing more on their mortgage than the home is worth; being "underwater" increases the risk of falling into foreclosure and makes it more difficult to modify the mortgage. Outlook The housing market will remain exceptionally weak this year although the free fall has ended. Home sales are firming, although much of the improvement is due to sales of distressed properties. By year's end, sales will likely inch up to a pace comparable to that of the late 1990s. Low mortgage rates, stabilizing consumer confidence, and low house prices will help place a floor under demand for housing. Residential construction is also finding a bottom, but given the large overhang of distressed homes and the tough financing environment, it is expected to crawl at a pace near its current record low until 2011. House prices will be one of the last indicators of housing to recover. Prices will fall until the beginning of next year, with a peak-to-trough decline of 38% for the Case-Shiller Home Price Index. Although the Obama administration's Homeowner Affordability and Stability Plan will help limit foreclosures, rising negative equity and increasing job losses will make it impossible to halt the tidal wave this year, placing downward pressure on house prices. Risks . Although the outlook is firming around a bottom for housing, risks remain on the downside. Moreover, the longer it takes to ramp up the mortgage modification portion of the HASP the worse the downside risks for housing and for the broader economy become. A key to the current outlook is that policy measures significantly reduce foreclosures. While the HASP will not prevent foreclosures from increasing this yeah under the baseline scenario, it will help modify some 1.5 million to 2 million loans. The slow start to the modifications, however threatens this assumption, as the continued descent in house prices will erode home equity and render fewer borrowers eligible for these programs. Other risks include the possibility that the job market recovers more slowly than expected, that consumer confidence may be too fragile to encourage potential homebuyers to step back into the market, and that lenders remain reticent to underwrite mortgages to all but the best credit risks. Celia Chen June 2009

Economy . com www . economy . com help @ economy. com Precis MACRO June 2009

INDUSTRY VIEW

4 Wr

Foreclosures Rise Again

10 % of mortgages outstanding Source: Mortgage Bankers Association 1.4 1.2 1.0

Job Losses , High Obligations Drive Foreclosures

Unemployment/loss of income Illness/death in family Excessive obligation Marital difficulties

9+ 8+

0.8 7t 0.6 6t 0.4 0.2 0.0 98 99 00 01 02 03 04 05 06 07 08 09 0 10 20 30 40 50

Other Property problerrVcasualty loss Inability to sell or rent property

5+

Employment transfer/military service Extreme hardship

I I I Main reason for delinquency among prime borrowers, % Source: Freddie Mac

Foreclosures continue to plague the housing market. According to the Mortgage Bankers Association, foreclosures started as a share of total mortgages outstanding increased again in the first quarter of 2009 to a new high of 1.34%; this follows a slight decline at the end of last year. Behind the most recent increase in the foreclosure rate is the end of the moratoriums that Fannie Mae, Freddie Mac and several large mortgage banks implemented. Foreclosures will climb higher in the coming quarters, even though loan modifications are stepping up under the Obama administration's Homeowner Affordability and Stability Plan. Foreclosures Are Supporting Sales
120
s Normal I] Short sales Foreclosure sales

Two of the main forces driving homeowners into mortgage delinquency are related to economic conditions. About 43% of those surveyed by Freddie Mac cite a job or income loss as the main cause of delinquency. Job losses are expected to continue through the end of this year, pushing delinquencies up even further. Excessive obligation-that is, being highly indebted-is another leading cause of delinquency. The share of delinquent borrowers citing excessive obligations has risen measurably since 2001-2005, as the lending binge earlier in the decade is now weighing on consumers.

Excess Inventories Regionally Concentrated

Difference between 2008 vacancy rate and average rate, percentage points Sources: Census Bureau, Moody's Economy.com

100

80

60

40

20 Share of existing-home sales by type of sale, % Source: National Association of Realtors

0 0'08 N D J'09 F M

U >1.8

u 0.4to0.8

0.8 to 1.80<0.4

Sales of distressed homes are growing steadily as a share of total existing-home sales. According to the National Association of Realtors, just over 50% of homes sold in March were either short sales, in which the sale price is below the amount outstanding on the mortgage, or foreclosure sales. This share likely understates the true depth of the problem, however, since the statistics represent only sales that are listed through a real estate agent, and large numbers of distressed homes are being sold without the use of an agent. Distressed sales are elevating inventories and pushing down house prices and will continue to do so until early next year.

Foreclosures are keeping inventories high despite drastic construction cuts by homebuilders. Nonetheless, excess inventories are concentrated regionally. As measured by the difference between the current homeowner vacancy rate and its historic average, states such as California, Arizona, Nevada, Michigan and Florida have large inventory overhangs, and homebuilding will remain depressed in these states. At the other end of the spectrum, Texas, Oklahoma and other states with commodity-based economies are better balanced. In these areas, there is the potential for an increase in residential construction in the second half of this year.
2009 37

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Recent Performance . With no meeting of the Federal Open Market Committee in May, purchases of government securities, management of the Fed balance sheet, and rhetoric in response to movements in the bond market defined the performance of the central bank during the month. The FOMC is keeping the federal funds rate between zero and 0.25%, while the bank's balance sheet remains in the $2.07 trillion to $2.16 trillion range. Fed attempts to manage the yield curve suffered a modest setback in the intermeeting period. Concerns over inflation and the exploding federal deficit were the primary reasons behind the sharp steepening in the yield curve. The spread between yields on 10-year and two-year Treasuries increased to 279 basis points, after averaging 214 basis points since the March 18 quantitative easing announcement. Yields on the 10-year moved from 3.2% in early May to 3.9% by early June. Mortgage rates also trended higher, with the 30-year fixed rate rising from 4.8% to 5.3%. If sustained, rising rates will restrain refinancing activity in the housing sector and discourage the rebuilding of inventories by firms which will short circuit any prospective economic recovery. Although some high-frequency economic indicators suggest that the economy has bottomed out, it is premature to declare that a recovery has begun. The labor market remains weak, and the unemployment rate will move up well after the start of the expansion. This will constrain any inclination by the Fed to embark on an early rate hike campaign. Moody's Economy.com expects that the Fed will begin tightening rates in the middle of 2010. Policy actions . The Federal Reserve's balance sheet contracted by 4% in May and stands below the peak of $2.3 trillion recorded in December. Holdings of government securities breached the $1 trillion mark the week ending May 8, and stood at $1.1 trillion as of May 29. Demand for emergency liquidity via the Primary Dealer Credit Facility, discount window and currency swaps with foreign central banks all declined sharply over the past month. The Fed's purchases of government securities are on pace to exhaust the $300 billion committed by the central bank to target longer-dated maturities well in advance of its self-imposed autumn deadline. Thus
38

far, the Fed has purchased $145 billion in Treasuries in total, with roughly one-third of those targeting the critical seven-year to 10-year area. During the April 28-29 FOMC meeting, there was discussion of expanding the outright purchases of securities above the $1.75 trillion that was authorized at the March 18 meeting. However, considering spreads on agency paper have been compressed to remarkably low levels, any prospective increase in purchasing will almost certainly have to be targeted toward the purchase of government securities. The Federal Reserve Board announced that starting in July, certain high-quality commercial mortgage-backed securities issued before January 1, 2009 will become eligible collateral under the Term Asset-Backed Securities Loan Facility. Participation in the TALF has increased marginally, but the $27.5 billion in outstanding loans remains well short of the Fed goal of allocating $1 trillion in credit in 2009. Private sector actors are hesitant to participate in the TALF due to concerns that profits may be subject to ex-post lawmaking by Congress. The TALF is critical to restarting the trillion dollar asset-backed securities market and increasing the overall flow of credit while the private financial system recapitalizes itself. Listening to the Fed . The Federal Reserve was clearly caught off guard by the steepening yield curve during the intermeeting period. Central bank attempts to reframe the shifting yield curve as a function of positive developments in the economy met with mixed success. The fixed-income community sought to test the resolve of monetary authorities by pushing up the spread between 10-year and two-year yields to intraday record levels in the hours preceding the Fed's outright purchase of Treasury coupons. Indeed, these concerns were foreshadowed by Dallas Fed President Fisher who earlier in May stated that the looming challenge for the Fed is to reassure financial markets that the monetary authority is not going to become the "handmaiden" to fiscal profligacy. The Fed has attempted to communicate to markets in recent weeks that it intends to support the functioning of private financial markets without monetizing the federal deficit. Fed Chairman Bernanke pointed out the need to control federal spending, and Kansas City Fed President Hoenig suggested that higher yields

are a signal that the Fed should begin to bring monetary policy into better balance due to market concerns over inflation. Outlook . The Federal Reserve has committed to keeping the federal funds rate at the zero bound for an extended period. Ahead of the June 23-24 FOMC meeting, Fed speakers will be sure to address Treasury yields in general and rising mortgage rates in particular. The Fed has explicitly targeted the 30-year fixed rate to mend the housing market. The central bank will be reluctant to give up hardearned terrain to a trigger-happy bond market. The FOMC may choose to use the upcoming monetary policy statement to outline an increase in its commitment to purchase government securities and suggest a willingness to hold these securities to maturity. The central bank will support financial markets through at least the end of 2010. The Fed will seek to slowly withdraw from financial markets by selling some assets outright or on a temporary basis through reverse-repurchase transactions. They may also choose to draw down holdings slowly while raising the federal funds rate, using the rate paid on excess reserves held at the Federal Reserve to establish an effective floor on the policy rate. Core measures of inflation remain within the implied target of the monetary authority. Headline inflation will fall in the near term due to the impact of past declines in commodity and energy prices. Some disinflation is moving through the system, but the effective integration of monetary and fiscal policy should work to reduce the risk of an extended bout of deflation. Risks . Risks to the monetary outlook are twofold. First, market or political pressure to prematurely withdraw from financial markets could short-circuit a potential recovery. Second, over the longer term, the integration of monetary and fiscal policy will create the conditions for higher inflation, should the central bank not withdraw from financial markets at the proper time. Once recovery is identified as sustainable, inflation risks may increase due to potential interference from the administration or lack of political support for the central bank from Congress. The Federal Reserve will need to carefully navigate these potent cross currents as it seeks to mend financial markets and support the economy. Joseph Brtisuelas

Jtuie 2009

Moody 's Economy.com www . economy . com help @ economy. com Precis MACRO June 2009

Yield Curve Steepens Over Inflation Fears

2.8 Yield spread, 10-year Treasury over 2-year Treasury, ppt. 2.6

Securities Purchases Intensify on Fed Balance Sheet

2,500 ^ Federal Reserve assets, $ bil Others s Swap lines s PDCF s Term auction facility o Discount window
O Repurchase agreements O TSLF

2,000 t 2.4 2.2 2.0 1.8 500 + 1.6

1.4

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s Securities lent to dealers O Securities held outright 1,000

J'09

0 J'08 F M A M J J A S O N D J'09 F M A M

Anxiety over the U.S. fiscal position and the Federal Reserve's quantitative easing program has led to a sharp steepening in the yield curve. The difference between 10-year and two-year Treasury yields widened to 275 basis points in early June but has since narrowed to about 250 basis points, well above the 214-point average since the March 18 FOMC statement. The 10-year yield has traded in a range between 3.5% and 3.75% over the past few weeks, well above the 3% implied target range assumed by the fixed income community. The 30-year fixed mortgage rate, which is sensitive to movements in the 10-year yield, briefly moved to 5.3% but has subsequently fallen back to below 5%. Strong Money Demand Requires Increase in Money Supply
15

The purchase of government securities dominates the expansion of the Federal Reserve's balance sheet. Securities held outright increased to $1.107 trillion for the week ending May 29. The Primary Dealer Credit Facility saw zero demand for the third consecutive week, and the Federal Reserve, in conjunction with its foreign counterparts, reduced currency swaps to $181 billion, down from $682 billion in December 2008. At the April 23-24 FOMC meeting, participants discussed increasing the $300 billion committed to purchase long-dated U.S. Treasuries. Given the ongoing turmoil in the bond market, the FOMC may choose to increase its commitment to purchase longer-dated government securities. Rising Unemployment Rate Suggests Fed on Hold for a While

10

-5

-10

HHHHHHHHHHH 65 69 73 77 81 85 89 93 97 01 05 09

-3 00 01 02 03 04 05 06 07 08 09

The broad money supply, both nominal and adjusted for inflation using the CPI, is expanding at a swift pace. Although there has been some perceptible improvement in the economy, the pace at which money circulates through the economy, or the velocity of money, continues to fall. Without the increase in the money supply, real economic activity would be far weaker than it is now. Due to job losses and a rising unemployment rate, the monetary supply will continue to expand in the near term. The challenge for the Fed will be to anticipate when the demand for money begins to ease and to start restraining growth in M2 to prevent an outsized increase in inflation.

Fixed-income players will test the Fed's resolve. In past recessions, the central bank has been reluctant to withdraw liquidity from the economy until it is certain that the unemployment rate has crested. Moody's Economy.com does not expect the Federal Reserve to raise policy rates until the second half of 2010. The Fed balance sheet has fallen by 4% as demand for emergency liquidity has faded and the banking system remains capital constrained. With the economy still contracting, the central bank is likely to further increase the size of its balance sheet and reduce the real federal funds rate, making monetary policy much more accommodative, before entertaining any serious discussion of higher rates.

Moody's Economy.com www.economy.com help@economy.com Precis MACRO June 2009 39

Recent Performance . The federal budget deficit continues to widen in response to the financial crisis and recession and is running far ahead of last year's record pace. The deficit through the first eight months of fiscal 2009 was more than three times larger than at the same point in fiscal 2008. Revenues were down 18%, while outlays were up 19%. The on-budget deficit, excluding Social Security and the Postal Service, was up more than 200% on a year-ago basis in the first eight months of fiscal 2009. The federal government recently announced a change in its accounting for capital injections into banks and automakers as part of the Troubled Asset Relief Program. The government is now measuring these purchases on a net present value basis, offsetting the cost with future expected returns. Previously, the government was simply counting the entire capital injection as an outlay, with no adjustment for expected returns. The impact is to reduce measured spending on the TARP and lower the budget deficit. Deficit concerns . Concern about the federal government's long-run budget picture has intensified recently, with negative ramifications for the economy. With the economy showing signs of stabilization, investors are now looking at what happens after the recovery begins. The combination of large budget deficits, very expansionary fiscal policy, and a return to economic growth has raised concerns about inflation. There is also worry that the federal government will deliberately use a policy of high inflation to monetize the debt that it is now taking on. As a result, forward-looking measures of inflation, based on differences in yields between nominal and inflation-indexed Treasury securities, have moved much higher over the past couple of months. With inflation fears rising, investors are demanding higher yields on longer-term Treasuries to compensate for the perceived risk. The yield on the 10-year Treasury has gone up from 2.2% in January to almost 4% in early June. Although spreads over Treasuries have been declining, the net impact has been to push various long-term interest rates higher, especially 30-year fixed mortgage rates. Higher mortgage rates could end the nascent stabilization in the housing market, and higher rates more generally would threaten the economic recovery. Some of these fears are likely overdone. The economy remains very weak, with a great deal of slack in labor and product markets, making it

difficult for workers to earn wage increases and for firms to raise prices. Still, with higher rates threatening the expansion, the Obama administration is talking up longer-run efforts to reduce the budget deficit once the current crisis passes. Healthcare . President Obama is moving ahead with efforts to expand health insurance coverage. He has called for Congress to pass a bill sometime this year and has included some of the hundreds of billions of dollars needed to expand coverage in his proposed budget for fiscal 2010. Many of the most basic details still need to be resolved. Perhaps the top issue is whether the federal government will require individuals to purchase health insurance. During the presidential campaign, Obama opposed such a mandate, but he is now considering it. Lowincome Americans would presumably receive some sort of federal government subsidy to purchase health insurance. Another key unresolved issue is who would offer health insurance. Most politicians favor keeping the current system of employer-provided coverage in place. In addition, President Obama is pushing for a government-sponsored health insurance plan. He maintains that such a plan would guarantee more competition in the health insurance marketplace, helping keep premiums low. Opponents argue that a government plan would end up taking over the market and eventually lead to a government-controlled healthcare system. Private insurers are strongly opposed to a government-run program. As a fallback position, congressional leaders and the administration are looking at nonprofit cooperatives that would provide health insurance. Also still unresolved is how to pay for expanded health insurance coverage. The Obama administration has called for rolling back the personal income tax cuts enacted under President Bush for wealthy households and using the money to pay for health insurance. This would cover some, but not all, of the cost. It also means that the money would not be available for deficit reduction. The administration argues that health insurance changes are key to reducing longrun spending on healthcare. Budget director Peter Orszag has made the point that federal spending on Medicare and Medicaid is expected to see enormous growth as the baby boomers age, putting tremendous pressure on the federal budget. He argues that substantive healthcare changes would lead to greater ef-

ficiencies and result in lower federal spending on these programs, even with expanded coverage, reducing long-run budget deficits. However, the Congressional Budget Office has been unwilling to adopt this view and thus is likely to score healthcare proposals as adding to the budget deficit, making it more difficult to get them through Congress. Outlook . With the combination of the recession, stimulus, TARP and additional aid for the financial system, the federal government will run enormous budget deficits of close to $2 trillion over the next few fiscal years. This compares with a deficit of $459 billion in fiscal 2008, the largest ever in nominal dollars. These deficits will be about 12% of GDP the largest as a share of the economy in the postWorld War II era. The deficit will shrink for a few years as economic growth picks up and the direct impact of the financial crisis fades from the budget. However, over the longer run, given current trends and higher interest payments as a result of the debt that the federal government is taking on to battle the downturn, there is a structural imbalance between taxes and spending. Greater federal spending on retirement programs as the baby boomers age, particularly for healthcare, will lead to consistent budget deficits of close to 4% of GDP absent a dramatic reorientation in fiscal policy. Risks . There are signs of stabilization in the economy, but if the financial crisis heats up again and the recession is longer and more severe than expected, the budget deficit would widen further because of a large decline in revenues and stronger growth in spending on social programs. Congress would also be more likely to implement even more fiscal stimulus or another financial relief plan, further boosting the near-term deficit. President Obama is more likely to raise taxes than President Bush, at least for highincome earners. This would reduce the deficit, although any tax increases would not come until the recession is over. However, he could also push for more spending, especially as part of efforts to expand health insurance coverage. There is talk that the president and Congress could reach a "grand bargain," designed to reduce long-term spending on retirement programs in exchange for higher taxes. Such a deal could dramatically lower long-term budget deficits. Augustine Faucher June 2009

40 Moody's Economy.com www.economy.com help@economy.com Precis MACRO June 2009

Social Security Deficits Will Start Soon 18 Social Security program, % of taxable pay roll 17 16 Costs 15
14 13 12 11
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Medicare Is Already Running Deficits...

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The Trustees of the Social Security and Medicare programs-the secretaries of the Treasury, Labor and HHS and the Social Security commissioner-recently released their annual reports on the programs' financial status. Right now, the Social Security program is running a surplus, with revenues-including interest on money the Social Security Trust Fund loans to the Treasury Department to finance the rest of the budget deficit-exceeding outlays. However, the program will start to run deficits in the middle of the next decade, as the baby boomers retire and smaller cohorts replace them in the labor force. By 2037, Social Security will be unable to pay all of its promised benefits. ...And Is the Real Long-Run Problem
12 11

The problems for Medicare are more immediate. The Hospital Insurance Trust Fund, which covers inpatient Medicare expenses, ran a deficit in 2008. Income to the HI program, including payroll tax revenues and interest on the trust fund, exceeded outlays last year, and deficits will continue. The HI Trust Fund is projected to be exhausted in 2017, when it will be unable to pay full benefits; this is two years earlier than in last year's report. The Supplementary Medical Insurance component of Medicare, which covers outpatient physician bills and prescription drug coverage, is funded from general revenues and premiums and has no long-term trust fund. Real Defense Spending Still Growing

Federal defense spending, 12 mo. MA, % change year ago -5 10F 20F 30F 40F 50F 60F 70F 80F 00 ,
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Although the political debate over entitlement programs generally focuses on Social Security, Medicare faces more severe longterm problems. Medicare faces the same demographic crunch as Social Security from the retirement of the baby boomers, but new technologies and healthcare inflation will also result in very strong growth in per-beneficiary costs. Total Medicare spending, including both HI and SMI, is projected to exceed Social Security spending in about 20 years and to increase rapidly as a share of GDP throughout the trustees' 75-year projection period. Social Security spending is expected to see a slight decline as a share of GDP once all of the baby boomers retire.

Defense spending growth slowed in 2004 after the initial invasion of Iraq, although it continued to increase strongly. Growth reaccelerated in 2007 as the U.S. undertook the "surge" in Iraq. With relative calm now in that country, nominal defense spending growth is slowing once again. Taking into account very low inflation, however, defense spending is increasing in real terms, up about 7% over the past year. Real defense spending growth is likely to accelerate even further in the near term as the U.S. focuses more attention on Afghanistan and brings some troops home from Iraq; the costs of redeployment will add to spending in the short run.

Moody's Economycom www.economy.com help@economy.com Precis MACRO June 2009 41