Economic Update

1
Southwest Corporate FCU30th Annual Economic
ForumFrisco, Texas230330, Tuesday, October
16, 2007

• Economic Update
• the Effect on Your CU
• Steven W. Rick
• Senior Economist
• Credit Union National Association
• PO Box 431
• Madison, Wis. 53701, USA
• Telephone [phone] Facsimile
  608-231-4924
• E-Mail srick_at_cuna.com

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• Recent Economic Trends
• The mortgage credit crunch is spreading to the
  real economy
• The Federal Reserve is easing monetary policy
• Relative to the rest of the world. U.S. economic
  growth will slow in 2007.
• The housing market is slowing rapidly
• Falling home prices will restrain consumer
  spending
• Strong profits, high capital utilization, low
  cost of capital and need to remain competitive
  should keep business fixed investment (capital)
  spending strong but economic uncertainty may
  cause it to decline.
• A weaker dollar and strong overseas growth will
  keep export growth strong. The global trade
  imbalance correction has begun
• Rising energy prices will provide a negative real
  income effect for consumers
• The Fed is worried about sluggish growth and
  higher expected future inflation
• Households have a near zero savings rate
• Capital funds now flow from poor to rich
  countries
• Long-term Economic Trends
• Chinas entry into the global economy will have
  profound effects on inflation, wages, and
  interest rates for the next 50 years.
• World economy is becoming less dependent on U.S.
  economy
• Massive U.S. current account deficits gt question
  of Americas foreign borrowing sustainability
• Massive U.S budget deficits

3
Percent
ROA basis points
Globalization of financial markets gt ? Fed
Reserves control of iLT
4

• Economic Growth
• Point
• Economic fundamentals remain strong with high
  corporate profits, tight labor markets, strong
  income growth, low inflation and interest rates
• The lagged effect of expansionary monetary policy
  is still powering the economy.
• Falling dollar gt increase in net exports.
• The supply side tax cuts in June 2003 (lower
  marginal income tax rates, and lower dividend and
  capital gains tax rates-15,) are stimulating
  work and investment
• Profits per unit of GDP was the highest in 4
  decades because of recent restructuring and cost
  saving initiatives.
• Firms have a lot of cash but will only invest if
  expectations of economic growth are robust
• Counter Point
• The Federal Reserve has moved to a mildly
  expansionary monetary policy to calm the credit
  markets and offset a slowing economy.
• Productivity growth slowed significantly in 2006
  to 1.6
• Revenue and profit growth will slow in 2007 as
  economic activity slows. Business investment
  spending fell 2.4 in Q4 06
• Growth will be below long-term sustainable
  (potential) rates for an extended time due to
  slowing housing and manufacturing.
• Weak housing construction will shave 0.5 off GDP
  growth
• Falling home prices will decrease home equity
  borrowing and consumer spending.
• A weak auto market will encourage production cuts
• High consumer spending and low savings is
  unsustainable

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• Housing Construction
• the New Home Market
• Point
• Some regional and local real estate markets may
  see price increases around the rate of inflation
• Housing construction was recently at record
  levels.
• Potential home buyers should bargain hard.
  Sellers are reluctant to drop prices because they
  still expect prices to rise.
• Potential home sellers should cut prices now to
  avoid riding the market to the bottom.
• Counter Point
• The drivers of housing demand will remain weak in
  2007.
• It will take big price cuts and a long time to
  clear the new home inventory of 8.2 months supply
• Credit is becoming tighter for marginal borrowers
  as regulators force lenders to tighten lending
  standards.
• A greater share of mortgage loans are going bad.
• Housing starts fell 23 over the last year to
  1,331,000 annual pace, the lowest level since the
  summer of 1997
• The housing market is overbuilt
• The fall in housing demand has had a direct
  effect on economic growth by reducing residential
  construction activity
• The fall in housing demand has had an indirect
  effect on economic growth by reducing home prices
  and household wealth and therefore consumer
  spending.
• Lower housing construction will reduce
  construction employment and prices for building
  materials, appliances and home furnishings.

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Permits
Source Census Bureau, http//www.census.gov/const
/www/newresconstindex.html
Source Census Bureau, http//www.census.gov/const
/www/newressalesindex.html
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• Existing Home Market
• (state of disequilibrium)

Median Home Price ( thousands)

• ? foreclosed houses
• Expected lower future
• home prices

• Low pent up demand
• Fewer investors
• Tighter underwriting
• Higher interest rates
• Expected lower future
• home prices

S06
S07
222
Sticky prices in SR gt ? Inventory
(overhang)
Market Correction
Market bottom
211
D06
Market clears in the long run
D07
of Houses (thousands)
6,510
6,100
9
1994-2003 25 annual increase in subprime
mortgage loan originations
Source National Association of Realtors,
http//www.realtor.org/Research.nsf/Pages/EHSdata
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• The Housing Property-Price Bubble
• Has Popped
• Irrational Exuberance - Bubbles form when asset
  prices get out of line with underlying value
• House Price Rent Yr-1 Rent Yr-2
  Rent Yr-3
  (1disc rate)1 (1disc. rate)2 (1disc.
  rate)3
• Rent future rental income of landlord or
  implicit rent saved by owner-occupier
• Downside Risks for Housing
• Rising short-term market interest rates will
  increase ARM rates and dampen home sales
• The 2003-2005 home sales pace was greater than
  long-term demand because of unusually low
  interest rates and loose credit standards.
• Spent-up demand for housing will reduce home
  sales in 2006-2008
• The recent large presence of investors will make
  a price decline more likely as rising rates and
  lower probability of continued price increases
  will lower investors purchases.
• The large number of nontraditional mortgage
  holders will intensify the downside.
• Large inventory overhang will force a housing
  correction.
• Expect nominal home prices to fall another 2 in
  2007
• It may take many years for housing market prices
  to reach inflation adjusted highs.

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Income Ratios (Financial Capabilities)
3-Dimensional Mortgage Loan Underwriting
65
Total Debt Expense Gross Income
Loan Approval Zone 2005
36
35
Housing Expense Gross Income
28
Loan-to-Value Ratios (Physical Security)
Loan Approval Zone 2007
80
100
670
620
580
500
Credit Scores (Credit Characteristics)
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• Sub-prime Mortgage Lending
• Lending to those with elevated credit risk
• Weak credit history (FICO lt 620)
• Weak capacity to repay loan
• High loan-to-value mortgage (low down-payments)
• Property attributes
• gt ? delinquency rates (7) gt ? interest rates
  (350 bps)
• Natural Evolution of Credit Markets
• Pre 1980, sub-prime borrowers denied credit
• DIDMCA 1980 (eliminated usury controls on first
  mortgage interest rates gt search for profits gt
  credit scoring technology gt risk-based lending
  interest rates
• CRA 1977 (incentive to make loans to low/moderate
  income borrowers)
• FHA (liberalized mortgage guaranteeing rules for
  1st time borrowers gt ? interest rates
• Fannie Mae Freddie Mac-secondary market
  purchasers (federally mandated affordable housing
  goals)
• Credit Extension Consequences
• High risk borrowers have increased access to
  credit gt 68 homeownership rate gt positive
  externalities
• Higher delinquency rates and foreclosures gt
  bankruptcy, equity loss, neighborhood blight
• Some lenders used fraudulent, abusive, and
  predatory lending practices when cash-strapped
  low-income borrowers need financing

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• Retail and Oil Markets
• Point
• Gains in the labor market and productivity gt
  rising incomes gt strong consumer spending
• High oil prices have had little impact on core
  inflation
• High oil prices will encourage new supplies of
  conventional and non-conventional fuels in the
  long-run which will reduce oil prices.
• Counter Point
• Retail sales is growing below its long-term trend
  of 5.5, indicating weakening consumer spending.
• A negative wealth effect will lower spending
  growth in 2007.
• Consumer spending faces many constraints high
  debt burden, low savings levels, lack of pent-up
  demand, high energy prices, rising interest
  rates, and falling home prices
• High interest rates and flat home appreciation gt
  decline in HELOC gt lower spending
• Rising interest rates gt increase debt servicing
  gt lower spending
• U.S. households cannot maintain their profligate
  spending patterns.
• The debt laden consumer will reduce consumption
  spending and increase savings
• High energy prices are reducing cash for other
  purchases.
• Limited excess capacity, low oil investment,
  strong demand and OPEC production limits with
  keep oil prices relatively high for the next 2
  years

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• Employment
• Point
• Labor market slack is now gone gt increase wages
  gt increase in unit labor costs gt inflation
• Expect unit labor cost growth to remain strong in
  2007 and slow in 2008. Wage pressures will ebb
  in 2008 as productivity growth picks up. This
  will reduce inflationary pressures from the labor
  market
• The unemployment rate remains below the natural
  unemployment rate of 5 percent, according to the
  smaller sample size Household Survey.
• Counter Point
• Monthly payroll employment growth is below the
  long term trend, according to the Establishment
  Survey
• Businesses are reducing labor costs by using
  technology to increase productivity and offshore
  outsourcing
• Goods-producing jobs are being substituted with
  service-producing employment.
• Wages/earnings increased 4.9 over the last year
  reflecting the tightening labor markets. With
  inflation at 2, real wage growth is 2.9.
• The unemployment rate falls as job gains top
  150,000 a month, which is the average monthly
  increase in the workforce
• Unit labor costs increased 3.4 in 2006 and have
  been accelerating since 2002. Wages grew 4.8
  and productivity increased 1.4 in 2006

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Cyclical Unemployment
Full Employment 5
Frictional Unemployment
Structural Unemployment
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• Savings Net Worth
• Point
• The purpose of savings is to increase the
  resources available for future consumption.
• The NIPA personal savings rate does not include
  capital gains and losses on existing assets.
• Household net worth as a percent of disposable
  income grew 40 in 2006, above the 35 long-run
  average
• A 1 increase in net worth raises consumption by
  3 cents (life-cycle consumption function)
• Rising stock and home price increased consumption
  relative to current disposable income gt a lower
  savings rate
• Empirical evidence demonstrates HHs rationally
  assess future retirement needs and adjust savings
  and consumption appropriately as current asset
  values change (permanent income hypothesis/life
  cycle model)
• Counter Point
• The personal savings rate has been on a downward
  trend
• Need savings to fund the large aging
  baby-boomers unfunded liabilities (Social
  security and Medicare)
• ? Savings gt ? interest rates gt ? investment
  gt ? capital stock gt ? productivity gt ? wages
  gt ? SS tax payments
• Sub-prime borrowers increased access to credit is
  one factor pushing down the savings rate.
• Large personal savings rates adjustments gt
  short-term cyclical economic downturn.
• Low income HHs may not be saving enough for
  retirement

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1st Qtr. 2007 Household Net Worth 56.2
Trillion, 5.5 Year-Over-Year growth
Trend 4 yr moving average
Source Federal Reserve Flow of Funds B.100 R100
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• Inflation
• Point
• The August Core CPI rose 2.2 from a year ago,
  within the Federal Reserves proverbial comfort
  zone of 1.5-2.5, indicating moderating
  underlying inflation.
• A slowing economy and slower increases in housing
  costs will lower price pressures and core
  inflation in 2007.
• Contracting housing and manufacturing sectors
  will produce below-potential growth and a
  reduction in inflationary pressures.
• Forces restraining prices are efficient big box
  retailers, intense global competition and tepid
  wage growth.
• Core inflation stabilizing around 2 should
  dampen inflation expectations in 2007
• Fed inflation fighting credibility gt low
  inflation expectations
• 1-yr inflation expectations are moving down
• (Inflation expectations Treasury nominal rate
  TIPS real rate)
• 6 10-yr inflation expectations are low
• (Inflation expectations Treasury nominal rate
  TIPS real rate)
• 2.28 4.66 - 2.38
• Counter Point
• Core PCE inflation (2.2) is at the high end of
  the Federal Reserves price stability comfort
  zone (1-2).
• Large swings in energy prices have increased
  volatility in overall inflation, amid a general
  decline in the underlying rate of inflation.

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Annual Percentage Change
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Policy Response
Economic Growth Zone 3.0-3.5
(-)
(-)
Price Stability Comfort Zone (1-2)
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?
?
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• Federal Funds Futures
• 30 Day Fed Funds
• (October, 2007)
• Lifetime
• Open High Low Settle Chg High
  Low Int.
• Oct xx xx xx 95.26 xx xx
  xx xx
• Nov xx xx xx 95.42 xx xx
  xx xx
• Dec xx xx xx 95.54 xx xx
  xx xx
• Jan xx xx xx 95.60 xx xx
  xx xx
• Feb xx xx xx 95.69 xx xx
  xx xx
• Mar xx xx xx 95.72 xx xx
  xx xx
• April xx xx xx 95.74 xx xx
  xx xx
• May xx xx xx 95.79 xx xx
  xx xx
• June xx xx xx 95.78 xx xx
  xx xx
• What does it tell us about future fed funds
  interest rates?

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• Economic Environment
• Overall Economy
• Fragile economy in face of liquidity crunch.
• Unprecedented real estate deflation, will create
  a wealth effect on consumer spending.
• Strength from business investment spending and
  foreign demand.
• Recession a rising possibility, but a very
  difficult call.
• Housing and autos will be weak.
• Interest Rates
• Modest Fed Funds rate cut(s) likely in second
  half, yield curve still flat.
• If a recession, rates will fall by more, with a
  steepening yield curve.
• Credit Union Environment
• Savings growth relatively stronger than loan
  growth, compared to last few years.
• Relative shift from core to interest sensitive
  deposits.
• Changes in consumer auto buying behavior, but
  pressure from dealer incentive financing.
• Economic distress for some members.
• Growth opportunities in unsecured loans.
• Continued margin pressures.
• Some investments may need to be written down.

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• Top 14 Credit Union Responses
• Find ways to productively deploy capital.
• Faster growth, more attractive pricing.
• Modest risk increases.
• New services and outreach.
• New world of margin management, 1 no longer
  sacrosanct.
• Expense control even more important.
• Seek non-fee, non-interest income.
• Segmentation in deposits. (CD specials)
• BUT, flat yield curve wont be permanent.
• Align auto loan marketing to current car buying
  habits.
• Tighter lending at other lenders provides an
  opportunity for credit unions.
• Improve business planning consider
  demographics, new products and services,
  membership growth.
• Differentiate ourselves in how we treat
  borrowers, especially ones who might be victims
  of predatory lenders.
• Consider earlier trip wires for loss mitigation
  and default workarounds.
• Build investment ladder, consider extending
  maturities in face of falling rates.
• Conduct member research to improve member
  satisfaction.
• Consider aggressive loan recapture programs

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• CUNAs Economic and Credit Union
• 2007 2008 Forecast
• ECONOMIC FORECAST
• Relative to the rest of the world, U.S. economic
  growth will slow in 2007, below the long-term
  sustainable trend growth rate of 3.5. Rapidly
  cooling housing and manufacturing sectors and a
  negative income effect from high energy prices
  will slow the economy in 2007. Falling home
  prices will reduce consumer spending and increase
  household savings rates over the next two years.
  
• Inflation will moderate in 2008 to around 2.0.
  Rising energy prices will keep headline inflation
  in 2007 around 2.3, but will decline to 1.7 in
  2008. Core inflation (excluding food and energy
  prices) will gradually decline over the next two
  years as below potential economic growth reduce
  wage and price pressures.
• The unemployment rate will remain below the
  natural unemployment rate of 5.0 in 2007, but
  increase somewhat in 2008. Falling residential
  construction activity and durable goods
  production in 2007 will push the unemployment
  rate over 5 and ease wage pressures moving into
  2008.
• The fed funds interest rate target will fall to
  3.75 by summer 2008. Instability in the credit
  markets will spill over into the real economy
  reducing economic production and employment. The
  Federal Reserve will respond by lowering interest
  rates 1 by year-end 2007 and another 0.5 in the
  first half of 2008.
• The 10-year treasury interest rate will increase
  modestly in 2007 and 2008. A slowing economy
  and the flight to safety will keep long-term
  interest rates below 5 for the next 2 years.
  The quantity of foreign capital channeled into
  the U.S. Treasury market is the big question
  moving into 2008. If Asian central bank switch
  their foreign exchanges reserves to higher
  yielding assets, the drop in supply will put
  upward pressure on long-term interest rates.
• The Treasury yield curve will remain inverted in
  2007 but will regain a positive slope in 2008.
  Short-term rates will remain above longer-term
  interest rates for most of 2007. By 2008,
  short-term interest rates will fall creating a
  steepening of the yield curve.
• CREDIT UNION FORECAST
• Credit Union saving growth will rise in 2008 to
  9 due mainly to a slowing economy and falling
  home prices. We expect the national savings rate
  (personal savings to disposable personal income)
  to return to positive territory in the summer of
  2007 after being negative for the last two years.
  
• Credit union loan growth will slow in 2008 to
  around 5, the slowest since 1998, as a slowing
  economy, falling consumer confidence, tighter
  underwriting standards and low pent-up consumer
  demand reduce members demand for loans.
• Credit quality will deteriorate in 2007. Slower
  loan growth, loan seasoning and a slower economy
  will increase both delinquency and net loan
  charge-off ratios.
• Credit union return on assets will fall to 0.70
  in 2008. Deteriorating credit quality and slower
  loan growth will lower credit union ROA numbers
  to around 0.70. A steepening yield curve in
  2008, however, should remove some downward
  pressure on credit union net interest margins.
• Capital-to-asset ratios will decline slightly in
  2008. Capital contributions will keep pace with
  asset growth in 2007 and 2008, maintaining net
  worth ratios at current or slightly lower levels.

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System Challenges