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September 2008 Ethan Harris An “L”-Shaped Recovery Confidential Presentation.

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Presentation on theme: "September 2008 Ethan Harris An “L”-Shaped Recovery Confidential Presentation."— Presentation transcript:

1 September 2008 Ethan Harris An “L”-Shaped Recovery Confidential Presentation

2 Us and Them Lehman Brothers forecast and consensus 1

3 Triple Threat  Housing hiatus  Credit crunch  Commodity costs …but some positive offsets… 2

4 m saar ________________ Source: Census Bureau, Lehman Brothers Global Economics. Note: Starts only include single family built for sale. Forecast Housing Hiatus – A Mountain of Inventory New single family home sales, starts and inventory 3

5 ________________ Source: Commerce Department, Lehman Brothers Global Economics. Housing Hiatus – Construction Correction Real residential investment (% q-o-q ar) (0) 4

6 Housing Hiatus – Falling Behind Mortgage delinquencies and foreclosure starts Delinquencies by sectorForeclosures started by quarter % total of loans ________________ Source: MBA 5

7 Housing Hiatus – Foreclosure Frenzy Single family foreclosed homes Foreclosures, millions of homes, arForeclosures, % of existing home sales ________________ Source: Lehman Brothers Mortgage Research, Lehman Brothers Economics Forecasts 6

8 ________________ Source: National Association of Realtors, Census Bureau, Lehman Brothers. Housing Hiatus – Imbalance Total home sales and inventories (million units, saar) 7

9 ________________ Source: OFHEO, S&P / Case-Shiller, and Lehman Brothers Global Economics. Housing Hiatus – Unstuck Prices National home prices (% y-o-y) Forecast 8

10 ________________ Source: Federal Reserve Flow of Funds, Commerce Dept, Lehman Brothers; Note: Housing wealth effect assumes consumers spend 6¢ for every additional dollar of housing wealth over a two year adjustment period. Stock market wealth effect assumes consumer spend 4¢ for every additional dollar of equity wealth over a three year adjustment period (assuming no change in equities from now through year-end and 8% average increase next year). Forecast Consumption – Collateral Damage Wealth effect on consumption growth (%q-o-q ar) 9

11 ________________ Source: Lehman Brothers Global Economics. Consumption – Record Rebates Comparison of rebate plans Total Amount ($bn)% GDP Tax Reduction Act of 197580.5 Economic Growth and Tax Relief Reconciliation Act of 2001 360.4 Jobs and Growth and Tax Relief Reconciliation Act of 2003 140.1 The Economic Stimulus Act of 2008106.70.8 10

12 Forecast ________________ Source: Commerce Department and Lehman Brothers Global Economics; Note: Assumes rebates received over ten week period starting in late May. Consumption – A Shot of Caffeine Disposable personal income ($bn) 11

13 ________________ Source: BEA and Lehman Brothers Global Economics. Forecast Consumption – Choppy Fade Real consumption expenditures (%) 12

14 Credit Crunch – Clogged Transmission ________________ Source: FBNY Economic Policy Review / May 2002. Fed funds rate Open market operations Reserves Monetary base Money supply Market interest rates Exchange rate Real rates Asset price levels Loan supply Infl. exp. Collateral Relative asset prices Aggregate demand 13

15 ________________ Source: Bloomberg, Markit, Lehman Brothers. Credit Crunch – Tight Financial Conditions Financial conditions 9/8/083/14/084Q073Q072Q071Q07 Core Markets 2-year Treasury Yield2.24%1.423.073.964.884.57 10-year Treasury Yield3.66%3.424.034.585.034.64 30-year Jumbo Mtg. Rate7.13%7.056.716.926.536.06 S&P 5001,2421,2881,4681,5271,5031,421 Money Market Fed Funds Rate2.00% 3-month LIBOR2.81%2.764.705.235.365.35 Spread to Expected FF80bp8367 1211 3-month TED Spread114bp1541351516440 Credit Spreads Investment Grade Corp.312bp2931981459792 CDX.IG151bp19077554139 High Yield Corp.818bp806569405292275 CDX.HY698bp771494403340293 LCDX (Loans)399bp473310208181– AAA ABX (Subprime)1105bp86448310819 AAA CMBX (CMBS)173bp263651877 14

16 Credit Crunch – Tighter Bank Lending Standards ________________ Source: Federal Reserve; Note: only prime loans included in residential mortgages from April 2007-Present. Net percent of banks reporting tighter lending standards (%) 15

17 Credit Crunch – Lagged Restraint Growth in credit card debt and credit standards %y-o-yNet % reporting tighter standards ________________ Source: Federal Reserve. 16

18 Credit Crunch – Hard to Quantify Impact of credit shock on 4-quarter GDP growth (%y-o-y) Quarters ________________ Source: Lehman Brothers Global Economics; Note: Recreation of VAR model in IMF’s April 2008 Global Financial Stability Report; “Crunch” and “Squeeze” scenarios assume borrowing growth falls to 1% and 4% of outstanding private sector credit, respectively; For model details see The Missing Link, 2 May 2008. 17

19 ________________ Source: Commerce Department and Lehman Brothers Global Economics. Forecast Positive Offsets – Modest Investment Decline Business fixed investment (% q-o-q ar) 18

20 Commodity Shock – The Income Squeeze CPI inflation and average hourly earnings (%y-o-y) ________________ Source: Bureau of Labor Statistics. 19

21 Commodity Shock – Crushing Confidence Consumer confidence (Index) ________________ Source: University of Michigan. Note: Shaded areas denote NBER recessions. 20

22 ________________ Source: Bureau of Labor Statistics, Commerce Dept. Note: Shaded areas denote NBER recessions. Forecast Positive Offsets – Lean and Mean Corporations Non-farm payrolls and business fixed investment (% y-o-y) 21

23 ________________ Source: BLS and Lehman Brothers Global Economics. Forecast Positive Offsets – Modest Job Cuts Non-farm payroll employment (change, ’000) 22

24 Growth – Major Economies Growth is set to slow across the board ________________ Source: Lehman Brothers Global Economics. 23

25 ________________ Source: Commerce Department and Lehman Brothers Global Economics. Forecast Positive Offsets – Trade Turn Net exports contribution to GDP growth (percentage points) 24

26 ________________ Source: Commerce Department and Lehman Brothers. GDP Components (%Q4/Q4)2006200720082009 Home Construction-7.1-17.9-20.5-6.9Four years of recession Private Consumption3. slowdown Business Investment7.54.93.4-1.8Reluctant fade Government Expenditures1. states Exports9. global economy Imports6.02.2-2.20.1Consumer slowdown GDP2. Growth – Adding It Up 25

27  Case for higher inflation –Tight commodity markets –Rising import prices  Case for lower inflation –Below potential growth –Weak consumer spending –Softer labor market –Rent relief Inflation – High Now, Low Later 26

28 ________________ Source: Institute of Supply Management. Inflation – Tight Commodity Markets ISM prices paid (Index) 27

29 ________________ Source: Federal Reserve, Bureau of Labor Statistics. Inflation – Import Competition Cools Consumer Goods Import Prices and Broad Dollar Index %y-o-y Index, Jan 1997 = 100 28

30 ________________ Sources: Commerce Department, CBO, and Lehman Brothers Global Economics. Note: Congressional Budget Office (CBO) estimate of potential real GDP growth. Potential Inflation – Below Potential GDP Actual and potential GDP growth (% q-o-q ar) 29

31 ________________ Source: Bureau of Labor Statistics and Lehman Brothers. Note: Inflation threshold (or “NAIRU”) is based on regression of change in core CPI inflation on the lagged unemployment rate for the 1990–2006 period. Inflation – Softer Labor Market Unemployment rate and NAIRU (%) 30

32 ________________ Source: Bureau of Labor Statistics. Inflation – Rent Relief Rent and owner equivalent rent (OER) inflation (%y-o-y) 31

33 ________________ Source: BLS. Note: Shaded areas denote NBER recessions. Inflation – Recessions Kill Inflation Core CPI inflation and recessions (%y-o-y) 32

34 Inflation – Oil’s Overshooting West Texas Intermediate crude oil ($/bl) ________________ Source: Federal Reserve Bank of Saint Louis. 33

35 ________________ Source: Bureau of Labor Statistics. Inflation – Peaking Now CPI inflation (%y-oy) Forecast Using oil futures Headline CPI Core CPI 34

36 ________________ Source: Federal Reserve and Lehman Brothers. Note: Market expectations derived Fed funds and Eurodollar futures on August 11. Fed – Back to Square One Federal funds rate (%) 35

37 Fed – Inflation Expectations 5y5y inflation breakeven rate (%, annual rate) ________________ Source: Lehman Brothers; Note: Straight lines indicate +/- one standard deviation from sample mean. 36

38 ________________ Note: Expectations are calculated using Eurodollar futures. We use a model-based term premium after 1994 and a term premia of 15bp per year prior to 1994. The LIBOR-Fed funds basis is assumed to be 14bp through 2006, but with the recent market turmoil, from 2007 on we adjusted for the FF-LIBOR spread using basis swaps. Shaded areas denote NBER recessions. Fed – Hairy History Funds rate and 24m expectations derived from ED futures (%) 37

39 Fed – Another Weak Recovery Unemployment rate and Fed turning points (%) Last rate cut First rate hike Last rate cut First rate hike Fed forecast ________________ Source: BLS, Federal Reserve, Lehman Brothers Global Economics; Note: Shaded Bars denote NBER recessions. 38

40 Outlook at a Glance ________________ Notes: Real GDP is expressed as a seasonally adjusted annual rate. Unemployment is measured as a percentage of the labor force. Core PCE inflation is y-o-y percent change. Interest rate forecasts are end of period. Payrolls are monthly average changes. Table last revised August 22. 39

41 Appendix

42 ________________ Source: BEA, Lehman Brothers Global Economics. Recessionomics – Worse Than 1990 or 2001 Real GDP outlook (indexed to 100 at peak) 40

43 ________________ Source: ISM. Recessionomics – Flat, not negative growth ISM purchasing managers indexes 41

44 ________________ Source: BLS and NBER; Note: Shaded areas indicate NBER recession rates. Recessionomics – A New Definition Unemployment rate (%) 42

45 Analyst Certification The views expressed in this report accurately reflect the personal views of Ethan Harris, the primary analyst responsible for this report, about the subject securities or issuers referred to herein, and no part of such analyst's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein. Important Disclosures Lehman Brothers Inc. and/or an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the fixed income securities that are the subject of this research report (and related derivatives thereof). The firm's trading desks may have either a long and / or short position in such securities and / or derivative instruments, which may pose a potential conflict with the interests of investing customers. Where permitted and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to determine current prices of fixed income securities. The firm's fixed income research analyst(s) receive compensation based on various factors including, but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potential interest of the firm’s investing clients in research with respect to, the asset class covered by the analyst. Lehman Brothers generally does and seeks to do investment banking and other business with the companies discussed in its research reports. As a result, investors should be aware that the firm may have a potential conflict of interest. To the extent that any historical pricing information was obtained from Lehman Brothers trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document. Lehman Brothers' global policy for managing conflicts of interest in connection with investment research is available at To obtain copies of fixed income research reports published by Lehman Brothers please contact Valerie Monchi (; 212-526-3173) or clients may go to Legal Disclaimer This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates ("Lehman Brothers"). Lehman Brothers Inc. accepts responsibility for the content of this material in connection with its distribution in the United States. This material has been approved by Lehman Brothers International (Europe), authorised and regulated by the Financial Services Authority, in connection with its distribution in the European Economic Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch ("LBIS"). Where this material is distributed by LBIS, please note that it is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. An investor should consult his Lehman Brothers' representative regarding the suitability of the product and take into account his specific investment objectives, financial situation or particular needs before he makes a commitment to purchase the investment product. This material is distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. Any U.S. person who receives this material and places an order as result of information contained herein should do so only through Lehman Brothers Inc. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers. With exception of the disclosures relating to Lehman Brothers, this report is based on current public information that Lehman Brothers considers reliable, but we do not represent that this information, including any third party information, is accurate or complete and it should not be relied upon as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of Lehman Brothers' Fixed Income Research Department and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and the income produced by products may fluctuate, so that an investor may get back less than he invested. 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