OLMIS

by Dallas Fridley
Published Sep-26-2007

Introduction Building Permits Point Downward Oregon’s Outlook is Also Mixed Housing Starts and Completions Point Downward Pointing Fingers Residential Improvements and Repairs to the Rescue? Depth of Construction Losses Still Unclear FOMC Statement: August 17, 2007

In a very short time span the Fed pumped around $120 billion into the banking system, cut its discount rate a half percentage point to 5.75 percent, and acknowledged that stock market turbulence posed a risk to economic growth. Or, put another way, the Fed made a 180 degree turn and reversed its bias toward tightening credit markets.

Actually the Fed did more than that – it also lengthened its credit window from one day to 30 days and offered to accept a "broad range of collateral for discount window loans," including residential mortgage-backed securities and related assets. By moving the discount rate, the Fed reversed its 2003 policy to maintain a 100 point margin against the lower Fed Funds rate. It's been 27 years since the Fed moved the discount rate without also adjusting the Fed Funds.

Sub-prime mortgage lenders have dominated economic and financial news in recent weeks; here is a small sample of the more prominent announcements during August 2007:

• Sub-prime mortgage lender Novastar Financial Inc. plans to cut 500 employees.
  
  
• The nation's biggest home lender, Countrywide Financial Corp., had to draw down an $11.5 billion credit facility to boost its liquidity.
  
  
• Bear Stearns announced it will cut about 240 sub-prime lending jobs
  
  
• American Home Mortgage Investment Corp. filed for bankruptcy days after laying off most of its work force – some 6,500.
  
  
• Capital One Financial announced that it will close its wholesale mortgage banking business and slash 1,900 jobs.
  
  
• According to RealtyTrac Inc., 179,599 foreclosure filings were reported during July, up from 92,845 one year ago. Nationally, the foreclosure rate in July was 1-in-693 households.

Despite all the doom and gloom presented thus far, the current outlook for construction employment – both nationally and in Oregon – remains only mildly negative. Early indicators – like building permits – and leading indicators such as residential housing completions foretell a bleaker outlook for construction employment in the months ahead.

Building permits are an early indicator of construction activity and offer an outlook that suggests employment in residential building trades will fall, although the pace and the magnitude of the job loss is still open to speculation.

U.S. building permits in July 2007 – as reported by the U.S. Census Bureau on August 16^th – fell by more than 22 percent compared with the July 2006 level. The Census Bureau's seasonally adjusted annual rate of 1,373,000 units represented a drop of more than 400,000.

U.S. construction industry employment in July 2007 – at 7.65 million – dropped by just 53,000 jobs compared with its year-ago level. Not every component industry lost jobs – heavy and civil engineering construction (+2.3%) and nonresidential specialty trade contractors (+2.3%) added jobs over the year. Residential specialty trades – like roofing contractors – have taken the brunt of the losses, falling by 97,600 jobs (-3.9%), while residential building contractors lost 24,600 jobs (-2.4%).

Residential construction is faced with a period of decline. While national construction employment data has fallen from its peak, the magnitude of the loss is well short of what building permit activity suggests. Building permits are an early indicator of construction activity; however, they do not guarantee when or even if construction will occur.

In Oregon, building permits totaled 15,514 units for the first six months of 2006, while the six-month total this year fell to 12,765, a decline of about 18 percent.

Construction employment in Oregon, which totaled 106,600 in July 2007, has yet to show signs of retreat, posting a gain of 1,400 jobs compared with its July 2006 total. At the component industry level, building construction offered mixed results, with residential construction cutting jobs (-400), and non-residential construction adding jobs (+900). In heavy and civil engineering construction, employment fell by 1,700 (-13.4%), while specialty trade contractors added 2,600 thanks to the strength of building equipment contractors, where 2,000 jobs were gained over the past year.

In addition to construction, some other industries are likely to feel the effects of the housing downturn. Nationally, wood products manufacturing lost 34,600 jobs (-6.1%) over the past 12 months, real estate gained 25,800 jobs (+1.7%), and finance and insurance climbed by 89,500 (+1.4%).

These industries saw weaker conditions locally. Oregon's real estate industry cut its employment total by 300 jobs (-0.8%) compared with July 2006, while finance and insurance dropped by 1,200 (-1.9%). Job losses in wood products manufacturing are more substantial, with the July 2007 total falling 3,100 jobs (-9.4%) short of its year-ago total.

National employment figures, particularly in residential related construction, have raised a few eyebrows, particularly so when compared with new residential housing starts and housing completions. Although not really a leading indicator, the seasonally adjusted annual rate of privately-owned housing starts in July 2007 fell to 1,381,000, a drop of 20.9 percent compared with the prior year. Privately-owned housing completions – a true leading indicator which has historically tracked well with residential construction employment – didn't improve that outlook, falling 22.2 percent to a seasonally adjusted annual rate of 1,512,000.

A quick review of how our early and leading indicators have fared over the year:

• building permits, -22 percent
  
• housing starts, -21 percent
  
• housing completions, -22 percent

What a great opportunity to throw in a graph (Graph 1), with housing starts and housing completions on the left-hand scale and U.S. residential construction employment (residential building construction and residential specialty trade) on the right.

From its seasonally adjusted peak in March 2006, residential construction employment rested just 4.9 percent lower in July. Completions have fallen 22 percent in one-year's time but in reality the February through July period represented the brunt of that loss. Given the recent nature of that loss, it may be premature to declare a disconnect between construction employment and completions.

Are undocumented – and presumably uncounted – workers to blame? This explanation has been studied in depth in a report by Deutsche Bank, offering an estimate of 500,000 cheap-to-hire and easy-to-fire illegal workers to offset an expected and as yet unrecognized loss of 900,000 construction jobs since the industry's March 2006 peak.

There are also reasons to suggest that Current Employment Statistics estimates may have missed the turning point for construction following its March 2006 peak. Non-reporting firms represent a real challenge because you don't actually know if they missed a report or if they have gone out of business. The creation of new firms and the demise of existing ones are left to the Bureau of Labor Statistics (BLS) birth/death model.

It is possible that the BLS birth/death model overstated the creation of new firms and understated the loss of existing firms. Housing completions, as shown in Graph 1, have historically tracked reasonably well with residential construction employment – up until February 2007 – when completions took a steep dive. Comparatively, the seasonally adjusted residential construction employment series merely flattened out.

Undocumented workers and a missed turning point vis-à-vis the BLS birth/death model offer some compelling arguments to explain differences between leading indicators and construction employment – and of course there are others. Some workers may have moved into nonresidential construction – although the skill sets do differ depending on the trade. Likewise, there is a potential that some residential construction firms have shifted over to non-residential and haven't bothered updating their industry coding. And residential construction workers could still be employed – just working fewer hours.

If we look back to May 2001, the seasonally adjusted annual rate of residential completions rested at 1,497,000 units, while residential construction employment totaled 2,631,500. July 2007 completions were close to that level, at 1,513,000 units – and yet construction employment, at 3,301,500 perched 670,000 jobs (+25%) higher.

Don't count on residential improvements and repairs to pick up the slack. Expenditures on residential improvements and repairs reached a fourth quarter 2005 peak of $233.5 billion (seasonally adjusted – annual rate). Since that time, total expenditures have fallen nearly 7 percent through the first quarter of 2007 (Graph 2). The largest component – improvements – fell 9.3 percent from its fourth quarter of 2005 peak ($178.8 billion).

Another important measure, the value of residential construction put in place, has fallen $150.4 billion – more than 21 percent – since its February 2006 peak to a June 2007 seasonally adjusted annual rate of $551.6 billion. Improvements and repairs certainly won't make up for the loss in new residential construction spending. Using annual consumer price index estimates (U.S. cities average) to adjust the quarterly series, expenditures on improvements and repairs remain 10 to 15 percent above those made during 2002 and 2003.

Construction employment estimates are but a small problem compared with the melt-down in sub-prime lending, the glut of existing and growing housing inventory, dramatically rising mortgage foreclosures and the tepid pace of new home sales. Corrections are certainly on the horizon and it appears to be a safe bet that residential construction employment estimates for 2007 will fall sooner than later.

The biggest uncertainty is when this all turns around. Sub-prime mortgages provided a second wind for construction by opening up the housing market (and driving up prices) to buyers that could not qualify for a loan under conventional terms. But it is very unlikely that "exploding-ARMs" and no-document "liar-loans" will return to a place of prominence like that seen in 2005 and 2006.

"Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward," the board said. "In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably."