Fate of the States: The New Geography of American Prosperity
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Authors: Meredith Whitney
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Copyright © Meredith Whitney, 2013
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Illustrations by Meredith Whitney Advisory Group unless otherwise indicated.
Library of Congress Cataloging-in-Publication Data
Whitney, Meredith.
Fate of the states : the new geography of American prosperity / Meredith Whitney.
pages cm
Includes bibliographical references and index.
ISBN 978-1-101-60149-5
1. United States—Economic conditions—2009– 2. U.S. states—Economic conditions. 3. United States—Economic policy—2009– 4. U.S. states—Economic policy. 5. Recessions—United States. 6. Financial crises—United States. I. Title.
HC106.84.W48 2013
330.973—dc23
2013006821
While the author has made every effort to provide accurate telephone numbers, Internet addresses, and other contact information at the time of publication, neither the publisher nor the author assumes any responsibility for errors or for changes that occur after publication. Further, publisher does not have any control over and does not assume any responsibility for author or third-party Web sites or their content.
For my grandfather, Kenneth W. Elvin, who raised me believing in the original American Dream: that with hard work, anything is possible.
And, of course, for John
Pensions: The Debt Bomb Nobody’s Talking About
The Negative Feedback Loop from Hell
I was a history major in college. Studying history is all about learning stories—stories about what led to seminal events and then sequels that explain what happened next and why. I love stories. My brain instinctively works to connect the dots in life, turning mosaics of information into narrative tales of how things came to be and what I think will happen as a result. I never look at any one data point or event in a vacuum. Rather I use a series of data points from myriad sources to tell the story of what is to come. Throughout my twenty-year career on Wall Street, the stories that have interested me most centered on the U.S. consumer. Not only does consumer spending account for 70 percent of U.S. gross domestic product, but it drives investment returns in almost every asset class, from stocks to commodities. Understanding the consumer and the direction of demographic trends means understanding where to invest.
For most of my career, I worked in equity research. In plain English, that means I immersed myself in one industry—in my case, the financial industry—and then informed clients about the latest trends in finance and about which companies were going to be the future winners and losers. You’d be surprised how many people on Wall Street don’t know how to read company financial reports or interpret the underlying data. But delving into the numbers was always my favorite part of the job. With bank stocks, ensuring that a complex set of data isn’t hiding something worrisome is crucial because a lot of the investors are mom-and-pop types who gravitate toward banks for their big dividends and their perceived safety.
I started my career covering one of the sketchier neighborhoods in the financial world—subprime consumer lenders. Companies like subprime auto-finance lenders, home-equity lenders, and credit-card lenders. During the 1990s, subprime loan volume soared, as did the profits of subprime lenders. I spent a lot of time visiting with the management teams of these firms. Most had no idea they were living on borrowed time. Their institutions’ continued prosperity and survival hinged on their ability to access cheap credit—borrowing at low interest rates and then relending that money to subprime borrowers. One way they accessed this cheap credit was through securitization. That is, they would bundle the loans they’d made into newfangled bonds known as asset-backed or mortgage-backed securities. But securitization is like any other loan. Access to the market is tied to perceived ability to repay. In the late 1990s, investors started to lose faith. By the summer of 1998, the Russian credit crisis had stopped the global securitization market in its tracks. For many of the lenders I followed, that was the end.
Fast-forward ten years, and it wasn’t just the ultratan guys with lots of gold jewelry making subprime loans. It was mainstream banks—New York–based financial giants—diving deep into subprime. This wasn’t just what had been traditionally defined as subprime, a borrower with a dented credit record or no credit record; it was a whole new definition of subprime. It’s a mistake to define “subprime” based upon the credit rating of the borrower. It needs to be defined by the type of loan and the borrower’s ability to pay it back. For instance, if too much debt is loaded onto any borrower, no matter what their credit score may be, it becomes that much more difficult for the borrower to make good on that loan. And a lot of the mortgages that banks were underwriting—interest-only loans with deceptively low teaser rates, for example—were subprime loans even though the market didn’t necessarily define them as subprime. For me, the summer of 2007 was déjà vu all over again. Banks were making bad loans, but the asset-backed and mortgage-backed securities markets kept buying them. As Citigroup CEO Chuck Prince famously pronounced in July 2007, “As long as the music is playing, you’ve got to get up and dance.”
1
Well, the music seemed to stop almost immediately after Prince made that ill-advised remark. Investors pulled out of the securitization markets and, just as in the late 1990s, lenders started falling like dominoes. If they couldn’t borrow, they couldn’t stay in business.
I knew this story would end badly largely because I had lived through it once before. The fact that the protagonists were now the nation’s leading banks and brokerage firms—not some lender-of-last-resort paying old ballplayers to hawk second mortgages on late-night TV—was irrelevant. It boiled down to math, and math doesn’t play favorites based on pedigree. If a company cannot fund itself and cannot pay its obligations, the lights will ultimately go out (unless, of course, it gets a federal bailout). I saw early on what was happening, but at first a lot of people didn’t want to hear what I had to say. Then I released an ominous report on Citigroup and, to my shock, it became the shot heard round the financial world.
The original, and now famous, call I made on October 31, 2007, tripped a wire in the markets. The report raised concerns about mortgage losses at Citigroup and warned that the megabank might be forced to cut its dividend. When the stock market reopened the next morning, Citigroup’s stock plummeted, losing $17 billion in market value in one day. The S&P 500 dropped $374 billion.
2
The call that I made was similar to warnings I would make throughout 2008 about other banks. The reality was that Citigroup and the entire banking industry had amassed entirely too much debt and the all-night dance party of cheap and loose credit was over. Making matters worse, banks didn’t even realize how much trouble they were in. A lot of the debt that they considered low risk was backed by residential real estate and other assets that were worth considerably less than they thought. Their financial statements were illusions—more like wishful thinking than clear-eyed accounting.
The problem with too much debt is that it narrows the margin of error for both the borrower and the lender. A bad quarter becomes a catastrophic one on the turn of a dime if a company has played too close to the edge and the mood of the market shifts quickly. That proved true for Bear Stearns in the summer of 2007, just as it did for Citibank by the fall of 2007.
3
By 2008 the entire financial system was essentially felled by debt overload and an inability to access cheap money. By 2009 the industry had lost over $600 billion in write-downs and destroyed over half a trillion dollars in stock market valuation.
4
How did this happen? And what might the sequel to this sad tale be? Looking for answers, I followed the money. Typically, the larger banks lend to the regions, businesses, and demographic groups demonstrating the highest rates of income growth. But during the housing boom, this approach became perversely self-fulfilling. By feeding the housing bubble, banks injected wads of new cash into local economies, generating new income for builders, decorators, real-estate agents, and hardware stores. Everyone felt a little richer—which led to ever-crazier bidding wars for homes on the market.
Easy money had big consequences. Banks borrowed more so they could make the loans that allowed consumers to borrow more. This destructive, codependent relationship allowed the financial services industry to expand rapidly, displacing manufacturing in economic importance after those jobs and production moved overseas beginning in the 1980s. This is why the system was so fragile. Consumer defaults would trigger banking defaults and vice versa, crippling the U.S. financial system for years to come. Five years after the beginning of the crisis, the U.S. lending system still hasn’t recovered. Over $7 trillion has come out of the lending system, and more than 30 percent of Americans now have no access or limited access to credit.
5
People who need credit can’t get it, and the housing market can’t properly recover because mortgages are so much harder to come by. One key consequence: The unemployment rate has been high for longer than at any time since the Great Depression.
Over the course of 2007 and 2008, my name on Wall Street became synonymous with doom and gloom, which I found frustrating because for most of my career I had been a relentless seeker of growth and investment opportunity. By late 2008 I was more interested in figuring out where the next phase of American growth was going to come from than in dwelling on what part of the system still wasn’t working. I wanted to figure out what the recovery from the worst financial crisis since the Great Depression might look like. What I knew for certain was that the road ahead would look nothing like the road we had been on for the past twenty-five years. The new economy would not resemble the old one. The numbers simply wouldn’t allow it.
My grandfather grew up during the Great Depression. His father was a cop in Paterson, New Jersey. He grew up tough and close to broke. He saw how difficult it was to break the cycle of debt—how friends and neighbors who lived beyond their means would spend years digging out of debt. Witnessing such hardship turned my grandfather into the consummate debtophobe. When he bought a car, he paid in cash. When he bought a home, he paid in cash. “You can’t make money,” he’d often tell me, “if you owe money.”
My grandfather’s words kept coming back to me the deeper I dug into the latest economic data. It became clear that there were some regions of the country so burdened with debt that a muscular rebound in consumer spending would be virtually impossible. California, Florida, Arizona, Nevada, Illinois, and New Jersey had some of the most highly indebted residents in the country—which I knew because I tracked the banks’ geographic lending concentrations. During the housing bubble, banks had targeted these areas for their hot real-estate markets and for rising personal income levels. When the bubble finally burst, these states wound up with the nation’s highest levels of negative equity (i.e., owing more on your mortgage than your house is worth) as well as some of the highest unemployment rates. They were also where banks had cut back credit lines most dramatically. Anyone in these areas living paycheck to paycheck had gotten a sobering margin call over the past few years. Without equity to borrow against—a key source of funding for small businesses—new-business creation, along with new-business job creation, plummeted and unemployment soared. Choked off from credit, consumers cut back on spending, digging the economic hole even deeper.
The recovery in those states would be plodding at best. But the story was very different in the states that had never been targeted by the banks during the boom years. In the central corridor of the country—sometimes referred to as the “flyover” states—the boom years were less exuberant. In Ames, Iowa, for instance, home prices went up a mere 5 percent in 2005, compared with 20 percent in Jacksonville and 41 percent in Phoenix.
6
Banks weren’t offering folks in Iowa or Texas unlimited access to credit, and thus homeowners never got in over their heads. Because housing didn’t boom, it didn’t bust there either. Consumer spending was more closely correlated with employment and wage growth than with availability of credit. Since jobs in the central corridor weren’t dependent upon housing, these states didn’t see huge spikes in unemployment after the bust. What’s more, manufacturing jobs are now coming back to these areas in a big way, as more and more companies locate there to take advantage of less expensive real estate and incredibly cheap and plentiful U.S. energy.
But there was something else I discovered that made these flyover states so attractive to employers and job seekers. Their state and local governments hadn’t piled on scads of debt during the boom times. As a result, there was no pressure to hike tax rates. And because they didn’t have crippling debts, they had money to invest in education, roads, airports, job training, and other public services. To be sure, energy production is a big part of the story in some locales. There’s no doubt, for example, that North Dakota’s oil patch would still be booming even if, back in the 2000s, there’d been a housing bubble on the prairie. Nevertheless, more companies were starting to pay close attention to which states offered the lowest tax rates, boasted the best and most sustainable infrastructure, and were the most probusiness as measured by right-to-work laws and workers’ compensation rules. Since 2008 these central corridor states have had unemployment rates well below the national average, as well as rising consumer spending and robust tax receipts—the exact opposite of what’s happened in the housing-bust states.
7
Talk about a shocking reversal of fortunes. California, New Jersey, and Illinois were economic powerhouses. Postrecession, not only are their citizens eyeball deep in debt, but their state and local governments are awash in red ink too. Today these states can’t help but have outsized tax rates because their government budgets are so out of control. They’ve been forced to cut deeply into education, infrastructure, and other public services. And in an unhappy coincidence, these states also happen to be three of the most politically and bureaucratically gridlocked in the nation, making reform incredibly difficult. California, notoriously unfriendly to business, raised the marginal state tax rate on those making over $250,000 to the highest rate in the country in 2012.
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The result: a rush to the door by many of those high earners. In 2011, Illinois hiked its income tax rates by 66 percent.
9
The governor was then forced to try to strike side deals with large businesses that threatened to leave the state. Even after the tax hikes, these states still have enormous budget gaps that require even deeper cuts to education and other public services. State and local government spending cuts combined with severely weakened consumers don’t exactly help the job market either. Unemployment in these former boom states has been consistently above the national average since 2008.
10
Last decade’s housing boom and bust may have been a national story, but until I pored through the numbers, I didn’t realize how distinctively local some of the fallout truly was. It wasn’t just the consumers or banks whose fates were tied to housing; state and local governments were deeply connected in ways I had never imagined. In fact, many state and local governments had made the same types of gambles on housing that banks and consumers had: They bet that home prices (and thus property-tax revenues) would never, could never decline—and then borrowed and spent accordingly. Too many government budgets baked in overly optimistic assumptions about property-tax receipts. Even the worst-case scenarios anticipated only a temporary 5 percent to 10 percent decline in real-estate prices. When the bust did occur, governments had no backup plans other than piling on more debt while they waited for revenues to rebound. This created a negative feedback loop from hell: Higher debt (including unfunded pension obligations—more on those later) required higher taxes to meet debt service, which indirectly added to the indebtedness of taxpayers already struggling with their own mortgage and credit-card debt. When the states were forced to cut costs, public services deteriorated, thus pressuring home prices and effectively eliminating the home-equity lines of credit some consumers had once used as safety nets. The only thing that could break this cycle would be employment and income growth, but local businesses and state and local governments were all cutting back, dampening the job market. There would be more existing jobs lost than new ones created.
