Thursday, October 9, 2008

California Points The Way...

First Into Recession, California Shows Possible Future For U.S.

By Conor Dougherty, Rhonda L. Rundle and Justin Lahart | 9 October 2008

Here's the latest trend that started in California and is spreading to the rest of the country: recession.

It's all but certain the U.S. economy is in a recession, as falling home prices and Wall Street turmoil have put the brakes on consumer spending and stoked unemployment. But California got there first. Now, the state provides a template of how a broad U.S. downturn could look. California's current problems started with the housing bubble, which hit places like Moreno Valley, below left, particularly hard.

With its export businesses, manufacturing sector, professional services and big retail employers, California looks like many other U.S. states, only more so. California's $1.8 trillion economy— twice the size of India's and accounting for about 15% of the U.S. gross domestic product— is powerful enough to have ripple effects nationally. It is home to Hollywood, five of 30 Major League Baseball franchises and the largest farming sector in the nation.

California was also at the leading edge of the nation's recent housing bubble, which is where its current problems started. Home prices in California rose higher and faster than in most of the U.S., and started weakening earlier, in 2005. Some mortgage-holders defaulted. Others struggle along under a mountain of debt.

The problems spread to the state's financial sector, which was heavily exposed to local real estate. As Californians cut their spending, job losses spread from the housing sector to retail stores and auto dealers. Now the state's unemployment rate is 7.7%, among the highest in the nation.

Along with Sunbelt states such as Florida and Nevada, California is a big source of the shocks now working through the world's banks, corporations and stock markets. The financial crisis has frozen credit markets, cutting into companies' ability to engage in even the day-to-day borrowing they need to run their businesses.

But even before the most recent blows to the national economy, Californians were feeling the downward drag of a consumer-led recession— in which shrinking home values caused people to rein in their spending, fueling unemployment and, in turn, sparking further spending cuts and joblessness.

John Luc has seen how housing problems bleed into the broader economy. Mr. Luc is the 36-year-old manager of Homestore Furniture in Ontario, a middle-class community 40 miles east of Los Angeles and one of the centers of the housing bust. Since last year, retail sales have fallen, while unemployment and office vacancies have soared.

Eighteen months ago, he watched a nearby Levitz furniture store close down in a bankruptcy sale. Since then, he said, the few buyers who've visited his store ask for discounts. "Everybody negotiates," he says.

The other day, Mr. Luc was presiding over the store's going-out-of-business sale. Although the father of two young children expects to get a job at another Homestore outlet, he and his wife have checked their spending. He says he saves $50 or more each week by packing a lunch each day, and he makes coffee at home instead of stopping at Starbucks during his long commute. "I haven't gone into a steakhouse like a Black Angus for dinner in six to eight months," he says.

Consumer spending accounts for about 70% of U.S. economic activity, so as people like Mr. Luc cut back, job losses and other economic woes follow. In the third quarter of 2007, California's taxable sales declined 1.82% from the year-earlier period, the first annual decline since 2002. Taxable sales have fallen every quarter since. Now in addition to construction workers and mortgage brokers, people like retail clerks, accountants and information-technology consultants are losing their jobs.

A similar dynamic is playing out nationally. Retail sales recently started declining, after peaking in June. Rising job losses appear likely to cut into future sales. In September, the U.S. economy shed 159,000 workers from its payrolls. The unemployment rate was 6.1%, compared with 4.7% a year earlier.

There's no universal definition of recession, and little agreement of what constitutes one in a state economy. But by most measures economists use— rising job losses, shrinking consumer sales— California fits the bill. "There is no question that this area is in a recession," says John Husing, an economist in Redlands, Calif., who tracks the Inland Empire region east of Los Angeles. "We're the canary in the mine shaft."

It's unclear whether the state, as one of the first to enter an economic slowdown, will be among the first to emerge. Problems in the broader economy could also hit California in a second wave. Stephen Levy, director of the Center for Continuing Study of the California Economy, expects the state's economy to get worse before it gets better. He expects job loss to continue through 2009, as consumers continue to pull back. While the housing sector probably won't fall much further, Mr. Levy said, many consumers aren't able to tap the equity in their homes for purchases. Falling stock prices and expensive gasoline and food will continue to eat into spending, he says.

Not Always A Bellwether

California isn't always a bellwether for the nation's economy. In fact, in the past two national recessions, the state was stung by sharp job losses in important industries— aerospace and defense in the early 1990s, and technology in the early 2000s— but was among the last group of states to succumb to recession.

But this time around, after years of double-digit price rises, median home prices stood far above what a household with a median income could afford. Permits for new homes began dropping sharply in fall 2005, something that didn't happen for the nation as a whole until spring 2006. Home prices in the state's largest real-estate markets fell earlier and further than those countrywide.

Prices in San Francisco, Los Angeles and San Diego are currently down an average of 28% from their 2006 levels, compared with 19% for the S&P/Case-Shiller 20-City Composite Home Price index nationally. The mortgage-lending frenzy was at its hottest in California, and the state's financial firms were at the forefront of extending 'non-traditional' mortgages that were then folded into layers of complex securities. Those firms were also among the first to face disaster when the value of those securities collapsed.

In April of last year, New Century Financial Corp., a subprime lender in Irvine, filed for bankruptcy protection. Four months later, Calabasas-based Countrywide Financial Corp. was at the center of the credit-market convulsions. The fallout continued into this year: When federal regulators seized Pasadena-based IndyMac Bancorp Inc. in July, it was the third-biggest U.S. bank failure to date.

California's losses prefigured the later fallout on Wall Street. Through August, California had seen finance-related jobs fall 6.8% over the past two years, compared with 1.5% nationally. And California's consumers are among the country's most indebted.

For every dollar they take home, Californians spend about 19 cents on mortgages, cars, credit cards and other debt payment, compared with about 15 cents nationally, according to Equifax and Moody's As consumers pay down that debt, there will be less left over for purchases, which is better in the long run for the economy's health but hard on retailers now.

Pool And Pet Toys

With banks tightening the flow of credit, even companies with rising consumer demand are having a hard time expanding. For the past decade, CoopSport in Vista has sold its beach, pool and pet toys mostly in specialty retailers. But last month, it received orders for the first time from mass merchants Target Corp., Wal-Mart Stores Inc. and Toy "R" Us Inc.

In the past, says owner Scott Cooper, CoopSport was able to get credit from its Chinese factories at an annual interest rate of about 10%. But as the credit crisis spreads globally, Chinese factory owners won't provide him the usual financing. He also can't get the credit he needs from the U.S. banks he has contacted. So he has stitched together loans from a series of nontraditional lenders, which charge as much as 18% annual interest.

Mr. Cooper says he has sold a 7.5% equity stake to raise additional capital to fund the expansion. Far from adding staff as he gets ready to expand, CoopSport eliminated eight warehouse workers and two office staff. The company further cut costs by switching to a cheaper box manufacturer and a cheaper truck company. "It's all the things you do when you go into survival mode in this economy," he said.

California's big technology sector could also get hit hard by slowing overseas growth and the troubled financial sector. Santa Clara-based semiconductor-equipment manufacturer Applied Materials Inc., for example, fetches more than 80% of its revenue from overseas sales. And financial firms are among the technology sector's biggest customers.

Of course, even in recession California has its strengths. With its universities producing new technologies and entrepreneurial talent, the state has a disproportionate share of well-paying jobs in sectors like telecommunications, biotechnology and energy-efficient technology. Its health-care sector, like that of the rest of the U.S., has continued to add jobs.

Exports also have been a bright spot as a weak U.S. dollar has made goods cheaper abroad. The ports of Long Beach and Los Angeles are the nation's two largest, and have seen a rising stream of goods headed overseas. Through August this year, 22% more full containers were shipped out of the ports combined, compared with the first eight months of last year. With the world economy slowing, exports are expected to slow locally and across the country.

Some economists also believe the state's housing market may hit bottom before the rest of the nation's, and could start an upward tick earlier as well. The loss of construction and finance jobs has slowed. In San Diego, one of the first housing markets to falter, home prices are roughly in line with the city's incomes and rental rates. "Housing is becoming affordable again," said Steve Cochrane, an economist at Moody's

Trouble In Stockton

The pain of the housing bust has been harder on inland areas than it has been in coastal cities such as San Francisco and Los Angeles, which generally have more high-paying jobs.

Stockton, a bedroom community to the Bay Area known for its asparagus festival, saw a boom in home-building and subprime loans this decade. Now, median home values are down nearly 50% from the market's peak, according to real-estate information service Stockton's unemployment rate has risen 2.8 percentage points, to 10.3% over the past two years. In San Francisco, which has a greater concentration of jobs in areas like technology and professional services, the unemployment rate has risen 1.1 percentage point, to 5.1% over the same period.

In the Bay Area, the creep of economic weakness unfolds in an hour's drive from the San Francisco exurbs. Cities like Antioch and Brentwood, past the last stop on the BART commuter rail line, are among the hardest hit by the housing bust. Closer to the coast are Concord and Walnut Creek, two San Francisco suburbs that have previously thrived with light industrial and office buildings that are a lower-cost alternative to downtown San Francisco and the Silicon Valley.

Now, downtown Walnut Creek's commercial vacancy rate for Class A space has risen to 14.7% from 9.9% last year. Concord's commercial vacancy rate has jumped to 21% from 9.5% in 2007. Ed Del Beccaro, an office broker and senior managing partner at Colliers International in Walnut Creek, says his office's income is down about 20% this year. Mr. Del Beccaro cut four of his 38 brokers in January. Others, he says, have left for "real jobs" because their commissions were so low.

Car Sales Down

As East Bay consumers have struggled, so has Darren Anderson, whose family owns Lehmer's Buick Pontiac GMC in Concord. Mr. Anderson says Buick Pontiac GMC dealers in Northern California sold about 1,000 cars in August, compared with around 1,900 last year. In the past few months, Lehmer's has cut 10 of its roughly 50 employees.

As sales fall, so have the taxes collected by California governments, whose spending can offer a buffer during times of economic weakness. Through the first three quarters of this year, California's sales tax revenue is down about 5% compared with the first three quarters of 2007. Ongoing budget troubles resulted in a $15 billion deficit this year for California.

Budget troubles are déjà vu for many Californians. In the aftermath of the dot-com bust, falling incomes and stock-market losses created a $38 billion budget deficit, and the ensuing furor sparked a recall election that brought current Gov. Arnold Schwarzenegger to power. Today's budget troubles are potentially even worse than in the late 1990s: Falling home prices have reduced property taxes on which local governments depend, at a time when the state is cutting aid to municipalities. Also, the credit crunch has made it harder to sell bonds to fund longer-term capital projects such as roads and schools.



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