Cambridge Advisors Inc.
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Third Quarter GDP estimates were released showing the economy grew at 3.5% - the first increase in GDP in over a year. The US has unofficially emerged from the worst recession since the Great Depression. This estimate was even above expectations of 3.2%. The growth in GDP was led by personal consumption, inventories and homebuilding. Personal consumption was high partly due to auto sales. Inventories had been depleted the past several quarters and so restocking provided gains this quarter. Homebuilding increased at a rate of 23.3% which is its fastest increase since the 1980’s. The ISM Manufacturing Index also increased to 55.7 in October, further evidence that the recession has ended. Readings above 50 are a sign of expansion, and the ISM Index has been above that level for several months.

Although the economic numbers are encouraging on the surface, we are concerned about the strength of the recovery. A deep recession like we had normally is followed by much stronger GDP growth - twice what we are experiencing. Many analysts are questioning if the recovery will continue once the government stimulus ceases.

Analysts are also concerned that the recovery has not been able to curtail the loss of jobs.
Unemployment is now 10.2% which is the highest it’s been since 1983, and officials agree it may remain “high” for several years. High unemployment weighs on the economic recovery because consumers are less likely to spend. If the rebuild in inventories we saw in the Third Quarter is not followed by consumers buying, inventory levels will be higher again and the inventory build will have only been a short-term boost to GDP growth.

With high unemployment, we are also likely to see foreclosures continue rising. According to
RealtyTrac, an online marketer of foreclosed homes, nearly a million homes received a foreclosure letter during the Third Quarter. Now, one out of every 136 homes in America is involved in foreclosure procedures. Adding to foreclosure risk are loans that are “underwater” where the amount of the mortgage is higher than the value of the home. Zillow reports that 23% of mortgages are underwater and they expect that figure to rise to 30% by mid 2010.

Option ARM loans are expected to increase foreclosures and bank write-offs over the next
several years as well. Option ARM loans are interest-only loans that allowed borrowers to pay
less than the interest they owed each month; 94% were making only the minimum payment. The difference is added to their total principal. After five years, the loan resets and the new loan payment is based on an amortization schedule. The new payments may be significantly higher – 63% higher on average – since it now includes interest and principal which may have increased if the full interest owed was not paid in the earlier years.  Many Option ARM loans are underwater and already 46% are delinquent before they reset. Some have been modified, but only 3.5% and of those, 24% re-defaulted. Of the current $189 billion outstanding in Option ARM loans, about 70% will adjust in the next 2 years, with the peak coming in August 2011 leading some analysts to expect foreclosures to continue rising through 2011 or later.

Similar problems prevail in the commercial real estate market. With office vacancy rates rising,
rents declining and property values falling, lenders are facing rising default rates which will lead to write-offs. Many commercial property owners can't pay back loans and they can’t qualify for new ones. According to Richard Parkus, head of commercial real estate debt research at Deutsche Bank Securities, delinquency rates on construction loans have already soared to 16% and could go much higher. He estimates that banks stand to lose $200 billion to $300 billion on commercial real estate loans but very little has been written off. Deutsche Bank believes that less than 1% of commercial real estate loans have been written off but expects losses to exceed 8%. These write-offs would likely result in more bank failures.

With these credit issues looming, along with a growing Federal debt and likely higher taxes, we will be monitoring the numbers closely and making changes as appropriate in our client accounts. If you have any questions, please do not hesitate to call us. Please also let us know if you have friends and family who would like to be introduced to Cambridge Advisors to see how we could benefit them.

Lori L. Liffring, CFA
Michael L. Bridgman, ChFC
Gaylan C. Abood, CFA
Justin S. Anderson, MBA AAMS
Karen K. Benefiel, CPA AAMS
www.cambridgeadvisors.net
402-697-1166
17330 Wright Street, Suite 205
Omaha, Nebraska 68130
Economic Update November 2009

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