"How Bad Can Texas Get?" Goldman Answers

On Friday, we noted that at least some local businesses in Texas are sympathetic to the pitiable plight of the state’s beleaguered oil patch workers.

Houston-based Gramercy Cleaners on Richmond avenue, we observed, is demonstrating their compassion for the imploding energy sector by offering service discounts.

Much like Calgary and many other oil boom towns north of the border, many a Texas city is feeling the squeeze of rock bottom crude prices. As we documented in "The Next Chicago? Houston Faces Pension Crisis In Latest Example Of Local Government Fiscal Folly," Houston is staring down a $3.2 billion funding gap and reduced revenue from oil and gas ops isn't doing anything to help.

"Home sellers are slashing prices and offering incentives to keep buyers from walking away from contracts as an 18-month oil slump buffets this city’s once-booming housing market," WSJ wrote last week, underscoring the impact "lower for longer" is having on the city. "Home-construction permits in the area plunged 26% from a year earlier in the third quarter, while December sales of existing single-family houses fell nearly 10% from the same month of 2014."

In short, a year of crude carnage has wreaked havoc upon what, until last year anyway, was the engine driving the "robust" US labor market

As we showed in November, layoffs in Lone Star land far outrun job losses in any other state:

"The Texas recession is only in its early innings," we said on Friday, because we are just now beginning to witness the bankruptcies and shut-ins that will soon become endemic and sweep across the entire US oil patch as revolvers are reigned in and Wall Street suddenly refuses to finance uneconomic producers' funding gaps.

So what happens when the pain really begins to hit home in Texas, you ask? And what are the implications for the broader economy considering the state has for years served as a kind of counterbalance to a job market that increasingly resembles a feudal system as opposed to the manufacturing-led middle class utopia American enjoyed five decades ago?

Here with some answers is Goldman who sets out to address the US oil patch's burning question: "How bad can Texas get?"

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From Goldman

The historical episode most similar to today’s ‘lower for longer’ environment is the oil bust of the 1980s, when WTI oil prices fell from $31/bbl in 1984 to $10/bbl in 1986. Given its high exposure to the energy sector, Texas experienced significant stress in the 1980s. The unemployment rate in Texas rose sharply to 9.2% in 1986, an all-time high for the state. Real house prices fell 30% peak to trough, and the number of bankruptcy filings (including both business and non-business filings) more than doubled from 1984 to 1986.

The experience of the 1980s has naturally raised concerns over oil and Texas today. When banks reported their 2015Q4 earnings recently, bank executives stated that they are increasing reserves in anticipation of losses in the energy sector. In this Global Markets Daily, we compare the experience of households and businesses in Texas during the two oil busts. We find that damages in Texas have been significantly more contained thus far relative to the 1980s.

Loans backed by properties in the oil-producing states of Texas, North Dakota, Oklahoma and Louisiana comprise 10% of US commercial mortgage-backed security collateral, so the performance of commercial real estate in these areas is in focus for structured product investors. The office vacancy rate in Houston increased sharply in the early 1980s, likely driven by a combination of two recessions, elevated supplies and the oil price plunge. In 2015, the vacancy rate of Houston office properties also moved up, but remains far below the levels seen in the 1980s. We expect the vacancy rate to climb further over the next few quarters, posing downside risk to loans backed by Houston commercial properties. But we do not think default rates will match the 1980s experience.

Turning to the residential sector, the 2014 oil price decline has so far manifested itself in the housing market quite differently from the 1980s experience. The right panel of Exhibit 1 shows that the share of residential mortgages in foreclosure in Texas increased sharply after the 1985 oil price peak. In contrast, the Texas foreclosure inventory has continued to edge down over the past year. One explanation for this difference may be that the housing market is still recovering from the 2009-2011 foreclosure crisis. The impulse from the healing process so far outweighs the shockwaves from lower oil prices.

The Texas housing market may be more resistant to mortgage defaults and foreclosures than other states in the US. Even with the large house price decline in the 1980s, foreclosure inventory in Texas peaked at below 2%. In contrast, foreclosure inventory surged to 6% in Arizona and California in 2009 and over 10% in Florida and Nevada in 2010. One reason for this difference may be the home equity restrictions in place in Texas. Texas residents are generally prohibited from taking out cash-out refinancings or second liens that would raise the total loan-to-value ratio to above 80%.

Five quarters after oil prices peaked, business and non- business bankruptcy filings increased 30% and 70%, respectively, in the 1980s. In contrast, both types of bankruptcy filings fell by about 10% from 2014Q2 to 2015Q3. In the case of non-business filings, the more limited response in the current episode may partly be due to effects of the 2005 US bankruptcy legal reform, which introduced tighter eligibility requirements for consumers filing for bankruptcy. 2015Q4 US bank earnings releases featured increases in loss reserves, in anticipation of possible future losses on energy exposures. However, the losses experienced by the banks to date have so far been limited. Our bank analysts believe the recent sell-off in bank equity is pricing in a worse loss scenario than is likely.

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In other words, things are going to get bad but not, Goldman figures, as bad as they could be.

Muppets should take that with a grain of salt because as Scott Merovitch, Houston division president for builder Chesmar Homes told WSJ, Texas may have figured out "how to diversify [its industry makeup] a lot, but it's still going to ebb and flow with oil and gas.”