Picking through the rubble of post-bubble America
By Mike Whitney
Online Journal Contributing Writer
Mar 11, 2008, 00:46
�Market conditions are the worst anyone
in this industry can ever remember. I don't think anyone has a recollection of
a total disappearance in liquidity . . . There are billion of dollars worth of
assets out there for which there is just no market.� Alain Grisay, chief
executive officer of London-based F&C Asset Management Plc; Bloomberg News
The hurricane that began with subprime mortgages, has swept
through the credit markets wreaking havoc on municipal bonds, hedge funds,
complex structured investments, and agency debt (Fannie Mae). Now the first
gusts from the Force-5 gale are touching down in the real economy where the
damage is expected to be widespread.
The Labor Department reported on Friday that US employers
cut 63,000 jobs in February, the biggest monthly decline in five years. The cut
in payrolls added to the 22,000 jobs that were lost in January. Fifty-two
thousand jobs were cut in manufacturing, while 331,000 have been lost in
construction since September 2006.
The Labor Department also reported last Wednesday that
worker productivity slowed significantly in the last quarter of 2007. When
productivity is off; labor costs go up which adds to inflationary pressures.
That makes it harder for the Fed to lower rates to stimulate the economy
without inviting the dreaded �stagflation� -- slow growth and rising prices.
The news on commercial construction is equally bleak. The
Wall Street Journal reports, �For the second month in a row, the Commerce
Department reported a decline in spending on nonresidential construction --
which includes everything from hospitals to office parks to shopping malls. . .
. Signs of trouble cropped up at the end of the year. As credit markets
tightened, office space sold in the fourth quarter dropped 42 percent from a
year earlier, and sales of large retail properties declined 31 percent, says
Real Capital Analytics, a New York real-estate research group. . . . If
spending continues to slow, construction workers, who are reeling from the
housing slowdown, face more layoffs.� [�Building Slowdown Goes Commercial,�
Wall Street Journal]
Commercial real estate is the next shoe to drop. There's a
tremendous oversupply of retail space nationwide and the bloodletting has just
begun. Builders have continued to put up shopping malls and office buildings
even though residential real estate has gone off a cliff. Now the battered
banks will have to repossess thousands of empty buildings in strip malls with
no chance of leasing them out in the near future. It's a disaster. From
December 2007 to January 2008 spending on commercial construction took its
steepest drop in 14 years. The sudden downturn is adding more and more people to
the unemployment lines.
So, what does it all mean? Unemployment is up, productivity
is down, inflation is increasing, the dollar is under water, commercial real
estate is in the tank and the country is sliding inexorably into recession.
The housing market
Housing is in its "deepest, most rapid downswing since
the Great Depression," the chief economist for the National Association of
Home Builders said last Tuesday, and the downward momentum on housing prices
appears to be accelerating.
"'Housing is in a major contraction mode and will be
another major, heavy weight on the economy in the first quarter,' said David
Seiders, the NAHB's chief economist.� [�Rapid Deterioration,� MarketWatch]
Home sales are down 65
percent from their peak in 2005. Inventory is stacked a mile high. Vacant homes
now number about 2 million, an increase of 800,000 since 2005. Demand is weak
and prices are plummeting. It's all bad. Meanwhile, the Federal Reserve and the
Bush administration are scrambling to devise a plan that will keep homeowners
from packing it in altogether and walking away from their mortgages. But what
can they do? Will they really write-down the principle on the mortgages like
Bernanke recommends and face years of litigation from bondholders who bought
mortgage-backed securities under different terms? Or will they simply allow the
market to clear and send 2 million homeowners into foreclosure in 2008 alone?
The deflating housing bubble is finally being felt in the
broader economy. Home equity is vanishing which is putting downward pressure on
consumer spending and shrinking GDP. Also, the dollar is at historic lows, and
an intractable credit crunch has left the financial markets in disarray.
Experts are now predicting that consumer spending won't rebound until housing
prices stop falling which could be late into 2009. When Japan experienced a
similar credit/real estate meltdown, it took more than a decade to recover.
There's no reason to believe that the present crisis will unwind any faster.
On Friday, banking giant USB estimated that credit woes
would end up costing financial institutions $600 billion, three times more than
their original estimate of $200 billion. But USB's forecast does not take into
account the $6 trillion of lost home equity if housing prices fall 30 percent
in the next two years, which is very likely. Nor does it account for the
potential losses in the structured finance market where $7.8 trillion of loans
(which are presently in �pooled securities�) have gone into a deep freeze.
There's no way of knowing how much capital will be drained from the system by
the time all of this plays out, but if $7 trillion was lost in the dot.com
bust, then it should greatly exceed that figure.
The housing bubble was entirely avoidable. It was the
policies of the Federal Reserve which made it inevitable. By fixing interest
rates below the rate of inflation for almost three years, then Fed chief
Greenspan ignited speculation in housing and created a false perception of
prosperity. In truth, it was nothing more than asset-inflation through the
expansion of debt. The Fed's actions were complemented by repeal of regulatory
legislation which prevented the commercial banks from dabbling in securities
trading. Once the laws were changed, the banks were free to peddle their
mortgage-backed securities to investors around the world. (A-rated
mortgage-backed bonds are currently fetching just 13 percent of their face
value!) Now, those sketchy bonds are blowing up everywhere leaving large parts
of the financial system dysfunctional.
As investors continue to run away from anything remotely
connected to mortgages; the price of risk, as measured by the spread on
corporate bonds, has skyrocketed. In fact, investors are even shunning
overextended GSEs like Fannie Mae and Freddie Mac. As the number of
foreclosures continues to soar, the aversion to risk will intensify, triggering
a savage unwinding of leveraged bets in the hedge funds as well as a wider
paralysis in the financial markets.
There's absolutely no doubt now that the storm that is
currently ripping through the financials will soon bring Wall Street to its
knees. It may be a good time to remember that on March 24, 2000, the NASDAQ
peaked at 5048. On October 9, 2002, it bottomed out at 1114; a loss of nearly
80 percent. Could it happen again?
You bet. Expect to see the Dow hugging 7,000 by year's end.
The Wall Street Journal ran an article last Tuesday which
outlined how the banks changed standards at the Basel meetings in Switzerland
to give them greater autonomy in deciding issues that should have been governed
by strict regulations:
�Some of the world's top bankers spent nearly a decade
designing new rules to help global financial institutions stay out of trouble .
. . Their primary tenet: Banks should be given more freedom to decide for
themselves how much risk they should take on, since they are in a better
position than regulators to make that call.� [�Mortgage Fallout Exposes Holes
in New Bank-risk Rules,� Wall Street Journal]
It is a classic case of
the foxes deciding they should oversee the henhouse.
The Basel Committee on Banking Supervision is an
industry-led group comprised of the central bank governors from the G-10
countries: Belgium, Canada, France, Italy, Japan, the Netherlands, Sweden,
Switzerland, Britain and the US. Basel is supposed to establish the rules for
maintaining sufficient capitalization for banks so that depositors are
protected. But it's a sham. It appears to be more focused on maintaining US and
European dominance over the developing world and making sure the levers of
financial power stay in the manicured paws of Western banking mandarins.
Now that the financial system is in terminal distress; many
people are questioning the wisdom of handing over so much power to
organizations that don't operate in the publics interest. Thomas Jefferson
anticipated this scenario and issued a warning about the perils of abdicating
sovereignty to unelected, profit-oriented bankers.
He said, �If the American people ever allow private banks to
control the issue of our currency, first by inflation, then by deflation, the
banks and the corporations that will grow up will deprive the people of all
property until their children wake up homeless on the continent their fathers
Even though the nation is stumbling towards an economic hard
landing, the banks are still only interested in finding a way to save
themselves. Last week, the New York Times revealed a �confidential proposal�
from Bank of America to members of Congress asking the US government to
guarantee $739 billion in mortgages that are at �moderate to high risk� of
defaulting to save the banks from potential losses. Last Thursday, Rep. Barney
Frank, operating in the interests of his banking constituents, made an appeal
in the House of Representatives on this very issue, saying that Congress should
consider buying up some of these sinking mortgages to help struggling
homeowners. But why should the taxpayer pay for the mistakes of privately owned
banks, especially when those banks have been bilking the public out of billions
of dollars through the sale of worthless subprime securities?
The Fed has already
lowered the Fed Funds rate by 2.25 basis points to 3 percent (more than a
full-point below the current rate of inflation) to help the banks recoup some
of their losses from their bad bets. Bernanke has also opened a Temporary
Auction Facility (TAF), which allows the banks to use mortgage-backed
securities (MBS) and other structured investments as collateral at 85 percent
their face value, even though the bonds are only worth pennies on the dollar on
the open market. So far, the TAF has secretly loaned out $75 billion to
capital-depleted banks, which Bernanke thinks is a positive development. But
why is the Fed chief encouraged by the fact that the country's largest
investment banks need to borrow billions of dollars at bargain rates just to
stay solvent? The truth is that many of the banks are just padding their
flagging balance sheets so they can scour the planet looking for investors to
buy parts of their franchises.
Last Tuesday, Bernanke addressed the Independent Community
of Bankers of America, exhorting them to take whatever steps are required to
keep homeowners with negative equity from walking away from their mortgages.
Along with the proposed �rate freeze� on adjustable rate mortgages (ARMs), the
Fed chief also suggested that the lenders lower the principle on the mortgages
to entice homeowners to keep making nominal payments on their loans. But,
clearly, foreclosure is the wisest choice for many homeowners who may otherwise
be chained to an asset of steadily declining value for the rest of their lives.
Homeowners should base their decisions on what is in their best long-term
financial interests, just as the bankers would do. If that means walking away,
then that is what they should do. The homeowner is in no way responsible for
the problems deriving from the subprime/securitization scam. That was entirely
the work of the bankers.
The FDIC has begun to increase staff at many of its regional
offices to deal with the anticipated rash of bank failures in states hardest
hit by the housing bust. California, Florida and parts of the southwest will
definitely need the most attention. These states are undergoing a housing
depression and many of the smaller banks, which issued the mortgages and
commercial real estate loans, are bound to get hammered. They simply do not
have the capital cushion to withstand the tsunami of defaults and foreclosures
that are coming. Depositors should make sure that all their savings are covered
under FDIC rules; no more than $100,000 per account. Money markets are not
Also, the G-7 nations announced last week that if
�irrational� price movements persist, they would �collectively take suitable
measures to calm the financial markets.� The group added that they would
conduct their activities secretively for maximum effect. Consider how desperate
the situation must really be for G-7 finance ministers to issue a public
warning that they are planning to intervene in the market to prevent a
calamity. This is stunning. The group did not specify whether they were talking
about propping up the stumbling greenback or buying up futures in the equities
markets like a global Plunge Protection Team. Nevertheless, their comments add
to the growing perception that things are out of control and deteriorating
With oil, gold and food prices soaring, the
Fed has been roundly criticized for cutting rates and risking further erosion
to the value of the dollar. (Friday morning the dollar fell to $1.53 on the
euro!) But Bernanke is right; the real danger is deflation. We are at the
beginning of a consumer-led recession; characterized by weakening demand, lack
of personal savings, declining asset-values (particularly homes) and over-indebtedness.
The Fed's increases to the money supply via low interest rates will not affect
the dramatic economic slowdown that will be evident within the year. Trillions
of dollars of derivatives, over-leveraged subprime assets and otherwise bad bets
are all unwinding at the same time, draining an ocean of virtual capital from
the economy. If credit keeps getting destroyed at the present pace, the country
will be in the grips of a depression-like slump by 2009.
The Wall Street Journal's
Greg Ip puts it like this in his article �For the Fed, a Recession�Not
Inflation�Poses Greater Threat�: �So why is the Fed more worried about
growth than inflation? First, it thinks run-ups in commodity prices explain the
increases, not only in overall inflation but also in core inflation: higher
energy costs have 'passed through' to other goods and services. Core inflation
rose and fell with energy inflation between early 2006 and mid-2007, and the
Fed thinks the same thing is probably happening now. If energy and food prices
stop rising -- they don't have to actually fall -- both overall and core
inflation should recede."
Ip continues: �Fed officials don't think the latest jump [in
food and energy] can be justified by fundamental supply and demand. . . . A
more likely explanation, investors perhaps alarmed by the Fed's dovish stance,
are pouring money into commodity funds and foreign currencies as a hedge
against inflation. . . . But speculative price gains can't be sustained if the
fundamentals don't support them. If the Fed and the futures markets are right,
prices will be lower, not higher, a year from now.�
Bernanke is right on this point. Temporary price increases
are not the result of shortages, increased production costs, or fundamentals,
but speculation. In fact, demand for petroleum products has been down by 3.4
percent over the last four weeks compared to the same time last year, which
means that prices will probably drop steeply once the commodities frenzy runs
out of steam. Investors are simply looking for somewhere to put their money
rather than in shaky corporate bonds or overpriced equities. Commodities are
the logical alternative. But as soon as consumer spending stalls, all
asset-classes will fall accordingly, including gold and oil. (And, yes, the dollar
should recover some lost ground, however temporary.)
Many analysts believe oil's rally will be short-lived.
Falling demand for overall petroleum products, which was down 3.4 percent over
the last four weeks compared to the same time last year, suggest prices could
drop steeply once the dollar-driven oil investment frenzy runs out of steam,
Cyclical downturn or post-bubble recession?
An article in the New York Times by Morgan Stanley's Asia
chairman, Stephen Roach, states that the country is not in a cyclical downturn,
but post-bubble recession. There is a big difference. The Fed's interest rate
cuts and Bush's �Stimulus Plan� are unlikely to stop housing prices from
continuing to fall nor will they miraculously fix the problems in the credit
markets. The massive expansion of credit in the last six years has created a
$45 trillion derivatives balloon that could implode or just partially unwind.
No one really knows. And no one really knows how much damage it will cause to
the global financial system. Stay tuned.
Roach notes that the recession of 2000 to 2001 was a
collapse of business spending which only represented 13 percent of GDP. Compare
that to the current recession which �has been set off by the simultaneous
bursting of property and credit bubbles. . . . Those two economic sectors
collectively peaked at 78 percent of gross domestic product, or fully six times
the share of the sector that pushed the country into recession seven years
Not only will the impending recession be six times more
severe; it will also be the death knell for America's consumer-based society.
Attitudes towards spending have already changed dramatically since prices on
food and fuel have increased. That trend will only grow as hard times set in.
Roach adds: �For asset-dependent, bubble-prone economies, a
cyclical recovery -- even when assisted by aggressive monetary and fiscal
accommodation -- isn�t a given. . . . Washington policymakers may not be able
to arrest this post-bubble downturn. Interest rate cuts are unlikely to halt
the decline in nationwide home prices . . . Aggressive interest rate cuts have
not done much to contain the lethal contagion spreading in credit and capital
markets. A more effective strategy would be to try to tilt the economy away from
consumption and toward exports and long-needed investments in
The Federal Reserve and Washington policymakers are still
stuck in the past trying to revive consumer spending by creating another equity
bubble with low interest rates and their $600 per person �stimulus� giveaways.
This is a mistake. Invest in infrastructure and environmentally-friendly
technologies, rebuild the economy from the ground up, reestablish fiscal sanity
and minimize deficit spending, put America back to work making things that
people use and that improve society, and (as Roach says) �help the innocent
victims of the bubble�s aftermath -- especially lower- and middle-income
families.� And, most importantly, abolish the Federal Reserve and give the
control of our money back to our elected representatives in Congress. That is
the only way to put America's economic future back in the hands of the people.
That's a plan we can all get behind. It's time to split the
new wood and start fresh.
Whitney lives in Washington state. He can be reached at email@example.com.
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