The financial system is coming apart at the seams. When historians set the starting date of the first depression of this century, it will be very close to now. Huge amounts of privately-issued debt securities have fallen seriously in price. More will be doing so. Stock markets are in bear markets, with financial stocks taking simply amazing nose-dives. Residential real estate tanked some months ago and is still falling in price. Commercial real estate prices fell in the last six months of 2007. The economy is in recession. The severity of the financial explosion suggests that the recession will be severe. A second Great Depression may occur, especially if our leaders make further policy mistakes.
Policy-makers and potential Presidents are behind the recognition curve. They are hardly even talking about the problems. They see some flames, but they don’t realize they are bonfires turning into rampaging wildfires. We hear the usual calming words that all is well and the economy is sound. We witness the usual actions, such as a tax cut and the Federal Reserve lowering its target interest rates. But these measures cannot and will not stop that which we are starting to experience: Deflation. The bubbles of 2000—2007 have burst. Asset prices are going lower. Debt defaults are coming out of the woodwork from every direction. In the words of Al Jolson, "You ain’t heard nothin’ yet."
McCain has said almost nothing about the mortgage defaults and foreclosures. Clinton has focused on the peccadilloes of the mortgage brokers. Obama’s concern has been mortgage fraud. Bush is providing the usual pap about the system being sound. Bernanke is simply following down the market’s decreases in interest rates of U.S. securities.
These leaders can see in part what’s going on. Who cannot? But they under-estimate its severity because they don’t know why it’s going on. Worse, they often have the wrong explanation for the deflation. And because they don’t know the reasons for the problems, they don’t know what to do or say about them. Speculators will sell assets even harder whenever they witness such high-level confusion. Band-aids and ritual motions won’t stop a severe hemorrhage.
The U.S. is experiencing a tidal wave of deflation, and it is hitting all sorts of credits. Every week a new category is swept along by the wave. Every week, we learn a new acronym for some financial instrument. Nothing can stop this wave, it appears. The market players are finally coming to terms with the risks they have for so long ignored. Risk premiums have risen very sharply and steeply.
The rating agencies can maintain the high bond ratings of the monoline insurers, but that will not fool the markets for long. It will merely give sellers and short-sellers a chance to liquidate more stocks. The banks can dream up plans of merging with their own providers of credit default swaps, but this will not fool anyone for long. If an insurance company that insured homes against fire was insolvent, would the homeowners be any better off by taking over the company? These proposals are acts of desperation. They only serve to underscore the severity of the problem as the bankers try to hide their insolvency.
The asset price deflation is evident, but the extraordinary commodity price rises (commonly called inflation) of the last six months or so confuse the recognition of the deflation. Like stocks and commercial real estate, commodities have been rising in price since 2004. That is simply part of the bubble economy, with the worldwide global monetary inflation contributing to this price rise. If the severe declines in asset prices we are seeing in bond and stock markets are any indication, commodities may simply be the last of the bubbles. Their prices will pursue a downward course at some point.
The Fed is powerless to stop the deflation. Bernanke is fighting the last war with the weapons of the last war if he thinks helicopters armed with greenbacks can curb the deflation. The existing bad debts are too large. They are held by too many large banks. It is not a case of one institution that is too large to fail. It is a case of too many institutions that are too large to save. If the Fed attempts to save them all by outright large-scale debt purchases, the result will be a huge dollar devaluation and increases in Treasury bill rates that lower the value of the Fed’s own holdings. The risk of that policy is hyperinflation. That option is not open.
What we instead are more likely to see is a lengthy workout process in which the bad debts are renegotiated and recontracted. We already see the start of this in the Fed’s TAF (Term Auction Facility) program. The Fed is making loans to banks in exchange for some of the bad paper the banks have. This step delays the problem from being legally recognized by a bank default, which would bring the FDIC into the act (and it has nowhere near enough funds to cover all the possible bank defaults.) The banks who are borrowing from the Fed still have to repay the loans, and the foreclosed homes behind the collateral will not provide the debt service. Sooner or later, these and all the other bad debts that will occur in the next few years will have to be worked out. The political system, including states and localities, will get into the act.
Behind the current deflation is a preceding inflation that has gone on since 1982. There has been no serious deflationary recession for decades. The Federal Reserve System and our leaders have encouraged the notion that they would not countenance a serious recession. They would prevent the downside risks of investing. That attitude, along with other political actions, encouraged a large debt or credit bubble to finance stock, bond, and real estate purchases.
The political system encouraged a basic financial sin. That sin was overtrading or overleveraging. Market players and borrowers, thinking the risk of loss or downturn was minimal, borrowed too heavily and loaded up too highly on assets. When those asset prices fell, even by moderate amounts, their losses shot upwards by large amounts due to the effect of the borrowing.
Financial education has played a role in this catastrophe, especially in the use of derivatives. Many of the ideas and models that finance professionals have been using to price derivatives have holes in them. Some professors knew of these holes, but many did not. Many professors lacked the practical experience to know how financial markets really operate, how great the risks can be, and what their character is. They relied too heavily on recent experience. And they turned out great numbers of students who implemented these models using assumptions that have proven to be false.
The bubbles have clearly now burst, except for the commodity price rises and they may end this year. (A large Fed inflationary action would keep that bubble alive.) A cascade of debt defaults is setting in. The highly leveraged condition of the banks and others is at work. The sub-prime collapse was the first notable collapse, but several others have followed in its wake. There is no sign that this process has terminated, and there is no evident reason why it should have yet terminated. This is why the bear markets in capital assets will keep on going. Prices have further to fall and will.
The Fed played a big role, but the Fed is not independent. Congress created it, and it is answerable to Congress. The Executive co-ordinates closely with it, especially through the U.S. Treasury. The Employment Act of 1946 applies to the Fed, and so it has a mandate related to full employment.
In the most recent episode, the housing market has been front and center. Our political leaders, including Alan Greenspan, encouraged home equity loans, legislatively encouraged home ownership among persons who could ill-afford them (see the American Dream Down Payment Act of 2003), and encouraged variable rate loans at teaser rates. They downplayed the risks. This speech by Greenspan pooh-poohed the massive debt increases of American homeowners.
The Congress is still playing the same game, encouraging more debt among Americans by raising the Fannie Mae loan limits. Spending instigated by borrowing will neither help the economy nor help untangle the foreclosure mess. The Congress is out of step with reality. Fannie Mae and Freddie Mac are at the center of the housing meltdown. They securitize mortgage loans. They themselves maintain incredibly high financial leverage. Their purchases of loan bundles enable mortgage originators to create new mortgage loans. Congress’ answer to the housing bubble is an attempt to blow it up again. Meanwhile, the stock market is deflating the stocks of Fannie Mae (FNM) and Freddie Mac (FRE).
The Congress worries about drug pushers while it is the biggest pusher of all. It is the master mortgage pusher. It has pushed home ownership and mortgaging for decades. In recent years, Congress was comfortable with lenders pushing loans of greater value than the house value at vanishing interest rates. It was comfortable with Fannie Mae securitizing these loans. Now, millions of foreclosures are the result of Uncle Sam’s mortgage pushing.
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.