Sorting Through the Rubble in Post-Bubble America

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"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. 52,000 jobs were cut
in manufacturing, while 331,000 have been lost in construction since
September 2006.

The Labor Department
also reported on 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 per cent from a year earlier, and sales of large retail
properties declined 31 per cent, 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 underwater, commercial real estate
is in the tank and the country is sliding inexorably into recession.

As
for 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 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 per cent 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 bond
holders 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 per cent 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 3 years, 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 per cent 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 per cent. Could it happen again?

You bet. Expect
to see the Dow hugging 7,000 by year end.

The Wall Street
Journal ran an article on 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 hen-house.

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 public’s 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 conquered."

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. On 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 per
cent (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 per cent 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.

On 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 insured.

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
quickly.

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.
(This 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 per
cent 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, analysts said.

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 6 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 a 13 per cent 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 ago."

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 infrastructure.”

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.

March
10, 2008

Mike Whitney
[send him mail] lives
in Washington state.

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