Precipitating the fall
By Jack Rasmus
Rasmus's ZSpace page
Last year we witnessed the emergence of the most serious financial crisis to hit the U.S. and the greater global economy since the 1930s—a crisis that has already begun to precipitate a major recession in the U.S. in 2008 and, in turn, raising the odds for a wider global downturn in 2009.
History will show a remarkable congruence between the conditions, events, and policies of the decade of the 1920s, on the one hand, and the events and policies of the past decade.
The 1920s were characterized by:
an over-extended housing and construction boom in mid-decade that imploded
a slowdown in investment in the productive economy as speculative investment steadily crowded out real investment
a Federal Reserve System that pumped up the money supply without concern for its eventual speculative impact
an increasing imbalance in world trade and currency instability
the near destruction of labor unions—to name the more notable
The progressive destruction of unions over the course of the 1920s, when combined with the radical restructuring of the tax system that provided massive tax cuts for the wealthy and corporations, resulted in a dramatic shift in income distribution toward wealthy investors and corporations from the rest of the working population. By 1928 the wealthiest households had doubled their share to 22 percent of all incomes in the country, according to IRS data. Perhaps more than any single contributory factor, the rapid and extreme growth of income inequality during the decade was eventually responsible for the ultimate financial implosion of 1929 and the consequent depression. The massive shift in incomes that fed the speculation in turn resulted in a further income shift, as super-profits were realized by the wealthy from the speculative investment frenzy. More concentration of income in turn provoked a dizzy spiral of asset price inflation, speculative profits, and a euphoric expectation the process would continue without limit.
The speculative excesses of the 1920s were assisted by a host of shady business practices—in the banking industry in particular—that were condoned by business, media, and the government. Some of the more notable practices included the explosion of buying stocks and securities on margin—or what is sometimes called leveraging. It included practices that ensured the speculation remained near invisible to average investors; practices by which private businesses, responsible for rating investments for the general public, lied to the public as a consequence of conflicts of interest. The government refusal to monitor or check the speculative excesses also contributed.
The foregoing process culminated in a stock market crash, once the cracks in the real economy began to appear and the speculative boom quickly turned to the bust of October 1929. As in all such similar speculative booms and busts, the financial crisis of 1929 in turn exacerbated and accelerated the already declining real economy by freezing up credit for investment, ensuring further corporate defaults, massive job losses, and subsequent decline. Thus, while the increasingly speculative activity was not the sole cause of the crisis, it was a critical and central development provoking the crash and the depression that followed.
As in the 1920s, in the last decade the U.S. has been lurching from one speculative bubble to the next. These include:
the Long Term Capital Management (LTCM) hedge fund bailout of 1998
the Asian debt crisis of 1998 (at the center of which were U.S. money center banks)
the dot-com technology asset bubble of 1999-2000
the recent subprime mortgage bust (the foundations for which were laid in 2003-04)
the recent rapid spread of the subprime crisis in 2007-2008 to other capital markets in the U.S.
The series of speculative bubbles from 1998-2008 in each case were temporarily contained by an unprecedented expansionary monetary policy engineered by the U.S. Federal Reserve under Alan Greenspan. The Greenspan Fed thus contributed to the series of bubbles with money injections designed to stave off the spread of liquidity crises and credit crunches. The temporary fixes did not solve the problem, but postponed the crisis for the short term. The result has been a containment each time that has bottled up pressures, which then emerged once again with subsequent greater effect.
While Federal Reserve policies have thus enabled the speculative flames, the rapid growth of income inequality since 2000 provided the kindling. A major, historic shift in incomes in the U.S. clearly began under President Reagan and continued unabated under Clinton. In recent years, under George W. Bush, that inequality has accelerated. Starting with a share of only 9 percent of total national income, for example, by 2006 the wealthiest 1 percent of households had again raised their total share to the 22 percent they enjoyed in 1928.
As in the 1920s, the rapid rise of income inequality has been driven largely by the restructuring of taxation, as more than $4 trillion of tax cuts were passed in Bush’s first term alone, 80 percent of which is projected to accrue to the wealthiest households and large corporations. Further corporate tax cuts of more than a $1 trillion were passed in his second term. Meanwhile, the rest of the population has experienced income stagnation and reduction as the decline of unions has continued, the post-World War II pension and health-care benefit systems have accelerated their collapse, the shift to part-time and temp jobs from full-time and permanent employment has continued, and millions of high paid jobs have disappeared due to neoliberal trade and offshoring.
The growth of incomes by the wealthy provided the huge pool of income and wealth with which to engage in speculative investment activity. As short term speculative activity resulted in significantly greater returns than real investment activity, more and more investment was shifted into speculative activity or from real investment in the U.S. home market to investment offshore in the so-called emerging markets—in particular, in China and Asia. In addition to the growing income imbalance and the easy money policies of the Greenspan Fed, a third critical element has been the elimination of any semblance of financial regulation and oversight, which was given a coup-de-grace in 1999 with the repeal of the 1930s-era Glass- Steagall Act. Glass-Steagall was supposed to prevent speculative and other abuses.
As Glass-Steagall was being progressively undermined under Reagan, Bush I, and Clinton, the so-called financial revolution was taking off. With that revolution in finance came a corresponding proliferation of new financial structures and relations. When combined with new technologies of computer processing power, soft technologies (e.g. quantitative modeling), networking, and the Internet, the financial system has become the first sector of economy that has been truly globalized. In turn, with globalization has come the further inability to regulate finance capital and, indeed, even to monitor its activity accurately. Thus, deregulation plus technology and globalization has meant further de facto deregulation.
In the past decade U.S. finance capital has been unleashed, as it once was in the 1920s, to do whatever it wishes and to push the speculative investing envelop as far and in whatever direction it pleases. It is therefore no coincidence that since the late 1990s the U.S. economy has veered headlong from one financial crisis to another with virtually no breathing space in between. We are now beginning to see the consequences of this concurrence of total financial deregulation, unchecked financial restructuring, accelerating income inequality, and accommodative government monetary policy which is now yielding even greater financial crisis, U.S. recession, and a threat of global instability.
Derivatives and the Securitization Revolution
If Structured Investment Vehicles (SIVs) and hedge funds are the vehicles of the new speculative and financial crisis, their products amount to a vast array of acronyms like CDOs, ABCP, CBO, CMBS, CLO, CDS, CDPO, and so on. To understand the current financial crisis it is first necessary to understand the so-called securitization revolution that the new institutional structures and financial devices represent. And the securitization revolution is based upon the granddaddy of over-leveraging called derivatives.
Derivatives involve the fictitious development of financial asset products offered for sale to investors, private and corporate. They have no intrinsic value. They derive their value from other real assets or other financial products. They have virtually no cost of production. Their costs of distribution and sale are essentially non-existent. Their market price is largely the outcome of speculative demand and, to a lesser extent, how fast financial institutions can create the original financial assets (e.g., mortgage loans) on which the derivatives are then developed. Moreover, derivatives can be created on top of derivatives in an unlimited pyramid of speculative financial offerings. Like a house of cards, the offerings may be stacked upon each other, until such time as one of the cards slips out of place and brings the rest down with it.
In today’s global economy there are more than $500 trillion in derivatives outstanding. That compares to a global annual gross domestic product for all the nations of the world of less than $50 trillion, and to the U.S. annual GDP of approximately $13 trillion. In other words, there are now more than ten times in derivative contracts than all the real goods and services produced by all economies in the world annually. The world’s wealthiest investor, Warren Buffet, has called derivatives “time bombs both for the parties that deal in them and the economic system.” They represent, according to Buffet, “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Subprime mortgages represent one relatively small land mine in the panoply of “financial weapons of mass destruction” described by Buffet. Subprimes are an essential element of just one example of super speculative investment built on one form of derivative called a CDO, a Collateralized Debt Obligation. Subprime mortgages lay at the foundation of the CDO’s derivative pyramid. The mortgages themselves represent the value of a real asset—i.e., the housing product on which the mortgage is based. The mortgages are then packaged into the fictitious financial asset package called the CDO, which is then marked up by the financial institution which sells the CDO to wealthy investors, hedge funds, other funds, or corporations. The mortgages themselves are not packaged in original form in the CDO, but instead are broken up, i.e., divided into slices that may be distributed across various CDOs. Only parts of any given subprime mortgage may thus reside in any given CDO offering: parts of other assets are typically sausaged into the same CDO alongside the subprime slice as well. These other assets may themselves be fictitious in character (i.e., not based on any real physical asset) or may be based on some real asset—for example commercial paper issued by some real company to raise funds to carry on or expand its real business; or a loan issued by a bank backed by real collateral (e.g., CLO). Other forms of bundled assets may include fictitious securities issued based on expectations of future ticket sales for sports events, a rock star’s future concert royalties, or even more absurd examples of so-called bonds.
Not all CDOs have subprime mortgages bundled within their packaged market offering. Some may have slices of higher grade mortgages or what are called Alt-A mortgages. Or they may have both. Many CDOs also include what are called Asset Backed Commercial Paper (ABCP). Many companies with doubtful performance and future prospects unable to raise capital more economically from other sources have entered the ABCP market in recent years to raise cash and stave off default. Their commercial paper is then bundled with a CDO and offered to market. Thus shaky subprime mortgages may be packaged with equally shaky corporate commercial paper.
But the banks and other institutions that eventually sell the CDOs were, at least until the recent crisis began to appear in late summer 2007, not all that concerned about the quality of such derivative-CDOs. Their relative unconcern flowed from their ability to buy insurance for the CDO in the form of yet another derivative called a Credit Debt Swap or CDS. Yet another means by which banks attempted to insulate themselves from the shaky quality of speculative investments has been their creation of Secured Investment Vehicles. SIVs are in essence electronic shadow banks set up by investment and commercial banks like Morgan Stanley, Bear Stearns, Citigroup, Bank of America (and virtually every known national or regional major bank in the U.S.) to offload potentially risky CDOs from the banks’ balance sheets, where bank record keeping is subject by law to review by the U.S. Securities and Exchange Commission. With SIVs typically quickly turning over, or selling, to hedge funds and other wealthy investors and corporations, a third safety valve presumably existed.
Subprime mortgages, bundled within CDOs, issued by SIVs, and held off balance sheet by the big banks represent a highly profitable enterprise for the banks. First, the banks make money from fees issuing the CDO. Second, they are able to offload assets from their bank balance sheets thereby both reducing capital carrying costs as well as making available more bank reserves for loaning out at interest. Third, their SIVs make money from marking up and selling the CDOs as well as from insuring them at an additional charge with credit debt swaps. It is therefore not surprising that mainline investment and commercial banks experienced compound profit growth of more than 20 percent per year collectively for each year from 2004 through 2006—i.e., roughly the period of the most explosive growth of subprime mortgages bundled with CDOs.
The above scenario is sometimes referred to as an example of the so-called securitization revolution in finance. Securitization is the process of assembling assets on which new securities are issued and then sold to investors who are (in theory) paid from the income flow created by the assets. The more risky the assets contained within the CDOs, the lower the credit ratings but the higher the potential return. The justification for the highly speculative and high risk character of the offerings is that by slicing the CDOs into tranches, based on the degree of risk in the assets in the given CDO, the risk would be dispersed among a large population of investors. In reality, however, the result was the dispersion of contagion not dispersion of risk from the risky investments.
In 1998 the total international volume of securitized offerings amounted to less than $100 billion. By 2003 it had risen only to $200 billion, more than $500 billion in 2005, and exceeded $1 trillion in 2006.
Bursting the Subprime-CDO Bubble
Business press pundits repeatedly query about why so many subprime mortgages were issued to home buyers who clearly could not qualify for mortgage loans on any reasonable criteria or would be unable to make payments once interest rates inevitably rose to normal levels. What the pundits don’t understand is that, given the increasing trend over time toward a greater relative mix of speculative to total investment arrangements in the capitalist economy, it is quantity, not quality, of investment opportunity that takes precedence. Since 2003 the practice of banks had been to encourage mortgage loan companies to produce more loans regardless of the quality. Mortgage loan companies in turn encouraged real estate brokers to deliver more loans without consideration of quality. And real estate brokers did whatever was necessary to close the deal with home buyers.
No matter if the total volume of mortgage loans by 2005-06 were more subprime than not. The quantity of loans, not their quality now mattered most. And quantity was only part of the new profit model. Finance profitability was becoming less and less dependent on the issuance of loans per se, but increasingly on derivatives and their supporting institutions. By 2005 more than $635 billion of subprime loans were issued. In 2006 the amount was another $600 billion and the cumulative total by 2007 was more than $1 trillion.
By mid-2006 it had become clear that the subprime mortgage market was in freefall. Home buyers with subprime mortgages were now defaulting on payments at record rates and foreclosures were beginning to rise. By late summer 2007 it was estimated that there would be two to three million potential foreclosures over the next few years. The value of subprime mortgages quickly plummeted and with them many of those CDOs in which they were imbedded. The subprime mortgage market virtually shut down. It was not possible to accurately estimate the magnitude of the losses from the subprimes since they were sliced and distributed within different CDO offerings. And if the losses for the subprime elements in CDOs could not be accurately valued, the CDOs could not be accurately valued. Nor could the asset backed commercial paper often bundled with the CDOs. And so on.
The typical response of investors in such situations is to ask how much their investments were under water. When they cannot be accurately told, their next response is often “sell my investment and give me the cash remaining.” But with no markets for subprimes by late 2007 their remaining value was impossible to estimate. No sales meant no price meant no possible valuation estimate and in turn no cash out. Investors, like the banks and their SIVs, were locked together in many cases in a death spiral, unable to bail out and destined to ride the doomed vehicle into the ground.
By late 2007 various estimates place the value of expected losses from the subprime market collapse from Goldman Sachs’s low of $211 billion and the OECD’s estimate of $300 billion to estimated losses— based on the ABX Index, the official measure of subprime mortgage securities’ value—at approximately $400 billion. In stark contrast to these estimates the losses admitted by the major banks as of year end 2007 amounted to only a paltry $60 billion. More, indeed, much more in terms of bank losses and bank write-downs are yet to come in 2008.
But subprime losses and write-downs on bank balance sheets were only part of the bigger picture.
Spreading the Subprime-CDO Pain
The estimated total volume of all CDOs worldwide (not all of which have subprime mortgages bundled with them) is, according to the OECD, approximately $3 trillion in total value. Approximately half that total is held by hedge funds, a fourth by banks, and the remaining exposure by asset managers and insurers.
As noted, many of CDOs also bundled commercial paper—sometimes with subprimes and often without. But asset backed commercial paper appears equally at risk as subprime mortgages and the consequences of its collapsed are yet to be fully realized.
Like the subprime mortgage market, the ABCP market experienced a sharp run up between 2003-07 in conjunction with the acceleration of CDOs and other derivatives. Many companies in trouble financially and unable to raise capital to continue turned to the ABCP to issue commercial paper on their remaining real assets to raise cash for operations or investment purposes. Much of their risky commercial paper was bundled with CDOs. But like the subprime market, the ABCP market has virtually shut down as well since the advent of the financial crisis in late summer 2007. The ABCP market in the U.S. peaked at $1.2 trillion in August 2007 and had fallen to $700 billion by year end. By June 2008 an additional $300 billion is projected to come due. That’s another $300 billion banks may have to provide for on their balance sheets, in addition to the $400 billion in additional subprimes coming due. In Europe the commercial paper market is also declining rapidly, having fallen 44 percent by October 2007 to $172 billion from a May peak of $308 billion.
With the ABCP market largely shutting down, many corporations straining to stay in business in recent years by selling their commercial paper will likely begin to default. That means a sharp rise in business bankruptcies. For example, non-farm business debt rose by 30 percent in 2004 and continued thereafter at above average levels. Many CDOs helped hold off defaults and failures between 2003-07 by imbedding their commercial paper. But with the shutdown of the ABCP markets, pressures for corporate defaults will be released with the consequent result of sharp increases in corporate bankruptcies in 2008-09. The corporate ratings agency, Moody’s, predicts an increase in default fates between four and ten times in the period immediately ahead, the highest since the peak fallout from the dot-com bust in 2002.
How the current financial crisis has been spreading at an historically rapid rate from the subprime to other capital markets, and how the crisis is being transmitted in turn from those latter markets to the general economy in the U.S.—thereby guaranteeing a recession in the U.S. in 2008 and threatening to expand globally in 2009—will be addressed in Part II of this analysis.
From Financial Crisis to Recession, Part II
Symptoms appear of a fundamental financial instability
By Jack Rasmus
Rasmus's ZSpace page
Part I of this series appeared here in the March issue of Z Magazine
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In testimony before the U.S. Congress House Financial Services Committee at the close of February 2008, U.S. Federal Reserve Bank (Fed) Chair Ben Bernanke acknowledged for the first time what many in finance, banking, and government policy circles have quietly begun to admit: that the current financial crisis is now spreading rapidly beyond the subprime residential mortgage sector to other credit markets and that monetary policy action by the Fed (i.e., lowering interest rates) appears increasingly unable to do much about either the financial crisis or the emerging recession.
As Bernanke admitted to the Committee on February 27, 2008: "The (recent) economic situation has become distinctly less favorable," with the residential mortgage market decline accelerating, non-residential construction "is likely to decelerate sharply in coming quarters," consumer spending and the business sector will both slow significantly, and general credit conditions likely to "tighten substantially." Moreover, "the risks to this outlook remain to the downside." Bernanke admitted that the Fed, despite repeatedly lowering short term interest rates since September 2007, had failed to lower long term interest rates. In fact, long term rates—which have a far greater impact on consumer and business spending and thus on the likelihood of recession—have actually begun to rise "across the board."
What follows is a description of how the financial crisis has been spreading at a rapid rate in the U.S., from the subprime mortgage to other credit markets, and how that contagion is beginning to penetrate the real (non-financial) economy, causing the deep recession now emerging in the U.S.
July-December 2007
The subprime mortgage crisis that erupted publicly in July-August 2007 did not cause the current financial crisis, but was just one of several (and now growing) symptoms of a deeper more fundamental financial instability. Speculation in subprime mortgages—fueled by the new securitization and derivatives revolutions in finance, virtual deregulation of finance capital since the late 1990s, new technological forces, and widespread corruption and fraud on numerous fronts—produced a housing asset price bubble of epic dimensions between 2003-2006. Mortgage borrowing rose more than $4 trillion between 2003-6 with $2 trillion of that issued in subprime mortgages. That's approximately $1 trillion a year for 4 consecutive years. Today, the subprime mortgage market has virtually evaporated, with much of the non-subprime market in turn rapidly coming to a standstill.
With the evaporation of the subprime market came a collapse in prices and value for subprime mortgage securities (bonds). Because of the magnitude of the speculation ($2 trillion) in subprime mortgages, the magnitude of losses by banks and financial institutions was immense as well. According to rating agencies Moody's and Standard & Poor's, by early 2008 the losses totaled a minimum of $400 billion. Other foreign bank sources estimate the potential losses from subprimes in the U.S. at $600 billion. Banks and finance institutions have thus far written off only $120 billion. That leaves $280-$480 billion to go.
The massive nature of the losses quickly led to the collapse of other credit markets most closely related to the subprime market. Subprimes were often bundled with other securities before being sold as repackaged deals by banks and hedge funds to investors, with commercial paper called asset backed commercial paper (ABCP). As subprimes collapsed by $600 billion in 2007, the ABCP market plummeted by about $500 billion along with it within a matter of a few months. Contagion from the subprime market also infected the non-subprime mortgage market (called Alt-A mortgages). Similarly, the ABCP market infected the non-asset backed broad commercial paper market. In turn, the commercial property mortgage market plummeted by several hundred billion dollars by the end of 2007, with projections for its likely shut down to occur by mid-2008.
The cumulative credit contraction for just these 5 inter-related markets amounted to more than $1.6 trillion, occurring in less than 6 months, with associated bank losses and write downs estimated at around $600-$800 billion.
January-February 2008
The construction (housing-commercial) and closely related commercial paper markets' decline almost immediately began to spill over to the corporate bond markets, in particular the so-called high yield corporate or junk bond market which contracted by 90 percent by January 2008 compared to January 2007, dropping by more than $900 billion. Like the ABCP market, the junk bond market is where economically shaky corporations go to raise funds by issuing and selling their unsecure bonds. With ABCP and junk bond credit markets collapsing, corporations that previously relied on them are predicted to default in record numbers. Default rates are predicted to surge from one percent to more than ten percent, according to both Moody's and Standard & Poor's. That in turn means massive further losses for banks on top of subprime and commercial property mortgage losses already occurring. It also means that as those corporations default, many going bankrupt and out of business, the result will be widespread layoffs over the next 18 months.
Rising corporate defaults and anticipated subsequent bank losses translate into rising interest rate costs for otherwise stable companies. From the corporate junk bond market, the credit contraction has spread to more mainstream business credit markets, like the commercial and industrial bank loans and short term commercial paper markets. Together, these two represent credit markets that most medium and smaller sized corporations most heavily rely upon to finance business operations. The two markets had a combined total of $3.3 trillion in outstanding credit issued to business in August 2007. By early 2008 that amount had declined by more than $300 billion.
Another credit market taking a dive by early 2008 was the leveraged buyout (LBO) market. This was a hot speculative investment area in which companies arranged loans and other financing through investment banks in order to buy out other companies or go private in order to avoid government oversight of speculative and other even more shady business practices. By early 2008 more than $200 billion in loans for leveraged buyouts were left hanging without interested buyers. This meant banks and original investors would eventually have to absorb the losses themselves.
But the even bigger news of early 2008 was the growing likelihood of bond insurer companies, like MBIA, Ambac, and others (called monolines) facing downgrading and perhaps default themselves. These companies insured other companies' bonds and loans, promising to pay investors for corporate and other bond defaults should they occur. But with combined reserves of only $20-$30 billion on hand, the half dozen bond insurers are themselves grossly underfunded. Their combined liabilities (i.e., insurance commitments) amount to more than $1.9 trillion. Moreover, they too speculated in subprimes as well as other derivative investments in the amount of $572 billion. It has become increasingly clear to investors and markets that the reserves monolines were woefully inadequate. Rating agencies had conveniently overlooked their condition during the speculative run-up. But Moody's and S&P are now threatening to downgrade the bond insurers. Should that occur, countless corporations and banks that purchased their insurance could face severe downgrades as well, resulting in further losses and defaults.
The precarious position, and potentially huge losses of the monolines prompted global financier George Soros recently to comment, "There is a growing concern about the monolines...there is also a potential problem with money market funds which could be holding doubtful assets." Soros's concern was echoed by JP Morgan CEO, Jamie Dimon, who added, "If one of these entities (bond insurers) doesn't make it, the secondary effect could be terrible." That secondary effect would be the downgrading and consequent default of hundreds of billions in corporate bonds—on top of the already projected 10 times increase in corporate defaults in 2008.
Some analysts predict that the bankruptcy or even major downgrade of one or more bond insurers could easily spill over to the $3.3 trillion money market fund market or the $2.5 trillion municipal bond market, precipitating an institutional run on the banks that would be quite unlike individual depositors' bank runs in the 1930s and before. Early indications of just such a possible scenario began to emerge in February 2008, as key sectors of the muni bond market began to dry up. With about half of municipal bonds insured by the bond insurers, the safety of muni bonds began to be questioned. Two key segments of the muni market contracted sharply—i.e., auction rate and variable rate municipal bonds, which finance around $330 billion and $500 billion, respectively. Strategically critical for state and local government funding, shrinking trades at muni markets threatened significant cost increases and funding problems for local governments. Many state and local government authorities now face excessive borrowing costs at a time of accelerating recession and lower tax revenues.
Another insurer avenue also began to come under pressure by early 2008. This was the derivatives-based credit default swaps market. Virtually nonexistent prior to 2002, outstanding credit default swaps now total more than $45 trillion, bigger than the total U.S. government bond and housing markets combined. Most securities in this market reside in a shadow banking system, itself largely a product of the post-2001 period, set up by banks to park risky assets "off balance sheet" and hidden from investors and government oversight agencies alike (an arrangement similar to that at the now defunct ENRON Corp., for which that company's senior management were indicted and jailed). Like the monolines, credit default swap derivatives are designed to insure against defaults. But if corporate bond defaults approach normal levels of 1.25 percent, Bill Gross, managing director of the world's largest bond fund, Pimco, publicly pointed out that $500 billion in credit derivative contracts would result in losses of at least $250 billion.
Perhaps an early red flag of the beginning of just such a fracturing of the $45 trillion credit derivatives market was the dramatic losses announced in January by the major French bank, Societe General, which raised the possibility that the problem was not limited to subprimes and asset backed paper, but was actually far more widespread, just as Pimco head Bill Gross had predicted.
Signs of major problems in the insurance industry also emerged in early 2008, as AIG Inc., the largest insurance company by assets, announced record losses of $11.5 billion due to credit default swaps trading. The picture by the end of February 2008 was one of a rapidly spreading credit contraction, in part the product of accelerating write downs and losses.
The losses and credit contraction do not include additional potential losses and contraction in consumer credit—in particular in areas of auto loans, credit card debt, and student loans. Evidence now appearing suggests significant losses are anticipated in these markets as well. Major credit card companies like American Express and others have announced record level loss provisioning and set asides in anticipation of consumer defaults. A growing list of public universities have announced shutting down student loan programs due to sharply rising borrowing costs. General Electric Corp. announced its intent to exit the consumer credit markets altogether. Thus, the mortgage, bank, and corporate debt problem appears by early 2008 to be infecting consumer markets. Like excessive corporate debt, total household debt from 2003-07 roughly doubled, rising by nearly $7 trillion.
Financial Crisis Is Creating Recession
How do these financial losses translate to a deepening recession in the general U.S. economy? The short answer is that financial losses have two immediate consequences. First, losses on financial institutions' balance sheets mean losses must be restored by raising additional real capital. If not, the institutions themselves may default. They can borrow from other banks, from the Federal Reserve, or, as has recently been the case, from what are called sovereign wealth funds, which are foreign government owned investment funds. The first option is a problem when banks are suspicious of each other's financial viability. Interbank borrowing thus dries up, as it almost did in late 2007. Borrowing from the Federal Reserve is the second option and has been occuring since late 2007 under especially favorable terms by the Fed. But Fed loans have thus far proved insufficient to cover the anticipated magnitude of future losses by the banks. Similarly, sovereign wealth funds located in Dubai, Singapore, and elsewhere have injected funding into the banks by purchasing partial ownership of Merrill Lynch, Citicorp, and others. But the amounts are measured in the low tens of billions, nowhere near the high hundreds of billions of losses to date and anticipated.
Given the still massive anticipated losses and likely insufficient available funding, banks turn to loan out the funds they do have. So they raise interest rates to record levels. These interest rates are not the short-term interest rates of 3 to 4 percent at which the Fed loans money to the banks. Banks' rates offered to customers are long-term interest rates—essentially bonds and long-term loans—loaned out at 7 percent, 10 percent, or more. Rising long-term rates raise the cost of borrowing by non-bank corporate customers and to consumers buying durable products like cars, furniture, homes, etc.
In an accelerating recession, banks are reluctant to lend and corporations equally reluctant to borrow. Only the most exposed companies are willing to borrow at the high rates, which means in many cases they will eventually go under—thus Moody's and S&P's predictions of a 10 times increase in corporate default rates over the next 18 months. Lower investment and business spending translates eventually into layoffs, defaults in auto, credit card, and student loans, and thus further momentum in the direction of recession.
The above process then takes on psychological dimensions at some point, which worsens the economic decline. Fear and uncertainty over still unannounced, further bank losses leads to lack of confidence in the banking system and even further reluctance to loan or borrow. Another psychological scenario is when fear of losses in the subprime mortgage market lead to concerns of losses as well in non-subprime residential mortgage, commercial property markets, and closely associated markets like asset backed commercial paper. Borrowing rates rise and investors turn away from borrowing not only in subprime and related markets, but other mortgage markets. Prices of property then nose dive across the board. This kind of debt price deflation, when spreading from an isolated to associated credit markets, is historically closely associated with depressions rather than recessions.
Another example: concerns that the bond insurers (monolines) and credit default swaps will not be able to cover anticipated defaults leads investors to withdraw in growing numbers from even safe credit markets like muni bonds, about half of which outstanding are insured. In turn state and local governments reduce spending, lay off workers, reduce benefits for others, raise property taxes and various fees, etc.—all which translate into further recessionary pressures.
A third example: rising financial institution losses translate into rising rates and to a tightening of credit terms for consumers as well as business borrowers. Credit card rates rise, terms become more onerous, banks start charging consumer customers more fees, auto loan rates rise, student loans become harder to get with higher rates, state and local governments must spend more to borrow and in turn pass on costs to citizens in higher local fees, property taxes, and lower spending (resulting in less hiring or layoffs). Increasingly, consumers default on auto, student, and credit card loans.
Contradictions of Monetary and Fiscal Policy
Both Fed monetary policy and the recent $168 billion Congressional tax cut package will prove grossly insufficient in dealing with the current financial crisis and the recession. Rapid deflation (i.e., price collapse) is now occurring in the general housing and commercial property markets and may soon spread to other non-construction markets as corporate defaults rise and additional bank losses are reported. Debt deflation in housing and property markets is the inevitable consequence of prior (housing and property) asset price inflation, which was produced by excessive speculation. Excessive speculation breeds extraordinary inflation and eventually just as extraordinary deflation. But deflation is the greater danger.
When debt deflation spreads from housing to other sectors of the economy, the real crisis begins. Companies facing rising costs and unavailability of funds to finance day to day business, turn to raising revenue on an emergency basis by selling their products below market prices. This raises immediate cash necessary to operate or even stay in business, but sets in motion a downward price spiral—i.e., deflation—that ultimately accelerates losses and the need for still further price cuts. This is what especially distinguishes depression from recession. Efforts to raise revenue by price cutting, moreover, is often accompanied with cutting costs by mass layoffs. Thus rising unemployment accompanies the deflation in parallel. The U.S. economy is approaching the cusp, heading in that direction.
Fed interest rate reductions of more than 3 percentage points by March 2008 has assisted banks' sagging profitability, but has not succeeded in heading off the general credit crisis and recession. The crisis has continued to outrun Fed actions as long term interest rates have risen and thus pushed the economy further into recession. The Fed may have even assisted the momentum toward recession by its recent lowering of short term interest rates. For example, lower rates have resulted in an accelerating decline of the U.S. dollar and a growing shift from the dollar to the Euro and other currencies as the preferred medium of global trade and financial transactions. The financial crisis is rapidly translating into a parallel currency crisis—which is also a characteristic of depressions as compared to recessions.
The fall of the dollar is also provoking another speculative price bubble, in the form of rapidly rising commodity prices—e.g., food grains, food commodities, raw material commodities, metals, and, of course, oil. As the dollar falls, OPEC and Middle Eastern oil producers have been raising their prices to offset the fall of their investments held in dollars. Oil prices have shot up over $100 a barrel. Rising commodity prices translate into U.S. consumers' reduced spending power, which in turn reduces consumption dramatically, and feeds the recession. Oil and other commodity speculators may also push up the prices of oil and food even further before it reaches the U.S. consumer, but the Fed action initiates and feeds the whole process. Thus, Fed efforts to stave off recession actually provide more impetus for recession. At some point the Fed will likely give up on lowering interest rates as a consequence. When that happens, yet another psychological effect will occur and the impact will be immense. By that action the Fed will in effect admit it cannot do anything about the crisis.
On the fiscal side, the recent $168 billion Congressional (and Bush) package to stimulate the economy will also prove ineffective. First, a good portion of the tax cut package are business tax cuts that will largely have no effect in a recessionary downturn. In a period of accelerating recession, lower tax cuts for business do not stimulate net investment. Business may absorb the tax cuts, but delay decisions to invest while actually reducing employment. A good part of the business tax cuts will also likely be shuffled to offshore expansion by corporations that will have no effect on U.S. economic conditions, a trend that has been occurring for several years now. Finally, what business spending does occur as a direct consequence of tax cuts will be more than offset by mass industry layoffs coming later this year.
Little of the consumer tax rebate will translate into new spending. Many consumers, now deeply in debt, will use rebates to pay off record debt. Perhaps only a third of the $168 billion will constitute actual new consumer spending. And that consumer spending will be largely offset by reductions in spending and higher fees by state and local government, as tax revenues plummet due to recession while costs of borrowing rise significantly. Before the November 2008 election it will become increasingly clear that the recent Congress-Bush fiscal package was a classic example of too little too late.
Should the crisis and recession continue to accelerate, new solutions will be required. As during the Depression of the 1930s, new solutions may require a major overhaul of the Federal Reserve System, the return of something like the Reconstruction Finance Corp. government agency of that period, and a fundamental re-regulation of the financial sector in the U.S., and reversal of policies since the 1980s that have resulted in a massive redistribution of income that has fed the speculative excesses of recent decades—to name just a few.
Scenario 2008-09
Fundamental structural and in some cases radical reform of the U.S. political economy will be necessary to deal with the economic crisis. This crisis may include some of the following features:
Widespread corporate defaults and mass layoffs occurring later in 2008 and into 2009
Continuing revelations of further losses by banks and financial institutions
The collapse of one or more of the mainstream banks in the U.S., setting off a major stock market correction of an additional 20-30 percent
A further decline of 10-20 percent of the dollar in international currency markets
Continued rise in oil and commodity prices as offshore speculators continue to take advantage of the U.S.'s worsening dual financial-devaluation crisis
Deflation spreading from housing and other asset investments in the U.S. to goods and services. Record U.S.
(unified) budget deficits of $700 billion plus
Growing general awareness that traditional monetary and fiscal policies are increasingly ineffective in addressing financial crisis and recession
Whomever is president in 2009 will almost certainly have to confront the growing reality that the rest of the global economy is also slipping, along with the U.S., into a synchronized downturn.
Z
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Jack Rasmus is the author of The War At Home: The Corporate Offensive From Ronald Reagan to George W. Bush (2006) and The Trillion Dollar Income Shift: Essays on Income Inequality in America (forthcoming).
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