by Robert Freeman
For the better part of a year every senior government official involved with the economy, from Fed Chairman Ben Bernanke to Treasure Secretary Henry Paulson, has said that the bursting housing bubble and the sub-prime mortgage meltdown were “contained.” This, we now know, was the financial equivalent of “Mission Accomplished.” If only reality could be managed forever with sound bites.
The question now is not whether the problem is contained but how damaging will be the fallout. Not whether the contagion will infect other sectors of the economy, but how badly. Not whether other economies will be dragged into the maelstrom, but how many and how deeply. And the most important question, where’s the bottom?
The easy truth is that nobody knows the precise answer to these questions. The harder truth is that things will get a lot worse before they get better and that the bottom will be much lower than official posturing now dares reveal.
The problem with the market today has two roots. The first one is intrinsic to the market itself. The second is part of the larger economic context in which the market operates.
The problem intrinsic to the market itself is that investors have only a partial idea what their widely-traded mortgage-backed securities are worth. These are the instruments that the self-styled Masters of the Universe devised to turn inflated housing prices and onerous personal debt into the financial equivalent of perpetual motion.
Home mortgages were bundled into securities called collateralized debt obligations, or CDOs. These were sold, resold, re-resold, and re-re-resold, to ever more credulous buyers based on two things: 1) the flow of funds to be generated by monthly mortgage payments, and 2) the underlying worth of the real estate itself. The problem is that neither the flows nor the underlying worth are anything like what they were represented to be.
Soaring foreclosures (up 93% in July) have winnowed the flows of funds while collapsing housing prices (down nation-wide for the first time since the Great Depression) have eroded the value of the underlying collateral. It is the worst of both possible worlds.
But even as bad as that is, it gets worse still. Adjustable rate mortgage resets won’t peak until March 2008 meaning the worst of the foreclosure pain is still more than a year out. And the housing price decline is accelerating as more and more foreclosed properties flood the market.
As a result, nobody is able to state with any certainty what the actual values of many of these securities even are, and they don’t know when they will be able to know. It is this uncertainty more than anything else that has wrought such havoc with the markets.
And far from being “contained,” the “contagion” has spread from consumer real estate to commercial real estate, commercial paper, corporate buyouts, into industrial, and other financial markets, and now into the economies of other industrial nations. Indeed, throughout the global economy.
European central banks, witnessing the implosion of hedge funds that had invested in U.S. originated CDOs, were forced to inject $370 billion into financial markets in recent weeks to try to stabilize them. This is on top of the $120 billion the Federal Reserve pumped into U.S. markets, hoping to restore order and prevent another recession.
But four powerful forces now conspire to all but guarantee a recession: tighter credit standards; higher credit prices; shrinking personal wealth (a concomitant of falling housing prices); and layoffs in all industries even remotely connected to real estate, from construction, mortgage, and real estate brokerage, to household appliances, carpeting, furniture, trucking, and more.
A general recession will make everything about the real estate meltdown still worse. Faltering incomes at large will act as a veritable bellows to the twin flames of soaring foreclosures and collapsing housing prices.
The reality nobody knows is where it all ends. Until institutional investors can determine with a high degree of certainty the value of the mortgage backed securities in their portfolios, the markets will not stabilize because investors will not be able to price the risk inherent in such investments. But that is exactly what they cannot do. Until they can, the turmoil will continue.
The second root cause of the problem lies in the larger context of the U.S. economy and its dependence on debt to sustain its growth.
When Ronald Reagan took office, in 1981, the cumulative national debt stood at $1 trillion. Today, it approaches $9 trillion, more than $3 trillion of that total added by George W. Bush alone.
Consumers are especially strained. In 1975, personal household debt amounted to only 61% of disposable income. Today it stands at over 135%, more than double. Consumers have expanded mortgage debt by over $11 trillion since 2001, using mortgage equity withdrawals to purchase life styles far beyond what their incomes alone could support.
Finally, the annual trade deficit that stood at $377 billion in 2000 now exceeds $800 billion. Over the past six years, it has added a cumulative $3 trillion of debt to the economy.
Add it up: national debt; consumer debt; and trade debt. The increase in debt over the past six years comes to $17 trillion. Any economy that borrows $17 trillion in six years can be made to look good, at least for a while. The problem is, what happens when those bills become due?
It’s difficult to make a case for how the U.S. can pay them back. Lawrence Kotlikoff, writing for the Federal Reserve Bank of St. Louis, revealed last year that the U.S. faces $65 trillion (yes, that’s a “t”) in “unfunded liabilities,” debts it has committed to pay but for which there is no identified source of funding. Kotlikoff suggests that the U.S. may be actuarially bankrupt, that it cannot pay its obligations under any reasonable scenario. It borrows $2.5 billion every day from the rest of the world just to keep the lights on. That amounts to 85% of the entire world’s net savings, an astonishing, unprecedented dependency that simply cannot - will not - be sustained.
This is the background context for the real estate bubble: a nation living so far beyond its means it can only maintain its lifestyle by mortgaging ever more of its assets-in this case, its houses. But when even those prove unreliable, creditors will prove unwilling to continue lending. Unless new, verifiable assets can be pledged against borrowed funds, new lending will cease.
Perhaps the most sobering fact is that this unprecedented run up in debt has occurred during a period of supposed economic prosperity. It is usually during prosperity that a nation pays down the debts incurred in the last downturn. But the U.S. has not done that. It continues to add debt at a reckless, unsustainable pace, consuming more than its entire income. Its savings rate is below zero, another first since the Great Depression.
When the next downturn occurs - not whether but when - government deficits will soar even higher. Bankruptcies will explode. Foreclosures will skyrocket. The question is, who will lend us the money to bail us out, for we don’t generate it on our own. It will surely not be those who have been burned in the latest mortgage asset meltdown. But if not them, then who? And at what price? This is the really frightening question lurking over our financial future.
Robert Freeman writes on history, economics, and education. His email address is robertfreeman10@yahoo.com.
Vauban | 09.03.07 - 10:00 pm | #