The next phase of the financial and economic crisis is creeping up on us. You can see the signs in the U.S. stock market, where all the major indexes have reversed a three month rally and are now declining back to their March lows. This decline is led by the Dow and is in fact accelerating, taking with it last month’s cheerful prognostications that the U.S. not only has escaped a recession, but is bouncing back into full growth mode for the second half of this year.
The economic data do not confirm this picture at all. The employment situation continues to worsen, industrial production and factory utilization are lodged firmly in recessionary territory, and the only retail stores showing any sign of life are the deep discounters like Wal-Mart, benefiting temporarily from the tax rebates. Wall Street executives are telling us that the credit crisis is halfway over, but their behavior suggests otherwise. Lehman Brothers, for example, assured us last week that it was well-capitalized and fully in control of its future, but a few days later it announced a $2.8 billion loss and was forced to turn to the stock market and private investors to raise $6 billion more in capital. Where have we heard this story before?
Wall Street continues to underestimate the spreading default carnage that is going to bring down a few more financial powerhouses before this crisis is over. The big story emerging in the housing markets is the galloping number of foreclosures affecting ”œdecent ordinary folks” with prime mortgages (as opposed to the sub-prime customer species that kicked off the housing market crisis). Defaults and foreclosures on alt-A and prime mortgages are jumping to record levels. It seems that quite a lot of these customers, just like their sub-prime brethren, never really had much equity in their houses in the first place, and now that housing prices are declining across the nation, nearly 20% of them are in a negative equity position. If you can’t afford the mortgage in the first place, why continue to make payments on a property that is continuing to lose value?
These people are not typically walking away from their mortgages, as the ”œjingle mail” stories suggest. They would like to stay in their homes, but they can no longer make the payments. In many cases, the financial entity that they need to talk to in order to obtain some relief is a ”œmortgage servicer” who doesn’t own the mortgage, and can’t possibly get agreement from all the hundreds of investors worldwide who own a tiny sliver of the mortgage that was long since sold off in a security. Congress can pass all the legislation it wants to provide relief from foreclosure for these homeowners, but it will be mostly fruitless. The securitization of mortgages in the past eight years has legally and practically destroyed the ability for the financial industry to come through with any accommodations, so the homeowner is ejected and the banks wind up owning the property.
The banks now own so many homes through foreclosure that cities across the U.S. are suing them to force them to keep the properties in decent shape. It most places it costs thousands of dollars to get the lawn mowed and trash picked up, and there are many circumstances where the home has been vandalized, costing the banks much more. The banks are learning a terrible lesson last experienced in the Depression ”“ foreclosure is something to be avoided at all costs. It doesn’t just destroy the profit a bank may have had in the mortgage ”“ it can destroy the bank. We are now seeing banks dump whole subdivisions onto the real estate market at 20% of the value at the market peak in 2006.
The bond market has learned that the mortgage crisis is just the beginning of the problems that banks are facing. Stage two is underway with deterioration in corporate debt, starting with the bonds issued by real estate developers, but spreading now to the high yield securities and bank loans of poorly capitalized and over-leveraged corporations. Well over 50% of all the corporate debt issued in the past eight years has been rated as junk debt, meaning it is not even investment grade (Baa rated or higher) and it has a very high probability of default. These probabilities are now working against the holders of these bonds, and the banks that have lent to these companies.
In normal circumstances the economy can work through these excesses, as consumers and corporations reduce their leverage and banks absorb the losses on bad debts. But these aren’t normal circumstances. The U.S. is no longer entirely in control of its economic destiny, and it isn’t even the engine that drives the global economy. China and India have created their own self-reinforcing economic dynamic, in which exports finance a growing demand for raw materials, starting with oil. As the price of petroleum has now crossed $130/bbl., an intolerable burden is being placed on a U.S. economy sinking in recession.
Consumers are increasingly turning to public transport ”“ if it is available ”“ to avoid paying over $4/gal. for gasoline. Part of the pricing pressure on the suburban McMansions built in the past five years comes from the cost of commuting to these homes built 50 miles or more from any jobs. Independent truck drivers are going out of business because the cost of diesel fuel over $5/gal. has shredded what were already dangerously thin profit margins. Their trucks are piling up on dealer’s lots, and used car dealers are now hesitant to accept any more SUVs. General Motors is thinking of canceling altogether its Hummer model, a war-chic road hog that at its best gets only 11 miles to the gallon.
The high price of oil is now clearly affecting all facets of the global economy, with one exception: wages. Workers are not being given pay increases, but instead are being pressed to put in longer hours, which is always management’s way of coping at first with an economic downturn. But usually around six months into a recession, companies cave in to reality and start letting people go. We’ve just passed the six month mark for this downturn, so expect the unemployment data to noticeably deteriorate; last month the unemployment rate jumped up Â½% of a percentage point alone.
Just about the last people in America to recognize that we have an inflation problem are the esteemed governors of the Federal Reserve, who preferred to concentrate on the fictitious construct of ”œcore inflation”, which eliminates from the calculation energy and food costs. But even Fed chairman Ben Bernanke is now beginning to face up to everyday reality, and has announced this month that Fed policy is now focused on combating inflation and fighting any further depreciation of the dollar on the foreign exchange markets. The days of interest rate declines are over, and the market is now estimating there is more than a 75% chance that the Fed will raise interest rates at their next Open Market committee meeting.
That’s just what the economy needs: higher interest rates on top of raging energy and food inflation, at the same time the entire housing sector is deflating. Obviously the Fed wouldn’t be piling on to our economic woes if it had a choice. The fact that it has no choice, and that it is trapped in the policy dilemma it now faces, is in good part its own fault. It’s not enough to blame China and India for oil price increases. There is still a lot of loose cash around the world that is being pumped into oil futures, which has helped as well to push prices to record levels. Most of this loose cash has been generated by the United States. We continue to flood the world with Treasury securities to finance both our domestic federal budget deficit, and our current account deficit, which combined exceed $1.5 trillion per year. On top of this, Bernanke’s dramatic interest rate cuts in the past six months have added yet more ”œliquidity” to the market. The banks aren’t using these funds to make loans, and investors aren’t eager to plow the money into the stock market given the inevitable decline ahead in corporate profits. That leaves the last great bubble as the only investment alternative: the commodities market, and specifically energy.
You’ve read no doubt about the nasty speculators who are involved in the commodities bubble. While there are certainly hundreds of hedge funds engaged in this speculative exercise, most of the money is coming from staid mutual funds, pension plans, university endowments, and other respectable entities desperate to find some investment vehicle that returns anything even matching the rate of inflation. Senator Joe Lieberman already has a bill submitted to restrict speculators from investing in commodity funds, but we’ll see how far this measure gets when Yale University’s endowment management have a quiet word with him about just who is going to get hurt if the bill is passed.
What can we expect in stage two? Expect first of all for the credit crisis to return with a vengeance. The omens are already lining up. Remember when Congress was all excited a few months ago about turning loose the Federal Housing Administration, and allowing them to jump-start the mortgage market with low-cost loans and down payment guarantees? It turns out the FHA isn’t interested in these broad new powers. It has enough problems of its own with its existing portfolio, which took a $4.6 billion write-down this past quarter due to rising foreclosures. That ate up over 25% of the FHA’s equity, and the commissioner had to reassure the market that the FHA itself isn’t facing bankruptcy ”“ it just may need to turn to the Congress for an ”œappropriation.”
Right behind the FHA will be Freddie Mac, the Home Loan Banks, and the behemoth of them all, Fannie Mae. All of these federally chartered agencies are under stress from the worsening housing crisis, and all of them operate on thin amounts of capital. Congress thinks at the moment it has the luxury of opening up the taps of federal largesse in order to do something about the housing crisis, but the reality is that the agencies set up to help at a time like this will all have their hands out looking for taxpayer money just so they can survive.
The second thing you should watch for is the coming wave of corporate and municipal bankruptcies. Too many corporations are poorly capitalized and completely unprepared to meet their liabilities in a weak economy. Too many state and local governments are seeing tax revenues plummet, just at a time when decades of promises on employee pensions and medical plans are coming due. Something will have to give here, and ultimately the weakest players will seek protection from the bankruptcy courts.
That will leave hundreds of thousands of retired government workers facing an abrupt shift in their fortune, and equally large numbers of currently employed workers suddenly facing unemployment. That’s the third thing you should watch for: large-scale layoffs in the public and private sector, with significant second order economic effects on consumer spending. This is all part of the vicious cycle common with recessions ”“ stressed out employers let staff go, leading to declines in consumer spending, leading to yet more pressure on corporations and government to fire even more workers. The difference now is that the viciousness of this cycle will far outweigh whatever pain was experienced in the last oil recession of 1974. This recession will be lucky to avoid being labeled as a depression when it is over.
Fourth, this recession is spreading globally. Housing markets in the U.K., Spain, Australia and Ireland are all reversing direction and following the U.S. into an implosion of foreclosures. Energy costs are rising everywhere, driving up as well the cost of basic food and things like livestock feed and fertilizer. This has led to riots in many emerging markets where fundamentals such as wheat and rice are hard to come by. Even the oil producing countries in the Gulf States are not immune to food scarcities. Central banks everywhere are talking tough about battling inflation, and a few are raising interest rates. Many of them are also raising margin requirements in the commodities markets to prevent speculation, and there is widespread condemnation of profiteers.
This is a very nasty situation for the central banks, forced to choose between accepting inflation that is accelerating well beyond target ranges, or raising interest rates and throwing the global economy into a much worse recession. As part of this conundrum, there is serious doubt about the value of repeating the Fed’s rescue for a financial firm like Bear Stearns, but if another such disaster crops up, letting yet another large bank or broker fail could lead to a systemic crisis of unimaginable magnitude. At some point though, governments including their central banks have to do something about the plight of the average citizen rather than continue to coddle millionaire bankers. To do otherwise is to risk social disorder.
These dreadful policy choices are only now beginning to play out in the U.S. electoral campaign, which is also beginning to focus on the domestic burden of continuing to fund the Iraq war. The American public has already turned against this war because of the high price that is being paid in death and injury, but the interplay between the war and America’s economic woes is beginning to become apparent. You can expect the Democrats to emphasize this linkage, and to ask Americans how fair it is that they are spending $12 billion a month to build Iraq, a country rich in oil, when at home people are losing their jobs, their pensions, their medical insurance, and in many cases their homes and the ability to feed their family. It will be the first time that the electorate will have to confront the economic costs of maintaining the vast American empire.
There is a point of inflection in any economic crisis where it becomes apparent to everyone that something has gone dramatically wrong and painful course corrections are needed. It often takes a major bankruptcy, or a sharp rise in unemployment, or a stock market crash, to awaken the public to the realities they have ignored or that have been hidden from them. The U.S. could experience any or all of these calamities, and at any time now. Heaven help the Republicans if this should occur prior to the first Tuesday in November.