The current rise in stock prices does not indicate a healthy
economy. It simply proves that the market is awash in cheap credit
resulting from the Fed's increases in the money supply. Consumer
spending is a better indicator of the real state of the economy than
stocks. When consumer spending drops off; it is a sign of overcapacity,
which is deflationary. That means that growth will continue to shrivel
because maxed-out workers can no longer purchase the things they are
making.
The underlying problem is not simply the Fed’s
reckless increases to the money supply, but the growing “wealth gap”
which is undermining solid economic growth. If wages don’t keep pace
with productivity; the middle class loses its ability to buy consumer
items and the economy slows.
The reason that hasn’t happened yet in the US is because of the
extraordinary opportunities to expand personal debt. The Fed’s low
interest rates have created a culture of borrowing which has convinced
many people that debt equals wealth. It’s not; and the collapse in the
housing market will prove how lethal that theory really is.
To large extent, the housing bubble has concealed the systematic
destruction of America’s industrial and manufacturing base. Low
interest rates have lulled the public to sleep while millions of
high-paying jobs have been outsourced. The rise in housing prices has
created the illusion of prosperity but, in truth, we are only selling
houses to each other and are not making anything that the rest of the
world wants. The $11 trillion dollars that was pumped into the real
estate market is probably the greatest waste of capital investment in
the nations’ history. It hasn't produced a single asset that will add
to our collective wealth or industrial competitiveness. It’s been a
total bust.
The Federal Reserve produces all the facts and figures related to the
housing industry. They knew that trillions of dollars were being
diverted into a speculative bubble, but they did nothing to stop it.
Instead, they kept interest rates low and endorsed the lax lending
standards which paved the way for millions of defaults. Now the effects
of their "cheap money" policies have spread to the hedge fund industry
where hundreds of billions of dollars in pensions and savings are in
jeopardy.
Alan Greenspan played a major role in the housing boondoggle. On
February 26, 2004, he said, “American consumers might benefit if
lenders provide greater mortgage product alternatives to the
traditional fixed rate mortgage. To the degree that households are
driven by fears of payment shocks but willing to manage their own
interest-rate risks, the traditional fixed-rate mortgage may be an
expensive method of financing a home.”
Greenspan tacitly approved the whacky financing which produced all
manner of untested loans—including ARMs, piggyback loans, “no doc”
loans, “interest only” loans etc. These loans are a break from
traditional financing and have contributed to the increase in
bankruptcies.
Millions of people who were hoodwinked into buying homes with
“interest-only”, “no down” loans will now either lose their homes or be
shackled to an asset of decreasing value for the next 30 years. They've
been tricked into a life of indentured servitude.
A recent article in the Wall Street Journal revealed the extent of
Greenspan’s involvement in the housing fiasco. Here’s an excerpt from
the article:
“Edward Gramlich, who was Fed governor from 1997 to 2005, said he
proposed to Mr. Greenspan in or around 2000, when predatory lending was
a growing concern, that the Fed use its discretionary authority to send
examiners into the offices of consumer-finance lenders that were units
of Fed-regulated bank holding companies.
"I would have liked
the Fed to be a leader" in cracking down on predatory lending, Mr.
Gramlich, now a scholar at the Urban Institute, said in an interview
this past week. Knowing it would be controversial with Mr. Greenspan,
whose deregulatory philosophy is well known, Mr. Gramlich broached it
to him personally rather than take it to the full board.
"He was opposed to it, so I didn't really pursue it," says Mr.
Still, Mr. Greenspan's views did color the regulatory environment,
facilitating growing concentration in banking and a hands-off approach
to derivatives and hedge funds. That approach, broadly shared by both
the Clinton and Bush administrations, is coming under increased
scrutiny”. (Wall Street Journal)
So, Greenspan had the chance to “crack down on predatory lending” and
he refused. Now millions of low income people are saddled with payments
they have no reasonable prospect of paying off. How much of the present
carnage could have been avoided if he had Greenspan done the right
thing?
The “Not So Great” Depression
An article appeared this week in the UK Telegraph by Ambrose
Evans-Pritchard which supports the theory that Greenspan’s “loose
monetary policy” fueled a huge credit bubble, which is pushing the
global economy towards a “1930s-style slump.”
The article quotes from a statement made by The Bank for International Settlements:
"Virtually nobody foresaw the Great Depression of the 1930s, or the
crises which affected Japan and Southeast Asia in the early and late
1990s. In fact, each downturn was preceded by a period of
non-inflationary growth exuberant enough to lead many commentators to
suggest that a 'new era' had arrived".
But today we face “worrying signs” of another economic meltdown.
The BIS said that they were “starting to doubt the wisdom of letting
asset bubbles build up on the assumption that they could safely be
‘cleaned up’ afterwards”. (Greenspan’s method) and that, “while cutting
interest rates in such a crisis may help, it has the effect of
transferring wealth from creditors to debtors and sowing the seeds for
more serious problems further ahead.’"
“The bank said it was far from clear whether the US would be able to
ignore the consequences of its latest imbalances, ($800 billion per
year) citing a current account deficit running at 6.5% of GDP, a rise
in US external liabilities by over $4 trillion from 2001 to 2005, and
an unprecedented drop in the savings rate. ‘The dollar clearly remains
vulnerable to a sudden loss of private sector confidence.”’
The BIS referred to the toxic effect of the
“$470 billion in collateralized debt obligations (CDO), and a further
$524 billion in "synthetic" CDOs which have spread through hedge funds
industry. These CDOs are the loans (many sub primes) which were bundled
off to Wall Street and turned into securities which are highly
leveraged in hedge funds for maximum profitability. As Bear Stearns is
discovering, these CDOs are like roadside bombs; exploding without
notice whenever the stock market suddenly dips.
The BIS also cautioned about the excess of “leveraged buy-outs
(mergers) which touched $753bn, with an average debt/cash flow ratio
hitting a record 5.4…. ‘Sooner or later the credit cycle will turn and
default rates will begin to rise.’”
The central banks around the world are increasingly worried that the
Bush administration’s profligate spending and irrational monetary
policies will trigger a global depression. The recent volatility in the
stock market suggests that the credit boom is just about over. Once the
liquidity dries up — -stocks will fall sharply.
The Housing Slump
Yesterday’s
housing data, shows that sales are still weak while inventory continues
to grow. Existing home sales dropped 3% while prices dropped another
2.1%. Falling prices mean that cash-strapped home owners will not be
able to tap into their home’s equity for other expenses. Last year,
mortgage equity withdrawals (MEWs) accounted for $600 billion of
consumer spending. This year, the amount will be negligible at best.
The media and the Fed continue to mislead the public about the
magnitude of the housing bubble. Fed chief Bernanke assures us that the
sub prime calamity hasn’t “spread to other parts of the economy” (tell
that to Bear Stearns) and the media keeps cheerily reiterating that a
“turnaround” or “soft landing” is just ahead.
These claims are ridiculous. Apart from the 80 or more sub-prime
lenders that have gone “belly-up” in the last few months, the rickety
collateralized debt obligations (CDOs) and mortgage backed securities
(MBSs) are steamrolling their way through the stock market bowling down
everything their path. Bear Stearns is just the first on the casualties
list. There’ll be many more before the storm is over.
Fed-chairman Bernanke knows what’s going on. He was given a full
rundown by “John Burns Real Estate Consulting that the national sales
information for both new and existing homes, is “misleading and
covering up a deep plunge of the housing sector.” The housing market is
freefalling. Existing-home sales are down 22% in May and mortgage
applications have fallen a whopping 18%....In Florida home sales are
down 34%, not 28% as NAR reported; Arizona sales are down 38%, not 28%;
and California's down 37%, not 24% as NAR reports.”
Down 37% in California!?!
Gadzooks! It’s a landslide.
As the defaults continue to pile up; the hedge funds will take a bigger
and bigger pounding. It can’t be avoided. That’s what happens when
bankers abandon traditional lending standards and lend trillions of
thousands of dollars to people who have bad credit and lie on their
loan applications.
Thousands of these same shaky sub primes loans have been wrapped up
like the Crown Jewels and sold off to Wall Street as CDOs. Now they are
ripping through the hedge fund industry like a tornado in a trailer
park. The media has tried to downplay the damage, but its not hard to
see what is really going on. According to Reuters:
“Banks doubled the amount of CDOs outstanding in the past two years to
$2.6 trillion, including a record $769 billion sold last year,
according to J.P. Morgan. These figures include funded and unfunded
issuance. Pimco’s Bill Gross said there are hundreds of billions of
dollars of subprime residential mortgage-backed securities (RMBS),
derivatives on subprime RMBS and collateralized debt obligations (CDOs)
that buy subprime RMBS and/or the derivatives on the RMBS — all of
which he considers "toxic waste.”’
"$2.6 trillion"! That's
enough to bring down the whole economy. And, as Bear Stearns proves,
the whole mess is beginning to unwind pretty quickly.
“Foreign investors have been the
dominant buyers of these exotic debt instruments in recent years, owing
to their insatiable demand for yield. ‘If investors start dumping them,
oh boy, watch out for some massive credit widening," said Dan Fuss,
Vice Chairman at Loomis Sayles. (Reuters)
If the hedge fund industry follows the downward slide of the housing
bubble, foreign investors will run for the exits. In fact, this may
already being happening.
China sold $5.8 billion in US Treasuries in May; the first time they
have dumped USTs on the market. This may be the first sign of “capital
flight” — -foreign investment fleeing the US for more promising markets
in Asia and Europe. The greenback’s survival now depends on the
generosity of foreign bankers. If they refuse to recycle our $800
billion current account deficit by purchasing US bonds and securities,
then the dollar will sink like a stone and lose its place as the
world’s reserve currency.
More Housing Blowdown
Last Friday, the stock market took a 185-point nosedive on the news
that Bear Stearns was trying to raise $3.2 billion to rescue its
battered hedge fund. According to the New York Times, however, Bear was
only able to came up with "$1.6 billion in secured loans to bail out
one of the 2 hedge funds".
The funds are the latest victim of the sub-prime meltdown which
Bernanke and Paulson assured us was “largely contained”. In fact,
Paulson even said, "We have had a major housing correction in this
country," and "I do believe we are at or near the bottom."
Anyone who believes Paulson should take a look the chart linked below:
http://www.belowthecrowd.com/photos/ackman.jpg?ref=patrick.net
It illustrates that how loan “resets” will continue to pound the
housing market for at least another year and a half getting steadily
worse as inventory grows.
The disaster is so bad that even
the realtors are beginning to tell the truth. As one agent noted, “It’s
a bloodbath.”
But the debacle in housing is only the first part of a much larger
problem—a global liquidity crisis. Banks and mortgage lenders have
already begun to tighten up their lending practices and many have
abandoned sub prime loans altogether. (20% of the housing market in
2006 was sub prime) Now the focus has shifted to the stock market,
where banks are beginning to see that “risk” has not been properly
calculated. That means that if more hedge funds collapse, the banks may
not be able to cover the losses.
The Bear Stearns fiasco has had
a chilling affect on lending. In fact, the New York Times reported on
6-26-07 that “After years of supersize private equity deals…the buyout
boom may be about to hit a bump…Rising interest rates and tougher terms
from investors may signal that private equity players will soon be
struggling to continue reaping the outsize returns that have made the
buyout business so lucrative.” (Private Equity Investors Hint at Cool
Down” NY Times)
Liquidity is drying up in the private equity business. The troubles at
Bear Stearns has changed the credit-landscape overnight. Bankers are
nervous, money is getting tighter, and liquidity is vanishing.
"We know that these holdings are not unique to Bear Stearns," said
Professor Joseph R. Mason, co-author of a recent study warning of
dangers in securities backed by home loans to high-risk borrowers. "It
would be hard to find a Wall Street firm that hasn't created similar
funds."
That’s right; the industry is waist-deep in these
sub-prime time-bombs. Shaky loans and rising foreclosures threaten to
knock the foundation blocks out from under the stock market and set off
a wave of panic selling.
Could it have been avoided?
Perhaps, if there were better regulations on rating bonds and restricting leverage.
Consider this: one of Bear Stearns hedge funds took a $600 million
investment and leveraged it 10 times its value to $7 billion. Their
portfolio was chock-full of dicey CDOs and “illiquid assets” such as
timber holdings in foreign countries and toll roads. These assets are
difficult to price and nearly impossible to quickly auction off if the
market suddenly takes a downturn.
It looked like Merrill
Lynch & Co., was going to auction off $850 million of Bear Stearns
CDOs this week, but backed off at the last minute. (They were
reportedly only offered 30 cents on the dollar!) Once the hedge funds
start selling these CDOs, then everyone will know how little they're
worth. That could trigger a wave of selling that could bring down the
stock market. Even if that scenario doesn’t play out, the Bear Stearns
incident ensures that CDOs in other hedge funds will be face a
substantial downgrading that could take a big chunk out of their bottom
line.
And, there’s a bigger fear on Wall
Street than the fact that 2 hedge funds are headed into bankruptcy,
that is, that a sudden tightening of credit will send the
over-leveraged stock market into a downward spiral.
The market is particularly sensitive to any rise in interest rates or
tougher lending standards. It's become addicted to cheap credit and any
break in the chain will cause equities to plummet.
Economist Henry C K Liu sums it up like this:
“The liquidity boom has been delivering strong growth through asset
inflation without adding commensurate substantive expansion of the real
economy. …. Unlike real physical assets, virtual financial mirages that
arise out of thin air can evaporate again into thin air without
warning. As inflation picks up, the liquidity boom and asset inflation
will draw to a close, leaving a hollowed economy devoid of substance.
…A global financial crisis is inevitable”. (Henry C K Liu “Liquidity
boom and looming crisis” Asia Times)
In other words, the “virtual” wealth of Wall Street is a chimera which
was created by the Fed's inexorable expansion of debt. It can vanish in
a flash if the sources of liquidity are cut off.
Puru Saxena draws the same conclusion in his article “A Gradual Transition”:
“Thanks to the Federal Reserve’s expansionary monetary policies over
the past 5 years, US asset-prices have risen considerably; also known
as the “wealth effect”. At the end of last year, the market
capitalization of the US stock market rose to a record-high of US$20.6
trillion, matching the value of household real-estate, which also rose
to a record-high at the same time. On the surface, this may seem like
brilliant news, however you must realize that this “wealth illusion”
achieved by an ocean of money and record-high indebtedness is only a
consequence of inflation."
Code Red: Subprime Chernobyl
We expect that the mounting losses in CDOs and the continuing defaults
in the housing industry will precipitate a “severe credit crunch” which
will end in a stock market crash. A report which appeared yesterday in
the UK Telegraph appears to agree with this analysis. Lombard Street
Research predicted that:
“Excess liquidity in the global
system will be slashed. Banks Capital is about to be decimated, which
will require calling in a swathe of loans. This is going to aggravate
the US ‘hard landing”’ (“Banks set to call in swathe of loans” UK
Telegraph 6-26-07)
Three of the main hoses which provide
liquidity for the market, have either been cut off or severely damaged.
These are "securatized" subprime CDOs, corporate mega-mergers and hedge
fund leveraging. Without these instruments for expanding debt;
liquidity will dry up and stocks will fall. The period of "easy credit"
will end in disaster.
We should now be able to see the
straight line that connects the Fed's low interest rates to the
impending stock market meltdown. The problems began at the central
bank.
Presidential candidate Rep. Ron Paul (R-Texas) summed it up best when he said:
“From the Great Depression, to the stagflation of the seventies, to the
burst of the dot.com bubble; every economic downturn suffered by the
country over the last 80 years can be traced to Federal Reserve policy.
The Fed has followed a consistent policy of flooding the economy with
easy money, leading to a misallocation of resources and artificial
“boom” followed by recession or depression when the Fed-created bubble
bursts”.
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