By
Jack Rasmus
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.
