October 24, 2008
The Economic Meltdown
In the last four weeks the American financial system teetered on the verge of complete collapse. Lending money, to the public, businesses, and even between banks, came to a near halt. With it, a yearlong slide in the stock market accelerated into a sickening dump. At the market low on Friday October 10, 10% of American companies had share prices less than the cash they possessed in the bank.
The root of the crisis was created in 2005 and 2006, when the inflating housing bubble culminated in widespread lending to non-credit worthy borrowers. The use of no money down loans, loans with negative amortization, loans that borrowers qualified for based just on the teaser rate, but not the rate after a few years, and loans in which no documentation of income or assets was required, resulted in a vast bubble of a trillion dollars of bad debt. The whole scheme was based on the false notion that home prices would continue to climb at double digit rates, allowing these fresh borrowers to sell at a profit and repay the loans.
This was bad enough, but what it made it a global disaster was a new process called “securitization”. In this, the original mortgage lender would not hold the loan till it had been paid off in 15 or 30 years. Instead the loan was sold to Wall Street or Fannie Mae, who then bundled the loan with a thousand other bad loans and created a bond based on that debt. This bond (called an MBS, or mortgage-backed security) would then be sold to anyone on the planet, but much of it was bought by Wall Street firms, and American and European banks. To protect themselves against a possible default of these bonds, the buyers then went to insurers such as AIG to buy default insurance. These policies were sold very cheaply, because AIG and others really had no idea what the default risk was.
When the housing market began its epic collapse about a year ago, this whole edifice crashed to the ground. The unqualified borrowers went into foreclosure and lost their homes. The MBS bonds then began to default, collapsing the price of the bonds that were stuffed into the balance sheets of many titans of finance. This led to a run on the insurers of the bonds, resulting in the collapse of AIG. Finally, the entire banking system and the money market fund system that form the basis of lending in the country came to a halt. Without lending, the entire economy is at risk of a seizing up. This panicked the government and collapsed the stock market.
Bush responded initially by asking for 700 billion dollar authority to buy up the MBS bonds that were choking the banks, and take them off their balance sheets. This proposal was initially rejected by the Republicans in the House, but after some pressure they came around. However, it rapidly became clear that this approach was politically not going to work. If the government paid market price for the MBS bonds (which was 20 cents on the dollar), the banks would end up still frozen from lack of capital. If the government overpaid, this would help the banks, but would not be accepted by the voters.
Over in England, the British realized the only way to fix this was to put public money directly into the banks. Ultimately that is what the US went with too. On October 14, Treasury pushed all the US banks to accept a government takeover with 250 billion dollars in fresh money injected directly into the banks. With these additional funds, the banks could go back to lending, and slowly work out the MBS issue as it becomes clearer how big the default problem will be. Meanwhile, Bush, the extreme right-winger President, will ironically go down in history as the one who engaged in the most socialist of policies.
How would this play out in the real world? If the credit and finance system can be made to work relatively normally in the next few months, then the pain in the rest of the economy will not be overwhelming. We will have a recession, but I think it will be moderate and not severe. Once home prices reach a bottom, and we should get there in the next few months, then banks will be able to get a clear picture of their true situation, and normal trust and lending will return. Meanwhile, the drop in oil prices will give consumers a much needed boost, and help the economy. The stock market will also make a recovery, but will not go all the way back to where it was at its peak.
Obama, who looks likely to inherit this situation, may find that he is the recipient of a double-dose of good luck. The collapse of Wall Street in mid-September helped change this very close race and break it decisively in his favor. By getting to start his new administration with a recession, he will then benefit in four years when we should be in a cyclical upturn that will allow him to win reelection with ease. Comments can reach me at nali@socal.rr.com.
