From One Disaster To Another

This has been one hell of a weekend. On Friday night my wife and I were in Houston, Texas. We survived Ike intact; I'm fine, Mr$. Bonddad is fine, all three dogs are fine and the house is fine. However, I am currently in Austin, Texas for the week.

Then I wake up and find out Lehman and Merrill Lynch are no longer going concerns on Wall Street. And this is a few weeks after the "free market" U.S. nationalizes its mortgage industry.

Let's back up a bit and see how we got here. Advance warning: this will be long and fairly complicated, so get a cup of coffee now (actually, get the pot ready).

A few weeks ago, I wrote an article titled, "An extended shallow near recession." This was a riff off a comment made by one of the people who writes at Angry Bear. The point is this expansion has not felt like a real expansion. Job growth has been the weakest of any expansion since 1960. Real median household income is now at the same level it was in 2001. (Please see The Bush Boom Was A Complete Bust.) Combined these elements tell us the economy is doing very poorly. These two points also tell us there is at least one fundamental problem with the economy if not more.

So -- let's look at am important fundamental issue with the US economy. At the beginning of this expansion the US savings rate was right around 2%. Here's a graph from the St. Louis Federal Reserve:

Here's what this figure means. An economist defines savings as all the money left over after a person spends money on everything else. In other words, after a person has paid their bills and mortgage and bought all their other stuff (clothes, restaurants etc...) the left over money is "savings". The assumption here is people buy stuff and then save whatever is left. The point with this data is at the beginning of this expansion people were already spending just about everything they made.

Let's add in two more data points. Personal consumption expenditures increased for the duration of this expansion. According to the Bureau of Economic Analysis, real personal consumption expenditures increased from a level of 104.128 to 123.931. So people kept spending. At the same time, incomes have been stagnant for the vast majority of the US population.

Workers with professional degrees, such as doctors and lawyers, were the only educational group to see their inflation-adjusted earnings increase over the most recent economic expansion, adding to the concern that the economy has benefited higher-earning Americans at the expense of others.

Workers in every other educational group -- including Ph.D.s as well as high school dropouts -- earned less in 2007 than they did in 2000, adjusted for inflation, according to data from the Census Bureau. Data don't include 2008 earnings.

This same data is born out in the Census Bureau's real median household income:

So let's sum up. Real (inflation adjusted) incomes for the vast majority of Americans declined this expansion. At the same time, people were already spending most of their incomes at the beginning of this expansion yet they continued to increased their spending for the duration of this expansion. Where did all of the new money for increased spending come from?

Tons of debt. At the beginning of this expansion total household debt outstanding stood at $7.6 trillion. That current figure is $13.9 trillion. That's an increase of 82%. To place that figure in perspective, total household debt outstanding is now almost as large as total US GDP. All of that does not exist in a vacuum; it has to go somewhere. And that's where we get to the current problems in the markets.

As the figures above shows, the US went on a debt orgy primarily concentrated in mortgages. First, the Federal Reserve lowered interest rates to 0% after adjusting for inflation. Then the financial system had to increase the number of people who could access the debt market and increase the amount of money they could get access too. However early on it was obvious this would cause problems:

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."

All of this debt was cut into a large amount of securitized debt -- collateralized mortgage obligations (CMOs), collateralized debt obligations and the like. The belief among everybody was securitization so spread out risk that possible problems (like the ones we are currently having) were non-existent.

All of this debt was based on the housing sector, which was grossly inflated from the overly aggressive federal reserve. All of this debt was purchased by, well, everyone. And that's what's leading to all of the problems on Wall Street. As housing collapses we are learning the following:

1.) Record low interest rates increase borrowing. This is standard economics. Lower the cost of most goods and demand will increase.

2.) Housing was clearly in a bubble.

3.) Increasing the number of people who have access to debt and the amount of money they can borrow is not the greatest idea.

4.) Securitization -- while a solid financial development -- does not so spread out risk that risk is eliminated.

As the value of housing has dropped, the number of people who have defaulted on their loans has increased. This means the collateral backing all of these securitzed loans has deteriorated. This means that all of the CMOs, CLOS and the like that everyone has purchased are no longer worth anywhere near what everybody thought they were worth. As a result, you are seeing tons of "writedowns" all over Wall Street. This simply means firms are saying "this bond isn't worth $100, it's worth $90." The problem is everybody is writing down debt. So far we've had over $550 billion in writedowns. And these writedowns are what is leading to events like those we are having today. And there is no reason to think we are anywhere near done with these problems.

So, let's sum up all the points made above.

1.) Incomes shrank for most Americans over the last expansion.

2.) But Americans kept spending thanks to a mammoth increase in household debt.

3.) To increase the amount of debt in the system, lending standards were lowered.

4.) Lowered lending standards have led to a higher default rate from borrowers.

5.) Higher default rates have lowered the value of all the collateral backed by mortgages.

6.) Lowered collateral values have killed the balance sheets of literally every major financial company.

Comments

[mezz1962a]

And waht does Obama do...Goes out and makes the EX CEO's of Lehman and Fannie.Freddy his top economic advisers.

With judgemnet like that I would not let Obama handle my 10 year olds budget for his lemonade stand

Great to see all of Obama's experience working in choosing the people he surrounds himself with

[idest]

Two words for you....Phil Gramm.

[DayoftheLiberal]

In the 90s in Texas we amended the state constitution to get rid of the longstanding prohibition of second liens on homesteads. The argument from everyone to allow home equity loans was: "Why can't I access the value in my own house to start a business, pay medical bills, or just go out and have fun? Why does the government have any business telling me what to do?"

This is why.

[ParroPhernalia]

I like everything about your analysis and it is definately a major reason for our current predicament. I would like to add a few things.

Regulations were passed in 1929 after the first big stock market crash, in order to make sure speculators couldn't make it happen again. Senator Graham, McCains economic puppet master, destroyed those regulations and single handed caused the Enron debacle and the current oil crisis by allowing speculation on futures of energy.

There are some people who have hed their salaries or incomes or whatever increase and it has been those speculators and the others in the top 1 percent of the economic population. We have produced more billionaires in the past ten years than in any other period.

Either way, we are in trouble of a serious kind.

[ErnestineBass]

That's former Senator *Gramm*, dear. The devil's in the details. 8-]

[humbug]

Dear Bondad: I read your column regularly and it does help me understand what is happening and why. I have a question, the answer(s) to might make a good column. The question: What do economists mean when they talk of "fundamentals"? What are the components that would be considered in making an assessment of the economy's status and direction? Is the word "fundamentals" a bulls--t word that people like politicians fling around to sound support their positions and to seem knowledgeable? What is the textbook definition (if there is one) of the word "fundamentals? Thank you again for an excellent column.
humbug

[mitchgrrt]

Good article. You list 4 lessons learned but you missed one. The agencies like Moodys that rate the riskiness of investments totally missed this. They should have been giving "risky" ratings to bonds that carried lots of subprime mortgages and other dodgy investments. Instead they continued to rate these bonds as AA and AAA. Does the whole investment-rating system need an overhaul?

[wardropper]

The ultimate humiliation for the GOP:
Republicans are actually going to have to recommend rather large tax increases, and socialism in America will be brought about by THEIR actions.

This is Dante's "Divine Comedy" with extra laughs.

Of course, they could always do their typical and cowardly thing:
They could arrange for the Democrats to win the election and then blame them for the socialism which is to come.

This WILL be an exciting election after all, and thinking Americans will, for once, win, whatever the outcome.
Either we get the divine comedy outlined above, or we get a Democratic government with Obama and REAL change.

[Craig]

The National Debt is probably the largest central planning experiment in human history--it would make Marx and Mao blush. Those of us living today knows what is best for generations to come and by spending their future earnings now we will leave a better country for them to inherit. NOT

[lennylizard]

either way it doesn't sound great...divine comedy (not) or the democrats to win and the socialism to come. Doesn't the American people lose either way? What happened to thinking that it's the people, it's the ideas?

[mrcontinental]

Most don't want the truth Bonddad but thanks for putting it out there anyway.

[Zan-Gah]

I am almost 70 years old. I have some savings which I depend on, and am absolutely afraid that they will disappear in an Argentina type meltdown. Where are people going for safety? Stocks? Bonds? Gold? Cash? I feel like a deer caught in the headlights of an oncoming car.

This Republican administration is destroying the country. I can't imagine why anyone would vote Repub.

[Aaror]

keep half of your savings in US non-bank bonds or CD's, use half of your savings to buy non-bank bonds in a few old European companies. That way half of your money will be in Euro's if the dollar tanks, but half will be in dollars to spend easily. Every year or so, re-balance so half your money is in euros and the other half in dollars.

[UnknownSoldier]

The people in the Red States are trying to start a movement to sucede from the United States if Obama Wins. I think the people in the Blue States need to start a similar movement. We don't need bloodshed, NO Civil War. Let them run the Red States the way they want, and we Run the Blue States the way we want. Give it 30 Years if one group wants to rejoin and make the country whole again, then they get taken back in no questions asked.

What we have now is not going to work.

ENOUGH!!!

[Star2000dancer]

How insipid!! We come from only 4 different DNA groups. There is no such thing as a blue blood anymore. We are all of mixed blood. The only difference is in thought & language. The elitiast are the ones born int o aristocracy. The big churches with the big money are controlled by the government & banks, however they control your thinking.

We must start thinking for ourselves. Over 90% of the world are acttually Independents, they just do'nt reaize it yet. Make your own decisions, do what feels right, do'nt let anyone fool you anymore. And for God's sake, understand we are not a 4000 year old planet. Even if we were, Cain & Able had to get married..to who? They're sisters? That still means we are all related.

Perhaps we should just break open a bottle of wine & have one big happy reunion.

[Aaror]

Not sure how that affects the military. I am not knocking the idea, but who will finish the Iraq war? Also, the "Blue states," are not contiguous. We would have to create two nations, New England and Pacifica. Exact borders would be troublesome as well, states like Michigan, Ohio, and Illinois could go either way.
On the flip side, it might be good for the nation anyway. The US may be too big to govern. Having a few smaller states would reduce the graft. Still, I think I would rather see us change the form of the existing government. The articles of confederation from before the constitution should be dusted off and looked at. Let each state run itself the way it wants, with only tarriffs and the military shared. Or we could do something like the EU...

[LiberalBuzz]

Seriously Aaror, would you like to really let some states run things the way they want?

Can you imagine what the South would be like in one year? It's make the taliban look like amateur night at the local comedy club.These people are better armed. And let's not forget all those other red states. YES I said red states, because those states with a majority of conservatives would be back in the 17th Century in no time. They disdain science and intelligence.

Traveling to blue states having to go through red states would be a nightmare. I am sure you think it might be all normal, but you haven't seen how these people think. I have relatives in Norco Louisiana and let me tell ya, they are so typical of the South that we would be in intrastate wars within a few years. Backwards doesn't even begin to define them.

Just look at the belief that Creationism should be taught INSTEAD of evolution. These mo rons think The Flintstones was a documentary. Have you seen the creation museum? It shows dinosaurs with SADDLES.

Work limitations stop me, but you get the idea.

[Hattie]

Yes.

[zizyphus]

The FED should be abolished now, before they do any more damage.

Sadly, as Max Keiser, a prediction market analyst, sees it: "There's a decoupling in the wind, America is essentially finished as a global economic power.

"The US dollar is now finished as the world's reserve currency and we are going to see now some other country rise up and take its place, most probably China."

Thanks FED, thanks for nothing.

[pdooley]

So is this a softening up exercise for another dose of "The Shock Doctrine"? (Perfect paranoia is perfect awareness).

[Crowhaul]

The Shock Doctrine should be required reading for all Americans. The rise of disaster capitalism needs to be understood by those who were brainwashed into somehow believing that capitalism was in any way patriotic; at its core, it's not.

[deminmo]

Many people dismiss "Shock Doctrine" as liberal bias. If you
read the book, then look seriously at the last 8 years, you can see
Ms. Klein was trying to warn us. The sad part is, we are going to
continue with the shocks for a while. The only thing that would finish
our economy off would be a war with Iran, Pakistan or Russia. And
Bush/Chaney still have time for that.

[BeltwayBette]

OBAMA (NYT):
"Mr. Obama set out his general approach to financial regulation in March, calling for regulating investment banks, mortgage brokers and hedge funds much as commercial banks are. And he would streamline the overlapping regulatory agencies and create a commission to monitor threats to the financial system and report to the White House and Congress.

MCCAIN: (NYT)
"His record on the issue, and the views of those he has always cited as his most influential advisers, suggest that he has never departed in any major way from his party"s embrace of deregulation and relying more on market forces than on the government to exert discipline.
"While Mr. McCain has cited the need for additional oversight when it comes to specific situations, like the mortgage problems behind the current shocks on Wall Street, he has consistently characterized himself as fundamentally a deregulator and he has no history prior to the presidential campaign of advocating steps to tighten standards on investment firms.

"He has often taken his lead on financial issues from two outspoken advocates of free market approaches, former Senator Phil Gramm and Alan Greenspan, the former Federal Reserve chairman. Individuals associated with Merrill Lynch, which sold itself to Bank of America in the market upheaval of the past weekend, have given his presidential campaign nearly $300,000, making them Mr. McCain"s largest contributor, collectively."

[Gronamox]

It is time to make the World really stop and consider the truth. We are not as rich as we suppose, neither is the rest of the world really catching up. In fact, they are using petro-dollars to buy everything. Those dollars are soon going to be worthless. Why, we will not be using oil the way we used to. Also-we will not be able to pay our debts. The Iraq War alone has placed us in a hole so deep, there is no way out. We will default. Once we do, the markets will not collapse, but readjust-back to the good old days, when the Republicans were not in power. They have stolen so much money and with all of there illegal schemes-Enron, Deregulation, Union Busting, defrauding the worker of his unemployment insurance, and the Greenspan years that have ruined the non-functioning myth called the Global Economy-it needed ruining. It does not work. There is no model for it-Greenspan got out when the crash was beginning. A crash, that little mother caused. We will go back to National Economies. International trade will continue. International banking will not. Also, if you have a company called the Gap and it makes all of its stuff in China-we will no longer allow it inside this country without tariffs that jack up the price so high, it no longer makes sense to out source American work. Workers Unite.

[Abndant1]

This economical meltdown could have been avoided, and indeed, could still be stopped in its tracks. The Real Estate industry does not reflect the economy but drives it. We don"t need another bailout. The banks sold the "risky" loan, "rip off loans" disguised as "risky" intended to dupe unsuspecting consumers. They banked on these loans being unaffordable within 3-5 years, being refinanced, making them more money. They did not foresee the avalanche coming down the mortgage mountain. They repossess these homes, don't do the basic cleaning, cosmetic repair or even mow the lawn. They sell them below market, "as is," further damaging the market. The home owners who lose their homes have trouble renting, or making any major purchasers, taking the economy deeper into job market that supports the very industry that created the problem to begin with. Those job cuts, permeate into other areas, from real estate, building, repairs, home improvement, landscaping, and all their employees. The answer: STOP THE FORECLOSURES!! This would stop the red ink and the influx of under priced housing into the market, and begin the healing. The loans need to be required to be recast, folding in any arrears, reducing the interest rate to the start rate, fix it for 5 years, then cap the increase at .5% per year for a maximum of 4 years. (McCain"s idea of getting an FHA loan at the current value, just allows additional loses and continues the bank bleeding).