The Great Debt Crisis Begins

There is growing talk on Wall Street about the possibility of a recession. Since the beginning of the year three Wall Street firms (Merrill Lynch, Morgan Stanley and Goldman Sachs) have all stated they believe we are either in a recession already or are very close to a recession. In other words, it's no longer a matter of if a recession happens but when it will happen and how long it will last. In response to these developments, various presidential candidates have proposed various solutions. However, none of these will work, largely because this is not a typical slowdown caused solely by slowing consumer spending or business investment. Instead, it is a slowdown caused by inflated asset prices and a nation gorging on debt. As a result, it will probably take a lot longer to come out from under this problem.

A recent Los Angeles Times Article stated the basic problem thusly:

What makes bubbles so dangerous is that their consequences, when they burst, are wider, often more damaging, and certainly more unpredictable than those of ordinary downturns.

"We are more prone to bubbles than we used to be," said John H. Makin, a former senior Treasury official with several Republican administrations and now a scholar with the conservative American Enterprise Institute in Washington.

"The old-fashioned recession, where the consumer ran out of gas or there was an economic policy mistake, doesn't seem to occur much anymore," said Alice M. Rivlin, a former vice chair of the Federal Reserve and Clinton administration budget director. "As we've seen from recent events, bubbles seem to be playing a bigger role."

The basic problem faced by the US economy right now is excessive debt caused by recklessly low interest rates from the Federal Reserve. Here is a chart from the St. Louis Federal Reserve of the effective Federal Funds rate since 2000.

Notice the US had record low interest rates for a period of nearly three years. This led to a debt binge of mammoth proportions. Here is a chart of total household debt outstanding from the St. Louis Fed:

Notice the amount outstanding increased from around $8 trillion to a little shy of $14 trillion within a period of seven years. That's approximately a 75% increase in total household debt outstanding.

All of this debt has to go somewhere; it doesn't just exist in a vacuum. To accommodate this increase in total debt, we've seen a huge increase in structured financial products. In and of themselves, these are not bad devices; they have been around for approximately 25-30 years. However, they were used very recklessly over the last 7 years, and especially over the last 3-4 years. The short version of what happened is simple: lending standards deteriorated to the point where literally anyone could get a loan. These loans were then sold to investment firms, who pooled them together and carved them into various bonds, which were in turn sold to large institutional investors like pension funds, insurance companies and hedge funds. The idea underlying structured financial products was that risk was spread out to the point where the bonds were more or less insulated from default problems. However, when defaults skyrocketed higher than anticipated, we discovered that the risk wasn't contained nearly to the degree we thought. Instead, everybody started getting hurt.

Right now the Federal Reserve is treating this situation as a "liquidity crisis", meaning they are literally throwing money at the problem. They are hoping that by flooding the markets with money the money will get spent in the form of loans and credit. However, the market has ample liquidity. The problem is we are in the middle of a debt crisis:

During a liquidity crisis, the issue is one of supplying money to those who, for whatever reason, have suddenly shortened their time preferences. Mr. Practical, writing on Minyanville's Buzz & Banter, characterized it this way:

Suppose there is a rumor that a large bank has made a bad loan. Because banks lend out more money than they have on deposit - this is called a fractional reserve banking system - if everyone goes to the bank and demands their money at the same time, a liquidity crisis can occur because the bank does not have enough cash on hand to satisfy the demand from its depositors. The Federal Reserve will then step in and provide liquidity, allowing the depositor demands to be satisfied. If the rumor of the bad loan proves to be false, then the issue is one of liquidity. Time preferences soon return to a more normalized state, depositors return, everyone feels better. But, if the rumor turns out to be true, it doesn't matter how much liquidity the Fed provides, the bank will go bankrupt.

Similarly, the issue today is not one of temporary liquidity, time preferences being shortened out of a temporary risk aversion. The issue is too much debt supported by too little value and income generation. As a result, time preferences are retreating, risk aversion is growing, and access to credit is diminishing.

Here's the basic problem. All of that debt in the household debt chart assumes a certain asset value. Here's a simple example. Suppose a bank makes a $100,000 loan for a home valued at $100,000. If the home appreciates in value, everything is fine. However, let's assume the home's value decreases to $90,000. Now the loan is inherently less valuable because the underlying asset has decreased in value. If this situation persists or worsens, the lender will have to devalue the loan to some degree to reflect the lower asset value. Now, take this situation and apply it to the entire US economy and you get an idea for what exactly is going on right now.

To make matters worse are two inter-related issues. First, the US economy is very much based on credit creation. As a result, the financial sector sits at the center of the US economy. Here is an overly-simplistic (and poorly drawn) demonstration.

Basically, the financial sector acts as an intermediary between consumers and business, pooling deposits and investments and funneling those to business in the form of credit. Also note the financial sector provides credit to consumers in the form of credit card, consumer and mortgage loans. In other words, when the financial sector takes a bit hit, it impacts the entire economy.

The second problem is the accounting nature of the financial system. It is essentially based on a "fractional reserve" system. All this means is financial firms have to have a particualr asset to loan ratio. For example (and hypothetically) this means financial firms must have say 10% of their total outstanding loans in assets. Now, suppose the value of the assets on their books starts to decrease. The financial firms ability to make loans is diminished. This is why all of the writedowns announced by literally every financial firm out there is so important. It means their ability to extend credit is diminished. As a result, the ability to borrow in the economy at large is diminished, which is devastating to an economy like the US' which is heavily dependent on credit creation to function.

In summation, the US economy is at the beginning of a huge problem. The economy depends on credit creation. However, the financial sector is hampered in that ability right now because the value of assets backing outstanding loans is decreasing. This lowers the value of outstanding loans, which in turn limits the financial sectors' ability to extend credit. So long as the US economy is experiencing deflation this process will continue.

Comments

[Kungfublood]

Pay no attention to those wars behind that curtain! Smoke and mirrors puff puff ,don't look at the fact that most investments have been going on outside America puff puff. Everyone was just following the traitor cheney's lead after all! Just blame it on interest rates?!

[FarSeeingArt]

Extension-of-credit is the opiate of the masses.

Now what?

Withdrawal may be difficult, even ugly.

[Purple Girl]

I HAD NO IDEA THA THE FEDERAL RESERVE WAS NOT A GOV'T INSITITUTION - BUT PRIVATE BANKERS.They have stolen our Gold an dgiven US shit in return. this entity was not in exisitence befor 1913- when the tycoons Morgan , Rockefeller and any other money monger worked a deal with the corrupt Gov't officials.they ahve been screwing US ever since.

BRING DOWN THESE FACIST REGIME ORWELLIAN CORPORATION!!!

Only candidate to refer to this long standing scam is KUCINICH. He at least has th eballs to say we need to review this entities exisitence and the effects it has really had on our economy for the last century.

KUCINICH FOR PRES FOR REAL CHANGE

BOYCOTT MSNBC

[daddysboy]

What aspect of America hasn't been weakened in the early years of this new century? What happens when the less fortunate are finally completely incapable of participating in the economy? What happens when the attempt to slowly wrestle all economic capital from the hands of individual Americans backfires and lands us a non-functioning government?

[Soulsurfer]

And anutha thing.......its no secret that the corportacracy wants us all in debt. That way, we don't make trouble for the employers with unions, demands for more time off, better pay, etc. They want jobs scarce, and a scared, compliant work force. Just like China.

[Soulsurfer]

Also adding to the problem is low job creation, loss of jobs to outsourcing, and flat to negative income increases. "The experts" will always yell that outsourcing is barely a blip on the unemployment numbers, and is actually good for the economy because we can purchase cheaper products. BS! Just like they always say that when I (we) get a raise in wages, its INFLATIONARY! GASP! But when CEO's pay rises, the economy is doing fine.....uh huh. The unregulated capitalism that started with the Reagan administration is slowly strangling the middle class in this country. And giving people access to cheap credit, regardless of their ability to pay is down-right stupid. Cutting interest rates is the worst thing Bernanke could do now, but he will anyway.

[alto]

Bonddad can you write about the larger cause and effect of fed funds rates? For many months I have been reading Dr. John Hussman hussmanfunds.comm) convincingly demonstrate that Fed Fund rate is irrelevant to the larger economy.

The rate applies only for short term (days/weeks) loans to banks that need the cash to meet their reserve requirements. The reserve requirements apply ONLY to checking accounts (which are a total of less than $100 billion). The total outstanding Fed Fund loans at any time are in the 10's of Billions.

Obviously, $10 billion is insignificant in a $10 trillion economy. This is very obviously true since the Fed Funds rate is completely disconnected from the market set rates like Treasury Bills.

Also - the highly touted weekly "injections of liquidity" are actually recurring rollovers (repos) of the same batch of money. One repo expires and is replaced by another repo - with absolutely zero new liquidity provided.

I'd like to hear your take on this idea.

[Spookcatcher]

Americans having "low interest rates" is the cause of our economic problems? BS!!! The biggest lies and propaganda always comes from Wall Street, Economists, and their hacks/salesmen: "Notice that the US had record low interest rates for nearly three years. This led to a debt binge of mammoth proportions"! Low of interest rates is what held the False Economy together after the TechnoRevolution BS. Otherwise we would already have had a class revolution. It was bad political and Capital Money brokers/Globalist that lured money from infrastructure and Government Fiscal responsiblity, not the ordinary people, who have been worjking longer hours, more than 2 jobs per head of household, lost higher paying jobs, lost wages, assumed higher or all of their own healthcare costs, and weathered higher food and utlity and transportation costs, so the only thing that has prvented complete collapse of America is from having low interest rates! This saved us or millions would be on the streets homeless and jobless. Small businesses singlemost important neccessaty is to have low cost of money, or they will never expand, much less survive. The low interest rates predatory lending and abuses between banks and brokers themselves and their Wall Street friends investment fshioned by the elitists to create a semblance of economic boom is what the problem is and was as ALWAYS!. Their schemes and ideas by banks and Wall Street are the sole culprits. They buy the Government, spend the U.S. Treasury, write the rules, and decide whether they want to follow them or not. 299,990,000 Americans live from paycheck to paycheck or may an extra one or two, in any given year
! Think how big our economy would be without the Iraq War. no Bush Tax cut for the rich, and no subprime mortgage lending bank failures!!!

[fundysdotcom]

I've been watching CNBC for the past 6 months as the stockmarket tanks. All the supply siders like Larry Kudlow and Jim Cramer kept saying things really aren't so bad. If only the Fed would cut the rates again another 50 basis points, LOL. All lies. Now in January, it's even worse and they are STARTING to debate whether or not we are in a recession. Bunch of fools. Now they say that another 100 basis point Fed cut will do. Meanwhile, Argentina, with no credit is doing great. Bush and all his Wall Street Buddys are on a sinking ship of fools.

[azrix]

What's sad is that the cheap credit provided by the Fed drives investment to financial markets and away from capital equipment investments. We as a country then get more wealth created on paper from Wall Street instead of real wealth created with basic manufacturing done by good old American labor. "Free trade" gets blamed for our decreasing manufacturing base but all this easy credit makes things much worse.

[DRaymond]

Well bear in mind that the Federal Reserve did not reduce the rates on a whim or in a vacumn. It did it because Bush's economic policies had resulted in a stagnant economy and miniscule to no job growth.

This is continually represented as a problem in the housing market, but it is not alone. Auto lending has also been ridiculously reckless in the last few years, offering to roll over the net negative loan on the buyer's trade-in into the new car loan, which immediately puts the new loan at an even worse loan-to-value ratio. We may soon see auto repossessions reaching the same sort of lending crisis as we are now seeing for home mortgages.

[mbaty]

I think this problem is even deeper, and that it will not be solved overall until it is basically solved for each individual. I know that I used to use a bank to hold my money...until they started charging so many fees that the account became prohibitive. Most of the fees were charged without any notice to me, in fact, if my account went overdrawn I was never informed, and my card was never declined. Eventually, though, the debt that the bank heaped on me became too much; I closed the account, and they still haven't recieved all their money. And they won't until I'm financially stable enough to pay all of my "survival" bills easily with money left over. They weren't willing to negotiate or work something out even when I brought in hundreds of dollars, and so they got nothing...and if everyone has to default on their debts, if everyone has to put off paying off their credit cards so they can survive, the problem just gets worse for the economy. But a living wage and fair bank practices would go a long way towards rectifying these situations.

[yappnmutt]

someone should study the relationship between the repeal of the glass/steagall act and the current banking excess.

i've been on the fence about whether the future leans toward inflation, stagflation or deflation. i'm beginning to lean more towards deflation as it becomes clearer that the consumer is finally tapped out. there's way too much capacity out there forecasting brutal price wars in all sorts of consumer "crap" categories. "its" beginning to look more and more like japan's asset bubble bursting. the biggest difference is the japanese had/have a lot of savings to lean on. the real, maybe still a little early, story is the effect upon the middle class family with no job, no money, no house, no car and no social network to catch them.

ironically, a US recession may benefit china handsomely. a slowdown in europe and the US will slow china down to what? maybe 4% growth instead of 10% growth. the chinese economy will emerge as the strongest economy of the era if they have a chance to slow down a bit for a coupla years and catch up on the gaps in infrastructure.

[Sundialsvc4]

You know, it might be a consequence of just being a "lowly customer" of these august institutions that prompts me to regard "the lowly-customer side" of the equation as being far more important than the abstract statistics that are thrown-about by the financial press.

During the last week, and it's a pretty typical week, I think I got more than thirty credit-card offers. I keep them in a box. I need to get a bigger box.

Each one of these "pre-approved" offers has the same pitch: we'll take over your existing credit-cards, charge you zero percent interest (they don't bother to mention things like "fees"), and reserve the right to change your interest-rate anytime we want to, for any reason or for no reason at all.

I see "title pawn" shops filling entire shopping centers. I know they charge more than nine THOUSAND Percent interest-rates. And, I know where they get the funding. So, no doubt, do you.

Anyhow, I can put two and two together, especially when I look at the annual report (always starting from the back page and reading to the front) of pick-any-one National Bank. And what I see, when I sum up these numbers, is utter and complete ruin... which has nothing at all to do with a quarter-percent shift in the Fed's prime-rate.

I see a game of musical chairs in which the music stopped a very long time ago. I see consumer debt that has buried tens of millions of consumers under a "cross of gold," and banks whose money simply isn't anywhere at all to be found. And I see a press, and government regulators, who seem to be not the slightest bit concerned by this.

I call it the "inverse Rumpelstiltskin effect," busily spinning gold into straw.

What do you get when you dump trillions of "dollars" of imaginary "money" on top of what would otherwise long ago have been a Great Depression? You get "this." So, is a "re-cession" coming? No: a "de-pression" is already here.

[olephart]

Fifty years ago our neighbors were a working class family. They saved their change in jars for various things they wanted to buy and for vacation money. We were somewhat better off but didn't embark on conspicuous consumption and also lived within our means. Everyone at that time paid cash for most purchases. Everyone had a house, a car, food and clothing, well almost everyone. People even paid off their mortgages and owned their homes free and clear, how quaint.

Now everyone uses a credit card, even for routine purchases. There’s even a commercial that depicts some loser paying cash and gumming up the works! Credit cards are convenient and most Americans, contrary to what many think, pay off their balances monthly. Many others, however, have been sold on credit being a way to avoid all that needless waiting until you can actually afford something. The credit splurge alluded to here has made it possible to actually “spend your house”. Did it ever occur to anyone that taking the “equity” out of your house and spending it wasn’t a good idea? Did anyone actually think that paying $839,000 for a house that originally sold 10 years ago for $225,000 was a good “investment”? A general rule of thumb for a home’s value is to multiply its monthly rental value by 100 (+/- 20). All those million dollar houses would have to have rental values of $10,000 a month. That would require a yearly income of $360,000 to equal one third of a family’s gross income. I know that the lottery is a tax on the mathematically illiterate but home valuations shouldn’t require an Einstein to figure out.


“The economy depends on credit creation.”

It might be time to base the economy on common sense, how quaint.