Great Plans to Destroy U.S. Economy

We are in recession and have just began to chip away at the tip of an iceberg that is credit crisis. Former Treasury Secretary Larry Summers recently stated, “We are facing the most serious financial stress that the U.S. has seen in at least a generation.” I think to call our economic situation a recession and the subprime bubble a credit crisis is a gross understatement.

This is just the beginning – an opinion shared by Satyajit Das, a world-renown expert on credit derivatives, who is also the author of 4,000+page reference text on this subject.




I believe we are going into a nasty bear market. Why?

1. Extraordinary level of debt characterizes a very weak economic state.

2. Political leadership with silly intervention proposals.

3. Subprime market bubble that is just a key to Pandora’s box…watch out!

Massive Debt

Bush’s oil war on Iraq is a $300 billion dollar per year burden on the U.S. economy (by many scholarly and economic estimates). This is expensive by itself, but becomes completely unaffordable when we factor in that the US Government borrows $250-300 billion dollars form China every year above and beyond what it already collects in taxes in spite of tax payers overpaying (i.e. most do not take advantage of the deductions they are legally entitled to).

These numbers do not factor in that Social Security and Medicare are in trouble, which will translate into increased taxes on U.S. citizens in a relatively near future. Our public education system is also a wreck, with 60% high-school drop-out rate in some larger cities…

But that’s only a part of the picture. Much larger debt and dangerous leverage hides in the world economic system and is unfortunately not limited to the U.S. credit crisis.

That said, some form of intervention is necessary to ease the pain; the problem is that no one really knows what this intervention should be. Many proposals are playing around with interest rates, which lead to my next point.

Silly Intervention Proposals

Stimulus Package

If you are waiting for your stimulus check, I am very happy for you. But lets be blunt; it will not do jack to help the troubled economy. The government’s goal should be to make sure we do not dive into a greater mess than the one we already in. Mailing out checks is not a solution for a system for a country that is already so heavily in debt.

Excuse me for stating the obvious, but the government is planning to give out money it does not have! What is it going to do? Borrow another $200 billion from China or just print it up? The little I remember from freshman year at Yale when William Nordhouse still taught introductory economics suggests that created money (regardless of the method used) comes with negative repercussions of a plunging dollar and a rapid inflation.

As the stimulus package receives coverage by most major news channels, one item that is not getting much attention is that it will useless to those who really needed. To get a tax refund you must first be earning money, so the low class who are not required to pay federal income tax will receive half as much as people with higher incomes, while retirees on social security may not get anything at all. [To be precise, the relief package is not a tax refund. It has to be claimed as if there was an overpayment of an income tax]. When the check does arrive, (consumer agencies estimate that) about 80% of the people will spend it on pricey items like electronics in which case most of the money will go right out of the window to foreign manufacturers. This does not address the underlying issue.

The existing problem does not have anything to do with consumer spending. It does not even has much to with the homeowners who are defaulting on their mortgages and are eaten up by mass media, as I will discuss shortly. On the contrary, the problem has more to do with too much spending, highly leveraged financial instruments, and unrealistic real estate valuations.

Feldstein's Plan

Another plan, more colorful than the stimulus package, came from Martin Feldstein (former Reagan advisor). Recently presented in The Wall Street Journal, it proposed for the government to lend homeowners who are in trouble 20% of their outstanding mortgage balance. This money, according to Mr. Feldstein, would come from selling T-bills and have a payoff period of 15 years. The interest would be tax deductible.

So…the plan does not actually help the homeowners; it just moves debt from one place to another, and tries to pay off loans that were created on ridiculous real estate values (and should not have been underwritten at all). Government loans, as Mr. Feldstein pointed out, will lower the interest payments…but weren’t lower interest rates partly what got us into current trouble?

Reality Check

How much trouble our economy is in is debatable. The fact is that the real estate that is backing current outstanding mortgages is worth much less than it was worth before.

The most comparable historic scenario I can think of is Japan (albeit the magnitude of their real estate market was quite a bit larger). One industry fueled economy, leading to widespread speculations. The formed bubble raised real estate values sky-high. Then it came crushing. Then the Nikkei followed, falling for a decade. Sounds familiar?

The Japanese were reluctant to write off bad debt in hopes that the prices would eventually recover. This did not happen and as banks tried to survive, the credit crunch stalled the economic growth so much that for 9 or 10 years the average GDP was 1.5% despite near-zero interest rates.

If history repeats itself, then Japan demonstrated that waiting for property values to rise will not work. That interest rates are not the issue. And that trying to do everything possible to keep bad loans on the books will only exacerbate the bear market.

It Gets Worse

At the beginning I said that we are in for a nasty bear market, and that the subprime credit crunch is just a key to Pandora’s box...What I am talking about stems far beyond the defaulting homeowners, or yesterday's meltdown (and Federal Reserve’s rescue) of Bear Stearns (BSC). I am talking about global levels of debt beyond of what you and I can imagine.

What we are seeing now is that homeowners who are defaulting on their mortgages are being blamed for the credit crisis. This criticism is misdirected. The real players in this game are:

- Financial Technicians who piled up mountains of “securitized” debt with mathematical models that were fundamentally problematic

- US Banks who created genius methods of moving dangerously large amounts (trillions of dollars) of credit risk from their balance sheets into accounts of money managers and less sophisticated investors across the world

- Regulators who stood by and allowed US banks to carry on

- Hedge fund managers who invested heavily in high-yield debt products without thoroughly understanding them

Past to Present

15 years ago banks funded (and obviously wrote) their own loans. Already in 2003 when I was at a mortgage brokerage firm learning the ins and outs of back-end financing the banks would originate the loans through variety of subsidiaries (sometimes directly), and keep them on their own balance sheets for a relatively short period of time before pushing them to investors by rolling a batch of mortgages into CDOs (collateralized debt obligations). This system allowed banks to tie up much less capital in these mortgages, enabling them to put more money out to finance more loans.

The more loans sold, the more could be used to back more loans. The credit standards were lowered to sell more paper (something that the loan sharks helped considerably with). Buyers were primarily pension funds, insurance companies and hedge funds. U.S. and Japanese managers leveraged their bets by buying CDOs with borrowed money on low interest rates. Then credit-agencies (relying on the models developed by the above-mentioned technicians), claiming that these loans would rarely default, used CDOs as collateral to borrow more funds. If you followed me through the loop, that’s 3 stages of borrowed money further buying on borrowed money.

That is how the credit risk moved from the banks, where it was regulated, to places so obscure it was even difficult to observe. In the mean time, it made sense to money managers that if these “assets” (purchased with borrowed money) rose in value, they should borrow more money against the same asset to buy even more in order to maximize returns.

The Problem

These triple-borrowed and inflated assets were then used to back commercial paper. According to several international credit experts, up to 55% of the $2.3 trillion of commercial paper in the U.S. market is currently asset-backed; 50% of that in mortgages.

To sum up, $1 real dollar has been leveraged to support $25-30 dollars of loans. These repeated rounds of loans that were financed in spite of decreasing presence of assets to back them up led to current world economy in which derivatives outstanding stand at $516 trillion (2007 figures) or roughly 8.6 times the global GDP of $60 trillion.

Leverage increases losses just as it increases gains. Attempts to sell “stuff” to fulfill the loan-to-value (LTV) contracts will be desperate and fruitless. This is the reason why banks would’ve liked to stop clients from selling their derivatives at a discount. It would require marking down the value of all the assets in the debt chain, leading to margin calls on customers who already had very little cash.

More troubling, according to experts like Satyajit Das, is that recent gains in the stock market were underwritten by CDO-type instruments (aka structured finance; these include private-equity takeovers, leveraged buyouts and corporate stock buybacks). Now with the structured finance market unwinding, the support for equities will disappear, and many recent deals that depended on the easy availability of money will probably go bust as well.

Conclusion

Before we look to the U.S. Federal Reserve to help prevent a disaster by lowering interest rates dramatically, or look to the U.S. Government to come up with another economically-crippling support package that is dependent on lowering the interest rate, we should think of the lessons we learned from Japan. Interest rates were not the problem then and are not the problem now. Low interests rates might ease the pain, but they are not the solution. The longer banks insist on keeping bad loans on the books the more debilitating it will be to the U.S. economy. Government-proposed solutions should focus not on the interest rates but on the fact that the disillusioned buyers are, step-by-step, refuse to utilize the new model of risk transfer with its associated leverage and other risks.