Smoke and Mirrors

So, it's finally happening - the bubble has burst and the economy is in a melt down. This comes as no surprise to many of us. Paul Krugman anticipated it in August of 2005.

Well, last week Mr Greenspan warned us about the very condition his smoke and mirrors economics had created and Paul Krugman explains.
Greenspan and the Bubble

What he did say, after emphasizing the recent economic importance of rising house prices, was that "this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent." And he warned that "history has not dealt kindly with the aftermath of protracted periods of low-risk premiums." I believe that translates as "Beware the bursting bubble."

Like everything else, the economic policy of the Bush administration has been driven by politics. The so called "recovery" has not created new wealth, only debt and Alan Greenspan has been a good Republican soldier first and an economist last. A recovery based only on debt is not a recovery and can't be sustained. As Krugman points out Greenspan is now warning us about the very things he was encouraging less than a year ago.

But as recently as last October Mr. Greenspan dismissed talk of a housing bubble: "While local economies may experience significant speculative price imbalances, a national severe price distortion seems most unlikely."

Wait, it gets worse. These days Mr. Greenspan expresses concern about the financial risks created by "the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages." But last year he encouraged families to take on those very risks, touting the advantages of adjustable-rate mortgages and declaring that "American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage."

If Mr. Greenspan had said two years ago what he's saying now, people might have borrowed less and bought more wisely. But he didn't, and now it's too late. There are signs that the housing market either has peaked already or soon will. And it will be up to Mr. Greenspan's successor to manage the bubble's aftermath.

In June of 2005 Eric Englund discussed the The Austrian Theory of the Trade Cycle.

The Austrian theory of the business cycle emerges straightforwardly from a simple comparison of savings-induced growth, which is sustainable, with a credit-induced boom, which is not. An increase in saving by individuals and a credit expansion orchestrated by the central bank set into motion market processes whose initial allocational effects on the economy's capital structure are similar. But the ultimate consequences of the two processes stand in stark contrast: Saving gets us genuine growth; credit expansion gets us boom and bust.

Since busts are not politically acceptable credit was eased to create a new boom:

Alan Greenspan, of course, would not tolerate a recession. Accordingly, the Federal Reserve went on a money and credit creation binge and eventually brought short-term interest rates down to 1% (in 2003). The Federal Reserve, in total, cut interest rates 13 times between 2001 and 2003. With interest rates so seductively low, Americans went on a borrowing and spending spree which pulled Uncle Sam out of the recession – at least for now.

As Murray Rothbard explains, in The Austrian Theory of the Trade Cycle, America’s debt-driven "prosperity" is a mirage built upon the opiate of easy credit. Alan Greenspan’s multiple interest rate cuts, as Dr. Rothbard conveys, is nothing new in the field of central banking:

… the point is that the credit expansion is not one-shot; it proceeds on and on, never giving consumers the chance to reestablish their preferred proportions of consumption and saving, never allowing the rise in costs in the capital goods industries to catch up to the inflationary rise in prices. Like the repeated doping of a horse, the boom is kept on its way and ahead of its inevitable comeuppance, by repeated doses of the stimulant of bank credit.

Well nearly three years later many more are catching on.
How Real Was the Prosperity?
We're just beginning to figure out how much of the nation's recent growth was the result of a credit-induced frenzy. Here are some guideposts

The housing markets, of course, overshot as too many buyers took out subprime mortgages they couldn't afford. The outcome will be a decline in home values, with prices in some areas already down.

But the economic writedown is likely to go far beyond housing. Household spending, consumer debt, financial sector profits: All may need a retrenchment, sudden or gradual, to get back to sustainable levels. That's bad news for investors and the global economy, which still depends heavily on U.S. consumption for growth.

There may even be a reassessment of whether recent productivity gains were fueled by excess credit. If growth in productivity slows, the economy will stagnate, real wages will weaken, corporate earnings targets will be harder to meet, and inflationary risks will increase.

Hale "Bonddad" Stewart has more:
The Illusion of the Bush Economy's Growth is Revealed
The current mess was predicted but was politically inevitable.

Thanks Alan

Well I'm a little poorer tonight. Not as poorer as I could be since only about 25% of my investments are in the US but still poorer. And I have Alan Greenspan and the Bush Administration to thank. In 2004 Greenspan was still pushing the "creative" lending packages that many were already were concerned about. The reason was to keep the bubble inflated through the 2004 election. Well Big Al's chickens have come home to roost. Of course ignoring the inevitable oil shortages since Reagan was elected has not helped any and neither has George W. Bush's mortgaging the country to finance his occupation of Iraq.
Stocks Tumble on Weak Dollar and Oil Prices

Stock markets were hit today by their second sharp sell-off in less than a week, sending the Dow Jones industrial average down 360 points to a level last seen in September, before the Federal Reserve cut interest rates.

Banks and brokerage firms led the steep declines as investors remained skittish about lingering fallout from the summer’s subprime mortgage crisis. The dollar hit a new low against the euro and analysts predicted a broad fourth-quarter slowdown in businesses and consumer spending.

The Dow industrials declined 2.64 percent, to 13,300.02, its lowest finish in nearly two months. The Standard & Poor’s 500-stock index tumbled 44.65 points, or 2.94 percent, to 1,475.62. The Nasdaq composite index fell 76.42 points, or 2.7 percent, to 2,748.76.

Stocks dropped from the opening bell and never recovered, with the sell-off accelerating in the final hour of trading. General Motors weighed down the Dow after announcing the biggest quarterly loss in company history. G.M. is considered something of a bellwether for the broader business climate.

Financial stocks were off by more than 3 percent for the day. Investors remain wary that investment banks will announce more write-downs of assets related to mortgage-backed securities.

When you see the train coming you should get off of the tracks. Politics won.

Another Failed Experiment

In a paper presented just before his death, Mr. Gramlich wrote that “the subprime market was the Wild West. Over half the mortgage loans were made by independent lenders without any federal supervision.” What he didn’t mention was that this was the way the laissez-faire ideologues ruling Washington — a group that very much included Mr. Greenspan — wanted it. They were and are men who believe that government is always the problem, never the solution, that regulation is always a bad thing.

Unfortunately, assertions that unregulated financial markets would take care of themselves have proved as wrong as claims that deregulation would reduce electricity prices.

We are just beginning to realize the impact of the subprime lending crisis will be. Today Paul Krugman explains how the crisis was predicted and how it could have been prevented but wasn't.
A Catastrophe Foretold

“Increased subprime lending has been associated with higher levels of delinquency, foreclosure and, in some cases, abusive lending practices.” So declared Edward M. Gramlich, a Federal Reserve official.

These days a lot of people are saying things like that about subprime loans — mortgages issued to buyers who don’t meet the normal financial criteria for a home loan. But here’s the thing: Mr. Gramlich said those words in May 2004.

And it wasn’t his first warning. In his last book, Mr. Gramlich, who recently died of cancer, revealed that he tried to get Alan Greenspan to increase oversight of subprime lending as early as 2000, but got nowhere.

So why was nothing done to avert the subprime fiasco?

That question is of course answered above. Nothing was done because the officials in charge believe in unfettered laissez-faire capitalism and that any form of government regulation is bad. That was Herbert Hoovers belief in the 20's and so when he did nothing the result was the great depression. That was the first experiment. Some 80 years latter a new crop of laissez-faire ideologues were in charge and we have the sub prime lending crisis.

Both borrowers and investors got scammed

I’ve written before about the way investors in securities backed by subprime loans were assured that they were buying AAA assets, only to suddenly find that what they really owned were junk bonds. This shock has produced a crisis of confidence in financial markets, which poses a serious threat to the economy.

But the greater tragedy is the one facing borrowers who were offered what they were told were good deals, only to find themselves in a debt trap.

In his final paper, Mr. Gramlich stressed the extent to which unregulated lending is prone to the “abusive lending practices” he mentioned in his 2004 warning. The fact is that many borrowers are ill-equipped to make judgments about “exotic” loans, like subprime loans that offer a low initial “teaser” rate that suddenly jumps after two years, and that include prepayment penalties preventing the borrowers from undoing their mistakes.

Yet such loans were primarily offered to those least able to evaluate them. “Why are the most risky loan products sold to the least sophisticated borrowers?” Mr. Gramlich asked. “The question answers itself — the least sophisticated borrowers are probably duped into taking these products.” And “the predictable result was carnage.”

How many more failed experiments do we need.

Sowing the seeds of successive asset bubbles

I've never been one who thought that Ayn Rand disciple Alan Greenspan was a miracle worker and economic genius. A couple of my previous commentaries can be found here and here. He proved my point today:
Greenspan says didn't see subprime storm brewing

WASHINGTON (Reuters) - Former Federal Reserve Chairman Alan Greenspan said he was late to see the storm gathering around U.S. mortgage lending practices and commended his successor Ben Bernanke's handling of the crisis, saying he would likely be responding in a similar fashion.

[.....]

Greenspan said that as Fed chief he knew about questionable lending practices that were leaving subprime borrowers with adjustable rate loans vulnerable to harm from rising interest rates, but did not recognize those loans would trigger broader problems until fairly recently, CBS said.

"While I was aware a lot of these practices were going on, I had no notion of how significant they had become until very late," Greenspan said. "I really didn't get it until very late in 2005 and 2006."

He knew about it but didn't think it would be a problem? he's either a liar, an idiot or both. I vote for liar. He knew full well what would eventually happen. As a political hack he also knew full well that the easy credit was the only thing that prevented the economy from going south before the 2004 election and threaten the reelection of George W. Bush.

Greenspan, 81, has received credit for leading the economy to its longest-ever expansion in the 1990s and many economists have praised his handling of a sequence of crises.

Indeed, some have hailed him as the greatest central banker in U.S. history.

However, others criticize Greenspan for sowing the seeds of successive asset bubbles, first in U.S. stock markets and later in housing. He has also come under fire for suggesting during his Fed tenure that adjustable rate mortgages could be a cost-saving financing option for many borrowers, just shortly before the Fed embarked on a long push to move rates higher.

Credibility Shortage

The DOW lost nearly 400 points yesterday and opened over 100 points down this morning. And it's not just the US.
Fears of global liquidity crisis grip markets

LONDON (Reuters) - Fears of a global liquidity crisis intensified on Friday, knocking stocks and high-yielding currencies, while the European Central Bank and Asian authorities acted to calm surging short-term borrowing costs.

What started as trouble with risky U.S. residential mortgages is gripping world financial markets as the fallout hits banks globally, squeezes once ample liquidity and threatens to damage world growth.

World stocks have shed over seven percent since they hit record highs only a month ago. Investors rushed to buy safe-haven government bonds, unwind yen-financed carry trades and moved to scale back expectations for interest rate hikes by some major central banks this year.

Emergency action by central banks -- with the ECB acting for the second time on Friday -- underlined that the risk of a global liquidity crunch was more serious than anticipated.

"What we have at the moment is just an all-round sense of panic," said Marc Ostwald, bond analyst at Insinger de Beaufort in London.

So what do you need at a time like this? Someone with credibility - something we don't have.

Very Scary Things
By PAUL KRUGMAN

In September 1998, the collapse of Long Term Capital Management, a giant hedge fund, led to a meltdown in the financial markets similar, in some ways, to what’s happening now. During the crisis in ’98, I attended a closed-door briefing given by a senior Federal Reserve official, who laid out the grim state of the markets. “What can we do about it?” asked one participant. “Pray,” replied the Fed official.

Our prayers were answered. The Fed coordinated a rescue for L.T.C.M., while Robert Rubin, the Treasury secretary at the time, and Alan Greenspan, who was the Fed chairman, assured investors that everything would be all right. And the panic subsided.

Yesterday, President Bush, showing off his M.B.A. vocabulary, similarly tried to reassure the markets. But Mr. Bush is, let’s say, a bit lacking in credibility. On the other hand, it’s not clear that anyone could do the trick: right now we’re suffering from a serious shortage of saviors. And that’s too bad, because we might need one.

What’s been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in stuff that is normally traded all the time — in particular, financial instruments backed by home mortgages — have shut down because there are no buyers.

This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults.

It's not like we didn't see this coming. The Bush "recovery", like everything else in his administration, has been done with smoke and mirrors. It was based entirely on lots of credit and lots of bad loans. It's now time to pay the piper.

The origins of the current crunch lie in the financial follies of the last few years, which in retrospect were as irrational as the dot-com mania. The housing bubble was only part of it; across the board, people began acting as if risk had disappeared.

Everyone knows now about the explosion in subprime loans, which allowed people without the usual financial qualifications to buy houses, and the eagerness with which investors bought securities backed by these loans. But investors also snapped up high-yield corporate debt, a k a junk bonds, driving the spread between junk bond yields and U.S. Treasuries down to record lows.

Then reality hit — not all at once, but in a series of blows. First, the housing bubble popped. Then subprime melted down. Then there was a surge in investor nervousness about junk bonds: two months ago the yield on corporate bonds rated B was only 2.45 percent higher than that on government bonds; now the spread is well over 4 percent.

Investors were rattled recently when the subprime meltdown caused the collapse of two hedge funds operated by Bear Stearns, the investment bank. Since then, markets have been manic-depressive, with triple-digit gains or losses in the Dow Jones industrial average — the rule rather than the exception for the past two weeks.

But yesterday’s announcement by BNP Paribas, a large French bank, that it was suspending the operations of three of its own funds was, if anything, the most ominous news yet. The suspension was necessary, the bank said, because of “the complete evaporation of liquidity in certain market segments” — that is, there are no buyers.

When liquidity dries up, as I said, it can produce a chain reaction of defaults. Financial institution A can’t sell its mortgage-backed securities, so it can’t raise enough cash to make the payment it owes to institution B, which then doesn’t have the cash to pay institution C — and those who do have cash sit on it, because they don’t trust anyone else to repay a loan, which makes things even worse.

And here’s the truly scary thing about liquidity crises: it’s very hard for policy makers to do anything about them.

The Fed normally responds to economic problems by cutting interest rates — and as of yesterday morning the futures markets put the probability of a rate cut by the Fed before the end of next month at almost 100 percent. It can also lend money to banks that are short of cash: yesterday the European Central Bank, the Fed’s trans-Atlantic counterpart, lent banks $130 billion, saying that it would provide unlimited cash if necessary, and the Fed pumped in $24 billion.

But when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn’t do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn’t do much if the cash stays in the banks’ vaults.

There are other, more exotic things the Fed and, more important, the executive branch of the U.S. government could do to contain the crisis if the standard policies don’t work. But for a variety of reasons, not least the current administration’s record of incompetence, we’d really rather not go there.

Let’s hope, then, that this crisis blows over as quickly as that of 1998. But I wouldn’t count on it.

FAIR USE NOTICE

This article contains copyrighted material, the use of which has not always been specifically authorized by the copyright owner. I am making such material available in my efforts to advance understanding of democracy, economic, environmental, human rights, political, scientific, and social justice issues, among others. I believe this constitutes a 'fair use' of any such copyrighted material as provided for in section 107 of the US Copyright Law. In accordance with Title 17 U.S.C. Section 107, the material in this article is distributed without profit for research and educational purposes.

From the people that brought you Enron

Paul Krugman explains that the meltdown in the sub prime home lending market is the responsibility of the same folks who are responsible for Enron, S.& P., Moody’s and Fitch, the bond-rating agencies.
Just Say AAA

What do you get when you cross a Mafia don with a bond salesman? A dealer in collateralized debt obligations (C.D.O.’s) — someone who makes you an offer you don’t understand.

Seriously, it’s starting to look as if C.D.O.’s were to this decade’s housing bubble what Enron-style accounting was to the stock bubble of the 1990s. Both made investors think they were getting a much better deal than they really were. And the new scandal raises two obvious questions: Why were the bond-rating agencies taken in (again), and where were the regulators?

What you see is not what you get or Enron redux.

To understand the fuss over C.D.O.’s, you first have to realize that in the later stages of the great 2000-2005 housing boom, banks were making a lot of dubious loans. In particular, there was an explosion of subprime lending — home loans offered to people who wouldn’t normally have been considered qualified borrowers.

For a while, the risks of subprime loans were masked by the housing bubble itself: as long as prices kept going up, troubled borrowers could raise more cash by borrowing against their rising home equity. But once the bubble burst — and the housing bust is turning out to be every bit as nasty as the pessimists predicted — many of these loans were bound to go bad.

Yet the banks making the loans weren’t stupid: they passed the buck to other people. Subprime mortgages and other risky loans were securitized — that is, banks issued bonds backed by home loans, in effect handing off the risk to the bond buyers.

In principle, securitization should reduce risk: even if a particular loan goes bad, the loss is spread among many investors, none of whom takes a major hit. But with the collapse of the $800 billion market in bonds backed by subprime mortgages — the price of a basket of these bonds has lost almost 40 percent of its value since January — it’s now clear that many investors who bought these securities didn’t realize what they were getting into.

And it’s also becoming clear that in addition to failing to appreciate the risks of subprime loans, many investors were fooled by fancy financial engineering — those collateralized debt obligations — into believing they had protected themselves against risk, when they had actually done no such thing.

Like Enron before it the bond rating agencies gave these bonds AAA ratings giving investors a false sense of security.

The details of C.D.O.’s are complicated, but basically they’re supposed to transfer most of the risk of bad loans to a small group of sophisticated investors, who are compensated for that risk with a high rate of return, while leaving other investors with a “synthetic” asset that is, well, safe as houses.

S.& P., Moody’s and Fitch, the bond-rating agencies, have gone along with the premise, telling investors that the synthetic assets created by C.D.O.’s are equivalent to high-quality corporate bonds. And investors have, in the words of a recent Bloomberg story, “snapped up” these securities “because they typically yield more than bonds with the same credit ratings.”

But the securities were never as safe as advertised, because the risk transfer wasn’t anywhere near big enough to protect investors from the consequences of a burst housing bubble. It’s not quite the metaphor I would have come up with, but here’s what the legendary bond investor Bill Gross had to say about C.D.O.’s in Pimco’s latest “Investment Outlook”:

“AAA? You were wooed Mr. Moody’s and Mr. Poor’s by the makeup, those six-inch hooker heels, and a ‘tramp stamp.’ Many of these good-looking girls are not high-class assets worth 100 cents on the dollar.”

But we shouldn't just blame the bond agencies, the Federal Reserve should have known what was going on. In fact they probably did but chose to do nothing because politically connected people were making lots of money and the sub prime market was the smoke and mirrors that made the Bush economy look like something it wasn't - a success.

FAIR USE NOTICE

This article contains copyrighted material, the use of which has not always been specifically authorized by the copyright owner. I am making such material available in my efforts to advance understanding of democracy, economic, environmental, human rights, political, scientific, and social justice issues, among others. I believe this constitutes a 'fair use' of any such copyrighted material as provided for in section 107 of the US Copyright Law. In accordance with Title 17 U.S.C. Section 107, the material in this article is distributed without profit for research and educational purposes.