Page 1 of 2 Terror state - US style
By Julian Delasantellis
How sublimely exquisite is it that leather is the traditional gift of choice
for third anniversaries. As the capitalist world passes through the third
anniversary of the global crisis that started with collapses in the secondary
markets for subprime mortgages, it's almost as if, back then, the world's
investors suddenly morphed into randy, bored suburbanites, trussing themselves
into leather playgarments to try new diversions. If what's happened since
didn't light their spark, God help us all for what will come next.
It is now three years since I first wrote on this website about the world
financial crisis (see
Rocking the subprime house of cards, Asia Times Online, March 6, 2007).
Throughout the early days of
that month there had been a mild (at least compared with what has come after
it) world equity market selloff. The financial media didn't understand what was
going on, so, as if the whole thing was nothing but a plot by Hawaii Five O's
ever-nefarious communist operative Wo Fat (Khigh Dheigh), they blamed it on
China.
I demurred, suggested an entirely different culprit.
In the US, it's
called "subprime lending". ... Instead of denying these less than fully
creditworthy borrowers mortgages, let's give them loans, only at a much higher
interest rate. Instead of having them pay 1 or 2 percentage points over US
Treasuries, they'll pay 3 or 4. We can then bundle, or "securitize", these
mortgages into high-yield bonds. (Some bond investors became addicted to the
double-digit bond yields in the early 1980s, and over the past two decades have
again and again proved themselves more than willing to "reach for yield", to
take on significant extra risk to get another fix.) Sure, there might be more
defaults on these mortgages than you'd see from high-quality borrowers, but the
higher interest rates would more than make up for a few defaults and
repossessions here and there, and besides, as long as real-estate values
continued the meteoric rise of the early and middle part of this decade, the
subprime borrowers could soon use the new extra equity in their home's values
to refinance into more prudent borrowing arrangements.
Thus all the ingredients were in place for the real-estate frenzy that gripped
the US, and much of the rest of the capitalist world, over the past few years.
With the tremendous new demand from this cadre of buyers now able to get the
housing finance once denied them, and with new supply a lengthy process, there
was suddenly a significant imbalance between demand and supply in the US
housing market. Other mortgage finance innovations, such as low initial
"teaser" rates, interest-only mortgages, or the spread of floating rates,
allowed more and more people to move into properties they couldn't really
afford.
When prices took off, this attracted more buyers, more demand in the market,
and the price-appreciation cycle became self-reinforced. Soon, people were
paying close to US$1 million for one-bedroom condos in San Diego or Miami
Beach, and they were happy to do so; they thought they were getting a bargain.
By 2005 and 2006, between 25% and 33% of all newly written US mortgages were
subprime, but this was thought to be okay. The borrowers had their homes (or
they thought they did), the investors had their high-yield securitized mortgage
bonds, and incumbent politicians could point to the healthy home-ownership
numbers as proof that the mighty American dream still rang strong and true.
Just about the time that soaring real-estate prices were replacing celebrity
sex as the central obsession in the US psyche, something funny happened. Price
rises slowed or stopped; in some of the hottest markets, home prices actually
began to decline. Between June 2004 and June 2006, the US Federal Reserve
raised short-term loan rates 17 times. Starting at 1.25%, the Fed eventually
drove them up to today's 5.25%.
Floating-rate mortgages had their rates tied to these Fed rates. For those
mortgage borrowers who only got into their homes by being able to handle a
floating-rate payment that started with the low payment implied by a 1.25% Fed
rate, this meant a big mortgage-payment increase. These borrowers could barely
qualify for loans and then handle the payments calculated with the low rates;
when the mortgage payments were recalculated to reflect the higher rates (were
"reset" in mortgage jargon), they would be unable to pay the mortgage. The rise
in mortgage interest rates, along with the fact that in the areas where the
price appreciations had been the craziest, prospective buyers soon realized
that everybody in the household up to and including the family pet would have
to work two or three jobs to generate enough income to afford the payments
inherent in the $700,000 selling price of a two-bedroom rambler, finally broke
the back of US housing's wild ride.
The warning flags have been flying for months, but with every five-point rise
in the Dow index being wildly celebrated as another glorious new record,
another gushing multiple orgasm in the fabulous orgy of US market capitalism,
the US media ignored the story that it should have told in favor of the one it
wanted to tell.
On February 7, HSBC Holdings, formerly called Hong Kong Shanghai Bank Corp,
warned of massive forthcoming losses, arising mainly out of problems at its US
subsidiary, Household Bank, a leader in subprime lending. Another big subprime
lender, New Century Financial, did the same. Along with the waves of
real-estate foreclosure notices now piling up in the clerk of court offices in
the former hot markets, the markets slowly started to realize what was, for the
lenders anyway, a very inconvenient truth: a lot of these mortgages were never
going to be paid back. A lot of major financial institutions that had invested
in subprime mortgage debt, not just HSBC and New Century, were looking at very
serious balance-sheet problems.
A lot of wags have noticed that for the US stock market, bad news is frequently
treated as good news. Unemployment is up, or industrial production is down, and
stocks rally (due to attendant possibility seen in these reports of upcoming
Fed interest-rate cuts). However, when major financial institutions have what
are delicately called "liquidity issues" (ie, their loans aren't being paid
back - they have no income), that is always bad news. What if the bank
defaults, declares bankruptcy? Other banks that it had borrowed money from now
won't be getting paid back, they'll lose whatever income stream they were
receiving from the first bank. The same with that bank's creditors, and then
other banks and so on.
This kind of cascading financial catastrophe is often called a "contagion", and
with good reason. Like a virus, it can spread and bankrupt the entire financial
system. It almost did in 1998, during the Long-Term Capital Management
hedge-fund crisis; in 1929, in an era when the worldwide financial system was
far less globalized and integrated than it is today, after the Great Crash it
actually did, and so initiated the Great Depression of the 1930s.
Is it over? Not necessarily. Two little-known indicators that more investors
should be cognizant of are what are called the VIX and VXN indicators. (Put
these letters in the stock symbol line of your quote website; they should come
up - watch how their values move inversely to stock prices.) Technically, what
these two indices measure is what is called stock-option volatility (stock
"beta", in jargon), but what they really tell smart investors is just how much
fear there is in the markets. When these levels get very high (roughly above 30
in both indices; after the selling caused by the Enron corporate-management
scandals of 2002, the VXN actually topped out over 70), it indicates that the
market has seen so much fear-driven panic selling that, by the rules of what is
called contrarian investment philosophy, stocks are due for a turnaround. As of
the first weekend in March, neither index had reached those extreme levels.
So it's not China. It's not Nancy Pelosi, it's not the Easter Bunny, nor is it
the War on Easter. It has been said that all market psychology, all market
movement, is a continuous oscillation between the mental polar opposites of
optimism and pessimism, between greed and fear, between Pollyanna and
Cassandra. Since at least the market rally that started in early 2003,
optimistic Pollyanna has ruled the markets, and greed has run rampant. As the
markets wait for Fed chairman Ben Bernanke to put on his best Donna Reed mask
to bail out the subprime lenders with the Bailey family's honeymoon money,
Cassandra and her fear are ruling the day. "
The stock market
recovered a bit and was rallying through the highs in October 2007, but, like
an opportunistic infection, the disease was showing up in very unexpected
places. In early summer, two of Bear Stearns' most highly leveraged and
aggressive subprime hedge funds bit the dust, as would Bear Stearns itself in
March 2008. August saw the short-term credit markets freeze, Jim Cramer melt
down, and the US Federal Reserve commencing its series of short-term interest
rate cuts, eventually ending with short-term rates down around zero, that
certainly put the lie to the old shibboleth that America was a land that valued
thrift and deferred gratification.
In December 2007 came the commencement of the recession, and, although during
the next year politicians would charge any opponent who actually noted the
gathering gloom with disloyalty or worse, 8.4 million Americans would lose
their jobs in the next few months, many of these occurring even after the
nominal recession ended in the middle of 2009, and growth supposedly resumed.
On the first anniversary of that March 6, 2007, I posited a possible solution
to the whole thing, at a price that would have been but a miniscule fraction of
what such an endeavor would cost today (see
And the band played on, Asia Times Online, March 6, 2008).
If
foreign governments aren't going to save American finance, and the private
sector can't, who's left? Maybe - get this - the American government? Various
proposals are floating around the public policy wonk world that call for a far
greater role by the US government in saving the subprime/structured finance
world.
Most of these call for some branch of the government to, in effect, take the
subprimes out of the hands of the private sector, by buying these mortgage
securities from the banks. Since it would take these rapidly declining in value
securities off their hands, in exchange for cold, hard, rock-solid (as long as
you're not comparing its value to that of the surging euro) American cash, the
banks would love this.
Amazingly enough, that was precisely the
strategy attempted, with Treasury Secretary Henry Paulson's Troubled Asset
Relief Program (TARP) after the short-term credit markets froze even more
solidly in September 2008. That, even in the face of a once-in-a-century
crisis, nothing of much value came out of these efforts, and the real lesson of
the past three years begins to dawn.
And just why is that? Why, in the face of a withering contemporary crisis (as
opposed to something like global warning, scheduled to do its worst decades
from now), does the US government stand impotent?
The TARP was always wildly unpopular; it was organizing this past year's tea
parties even before they were created. (See
The cost of 'no government', Asia Times Online, October 1, 2008).
Basically, the nation, on both sides of the political system, rose up against
it. That's what stood in the way of the successful, adoption and implementation
of the TARP, with only the near-unanimous advocacy of the academic and
government economics and finance community carrying its flag.
Well, as long as the contest was fair.
Not one dollar of what came to be called the banks' " toxic mortgage
securities" was ever bought away from the portfolios of the financial
institutions, and even though I watched the process intently, and wrote about
it just about every week, I can barely say why. If pressed, I'd have to say
that the simplest explanation was pique.
On its second run, following a 770-point Dow Jones Industrial Average selloff
that occurred upon minutes of the TARP's first failure in the US House of
Representatives, the program was passed. Plans were drawn up to commence the
prosecution of the purchases with alacrity; then Paulson stabbed in the back
all the legislators who went out on a limb for him with their votes (and many
limbs of those limbs were sawn off in the election five weeks hence); he
giggled, he said he was kidding.
In the place of the TARP asset purchases would come direct injections of
government capital onto bank balance sheets. One can debate which was, or would
have been, the more effective strategy; what was clear was that, by the middle
of the next year, with the banks effectively operating as appendages of the
government and so thus saved, the only purpose the capital injections served
was to serve as the lightning rods over the fat bonuses paid by the bailed out
banks to their churlish executives.
So, still, the mortgages wither and die in the banks' vaults, and, in doing so,
constrain new bank lending due to the hit the bad loans cause to the banks'
capital bases. In an era where the federal government is running huge budget
deficits, desperately trying but still falling behind the effort to replace in
the economy what the banking system is taking out, one might think that this
situation would engender some sympathy for the accursed prophet that was the
TARP.
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