Real Lessons from the Sub-Prime Collapse

Who's to blame for the "sub-prime collapse"? The two competing narratives place reckless mortgage-borrowings and investors on one side while greedy, unethical mortgage companies and falsely secure funds are at the other end. The first emphasizes personal responsibility and is a Republican favorite. The second emphasizes the failure of business to act in a prudent manner and plays to the Democratic base. Yet, the lesson from the recent economic instability and the stark increase in foreclosures is not really about either. Although these remain problems, they are symptomatic of a much more significant, underlying trend.

Over the past thirty year, the medium wages for households have been stagnant. And, for males, they have noticeably decreased. With deregulation of industry in this period, as well as the decline in unions and shifting "market value" of formerly valuable skills, has caused the average American to benefit less and less from the general productivity increases in society. Thus, corporate profits increase but wages remain the same. But how does this connect to what we've seen recently?

For one, many families were unable to secure homes, thanks to loss jobs, poor credit (due to health expenses), or low wages. The savings rate has collapsed and with the ability of many to put down payments on homes. In response to a reduced client base, mortgage lenders developed new tactics to increase their bottom line; they offered to mortgages to people who could not afford them, and then quickly sold them to others for re-packaging into (inexplicably) AAA-rated securities. The first action was a response to dwindling returns, while the second was a chance to avoid the risk. But this risk was not diminished, just passed elsewhere.

This brings us to the other part of this story, the other underlying condition: our economy is in lousy shape. While I doubt any macro-economists or financial analysis will agree with that statement -- what with ExxonMobil taking in record profits and growth still at historically high levels -- this truth is evident from many snapshots of the economy. A simple look at the Dow shows that economy only began to significantly recover from the post-9/11 fall in April of 2003. To what does this month correspond? Well, the Iraq Invasion, of course. And the rapid rise of the equity market was catalyzed by the rise of deference contractor stocks. The military-industrial complex, therefore, brought the economy back from failed recovery. Would the economy have been revived if not for the war? The answer is a simple no. The government did not put policies in place -- mainly those that support government spending or tax cuts that disproportionately benefit the bottom third of the society -- necessary to create a sustained recovery. The "war" was an opportunity to jump start things.

And there is nothing inherently wrong with that -- except, of course, that the war was waged on bad intelligence and falsehoods purposefully presented to the American public and aided by the media. But all those "minor" concerns aside, wars have been used in the past to aid the economy; this can be seen in World War II, the Korean War, Vietnam, and the Cold War in general. The problem in this case is that the Iraq occupation was nothing more than a false economic catalyst. This war, although involving the loss of nearly 4,000 lives, has not required any economic sacrifice from the public nor has it bolstered any industries except those closely related to the continuing conflict. But rising equity markets, aided by the war, gave a sense of perpetuating positiveness. Meanwhile, the house bubble, blown up on bad loans and new collectivized securities, catalyzed this seeming economic "growth". And, in addition to this bubble, an excess of buy-outs, buy-backs, mergers, and hostile takeovers -- all aided by cheap credit, in turn connected to the mortgages -- fueled continued expansion. Without all of these economic tricks (a false complete war, a mortgage bubble, and creative leveraging), as much as half of our recent economic growth would not have occurred. So, what are we left with?

The United States economy faltered in the 1970s, due to expensive oil, increased international competition, and eroding government spending (thanks to lowered taxes). The response to the downturn of the "me" decade has only been illusive measures to temporary bolster the economy while ignoring long-term submerged problems. The excessive interest rates of the late '70s and early '80s may have tamed inflation but did nothing to deal with the decline in the value of wages in substance terms; it was all about exchange rates and the financial system. The Reagan tax cuts were used to compensate for the interest rate rises. And, throughout this period, deregulation guaranteed rising profit margins through mergers. As a result, we had the gains in the 80s. The success of the following decade was mainly due to the emergence of the internet and the false expectations for an unlimited rise. That partially collapsed. And, in this decade, the occupation of Iraq and creative accounting and investment techniques not seen since the 1920s have been responsible for much of the gains. Might we finally see the reckoning for all the knee-jerk policies of the past thirty years?

One example of this is the failures in New Orleans and in Minnesota. The infrastructure of the U.S. is severely weakened by a government which prefers pet projects and politically beneficial legislation (tax cuts, welfare reform, the Medicare subscription benefit) to any substantial investment in the future of America. Today, everything is about painless solutions to false problems, while real ones are ignored until disaster strikes.

The recent downturn in the stock market and the excess of foreclosures is not about individual actors in the economy. It is about the economy itself, and the economy is sick. But much like the uninsured or under-insured in this country, they cannot get better without breaking the bank. Because, as all of this transpired, taxes have been decreased to the lowest level since the 1920s, government spending has went disproportionately to boondoggles home and abroad, and the national and trade debt has increased to significant and historic levels, respectively.

The problem is not that people were pushed into financially-unfeasible loans, it's that mortgage-buyers were unable to buy homes in the first place. This is a fundamental indictment of a society that holds paramount the dream of homeownership. The tactics employed by mortgage lenders show their desperation with an untenable economic spectrum. The financial markets, meanwhile, demonstrate how capitalism requires persistent growth; and when such growth cannot be found, it is created through unique investment strategies, unnecessary cost-cutting, and malfeasance. Our society has become cutthroat not because we are inherently so, but because things are collapsing around us and we are fighting over the remnants.

But how can this be fixed? The solutions will be painful. The government needs to make a substantial investment in the bottom half of American society, through universal health care, better education funding, increased government assistance to the unemployed, greater employment, lowered taxes, and increased funding of infrastructure. This can be accomplished through significant tax increases on any income over $150,000 per year, either from corporations or individuals, and the elimination of many tax deductions and shelters. Right now, too much wealth is concentrated in too few hands, and those hands -- while sometimes doing a noble job of spreading the wealth -- are consuming and investing in ways that do not significantly help the real economy. It's time for the government to take it back and ensure it is used to enrich America not certain Americans. The government also needs to increase regulation, in order to ensure that the rights of workers and the average American is taken to greater account than the whims of aloof corporate officials or greedy shareholders.

Over the past thirty years, the United States have sacrificed constant growth that benefits of the majority for rapid growth that favors the few. Such economic policy has not led to rebellions like the French Revolution nor widespread strikes (these kinds of activities are not traditionally American), but it has led to significant cracks in the economic and physical infrastructure. The government operates in deficits and cuts non-security-related, discretionary domestic spending, while consumers max out their credit cards, deplete their savings, and too many lose their homes. The US policy over this period, much like that during the 1920s, has been a recipe for disaster. That the creativity of the finance class, the Federal Reserve, and Congress has kept things going over this time is not a cause for cheer. The inevitable remains.

Where Did All The Money Go?

With the collapse of sub-prime real estate market as well as some prominent hedge funds, traders have increased volatility in the market and necessitating constant dismissal of (legitimate) economic fears. All of these dismissals -- from the White House, the Fed, Goldman Sachs analysts -- only enhance these underlying fears. As Floyd Norris of the NY Times wrote in recent column, declarations of stability only serve to highlight the instability hiding just below the surface.

On Thursday, the key US indexes were down nearly 3% with the Dow experiencing a near 400 point drop. Today, the (inexplicable) optimists were celebrating a mere 30 point drop after a day that saw the index down over 200 at one point. But the celebration is premature. The volatility (and drops) in the equity markets are just a symptom of a much larger problem. In opposition to what many investment analysts are saying, nearly all equities are bloated. When it comes down to it, everything is over-leveraged. And the money, well, it just is not there.

But then where did it go? As always, market processed begin with real money. A wannabe homeowner takes out a $500,000 mortgage with a $10,000 down payment. This money has transferred to the home seller, and the new owner is indebted to the bank for that amount. But, in recent years, the bank has relinquished the risk by immediately selling the debt to third party. In most cases this sold mortgage is bundled with thousands others to create a CDU fund. This fund is then sold to investors -- hedge funds, pensions, rich people -- who often earn a nice return. But the real scandal, which has been much discussed, is how bundles of high-risk mortgages -- those taken out by individuals of dubious creditworthiness -- were consolidated into AAA, or seemingly low risk, funds. Thus, a pension manager looking for a high return would be ecstatic to invest in a low risk fund that may yield 11% or more. With many of these sub-prime loans set to see massive interest-rate increases, the yield could potentially be higher. But, if that seems to good to be true, it's because it is.

Those loans should never have been lent in the first place. And, instead of a windfall of high interest payments, investors are left with defaults. The pension that I gave as an example could lost all its investment. So much for that AAA rating.

But it is not just mortgages that are bundled and mislabeled in such ways. This practice is endemic in the marketplace. And the unfortunate part is that as the bluff is finally called, the withdrawals will only cause more withdrawals. The end result may very well be a run on these funds. With this, liquidity will dry up, as we have been made obvious by the Fed infusions today. The effects, however, will not as many believe be contained in narrow equity markets. The lack of liquid capital will cause a decline in mortgages, but also in much of the financial services activity (mergers and acquisitions, leveraged buy-outs, stock buybacks, and leveraged investments) that have made so many companies so profitable. The result here could be a decline in profits among numerous companies, mass layoffs, and general malaise in capital markets.

But it only gets worse from there. The policy measures that the Fed has at its disposal can only escaberate one side of the problem. Of course, any rate increase now could cause instant recession and perhaps worse. But a rate decrease and continued liquidity could potentially cause the dollar to collapse. And, the chief trade partner of the US, China has consistently unvalued its currently. The effect here is two-sided. A crashed dollar may no longer be seen as an effective investment for the Chinese and may shift to

(to be continued)

Jim Cramer Melts Down. Is the Economy Next?

If his fears turn out to be justified, this video may end up a classic.