What's happening to the economy?
As you may have read, Bear Stearns -- a large, ruthless investment bank that has been around since 1923 and survived the Great Depression without firing a single employment -- essentially failed last week. Due to their investment in mortgage securities and the fear that they could not meet their obligations, they suffered a bank run on their investments. People took their money out of the company, which caused them to, in fact, be unable to meet their debt obligations. Assessing Bear Stearns as "too big to fail", the federal government with assistance from JP Morgan bailed them out, that is, they lent them to the money to help them survive. But, upon announcement of this deal, Bear Stearns common stock (code: BSC) plunged nearly 50%. That was the end. JP Morgan, two days later, announced a plan to buy Bear Stearns for $2 a share; it had been $60 just a few days earlier and $140 a year ago. The Chairman of the company, James Cayne, lost $100 million overnight (bye, bye Forbes 400). And with that, we had panic.
How could this have happened? Bear, as people on the Street refer to the firm, had been around for over eight years, had over 14,000 employees, and some of the most aggressive (read: high yielding) hedge fund portfolios. What injected fear into the hearts of economists and registered as a foreboding curiosity to those not of the investor class was in fact the first culmination of a new era. It is one of declining house prices, bank runs (Northern Rock, Citigroup), and the realization that our "growth" over the past thirty years have been far more superficial than we realize.
Bear Stearns was not the first company to fail. New Century Financial, a sub-prime mortgage provider, went into bankruptcy in what turned out to be the opening salvo of this new econ-epoch. Countrywide Financial, a similar company also based in suburban Southern California (the Valley as opposed to New Century's O.C. base), neared bankruptcy in August of last year, until Bank of America came to its rescue and, like in the Bear and JP story, bought the failing mortgage-monger. Around the same time, all the big investment banks announced major write-downs (meaning assets they owned sunk in value). No one was immune and the market was scared. But the Dow Jones Industrial Average still managed to bounce back to an all-time high by October. Some even though the worst was over.
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Back in 2005, new Dow highs were finally being reached, five years after the dot-com bubble popped. The gains from Iraq War spending and (supposedly) the earlier tax cut were causing the economy to rapidly expand. But some economists looked at house prices and didn't like what they saw. Yale economist Robert Schiller's housing index showed a blatant peak in house prices, a trend that was most severe in Florida, California, and a few cities in the Northeast. Ed Gramlich, who worked for the Federal Reserve, cautioned about this "housing bubble". NY Times columnist and Princeton economics professor Paul Krugman cautioned that the bubble, not mere "froth" as Alan Greenspan had noted, would pop and the population could suffer a "hard landing", that is, large drops in house prices and its result on the economy.
But why would the landing be "hard"? It was not merely that an important asset's value was going to decline, it was that this asset was financing a good portion of the population's well being. It seemed that everyone was taking advantage of increasing house values by tapping it to take out home equity loans. What good was a house if it couldn't be used to buy cars, vacations, and, hell, medicine for little Johnny, Jr., after Johnny, Sr., lost his job? And if people weren't taking out loans on their free-lunch "equity" surge, then they were waiting for the house to max out in price so that they could "flip" it and make a "tidy" or just absurd profit. (In fact, today nearly 1/4 of houses that cannot sell are such speculation investments.) But with so many families relying on tapped equity and so many people "in real estate" (as the speculators say), most still thought that house price declines -- and they would be small in any case, right? -- would cause only a soft landing...on, say, feathers. A soft landing, they say. Yet, what if the feathers were artificially puffed, giving only the illusive of a suitable landing spot? What if spikes lied beneath them? There might be blood.
And blood there would be. No safety net of regulation was there to prevent us from the fall. Excessive spending sped our fall, while the Iraq War and tax cuts swallowed up all of our parachutes. The lack of real upward change in medium wages ensured that the majority wouldn't have enough feathers to protect them from the drop. Plus, they were made in China, so they were worthless anyway. (The mixed metaphor meter just exploded.)
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House prices declined and Bear Stearns failed. A Bushie waved his sword and Katrina drowned. The connections are clearer now. House prices just couldn't go up anymore. Eventually, everyone who wanted a house -- even those who could not afford one -- had one. The marketed dried up, and when supply, pumped by illusory expectations, exists when demand doesn't, prices fall. It started in Florida. It spread. It ended up in Cleveland and Detroit, cities where house prices never even increased in the first place. But what was the factor of house price inflation, especially in those (literal) hot spots. Was it small enough to ensure a "soft landing"? In Florida and California and Las Vegas, the declines have already exceeded 10 percent, much to high to walk away with a mere broken leg. House prices in the first half of this decade nearly doubled. The Case-Schiller index predicts a 20-30% decrease to get prices back on the long term trend; that's a 30-story fall. Maybe Keynes got it wrong; in the short term, we all are dead, especially if we own a negative equity mortgage or are fighting in Iraq.
While house prices fall, so do soldiers. (Am I making a stretch? Nope, my flexibility just ain't that good.) In 2002, the US economy was in shambles. Even with the burst of spending due to our Afghanistan takeover, business languished; things were still a mess from the dot-com collapse and Enron provided the beginning of the land-mines-in-the-wreckage era. What saved America? Well, George Bush and Alan Greenspan, of course. The unelected president, now popular, launched an invasion and Maestro kept interest rates so low that everyone bought a house. Mr. Federal Reserve even waxed weepy about the power of adjustable rate mortgages (ARMs) and sub-prime mortgages (sub-primes) to give Americans their titular dream.
"The American dream, we're going to steal it." (Wayne Malloy, "The Riches") But no one needs to steal it when it's given to them for free. Bush gave us the Iraq Invasion Party, intended to return our lives to the carefree past, free of mushroom clouds, free-of-charge: without sacrifice or debate. Oh, but this was only a teaser rate; we forgot to read the fine print. The rates increased to 800 lives and $200 billion per year. Think you can afford that? And while we're at it, your mortgage rate has now doubled and -- thanks in part to our business practices, endorsed by Greenspan himself -- your house has just lost one-fifth of its value. We'll give it to you free but then we'll take it away, the American dream as shareware.
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Wal-Mart is the American dream: everything one wants at low prices. Everyone wants a bargain, but maybe they need one too. Real medium wages (that is, adjusted for inflation) have flatlined over the past 35 years. Sure, many of us have plasma TVs, enhanced automobiles, and Super Wal-Mart to fill in the gaps. The middle class has Louis Vutton, Coach, and Tiffany to the point that luxury has lost its luster. And the upper class has seen their tax rates cut in half, their incomes triple, and their portfolio of property grow to include islands in Dubai or a Gulfstream V jet. Everyone's consumin' but do they have the coin to do so? Read just a few sentences up: real medium wages have flatlined. Cognitive dissonance, anyone?
But it's not. The dual trends of globalization and the internet have given us goods faster and cheaper. Chinese production has lowered prices and decreased quality only marginally, save a little lead, poison, and a few other inconsequential "inconveniences". Deregulation has increased competition and lowered quality and prices. Oil prices remained low from 1984 through 2003, ensuring industry and consumers were suitable greased. Yet while wages are still at 1973 level, the economy is finally starting to get the time-warped message: we're still in "me" decade. Even after 35 years of deregulation, extreme increases in upper quintile incomes, massive increase in quality-of-living and consumerism, fluctuations in oil prices, the internet, and two wars in the middle the east, the U.S. has gone full circle. Record oil prices, whispers about stagflation, large capital infusions from Asia, and rapid consolidation due to financial woes in major industries -- we've seen this movie before and the people in it were wearing bell-bottoms and had feathered hair.
The U.S. economy, even through rapid changes over three decades, merely avoided the inevitable conclusion: increased government dominance of the economy (its spending, its research/developments, its soul) made the post-war boom possible, but the 1970s provided the first real challenge. Instead of evolve to face it, we retrogressed slowly back to the 1920s ideology coupled (absurdly) with 2000s technology and large government spending. The result is one big circle (or spiral). Only, the problems of the 1970s (commodity inflation, consumer good deflation, depressed wages, structural problems) have been made several times worse by the ironic mix of increased government and decreased economic regulation.
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The recent "calamities" on Wall Street are merely symptoms of this acid flashback. In fact, their causes are also symptoms. All the new fangled mortgages of this decade were needed to increase home ownership, because people just didn't have the money to make this orthodoxical pillar of the American dream possible. People tapped their houses for money, because they did not have enough money to live, either in the absolute sense or in the keeping-up-with-the-jones one. Credit card debt surged thanks to a commerical-backed consumer culture of must-have things, available cheap, easily assessable, and often made in China. If the ;20s brought us automobiles and houses, the '50s refrigerators, televisions, and the suburbs, the '90s/'00s brought us not only computers but Best Buy, Wal-Mart, and a bunch of embellishments. People are buying most things in Version 6.0. People aren't buying cars but transport devices with video screens, iPod connectors, and the perception of safety. We are re-inventing and re-branding too great a percentage of consumer goods. Consumerism guaranteed maxed out credit cards and tapped houses. Falling house prices guaranteed Americans would reap what they sow. Add the disastrous health care system, ARM and subprime mortgages, and inflation into the mix and the US economy becomes unhinged.
Meanwhile, the financial system, trying to keep pace with consumers in the valiant effort to fully realize one's raison d'etre, decided that old was not good enough for them either. They also decided that post-modern repackaging was the key. Mortgages didn't have to be debts on houses; they could be collateralized debt obligations (CDO) as part of structured investment vehicles (SIV), guaranteed (S&P stamp of approval) to see large gains. Still, afraid that your SIV may get a flat or roll-over? No worry, just buy a credit default swap (CDS) as insurance . The theory was that, up or down, there was no way to lose. Those mortgages packages as CDO in SIV funds were supposed to be a safe investment, like a government bond. But what if one of every 10 mortgages (or even one out of 3) is bad (i.e., a person defaults)? What seems safe is not so; the SIV becomes infected, and since everyone owns them (why not?), the virus spreads. "But I have CDS," a man might say to his broker. "Shouldn't I be okay?" Not if the same people who insured your SIV also certified it was safe. If the insurer loses credibility, people pull out their money and decrease the insurer's cash reserves. Now, lots of people SIVs have crashed and when investors try to claim their insurance, the insurer cannot cover the losses and goes bankrupt. Oops.
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And that brings us back to Bear, not only as in Bear Stearns but also as in bear market. In the first case, the SIVs failed and brought down several of Bear Stearns funds. Some failed, other declined in value, and Bear extended cash to cover them. But they had made too many bets on these SIVs, and as house prices declines, the investment bank ran out of money. The SIV insurer couldn't provide cash, and so Bear Stearns was left with no cash and margin call debts due the next day. No more Bear Stearns.
The bear market, conversely, is very real indeed. Analysts on Wall Street like to dismiss the idea; they believe everything's always sunny in the new economy. But the "shadow economy" that I outlined above, in which creators thought they could eliminate risk and ensure the proverbial free lunch, was just as dark and opaque as its name suggest. And within the murkiness lay several million monsters: Jack and Jill homeowners leaving their house to foreclosure. In the end, Wall Street was defeated by the same average Americans that they see themselves miles above.
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The have-mores were not smiling as much any more. Their portfolios were somewhat diminished, the quality of life somewhat declined (only a month in the Hamptons this year instead of the typical two -- oh, no). But behind their shortened summering, it was not just John Q. Public that caused this marginal demise. Their patron saint president, slightly-less-than-dear leader George W. was to blame as well.
It was not just the Iraq occupation debacle, the unnecessary, profligate tax cuts, the complete dismissal of the regulatory regime, or the unyielding faith in "free" markets. It was the rhetorical climate that pronounced illusive economic gains as if they were substantial, that proclaimed the American economy was stronger than ever, that failed to ever recognize these weak underpinning of the new economy. The Iraq war drained (hell, drains) funds from the treasury. Tax cuts did the same, while arguably having no affect on job growth. The lack of regulation, spearheaded under Reagan and continued under Clinton with the (in retrospect) disastrous repeal of the New Deal era Glass-Steagal Act, was taken to an extreme over the last several years. The shadow economy may have begun under Clinton but grew to mirror the real economy in size by 2007. And free markets? Nothing was more free, less regulated, then SIVs and their ilk. Most of the mortgage companies that sold subprime and ARM mortgages were outside of government oversight, just as Saint Greenspan wanted it. With budget deficits increases and markets in chaos, collapse was inevitable.
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What have we wrought?
In a country where only the select gain to the determent of the many; where creativity means repackaging; where cheap and easy matter over everything else; where a free lunch is possible; where growth is ensured and insured and infinite; where people are told, begged, to consume but not compensated enough to do so; where billions are wasted on bloodshed; we have damned ourselves.
Fast, cheap, and out of control, the American economy hoped that it could get away without any pesky obstacles getting in the way. At the same time, in the fast lane, we called the contractor to build our dream house. Little did we know that it would be built in the middle of the road. CRASH!
