Over the weekend the finishing touches will be put into place for the auto industry to gain access to the government TARP funds. The failure of congress to come up with a plan forces the administration to take these steps. After all, if we can spend 80 billion on just one company AIG, why can't we spend 15 billion on the working stiff in Detroit? The argument that the auto workers are over paid pales in comparison to some of the Wall Street and Fannie Mae abuses.
Let’s review some of the major events in our control and out of our control that have led us here.
The first major event contributing to our problem is the passage of Gramm Leach Blilely Act in 1999. This repealed the 1933 Depression era Glass Steagull act which had erected a wall between the lending of money and the investing or leverage of money. This came on the heels of the elimination of interstate banking restrictions in 1997.
The first activities post passage was the consolidation of banking, brokerage and insurance. This was illustrated most prominently by the combination of Citibank, Travelers insurance, Smith Barney and Saloman Brothers.
The next significant event was historically low interest rates. At the end of the century, rates stood at 6.25% and began to come down as the Fed was dealing with the bursting of the internet bubble. At the time of the attack on New York, rates stood at 3%. Six days after the attack on the towers the Fed cut 50 basis points and continued to cut until November of 2002 with rates hitting post WW2 lows of .75%.
What followed was a natural reaction to cheap money. Huge amounts of debt were issued throughout the US economy. Home owners increased credit card debt and accessed equity in their home, nonprofits went on building sprees, big business and municipalities floated bond issues. The states and federal government did as well.
A combination of cheap money and new Wall Street capital being available to the housing market spurred a real estate and housing boom not seen since 1990. Traditional lending criteria were now replaced by such things as structured investment vehicles (SIVS) namely collateralized debt obligations (CDO’s). Because of very low interest rates, the fixed income investment community was yield starved. Wall Street recognized this and began bundling mortgages into securities and selling them in tranches as secured, higher yielding instruments that were backed by the American home owner. What better collateral could you get? The problem was that brokers were being paid to produce loans and Wall Street was being paid to create securities. However, because neither of them were holding the asset in their long term portfolio they weren’t concerned with credit quality. Hence the term “subprime” now enters the American Lexicon.
Tremendous amounts of capital in the market as well as lowered lending standards and a host of new products like interest only and LIBOR plus mortgages produced a typical reaction. To much money chasing to few houses resulted in an imbalance that was reflected in values. I can use our home town as an example. From 1990 to 2000 Burlington Home values rose from 1.24 billion to 1.58 billion or 27%. From 2000 to 2007 we went from 1.58 billion to 3.2 or over 100% in just 7 years.
The affect of cheap money and consumer driven buying can be seen in the equity markets as well. The Dow, after hitting a high of 11,000 in March 2000 struck a post 9/11 low of 7181 on October 10 of 2002. Almost 5 years to the day in on October 9, the Dow reached a high of 14,164 a little more than 1-year later we hit the current closing bottom of 7552 on November 20th.
The bloom began to come off the rose in late 2003 as the fed began to raise rates to bring a more realistic cost of money into the market place. By August 2005 they had completed 10 consecutive raises. But they weren't done. They completed 7 more raises and by June of 2006 The Fed Funds rate was now 5.25%. Just as they had overreacted and cut to much post 9/11, they now overreacted and raised to much and in fact inverted the yield curve.
An inverted yield curve means that long-term rates were lower than short terms rates. Long-term treasury yields showed that inflation was not a concern yet the Fed kept raising rates. An inverted yield curve has been a leading economic indicator in 5 of the last 6 recessions.
The rise in rates and in residential values coupled with energy costs resulted in a triple whammy for home owners. Affordable mortgages at a couple of percent now were less affordable as adjustable rates began to reset at much higher levels. Higher rates, rising property taxes and higher heating and utility costs and home owners began to feel the pinch. Those who began to have trouble found that their homes were now significantly under water. Again as an example I will use our own community. Three years ago we experienced a 25% tax increase on the residential sector not because of a rise in the budget but because of a significant shift in value.
Oil and gas prices significantly aggravated the general economy during this period and once again government was partially to blame. The war in Iraq affected prices but the real rise came from hurricane Katrina, unrest in Nigeria, Chinese and Indian demand and lastly the two most important elements were government buying and speculation in the markets. The Chinese, Americans, Germans and Japanese were all buying to fill their strategic reserves. Volume in contracts on the Nymex exchange increased by ten fold. This was primarily driven by the entry of hedge funds using commodities contracts for alternative investment classes. These contracts were previously used by people in the energy business to hedge prices for their inventories.
The first major crack in the financial system occurred last year when the auction rate market failed. This was followed by Bear Stearns and then the real thunderclap was when Lehman Brothers failed. The culprit was subprime mortgages and it wasn't long before Indy Mac, Fannie Mae and Freddie Mac and Washington Mutual have all followed suit.
The liquidity crisis became the new headline. Because values were falling so rapidly in these mortgages very few people had any confidence in them as collateral and were hesitant to lend against them. One example was a major brokerage house selling over 30 billion dollars of these securities. Pressed for cash to pay maturing bonds, they were only able to get a little over 6 billion for the bundle. The company sold off shortly there after.
That brings us to where we are today. The investment banking business in shambles if it even exists anymore. Once great franchises like Wachovia, Merrill Lynch, Citigroup, Morgan Stanley and Goldman Sacks have been sold or are continuing to sell assets.
The good news is we are first in and will probably be first out. The Europeans were slower to recognize the problem and have only recently begun to take action. The Fed is aggressively cutting rates again and pumping liquidity into the system. Unlike 1929 the government has acted quickly to prop up the banking system, and unlike 1990 most of the regional and community banks have avoided these problems.
We will recover from this just as we have recovered from other economic calamities in the past. It may take longer and it will probably get worse before it gets better. The stock market is a leading economic indicator and unemployment is a trailing one. We will be lucky if the nation stays under 9% and Massachusetts stays below 7.5%. One comforting aspect of this is that our adversaries are doing much worse.
The North Koreans may face threats of famine. Hugo Chavez will get quieter and quieter as oil continues to fall. Iran is facing a similar problem. With the fall in price of their principle export product and the corresponding impact on the domestic budgets, these guys will be more interested in staying in power than creating problems for the United States. In particular, Iran will have less money to fund a nuclear program or Hamas and Hezbollah.
One major international problem may result in China. The standard of living for the average Chinese has risen dramatically. The government compact with the Chinese people has been acceptance of rigid controls on personal freedom in exhange for economic gains. What will happen to the Chinese social fabric if extraordinary growth is replaced by rising levels of unemployment? The last time this happened resulted in the events of Tiannemen Square. Since that time many more Chinese have left the agrarian culture and emigrated to new cities. The New Year will certainly be a challenging one around the globe.
