Notes on the Way to Armageddon

Best headline of the day: “Congress lives up to its 10% approval rating.”

I suppose you can’t expect a bunch of venal vote whores –Republican and Democrat-- to act on their consciences so close to Election Day.

On the other hand the people oppose the bailout. I have great faith in the vox populi, but they are being educated on the subject of the credit crisis by the vox vapuli, the mainstream press and the politicians.

The press certainly is not qualified to either explain the crisis or to advise the public on the best solution. The press is made up today of J-majors: persons who majored in journalism.

Rather than immersing in subjects that might allow insight into current affairs; such as political science, economics, business, science or history; J-majors learn the newspaper and broadcast news business. This is why the press gullibly repeats the talking points of the political parties, makes horrible errors of fact, succumbs to bias and speaks and writes such terrible English.

So the people are without a clue as to the best course to follow and simply repeat what they have heard about not bailing out Wall Street “Fat cats” with taxpayer money and eliminating “golden parachute” severance pay for failed executives. This winds up in constituent letters, emails and phone calls sent to our representatives and is why Congressmen fear voting for the credit relief act.

A cheerier scenario might be the failure of Congress to act and the adjustment of the economy by market forces. Let me take another sip of Kool Aid and explain.

If the credit markets freeze up, it will not be permanent. Smaller and more solvent banks will get lending back on its feet after a few months on a limited basis and on a regional scope.

There was a time when smaller hometown banks administered most credit cards and mortgages were written almost exclusively by local financial institutions. The smaller banks are in a great position to fill that niche, as are corporations and individuals with capital to lend who are willing to take only reasonable credit risks when writing mortgages and business loans.Meanwhile one of the main contributors to our misery, the OPEC nations, can be expected to bring down the price of oil substantially as dollars dry up and oil purchasers are affected by the credit crunch. $30 a barrel oil will put the roses back in the cheeks of the economy.

Eventually new investment banks will rise to take the place of Bear Sterns, Lehman Brothers, et al. If they loan money wisely and resist excessive greed, they will finance the recovery of the economy.

While we wait for this miracle to happen we will have to tighten our belts. At the last debate, when asked what he might cut in such an economic crisis, Senator Obama listed several programs he would ADD, including aid to education, national health care and a drive to alternative energy solutions, which would cost us an additional trillion dollars. He was unable to tell Jim Lehrer the name of a single area in which he might make cuts.

I give Obama credit for his sincerity, because these are the programs represent why he is running for President in the first place. But if he does implement these programs, we will have to bankrupt the general population with massive new taxes. Barack Obama just does not understand the mess we are in.

One Week That Shook The World

This was a week to remember. Students a hundred years from now will be writing doctoral theses on what happened in the last seven days (and in the week to come), and scholars will still be arguing over what precisely happened. This is History with a capital “H,” a turning point in the affairs of the nation and of mankind so fundamental that not a single man, woman or child on this planet will be able to avoid its effects.

For the great industrial nations, especially the United States, the course of history has been drastically altered. Even our dreams will have to adapt to the new financial and economic realities.

By Thursday of this week it had become apparent that the U.S. Treasury bailout of American International Group had bandaged one major wound to the system of credit in this country, but a $89.2 billion run on mutual funds (long considered one of the safest investments this side of a savings account) was threatening to dry up most of the available investment capital available in the United States and the Free World.

Making matters worse, the fall of Lehman Brothers, Bear Stearns, Merrill Lynch, Freddie Mac, Fanny Mae and the inability of Washington Mutual to find any bidders for their assets had dealt confidence in the banks a seeming deathblow. People were wondering aloud by Thursday afternoon if Morgan Stanley and Goldman Sachs were next to go. The financial underpinnings of the real estate industry were crumbling.

Within days, perhaps even hours, the deluge would come. The last great investment banks would close, the stock market would crash, mutual funds (and thus the world’s investment capital) would be drained dry by panicked investors and the developed world, including all of the Americas, Europe, Russia, India and the Pacific Rim nations would be thrust into a protracted and catastrophic economic depression that made no distinction between capitalist or socialist systems. All would suffer deeply.

The United States Government, the only entity on the planet big enough and powerful enough to have a chance at avoiding this global catastrophe, has decided to effect a revolution in the relationship between Government and the private sector every bit as profound as the New Deal. The United States is becoming the real estate owner of last resort. Only instead of phasing these massive changes in over six or seven years, we intend to write the program this weekend and enact it as law next week.

The United States is undertaking to acquire the “toxic assets” of the banking system –the home loans, especially, that are in danger of foreclosure, the exotic derivatives based on real estate and so forth…to the tune of as much as one trillion dollars ($1,000bn). This will free up the resources of the banks needed to fund economic expansion.

The alternative, which was to let the banks fold, would have meant a freeze or a collapse of credit in this country, bringing the economy to a screeching halt and negatively impacting every American family.

Since the great banks of the world are so intimately interconnected, it is also likely that the misery would not have been limited to the United States –a notion appreciated by investors world wide in the past week.

Government is also coming to the rescue of the mutual funds industry. President Bush announced that the United States will extend dollar-for-dollar insurance to mutual fund investors.

So far so good. The details are being hashed out even as I write these words by Federal Reserve Bank officials, Treasury Department representatives and congressional leaders. The final product, if it is not a horn of plenty including every goodie that well connected congressmen and senators could wish for, it will be passed by Congress and signed into law in the next few days.

If it works, like the government’s Resolution Trust Corporation, it will be one of the great achievements in this history of the Republic. But it will come at a price.

Where do we get the $1,000,000,000,000? We can’t borrow that much from the Chinese. We can’t print it because the dollar has already lost too much of its value. It will have to come from taxes. And if it does, we will not have a lot of money left over for national health care, global warming, alternative energy, an expanded military, college for all, and the other items on the Democratic and Republican wish lists.

This may also mean the end of Reaganomics, which had a lovely run from 1983 to date under four presidents. One of the central props of the system, de-regulation, is doomed. Not that regulation would have prevented the bad banking and management practices that got us into this mess, but the people and the politicians will definitely re-burden the private sector with tons of paperwork after this.

The other prop of Reaganomics, affordable taxes, may also go by the boards. My math may be faulty but if we need one trillion dollars that means every man woman and child in the United States will have to kick in an additional $3,322 in taxes to obtain the money.

We may not be ready to exhale just yet, but we have more hope this evening than we have seen in months.

Doomed!

We avoided The Perfect S**tstorm just in the nick of time this week, thanks to the government bailout of American International Group (AIG). That is not to say that the worst of the liquidity/credit crisis is over, just that we’ve avoided a sudden and terrible climax to it. We may yet see the credit system in the United States come crashing down, taking with it financial institutions from across the globe and initiating a universal economic depression.

To figure out what happened let’s climb into the Wayback Machine and set the dial for 2005. We arrive in, for the sake of argument, Scottsdale Arizona, a prosperous suburb of Phoenix and one of the most desirable mixed residential and commercial communities in the United States.

A glance at the Arizona Republic or Craig’s List tells us that housing costs, which have always been moderate for this area (since incomes are moderate, at best) are starting to soar. Property owners are being told by real estate agents and mortgage lenders that their homes could list for double and triple what they would have brought a mere five years ago. Homes bought at $300,000 are now worth $700,000. Why not sell now, make a killer profit, and buy some more houses, flip them and make even more profit?

The real estate in the desert at the edges of town is becoming hot property in ways other than temperature as well. Take a parcel of land, develop it for condominiums and sell 2,500 square foot units for $600,000 and $800,000! Construction costs are holding steady, so this looks like a wonderful way to get rich quick.

Now whether you want to buy houses to flip them, or to live in, or if you want to build luxury condos in the middle of the jumping cactus fields as an investment, you will need capital, i.e. money. This means establishing credit and obtaining a loan…a mortgage.

Nothing surprising there, but home values have outpaced earnings drastically. Where real estate values have jumped by 100 and 200 percent, wages and earnings have increased, oh, maybe 10 percent in the same period of time. These wage earners still need places to live and many want to make money in the real estate boom.

The banking industry makes a substantial portion of its earnings by writing loans for residential and commercial properties. With a real estate boom on there is a lot of business to be had. Soon the airwaves are buzzing with countless ads from banks, credit unions and acceptance corporations telling you that if you want credit, you can not only get it, but that banks will fight for the chance to lend you the money!

To attract business the stringent risk assessment process by which your ability to pay was measured is being relaxed. For some categories of borrowers special interest rates below prime are being made available. Banks are writing loans that are not secured by anticipated future earnings of the borrowers, and which rely on the current rising values of real estate during the boom.

It seems risky, but isn’t it a truism that real estate prices only go up? Even if a borrower defaults the foreclosure value of the property, given the current rate of growth of property values insures the lenders are not going to lose money. What is more likely is that everyone gets rich.

Back on Wall Street great corporations are buying investment portfolios based on this massive wave of mortgage lending. In fact, they are going “all in,” putting all their chips on exotic investment instruments --derivatives-- based, ultimately, on poorly secured residential mortgages. A measure of solace for the stockholders of these corporations is provided by AIG, which is doing a land office business writing insurance for these investments.

Back in our own time, it is obvious something has gone unexpectedly and dreadfully wrong.

The people who have been renovating houses to flip them are now unable to find buyers for their properties. The condos out on the desert the edge of Scottsdale are standing vacant. All signs of a real estate boom are missing.

Except it wasn’t a real estate boom; it was a bubble, and it has burst.

Without a buyer for the house he renovated the would-be Bob Vila cannot make the payments on the mortgage he got when banks fought for his business. During his struggles he probably got equity lines of credit on the house he wants to flip and his own residence which he has maxxed out. His credit card revolving debt is probably in the low five figures. There’s no way he can make the payments. He goes to foreclosure and the value of the properties do not make good the loss to the bank. The investors who built the condominiums are losing money on property taxes and defaulting on their mortgages.

AIG offered insurance on derivatives built on other derivatives built on mortgages. When real estate prices declined by 10 to 20 percent, these derivates in some cases declined in value by 100 percent! The people holding these exotic investment instruments based on mortgage lending are now flooding AIG with claims. AIG essentially insures the entire credit industry of the United States. The claims have exhausted AIG's liquidity...there's no more money to pay claims.

If they cannot meet their obligations then a credit blackout effecting every kind of borrowing from bank credit cards at the supermarket through mortgages will paralyze the economy. With no one to insure credit, no one will risk extending credit.

Now other factors enter into play, making this The Perfect Economic S**tstorm. The big one is energy costs. With the cost of light, heat and transportation increasing exponentially for American business, belt-tightening is in order –especially if the business in question has had failed investments in real estate! Belt-tightening means firings, layoffs and work reductions. Aside from more foreclosures, this means less consumer spending which means, in turn, layoffs and business failures in a wide range of industries supplying consumer goods, and fast-rising unemployment.

The federal bailout of AIG has postponed, maybe prevented, a credit collapse. Is that the happy end of the story? I doubt it.