Over the past few days economists have agreed there is a better than 50% chance our economy will face a recession or at least a significant slowdown. A recession is defined as a two consecutive quarters where the GDP declines or retraces. Just as with the theory of relativity, economic cycles often are filled with equal and opposite reactions.
Amid all of the whys lies the credit crunch, which is rooted in the sub-prime lending mess. Contrary to popular thought it wasn’t poor Americans and their lack of repayment on substandard mortgages that caused this debacle. They did play an early role but rather the original blame can be placed at the feet of Congress. Yes it seems that Americans and our industries are forced to adhere and suffer for the decisions made by folks who have often never ventured any bfurther in their career outside of being a career politician and future lobbyist.
The sub-prime mortgage industry, which is nearly defunct if recent bankruptcies from the participants are any indication, was the child born out of The Community Reinvestment Act (CRA), a federal law that required banks and financial institutions to offer credit throughout their market regardless of wealth or income. The federal law was passed in 1977 and at the time interest rates were relatively high, thus the masses were seeking financing.
In 1995 under the Clinton Administration the law was reviewed and as a result sub-prime loans were allowed to be placed in bundles of bonds and sold on the market. Within a few years a new industry was born that being those that purchased mortgages, batched the maturities to match and sell them to the investment public. Both quasi government agencies known as Fannie Mae (Federal National Mortgage Association) and Ginnie Mae (Government National Mortgage Association) would become significant participants in this arena of finance. Many times, especially with Fannie Mae issues, the credit ratings on such bonds were considered stellar and both agencies were perceived to have the bail out and full faith and credit of the federal government, which was not true. On the other hand banks were freed from the risks associated with holding a large pool of mortgages.
This worked fine for nearly a decade and coupled with lower rates, a housing boom was born. Suddenly your author was receiving real estate tips from others who had never struck him before as having knowledge in such investment. In fact one acquaintance argued that real estate should be considered a liquid investment. Real estate, unlike the securities market, does not always have a ready buyer, which is a fact we in our nation are starting to realize.
There is a popular misconception that a sub prime borrower had poor credit, a history of delinquent payments or even a past bankruptcy. First and foremost a sub prime borrower’s general credit score was below 730. Credit reports and their usage is another subject that many of ignorance has attempted to educate your author. The reader’s personal credit score can be manipulated. An easy example is having previously possessed a credit card where a delinquent payment at some time in the past and card has been paid in full and cancelled. The reader can simply contact the bureau and file a review stating the card has been cancelled. This will often times mitigate the previous delinquency.
Since banks and banking in general is a commodity industry, whereby there are few distinguishing characteristics between competitors, items such as home equity loans or home equity lines of credit began to take place. These were often accompanied with fees and ‘points’. At one time they would have been called second mortgages and were often frowned upon.
Additionally hedge funds began to invest in the sub prime industry. Now remember hedge funds are probably the second largest contributor to the volume of most stock markets. Mutual funds are often considered the first. Suddenly individuals such as former senator, retired ambulance chaser and failed 2004 John Kerry running mate John Edwards (D-NC) and his investment in the hedge fund Fortress Investment Group were sub prime lenders.
So now you have banks and hedge funds encouraged to lend, which under normal circumstances sounds fine. You have a Federal Reserve that has encouraged more liquidity, regardless of the long term impact, with plenty of greenbacks at very low borrowing rates. There are plenty of players with plenty of supply. Then you have the customers who ventured into real estate speculation often by drawing on a home equity loans to facilitate a down payment for another purchase in what is known as ‘flipping’, never actually residing in the home and merely passing it along to the next available buyer.
Furthermore you have home developers suddenly engaging in the mortgage business as they build houses like there is no tomorrow. The problem being there is a tomorrow. When the last person or family has purchased their residence it will be over and predictably it came to an end. Just like with any hyper market, whether it is the dot com bubble of the 1990s or the 17th century Dutch tulip craze, inflated and irrational markets always collapse and collapse badly.
For whatever reason our society and probably those of other countries always look to blame someone or something when the good times end and the hangover begins. When borrowing rates increased, partly to offset the action from the previous Federal Reserve, the foreclosures and late payments began. Whether it was a case of bank customers living beyond their means or banks not properly analyzing scenarios based on cash flows against rate changes, we will never know but your author believes the truth lies somewhere in between. In this case many were quick to blame the original sub prime borrowers, those perceived or otherwise as being the less well to do in America. However statistics have shown that the credit risky customers only accounted for about 20% of the current foreclosure rate. This leaves only the speculator, seasoned or rookie as failing to meet their obligations. They were caught holding the bag and without a buyer.
Suddenly Federal Reserve head Ben Bernanke had a mess on his hands as economic data began to pour out from the various banks telling the tale of doom and gloom. Why should anyone be shocked? Bernanke and his board then recommended rate cuts or rates to remain the same, which will only exasperate the dilemma . During this past Fall the Fed began to shoot funds into the stock market in a desperate attempt to prevent a sudden sell off.. Why would they do such a thing if the debacle was in the mortgage industry? While we may never know the exact reason your author believes it was because of hedge funds. As the hedge funds began to feel the heat from the foreclosure meltdown, as stated many had ventured into the sub prime business, their investors would want to pull out their investment. If this is the case and since many such funds do hold large blocks of publicly traded shares, a sell off in the stock market would have occurred. Now the reader must ponder why is this an issue? It would not be one if it wasn’t for the fact that millions of 401-K and IRAs are directly tied to the equity markets. So did the Federal Reserve "bail out" hedge funds or did it attempt to save the average American concerned with their retirement? Furthermore it should be noted that hedge funds have changed so much from their original inception, from days when ultra-wealthy, often those in another country were the investors to now where you have major American based investment houses often engaged in finding clients for these funds. Hedge funds themselves are nothing mysterious, they are not regulated and are located offshore. Due to their ability to short and buy long on securities they offer their investors a multitude of investment scenarios and allows them to "hedge" against risk. However as stated the hedge funds have become mainstream, which was never their intention and often no longer practicing the hedging aspect. This is yet another piece of this economic puzzle and that being there are more streams of cash than ever before, suddenly (in this case) mortgages were being funded by private investors.
In two weeks the Federal Reserve Board will meet and it is believed that Bernanke and company will again suggest a further rate cut. This will only pave a smooth track for the already current sliding slope of the US dollar. A rate decrease could be perfectly manageable if our country did not have a growing federal deficit and balance trade debt, which isn’t nearly as dismal when oil imports are taken out of the equation. We have already seen the Euro and Canadian dollar climb against our own currency. It is expected that both the Australian and New Zealand dollars will appreciate against the dollar. The US greenback is referred to as the "world’s reserve currency" but it has become terribly flawed and may be a known as such in name only.
What does this mean to the reader? It should mean plenty. A depreciating currency will make imports cheaper. This was fine when imports often were used in the same sentence with luxury goods. But are televisions sets and CD players made in China considered a luxury or luxury item? No not by many consumers. Also your author does not propose the political rhetoric that we should bring the manufacturing back to our country. We had our time and our economy has changed for the better and allowed us to remain competitive. Besides you can thank the unions and federal regulations for encouraging manufacturers to find cheaper labor.
What can be done? This is where your author would like to provide a silver lining around a grey cloud but for now none can be found. It won’t materialize until members of Congress stop proposing bail outs and other lofty ideas, which will only legitimize and band aid some of these ridiculous transgressions. In fact nothing will happen that will hint of good economic sense until those participants along with the Fed pop an aspirin and sober up.
