From Financial Crisis to Recession, Part II
Part I of this series appeared here in the March issue of Z Magazine
In testimony before the U.S. Congress House Financial Services Committee at the close of February 2008, U.S. Federal Reserve Bank (Fed) Chair Ben Bernanke acknowledged for the first time what many in finance, banking, and government policy circles have quietly begun to admit: that the current financial crisis is now spreading rapidly beyond the subprime residential mortgage sector to other credit markets and that monetary policy action by the Fed (i.e., lowering interest rates) appears increasingly unable to do much about either the financial crisis or the emerging recession.
As Bernanke admitted to the Committee on February 27, 2008: "The (recent) economic situation has become distinctly less favorable," with the residential mortgage market decline accelerating, non-residential construction "is likely to decelerate sharply in coming quarters," consumer spending and the business sector will both slow significantly, and general credit conditions likely to "tighten substantially." Moreover, "the risks to this outlook remain to the downside." Bernanke admitted that the Fed, despite repeatedly lowering short term interest rates since September 2007, had failed to lower long term interest rates. In fact, long term rates—which have a far greater impact on consumer and business spending and thus on the likelihood of recession—have actually begun to rise "across the board."
What follows is a description of how the financial crisis has been spreading at a rapid rate in the U.S., from the subprime mortgage to other credit markets, and how that contagion is beginning to penetrate the real (non-financial) economy, causing the deep recession now emerging in the U.S.
The subprime mortgage crisis that erupted publicly in July-August 2007 did not cause the current financial crisis, but was just one of several (and now growing) symptoms of a deeper more fundamental financial instability. Speculation in subprime mortgages—fueled by the new securitization and derivatives revolutions in finance, virtual deregulation of finance capital since the late 1990s, new technological forces, and widespread corruption and fraud on numerous fronts—produced a housing asset price bubble of epic dimensions between 2003-2006. Mortgage borrowing rose more than $4 trillion between 2003-6 with $2 trillion of that issued in subprime mortgages. That’s approximately $1 trillion a year for 4 consecutive years. Today, the subprime mortgage market has virtually evaporated, with much of the non-subprime market in turn rapidly coming to a standstill.
With the evaporation of the subprime market came a collapse in prices and value for subprime mortgage securities (bonds). Because of the magnitude of the speculation ($2 trillion) in subprime mortgages, the magnitude of losses by banks and financial institutions was immense as well. According to rating agencies Moody’s and Standard & Poor’s, by early 2008 the losses totaled a minimum of $400 billion. Other foreign bank sources estimate the potential losses from subprimes in the U.S. at $600 billion. Banks and finance institutions have thus far written off only $120 billion. That leaves $280-$480 billion to go.
The massive nature of the losses quickly led to the collapse of other credit markets most closely related to the subprime market. Subprimes were often bundled with other securities before being sold as repackaged deals by banks and hedge funds to investors, with commercial paper called asset backed commercial paper (ABCP). As subprimes collapsed by $600 billion in 2007, the ABCP market plummeted by about $500 billion along with it within a matter of a few months. Contagion from the subprime market also infected the non-subprime mortgage market (called Alt-A mortgages). Similarly, the ABCP market infected the non-asset backed broad commercial paper market. In turn, the commercial property mortgage market plummeted by several hundred billion dollars by the end of 2007, with projections for its likely shut down to occur by mid-2008.
The cumulative credit contraction for just these 5 inter-related markets amounted to more than $1.6 trillion, occurring in less than 6 months, with associated bank losses and write downs estimated at around $600-$800 billion.
The construction (housing-commercial) and closely related commercial paper markets’ decline almost immediately began to spill over to the corporate bond markets, in particular the so-called high yield corporate or junk bond market which contracted by 90 percent by January 2008 compared to January 2007, dropping by more than $900 billion. Like the ABCP market, the junk bond market is where economically shaky corporations go to raise funds by issuing and selling their unsecure bonds. With ABCP and junk bond credit markets collapsing, corporations that previously relied on them are predicted to default in record numbers. Default rates are predicted to surge from one percent to more than ten percent, according to both Moody’s and Standard & Poor’s. That in turn means massive further losses for banks on top of subprime and commercial property mortgage losses already occurring. It also means that as those corporations default, many going bankrupt and out of business, the result will be widespread layoffs over the next 18 months.
Rising corporate defaults and anticipated subsequent bank losses translate into rising interest rate costs for otherwise stable companies. From the corporate junk bond market, the credit contraction has spread to more mainstream business credit markets, like the commercial and industrial bank loans and short term commercial paper markets. Together, these two represent credit markets that most medium and smaller sized corporations most heavily rely upon to finance business operations. The two markets had a combined total of $3.3 trillion in outstanding credit issued to business in August 2007. By early 2008 that amount had declined by more than $300 billion.
Another credit market taking a dive by early 2008 was the leveraged buyout (LBO) market. This was a hot speculative investment area in which companies arranged loans and other financing through investment banks in order to buy out other companies or go private in order to avoid government oversight of speculative and other even more shady business practices. By early 2008 more than $200 billion in loans for leveraged buyouts were left hanging without interested buyers. This meant banks and original investors would eventually have to absorb the losses themselves.
But the even bigger news of early 2008 was the growing likelihood of bond insurer companies, like MBIA, Ambac, and others (called monolines) facing downgrading and perhaps default themselves. These companies insured other companies’ bonds and loans, promising to pay investors for corporate and other bond defaults should they occur. But with combined reserves of only $20-$30 billion on hand, the half dozen bond insurers are themselves grossly underfunded. Their combined liabilities (i.e., insurance commitments) amount to more than $1.9 trillion. Moreover, they too speculated in subprimes as well as other derivative investments in the amount of $572 billion. It has become increasingly clear to investors and markets that the reserves monolines were woefully inadequate. Rating agencies had conveniently overlooked their condition during the speculative run-up. But Moody’s and S&P are now threatening to downgrade the bond insurers. Should that occur, countless corporations and banks that purchased their insurance could face severe downgrades as well, resulting in further losses and defaults.
The precarious position, and potentially huge losses of the monolines prompted global financier George Soros recently to comment, "There is a growing concern about the monolines…there is also a potential problem with money market funds which could be holding doubtful assets." Soros’s concern was echoed by JP Morgan CEO, Jamie Dimon, who added, "If one of these entities (bond insurers) doesn’t make it, the secondary effect could be terrible." That secondary effect would be the downgrading and consequent default of hundreds of billions in corporate bonds—on top of the already projected 10 times increase in corporate defaults in 2008.
Some analysts predict that the bankruptcy or even major downgrade of one or more bond insurers could easily spill over to the $3.3 trillion money market fund market or the $2.5 trillion municipal bond market, precipitating an institutional run on the banks that would be quite unlike individual depositors’ bank runs in the 1930s and before. Early indications of just such a possible scenario began to emerge in February 2008, as key sectors of the muni bond market began to dry up. With about half of municipal bonds insured by the bond insurers, the safety of muni bonds began to be questioned. Two key segments of the muni market contracted sharply—i.e., auction rate and variable rate municipal bonds, which finance around $330 billion and $500 billion, respectively. Strategically critical for state and local government funding, shrinking trades at muni markets threatened significant cost increases and funding problems for local governments. Many state and local government authorities now face excessive borrowing costs at a time of accelerating recession and lower tax revenues.
Another insurer avenue also began to come under pressure by early 2008. This was the derivatives-based credit default swaps market. Virtually nonexistent prior to 2002, outstanding credit default swaps now total more than $45 trillion, bigger than the total U.S. government bond and housing markets combined. Most securities in this market reside in a shadow banking system, itself largely a product of the post-2001 period, set up by banks to park risky assets "off balance sheet" and hidden from investors and government oversight agencies alike (an arrangement similar to that at the now defunct ENRON Corp., for which that company’s senior management were indicted and jailed). Like the monolines, credit default swap derivatives are designed to insure against defaults. But if corporate bond defaults approach normal levels of 1.25 percent, Bill Gross, managing director of the world’s largest bond fund, Pimco, publicly pointed out that $500 billion in credit derivative contracts would result in losses of at least $250 billion.
Perhaps an early red flag of the beginning of just such a fracturing of the $45 trillion credit derivatives market was the dramatic losses announced in January by the major French bank, Societe General, which raised the possibility that the problem was not limited to subprimes and asset backed paper, but was actually far more widespread, just as Pimco head Bill Gross had predicted.
Signs of major problems in the insurance industry also emerged in early 2008, as AIG Inc., the largest insurance company by assets, announced record losses of $11.5 billion due to credit default swaps trading. The picture by the end of February 2008 was one of a rapidly spreading credit contraction, in part the product of accelerating write downs and losses.
The losses and credit contraction do not include additional potential losses and contraction in consumer credit—in particular in areas of auto loans, credit card debt, and student loans. Evidence now appearing suggests significant losses are anticipated in these markets as well. Major credit card companies like American Express and others have announced record level loss provisioning and set asides in anticipation of consumer defaults. A growing list of public universities have announced shutting down student loan programs due to sharply rising borrowing costs. General Electric Corp. announced its intent to exit the consumer credit markets altogether. Thus, the mortgage, bank, and corporate debt problem appears by early 2008 to be infecting consumer markets. Like excessive corporate debt, total household debt from 2003-07 roughly doubled, rising by nearly $7 trillion.
How do these financial losses translate to a deepening recession in the general U.S. economy? The short answer is that financial losses have two immediate consequences. First, losses on financial institutions’ balance sheets mean losses must be restored by raising additional real capital. If not, the institutions themselves may default. They can borrow from other banks, from the Federal Reserve, or, as has recently been the case, from what are called sovereign wealth funds, which are foreign government owned investment funds. The first option is a problem when banks are suspicious of each other’s financial viability. Interbank borrowing thus dries up, as it almost did in late 2007. Borrowing from the Federal Reserve is the second option and has been occuring since late 2007 under especially favorable terms by the Fed. But Fed loans have thus far proved insufficient to cover the anticipated magnitude of future losses by the banks. Similarly, sovereign wealth funds located in Dubai, Singapore, and elsewhere have injected funding into the banks by purchasing partial ownership of Merrill Lynch, Citicorp, and others. But the amounts are measured in the low tens of billions, nowhere near the high hundreds of billions of losses to date and anticipated.
Given the still massive anticipated losses and likely insufficient available funding, banks turn to loan out the funds they do have. So they raise interest rates to record levels. These interest rates are not the short-term interest rates of 3 to 4 percent at which the Fed loans money to the banks. Banks’ rates offered to customers are long-term interest rates—essentially bonds and long-term loans—loaned out at 7 percent, 10 percent, or more. Rising long-term rates raise the cost of borrowing by non-bank corporate customers and to consumers buying durable products like cars, furniture, homes, etc.
In an accelerating recession, banks are reluctant to lend and corporations equally reluctant to borrow. Only the most exposed companies are willing to borrow at the high rates, which means in many cases they will eventually go under—thus Moody’s and S&P’s predictions of a 10 times increase in corporate default rates over the next 18 months. Lower investment and business spending translates eventually into layoffs, defaults in auto, credit card, and student loans, and thus further momentum in the direction of recession.
The above process then takes on psychological dimensions at some point, which worsens the economic decline. Fear and uncertainty over still unannounced, further bank losses leads to lack of confidence in the banking system and even further reluctance to loan or borrow. Another psychological scenario is when fear of losses in the subprime mortgage market lead to concerns of losses as well in non-subprime residential mortgage, commercial property markets, and closely associated markets like asset backed commercial paper. Borrowing rates rise and investors turn away from borrowing not only in subprime and related markets, but other mortgage markets. Prices of property then nose dive across the board. This kind of debt price deflation, when spreading from an isolated to associated credit markets, is historically closely associated with depressions rather than recessions.
Another example: concerns that the bond insurers (monolines) and credit default swaps will not be able to cover anticipated defaults leads investors to withdraw in growing numbers from even safe credit markets like muni bonds, about half of which outstanding are insured. In turn state and local governments reduce spending, lay off workers, reduce benefits for others, raise property taxes and various fees, etc.—all which translate into further recessionary pressures.
A third example: rising financial institution losses translate into rising rates and to a tightening of credit terms for consumers as well as business borrowers. Credit card rates rise, terms become more onerous, banks start charging consumer customers more fees, auto loan rates rise, student loans become harder to get with higher rates, state and local governments must spend more to borrow and in turn pass on costs to citizens in higher local fees, property taxes, and lower spending (resulting in less hiring or layoffs). Increasingly, consumers default on auto, student, and credit card loans.
Contradictions of Monetary and Fiscal Policy
Both Fed monetary policy and the recent $168 billion Congressional tax cut package will prove grossly insufficient in dealing with the current financial crisis and the recession. Rapid deflation (i.e., price collapse) is now occurring in the general housing and commercial property markets and may soon spread to other non-construction markets as corporate defaults rise and additional bank losses are reported. Debt deflation in housing and property markets is the inevitable consequence of prior (housing and property) asset price inflation, which was produced by excessive speculation. Excessive speculation breeds extraordinary inflation and eventually just as extraordinary deflation. But deflation is the greater danger.
When debt deflation spreads from housing to other sectors of the economy, the real crisis begins. Companies facing rising costs and unavailability of funds to finance day to day business, turn to raising revenue on an emergency basis by selling their products below market prices. This raises immediate cash necessary to operate or even stay in business, but sets in motion a downward price spiral—i.e., deflation—that ultimately accelerates losses and the need for still further price cuts. This is what especially distinguishes depression from recession. Efforts to raise revenue by price cutting, moreover, is often accompanied with cutting costs by mass layoffs. Thus rising unemployment accompanies the deflation in parallel. The U.S. economy is approaching the cusp, heading in that direction.
Fed interest rate reductions of more than 3 percentage points by March 2008 has assisted banks’ sagging profitability, but has not succeeded in heading off the general credit crisis and recession. The crisis has continued to outrun Fed actions as long term interest rates have risen and thus pushed the economy further into recession. The Fed may have even assisted the momentum toward recession by its recent lowering of short term interest rates. For example, lower rates have resulted in an accelerating decline of the U.S. dollar and a growing shift from the dollar to the Euro and other currencies as the preferred medium of global trade and financial transactions. The financial crisis is rapidly translating into a parallel currency crisis—which is also a characteristic of depressions as compared to recessions.
The fall of the dollar is also provoking another speculative price bubble, in the form of rapidly rising commodity prices—e.g., food grains, food commodities, raw material commodities, metals, and, of course, oil. As the dollar falls, OPEC and Middle Eastern oil producers have been raising their prices to offset the fall of their investments held in dollars. Oil prices have shot up over $100 a barrel. Rising commodity prices translate into U.S. consumers’ reduced spending power, which in turn reduces consumption dramatically, and feeds the recession. Oil and other commodity speculators may also push up the prices of oil and food even further before it reaches the U.S. consumer, but the Fed action initiates and feeds the whole process. Thus, Fed efforts to stave off recession actually provide more impetus for recession. At some point the Fed will likely give up on lowering interest rates as a consequence. When that happens, yet another psychological effect will occur and the impact will be immense. By that action the Fed will in effect admit it cannot do anything about the crisis.
On the fiscal side, the recent $168 billion Congressional (and Bush) package to stimulate the economy will also prove ineffective. First, a good portion of the tax cut package are business tax cuts that will largely have no effect in a recessionary downturn. In a period of accelerating recession, lower tax cuts for business do not stimulate net investment. Business may absorb the tax cuts, but delay decisions to invest while actually reducing employment. A good part of the business tax cuts will also likely be shuffled to offshore expansion by corporations that will have no effect on U.S. economic conditions, a trend that has been occurring for several years now. Finally, what business spending does occur as a direct consequence of tax cuts will be more than offset by mass industry layoffs coming later this year.
Little of the consumer tax rebate will translate into new spending. Many consumers, now deeply in debt, will use rebates to pay off record debt. Perhaps only a third of the $168 billion will constitute actual new consumer spending. And that consumer spending will be largely offset by reductions in spending and higher fees by state and local government, as tax revenues plummet due to recession while costs of borrowing rise significantly. Before the November 2008 election it will become increasingly clear that the recent Congress-Bush fiscal package was a classic example of too little too late.
Should the crisis and recession continue to accelerate, new solutions will be required. As during the Depression of the 1930s, new solutions may require a major overhaul of the Federal Reserve System, the return of something like the Reconstruction Finance Corp. government agency of that period, and a fundamental re-regulation of the financial sector in the U.S., and reversal of policies since the 1980s that have resulted in a massive redistribution of income that has fed the speculative excesses of recent decades—to name just a few.
Fundamental structural and in some cases radical reform of the U.S. political economy will be necessary to deal with the economic crisis. This crisis may include some of the following features:
- Widespread corporate defaults and mass layoffs occurring later in 2008 and into 2009
- Continuing revelations of further losses by banks and financial institutions
- The collapse of one or more of the mainstream banks in the U.S., setting off a major stock market correction of an additional 20-30 percent
- A further decline of 10-20 percent of the dollar in international currency markets
- Continued rise in oil and commodity prices as offshore speculators continue to take advantage of the U.S.’s worsening dual financial-devaluation crisis
- Deflation spreading from housing and other asset investments in the U.S. to goods and services. Record U.S.
(unified) budget deficits of $700 billion plus
- Growing general awareness that traditional monetary and fiscal policies are increasingly ineffective in addressing financial crisis and recession
Whomever is president in 2009 will almost certainly have to confront the growing reality that the rest of the global economy is also slipping, along with the U.S., into a synchronized downturn.
Jack Rasmus is the author of The War At Home: The Corporate Offensive From Ronald Reagan to George W. Bush (2006) and The Trillion Dollar Income Shift: Essays on Income Inequality in America (forthcoming).