Capitol Hill Blue Forums Political Issues Finance, the economy & Economics How will the financial crisis develop?

Standard & Poor’s yesterday highlighted the task facing the next finance chief, saying it may cut Britain’s AAA credit rating for the first time as debt heads to 100 percent of gross domestic product amid the worst recession since World War II.

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“Does this government in its current state have the steel and the authority to put through a painful program of tax increases and spending reductions and nurture the economy in a consensual way through a period of difficult economic adjustment?” said George Magnus, senior economic adviser at UBS AG. “No. The politics just aren’t right.”

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“Britain’s economic reputation is on the line,” said George Osborne, the lawmaker in charge of Treasury affairs for the Conservatives. “Unless Britain has a government with a credible plan to reduce debt, there will be a further downgrade, with all of the serious consequences for our prosperity that would entail.”

Debt and ratings concerns are already starting to affect other countries. Yesterday, U.S. Treasury Secretary Timothy Geithner committed to cutting the budget deficit as concern about deteriorating creditworthiness deepened.

The bottom line is that the attempt to save bank bondholders from losses – to provide monetary compensation without economic production – is not sound economic policy but is instead a grand monetary experiment that has never been tried in the developed world except in Germany circa 1921. This policy can only have one of two effects: either it will crowd out over $1 trillion of gross domestic investment that would otherwise have occurred if the appropriate losses had been wiped off the ledger (instead of making bank bondholders whole), or it will result in a stunning and durable increase in the quantity of base money, which will ultimately be accompanied not by a year or two of 5-6% inflation, but most probably by a near-doubling of the U.S. price level over the next decade. As I've noted previously, the growth rate of government spending is better correlated with subsequent inflation than even growth in money supply itself, particularly at 4-year intervals. Regardless of near-term deflation pressures from a continued mortgage crisis, our present course is consistent with double digit inflation once any incipient recovery emerges.

As Nobel economist Joseph Stiglitz recently noted, the bureaucrats that designed this bailout are “either in the pocket of the banks or they're incompetent. It's a real redistribution and a tax on all American savers. This is a strategy trying to recreate the bubble. That's not likely to provide a long-run solution. It's a solution that says let's kick the can down the road a little bit. They haven't thought enough about the determinants of the flow of credit and lending.”

Not that anyone is listening, unfortunately.

The Treasury does not have any power to create new money. It has to borrow from the credit market, thus shifting private debt into public debt. The Fed has the authority to create new money. Unfortunately, the Fed's new money has not been going to consumers in the form of full employment with rising wages to restore fallen demand, but instead is going only to debt-infested distressed institutions to allow them to deleverage from toxic debt....

Falling demand deflates commodity prices, but not enough to restore demand because aggregate wages are falling faster. When financial institutions deleverage with free money from the central bank, the creditors receive the money while the Fed assumes the toxic liability by expanding its balance sheet....

What we will have going forward is...a financial profit inflation in which zombie financial institutions turn nominally profitable in a collapsing economy. The danger is that this unearned nominal financial profit is mistaken as a sign of economic recovery, inducing the public to invest what remaining wealth they still hold, only to lose more of it at the next market meltdown, which will come when the profit bubble bursts.

The solution then is to make the working poor pay for the pain of inflation by giving the rich a bigger share of the monetized wealth created via inflation, so that the loss of purchasing power from inflation is mostly borne by the low-wage working poor and not by the owners of capital, the monetary value of which is protected from inflation through low wages. Thus the working poor loses in both boom times and bust times.

Investors aren't shunning these assets because they're afraid, but because the banks want too much for them given their implicit riskiness.

...[asset] prices have collapsed because investors recognize the inherent toxicity of the assets themselves. The market isn't driven by fear, but by common sense. $.30 cents on the dollar is probably all they are worth.

Do people realize that the reason their home equity is vanishing, their 401ks have been slashed in half and their jobs are at risk is because Wall Street was gaming the system with leverage and financial innovation? The current downturn is not really a recession at all; it's more like a self-inflicted wound perpetrated by avaricious speculators who put a gun to the economy's head and blew its brains out. The banks and Wall Street have created a capital hole so vast that the entire economy is being sucked into the abyss. And it all could have been avoided.

Credit production is too important and too lethal to entrust to profit-driven vipers whose only motivation is self-enrichment. The whole system needs rethinking and public input before Bernanke wastes trillions more trying to revive the same crisis-prone business model. If "credit is the economy's life's-blood," as President Obama says, then it should be distributed through a government-controlled public utility. The real lesson of the financial crisis is that privatizing credit has been a disaster.

If you think it's bad now, wait a year or more. The subprime adjustable rate mortgages have already peaked and bottomed. That's good. However, due to the longer initial low interest periods inherent in these groups, prime, Alt-A, and option ARM resets just started ramping up in April.
For the next couple of months, these will rise and reach an intermediate plateau in June. This plateau will last for about a year and then will start rising again in May of 2010 peaking in August of 2010. They'll then tail off a bit until May of 2011 where they'll ramp up again but not as high as the 2010 peak. Finally, in October 2011, they'll start moving down again to hit bottom rates in early 2012.
Contrary to what the pundits are saying, this has a long way to go.
The number of ARMs among prime, alt-a, unsecuritized, and options are higher overall than subprime however, it's also more likely that prime and alt-a would have been able to refinance into fixed mortgages at the recent low rates. If they weren't able to, with rapidly rising mortgage rates, those ARMs are going to reset to much higher rates and defaults among those categories are likely to rise signficantly.
Alt-a mortgages are better than sub-prime but worse than prime.
Unsecuritized mortgages are a mixed bag. Some are so good that the mortgage originator wanted to keep them and didn't sell them into the securitization market (MBSs). The others though, are so bad that no one wanted them. Consider that at the time, the standards were pretty low for what the securitization market wouldn't buy.
Option ARMs are a scary mix of mortgages and likely to suffer really high default rates. They're composed of those exotic mortgage types such as "interest only" mortgages and even those where the initial low payments were less than what the interest amounted to so the amount owed after several years is guaranteed to be more than what the home is worth even in cases where the home prices didn't go down.
Sad times and we're paying the piper for the multi-year banquet and spending spree that the country just binged upon.

A former Chinese central bank adviser says Global Crisis ‘Inevitable’ Unless U.S. Starts Saving.

Another global financial crisis triggered by a loss of confidence in the dollar may be inevitable unless the U.S. saves more, said Yu Yongding, a former Chinese central bank adviser....

The Obama administration aims to reduce the fiscal deficit to “roughly” 3 percent of gross domestic product from a projected 12.9 percent this year, Geithner reaffirmed today....

It may be helpful if “Geithner can show us some arithmetic,” said Yu. “We need to know how the U.S. government can achieve this objective.”

The U.S. needs a higher savings rate and a smaller deficit on the current account, which is the broadest measure of trade, or “another financial crisis triggered by a dollar crisis could be inevitable,” the Chinese academic said.

Referring to the Federal Reserve “as the world’s biggest junk investor,” and to Chairman Ben S. Bernanke as “helicopter Ben,” Yu said the Fed has dropped “tons of money from the sky since the subprime crisis.”

“The balance sheet of the Federal Reserve not only has expanded like mad but is also riddled with ‘rubbish’ assets,” he said.

Think back to Citicorp. I looked at the ticker today: the market capitalization of Citicorp is $17 billion. So the government could buy Citicorp for a fraction of what we've already obligated the taxpayer for. And in buying Citicorp, as an example—there could be one or two others—the government would announce in four to six months that it is going to sell the good assets of the bank back to the public. If the government bought Citicorp for, let's say, $20 billion, what would it be worth if the government sold the good assets back to the public? Surely, several times what it paid for it.

I don't mean selling these assets to hedge funds, although they can participate; but I would propose offering them to any American who wants to invest in this good bank the opportunity to do so.

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But there are only a few ways of resolving that debt problem: either you default on it as countries like Argentina did; or you use the inflation tax to wipe out the real value of the debt; or you have to raise taxes and cut government spending. And given the size of the deficits, over time that's going to be a painful political choice to make.

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One result was that the 374 people in the London office of AIG who were responsible for AIG derivatives destroyed a company that had 116,000 employees in 120 countries. Why? Because there was no regulation at all.

Aside... The Hussman article (IMHO), represents a very strong argument for the concept of "finite wealth"... another subject that tweaks the hot button of some of our RR friends.