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3 Why the subprime bust will
spread By Henry C K Liu
Years ago when the US debt bubble spread
over to the housing sector, warnings from many
quarters about the systemic danger of subprime
mortgages were categorically dismissed by Wall
Street cheerleaders as Chicken Little "sky is
falling" hysteria. Even weeks before bad news on
the housing finance sector was shaping up as a
clear and present danger, adamant denial was still
loud enough to drown out reason.
Both
Federal Reserve chairman Ben Bernanke and Treasury
Secretary Henry Paulson, two
top officials in charge of US monetary policy,
continue to provide obligatory assurance to the
nervous public that the United States' economic
fundamentals are sound in the face of a jittery
market. Days before being delisted from the New
York Stock Exchange, shares of the collapsed New
Century, a distressed subprime mortgage lender,
were recommended by a major Wall Street brokerage
firm as a "buy". That firm is now under criminal
and regulatory investigation.
On the pages
of Asia Times Online over the past two years, I
have tried to put forth the rationale for the
inevitability of a US housing bubble burst,
pointing out reasons that the resultant financial
meltdown will be much more widespread and severe
than has been generally acknowledged.
History has shown that the Fed, more
often than not, has made wrong decisions based
on faulty projection. Greenspan has been rightly
criticized for letting a housing price "bubble"
develop, equating it to the one that swept
technology stocks to stratospheric levels before
bursting in 2000. Greenspan argues the Fed's
role is to mop up after bubbles burst, since
bubbles are hard to spot and deflate safely. But
accidents are also difficult to predict, and
that difficulty is not a good argument against
buying insurance. There is no doubt that there
is a price to be paid for every policy action.
But the price of prematurely slowing down a debt
bubble is infinitely lower than letting the
bubble build until it bursts uncontrollably. In
finance as in medicine, prevention is preferable
to even the best cure. All market participants
know pigs lose money. And a monetary pig loses
control of the economy.
Alan
Greenspan, then Fed chairman, notwithstanding his
denial of responsibility in helping through the
1990s to unleash the equity bubble, had this to
say in 2004 in hindsight after the bubble burst in
2000: "Instead of trying to contain a putative
bubble by drastic actions with largely
unpredictable consequences, we chose, as we noted
in our mid-1999 congressional testimony, to focus
on policies to mitigate the fallout when it occurs
and, hopefully, ease the transition to the next
expansion."
By "the next expansion",
Greenspan meant the next bubble, which manifested
itself in housing. The mitigating policy was a
massive injection of liquidity into the US banking
system.
There is a structural reason that
the housing bubble replaced the high-tech bubble.
Houses cannot be imported like manufactured goods,
although much of the content in houses, such as
furniture, hardware, windows, kitchen equipment
and bath fixtures, is manufactured overseas.
Construction jobs cannot be outsourced overseas to
take advantage of wage arbitrage. Instead, some
non-skilled jobs are filled by low-wage illegal
immigrants.
Total outstanding home
mortgages in the US in 1999 were US$4.45 trillion,
and by 2004 this amount had grown to $7.56
trillion, most of which was absorbed by
refinancing of higher home prices at lower
interest rates. When Greenspan took over at the
Fed in 1987, total outstanding US home mortgages
stood only at $1.82 trillion. On his watch,
outstanding home mortgages quadrupled. Much of
this money has been printed by the Fed, exported
through the trade deficit and reimported as debt.
The most popular of all derivative
products is the interest-rate swap, which in
essence allows participants to make bets on the
direction interest rates will take. According to
the US Office of the Comptroller of the Currency
(OCC), interest-rate swaps accounted for three out
of four derivative contracts held by US commercial
banks at the end of 1999. The notional value of
these swaps totaled almost $25 trillion; 2-3% of
that ($500 billion to $750 billion) reflected the
banks' true credit risk in these products.
Monetary economists have no idea whether notional
values are part of the money supply and with what
discount ratio. As we now know from experience,
creative accounting has legally and illegally
transformed debt proceeds as revenue.
The
2005 OCC report "Condition and Performance of
Commercial Banks" shows that loan demand in the US
grew at 11% in the first quarter of 2005 while
core deposits grew at 7%, producing a
4-percentage-point gap. That meant that US banks'
loan growth was not fully funded by deposits. The
report identified possible risks as: cooling off
in housing markets accompanying slower loan
growth; past regional housing-price declines
lingering; and credit-quality problems in housing
spilling over to other loan types. Not a
comforting picture.
Derivatives of all
kinds weigh heavily on banks' capital structures.
But interest-rate swaps can be especially toxic
when interest rates rise. And since only a few
business economists predicted a jump in rates for
the first half of the year when 1999 began while
yields in fact rose 25%, these institutions found
themselves on the wrong side of an interest-rate
gamble by 2000. Moreover, as interest rates rose,
US banks' income diminished from
interest-rate-related businesses such as mortgage
lending. Interest-sensitive sources of income were
the revenue disappointment in 2000, as trading was
in 1999. The banks' response was to lower credit
requirement for loans to increase interest-rate
spread.
On Greenspan's 18-year watch,
assets of US government-sponsored enterprises
(GSEs) ballooned 830%, from $346 billion to $2.872
trillion. GSEs are financing entities created by
the US Congress to fund subsidized loans to
certain groups of borrowers such as middle- and
low-income homeowners, farmers and students.
Agency mortgage-backed securities (MBSs) surged
670% to $3.55 trillion. Outstanding asset-backed
securities (ABSs) exploded from $75 billion to
more than $2.7 trillion.
Greenspan
presided over the greatest expansion of
speculative finance in history, including a
trillion-dollar hedge-fund industry, bloated Wall
Street-firm balance sheets approaching $2
trillion, a
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