The US Congress went into labor this weekend, and gave birth to a gnat. With
some cosmetic adjustments, Treasury Secretary Henry Paulson's US$700 billion
bank bailout plan will be adopted this week. Markets barely budged on the news,
which was punctuated by government bailouts of two giant banks - America's
Washington Mutual and Belgium's giant Fortis group. A third rescue, of
Britain's Bradford and Bingley, sees it taken over by the government.
Paulson's plan likely will provide temporary relief to the stockholders of some
American banks, whose balance sheets do not look all that different from
Washington Mutual's. But this has nothing to do with the larger problem, namely
the de-leveraging of the American household.
Leverage is the secret of American wealth. The average American
family in 2004 had a net worth of US$448,000 on an income of $43,000, according
to the Federal Reserve's survey of consumer wealth. Wealth equaled 10.4 years
worth of income. In 1989, the Fed survey shows, it was only 7.3 years of
income, and just 3.8 years worth in 1962. Measured in years, why should the
ratio of Americans' net worth amount to annual income have tripled between the
administrations of John F Kennedy and George W Bush?
US individualís net worth to annual income
Annual Income ($1000's)
Wealth/Income ratio in years
Source: Federal Reserve Survey of Consumer Finances
That is an odd result. It cannot be due to productivity, because productivity
should show up in higher income as well as higher wealth. I suppose one could
argue that expectations for higher productivity growth in the future than in
the past might jack up the ratio, but that is hard to believe that is true
after the collapse of the Internet bubble. The answer is leverage.
If the wealth-to-income ratio falls back to its 1989 level, the net worth of
Americans would fall by a third. That is a frightening prospect, but it is not
necessarily the bottom.
Some economists, including former Federal Reserve chairman Alan Greenspan, have
claimed that the rising ratio of wealth to income expressed the decreasing
riskiness of capital assets as the US economy showed that it could continue
growing with low inflation practically without interruption. That doesn't quite
make sense, though, for there is no trend in market measures of risk.
The cost of options on the S&P 500 equity index in terms of implied
volatility, a broad gauge of investors' risk perceptions, shows no downward
trend over the past 20 years. There is no trend towards lower risk over the
past 20 years, at least not according to tradable hedging instruments. The
notion that the US economy is one-third as risky as it was in 1962, and that
valuation of financial assets should be three times as great relative to
income, makes no sense at all.
Part of the explanation must be leverage. Total household debt in the US was
roughly half of disposable income in 1962, but nearly equal to disposable
income in 2004. In proportion to income, the household debt burden nearly
doubled. Americans took on more debt, acquired more assets in the form of
homes, and watched home prices appreciate on a levered basis. That did the
trick. This time, however, the magician really is going to saw the lady in
Foreign demand for American assets surely has contributed to trebling of
relative asset valuation in the past two generations, although the bulk of this
has occurred indirectly. Foreigners lend money to the United States, and this
money is re-lent to consumers and corporations. In a recent essay (see
The monster and the sausages, Asia Times Online, May 20, 2008) I
observed that the rapid aging of the world population has funneled money into
the few venues that provide open and liquid capital markets, and made America
the beneficiary of the thrift of prospective retirees from Europe to China and
Leverage is slathered onto assets, and eventually loans go bad, and banks lose
capital. The collapse of American home prices to date has forced $500 billion
in write-downs of bank capital, against which banks have raised $350 billion in
new capital. But the private market will not provide new capital to the banks
unless the federal government in effect underwrites the risk to shareholders.
That is the upshot of Paulson's plan, which proposes to buy mortgages and other
assets from banks at high prices (what Federal Reserve chairman Ben Bernanke
euphemistically calls the "hold to maturity price") so that they do not have to
sell them at low prices. It is a transfer of capital from the government to
bank shareholders. In response to complaints from its constituents, Congress
has amended the Paulson plan to give the government a claim on the share price
appreciation of banks that benefit from the program.
At most, Paulson's plan will preserve the privileges of the financier caste
that enabled the debt addiction of American households; at worst, it will give
a few of the bankers an extra couple of months to unload stock in financial
companies before they, too, go the way of Bear Stearns, Lehman Brothers and
Washington Mutual. It is very difficult to understand why Washington Mutual's
share price fell to zero, and the shares of laggards such as Fortis and
Wachovia Bank fell sharply, while other financial shares have risen. The
differences between the business models of these banks are trivial compared
with their similarities.
The trouble is that no one knows where the process will end. American
households cannot be worth 10 years of income, but should they be worth seven
years of income as in 1989, or just three years of income as in 1962? Where
should American home prices find a level? If they return to the prices of 1998,
they will fall by half, which is where homes offered in foreclosure are
clearing the market today in California and Las Vegas.
Banks that provided the leverage for American households and corporations will
remain under siege until asset prices find a level, and that will take two
years, give or take a lifetime.
Sadly, the Asian public and private sector will continue to pour money into the
United States because their home markets are not deep or secure enough to
provide an alternative. America will have an extended grace period to put its
house in order before the rest of the world finds alternatives to its capital