How The Economy Got Here…

By: Sal Palma

This will be my last piece under the Election Year BS topic. I felt it was important and it has received little attention in the media who chooses to focus on Romney’s 47% and Obama’s redistribution of wealth.

The economy, moves in cycles. It is an almost rhythmic movement that some say is predictable. It has its ups and it downs; we know this to be historically correct. The sharp downturn of 2008 was triggered by a downward movement in the business cycle but its severity is attributable to much more complex factors.

You’ve all heard the term leverage used but do you understand it? Leverage refers to borrowing. For example, if you have $200,000 and you buy a house for $200,000, you have no debt and a $200,000 asset. In a normal market, you can expect your home to appreciate at an annual compounded rate of 6% per year – that will vary market to market. After the first year in your new home, you can reasonably expect it to have a fair market value of $212,000. Your asset appreciated by $12,000.

Now lets take a look at what leverage does. You have $200,000 but you decide to purchase a $600,000 home. You put down your $200,000 and borrow $400,000 to purchase an asset worth $600,000. At the end of your first year, your asset is worth $636,000. Your asset appreciated by $36,000 in the first year. As long as your job remains secure with a reliable income stream, leveraging allows you to amplify your earnings. However, leveraging also has an amplifying effect in a downward direction when the economy takes a downturn.

So why is it that we’ve had such a terrible time coming out of this recession. To understand that, we need to go back in time.

So, let’s go back to the late 1980’s and early 1990’s, which is when the real estate market started heating up; by heating up I mean excess demand with a lagging supply that resulted in what’s been called the housing bubble. When we refer to the housing bubble we mean that the housing market was dysfunctional; resulting in housing prices rising at a much higher rate than a normal market appreciation of 6% per annum. Why do bubbles occur?

Bubbles occur when demand increases sharply aggressively leading supply. You’ve heard of a stock market bubble. Quite often stock prices rise simply because there are vast sums of cash sitting idle that needs to be invested. When that money jumps into the market, stock prices rise for no other reason than the demand for stock exceeds the supply. It has no bearing on the economic health or viability of the market. It’s simply money jumping into the market. Some see it as an indicator that investors are optimistic about the markets but that is not the complete picture.

So, where did this demand for housing come from? The short answer is mortgage lenders made up of private investment firms, and retail and commercial banks.

Every time a lender writes a mortgage, they add to the asset side of their balance sheet. When the asset side of the balance sheet increases, the earnings potential for that institution also increases and, in the absence of proper financial disclosure, the markets reward the increased earning potential by bidding the institution’s share prices higher.

Lenders generally do not keep mortgages on the books for the life of the mortgage. They bundle them and sell the bundle on the secondary  markets. The secondary market, which in many cases are firms owned by the lenders, leverage the purchases. That is they borrowed money so they can purchase more and larger bundles; many times, the borrowing is facilitated by the institutions that own them. You can begin to see a spiraling effect. The more banks lend the higher the stock price, the more and larger bundles the secondary market buys and the more the secondary markets leverage, etc. A large percentage of the bundles are sold to Fanny and Freddy as well as international investors. It became in every sense of the word a feeding frenzy!

I was at a Starbuck’s a number of years ago and inadvertently sat through a sales pitch to a young couple from a realtor. What the realtor was attempting to do, was to have the couple make an offer on a higher priced home. The essence of the sales pitch was this. I can get you together with a mortgage broker that can structure your loan so that in the first 18 months you’d be paying what you can afford. After 18 months, your income will rise and you can afford the higher mortgage payments; besides, even if you can’t afford the mortgage payments you can sell your house on the market and make 30K. Unbelievable!

What is more astonishing, is that lenders were knowingly booking high risk loans without disclosing the higher risk on their financial statements. The result was that their stock prices kept going up and up. To give you an example of just how bad things got, lenders were running ads in local markets offering loans of up to 125% of the appraised property value.

Lenders were adding huge amounts of risk to their loan portfolios, which was subsequently bought by investment banks in the secondary markets and Fanny Mae and Freddie Mac. Regrettably, no one had the integrity to disclose, on their financial statements, they were taking on large amounts of risks. Disclosure, by the way, is required under G.A.A.P. (Generally Accepted Accounting Principals) and under various regulations by the S.E.C. (Securities and Exchange Commission) for publically traded companies. Not only was there no disclosure by lenders, there was no disclosure by the firms comprising the secondary markets.

This unrestrained bonanza in lending created the housing bubble. It was common place to see homes appreciating in value by 20% per year or more, which sparked residential housing speculation making matters even worse. Individuals were taking the equity out of their homes to buy second homes, cars, add a room, vacations you name it. The economic growth that we saw, and politicians like taking credit for, was fueled by the housing bubble, which by any measure was unsustainable.

Suddenly, a downturn in the business cycle kicked in and folks began to get laid off. Unable to meet the mortgage payment, the entire house of cards collapses. Investors discover that housing prices are now half of what they used to be and loans are going bad, developers are going bankrupt and financial firms have inadequate reserves ( we call this liquidity) to weather the storm – a storm created by them, I might add.

When liquidity dried up, the government had to step in to keep banks from collapsing. So as much as I hate to say this, bailouts were indeed necessary. With lending at a halt, consumer spending declined, businesses were unable to finance  plant and equipment and the economy came to a grinding halt.

To provide you with some dimension of the severity of the problem, in 2008-2009 there was a total of $30 trillion dollars of uncollateralized debt floating about. Much of this was loans to Wall Street firms, hedge funds and speculators who leveraged their way to huge profits virtually undetected and therefore unregulated.

Going into this election and the Presidential debates, the question you need to ask of yourself, and your elected officials is, why has the economy been unresponsive to all the stimulus. I’ll give you what I think the correct answers are.

1. Banks are still not lending to consumers and small businesses. They would rather lend to the investment banks they own or have interest in and to global corporations who are now borrowing at historically low interest rates.
2. The United States has lost control of its manufacturing base. We no longer have a steel industry, we no longer have a garment industry, we no longer have a consumer electronics industry. Because virtually everything we come in contact with is made in China, India or Indonesia, the benefits of domestic stimulus programs don’t remain in the U.S. Instead, they flow, at an increasing rate, to China, India and Indonesia. If we fail to gain control of our manufacturing, China will be able to exercise monopoly pricing power on manufactured goods, in the near future. This means that what used to be inexpensive Chinese parts and sub-assemblies will become expensive. We are beginning to see signs of that in the garment industry.
3. There is still a very large amount of risk in our financial sector. There is an urgent need to break up the banks. If you think we’re out of the woods you’re dreaming and another major collapse could be the one that does us in. We need to do everything possible to make banking a competitive industry. What we have today is an oligopoly with price fixing along the lines of fees that bare no relationship to business risk. It is out of hand!
4. Leveraged speculation, especially in oil, fuels and other commodities remains high.
5. We need to have fiscal policy that rewards investing in business creation so that investing in new business provides an after tax return superior to competing alternatives.