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The sad state of our economy - liquidity crunch

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Americans have many reasons to be gloom; Steve Chapman in today’s Tribune told us. He noted that: ”The war in Iraq has yet to turn around, we can't agree on a solution for illegal immigration, and Lindsay Lohan isn't cute anymore.”

A report yesterday by the Pew Research Center notes “distrust of the United States has intensified across the world.” I can’t blame them: we have a lunatic Vice President who today’s Tribune Editorial calls “loopy”—if not out right arrogant—and is using the constitution as toilet paper. He forgets to mention that we’ve been lied about a war that should have never occurred. This “loopy” character has single handedly cause the death of over 3600 brave American soldiers with over 20,000 injured, not to mention the three to four hundred thousand dead, displaced innocents Iraqis and several million refugees, who had NOTHING to do with 9/11.

Mr. Chapman continues: “When it comes to the economy, the national mood is a combination of dissatisfaction and fear. A recent Gallup poll found that 66 percent of Americans think national economic conditions are ‘only fair’ or ‘poor.’” And then proceeds to mention the reasons why we should rejoice: Unemployment stands at 4.5 percent, down from the peak rate of 6.3 percent four years ago.” The problem with that figure is that it if you go eight years back, the unemployment was 4.5% also; but the jobs were paying a higher salary. What Mr. Chapman’s employment figures fail to mention is that the new jobs created by the Bush administration are low paying jobs. Mr. and Mrs. Average American are both working to barely keep up. Meanwhile, according to the Financial Times, last year the assets of those with more than $30m (£15m) to invest - the so-called ultra-high net worth individuals - expanded by 16.8 per cent. The rich to poor gap has widened sharply.

Mr. Chapman thinks that higher gas prices is part of the syndrome—but that is not of what is worrying Americans. You see, when the Fed rates were at 1.25%, a very large number of Americans refinanced their homes and went on a shopping spree. What’s worse, even the unqualified Americans went and refinance their homes at subprime rates. Most took ARM mortgages or interest only mortgages because there was a housing boom and your house value just kept going up. If they overspent, they went again and took more money out of their homes.

Unfortunately, the Bush Administration went on the same shopping spree. Fueled by low interest rates, they borrowed over one trillion dollars in debt in six years. They issued bonds until every pork bill passed by the Republican Congress was properly funded.

Today, two countries hold 40% of that debt: China, and Japan. Two weeks ago, fueled by distrust in the American economy, these countries diversified their holdings and there was a sharp sale of bonds. Last two weeks saw the 10 year bond yield rise from to 5.3%, higher than the Fed rate of 5.25%.

The results are now beginning to take effect. The Financial Times reports that on the international scale widespread jitters in the credit markets and rising risk-aversion among investors have cancelled bond deals planned by several companies this week. MISC yesterday became the first company in Asia to pull its planned bond issue, citing the volatile market conditions sweeping the corporate credit markets in the wake of worries of about the potential fallout from the US subprime mortgages. The world's biggest owner of liquefied natural gas tankers, which is based in Malaysia, had hired Citigroup and Deutsche Bank to sell $750m of 10-year US dollar bonds and had initially set price guidance on Monday. Yesterday, it indicated that it would wait until market conditions became more stable.

Sentiment in the European credit derivatives market fell to the lowest point seen for several months yesterday, as investors in the corporate credit world began to fear that some of the jitters seen in the US mortgage market could spread to other financial arenas. The deterioration in sentiment follows a similar decline in American credit derivatives earlier this week, with a particularly marked movement in the price of instruments linked to financial institutions that are involved in the subprime sector. Taken together, the movement suggests that although the corporate credit world has been relatively insulated so far from the market turmoil of recent weeks, this may be starting to change.

The subprime crisis has created a real estate nightmare. The head of one of the largest US house builders on Tuesday warned that prices have further to fall in order to restore consumer confidence in the troubled sector. The glut of existing homes has become an increasing concern for builders, who have cut construction and increased discounts in an effort to clear an inventory of single-family houses now at its highest level since 1992. The closely watched Case-Shiller index for May showed that prices for single-family homes fell by 2.1 per cent from the year before in 20 metropolitan areas.

So now, Mr. and Mrs. Average American can’t afford to go back and ask for more money on the value of their homes. The share of all mortgages entering foreclosure rose to 0.58 percent in the first quarter from 0.54 percent in the fourth quarter, according to a quarterly report from the Mortgage Bankers Association. Subprime loans entering foreclosure jumped to a five-year high of 2.43 percent from 2 percent in the fourth quarter, and prime loans rose to 0.25 percent, the highest ever, from 0.24 percent. It was worse for subprime borrowers who took out adjustable-rate mortgages. The association said the percentage of payments that were 30 or more days past due for subprime ARMs jumped to 15.75 percent in the first quarter. That's the highest level ever and up from 14.44 percent in the fourth quarter. The percentage of subprime ARMs that started the foreclosure process climbed to 3.23 percent, also a high, from 2.70 percent. People who have taken out subprime mortgages, especially ARMs, have been clobbered as rising interest rates and weak home prices have made it increasingly difficult for them to keep up with their monthly payments. Some lenders in the subprime market have been forced out of business. Analysts estimate that nearly 2 million ARMs will reset to higher rates this year and next. Some subprime borrowers were lured by initially low "teaser" rates offered during the five-year housing boom that ended in 2005. But those rates can spike upward after the first few years, causing payment shocks. "Housing is in a recession, and we're seeing that reflected in prices,” said Doug Duncan, chief economist for the group. "If you're in a position where you can refinance or sell, but house prices have fallen below your outstanding loan balance, you're in trouble."

I’ll quote what the Financial Times editorialized on June 16: “The surge in yields came in the past couple of weeks but the upward move, from about 4.5 per cent to about 5.25 per cent on the 10-year bond, has been under way since March. Borrowing US dollars for a few years has got more expensive, and the shape of the yield curve has changed as well. At the start of the year, borrowing for five or 10 years cost less than borrowing for one. Now the reverse is true. Though the shift in yields was sudden, it was not especially alarming. Bond investors had a great run until June 2003 when the Federal Reserve cut rates to 1 per cent (lower interest rates are good for bonds). A return to 10-year yields above 5 per cent is just a return to normality, as is the reappearance of an upward-sloping yield curve. What happens next depends on why yields went up. One explanation - that traders have got into a panic about inflation - does not stand up. The US Treasury issues bonds with an interest rate linked to inflation and their value should be unaffected by expected changes in the price level. Yet, in the past few weeks, they have fallen by just as much as normal bonds. Another possibility is that central banks in East Asia and the Middle East suddenly decided to stop buying Treasuries. Those purchases, made to balance trade surpluses and keep exchange rates down, are probably the main reason why US bond yields have stayed so low for as long as they have.”

What this means according to Francesco Guerrera from the Financial Times "is that for the first time in years - investors said 'thanks, but no thanks' to risky bonds issued by buy-out groups to fund takeovers. Companies such as US Foodservice, a caterer, Dollar General, a US retailer, and Arcelor Finance, part of the Arcelor Mittal steel group, had to shelve their debt offerings. Put simply: investors got fed up with taking on risk without being adequately paid for it. They took particular issue with bubble-like features such as the one allowing private equity-owned companies to stop paying interest on debt when cash flow was low. In this case, however, it was the over-eager investment banks, not the buy-out funds, that were left carrying the can. But that will soon change. The latest rout should persuade even the most short-sighted of lenders to share the financing risk with private equity groups.

That, in turn, is likely to have a chilling effect on the buy-out bonanza. As for the fate of the rest of the market, keep an eye both on the global economy and investors from emerging markets. Healthy economic growth across the world will help companies and markets to weather the credit downturn. That is why stock markets were relatively unaffected by the recent turmoil. And as long as investors from the Middle East, Russia and China keep pouring their petrodollars and foreign exchange reserves into the West, there should be a well-stocked source of liquidity. I would not, however, subscribe to the complacent optimism emanating from self-interested sources. The mellifluous words that came from several heads of Wall Street banks this week for example, should be taken with a shaker of salt. The truth is that we are facing a mini-liquidity crunch."
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Travel website: The Pink Agenda. Several Blogs. Weekly newsletter, available upon request. Publications - Fiction: Borrowing Time: A Latino Sexual Odyssey - Floricanto Press 2003. Poetry: The Refined Savage Poetry Review - Refined Savage (more...)
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