“Market conditions are the worst anyone in this industry can ever remember. I don't think anyone has a recollection of a total disappearance in liquidity...There are billion of dollars worth of assets out there for which there is just no market.” Alain Grisay, chief executive officer of London-based F&C Asset Management Plc; Bloomberg News
The hurricane that began with subprime mortgages, has swept through the credit markets wreaking havoc on municipal bonds, hedge funds, complex structured investments, and agency debt (Fannie Mae). Now the first gusts from the Force-5 gale are touching down in the real economy where the damage is expected to be widespread. The Labor Department reported on Friday that US employers cut 63,000 jobs in February, the biggest monthly decline in five years. The cut in payrolls added to the 22,000 jobs that were lost in January. 52,000 jobs were cut in manufacturing, while 331,000 have been lost in construction since September 2006.
The Labor Department also reported on Wednesday that worker productivity slowed significantly in the last quarter of 2007. When productivity is off; labor costs go up which adds to inflationary pressures. That makes it harder for the Fed to lower rates to stimulate the economy without inviting the dreaded “stagflation”---slow growth and rising prices.
The news on commercial construction is equally bleak. The Wall Street Journal reports:
“For the second month in a row, the Commerce Department reported a decline in spending on nonresidential construction -- which includes everything from hospitals to office parks to shopping malls....Signs of trouble cropped up at the end of the year. As credit markets tightened, office space sold in the fourth quarter dropped 42 per cent from a year earlier, and sales of large retail properties declined 31 per cent, says Real Capital Analytics, a New York real-estate research group....If spending continues to slow, construction workers, who are reeling from the housing slowdown, face more layoffs.” (“Building Slowdown Goes Commercial”, Wall Street Journal)
Commercial real estate is the next shoe to drop. There's a tremendous oversupply of retail space nationwide and the bloodletting has just begun. Builders have continued to put up shopping malls and office buildings even though residential real estate has gone off a cliff. Now the battered banks will have to repossess thousands of empty buildings in strip malls with no chance of leasing them out in the near future. It's a disaster . From December 2007 to January 2008 spending on commercial construction took its steepest drop in 14 years. The sudden downturn is adding more and more people to the unemployment lines.
So, what does it all mean? Unemployment is up, productivity is down, inflation is increasing, the dollar is underwater, commercial real estate is in the tank and the country is sliding inexorably into recession.
As for the housing market:
“Housing is in its "deepest, most rapid downswing since the Great Depression," the chief economist for the National Association of Home Builders said Tuesday, and the downward momentum on housing prices appears to be accelerating.
"Housing is in a major contraction mode and will be another major, heavy weight on the economy in the first quarter," said David Seiders, the NAHB's chief economist.” (“Rapid Deterioration”, MarketWatch)
Home sales are down 65 per cent from their peak in 2005. Inventory is stacked a mile-high. Vacant homes now number about 2 million; an increase of 800,000 since 2005. Demand is weak and prices are plummeting. It's all bad. Meanwhile, the Federal Reserve and the Bush administration are scrambling to devise a plan that will keep homeowners from packing it in altogether and walking away from their mortgages. But what can they do? Will they really write-down the principle on the mortgages like Bernanke recommends and face years of litigation from bond holders who bought mortgage-backed securities under different terms? Or will they simply allow the market to clear and send 2 million homeowners into foreclosure in 2008 alone?
The deflating housing bubble is finally being felt in the broader economy. Home equity is vanishing which is putting downward pressure on consumer spending and shrinking GDP. Also, the dollar is at historic lows, and an intractable credit crunch has left the financial markets in disarray. Experts are now predicting that consumer spending won't rebound until housing prices stop falling which could be late into 2009. When Japan experienced a similar credit/real estate meltdown; it took more than a decade to recover. There's no reason to believe that the present crisis will unwind any faster.
On Friday, banking giant USB estimated that credit woes would end up costing financial institutions $600 billion, three times more than their original estimate of $200 billion. But USB's forecast does not take into account the $6 trillion of lost home equity if housing prices fall 30 per cent in the next two years. (which is very likely) Nor does it account for the potential losses in the structured finance market where $7.8 trillion of loans (which are presently in “pooled securities”) have gone into a deep-freeze. There's no way of knowing how much capital will be drained from the system by the time all of this plays out, but if $7 trillion was lost in the dot.com bust, then it should greatly exceed that figure.
The housing bubble was entirely avoidable. It was the policies of the Federal Reserve which made it inevitable. By fixing interest rates below the rate of inflation for almost 3 years, Greenspan ignited speculation in housing and created a false perception of prosperity. In truth, it was nothing more than asset-inflation through the expansion of debt. The Fed's actions were complimented by repeal of regulatory legislation which prevented the commercial banks from dabbling in securities trading. Once the laws were changed, the banks were free to peddle their mortgage-backed securities to investors around the world. (A-rated mortgage-backed bonds are currently fetching just 13 per cent of their face value!) Now, those sketchy bonds are blowing up everywhere leaving large parts of the financial system dysfunctional.
As investors continue to run away from anything remotely connected to mortgages; the price of risk, as measured by the spread on corporate bonds, has skyrocketed. In fact, investors are even shunning overextended GSEs like Fannie Mae and Freddie Mac. As the number of foreclosures continues to soar, the aversion to risk will intensify triggering a savage unwinding of leveraged bets in the hedge funds as well as a wider paralysis in the finacial markets.
There's absolutely no doubt now that the storm that is currently ripping through the financials will soon bring Wall Street to its knees. It may be a good time to remember that on March 24, 2000, the NASDAQ peaked at 5048. On October 9, 2002 it bottomed-out at 1114; a loss of nearly 80 per cent. Could it happen again?
You bet. Expect to see the Dow hugging 7,000 by year end.
The Wall Street Journal ran an article on Tuesday which outlined how the banks changed standards at the Basel meetings in Switzerland to give them greater autonomy in deciding issues that should have been governed by strict regulations:
“Some of the world's top bankers spent nearly a decade designing new rules to help global financial institutions stay out of trouble...Their primary tenet: Banks should be given more freedom to decide for themselves how much risk they should take on, since they are in a better position than regulators to make that call.” (“Mortgage Fallout Exposes Holes in New Bank-risk Rules”, Wall Street Journal)
It is a classic case of the foxes deciding they should oversee the hen-house.
The Basel Committee on Banking Supervision is an industry-led group comprised of the central bank governors from the G-10 countries; Belgium, Canada, France, Italy, Japan, the Netherlands, Sweden, Switzerland, Britain and the US. Basel is supposed to establish the rules for maintaining sufficient capitalization for banks so that depositors are protected. But it's a sham. It appears to be more focused on maintaining US and European dominance over the developing world and making sure the levers of financial power stay in the manicured paws of western banking mandarins.