Imploding Credit Bubble to Hit $1 Trillion

Image has not been found. URL: /wp-content/uploads/2008/09/greenspan.jpgFormer Chairman of the Federal Reserve Alan Greenspan (WDCPix)

The current credit and financial crisis, unusually, is almost entirely the creation of the financial services industry.

Financial services now dominates American business to an astonishing degree. Though the industry accounted for only about 16 percent of corporate output in 2007, it racked up more than 40 percent of corporate profits. From 2000 through mid-2007, total American stock market value grew about 6 percent, while the value of financial services stocks grew by 78 percent. And though total corporate profits roughly doubled, business investment was almost flat.

Illustration by: Matt Mahurin

Where did the profits go? Mostly to dividends and stock buybacks, much of which, in turn, poured into the hedge funds and private equity funds driving the company buyout boom. Martin Wolf, an economist and columnist for the London Financial Times, laments that America is turning into “a giant hedge fund.”

From 2002 through 2005, Federal Reserve Chairman Alan Greenspan kept banks’ own borrowing rates lower than the rate of inflation – in effect, for bankers, money was free. Bankers also began to package up their loans into new types of bonds that they could sell off to pension funds and other investors to free up their capital for more lending. When money is free, and banks can earn rich lending fees without tying up capital, the rational banker will lend to infinity.

…in effect, for bankers, money was free…

Countrywide Financial, one of the more notorious pushers of toxic mortgages, is a good example. Unusually easy money allowed it to employ extreme leverage, and incur heavy cash flow deficits – a total of $38 billion in operating cash deficits from 2003 through 2007. Not to worry. That was covered by $44 billion in low-rate borrowing from the Atlanta federal home loan bank. Angelo Mozilo, the Countrywide CEO, was paid $48 million in 2006, and made another $100 million-plus selling his Countrywide stock just before the subprime mortgage crash.

Your taxpayer dollars at work.

Over the past few weeks, there has been a steep fall in the trading value of company-takeover loans. That is a huge market, and forced sales and rising delinquencies are ominously reminiscent of last summer’s subprime debacle. The unfolding consumer recession will only make it worse.

The total losses and writedowns from the imploding credit bubble – leveraged loans, mortgages of all kinds, credit cards and much else – (See Part I of this article) will be on the order of $1 trillion. About half of the losses will be absorbed by banks. They have already taken some $130 billion of writedowns, so they have some $250-350 billion to go.

Which brings us back to the Fed. The floods of easy money from chairman Ben Bernanke look like a doomed effort to paper over the inflated asset values, the phony triple-A ratings and the hidden liabilities marbled through American balance sheets.

There is a precedent for such behavior. In the late 1980s, Japan experienced an asset bubble much like our current one. The tight network of government and financial executives conspired to conceal it with cheap money. And the crisis dragged on for another 15 years.

It is desperately important that we start the painful conversion from the recent debt-driven consumption circus to a more balanced, higher savings economy.

It is desperately important that we start the painful conversion from the recent debt-driven consumption circus to a more balanced, higher savings economy. But that transition can’t start until the financial sector reprices assets down to real values – and the faster the better.

The scale of the required writedowns is scary. Bank capital will be decimated, necessitating perhaps $150-$200 billion in new capital raising. The tens of billions in new capital raised by banks last year almost all came from sovereign wealth funds – murky investment vehicles mostly under the control of Asian and Arab governments. It is not xenophobic to worry about the sale of yet another huge block of ownership to such entities.

Wall Street seems to be hoping that the federal government will simply take over its bad assets, much as we funded Countrywide; such ideas are floating around the Congress. The banks would doubtless garner big fees for helping the government manage its new financial garbage dump.

There is a better alternative. Instead of a government bail-out, or a fire sale to foreign governments, let the banks absorb their writedowns and then recapitalize by selling new debt and equity to the American government on private market terms. The securities would be deposited in the Social Security trust funds, doubtless improving their long-term returns. Contractual and legislative provisions could protect against political meddling.

But choices are narrowing fast. The Great Inflation of the 1970s was ended only when then Fed Chairman Paul Volcker restored financial stability by forcing a painful repricing of the American economy. It took more than two years, but laid the groundwork for the high-growth era of the 1980s and 1990s. Or we could temporize as Japan chose to do – and slide into the assisted-living limbo of nations that have run out of energy and ideas.

Charles R. Morris is the author of “The Trillion-Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash,” due out next month. His earlier books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed and Risk.”