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Entitlement
Generations
Living beyond
our means for too long is the primary reason we’re in such a
financial mess.
by:
Wes Ishmael |
Rain and prosperity are much the
same, according to the old saying: when you’ve got it, you can’t
imagine ever being without it; when you don’t, you begin to
doubt that it will ever blow your way again.
As you and your banker know by now, these are the most arid
economic times the United States has endured since the end of
World War II. Some, with more than reasonable cause, claim it’s
as bad as or worse than the Great Depression of the 1930’s.
For perspective, a widely accepted definition for economic
recession is when the economy experiences two consecutive
quarters of negative growth in Gross Domestic Product (GDP).
According to the Federal Reserve Bank of Minneapolis, there have
been 10 economic recessions in this country since the second
Great War, lasting from six months to 16, averaging about 10.5
months.
According to the Business Cycle Dating Committee—yes, there is a
committee for everything—at the National Bureau of Economic
Research, this current one began in December of 2007. So, we’re
already charting new territory.
What makes this current financial crisis more painful, if you’re
brave enough to admit it, is that each of us is to blame. Yep,
every single one of us who drew a check for at least the past
two decades.
Even if our personal balance sheets are in order, albeit
lighter, we share the blame for allowing laws and financial
institutions to sow the seeds of economic destruction.
Hubris and Ignorance
If you doubt individual culpability, consider this:
National debt increased about 7.9% per year from 1980 to 2008,
growing from approximately $909 billion to more than $10
trillion.
During the same period of time, Gross Domestic Product (GNP)
grew at an annual rate of 5.7%.
The federal government’s share of national debt was projected to
be $4.22 trillion at the end of 2008; it was about $197 billion
in 1980.
Consumer debt was about $350.5 billion in January of 1980; it
was $2.54 trillion in August last year.
The consumer savings rate was 11.2% of disposable income in
1982; it was 0.4% by the end of 2007, or 40 cents for every $100
of disposable income.
For reference, 1 billion equals 1,000 million; 1 trillion equals
1,000 billion.
“The majority of Americans—from individual citizens to
governments—have been living beyond their means for decades,”
says Vincent Amanor-Boadu, an agricultural economist with Kansas
State University. He authored the most insightful,
straightforward analysis of the situation that you’re likely to
find, which includes the statistics cited above.
It’s hard to ignore such a spending orgy, at least in the
beginning. Since then, we got too used to it to recognize it for
what it was.
Even if you never borrowed to pay Paul, or to buy a ticket to
his must-attend party, it’s equally hard to ignore the fact that
we all benefited from the spending binge, the associated easy
credit and subsequent advances in living standards.
The Perfect Storm comes Home
Along the way, we figured anything that supported the party was
surely fine.
“Well-intentioned but flawed policy decisions, irrational
confidence of finance industry personnel in their own brilliance
and cheap credit that influenced unrealistic expectations about
prosperity over nearly three decades created the environment for
the economic crisis now at play,” believes Amanor-Boadu.
As for the flawed policies that were aimed at the positive,
Amanor-Boadu points to home ownership—the American Dream. In
order to make the reality possible for more Americans, the
government did things like create Fannie Mae and Freddie Mac.
Amanor-Boadu explains these government-backed lending
institutions were created to broaden and ensure liquidity in the
primary mortgage market. They accomplish that by purchasing
mortgages from primary lenders. In other words, if you’re a
lender with only $100 to lend you can accommodate only as many
borrowers as that balance supports. On the other hand, if you
know you can sell that note to someone else—Freddie Mac and
Fannie Mae—then you can lend knowing that you’ll have more money
to lend to more people.
That’s one of the flaws, as it turns out. If primary lenders had
only $100 to lend, you can bet they’d make doubly sure whoever
borrowed it was capable of paying it back. Since they knew there
was a market for the loan, there was no incentive for them to
minimize lending risk because they could easily sell the risk to
one of the federal institutions.
Freddie Mac and Fannie May, in turn package the mortgages
they’ve purchased and sell them to investors as mortgage-backed
securities. By September of last year, Amanor-Boadu says the two
institutions held or guaranteed about half of the nation’s $12
trillion mortgage market.
That’s another flaw. By their design and the public policy
behind them, these chief secondary lenders are in business to
help folks who might not be able to secure home financing from a
primary lender.
Hello sub-prime lending, which enabled primary lenders to
originate loans with features that Amanor-Boadu says were
previously prohibited by individual states. Think here of
features like adjustable interest rates on mortgages and balloon
payments.
These new tools allowed mortgage banks and brokers to grow their
pool of borrower prospects exponentially. But, there had to be
more and more money to lend; liquidity had to keep pace. More
investors entered the market to buy mortgage-backed securities,
be they of the prime or sub-prime variety.
Escalating home values served as both the chicken and egg. As
easier consumer credit access fueled demand, home values
continued to rise, one lie feeding another.
Buyers of mortgage-backed securities aren’t riverboat gamblers,
though. They wanted a way to manage their risk. Enter something
called a Credit Default Swap (CDS). It’s kind of like insurance.
Buyers of these securities would pay a hefty premium to folks
like the now infamous AIG to indemnify them if their
mortgage-backed security turned sour.
According to Amanor-Boadu there are four primary risks
associated with mortgage-backed securities: interest rate,
credit default, prepayment, and prices of the homes
collateralizing the mortgage.
Now, these CDSs sound straightforward enough, except the
insurers traded them like you do futures, with massive amounts
of leverage. They achieved that by selling insurance for the
same mortgage-backed security to lots of speculators, who were
betting the borrower would default, meaning that the buyer of
the insurance would collect the settlement just like the guy who
actually owned the security.
It’s a lot like letting anyone with enough money buy total-loss
insurance on one pickup. If nothing ever happens to the pickup,
the insurer collects multiple premiums and never has to pay out
anything. If that one pickup gets totaled, though, the insurer
is liable to pay its value to lots of people who never turned
the key in the ignition.
Unlike futures market transactions, this is not a zero-sum game;
there is no requirement for every position taken in the market
to be offset by an equal and opposite position.
Plus, Amanor-Boadu explains Credit Default Swaps are not
regulated. There was no oversight or rules demanding CDS issuers
maintain a certain equity or leverage level, for instance.
Some of the biggest players selling CDSs were insurance
companies like AIG, but most were banks like Lehman Brothers and
Bears Stearns. By the end of 2007, Bears Stearns had a whopping
leverage ratio of 33.5 X, says Amanor-Boadu. The notional value
of the financial derivative contracts issued by Bears Stearns
was $13.4 trillion in November of 2007. They went belly-up in
March last year.
Keep in mind, CDSs aren’t some new, arcane financial instrument.
Amanor-Boadu cites a 2006 British Bankers Association report
underscoring the fact that CDSs were the most widely traded
credit derivative product. Since CDSs are an un-regulated,
over-the-counter product, there’s no concrete way to assess
volume. However, Amanor-Boadu points to the Bank for
International Settlements, which estimated the notional amount
of outstanding CDSs worldwide at $46.2 trillion in June of 2007,
up 47% within six months.
This massively leveraged house of cards came unwound when home
prices began to slide, more home-mortgage borrowers went
delinquent or defaulted on loans they couldn’t afford, and CDS
sellers had to make good on more and more claims.
Amanor-Boadu summarizes, “First, policy makers, in their desire
to create a prosperous society, created an expectation that
economic progress could be measured by home ownership and they
worked hard to make sure that the number of Americans,
regardless of their economic conditions, living in their own
homes was increasing. They did this through legislation,
mandates and monetary policies that created cheap credit. As
economic growth slowed, lenders had to become ingenious in their
lending practices, leading to the aggressive application of
sub-prime mortgages and the use of such devices as adjustable
rate mortgages. The reduction in credit standards that
accompanied these practices would ordinarily trigger concerns
about risk, however, because the mortgage lenders sold their
sub-prime loans to investment banks that packaged and repackaged
them into multi-tiered collateralized debt obligations, these
normal concerns were overlooked or ignored.
“To protect themselves from potential default risks, issuers of
mortgage backed securities entered into Credit Default Swaps
contracts with other banks, financing these obligations with
leveraged assets. When the home values started plunging and
mortgage defaults started increasing, the parties to the credit
default swaps started making claims which had swollen
tremendously because of the leverage activities of the banks. As
investors and lenders became aware of the financial challenges
of the participants in CDS and other hedge funds, they stopped
buying their securities, and as the banks became conscious of
the uncertainty of their own exposures, they stopped lending to
each other. This created the liquidity freeze.”
Equal Opportunity Misery
All of that is merely the credit aspect of our ruinous tale, the
linchpin around which domestic and international credit
disintegrated faster and more completely than confetti in a hail
storm.
Just ahead of it, making it tougher for folks to pay their
mortgages, commodity prices ballooned to historical proportions
like sun-ripened road kill, and then they burst (see Popping
Perceptions, page 18). When the commodity bubble exploded
speculators lost their shirts, making their portfolios more
vulnerable to the looming credit crisis that few saw coming.
Incidentally, you can bemoan the fact that speculators are
allowed to play in the commodities futures markets. If you do,
also realize that if speculators weren’t allowed, fewer
producers could transfer their price risk to someone else. After
all, for every seller in these markets, there must be a buyer,
and visa versa.
During this same period of time home and real estate values were
deteriorating, something plenty of folks never seemed to think
could happen ever again.
“Data from the Case-Shiller home price index show that in a
dozen states, including the District of Columbia and Hawaii, and
seven metropolitan areas, home prices increased in excess of 80
percent between 1998 and 2006,” says Amanor-Boadu. “These trends
influenced the mortgage lending and borrowing decisions from the
late 1990s through the middle of the 2000s. However, the price
response led to excess supply and by mid 2005, the housing
market was beginning to soften rapidly. Declining home prices
coincided with the end of the moratorium on interest-only
mortgages and the upward adjustment of adjustable rate
mortgages, leading to payment shock and negative amortization
and a spike in mortgage delinquency rates.”
Though key cogs in current financial misery, the commodity
bubble and collapse of the housing market exacerbated the
circumstances, perhaps even accelerated our economic clunker to
the precipice, but it was the seizure of credit markets than
pushed us over.
None of this is an American phenomenon; it couldn’t be in a
global marketplace. Virtually all nations and all industries
around the world are embroiled in economic recession.
Because everyone is sucking dregs at the same time, and because
it was a financial crisis precipitating the event, it’s doubly
tough to make sense of when and where bottom is, or when and if
the economic stimulus packages of global governments will do
much to speed recovery.
Predicting Recovery
In a May presentation to the Haas Business School at the
University of California, Berkley, Janet Yellen, President and
CEO of the Federal Reserve Bank of San Francisco explained,
“…recessions caused by financial crises are generally followed
by more measured upswings (than those caused by non-financial
crises). In addition, when recessions occur in many regions
simultaneously, recoveries are slower than when downturns are
confined to just a few countries. Now we have a double whammy—a
highly synchronized global recession and a financial crisis.
That’s a daunting combination.”
You can find analysts who believe the nation’s economy has
already hit bottom. They point to such indicators as late spring
gains in the Dow Jones Average, inventory reductions and the
fact that Case-Shiller Housing Index, though significantly lower
than last year is at least not declining as fast.
You can also find those convinced that what we’re living through
currently is merely a harbinger of the real pain to come. Some
in that camp point to unemployment that continues to escalate,
the sheer depth of personal and national debt, and their belief
that there are too many risks of further economic upheaval for
none to occur.
Bill Helming , a long-time respected economist and business
consultant at Olathe, KS is one in that camp.
“The U.S. and much of the world as we have known it
economically, politically, socially and spiritually has
fundamentally changed and will be very different in the near and
long-term future, compared to the past 80 years, especially
compared to the 1990-2007 time period,” says Helming. “From an
economic standpoint, the U.S. economy will not be able to return
to what we experienced in the last 17 years (the 1990-2007 time
period), relative to economic growth, increasing consumer
incomes, increased spending, borrowing our way to prosperity,
living beyond our means and rising home, commercial and
farm-ranch real estate, commodity and stock market values. Those
days are gone for at least the next 8-12 years.”
Helming expects the worst of the current recession to unfold
between 2010 and 2013. Reasons he cites include: “1) significant
further bank, insurance company and lender balance sheet
liquidity problems; 2) massive and continued private debt
de-leveraging, write-offs and write-downs; 3) further declines
in home values; 4) major increases in home mortgage jumbo loan
delinquencies, plus those millions of home owners wanting to
sell their homes, resulting in a significantly larger supply
(inventory) of homes being placed on the market over the next
several years; 5) continued and serious declines in commercial
and retail real estate values, and increased delinquencies over
the next 5-7 years; 6) the impact of Baby Boomers reducing
spending, increasing savings and downsizing significantly over
the next 10-15 years; 7)banks and insurance companies not
lending or able to lend moving forward anywhere close to what we
experienced in the past 15-20 years (a major decline in the rate
of credit growth over the next 8-12 years, compared to
1990-2007); 8) major price and asset deflationary forces over at
least the next 3-5 years.”
“The sobering reality is that the standard of living will be
declining for a growing and large number of Americans moving
forward over the next 10 years,” says Helming.
“The pending U.S. economic recovery will be L-shaped, rather
then V-shaped,” Helming says. “The average annual rate of GNP
growth in the U.S. was 3.3% per year from 1957 to 2007. The
average annual rate of GNP growth was 1.3% in the 10 years of
1930-1939—the last Depression.” He believes the annual rate of
GNP growth will be 1.5-2.0% at best for 2008-2020.
In fact, Helming believes the beef industry is at the threshold
of producing a higher percentage of ground beef out of economic
necessity (See Hamburgers are Us). He envisions an industry that
will produce more non-fed, half-fed and grass-fed cattle than in
the past.
Yellen’s perspective, lies between the most pessimistic and
optimistic. “I see the economy as vulnerable to a number of
downside risks, including the possibility of another disruptive
financial event—another shoe dropping, if you will,” said Yellen.
“Commercial real estate is an area that seems vulnerable.
Nonresidential construction declined sharply in the first
quarter as business activity slowed; new buildings came on line;
vacancy rates on office, industrial, and retail space rose; and
property values fell. For developers, financing is extremely
hard to get…”
Bottom line, Yellen said, “I expect the U.S. recovery to be
frustratingly tepid once it does get started. It likely will
take several more years to bring unemployment back to its
long-run equilibrium value.”
The reality, of course is that no one knows for sure whether the
worst has passed or is yet to come. What does seem certain is
that we’re the folks who got us here.
Somewhere along the line, the American Dream was replaced by a
sense of American Entitlement, says Amanor-Boadu, the belief
that prosperity would increase infinitely and that it was our
right.
For Amanor-Boadu’s paper, see
www.agmanager.info.
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