Last year may very well go into history as the year most everybody wants to forget. What started in 2007 as a seemingly obscure set of problems in the arena of sub-prime mortgage lending morphed into a much larger banking crisis that culminated in the now infamous $800 billion banking sector bailout request to Congress last September. Along the way, another equally threatening crisis emerged, with the cost of fuel running amok during the summer, but then rapidly fading during the fourth quarter of the year.
But the crisis of the financial services industry ended up inviting a much larger problem, a massive decline in real estate values, combined with a major retreat of stock markets, not just in America but around the world. Through the fog, it is sometimes difficult to separate one crisis from another, let alone get a fix on what caused one crisis and what exactly triggered the next.
Everybody agrees that this crisis is really big, and that it is a real challenge. But how big is the crisis? Is it $800 billion? Will a stimulus package of $700 billion fix the problem? After all, during the summer of 2008, every family in the country got a stimulus check from the Federal Government and whatever it did, it did not stimulate the economy!
So, let's start at the beginning and try to get a fix on how big the total group of embedded crises really is. We'll take a five-year look at real estate markets, at the stock market and at the bailout numbers for the financial services industry. We will look at these three interconnected crises through the prism of the American middle class, that rapidly shrinking sector of society that seems to be hardest hit by the crises that are all around us right now.
I. Real Estate Markets
Our first stop is at the U.S. Bureau of Economic Analysis in Washington, DC., an organization that maintains detailed records on real estate market values. Capturing data from this source, Exhibit One shows trends in the three most relevant parameters of the residential real estate market, namely the aggregate market value of homes, the aggregate amount of mortgages owed on these properties, and the net aggregate equity held in those properties by U.S. households.
The exhibit shows the trend lines from 2003 to 2008. For years, market values have risen steadily, but from 2006 onward, market values started to slide. With mortgages staying at the same or slightly higher levels, this combination of trends morphs into a serious decline in the aggregate net equity values that U.S. households have in their homes.
Even today, there is still significant excess inventory in the stock of residential homes throughout the country, and it is not unreasonable to project another ten percent decline in those aggregate market values before residential housing markets reach a new equilibrium. In all likelihood, this re-balancing will play itself out in 2009. Why is this decline important?
Traditionally, households have looked at the equity in their homes as an economic cushion, an invisible savings account that provides security for the long term. During the last five years, many families had started to borrow against that security cushion. Egged on through aggressive advertising by the very financial institutions that are now in trouble, families borrowed against the value of their homes in the form of lines of credit or home equity loans. With market values in retreat, and their perceived equity cut in half, families' appetite for borrowing against their home equity has come to an abrupt halt. The aggregate value of this net loss for U.S. households amounts to approximately $4.3 trillion.
II. Stock Markets
Our next stop is at the stock markets, where another dimension of the financial crisis of 2008 is playing itself out. Beyond the widely published indices, it is difficult to measure exactly how much money investors have actually lost in the stock market as a result of the markets turning bearish throughout the year. But there are some reliable sources in the private sector that shed light on at least part of the problem. One such source is the Investment Company Institute, a trade organization that monitors the mutual funds industry.
Capturing data published by this source, Exhibit Two provides a five year perspective on the combined net assets held by mutual funds, exchange traded funds and closed-end funds. This, after all, is where many middle class families park their savings for retirement and for a rainy day.
From 2003 to 2007, net assets under management grew at a steady pace. 2008 reversed this trend, with the total net assets held by this group of funds declining by a whopping $2.6 trillion!
III. Banking Bailout
Now is a good time to take a look at the third dimension of the crisis, the bankers’ bailout of 2008. In September of last year, Congress appropriated an amount of $800 billion earmarked to free a select group of financial institutions of the "toxic assets" they had so eagerly sold to buyers around the world. Look at this Bailout as the "Largest Product Recall" in the history of mankind, with the exception that this is not about traditional products such as automobiles, but about financial instruments such as "mortgage-backed securities".
Another big difference is that product recalls usually are funded from the coffers of the industries that created the problem in the first place. In the case of the Bankers, it was the American taxpayer (U.S. Households) to the rescue. How do we get a fix on the scope of this problem? The official website of the U.S. Federal Reserve provides a glimpse at the size of the bailout.
Capturing data extracted from the Federal Reserve's official website, Exhibit Three provides a five-year perspective on the Reserve's liabilities. From 2003 to 2007, its total liabilities steadily increased by 3-5% per year.
But then comes the last quarter of 2008. During the last three months of 2008, the Federal Reserve managed to increase its liabilities three-fold, an unprecedented increase to a whopping $2.2 trillion!
Without the slightest hesitation it can be said that such an increase has never happened before in the history of the Federal Reserve. The money is earmarked for a bailout of the likes of AIG, Bear Stearns, J.P. Morgan, et al. Where did these new liabilities come from? The bulk of these new liabilities came from the U.S. Treasury and from other sources, predominantly foreign.
First of all, the new amounts of debt created here are much larger than the publicly acknowledged $800 billion bailout money requested from Congress immediately after Labor Day. Granted, the moneys are used in part to acquire preferred equity in the companies that need to be bailed out. If things go perfectly right, some day these preferred equity positions may be worth something. But for now, I cannot help but think that it looks suspiciously like borrowing short term to pay off toxic obligations that are worthless regardless of economic recovery in the near future.
In other words, sooner or later, a large chunk of these newly created liabilities may end up as debt held by the public (the same U.S. Households that have already been whacked twice). And if the government decides to get cranking with the printing presses – a scenario closer to reality than we might think today – U.S. Households will pay through inflation.
A $9 trillion problem
In review, Exhibit Four summarizes the results of this brief inquiry into the financial crisis of 2008:
Our inquiry results in a finding that the Crisis of 2008 amounts to approximately $9.0 trillion. Yes, Nellie, that is a lot of money, but how much, really? Here are some comparisons to give you a sense of how much $ 9.0 trillion really is:
- It is almost as much as all of last year's aggregate disposable income of $10.5 trillion;
- It is 180 times the size of the Madoff Scandal, estimated at $50.0 billion;
- It is 450 times the cost of Boston's much maligned Big Dig, which was approximately $16.0 billion (spread out over a period of ten years!);
- It is three times the total lifetime costs associated with the War in Iraq.
With all this wealth either disappearing or debt being added to the already sizable public debt, it is no wonder the American consumer went on strike this Christmas! Now, in its on-going effort to deal with the crisis, the Federal Reserve did something else that is unprecedented, it lowered the discount rate charges to almost ZERO, as shown in Exhibit Five:
The discount interest rate is the rate charged to "eligible" depository Institutions. The purpose of this lower interest rate is to allow banks to lower the rate they charge their customers such as U.S. Households. But U.S. Households are not borrowing. Why?
Well, beyond the numbers – however staggering in their dimensions – there is something else happening that helps explain the nature of the problem. During 2008, something very important happened to the intricate web of business dealings between the public (U.S. households), and their financial institutions, and that was the disappearance of TRUST!
U.S. households are not borrowing, not only because they saw the equity in their real estate evaporate, but also because they are not sure what tomorrow will bring. Will the real estate market go even lower? It is very possible with the excess housing inventory still amounting to a full year of absorption. More importantly:
- Why should one trust the bankers who have so thoroughly discredited themselves?
- Why trust the politicians who have so thoroughly discredited themselves?
- Why trust the regulators and system supervisors (i.e. The Securities and Exchange Commission et al.), who have so thoroughly discredited themselves?
What else may come out of the woodwork? Will we see a repeat of Hank Paulson on his knees again in front of Nancy Pelosi, pleading for yet another $800 billion taxpayer-funded bailout without strings attached?
The lack of trust is a reflection of the crisis of leadership, leadership at the highest echelons of society. For the last two decades a model of capitalism was created based on theories and dogmas that are now thoroughly discredited. A new model is needed, a model that brings the middle class back to center stage, the engine of prosperity for the next generations.
The immediate question of course, is: what to do about this crisis and how to resolve it without throwing the entire world into a tailspin. News reports suggest that the new administration is thinking of a stimulus package in the range of $800 billion over two years. Of course, these additional amounts are not included in the above table. Also, they expect government deficits of $1 trillion per year for the foreseeable future.
America's New Deal with Capitalism
In the second part of this two-part series, I will address this question and suggest a "rescue plan" for the American Middle Class. It is about America's New Deal with Capitalism.
For now, we have learned that we are dealing with a $9 trillion problem and that without a major effort to restore TRUST among the various constituents of the American economic system, nothing will work to fix it.