Posted 3/30/2010

THE GREAT RECESSION
and The Perfect Storm That Created It

The United States could collapse financially, losing its superpower status.

We are like a general who has been forced to commit his reserves to the front line to oppose an enemy breakthrough. His position is tenuous. If there is a second breakthrough, he has nothing left to fight it with.

President Obama has committed all our reserves (our capacity to use debt) to the current crisis. If there is a second crisis, we will have virtually nothing left to fight with.

A second major economic crisis would put us in the position of Great Britain in 1948, when a phone call from 10 Downing Street to the White House stated, "We have fought two world wars, endured a terrible depression and lost our empire. We are broke and are pulling back all over the world. From here on, it is up to you."

This is why it's so important to understand Senator Dodd's Financial Reform Bill, now being debated in Washington. A bad bill could do us in. A good one could save our future.

In order to prevent another Great Recession, we must first understand what caused the current problem. If we can understand the underlying causes, we can prepare effective financial reforms.

This column will attempt to explain in clear terms that which is too often left to finger pointing and pleadings of "complexity."

No person or political party was innocent. We were all guilty of helping construct the Great Recession, which was caused by a perfect storm of seven factors which started building in the 1990s.

1. The Consumer Sector indulged in

• Growing debt and reducing savings
• Exuberant spending
• Using home equity like credit cards
• Buying larger houses
• Artificially stretching stagnant incomes
• Leaving no reserves for emergencies and few for retirement
• Expanding the home price/income ratio from 2½ to 4
• Defaulting on the way to the first payment (2006)
• Buying "aspirational" products with flat incomes

Our desire to acquire ever more luxurious goods, from houses to groceries, while earning 20th century incomes moved us to the brink of debt disaster. Any down cycle in the economy would harm both the poor and the middle class. The rise of costly bottled water was an indicator of the spending foolishness of the age. More important was the spectacular growth of financially unsound mortgages.

2. The Mortgage Boom resulted from

• The Federal Government pushing home ownership
• The banks complying by drastically lowering lending standards
  • Sub-prime mortgages & auto loans
  • "Liars' mortgages" (no income verification)
  • "Ninja mortgages" (interest only, no job verification)
  • Adjustable rate Mortgages (ARMs)
  • Speculators accounting for 30% of home sales in many markets

These factors – multiplied by low personal savings, flat incomes, excessive home costs and adjustable rate mortgages – guaranteed the housing collapse. By 2006, 40% of mortgages were sub-prime and 80% of those were ARMs. This means that ARMs became, in effect, "balloon" mortgages.

3. Mortgages and loan forms became securities

• Banks created CMOs, or collateralized mortgage obligations
• CBOs (bonds), CDOs (debt), CLOs (loans) soon followed
• Banks packaged their loan products into securities
• Banks sold these securities worldwide to increase fees and lending
• Mortgage brokers sprang up everywhere
• Mortgage-backed securities were sold all over the world
• Everyone in the mortgage supply chain made money
• A real estate fever gripped the country and much of the world

Early in the process, the disaster could have been lessened by the action of the three rating agencies: Moody's, Standard & Poors, and Fitch. If these agencies would have labeled securities backed by bad loans as "junk" or "C," fewer institutions, governments and people would have bought the securities, which would have reduced housing sales volume – and the size of the resulting collapses of the housing and financial markets.

But did the rating agencies do their jobs?

4. Moody's, S&P and Fitch seemed to put profits ahead of integrity by refusing to bite the hands that fed them.

• Key flaw: The rating agencies are paid by securities issuers
• The issuers pressured agencies into unjustifiably high ratings
• Rating agencies' actions drastically increased risk
• Rating agencies mistakenly applied a poor statistical formula to the ratings computation process
• The flawed statistical method further elevated ratings
• Example: Credit Suisse lost $150 million on an Aaa security of $348 million
• Junk securities became "investment grade"
• Securities buyers had little inkling they were getting junk

The regulators were not aware of the global power of the rating agencies.

• Moody's and Fitch control the credit ratings of 200 nations
• Moody's blocked President Bush's attempt to pressure China on currency issues in 2003
• In 1995, Moody's criticized Canada, causing world turmoil
• In 2010, Fitch downgraded Portugal, hurting the Euro
• In 2010, Moody's threatens Greece's credit rating, hurting the Euro
• In 2010, Moody's threatens the U.S. credit rating, which would damage the dollar and the U.S. budget by raising borrowing costs

The rating agencies, whose inflated ratings contributed to the Great Recession, now threaten the credit ratings and budgets of nations which fell victim to the inflated security ratings.

5. The Federal Reserve drove interest rates down to zero (Greenspan, Bernanke), which caused bonds and savings accounts to become worthless as income producers. The results:

• Investors and institutions demanded replacement products
• Wall Street geniuses responded with high-risk new products
• Wall Street expanded older high-risk products
• Hedge funds grew astronomically
• Derivatives expanded in volume and kind
• Cheap U.S. money drew huge foreign fund in-flows
• Banks, operating on edge, expanded the short-term lending format known as "repos" (repurchase agreements)
• Lehman snookered JPMorgan out of $3 billion with the "Fenway" repo which, according to Morgan, "was practically worthless"

The interest rate policy of the Federal Reserve has a huge dark side. It forces conservative savers and investors to seek income from higher-risk securities. By March 2010, junk bond sales had begun to rise again.

6. The Security and Exchange Commission became dormant.

• Major financial areas escaped regulation – Hedge Funds
• There was "look the other way" activity – Bernie Madoff
• There was much lack of product understanding – credit default swaps

There was so little understanding of what the term "credit default swap" meant that the New York Times and Wall Street Journal both wrote that AIG's insurance units were profitable during the period of the big insurer's collapse. Yet AIG was losing its shirt in its massive credit default swaps business, which is made up of insurance policies which transfer risk from the holder of bonds (or other securities) to the issuer of swaps, the insurer. AIG fell because it got greedy over collecting lush fees from the holders of securities which were bound for failure from the day the first sub-prime mortgages and loans were issued.

According to Moody's, "junk" securities are professionally known as "highly speculative" securities, which "have questionable credit quality." "C rated" securities are "the lowest rated class of bonds and are typically in default" and "potential recovery values are low," according to Moody's.

7. Lehman Bros. collapsed, sending shock waves around the world.

• Financial markets froze up
• Bankers, fearful of the quality of their reserves, hoarded money
• Financial panic quickly went global
• Bankers refused to lend to each other (a $20 trillion market)
  • "I can't trust the securities we own."
  • "I can't trust the other guy's security, either."
  • "I cannot lend money that will not be paid back."
  • "I don't want to be the last man standing (holding the toxic bag)."
• The crises radiated worldwide, causing the global financial crisis

The Great Recession commenced.

• Consumer morale was destroyed as the stock market and housing crashes slaughtered personal net worth
• The U.S. consumer-driven economy stopped spending
• Business morale collapsed due to absence of customers
• Unemployment reached 10%
• Underemployment brought the employment problem to 17%

* * * * *

In order to prevent a second Great Recession, we must enact legislation which prevents the actions which caused the first Great Recession. And we must do away with age-old beliefs. For example, the country does not become better off force-feeding everyone into home ownership.

There is a positive economic value in having multiple housing opportunities available to the American society. Multi-generational housing design and development is a necessity, now that six percent of the population are forced by economic conditions to live that way. As long-term care becomes increasingly unaffordable to a rapidly aging population, we should be developing multi-family homes for seniors which have a combination of private and public rooms. Seniors are already beginning to live that way to reduce living costs.

But most important, we must regulate – and restrict, if necessary – the development and promotion of financial products which can threaten the well-being of the American society.

Man's intense motive of economic greed cannot be allowed to flourish by putting the people and the nation at risk. Adam Smith, the philosophical founder of capitalism, wrote "You must never allow the reins of government to fall into the hands of the mean and rapacious merchant." This was harsh language in 19th century Victorian England. It applies to the United States today, since the reins of financial government appear to have fallen into the hands of the "mean and rapacious" Wall Streeter.

The expressions "too big to fail" and "bail out" clearly mean that our government has effectively transferred financial risk away from the speculators and placed it squarely on the heads of the American people. No bank should be "too big to fail." Only the U.S. government should be too big to fail.

Keep an eye on Senator Dodd's proposals as they are discussed. Carefully watch to see who the "reforms" are designed to protect – bankers over people? Wall Street over Main Street? Bonuses over jobs?

Remember, an ounce of prevention is worth a thousand cures.

Especially if we cannot afford the cures the next time around.

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