For the securities industry to unravel as spectacularly as it did in September, many parties had to pull on many threads. Mortgage bankers gave loans to Americans for homes they could not afford, often based on inflated house appraisals and no documentation of income or assets. Mortgage bankers immediately transferred these mortgage loans to Fannie Mae or Freddie Mac, who packaged them into debt securities for sale to institutions. Investment houses also gathered in the mortgage loans, repackaging them into complex debt instruments whose risk they didn’t always understand. Rating agencies gave their seal of approval, investors (many of them hedge funds) borrowed heavily to buy them, and regulators ignored the warning signs.
Efforts to reign in Fannie and Freddie were blocked in the House and the Senate by powerful legislators. But at the center of it all — and paid hundreds of millions of dollars — were the five major investment banks: Bear Stearns, Lehman, Merrill Lynch, Morgan Stanley, and Goldman Sachs. These firms fed a market hungry for yield and ever higher returns with more and more unusual debt instruments. Wall Street’s function is to create supply to meet demand, and they fulfilled this function, as they always do. As it turned out, however, they were, in effect, dispensing the equivalent of high-octane financial steroids.
The first block to fall was Bear Stearns, the smallest of the five stand-alone investment banks. It sank within months after it was unable to price sub-prime mortgage instruments it had created and sold into hedge funds it had set up and managed. In March 2008, the government brokered the sale of Bear Stearns to J. P. Morgan Chase, giving Chase a guarantee that it would be made whole on most of the sub-prime instruments it held.
After the Bear Stearns brush with death, the Federal Reserve, for the first time ever, allowed investment banks to borrow from the government on the same basis as commercial banks. Access to the discount window was thought to be a blank check that would insulate the remaining four investment banks from a similar fate. However, by allowing investment banks access to the discount window, it reduced the sense of urgency the banks had in facing their own sub-prime problems, and ultimately proved to be the camel’s nose in the tent.
Given such assurances, or implied assurance, that they were protected from failure, the surviving investment banks — Lehman, Merrill Lynch, Goldman Sachs, and Morgan Stanley — essentially continued on their merry way. Richard Fuld, CEO of Lehman, was quoted by the Wall Street Journal saying, “We have access to Fed Funds. We can’t fail.”
While they felt a sense of relief, however, the investment banks knew they had essentially the same problem on their books that torpedoed Bear Stearns. They began to total up their sub-prime mortgages, now distinctly soured. Merrill Lynch had $55 billion in sub-prime mortgage assets. Lehman wrote off a bunch of sub-prime mortgages in the second quarter, reporting its first loss in a quarter in 14 years. Lehman followed the report with an announcement that it was facing a worse loss in the third quarter: $4 billion.
The other investment banks started demanding increased collateral to trade with Lehman. Rating agencies announced they were considering downgrading Lehman debt. The Federal Reserve, in a secret meeting on Saturday, September 13, tried to get the other investment banks to come up with a plan to invest capital in Lehman, Ã la the Long Term Capital lifeboat in 1998. All refused, stating that they were facing massive sub-prime mortgage write-offs themselves. John Thain of Merrill Lynch said effectively that the same fate might happen to anyone of them, and who would be left to rescue the sole survivor?
At that point, it was every man — or every investment bank — for himself. According to the Wall Street Journal, that very weekend Thain negotiated the sale of Merrill to Bank of America. Goldman Sachs and Morgan Stanley fled into the arms of the government and became commercial banks. No large stand-alone investment banks remain in Wall Street today.
The quick unraveling of the sub-prime debt market brought a violent halt to the financial markets and slammed the door on all mortgage lending. Fear replaced complacency, and banks simply withdrew from all lending. Commercial banks would not even lend overnight fed funds to each other. The lynchpin of business financings, the commercial paper market, simply dissolved, virtually overnight. On Friday, September 19, the Federal Reserve announced a massive $700 billion bailout, TARP. The stock market cheered the event, with the DOW rising 650 points the next trading day. On Monday, September 29, the day the plan failed to pass in the House, it declined 771 points.
Banks started failing both in the United States and overseas. Washington Mutual and Wachovia were essentially forced into unwanted marriages. Several German banks went under. A large Belgian Dutch bank, Fortis, failed. All three Icelandic banks collapsed. Volatility in the stock market hit a record on October 18: The Treasury, Federal Reserve, and Federal Deposit Insurance Corporation joined in a massive effort to do CPR on an economy that came to a screeching halt in the fourth quarter.
So where does that leave the economy in early 2009? Unfortunately, if one looks at the raw data alone, it’s not a pretty picture. The final numbers for the third quarter GDP showed the economy contracting at a 0.5 percent rate. Turmoil in the financial markets, rising unemployment, and tight credit conditions were even more acute in the fourth quarter. This was starkly illustrated by the brutally weak data reported in November and December for new orders, retail sales, and employment. It is quite likely that the economy contracted at a severe 5 percent rate, or more, in the final quarter.
Ours is a consumer-led economy. Consumers accounts for about 70 percent of the total GDP, so their condition has a lot to say about how quickly we can pull out of this downturn. In the fourth quarter, consumers were hit by a perfect storm of negatives: Economists estimate that the consumer lost about $13 trillion in wealth between the decline in the equity value of homes and the decline in the stock market. Moreover, unemployment picked up in the quarter and now stands at 7.2 percent. Judging from initial jobless claims, which are rising, unemployment is going higher. We could see as much as another three months of negative job postings. Finally, income growth has stagnated of late. On an annual basis, personal incomes increased just 2.5 percent from November 2007 to November 2008.
There are certain common-sense things people do when they are worried about loss of jobs and an uncertain economy. For starters, they turn off the spending spigots. This was apparent from the reports of retail sales over Christmas. They certainly don’t buy a new car, and the $6 billion lifeline the government just threw at the automobile industry is not going to change that. And they pay down debt. Consumer credit actually declined in October and November, and probably December also.
While these things are often portrayed as negatives for our economy, over the long term they are in fact positives. They indicate a constructive return to spending within one’s means, to saving for the future, and to avoiding unnecessary purchases — things that have more to do with status or style than maintaining a healthy and sound lifestyle for their families. Thrift also sets the stage for recovery by reliquifying the consumer. This process already appears underway.
Housing is the other area of critical importance that was brought to its knees by the financial crisis and the tightness of credit. Both new and existing homes sales are as low as they have been for many years — though at least here it seems we may be nearing the bottom.
The inventory of new homes has declined to 372,000 units. This is bittersweet, in a sense, because it reflects mainly the collapse of residential construction, but it is necessary to clear up the inventory. The important point is that, from a GDP standpoint, the decline in residential construction has already had most of its negative impact on the GDP.
Sales of existing homes have also declined sharply, and are now as low as they have been since November 1997. The inventory has also been whittled down to about 4.2 million units. But winter isn’t the best time to get a picture of house sales, even using seasonally adjusted numbers; by late spring or early summer, the picture should be brighter. Affordability has clearly improved dramatically: The 30-year fixed-rate mortgage is about 5.01 percent, a rate we haven’t seen in many years. And the median price of a house has also declined substantially. It may take a little while and a more confident attitude by the consumer, but at some point in the not-too-distant future, house affordability today will be viewed as a bargain.
Other sectors of our vast economy — exports, manufacturing, business spending, construction — which previously had held up pretty well, all succumbed to the financial panic in the fourth quarter. The numbers are grim, but they’re abnormal — and meanwhile, they have obscured some positive trends.
Primarily, the consumer received a strong tailwind from the decline in gasoline prices. The decline in the price of gasoline from a peak of $4.17 per gallon in July to around $1.70 currently is the equivalent of a very large income tax cut — a cut for everyone who drives, not a so-called targeted cut. Economists have tried to quantify the effects of the reduced cost of gasoline in a number of ways. One interesting study done by Deutsche Bank economists estimated that each $1 decline in the price of gas is equivalent to a $100 billion change in household cash flow on an annual basis. To put this into perspective, $100 billion is approximately the amount of the tax rebate the Bush Administration enacted in the second quarter of 2008.
Another favorable factor is the outlook for inflation. The downturn has brought down the price of all commodities, and both core inflation and headline inflation are retreating rapidly. It is likely that this trend will persist for most, if not all, of 2009. Corporate America should benefit over time, as lower input costs work their way through the supply chain. There is a reasonable chance of the manufacturing sector reaching stability by the third quarter, especially since costs seem to be under strict control.
The Federal Reserve also benefits from current inflation trends. Monetary policy is clearly free from any consideration of fighting inflation, and the Treasury is benefitting from the flight to quality, which has brought interest rates on Treasury debt down dramatically. In fact, around year end, the discount bill out to about three months’ maturity carried a negative return, meaning that the investor was paying the Treasury a small premium to safeguard his or her money.
The big question, of course, is when do we pull out of this recession, and what are the conditions that will lead our economy to begin growing again?
We believe we are looking at the worst of the economic numbers now, in the first quarter. We will soon learn just how bad things became toward the end of last year. The reports will be ugly. As I mentioned earlier, business came virtually to a standstill in October and November. Unemployment will continue to increase, and this is an important influence on consumer attitudes, which are likely to remain edgy. Unemployment, however, is a lagging indicator, not a leading indicator.
Meanwhile, the raw material for an improvement in the economy is building:
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- Oil prices have declined about 76 percent in the last six months, creating a strong tailwind for consumers and businesses.
- Fiscal and monetary policy is extraordinarily aggressive. Both operate with a lag — some estimate about six months. Most of the monetary stimuli enacted in the fourth quarter are just now starting. For example, the new program by the Federal Reserve to purchase mortgage-backed securities directly from Fannie Mae and Freddie Mac in support of the housing market started recently. This program greatly expands the original one announced in late November and, according to the financial press, is being well received.
- Interest rates domestically are essentially zero, and are heading there around the world.
- Cash is plentiful. The $8.55 trillion held in cash, bank deposits, and money market funds is equal to about 75 percent of the market value of Standard and Poor’s 500 companies. Cash on the balance sheet of American corporations is also high and being hoarded. At some point the cash will start to be put to use.
- We anticipate new and expanded spending programs by the new administration, focused on infrastructure spending.
- Growth is the natural condition of the American economy. We often forget that we are blessed with a natural optimism and entrepreneurial spirit which is most evident in the large number of new business startups every year. Tax policy and the regulatory environment have been basically supportive of this intangible spirit.