By Logan Scisco
In August the economic crisis fuelled by the growing worldwide credit bubble was finally set in motion. Extempers have been focusing on this growing credit bubble for years and some of the readers of this brief might have already given a speech about credit conditions in the United States economy. These speeches most likely focused on America’s housing market, which has boomed over the last several years. However, this housing boom was built on a risky foundation of adjustable rate mortgages and subprime loans. Public forum debaters who also do extemp may also be familiar with the credit conditions in the United States due to a March resolution concerning the limitation of credit last season.
The recent credit meltdown in the United States economy has been felt across the world. It has been fuelled by a rise in home foreclosures and a hesitation by lenders to keep funneling money into economic institutions. Tightened credit standards have started to restrict the flow of money into the economy and financial markets, which have been boosted for the last several years on the free flow of money for investment and business acquisitions, have been jolted.
The credit crisis that is unfolding is something that extempers should start reading about soon. Understanding the complexity of hedge funds, pension funds, private equity firms, and the lending practices done by banks can be difficult, especially for beginning extempers. However, the more reading extempers do on these topics the more familiar with them they will be. Knowing about the workings of these different economic areas can help extempers feel confident about economic rounds and will also help them understand the current credit crunch.
Due to the fact that a presidential election is on the horizon, the U.S. economy is bound to play a role. How big a role it will play, though, will depend on how the economy is performing as we near November 2008. The economy under George W. Bush has grown at a continual rate of three percent but it has been criticized for leaving working class Americans behind. Furthermore, the credit crunch at the moment is prompting calls for the federal government to intervene in the economy and help those homeowners who are facing foreclosure. Therefore, knowing more about the current credit crunch can aid in your knowledge of how the 2008 presidential election will play out.
This credit crunch topic is also important for extempers because it is the first economic crisis that Federal Reserve Chairman Ben Bernanke has had to confront. How he handles this first crisis will determine how markets will perceive his leadership and will also go a long way towards defining his legacy at the Federal Reserve.
Due to the reasons mentioned above I felt that it was important to dedicate one of the extemp briefs for September to this credit crisis. Within this brief extempers will learn how the current crisis developed, Bernanke’s leadership of the crisis, and the economic fallout of the current crisis on the United States and the global economy.
How the Crisis Developed
Shortly after President George W. Bush took office the U.S. economy was reeling. The Clinton years were an era of great economic growth but that was fading by the end of Clinton’s term in the White House. Federal Reserve Chairman Alan Greenspan was blamed for not lowering interest rates when the economy began to slow and as a result a recession gripped the economy from 2001 to 2002. During this period of time the Federal Reserve under Greenspan made it a habit of continually cutting interest rates in each of the Federal Reserve’s monthly meetings.
It is important for extempers to realize how low interest rates effect economic growth. Low interest rates allow people and business entities to borrow cheaper from lending institutions such as banks. Due to the lower cost of having to borrow, people and businesses are encouraged to take out loans and put that money into the economy through spending or investment which goes on to fuel economic growth. During times of economic hardship the Federal Reserve will cut interest rates to encourage spending and investment in the economy. However, during times of economic prosperity the Federal Reserve will raise interest rates so that the economy does not overheat. This is because if there is too much money in the economy it can lead to inflation, or a general increase in prices. Therefore, raising interest rates by the Federal Reserve helps to take money out of the economy by encouraging people to save and making borrowing more costly and helps to keep economic growth from getting out of control.
Keeping the above lesson in mind, when the Federal Reserve lowered interest rates it encouraged businesses and consumers to take out loans and put it into the economy. Looking at low rates of interest, some businesses took out money to buy other companies and expand their enterprises. Furthermore, private equity firms, firms that buy companies that are underperforming and improve them before eventually selling them back off for a profit, took out massive loans to finance the takeover of companies across the world. The last several years has seen a rise of these takeovers which have been criticized in nations like Germany, where a government official once criticized private companies as “locusts” that were stripping German firms bare without any care for their workers. It is also worth noting that Chrysler, the struggling American car manufacturer, recently completed a $7.4 billion sale worth eighty percent of its company to Cerberus Capital Management which is a private equity firm.
On the consumer front, aspiring homeowners across America saw the low rates of interest as a sign that they could afford to take out loans and buy a home. However, they were joined in their ranks by market speculators who used the easy credit from banks to buy homes for minimum value and then sell them for a massive profit. This speculation assisted in the rapidly rising house prices that gripped the American market for much of the last few years. Most importantly, there was a rise in the business of sub-prime mortgage companies. These companies gave out sub-prime loans, which are loans given to those with a very high credit risk. Many of these sub-prime mortgage companies were financed by investment banks, institutions that help businesses raise money through the issuing and selling of securities, which are instruments of debt (often through items such as bonds). Investment banks then took on the debt of the sub-prime loans from the sub-prime mortgage companies and packaged them into bonds. The Los Angeles Times alleges that investment banks went to great lengths to persuade credit agencies to give these bonds a high credit rating while ignoring the large credit risk that existed within them, mostly that the people taking out these sub-prime loans would not pay them back. When the high credit ratings were established, the investment banks then sold the bonds to investors who were looking for high yields, or returns, on their investments. Non-investment banks were also accused of predatory lending practices towards those who were high credit risks. Banks issued so-called “ninja loans” where people were lent money regardless of whether they could prove their income or assets. In addition to this, regular homeowners often refinanced their homes at generous rates of interest and used that money to buy consumer items such as cars or to finance home repairs.
As you can see above, there were many effects of the historically low interest rates felt throughout the economy. However, there were many risks that were built into this period of generous credit. First, house prices rose to considerable levels which started to price out first time home buyers as well as other segments of the working class. In fact, this rise in prices led to economists to conclude that America was experience a “housing bubble” as speculators of houses admitted that they were buying and selling homes in the belief that prices would continue to rise, the exact definition what a bubble is. This housing bubble also fuelled a construction boom as people were taking out loans and financing home building projects. Therefore, a huge risk in the system began to emerge about what would happen when prices began to slide and speculators and investors who were tied into hedge fund companies and construction companies would have to take on financial losses. A second risk that quickly emerged is that people took out mortgages from banks at adjustable rates of interest. This meant that after a given period of time the interest rate on their mortgages would rise. The risk here was when the interest rates rose on their mortgages these homeowners would feel the pain of more payments. There was also the risk that their interest rates could rise further if the Federal Reserve raised interest rates, which is what began to happen when the Federal Reserve grew concerned about this credit bubble and also grew concerned about inflationary fears in the economy. Finally, companies were using low levels of credit to finance acquisitions of other companies and there was speculation as to what effect on economic growth a restriction of credit would have.
Several months ago, banks across the world began to become wary of the amount of credit risk they were taking on by giving money to private-equity firms and giving mortgages to individuals that possessed a high level of risk. This anxiety reached a peak when two Bear Stearns hedge funds were nearly bankrupt by the large default of 2006 sub-prime loans which were tied into collateralized-debt obligations (CDOs). CDOs are a bundling together of risky assets by banks. The ensuing pull back of liquidity in the market, which means a pull back of the amount of money in the market, has led us to the current credit crunch and firms are backing out of deals they thought they could have made in times of easier credit. Furthermore, home foreclosures are on the rise as adjustable rate mortgages have burdened Americans and they cannot make the payments on their homes. These foreclosures have not only burdened homeowners but also represent a lost investment for banks and many do not want to go anywhere near the housing market now. Also, those banks and investors who are holding sub-prime mortgage securities are trying to sell them off as they have become a highly toxic asset to have. These sell offs are what has fueled the rush of activity on the New York Stock Exchange (NYSE) and other stock exchanges around the globe. It is this sell off that has led to recent ups and downs in economic activity and has caused investors to look to the Federal Reserve for guidance in what to do about the mess they are currently in.
Ben Bernanke: The Man with the Cards
Federal Reserve Chairman Ben Bernanke has presided over several interest rate hikes since he arrived on the scene. The Federal Reserve’s benchmark interest rate has crept up to 5.25% and Bernanke has reassured investors that he is an “inflation hawk.” This means that he will vigilantly fight inflation and not allow it to get out of control. Reassuring investors about inflation had to be Bernanke’s first priority at the Federal Reserve because many were getting jittery about the consumer price index (CPI) showing that America’s rate of inflation was above the “normal” two percent threshold seen by economists as typical of a sound economy. The Fed has had to fight off inflation scares which have been mostly motivated by rising oil prices.
When I wrote an extemp brief about Bernanke for Victorybriefs in the fall of 2005, I said that economists were “worried that like Alan Greenspan, Bernanke thinks the Federal Reserve should not do something about asset bubbles unless they start to affect inflation. Economists point to the massive damage done to the economy by the bursting of the tech stocks bubble in 2000 and say that the Federal Reserve needs to take on a role of preventing bubbles from forming instead of simply trying to mop up the mess.” The fears that were mentioned in that brief are still true today. Although Bernanke has proven himself to be an inflation hawk, he has chosen not to deal with the credit crunch until now.
In fact, Bernanke first tried to tell jittery markets that the Federal Reserve was not going to intervene on their behalf. On August 7th, the Federal Reserve released a statement shortly after choosing to leave the benchmark interest rate unchanged. In that statement, Bernanke and other Federal Reserve governors noted that there was a credit crunch that was causing some market instability. However, the ultimate conclusion of the Federal Reserve was that America’s economy was still going to achieve a good rate of growth and that inflation was their number one priority. To say that markets took this happily would be a joke. Financial markets had expected the Federal Reserve to intervene and had anticipated a reduction in the benchmark interest rate. Since this did not occur more chaos occurred in financial markets.
Ten days after its initial statement when it appeared that the credit crunch was only getting worse, the Federal Reserve finally intervened and cut the “discount rate” by half of a percentage point. The discount rate is the rate that is charged to banks to borrow from the Federal Reserve. Markets reacted favorably to this move and by the time you read this the Federal Reserve may have issued a cut in the benchmark interest rate. The Federal Reserve is undertaking these moves to put more money into the financial system so that the credit crunch can be less severe and to intervene in a situation where banks were becoming hostile in lending to each other. However, analyzing whether the Federal Reserve’s move has had a positive impact on the current state of affairs will take several more weeks to analyze.
By looking at his recent actions Bernanke clearly made a flip flop. Economists believe that the Federal Reserve overstated the inflationary threat to the economy. Economist Lincoln Anderson of LPL Financial Services recently remarked that the core inflation rate is only 1.9%. Granted, the core inflation rate ignores fuel and food prices but the low core inflation rate offers an indication that interest rates do not need to go any higher than they are right now.
Economic Fallout for the US Housing Market
The credit crunch will impact many sectors of the United States and the global economy. The biggest impact will be felt in the housing market which can have several economic repercussions. First, the rise in foreclosures will leave some individuals with what is called a 1099 shortfall. This occurs when someone’s debt is cancelled by an institution but is still subject to federal income tax. Some homeowners are finding out that when they were foreclosed upon by banks that they owned the Internal Revenue Service a gigantic tax bill. Therefore, besides being left without a home, individuals are having to pay the IRS gigantic sums of money that they cannot afford.
Second, individuals who are looking to be first time home buyers are not going to be able to get a bank to assist them in that task. The Christian Science Monitor reported on August 15th that banks are not making loans to people with spotty credit records and are requiring large down payments, which younger Americans and young couples can most likely not afford. This has the potential to create social conflict between those Americans who were able to reap the benefits of home ownership during the loose credit era and those who are left without in the credit crunch era. Banks are also not making “jumbo” mortgage loans which are over $417,000. This should have a very negative impact on the California property market.
Third, people are finding that they cannot sell their overpriced homes on the market for higher prices or what they bought them for. The price pressures that once forced house prices to go up are now forcing them to go down. The stock of houses that are currently occupied and for sale is close to a fifteen year high showing that there is a glut in the market and demand simply is not meeting supply. Due to people having to cope with high mortgage payments and not being able to sell their homes to move to somewhere cheaper, money is being taken out of the economy. The Economist on August 11th noted that consumer spending rose by only 1.3% in the second quarter which was the smallest increase since the end of 2005. Extempers must realize that consumer spending makes up two-thirds of the American economy. Commit this figure to memory! If consumer spending declines, the chances of an economic recession are high and that is a large concern for the Federal Reserve and might explain why some financial experts are anticipating several interest rate cuts by December. Financial experts are arguing that if conditions stay the same, America will see at least .5% of its gross domestic product (GDP) growth shaved off for next year.
Finally, a major concern for the Federal Reserve is also unemployment and the downturn in the housing market can affect that as well. The construction boom that accompanied the housing boom has gone into a severe tailspin. This might have contributed to the rise in the unemployment rate to 4.6% in January. Why this figure is alarming is that it is being attributed entirely to job losses rather than frictional economic factors such as people simply leaving their current job to look for another. In fact, the job losses that have accompanied the housing downturn is why economists believe the housing bubble bursting will be much worse than when the tech bubble burst in 2000.
Economic Fallout for the Financial Sector
The financial sector has got itself into a mess in the current credit crunch. As I described earlier in the brief, the sub-prime mortgage loans were put into securities by investment banks and then sold to investors. In fact, some banks actually bought sub-prime mortgage companies during the housing boom. The securitization of debt was thought of as an innovative way to spread credit risk across the financial system. It is also worth noting that sometimes securities were repackaged by investors who first bought them and they in turn sold them to other investors. The real risk that has emerged in the financial sector from various credit defaults is no one knows who has suffered the losses. The overall fear is that some individuals did not realize what risk they were taking on through these securities, which might be a valid claim considering investment banks talked credit ratings agencies into giving their risky securities high credit ratings, and that the fear of taking on more risky investments could have a chilling effect on the global stock markets. Financial experts have begun to criticize the securitization of the debt market by saying that instead of concentrating risk in one area of knowledgeable people, risk is now spread across the financial spectrum and debt is in the hands of those who do not know how to handle it.
There is no doubt that business transactions will be heavily effected by the current credit crunch. Private equity firms have looked to banks to help underwrite some of the business deals that they undertook, which has opened several banks up to big risks, and it is now certain that banks are going to be wary before underwriting any more private equity deals. In fact, the real risk to the financial system has come through this underwriting as banks have underwritten over $300 billion in debt that they have found an inability to funnel out to investors. Furthermore, the ability of private equity firms to turn to investors to raise money to acquire other firms will be severely impaired if a chilling effect takes hold in financial markets.
Hedge funds could also be impaired by the current crisis. Banks lend to hedge funds and if loans dry up from banks hedge funds could end up in dire shape. Furthermore, hedge funds fate will be decided by pension funds and rich investors who have been giving hedge funds their capital flow. The hedge funds hardest hit by the current crisis will be those involved in the credit securities we have described in this brief.
Economists are worried that banks have opened themselves up to too many risks. The fear is that by underwriting private equity deals and not being able to pass that debt onto investors they might put themselves in a bad financial position. In a bad financial position, the assumption is that banks would not issue many loans and the credit that the American financial system has come to be used to could quickly dry up impairing economic growth.
Reasons to Calm Down
Although the credit crunch we are facing is dire and could have some very negative repercussions there are several reasons to calm down about the situation. First, although America’s banks are thought to have spread themselves too thin in the current crisis and are teetering on the brink of insolvency nothing could be further from the truth. Analysts have reached the conclusion that banks will achieve higher profits for the next several years. Banks also demonstrated early this year they had abundant financial resources when they chose to buy back $58 billion worth of their shares.
Another reason that people need to calm down about the current meltdown is that America’s businesses will largely be unaffected. This is because many firms do not need to borrow as their balance sheets are clearly in the black after years of solid economic growth.
Finally, hedge funds are not just concentrated in the credit industry. Hedge funds have investments all across the global economy and although some have been hurt by the credit crisis industry experts believe they can recover or be bought by other funds.
Political Element
If any extempers saw the Iowa debate among Democratic presidential contenders they know that there was a discussion about a government bailout for homeowners who face foreclosure from rising mortgages. All of the Democratic contenders seemed to favor some form of government intervention which is a very controversial move. The obvious debate centers on what form of personal responsibility sub-prime lenders and those who took out the loans have for their own financial well-being. John Edwards is using his populism to paint the picture that people were taken advantage of by sub-prime lending companies and banks and persuaded to take on loans they could not pay for just so those institutions could make a hefty profit. While there is no doubt some of this has occurred, the general attitude of the American public does not favor a significant bailout for homeowners at the moment. The prevailing attitude is that homeowners knew what they were getting into when they signed these mortgages and to bail them out would send a very negative signal about personal responsibility and set a dangerous precedent for government intervention into the economy. After all, if the government is going to bail out homeowners who cannot meet their mortgage obligations does that mean the government should intervene to help those who cannot pay their credit card bills?
As you can imagine, the Democrats and Republicans are divided on the issue. In an interview with Neil Cavuto of Fox News several weeks ago, President Bush said he did not favor a government bail out for people who have gotten in over their heads with mortgages or for the sub-prime loan industry in general. Thus far President Bush has resisted calls from Democratic presidential candidate and Connecticut Senator Christopher Dodd to lift the ceilings on how much Fannie Mae and Freddie Mac, government buyers of mortgages, can hold in their portfolios. Dodd believes this could add $80 billion to the current mortgage market. However, President Bush has said that he wants both of those entities to undergo several structural reforms before he is willing to inject that liquidity into the market.
Due to this political element, the credit crisis will be a very important issue extempers will want to know about. After all, if the problem gets worse it could add another black eye to the Bush administration and give the Democrats more momentum. However, if it smoothes over it may empower the free market beliefs of the Republican Party and empower some of their candidates for the 2008 election.
Cards:
Fed Eyes Rate Cuts to Calm Market. The Christian Science Monitor. 20 August 2007. http://www.csmonitor.com/2007/0820/p01s01-usec.htm
Concerned that turmoil in the credit markets might spark a broader economic slide, the Federal Reserve is now signaling that it may cut interest rates – perhaps next month.
An interest-rate cut would be the latest weapon employed by the central bank to try to bolster the short-term debt markets, which have been frozen by investor fears about the quality of loans.
Loan Standards Tighten. The Christian Science Monitor. 15 August 2007. http://www.csmonitor.com/2007/0815/p01s01-usec.htm
Americans are quickly finding out that the turmoil in global credit markets is making it difficult – and in some cases impossible – to buy a home or refinance a mortgage.
Surviving the Markets. The Economist. 16 August 2007. http://www.economist.com/opinion/PrinterFriendly.cfm?story_id=9646451
THE lifeguards had been scanning the horizon for an oil-price shock, a bankrupt buy-out or a terrorist attack. But when the big wave struck last week it surprised them by coming from inside the financial system and threatening to swamp an unlikely shore, the money markets where banks lend to each other to help cover their daily operations. Investors have been asking for years if the frantic innovation in finance, especially the securitisation of just about every form of debt into a tradable asset, was a way to spread risk efficiently, or whether this left the financial system prone to rare-but cataclysmic-failures. It looks as if investors are about to find out.
Should Wall Street Pay for Sub-Prime Sins? The Los Angeles Times. 20 August 2007. http://www.latimes.com/business/la-fi-blame20aug20,0,4686500,print.story?coll=la-tot-business
Don Williams doesn’t know it, but he may be helping to bail out Wall Street.
Williams, a 64-year-old retired firefighter, lives off a pension and a handful of stock and bond mutual funds. “If the financial markets were to collapse,” he said at home in Genoa, Nev., “I have so much tied into it that it would have a strong effect on my standard of living.”
It Ain’t Easy. The Economist. 11 August 2007.
CALL a man like Ben Bernanke a pushover and you deserve a punch in the jaw. With a calm resolution that is beginning to mark his tenure, the Federal Reserve chief and his colleagues left America’s benchmark interest rate unchanged at 5.25% after a meeting on August 7th and gave little indication that they were minded to cut rates in the near future.
Abandon Ship. The Economist. 4 August 2007.
THE symbolism is almost too perfect. According to TheStreet.com, a financial website, John Devaney, a hedge-fund manager, has put his 142-foot yacht “Positive Carry” up for sale, along with his 16-bedroom mansion in Aspen, Colorado. Funds run by Mr Devaney’s group, United Capital, have had to halt payouts to investors after making heavy losses on mortgage-backed bonds.
U.S. Second Quarter Job Growth Recovers, Jobless Claims Up. The Los Angeles Times. 30 August 2007. http://www.latimes.com/business/la-fi-econ31aug31,1,756485.story?coll=la-headlines-business&ctrack=1&cset=true
WASHINGTON — The U.S. economy grew at an annual rate of 4 percent in the second quarter, as strong business investment led the fastest pace of expansion since early last year, the government reported today.
Home Builders Hurt by Credit Crunch. Reuters. 28 August 2007. http://www.reuters.com/article/basicindustries-SP-A/idUSN2838869920070828
NEW YORK, Aug 28 (Reuters) – Tighter lending standards in recent months have hurt business at two-thirds of the nation’s home builders that were already suffering from burgeoning inventories, an industry association executive said on Tuesday.