In September 2006, PSLweb.org published an article entitled, “Housing bubble deflates: Harbinger of a new economic crisis?”
The article answered in the affirmative, citing the dismal outlook for housing construction and sales as reported by the National Association of Homebuilders; the fact that short-term interest rates had risen above long-term rates (commonly referred to as an “inverted yield curve,” a reversal of the normal relationship, usually heralding an economic downturn); and soaring prices of oil, copper and other primary commodities, characteristic of a boom heading for a bust. Read the article
The boom phase of the capitalist business cycle—such as it was—may now be giving way to a new overproduction crisis. The evidence is piling up:
- A meltdown of the credit markets has spread from “sub-prime” mortgage lending (mostly to lower-paid workers) to supposedly low-risk lending (to companies and middle-class homebuyers) and internationally, as well.
- Dozens of hedge funds and mortgage lenders have gone belly up.
- Countrywide Financial, the nation’s largest mortgage lender, said July 24 that more borrowers with good credit were falling behind on their loans and that the housing market might not begin recovering until 2009 because of a decline in house prices that goes beyond anything experienced in decades.
- New “ghost towns” are sprinkled around the country as a result of overbuilding and reckless builder lending. (Business Week, Aug. 13)
Recession alert
If this turns out to be a full-blown crisis of overproduction, a generalized downturn has already begun or will soon be underway. Millions will lose their jobs and/or their homes as a result. Historically, declining residential construction and difficulties in the bond market are both strong warning signs. Right now we have both.
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The report released by the U.S. Labor Department Aug. 3 of the jobs numbers for July showed that only 92,000 new jobs were created in the month, well short of Wall Street forecasts of 130,000 and another downer for the markets.
Since its most recent peak in September 2006, employment in construction has fallen by 75,000, the report stated. That job loss figure is probably higher, since many construction workers are undocumented immigrants and may not be included in the official count. The downturn in residential construction is already severe. Job losses are sure to mount when commercial and industrial construction also turns down.
Market participants became especially alarmed after American Home Mortgage Investment Corp., the 13th largest mortgage lender in the United States, announced large losses due to defaults. The company, which an Aug. 6 Associated Press article pointed out was not even a sub-prime lender, saw its stock drop more than 90 percent in value and announced it will not make any more new loans, will lay off 90 percent—more than 6,000—of its employees, and is declaring bankruptcy.
Going global
The market alarm bells rang louder when a report hit the wires that German monetary authorities were forced on Aug. 2 to organize a last-minute rescue of a bank— IKB, a lender based in Dusseldorf—hit by a plunge in the value of its leveraged holdings in sub-prime mortgage bonds and derivatives (securities based on other securities).
France’s Oddo & Cie, a stockbroker and money manager, had to close hedge funds with $1.37 billion in assets due to what the firm called “an unprecedented crisis” in the asset-backed securities market.
“The fund was devastated when the value of its illiquid collateralized debt obligations—which are bonds made from other bonds—plunged, leaving the portfolio managers locked in to losses with little chance of finding buyers,” an Aug.3 New York Post article reported.
According to the same article, “The problems are even worse in Australia, which is now second only to the U.S. with advanced symptoms of what Wall Street wags have dubbed the ‘subprime contagion.’”
Hedge funds in Australia and elsewhere have had to suspend investor withdrawals in the wake of sharp losses in U.S. bond markets.
Worse to come
The crisis in the mortgage market is certain to get worse before it gets better.
An article in the Aug. 1 New York Times points out: “In fact, the mortgage meltdown has arrived at something of a turning point. So far, most of the loans gone bad were among the worst of the worst. … In many cases, buyers were never going to be able to make their monthly payments and were instead banking on a rapid appreciation in home values.
“But the pool of people falling behind on their house payments is starting to widen beyond this initial group, and adjustable-rate mortgages are the main reason. Starting in the spring of 2005, these mortgages began to get a lot more popular, largely because regular mortgages no longer allowed many buyers to afford the house they wanted.
“They turned instead to a mortgage that had an artificially low interest rate for an initial period, before resetting to a higher rate. When the higher rate kicks in, the monthly mortgage bill typically jumps by hundreds of dollars. The initial period often lasted two years, and two plus 2005 equals right about now.”
Since home equity loans supported much of the boom in consumer spending, many other sectors of the economy here and abroad will be hit as those loans freeze up.
Federal Reserve response
The Federal Open Market Committee, which sets the target “federal funds rate,” the rate charged when commercial banks loan each other money overnight to meet reserve requirements, convened Aug. 7 and took no action.
The statement it issued at the close of its meeting was, however, clearly aimed at soothing market anxiety.
While taking note of recent volatility and the fact that “credit conditions have become tighter for some households and businesses,” the FOMC assured that “the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.”
This “happy face” stance by the Federal Reserve calmed the markets for about a day. But then more bad news from France sent the Dow plunging almost 400 points on Aug. 9. BNP Paribas, the largest publicly traded bank there, announced that it had to freeze several of its funds involved in sub-prime lending because it was unable to properly value their assets.
It was also reported that the European Central Bank and the U.S. Federal Reserve had injected $130 billion and $25 billion, respectively, into the banking system in an attempt to contain the spreading crisis. It was the biggest ECB injection ever. (AP, Aug. 9)
Clearly, more financial and economic turbulence lies ahead.
