Commentary

What the Financial Pundits are Missing

As the stock market reaches positive territory for the year, and the pundits who were teetering on the ledges of their over-priced office suites scream for joy that the worst is over, the very real problems that face the U.S. economy have not gone away – they are just being ignored.

I found several useful articles that discuss the major issues that stand in the way of a true and sustainable economic recovery in the United States. The first, from Barron’s Alan Abelson, deals with the sickly state of the housing market. The second article concerns the rising ranks of U.S. citizens who are finding it tougher to land a new job, and the third deals with the U.S. government’s attempt to manipulate the yield curve through quantitative easing (buying U.S. Treasury bonds) in order to reduce mortgage rates and overall lending rates for consumers and businesses – actually there are a few articles that I found on this subject.

After the credit bubble burst, the housing bubble soon followed, for there was no longer free money to support ever-rising prices for poorly built McMansions, unnecessary strip malls and bland office parks. The financial crisis that started brewing in mid-2007, and came to a head last fall (we hope) with the collapse of Lehman Brothers, made the situation even worse. Lenders had to cease with their reckless ways and demand down payments and income verification from prospective home buyers. This, along with a massive inventory overhang, put further pressure on real estate prices. But then the federal government came riding to the rescue of both the banks who made so many foolish loans, and the gullible public, who lapped them up. The feds cobbled together a massive financial bailout of the banks, and helped restructure existing exotic mortgages that were forcing so many over-indebted Americans out of their homes – they also started purchasing mortgages from Fannie Mae and Freddie Mac, and declared a moratorium on foreclosures.

Alan Abelson of Barron’s, who writes one of my favorite weekly financial columns, sites the work of Whitney Tilson and Glenn Tongue of T2 Partners:

T2 posits five waves of (mortgage-related) losses, two of which have crested, while the remaining three have yet to peak. In the first two waves, the losses of which appear largely behind us, the chief causes of distress were rooted in fraud, feckless speculation and payment shock induced by mortgage resets.

The last three waves, the big losses of which have still to come, include prime loans (mostly owned or guaranteed by Fannie and Freddie); jumbo primes, second liens and home-equity lines of credit (most of these are on banks’ books), and loans outside housing, notably the tidy $3.5 trillion of commercial real estate.

Along with a deathly ill housing market, Americans also have to deal with a more treacherous employment landscape. Although there was much cheering form the clueless canyons of Wall Street last Friday as a result of a less than disastrous monthly jobs report (only 350,000 received the boot in May), yesterday’s release of weekly jobless claims showed continuing claims for benefits reached record levels. (There was a good, brief article from Marketwatch.com spelling out the details.)

In order to ease the pain in housing, and induce American consumers and businesses to resume borrowing, the Federal Reserve resorted to quantitative easing to reduce long term interest rates. The Fed started buying U.S. Treasury bonds in March to reduce interest rates on these securities, which are instrumental in setting mortgage interest rates, credit card rates and corporate bond yields. The problem is that this does not appear to be working, because our biggest creditor, China, is shunning long-dated securities in favor of notes maturing in two years or less. Apparently, China does not want to tie up its reserves with a chronic debtor for any longer than it has to. As long rates continue to rise, the Fed will lose billions down the road when it comes time to redeem these securities (rising yields equal lower prices), which will endanger the economy and the Fed’s independence because they’ll have to beg the U.S. Treasury for a bailout.

Reuter’s had a great article last month on this topic. Here’s an excerpt:

Between August 2008 and March 2009, China bought $171.3 billion of bills, debt that carries a maturity of up to a year, compared with just $22.9 billion of longer-term notes and bonds with a maturity of two years or more. It also sold $23.5 billion of long-term agency debt, U.S. data shows.

In an attempt to make things better in the short term, the Federal Reserve and the Obama administration risk making things much worse down the road. Extending a lifeline to reckless businesses and homeowners, guaranteeing all manner of risky assets, encouraging the buildup of even more debt and manipulating interest rates will have dire consequences. These policies will have the accumulative effect of encouraging the same behavior that caused the credit and housing bubbles in the first place, which resulted a nasty financial crisis and a severe recession. Only the next series of bubbles that is currently brewing will be much worse.

For further reading:

The Financial Times on rising yields.

Marketwatch.com on the precarious state of the U.S. dollar.

Latest retail sales figures from Marketwatch.com.

The continuing decline in U.S. household wealth – also from Marketwatch.com.

The New York Times on America’s “Sea of Red Ink”.

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