Everyone loves a good panic, just like everyone loves a parade. The U.S. subprime meltdown story has the potential to be a great story because it has all the elements of good newspaper copy. Money will be lost. Lives ruined. Arrests will be made. There is blame to dish out! Who is responsible for the destruction of dreams!?
Yet the reaction in the national papers here in Australia is muted. “The subprime ‘meltdown’ is only a meltdown in quotation marks. That’s to say, in my judgment, it is neither real nor significant. Either in its own terms or across the broader financial system,” writes Terry McCrann in today’s Herald Sun. The subprime story is, “a scandal that does not, as yet, put taxpayers at risk, nor pose much of a threat to the economy,” writes Stephen Ellis.
Really? Tell a man who just lost his home and his credit rating that what happened is neither ‘real’ nor ‘significant.’ Then duck, before he catches you with a left hook. Tell the world that the sputtering of the engine that’s been driving global growth is neither real nor significant. The world can’t talk back, of course. But if it could, it might laugh at you, in a non-judgmental way of course.
Let’s get a few things straight. First, as tempting as it is, you should not think of the subprime meltdown as the comeuppance for fat, Wal-mart-shopping, cigarette-smoking, SUV-driving, Fox-news-loving, American trailer trash who didn’t belong in a well-furnished McMansion anyway. Go ahead and think that if you’d like. But it’s best to keep those thoughts to yourself, instead of slyly alluding to them. Either that, or shout it from the rooftops with both lungs proudly. Tojours l’audace!
Here’s a more important point. The subprime scandal is definitely going to hurt financial company earnings, especially banks, which loaded up on mortgage-backed loans on the last few years. A lot of firms, in fact, have loaded up on high-yielding mortgage-backed debt to goose earnings.
Now, no one is going to go home and cry to momma if banks make less money because the margins on lending to deadbeat borrowers collapse. We rarely cry at the Old Hat Factory and our eyes have been dry all week. But what we don’t really know-yet-is how important those mortgage loans are to other balance sheets, or pension funds, or retirement funds, or mutual funds, or hedge funds.
Anyone who was looking for high-yield the last few years probably dabbled in the mortgage-backed market, even if they pretended not to know. Everyone was doing it. It was cool. It was hip. And it paid. Besides, how bad can it be to own just a little piece of risk? Everyone owned it. And now everyone is going to pay, at least a little bit.
The subprime meltdown is going to result in tighter credit conditions in the American economy. And that’s not good for American consumers, who enjoy the arduous task of driving global economic growth through manic, vulgar, incessant, soul-destroying consumption. Take notice world, you won’t have the strung-out American consumer to rely on to buy your $100 trainers anymore.
So it’s not just a yawner of a moment gents. You may be seeing that singular event which leads to a shift in the leadership of the global economy, a great migration in global purchasing power. And by the way this shifts in the composition of global growth never come without some volatility and the loss of a few hundred billion in stock markets. Or a few trillion.
What’s the big switch to watch for? Out is the American consumer-with his zero savings and collapsing balance sheet and flat wage growth and Iraq-weary, Oprah-watching soul. In is the Asian saver, with his pent up savings and his dawning knowledge that you can do better in this financial life than American Treasury bonds and that Xboxes, iPods, and $700 Dyson vacuums make nice little presents, even when you make them to yourself.
Do not confuse this with previous financial “crises” whose effects have been contained or mitigated by an easing in credit conditions. In the Savings and Loan crisis of the late 1980s, the effects of risky lending were never passed through to the larger economy. Only the lenders and U.S. taxpayers were on the hook for the bad loans. And the borrowers were commercial real estate developers, not American homeowners/consumers.
It’s an important point. So let’s explore it some. There are a few key differences (and a few key similarities). The S&L’s were doomed by paying variable interest on short term deposits but receiving fixed interest payments on long-term loans. When short-term U.S. interest rates spiked in the early 1980s, the S&L’s were in an awful position. The interest spread went negative!
Yes, it is the stuff of nightmares isn’t it, probably the sort of thing that keeps you up at night too. In plainer terms, the S&L’s paid out more money on their short-term deposits than they made on their long-term fixed interest loans (although come to think of it, this reminds us a little of negative gearing on property).
Only a stupid act of the American Congress and the American President (imagine that, politicians doing exactly the wrong thing at precisely the wrong time) made the situation worse. To make up for the margin squeeze of a rising rate environment, the S&L’s were allowed (encouraged) to enter the commercial real estate market, where they could earn much higher interest rates on admittedly riskier loans.
Faced with a disaster in their regular business, but backed by Federal deposit insurance which guaranteed deposits up to US$100,000, the S&L managersunder no one’s watchful eye-went hog wild in the commercial lending market. It must have been a little bit like finding free money at the dog track and betting on every single greyhound. Somebody has to win, right?
The desperate men running the S&L’s knew the taxpayers would bail the banks out if they exhausted (ruined) the bank’s capital with non-performing loans. Besides, the only way to make up for the mounting losses from lending long and borrowing short was to gamble big! There was a perverted logic to the risky lending they engaged in. It was the only way out, even if it led directly to going under.
The gambles, of course, did not pay off. All across the country, but especially in the oil belt in Texas and Oklahoma and in Colorado where your editor was at the time, commercial real estate become glutted with massive overcapacity. It was, in economic terms, a tremendous mis-allocation of capital.
But here is the important point: the bad lending leading to non-performing loans took place mostly in the commercial real estate market. Office space was built and left unoccupied for years, later sold off at fire-sale prices by the Resolution Trust Corporation. Eventually, the cycle turned and the commercial space was occupied. And those American savers who were affected by failing institutions at least had Federal deposit insurance as financial consolation.
Fast forward to today. The meltdown in the subprime market rips out the beating financial heart of the marginal buyer in the center of the American economy, and thus the global economy. Our leading American actor finds his balance sheet wrecked. He has huge liabilities. He has no assets. He has wage-growth that barely keeps up with inflation. What effect does his financial destruction have on the rest of the global economy?
Well, an insolvent consumer consumes less. But the real effects won’t be known until we see how much the marginal home buyer has been supporting American house prices. If the fallout of the subprime implosion is contained to just those subprime borrowers, then maybe everything will be fine.
But when the marginal buyer in any market is gone, he takes his buying power with him. Our guess is that this will lead to falling house prices in the U.S., which will lead to a further retrenchment in consumer spending-even by those Americans with more discretionary margin for error. Faced with flat home price growth (negative when adjusted for inflation) the remaining solvent American homeowners can afford to sit tight and not sell their houses. But they will probably rein in their consuming horns.
And keep in mind it’s not just consumer spending that’s benefited from America’s housing bull. It’s employment as well. Take away this employment growth and you get even slower American GDP growth. The American housing market has been far more important to U.S. GDP growth than you might think when observing from Australia.
And don’t think Ben Bernanke can fix this and make it all better. Lower rates are good for debtors and bad for the dollar. The Fed controls the short end of the interest rate curve, not the longer end. It can’t relieve the American housing market by forcing banks to lend to people who don’t want to borrow.
For its part, Australia can survive the decline of the importance of the American consumer just fine. That’s because most of Australia’s export growth is leveraged to China, and not to America. It’s China, then, we’ll have to watch. With the American consumer bleeding a slow death on center stage, when will the current come down on this era of U.S.-centric growth? And can China make its debut as the star of the global show without a painful global recession at the intermission?
Of course, there is always the panic button. A real financial crisis begins when people suddenly lose faith in certain, widely-accepted financial truths. These truths vary from generation to generation. But generally they are things like: house prices never go down…if you buy and hold you’ll be alright…or…it’s not illegal if you don’t get caught.
When a truth is exposed as a lie, or maybe when it just cease to be true, people (especially investors) tend to react in very non-rational ways. And that’s why this is no run-of-the-mill scandal. It has the potential to destroy the economic beliefs of a generation (that you can get rich buying and selling houses). And once that belief collapses, a whole slate of economic behaviour begins to change. And the world changes with it, starting, usually, with a crash.
Markets and Money