February 1, 2009

Financial Bubbles Burst – Can Effervescence Ever Return?

Last year we ran a piece on financial bubbles. The housing bubble was already deflating, but few thought its subsidence would result in carnage on the scale that has subsequently occurred. Rather, the thinking was that fresh bubbles would soon appear, each with the buoyancy to lift the economy once again. Now it would seem that the bubble machine has been rendered inoperable and that the economy must somehow manage without them.

Indeed it is difficult to imagine where a bubble sufficiently expansive to float the floundering financial sector could develop today. The greatest potential for such a development lay in the privatization of Social Security which was strenuously promoted by President Bush and later by Presidential candidate John McCain though to no avail in either case. I'm assuming that both men realized the fragility of the Bush era prosperity and knew that it rested primarily upon a vastly inflated real estate market that was declining very rapidly even as they addressed the Social Security privatization issue. They knew that this particular economic regime needed a rescue and fast.

Whether the influx of funds from that source would have re-inflated the economy sufficiently to stave off recession is difficult to determine. I am doubtful because I perceive that the money would have gone directly into financial markets in the form of brokerage fees and percentages, not into the hands of consumers as did the money obtained from refinancing homes in a bull real estate market. My guess is that it would have boosted the consumer economy scarcely at all though it might have staved off some the bank failures. And who knows, it might even have provided enough leverage for investment in yet more rarified forms of derivatives.

But at this point discussing Social Security privatization is an exercise in counterfactual history. It's not going to happen any time soon. So what's going to happen to the economy in the near and mid terms and what will be the impact of economic trends on alternative energy?

Unfortunately economic history gives us relatively little guidance.

The Absence of Big Ones

In the entire modern period extending from the early seventeenth century up to the present there have been very few epic crashes, and probably we can ignore earlier travails like the collapse of the Bank of Scotland and the South Sea Bubble which were the products of nascent rather than ascendant capitalism. What is strictly relevant to this discussion are events in the nineteenth, twentieth, and early twenty-first centuries, the period of capitalism and industrialization triumphant.

Within that period there are only two economic downturns of comparable magnitude to the present one, the Great Depression which began in Europe in the late twenties and struck America last among the economic Great Powers and the Panic of 1893. Some would count the Panic of 1873 as well, but economic historians are divided as to the severity of that episode and the issue may never be resolved due to the relative paucity of economic data from the period.

In both the Great Depression and the Panic of 1893 massive bank failures occurred, freezing up credit and causing thousands of other businesses to fail as a consequence. Something very similar is occurring now. The other similarity has to do with publicly traded assets that have become greatly overvalued. In the eighteen nineties those assets were chiefly railroads and mines. In the twenties they were much more various and included airlines, radio and television manufacturers (experimental television was a hot investment at the time), automobile companies, real estate plays, and various stock trusts and financial derivatives.

The eighteen nineties depression occurred during a period when scores of new industries were developing including street railways, automobiles, aluminum smelting, telephone networks, motion pictures, electric illumination, and on and on. Such was the demand for new technology that the troubled economy corrected itself. In the nineteen thirties no such self correction occurred and whether it eventually would have taken place is still a matter of intense debate among economists. And even with strong government intervention the Great Depression was only subject to amelioration not any decided reversal.

The current malaise is being confronted by a strongly interventionist Federal Government just as was the Great Depression. Might we anticipate similarly disappointing results from this latest intervention? Maybe even more disappointing.

Overvaluation, Past and Present

The nature of financial markets is that they are cyclic. Assets are periodically overvalued by enthusiastic investors and reach a level where they can no longer find ready buyers. Owners of these assets, attempting to liquidate them at the highest price levels, begin selling them off, precipitating a significant devaluation as the market is flooded with securities. Eventually those assets become undervalued and are purchased at bargain prices—rescued as it were—and begin another ascent.

Within a healthy economy, i.e. one that is productive, reasonably equitable, and properly regulated, the oscillations of the market are fairly subdued. An excellent model is provided by America's Affluent Society of the nineteen fifties.

One of the reasons such a healthy economy has business cycles of low amplitude is because the extent to which assets are overvalued or undervalued is limited. That sounds like a tautology but if we look at precisely what is being valued we see that speculation in such an economy is remarkably informed and that most speculation involves reasonably good bets. Those bets in turn involve industries producing various commodities, durable goods, real properties, and services for which there are perceived needs and where those needs reside within an expanding customer base.

If, for instance, I were thrust back into the Affluent Society, and I decided to invest in vacant lots within a municipality that had zoned those lots for tract housing, I could certainly pay too much by assuming the area would develop faster than it did or that the tracts would be more attractive than they actually were. But except in cases where an egregious fraud was perpetrated as when a developer falsely claimed that a military base or large factory was to be built adjacent to the development, I would be unlikely to be stuck with a property that couldn't be sold at all. And,if I were fortunate, I might make a double digit return on my investment within a couple of years, though I would be unlikely to make multiples of the purchase price.

And the reason why real estate was such a good investment in those times was that the new tract homes being built in suburbs all across America met a huge demand for housing on the part millions of Americans raising families rather larger than was the case during the Depression years that came before. Furthermore, most of the new homeowners snapping up such properties in the early post War period were entirely credit worthy and were provided with government backed loans that assured the integrity of the overall system. And the fact that most of the breadwinners heading those families were the recipients of rising real incomes which they used to pay off long term fixed rate mortgages gave the system an added stability. But, of course, the rate of return was limited. One could grow wealthy by trading up in real estate, but it took time and usually considerable effort and sacrifice. Call it restrained speculation. And if one didn't make out and was forced to sell one's home, one was seldom ruined. Generally one made a profit in fact.

Now consider the crisis of the present. Debt representing home mortgages, often as not obtained under usurious terms, has been sold and resold and packaged in complex financial instruments which are then used as leverage for further risky investment. One is building as it were a pagoda where each story is rickety and unstable and about in equal degree. What was formerly the personal collateral of the home buyer and his principal form of individual wealth has been transmuted into collateral for the institutional investor who is using it to enrich the institution enormously while the home owner enjoys no benefit thereof beyond having a roof over his head. He is staking the gambler but receiving nothing from the pot.

What is intriguing about this type of securitized debt based on home mortgages is that it appears to meet the requirements of an excellent investment. It is founded upon something solid, to whit, a house, which has always enjoyed a ready market in the past, it provides a dependable income stream from the payments of the home buyer, and finally the income stream can be manipulated by imposing balloon payments of various sorts on the hapless debtor. And of course in the event of a default the mortgage holder gets to keep all of the payments plus being able to sell the property anew, quite possibly at a price that is higher than for the last sale. In addition, it provides for hedging in that solider mortgages can be blended in with those of potential defaulters and the resulting mélange valued in the market largely on the basis of the higher quality loans.

Everyone knows that these instruments were bid up to astronomical heights in the global financial markets, and, as was the case with the most insubstantial investments of the past such as dotcoms and competitive telephone exchanges, were rather suddenly deserted by investors. In the case of overheated tech companies of a decade ago, the loss of confidence was clearly attributable to the eventual failure of most of the New Economy companies to achieve significant earnings. But with mortgaged based investments of our own decade the mass psychology behind the market collapse is more difficult to discern. After all, the mortgaged based instruments had earnings associated with them, indeed, accelerating earnings. And they were insured because the mortgages that underlay them were insured. On the surface they had everything going for them.

To see why they were so bad, one has to look beyond the instruments themselves. The frenetic trade in securitized debt occurred in tandem with a wild speculation in individual properties that were often as not trammeled in these indecipherable debt instruments. Mortgage payments were flowing into some mysterious entity that now held title or partial title, but the speculator in individual homes didn't care. He collected the sale price, made a tidy profit, divested himself of house and mortgage burden both, and proceeded to buy another house, often by borrowing dangerously large sums of money to do so. And meanwhile the trade in individual houses increased the value of collateral in the securitized debt packages. Everybody wins, at least for awhile.

But everybody is leveraged. As always, the first guys to lose are the guys at the bottom. Just as the habitués of nineteen twenties bucket shops got hosed badly in '28 and '29 before the big boys went down, the poor un-creditworthy schmucks buying houses with variable rate mortgages were the first to fall. The schmucks were necessary because their participation in the market helped to drive prices up—way up. They agreed to pay inflated prices because they were given the opportunity to do so on initially easy terms, and the fact that they did so and took more and more properties off the market, further inflating prices. Just like buying stocks on the margin in the late twenties.

True, some of the schmucks made out. Some sold out before their balloon payments came due, dodging the bullet as it were. But most of them hung on because they really wanted to own homes. The American dream. But they weren't getting in on that dream in the nineteen fifties. They weren't paying reasonable rates and they weren't enjoying expanding incomes. So the defaults started happening and they became a cascade. Suddenly there were lots of foreclosed houses for sale, more than anyone wanted to buy. The schmucks that got hosed weren't going to get further loans, and most of them couldn't get back in the market even at reduced prices. So more and more houses accumulated on the market and prices kept going down.

Among the big time debt holders it was like being in the grand ball room on the Titanic. You felt this thump but then nothing more and you returned to your brandy and soda. It was like that with the securitized debt instruments. The crumbling of their foundations was not immediately reflected in their prices. But eventually as the underlying value of the core assets came into question people started to have doubts. Say this institution is offering shares in this fund for sale or for collateral and the fund is based on home mortgages. After a certain point, home owners are defaulting on a large percentage of those mortgages so the income from them is diminishing, and, worse still, the holder of the mortgages can't sell the foreclosed homes because there is a glut on the market. What then are the shares in that fund really worth? What are the underlying mortgages really worth? Sure, they're backed by the collateral of the house itself but the lender repossessed the house too soon before he got all that many mortgage payments and now he can't get anything more at all. The house has become a liability.

So what was rock solid becomes quicksand.

In a well damped business cycle of the sort that obtained in the nineteen fifties overvalued assets become properly valued after a brief interlude of undervaluation. In a real crash that doesn't happen.

How does one establish the proper valuation for a securitized debt instrument which is really a form of derivative? It's not like stockpiled petroleum which the global market will purchase and consume in due course. Those foreclosed homes could remain unoccupied and without buyers for months, maybe years. And in the interim they will surely deteriorate and may be vandalized, stripped of the house wiring and plumbing, and sustain tens of thousands of dollars of loss which is ultimately your loss, Mr. Big Time Investment Banker. You need to get rid of those toxic assets, you need to assign some kind of value to them and sell them off, but now nobody wants to buy them.

So what happens to sound mortgages bound up in these indecipherable instruments? Now that's really scary. Some good prudent citizen who works hard and pays his bills had his mortgage sold out from under him and it now belongs to a bank or hedge fund which is in danger of going under, or which already has gone under.

The presence of all those real houses with real occupants which was supposed to make the mortgage based securities sounder than other derivatives has actually made them profoundly unsound. Somehow or other those houses and those householders have to be dealt with. They're not like some failed business where the owner and employees simply move on and the storefront is reoccupied and the business equipment sold off. These failures involve millions of lives.

Because the resolution of multiple failures associated with these mortgage based instruments is so difficult and the ultimate ownership of the debts and assets will be so difficult to determine, this economic downturn is apt to be very difficult to reverse.