Deja Vu: 2008 All Over Again . . . ?

After a five-trading-day respite, the Dow-Jones Industrials returned to a 500-point intraday price swing on Thursday, ending down almost 420 points; on Friday, the volatility was lower but the market lost another 170 points to finish at 10,817, a loss of 4% for the week and 15% from the May high. Similar changes were seen in the broader indices, such as the S&P500, which finished at 1,124, down 5% for the week and 16% from the May high. What is responsible for this collapse in the stock market? Was it those pesky tea-partiers, who “held the government hostage” while demanding serious action on reducing the ever-ballooning national debt? That is what you will hear from pundits on the left.

In reality, it is just an end to the “irrational exuberance” that took the stock market up more than 25% from last summer. What was the reason for this bubble? Apparently, investors were betting on an economic recovery in the U.S. Unfortunately for us all, they have been disappointed by a reality check.

Unemployment remains stubbornly above 9%. As of July 2011, the Bureau of Labor Statistics reported that only 140.38 million Americans were working, which was only 204,000 more than July 2010, even though the U.S. population had increased by 1.8 million. The unemployment rate would be even worse had not almost a half-million workers given up and left the labor force. Clearly, the labor market is no healthier today than it was a year ago; in fact, it is worse and likely to deteriorate further as recently announced corporate layoffs take place in coming months.

The housing market is faring no better than the labor market. Residential mortgages are the “original sin,” the true underlying toxic assets that led to the Oct. 2008 market meltdown; yet the Obama administration has done nothing (outside of the hideous HAMP, which “duped into default” more homeowners than it helped) to stabilize the housing market. Fortunately, sanity has returned to the underwriting of residential mortgages after 2007 so that the bad vintages of 2004-2007 are slowly working their way out of the market. According to Lender Processing Systems, the number of non-current mortgages (30+ days delinquent or in the process of foreclosure) has dropped from a peak of 8.1 million in Jan. 2010 to only 6.5 million as of Jun. 2011, largely the result of about 1.5 million completed foreclosures during those 18 months. Yet, 2.2 million mortgages remain in the process of foreclosure and another 1.9 million remain seriously delinquent (90 days or more). Even if not one more current mortgage went into default, we would be looking at about four years to work through this inventory at the recent pace of about 1 million completed foreclosures per year. However, the robo-signing and forgery scandals associated with the practices of mortgage servicers seeking to foreclose on delinquent borrowers has drastically slowed down the pace of foreclosures, at least in states that require the courts to sanction foreclosure. In addition, the lousy economy is still leading to more than 500,000 newly delinquent mortgages each month so that more bad loans are going into the pipeline than are coming out the other end as completed foreclosures.

This puts downward pressure on housing prices, further eroding the home equity of more than 100 million homeowners. Core Logic already estimates that about 30% of the 50 million homeowners with a mortgage are “underwater,” owing more than their home is worth. A new study by John Y. Campbell, Stefano Giglio and Parag Pathak in Volume 101 (5) of the American Economic Review indicates that each foreclosure within 1/20th of a mile reduces the value of your home by one percent. In other words, there are important spillover effects of foreclosures that impact the home values of neighboring homeowners. In order to put a floor on housing prices, we must first stanch the flow of foreclosures. Yet the Obama administration has failed miserably in its policies to address this critical problem.

The latest problem is European Sovereign Debt, but this problem really is no different than the residential-mortgage problem of 2008. Ultimately, big banks around the world lent too much money to unqualified borrowers—this time the governments of the PIIGS countries. Once markets realize that the banks are not going to get paid back by those borrowers, they refuse to lend to the big banks. This causes liquidity problems for the big banks, whose business model is to borrow short-term and lend long-term. They become unable to “roll over” short-term funding, leading to a liquidity squeeze that can force them to sell good assets at firesale prices and render them insolvent. This, in turn, pushes down their stock prices and pushes up the price of credit insurance against default by those banks, leading more and more lenders to refuse to lend to the big banks. Eventually, no one will know who is and who is not solvent, so that the short-term credit markets will freeze up entirely, just as they did in 2008. Look for the Fed to once again ride to the rescue with trillions in resurrected lending facilities from 2008 – 2009.

Is this 2008 all over again? We’re not there yet, but the signs of a repeat are ominous. What can be done to prevent a repeat? Governments in Europe (and the U.S.) need to move swiftly to force banks to recognize their losses on sovereign debt (and other toxic assets), and seize those that are insolvent. Then these trillion-dollar casinos need to be broken up into smaller pieces and sold off to the private sector. Only when we eliminate these too-big-to-fail institutions will we be free from the specter of yet another financial meltdown.

One Response to “Deja Vu: 2008 All Over Again . . . ?”

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