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Five Things You Need to Know: Where Does the Debt Crisis Leave Us Now?


Some look back to the 1970s for clues to what's happening today - the era of Stagflation - we're going to look back a bit further.


Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. Air of Familiarity

Not since the Depression has a larger share of Americans owed more on their homes than they are worth, a New York Times article, "Rescues for Homeowners in Debt Weighed," intones ominously this morning. The article goes on to say that, "With the collapse of the housing boom, nearly 8.8 million homeowners, or 10.3% of the total, are underwater. That is more than double the percentage just a year ago."

While some look back to the 1970s for clues to what is happening today - the era of Stagflation - a word that appeared in nearly every newspaper in America yesterday, we're going to look back a bit further.

2. Things Are Beginning to Look Grim

Apparently, things are looking grim these days as the debt crisis that was initially contained to subprime mortgages, and then contained to investors in assets collateralized by subprime mortgages, and then to all residential-backed mortgage securities, and then to structured investment vehicles filled with collateralized debt obligations, and then to the money center banks that sponsored these structured investment vehicles, and then to short-term enhanced money market funds, and then to the bond insurers that may have underestimated the risk of the bonds they were insuring, and then to short-term auction rate securities, and then to corporations, institutions, schools and municipalities that may have assets in short-term auction rate securities that no one wants to buy or sell, and then to the corporate bond market, and then to the municipal bond market, spreads to Main Street.

Meanwhile, as the Debt Crisis becomes more apparent to Main Street, government officials, including most notably President George W. Bush and Treasury Secretary Henry Paulson, who insist "no government bailout" is in the works, are busy working diligently to maintain the ongoing government bailout using public institutions such as the Federal Housing Administration and Federal Home Loan Bank system while simultaneously shaking the bushes to draw out even more exotic bailout proposals.

3. The Response

Among the proposals being considered are broad "rescue bills" that would enable the government to purchase outright some troubled mortgages and even a plan offered up a few days ago by the Office of Thrift Supervision that would create a system allowing borrowers to refinance into government-insured loans that cover the current value of their homes while the refinancing package would pay part of what's owed to the original lender with the remainder of the balance that isn't covered issued to the lender as a "negative equity certificate." The lender could then redeem the certificate if the home is eventually sold at a higher price.

This is nothing new. As the Debt Crisis continues its inexorable march from Wall Street to Main Street the call for government intervention will grow louder, the pressure more intense.

"The demands throughout the country and in Congress for direct Federal financial aid were growing more persistent during the summer of 1931. William Randolph Hearst, through his newspapers, advocated $5,000,000,000 Prosperity Loan to provide work relief for the millions of the unemployed. This plan was endorsed in resolutions sent to President Hoover by labor unions and municipalities in various parts of the country."
- From Spending to Save, 1936, by Harry L. Hopkins, relief administrator for the Federal Emergency Relief Administration and the Civilian Works Administration and Works Progress Administration under President Franklin D. Roosevelt.

4. 1930s vs. 2000s: More of the Same

Since mid-December the Federal Reserve has loaned more than $130 billion to banks through the Term Auction Facilities that were initially proposed as a temporary solution to the Debt Crisis, but which the Federal Reserve has since expanded to continue indefinitely "as needed." Similarly, in 1932 the Federal Reserve initiated an open market program to buy $1 billion worth of securities.

The purpose of the Fed's TAF is really to allow the Fed to take a broader array of collateral than the Discount window allows while protecting the anonymity of the banks that are using the TAF's. Ironically, in 1932 a federal law was passed requiring that the names of banks borrowing from the Reconstruction Finance Corporation be made public, basically a relief fund set up to serve a purpose similar to the TAFs.

And don't forget the Glass-Steagall Act, passed later that year. Although best remembered for establishing the Federal Deposit Insurance Corporation (FDIC) in 1933, the first version of the Act passed in 1932 served really just one purpose: it broadened the terms under which banks could borrow from the Federal Reserve.

One more dose of irony, Glass-Steagall was repealed in 1999, paving the way for the consolidation of commercial and investment banks.

5. Where Does the Debt Crisis Leave Us Now?

While everyone turns toward the 1970s for clues as to how our Debt Crisis will play out, we'll remain fixated on the 1930s. As we wrote yesterday, this is indeed not your father's stagflation, but it's also not quite like your grandfather's depression. Ours is a Stealth Depression. It's been with us for some time, it's just that most of us haven't bothered to notice it. As social mood continues to shift from what have been two decades of underlying positive and optimistic sentiment, the cracks in the facade will become more apparent.

Household debt-service ratio is near a record high 14.3%, while the personal savings rate hovers near a record low 0.5%. Still, it is worth noting that in many cases debt service is as much about perception as reality. Optimistic social mood creates the right conditions for enhanced credit appetites and an optimistic view of how much debt one can service without stress. That is one reason the high-debt service ratio and low savings rate has been able to persist, and to grow to unimagined heights, for so long. A negative social mood can take things to an opposite extreme, where debt is repudiated or shunned.

There were many books written in the 1970s about how over-indebted U.S. society was. Those books seem laughably naive now. There is no question that at least based on the preceding decade the debt burden of Americans in 1980 seemed extraordinary. We managed to grow our way out of that. I am not so sure we can do so this time. In fact, as a report by Merrill Lynch's (MER) David Rosenberg shows, our debt-service ratio has grown more over the last six years than in the preceding 39 years.

One thing to keep in mind is that the Depression was not an event, it was an era. And even during the peak of unemployment during the Great Depression 75% of the country continued to work, a lot of children continued to go to school, colleges continued to teach students who could afford to attend, sporting events continued to take place... the point being that the world didn't simply shut down.

The media often portrays that hard era as one where everyone in America either stood around on street corners panhandling or in a bread line. That is simply not the case. A closer look shows that, similar to today, economic hardship for what would then have been considered middle class and lower middle class began well before 1929. The stock market crash of 1929 was simply one manifestation of the spread upwards (the trickle up effect) of economic hardship, similar to the subprime mortgage implosion. In other words, the stock market crash didn't cause the Depression, it was merely a symptom of it.

Even after the crash, for the first couple of years, the stock-owner class, far and away a more elite class than stock-owners today, felt things would get better. And also similar to today, the rush by government to "do something" didn't really occur until after the economic elites were impacted.

This is what we are experiencing now. Economic hardship for a large number of Americans began more than eight years ago. It is quite true that, comparatively, living conditions for the vast majority of Americans are much better today than 70 years ago, arguably even for those living below the poverty line. But that does not change the socionomic impact of what is taking place.

It is doubtful we will ever experience the massive degree of unemployment that the U.S. saw during the Great Depression, but not because the Federal Reserve or some other such entity is better at preventing recessions and depressions, only because government in general is better at creating publicly funded employment for citizens.

We will likely come to view this bout of recession, retrenchment, whatever one calls it, like those living in the Depression did: "Just when we thought it was over, it was really only beginning."


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