Our Financial House of Cards and How to Start Replacing It With Solid Gold (I)

by By George Reisman

A credit crisis has been spreading through the economic system. It began with the collapse of the housing bubble, which was the result of years of Federal Reserve–sponsored credit expansion. This credit expansion poured hundreds of billions of dollars into the purchase of homes largely by subprime borrowers who never had a realistic capability of repaying their mortgage debts in the first place. And, not surprisingly, large numbers of them in fact stopped making the payments required by their mortgages.

At first apparently confined to the market for subprime mortgages, the credit crisis has spread to other portions of the mortgage market, to the usually staid municipal bond market, and within the last week or so has led to a run against a major investment bank (Bear Stearns). Along the way, triple-A rated securities have overnight turned into junk bonds, multibillion-dollar hedge funds have collapsed, and major commercial banks have lost tens of billions of dollars of capital. All this, despite massive infusions of funds into the market by the Federal Reserve System and other central banks and a reduction in the federal funds rate from 5.25 percent in September of 2007 to 2.25 percent currently.

In the process, the triple-A rated securities that turned out to be junk served to confirm the old truth that lead cannot be turned into gold: the alleged triple-A securities were backed by collections of mortgages that in the last analysis consisted largely or even entirely of subprimes. An important new truth also appears to have emerged: namely, that PhDs in finance, the likely authors of the schemes for creating such securities, can turn out to be far more costly than anyone had ever dreamed possible.

Currently, untold billions more of banks' capital now hinge on the survival of bond insurers striving to insure more than two trillion dollars of outstanding bonds on the basis of capital of their own of roughly ten billion dollars. Collapse of the bond insurers would mean that credit-rating firms, such as Moody's and Standard and Poor's, would reduce the ratings of all the bond issues that would consequently be deprived of insurance coverage. This in turn would serve to reduce the prices of those bonds, because lower credit ratings would make them ineligible for purchase by numerous investors, such as many pension funds. To the extent that the bonds were owned by banks, the value of the banks' assets would be correspondingly reduced and with it the magnitude of the banks' capital.

The decline in the assets and capital of banks that has already taken place has served to reduce the ability of banks to lend money to borrowers to whom they would otherwise normally lend. To the extent, for example, that subprime mortgage borrowers have stopped paying interest and principal on their loans, the banks do not have those funds available to make loans to other borrowers.

The effects of such credit contraction can already be seen in business bankruptcies precipitated by an inability of firms to obtain refinancing of debts coming due. It can also be seen in the growing difficulty even of sound firms to obtain financing required for expansion.

The Role of Leverage

Our present circumstances follow decades, indeed, generations of almost continuous inflation and credit expansion, in which almost everyone has become accustomed to assume that asset values will always rise or at least will quickly resume their rise after any pause or decline. This assumption not only played an important role in the eagerness with which people lent and borrowed in the mortgage market, but also in bringing about the very high degree of financial leverage that has come to characterize practically all areas of our financial system. (Leverage is the use of borrowed funds to increase the returns that can be earned with a given sized capital. It equivalently increases the losses that can be incurred on that capital.)

Unduly high leverage explains the failure of major lenders in the prime portion of the real estate market. As the result of losses sustained in subprime mortgages, banks and other lenders could no longer provide funds as readily for the purchase of prime mortgages. The resulting few percent drop in the value of prime mortgages has served to wipe out the entire capital of prime mortgage lenders whose capital was so highly leveraged that it constituted an even smaller percentage of the value of their assets than the few percent drop in the price of those assets. For example, if a mortgage lender initially had assets worth $103 and debts of his own of $100 incurred in order to finance the purchase of those assets, a mere 4 percent decline in the value of his assets would wipe out his entire capital and then some. Multiply these numbers by many billions, and the example corresponds exactly to the real-world cases of Thornburg Mortgage and Carlyle Capital reported on the front page of The New York Times of March 8, and to that of Bear Stearns reported on the front page of The New York Times just one week later.

The liquidation of the assets of such lenders, which consisted mainly of prime mortgages, has meant a further fall in the price of prime mortgages, to the point where the credit even of the government-sponsored mortgage lenders Fannie Mae and Freddie Mac has come into question. These two lenders have outstanding mortgage-backed obligations of more than $4 trillion, which sum until recently was assumed also to be an obligation of the US government. Now it has become uncertain whether the actual obligation of the US government extends beyond the less than $5 billion in lines of credit these lenders have with the US Treasury.

The Federal Reserve's rescue of Bear Stearns can be understood in part in the light of its desire to avoid further declines in the assets and capital of Fannie Mae and Freddie Mac, which would have resulted if Bear had had to sell off its holdings of mortgages. The likelihood that the failure of Bear would have triggered the failure of other major Wall Street firms and thereby have resulted in even more massive sell-offs of mortgages, along with other assets, was a related important consideration.

Remarkably, at the very same time that the Federal Reserve has been striving to cope with the consequences of excessive leverage and possibly thereby help to prevent the collapse of Fannie Mae and Freddie Mac, the government regulator of these institutions — the Office of Federal Housing Enterprise Oversight — is not content with the fact that they are already skating on dangerously thin ice. Thus, The New York Times of March 20 reports that the regulator has just decided to reduce their capital requirements, for the purpose of enabling them to take on still more leverage. The effect of this will be that an even more modest decline in home prices and mortgage values will be sufficient to drive Fannie Mae and Freddie Mac into bankruptcy than is now the case.

As these examples illustrate, the failure of debtors can serve to wipe out the capital of highly leveraged creditors, who then become unable to pay their debts, perhaps causing the failure of their creditors, and so on. In other words, one failure can set off a domino effect of a chain of failures. What serves to end the process is when someone in the chain finally accumulates enough salvageable assets from those earlier in the chain to be able to satisfy his creditors.