Last night in his prepared remarks to the US Senate Banking Committee, Federal Reserve chairman Ben Bernanke said: “The downturn in the housing market has been a key factor underlying both the strained condition of financial markets and the slowdown of th
Don’t forget this is all happening because there was a housing bubble in the United States (and Australia, for that matter).
Last night in his prepared remarks to the US Senate Banking Committee, Federal Reserve chairman Ben Bernanke said: “The downturn in the housing market has been a key factor underlying both the strained condition of financial markets and the slowdown of the broader economy.”
Actually make that the key factor. The housing bubble was the basis of two separate, but related debt inflations; households and financial sector, the former to finance increased consumption, the latter to produce inflated profits.
The housing bubble peaked in August 2006, according to the S&P/Case-Shiller indices, and has since fallen 20% nationally (to June this year). Some markets have fallen more – for example Miami is down 32%, Phoenix 30% and Las Vegas 26%.
As the housing bubble deflated, the most highly geared ends of each sector – sub-prime and Alt-A borrowers among the households, and investment banks and other parts of the “shadow banking system” among the financiers – quickly lost their equity.
Defaults rose and investment banks reported balance sheet write-downs so great in relation to their capital that the industry has disappeared entirely.
Now Bernanke and US Treasury Secretary Henry Paulson are trying to get the US Congress to support the establishment of a false market in housing assets by using the US Government’s ability to borrow and tax.
Unusually, Bernanke departed from his prepared comments in the testimony to the Banking Committee and argued passionately for the Paulson plan: “I believe if the credit markets are not functioning, that jobs will be lost, the unemployment rate will rise, more houses will be foreclosed upon, GDP will contract, that the economy will just not be able to recover.”
This is to be achieved by replacing “fire-sale” pricing in the housing market with “hold-to-maturity” pricing – in other words, a false market. That’s because the suspension of “mark-to-market” accounting rules, backed by many banks, would hurt investor confidence, according to Bernanke.
He didn’t say this, as far as I can tell, but the third alternative of directly recapitalising the lenders would simply not be acceptable to the community. It was acceptable for Fannie Mae and Freddie Mac, because they were already so-called Government Sponsored Enterprises, and AIG had to be recapitalised because of the effect its insolvency would have on relations with China and other Asian nations.
According to Robert Shiller’s book, The Subprime Solution, Bernanke (the then chairman of the President’s Council of Economic Advisers) said in 2005: “House prices have risen by nearly 25% over the past two years. Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals, including robust growth in jobs and incomes, low mortgages, steady rates of household formation, and factors that limit the expansion of housing supply in some areas.”
OK, so who among us would want our words of three years ago quoted back?
And Bernanke was simply part of a generally sanguine response to the housing bubble from officialdom in the US. President Bush, in particular, continually boasted about America’s economic successes, based on low mortgage rates and rising levels of home ownership.
In fact, the bubble was much more than the 25% mentioned by Bernanke in 2005. According to S&P/Case-Shiller index, devised by Robert Shiller, national house prices rose 154% between August 1997 and 2006. This was 85% in real terms.
But can the US Treasury really now step in and support the market with taxpayers’ money, like Samson from the Book of Judges, slaying an entire army with nothing but the jawbone of a donkey?
Bernanke thinks so. Speaking off-the-cuff to the Banking Committee last night, he said: “If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.
“First, banks will have a basis for valuing those assets and will not have to use fire-sale prices. Their capital will not be unreasonably marked down. Second, liquidity should begin to come back to these markets. Third, removal of these assets from balance sheets and better information on value should reduce uncertainty and allow the banks to attract new private capital. Fourth, credit markets should start to unfreeze. New credit will become available to support our economy. And fifth, taxpayers should own assets at prices close to the hold-to-maturity values, which minimises their risk.”
And sixth – which he didn’t say – is: We got you into this mess, so we have to get you out of it.
American free-market capitalism has never been all that free. The home mortgage market was manipulated by the presence of Fannie Mae and Freddie Mac, and the Federal Reserve held interest rates artificially low through 2002, 2003 and 2004.
And now it definitely can’t be free. The Government boosted housing during the boom, and now really has to boost it during the bust to avoid economic collapse.
The question is not just whether it should, but whether it actually has the resources to do that. The package of measures announced so far will add close to $US1 trillion to the US budget deficit. It’s already $US400 billion.
It is very unlikely that this many extra treasury bonds can be sold to global central banks and sovereign wealth funds already looking to reduce their exposure to the US. The alternative is to print money. Either way, the US dollar is heading south.
I heard one American commentator on ABC radio’s PM program last night predicting, at the top of his voice, that US would end up with Zimbabwe-style hyper-inflation and depression as a result.
But what is the consequence of not doing it? No one really knows, but it’s also bad.
And this comes at a time when the Bush administration’s credibility is not all that it should be.
As Mike McNulty, a New York Democrat on the Banking Committee, said last night: “This is eerily similar to the rush to war in Iraq. We have been told repeatedly by this administration that the economy is fundamentally sound, and then all of the sudden they say the economy is going to collapse. That is unacceptable.”
So this is not only an economic calamity for the United States, it’s a psychological one too.
Oh, and as for Australia, our housing bubble has also busted, but the effect on the financial sector has not been as devastating because its gearing and the excesses were not as great, and the national income has been supported by a terms-of-trade boom.
But don’t get too complacent – the housing bust probably has further to go.
This article first appeared on Business Spectator