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An Economic Heart Attack

By Dean Whittaker

In the past few months, the living body that is our economy has suffered a massive heart attack. The circulation of blood (currency) has ceased, and permanent damage has begun to occur in the form of foreclosures and bankruptcies.  The first signs—subprime-mortgage defaults–began a few years ago. But we turned away, as one does from the first twinge in the chest, the shortness of breath, hoping the body of our economy was not really sick, and, if it were, that it would magically heal itself.

Sub-prime mortgages were provided to home buyers with questionable credit and little or no down-payment.  The mortgages had complicated and confusing documentation that hid the rapid increase in payments that would occur after the first few years.  These sub-prime, risky mortgages, which paid a high interest rate, were packaged by investment banks into securities that were AAA rated, guaranteed by the borrowers’ homes, and insured against default by an insurance company.  Trillions of dollars of these “good as gold” securities (stock) were sold to banks around the world, who bought them because of the “guaranteed” high interest rate they paid. The banks used them as part of their required reserve capital, which they must keep in order to be allowed to loan money.

Banks are allowed by law to loan more money than they have in their capital reserve. In fact, banks can loan 10 times as much, resulting in “leverage.” This leverage means that they can have $1 on deposit and loan out $10. Banks are formed when wealthy individuals buy stock in the bank, giving it the capital it needs to make loans.  Rather than let the required $1 sit not earning interest, banks invest the reserve in Triple-A rated securities, especially ones that pay the highest rate of interest, which the asset-backed, triple-A rated, insured securities based on the risky real estate loans did.

As the sub-prime borrowers failed to be able to pay their ever-increasing monthly payments, their homes went into default and eventually into foreclosure.  The insurance companies that had insured these homes against default were overwhelmed by the size and scope of the defaults and quickly ran out of capital to reimburse the banks for their losses.   The Federal Reserve, our bankers’ bankers, saw the first signs of the “house-of-cards” starting to fall and attempted to prop it up by loaning the insurance companies billions of taxpayer money so the insurance companies could make good on their promises to pay when the borrower defaulted on their mortgages.

The securities that the commercial banks had purchased to cover the capital reserve requirement became worthless, as there were no buyers who wanted to purchase them. Banks, which normally loaned each other money at the end of the day to balance their books, lost confidence in each others’ ability to repay these short-term loans and stopped making them.

The Wall Street investment banks that created the sub-prime-backed securities kept some of the asset-backed securities for themselves, and they soon found themselves in the same dire straits as the commercial banks.  Once again, the Federal Government bailed them out, with the exception of one large investment bank, Lehman Brothers.  When Lehman Brothers went into bankruptcy, a domino effect was set in motion.

Other Investment banks, such as Goldman Sacs, transformed themselves into commercial banks in order to be eligible for “bail-out” money from the Federal Government or were bought by commercial banks.

Bankers, fearing the insolvency of their fellow bankers, continued to refuse to provide the overnight loans used in common practice to balance their books at the end of each day.  As a result, shock set in at the sudden loss of circulation, and the credit markets froze. The circulation of currency suddenly stopped.

The sudden loss of access to borrowed capital triggered a series of responses.  The housing sector, which was most dependent on the easy flow of borrowed money, felt the lack of circulation first. Through speculation aided by easy access to capital, the housing sector itself had become over-built.  Multiple-home ownership created a false sense of demand as homes became speculative stock bought on margin to be sold in a few years before balloon payments became due. The true value of these speculative properties became clear when there were no buyers (and thus no value) when the circulation of currency stopped.

The financial sector, which had securitized the mortgages of the real-estate speculation, began to feel the reverse effect of their high-yield leveraged positions, which amplified the effect by the degree to which they were leveraged (in some cases 30 to 1 or more). As highly leveraged hedge funds began to have their margins called, financial organizations were forced to begin to sell their stock portfolios, triggering a downward spiral of stock prices. As the value of their portfolios fell further, financiers were forced into selling even more of their stock at whatever price they could get, causing a massive drop in value as no buyers appeared. Knowing that the passage of time would result in yet lower stock prices, short selling was the new game, and major bets were made that tomorrow’s stock price would be lower than today’s.  These bets became a self-fulfilling prophecy.

Other parts of our economic body began to shut down. The manufacturing sector, in particular automotive (which is highly dependent on the consumers’ access to borrowed money), felt the demand for their products suddenly stop.  The ripple effect of the loss of demand for automobiles triggered major cash flow issues for the “big three” in the older automotive sector.  Their union contracts, which demanded near-full pay even for idled workers, created high fixed costs. In addition, these unionized auto companies have the legacy cost of the generous retirement benefits owed their ever-increasing ranks of retired workers.

After the government tried and failed to re-start our economic heart with the $700 billion shock from the paddles of the defibrillator, our economy has gone into cardiac arrest.  It now waits in the intensive care ward for open-heart surgery for possible multiple bi-pass operations or heart replacement.  Our newly elected President has lined up a team of the best economic surgeons to do the operation.  If our economic heart cannot be repaired because the damage is too great, a heart replacement may be necessary.  Massive public works projects, along with expenditures in alternative energy and other efforts to jump-start the economy may be necessary. A whole new economic system, which would provide a more equitable distribution of income among all classes of society, may be required. No one on our surgical team has had experience replacing an economic heart.  The procedure has never been done before.

Regardless of whether the heart can be repaired or must be replaced, our economic recovery will be long and slow.  Economic cardiac rehabilitation will require a change in life-style, exercise and diet.  We will need to lose weight to reduce the work load on our heart and take extremely good care of our economic body to allow it to heal itself.   While drugs can artificially control our blood pressure and aid in healing, the natural markets need to be allowed to work in order to heal our economy.  Time, patience, and compassion will see us through to new economic health based upon sustainability. A time of innovation is at hand, and we will re-invent ourselves and the economic system on which our prosperity is built. This too shall pass, and we will learn from the experience and be stronger (and hopefully wiser) because of it.  With change comes opportunity, and as economic developers, we have our work cut out.

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