"The severe market turmoil seen this month was largely predictable. The seeds were sown in the aftermath of the dot-com bubble collapse, the major decline in the stock market and the 2000-2001 recession. Since corporations built far too much capacity in the late 1990s and households saved too little and piled up record debts, the Fed had to figure out a way to stimulate growth and employment. It did this by lowering interest rates to 1% and promising to maintain that rate for an extended period. As a result households took on vast amounts of additional mortgage debt to buy new houses, helping to stimulate an economic recovery even though both employment gains and capital expenditure growth remained sluggish.
To goose the economy even further, credit standards were lowered, allowing adjustable-rate mortgages (ARMS), undocumented loans, and zero interest rate mortgages. Consumers were actually encouraged by Fed Chairman Greenspan, who publicly stated that homeowners could save a substantial amount of money by taking out ARMs. Vast numbers of people were thereby enabled to purchase houses that they could not otherwise afford based on their income and assets. The result was an unprecedented housing boom and soaring house prices that allowed households to extract hundreds of billions of dollars from their homes through cash-out refinancing, home equity loans and outright sales. At one point such mortgage equity extractions (MEW) were running an annualized rate of about $800 billion. Mostly due to the housing boom and MEW, consumer spending, accounting for 70% of GDP, supported an economic recovery that boosted growth throughout the globe.
In addition these mortgages were sold and packaged into collateralized debt obligations (CDOs) consisting of tranches of quality—senior (rated AAA), mezzanine (AA to BB) and equity (unrated)—and given an AAA rating by the ratings agencies. The CDOs ended up everywhere including hedge funds, pension funds and money market funds all over the globe. As we and others predicted the housing bubble eventually broke, prices started to decline and holders of both subprime and alt-A mortgages began to default in substantial numbers, exposing large amounts of CDOs as the junk they always were. The result is what we have recently been witnessing—a global chain of margin calls bringing down what we have in the past called a house of cards.
The carnage is far from over. Amazingly, one guest on bubble TV today casually referred to the recent market turmoil as "financial gamesmanship" as opposed to what he termed "solid economic fundamentals." This is a widely-held view that has minimized the market decline so far and has prevented widespread capitulation. The implication is that the credit problems and stock market decline is merely a tempest in as teapot caused by some panicky investors who can’t see a great buying opportunity. In our view, nothing could be further from the truth. Some studies indicate that as much as one-half to two-thirds of the increase in output and employment since the last recession bottom were a result of housing, housing-related activities and MEW. That support is now gone and the so-called "financial gamesmanship" is in reality the dismantling of the rickety debt structure built up over a period of years. As the house of cards come tumbling down the economy, which has already been slowing down, seems inexorably headed for a hard landing and severe earnings disappointment. We also point out that housing starts in July were down 39.6% from the peak. Over the past 47 years housing starts have declined 35% or more six times and each time was associated with a recession. The credit and asset bubble today is much larger than in any of the previous instances.
The credit market problems and coming economic dislocations strongly suggests that a major bear market is now underway. As in the bear market of 2000-2002, it is likely that we will see a number of vigorous rallies that investors mistake for the end of the overall decline. One such rally could occur when the Fed first makes a dramatic move toward ease. It should be noted, however, that the S&P 500 soared 5% on the day the Fed first lowered rates in early January 2001, only to fall 44% over the next 21 months."
Good article. What’s the source?