Thursday, April 24, 2008

Subprime Country: A Nation Within a Nation

Knowledgeable correspondent Eugenio M. sent in a fascinating academic paper (I know, that sounds like a contradiction) which traces the similarities between the Developing nations' debt meltdowns in the 1980s and the current Subprime-triggered debt meltdown in the U.S.


The key take-away is how oil exporting countries' enormous profits--generated by the late-70s-early 80s spike in the dollar-denominated price of crude oil-- were recycled by U.S. banks into high-interest loans to Argentina and other risky Developing Economies. When Argentina et. al. defaulted, the losses drove Citicorp and Bank of America to the brink of insolvency.


Fast-forward to the 2000s: now this stupendous oil-revenue wealth has been supplemented by veritable mountains of dollars piling up in Asian exporters' accounts. Where to put all this cash to work in a low-interest rate world?


Answer: credit-risky mortgage borrowers in the U.S. The authors also report that bubblicious U.S. house prices far exceeded the heights reached during other advanced-economy banking crises.


The paper also charts how the U.S. current account deficit (trade deficit) at 6% of GDP is double that experienced by other advanced-economies at the height of their banking crises.
In other words: the U.S. housing bubble inflated in a macroeconomic setting of one extreme after another. It's not just housing prices which shot to the moon, but debt, leverage, the trade deficit, risky financial "innovations" and on and on.


Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison:


"Next comes reality. Starting in the summer of 2007, the United States experienced a striking contraction in wealth, increase in risk spreads, and deterioration in credit market functioning. The 2007 United States sub-prime crisis, of course, has it roots in falling U.S. housing prices, which have in turn led to higher default levels particularly among less credit-worthy borrowers.
The impact of these defaults on the financial sector has been greatly magnified due to the complex bundling of obligations that was thought to spread risk efficiently. Unfortunately, that innovation also made the resulting instruments extremely nontransparent and illiquid in the face of falling house prices.


While each financial crisis no doubt is distinct, they also share striking similarities, in the run-up of asset prices, in debt accumulation, in growth patterns, and in current account deficits. The majority of historical crises are preceded by financial liberalization, as documented in Kaminsky and Reinhart (1999). While in the case of the United States, there has been no striking de jure liberalization, there certainly has been a de facto liberalization. New unregulated, or lightly regulated, financial entities have come to play a much larger role in the financial system.
During the 1970s, the U.S. banking system stood as an intermediary between oil-exporter surpluses and emerging market borrowers in Latin America and elsewhere. While much praised at the time, 1970s petro-dollar recycling ultimately led to the 1980s debt crisis, which in turn placed enormous strain on money center banks.


It is true that this time, a large volume of petro-dollars are again flowing into the United States, but many emerging markets have been running current account surpluses, lending rather than borrowing. Instead, a large chunk of money has effectively been recycled to a developing economy that exists within the United States’ own borders. Over a trillion dollars was channeled into the sub-prime mortgage market, which is comprised of the poorest and least credit worth borrowers within the United States. The final claimant is different, but in many ways, the mechanism is the same. Simply put: U.S. banks found a Third World nation of borrowers willing to shoulder high interest rates within the U.S. itself: let's call it Subprime Nation. Here are three snapshots of Subprime/Alt-A/No-Doc/Option ARM Nation:


1. Subprime Nation has little or no ownership of assets

2. Subprime Nation's mortgage resets will continue to climb through 2011

3. Subprime Nation has borrowed itself into a deep, deep hole

(Please go to www.oftwominds.com/blog.html to view the charts)

In an election year, politicos' electability rests largely on their ability to woo Subprime Nation's shellshocked voters. Leaving aside personalities, race and gender for a moment, let's consider the Pennsylvania Democratic primary results. Clinton won the majority of Caucasian "working class" (a.k.a. Subprime/Alt-A/No-Doc/Option ARM Nation) females and males; Obama won the majority of African-American and young/Caucasian urban dwellers.


Let's talk about political pandering, and what drives the rush to pander most/best. The 'gummit' must save Subprime Nation's citizenry from their own excess and lack of caution, we are told, lest their 'betters' (see wealth-distribution chart above) actually suffer as the meltdown proceeds into other asset classes like stocks and commercial real estate.


And as if cue, the "magic bullet" legislation which was supposed to hit insolvent Subprime Nation actually hits lenders and builders. Hmm. And who owns those institutions? Not Subprime Nation. They own zilch, nada, zero assets--but they do "own" debt--a lot of it.


It seems there are two nations within the borders of the U.S.: Subprime Nation, its wages and income shrinking, its gamble on the housing bubble lost, and those who are still pulling down big salaries and bonuses, still accumlating frequent flyer miles and still (occasionally) buying horrendously overpriced homes in San Francisco and other "islands" of wealth in a sea of debt and asset destruction.


Astute correspondent Jon H. sent in this reader-report from Urban Survival which describes the true plight of Subprime Nation:


"I wanted to tell you about what I saw at Wal-Mart this weekend that even took me aback. I stood in line at the self checkout while a woman in front of me rang up a few items. I didn't pay attention of course, but purchasing only a couple plastic food containers and a plunger couldn't have cost more than about $10. Each time she attempted to pay with a credit card, the machine belted out "card not accepted".


Being curious, I watched her try FIVE different cards, and I could see her hands beginning to shake as she laid he wallet down on the scanner to search for more cards. This was taking so long that I moved over to the next self checkout lane, where one man with his son were just finishing to ring up a few items he had purchased. I watched the other woman get help from one of the attendants, after which she abandoned the items and just left.


Meanwhile, I heard "card not accepted" from the new machine I was at. The man in front of me had the same problem. This time, he tried 2 credit cards until he finally pulled out his check debit card (it was the same one I had from the same bank) and his purchase was approved. He had only purchased a few items as well, undoubtedly not more than $10 also.


As I began to ring up my $6 order, I heard "card not accepted" from another self checkout around me, but I didn't bother to look. I just paid and left.


I realize this was only one incident, but now I'll be more alert in other stores to see if similar things happen. I have a feeling, though, that people are far more squeezed than most realize."

It doesn't take much insight to gather than Subprime Nation (or at least the Caucasian and Hispanic citizenry of that nation-within-a-nation) voted for Hillary Clinton as their most likely supporter/savior. The question, of course, is whether the next President can do anything to "save" Subprime Nation from its own debt explosion--and if such a "save" is even possible or helpful in the long run.


Though his stance seems to be changing, McCain recently said the 'gummit' should not be in the business of bailing out speculators. (Note to Mr. McCain: Mr. Bernanke has already spent $360 billion (link courtesy of patrick.net) doing exactly that--but it isn't the Subprime Nation speculators he bailed out, it's the Top 1% owns 90% of the Productive Assets Fat Cats.)


We should also recall that fully 40% of the housing purchased in the bubble years was bought by speculators. As the bubble house of cards tumbles down, then even middle-class real estate speculators are finding that they have have just been issued passports to Subprime Nation.
What drove Americans to eagerly immigrate to Subprime Nation? The simple, and I think inadequate, explanation is simple pure human greed: to get something for nothing, to join the free-money bandwagon.


As I have suggested here before, I think the underlying motivation was to make up the decades of stagnant/sinking income and the decades of rising prices--not for food back then, but for college and medical care and much else that defined the "middle class" lifestyle--via speculation in an asset class everyone understood (or thought they understood): housing and real estate.


Now that the bet to make up for decades of declining income has been lost: now what? Though Obama's comment about "bitter" rural dwellers has earned him a lot of spilled ink and indignant ire, I wonder if he wasn't mis-describing something important. Perhaps Americans of all ethnicities, religions and types--rural, small-town and urban dwellers alike--aren't bitter so much as despairing: depairing about staying in the middle class (college education, secure employment with medical benefits, home ownership with a 30-year fixed rate mortgage, etc.) or about bootstrapping themselves up into the middle class.


These are not phony concerns. Global wage arbitrage (i.e. somebody overseas can do your job for much, much less than we pay you), temporary/contract jobs replacing full-time jobs, the erosion of employer-provided pension plans and healthcare--these are real. State college tuition, once relatively cheap, has risen to the point that being saddled with tens of thousands of dollars in student loans is considered "normal" now, when a generation ago they were unheard of.


Just as disturbing is the rise of cheating in American schools and life: cheating on exams, fabricating or exaggerating resumes, etc. The trend points to a people desperate enough and fearful enough of "losing their big chance" to throw away personal integrity for a cheap "A" or liar-loan or puffed-up resume. What does a fabricated excellence or expertise say about the holder of that resume? Nothing good, that is certain.


So now the question becomes: have Americans more or less given up? Have they lost confidence in their own abilities to prosper in a hyper-competitive world? Is that why so many were eager to belly up to the roulette wheel of the housing bubble and throw down their borrowed chips on a last-ditch gamble "for the good life," a life of new cars and suburban homes, all acquired without savings or sacrifice?


Frequent contributor Harun I. wrote the following in response to yesterday's entry on the "bottom" in housing, and it is a powerful commentary on the psychology of want/need, optimism and confidence:


"Beyond all mathematical reasoning we simply have not reached the point of maximum pessimism in anything. The magnitude of all the varied issues (credit, weak dollar, energy crisis, food crisis, budget crisis (state/federal) and their convergence is misunderstood at a conscious level.


I don't perceive doom because doom is relative. There will be those that prosper in all circumstances even if it is not readily apparent.


I believe the trick is to be confidently optimistic based on trust in ones efficaciousness in any environment. Perhaps it is a lack of trust in ones' abilities that leads to fear and despair."

It is sobering to contemplate the possibility of a debt-ridden, anxious nation within a nation, a nation of residents who may, at some deep level, have lost confidence in themselves, in their supposed leaders, and perhaps in their nation itself.


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