Credit crunch; is it easing or about to get worse?

When the US housing bubble burst last summer many banks found themselves saddled with unquantifiable debts wrapped up in the sub-prime mortgage market. This is the market for high-risk loans to poor people with bad credit ratings and so most vulnerable to being unable to keep up payments on the mortgage as interest rates increase – as they did sharply in 2005-2006.

While this form of risk taking seems crazy and self-defeating it was in fact the inevitable result of changes in capitalist profit searching in the banking sector. Banks have not speculated in this form of lending because there were no profitable outlets in productive industries. On the contrary, US corporations have been enjoying historic levels of profits this century. Rather these big firms have turned their back on the banks as a source of investment funds.

Big US companies are flush with money and they financed their investment in recent years through retained earnings or issuing company bonds. Banks were forced to go in search of higher profits by turning increasingly to the consumer markets. In the past banks took a portion of surplus vale generated by industrial capital via interest on money loaned to firms; but as this became less available to them they turned to worker-as-consumer to wrack up their profits.

Issuing more credit card and other loans was one avenue, plus making lending easier to get mortgages for houses, while this had the effect of piling up risk for the future it certainly increased profitability: banks’ rate of return on capital shot up from 14% in 1999 to 21% in 2006.

Inevitably, the banks have taken more and more of household income. As wages have been broadly flat in the US and consumers borrowed to finance spending, the proportion of disposable income going to banks in interest payments has shot up from 14% in the late 1990s to 19% last year.

The bubble bursts

But last summer high returns for high risk rebounded on the banks and the bubble burst as defaults on mortgages mounted and house prices fell as supply rose fast. The assets on the banks’ balance sheets had to be sharply revalued. But there was a problem.

The scale of the debts was unclear due to a complex process of “securitisation” (parcelling up the mortgages/assets into bits and selling them on and on until it was not clear who held what on its books). So in a defensive measure, the banks stopped lending to each other; they feared they would be lending to another bank with untold and unknowable debts.
The so-called credit crunch had arrived.

This threatened US capitalism (and Britain by extension) with a serious financial meltdown as the system of payments that lubricate the economy broke down. It would eventually see the wheels of industry and commerce grind to a halt.

The US and UK central banks stepped in smartish and provided billions of dollars and pounds to banks to keep the wheels turning. One measure of the scale of the credit crunch is the interbank rate – the rate at which banks lend to each other. It is usually a shade above the central bank interest rate; in the UK it is called the Libor rate.
In the US the interbank rate soared to 5% at its peak last November.

Credit crunch easing?

But in the last two months as the scale of the banks’ bad debts has become clearer (and written off to some degree) and the banks remained solvent, the rate has declined. Last week it fell to 3.95%, near to normal levels. In addition, U.S. longer-term bond yields have also dropped indicating an easing of the interbank crisis of confidence

This news has filtered through to retail borrowers. Thirty-year mortgage rates have dropped to their lowest level in two years at 5.62%, prompting a surge in mortgage applications last week to their highest level since April 2004
So is the credit crunch over?

While it has eased in some areas it remains severe in other sectors and is likely to get worse before it improves; so much worse that it is likely to effect economic output this year, pushing the US to near recession level by spring if not into recession.

But first let’s start with the banks’ continuing problems.

The latest spate of bad news for major US investment banks announced this week brings the combined losses so far on sub-prime mortgage collapse to $100bn. With about 20% of these loans in total likely to be delinquent the final bill could be $200bn.

Yet, despite the scale of the losses none of these banks has gone bust or seems likely to, and yet none has been propped up by government intervention, as was the case in LTCM hedge fund in 1998 when the Federal Reserve organised a bailout. Why?

The answer reveals something about the reserves in the world economy that are being deployed to offset the crisis in one of its parts – the United States.

As a result of the strong – even unprecedented – growth in any economies of the global south this last ten years (due mainly to huge demand for energy and raw materials), many third world governments are sitting on huge cash reserves. Being unable to find profitable outlets for them in their own underdeveloped economies and unwilling to distribute the wealth to the people, the governments establish what are called “sovereign wealth funds”. The 29 sovereign-wealth funds monitored by Morgan Stanley are now worth about $2.9 trillion The largest funds are in the hands of Gulf oil states and China.

And it these funds that have been plugging the huge gap left in US investment banks’ balance sheets. Recapitalisation of these banks has been taking place on a huge scale since last spring, preventing bankruptcies – some $69 billion in the past ten months.

It is inevitable that more losses will be revealed in 2008 as housing defaults rise well into this year, and not only in sub-prime sector. Rising unemployment and falling disposable incomes will ensure that other “normal” mortgage holders will default too, adding to the downward pressure on banks balance sheets. But given the known scale of the problem ahead and the resources available, the banks should weather the storm – even at the cost of giving Chinese government et al a sizeable stake in these banks, once more sign of the advance of the new Asian economies.

Recession on the horizon?

The real threat of economic recession in the USA lies in the root of the banks’ problems – the housing market.
The Financial Times reported this week that:

“New residential building in the US last year suffered its biggest drop in nearly three decades….Housing starts for 2007 fell by more than 25 per cent to 1,376,100 homes. The largest previous drop was recorded in 1980, as the US entered a deep recession.
Builders broke ground on fewer new homes in December, leaving the annual rate of construction at 1,006,000 – its lowest level since 1991, and down 14 per cent from November and 38 per cent from the same month a year earlier.”

House prices continued to fall, 4% in the third quarter 2007 at an annual rate. As foreclosures increase in 2008 the supply on the market will increase, depressing prices further and deterring new building. Eventually, as repayments become easier to manage at lower interest rates and the supply is absorbed, new building rates will stabilise and a floor put under prices. But this is some way off.

Stock markets fall

For most of the second half of last year stock markets remained pretty resilient in the face of the credit crunch. Share prices yo-yoed depending on the latest set of data released. For each piece of bad news on bank write-offs or construction industry lay-offs there was “good news” from strong export performances as the low dollar boosted trade and as consumer spending held up.

Since the latter forms the bulk of US GDP this kept the markets buoyant. It seems that faced with falling house prices (and hence unable to borrow money on the back of this to finance spending), people started to return to maxing out their credit cards again.

But late on the year matters changed. It became clear that in Q3 the mass of profits fell, even if the rate of profit remained high for non-financial US companies. This was an augur. Then in the new year as provisional data on retail figures from Q4 were published and the reports on Xmas sales highlighted the downturn in consumer spending, then stocks started to fall sharply as firms lined up to issue sales and profit warnings for 2008. Since the new year stocks have fallen 9% in New York, trading a little below 6000 (they peaked at a shade under 7000 in summer 2007).

The period ahead

Financial crises can have varying effects on the underlying “real” economy, that is, industrial output levels, factory closures, wage levels and unemployment. The banks are likely to weather the storm from the sub-prime crisis, thanks to foreign capital, though they will have to adjust to lower levels of profitability. Paring back on fat bonuses and clearing out a few or even tens of thousands of jobs from this sector is not going to bring the US economy to its knees.

But a “perfect storm” of falling house prices, consumer retrenchment, leading to output falls, closures and job losses across most sectors, would hit hard. In the 2001-2003 recession more than 3 million manufacturing jobs were lost. Unemployment has already started to rise, from 4.6 to 5% in December. How fast and how far this downturn in real economic indicators, should become clear in the next three months, and much depends on two variables. The counter-cyclical measures the US government takes in the next weeks and secondly, the strength of the world economy outside the United States.

The Federal Reserve reacted to the credit crunch last summer by injecting funds into the interbank market to avoid a collapse in lending; then they started the process of lowering interest rates to cheapen the cost of borrowing. Later the Bush administration acted to freeze some interest rates on sub-prime mortgages to slow the rate of housing defaults.

At the end of this month, because the economic scenario has deteriorated, the Federal Reserve will certainly cuts rates again, and not for the last time. This again will help cut the rate and volume of mortgage foreclosures and stimulate the housing market.

But these counter-cyclical monetary measures have a downside. First they add to the downward pressure on the dollar as holders of US dollars abroad sell them rather than see their value fall further as rates are cut. In the medium term this undermines the global reserve currency role of the US dollar, something that has been crucial in recent years. Without sovereign governments being willing to hold their currency reserves in dollars or buy dollar assets (property, bonds etc) then it is harder for the US government to finance the country’s current account deficit. And this in turn has been critical in allowing US consumers to spend more than they earn in the past.

But for now the US Fed and government are less worried about this decline in the dollar’s reserve status than in forestalling a domestic recession.

But there is a further downside in the dollar’s slide as rates fall: inflation. A declining dollar means higher import prices and this adds to inflationary pressures (which have been strong recently due to surging global energy demand). Of course higher inflation can only be counteracted by higher interest rates, the exact opposite of what is needed today. Hence there is a limit to which the Fed can cut interest rates aggressively to forestall recession without stoking inflation.

In addition to the monetary measures, Bush and Congress will agree in the next weeks a package of tax breaks for business and tax repayments for workers amounting to a $145bn injection of demand into the economy (equivalent to about 1% of US GDP).

Whether it is a large enough stimulus and/or is agreed and enacted soon enough to have a meaningful effect is not clear, and whether any of this can prevent a recession in the US (ie a decline in output for six months) remains to be seen. But whether it happens, how deep it is and how long it lasts – and whether it draws in other parts of the world – depends ultimately on how strong the rest of the global capitalist economy is.

The historically unprecedented expansion of capitalism in China, India, Russia and others parts of the global south helps provide markets for US manufactures and services, while the dependence of these countries on exports to the US is less than has been suggested in the past.

As we have already seen these countries have already come to the rescue of the USA’s stricken investment banks and have massive resources to lend, invest or stimulate their own domestic economies, or absorb the cost of revaluing their own currencies against the ailing US dollar.

For sure, the length, depth and breadth of the US recession and its effects globally will test the strength and durability of the latest long wave in capitalist world economy.

Sun 20, January 2008 @ 11:59