The Great Debt Crisis Begins

January 13, 2008, by Hale “Bonddad” Stewart

Posted in the Huffington Post

http://www.huffingtonpost.com/hale-stewart/the-great-debt-crisis-beg_b_81264.html

Hale "Bonddad" Stewart is a former bond broker with several regional firms. He has been involved with the financial markets since 1995. He currently practices law in Houston, Texas and is a graduate student in taxation at Thomas Jefferson Law School, working towards an LLM in international and domestic (US) taxation..

A recent Los Angeles Times Article stated the basic problem thusly:

What makes bubbles so dangerous is that their consequences, when they burst, are wider, often more damaging, and certainly more unpredictable than those of ordinary downturns.

"We are more prone to bubbles than we used to be," said John H. Makin, a former senior Treasury official with several Republican administrations and now a scholar with the conservative American Enterprise Institute in Washington.

"The old-fashioned recession, where the consumer ran out of gas or there was an economic policy mistake, doesn't seem to occur much anymore," said Alice M. Rivlin, a former vice chair of the Federal Reserve and Clinton administration budget director. "As we've seen from recent events, bubbles seem to be playing a bigger role."

The basic problem faced by the US economy right now is excessive debt caused by recklessly low interest rates from the Federal Reserve. Here is a chart from the St. Louis Federal Reserve of the effective Federal Funds rate since 2000.

Notice the US had record low interest rates for a period of nearly three years. This led to a debt binge of mammoth proportions. Here is a chart of total household debt outstanding from the St. Louis Fed:

Notice the amount outstanding increased from around $8 trillion to a little shy of $14 trillion within a period of seven years. That's approximately a 75% increase in total household debt outstanding.

All of this debt has to go somewhere; it doesn't just exist in a vacuum. To accommodate this increase in total debt, we've seen a huge increase in structured financial products. In and of themselves, these are not bad devices; they have been around for approximately 25-30 years. However, they were used very recklessly over the last 7 years, and especially over the last 3-4 years. The short version of what happened is simple: lending standards deteriorated to the point where literally anyone could get a loan. These loans were then sold to investment firms, who pooled them together and carved them into various bonds, which were in turn sold to large institutional investors like pension funds, insurance companies and hedge funds. The idea underlying structured financial products was that risk was spread out to the point where the bonds were more or less insulated from default problems. However, when defaults skyrocketed higher than anticipated, we discovered that the risk wasn't contained nearly to the degree we thought. Instead, everybody started getting hurt.

Right now the Federal Reserve is treating this situation as a "liquidity crisis", meaning they are literally throwing money at the problem. They are hoping that by flooding the markets with money the money will get spent in the form of loans and credit. However, the market has ample liquidity. The problem is we are in the middle of a debt crisis:

During a liquidity crisis, the issue is one of supplying money to those who, for whatever reason, have suddenly shortened their time preferences. Mr. Practical, writing on Minyanville's Buzz & Banter, characterized it this way:

Suppose there is a rumor that a large bank has made a bad loan. Because banks lend out more money than they have on deposit - this is called a fractional reserve banking system - if everyone goes to the bank and demands their money at the same time, a liquidity crisis can occur because the bank does not have enough cash on hand to satisfy the demand from its depositors. The Federal Reserve will then step in and provide liquidity, allowing the depositor demands to be satisfied. If the rumor of the bad loan proves to be false, then the issue is one of liquidity. Time preferences soon return to a more normalized state, depositors return, everyone feels better. But, if the rumor turns out to be true, it doesn't matter how much liquidity the Fed provides, the bank will go bankrupt.

Similarly, the issue today is not one of temporary liquidity, time preferences being shortened out of a temporary risk aversion. The issue is too much debt supported by too little value and income generation. As a result, time preferences are retreating, risk aversion is growing, and access to credit is diminishing.

Here's the basic problem. All of that debt in the household debt chart assumes a certain asset value. Here's a simple example. Suppose a bank makes a $100,000 loan for a home valued at $100,000. If the home appreciates in value, everything is fine. However, let's assume the home's value decreases to $90,000. Now the loan is inherently less valuable because the underlying asset has decreased in value. If this situation persists or worsens, the lender will have to devalue the loan to some degree to reflect the lower asset value. Now, take this situation and apply it to the entire US economy and you get an idea for what exactly is going on right now.

Must watch:

Parts of Europe (such ask Netherlands and Denmark) use small local electricity generation plants, which permits the use of the byproduct heat for heating.  In one example they use all he CO2 generated to supply 4,000 hectares of green houses.   The combined heating and energy production (CHP) is a proven technology that lowers the energy consumption for electricty and heating by over 50%.   British (BBC) documentary on this http://www.youtube.com/watch?v=klooRS-Jjyo&mode=related&search

Teddy Roosevelt's advice that, "We must drive the special interests out of politics. The citizens of the United States must effectively control the mighty commercial forces which they have themselves called into being. There can be no effective control of corporations while their political activity remains."