The worst of the recession is still ahead

The credit crunch stage of this recession is far from over judging by the losses reported by AIG this week. Even more worrisome, the coming cyclical deterioration in consumer and business spending in the US and around globe has not even begun in earnest.

This cautionary point of view is clearly at odds with calming statements by public figures suggesting the worst of the credit crunch is over. Jamie Diamon of J P Morgan Chase, who has a boatload of Bear Stearns paper to sell at what he hopes are better than fire sale prices, indicated that the credit crisis was 75% to 85% over. Treasury Secretary Hank Paulson diplomatically said we are closer to the end than the beginning of the credit crisis. The obvious intent of these calming statements was to encourage risk taking and speculative buying of mortgage-backed bonds and other distressed financial paper.

Even if there were an element of truth in these calming statements, it would be primarily limited to "too big to fail" goliath-sized commercial banks with access to virtually unlimited Fed financial backing. These banks have a protected franchise. This includes a realively dependable source of substanial profit in the wide interest rate spread between low borrowing costs at the Fed or equally low-cost captive deposit funds on the one hand and lending rates on presumably prudent loans. But, even these major banks would be jeopardized if there are further surprise losses that outrun their ability to raise fresh capital. Citibank this week indicated a need to shrink its assets, presumably to avoid the need for still more capital.

Other types of financial institutions remain at risk. There are a sizable number of medium and smaller troubled banks caught up in the sub-prime mortgage and housing debacle that are on the watch list of the Fed and other bank supervisory authorities. AIG, the giant insurance company, this week reported a $7.8 billion loss, exceeding a $5.3 billion loss posted for the prior quarter, neccesitating their raising $12.5 billion in new capital. It, like other insurance companies, hedge funds, investment banks and other types of financial institutions may yet have other losses still to come to light. Other types of credit are also vulnerable, including credit card debt, auto loans and conventional conforming mortgages, which ought to be better risks than sub-prime mortgages.

Former Fed Chairman Greenspan this week indicated that the depth of the credit crisis depends on the extent of the drop in home prices. This is a realistic appraisal of the causal relationship of the worsening credit crunch. The sub-prime mortgage debacle the unwillingness or inability of homeowners to meet their mortgage payments. The decline in home prices, especially to below mortgage principal, undermines the commitment of borrowers to meet their mortgage obligations. It certainly precludes homeowners ability to continue using their homes as an ATM machine. At the same time falling home prices erode the value of mortgage-backed securities as well as contibuting to mounting mortgage delinquencies, defaults and foreclosures. Rising foreclosures, and the ultimate sale of the properties at distress prices, reinforce the credit crisis, as it further depresses home prices.

Thus, it is reasonable to expect a sustained turnaround in the credit crisis will depend on a bottoming, and still better, an improvement in home prices. Unfortunately, a bottoming in home prices is unlikely to be reached until next year or 2010. And a rise in home prices may well be delayed until 2011. This prolonged delay in a recovery in home prices is reinforced by the accelerated plunge in home prices in recent months reported in the Standard & Poors/ Case Schiller home price index, the liklihood of at least a further 10% to 15% home price drop nationally, a huge and rising inventory of unsold homes, rising foreclosures, a slowing home sales pace, and continued new construction.

As an aside, it is worth questioning why if Greenspan recognized the linkages,
he did not act to prevent the housing bubble from ballooning or prevent the banks from excessive and imprudent sub-prime related lending. This question seems especially relevant since Fed staffers reportedly prepared rgulations to accomplish such objectives which Greenspan refused to implement. It could also be asked why the Greenspan Fed did not act or even attempt to head off the equity market bubble of late 1990s, the bursting of which contributed to the last recession.

Philip Braverman, President
Braverman Economic Consulting
One Hewitt Square #249
East Northport New York 11731

philipbraverman@Gmail.com