Thursday, August 23, 2007

Recent Stock Market Events

The steep, breathless reaction of the stock market to the escalating defaults in the mortgage market was rescued by a Federal Reserve cut in the discount rate. The fall in stock prices, almost 10% in one month, was exaggerated by two factors. First, hedge fund liquidations, the extent of which we will never know, were in the trillions of dollars. Second, panic in the mortgage market began spreading into other credit markets because other banks and corporations were unsure of the risk in each other's investment portfolios. As a result, they became hesitant to loan money to one another, even over night.

On Tuesday 8/20, the Fed encourage 5 of the nations largest banks to borrow from the discount window. Normally, this is an embarrassment for a bank, like borrowing money from your grandmother. The goal is to break the gridlock in intra-bank lending and to signal banks in the short run that the discount window is open for business.

What has not been mentioned in the media as far as I can tell is the underlying catalyst for the collapse in the mortgage and real estate markets. According to IRS data, real incomes have failed to rise for most of the 2000s. To make up for this shortfall most families have relied upon the increase in equity of their homes and credit cards to suppliment their incomes.

The strategy worked well, of course, when home prices were rising. However, home prices began to stall 2 years ago and we have just now begun to see the death of the creative financing that kept people upside-down in their homes. The real crisis is still ahead; supporting 2007 homes prices on year 2000 incomes.

The second bell of the credit crunch has yet to ring. Banks have been just as reckless with their credit card lending practices as they have with their mortgage lending if not more so. Capital One has already begun raising the cost of credit citing “business and economic factors." Should the rate of default begin to increase on credit card debt as well, banks can be counted upon to panic in an equally vigorous way. This could be a combination of raising interest rates and/or calling in existing balances in full bringing a collapse in upon themselves.

The unregulated growth of both mortgage lending and credit card debt has much to do with the Bush economic expansion. According to IRS data - "The growth in total incomes was concentrated among those making more than $1 million a year. The number of such taxpayers grew by more than 26 percent, to 303,817 in 2005, from 239,685 in 2000. These individuals, who constitute less than a quarter of 1 percent of all taxpayers, reaped almost 47 percent of the total income gains in 2005, compared with 2000." These fortunate few had little to do with economic growth over the past 6 years. Rather it was optimism and the hope of economic growth by the average citizen the fueled the expansion.

The most efficient way to redistribute this bulge of wealth is for the Federal Reserve to inflate the economy. To do so runs contrary to its primary mission. However, it may be the lesser of evils. Because the economy, like everything else touched by this adminstration, has been so grossly mismanaged, a radical approach may be required to jolt the balance of wealth back into equilbrium.