"I Wonder". . . If the Recession Has Already Started
(February 28, 2007)
I wonder if the recession that former Chairman Greenspan hinted might start later
this year has in fact already started. As you know, the "official" beginning and end
of a recession are only established long after the fact; so it is entirely possible that
sometime in early 2008 the announcement will be issued: the recession started in January 2007.
I was mildly amused by Mr. Greenspan's reference to the "business cycle," as that was
precisely what he tried to eliminate with his unprecedented "free loans for everybody with a job!"
liquidity explosion in 2001-2003. The U.S. business cycle had a recession in those years,
but rampant consumer spending and the housing bubble erased the consumer side of the cycle.
Now we have to wring two recession's worth of excesses from the economy--starting with the
housing market and then moving to the stock and bond markets.
Why do I wonder if the recession has already started? The reasons have long been discounted via the
"it's different this time" rationalization. Here are the usual suspects:
The short-term/long-term yield inversion, which has generally presaged recession
The weakness in trucking/shipping last quarter which indicates lower economic activity
The decline in housing prices means the equity extraction/"house as ATM machine"
borrowing which fueled consumer spending is grinding to a halt
Sub-prime mortgages are blowing up, wreaking havoc on lenders, holders of the debt via
mortgage-backed securities and of course, the hapless borrowers
A trillion dollars in ARMs (adjustable rate mortgages) start re-setting to much higher
Equity lines of credit and second mortgages also re-set to higher rates
Jobs are being lost in housing-related employment; this trend will accelerate as
housing starts and sales plummet
The savings rate has been negative for months. You have to love the justification on
this one: "Savings, smchavings. Americans' equity in the stock market and their homes has
generated all the equity they need." So what happens when housing drops $1 trillion and the stock
market drops $1 trillion (got a good start today)--a trillion here, a trillion there, and pretty soon
Americans with little or no savings won't feel quite so nonchalant and "wealthy," will they?
Every derivative sold has a winner and a loser. Please think about this for a moment:
there can't be winners on each side of a derivative. One side gains, the other loses.
The losers will have to liquidate real assets to cover their derivatives losses.
Mortgage-based instruments will trigger losses, as will the stock market meltdown. Hedge
funds don't lose their own money; they lose other peoples' money. Those people will feel
less wealthy, and disenclined to spend the money they no longer own.
Lenders are finally tightening their credit standards
Lenders are finally raising their loss reserves
Margin borrowing is at a record high, exceeding the speculative excess of the 2000
dot-com era borrowing against stock portfolios. As of tonight, millions of margin accounts
will be getting margin calls, meaning they will have to sell within three trading days or
deposit vast quantities of cash to cover the losses in their account.
As margin selling begets more declines, more accounts get margin calls, which triggers
more selling... you see where this goes: A negative feedback loop of selling, more margin
calls, more selling and so on, until the debt (and the unlucky debtor's account) is liquidated.
Bottom line: tighter lending and lower housing values, derivatives and market losses,
margin calls and job losses--they all add up to less money being borrowed and spent and less
money available to spend because it was just lost in the market. Less money being spent
means recession. I wonder what part of this equation the bullish pundits don't understand.
Frequent contributor U. Doran was kind enough to forward
a recent report from
(subscription service; thank you, U. Doran, for sharing it with us), which substantiates
some of the major points listed above:
The ISM (Institute for Supply Management) index fell to 49.3 percent in
January, the lowest level since April 2003 and below the key 50 percent
line, indicating that most firms in the factory sector are not growing. The
index had stood at 51. The decline in US inventories was breathtaking. In
January, inventories dropped by the largest amount since 1984, dropping
to 39.9 percent in January from 48.5 percent the previous month. This is
the lowest level of inventories since February 2002. The ISM survey
committee said the “major sign of weakness” was the low level of order
backlogs which fell to 43.5 percent from 45.0 percent in December. The
National Association of Purchasing business barometer fell to 48.8 from
51.6 in December. The REAL numbers are all negative.
And from the Financial Times:
The US savings rate has been negative for an entire year only four times in American history
- in 2005
and 2006 - and back in 1932 and 1933. In December 2006, the US savings rate descended to a
1.2 percent compared to a negative 1.0 percent in November. The US savings rate has been in negative
territory for the past 21 consecutive months. Personal spending in the US has jumped in December by the
most in five months! The 0.7 percent rise in purchases followed a 0.5 percent increase in November, the
US Commerce Department said on February 1 in Washington.
US personal consumption increased 4.4 percent in the fourth quarter, the Commerce Department reported
on January 31. Confidence among US consumers approached a five-year high in January in the latest
national surveys. But their actions belie their words. 2006 saw existing US home sales decline by 8.4
percent (the biggest drop in 17 years) while new homes sales fall by a stunning 17.3 percent (the largest
in 16 years). US house prices are falling slowly and more houses are now being taken off the market.
General Motors Corp. and Ford Motor Co.'s US auto sales plunged in January as the two US automakers
yielded market share while scaling back on low profit deliveries to rental-car companies. Ford’s sales fell
19 percent and GM’s dropped 17 percent, prompting a deeper cut in GM's North American production.
But the investment banks that fuelled the craze of lending to borrowers with weak credit
histories look like they are escaping relatively unscathed. Amid increasingly ominous signs
of a shakeout in the subprime mortgage industry, investors in securities backed by these
risky mortgages have seen the value of their holdings slide this year. Risk premiums - or
the spreads over government bonds - on the lowest-rated cash securities have risen by up
to 400 basis points, while the cost of insuring such deals against losses through the
derivatives market has doubled.
I wonder how many pundits in the financial press issued a warning as pointed as I
did Monday any time in the past 2 weeks. I think the answer is near-zero.
The problem for investors who bought last year’s crop of
high-risk mortgage originations was that, after several years of booming house price
appreciation, the US housing market last year hit a wall. In response, mortgage lenders -
financed by the Wall Street banks that can sell this debt into capital markets - relaxed
their standards to prop up sagging origination volumes, lending to ever-riskier borrowers
on ever more favourable terms. Last year, 38 per cent of new subprime mortgages were for
100 per cent of the value of the home. ‘Years ago, the banks had to live with what they
underwrote, so if they got too aggressive they had to bear the consequences,’ says
David Hendler, analyst at CreditSights. ‘Now the worst losses will be held by a handful
of hedge funds who thought they knew better.’”
I wonder if the average investor who gets a margin call tomorrow will suddenly become
more skeptical of the "happy-happy, always Bullish, all the time" media coverage he/she has
been reading/watching for the past five years. I wonder if anyone will become angry
at the screaming "mad money" types who have relentlessly hyped and pumped stocks for the
past five years.
I wonder just how disappointed hopeful speculators will be when they realize the Fed
can't lower interest rates for the simple reason it has to raise rates to defend the dollar.
I wonder how long the charade of "permanent prosperity based on borrowing more"
and "there won't be any recession this year" will continue. If the stock market falls
by 20% or more, it will certainly be more challenging to maintain the ruse which has worked
to perfection for five long years: you're richer, because you borrowed more.
Here's the party line, issued today by the AP wire service:
Economists Say Recession Unlikely.
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