Credit Contraction: It's Payback Time
"Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years." ~ Warren Buffett
As we all know (or at least should know), the United States economy became imbalanced in the late-1990s as too much speculative capital surged into the Internet and Telecom sectors of the economy. As this speculative boom expanded, rising asset prices allowed the boom to move into the broader economy. Throughout the late-'90s, speculative funds and increased leverage played a primary role in the expansion of credit throughout the economy. If someone wanted cash and had a semi-viable story as to how he would pay it back, he could procure a loan or venture funds quite easily. This process played out throughout the economy, as consumers, businesses and every level of government piled into debt in order to finance projects for current consumption, with little or no concern given to having to pay it off. Our fiat monetary system, with limitless fractional reserve banking made possible by low reserve requirements and a general lack of prudence by our questionable Federal Reserve establishment, played a significant role in creating the initial imbalance.
As economic imbalances always do, the Tech/Telecom bubble burst. Too much bad money had been thrown around, consumers had taken on far too much debt, and very questionable companies burned through cash at a rapid pace, only to go belly up. The general economy suffered through 2000-2002 as the imprudent credit bubble contracted somewhat.
Not realizing that cheap money was the problem that caused the headache in the first place, the (dis)honorable Alan Greenspan stepped into the fray and slashed interest rates and loosened other Fed requirements, thereby making money much cheaper and credit far easier to secure.
American homeowners had traditionally been quite conservative with their finances, typically paying down home loans over time, living within their means and properly managing their debt load. Now, all of a sudden, they were given a crack at unprecedented and easy mortgage credit. From 2003 through 2006, mortgage credit (and its brother, mortgage debt) exploded at a rate unseen in the history of the United States. If an organ grinder's monkey felt like owning a $500,000 home, he would likely find someone to give him a piggyback loan and fulfill his dream with zero money down.
As this cheap-and-easy credit worked its way through the U.S. financial system, the water level of the economy generally rose right along with it. Banking institutions, home builders, home flippers, product suppliers, electronics gadget sellers, producers and developers -- in a nutshell, nearly anyone selling anything -- benefited from the orgy of credit being supplied to the marketplace. Bear in mind, this was an orgy of credit unseen in the history of the financial world.
Given the explosion of credit, people felt generally happy and well-off. The "wealth effect" took hold as asset values "rose." Individuals could cash out seemingly any time, achieving bountiful, almost unexpected premiums for their assets (be it homes, businesses, art -- you name it). Given that same sense of euphoria and well-being, leveraged buyouts began growing in size and scope, and eventually the pace of that type of activity surged, as well.
Problem was, this new and sudden "boom" came about almost entirely via borrowed money. Government, business and consumer debt became the rage. Current speculative credit was being financed against future earnings, and that explosion of credit meant that future obligations were multiplying very rapidly.
Structured finance exploded along with the credit bubble. Derivatives, credit default swaps, mortgage-backed securities, collateralized debt obligations, (I could go on) burst onto the scene and multiplied at rates made possible by virtue of the implied put of fiat paper money and competitive worldwide currency debasement. Deep inside their souls, financial market players felt that no matter what risks they took on, those risks would never be allowed to materialize into losses. Their sense was that at the first sign of trouble, the Federal Reserve and other central bankers would unite to "paper-over" the trouble. The new assumed debt would never be faced in real terms; dollars used to pay it back would simply be worth maybe half of their original face value. Why be cautious when currency debasement always has your back, right?
Alas, things are never so easy. With so many individuals, institutions, households, governments, and especially Wall Street firms lining up to take the same risks at the same time with the same inherent complacency and fiat-backed hubris, that "can't miss" trade became far too one-sided. Credit explosions never last because eventually, extremely poor decisions come back to haunt those who made them. There is no way to eliminate risk associated with speculative leverage; it's like drinking a case of beer, then proceeding to juggle hand grenades.
And eventually, the piper must be paid.
(Chart courtesy of www.prudentbear.com)
Fast forward to 2007, where we see the first salvos being fired in "The Great World Credit Contraction." Symptoms are everywhere:
**The subprime mortgage debacle.
**Homebuilders going from 60 to zero in record time.
**A developing crisis of mortgage foreclosures.
**CDO's suddenly determined to be worth much less than the "model" would suggest.
(Chart courtesy of www.elliotwave.com)
**Bear Stearns hedge funds going belly up.
**Massive, leveraged buy-out deals being reversed, as lenders wise up to the fact that these deals are Losers with a capital "L."
**Local economies being sucked dry by disproportionate mortgage payments, a decline in the velocity of money associated with significantly reduced housing turnover (think real estate and mortgage broker commissions, for example), and the increasingly-unwieldy burden of debt faced by all-too-many homeowners and consumers.
This list will continue to grow -- once the stock market properly reflects these developments and people realize that gains have been driven by unprecedented merger and acquisition activity, share buybacks funded by debt, and general liquidity-pumping, all of which are unsustainable. Earnings previously padded by easy and massive credit will be affected, too, as the credit spigot gets turned off and the entire economy acts like a man in a desert with no canteen.
The defensive course of action is to wean yourself of leverage as quickly as possible, then sit back and watch as the fireworks associated with credit contraction explode. Be on the lookout for additional scandals (even in pro sports), more political turmoil (will George Bush take much of the blame?), more fear and anger represented in society, increased totalitarian rhetoric coming from our executive branch, increased geopolitical tensions, and a general, "what the hell is going on?" societal head-scratching.
And remember, when our policymakers come to the conclusion that contracting credit is the problem and that printing more money is the solution, for heaven's sakes, JUST SAY NO! Shout it to the high heavens! "No more!" you might say. "It was your preposterous credit expansion that got us here in the first place!"