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Thursday, Mar 28, 2024
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Debt Bomb



By CHARLES MARTIN

In the mid-1990s, consumers started what was to become a credit binge that would last 15 years.

During this period, consumer debt grew faster than incomes. From 2003 to 2008, consumer credit tripled while the economy did not grow sufficiently to support that debt load.

Consumers weren’t the only ones. The federal government dramatically increased its borrowing. In addition, the government took on huge liabilities in the form of growing Social Security and Medicare burdens, neither of which shows up on its balance sheet.

U.S. society during this period embarked on a “borrow from tomorrow and spend today” way of conducting business. This caused the American economy to grow faster than the fundamental drivers (productivity and wage expansion) would justify. The result: We leveraged up our economy.

At the same time, the excessive demand that resulted from credit expansion (and the excessive spending that accompanied it) caused asset prices to grow faster than the underlying economic expansion could support. No place was this more evident than in housing.


Government Factors

Pubic policy was a major factor in the explosion of credit and unrealistic growth in housing prices. Congress and presidential leaders promoted the concept of expansion of home ownership. They dramatically expanded the scope of mortgage financing.

The extraordinary expansion of Freddie Mac and Fannie Mae were central to this public policy adventure. Politicians believed that home ownership should be a right of all Americans, regardless of their economic status or creditworthiness.

Consumers bought homes they could not reasonably afford and refinanced them to higher levels, all of which fueled a spending boom. This metastasized through the economy as consumers spent on furniture, furnishings, house wares, boats, cars, recreational vehicles and much more.

The private sector contributed to the credit binge in a big way.

The securitization of mortgages added fuel to the fire. Credit default swaps provided a form of insurance against borrower defaults that allowed low-quality credit to be upgraded and sold to the market.

Collateralized debt obligations were another “creation” that fueled the flow of money to the credit markets. Through these instruments, portfolios of loans (mortgages, autos loans, credit card loans, etc.) could be bundled and divided and sold to investors.

The symbiotic relationship between credit rating agencies and mortgage financing firms also was an unsightly mechanism that contributed to the growth of these debt securities.

For almost two decades, this dramatic expansion of credit has fueled a growth in asset values, pumping money into the economy and creating a mass of buyers (spenders).

Home prices grew to well above the affordability level that could be supported by incomes. The low cost of mortgage debt masked the fact that homeowners simply could not afford the purchases that they made. Artificially low interest rates contributed to this problem.

The artificial stimulation of demand led to an expansion of capacity in the economy that was not sustainable. Too many stores. Too many homes built. Just too much “stuff.”

We now find our economy oversupplied. It must shrink to the level that is required to supply the real demand.

Enter 2008, when the “day of reckoning” occurred.

The economy has begun to go through a deleveraging process. Unwinding leverage is a painful process and can take time to reach a state of normalization. In this process, asset values must fall.

There are no buyers and all parties seek to sell at the same time. Banks, brokerage firms and consumers must follow this painful course. Fortunately most (non-financial) companies did not fall into this trap and have good balance sheets.

Financial firms will make this journey fairly quickly, but it will take a long time for consumers to deleverage. This will curtail their spending and investing for a protracted period.

The backbone of the growth of the American economy in recent years has been the consumers. They have been spending beyond their means for a long time and have now crawled into a fox hole and will stay there.

In a strange way this is intelligent behavior. After partying all night and waking up with a hangover, consumers must dry out, live more conservatively and moderate their spending.

Consumers have seen their household wealth disappear. Home equity has vanished, retirement savings and savings for the college educations of their children have dropped precipitously in value. Unemployment is running at very high levels. They’re afraid. It will be a long time before they feel confident again.


Government Help?

So what about government intervention to save the economy? We have just witnessed the loony tunes in Washington pass a “stimulus” bill, the size of which is the largest in history.

Presumably it will create millions of jobs. Politicians point to a large number of “shovel ready” projects that will be funded. This may help employment in the construction industry, but will not support employment in financial services, retail, manufacturing and virtually all other industries. Somehow I do not see a retail clerk, auto executive or bank executive getting a shovel and going to work.

It was a “borrow from tomorrow and spend today” scheme that got us into this mess.

The government, through the Federal Reserve, also has attempted to manage the economy through monetary policy. Interest rates were lowered to unreasonable rates in the early 2000s and fueled excessive, unsustainable growth in the years that followed.

Now it is happening again. Why can’t these economically illiterate political leaders keep their hands off the “steering wheel” and let the market do its thing?

This would mean that our economy would grow at a slower pace, but at a sustainable rate and perhaps might not go through the big cycles created by too much stimulus and too much government meddling.


Martin is chairman, chief executive and chief investment officer of Mont Pelerin Capital LLC in Newport Beach.

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