Suchit Singhal View on Current Economical Crisis

The Current Economical Crisis—Causes and Consequences


Report- 1
It is not yet clear whether we stand at the start of a long fiscal crisis or one that will pass relatively quickly, like most other post-World War II recessions. The full extent will only become obvious in the years to come. But if we want to avoid future deep financial meltdowns of this or even greater magnitude, we must address the root causes.
In my estimation two critical and related factors created the current crisis. First, profligate lending which allowed many people to buy overpriced properties that they could not, in reality, afford. Second, the existence of excessive land use regulation which helped drive prices up in many of the most impacted markets.
Profligate lending all by itself would not likely have produced the financial crisis. It took a toxic connection with excessive land-use regulation. In some metropolitan markets, land use restrictions, such as urban growth boundaries, building moratoria and large areas made off-limits to development propelled house prices to unprecedented levels, leading to severely higher mortgage exposures. On the other hand, where land regulation was not so severe, in the traditionally regulated markets, such as in Texas, Georgia and much of the US Midwest and South there were only modest increases in relative house prices. If the increase in mortgage exposures around the country had been on the order of those sustained in traditionally regulated markets, the financial losses would have been far less. Here is a primer on the process:
The International Financial Crisis Started with Losses in the US Housing Market: There is general agreement that the US housing bubble was the proximate cause for the most severe financial crisis (in the US) since the Great Depression. This crisis has spread to other parts of the world, if for no other reason than the huge size of the American economy.
Root Cause #1 (Macro-Economic): Profligate Lending Led to Losses: Profligate lending, a macro-economic factor, occurred throughout all markets in the United States. The greater availability of mortgage funding predictably led to greater demand for housing, as people who could not have previously qualified for credit received loans (“subprime” borrowers) and others qualified for loans far larger than they could have secured in the past (“prime” borrowers). When over-stretched, subprime and prime borrowers were unable to make their mortgage payments, the delinquency and foreclosure rates could not be absorbed by the lenders (and those which held or bought the "toxic" paper). This undermined the mortgage market, leading to the failures of firms like Bear Stearns and Lehman Brothers and the virtual failures of Fannie Mae and Freddie Mac. In this era of interconnected markets, this unprecedented reversal reverberated around the world.
Root Cause #2 (Micro-Economic): Excessive Land Use Regulation Exacerbated Losses: Profligate lending increased the demand for housing. This demand, however, produced far different results in different metropolitan areas, depending in large part upon the micro-economic factor of land use regulation. In some metropolitan markets, land use restrictions propelled prices and led to severely higher mortgage exposures. On the other hand, where land regulation was not so severe, in the traditionally regulated markets, there were only modest increases in relative house prices. If the increase in mortgage exposures around the country had been on the order of those sustained in traditionally regulated markets, the financial losses would have been far less. This “two-Americas” nature of the housing bubble was noted by Nobel Laureate Paul Krugman more than three years ago. Krugman noted that the US housing bubble was concentrated in areas with stronger land use regulation. Indeed, the housing bubble is by no means pervasive. Krugman and others have identified the single identifiable difference. The bubble – the largest relative housing price increases – occurred in metropolitan markets that have strong restrictions on land use (called “smart growth,” “urban consolidation,” or “compact city” policy). Metropolitan markets that have the more liberal and traditional land use regulation experienced little relative increase in housing prices. Unlike the more strongly regulated markets, the traditionally regulated markets permitted a normal supply response to the higher market demand created by the profligate lending. This disparate price performance is evidence of a well established principle of economics in operation – that shortages and rationing lead to higher prices.
Among the 50 metropolitan areas with more than 1,000,000 population, 25 have significant land use restrictions and 25 are more liberally regulated. The markets with liberal land use regulation were generally able to absorb from the excess of profligate lending at historic price norms (Median Multiple, or median house price divided by median household income, of 3.0 or less), while those with restrictive land use regulation were not.
Moreover, the demand was greater in the more liberal markets, not the restrictive markets. Since 2000, population growth has been at least four times as high in the traditional metropolitan markets as in the more regulated markets. The ultimate examples are liberally regulated Atlanta, Dallas-Fort Worth and Houston, the fastest growing metropolitan areas in the developed world with more than 5,000,000 population, where prices have remained within historic norms. Indeed, the more restrictive markets have seen a huge outflow of residents to the markets with traditional land use regulation (see: http://www.demographia.com/db-haffmigra.pdf).
Toxic Mortgages are Concentrated Where there is Excessive Land Use Regulation: The overwhelming share of the excess increase in US house prices and mortgage exposures relative to incomes has occurred in the restrictive land use markets. Our analysis of Federal Reserve and US Bureau of the Census data shows that these over-regulated markets accounted for upwards of 80% of “overhang” of an estimated $5.3 billion in overinflated mortgages.
Without Smart Growth, World Financial Losses Would Have Been Far Less: If supply markets had not been constrained by excessive land use regulation, the financial crisis would have been far less severe. Instead of a more than $5 Trillion housing bubble, a more likely scenario would have been at most a $0.5 Trillion housing bubble. Mortgage losses would have been at least that much less, something now defunct investors and the market probably could have handled.
While the current financial crisis would not have occurred without the profligate lending that became pervasive in the United States, land use rationing policies of smart growth clearly intensified the problem and turned what may have been a relatively minor downturn into a global financial meltdown.
Never Again: All of the analyst talk about whether we are “slipping into a recession” misses the point. For those whose retirement accounts have been wiped out, or stock in financial companies has been made worthless, those who have lost their jobs and homes, this might as well be another Great Depression. These people now have little prospect of restoring their former standard of living. Then there is the much larger number of people whose lives are more indirectly impacted – the many households and people toward the lower end of the economic ladder who have far less hope of achieving upward mobility.
All of this leads to the bottom line. It is crucial that smart growth’s toxic land rationing policies be dismantled as quickly as possible. Otherwise, there could be further smart growth economic crises ahead, or, perhaps even worse, a further freezing of economic opportunity for future generations




Report- 2

The house of cards built on easy credit has finally come tumbling down, triggered by the failure of one of the most flimsy of the cards, subprime mortgages. We'll look at the causes—it's important to understand causes if one has any reasonable chance of analyzing the present and assessing the outlook—and weigh the likely outcome of the government's actions. Not to keep you in suspense any longer, we believe the bailout and associated actions, adding yet more credit to an economy already over-ripe with easy credit, far from solving the problem (i.e., getting banks to lend again), will make matters ultimately worse, by postponing the necessary adjustments, building up inflation, and destroying the dollar and its purchasing power, devastating savers and undermining the foundations of the economy. This will be a protracted slowdown as corporations and households de-lever and attempt to restore some health to broken balance sheets. Nevertheless—to jump ahead to the critical conclusion for investors we'll discuss next time—we are far beyond the time for wholesale liquidation, if it means selling quality companies well below their intrinsic values. It may be too early for aggressive across-the-board buying, but remember the words of the late, great John Templeton, who advised us to “buy at the point of maximum pessimism.” What Brought Us Here? It is critical to start by analyzing the causes of the problem, and assessing the likely outcome. Only by understanding that, can we hope to know what to do. So what brought us here, and what's next? The root cause of our current problems is clear: excess credit creation over these many years. Too much money and artificially low interest rates always and inevitably lead to speculation and mal-investment. Whatever excesses there have been on Wall Street—and there have been many, as well as the abject ignoring of any sense of fiduciary responsibility—nonetheless, blaming “Wall Street speculators” for the mess is a little like blaming a drunk child when the parent left the open bottle in the playpen. Critical to understand is that this is not a normal cyclical downturn. Such is triggered by tightening money and higher rates in a deliberate attempt to cool an “overheated” economy and restrain inflation. The resulting recession can be sharp but is typically short. Similarly, it is relatively easy to get out of a cyclical recession: do the opposite of what triggered it, that is, ease money and lower rates. But this is not a cyclical downturn; it is, rather, a secular de-leveraging contraction. Tighter money and higher rates did not trigger it, and easing money and lowering rates will not get us out of it. Au contraire. We currently have easy money and low rates, rates that are actually negative at the short end. And easier money and even lower rates, such as we've seen over the past year, have not helped. (Indeed, despite the Fed slashing the overnight loan rate from 5¼% to 2% in the seven months to April, rates in the real market—mortgage rates, credit card rates, etc.—actually increased and, of course, available credit contracted.) This is important to recognize. Selling Begets Selling Thus, this de-leveraging process is likely to be a protracted process as banks, other firms, and households restore health to their balance sheets. But such a process feeds on itself, as we have all-too-painfully seen this year. Companies sell assets to raise capital, which pushes down prices, which forces others to raise capital, pushing prices down further, which causes banks to contract credit. And as banks contract, small businesses have difficulties, reducing purchases, and so on. So much of the selling in the market has been forced (by financial companies needing to raise capital to meet ratios; by investor receiving margin calls, and funds getting redemptions). The waves of forced selling then cause panic among investors, leading to the very worst kind of selling, blind liquidation of thinly traded securities into down markets. This can, and has, driven prices down sharply and suddenly. Will the Bailout Work? The banks have no capacity or appetite for lending, which is why lower rates haven't helped. And why, given that for investment banks to reduce their average leverage from 30 times to 20 times would require that $6 trillion of assets be sold, the government's $700 billion bailout won't change the picture either. (Another question: Do they buy bad assets at prevailing prices, in which case it won't improve banks' capital ratios at all, or do they defraud the taxpayer and buy back at above-market prices, as Paulson seemingly wanted to do?) It may plug a hole short term, but it doesn't mean the banks open up and start lending again. Washington is attempting to solve the problem by doing more of what caused the problem in the first place (and—greatest irony and travesty of all—with the very same people in charge who caused the problem in the first place, who encouraged the excesses, and who didn't see the problem until too late). By trying to keep asset prices up, Washington is repeating the error of the 1930s and ensuring that the downturn lasts longer. No parallel is precise, but we might look at what happened when Japan's stock market and real estate bubbles burst at the beginning of the 1990s. The Bank of Japan slashed rates, down to ½% on long-term government bonds, and bought up bad assets from the bankrupt banks. (They didn't open the monetary spigots, as has Washington.) Neither high interest rates of shaky banks have been a problem in Japan for many years. But that didn't cause banks to resume lending. Japan also increased deposit insurance (covering accounts in full until 2006.) That simply slowed the needed restructuring, and caused the banks to withdraw, as The Wall Street Journa l put it, “led to the establishment of zombie banks.” There has been essentially zero net capital investment in Japan in the last 15 years. Despite near-invisible interest rates and strong banks, Japan has been in either recession of deflation (or both) for most of the past 18 years. And Japan had one huge advantage over the U.S. today, namely that households had low debt and high savings. It's Not Pretty Ahead Not only will current policies not solve the problem, they protract the downturn and delay the needed resolution. But they make matters worse by ensuring more inflation, already at a 17-year high in the U.S., adding another disincentive to save. Taxes will go up, further suppressing economic growth or chances of a recovery. The likely result is a severe case of stagflation So the economy is likely to enter a recession soon, but it will be a long and painful experience coming out of it, a protracted period of sluggishness, with other economic problems. And the market, likewise, is likely to be sluggish for some time, though once we see some stability return, specific sectors and individual companies will recover sooner, while we will see short-term rallies. Next time, we'll look at the outlook for various markets, including, most importantly, the dollar, and then discuss how investors should act in the current crisis (clue: don't dump quality companies below their intrinsic value into a declining market).