We have officially started year 2 of the credit crunch. Some could argue that the actual start was in late May or June of 2007 when the first signs of widening credit spreads were observed. In real time that was a difficult conclusion to reach since those early warning signs then were within the normal trading ranges and seemed to be nothing more than ordinary volatility.
We believe the first apparent sign was the Bear Stearns (BSC) announcement in July 2007. BSC admitted problems with their hedge fund construction and indicated they would have to add funds and recognize losses. At that time no one believed that this first chapter in the Bear Stearns saga would end eight months later, with the final chapter in March 2008. BSC disappeared in a remarkable application of the Federal Reserve’s power and emergency funding tools.
So where are we now?
We are watching a massive adjustment in finance. The next generation of textbooks will have chapters devoted to Bear Stearns, JPMorgan Chase, and the Fed-financed weekend shotgun merger. There will be whole sections on the Federal Reserve and how it has hugely altered its balance sheet and is reconstructing its role.
Fannie and Freddie will require a treatise on the largest de facto nationalization in American history. Bank failures will be examined to determine how and why they happened. IndyMac is also a chapter in this new book. How is it that a $32 billion failure is deemed adequately capitalized in March and fails 100 days later? I will stop this listing of what we know, so we can articulate what we don’t know.
We don’t know if the stock market correction is finished or if there is another serious decline ahead. We don’t know if the Treasury bond market faces a sustained upward movement in yields or will rally to lower yields. We don’t know if we are going to see the deflationary forces of falling housing, collapsing autos, and distressed consumers prevail over the inflationary forces of commodities and a weaker currency.
We don’t know if the 2009 fiscal condition of the US and its 50 states and local governments will break the limit on deficits. It is starting to appear that the public sector total borrowing requirement in the United States will exceed $600 billion in fiscal 2009. And please remember that is the cash borrowing portion, not the accrual. With the accrual it is likely to exceed $1 trillion. If the US reported its liabilities the way it requires every private company to report, we would be routinely seeing this trillion appendage to the national numbers.
In the corrective actions taken by the Congress and the Treasury Secretary and the Federal Reserve Chairman, we are witnessing a massive expansion of leverage. And we witness a growing intervention of the government into finance, economics, and markets. Some argue this is for the better. Maybe so? Others argue for the laissez faire ways of yesteryear. They are in the distinct minority, and their arguments are not persuasive to the majority. Like it or not, the outcome of the credit crunch is more and bigger government intervention into the economy and the financial structure of the country.
That means the seeds of the next crises are being sown right now, as these fixes of the past problems are enacted. The very same folks who planted the soil in the breeding ground of housing finance or leverage loans are now fertilizing the successor crisis during this rocky period.