America's Addiction to Debt Finally Crashes the System

We have to deal with the fundamental reality that Americans are addicted to debt. Debt today in the United States is at an all-time high in each of the three primary sectors: public, corporate and consumer debt. The national debt last week topped $9 trillion, up from approximately $5 trillion when George Bush took office.

To put this in perspective, the government of Bush & Co. has borrowed almost as much as the governments of all the other presidents of the United States combined. Consumer credit is now at scary levels almost: $2.5 trillion, and analysts are beginning to speculate that credit card debt could be the next bubble to burst. Corporate debt has reached astronomical levels through highly leveraged private equity deals, and no one knows just how how much froth is still in the system.

Central banks worldwide have reacted to the crisis by injecting over $700 billion into the global financial system. This is an astronomical level of liquidity, but it seems somehow to defy any human element. However, it has intensely human consequences that will affect each and every one of us. By pumping so much liquidity into the system, it ultimately inflates the currency. Put in human terms, everything is going to start costing us more. Even worse, this approach simply postpones the eventual reckoning.

For the average worker who is already struggling to make ends meet, this could have devastating consequences. Median family earnings of $48,201 in 2006 were 2 percent less than they were in 2000. So already people are running on the economic treadmill, like hamsters, spinning faster, working harder and making less.

For those who had taken some measure of financial solace from the appreciation of their homes, the game has suddenly taken a turn into a dark tunnel. Prices which had become divorced from reality, are now being corrected with a vengeance. Here's the rub for homeowners: When real estate prices go down, the debt associated with those assets does not go down. This induces a downward spiral of asset values induced by negative leverage. With a record high of 15.75 percent of all subprime loans now 30 or more days past due, many homeowners now are stuck with negative equity.

And this is where things really start to get dicey, because the stability of the entire financial system is at risk. In other words, the downward spiral of real estate assets puts the solvency of major financial institutions in jeopardy.

There was a fervent belief, spread with evangelistic zeal by many of the key players in the creation of the debt bubble that this was different from other lending cycles and it could continue indefinitely. The belief was based upon the contention that there was now more reliable information that enabled mortgage lenders to make better judgments about the credit worthiness of borrowers.

The evangelists argued that sophisticated algorithms enabled them to determine with precision exactly which borrowers were good bets and which ones were likely to default on their loans. This belief fueled the creation of an entire market for leverage in the form of CDOs (Collatoralized Debt Obligations), which were sold to major players such as hedge funds. Evangelists argued that these new financial instruments would diffuse risks throughout the financial system and that somehow, through financial alchemy, the entire system would become more stable.

That absolutist belief, like the debt bubble, has now been punctured. In the words of Warren Buffet, "Many institutions that publicly report precise market values for their holdings or CDOs and CMOs are in truth reporting fiction."

It turns out that many of the lenders were unable to verify the accuracy of income and asset information supplied by borrowers and still went ahead with the loans. Garbage in, garbage out. In other words, it is now much more difficult to know who is holding the bad debts. It used to be that banks could assess their portfolio and fairly easily identify the trouble spots. But now, we don't really know how far into the layered labyrinth of leverage the trouble goes.