The Great Debt Crisis Begins

By Hale Stewart, Huffington Post. Posted January 14, 2008.

There is growing talk on Wall Street about the possibility of a recession. Since the beginning of the year three Wall Street firms (Merrill Lynch, Morgan Stanley and Goldman Sachs) have all stated they believe we are either in a recession already or are very close to a recession. In other words, it's no longer a matter of if a recession happens but when it will happen and how long it will last. In response to these developments, various presidential candidates have proposed various solutions. However, none of these will work, largely because this is not a typical slowdown caused solely by slowing consumer spending or business investment. Instead, it is a slowdown caused by inflated asset prices and a nation gorging on debt. As a result, it will probably take a lot longer to come out from under this problem.

A recent Los Angeles Times Article stated the basic problem thusly:

What makes bubbles so dangerous is that their consequences, when they burst, are wider, often more damaging, and certainly more unpredictable than those of ordinary downturns.

"We are more prone to bubbles than we used to be," said John H. Makin, a former senior Treasury official with several Republican administrations and now a scholar with the conservative American Enterprise Institute in Washington.

"The old-fashioned recession, where the consumer ran out of gas or there was an economic policy mistake, doesn't seem to occur much anymore," said Alice M. Rivlin, a former vice chair of the Federal Reserve and Clinton administration budget director. "As we've seen from recent events, bubbles seem to be playing a bigger role."

The basic problem faced by the US economy right now is excessive debt caused by recklessly low interest rates from the Federal Reserve. Here is a chart from the St. Louis Federal Reserve of the effective Federal Funds rate since 2000.

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Notice the US had record low interest rates for a period of nearly three years. This led to a debt binge of mammoth proportions. Here is a chart of total household debt outstanding from the St. Louis Fed:

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Notice the amount outstanding increased from around $8 billion to a little shy of $14 billion within a period of seven years. That's approximately a 75% increase in total household debt outstanding.

All of this debt has to go somewhere; it doesn't just exist in a vacuum. To accommodate this increase in total debt, we've seen a huge increase in structured financial products. In and of themselves, these are not bad devices; they have been around for approximately 25 - 30 years. However, they were used very recklessly over the last 7 years, and especially over the last 3-4 years. The short version of what happened is simple: lending standards deteriorated to the point where literally anyone could get a loan. These loans were then sold to investment firms, who pooled them together and carved them into various bonds, which were in turn sold to large institutional investors like pension funds, insurance companies and hedge funds. The idea underlying structured financial products was that risk was spread out to the point where the bonds were more or less insulated from default problems. However, when defaults skyrocketed higher than anticipated, we discovered that the risk wasn't contained nearly to the degree we thought. Instead, everybody started getting hurt.

Right now the Federal Reserve is treating this situation as a "liquidity crisis", meaning they are literally throwing money at the problem. They are hoping that by flooding the markets with money the money will get spent in the form of loans and credit. However, the market has ample liquidity. The problem is we are in the middle of a debt crisis:

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Hale "Bonddad" Stewart is a former bond broker with several regional firms. He has been involved with the financial markets since 1995. He currently practices law in Houston, Texas. Stewart is the proprietor of the Bonddad Blog.