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The road to perdition

The road to perdition
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First Published: Tue, Sep 16 2008. 11 48 PM IST
Updated: Tue, Sep 16 2008. 11 48 PM IST
Hardly had pundits such as CNBC’s Jim Cramer finished pronouncing the bottom of the US housing downturn, leading many to believe that the worst is over, came the double blow over the weekend — bankruptcy of Lehman Brothers and the sale of Merrill Lynch. As I will explain here, we are still in the early stages of a protracted downturn in the US economy and what has happened to Lehman Brothers (an institution that survived the US civil war and the Great Depression) is merely a forerunner of what is in store for the US financial industry.
As I have written earlier, the failure of these financial institutions was easily predictable, given the lax lending standards they were adopting and the excessive leverage on their balance sheets. With zero down payments providing little incentive for the owners not to foreclose on falling prices, these institutions were very vulnerable to a downturn in housing.
Excessive leverage ensured that the effects of a downturn were magnified (just as on the way up, the results looked fantastic due to leverage). As investor Jim Rogers has repeatedly pointed out in recent years, most US financial institutions would be bust “today” if they were to simply recognize the losses on their balance sheets.
What lies ahead for US housing? Unfortunately, more of the same thing. Given the lack of US domestic savings and the dwindling interest of foreign investors in supporting these securitized debts, the only direction for US housing prices is down. And the problem would not just be confined to subprime: When majority of option ARMs (adjustable rate mortgages) reset over the next year from their initial teaser rates, we will witness the transformation of the prime to the subprime.
But for the statistical gimmick of using a gross domestic product deflator of 1%, the US economy would already be in a recession. But even such fabrications are not going to be very helpful in the months ahead, as the continued housing downturn would lead the US economy into a severe recession. The only legitimate response of the government in such a situation would be to cut its spending and allow the markets to prune excesses. But all that we have heard from Barack Obama, as well as John McCain, suggests that we are very likely to witness a Hoover “New Deal” Version 2.0 with its unintended but predictable consequences. In some sense, we are already in the early days of the unspoken New Deal with the nationalization of Fannie Mae and Freddie Mac, a solution that would have been undertaken only in communist or socialist societies.
The difference this time around is that depression is going to be accompanied by soaring prices of consumer goods. With the national debt at around $10 trillion, and a budget deficit expected to touch $1 trillion, there is no legitimate way (taxation or borrowing) to service this debt. The US government would either have to default on its debt (in which case the US treasurys become subprime) or default through massive inflation (in which case the US dollar becomes subprime). My guess is that it would be the latter, as that would be the path of least resistance, with the result that there would be a collapse in the purchasing power of the US dollar.
Alan Greenspan is right: This indeed is a “once-in-a-century” crisis. But I am surprised that Greenspan is saying it so late. After all, he pretty much wrote the screenplay for unfolding drama—by flooding the system with easy money, keeping interests rates too low and encouraging the adoption of speculative ARMs— when he was chairman of the US Federal Reserve.
Shanmuganathan N. is director of Benchmark Advisory Services. Comments are welcome at otherviews@livemint.com
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First Published: Tue, Sep 16 2008. 11 48 PM IST