"There can be no return to normality when the earlier 'normality’ was a freakish bubble—unless, of course, another bubble is created."
John Plenders in the Financial Times
There is a great deal of wisdom in that one simple sentence. Although the credit markets should calm down over time, where does that leave us? There is virtually no possibility of a return to the economic and financial world that existed over the last few years. First, it is doubtful that anything the Fed can do now will work, and second, the negative effect on the real economy will remain long after the immediate crisis settles down. Referring to the innovative Fed efforts to separate the orderly markets problem from the real economy, leading economist Martin Feldstein recently stated, "It is not clear whether this will succeed since much of the credit market problem reflects a lack of trust, an inability to value securities, and a concern about counterparty risks." Although the Fed can open up the discount window and make funds available, the lack of transparency causes lenders to be unwilling to lend. As long as unanticipated disclosures of new problems keep popping out of the woodwork from unlikely sources financial turmoil will continue.
Furthermore the Fed can’t bring back the subprime and Alt-A mortgage market with any conceivable weapon currently in their arsenal. Stricter lending standards have been put into place and will remain. In fact, if additional regulations are promulgated to rein in loose lending standards, as congressional leaders are proposing, the mortgage market will get even tighter. The Bear Stearns funds are not coming back and neither are all of the mortgage-related entities that have gone out of business or cut back sharply. The world credit markets are de-leveraging on a massive scale despite anything the global central banks can do.
The housing situation continues to worsen with no end in sight. Pending home sales in July dropped a whopping 12.2% to the worst level since the record began in 2001. Some contracts are not closing because mortgage commitments are falling through at the last possible moment. Foreclosures are at record highs and will get a lot worse since the peak of mortgage rate resets on ARMS are not due to peak until the 4th quarter of 2007 and the 1st quarter of 2008. An increased rate of foreclosures generally follows resets by about three-to-six months.
The housing mess is almost certain to spread to the rest of the economy. As we have previously shown, even in normal business cycles major downturns in housing almost always leads to recessions, and the current cycle is far from normal. Some softening in the economy is already evident. According to Real Capital Analytics investors in July bought the fewest commercial properties in a year. Industry sources expect commercial property price to fall up to 15% over the next year. One real estate investor said "There are so many deals falling apart.People who can get out are getting out." Despite today’s positive sales reports from retailers, consumer spending growth on a year-over-year basis is at its lowest level since late 2003. ADP estimated that U.S. employers added 38,000 jobs in August, the fewest since June 2003. This week declines were reported in the ISM manufacturing index and construction spending, while scheduled 4th quarter vehicle production has been cut significantly. Chancellor Grey Christmas reported a big increase in announced layoffs. Even the Beige Book released yesterday was not as optimistic as the headlines depicted. The report summary termed six of the 12 regions as "slowed" or "mixed", a change from the prior report that called only two regions "mixed" and none "slow".
In sum, although we think the current financial turmoil has longer to run, the real problem is fundamental as the economic expansion that started after the dot-com bust was largely based on a credit-induced housing boom that ignored risk and cannot be resuscitated anytime soon. That the stock market is a long way from discounting this probability is indicated by the current article in Barron’s titled "No Bears Here". This is likely to go down in history with the famous January 1973 article titled "Not a Bear Among Them".
