A Recession: Six One Way and Half a Dozen the Other

Apparently the state of the American economy hangs in the air, waiting to receive its fate from Ben Bernanke and the Federal Reserve (the “Fed”), who will announce this Tuesday whether or not interest rates will be lowered. The decision reflects a series of bearish events that have given credence to the possibility of a recession in the near future. If the Fed chooses to lower interest rates, Americans can expect sluggish markets across the board through 2008. But if interest rates remain unchanged, should American’s believe that somehow they’ve been spared from the “credit-crunch” disaster? No, that would be ignorant. Regardless of the outcome on Tuesday, the economy must reckon with the negligent decisions that were made by the credit-lending institutions, specifically those in the sub-prime mortgage sector, and the ensuing financial turmoil that will inevitably come of it.

To accurately understand the scope of the “credit-crunch,” it’s worthwhile to understand how this whole downward spiral started. Basically, the sub-prime mortgage lenders were ignoring the rules set in place to ensure that an individual’s mortgage accurately reflected his or her credit worthiness to take on the loan, which is shown by the specified interest rate the borrower receives on the loan. Worse, the individuals at fault here received little of the downside; these individuals work under a quantity-over-quality philosophy, simply trying to sell off as many mortgages as they possibly can. In doing so, the mortgage broker transfers the inherent risk of the mortgages to what are known as whole loan buyers. These are the large financial institutions that buy, aggregate, package, tranche, and sell loans as quickly as possible to clueless buyers who believe they are buying BBB or BBB- rated securities (generally in the form of Mortgage Backed Securities). As stated by Kyle Bass, managing partner at Hayman Capital, “this transference of risk is the crux of the Subprime situation,” and what has ultimately reeled in the numerous other markets that are feeling the adverse effects of the loan-crisis.

So who loses out? Well to begin, those who bought the packaged securities composed of mainly ultra-risky junk-loans, but with just enough prime, AAA tranche loans to get the package rated above Moody’s minimum BBB requirements, exposing investors to an unforeseen (and unimaginable) downside to their investment. This is only the tip of the iceberg, however, as numerous markets have felt the backlash from the sub-prime fiasco. For instance, nearly $2 trillion worth of commercial paper “remains locked up” due to investor wariness of a non-asset-backed security, driving yields on the paper way up, forcing banks to either sit on their current allotments of paper or sell at a loss. Either way, banks are seeing their lending power dwindle inversely to the rising yields on these papers, which is bad for them, and worse for us. As banks’ lending power decreases, their required minimums for borrowing rise. So not only are mortgages defaulting at astonishing rates (which aren’t expected to slow down until at least 2009), but daily loan applications are falling in number as well. Connect the dots, and it now seems obvious that the real estate market is headed for bad times.

What might be conveniently dismissed as typical summertime lows in the housing market is merely the beginning of what will be a long-run downward spin in the housing market. This is not merely a notion but a fact, and there are telltale signs everywhere. For example, foreclosures have more than doubled since this time last year. Also, home sales for the month of July have decreased by more than 1.2% from where they were last year. Together, these two facts detail the inevitable; the number of houses available for sale is rapidly increasing while the number of homes being bought is declining. This means that house prices will have to drop in order to find buyers, and they have – median home prices fell for the 12th month in a row this July.

Not only is the backlash of the credit crunch affecting the housing and financial markets, its likely going to hit the retail market as well. Historically, retail trends trail those of the housing market by just a few months. This time, however, the trend is not as prevalent. While this could be due to the relatively healthy economy, it’s more likely due to the large gains homeowners saw in their home’s equity over the past several years. This makes sense given that in 2006 alone, a whopping $382 billion worth of home equity was pulled out of homes across the U.S. In addition, the unemployment rate is the lowest it has been in six years. Therefore, not only are homeowners still riding the additional income generated by their home’s equity, they have little concern about their economic situation and are therefore disinclined to cut-down their retail spending. However, this disparity between economic reality and consumer spending cannot last, and as retail sales growth figures suggest, retail growth may decline until it reflects more accurately the flailing housing market. That is, unless the Fed reduces interest rates.

Well, if lower interest rates will save the home buyers and consumers alike, at least in the short run, why on Earth doesn’t the Fed just lower interest rate?

Because then we’d be in a recession…