Flipping Real EstateDebt is a necessary part of economic life. Without it, families would never get a mortgage, and new businesses would never get a startup loan. Interest payments on debt are really just the cost of 'renting' money. Everyone carries debt. Households, businesses and governments. Every corporation that floats a new bond issue is creating additional debt. Making payments on a mortgage or loan is just another form of paying rent. Americans are often more worried about the federal debt, because it keeps growing. But that's because the economy is also growing. As a percentage of GDP, federal debt has actually remained fairly stable, near 50% (left chart). But events initially triggered by the dot-com market crash eventually create conditions that favor home-buying, with interest rates near zero. What follows is a housing 'bubble,' which is echoed worldwide. Then chaos. |
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Ready to Blow As Americans rush to buy homes at the new super-low interest rates, banks start running out of money to lend out to the flood of new mortgage applicants. Happily, Wall Street geniuses come up with a clever way to recycle existing mortgages, which they buy from the banks to package and re-sell to investors as a brand-new type of bond. They promise sky-high yields, but (amazingly) no risk at all. Something smells fishy, but everyone is making money, so who cares? Banks now have new money to lend out on new mortgages, often under very loose scrutiny, to people with increasingly dubious credit. They're called 'subprime' mortgages, to reflect the unusually low credit ratings of the new homeowners. Many will soon go delinquent on their mortgages. | |||||||||
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Nightmare on Wall Street The total value of re-packaged mortgages is now approaching three $trillion. The word 'trillion' isn't normally needed when describing economic indicators. Mere 'billions' is normally sufficient. This top-heavy financial pyramid finally collapses when home prices abruptly roll over and start to plunge. As subprime borrowers begin defaulting on their hastily-approved mortgages, the price of Wall Street securities based on those mortgages also plummets, revealing far more risk than brokers promised. Investors will no longer touch the now-dangerous securities, which have become almost worthless. This, in turn, brings down a top-tier Wall Street firm caught holding too many of them. America is suddenly facing a terrifying new financial crisis. | |||||||||
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Financial Contagion Meanwhile, foreign bankers have been following the lead set by the US, slashing interest rates and goosing housing. All the big economies now have housing bubbles, and even bankers are becoming gullible. Banks that get farthest ahead of the curve, such as those in Iceland, are in deep trouble. The complex world of international banking has tentacles that intertwine, so that a bank failure in one country can lead to others, elsewhere. The panic is now global. In America, the Treasury secretary quickly puts together a truly monster bailout package, with an eye-watering price tag. | |||||||||
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Get-out-of-Jail-Free The crisis in America subsides quickly, as a hastily-arranged meeting persuades the nation's largest banks to accept a direct bailout from the US government that totals $700 billion. Congress follows with an even bigger stimulus package. The country is initially stunned by the price tag, but the next shoe never drops. Instead, the smoke clears quickly, as the Fed pushes interest rates all the way down to zero. This defies logic, implying that the cost of renting money is also now zero. Money is essentially free. Meanwhile, the Treasury secretary is congratulated for averting a meltdown. Lost in the noise is the fact that the federal deficit is about to balloon wildly, going far above the previous threshold of 50% of GDP. America is now hooked on easy money. | |||||||||
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The New Normal America now appears to conclude that deficits no longer matter. If the government can magically conjure up a trillion dollars over the weekend, and nothing bad happens as a consequence, then perhaps all the hand-wringing over mounting debt is unwarranted. Billions, trillions ... whatever. During the 15 years following the bailout, the national debt as a percentage of GDP doubles. This comes after 100 years during which this level was only reached once, to fund the Second World War. Back then, it took 10 years of fiscal discipline to whittle the debt back down to normal levels. Now, however, America is making no effort at all to return to historic norms, and neither are other developed nations. Only time will tell if this can continue. | |||||||||