Credit crunch spreads outside U.S.subprime markets to the rest of the world.

The politically-inspired Bush-Greenspan housing bubble and the corrupt sub-prime mortgage market designed to create that bubble (and reelect Bush in 2004 along the way) has not only collapsed, it is starting to take worldwide credit markets with it. A lot of midnight oil is being burned and a lot of caffeine being drunk by very bright men and women whose personal wealth is wrapped up in the current system. If they succeed the degree of the disaster can be limited. But they won't prevent the disaster. It has already happened. At best they will keep it from spreading too much more.

So where are we now, and how did we get here? Politics was the cause. Economics is the symptom. We'll start with the symptoms and work back.

From Bloomberg this morning:

Aug. 10 (Bloomberg) -- Deutsche Bank AG's DWS unit, Germany's biggest mutual fund company, said the assets in one of its investment funds have fallen by 30 percent since the end of July as sub prime mortgage losses roiled credit markets.

Assets in the DWS ABS Fund fell to 2.1 billion euros ($2.9 billion) from 3 billion euros, mostly as a result of client redemptions, DWS spokeswoman Anke Hallmann said today. The fund, registered in Luxembourg, has no investments in U.S. subprime- related debt and hasn't halted withdrawals, she said.

Investors are shunning bonds backed by home loans after late mortgage payments by U.S. borrowers with poor credit histories rose to the highest since 2002. BNP Paribas SA, France's biggest bank, contributed to financial market turmoil yesterday by halting withdrawals from three investment funds because it couldn't value their holdings.
[Underlining mine - Editor WTF-o]

The fact that the fund has no investments in the U.S. subprime-related debt and yet has lost 30% of its value means that the problem has spread from sub-prime loans to the general credit markets. People with money to lend are delaying lending it because they are concerned about losing what they lend. Then people in the sub-prime market are having to sell investments to cover losses. This is a reasonable and expected reaction when the underlying asset (homes) is declining in value. Hedge funds which borrowed money at lower interest rates to lend in the riskier subprime markets are being battered by their leverage as they lose lots of money on the way down.

The problems in the U.S. sub-prime mortgage market are important because the amount of money involved is extremely large. The problems in the U.S. has spread world-wide. From Market Watch:

By Simon Kennedy, MarketWatch
Last Update: 10:45 AM ET Aug 10, 2007

LONDON (MarketWatch) -- Central banks in Europe, Asia and the U.S. injected billions of dollars into banking systems Friday, moving to further boost liquidity in markets suffering the ripple effect of the subprime-credit crisis and saying they stood willing to provide more cash.

The European Central Bank said it had provided 61 billion euros ($84 billion) to banks in a three-day tender offer, and the U.S. Federal Reserve carried out a $19 billion three-day repurchase agreement.

In Asia, the Bank of Japan supplied 1 trillion yen ($8.48 billion) after a rise in the overnight call rate. And The Reserve Bank of Australia added A$4.95 billion ($4.17 billion).

The Fed said it will provide reserves "as necessary" to promote trading in the federal funds market at rates close to 5.25%, the base rate. Other central banks made similar pledges about being willing to lend more.

The overnight rates at which banks lend money to each other rose again Friday, with the dollar-denominated rate hitting 5.96% from 5.86% the previous day, according to data from the British Bankers' Association.

The loans by the ECB follow the roughly 95 billion euros it handed out in its biggest-ever cash injection Thursday, in the aftermath of overnight interest rates spiking.

All of this was started by the slow (and continuing) collapse of the U.S. housing bubble. So where did the housing bubble come from?

The housing bubble was a creation of the Bush administration and Fed Chief Alan Greenspan. As I wrote previously, The Bush administration needed an adequate economy for political reasons, yet their taxing, borrowing, war spending and anti-Union policies did not provide it. The economy is run based on demand, and consumers needed money to buy the products and services produced.

The money that consumers needed to spend wasn't there in wages (there has been no increase in real wages since 2000) and in spite of the tax cuts there has been no significant increase in national investment, so where could it come from? The answer was home equity loans and real estate speculation. But this only worked if the Fed lowered interest rates a great deal and convinced banks to be willing to loan money to anyone, no matter how poor their credit was. That's what happened.

What the Bush administration has done is to deregulate home mortgages to the extent that the most recent ones are called "NINJA" mortgages. That is, a person could get one with No Income, No Job, No Assets.

That was intended to boost the economy. About two-thirds of American Gross Domestic Product is bought by consumers. Essentially the U.S. economy has operated on government spending and consumer spending since 2000, with consumer spending being the more important. Since Bush took office those consumers have not gotten an increase in after-inflation pay, but they had to get money to spend from somewhere. It has come from refinancing and second loans on the value of the homes they have title to, which required ridiculously easy lending policies and ever-increasing home prices.

This couldn't go on forever, but it really only needed to last beyond the 2004 Presidential election. It did.

By late 2004 the housing bubble was dangerously stretched. Financial bubbles break when someone seriously questions whether to gamble on buying an asset - in this case a home - at a ridiculously high price on the assumption that some greater fool will pay even more for it later, or when they can't get a loan to buy the home at the higher price. Home prices topped out after the federal reserve tried to bring the bubble down softly by a long series of small interest rate increases.

Starting about February 2005 the fed increased the federal funds interest rate by 1/4% per month for 17 months, ending at an interest rate of 5 1/4% in June of 2006 (from BBC News.) The increase in speculative housing prices could not survive this increase in interest rates. But it was more than just higher interest rates.

To get enough people to buy, sell and refinance more homes the banks needed to drop credit standards. Along with poor credit standards the mortgage industry pushed riskier types of mortgages from Adjustable Rate Mortgages with ridiculously low teaser rates at the beginning into interest only mortgages where the borrower paid only the interest and no principle. A large number of the people with poor credit who were induced to gamble in the market could not survive both the higher interest rates and a lackluster economy. People with those risky mortgages suddenly faced higher payments as the new, higher interest rates kicked in and many had to sell at a loss - if they could. An increasing number of individuals just stopped paying on houses they could no longer afford the payments for and let them be foreclosed.

When enough people have those problems then the sub-prime mortgage markets themselves became damaged seriously. It takes a lot of financially strapped people all at once to create major problems for a large market, but that point was reached and recognized in early 2007.

I am not sure exactly why the Federal Reserve started moving the interest rate back up, but the timing of their actions suggests that it probably had to do with the fact that the 2004 election was over. Greenspan worked hard to reelect Bush. At the same time the extremely low interest rates in the U.S. economy were causing the value of the dollar against the EURO, Yen and Pound to drop too much. This led to real concern that inflation would begin. The $70 per barrel price of oil has also remained consistently high and was a key element threatening new inflation. Inflation frightens the bond market. For good reason.

The Bond market had not been pricing the money they lent out to include estimated future increased inflation. Presumably they kept the interest rates they charged low because they depended on the Federal Reserve to prevent future inflation. Lenders felt that they could offer lower interest rates by eliminating the inflation premium because Greenspan promised that at any hint of inflation the Federal Reserve would step in to stop it.

If the Fed reneged on its promise to the bond market to restrict inflation, a lot of money would be lost. So the Fed had to act. It looks like the Fed did not recognize how the sub-prime mortgage market had been growing more unstable in the previous years. The instability crept up slowly as interest rates went down, credit standards were reduced and types of mortgages got more risky.

The problems did not occur overnight and without warning. But any action to stop the growth of the problems was going to cause some trouble in the markets somewhere. Bush's reelection depended on those problems not happening until he was reelected. That meant that the Fed could not act on the housing market problems before the Spring of 2005. Beginning the 17 month slow increase in interest rates in February of 2005 shows that the election was the reason for not acting sooner.

That explains how we got to the present set of financial problems. Now we have had the (long-predicted and continuing) drop in housing prices that started in 2005. Next followed the near collapse of the sub-prime mortgage market in the U.S. which became obvious late this Spring with Countrywide Mortgage Company's announcement of problems. Now we have the spread of the American sub-prime mortgage problems to the general credit markets world-wide.

Where is it going next?

Good question. No one knows. The current economic situation is one that has never occurred before. Every economic reporter I have heard in the last few days has ended his report saying something like "We expect conditions to get better tomorrow."

Even Bonddad is optimistic this morning, but his optimism is more realistic than that of most economic reporters (who, I suspect, are saying what they are told to say.) Here is what Bonddad said today:

The point is Wall Street and the central bands [banks, obviously] around the world are on the job. And these are some really smart and capable people who will get the markets through this mess. That does not mean it will be easy. In fact, the news will continue to be bad for awhile. But the markets and the economy will get through this; it will end at some point.

Bonddad recognizes that economic commentators have to appear optimistic right now but his optimism is at least realistic. He doesn't know what will happen next either, but he has faith that a lot of very smart people are working very very hard to keep disaster at bay. And what he says is true. The U.S. and the world did (finally) pull out of the Great Depression - after more than a decade of bad economic performance. If there is anything humanly possible to keep the mismanagement of the American economy by Bush and Greenspan from causing a world wide disaster, they will. That's a big IF.

The point is, none of the commentators are providing news. They are speaking optimistically in order to prop up the market long enough for something to happen to keep things from getting worse. Economic news reporters do this every time a financial market is having problems. If they don't, then there is a real danger that the market will simply stop working. Here's why. The problem is perceived risk and the behavior of lenders.

The estimate of how risky it is to lend money is subjective. If knowledgeable people don't say positive things, then that subjective estimate of the risk of loss of money will increase to where no one will dare to lend. If you have money, you lend it only to get a return on the principle. If the chances are high you will not even get the principle back, you do not rationally lend it out. You slide it under the mattress or something.

If that negative feeling takes hold, the markets themselves will collapse. No one in the financial community dares even whisper a word of negativity for fear of that collapse. A financial asset is worth only what it can be sold for, and if the market collapses, it cannot be sold. That means what was an asset becomes worthless.

I don't write this because I expect the markets to fall out of bed. I write that because no one knows what they will do. Any statements to the contrary presented as news simply ignore the fact that no one knows where the markets are going.

At the moment, prayer and good luck charms are at least as useful as knowledge of the markets.

That's why at the top of this article I emphasized that the problems in the sub-prime mortgage lending market had spread to the credit markets in general. This problem consists of the housing bubble and a myriad of bad mortgage loans, It was created by Alan Greenspan for political reasons. The economy had to be propped up to reelect Bush.

Now it has spread from the mortgage markets into the entire investment community and gone worldwide. Presently it is spreading like a forest fire and a lot of people are trying hard to put it out, but like stopping a forest fire, success is far from certain.

Politics matter, and bad politics comes back with really bad results. If you haven't suffered from the Bush-Cheney war of choice in Iraq or the Bush-FEMA failures on the Gulf Coast after Katrina-Rita hit, just wait. You will soon have a chance to suffer from the Bush-Greenspan economic mismanagement. If you aren't already.

Oh, and if you are a Republican, you are in political trouble too. The problems are hitting too soon for you to be able to blame the Democrats. You did this, and there will be political accountability.