The multitude of bad mortgages that were wrapped into collateral debt Obligations (CDO's) and sold to investors have caused severe erosion of bank and financial company capital. This has led to several large bank failures as banks like IndyMac (who specialized in so-called "Liar Loans") owe more in debt than they can pay back. Bear Stearnes failed after having to take two large failed Hedge Funds back onto their balance sheet when they went bankrupt last Fall, then finding their own capital so impaired that other banks and finance companies would no longer lend to them to keep their operations going.
Losses on the mortgage-backed CDO's has also caused other large banks (like Bank of America and Wachovia Bank as well as Citibank and J.P. MOrgan) and financial companies (such as Merrill Lynch) to have to sell additional stock to increase their capital and avoid bankruptcy.
This sale of stock at fire sale prices after their stock prices have declined 50% and more is seriously diluting the value of the shares owned by previous investors who bought their stock. That means that previous owners of the stock take all of the price decline, but the new stockholders will share in any later stock appreciation.
In addition to selling stock that dilutes the value previously issued stock, the banks are also selling CDO's at huge discounts to use the money to build up their capital - which they have to do to avoid bankruptcy. Merrill sold CDO's originally on their books at $30.8 billion for .22 cents on the dollar. The fire sale of discounted assets is only part of what the banks and financial institutions have to do to avoid going bankrupt. They are also laying off workers and seriously cutting back on lending money for any reason, even to long-time good customers.
The refusal to lend to previous long time customers has put other businesses into trouble. They have difficulty financing maintenance, repair and upgrading of their existing businesses, so they are also having to lay off workers.
Most of this was at first primarily in the financial economy, but when loans start drying up businesses in the real economy find it difficult to sell their goods and services on credit. After a decade when the Federal Reserve held interest rates inordinately low to pump up the economy and reelect George Bush in 2004, no one has bothered to save money. The low return on savings, essentially the same as or lower than inflation, meant that it was more rational to buy on credit than to save up for something the consumers wanted. The result is that now there a few consumers with savings to buy when they can't get loans.
Then Companies that produce the goods and services can't get loans to maintain their plant and equipment, so their production falls off. The layoffs of workers in both the financial and the real sectors reduces demand for goods and services, especially since the American economy has been operating on borrowed money instead of a well-paid middle class since the late 70's. The current recession is a direct result of a lack of consumer demand, caused by consumers who cannot afford to buy consumption goods and services. Expect more stories like this one about Bennigans and Steak-and-Ale in Florida suddenly going into Chapter 7 liquidation. Similar casual dining chains are also in trouble.
The key is that consumers are tapped out. Until recently they bet that things would turn around later. They would have increased debt, betting that their income would later increase to allow them to continue spending.
No more. Now a great many consumers are recognizing that any future turnaround is unforeseeable. They are reducing the us of credit cards and paying them off instead of increasing debt.
If anyone tells you that the American economy is fundamentally strong and that we are near the bottom, laugh at them. Because the economy is so weak the Fed can't raise interest rates to keep the dollar from declining. This has been a major cause of the increase in the price of oil and sets the picture for oncoming inflation. And no, the recent decline in the price of oil is not a result of it having been overpriced. It is a result of the decline in the economies of industrial nations so that there is less driving, along with the rational reaction of drivers to reduce the amount of driving because of the very high price of fuel. Any turnaround in the economy is going to be met by further increase in the price of oil as demand goes back up, which will dampen the turnaround for a long time.
Besides, the last of the Adjustable Rate Mortgages haven't reset upwards yet. When they do, the new prices will take into account the oncoming inflation and reset to their highest possible rate. That will cause even more foreclosures and shaky banks, which will mean further credit restrictions. Those credit restrictions mean that the free market economy will not be able to drag itself out of the recession.
The solution? In the short run, we all suffer. But to make the recovery, such as it is, happen sooner, the consumers have to get more jobs and more money to rebuild the economy. We are going to have to listen to Robert Reich:
The only way to keep the economy going over the long run is to increase the real earnings of middle and lower-middle class Americans. The answer is not to protect jobs through trade protection. That would only drive up the prices of everything purchased from abroad. Most routine jobs are being automated anyway. Nor is the answer to give tax breaks to the very wealthy and to giant corporations in the hope they will trickle down to everyone else. We've tried that and it hasn't worked. Nothing has trickled down.The only institution in the economy that can borrow in a bad economy is the government. It can borrow today based on future revenue anticipated from taxes, but if that money is spent in rebuilding the economy from the bottom up, future tax revenue will increase to cover the borrowing.
Rather, the long-term answer is for us to invest in the productivity of our working people -- enabling families to afford health insurance and have access to good schools and higher education, while also rebuilding our infrastructure and investing in the clean energy technologies of the future. We must also adopt progressive taxes at the federal, state, and local levels. In other words, we must rebuild the American economy from the bottom up. It cannot be rebuilt from the top down.
Banks and financial institutions can't borrow when their current capital position is negative, as most banks are today. And since the problems are getting worse, not better, an unregulated financial economy will not be of any use until after the recession is over. And after that, the financial economy will have to be regulated to keep it from creating another and larger financial bubble.
Consumption keeps the economy working, not investment. When there is economic demand (the desire for goods and services, combined with the money to pay for them) then investment will occur to meet that demand. Until that demand is there, no sensible investor is going to throw his money at a declining economy. So we need the government to step in and place its priority on supporting the middle class again instead of handing off all the profit from increased productivity to the wealthy who do not keep the economy afloat.
In short, we are looking at continuing economic hard times which are the direct result of conservative mismanagement of the American economy. Only rational government action can reduce the length of time of those hard times. That's going to require destroying the conservative movement as an effective political force and replacing most Republican and many Democratic politicians in office.
The recession is going to last at least until those people are out of power. After that there will have to be a long period of rebuilding what conservatives have destroyed. That rebuilding will require a combination of intelligent government and a lot of private enterprise working together.
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