Finance has been trending away from economic reality since the Ronald Reagan era on an accelerating basis. By this I mean the role of finance no longer represents sets of mechanisms and institutions designed to raise legitimate capital for investment in legitimate productive activities. Finance is now an end in itself, essentially a racket. The capital is no longer capital, i.e. genuine wealth accumulated from previous productive activities. Now it is jive-capital: notional "wealth" spun out of activities that are fundamentally not productive -- for instance, sub-prime mortgages bundled into tradable securities. In reality, the mortgages backing these securities are contracts for repayment of huge loans made on hazardous terms by shifty means to people with poor prospects for making their payments for assets (suburban houses made of vinyl and glue) that are, in any case, fated to lose much of their nominal value, becoming worth less than the obligations yet due on them, and rapidly so.and
The sub-prime loans were made in the first place because the contracting institutions (banks) could pass off the risks associated with these jive contracts by off-loading them to larger institutions such as the government sponsored enterprises Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) which are largely exempt from regulatory oversight and hence could buy up whatever cockamamie paper contracts they felt like buying and convert them into bonds, certificates said to represent future earnings. (Not.)
These mortgage backed securities were only one species of engineered abstract financial "instruments" among many orders of incomprehensibly abstract mutant financial "products" (derivatives, credit default swaps) and procedures (carry trade, leveraged buyouts,) based on the fundamental unreality that it is possible to get something for nothing.
The inertia part of the story is that this collective hallucination (that jive-capital was real) was sustained through 2006 by the sheer massive weight and flow of jive capital and its ability to elude scrutiny by countless chimerical conversions from one abstruse form to another -- from loan, to bond, to bet, to position, to Christmas bonus. . . . The final result, though, was a nation with an increasingly impoverished middle class, a bankrupt public treasury, and all remaining wealth (notional or residual) creamed off by a racketeering upper crust of logrolling insiders who, for the moment, could convert their dollars into multiple mansions, private jet planes, and sky boxes at the gladiatorial combats du jour.
The rest of the US economy was increasingly composed of a suburban development hyper-boom that amounted to little more overall than a colossal misinvestment in a living arrangement with no future (and the irreparable destruction of the remaining US landscape). The building-and-selling of suburban houses and the ancillary accessorizing of them with collector highways, strip malls, and big box stores, fast food huts, and all the jobs associated with constructing, lending, evaluating, selling, servicing, and staffing these things, along with additional rackets like home equity withdrawal refinancing to keep the cash registers ringing in the Wal-Marts and Home Depots -- these were the activities supposedly keeping the "regular" (i.e. lumpenprole) economy chugging along. If you subtracted all this "housing bubble" activity from the rest of this economy since 2001 there was very little left besides, hair-styling, fried chicken, and open heart surgery.
Yet, marvelous to relate, the whole toxic, entropy-laden, creaking, reeking cargo of shit-and-deceit that comprised this system just managed to keep rolling along for another year without collapsing under its own stinking, fantastically stupid weight.
I will be so bold to say that I called the housing crash correctly last year, though the worst symptoms are slow to present for technical reasons. There's no question that the action on the real estate scene changed drastically in mid-year. The implosion of this mighty structure of fraud, folly, and misinvestment so far has taken place in such breathtaking slow-motion that its victims have not really felt the pain from the falling bricks yet. By late summer, buyers started evaporating. Real estate signs planted in lawns last June are still sitting there on New Years. Prices have come down a bit in many markets, including most of the hotties such as Florida, Phoenix, Las Vegas, San Diego, and Boston. But the buyers are still not bidding. Meanwhile, the sellers have dug in, determined to get something at least close to their wished-for inflated prices, egged on by their representatives, the realtors. This mutually reinforcing psychology cannot hold indefinitely. Many of these sellers don't have the luxury to wait around forever. Some have had to move to other houses in other places because of job changes, and are stuck paying two mortgages. Many are stuck with "creative" mortgages that all the evil ingenuity of the human mind conjured in recent years to enable the feckless to live above their means -- adjustable rate, payment optional, no money down contracts that suckered buyers into booby-trapped obligations whose initial low-interest terms lured them in and are now set to blow up in their faces as terms automatically re-set upwards to higher rates and "optional" deferred payments get backloaded onto the principal, putting the mortgage holders so far underwater on their contracts that a tour of the Titanic would feel like a day at the beach.
The trouble is, when both the sellers and their agents decide to get with the reality program and lower their prices, they will only stimulate a massive death spiral of house price deflation as buyers see the numbers go lower and hold out longer in the expectation that prices will go down even further. That would, of course, put more sellers into gross distress and lead them either to dump their properties or enter the cold waters of default and foreclosure. The whole process could run for a couple of decades, and as that occurs it will be made much much worse by oil depletion -- as so many suburban houses drastically lose locational value, combined with the consequences of poor construction carried out in cheap materials like vinyl and chipboard.
Add to this that the late stages of the hyper-boom caused so much "product" to be brought onto the market by the "production home builders" that there now exists an unprecedented oversupply of exactly the kind of crappy suburban houses (in all price ranges) that are bound to lose value going just a little bit forward. Foreclosures will only add more to the oversupply. In the subprime mortgage niche, defaults are officially reported to be running at 20 percent. Foreclosures are trailing because the process is so awkward, and many have not yet shown up in the housing markets. I predict that foreclosures on subprime mortgages will run above the 50 percent range when all is said and done.
As the music stops in the lending rackets, liquidity in the form of mortgage backed securities and other sources of hallucinated "money" will dry up, and will start to make itself felt in all the other arenas and regions that "money" has been migrating to. Jobs associated with house-building and all those ancillary enterprises -- big box shopping, chain restaurant revenues, car sales -- will disappear and incomes with them. Many home sales in past decade were made to people benefiting directly from the housing bubble. (The sheer number of real estate agents in America more than doubled since 2001.) This evaporation of both credit and incomes will impact the so-called "consumer economy", said to make up 70 percent of the total US economy. In other words, the term "depression" might be applicable as this economy lurches into actual contraction of more than a few percentage points.
This scenario suggests that earnings in corporations listed on the public stock exchanges -- the companies that elude acquisition by "private equity" -- would necessarily see severe drops in earnings, and therefore in stock value. While many commentators view the rise in the Dow as just another symptom of inflation -- asset inflation -- the activity in these assets -- companies making, doing, and selling things -- must be reported on a quarterly basis. And if that activity is trending strongly downward, then stock prices will trend down even if the value of the dollar is going down and it takes more dollars to buy an equivalent share of stock year-over-year. So I would conclude by again predicting a substantial drop in the Dow and other equity markets. To some extent, it seems to me that the 2006 blow off in stock prices was just another symptom of the finance sector being decoupled from economic reality since real GDP probably contracted one percent in the second half of the year while misreporting and delusional thinking drove stock prices up.
One would think that the US dollar is poised to take a beating, and indeed the signs have been abundant that this is underway -- especially when the value of the dollar started to implode against the Euro around Thanksgiving. It has leveled off since then. But since then there have been other moves around the world to de-link commodity prices from the US dollar and restate them in Euros, especially oil, and the dollar's plunge will probably continue. A lot of commentators around the web have pointed out the side benefit for the US government to promote dollar inflation: to inflate itself out of crushing debt. But the government can't accomplish this without destroying the purchasing power of ordinary Americans and whatever remains of their meager savings. I'd have to conclude that the Federal Reserve is out of tricks for goosing economic activity. Their last major trick was hitching a jive economy to a real estate bubble by making loan money available to any jabonie with a pulse and promoting the demise of lending standards. The gambit lasted five years and is now blowing up in America's face.