Will subprime crisis lead to recession?

Following the first collapses among its lenders last year, the US subprime mortgage market began a sharper collapse in recent weeks, sustaining losses that an investment offshoot of Banque Agricole estimated in mid-August to be US$150 billion.

US subprime mortgage loans totalled $635 billion in 2005 and were a key source inflating the US housing bubble in the wake of the 2000 bursting of the "New Economy"/dot.com speculative bubble. But strains in the subprime market became evident in 2006, with new housing construction plunging 35%. The fall is continuing.

The trouble is also spreading. On August 6, American Home Mortgage Investment Corporation — a major lender in prime and near-prime mortgages — filed for bankruptcy protection. This brought to 13 the number US mortgage lenders in bankruptcy protection. Since early 2006, at least 70 US mortgage lenders have halted operations or sought a buyer to bail them out.

As of mid-August, hit by their exposure to subprime loans, at least five US hedge funds have gone belly up, including two managed by the giant Bear Stearns investment bank. The August 13 BusinessWeek quoted a Moody's Credit Strategies analysis as saying such major investment banks as Goldman Sachs and Lehman Brothers are being seen as no more creditworthy than casino operator Caesars Entertainment.

Subprime mortgage and other high risk loans have been widely repackaged into securities for sale to banks, hedge funds, pension funds and other institutional investors around the world for funds to generate new loans, with the result that no-one knows which of these investors is exposed to major risk of bad credit, and therefore possible bankruptcy.

The recent subprime troubles have sent the global stock markets on a roller-coaster ride, wiping out $5.5 trillion of corporate paper values in the four weeks to August 18 alone.

The corporate money market also reacted strongly, sending short-term interest rates soaring and practically cutting off some previously "respectable" borrowers, threatening to destablise the broader economy.

The bid to contain this trouble prompted major central banks around the world to inject substantial sums of cash into the money markets to shore up short-term "liquidity". On August 9-10, the European Central Bank injected an equivalent of $213 billion into the European money markets, in the wake of the freezing up of three funds managed by BNP Paris, France's biggest bank, due to the lack of buyers.

From August 9 to August 21, the Federal Reserve has injected at least $94 billion into the system. In all, according to the August 20 Toronto Financial Post, First World central banks had pumped about $400 billion into the money markets in the previous fortnight.

Sea of liquidity

The crisis is set to get worse. Of the huge increase in subprime mortgages that were issued in the last few years, most were set at an enticing low fixed interest rate for two to three years, after which a much higher variable rate would apply. That change over is expected to peak from October this year through to 2008, precipitating many more payment defaults and foreclosures.

The subprime implosion is likely to further unsettle the "normal" running of the capitalist economy, given the centrality of the credit to business functioning. The central banks can only fiddle on the edges, steer the economy from one crisis to another, rather than stop asset bubbles from being formed or prevent periodic financial panics and credit crunches that put the "real economy" toward recession.

Hence, the Fed took the dramatic action on August 18 of cutting by 0.5% to 5.75% the discount rate — the rate at which it charges banks for short-term loans usually when they're in distress. It has left the federal fund rate, which sets the tone for the other market interest rates unchanged for the time being.

"The Fed move has given everyone a psychological boost. It's a short-term thing, though", Song Seng Wun, head of research at CIMB, Malaysia's largest investment bank, told Reuters on August 20. "It doesn't deal with the longer-term issues, the underlying problem from decelerating housing sector in the United States."

Why, knowing the high risk, did lenders dive into the subprime market? It's because they couldn't find more secure outlets to invest their spare cash in. Under capitalism, capital owners gear to invest in productive activities only when they attract at least the average rate of profit.

But productive activities meeting such criteria are in short supply. This is due to the widening gap between rapid development of productive forces inherent under capitalism and the increasingly limited growth in the real purchasing power of the mass of consumers, most of whom are workers.

According a study by Yale University professor Kenneth Scheve and Matthew Slaughter, an economic adviser to the White House for the past two years, only 4% of US workers — those with doctorates and professional graduate degrees — saw their mean real money earnings rise from 2000 to 2005. Earnings fell for the other 96%, even those with master's degrees. Consumer spending however has continued to rise due to the extension of "easy" credit by banks and other lending institutions.

The limited returns to be made in big new investments in the production of goods and services, has led big investors to put large amounts of their money into gambling on the stock market and in all sorts of "innovative" speculative financial deals. These typically involve very short-term commitment, with the potential lenders fleeing on the first signs of repayment difficulties. Hence, the increasing volatility in the financial markets.

The 500 companies listed under the S&P 500, an index that excludes financial and utility stocks, had cash holdings "sitting in the bank" of up to $623 billion in the second quarter of this year, according to Standard & Poor's senior analyst Howard Silverblatt. This was equal to almost a year of their earnings.

Fuelled by such huge amounts of spare "liquidity", banks and other lenders have created a huge housing price bubble in the US over the last few years. Desperate to make money out of new housing loans, lendings have pushed housing mortgages onto millions of poor people creating the huge US subprime mortgages market, which grew from $35 billion in 1994 to $332 billion in 2003 and $625 billion in 2005.

Twin 'icebergs'

Some commentators blame the subprime crisis on the Fed's 17 consecutive increases in the federal fund rate since the 2001 US recession, which brought it to 5.25% since June last year. But steering interest rates to avoid the twin "icebergs" of inflation and recession is a basic task of capitalist central bank in the age of debt-sustained corporate capitalism.

Many mainstream commentators have expressed the fear that the subprime debacle might drag the US into a new recession, pulling the rest of the world with it. But, according to the August 16 New York Times, the Fed has been more concerned about the year-on-year rate of core inflation (which excludes volatile food and energy prices) persisting for a third month at 2.2%.

The NYT quoted Dean Maki, Barclays Capital's chief US economist, as saying that the "economic data suggests no need for the Fed to consider cutting [interest] rates". Rather, "there's ample reason to be concerned about inflation risks".

However, in announcing the cut in the discount rate, the Fed stated: "Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward... The downside risks to growth have increased appreciably."

Bloomberg financial news service columnist Caroline Baum observed in an August 22 article that the Fed's action "won't address the underlying problems in the economy. The subprime market is getting worse, not better. Delinquent home loans are piling up as fast as the inventory of unsold homes. Mortgage lenders are going belly-up...

"Consumer spending is slowing, capital spending is hardly robust, and exports aren't a big enough share of the US economy to take up the slack.

"The Fed may have been concerned about price pressures as recently as two weeks ago, but the abrupt shift in Friday's statement is tacit recognition that the focus has shifted from fighting inflation to preventing recession."

Institutionalised predation

The subprime crisis is particularly revealing of the sickening nature of capitalism. Despite dealing with a socially vulnerable group, subprime lenders have had no problem institutionalising predatory terms, and using outright fraud, to trick borrowers into unfavourable agreements.

According to a 2005 University of North Carolina study, The Impact of Predatory Loan Terms on Subprime Foreclosures: The Special Case of Prepayment Penalties and Balloon Payments: "While there is no catalogue of predatory loan features, those most often cited include underwriting loans based on the value of the collateral rather than on a borrower's ability to repay the loan; inducing a borrower to repeatedly refinance for no other reason than to generate additional points and fees for the lender ('loan flipping'); and engaging in fraud and deception to conceal from an unsuspecting or unsophisticated borrower the true nature and cost of the loan obligation. Also considered predatory are loans with lengthy and costly prepayment penalties that prevent borrowers from refinancing when interest rates fall or their credit record improves."

Agence France Presse reported on August 22 that a survey by RealtyTrac, a private firm that monitors US housing loan foreclosure activity, showed foreclosure filings running at over 1.1 million in the January-July period, 60% up from the same period of 2006.

"We're at a 37-year high of the rate of foreclosures in this country", Democratic Senator Christopher Dodd, the chairperson of the powerful US Senate banking and housing committee, told AFP. "We may have as many as one million and [up to] three million people who could lose their homes ... because they got bad deals on mortgages."

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