The attention the media is giving to yesterday’s stock market plunge is overplayed, although the underlying problems in the economy are real. As I have argued in times past, the stock market is not a good barometer of the economy’s health. It can be driven up as a result of a redistribution from wages to profits, or simply as a result of irrational exuberance. Neither story is good news for the economy as a whole, although anything that pushes up stock prices is obviously good news for the small minority of people who own substantial amounts of stock. Yesterday’s market plunge did not by itself mean much. The immediate precipitating factor was the collapse of one major investment bank (Lehman Brothers), the rushed takeover of a second (Merrill Lynch), and the prospect of the collapse of the nation’s largest insurer (AIG). It is news when major financial institutions face collapse, but this situation was totally predictable, even if the list of characters and the precise schedule was not. The collapse of the housing bubble is destroying $8 trillion in housing bubble wealth ($110,000 per homeowner). The bulk of this loss will be born by homeowners who will see much of the equity in their home disappear. However, homes are highly leveraged assets. In the old days, people typically bought homes with down payments of 10 to 20 percent. At the height of the housing bubble, they often bought homes with zero down. When these homes lose 30-40 percent of their value, as they have in many of the most over-valued markets, it is inevitable that many of the mortgages will go bad. This is especially likely when the home was purchased with an adjustable rate mortgage that resets to a higher interest rate, as was often the case in the heyday of the housing bubble. In other words a tsunami of bad mortgage debt was inevitable. The only question was where it would show up. (Fannie and Freddie were virtually certain to be nailed. All they hold is mortgages and mortgage backed securities. No serious economist should have been surprised by their collapse.) The collapse of housing equity will also lead to higher default rates in all sorts of other loans. People use the equity in their home as a backdrop for all the other loans that they take out, such as credit card loans, student loans, car loans, small business loans. When they lose the equity in their home, as tens of millions have, they no longer have a fallback when they lose their job, have a serious illness or face some other financial setback. Therefore, it is virtually certain that default rates on all sorts of loans will jump, even before we see the full effects of the recession. With this backdrop, it is guaranteed that we will see more major financial institutions collapse. Look for those who hold large amounts of mortgage debt, especially on homes in the former bubble markets. The aggregate impact will be large. The Fed will have to struggle to keep the financial system operating smoothly. We will also see more bailouts – perhaps of AIG, down the road expect Congress to bail out the Federal Deposit Insurance Corporation, which is likely to see its reserves exhausted by a few more IndyMacs and many smaller bank failures. I don’t know how much lower this will drive the stock market, but the economy will see a recession and quite likely a very bad one. This was all totally predictable. The tragedy is that those in a position of power did nothing to prevent this disaster (arguably they promoted it). It is especially unfortunate that the media are still covering up for the incompetence of those in government and business who are responsible. They should be held accountable.
--Dean Baker
