Notice the US
had record low interest rates for a period of nearly three years. This led to a debt binge of mammoth proportions. Here is
a chart of total household debt outstanding from the St. Louis Fed:
Notice the amount
outstanding increased from around $8 trillion to a little shy of $14 trillion within a period of seven years. That's approximately
a 75% increase in total household debt outstanding.
All of this debt
has to go somewhere; it doesn't just exist in a vacuum. To accommodate this increase in total debt, we've seen a huge increase
in structured financial products. In and of themselves, these are not bad devices; they have been around for approximately
25-30 years. However, they were used very recklessly over the last 7 years, and especially over the last 3-4 years. The short
version of what happened is simple: lending standards deteriorated to the point where literally anyone could get a loan. These
loans were then sold to investment firms, who pooled them together and carved them into various bonds, which were in turn
sold to large institutional investors like pension funds, insurance companies and hedge funds. The idea underlying structured
financial products was that risk was spread out to the point where the bonds were more or less insulated from default problems.
However, when defaults skyrocketed higher than anticipated, we discovered that the risk wasn't contained nearly to the degree
we thought. Instead, everybody started getting hurt.
Right now the Federal Reserve
is treating this situation as a "liquidity crisis", meaning they are literally throwing money at the problem. They are hoping
that by flooding the markets with money the money will get spent in the form of loans and credit. However, the market has
ample liquidity. The problem is we are in the middle of a debt crisis:
During a liquidity
crisis, the issue is one of supplying money to those who, for whatever reason, have suddenly shortened their time preferences.
Mr. Practical, writing on Minyanville's Buzz & Banter, characterized it this way:
is a rumor that a large bank has made a bad loan. Because banks lend out more money than they have on deposit - this is called
a fractional reserve banking system - if everyone goes to the bank and demands their money at the same time, a liquidity crisis
can occur because the bank does not have enough cash on hand to satisfy the demand from its depositors. The Federal Reserve
will then step in and provide liquidity, allowing the depositor demands to be satisfied. If the rumor of the bad loan proves
to be false, then the issue is one of liquidity. Time preferences soon return to a more normalized state, depositors return,
everyone feels better. But, if the rumor turns out to be true, it doesn't matter how much liquidity the Fed provides, the
bank will go bankrupt.
issue today is not one of temporary liquidity, time preferences being shortened out of a temporary risk aversion. The issue
is too much debt supported by too little value and income generation. As a result, time preferences are retreating, risk aversion
is growing, and access to credit is diminishing.
Here's the basic
problem. All of that debt in the household debt chart assumes a certain asset value. Here's a simple example. Suppose a bank
makes a $100,000 loan for a home valued at $100,000. If the home appreciates in value, everything is fine. However, let's
assume the home's value decreases to $90,000. Now the loan is inherently less valuable because the underlying asset has decreased
in value. If this situation persists or worsens, the lender will have to devalue the loan to some degree to reflect the lower
asset value. Now, take this situation and apply it to the entire US economy and you get an idea for what exactly is going
on right now.