In the coming months, it will become clear that the disaster of Greenspan's Tsunami has ruined the lives of three generations of US taxpayers. Current students will find no work when they graduate, their parents have lost half their wealth and can't access much of the remainder; their grandparents retirement will be cold and dark with pensions, health care, and real estate values tumbling.
Greenspan's Tsunami
Like an unexpected wave of disaster, the increase in Fed Funds from 1% to 5.25% caused the flood of defaults in the adjustable loan market, leading to the collapse in Fannie Mae, Freddie Mac, and AIG.
Bad Loans in the Mortgage Industry
Following the decision to relax loan standards in 1999 lenders flooded Fannie and Freddie with low quality paper: borrowers with insufficient downpayment, low income, and poor credit quality. As interest rates rose, these adjustable-rate loans fell into default, and foreclosure sales began.
As the assets behind these loans fell in value, investors in Fannie and Freddie paper looked to the agencies to make good on their promise to guarantee principal and interest. As the magnitude of the disaster became clearer, the markets knew the resources of Fannie and Freddie would not be adequate to make good the losses on mortgage-backed paper.
Credit Default Swaps
Standing behind Fannie and Freddie were sellers of Credit Default Swaps (unregistered insurance), but their capital proved insufficient too, and they failed. AIG and others are now wards of the US Treasury.
The lack of registration of CDSs meant that the risk of default, now spread throughout the system, was unknown and unknowable, leading prudent banks to shun all enterprises not protected by the Federal Reserve. Lending slammed to a halt.
For example, US exports now sit on the piers waiting for a letter of credit from a qualified lender so that the seller will release the goods.
Summary
In the months to come, the credit disaster will grow, and economic activity will collapse. Consumption, production, employment savings, investments, and tax revenues will all decline much more than the markets anticipate.
The stock market has anticipated most of the disaster, but not enough. There is still one more significant decline coming.
TACTICS
Continue money market arbitrage. Take advantage of low deposit costs and pick carefully through the wreckage of the market.
Lend only to solid companies or profitable residential real estate with good spreads.
STRATEGY
Tell the board we are in a long and deep depression and we will not recover soon.
