Thursday, October 16, 2008

The Other Shoe Begins to Drop

The financial meltdown that began in the US, and has now spread across the world, originated in the refusal of Americans and the US government to live within their means. The US government's effort to magically increase homeownership - by forcing banks and other lenders to give mortgages to people who had no way of paying for them, and then making Fannie Mae and Freddie Mac buy up those lousy mortgages so the lenders could go back and lend even more - caused the subprime mortgage fiasco that brought down Wall Street, which foolishly leveraged itself on US mortgage assets (which had been a traditionally safe bet). Now the second phase is ripe to begin: credit card defaults.

Since middle class income in the US has been stagnant for quite some time, Americans have been going heavily into high-interest debt in order to finance their buying sprees. Banks and other credit card issuers have been only to happy to let them because they know that most people don't pay off the balances on their credit cards, thus incurring enormous interest payments. With interest rates at around 30 percent on many credit cards, and numerous fees, credit cards have been a cash cow for many lenders. Credit card issuers have flexed their lobbying muscle in Washington to make certain no regulators rained on their party, and rewrote the consumer bankruptcy to their favor. Now that greed it beginning to catch up with them.

Consumers are increasingly unable to pay off their credit cards, forcing banks to hoard cash to protect against future losses and lend to fewer people, according to reports yesterday from several of the nation's largest banks.

These financial disclosures showed a spike in credit card loans going bad, putting further pressure on already-stressed balance sheets. J.P. Morgan Chase said the number of credit card loans in default rose 45 percent in the third quarter from the comparable period a year ago and predicted that default rates would sharply accelerate through 2009, with 7 percent of credit card loans going bad.

"We have to be prepared that it gets a lot worse," J.P. Morgan chief executive Jamie Dimon said about the overall economic outlook.

This was entirely foreseeable. But no one in Washington had an interest in reigning in the credit card issuers. Certainly not the Bush administration, which has borrowed trillions of dollars for its pork projects and wished for the illusion of prosperity to last at least until Dubya was out of office. And certainly not the Democrats, who wouldn't know sound economics it if hit them on the heads.

Now, credit card issuers find themselves caught in a perfect storm, largely of their own making. Unfortunately, the effect will harm the nation as a whole.

The deterioration in consumer credit, the latest downturn to whack Americans after the housing slump and mortgage meltdown, threatens one of the linchpins of the U.S. economy. Over the past 10 years, credit card debt has gone up 75 percent as Americans' real wages and savings rate have stayed flat. That means Americans have been spending beyond their means -- and fueling economic growth with borrowed money.

Now, the housing crash, financial downturn and contracting economy have made it more difficult for Americans to settle their bills, setting off a downward spiral. As people fail to pay off their credit card bills and other loans, banks must put away money to cover expected losses. So banks lend less. Americans who tended to rely on loans to fuel their spending must cut back, readjusting their spending habits to conform with what they earn.

"Given that the savings rate has been minuscule, there's no reserves in the tank for the consumer to tap his savings to support his spending," said Scott Valentin, a financial services analyst at Arlington investment bank Friedman Billings Ramsey. But consumers have been driving about two-thirds of the U.S. economy.

This means additional shocks to the US financial system over the coming year as bad credit card debt begins to weigh heavily against already shaky balance sheets. The credit crunch, in short, will deepen.

"There's a complete freeze of lending to low-income, high-risk borrowers as banks try to stabilize their balance sheet. They're not going after anyone with moderately shaky credit. They're even being cautious with people who have great credit," said Gregory Larkin, a senior analyst with Innovest.

Credit card debt is not the only area showing weakness. Defaults on auto loans are also rising fast. "Even somebody with great credit is going to have an extremely difficult time getting a loan if they don't have a down payment," said Greg McBride, senior financial analyst at

Of course, this is exactly how capitalism is supposed to work. When lenders behave foolishly, the market punishes them. Federal regulation was supposed to soften the market's harsher judgments by restraining the bad behavior in the first place. But regulation only works when the government actually does its job, and has little chance of working when the government is dominated by second-rate people as it is now. When the government's guiding ideology is deficit financed spending sprees, you can't expect it, or the electorate to behave reasonably.

And in this case, the fork-tongued politicians and shiftless bureaucrats of Washington aren't the only culprits...

In reporting sharply lower profits for his company earlier this month, Bank of America chief executive Kenneth Lewis called lending conditions "a damn disaster." Lewis added, "We are making every good loan we can find," but "it's not going to be pretty for awhile."

This is the CEO whose company has been issuing credit cards to illegal aliens. Gee, Mr. Lewis, exactly who created this "damn disaster" in the first place?

According to Forbes, Mr. Lewis has received $165 million in compensation over the last five years as Bank of America's CEO. That is the state of American finance.


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