Second Stimulus is a Waste Without First Fixing the Broken Credit Markets
Posted by Michael A. Kamperman on July 7, 2009
Today Dr. Laura Tyson, a member of the President Obama’s Economic Advisory Council, called for a second economic stimulus plan focused on infrastructure spending. Unfortunately, the White House quickly said there was no immediate need for a second stimulus plan since they were still monitoring the effectiveness of the first plan. Considering that the unemployment rate of 9.5% is well beyond the Administration’s worst case assumption for 2009 of 8.9%, just what in the world are they monitoring? However, the key reason for the collapse of the economy and for its failure to revive is the credit markets broke and are still broken. The media’s focus on Dr. Tyson’s comments helped obscure the much more important insights from an article in today’s Financial Times titled Under Restraint, the link to which is found in the far right column. This article details how the securitization market for loans fell apart in 2007 and remains broken in the middle of 2009. The securitization market allowed banks to make mortgage loans, auto loans, commercial mortgage backed loans, and credit card loans, and then sell the loans to investment banks for a fee. Importantly, the banks also sold all of the risk and could then make new loans with the proceeds from the sale. This significantly levered the ability of a bank to lend money off of its existing capital base. The investment banks pooled the loans together and sold them to investors all over the world in tranches, most of which were rated AAA by the credit rating agencies. The subprime debacle killed this market, and it will not be coming back in its previous form.
The problem is the securitization market accounted for $2.5 trillion in lending to the real economy in 2007. Most of the lending support offered by the Federal Reserve has propped up other areas of lending, and not the lending that came from the securitization market. The banks simply do not have the capital bases to absorb the lost lending from the securitization market. This is the root cause of the credit crunch. Until it is fixed the world economy will continue to not have adequate access to cash to grow the economy or stave off deflation. Yesterday, I read that an employed woman with a credit score of 705 was turned down by her local bank for the first time ever. She was attempting to purchase a $10,000 used car. If people with credit scores over 700 find credit conditions tight, imagine what it is like for those with scores under 690. Over half of the U.S. consumers have credit scores below 690 right now. According to Citigroup, the securitization market supplied from 30% to 75% of the lending to various sectors of the U.S. economy, such as the auto sector. Multiply this globally and it is clear a couple hundred billion dollars of roads and bridges will not offset a couple of trillion dollars of annual lending in the real economy.
The solution to fixing the broken credit markets has two components. First, there is not enough capital in the bond market to support all of the disparate credit needs. The Federal Reserve can fix this by printing $10 trillion and purchasing most of the outstanding U.S. Treasury bonds. The cash received from the sale of U.S. Treasuries will be forced into other more economically productive sectors of the credit markets. Second, the U.S. government can guarantee jumbo-mortgage backed securities and auto-backed securities to free up bank capital to lend to other sectors of the economy. President Obama needs to understand the economic pain we are experiencing is unnecessary. He can effect real change if he will simply stop listening to his political advisors to wait and see whether or not the first failed stimulus plan is enough, and instead demand drastic action.
