Is The Credit Bubble Beginning To Burst?

Fredrick Sheehan has an interesting article over at PrudentBear.com in which he asks (and answers to a degree) if the actions of the Federal Reserve are impoverishing the American people.

I'm not going to try to deconstruct his case as, while it is very dark in its outlook, I believe it has some merit. It may be a bit too pessimistic, but I can't say absolutely that it's wrong or going off in the wrong direction. I would recommend reading it and forming your own judgment about its validity.

I will say that his characterization of the average new bond investor as uninformed is absolutely accurate. In my post about the basics of bonds one topic I did not go into was how bond pricing is derived from the relation of perceived risk to interest rates. That is quite possibly the hardest part of bond investing to grasp - and is absolutely the most misunderstood part (I'll write a detailed post on bond pricing later tonight or tomorrow).

But if I've expressed concern in the past about the possibility that we may be heading towards a deflationary cycle, how could I possibly agree with the statement that it is being caused by the Fed printing too much money, as that would normally lead to inflationary pressures?

Eventually it will, but right now the hyperactive printing of money is leading to the current housing bubble we're seeing:

From the fall of 1997 to the fall of 2002, the average house price rose in the U.S. rose 42%. In New York City, they rose 67%; in Jersey City, 75%; in Boston, 69%, and in San Francisco, 88%.

Those are unsustainable price growth rates. Yet, there are lenders still making 125% loans based on the idea that housing prices are incapable of falling and that the inexorable rise in prices will protect their irrational lending practices.

The refinanced mortgage that squeezes an extra $30,000 of money is not a risk, because everyone knows that house prices always go up. If one were to point out that real estate prices have fallen 70% in Hong Kong since 1997 and by an equal percentage in Japan since 1991, the reply would be: "But, this is America."

As a result of these types of loans we've been keeping our economy afloat with a giant national credit binge. But what happens when the mortgage lenders become unwilling to lend any more? There is already some concern that this may be beginning to happen:

...mortgages are pre-paying so fast that bankers may be reluctant to make loans - Brian Wesbury, June 23rd Wall Street Journal editorial

Why would the lenders be reluctant to make new loans? They are beginning to believe that they will get more for their money tomorrow than they can today. As a result, they are willing to sit on it. This is deflation at its basic. There is no sense in spending a dollar on a 2% return today, when you can 2.1%, or more, tomorrow.

And as the access to easy money dries up, so will consumer spending. As consumer spending dries up so will the ability of companies, like GM in the article, to repay their debt obligations. As the bankruptcies mount, so will the real losses sustained by investors and the banks. This will painfully wipe out most of the money printing going on by today's Fed. In the end, we will end up in just about the same place as we were prior to the credit binge.

The problem is that the solvent banks and people who live on a cash basis, rather than in debt, will be sitting on a huge pile of cash when the economy does start to turn around, which will happen once the oversupply problems are worked out of the system. And just as the supply and demand equation comes back in balance, most all of that cash will be spent or lent. And as it chases around the limited supply of goods and services available at that point, we will be hit with some pretty severe inflationary pressures, which will serve to cause even more pain.

I think that we are going to suffer from this to one degree or another. Right now our economy is surviving going from bubble to bubble, but we're starting to run out of non-leveraged assets. Housing was one of the last. When the housing credit bubble bursts, I think it's over.

The lesson to take away from this is that, in the Nineties, when we said "this time is different," we were as wrong then as they were in early 1929. The marketplace still punishes excesses. This time is no different than any other.

During the Nineties we experienced a boom of incredible proportions. It's almost time to pay up. Hopefully we can still afford the bill.