Paradigm Shift 3: The Financial Markets

The seeds of the recent perfect storm now called the Great Recession were actually planted in the mid and late 1990's.  First, the Clinton administration kept pushing FNMA and Freddie Mac to increase the portion of their loan portfolio that consisted of what is now called "subprime" mortgages.

Secondly, the international bond market collapsed in 1997.  This started in Thailand in the spring of '97.  A real estate developer defaulted on $1 Billion worth of real estate loans which by August of '97 caused the complete collapse of the banking system in Thailand.  Thailand then defaulted on its international loans, which commenced to ricochet around the globe, culminating in Brazil, Mexico, Russia, as well as many other countries defaulting on their international bonds.

In order to dig their way out of the collapse, the Asian countries devalued their currency by 80% in 1998.  As a result, the goods they were selling to Americans for $5 each in 1997 were sold to Americans for $1 each by the end of 1998.  The obvious reaction to that was American manufacturers could not compete, so vast amounts of our manufacturing base was moved over to various Asian countries, but primarily China.

The third seed of the future perfect storm was the Community Reinvestment Act of 1999 (CRA99).  In that legislation, the Democratic Congressional leaders such as Nancy Pelossi and Barney Frank demanded that the CRA99 legislation include a requirement that all banks hold what we now call sub-prime loans in the amount of approximately 4% of their capital.

While 4% sounds like a nominal amount, banks are required to have capital equal to at least 8% of their total assets.  So, forcing banks to have "bad" loans equal to 4% of their assets means that one half of their capital could be easily destroyed.  If their capital goes below 8% then the bank is insolvent and will be closed by the FDIC.

Obviously that is exactly what happened in 2008 and 2009.  However, the same congressional leaders that created the problem are now pounding their chests about poor management, the need for more regulation, ad nauseum.

The perfect storm that occurred in 2008 resulted in the largest contraction of credit in the economic history of the world.  If you cannot finance real estate, then there really is no market.  Just as there was no market for the subprime loans that defaulted, today there is a diminished market for real estate because of the lack of financing.  In other words, our real estate economy is RE/setting.

For a more complete discussion and our forecast of the real estate market in 2010 and 2011, please download the presentation we made to the Board of a large community bank entitled "RE/set, RE/position and RE/start".