Our present misery dates back to Alan Greenspan's easy money policy of a few years ago. When the risk-free rate was pegged at 1%, financial market players, starved for higher yields, moved out on the quality spectrum for long maturity goods. Insurance underwriters, brokers, banks and some hedge funds that play the carry trade game have taken hits to their net asset value, but not enough to cripple them permanently.
The public's involvement is confined to its mortgage debt and speculation in second homes. Adjustable-note paper pegged far below the 5% rate on 30-year mortgages written in 2005-2006 is resetting hundreds of billions for home owners who must cover the cost to carry. Many are well past the traditional yardstick, 25% of disposable income.
This pressure is enough to cap consumer spending and take a little more out of GDP the next four to six quarters. The housing debacle already has cut 1% out of GDP. Fortunately, we are heading to the first anniversary of the decline in new construction, but there's more coming and no likely recovery before 2009. Existing home prices have peaked until the country absorbs new home inventory and coming defaults on mortgages outstanding.
To be fair to Greenspan, he worked to keep the economy purring in a non-inflationary environment. In fact, the Fed was more concerned about us lapsing into a Japanese-style deflation. This was pure nonsense, of course. We live in a resilient country where almost nobody saves and everybody overspends. IRAs and profit-sharing funds have bounced back from the Internet debacle in 2000. Lower tax rates on capital gains and dividends helped. We kept more of our invested gains and created a new class of plutocrats. Corporate earnings grew nicely while financial engineering excited the market.
In the buyout boom of the 1980s, as much as 20% of the market's appreciation was attributable to deals. Now, there's a pause in deal mania, until the banks and brokers figure out how to get the bridge loans they had to swallow off their books, repackaging them at higher interest rates. The market is reacting to this turmoil, but it will pass.
There's always an acceptable clearing price for inventory that's attractive to richly capitalized new players, individuals and corporations. Mike Milken, where are you?