And how did it get that way?

To my surprise and amusement, out of the reams of commentary produced over the last year or two, one of the best summaries I’ve seen showed up attached to the Semiannual Report from the mutual fund company behind some funds I own. In a “Message from the President” attached to the report, MainStay Investments president Stephen Fisher, attempting to explain why customers shouldn’t panic just because every sector of the market is tanking at once, offered a impressively succinct and logical account of just what chain of events and combination of factors created this mess.

An excerpt:

For equity investors, the first half of 2008 was particularly challenging, with major stock indexes recording negative returns across all styles and capitalization levels. A number of factors contributed to the market’s decline.

When interest rates hit all-time lows in 2003, some mortgage lenders relaxed their loan requirements to help homebuyers capitalize on the situation. When interest rates later began to rise, many homeowners found it difficult to cover rising mortgage costs. During the first half of 2008, the situation came to a head, and several financial institutions took substantial write-offs on subprime-mortgage portfolios.

In the meantime, rapid growth in emerging markets brought increased demand for commodities, including oil, natural gas and metals. Higher demand led to higher prices, which was good for the energy and materials sectors, both of which advanced during the first half of 2008. But airlines, automakers, and many manufacturing industries suffered as the cost of fuel and raw materials continued to rise. In time, many companies lowered their earnings estimates, sending a negative signal to equity investors.

Rising mortgage costs and higher gasoline prices left consumers with less money for discretionary spending, and retail sales declined. Real gross domestic product rose modestly in the first quarter of 2008 after declining in the fourth quarter of 2007. According to advance estimates from the Bureau of Economic Analysis, real gross domestic product increased at a seasonally adjusted annual rate of 1.9% during the second quarter of 2008.

During the first six months of 2008, many investors sought refuge in the bond market. But mortgage-backed securities and structured investment vehicles were facing difficulties, so investors flocked to Treasury issues, while riskier assets–including high-yield bonds and leveraged loans–tended to decline. During the second quarter, leveraged loans recorded their best quarterly performance in 15 years, but the gains weren’t enough to offset earlier setbacks.

The Federal Open Market Committee responded to the market difficulties during the first half of 2008 by progressively lowering the federal funds target rate from 4.25% to 2.00%. The Federal Reserve also took other steps to increase liquidity and give financial institutions access to low-cost funding. In March, the Federal Reserve even helped arrange for ailing Bear Stearns to be acquired by J.P. Morgan Chase.

Of course, Mr. Fisher then moved on to some soothing platitudes designed to keep his investors calm, urging them to take a long view rather than “being overly concerned about current conditions.” The basic situation, however, remains glaringly clear, even if Fisher’s account was carefully phrased to avoid placing any blame.

The consequences of deregulated securities markets were like a stone thrown in a pond. As the ripples continue to spread, we’re facing “the worst financial crisis since World War II,” in the words of Kenneth Rogoff, Harvard Professor of Public Policy and Economics and formerly chief economist of the IMF.

As I write this, Lehman Brothers is declaring bankruptcy for lack of a buyer to pick up its devalued shares, faring even worse than Bear Stearns a few months ago. Merrill Lynch has just been bought out for 30% of what it was worth 18 months ago. The huge insurance firm AIG is also restructuring, while eleven banks have failed this year, and others like Washington Mutual see their shares plunge.

And of course, the federal government just last week decided to take over Fannie Mae and Freddie Mac. It was a no-win situation:  letting them collapse would have led to an even worse financial meltdown. But this “solution” places a projected $25 billion of new debt on the shoulders of the taxpayers, and no one’s even trying to pretend that it achieves anything other than privatizing rewards while socializing risks. Even Treasury Secretary Henry Paulson calls it “government support for private profit.”

But that’s all the view from a mile high:  most of us aren’t involved in high finance, and it’s not always easy to grasp how it affects day-to-day life. In this case, though, the effects are painfully clear. Home foreclosures are continuing to set new records (both an effect and a cause of the financial crisis, creating a devastating feedback lop). Many of those holding on to their homes are effectively trapped there, unable to sell at a profit:  one-third of Americans who bought homes in the last five years are now upside-down on their mortgages, while home prices continue to drop at record levels.

Of course, prices on everything else continue to skyrocket, notably on such luxuries as food and energy…  while unemployment is climbing at the same time.The dollar continues to slide against foreign currencies. Those fortunate enough to have retirement savings are watching them shrink steadily as the markets contract.

And all that’s just the official statistics… if you use figures calculated consistently over the years, things are already worse than they were in the late 1970s.

It’s a perfect economic storm, and there are no safe harbors—businesses are afraid to invest or hire, lenders have no idea what anything is worth, and everyone expects things to get worse before they get better. That’s certainly what Rogoff expects, openly predicting that the worst is yet to come, and that inflation in particular will hit us hard. (And this is from an economist who famously has more faith in “the market” than his Nobel Prize-winning colleague Jospeh Stiglitz.)

All these problems have been allowed to fester under the reckless disregard of an administration that views things with rose-colored glasses, and the erratic attentions of a Federal Reserve that’s too busy tackling crises to have any long-term vision. One might hold out some faint hope that the election of a new president this November will provide a boost of optimism sufficient to stem the worst effects of the economy, but there are no easy solutions. Even with unlimited time and resources, which we clearly don’t have, we’re not going to just “grow our way out” of this situation.

The next president is going to have his work cut out for him just trying to climb us out of the hole we’ve dug ourselves into, and there’s going to be a lot of pain and suffering along the way. Let’s hope that in the midst of all that crisis management, he can still find the long-term vision to plan for and invest in a different future economy, one that offers a more level playing field and a more sustainable approach, rather than continuing to careen from bubble to bubble.

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One Response to “Just how bad is the economy?”
  1. […] It continues to be amazing, the things you’ll find looking at mutual fund reports. I got another one just the other day, from a fund that really used to have a solid track record […]

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