The U.S. Credit Crisis: Major Paradigm Shift

The credit crisis is getting worse and worse. The magic Wands (lowering interest rates and printing more dollars) which worked in the past several years have suddenly stopped working or working in the opposite direction, leading to higher commodities prices, including food and gas.

The US (government and public) has been used to the idea of "credit or financing" for everything from the birth of a baby, going to college, buying a house (or car), buying Chinese goods or to pay back-office workers in India or finance wars in Iraq and Afghanistan. It worked well for several years since there was strong demand overseas for dollars since everybody was doing business in the dollar. Technically this could have worked well indefinitely as long as the markets kept going up.

However some innovative people came with the idea to sell all that debt to investors in the form of complicated investment vehicles that not even their "inventors" or the CEOs of the companies which are holding them understand well. Financial institutions holding these investment vehicles borrowed heavily against them as they now become worthless.

On top of that these investment vehicles of uncertain value have been used as collateral against extensive borrowing. Now each investment dollar is covered with multiple layers of debt. According to some estimates, the US has debt obligations of over 265 trillion, almost 19 times the GDP (2007) of the country. For me it is amazing to notice how so many investors, central banks, and even the IMF and World Bank do not appear to realize the magnitude of the debt crisis.

Global investors are coming to realize that these levels of leverage are unsustainable and are becoming very defensive as a result. The US credit crisis is scaring investors everywhere from developed western markets to developing markets and frontier markets. This is evident from the synonymous and precipitous fall in stock markets from China to South America to Canada during the last several months. It is a matter of time before most of the investors will realize that it is not a global crisis, rather it is a credit crisis limited mostly to US and to some extent Western Europe and Japan. Now there are two questions facing the investor community. 1. How the credit crisis will be fixed? 2. How long is it going to last? Will the whole world's economic growth be hostage to the irresponsible investing practices of a few?

1. How this credit crisis will be fixed?

The best solution is, as some have been suggesting, to "let the markets take the pain and get cleared". This option will be good in the long run, however the majority of the big financial houses will go down as a result. This is the least likely possibility because of the politics involved (any president who will try to do this will be very unpopular) as well as consideration to protect the big banks.

The other option could have been that European, Asian and South American Federal banks and Sovereign wealth funds step up to the plate and salvage the problem. At the start of the subprime crisis when European central banks were not aware of the magnitude of the crisis they tried to help out by injecting substantial amounts of liquidity into the system. Similarly, Singapore and some Middle Eastern Sovereign Wealth funds stepped in, even individual investors like Saudi Prince Al-Walid bin Talal attempted to show solidarity by investing several billions in Citigroup (C), though now it seems these players are staying away from this mess.

Therefore it seems that the possibility of world financial institutions making a concerted effort to thwart this crisis is least likely at this stage. The only viable option left is to continue printing more and more dollars without consideration of and keep accepting junky securities as loan collateral from troubled financial institutions. This may salvage some of the financial institutions but it could also bring unpredictable and unforeseen consequences for the economy.

2. How long is the crisis going to last and how it will end?

Now the main question is how long this downward slide is going to last? I believe it can not be predicted however, as I argued in my previous articles, that there is a big wealth transfer going on from traditionally rich countries to traditionally cash poor countries e.g. India, Russia, China, Brazil etc. At some time point an equilibrium will be reached, however this may be 5-15 years down the road.

Until now, world markets have been acting in a way that the whole world has been in an economic crisis due to credit related issues. Over time investors will realize that the credit issue is limited to those countries and segments of the economy which have been living beyond their means or have been too greedy while others are just fine, healthy and kicking. I believe the so-called third world countries of yesterday (emerging markets) will be the biggest winner from the credit crisis because a) the debt they owe to rich nations is in dollars and as the value of the dollar goes down their debt will reduce proportionality; b) investments in those countries will keep on increasing for some time; c) many developing counties have stashed huge piles of cash which they can use to their advantage.

On the other hand, in the long run, I believe agricultural based/natural resources based companies will do better in the USA. To me, debt crisis is a major paradigm sift in the history of mankind. As World Wars I and II resulted in a major paradigm shift since all the third world countries got out of physical occupations, though still remained economically dependent afterwards, the current paradigm shift due to the debt crisis will lead to economic independence and prosperity of third world countries in Asia, Africa and Latin America.

For the above reasons, I recommend investing in emerging markets and US companies in the agriculture sector, natural resources and energy.

Disclosure: None

Comments

[jimmy46]

How this credit crisis will be fixed?""&quo...

The way all previous panics, depressions, & recessions were fixed,
bad debt will be written off, some people/companies will go bankrupt,
and some banks will close.

[Igorisky]

Who will most likely take the painful action, grab the bull by the horn, and fix the problem long term? Who will most likely skirt the issue and consequently prolong the agony?

We need a President who will be deliberate and mature to fix the problem. One who will fix it even if it is painful because it is good for the USA in the long run. This will be one who has already been tested and shown his courage, integrity, honorability and love of country. Our country's fate is in our hands; we all need to decide now .... McCain or Obama.

[.*.]

Interesting read, but only superficially. Quasi-literate and filled with some pretty wild statements with no backup, explanation or proof. Mostly hype with some truth mingled in. Example: 19x GDP in debt? Not even close. US debt is around 1x GDP. Where is the other 18x? Etc.

[Sherdil]

Sorry I should have put the reference I got the US debt and obligations numbers (265 trillions from Dr. Weiss website (www.moneyandmarkets.co..., and www.moneyandmarkets.co...). According to Dr. Weiss of Weiss Research the total US debt and obligations is 265 trillions, 20 times the total economy of USA ($49 trillion in interest-bearing debts, according to the U.S. Federal Reserve Board, $50 trillion in federal contingency debts, according to the Government Accountability Office (GAO), and $164 trillion in derivatives, according to the U.S. Comptroller of the Currency (OCC).

[mkreisel]

I would trust the Fed numbers far more than what some fringe groups/persons claim.

So the debt load is $50 trillion, 4 times the GDP.

[secmaven]

The credit crises boiled over in March. If truth were known before Bear Stearns the other WS bankers, Morgan, etc. all had probably equally weak balance sheets from undisclosed asset write downs. Look at the way that cute little tax lawyer turned CFO played games at Lehman with their first quarter!

But James Canne did not play ball with his brothers on street in the Long Term Capital Management bail out years ago and they never forgot it. Now that the sharks have feasted on Bear and gotten a planned for direct tap to the Fed as a result, exchanging worthless collateral that they no longer have to write down on their books for Treasury bonds, no more brothers will have to be eaten. Somebody had to be the sacrificial lamb for the Street to survive by government subsidy and Jimmy and his crew was the most appropriate candidate.

If you take a look at the Fed balance sheet now you will see the replacement of 200 billion in government bonds with all sorts of garbage. But since the Fed is not subject to any mark to market rule, the bankruptcy of Wall Street (and that of the commercial banking sector) has been swept under the Fed's rug.

The question is whether the Fed's rug is big enough to cover the credit crises indefinitely. Certainly not in the long run, too much debt will have to be monetized to restore its government bond assets. But until the next election is over so a Republican is put back in the White House..yes!

[gwa]

Seems like re-evaluation of the dollar is the ultimate solution.

[Farhan]

interesting article. with good solution to the problem.

[sivere]

At this juncture in history, we are getting hit with multiple punches simultaneously. We have a speculative bubble unlike anything we have ever seen (i.e., tulip bubble, etc.). This bubble CREATED the housing crisis. We have a serious energy problem, caused at least by a combination of US foreign policy (Iraq invasion), middle east geopolitics (related to the first point- Iran vs. US and Israel, Israel vs.the rest of the middle east, US support for Israel, Europe vs. US, etc.). Add to that the dynamic growth in China, India, and Asia in general, vying for the same oil, with no easy way to crank up production, plus an at least temporary food shortage, and we are potentially in a heap of trouble.

Now the peak oil folks are saying, 'see, we told you so' (high gas prices, political turmoil), and the environmentalists are saying ,' see, we told you so ' (food shartage, storms, bad weather).

We need to keep cool heads at this point. First, there is evidence enough that the various political situations, including relative falling petroleum supply (i.e., we cannot just crank up oil supply to meet demand) coupled with a panicked rush to commodities due to the financial collapse and various derivative contracts, shorting, etc. are big factors in the energy issues.

Now, peak oil eventually may be real, and with half the world waking up and developing, we need to take the underlying theory seriously. I think $120+ barrel oil may end up saving us IF we act NOW to start developing alternatives. We need tax incentives, government sponsorship, as well as good old American ingenuity to kick in NOW.The $120/barrel oil creates the economic framework to make alternatives possible.

This is not the time to give up as some of the more liberal peak oil advocates imply we should. A wise Catholic Saint once said something like 'Know that God can do anything, but act as though He will do nothing'. Let's not forget there is a God, and He could be testing us, He could be punishing us. We do not know for sure. But do not give up. Turn back to some of our basic Christian values (and natural law in general), think about what we are doing and why, and let's roll up our sleeves to solve this issue- not just prepare for the end, and hide in the wilderness. It is not all criticism for the more liberal peak oilers- some of their ideas about reviving urban living are not all bad, and make sense certainly in the short to medium timeframe. Much of their criticisms of suburbia deserve some consideration.

Let's also not get all tied up with Gore gloom and doom over highly speculative theories about disasterous human induced CO2 warming of the planet. In fact we may be headed for a little ice age! Let's develop any energy source we can, and not let the environmentalists tell us (especially the U.S., China and India which have extensie coal reserves) that coal is out because of the CO2 problem. This is pure insanity at this juncture. If the peak oil problem is allowed to play out because of our inaction, you will see an environmental disaster of unimagineable proportions. Even the anti-Christian Malthusian Darwinists could not create a scenario so hororible (though God knows they keep trying).

Turn back to basic values, including. God, country and family, roll up your sleeves, do not give up, and let's work together (with the rest of the world) to solve the problems ahead of us.

siv0.com
TakeBackTheFed.com

[Whidbey]

Provokingly kind and gentle, but why skirt the main point as most replies have done? The USA is broke, bankrupt,and likely to further complicate the problems with more monetary insanity. I agree:foods, fertilizers, commodities, gold, silver- and for a while, but only a while - bonds are the places to hide out during the storm. What we have not said is what kind of a society will these events spawn. Too early to be precise, but a very different society in the long run. We should be deeply concerned as should the world. No one wins on this round of events.

[buyitcheap]

What wealth transfer? Don't you mean debt/IOU transfer? They're sending cash back to us for paper & promises.

Excellent posts all.