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Why nothing that happens in Washington can make anything better

|Includes: Best Buy Co. (BBY)

Official unemployment is running at about 9.5%, give or take some indeterminate amount for fudging, with U-6, the measure of unemployment that includes discouraged workers and the underemployed running at 16.6%.  State budget deficits are mushrooming and while Washington appears poised to pass a $26 billion relief package this will still leave states collectively nearly $50 billion lacking in budgeted expenditures. Property values are down so local property taxes are coming up short, especially in light of the fact that the U-1 unemployed can't pay their taxes anyway.  Taken together, governments less national than the federal government are facing tough decisions, and cuts in services and/or (probably and) employment are coming.

The real problem, one that Washington can do nothing about, is that the United States has built itself an economic situation based on a fantasy.  For 30 years, this country's citizens have borrowed their way into a false prosperity, with GDP being artificially inflated by as much as 40%.  Having a new car every 3 years was no more difficult than signing a lease, enjoying a flat screen in every bedroom no more difficult than pulling out the 0%-for-six-months-teaser-rate VISA or MasterCard.  We lived large, on credit, and built an unsustainable economic reality.  When the credit cards were maxed out, people borrowed against the equity in their homes, paid off the cards and did it again.  At some point, as must happen in situations like this, there were no more assets against which to be borrowed.  Everything was encumbered and assets prices stopped climbing.  Suddenly the artificial, deficit spending enhanced spending stream was corrected to the "cash available" spending stream and the leveraged economy began to go away as a result.

Almost overnight, the housing construction industry stopped.  With no entry level buyers left to take on teaser rate ARMs to get into a house, the chain of housing upgrades ended.  This was followed by lenders tightening standards and making moves to improve their balance sheets, denying unsecured credit to even the strongest of borrowers.  The consumption sector, in the form of luxury cars, designer clothes and electronics suddenly didn't need all those sales people.  Some long time names didn't make it at all, such as Circuit City and Eddie Bauer; others such as Best Buy (NYSE:BBY) were fortunate to hold steady even with the failure of a major competitor.

The real problem, however, is that government grows with the economy and assets values, and never stops to ask itself if tax receipts are permanent enough to use as the base for long term spending.  Of course, most governments don't have this kind of wisdom, so when property values went up 100% in places and property tax receipts followed, the cities and states were more than happy to spend that extra money.  When GDP grew and income taxes with it, states and the federal government were more than happy to grow accordingly.  The problem is that nobody ever stopped to ask if it was real.

We all now know that it wasn't and that this country has collectively agreed to debt service levels it cannot support.  The only real solution is for that couple making $50,000 year in San Diego that bought the $500,000 house courtesy of a 1% teaser rate ARM to walk into the mortgage holder's office and hand over the keys.  Is this going to hurt? Yes, for both the borrower and the lender.  That is the price for greed in a capitalist economy. Rules of prudent borrowing have been well known for a long time; in fact, it used to be that they were part of the limits placed on mortgages that could be sold to Fannie Mae and Freddie Mac: 29%/41% front end/back end debt ratios with 90% LTV.  These limits were there for the protection of the American people who effectively backed those Fannie/Freddie bonds, even if it said on the prospectus that they don't.  So long as those limits were followed, a reasonable expectation existed that the borrower would not default on the loan.

Unfortunately, mortgage brokers and banks ran out of borrowers who could meet those limits so they came up with ways around them, the two most important being the teaser rate Adjustable Rate Mortgage and the piggy back loan.  With an ARM, a borrower could qualify for the debt payments under the initial rate.  With the piggy back loan, a borrower could borrow the 10% down payment to meet the 90% LTV requirement.  Freed from requirements to have income sufficient to make payments and the requirement to come up with a cash down payment all restraints were removed from the price of houses.  What does it matter what a person offers for a house if they don't have to put anything down and can take out a 1% Interest Only teaser rate loan?  Buyers who had no business buying houses costing as much as they did were buying and gambling that their incomes would go up enough to make payments or that the price (not value) would appreciate enough to sell before the rates reset.  The wave of delinquencies and default beginning in 2008 showed these to have been a poor gambles.

The reality of the US economy today is that our entire structure has been built upon artificial housing prices and economic activity unsupported by our national ability to both live and service debt.  The only solution left is to wipe the bad debt off the books, bankrupting more than a few people and many, many large financial institutions and shrink the government accordingly.  Of course, this is politically unpalatable, so Bernanke, Geithner and Obama will try to use ZIRP and QE15 to deficit spend our way into false growth and reinflate the asset and income bubble.  At some point, however, reality will impose its cold, hard truth and the system will be righted.  Until then, everything out of Washington is ignoring the elephant in the room.  The thing about elephants is that they are too big to ignore forever.

Disclosure: No positions

Disclosure: No positions