Is This the Big One?

For more than a decade, we Americans have been living on an economic San Andreas fault--a foundation of fracturing competitiveness covered by unsustainable consumer spending with money borrowed from foreigners. A financial earthquake was inevitable. We don't know how high on the recession Richter scale the current crisis will take us, but it increasingly looks like, as they say in San Francisco, "The Big One."

Since the last Big One, the Great Depression of the 1930s, we have had eleven small to medium recessions, lasting an average of ten months. The most severe--two back-to-back downturns that began in 1979--drove price increases and the unemployment rate to double digits.

We're not at those levels yet. But the structural supports underneath our shop-till-we-drop economy are considerably weaker. For starters, we have a historic depression in the housing market. Americans' total mortgage debt now exceeds their home equity, for the first time since 1945. Housing prices have dropped 10 percent since last spring, followed by record foreclosures. Most economists expect them to drop at least another 10 percent, which could leave more than 14 million households--at least 16 percent of the total--better off if they just walked away from their homes. Prices could go even lower.

Until last year, housing prices in most places had risen rapidly since the 1990s. This enabled middle-class homeowners with stagnant wages and maxed-out credit cards to keep spending by refinancing their mortgages. The housing boom also spawned the now infamous subprime mortgage--a scheme devised by Main Street realtors and Wall Street bankers to finance home buying with loans that let the borrower buy in with little money down but carried high interest rates. The expensive payments would be made later by refinancing the mortgage as prices continued to rise. These subprimes were sold to middle-class strivers upgrading to McMansions as well as to the working poor.

The increased demand pushed housing prices further into the stratosphere--until, inevitably, they fell back to earth. When the subprime borrowers could no longer make their payments, foreclosure signs went up, lowering the value of other houses in the neighborhood. The refinancing spigot shut off, retail sales sputtered and by January the economy was shedding jobs.

But it is not the squeeze on homeowners that is giving our central bankers nightmares. It is the blowback of housing deflation on the country's massively overleveraged financial markets, which has seriously constricted the flow of credit--the lifeblood of the world's largest debtor economy.

In a typical deal, subprime mortgages were sold to investment companies, where they were commingled with prime mortgages to back up new securities that could be touted as both safe and high-yielding. This new debt paper was then peddled to investors, who used it as collateral for "margin" loans to buy yet more stocks and bonds. At each change of hands, fees and underwriting charges added to the total claims on the original shaky mortgages. The result was a frenzied bidding up of prices for a bewildering maze of arcane securities that neither buyers nor sellers could accurately value.

Giant Ponzi scheme? Not to worry, responded the Wall Street geniuses. By spreading risks among more people, the miracle of "diversity" was actually turning bad loans into good ones. Anyway, banks were buying insurance policies against default, which in turn were transformed into a set of even murkier securities called "credit default swaps" and marketed to hedge funds, pension managers and in some cases back to the banks that were being insured in the first place. At the end of 2007 the market for these swaps was estimated at $45.5 trillion--roughly twice as large as all US stock markets combined.

This huge pyramid of debt was made possible by thirty years of relentless deregulation of financial markets, culminating in the 1999 repeal of the Glass-Steagall Act, which had prohibited banks from dealing in high-risk securities. In effect, Washington regulators became passive enablers to Wall Street's financial binge drinkers. When they crashed--for example, in the savings-and-loan and junk-bond debacles of the 1980s, the Long-Term Capital Management collapse of 1998 and the Enron and dot-com crashes of the early 2000s--the government cleaned up the mess with taxpayers' money and let them go back to the bar.

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