By David P Goldman
http://www.atimes.com/atimes/Global_Economy/JK22Dj01.htmlSubprime mortgages were the beginning, not the end, of a global financial crisis, and in recognition of this fact equity markets have crashed. The proximate cause of this week's retreat in equity markets to the lowest levels since the 1990s was the collapse of loans to American commercial real estate, which in turn implies the collapse of insurance companies and pension funds. Americans who relied on private pension funds, whether through their employer or insurance companies, will lose part or all of their pensions.
That is why it is so difficult to rescue General Motors, which has said that it may not last the year without official help. Not only stocks, but many of the fixed-income assets owned by insurance companies have fallen by half during 2008, including commercial mortgage-backed securities, and the capital securities of some commercial banks. Citigroup's preferred shares issued last March traded on November 20 at 50 cents on the dollar.
The problem now becomes self-feeding. The collapse of equity and credit values destroys the value of corporate pensions, requiring corporations with defined benefit plans that still cover 20 million workers to divert profits to their pension funds. The impairment of the credit of insurance companies, in return, eliminates a major source of long-term credit provision.
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Americans are beginning to understand how much of their economy depended on the housing bubble. Shopping malls sold goods to consumers who took on more debt because the appreciation of their homes made them feel wealthier. Office buildings filled with workers who sold real estate, processed home mortgages, and traded mortgage-backed securities. The US economy appeared to prosper by purchasing goods from China, and then borrowing the money back and using it to buy homes at higher prices. This, to be sure, exaggerates the problem, but the point nonetheless is valid.
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The liquidation of risk assets in favor of safe assets, and the shift from consumption to savings, will continue until Americans have restored some part of their lost wealth. Given that incomes will decline (through rising unemployment and lower compensation), Americans will be swimming against the current as they try to repair the household balance sheet. That portends a very long and painful economic downturn, worse than the 1979-1982 crisis that preceded the Ronald Reagan reforms.
President-elect Barack Obama is the only man in town with a checkbook, and by virtue of the Treasury's near-monopoly of financial power, will take office as the most powerful peacetime president in US history. Faced with the collapse of private pension, health care and financing systems, Obama will have every reason to use his mandate to socialize medicine, pensions and many other aspects of US economic life. The American economy may be hard to recognize afterwards.
David P Goldman was global head of fixed-income research for Banc of America Securities and global head of credit strategy at Credit Suisse.