If you can't pay back the bank, the bank takes your house or your car. If a stock you own loses its value, there's no collateral you can go after to cushion your loss. This is why Bush's debt recession will be far far worse than Clinton's equity one.
The stock market in the last year of George Bush's term is following a pattern that reminds me of the last year of Bill Clinton's. The Clinton market tumble -- where the NASDAQ fell in March 2000, rose through September 2000, and then began a straight down plunge through January 2001 -- preceded a brief recession in 2001. But I think that the Bush recession -- following Dow and broader market quakes in March 2007, August 2007, and the 14% decline since the October peak -- will be much much worse.
The reason? Clinton's recession was driven largely by a collapse in equity prices, while Bush's will be driven by an implosion in the value of debt. Before focusing on what Bush's recession might look like, it's worth remembering that Clinton's was driven by the collapse of the NASDAQ as the dot-com bubble burst. It also involved debt -- $1 trillion worth of borrowing by fiber optic network builders like Global Crossing that went bankrupt when they couldn't pay their debts as their customers, the dot-coms, went belly up.
For all those individual investors who got burned by the dot-com bust, after the dust had settled they had lost lots of money in their stock market accounts, but most people still had jobs, houses, and cars. And Clinton left the Federal budget in surplus with the national debt declining to $5 trillion. Bush used that recession to sell $1.3 trillion in tax cuts and to lower interest rates to 1%. With the $2.4 trillion worth of wars in Afghanistan and Iraq, the Federal budget went into deficit and the national debt ballooned to $9.2 trillion.
One effect of Bush's lower interest rates was to temporarily revive the economy by making it cheap for consumers to buy houses. Thanks to securitization, mortgages could be originated, packaged and sold as securities such as Collateralized Debt Obligations (CDOs) to investors around the world. The fees for closing CDO deals were so high that when the supply of credit-worthy borrowers ran out, the Securitization Industrial Complex (SIC) found a way to make loans to people who could not afford them -- 47% of the $1.3 trillion in subprime mortgages were made to people who did not document their income.
We now know that the CDO cancer has spread to Wall Street banks like Merrill Lynch & Co. (NYSE: C), which yesterday revealed, according to MarketBeat, that it was valuing these CDOs at 25 cents to 60 cents on the dollar. This means that wherever CDOs lie, there will be a huge capital shortfall as their holders must write down the value of the CDOs while begging for capital.
Meanwhile, consumers -- no longer able to borrow against their homes to pay their bills -- will start to default on their $2.46 trillion worth of debt in the form of credit card loans, auto loans, student loans and others. The two million families that will lose their houses to foreclosure by 2009 will put further downward pressure on housing prices. And as consumer demand falls off, companies will see their revenues drop. This will put pressure on the $3.7 trillion corporate bond market -- particularly the part that financed the formerly booming leveraged buyout market.
Unlike Clinton's equity recession, Bush's debt recession will be more demanding. When equity holders lose value in their stock, they have no recourse to get their money back. But lenders are different -- they need to be paid back. And if the lenders aren't paid back, they take possession of the collateral -- the house or the car. Moreover, regulators demand that CDO owners write down the value of their lousy investments and raise capital to make up for that loss of value in order to have enough capital to backstop their liabilities.
If layoffs start to spread throughout the economy, consumers will have to cut back on spending. And they'll also stop paying back the loans they've been using to keep up with rising gasoline and food prices. This will create a cycle of bank writedowns and capital shortfalls that will make your head spin.
If you need money this year that's now invested in stocks, use today's bounce to sell and deposit it somewhere safe.