The Great Depression Part 14 – Inverted Yield Curve
Good day to each of you reading the columns on the Great Depression.
Let’s begin by tackling the 2008 recession and the 1929 depression:
We can agree that there was a “speculative boom” or “roaring twenties” and then the bottom fell out in 1929. The speculative boom began during the early years of the 21st century with the growth of the housing sector.
The housing sector began to take a “nosedive” in October of 2006 with new permits 28% lower than those of October 2005. Here is a major red flag that was totally overlooked by the President and the Federal Reserve system.
The decline in the inverted yield curve? And what is an inverted yield curve? According to the balance.com, an inverted yield curve is when the yields on bonds with a shorter duration are higher than the yields on bonds that have a longer duration. It’s an abnormal situation that often signals an impending recession.
In a normal yield curve, the short-term bills yield less than the long-term bonds. Investors expect a lower return when their money is tied up for a shorter period. They require a higher yield to give them more return on a long-term investment.
When a yield curve inverts, it’s because investors have little confidence in the near-term economy. They demand more yield for a short-term investment than for a long-term one. They perceive the near-term as riskier than the distant future. They would prefer to buy long-term bonds and tie up their money for years even though they receive lower yields. They would only do this if they think the economy is getting worse in the near-term.
Investors, in the bond market, perceived that the economy was getting worse while the Federal Reserve & President took the stance that due to a present strong money supply flowing in the economy and low interest rates would retard any present and future problems to the real estate industry.
Questionable mortgages reared its ugly head – The cause, banks and hedge funds sold assets like mortgage-backed securities to each other as investments. According to the balance.com. an (MBS) or mortgage-backed securities are investments that are secured by mortgages. They’re a type of asset-backed security. A security is an investment made with the expectation of making a profit through someone else’s efforts.1 It allows investors to benefit from the mortgage business without ever having to buy or sell an actual home loan. Typical buyers of these securities include institutional, corporate, and individual investors.
When you invest in an MBS, you are buying the right to receive the value of a bundle of mortgages. That includes the monthly mortgage payments and the repayment of the principal. Since it is a security, you can buy just a part of a mortgage. You receive an equivalent portion of the payments. Worst of all, MBSs were not regulated. The federal government regulated banks to make sure their depositors were protected, but those rules didn’t apply to MBSs and mortgage brokers. Bank depositors were safe, but MBS investors were not protected at all before the great recession of 2008.
Note the last sentence in particular—the MBS investors were not protected at all before the great recession of 2008. Compare that thought to the 1929 crash when people were borrowing money from a broker to purchase stocks on margin. People also invested in real estate (land or buildings) with a similar hope of getting rich quickly.
The dilemma—Buying on Margin versus Questionable Mortgages—The greed of man—The grass is greener on the other side.
Back to those questionable mortgages—LOW interest-only loans offered to? Subprime, high-risk borrowers or those likely to default on a loan? Now for the hook, those so-called low interest rate loans would reset to a much higher interest rate after a certain time. Please read this again for this follows the same train of thought as borrowing money from a broker to purchase stocks on a margin—Is this too good to be true?
Rewind to 1929 — The outcome leading up to the October 1929 was wild stock market speculation, weak regulations inside Wall Street, margin buying, securities “subsidiaries”, inside trading among financial institutions, and market shares selling for more money than the company’s actual earnings.
October 24, 1929 — Black Tuesday or the day the dam burst and over the next four days the Stock Market prices fell 22% and cost investors 30 billion dollars. Americans throughout the land saw the amount lost was more than the First World War and fear spread the land.
Fast forward to 2008 — The “BIG” banks, hedge funds, insurance firms awaken and find themselves holding worthless investments. Lehman Brothers declares bankruptcy. The stock market crashed in 2008 and the Dow registered one of the largest point drops in history.
Reset to 2007 for that was the time when “the house of cards” came tumbling down in the real estate market. The time had come for those too good to be true interest rates to be reset and it was time to unload your purchase. As for home prices—they fell and real estate flooded the market. The perfect storm?
The golden parachute? The answer, the (CDS) Credit default swaps—(CDS) insures against the risk of defaults. According to balance.com, swaps were largely unregulated until 2010. That meant there was no government agency to make sure the seller of the swap had the money to pay the holder if the bond defaulted. In fact, most financial institutions that sold swaps were undercapitalized. They only held a small percentage of what they needed to pay the insurance. The system worked until the debtors defaulted.
And, according to balance.com, By mid-2007, there was more than $45 trillion invested in swaps. That was more than the money invested in the U.S. stocks, mortgages, and U.S. Treasuries combined. The U.S. stock market held $22 trillion. Mortgages were worth $7.1 trillion, and U.S. Treasuries were worth $4.4 trillion.2
Lehman Brothers found itself at the center of this crisis. The firm owed $600 billion in debt. Of that, $400 billion was “covered” by credit default swaps. Some of the companies that sold the swaps were American International Group (AIG), Pacific Investment Management Company, and the Citadel hedge fund.
These companies didn’t expect all the debt to come due at once. When Lehman declared bankruptcy, AIG didn’t have enough cash on hand to cover swap contracts. The Federal Reserve had to bail it out.
Even worse, banks used swaps to insure complicated financial products. They traded swaps in unregulated markets where buyers had no relationships to the underlying assets. They didn’t understand their risks. When they defaulted, swap sellers such as MBIA, Ambac, and Swiss Re were hit hard.
Overnight, the CDS market fell apart. No one bought them because they realized the insurance wasn’t able to cover large or widespread defaults. They accumulated capital and made fewer loans. That cut off funding for small businesses and mortgages. These were both large factors that kept unemployment at record levels.
Another mess—One must remember that the Federal Reserve had begun raising interest rates while housing prices were escalating to the tune of 5.25 percent by June 2006. As a result of more house inventory, housing prices began to plummet and banks including the “big banks” went into crisis mode.
This brings us to the end of 2006 and the bursting of the house bubble. The shockwaves of the housing market and banking industry reverberated throughout the country and spread globally.
A new year was arriving in 2007 with the hope of bailing out those in crisis—who better to bail out then the Federal Reserve. If you remember back in 1929, where was the Federal Reserve during this time? They were nowhere to be found for they showed their reluctance not to increase the money supply thus causing a money shortage.
Will this be the case in 2007 and they will do enough to prevent this recession?
In my next column, we will examine that question along with plummeting stock markets, mortgage giants collapsing, banking giants bankrupting or being sold and many American’s wealth lost in the stock market.
I look forward to the next column and as always, May You Bless God in all that you say and that you do.
Jeff
