The great bubble of the current boom-bust cycle is not tech stocks like in the late 1990s. Nor is it real estate like in the mid-2000s. Rather …
The great asset bubble or our times is none other than bonds, especially government bonds (also called sovereign bonds).
Not just bonds issued by countries on the brink of default like Greece is this morning, but also bonds issued by countries that are supposedly among the “strongest”!
This time around, it’s the price of those bonds that has blown up sky high to levels that are grossly overvalued.
It’s the bond market that has been the most directly impacted by the Fed’s massive injections of printed money into the banking system.
And it’s bonds all over the world that have been bid up by other central banks in their desperate attempts to keep their governments afloat and their interest rates down.
But the great bond bubble doesn’t stop with government bonds. When government bond prices are driven to nosebleed heights, all other kinds of debt follows along — corporate bonds, municipal bonds, mortgage debts, consumer debts and almost any kind of debt instrument imaginable.
Sure, bonds are different from stocks. But they obey the same laws of supply and demand.
In the stock market, if there’s a big enough buyer investing hundreds of millions of dollars to aggressively bid for a company’s shares, he drives the price sky high. And conversely, on the day that huge buyer walks away, the stock suffers a devastating crash.
The same is true for bonds.
But instead of a big stock investor, the buyer is the biggest of them all — the U.S. Federal Reserve.
Instead of investing hundreds of millions, it’s investing trillions.
And, instead of buying stocks, the Fed buys bonds, especially government bonds.
That’s been the pattern we’ve seen — almost nonstop — since 2008. That’s also been the pattern in every major foreign nation on the planet, including the U.K., the European Union, Japan and even China. And that’s why sovereign debt is such a great bubble today — globally.
Indeed, the sovereign debt bubble is the most immediate, most consistent and most dangerous consequence of the 2008 debt crisis.
So if you’ve forgotten — or have tried to forget — the true severity of that debt crisis, it might be helpful to flash back to a few memorable scenes from those days:
The scene of former Fed Chairman Alan Greenspan who, in testimony before Congress, stated flatly that it was the worst crisis in 100 years.
The unforgettable image of former Treasury Secretary Paulson, literally dropping to his knees before Congresswoman Pelosi, begging for the billions he said were needed to prevent “a total Wall Street meltdown.”
An America in which 1 out of 7 homeowners were delinquent or foreclosed on their mortgage; 4 out of 10 were upside down on their home equity; nearly 5 out of 10 were among the millions of unemployed who were out of work for over six months; and 7 out of 10 Americans were fearful of the future.
A government that rushed to bail out bankrupt banks, broken brokerage firms, insolvent insurers, ailing auto manufacturers and any company deemed “essential” to the economy.
And most shocking of all to anyone who understands the true consequences, a Federal Reserve that has pumped trillions of dollars into the government bond market, the mortgage market, the consumer credit market, and, indirectly, every other debt or bond market on the planet.
We warned of these events before they happened. We named the names of most large institutions that failed, also well in advance. But when the crisis hit, we were not nearly as pessimistic.
We saw several silver linings in this crisis that most others seemed to miss. But for the purpose of this article, suffice it to say that the urgent measures that leaders sought so strenuously to justify now beg equally urgent questions that I challenge them to answer:
Has the Federal Reserve run out of bullets? What happens when a similar or worse crisis returns? Will America’s leaders have the political will and the financial resources to save the day again?
Yes, they prevented another great depression. Yes, they saved the banks and helped drive stocks to new highs. But …
Have they truly addressed the cause of the crisis?
Will they be forever able to bail out bankrupt corporations like a General Motors, AIG and Bank of America? Can they again save smaller bankrupt countries like Greece?
Sure, they can kick the can down the road. They can buy time and postpone the day of reckoning. They can stimulate more stock market rallies and some more economic recovery. They can certainly create new speculative bubbles. But that’s not the same as assuming responsibility for our future. It doesn’t resolve the next crisis and the one after that. It does little for you and me, and even less for our children or theirs.
But the bigger question is: Who will bail out America?
No one can. No one will. Instead, ultimately, our government will create a broader crisis impacting a wider segment of the population for a longer period of time.
Indeed, even as the government sweeps piles of bad debts under the carpet, it accumulates mountains of new debts — the biggest federal deficits of all time.
This is why in recent years, we’ve seen a brand new crisis, never before witnessed in modern times: Instead of merely corporations going broke, we have seen entire countries that faced insolvency.
Greece was the first to get hit. Its federal accounting was a mess; its spending, out of control; its deficits staggering. Suddenly, global investors dumped old Greek bonds in their portfolios and went on a buyer’s strike for any new ones being issued. Portugal, Spain, Ireland, Italy and a long line of East European countries also got smacked hard. Even the U.K. and France were vulnerable to a similar onslaught.
Central bankers, finance ministers and top economists said they were taken entirely by surprise. But again, the sequence of events was too clear for anyone to have missed:
* In 2007, companies like Bear Sterns, Lehman Brothers, Citigroup and Merrill Lynch had accumulated huge amounts of bad mortgages and other toxic assets on their books.
* In 2008, when investors realized that the bad assets could sink the companies’ finances, they dumped their corporate bonds and stocks in panic.
* Beginning in 2009, the governments of the U.S. and Western Europe rescued the near-bankrupt banking giants, scooped up most of the toxic assets and shifted them to their own books. So …
* In the years that followed, whenever investors paid some attention to how bad their finances really were, they dumped foreign government bonds in panic.
To better understand why, let’s remember how deeply and thoroughly the government assumed ownership of the Debt Crisis of 2008 and of nearly everything that has happened since.
The Greatest Government Rescue of All Time
We saw the first telltale warning of the debt crisis in August 2007. Banks all over the world announced multibillion losses in subprime mortgages. Investors recoiled in horror. And it looked like the world’s financial markets were about to collapse.
The nation’s largest mortgage insurers, responsible for protecting lenders and investors from mortgage defaults on millions of homes, were ravaged by losses.
Municipal governments and public hospitals were slammed by the failure of nearly 1,000 auctions for their bonds, causing their borrowing costs to triple and quadruple.
Low-rated corporate bonds were being abandoned by investors, their prices plunging to the lowest levels in history.
Hedge funds got hit as well, with one fund, CSO Partners, losing so much money and suffering such a massive run on its assets that its manager, Citigroup, was forced to shut it down.
And above all, major financial firms, at the epicenter of the crisis, were being struck with losses that would soon exceed $500 billion.
The big question was no longer “Which big Wall Street firm will post the worst losses?” It was “Which big firm will be the first to go bankrupt?” The answer: Bear Stearns, one of the largest investment banks in the world.
Again, the folks at the Fed intervened. Not only did they finance a giant buyout for Bear Stearns, but, for the first time in history, they also decided to lend hundreds of billions to any other major Wall Street firm that needed the money. Again, the crisis subsided temporarily. Again, Wall Street cheered, and the authorities won their battle.
But the war continued. Despite all the Fed’s special lending operations, another Wall Street firm — almost three times larger than Bear Stearns — was going down. Its name: Lehman Brothers.
Over a single weekend in mid-September 2008, the Fed chairman, the Treasury secretary, and other high officials huddled at the New York Fed’s offices in downtown Manhattan. They seriously considered bailing out Lehman, but they ran into two serious hurdles:
First, Lehman’s assets were too sick — so diseased, in fact, even the federal government didn’t want to touch them with a 10-foot pole. Nor were there any private buyers remotely interested in a shotgun merger.
Second, foreshadowing the public rebellion that would later bust onto the scene in the Tea Party movement, there was a new sentiment on Wall Street that was previously unheard of: A small, but vocal, minority was getting sick and tired of bailouts. “Let them fail,” they said. “Teach those bastards a lesson!” was the new rallying cry.
For the Fed chairman and Treasury secretary, it was the long-dreaded day of reckoning. It was the fateful moment in history that demanded a life-or-death decision regarding one of the biggest financial institutions in the world — bigger than General Motors, Ford, and Chrysler put together. Should they save it? Or should they let it fail? Their decision: to do something they had never done before:
They let Lehman fail.
“Here’s what you’re going to do,” was the basic message from the federal authorities to Lehman’s highest officials. “Tomorrow morning, you’re going to take a trip downtown to the U.S. Bankruptcy Court at One Bowling Green. You’re going to file for Chapter 11. Then you’re going to fire your staff. And before the end of the day, you’re going to pack up your own boxes and clear out.”
In both the Bear Stearns and Lehman failures, America’s largest banking conglomerate, JPMorgan Chase, promptly appeared on the scene and swooped up the outstanding trades of the two companies, with the Fed acting as a backstop. In both failures, the authorities played a role. But Lehman’s demise was unique because it was thrown into bankruptcy.
It was the financial earthquake that changed the world.
Until that day, nearly everyone assumed that giant firms like Lehman were “too big to fail,” that the government would always step in to save them. That myth was shattered on the late summer weekend when the U.S. government decided to abandon its long tradition of largesse and let Lehman go under.
All over the world, bank lending froze. Borrowing costs went through the roof. Global stock markets collapsed. Corporate bonds tanked. The entire global banking system seemed like it was coming unglued.
“I guess we goofed!” were, in essence, the words of admission heard at the Fed and Treasury. “Now, instead of just a bailout for Lehman, what we’re really going to need is the Mother of All Bailouts — for the entire financial system.”
The U.S. government promptly complied, delivering precisely what they asked for — a $700 billion Troubled Asset Relief Program (TARP), rushed through Congress and signed into law by President Bush in record time.
In addition, the U.S. government loaned, invested, or committed …
- $300 billion to nationalize the world’s two largest mortgage companies, Fannie Mae and Freddie Mac;
- Over $42 billion for the Big Three auto manufacturers;
- $29 billion for Bear Stearns, $150 billion for AIG, and $350 billion for Citigroup;
- $300 billion for the Federal Housing Administration Rescue Bill to refinance bad mortgages;
- $87 billion to pay back JPMorgan Chase for bad Lehman Brothers trades;
- $200 billion in loans to banks under the Federal Reserve’s Term Auction Facility (TAF);
- $50 billion to support short-term corporate IOUs held by money market mutual funds;
- $500 billion to rescue various credit markets;
- $620 billion for industrial nations, including the Bank of Canada, Bank of England, Bank of Japan, National Bank of Denmark, European Central Bank, Bank of Norway, Reserve Bank of Australia, Bank of Sweden, and Swiss National Bank;
- $120 billion in aid for emerging markets, including the central banks of Brazil, Mexico, South Korea, and Singapore;
- Trillions to guarantee the Federal Deposit Insurance Corporation’s (FDIC’s) new, expanded bank deposit insurance coverage from $100,000 to $250,000; plus …
- Trillions more for other sweeping guarantees.
Grand total of money spent or promised as backstops: Over $14 trillion.
Yes, with these trillions, the government was able to calm the waters and restore credit markets. But the government could still not dissuade average American families from taking matters into their own hands.
Those families could feel the dead weight of their mortgages and credit cards. They feared for their jobs. And they abhorred piling on more debt.
So in the years after the debt crisis, they decided to do precisely the opposite. While most folks in Washington were still spending taxpayer money like drunken sailors, households were waking up to the real world and starting to cut their debts.
It was the natural, rational thing to do. But it was also very unusual. Since World War II, the U.S. economy had been consistently fueled and sustained by American households on a nonstop binge of borrowing and spending.
Indeed, in almost every year since 1946, consumers had borrowed more than in the prior year. Washington and Wall Street were happy: The more consumers borrowed, the more they spent; and the more they spent, the bigger the revenues at the nation’s manufacturers and retailers.
In the years immediately following the debt crisis, however, all that changed. American consumers not only borrowed less, but they also cut back on prior borrowings — either because they defaulted or because they voluntarily sought to restore their finances to avoid default.
Result: We witnessed the deepest decline in consumer credit outstanding since the government began keeping records after World War II.
Was this good or bad?
The answer should have been obvious. If too much debt was a major cause of the debt crisis, then it stood to reason that debt reduction was one of the best solutions.
Nevertheless, Washington and Wall Street didn’t see it that way. All they seemed to care about was their own wallets. They knew that less consumer borrowing meant less consumer spending. And they knew that less spending meant lower sales, reduced profits for corporations and a sharp decline in tax revenues for Uncle Sam.
So America’s corporate and political leaders did everything in their power to get consumers to borrow and spend like they used to.
Moreover, many Federal Reserve and Treasury officials were deathly afraid of another big threat, which, in their view, loomed even larger than debt reduction — deflation — declining prices.
If prices go down, they said, consumers will naturally wait for still lower prices before buying homes, automobiles, appliances and more. They’ll spend even less.
Worse, they feared, consumers will see, with their own eyes, that the purchasing power of their money is improving. So they’ll be more inclined to — God forbid! — salt it away. That, in turn, would reduce demand and cause further price declines, creating a “vicious circle” of sinking demand and sinking prices.
The fact that this process could help bring down the cost of living and make life easier for average citizens — especially retirees — was brushed aside. Instead, the authorities decided that this back-to-thrift trend was actually dangerous and must be stopped dead in its tracks.
Ironically, this was also the rationale that the U.S. Federal Reserve used to justify its greatest escapade of all, the focus of my next article in this series, coming next Monday, July 6.
Good luck and God bless!