FullFrogMoon: The Blog of the Frog

Who are the bubble blowers?

Who is responsible for blowing the bubbles that are threatening America’s economy?

It seems like every time I pick up a newspaper or read the Internet news, there is a story about a menacing bubble of one sort or another that is threatening the stability of our economy and indeed the entire world order. I decided to do a little research to see if I could characterize each of the more prominent bubbles to gain a better perspective of the dangers that they may or may not pose. In particular, I wanted to understand the processes that were producing the bubbles and explore the dynamics of these phenomena that are putting so many people in peril.

The Stock Market Bubble

The stock market has had its ups and downs over the years but it now appears that there is an evolving disconnect from reality that is preventing investors from acknowledging that things aren’t as good as they used to be. There is still a deep founded belief that somehow today’s situation is different and that stocks will succeed in navigating the stormy times ahead and continue to provide the generous returns of the past. The analysts and financial pundits have said it is so.

Individual and institutional investors have been ignoring some of the more conspicuous risks that could stifle future earnings and ultimately affect valuations. Advocates of investments in securities have been seduced by the alluring earnings records of US corporations in 2011, part of which can be attributed to the extraordinarily low interest rate environment in today’s economy. This could be seen as a repeat of the “irrational exuberance” phenomenon that Fed Chairman Alan Greenspan alluded to in a 1996 speech that caused markets to shudder from Tokyo to Frankfurt. It is hard to see how the trend can continue as deficits are increasingly funded by the prolific creation of money by the Federal Reserve, and which will at some point trigger a bear market in US Treasuries.

Prominent financial commentators suggested the prospect of a Facebook “IPO Halo” whereby a rapidly rising stock price for the social networking company would lift other technology stocks with a rising tide. Reality, however, played out differently. The company’s $100 billion valuation may not have been entirely justified by its recent financial performance. After a week of trading following the IPO, Facebook’s stock was hovering at around 85% of its IPO price of $38. At the same time the NASDAQ roller-coastered a bit but remained unremarkable with a 1.8% gain for the week.

Evidently, George Soros did not see any halo on the technology horizon as it was reported that his hedge fund, Soros Fund Management, recently liquidated its entire position in Google valued at some $168 million and also sold off half of its investment in Apple Computer.

One cannot help but wonder what will be in store for the financial markets. There would appear to be a mounting crisis of confidence on the part of investors, and particularly, the smaller players. For some time now they have been facing higher risks while experiencing meager returns. It’s as if the average person out there has come to believe that the game is rigged, and nowhere is this sentiment more in evidence than in the litigation that has been initiated against Facebook and the Wall Street firms of Goldman Sachs, Morgan Stanley and JP Morgan, the three of which reportedly shared a $100 million fee for their underwriting of the IPO. The litigants are alleging that negative information was concealed from the public prior to the IPO and that this led to losses for them. Adding to the sector’s crisis of confidence, JP Morgan announced less than two weeks ago that it had experienced a $2 billion loss as a consequence of derivative trades that went bad.

It was further reported that investors withdrew $85 billion from their mutual funds in 2011 and have pulled out $6 billion just in the first four months of this year. One cannot help but speculate that this investor retrenchment is driven at least in part by a sense that the little guy cannot win in a system that is permeated with corruption and special interests. Nowadays with Greece circling the drain and the European monetary system facing meltdown, this pessimism is understandable.

The Housing Bubble

There was a time in the not too recent past when housing valuations appreciated so consistently year after year that people began to assume that the trend would continue indefinitely. This gave rise to a subculture of “flippers” who bought houses with little or no money down and then resold them shortly thereafter earning them spectacular profits as due to the high leverage they enjoyed. The phenomenon was driven by a number of factors including low introductory interest rates and a failure on the part of lending institutions to exercise proper due diligence in the vetting of potential borrowers.

Another contributing cause was pressure exerted by Congress on banks to provide financing for affordable housing. The lending institutions were granted guarantees on the mortgages extended to individuals that lacked the financial wherewithal to make good on their commitments, especially in an environment of a declining economy with rising unemployment.

All good things must end sometime and that day occurred in December 2008 following several years of slow decline in the housing market. The subprime loan catastrophe that ensued left a trail of foreclosed and abandoned homes in its wake, bankrupting builders, ruining lives and compromising the solvency of some of the nation’s largest financial institutions. The impact was so great that the federal government was forced to step in with a series of rescue measures to assist foreclosed homeowners and banks that had become insolvent as a result of the large volume of delinquent loans.

The Student Loan Bubble

Earlier this year the rating agency, Standard & Poor’s, warned of the mounting danger posed by a growing student loan bubble. The situation was created by a convergence of factors which include tuition costs rising at twice the rate of inflation, a lack of proper underwriting that allowed young people to assume levels of debt inconsistent with their future earning power, and disregarding a weak job market that has left more than half of this year’s graduates under- or unemployed.

The New York Federal Reserve estimates that as of the third quarter of last year, 27% of all student loans have become delinquent. Incredibly, this level of unsustainable debt now exceeds $1 trillion and has eclipsed the nation’s aggregate credit card debt.

As more student loan defaults occur, there will be far-reaching consequences that will impact the entire market as asset-backed securities are inevitably downgraded by the rating agencies.

In 2005, Congress passed the Bankruptcy Abuse and Consumer Protection Act of 2005 that makes it impossible to discharge student loan debt in bankruptcy. However, this is of little comfort to the creditors who are finding it difficult if not impossible to collect from insolvent students who are living in their parents’ basements with scant prospects of employment.

Since universities depend heavily upon the income derived from repayment of government guaranteed student loans, it is not inconceivable that some ivory towers of knowledge will follow Greece in its death spiral into the abyss of debt.

The Unfunded Liabilities Bubble

There has been much fretting and arguing amongst the presidential candidates regarding the snowballing annual deficits that have spawned the nearly $16 trillion public debt now burdening the United States. However, there has been less attention focused on the much greater danger residing at federal, state and local governments attributable to unfunded and contingent liabilities. At the federal level, these additional obligations of about $46 trillion are largely composed of mandatory payments for entitlement programs such as Social Security, Medicare and Medicaid. Originally conceived as pay-as-you-go programs, evolving demographics and changing economic conditions have resulted in a situation where tax revenues and other sources of government income are going to be woefully inadequate to meet projected cash flow requirements for the future.

Nowhere is this looming crisis more evident than in Berkeley, California where the city has accumulated nearly $330 million in unfunded liabilities of which nearly 2/3 represent defined benefit pension obligations for city workers. Articles in the press have reported that Berkeley’s recently retired city manager will be entitled to an annual pension benefit of some $280,000. Assuming an annual cost-of-living increase of 2% and the current 2% yield on five-year certificates of deposit, the city would have to set aside a fund of approximately $15 million just to provide the cash flow necessary to support this one individual. When one considers that the city of Berkeley has in excess of 100 pensioners receiving at least $100,000 per annum, the unsustainability of the system becomes glaringly evident.

Estimates regarding the total figure of the unfunded liabilities of the United States range from $62 trillion to $144 trillion, a staggering amount in either instance. Depending on which estimate is selected, the amount of unfunded liabilities could exceed $1 million per US citizen, and it is hard to envision how this debt will ever be satisfied.

Am I on target here? Does anyone have any other bubbles you’d like to discuss? Suggest solutions? Please leave a comment.

Illustration by Kim Harris
Story by Don Rudisuhle