The global Pandemic is wreaking havoc on our medical systems and daily lives. Beyond the medical and societal consequences of the Pandemic, some are left wondering what will happen to the American Economy. Clearly, with markets tanking, millions of Americans laid off, and both large corporations and small businesses losing vital revenue, we can expect to see major economic fall-out. The American Government has already acted to mitigate the damage. The Federal Reserve has slashed interest rates, Congress has passed an unprecedented bailout package to buoy-up both American citizens and their small and large businesses, and President Trump has announced HUD (Department of Housing and Urban Development) will postpone all evictions and foreclosures until May. These measures are helpful for the short-term, but what can we expect to see over the next year as the effects of COVID-19 spread through the economy?
Let’s start with liquidity. It may sound like a buzz word, but it is the crux of the problem and the first place we will see signs of major Economic distress. Liquidity, simply put, is readily available funds—usually cash. For the individual, liquidity is the amount of cash they have on hand to immediately purchase goods and services or pay bills. For a business, liquidity is the amount of cash or liquid assets a firm has available to make purchases or cover debts.
Let’s look back to 2007 to see how liquidity played a role in the 2008 Great Recession. At the time, warehouse lending had become a fixture of Wall Street. Warehouse lending is a process by which banks extend lines of credit to nonbanks or ‘shadow banks’ to fund mortgages or other debts until the shadow bank finds a willing investor. Those lines of credit are not a stable source of funds due to the traditional banks’ ability to close those lines at will and for any reason, including at the direction of the Federal Reserve or its regulator.
Leading up to the 2008 financial crisis, these credit lines were critical to the success of the bond markets. The final collapse of the likes of Lehman Brothers occurred when their credit lines were closed. It was the disruption in the credit line sub-industry, which caused the massive banking disruption beginning in 2007, leading to the banking failures and the 2008 Great Recession. The credit lines had, in effect, become the load-bearing wall in their house of cards and remain its Achilles’ heel even today.
In 2019, according to the FDIC, the present bank lines of credit to shadow bank financial institutions have exploded to $400 billion, a seven-fold increase since 2010 and well over the 2008 amounts. Back in 2014, the Federal Housing Finance Agency Office of Inspector General (FHFA OIG) warned that shadow bank lenders lacked the financial capacity to support the loans they carried and could default on their financial obligations. In hindsight, perhaps the Federal Reserve should have required the banks to demand financial benchmarks and oversight before lending shadow banks the money and the debt became so unmanageable. This type of lending is now entering uncharted waters, and we currently have no plausible exit plan back to safe financial ground.
So, here is the likely chain of events we can expect to see:
- Laid-off Americans are unable to make their mortgage payments
- The shadow banks holding these mortgages have far fewer payments coming in
- The issuing banks become concerned and decide to withdraw the lines of credit
- The shadow banks have almost no liquidity and they begin foreclosures but still find themselves in economic turmoil
- GSE’s like Fannie Mae and Freddie Mac take the loans from the holding shadow banks.
- Fannie Mae and Freddie Mac are then left holding bad loans.
But, here’s the kicker. The 2008 Great Recession saw the big banks getting bailed out by the Treasury. However, in our current economic situation, it is not the banks carrying all the risks, it is the nonbank or shadow banking system, and they are not legally included in our current safety net like the banks. The Federal Reserve would have very little ability to buoy-up shadow banks, and it is my opinion that should this Administration elect to issue an Executive Order to bail out the shadow banks, the results of the bailout would be catastrophic.
I close this overview with a discussion of what might be the most difficult trial this Pandemic will bring: a crisis of confidence. Back in my college days, my economics professor, a member of Ford’s board of directors and an economic advisor, asked a student for a dollar bill. The professor then held up the bill and asked a straightforward question,
“What is this one-dollar bill worth?”
A discussion ensued between class members. We were then split up into groups to discuss the topic further and graded on our answers. In the end, we all failed; we had missed the mark. The actual value, he explained, lies not in economic theory but in our belief in the dollar—not how much a dollar will buy. We believe the dollar is worth a dollar because we believe the dollar has the full faith and confidence of the government, and that the government has the full faith and confidence of the people. This delicate relationship, a belief, and confidence in the system is critical for the American constitutional republic to exist. At all costs, this belief system must be protected.
Then, a student interjected, “What happens if we quit believing in the government because of their bad acts, for example? Nixon, as a case in point.”
“Good question,” the professor replied and then asked the student for a five-dollar bill. The professor took the bill and walked back to his podium to begin lecturing. The student looked stunned; five dollars was the price of a movie and combo refreshments back in 1980. After a bit, the student got brave enough and raised his hand.
“Yes?” the professor said.
“May I have my five dollars back?”
“No,” the professor replied, “You said that you did not believe in the government; therefore, you place no value on this bill. I, on the other hand, believe in the institution of the government, regardless of whoever holds the office, and therefore believe the bill is worth five dollars.” That was the end of the discussion; a lesson I remember from forty years ago.
How can we maintain confidence? We can push for our government to protect its vulnerable citizens. We can work together with private organizations to help those in need. After all, we, the citizens of America can have confidence in each other and move forward together through these difficult times.
Long-time banker and broker, James M. Nelson, noticed rental rates sky-rocketing across America and sought to discover the cause. He recently published a book detailing his findings, Stealing Home: How Artificial Intelligence Is Hijacking The American Dream.