Comments on the U.S. Mortgage Meltdown and Economic Outlook

Many banks and other mortgage lenders, including Countrywide, bear some of the guilt by encouraging borrowers to take out mortgages they could not afford.

J. Franklin SharpWho is at fault?

The recent mortgage meltdown in the United States is like Agatha Christie’s Murder on the Orient Express, in that everyone is guilty. For example, former Senator Phil Gramm bears some of the guilt because of his excessive deregulation legislation. Representative Barney Frank and Senator Chris Dodd certainly bear some of the guilt by getting legislation passed forcing banks to make mortgage loans to people who were unqualified.

Many mortgage borrowers bear some of the guilt by taking out mortgages on homes they could not afford. Many banks and other mortgage lenders, including Countrywide, bear some of the guilt by encouraging borrowers to take out mortgages they could not afford.

Fannie Mae and Freddie Mac bear some of the guilt because of their eagerness to buy bad mortgages from mortgage lenders (since it allowed them to report higher earnings and give very high bonuses to their top management). Now-defunct investment banks like Bear Stearns and Lehman Brothers bear some of the guilt because of their innovative financial engineering of mortgage-backed securities that covered up much of the risks involved. (Perhaps I should bear some of the guilt, because even though I frequently criticized the huge risk in some of their mortgage-backed securities products, I was a long-term investor in Bear Stearns and Lehman Brothers, and was lucky to get out with large gains a year or two before they collapsed.)

SEC bears some of the guilt due to lack of proper regulation. Former Fed Chairman Alan Greenspan bears some of the guilt also for lack of proper regulation, and by keeping interest rates too low for too long (that encouraged excessive housing speculation). (Note that Alan Greenspan was an outstanding student in one of my classes when I was a young associate professor at NYU Graduate School of Business and he came back to get a PhD.)

I tend to be in favor of much of the deregulation that has taken place in the U.S., but deregulation and/or lack of regulation can go too far. In my opinion, greater U.S. financial regulation was, and is, needed. Alan Greenspan now seems to agree. He used to think that financial industry self-regulation was sufficient, but apparently has changed his mind based on what happened.

U.S. Stock Market Implications for Economy

The U.S. stock market (measured by S&P 500) tends to be a leading indicator of the U.S. economy (measured by GDP). That is, the U.S. stock market tends to peak six to 12 months before the U.S. economy, and tends to bottom out four to six months before the U.S. economy (with some outliers at both peaks and bottoms).

Thus, after the U.S. stock market bottoms out, there still tends to be at least a four- to six-month delay before the U.S. economy bottoms out. But, has the U.S. stock market bottomed out? There certainly has been a significant rally in the U.S. stock market from early March to late April (when this viewpoint was written).

Scenario 1. Optimistic

If the U.S. stock market rally indicates that the U.S. stock market did bottom out in March, and historical relationships hold, the U.S. economy should bottom out in the second half of 2009.

Scenario 2. Most Likely

However, this U.S. stock market rally may be just a bear market rally (followed by a significant downside move). Some of my past research found a leading indicator of the U.S. stock market to be U.S. unemployment claims (with an inverse relationship and a lead time of six to 12 months). U.S. unemployment claims may have recently peaked and leveled off.

If so, and historical relationships hold, the U.S. stock market would tend to bottom out sometime late in 2009 or early 2010, while the U.S. economy likely would not bottom out until mid-2010 at the earliest.

Scenario 3. Pessimistic

However, something that might delay and/or dampen the U.S. stock market recovery and U.S. economy recovery is inflation. There seems to be agreement that some additional deficit spending may be appropriate to help get the U.S. economy out of the current recession.

But continuing additional deficit spending usually results in significant inflation problems. And the Obama administration seems to be planning on continuing additional major deficit spending for the rest of their administration.

Some of my past research found a very significant inverse relationship between U.S. stock market returns and inflation (that is, the U.S. stock market since 1950 has tended to perform the best when inflation has been relatively low, and has tended to perform the worst when inflation has been relatively high).