January 7, 2003 — I'm a small town banker and perhaps don't understand all the nuances of the national credit markets. But from where I sit, this economic recovery is extremely fragile, driven by excessive growth in consumer debt and likely to fail.

It seems to me the participants in this developing economic and financial market tragedy are living on hope. What but emotion filled hope can explain the apparent binging on consumer debt as bankruptcies reach historic highs? Public policy officials and many economists cheer on the extraordinary growth in consumer debt. They do so because they know a significant reduction in the rate of debt accumulation will doom the recovery, burst the real estate bubble and expose the official monetary policies of recent years as mania driven and futile.

When interest rates climb again, which may well occur in an effort to defend against a sell-off in the dollar, many consumers will choke on their higher debt service requirements and bankruptcies will reach new highs.

With these systemic market imbalances now maturing to critical stages, policy makers and economists seem to be reduced to hoping for a benign outcome. Their words and actions appear futile.

The banks, for the most part oblivious to the systemic risks, still are eager to grant consumer loans. In addition, the the home mortgage finance entities Fannie Mae, Freddie Mac and the Federal Home Loan Bank continue their outsized growth in mortgage loans. If and when the real estate bubble bursts it may well begin with serious trouble at these government sponsored enterprises. The auto manufacturers have contributed to the debt bubble with their easy finance terms. They are in a losing fight for market share as the industry has significant excess capacity to produce vehicles. It is most unpleasant to close plants and idle production machinery. But that is the answer to the problem.
There is a large degree of collective hope expressed in the utterances and actions of public officials, economists and market observers. This is a continuance of the collective hope which developed during the stock mania of the late 1990's. Reality for stocks proved to be much different and this may also be true for the debt bubble and the nascent economic recovery.

In the environment of small town banking, again, I'm still seeing banks stretch credit terms in haste to make loans. A bank in our market has grown assets about 55%, recorded no net income and is displaying signs of deteriorating loan quality. All of this occurred in the last two years and concurrent with a weakening economy and a burgeoning debt bubble. Their speculative excess is too common in banking and apparently barely noticed by observers of the credit scene.

The existence of a credit bubble problem is accepted by only few bankers and other financial professionals. Remember, however, non-recognition of the stock market bubble of the late 1990's was also widespread. The herd is often wrong and on the cusp of market and economic trend changes is usually wrong. Herd thinking and herd activity is, afterall, a major contributor to speculative excess.

Banker's hope is exemplified when making home loans of 90% -100% of appraised values while reality is growing loan delinquencies and foreclosures. Despair will be mounting foreclosures as borrowers' incomes are curtailed in a renewed economic downturn.

Bankers hope to increase income when purchasing collateralized debt obligations and governments agency securities. Reality is deteriorating credit conditions in the debt markets as rate spreads between the highest quality debt issuers[U.S. Treasuries] and others widens. Despair will be trying to liquidate second and third tier securities under adverse conditions and when it becomes apparent the "implied" guaranty of agency debt by the U.S. Treasury may not be fulfilled.

Investors show hope in recouping their devastating stock market losses by holding on through the bear market bottom. The hope is bolstered by repitition of the mantras: "invest for the long term" and "diversification". As if these slogans will ensure investment success. The reality is the recent stock price rally has been run-of-the-mill when measured against the previous rallies in this bear market or against rallies in historical market downturns. The bullish giddyness accompanying this rally has tempted many to believe the bottom is in. Despair will be unloading stocks as the DJI slips below 6000 and emotional fantasies of easy wealth are dashed.

Through it all the savers, many dependent on interest earnings for a portion of their income, have been shocked by low interest rates. They are caught between the rock of anemic interest rates and the hard place of risky stock markets.

As real estate bubbles, debt balloons and the economy stutters we collectively continue to hope. Reality is coming into focus and the picture is not encouraging.