Behind the Meltdown

N.C. State economist discusses financial crisis.

Published on: Nov 20, 2008

Editor's note: Some have called it the worst financial turmoil that the nation has faced since 1929's Great Depression. To better get our minds around the situation we recently discussed the termed "financial crisis" with N.C. State University Agricultural and Resource Economist Michael Walden.

Make certain to check out additional stories in this month's issue of Carolina-Virginia Farmer, including an analysis of the situation as it relates specifically to agriculture and to reactions by famers.

Carolina-Virginia Farmer: What is the nature of this financial crisis and how did it come about?

Mike Walden: "We're in a recession. The recession has had its origins in the financial sector. It was related to the boom in the housing market which was stimulated by very low interest rates earlier this decade, ample amounts of money and a lot of foreign investment. That money moved into the housing market.

"We had a tax law change in the latter part of the 1990s that also contributed to the situation. Banks were pushing the envelope on loans because money was plentiful, rates were low and housing values were appreciating. The view was that even if people fell back on their payments and defaulted the bank would take over an asset (a house) that was higher in value. "

Carolina-Virginia Farmer: What came about that changed the situation and derailed the economy?

Walden: "That model began to come apart in 2004 when the Federal Reserve began to raise interest rates, making home buying more expensive. That in turn caused the number of buyers to pull back. It caused housing price appreciation rates to slow and eventually caused all those marginal buyers who got in on good terms earlier to find they could no longer afford the home.

"What has been unusual and really unprecedented is the degree to which the housing market has turned around and prices have fallen. Houses have usually always risen in price. It is very unusual for home values to go down. And by one measure in the last year we've had a 16% decline in home values on average. Some say there is another maybe 16% in the pipeline. So what that has very simply meant is that lenders who made loans on an asset that was a certain value several years ago, thinking that asset would appreciate, now have an asset and have paper on that asset where the values are lower. That is really the crux of the problem that many of the financial institutions from banks to investment banks to insurance companies have had.

"That has led almost to a pulling in of lenders. Lenders are very afraid to loan because they are worried about their own asset liability situation. You've heard stories of the commercial credit market tightening up and the general lending market tightening up. We've had failures and we've had large institutions like AIG teeter on the edge of failure. This has prompted federal action - Treasury and Federal Reserve action, which has actually been their role for a long time.

"The Federal Reserve was actually set up to do exactly what they are doing because you can look at the financial system as if it is the heart of the economy. The financial system pumps the 'blood' of the system, which is money and credit, throughout the system. If that flow stops, the body, the economy, stops functioning. So it is serious to have this much turmoil in the financial markets and the Fed has been trying various forms of medicine. They seem to be having to try stronger forms of medicine but I think – and this is just my guess because it has been a moving, rolling target that has been very difficult for people to get their hands around – my best estimate is that, first of all we are in a recession and we've probably been in a recession for a year and we will likely be in a recession for I'd say another nine to twelve months. Eventually, things will loosen up but in terms of the financial markets we've not seen anything like this since the 1930s.

Carolina-Virginia Farmer: Some real estate people tell us the housing fall has not been as bad in the farming communities as it has in other parts of the country.

Walden: "For the most part North Carolina has been spared that. We've seen the biggest drops in the coastal counties, the resort counties. You'd expect to see the condominiums and houses on the beach where we saw the biggest boom to be harder hit. In many of the interior rural areas of North Carolina we didn't see as much as a housing boom when prices were going up: consequently we are not seeing the housing bust."