Saturday, March 8, 2008

It’s Getting Worse on the Financial Front

No one has mentioned this grim report from yesterday’s New York Times, so allow me to bring it to your attention. It should be read from beginning to end to get a sense of the scale and scope of the disruption. It’s especially not a good sign that there is an uptick in the perceived risk of a U.S. government default.

For superb background reading, take a look at this paper by Greenlaw, Hatzius, Kashyap and Shin. It’s low tech; in fact much of it reads like a macro principles text of the future, after the flow of funds and balance sheet analysis will have been integrated into the core model. Some readers will note that the authors make a structural case for Minsky cycles, one that does not depend directly on psychological postulates. All of this, plus an informed (but probably conservative) estimate of the contribution the credit crunch (“deleveraging”) will make to an overall economic slowdown.


S Molnar said...

"It’s especially not a good sign that there is an uptick in the perceived risk of a U.S. government default."

I don't see any such suggestion. On the contrary, the increased spread between Fannie Mae debt and Treasuries suggests otherwise. I don't take issue with your description of it as a "grim Report", however.

Peter Dorman said...

The point is that credit assets backed by the federal government are being given a substantially higher risk premium. The potential default I'm alluding to is not that of the treasury in general but of these particular obligations.

Bruce Webb said...

Well I have to agree with Molnar, 'government default' is a hell of a lot different than 'assets backed by the federal government' getting a higher risk premium. I understand the argument that a government charted corporation is a little closer than say a bank whose deposits are insured by the FDIC, but the last thing we need is the suggestion that Treasury is going to default on T-Bills.

Call me a contrarian but from the beginning I have not bought the idea that the current panic was being driven by fundamentals whether that being housing bubble or something else. At every step of the way Wall Street has over reacted and fed into the crisis. They simply did not have to slam shut the spigot to the lenders in the way they did in the winter of 2006/2007, there were ways to tighten underwriting standards in troubled markets without killing a total industry sector. At the time I was working in the private sector with a company that originated loans and financed houses in a market that was then booming and is now still strong with foreclosure rates far lower than the bubble markets. Did that matter to the banks that were funding the lenders? Nope they closed them down coast to coast, often overnight, taking perfectly sound loans down with them.

Wall Street wasn't writing down these assets a year ago because they didn't need to, instead they introduced a confidence crisis that led to a liquidity crisis that now looks to be spiraling out of control. Its kind of nutty, most people are in fact paying their mortgages because most people still have jobs and don't particularly want to live out of their cars, yet the noise machine is drowning out the real signals.

My local real estate market is still in good shape, a good thing since I am looking to sell in a month or so, but from my perspective people that somehow lost sight of the concept of risk/reward are bound and determined to take everyone down with them. What started out as pretty much a story of rich people losing money is now turning into a type of blackmail: bail us out or we take the financial system down in flames! Well working class and middle class people who manage to pay their bills, including their mortgages, have been down that path before, we don't like the 'Too Big to Fail' argument. Not that it looks like we will get much voice in the matter.

Peter Dorman said...

Rather than defend myself again on the interpretation of agency risk premia, I'll invoke the similar judgment of Brad Setser.

And Bruce, the magnitude of price declines in housing, combined with unfavorable credit terms and weak household income, do suggest large writeoffs on an aggregate level. With luck, this will all bypass you in your local market....

More generally, I have argued in other posts that the reliance of the US economy on massive capital inflows to offset its persistent current account deficits has set it up as chronically prone to bubbles.

Bruce Webb said...

Case-Shiller is in my opinion garbage. It misrepresents the national market. Drawing predictions of 20% declines from models that leave out Philly, Indy, SLC, and Houston are nonsense.

Myrtle Blackwood said...

Bruce, I can't see where you are coming from. Which institution in it's 'right mind' would want to lend to someone or something that has $1 of assets for every $30 of debt? And especially in the context of a slowing economy?

Large leveraged buy-out organisations, long history of loaning money without due diligence, scarcity of collateral, rife speculation drowning out genuinely productive activity, tax evasion, billion-dollar paydays.

I mean, come on! In a negative-return economy something has to give eventually. And it has. It's no surprise.