The Credit Crisis and the Economic Outlook
Low Growth in Q1. What Lies Ahead?
By blackhedd Posted in Bond market | credit crunch | depression | Economy | housing-market equilibrium | overnight repo | recession | stock marke — Comments (19) / Email this page » / Leave a comment »
If you follow my posts here at RedState, you know that I was among the first to compare the current economic situation to the Great Depression (in its genesis and dynamics, not necessarily in its severity), and also to predict a long, stubborn economic funk. Now that many, if not most, mainstream commentators on the economy basically agree with me, it's time to turn contrarian again and take another look into the crystal ball.
Given that all kinds of Armageddon scenarios have now been baked into financial-asset and commodity prices, it's not a bad time to ask whether something less bad than the worst-case will actually occur.
More...
We are still in the jaws of a very serious crunch in which traditional sources of credit have become extraordinarily risk-averse, to the point of disrupting not only financial markets but also the real-world economy of jobs, goods, and services. And this is a global phenomenon, not restricted to the United States.
The overnight money markets, which are the basement engine-room of the global economy, are showing significant signs of stabilizing in the US, thanks to constant and aggressive interventions by the New York Federal Reserve Bank. In Europe, overnight repo is still very sclerotic but not quite as bad as it's been. Bond markets are slowly limping back to near-normalcy, with corporate bond-issuance exceptionally well-received in recent weeks (albeit at abnormally high spreads to risk-free credit).
There is now significant upside risk in the stock markets, as the perception takes hold among equity investors that it might finally be safe to come out and play. (That's not a general recommendation to buy stocks, by the way, because the downside risk remains as strong as ever.)
But non-financial business corporations are a widely-overlooked bright spot in the general financial picture. Large public companies have been hoarding cash and avoiding leverage. I think this is at least partly because of the relative lack of good opportunities, so it's not an unmixed blessing. But the result is that corporate balance sheets are unusually strong. This gives them the ability to weather a period of economic weakness without major job cuts. That's very good news.
To me it's a forgone conclusion that the world of finance will not return to the conditions that prevailed over the last ten years or so. Too much has happened to discredit the risk-management procedures everyone has been using. The ultimate solution to the credit crisis will not come from a return to recent normalcy, but from structural changes that are not yet clear. But a solution will come.
The US consumer is another matter altogether. Economic weakness (translating to fears about job-security) combined with inflation is causing consumers to pull in their horns, and this is can very well become the proximate cause of a protracted recession. If you really don't like the "R" word, then let me just say that we could be in for a long period (possibly stretching into years) of slow growth, with continued anxiety about jobs, a higher saving rate (not necessarily a good thing), and less consumption.
And what's the real wild card? The housing market. At this point in time, there still is no sense for where the floor is. As I've written before, the financial world is in a maelstrom of deleveraging, and the worse-case scenarios here are extremely bad. Unfortunately, here there's not yet any visible reason for optimism. The big question is: what is the true value of all the mortgage-based debt out there? If traditional, leveraged, sources of mortgage financing don't come back into the game, then the debt will deflate, and the only lenders available will be "real money" (non-leveraged) lenders.
No one knows where the equilibrium point in the mortgage-finance market is. If it truly turns out to be way down at a non-leveraged level, then we will replay the Great Depression, with something resembling its length and severity, adjusting for a wide range of mitigating factors that didn't exist in the Thirties.
I really can't tell you how likely that outcome is. We've said a great deal these past few weeks about the valor of the Federal Reserve in combating the proximate credit crises, but not much about what can be done to stabilize the housing market.
Congress, of course, is working overtime on the problem. The systemic risk at this moment is extraordinarily high, ladies and gentlemen, because the cost of a Federal bailout will be huge. Forget about the moral hazard. Even if it works perfectly, it will constitute a government takeover of the economy rivaling the New Deal in its reach, and in the damage it will ultimately do to your freedom.
But if Congress does nothing, the housing market will find its own equilibrium by market forces. And that equilibrium could be anything from quite near normal 2003 levels, to someplace far, far lower.
Scylla and Charybdis.
-Francis Cianfrocca ("blackhedd")
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The Credit Crisis and the Economic Outlook 19 Comments (0 topical, 19 editorial, 0 hidden) Post a comment »
What happens when the Fed doesn't RAISE interest rates in the midst of a credit cruch (a la 1929).
Now lets hope the Dems aren't dumb enough to raise taxes and tarrifs (a la 1930).
BTW, you might want to put a disclaimer such as you have above on your posts as a general matter. Not legal advice mind you, but just a thought.
"That's not a general recommendation to buy stocks, by the way."
...everything I say here is for information and analytical purposes only, and does not constitute investment advice in any way, shape or form.
I'm available for private consultations, but not for free :-)
The securitization markets were key drivers of the debt fueled boom that propelled both the housing sector and the corporate sector for the past several years.
It got to the point where securitization investors were overly relying on rating agency guidance (that apparently didn't mean what they thought it did) and doing too little if any diligence on what they were investing in.
Obviously that situation, and the excessively loose lending standards that resulted, were not a good thing. But now, from my limited vantage point, the securitization market seems totally comatose and that's not a good thing either.
I've been trying to thing about what can be done to restart the securitization market to regain a reasonable level. It can probably be done with out government involvement, if the rating agencies can reexamine their role/responsibility in the process, and if the firms originating the securitizations can develop a structure where the originator retains a more meaningful level of risk in the security (to assure its not total garbage). But whatever happens, its probably 2009 before that sector starts to show signs of life again.
Securitization for non conforming loans has fallen off a cliff, to be sure. Subprime, Alt A, all that stuff - the chart looks like those loans fell off a cliff, even though if you look close levels have just gone back to levels of five or six years ago, when things were sane.
Conforming loan securitization is down, but not to the same degree. The market is still there.
In other words, mortgages entered into by credit worthy people, with documentation, with down payments, are still getting done, and still getting packaged into securities. Home sales are down, and credit for creditworthy people is a bit tighter, but that part of the market is far from gone away.
is more into the corporate lending side. And there as far as I know there are no Corp. Debt securitizations getting done these days. The CLO investor class has fallen off hard and no indication when its coming back.
I'll comment at sme length on the housing and mortgage markets later today, but for now lwt me note that any optimism in the housing markets are fueled by drugs left over from the "good times".
In the major housing markets that really fueled the run-up and the current crisis the bad news is still percing. Congress' actions to date are generally meaningless and if they try to head off what's around the corner your estimation of a New Deal sized bite of the economy is conservative.
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CongressCritter™: Never have so few felt like they were owed so much by so many for so little.
I email and forward your writings to a number of financial advisors.
I was wondering if by chance you have any thoughts on the upcoming demographic spending trends that Harry Dent Jr. addresses?
Solution to the real estate crisis:
1. Lower corporate tax rate (which currently stands as the second highest in the world) and eliminate capital gains taxes
2. Streamline immigration process
3. Provide significantly more visas to Asian immigrants
4. End result: the Asians who study in America are able to stay in America, and want to stay because they can reap greater rewards for their efforts in the US than anywhere else in the world. This drives up GDP and increases demand for real estate because of an influx of immigrants (the legal kind)
Ok, I'll admit I used this as a soap box on a different issue. But seriously. We would do well to listen to Calvin Coolidge:
"I want the people of America to be able to work less for the government and more for themselves. I want them to have the rewards of their own industry. This is the chief meaning of freedom...These results are not fanciful; they’re not imaginary. They’re grim, actual, and real."
- Calvin Coolidge
Want to ensure we stay the most powerful economy, and therefore country, in the world? This is how it's done.
On a more relevant note, blackhedd, LIBOR jumped about 20 bp a week ago w/w. I read a very interesting story about how banks were under-reporting LIBOR to avoid looking cash-strapped. It was over the course of the following week that LIBOR jumped. Was that story and the deeper investigating by the folks that put together LIBOR the cause for the jump, or was it symbolic of something happening in the debt markets that I missed?
I still wonder if it wouldn't have been best for us long-term had Bear Stearns actually failed. One must wonder if the Fed put is really a good thing for our economy in the long-run as it allows financiers to simply forget about, not just a six sigma event like LTCM, but something much more likely to occur. Every 10 - 20 years now the Fed has to step in and bail somebody out (S&L's, LTCM, now BSC). Is that really good finance? Doesn't seem like it to me.
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And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_
On 1 through 4 - nope, nope, nope & nope. Won't even scratch the surface.
One is a good idea, but for entirely different reasons.
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CongressCritter™: Never have so few felt like they were owed so much by so many for so little.
I was being mostly facetious on its impact on the real estate market. That said, you don't think #2-4 are a good idea?
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And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_
Not necessarily a bad idea, I have no particular problem with more Asians. It just won't impact the housing or the mortgage markets for reasons I'll cover in mre detail when I have some time later this afternoon.
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CongressCritter™: Never have so few felt like they were owed so much by so many for so little.
I was being mostly facetious on its impact on the real estate market.
That said, you don't think #2-4 are a good idea? They are talented people, especially those that study in the US. We need to convince them to stay in the US rather than take their American education and return to China.
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And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_
You're absolutely right, the credibility of LIBOR, which is an incredibly important benchmark rate, took a big hit when at least one bank in London was sanctioned for misreporting their overnight bids and asks.
Very, very ugly situation. And it most certainly did contribute to the London/Europe edition of the interbank lending crunch.
On mortgages, I'll leave the responses in mbecker's capable hands.
Should Bear have crashed instead of being taken out cleanly? I would say no, definitely not. The Fed did the right thing at the time.
But you're asking the question on everyone's lips. The next time something goes bad, the expectation will be there that the Fed will step in.
This creates a huge amount of new moral hazard, which sad to say, will need to be addressed with new regulations.
To repeat myself: ugly.
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"If we want to take this party back, and I think we can someday, let’s get to work." – Barry Goldwater
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And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_
I agree that the US residential housing market is currently illiquid. Here in the northwest it's mainly manifest as accumulating unsold inventory...that is only now translating into reduced selling prices.
It's hard to assess the true extent and duration of a storm while you're in the middle of it, but this economic juncture is perhaps even more difficult than average. Because the MSM is an echo chamber for the DNC, it's in their interest to exaggerate economic woes and maximize political damage for the Bush administration. Obviously, they hope the tar slops over onto John McCain in November. I suggest that whichever of the two remaining Dem presidential candidates individual reporters or newsrooms support, they would all be united in their desire to weaken Republican prospects.
Think, for example, of the MSM's sinister tone during this last quarter...yet we now know that the first Q1 macroeconomic reading was actually slightly positive. Yes, these GNP statistics are subject to subsequent revision but, using the official definition of a recession as two sequential negative quarters, we can't say that we're in a recession on the basis of the available information today.
So the data that we all urgently need to assess our economic peril and prospects is coming to us spun and filtered. Personally, my working hypothesis is that economic news is not as bad as it's consistently reported.
Bellinghamster
...until you lose your job, or you take a big hit to your investments, or you find yourself unable to afford things you need to buy. If none of those things are happening to you, then the economic news, however it gets spun, is largely a matter of indifference.
It's definitely true, however, that when people fear that they will lose their job, they often will curtail their spending. And that is a real effect that can slow the economy down all by itself.
To what extent is that behavior caused by media spin? My guess is less than one might expect.
Near as I can make out, the Fed and Congress seem bent on getting a nice inflationary cycle going that will lift housing prices along with the cost of everything else. That will bring nominally under water loans back to par, and support the securitized mortgage tranches issued back in the day.
Of course, anyone who saved for retirement or who is running a main street style business gets screwed, but that's the way it goes when Washington takes care of its own.
If they don't do that, or if it doesn't work, and housing prices still keep falling, a lot of banks will be shown to be insolvent. The Fed can't fix that - they can fix liquidity problems, but not solvency problems. Given the size of the banks involved, even nationalizing the big ones would be a huge commitment, dwarfing the S&L rescue of the 80s.
It's all pretty complicated, of course, because it's not just the US. One big British bank has already been nationalized, and only recapitalization can save RBS and HBOS. If they fall, it will affect us here. The contraction of credit that's going on also will have a deflationary impact, making it harder to get a good inflationary spiral going in time to prop up housing.
My bet, though, is that the inflation will work, allowing the banks to gradually work off their losses and recapitalize, and people will consider it a huge win to get gradually poorer due to inflation rather than to face up to a sharp sudden correction. Between the collapsed dollar and the fire sales as banks recapitalize, when it's all over a lot of key US financial assets will effectively have shifted to foreign ownership, not that anyone will notice. As a nation, we will be a bit poorer and a bit more foreign owned.
None of this needed to happen. It's not that new financial techniques got invented; it has more to do with monetary fed interest rate policies and fiscal federal spending policies that pumped up the bubble. To reward Washington for idiocy by giving Washington more power over the economy is the height of irony. You can be sure they won't use those regulatory powers for our benefit.
-- as usual, blackhedd. Thanks for all these excellent posts.
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And the Lord upon the Golden Horn is laughing in the sun.