Wednesday, August 15, 2007

Today's Econ Round Up

[On another blog I offered to compile a collection of readings on the current state of the economy, so here's the first installment in what I hope will be a daily series.]

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How to speak Hedge Fund:

Hedge-Fund Phrase: Challenging
Translation: Run for the hills!

The credit ratings system has flaws:

If the ratings agencies prevent the creation of a high percentage of triple-A paper, the deal won’t sell. The ratings agencies’ customers—the investment banks—will be unhappy, and the ratings agencies’ bottom lines will suffer. “Bankers get paid a lot of money. The ratings-agency people get pushed,” says a hedge fund manager who is betting that the securitization market will continue to sour. The agencies “never stopped to question” this, he says, “because they had zero economic risk.”

Or, for a specific example:

In 2000, Standard & Poor's made a decision about an arcane corner of the mortgage market. It said a type of mortgage that involves a "piggyback," where borrowers simultaneously take out a second loan for the down payment, was no more likely to default than a standard mortgage.
Six years later, S&P reversed its view of loans with piggybacks. It said they actually were far more likely to default. By then, however, they and other newfangled loans were key parts of a massive $1.1 trillion subprime-mortgage market.

Today that market is a mess.

A Zogby poll says consumers have low expectations of growth in the near term:

According to the poll, nearly 38 percent expect slow growth and 26 percent see the economy to be just treading water. Less than 3 percent expected the economy to advance at a fast pace.

Troubles in the housing sector have dampened voter sentiment about the economy, with more than 60 percent of those surveyed citing concerns about declining home prices.

A few days ago NYT’s Floyd Norris outlined what a modern day “bank run” would look like if it occurred to a contemporary financial institution. Here’s how Mark Thoma sums it up:

Hedge funds can be hit with withdrawals even if they are not in trouble themselves, at least initially, due to uncertainties about the future state of the market.

But like a bank who lends out most of the deposit it receives, a hedge fund uses the deposits it receives to purchase securities and other assets for its portfolio. Thus, unless it has substantial cash reserves on-hand (part of the scramble now is to build cash reserves), when investors make withdrawals the fund must begin to liquidate its portfolio to pay them off.

But if nobody will purchase mortgage-backed securities, who do you sell to? With nobody buying the assets the fund is trying to sell, they are forced to try to raise cash in other ways, and problems mount.

Now here’s an example of one.

But panicking isn’t as bad as it seems:

Financial markets, and particularly the big players within them, need fear. Without it, they go crazy. Moreover, it is impossible for outsiders to regulate a global financial system riddled with conflicts of interest and dominated by huge derivatives markets, massive trading by highly leveraged hedge funds and reliance on abstruse mathematics and questionable statistical models. These markets must regulate themselves. The only thing likely to persuade them to do so is the certainty that the players will be allowed to go bust.

Finally, guess who has yet to pick up on the issue:

The Fed and European Central Bank last week intervened in a big way (the ECB pumped substantially more money into the financial system in a single day last week than they did the day after 9/11) to inject liquidity and get the markets on their feet. Probably a good thing, unless you worry about moral hazard problems, but they don't intervene unless things are getting dicey. And things are getting dicey – and things are likely to get much, much worse before they get better. I don’t think the political world understands just how harrowing the last two weeks have been in the financial markets.


Where does it end? I’m not sure. I would say that the odds of a significant recession in the next 18 months are materially greater than 60%. If I were to venture a guess, I would bet that “it’s the economy stupid” is going to be right up there with “bring them home” when it comes to sloganeering on the campaign trial next year.

Just a quick note on this last excerpt: this piece was just published today -- I hadn't read it before I made a similar claim on Miles Maguire's blog a few days ago.

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