Monday, December 03, 2007

No Credit Where No Credit Is Due

Paul Krugman's discussion of the current credit crunch (I detest the word "crisis", because this isn't one; a crisis is a momentary problem where difficult choices confront us; we are in the midst of the contraction of the credit markets) is very good, and needs to be studied. I would like to add a thought or two (pretty big of me, huh, "adding" to Paul Krugman; maybe I'm not as humble as I advertise . . .).

First, the collapse of the housing bubble is not "the crisis". The collapse of the subprime mortgage market is not "the crisis". As Krugman rightly notes, these are symptoms of, and precursors to, a larger collapse not so much of consumer and home-owner credit, but of liquidity in general. That is, while it is indeed a human tragedy that thousands, and perhaps even a million or two, folks will be foreclosed upon, while the Bush Administration lectures us all on the wisdom and propriety of free markets. The systemic problem, however, is that the foundation upon which so much of business to business lending (via banks) depends no longer exists. Not just the subprime mortgages, but mortgages in general - second mortgages, taken out on over-valued properties; regular mortgages taken on over-valued properties - are in many ways the key ingredient, the "lubricant" as Krugman calls it, of lending. Most of those mortgages are worhtless, not because the people who are paying in to them are shiftless, lazy, and looking for a way to dodge their financial obligations, but because the homes for which these mortgages are supposed to pay have suddenly become less valuable. Imagine paying $10 for something, only to discover the real price was $5. You would feel ripped off. Now, imagine taking out a mortgage for $750,000 for a home now valued at $375,000. Not only would you feel ripped off, but you might be a tad annoyed at the bank that is suddenly demanding more collateral on the mortgage because the value of the primary asset is less than the amount of the mortgage.

Like yesterday's post on what happens to a nursing home when it's owned by investment bankers, this is a story about what happens when people look to financial instruments as a means toward personal wealth. Some people got incredibly wealthy, trading and re-trading all these loans, until it became clear the underlying real-world value upon which these loans were made couldn't cover them. It is nice that predatory lending services are taking a hit. It is nice that big banks are taking a bath. It isn't so nice, however, that credit in general is contracting; the loss in value of property is becoming a loss in the confidence between lenders and debtors.

The last time the United States had a liquidity crisis, it was called the Great Depression. In the weeks running up to the March 4 inauguration of newly elected President Franklin Delano Roosevelt, thousands of banks, and more and more states went under. There was no longer any real cash in the system for it to operate; what's more, there was no confidence it could operate. People hoarded what little money they had, refusing to spend it. What starts out as a collapse of credit markets could very easily, given a few wrong notes and some bad news, become a liquidity collapse. I don't know if that will happen, but the facts do not bode well for the near-term. Consumer prices are up sharply, durable goods orders are down, which means we will probably be facing a recession sometime in the next year. It could get nasty, however, if consumer prices continue to rise and there isn't the kind of cash-flow in the system to support purchases of necessity, especially of those consumer items for which elasticity is pretty low - like gas and milk (our local Wal-Mart raised the price of a gallon of milk 55 cents in one day last week).

While the bankers are looking to the Fed for a bail-out, I think the situation has passed the point where intervention could do much good. In fact, the point where intervention was needed was two years ago when some folks, like Paul Krugman, started talking about how ridiculously over-priced home values were, and how ridiculously easy it was to take out a mortgage on an overpriced home with little or no down payment or collateral other than the over-priced home itself. Whenever someone on Wall Street or in a Big Bank starts saying the old financial rules don't apply - that's when it's time to zipper your wallet shut and run in the opposite direction. That is also the time Financial Services Regulators should be doing some policing; of course, our current Administration thinks that is tantamount to blaspheming the Holy Spirit, so I'm not surprised there wasn't much help there.

My prediction is simple. Things are going to get quite nasty over the next twelve months. There isn't much anyone can do to ease the pain we are all going to feel, however, so I do think we need to fasten our seat belts, because the ride is going to get bumpy.

Virtual Tin Cup

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