2007 November 17 Saturday
Financial System Could Come To Grinding Halt?

A guy at Morgan Stanley thinks we are at very high risk of an enormous financial melt down as a result of fall-out from the sub-prime mortgage debacle. This really does not sound good.

There's a greater than 50 percent probability that the financial system ``will come to a grinding halt'' because of losses from mortgages, Gregory Peters, head of credit strategy at Morgan Stanley, said.

I really do not want to live through a worldwide depression. I don't feel the need to wash off my sins in extreme poverty, to suffer, to atone with a "Grapes Of Wrath" sort of existence. I'm not bored and in need of the excitement of a huge disaster. I don't get off on fantasies of doom and gloom.

The problem involves "structured investment vehicles" (SIVs). It sounds pretty bad.

``You have the SIVs, you have the conduits, you have the money-market funds, you have future losses still in the dealer's balance sheet in the banks,'' Peters said in an interview in New York. ``That's all toppling at once.''

The risk of systemic shock from the current subprime meltdown is quite large in the near term, Peters said. ``It's an overarching concern that we have,'' he said.

How long is this "near term" of which he speaks? If we make it past Christmas without a Black Friday (or Black Tuesday?) are we then out of the woods?

Anyone know how to watch this one? What particular indicators to watch? Came across any particularly telling statistics about things financial?

Click through and on the right click to watch the 8 minute interview of Gregory Peters. His fear is that securitization of debt has basically frozen up. So then how quickly does that start cutting spending by businesses or consumers? Will this cause a huge credit crunch and therefore a deep recession?

Will bond buyers go away because they will no longer trust the ratings of bonds assigned by credit ratings agencies?

Update: So how did we get into this mess? A massive market failure. James Surowiecki argues in a New Yorker piece that we are in this difficult financial situation because money managers were presented with incentives to take too much risk.

The havoc on Wall Street following the collapse of the subprime-mortgage market boils down to a simple truth: for years, lots of very smart people took lots of very foolish risks, betting borrowed billions on dubious mortgage derivatives, and eventually the odds caught up with them. But behind that simple truth is a more surprising one: the financial whizzes made bad decisions in part because that’s what they were paid to do.

Fund managers are much more rewarded for success than they are punished for failures.

Fund managers get bonuses at the end of each year, and they keep those performance fees even if the fund eventually goes south. So if a billion-dollar hedge fund rises twenty per cent in its first year and falls twenty per cent in its second, its investors will have lost money, while the fund’s manager might earn forty million dollars in performance fees. Hedge funds do have a rule that’s meant to deal with this problem: when a fund loses money, it yields no performance bonus until investors get back to even. The catch is that nothing prevents a hedge-fund manager from simply shutting down after a bad year and walking away with the fees he’s already accrued.

Even CEOs are incentivized to take too much risk.

To a shareholder, the difference between a stock that’s at thirty dollars and a stock that’s at twenty means a lot. But to a C.E.O. who has a pile of options with a strike price of thirty-one dollars, the difference means much less. As a result, that C.E.O. is likely to embrace projects that promise big rewards, even if they also entail a significant chance of failure.

That piece is worth reading in full.

Tyler Cowen responds to Surowiecki by saying we are taking the wrong kinds of risk.

With hedge funds, are we now above or below the optimal amount of risk? The answer of course is "we are taking the wrong kinds of risk." We are finding more and more ways to (implicitly) write naked puts in highly leveraged forms. Yes this has brought us new products but it all seems to be new mortgage products. Could those products possibly justify the financial carnage we have seen? That is the critical question but I suspect the answer is "no," that in this sphere we stepped beyond the bound of optimal risk-taking.

That financial carnage is so huge that the Federal Reserve is trying to prevent a total melt down and some guy from Morgan Stanley warns us that our credit markets are at high risk of entirely freezing up. I'd say these financial products haven't so sped up economic growth that they could possibly outweigh the costs of the added risks. Plus. as Tyler points out money has been misallocated to the wrong kinds of risks. Money lost in subprime lending could otherwise have funded venture capital start-ups or capital expansions of industrial corporations.

Update II: What is the mechanism by which the credit markets could freeze up? One part of it: Massive downgrades of debt. Hundreds of billions of dollars of bonds could (actually are) get downgraded from AAA or AA to junk levels of ratings. Worse yet, the ratings agencies that gave so many collateralized debt obligations (CDOs) AA and AAA in the first place are losing credibility with potential bond buyers. If you want to buy high grade debt and you find that AAA handed out to new debt last year means something between squat and zilch why trust what Fitch or Moody's claims is AAA this year?

The scope of this crisis is breathtaking. If you haven't been paying attention to it I strongly urge you take the time to do so now. Stoneleigh at The Oil Drum has a pretty good round-up of articles about debt downgrades and the possible collapse of private mortgage insurers. If this chokes off new mortgage availability the price slump we've seen so far in housing will seem pretty mild in comparison to what is coming. Take away sources of new mortgages and housing prices will plunge and that plunge will make mortgage companies even less willing and less able to loan. The vicious spiral could take the US economy down into a real depression. So the stakes in this financial crisis are enormous. Can the financial people in the US government and Wall Street figure a way out of this mess that avoids a huge downturn in real estate?

The financial guys do not sound confident.

The US mortgage crisis is “deeper” and “scarier” than anyone expected, Tony James, president of Blackstone, said on Monday, as shares in the US private equity group fell on news that its revenues had fallen sharply below expectations in the third quarter.

...

“The mortgage black hole is, I think, worse than anyone saw. Deeper, darker, scarier. [The banks] are now looking at new reserves and my sense . . . is they don’t have a clear picture of how this will play out and confidence is low.”

Is there a way to somehow firewall the effects of this crisis?

Share |      By Randall Parker at 2007 November 17 10:20 PM  Economics Business Cycle


Comments
John S Bolton said at November 17, 2007 11:03 PM:

This sounds like an exaggeration. Remember the world financial system today has no determinative free-market
features; it funnels dollar-support from central banks into embarassingly faux-capitalist Wall Street, and that
money gets spread around. Whatever it stampedes into next, will be the next bubble. Economic history no longer tells us much, not, that is if analogies from the 1930's or earlier are to be applied as if we were dealing with something other than government programs here and abroad. Our economy and those of most countries are evaluated and decided upon in terms of the dollar, the value of which is manipulated in extreme degree by central banks.

Dennis Mangan said at November 18, 2007 6:22 AM:

Someone, somewhere, is always preaching doom and gloom. Sometimes they're right, but most often not. Helicopter Ben will do whatever is needed to prevent financial meltdown. A Wall Street saying has it that "a bull market climbs a wall of worry".

Irish Savant said at November 18, 2007 3:34 PM:

I wouldnt be too worried. These 'experts' have got it wrong so often that this one should attract no greater credibility.

Jerry Martinson said at November 19, 2007 9:49 PM:

This whole thing seems scary to me. We haven't seen this since the late 1920's. There is now the very real spectre of massive bank runs that could really screw things up unless the Fed injects buckets of cash into the banks. The problem is doing so would not punish the idiots who helped get us into the mess. There are a few financial organizations (i.e. Vanguard's FGI) that had the foresight to screen so-called AAA securities for hidden foolish mortgage risks - and they'd be right if they complained that a huge Fed bailout was unfair to them because it effectively doesn't reward them for taking the smaller yields and not contributing to the stupid bubble. Not doing a huge bailout is going to focus the pain on those unfortunate few who get stuck without a chair when the bank run music ends. That will be a lot more disruptive than a drop in the dollar (which given the trade balance was long, long, overdue).

All during the housing boom I was smug thinking only idiots would lend money to people building spec houses in the middle of B.F.E. where there are essentially no jobs that aren't associated with real-estate. I thought that in a downturn those idiots would be getting what they deserved. Unfortunately, I had only recently become aware that even if one has kept their investments out of this mess, they can still get stuck in the mess because the banks are all busted. It would really burn me up if haphazard bank collapses screwed poeple who had nothing to do with the "Swap this House" fad.

It's pretty clear that many in the financial industry weren't doing their due-diligence. The financial industry obviously has little understanding of statistical phenomena if they can't properly model risks based on "fundamentals" rather than purely "technicals". This happened with LTCM, the tech bubble, and now this. Until the bias towards technical analysis in financial risk modeling (i.e the alter of Black-Sholes) is corrected in favor of fundamentals, we're going to continue to see bubbles caused by synthetic financial products that merely obscure risk rather than accurately communicate and arbitrage it.


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