The Subprime Crisis Explained

Oh, and it's hilarious:

Greenspan on the Economy

He runs down the situation. In his conclusion, he advocates not throwing the baby out with the bathwater by over-regulating financial markets.

(ht: Mankiw)

Upside-Down Town

From Greg Mankiw, we see that real interest rates are now negative. Is this a big deal? Mankiw says... probably not:

In standard models of asset pricing, negative real interest rates are most likely to arise if growth expectations are particularly low or if uncertainty is particularly high. Low growth expectations encourage households to save, which drives down equilibrium rates of return. High uncertainty drives up risk premiums, which in turn drives down the return on safe assets, perhaps below zero. Both forces seem to be working now.

In other words, this is a reflection of other bad things in the economy, esp. low confidence, but it isn't actually a horrible thing in and of itself.

However, credit markets are already having trouble staying afloat. With real rates of return now negative, it might be harder to get the credit markets back on their feet.

The Ignored Emerging Economic Power

Brazil is now the world's largest "emerging economy," pushing past China, as measured by Morgan Stanley's country index of equity markets.

What Is This 'Decoupling' of Which You Speak?

Dani Rodrik notices that businessmen in emerging economies are relatively nonplussed about the possibility of a U.S. recession:

But if you talk to businessmen (alas they were all men) from India, Russia, China, Turkey or the Gulf States, you would hardly know that we have just experienced a credit market freeze-out in the West. They are all ho-hum about it. Yeah, we could shave a point or two off our growth estimates, they say, if the U.S. goes into a deep recession, but it's no big deal--and can you pass the wine please. Indians are saying we don't rely that much on exports anyhow; the Chinese are relying on their growing middle class; and others have their own stories.

Is this the famous "decoupling" at work? Will this be the beginning of a new era of the world economy, with several key developing countries, the BRICs and the N-11 (using the faddish terms that attach to them), gaining real ascendancy over their Western counterparts?

Probably not. But something interesting is going on.

Meanwhile, the world's financial markets -- from the relatively deep and rich (EuroZone) to the relatively shallow and unsure (Asia) -- have not reacted very well to trouble in the U.S. markets and the possibility of recession:

Decoupling holds that European and Asian economies, especially emerging ones, have broadened and deepened to the point that they no longer depend on the United States for growth, leaving them insulated from a severe slowdown there, even a fully fledged recession. Faith in the concept has generated strong outperformance for stocks outside the United States - until now.

As opinion began to solidify after the start of the year that a recession, or something close to it, was likely in the United States, stock prices accelerated their declines, with the selling intensifying early last week. Contrary to what the decouplers would have expected, the losses were greater outside the United States, with the worst experienced in emerging markets and developed economies like Germany and Japan. ...

Decoupling was all the rage early last year when international financial markets all but ignored the increasing turmoil in the U.S. economy and stock market. Investment advisers point out, however, that the segments of the U.S. economy that were showing wear and tear then were those to which the rest of the world would never be heavily exposed. That is no longer true, they say, and markets are responding accordingly.

"Decoupling is yesterday's story," Stuart Schweitzer, a global strategist at JP Morgan Private Bank, said. "Last year, when the U.S. slowdown was driven almost entirely by housing, it made sense that the rest of the world kept right on going. Housing is a domestic story, plain and simple.

"The nature of the slowdown has changed in two key respects. The credit crunch that began in midsummer is not just a U.S. phenomenon; the rise in risk aversion is global and will have an impact on credit terms and availability everywhere. And we're finally seeing evidence that the U.S. job market is losing steam and consumer spending is slowing."

The fact of the matter is that many markets, particularly financial markets, are most integrated than they have ever been. This is good for spreading risk around, and it helps produce more efficient investment outcomes. And, if some developing country gets into trouble, it is both easier for them to get back on their feet and for investors in that country to not go bankrupt in the fall-out.

But this whole system still revolves around the U.S. It may be true that the world somewhat less dependent on the U.S. than they were in the 1990s (although this is arguable), but it is not true that the world isn't still dependent on the U.S. At this point, "decoupling" is something of a myth. In the future, it will probably become reality, but not in the sense that most people mean it. It won't mean that individual economies will be less susceptible to major movements in major companies; rather, it will likely that the relative importance of the U.S. over all others declines somewhat. The absolute importance of the U.S. will remain for a long, long time.

Another Glimpse into Chavez's Fantasy World

Hugo Chavez says that Latin American countries should pull their currency reserves from the U.S., and has established a brand new bank to house the relocated cash.

Because, you know, Latin America never has currency crises or anything, and Chavez has never manipulated his own currency in order to combat runaway inflation due to his misguided price controls.

Nope. The U.S. is an unsafe, unprofitable place for investors, which is probably why the U.S. receives more FDI than any other country in the world every year.

Bad Headline

Here's the headline: "Inflation jumps in 2007".

Here's the beginning of the article: "Higher costs for energy and food last year pushed inflation up by the largest amount in 17 years, even though prices generally remained tame outside of those two areas."

Yes, that's right. The first sentence contradicts the headline. You have to make it to the end of the article to get the appropriate context:

Outside of food and energy, inflation rose a more moderate 0.2 percent in December. This measure of core inflation rose by 2.4 percent for all of 2007, down slightly from a 2.6 percent increase in 2006.

The Federal Reserve is closely watching to see whether the jump in food and energy becomes more widespread and starts pushing core inflation higher.

Analysts said that with core prices generally remaining well-behaved, it will give the central bank the leeway to cut interest rates further to battle a serious economic slowdown triggered by a steep slump in housing and a spreading credit crisis. ...

Energy costs rose by 17.4 percent this past year while food costs rose by 4.9 percent. Both were the biggest increases since 1990. Gasoline prices were up 29.6 percent, the biggest increase since they soared by 30.1 percent in 1999.

The 2.4 percent rise in prices outside of food and energy was the smallest since a 2.2 percent rise in 2005.

The Fed looks at core inflation independent of food and energy costs because food and energy costs are much more volatile than the rest of the economy for reasons which have nothing to do with economic stability. A hurricane in the Gulf of Mexico, for example, might cause oil and food prices to rise but everything else in the economy to stay relatively the same. The Fed shouldn't be looking at weather forecasts when setting monetary policy.

Additionally, energy prices are highly sensitive to oil prices which are set globally, not nationally. Also, some rise in energy and food prices will affect core inflation, since energy and food are inputs to other goods, and can replace other types of consumption and investment spending.

All in all, I look at this and see good news: core inflation was lower in 2007 than it was in 2006. This should give the Fed some flexibility in combating the financial meltdown which is still deepening.

Mad About You

Alex Tabarrok directs us to Business Week, where we learn that "Mad Money" host Jim Cramer no longer supports stock-picking for most investors, instead encouraging people to buy index funds:

Most people actually won't get rich by buying individual stocks, Cramer says. Unless you do your homework, namely spending an hour a week researching for each stock you own, "You won't beat the market, and you'll probably lose money," he writes.

For Cramerites willing to do the research, the book helps construct a long-term, diversified portfolio. For most people, however, he advises low-fee stock index funds.

What Cramer doesn't mention is that even if you do your research, you are still as likely to under-perform the market as to beat it. Seasoned finance professionals, including Ph.D.s, fail to beat the market (on average) when they pick stocks. There is no good reason for most individuals to pick stocks unless they enjoy gambling and there isn't a casino nearby.

This interview with Eugene Fama, one of the founders of the Efficient Markets Hypothesis, is instructive (ht: Megan McArdle).

Great Primer on the Mortgage Situation

Steven Pearlstein is not optimistic:

It was Charles Mackay, the 19th-century Scottish journalist, who observed that men go mad in herds but only come to their senses one by one.

We are only at the beginning of the financial world coming to its senses after the bursting of the biggest credit bubble the world has seen. Everyone seems to acknowledge now that there will be lots of mortgage foreclosures and that house prices will fall nationally for the first time since the Great Depression. Some lenders and hedge funds have failed, while some banks have taken painful write-offs and fired executives. There's even a growing recognition that a recession is over the horizon.

But let me assure you, you ain't seen nothing, yet.

What's important to understand is that, contrary to what you heard from President Bush yesterday, this isn't just a mortgage or housing crisis. The financial giants that originated, packaged, rated and insured all those subprime mortgages were the same ones, run by the same executives, with the same fee incentives, using the same financial technologies and risk-management systems, who originated, packaged, rated and insured home-equity loans, commercial real estate loans, credit card loans and loans to finance corporate buyouts.

It is highly unlikely that these organizations did a significantly better job with those other lines of business than they did with mortgages. But the extent of those misjudgments will be revealed only once the economy has slowed, as it surely will.

At the center of this still-unfolding disaster is the Collateralized Debt Obligation, or CDO. CDOs are not new -- they were at the center of a boom and bust in manufacturing housing loans in the early 2000s. But in the past several years, the CDO market has exploded, fueling not only a mortgage boom but expansion of all manner of credit. By one estimate, the face value of outstanding CDOs is nearly $2 trillion.

But let's begin with the mortgage-backed CDO.

By now, almost everyone knows that most mortgages are no longer held by banks until they are paid off: They are packaged with other mortgages and sold to investors much like a bond.

In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its entire investment was wiped out, followed by the next riskiest and the next.

With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches -- those with the lowest credit ratings -- were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities -- some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.

It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used -- in buying the original mortgages, buying the tranches for the CDOs and then in buying the tranches of the CDOs -- the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. No wonder they were snatched up by British hedge funds, German savings banks, oil-rich Norwegian villages and Florida pension funds.

What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value.

One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those will suffer losses of 6 to 31 percent.

And looking across the sector, J.P. Morgan's CDO analysts estimate that there will be at least $300 billion in eventual credit losses, the bulk of which is still hidden from public view. That includes at least $30 billion in additional write-downs at major banks and investment houses, and much more at hedge funds that, for the most part, remain in a state of denial.

As part of the unwinding process, the rating agencies are in the midst of a massive and embarrassing downgrading process that will force many banks, pension funds and money market funds to sell their CDO holdings into a market so bereft of buyers that, in one recent transaction, a desperate E-Trade was able to get only 27 cents on the dollar for its highly rated portfolio.

Meanwhile, banks that are forced to hold on to their CDO assets will be required to set aside much more of their own capital as a financial cushion. That will sharply reduce the money they have available for making new loans.

And it doesn't stop there. CDO losses now threaten the AAA ratings of a number of insurance companies that bought CDO paper or insured against CDO losses. And because some of those insurers also have provided insurance to investors in tax-exempt bonds, states and municipalities have decided to pull back on new bond offerings because investors have become skittish.

If all this sounds like a financial house of cards, that's because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.

That's not just my opinion. It's why banks are husbanding their cash and why the outstanding stock of bank loans and commercial paper is shrinking dramatically.

It is why Treasury officials are working overtime on schemes to stem the tide of mortgage foreclosures and provide a new vehicle to buy up CDO assets.

It's why state and federal budget officials are anticipating sharp decreases in tax revenue next year.

And it is why the Federal Reserve is now willing to toss aside concerns about inflation, the dollar and bailing out Wall Street, and move aggressively to cut interest rates and pump additional funds directly into the banking system.

This may not be 1929. But it's a good bet that it's way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.

Might be a good time to go back to school, since the labor market is gonna suck next year.