Sunday, December 09, 2007

If Al Gore wrote about Economics

In Today's Sacramento Bee an article titled "Dark Days Certainly Ahead for the Economy" (the Post headline was even more ominous - It's Not 1929, but It's the Biggest Mess Since )Steven Pearlstein concludes with the ominous "This may not be 1929. But its 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."

Pearlstein is the business columnist for the Washington Post. And in the article he goes through a rough cut on how CDOs (Collateralized Debt Obligations) are somehow the newest evil plot from Wall Street. These relatively new financial instruments bundled things like mortgages together to sell in the financial markets thus increasing liquidity in the markets.

CDOs have introduced a lot of very positive things into the financial markets. However, there are a couple of problems with them. First, in relation to the bundling of mortgages - the real problem facing us here, like the problem we faced with the S&L crisis, was the liberalization of lending standards. Lenders, to compete for business, introduced two sets of "innovations" into the mortgage market in recent years. The first was a very low teaser rate which reset after an initial period. The second was a 100% (or in some cases a 105%) loan. In both cases the sting comes not from the way the mortgages are marketed but because the two new innovations allowed a number of buyers to get into a house without any real "skin" in the game.

I am not sure what the junk bond crisis of 1987 was. Indeed, during the 1970s and 1980s the financial markets increased the range of things they would finance and in the late 1980s there were a series of highly leveraged debt instruments which cratered. But before that we got the benefits of a lot of new ventures that were financed and which would not have been without the "junk" bonds. In the S&L "crisis" we changed a couple of rules for Savings and Loans - by raising the guarantee level and by diversifying the portfolio which these financial institutions could invest in. The result was a lot of junk in the market. Same thing here.

Pearlstein, like Gore, seems to throw around a couple of technical terms, paint a scary picture and then hope to hell that all of us shudder. Well, don't. Financial markets correct. Loan standards for mortgages are tightening. And for a while they are likely to be very tight. But then the markets will adjust. We still have highly leveraged debt instruments (Junk Bonds), we still have home lending institutions (most all of the federally chartered S&Ls are gone - and that is a good thing but there are lots of other places to get home loans), and we still have a vibrant tech sector(although we got rid of a lot of the wild talkers in the 1990s). The answer is that we will get through this problem. Hopefully, we will get away from the giddy exuberance of the last few years and some of the fools who were lured into idiotic mortgages and some of the fools in the financial markets who created these idiotic instruments will get burned.

But let's get some numbers clear. The most terrible estimates of the depth of this problem reach about 3% of GDP - certainly higher than the tech bubble (which was about 1%) but rivaling the S&L crisis and considerably lower than other financial crises that have faced the US or other nations (the Japanese bank crisis was about 7% of GDP). There are some things to worry about here including the perceptual problem since most of the assets here are leveraged. The perceptual problem could be significant - if people like Pearlstein continue to cry wolf - people might actually believe that the numbers are worse than they actually are. That could be a larger problem than the real one.

But because we should be cautious and alert does not suggest that we should be shuddering - we should not leap into solutions and that is the worry of Pearlstein's column. I am not a big fan of the President's freeze (although it seems so small that it will not affect many borrowers). And I would be even less excited about some other government solution - let the markets sort it out not some merchant of the apocalypse.

No comments: