Is an economic Katrina poised to overtake the financial system's levees?
(MarketWatch) -- Could the turmoil in the markets in the past few weeks be the precursor of a full-blown credit crunch that could force the U.S. and global economies into a recession?
Some observers think that the markets are exhibiting classic signs of a so-called "Minsky moment," when overleveraged borrowers must finally pay the piper for their euphoria. The result, they say, will be a credit shortage that could bring down even innocent bystanders in their wake.
Academics, economists and money managers are all sounding the alarm. Financial markets are counting on the Federal Reserve to drop interest rates to cushion the fall, and yet senior officials at the central bank have insisted that the markets must discipline themselves.
'I think the market wants to believe that we're pretty much done with the shakeout.'
— Paul Nolte, Hinsdale Associates
Market professionals seem resigned that the fallout is inevitable, and has already begun with losses in several rocky sessions on Wall Street.
"The feeling I have today is that of watching a very slow motion train wreck," wrote Jeremy Grantham, chairman of GMO LLC, which manages about $150 billion in assets.
The S&P 500 index is now pricing in a recession starting in late 2007 and lasting for most of 2008, led by the financial sector, said David Bianco, chief equity strategist at UBS. "We believe the market expects this recession to slash S&P 500 [earnings per share] by about 10%," Bianco said.
Most economists don't share that view. Of the more than 50 economists surveyed by the Blue Chip Economic Indicators, (many of whom have been warning about the housing bubble for years), none predict even one quarter of negative U.S. growth over the next two years.
A growth recession, with rising unemployment along with slow growth in output and sales, "is a certainty," said Dimitri Papadimitriou, president of the Levy Economics Institute, a think tank at Bard College. That's where economist Hyman Minsky fleshed out his theories of a credit-business cycle, which emphasized a close connection between the creation and destruction of asset bubbles in financial markets and the timing of economic expansions and recessions.
Hard landing?
The last two recessions, Papadimitriou said, follow the Minsky analysis to a "T." In the current cycle, he said, "economic activity will decline. The only debate is whether it'll be a soft landing or a hard landing."
While the stock market's gyrations are proof that credit-crunch fears are on the mind of many investors, thus far only a minority of market participants say they believe it will happen. Most seem to think it's far-fetched, largely because the global economy is strong, with ample reserves of liquidity.
"I think the market wants to believe that we're pretty much done with the shakeout, that the economy has been OK, and that the impact is more of a financial-related impact than an economic impact," said Paul Nolte, director of investments at Hinsdale Associates. "As long as those economic numbers stay solid, then we're fine."
Despite some signs that the carnage in the subprime sector has already slowed consumer spending growth, the problem is still mostly a financial one, said Tony Crescenzi, chief bond market strategist for Miller Tabak & Co., who asserts that corporations still have a ready source of funding for projects that will help the economy grow.
The loss of funding for the leveraged buyouts is a "yawn." Crescenzi said. "Good riddance to LBOs," which add no value to the economy except in the very long run.
In a research note to clients this past week, Crescenzi pointed to several factors that "weigh against the possibility of a broader credit crunch and make it likely that market turmoil will subside and credit formation will return to levels sufficient to power continued economic expansion."
Among Crescenzi's positive factors: Corporations are flush with cash and other highly liquid assets, some $1.7 trillion by one account. Banks are well capitalized. Money-supply growth rates are strong worldwide.
Still, even a skeptic such as Jay Bryson, global economist for Wachovia, acknowledges that "there is a significant risk that credit availability could become seriously impaired."
In a genuine credit crunch, Bryson explained, lenders broadly curtail credit - including for well-qualified borrowers. In such a scenario -- even if interest rates were to come down - the supply of credit wouldn't match the level of demand.
"Credit is the mother's milk of economic expansion," said Mark Zandi, chief economist for Moody's Economy.com.
Some economists see very real prospects there could be more bombshells later this year when a large number of homeowners' adjustable-rate mortgages are expected to reset at sharply higher rates.
Global credit markets are overleveraged, says economist Nouriel Roubini of Roubini Global Economics. That's how the hedge funds and private-equity firms were able to reap such fantastic returns. But with underlying assets leveraged 10 or 20 or 50 times, even a small decline in asset values can wipe out the entire investment, or trigger a demand for immediate payment, causing a cascading default among all the parties to a deal that's gone bad.
Ponzi investors
Minsky theorized that an asset bubble has three stages. In the first, so-called "hedge" investors can pay off the interest and principal from their cash flow. Healthy returns push up prices, attracting the "speculative" investors of the second stage, who can meet their interest payments from cash flow with the help of liquid capital markets, but would have to sell off assets to pay off the principal. In the third stage, "Ponzi" investors rush in, relying on the continual appreciation of the value of the asset to pay the interest or the principal.
If the asset loses value, Ponzi investors lose everything and speculative investors get squeezed. That's the Minsky moment.
Even the stodgiest economics institution in the world, the Bank of International Settlements, has a Minskyan analysis of the current situation: "There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking," the group said in its annual report last month. Such cycles inevitably end when fundamentals have been overpriced.
The Ponzi investors didn't stop with mortgages, as we now know.
Euphoric investors, greedy for return and insensible to risk, poured money into complex corporate debt deals that were as questionable as a subprime no-documentation interest-only adjustable-rate mortgage.
"Who now holds these risks, and can they manage them adequately?" the Bank of International Settlements said. "The honest answer is that we do not know."
Early signs of an impending credit crunch are everywhere:
Mortgage lenders going out of business, and the lenders left standing are closing their subprime and Alt-A origination channels.
The spread between corporate debt and riskless Treasurys has widened dramatically. Standard & Poor's has said most corporate debt is now speculative grade.
Credit for leveraged buyouts has dried up, with dozens of deals canceled, postponed or repriced. The market for complex derivatives such as collateralized debt obligations has shut down like a "constipated owl," according to bond fund manager Bill Gross.
The price of insuring asset-backed securities against default has soared.
Washington's policy-makers insist that the levees will hold, that the mess in subprime lending will be "largely contained," in the words of Treasury Secretary Henry Paulson.
For their part, Fed officials have been hinting strongly that it'll take more than an "upset" market to get them to cut interest rates at a time when they are still focused on inflation as the main threat. The "Greenspan put," which guarantees a market floor, is out of the question, they say.
"The Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment, or when financial market developments threaten market processes themselves," as William Poole, president of the St. Louis Federal Reserve Bank, put it in a speech this week. "The central bank can wait for market responses" most of the time.
Many people insist that low interest rates got us into this mess, and they should not be used to get us out, lest another bubble inflate in other assets. Loose lending standards are the last thing the economy needs.
But the looming election year makes it almost certain that both the Fed and the Congress would act if the economy slipped into recession. "Macroeconomic policy will be critical," Papadimitriou said. "If the Fed and Congress can work to stop any incipient recession, they will prevent job losses, which are one of the main contributors to foreclosures."
Washington should be the "employer of last resort," he said, and the Fed should be ready to step in as the lender of last resort, especially to pension funds that are more exposed than banks are.
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