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Monday, December 03, 2007

Why not just use the "D" word?
Posted by Jill | 6:40 AM
We've all been through recessions before. In my adult life, I've been through the oil embargo-fueled recession of 1973-75, the 1980 recession, the 16-month recession from July 1981 - November 1982 (during the sainted Reagan years), the 1990-1991 recession (during the King George I years), and the 2001 post-dot-com bust recession. Each one has meant some scary times, some scarier than others (like getting up at 4 AM to be on the line at the gas station by 5 to ensure being able to fill up the tank before the station runs out); and I hardly felt others. I suspect that many people's experiences are similar. If you can keep your income stream during a recession, it's historically been enough to largely insulate one from the recession's worst effects.

But the likely recession resulting from the housing bust and credit fiasco feels different; different to the point that I'm wondering why Paul Krugman doesn't just use the "D" (depression) word -- because that's what it's going to take before people wake up:

How bad is it? Well, I’ve never seen financial insiders this spooked — not even during the Asian crisis of 1997-98, when economic dominoes seemed to be falling all around the world.

This time, market players seem truly horrified — because they’ve suddenly realized that they don’t understand the complex financial system they created.

Before I get to that, however, let’s talk about what’s happening right now.

Credit — lending between market players — is to the financial markets what motor oil is to car engines. The ability to raise cash on short notice, which is what people mean when they talk about “liquidity,” is an essential lubricant for the markets, and for the economy as a whole.

But liquidity has been drying up. Some credit markets have effectively closed up shop. Interest rates in other markets — like the London market, in which banks lend to each other — have risen even as interest rates on U.S. government debt, which is still considered safe, have plunged.


“What we are witnessing,” says Bill Gross of the bond manager Pimco, “is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.”

The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction — and that will mean a recession, possibly a nasty one.


But the innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.

Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs. We know, in particular, that Alan Greenspan brushed aside warnings from Edward Gramlich, who was a member of the Federal Reserve Board, about a potential subprime crisis.

And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the Treasury secretary, admitted to Fortune magazine that financial innovation got ahead of regulation — but added, “I don’t think we’d want it the other way around.” Is that your final answer, Mr. Secretary?

Now, Mr. Paulson’s new proposal to help borrowers renegotiate their mortgage payments and avoid foreclosure sounds in principle like a good idea (although we have yet to hear any details). Realistically, however, it won’t make more than a small dent in the subprime problem.

The bottom line is that policy makers left the financial industry free to innovate — and what it did was to innovate itself, and the rest of us, into a big, nasty mess.

Here in Bergen County, the housing bust hasn't hit all that hard, at least not at the lower end of the "better" towns. What's known in the vernacular as a 1950's "POS Cape" or ranch, if maintained, can still sell if priced aggressively enough. But because this is an area with a sizable influx of undocumented immigrants, largely driven by the proliferation of landscaping companies and contractors, we're seeing towns creating intrusive ordinances designed to have the effect of preventing foreclosed and dumped houses from turning into warehouses for undocumented workers. One local town has an ordinance that if you add a fourth bedroom onto your house, you must have a two-car garage. The assumption is that if you add that fourth bedroom, the number of cars you have must be indicative of a larger family. Another is putting through an ordinance allowing inspectors to enter any premise if there is a suspicion that a homeowner is renting part of the house to an unrelated person.

With many adjustable-rate mortgages resetting in 2008, the subprime fallout has barely begun. Proposed legislation to freeze "teaser" rates may help homeowners in the short term, but doesn't address the underlying problem. ARMs allow banks to lend at low rates with the mortgagee assuming the risk of rate hikes. If teaser rates are frozen, suddenly the lender is assuming the risk. Does anyone think that the banks will absorb this or bite the bullet and reduce profits? Hardly -- and I suspect that what we'll see is a hike in lending rates for those with good credit to subsidize those who bit off more than they could chew. The net result will be a drop in healthy lending and the whole thing comes to a standstill. Then those whose teaser rates are frozen will still find themselves sitting in a depreciating asset; one they still can't afford to sell no matter what the rate.

I'm not sure what the answer is, other than that we are all in for a complete world of shit in the next few years.


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