How big a slump?

With the Oz stock market falling nearly 5 per cent on Thursday, and down nearly 15 per cent in the last few weeks, it’s a good time whether this will have real effects beyond the value of our superannuation. The immediate starting point of the current disruptions was evidence that defaults on US mortgage markets were worse than expected. An obvious question is whether this underlying shock is large enough to have substantial effects in itself, or whether the problem is mainly one of liquidity and confidence.

Ben Bernanke has estimated possible losses from subprime mortages at between $50 billion and $100 billion. As this article notes, that figure may sound large, but it would represent a tiny fraction of the $56.2 trillion in U.S. household net worth. To be precise, it’s somewhere between 0.1 per cent and 0.2 per cent of net worth.

Arguably, to the extent that real resources are dissipated, as commonly happens in a process of default the relevant comparator is something like annual output. Expressed relative to annual output, a loss of $50 billion to $100 billion bit larger (between 0.5 and 1 per cent) but still not really scary. We could get to a similar number by supposing that house values will decline modestly in response to the crisis.

It appears that there is around a $1 trillion dollars in sub-prime debt outstanding, and much of this is likely to go into default this year, as house prices fall and interest rates (initially at low teaser rates) reset. The loss from default is confined to the costs of foreclosure and the shortfall in recovery when the house is sold, but it seems likely to be at or above the high end of Bernanke’s range.

The real problems emerge if there are more bad loans elsewhere in the economy. It’s already become apparent that housing defaults go beyond the sub-prime sector to the Alt-A sector (low-doc loans to borrowers with good credit) and maybe beyond. More generally, a lot of recent financial market activity has been premised on the assumption of cheap debt or, more precisely, a low price for risk. A higher price of risk implies that there must be quite a few heavily geared assets that are worth less then the debt they secure.

We’re still waiting to see how large the losses are. As a rough guess, I’d say that a quick response from the central banks can deal with liquidity problems if the total losses are less than about $500 billion. After that, it’s anyone’s guess.

12 thoughts on “How big a slump?

  1. Fed just cut the discount window rate by 50 basis points.

    Normally the banks don’t like to “go to the discount window” – it’s like a reserve pool of Fed funds that sits 100 basis points above the normal Fed overnight rate and it is not a good look to tap it.

    By cutting the difference between the overnight and discount window rates in half the Fed is saying “come to the window if you need to”.

    Big short covering rally underway in the pre-market.

    Once that’s out the way, we’ll see whether credit starts to free up and things start to return to normal.

    If things do return to normal, look for AUD to shoot back up again as traders pile back into the commodities they’ve been piling out of.

  2. Catchy intro, but very, very wrong.

    With the Oz stock market falling nearly 5 per cent today

    John, that happened yesterday, not today, and it’s very misleading because the 5% drop was an intra-day movement that happened when the futures exchange computer crashed, and which corrected afterwards.

  3. I started the post on Thursday and didn’t go back to correct the dating. In any case, I don’t think the intro as a whole is misleading. There has been a lot of volatility, and the overall decline has been between 10 and 15 per cent.

  4. John, the Federal Reserve has gone further than simply cut its discount rate to the banks by 0.5%. It has also agreed to accept as collateral (for its loans to banks) the distressed home mortgages that have led to the current crisis and to extend the repayment of the loans. As well, it has raised strong market expectations that the official rate of 5.25% will also be cut appreciably soon. This is a very strong early intervention and must surely lessen the risk of a big decline in financial institution lending and a serious recession in the USA.

    Of course this affair has once more shown that central banks are happy to go along with market euphoria (just a bit of “exhuberance” they say) but will not tolerate a rapid decline from the euphoric heights. Is it becoming a one-way bet for share markets? What will it mean for moral hazard? These are issues for later. In the meantime, the danger of a financial crisis seems to be much reduced. Or am I being too optimistic?

  5. I agree with Fred. If the market goes up some crazy amount, no-one cares. If the market goes down even a relatively small amount, the bail-out of big business occurs. I can’t think of any better way of encouraging speculation.

  6. And, ‘nobody’ can complain any more about the scenario described by Fred Argy and conrad because ‘we’ were all made to become shareholders (but not share owners with voting rights).

  7. JQ, I am a little disappointed with your comment. Surely, the interventions of various Reserve Banks in ‘the global economy’ is an example of the empirical relevance of your recent policy paper on social risk management.

  8. The silence of the ‘free market’-verbal-theoretician-commentators on this blog is deafening.

  9. Nouriel Roubini has several posts on the topic. In one of them
    he says,
    “So a sound lending of last resort support that minimizes moral hazard requires:

    – an illiquidity rather than insolvency problem

    – penalty rates

    – good collateral

    – conditionality in the lending support

    – limits to the amount of support

    On all those dimensions the current injections of liquidity by the Fed and the ECB partly fail the test of sound lender of last resort support.”

  10. I think there’s deafening silence almost everywhere actually — not just from the usual commentators here. What surprises me about the whole matter is that even some of Asian governments joined in. I would have thought the lessons from 1997 would have been fresh in their minds.

  11. Re: Learning lessons. What methods of learning would be helpful?

    Suppose people are accustomed to statistical analyses and they associate the results with the word ‘facts’. How many ‘discontinuities’ (‘crashes’, ‘crises’, ‘meltdown’, ….) in financial markets would be required to learn a lesson?

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