The Great Perception Gap

There is a vast gap of perception between the real economy of production and jobs and the financial economy of loans and investments. The real economy, though weakening, is hardly in a state of collapse.In 2007, it has grown about 2%; payroll jobs are up by 1.3 million. Even economists who expect a recession generally think it will be mild. Meanwhile, financial markets are described hysterically as being “in turmoil”; there is a “credit crisis.” This contrast reflects fear of the unknown. Since 1980, America’s financial system has changed dramatically in ways that are now arousing widespread anxieties. Many loans once made directly by banks are “securitized”: packaged into bond-like securities and sold to investors (pension funds, investment houses, hedge funds and banks themselves).There’s been an explosion of bewildering financial instruments — currency swaps, interest-rate swaps and other “derivatives” — that are used for hedging and speculative trading.Until recently, the transformation seemed a splendid success. Credit markets had broadened; risk was being spread to a larger spectrum of investors. So it was said. This was an illusion.The securities containing “subprime” mortgages — loans to weaker borrowers — have experienced unexpected defaults, rating downgrades and losses. The unpleasant surprises have ignited fears among bankers and investment managers over how the new financial system operates.Credit and financial markets subsist on trust and confidence. The subprime crisis has corroded both. Estimated losses range upward from $50 billion. Because trading in subprime mortgage securities is thin, how can they be accurately valued? Who holds them? Banks and investors have reacted to these uncertainties.For example, banks now find the “interbank market”— banks lending to each other — riskier than before, because they don’t know which banks are most exposed. The three-month London Interbank Offered Rate jumped to more than two percentage points above U.S. Treasury bills, triple the historic “spread” of 0.6 percentage points.The subprime debacle also posed a question: What if it’s not the only problem? Consider “credit default swaps” (CDS) as a possible sequel. CDS are, in effect, insurance contracts on loans or bonds: The seller receives a payment and, in return, agrees to pay the buyer some or all of the amount of a designated loan or bond if the borrowing company — say, General Motors or IBM — actually defaults. But note, neither party to the CDS has to be the underlying lender or borrower. They usually are outsiders. They are simply betting on the creditworthiness of different borrowers.Since 2004, the volume of CDS has increased about sevenfold. Possible losses could dwarf those on subprime mortgages, argues Ted Seides of Protege Partners, an investment fund. In a strong economy, defaults on corporate bonds and business loans have been low. On “high yield” bonds (aka “junk bonds”), they’ve been about 1% recently, compared with a historic average of about 5% and 10% in recessions. As the economy weakens, junk-bond defaults will increase, Seides says. This will give rise not only to direct loan losses but to additional losses on CDS.There’s a pyramiding effect; the economy has become more vulnerable to credit setbacks. In theory, one investor’s CDS losses should be offset by another’s gains. In practice, Seides expects some CDS investors themselves to default. The capital and loss reserves of banks and investment houses would suffer, limiting their ability to lend to businesses and consumers.What ultimately matters is the connection between the financial economy and the real economy. In housing, that’s clear. Subprime losses reduced mortgage lending, housing construction, sales and prices. In some other markets, something similar has occurred. If too many junk bonds were sold at foolishly low interest rates to finance “private equity” deals — buyouts of companies — then the process had to reverse someday through higher rates and fewer bonds being sold. That’s not turmoil so much as the distasteful reality of recognizing losses on dubious investments.Despite all the bluster, evidence of a widespread credit crunch is so far scant. Though credit standards have tightened, bank lending is still increasing. Many U.S.companies have paid down short-term debt, and corporate cash flow is running at a respectable $1.2 trillion annual rate. This insulates many firms from strains in credit markets.The obvious danger is another wave of large losses that would cripple investors, particularly banks. The Federal Reserve last week acted to forestall that possibility by creating a new lending procedure by which banks can borrow from the Fed. This provides an escape valve if the interbank market remains too unforgiving. The Fed seeks to maintain confidence without bailing out lenders from bad decisions. It’s also trying to avoid recession while cutting inflation. The difficulty of reconciling all these worthy goals may well explain the great perception gap.

The Great Perception Gap

The Great Perception Gap

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