Changes in Financial Markets
CHANGES IN FINANCIAL MARKETS
Financial markets have been revolutionized by innovation and information processing technology.
Financial markets and the “real economy” are linked in new, complex ways. There are feedback effects.
Much of the American and global financial sectors are unregulated. The recent financial crisis in the mortgage-backed securities market indicates that the usual Fed tools to fix financial problems no longer work. The Fed is improvising new policies. They may become the basis for wider regulation or oversight of capital markets.
Since 1973, the year of the Black-Sholes equation to price options and the beginning of the Chicago Board of Options Exchange, the major changes in financial markets have been:
• Increased liquidity. Lower cost and shorter time to turn assets into cash.
• Securitization. Part of the innovation to make financial assets more liquid.
• Variable-rate instruments. Among other effects, this shifts interest rate risk.
• Using derivatives to price and hedge risk. Can lead to very complex investment strategies and linked financial markets.
• Globalization.
• Deregulation. Large parts of the U.S. financial sector are not regulated. One consequence has been increased leverage and risk.
Consequences:
• Long-term fixed-rate assets such as mortgages and bonds have become short-term, variable rate assets. One example is the call feature on long-term corporate bonds. Another is that second mortgages have become home equity lines of credit.
• Assets have become more liquid in the sense that it has become easier and less expensive to turn a fixed asset into cash. Example – home equity loans and mortgage refinancing. Another example is mortgage-backed and asset-backed securities. Also, there has been a huge expansion of the use of repurchase agreements (repos) to new markets and instruments.
• Derivatives are used to hedge risk (or speculate). This has led to complicated linking of separate markets.
• A larger group of major players in financial markets are hedge funds and private equity funds. There are about 7,000 in the U.S., more than the number of banks. They are mostly private, unregulated, often highly leveraged (lots of debt on a small capital base) and have complicated relationships with public financial firms.
• Deregulation means that all financial markets are linked, sometimes in very unexpected ways (securities backed by subprime mortgages and the municipal bond market). The danger of unexpected ripple effects is much greater now.
There has been an ongoing debate whether the ability to hedge individual risks reduce “systemic” risk, risk and instability to the whole financial system. The answer seems to be no. The Fed has intervened in new ways and on an unprecedented scale to improvise “damage control” because of systemic risk.
The complicated relationships between private and public financial institutions, combined with use of leverage and derivatives, means that the government’s ability to “wall off” a troubled part of the market is much more difficult than when the government dealt with the savings and loan crisis of the 1980s.
THE CURRENT SITUATION
Economic growth, especially above trend, drives up profits and the demand for commodities. So stock prices and commodities prices may move up together. After some point, demand grows faster than supply (more consumer borrowing, wealth effects, higher unit labor costs, accelerating commodity prices) and the price level begins to rise (inflation, often at an accelerating rate). Nominal interest rates rise (bond prices fall). The Fed steps in and slows down the growth rate of money creation (new funds available for borrowing) and/or increases short-term interest rates even higher. This leads to a recession. If there is a commodity bubble, for a time you could have rising commodity prices and lower economic growth or even the start of a recession (lower profits and falling stock prices). As the recession deepens, however, commodity prices and eventually interest rates fall (bond prices rise).
This scenario could be global. The global economy grew rapidly from 2002 to 2007. This greatly increased demand for industrial commodities such as metals and energy, creating the current commodity bubble. Even with a global slowdown in growth, some commodity prices will probably not fall back to earlier levels. This includes energy prices. Unless, of course, there is a large decrease in global economic growth or a global recession.
In the Unites States, the Fed drove short-term interest rates below two percent after 9/11 and kept them there for three years. Everyone borrowed like crazy, creating the housing bubble. Homeowners borrowed against or took out increased home equity (a wealth effect), which helped to sustain above-average growth in consumption and economic growth. This created housing and commodity bubbles in the U.S. and much the rest of the world (which had high real growth rates).
At the same time, the basically unregulated mortgage market began creating subprime mortgages. Often these mortgages had little or no money down and low introductory interest rates, and thus low monthly payments. But they reset at higher rates, usually after two years. This attracted speculators and potential homeowners whose low income would not qualify them for a “prime” mortgage. These types of mortgages carried higher sales commissions for mortgage originators and fees for banks. Speculators tried to “flip” the house quickly as housing prices rose. Some low income borrowers hoped to sell the house or refinance the mortgage (often difficult because of high refinancing fees) before the higher interest rates kicked in. Turnover rates rose. Developers were able to get low interest construction loans and often “pre-sold” a development, using the deposits to get further construction loans. A rising percent of new housing were second homes. Residential construction set new records every year. All this led to a housing bubble.
To raise more money to create more mortgages and home equity loans, financial institutions sold the loans to other financial institutions, often investment banks, in the secondary mortgage market. Financial institutions “securitized” the mortgages, meaning they sold tradable bonds to institutional investors like hedge funds backed by the cash flow of the mortgages. The interest on the bonds came from the monthly mortgage payments. Because of the increased risk, the bonds usually carried a higher interest rate than bonds backed by “prime” mortgages. But not much higher because the bonds carried a higher credit rating than justified by the credit (default) risk of the underlying mortgages. The stage was set for a massive meltdown of the mortgage market if the housing market softened or default rates rose. As they did.
Lenders borrowed large sums of money at low interest rates to buy these bonds. This created a great amount of leverage at every level of the housing market (homeowners, mortgage lenders, bond buyers). Everyone won as long as housing prices rose. Between 2002 and 2006, housing prices went up faster and longer than any time in the past. A bubble was created. When prices stopped rising and variable rate mortgages started to reset at higher rates, the system started to work in reverse. Because of lags, new construction of homes and condos continued to rise, creating excess supply. Default and then foreclosure rates started to rise rapidly in 2007, especially among subprime borrowers (there is $1-$2 trillion at risk in this market). Subprime mortgage-backed bond prices fell as defaults rose. Lenders to institutions that owned these mortgage-backed bonds demanded more collateral. As demand disappeared from this market, it was impossible to price and sell these securities. Highly-leveraged institutions then had to start selling off other assets, lowering their prices and creating losses in unrelated markets. “Mark to market” accounting meant that institutions had to mark down the price of the bonds and loans they held, and take losses against reported profits. As these losses mounted up – about $200 billion and counting – credit markets began to freeze up. The mortgage-back securities market and the part of the commercial paper market to finance some of this trade disappeared. Financial institutions with private repo and swap contracts began to doubt the solvency of some of the counterparties to these agreements. This led to many firms withdrawing funds and refusing to do business with Bear Stearns. If the Fed had not stepped in, there probably would have been an institutional “run on the bank” of other investment banks.
This created a liquidity and credit risk crisis because institutions could not find buyers or even price debt instruments. Uncertainty about the value of collateral rose. This increased the reluctance of institutions to roll-over short-term financing and everyone scrambled to protect themselves by demanding even more collateral and selling off assets. Deleveraging occurred throughout the whole system. There was a “run to safety” as institutions sold mortgage-backed bonds and similar securities, and bought safe and highly-liquid Treasury bonds. Some financial markets stopped working. Any company, like Bear Stearns, that was a major broker/dealer in asset-backed securities, found that there was an institutional “run on the bank” as other institutions wanted their money or refused to extend them credit.
Back in the real world, as defaults and foreclosures rose rapidly, everyone fled the subprime market and banks tightened lending standards. Demand for housing fell and construction followed. Housing prices started to fall, reaching about 20% in the most speculative markets. Contractors went bankrupt or greatly cut back on planned developments. Housing starts reached new lows and inventory of reposessed and unsold housing reached new highs. Unemployment in construction and related industries rose. Economic growth slowed and we may be in a recession.
Starting in 2002, stock prices were rising again after the technology stock bust, commodity prices (including building materials) were rising and housing prices rose faster and longer than at any time in American history. Consumer borrowing rose rapidly. This could not go on forever. The housing bubble burst, stock prices fell and eventually commodity prices will start coming down. The party’s over.
Thus far, the damage has been bearable (except at Bear Stearns) because of the unprecedented intervention of the Fed. Normally, when the inflation rate and risk premiums rise, the Fed would let interest rates rise or even raise them above market levels (as in 1980-1981). But the Fed is so worried about the freezing of financial markets that it is lowering interest rates aggressively. This will help some holders of variable-rate debt such as some homeowners. It will also reduce the cost of other borrowers and financial institutions, thus freeing up cash and possibly increasing demand. But it is the Fed’s direct intervention into financial markets that is unprecedented. The Fed owns about $800 billion of securities, almost all U.S. government debt. It appears that the Fed is willing to trade up to $400 billion of “risk-free” Treasuries for riskier private debt, including mortgage-backed securities. It is making funds available to investment banks, not just commercial banks, partly because the line between them has virtually disappeared through deregulation. The Fed has effectively guaranteed J. P. Morgan Chase’s losses stemming from taking-over Bear Stearns.
The Fed is improvising monetary policy to deal with this threat to the working of financial markets. It apparently believes that the economic consequences of a financial meltdown are more serious than the commodity bubble and rising inflation.
In addition to the Fed, institutions like Fannie Mae, Freddie Mac and FHA have been pressured to relax restrictions and provide more insurance and liquidity to the secondary mortgage market.
The U.S. government, in a swift, bipartisan agreement, is giving the American people a $160 billion temporary tax cut. The downside of this is that the budget deficit will rise to about $450 - $500 billion this year.
The big question now is how long will the financial damage continue and does the Fed have the resources and the will to contain the damage. The related worry is how long and how deep will be either zero economic growth or a recession, and how will this affect stock prices and liquidity and risk levels in other financial markets. No one really knows because the causes and interconnections are more complicated than ever before. As the Fed’s actions indicate, we are in new territory.
THE POSSIBILITY OF A “PERFECT STORM.”
Economists and corporate planners (I’ve been both) love to do “worst-case” scenarios. The “black swan” or “perfect storm” scenario is one with a low probability of happening but if it does happen, it does a lot of damage. This is my “perfect storm” scenario. But remember, almost all economists do not think this will happen. Yet.
The facts:
The U. S. government, like in the early 2000s, has already injected a large fiscal stimulus through tax cuts. The deficit will probably get somewhat larger, if only because of declining tax revenues. But there is little more it can do because of the large deficit, the cost of the war in Iraq, and taking on unknown new financial liabilities. Also, all presidential candidates have pledged to expand health care coverage at taxpayers’ expense.
Our trade deficit (current account deficit) is so large, about $750 billion a year, that it can only be sustained by attracting a huge amount of foreign capital. But lower interest rates, higher risk, and declining stock and real estate prices make foreign investment less attractive, especially using euros, yen and other appreciating currencies to buy dollar-denominated assets. One exception is luxury housing in New York City, which appears relatively cheap compared to comparable housing in other major cities.
The dollar will continue to depreciate but I do not see how it will have a major effect on the trade deficit. Only a combination of a large increase in net domestic saving (new saving minus dissaving and borrowing) as an alternative to borrowing to buy assets in the hope of capital gains, tax increases, and a serious effort to develop substitutes for imported oil will even begin to reduce the trade deficit.
The continued depreciation of the dollar might have an indirect effect on keeping prices of raw materials and oil higher than expected, since they are priced in dollars.
Commodity prices. Two bad scenarios. The first is that commodity prices stay high or keep rising. This means higher energy and food costs, reducing the real consumption of American families (already carrying historically high debt levels). The second is a sudden fall in commodity prices. On net, this will be good for the real economy but put added pressure on financial institutions like hedge funds that have been speculating in commodities with borrowed money.
Losses from asset-backed securities will continue. At least another $100 billion of losses in mortgages and mortgage-backed securities alone will be written off. Losses are spreading to other parts of the economy (commercial real estate, credit cards, car loans, etc.) and lending standards are tightening everywhere. Possibly another $100-$200 billion in losses in other financial instruments. This does not include any further fall in stock prices, which (except for financial stocks) has been rather mild so far.
Some of the losses are global as foreign banks have started to write down American financial assets. Banks such as HSBC and UBS have taken major losses. Even the Bank of China (owned by the Communist government) has exposure to the U.S. subprime market and has taken write-downs.
No one knows how many private counterparty deals in derivatives and repos will unravel. Many of these deals are highly leveraged. Losses from defaults and fire-sale dumping of securities to raise cash and collateral could lead to even greater stresses on the financial system. No one really knows how much damage the chain reactions in connected financial markets will do. Who expected that subprime losses would disrupt the municipal bond market? Who knew that some municipal bond issuers were playing a complicated game using interest-rate swaps? Who knew that the long-term bonds issued by New Jersey colleges through the State of New Jersey were being repriced every 30 days like commercial paper?
The Fed is doing “damage control” far beyond what anyone expected. But for how long? There is a limit to how much risk the Fed can take on. The Fed is worried that somewhere there is an inflection point where problems in different financial markets become a “perfect storm” that they can not control. Or worse yet, the trigger, such as a collapse in the Chinese housing bubble, may be beyond their control.
Watch the stock market. So far the fall in stock prices have not been that large, with financial stocks taking most of the hit. But if corporate profits fall due to a moderate recession and the stock prices of non-financial firms fall another 20%, then stock index funds will probably not match their 2000 highs for another 4-6 years. If this occurs, the rate of return from holding a diversified portfolio of stocks, such as the S&P 500, from 2000 to 2014-16 will be zero. Before inflation.
At a deeper level, the current crisis indicates to me that the U.S. government and the Fed was not prepared to deal with the new environment of global, unregulated, complex, interconnected financial markets. Hopefully this is a wake-up call.
Financial markets have been revolutionized by innovation and information processing technology.
Financial markets and the “real economy” are linked in new, complex ways. There are feedback effects.
Much of the American and global financial sectors are unregulated. The recent financial crisis in the mortgage-backed securities market indicates that the usual Fed tools to fix financial problems no longer work. The Fed is improvising new policies. They may become the basis for wider regulation or oversight of capital markets.
Since 1973, the year of the Black-Sholes equation to price options and the beginning of the Chicago Board of Options Exchange, the major changes in financial markets have been:
• Increased liquidity. Lower cost and shorter time to turn assets into cash.
• Securitization. Part of the innovation to make financial assets more liquid.
• Variable-rate instruments. Among other effects, this shifts interest rate risk.
• Using derivatives to price and hedge risk. Can lead to very complex investment strategies and linked financial markets.
• Globalization.
• Deregulation. Large parts of the U.S. financial sector are not regulated. One consequence has been increased leverage and risk.
Consequences:
• Long-term fixed-rate assets such as mortgages and bonds have become short-term, variable rate assets. One example is the call feature on long-term corporate bonds. Another is that second mortgages have become home equity lines of credit.
• Assets have become more liquid in the sense that it has become easier and less expensive to turn a fixed asset into cash. Example – home equity loans and mortgage refinancing. Another example is mortgage-backed and asset-backed securities. Also, there has been a huge expansion of the use of repurchase agreements (repos) to new markets and instruments.
• Derivatives are used to hedge risk (or speculate). This has led to complicated linking of separate markets.
• A larger group of major players in financial markets are hedge funds and private equity funds. There are about 7,000 in the U.S., more than the number of banks. They are mostly private, unregulated, often highly leveraged (lots of debt on a small capital base) and have complicated relationships with public financial firms.
• Deregulation means that all financial markets are linked, sometimes in very unexpected ways (securities backed by subprime mortgages and the municipal bond market). The danger of unexpected ripple effects is much greater now.
There has been an ongoing debate whether the ability to hedge individual risks reduce “systemic” risk, risk and instability to the whole financial system. The answer seems to be no. The Fed has intervened in new ways and on an unprecedented scale to improvise “damage control” because of systemic risk.
The complicated relationships between private and public financial institutions, combined with use of leverage and derivatives, means that the government’s ability to “wall off” a troubled part of the market is much more difficult than when the government dealt with the savings and loan crisis of the 1980s.
THE CURRENT SITUATION
Economic growth, especially above trend, drives up profits and the demand for commodities. So stock prices and commodities prices may move up together. After some point, demand grows faster than supply (more consumer borrowing, wealth effects, higher unit labor costs, accelerating commodity prices) and the price level begins to rise (inflation, often at an accelerating rate). Nominal interest rates rise (bond prices fall). The Fed steps in and slows down the growth rate of money creation (new funds available for borrowing) and/or increases short-term interest rates even higher. This leads to a recession. If there is a commodity bubble, for a time you could have rising commodity prices and lower economic growth or even the start of a recession (lower profits and falling stock prices). As the recession deepens, however, commodity prices and eventually interest rates fall (bond prices rise).
This scenario could be global. The global economy grew rapidly from 2002 to 2007. This greatly increased demand for industrial commodities such as metals and energy, creating the current commodity bubble. Even with a global slowdown in growth, some commodity prices will probably not fall back to earlier levels. This includes energy prices. Unless, of course, there is a large decrease in global economic growth or a global recession.
In the Unites States, the Fed drove short-term interest rates below two percent after 9/11 and kept them there for three years. Everyone borrowed like crazy, creating the housing bubble. Homeowners borrowed against or took out increased home equity (a wealth effect), which helped to sustain above-average growth in consumption and economic growth. This created housing and commodity bubbles in the U.S. and much the rest of the world (which had high real growth rates).
At the same time, the basically unregulated mortgage market began creating subprime mortgages. Often these mortgages had little or no money down and low introductory interest rates, and thus low monthly payments. But they reset at higher rates, usually after two years. This attracted speculators and potential homeowners whose low income would not qualify them for a “prime” mortgage. These types of mortgages carried higher sales commissions for mortgage originators and fees for banks. Speculators tried to “flip” the house quickly as housing prices rose. Some low income borrowers hoped to sell the house or refinance the mortgage (often difficult because of high refinancing fees) before the higher interest rates kicked in. Turnover rates rose. Developers were able to get low interest construction loans and often “pre-sold” a development, using the deposits to get further construction loans. A rising percent of new housing were second homes. Residential construction set new records every year. All this led to a housing bubble.
To raise more money to create more mortgages and home equity loans, financial institutions sold the loans to other financial institutions, often investment banks, in the secondary mortgage market. Financial institutions “securitized” the mortgages, meaning they sold tradable bonds to institutional investors like hedge funds backed by the cash flow of the mortgages. The interest on the bonds came from the monthly mortgage payments. Because of the increased risk, the bonds usually carried a higher interest rate than bonds backed by “prime” mortgages. But not much higher because the bonds carried a higher credit rating than justified by the credit (default) risk of the underlying mortgages. The stage was set for a massive meltdown of the mortgage market if the housing market softened or default rates rose. As they did.
Lenders borrowed large sums of money at low interest rates to buy these bonds. This created a great amount of leverage at every level of the housing market (homeowners, mortgage lenders, bond buyers). Everyone won as long as housing prices rose. Between 2002 and 2006, housing prices went up faster and longer than any time in the past. A bubble was created. When prices stopped rising and variable rate mortgages started to reset at higher rates, the system started to work in reverse. Because of lags, new construction of homes and condos continued to rise, creating excess supply. Default and then foreclosure rates started to rise rapidly in 2007, especially among subprime borrowers (there is $1-$2 trillion at risk in this market). Subprime mortgage-backed bond prices fell as defaults rose. Lenders to institutions that owned these mortgage-backed bonds demanded more collateral. As demand disappeared from this market, it was impossible to price and sell these securities. Highly-leveraged institutions then had to start selling off other assets, lowering their prices and creating losses in unrelated markets. “Mark to market” accounting meant that institutions had to mark down the price of the bonds and loans they held, and take losses against reported profits. As these losses mounted up – about $200 billion and counting – credit markets began to freeze up. The mortgage-back securities market and the part of the commercial paper market to finance some of this trade disappeared. Financial institutions with private repo and swap contracts began to doubt the solvency of some of the counterparties to these agreements. This led to many firms withdrawing funds and refusing to do business with Bear Stearns. If the Fed had not stepped in, there probably would have been an institutional “run on the bank” of other investment banks.
This created a liquidity and credit risk crisis because institutions could not find buyers or even price debt instruments. Uncertainty about the value of collateral rose. This increased the reluctance of institutions to roll-over short-term financing and everyone scrambled to protect themselves by demanding even more collateral and selling off assets. Deleveraging occurred throughout the whole system. There was a “run to safety” as institutions sold mortgage-backed bonds and similar securities, and bought safe and highly-liquid Treasury bonds. Some financial markets stopped working. Any company, like Bear Stearns, that was a major broker/dealer in asset-backed securities, found that there was an institutional “run on the bank” as other institutions wanted their money or refused to extend them credit.
Back in the real world, as defaults and foreclosures rose rapidly, everyone fled the subprime market and banks tightened lending standards. Demand for housing fell and construction followed. Housing prices started to fall, reaching about 20% in the most speculative markets. Contractors went bankrupt or greatly cut back on planned developments. Housing starts reached new lows and inventory of reposessed and unsold housing reached new highs. Unemployment in construction and related industries rose. Economic growth slowed and we may be in a recession.
Starting in 2002, stock prices were rising again after the technology stock bust, commodity prices (including building materials) were rising and housing prices rose faster and longer than at any time in American history. Consumer borrowing rose rapidly. This could not go on forever. The housing bubble burst, stock prices fell and eventually commodity prices will start coming down. The party’s over.
Thus far, the damage has been bearable (except at Bear Stearns) because of the unprecedented intervention of the Fed. Normally, when the inflation rate and risk premiums rise, the Fed would let interest rates rise or even raise them above market levels (as in 1980-1981). But the Fed is so worried about the freezing of financial markets that it is lowering interest rates aggressively. This will help some holders of variable-rate debt such as some homeowners. It will also reduce the cost of other borrowers and financial institutions, thus freeing up cash and possibly increasing demand. But it is the Fed’s direct intervention into financial markets that is unprecedented. The Fed owns about $800 billion of securities, almost all U.S. government debt. It appears that the Fed is willing to trade up to $400 billion of “risk-free” Treasuries for riskier private debt, including mortgage-backed securities. It is making funds available to investment banks, not just commercial banks, partly because the line between them has virtually disappeared through deregulation. The Fed has effectively guaranteed J. P. Morgan Chase’s losses stemming from taking-over Bear Stearns.
The Fed is improvising monetary policy to deal with this threat to the working of financial markets. It apparently believes that the economic consequences of a financial meltdown are more serious than the commodity bubble and rising inflation.
In addition to the Fed, institutions like Fannie Mae, Freddie Mac and FHA have been pressured to relax restrictions and provide more insurance and liquidity to the secondary mortgage market.
The U.S. government, in a swift, bipartisan agreement, is giving the American people a $160 billion temporary tax cut. The downside of this is that the budget deficit will rise to about $450 - $500 billion this year.
The big question now is how long will the financial damage continue and does the Fed have the resources and the will to contain the damage. The related worry is how long and how deep will be either zero economic growth or a recession, and how will this affect stock prices and liquidity and risk levels in other financial markets. No one really knows because the causes and interconnections are more complicated than ever before. As the Fed’s actions indicate, we are in new territory.
THE POSSIBILITY OF A “PERFECT STORM.”
Economists and corporate planners (I’ve been both) love to do “worst-case” scenarios. The “black swan” or “perfect storm” scenario is one with a low probability of happening but if it does happen, it does a lot of damage. This is my “perfect storm” scenario. But remember, almost all economists do not think this will happen. Yet.
The facts:
The U. S. government, like in the early 2000s, has already injected a large fiscal stimulus through tax cuts. The deficit will probably get somewhat larger, if only because of declining tax revenues. But there is little more it can do because of the large deficit, the cost of the war in Iraq, and taking on unknown new financial liabilities. Also, all presidential candidates have pledged to expand health care coverage at taxpayers’ expense.
Our trade deficit (current account deficit) is so large, about $750 billion a year, that it can only be sustained by attracting a huge amount of foreign capital. But lower interest rates, higher risk, and declining stock and real estate prices make foreign investment less attractive, especially using euros, yen and other appreciating currencies to buy dollar-denominated assets. One exception is luxury housing in New York City, which appears relatively cheap compared to comparable housing in other major cities.
The dollar will continue to depreciate but I do not see how it will have a major effect on the trade deficit. Only a combination of a large increase in net domestic saving (new saving minus dissaving and borrowing) as an alternative to borrowing to buy assets in the hope of capital gains, tax increases, and a serious effort to develop substitutes for imported oil will even begin to reduce the trade deficit.
The continued depreciation of the dollar might have an indirect effect on keeping prices of raw materials and oil higher than expected, since they are priced in dollars.
Commodity prices. Two bad scenarios. The first is that commodity prices stay high or keep rising. This means higher energy and food costs, reducing the real consumption of American families (already carrying historically high debt levels). The second is a sudden fall in commodity prices. On net, this will be good for the real economy but put added pressure on financial institutions like hedge funds that have been speculating in commodities with borrowed money.
Losses from asset-backed securities will continue. At least another $100 billion of losses in mortgages and mortgage-backed securities alone will be written off. Losses are spreading to other parts of the economy (commercial real estate, credit cards, car loans, etc.) and lending standards are tightening everywhere. Possibly another $100-$200 billion in losses in other financial instruments. This does not include any further fall in stock prices, which (except for financial stocks) has been rather mild so far.
Some of the losses are global as foreign banks have started to write down American financial assets. Banks such as HSBC and UBS have taken major losses. Even the Bank of China (owned by the Communist government) has exposure to the U.S. subprime market and has taken write-downs.
No one knows how many private counterparty deals in derivatives and repos will unravel. Many of these deals are highly leveraged. Losses from defaults and fire-sale dumping of securities to raise cash and collateral could lead to even greater stresses on the financial system. No one really knows how much damage the chain reactions in connected financial markets will do. Who expected that subprime losses would disrupt the municipal bond market? Who knew that some municipal bond issuers were playing a complicated game using interest-rate swaps? Who knew that the long-term bonds issued by New Jersey colleges through the State of New Jersey were being repriced every 30 days like commercial paper?
The Fed is doing “damage control” far beyond what anyone expected. But for how long? There is a limit to how much risk the Fed can take on. The Fed is worried that somewhere there is an inflection point where problems in different financial markets become a “perfect storm” that they can not control. Or worse yet, the trigger, such as a collapse in the Chinese housing bubble, may be beyond their control.
Watch the stock market. So far the fall in stock prices have not been that large, with financial stocks taking most of the hit. But if corporate profits fall due to a moderate recession and the stock prices of non-financial firms fall another 20%, then stock index funds will probably not match their 2000 highs for another 4-6 years. If this occurs, the rate of return from holding a diversified portfolio of stocks, such as the S&P 500, from 2000 to 2014-16 will be zero. Before inflation.
At a deeper level, the current crisis indicates to me that the U.S. government and the Fed was not prepared to deal with the new environment of global, unregulated, complex, interconnected financial markets. Hopefully this is a wake-up call.
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