Will life as we know it survive the market turmoil?

Now that the subprime mortgage crisis has brought the kite crashing down, mere mortals such as you and I are left trying to figure out what happened, what IS happening and what may YET happen. The stakes are large. Missteps by those in charge can lead to worldwide recession -- or worse. It will pay for us to ponder a bit.

Not being an economist, but interested in analysis and explanation that is accessible to common folk like us, I submit the following recent articles for your perusal.

You will have to draw your own conclusions.

James Grant, a financial writer and observer, points out in a NY Times OpEd the essential scheme of the Fed's approach to markets --

What could account for the weakness of our credit markets? Why does the Fed feel the need to intervene at the drop of a market? The reasons have to do with an idea set firmly in place in the 1930s and expanded at every crisis up to the present. This is the notion that, while the risks inherent in the business of lending and borrowing should be finally borne by the public, the profits of that line of work should mainly accrue to the lenders and borrowers. [Emphasis added.]

Now that the bill is coming due, Grant thinks Fed chair Bernanke may be --

...seeing the light that capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich.

However, Grant thinks the Fed's recent activity --

[In] jiggling its interest rate, the Fed can impose the appearance of stability today, but only at the cost of instability tomorrow. By the looks of things, tomorrow is upon us already.

does not solve any real problems.

Over at The Economist magazine, which has been looking over these issues for a century and a half, a clear-eyed view and crisp tone are taken. [Note: 'Sold on' is a Britticism; Americans might more readily say 'passed along'.]

First, The Economist points out a price that is now coming due for innovations in the financial markets over the last two decades --

Because lenders expected to be able to sell on the risk of default to someone else, they lent too easily. After all, they would not have to pick up the pieces. In theory, that risk should have been borne by the people best able to carry it. But with everybody having sold on the risk to everyone else—and the risk often being carved up, repackaged and sold again—nobody is sure where the losses are.

Now that markets have rediscovered the old capitalist principle of RISK, we can better understand what is going on --

Bankers and investors need to suffer precisely because the methods of modern finance have been found wanting. It sounds Darwinian, but the brutal demonstration that you pay for your sins is what leads the system to evolve. Markets learn from their mistakes. Only fear will spur investors to price risks better and get them to put more effort into monitoring their counterparties.

If these lessons are to sink in, central bankers must stand back...

In a second article, The Economist turns to the OTHER as-yet-undropped shoe: Collateralized debt obligations (CDOs), the tool by which things like subprime mortgages have been made to appear more valuable than they may really be --

...as the past few weeks have shown, the financial system remains brittle. Hedge funds, for example, have ventured into thinly traded securities, such as collateralised-debt obligations (CDOs), that nowadays are easy to dispose of only in the mathematical models they use to value them. On the other side of the balance sheet, the funds have short-term financing from multiple sources. If a fund starts to show losses, its backers may lose faith in its trades. But even if they believe it will eventually make money, they might grow nervous about the fund's other backers. Just like a nervous depositor eyeing the queues in front of a bank, one hedge-fund creditor may demand its collateral before everyone else grabs theirs. If, to muster collateral, a fund is forced to sell assets into a falling market, a profitable trade can quickly become unprofitable. In this way, seasons of alarm “beget the calamities they dread,” as Bagehot put it.

So, we have more to look forward to.

Lastly, Willem Buiter, a professor at the London School of Economics, offers suggestions in his private blog, Maverecon.

He proposes that central banks (of which ours is the Federal Reserve), can help ease the crisis by becoming 'market-makers of last resort', setting prices for securities -- such as CDOs -- that can no longer be sold in an 'orderly' fashion because panic sales have pushed prices below actual values.

How to sort out what actual values are? How to decide what CDOs are merely 'illiquid' and which are truly without value?

Thorny questions indeed.

Well worth pondering.

That should include the Dems in Congress who seem to be looking for a quick fix that may do more damage in the long run than letting those who have sinned in the market place pay for those sins.

---

More --

• OpEd, NY Times: "The Fed’s Subprime Solution" -- Archived here.
• The Economist - Risk: "Surviving the markets" -- Archived here.
• The Economist - Policy: "What would Bagehot do?" -- Archived here.
• Maverecon - Central Banks: "Market makers of last resort"
  

-- Dan Damon

View today's CLIPS here. Not getting your own CLIPS email daily? Click here to subscribe.

ARCHIVED POSTS OF PLAINFIELD TODAY FROM 11/03/2005 THROUGH 12/31/2006 ARE AT
http://plainfieldtoday.blogspot.com/