In the midst of the past March sell-off, we pointed out in our quarterly economic forecast that even if expectations were falling, fundamentals remained strong. After four months of tranquility, we are again in the middle of extreme market turbulence.
And while in March we were dealing with expectations, now we are dealing with reality. Unpleasant truths have been discovered, with potentially larger consequences, which are undermining the trust and stability of the financial system and the risk that lenders and investors are willing to take on.
In 2005, confident of ever-increasing home prices, some consumers took out excessive home loans – with the help of mortgage brokers who were paid to make loans, not maintain them. In this environment, debt standards and due diligence procedures declined – and the volume of questionable loans increased.
These dicey home loans were packaged together and sold as derivative financial products to buyers perceived to be knowledgeable investors, although these buyers – with the blessings of credit-rating agencies – also exhibited a lack of due diligence. The end result has been a snowballing transfer of unknown risk through the financial system.
There were plenty of alarming signs that few wanted to heed, citing those four most dangerous words on Wall Street: "This time is different."
No, it isn't. Even if economic laws are not as certain as physical laws, such as gravity, at the end of the day, excesses are brought back into balance and debts are to be paid or defaulted with a loss to someone.
The immediate impacts on the stock markets have been well reported. Let's focus here on what impact this credit and credibility crisis may have on future consumption, savings, economic growth, employment, and small-business financing.
From Credit Excess to Credit Crunch
For the first three weeks of August, outstanding commercial paper [IOUs issued by corporations to finance their operations] in the U.S. financial system has decreased by 11 percent, or $244 billion. The asset-backed segment, accounting for half of all the commercial paper, has decreased the most, representing $185 billion. As a result, companies financing their short-term cash needs with commercial paper have seen their cost of capital increase.
Asset-backed commercial paper, which up to the end of July carried a similar interest rate as commercial paper issued by financial and non-financial companies, has been adjusting upward its cost as a result of increasing risk of the underlying assets.
Thanks to this additional risk but insufficient additional reward, investors are opting to keep their money in cash instead, thus holding onto funds that usually would be buying financial products. Only exceptional borrowers in the commercial and real estate markets can still get loans. In addition to impacting the money market, a lack of financing – a liquidity crunch – can substantially undermine economic growth.
Smaller companies, which are more prone to finance their operations with either conventional bank credit or home equity, will feel more of the backlash. The U.S. Small Business Administration, through the guaranteed loan and other programs, can play a critical role in providing finance to small businesses in these circumstances.
Similarly, credit availability has been severely constrained in the mortgage markets, resulting in limited refinancing options for adjustable-rate mortgage borrowers. Plus, refinancings need to be "marked to market," reflecting the true price of the home. Refinancers must make a hard choice — accept a suddenly higher mortgage payment or recognize a loss to refinance.
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