I don’t pretend to be an economist, but the current effect the credit markets are having on the economy is simply fascinating. As always, the market seldom behaves as expected. The idea that so much debt was leveraged in such a seemingly safe way is tremendous. This is what I have gathered:
Debt was cheap and improperly assessed as high grade. That is, loans that might default were viewed as loans that wouldn’t default. Much of that was based on the assumption that housing prices would rise. Regular folks were getting interest only loans and other mortgages that allowed them to buy more house than they would have been able to with conventional instruments such as a 30 year fixed rate loan. Many people were doing that and the real estate market was able to increase prices faster than a more conventional credit market would have allowed. The result is inflated housing prices. Now, I don’t think we have really heard how much this permeates the commercial real estate market, but certainly we’ll see in the coming months.
Simultaneously, hedge funds have been leveraging (borrowing money for) huge positions as to make small profits, but many times over, on seemingly sure thing, historically validated, trades. As the ability to borrow money (form the credit markets, again) decreased because of sub-prime concerns positions had to be covered to prevent further losses. Hence the market plunges.
Now central banks step in and dump money into the economy. From my “globalist view” that is great because it make money cheaper for growing economies, but as any pundit will tell you, that devalues everything to create liquidity. Fundamentally, more money in the system facilitates economic growth at the possible risk of inflation. (I had to brush up my economics and did it here) Of course, increasing the money supply doesn’t have any effect on the rate of delinquency of those maybe not so sure not to default mortgages.
So what I would imagine comes next: Clearly housing prices have to correct. Some people that need to refinance adjustable rate mortgages are going to have to do so with their home’s value appraised at less than they paid for it and they will be unable to get new adjustable rate or interest only mortgages. People might have to see their homes (at a loss) or risk defaulting on their mortgage. Perhaps the same will occur in commercial real estate. Simultaneously, the “new reality” in the credit markets will make hedge funds less able to borrow money to buy companies which will inject less money into the stock market. I think the economy is strong, but at the same time, the possibility of a recession certainly seems reasonable, it just seems like there will be less money to invest in businesses and therefore grow the economy.
The most conservative (credit doomsayer) blog I read is MarketTicker. I think a lot of his predictions are valid and if you’re interested in this sort of stuff it seems like very informed analysis.
