Liquidity vs. Minor-Solvency vs. Major Solvency Crises--No--Panic vs. Interest-Rates-Are-too-High vs. The-Financial System-Is-Totally-B***ered Crises--No--I Need Better Names!
Calculated Risk has insightful comments on my Project Syndicate article. Here is one:
Calculated Risk: Delong: Three cures for three crises: I don't think it's quite that bad. Even if the losses for investors and lenders reach $1 trillion (a possibility), I think the financial system can absorb those losses. Sure, some players might disappear, and others might have to sell significant assets (or dilute their shareholders), but I don't think the choice is between serious inflation and depression.
Still, I think the "Yikes" tag fits...
And CR points us to Mark Thoma, who points us to an even-more-insightful than usual piece by the brilliant and hard-working Greg Ip:
Economics Blog : Liquidity Threat Eases; Solvency Threat Still Looms: As 2007 winds down, the much-feared year-end liquidity crisis appears to have been averted thanks to aggressive action by central banks.... Libor rates have dropped sharply since Thursday... [but] are still high relative to the expected federal funds rate because banks still have an ongoing demand for cash to fund new obligations and residual concerns about each others’ creditworthiness.
Nonetheless, as Lou Crandall, chief economist at Wrightson ICAP LLC said today, “Things are unfolding smoothly.” The first quarter is likely to start much as the fourth quarter did, with reduced concerns now that the statement date has passed. Balance-sheet strains will continue to create concerns about the price and availability of short-term funds, Mr. Crandall said. But for the most part, “We’ve moved beyond... liquidity concerns. The focus has moved to that part of the financial fallout that central banks can’t address through technical operations.”
In other words, as 2008 begins, it’s solvency, not liquidity, that threatens the economy... a likely decline in housing prices that will further undermine credit quality. Making banks more confident of their own ability to raise funds is not going to resolve a generalized shrinkage of lending driven by declining collateral values.
looming threat is an expected hit to housing demand as Fannie Mae and Freddie Mac impose new fees to buy or guarantee mortgages once considered prime... customers putting down less than 30% on a home and with credit scores below 680. Bianco Research... estimates “over one-third of prime] home buyers are going to get ‘crunched’ by tougher standards, much bigger downpayments and interest rate ’surcharges.’” The fees apply to mortgages the companies buy after March 8....
“We believe home prices will continue to fall,” Bianco wrote. “This is the cause of the credit crisis.” The collapse in issuance of mortgage-backed collateralized debt obligations is itself merely a result of falling home prices.
On the other hand, maybe home prices don’t have much further to fall.
I do badly need better names for my three-part classification of financial crises:
- Liquidity crises
- Solvency crises that are easily cured by easier monetary policy that boosts asset values
- Solvency crises that aren't easily cured by easier monetary policy
I also need to figure out what kind of crisis we are having. Let's get out the envelope and start scribbling...
Since 2000, roughly 3 million extra new homes have been built over and above those that would have been built if things had followed long-run trends. Figure $300K per extra home. That's an extra $900 billion of investment in housing that's 100% leveraged and currently occupied by the 3M American households that were priced out of the pre-bubble housing market. If the lenders foreclose on those 3M, they then will find themselves trying to sell the 3M houses to 3M other households that are even less-rich and less-credit worthy. So the best strategy is for the lenders to sit down and negotiate. Maybe the Fed can help more by lowering interest rates further. But some chunk of that $900B is going up in smoke.
Then there are all those who saw their houses rise in value and took out home-equity loans. We know there are a lot of them--household savings rates did not get driven to zero by accident. But how many of them are going to default on their home equity loans, and how big will the losses the lenders eat going to be?
My guess right now is $500B in total loan losses for both tranches of the crisis. But that's just a guess, and an unbacked guess at that...