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U.S. Economy "Heading For the Rocks"

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"Heading for the Rocks" is the title of a new report from The Economist on the U.S. economy. The title is a somewhat sensationalist. However, it is important that people understand there is tremendous risk in the markets right now. Below, I will go though the basic problems as The Economist outlines them.

Here is a link to the download. While the material is somewhat dry, I highly recommend it because it is one of the most lucid explanations about the current economy.

Here is the general conclusion.

• Scenario 1. The Economist Intelligence Unit's central forecast, to which we attach a probability of 60 percent, sees the impact being contained by timely monetary policy action, with only a modest effect on the global economy. Click here to find out more!

• Scenario 2. Our main risk scenario, with a 30 percent probability, envisages the U.S. falling into recession, with substantial fallout in the rest of the world.

• Scenario 3. Should the U.S. enter recession, another, darker scenario arises: that corrective action fails, and severe economic repercussions cascade from the U.S. into the world economy with devastating effect. We attach only a 10 percent probability to this outcome, but the potential impact is so severe that it warrants careful consideration.

Since scenario 1 informs our regular output and Scenario 3 has a low probability, the bulk of the report focuses on scenario 2.

The economist outlines three areas of problems that the economy must work through.

1.) An effect on the direct holders of subprime mortgage debt. According to the Federal Reserve's Flow of Funds report, total U.S. mortgage debt outstanding was $9.854 trillion in the first quarter of 2007. Estimates about the total value of outstanding subprime debt vary. According to the economist article, the Fed is estimating $50 - $100 billion in total losses. Just off the cuff, that number looks a bit low. However, we won't know until all of this is over.

Anyone who holds subprime debt is in danger of losing money right now. One of the biggest problems is there are a ton of holders spread all over the globe. That means the fallout from this mess will hit money managers in all of the big financial centers. In fact, we have already seen reports from the U.S., Australia, London, France and Germany about hedge funds/investment banks etc...who have already lost money.

The point here is simple. Anyone who holds subprime debt stands to lose. And the holders of subprime debt are all over the globe.

2.) The liquidity issue. There are several problems in the credit markets right now. The Economist points out that banks have stopped lending to each other -- or driven the price of short-term loans higher because of problem number 1. No one wants to make loans to other financial players right now because of the fear the borrower has large subprime exposure on their respective balance sheets.

The second problem is commercial paper issuance, which decreased again last week:

The U.S. commercial paper market shrank for a third week, extending the biggest slump in at least seven years and signaling that the Federal Reserve's attempts to lower borrowing costs have had a limited impact so far.

Asset-backed commercial paper, which accounted for half the market, tumbled $59.4 billion to $998 billion in the week ended yesterday, the lowest since December, according to the Federal Reserve. Total short-term debt maturing in 270 days or less fell $62.8 billion to a seasonally adjusted $1.98 trillion. The yield on the highest rated asset-backed paper due tomorrow rose today 0.11 percentage point to a six-year high of 6.15 percent.

Commercial paper outstanding has fallen $244.1 billion, or 11 percent, in the past three weeks, as the Fed's Aug. 17 reduction in the discount rate has yet to entice buyers back into the market. Yields of asset-backed commercial paper due tomorrow rose to the highest in six years as investors fled to the safety of Treasury bills.

As a result, investors have flocked into government bonds:

Treasury three-month bill yields fell in August by the most in almost six years as subprime mortgage losses weakened credit markets, encouraging investors to take refuge in the shortest-term government debt.

Investors bought bills this week as the commercial paper market extended its biggest slump in at least seven years. President George W. Bush yesterday announced a plan to contain mortgage defaults, and Federal Reserve Chairman Ben S. Bernanke said he would ``act as needed'' to contain the housing recession. A government report next week forecast by economists to show job growth accelerated in August may reduce the likelihood of a cut in interest rates by the central bank.

I have argued that the run-up in short-term government debt is actually a correctly functioning credit market. Investors are looking for safe assets right now. But as more and more investors flock to these investments, the yield on these investments drops which will eventually force investors to look for higher yielding assets. While we don't know when investors will move out of the T-Bill market, rest assured low yielding investments are usually the best motivator to encourage more risk taking.

However, there is no guarantee that this movement into higher-yielding assets will occur withing a time frame that is acceptable to market participants. As a result, the credit markets may remain frozen for a time that is unacceptable and force the Fed to act.

3.) Repricing Risk. As a former bond broker, I am use to the idea of always being able to value assets. At the end of every month, clients would call and ask for a bid or price on various bonds. This is called "mark to market" and it is something portfolio managers have to do every month.

However, some assets have not been priced this way because of a lack of an active secondary market. As a result, managers have developed models to price various CDOs and CLOs. This is an extremely troubling development because it is doubtful that managers have always used the best pricing method around. Instead, it is probable that some have been cooking the books (as it were) and reporting unrealistically high prices on some assets.

As the correct price of assets start to come to light, there could be a wide-ranging fall-out. It is possible (though in no way guaranteed) that a ton of financial institutions could see their balance sheets drop in value by very uncomfortable amounts. Put another way, the amount of the price drop could be significant. Until this process starts and is reported, we simply won't know.

The Economist states this is the most troubling aspect the markets much face, and I agree.

Conclusion

The markets have a lot of problems to work through right now. The process won't be easy -- and in fact is very dangerous. While I have faith we will get through this, it will be a difficult time for all.