U.S. Economy "Heading For the Rocks"

"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.

Comments

[daniel155]

This author tends to always predict an economic downturn and given the cyclical nature of business and the markets he will eventually be right if he keeps making the same prediction.

[daniel155]

The author states that there is risk in investing. Well, there is always risk in investing and there is risk in not investing as well. That risk is the risk of missing opportunities.

The author always predicts an economic downturn. Given the cyclical nature of business there will be one eventually so if the author continues to make the same prediction he will eventually be right--bullet points and all.

[givemycountryback]

I agree with Rule Of Law. I put nothing past the republicans and corporate America. They are destroying our country. Well I feel they already have. We have to grovel for low paying jobs if we are lucky enough to get one. Not everyone is in the top 1%. A lot of us have no insurance, no huge 401s which I am sick of hearing about, and not much of an old age to look forward to. I worked full time for 30 yrs in pink collar jobs which paid barely above minimum wage. Economic problems forced me to cash in my 401 early. Well i am rambling but I am so pissed at this bunch of wealthy crooks in Washington. I wish they would walk in our shoes for a while.

[realitytrumpsbull]

Well, maybe if the economy was less 'con me' and more honest, there'd be less of a problem.
Enron was just a symptom, the problem is the underlying mentality...good show, dobberdoss, debt-free is the place to be...

[dobberdoss]

The best news of all is that other nations are in the exact same boat heading towards ablivion.

Me, I bought a small life raft & started paddling down `debtfree` river. Good luck all the next few years!, GREED gets you nowhere.

[ReasonIsMyReligion]

Most Americans will NOT default on their mortgages.

And yet the FEW who do are having an effect on the NATIONAL economic picture.

So unless you're not only debt free, but living on a tropical island sucking coconut milk, you will be impacted.

[marko77]

"Ronald Reagan said when he signed the S&L deregulation bill,"Boys, I think we've hit the jackpot". We all know how that turned out. What would the great communicator think of deregulation now?" by Ranta
-------------------------------
What would Reagan say? I bet nothing different. That's why he was such a slug - i.e. someone with no intelligence.

[Rule Of Law]

Hey Fellas--I'm impressed. Learned a bunch reading through these posts about all things financial.

So here's the 1.2 Trillion dollar question--

What if--along with such grinding debt that all our social support programs die--this is all a part of a much larger plan to finally destroy the American middle class by taking that last thing that makes us all feel as though we are a part of something bigger; Our homes.

Our jobs, as you say, are already gone.

Our wages, such as they are, have not kept pace with inflation.

Our borders, and the problems they create, have allowed the jobs that remain to go to the lowest bidder.

Our retirement funds--See Enron etc...--and our unions are gone and powerless.

What else is there to take but our land?

They already have our constitutional freedom!

What is that called? Trickle-down enslavement?

[dadw5boys]

Did you not see the ecomonic slavery as the end game for NAFTA. What did you expect when you send jobs overseas where they pay pennys instead of dollars for a days wages.
With truckers now delivering good strainght thru from ports in Mexico don't you see the total collaspe of the middle class.
Workers in the northwest ports will have to take pay cuts or the ships will just begin dropping off in Mexico and shiiping cheaper from there.
American business bring forgien workers from ElSalvador, Equdor and other places into Mexico claiming they need these workers becasue MEXICAN WON'T DO THIS WORK.
How would you equalize the value of labor between South America and the worker in the USA without crushing the saftey nets like welfare, health insurance, worker saftey rules and retirement plans?

[themodernleader]

In the sub-prime discussion I believe these depressing facts have not been discussed. First, this bubble caused thousands of acres of good farm land for raising livestock and grains to be turned into buildings, roads and parking lots. This is a national disaster for it diminishes our food supply growth potential.
Second, the tax laws for the last couple decades of Reagonomics has encouraged the average homeowner to "buy up", that is, apply no capital gains if he or she bought a larger house after selling the old one. Now a huge percent of non-subprime, AAA loans, I believe (with no substantive data) are to people who have homes that they can ill afford to heat or pay the onerous taxes demanded by our new Mandarin Class of civil workers.
Third, the speculation in such places as Miami and Las Vegas fueled a condominium boom that has thrown billions of dollars down the drain on unjustified skyscrapers.
This management of the American economy is as bad as the old Central Committee that managed the Soviet Union's economy.
This gross incompetence is too big to contain without destroying our currency. The best action is the worst case scenario: Do nothing. Then allow the shocked, dispirited and suffering citizens to pick up the pieces with new leadership and spend the next 75 years undoing a bankrupting economic theory managed by ignomonious leadership.

[Ranta]

We have had the S&L shakeout in the early 90's, the Enron debacle recently and now this. Since the early 90's big business has touted deregulation. It's the "He who governs least governs best" philosophy.
Unfortunately, it doesn't work that way. Human nature is such that left unregulated, people are going to steal. I guess that's why anarchy will never work.
Ronald Reagan said when he signed the S&L deregulation bill,"Boys, I think we've hit the jackpot". We all know how that turned out. What would the great communicator think of deregulation now?

[milo9]

Headed for rocks? Well yea, like even a bucket like myself could see this coming a mile off.

[dobberdoss]

your not the only one!, I got out years ago

[Craig in GA]

What's killing real estate prices and liquidity in my region is that consumers are so tapped out, their only relief involves exchanging their residences for less expensive ones in order to pay off debt and reduce expenses. That means constant downward pressure on the high end of the market.

When these home owners are successful, they're usually replacing a big mortgage with a smaller one. The difference between the bigger and smaller mortgage represents the liquidity lost to the banking system.

This is a self-reinforcing downward spiral.

[montemalone]

The hedge fund managers and big banks will pressure (i.e.withhold donations) the administration until rates are back down to 1%. The fed will comply using the rationale that they are providing a means for those "trapped" in adjustable rate mortgages that have reset to higher rates to re-refinance, this time to lower fixed rate loans.

[Thingumbobesq]

The reason that so few can conceive the presence of various bubbles going back to the tulip and the John Law bubbles is that monetarism is a pathological belief system. Monetary values are not reality as Mark Twain humorously limned in one of his writings (I forget which one at the moment.) What is real about the economy is whether or not it can adequately sustain a population in the here and now AND in the future. The recent visible collapses of our nation"s infrastructure are the product of the ideological delusions wrought by monetarism"s salacious grasp upon the body politic (pardon the mixed metaphor.) I write this knowing full well of course that most readers will have very little idea whereof I speak due to the execrable state of our education system in this regard.

[Unsui]

Thingumbobesq: I believe that was "A Connecticut Yankee in King Arthur's Court". I may not be correct about that title but Twain's argument has always made perfect sense to me.

[kccrafts]

Remember, Karl Rove believes that the Bush Administration has the power to "create its own reality" >>> and it has with the employment situation.

Over the past five years, BLS has routinuely added jobs via the birth/death factor to meet analysts & economists expectations. Last month, more vapor jobs were added than they could actually count. In the real world, the US has been losing jobs net-net over the past two years. Essentially this number is entirely fictional and .... malleable.

Consequently, it is entirely likely that this month the powers will determine it is more politically expedient to show a job decline.........and not so many people will die needing to be replaced.

If you would like to look at more stats from the real world, go to shadowstats.com Its the best place to discover what is really happening with the US economy.

[Spookcatcher]

As with the overwhelming vast majority of the people in America, and even greater overwhelming people of the world, we personnally do not have enough, if any, money we cannot live without, invested! In case you didn't see the latest numbers, the median household income is $43,XXX. We are scraping by. We are trying to pay the bills we have, not gambling on the stock market, or on our mortgages! If the players of these obvious ficticious schemes of moneymaking activities that created these problems, have ruined their"credibility" across the globe, and some spoiled big concerns (greedy lenders)lose everything, Tough Luck! And, as for all of those, perhaps even a lowly bond broker, have to go to work at McDonald's (or Wal-Mart), welcome to the ground floor of Our Democracy. Oh, and when I order my hamburger from you, hold the onions, I'm out all out of tears....

[altohone]

Nice piece Hale.

Rather than looking back, how about a little prognostication of future targets for the speculators?

I keep hearing about all the cash sitting on the sidelines... I'm assuming the housing implosion will recover too slowly to attract bargain hunters for a while, and I know these types won't wait years to find better returns.

Any thoughts?

[Halsey]

alto..don't bother to ask for comments..hale..never comes back (Hale..do you READ the posts...please tell me you do)..
anyyyywayyyy...Hale..you add:

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.

MY ..not solution..but answer is...These young Wharton Turks..need to go to PRISON for fraud..sound extreme..well, these are extreme times. Their fraud is creative financing..giving some ad hoc value to securities (there's a misnomer if ever there was one)..is..in effect..fraud.. it would be like me..selling a 5 carat cubic zirconia for $75,000...they value just ain't there...

These guys have brought down a fragile house of cards, onto all of us...and need to pay..with their freedom... a burglar steals from one home..
Lehman, Bear Stearns...et al, have stolen from the world.