Friday, October 10, 2008

Academic perspective? or incessant rambling?

Trying to step back and answer some of the questions people have been asking over the past few days in particular. They will not be particularly formal and clearly I have no idea of anything in the future, but since I keep getting asked, at least this MAY cut down on that.

1. Why should the government do anything? They don't when other companies go out of business.

A. Well, maybe the government should not do anything. I am not sure what I would have done, but given the size and severity of what is happening, I do think I would have intervened.

Some very good cases can and have been made for letting markets sort this out. Indeed, I am a big free markets believer too, but (and this is always dangerous to say), things are different this time. Most notably when a store or even large manufacturing firm goes out of business, they only marginally impact the overall economy. But banks, by being a provider of liquidity for many businesses and people, can help spread the problem. For instance from a 1994 paper by George Kaufman in the Journal of Financial Services Research.
"Contagion is a term used to describe the spillover of the effects of shocks from one or more
firms to others,l It is widely considered to be both more likely to occur in banking than in
other industries and to be more serious when it does occur. Bank (depository institution)
contagion is of particular concern if adverse shocks, such as the failure or near-failure of
one or more banks, are transmitted in domino fashion not only to other banks and the
banking system as a whole, but beyond to the entire financial system and the macroeconomy...."
Limited intervention now may limit the severity of the problems and thus in the long run mean less intervention is needed.

2. Has there ever been anything like this?

Yes and no. Yes to the degree that markets collapse, yes. For instance from 1929 to 1932 the US markets dropped by nearly 90%!
From the BBC:
"In two days the Dow Jones industrial average fell by 25% (ending on Black Tuesday, 29 October).

The volume of stocks traded set a record that was not broken for 40 years.

When it finally reached its record low in July 1932, the Dow Jones had fallen 89%, and it did not recover to 1929 levels until 1954"
Similarly the recovery in Japan was long and difficult with even today, 18+ years later, the market at only a fraction of its 1989 peak.

But there are differences. Take the US for instance. Homeownership is at record levels (and real estate prices have fallen in many areas). Stock ownership by individuals (through mutual funds, retirement plans, or just in regular accounts) is MUCH higher than during even the crash of 1987. So we just do not know the wealth effects we will see of the estimated 8 trillion dollars in the US (remember that is just equities and does not include real estate losses) or approaching $30 trillion worldwide in stocks. Will people stop spending so much? Almost assuredly.

3. What caused it and who is to blame?

Many things and many people. Unfortunately there is no single answer. Among the things, we loosened credit to allow more people to own their own homes. This while good in and of itself, helped to spur a real estate bubble. A colleague Giles Bootheway pointed out at a recent forum on the subject, this was added to by the low rates the Fed maintained well after (too long?) 9-11.
As things often do, one thing lead to another and in many places homes kept going up in value. This led to people thinking that prices would always rise. This then led to banks believing the same (they definitely should have known better) and making loans with very little low downpayments and with clauses that often increased the required payments after a few years. When the economy slowed only marginally, this led to many sub-prime borrowers not being able to make payments.
As these mortgages are been combined into new securities, the owners of these (often the larger bank and if not the larger banks often had put provisions so we liable) saw asset values drop. As this happened, they both sold other things to get cash (which drove other assets down) and largely quit making loans.

4. What is next?

No idea. We are not going to be out of this for a while. Sure the correlation between market returns and teh economy is low, but I have a very tough time not imagining at least a fairly pronounced recession.

That said, there will be many other impacts as well. Regulation will surely increase. My guess is that serious talk of privatization of social security will be tabled for years. There will be many law suits. Bond rating agencies, audit firms, and others will no doubt be the target even if undeservedly so.

Also it is very likely that risk premiums will be higher as a large percentage of the population (and not just those involved in finance) realize the limitations of diversification and that markets do not always go up.

5. What should I do now with my own portfolio?

Well if I could answer that one do you think I would be giving away info like that!? lol....Won't touch it Sorry.

I do feel bad for you, but if misery loves company, it is largely happening to everyone. This collapse is global with many indexes are down much more than those in the US. Moreover, the ones I really feel bad for are those who just retired or are nearing retirement. Last night at the store I heard of one recently retired man who is already trying to reenter the workforce as he does not feel he had enough set aside now that his portfolio is down by almost a quarter (which could have been much worse!)

1 comment:

nick said...

When the government provide $700b, it can be save the economy?