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Jewish World Review
August 21, 2007
/ 7 Elul 5767
A crisis of confidence
Greed or fear, it is often said, propels financial markets. Today, it is fear. Compounding the fear is the eerie feeling that nobody really knows how bad things may be. The markets are seized by the sense that the air is going out of the global real-estate and financial bubble. Now the question to ask is who is going to suffer the consequences as the tide goes out and reveals who has been swimming without a bathing suit?
How could the public not be concerned when hedge funds run by two of the most sophisticated firms on Wall Street, Bear Stearns and Goldman Sachs, both renowned for their ability to quantify risk, ran into difficulties because their investments in highly rated structured bonds turned out to be worth less than thought? With the Goldman Sachs fund dropping more than 30 percent in a week, no wonder everybody began heading for the exit.
The virtual freeze in credit markets follows the extraordinary boom that financed a wave of corporate takeovers and created many first-time homeowners. No one knows the true value of all that residential real estate at the base of the pyramid in which mortgages back up the collateral debt obligations that in turn back up the short-term loans that many banks and hedge funds have made to finance these CDOs. A recent review of would-be homeowners is hardly encouraging. Almost all exaggerated their incomes to win approval, and almost 60 percent inflated their incomes by more than 50 percent. Too many home loans did not require any down payment, principal repayment, or documentation. In the state of Florida, home buyers last year devoted more than 30 percent of their median income to pay their mortgage, compared with 18 percent in 2003.
Guessing game. With home prices falling rather than rising, refinancing is impossible for borrowers who fall behind. Defaults have accelerated. As one pioneer in the bundling of mortgages into marketable securities put it, "We're not really sure what the guy's income is, and...we're not sure what the house is worth."
This is matched in the world of corporate finance, where "covenant-lite debt" that relieved the borrowers of much of their accountability for performance was barely 1 percent of corporate financing 18 months ago. Now it's one third.
Many pension funds, insurance companies, hedge funds, and banks hold swaps and subprime derivatives but have not yet reported their losses, or at least not all of their losses, making it difficult to understand how big their exposure is. They are having difficulties determining the value of assets, making them impossible to sell, i.e., illiquid. The danger is that a liquidity crisis will drive financial institutions into insolvency, which could have a major impact on the economy.
The central banks have seen the threat. The European Central Bank has put up $212 billion "to assure orderly conditions in the euro money market." It's an amount so staggering that it perversely led the markets to fear that the ECB knows something that would indicate the situation is worse than it seems. The Federal Reserve similarly stated that it would provide "reserves as necessary." The concern is that the market has such anxiety about all debts, up and down the food chain, that no one will wish to buy them.
Put it the other way: Fewer and fewer lenders are ready to lend. Many were going to sell high-yield bonds to finance their growth; they have had to withdraw them. In July, the issuance of these bonds dropped about 90 percent from June to a mere $2.4 billion. Even high-quality investment-grade bond offerings from companies with excellent credit fell from $109 billion in June to only $30 billion in July. This is bound to reduce economic activity and the jobs and incomes that go with it. The effect is similar to a run on the bank when depositors fear bank failure. The situation gives new meaning to the aphorism that nobody runs faster than a sophisticated banker who gets scared.
The Federal Reserve Board may not wish to create the moral hazard of solving problems for investors who made bad decisions. Investors have to pay for their mistakes yet the Fed cannot allow the crunch to get so severe that it imperils the nation's entire credit system.
Not all panics necessarily lead to economic downturns. But in this mood of uncertainty, confidence in the markets can deteriorate to the point where it mirrors the old Wile E. Coyote cartoon in which he thinks he has been running on solid ground but then comes to see he has passed over the edge of a cliff.
The Fed's lowering at the discount window will help the financial markets, but what remains to be avoided is an economic downturn. John Maynard Keynes, the greatest macroeconomist of the past hundred years, once famously said, in effect, "In the long run we are all dead." Wrong. In the long run, we will all survive and flourish; in the short run, we can be dead. That is what the central banks of America and Europe must prevent.
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© 2005, Mortimer Zuckerman