Thursday, January 24, 2008

A new acronym means recession could be worse than many claim

You’ve learned about CDOs and SIVs; now, it may be time to bone up on CDSs.

John Markman claims credit default swaps by banks and other financial institutions will add extra pain to the current recession:

Nearly seven decades ago, the eight months between Germany’s invasion of Poland in 1939 and its invasion of France in 1940 was known as the “phony war” — a period of escalating anxiety, denial, appeasement, danger and death, but nothing like the murderous global train wreck soon to follow.

Likewise, we may come to look at the period between July 2007 and January 2008 as a sort of phony war in the worldwide credit crisis, because although the market has fallen 15 percent since summer, there have been no defaults of key bonds or asset-backed securities. The curious lack of real blowups has led even seasoned observers to believe that fears were exaggerated and that chaos will be averted.

In reality, however, the skirmishes we’ve seen so far might be little more than a prelude to a deeper, harsher, longer decline than most yet perceive possible. And in a very postmodern twist, it is beginning to look like unexpected consequences of an investment instrument designed to mitigate risk could turn out to be the nuclear option that bombs the globe into the financial equivalent of World War III.

Here’s why CDSs could be a problem, according to Markman:
Because we are coming out of a long period in which debt defaults have been unusually low, hundreds of little-known hedge funds, pension funds and insurers worldwide were lulled by a false sense of complacency into the practice of selling CDSs — and their ability to pay up in the event of widespread defaults amid a long, hard recession is not just in doubt but completely unlikely.

Markman lists various ways these issuers are likely to try to get off the hook. They include contract loopholes, imprecise language not crafted to a specific bond insurance need, whether or not a bond issue’s “restructure” equals a default, available collateral and hedging of CDSs, and more.

Oh, for a good summary list of financial acronyms, visit this Economist story.

[More econ news below the fold]

Housing slump worst since Depression?

For the first time since comprehensive records going back to 1968, housing prices declined for an entire year in 2007. How bad is it? Even the financial guru for the National Association of Realtors was glum:
Lawrence Yun, the Realtors’ chief economist, said it was likely that the country has not experienced a decline in housing prices for an entire year since the Great Depression of the 1930s.

In other words, neither a Fed rate cut nor a one-off stimulus package is going to make a lot of difference. The housing market is going to have to suffer through this; I hope part of the price of that suffering is a variety of new regulatory legislation, not only on the marketing of subprime loans, but the use of things such as CDOs and SIVs by financial institutions, AND…

Regulation to address the currently incestuous relationship between these institutions and ratings agencies such as Moody’s.