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Economist's Corner: Is it a duck? (continued)

This time is different: balance sheet in-balances
With the breaking of the bond market bubble no one seems to want to take a flyer on asset backed commercial paper. This becomes a problem for banks that use commercial paper to finance their short term liquidity need. Since late July, the volume of commercial paper outstanding has shrunk by $300 billion, roughly 13 percent of the total.

This is a major problem for many of the structured investment vehicles that borrowed short in the commercial paper market and invested long in mostly illiquid assets. Banks have used these vehicles to take riskier illiquid assets off their balance sheets. The insolvency of these off-balance sheet entities will force the banks to infuse them with liquidity, hurting earnings or bring them back on to their balance sheets potentially creating serious challenges for the bank in meeting its own capital and reserve requirements.

The Risk CurveWe had a similar credit market freeze up in 1998. The difference then was there was only one firm with serious problems, Long Term Credit Management. The Fed and the Treasury were able to get the principals around a table and craft a solution. The credit markets were relieved, asset values were re-established and trading resumed. The equity markets rallied and the economy after experiencing a hiccup, continued to grow for another 30 months.

Today, there are dozens of firms that have been identified and very likely many more we don't know about that are at risk. These institutions are getting into trouble because they have taken leveraged hedged positions in different classes of bonds that depend on these classes maintaining a relative value. Unfortunately, the normal relationships between certain types of bonds have been turned upside down. There are a number of funds that are being met with high redemptions because they are exposed to the sub-prime markets. But no one is buying the sub-prime debt, so they have to sell what they can to meet redemptions. And so they sell the higher quality debt at a discount. 

If you are another fund holding that same debt instrument that just traded down, you just saw the value of your high quality bond drop. But because the lower quality debt you sold as a hedge is not trading, there is not a price for it; since you can't mark it to market you can't show the profit that should be on the hedged trade. Now, if the investor is not over-leveraged and forced to sell, it can wait a few weeks or a month and the normal relationship will come back. And they may even benefit as quality will rise even as the riskier instruments fall. But until there is a price made on the hedged low-quality asset, they cannot just make up a price based upon normal rational markets.

What we have is a banking system balance sheet problem. There is $900 billion in sub-prime paper on the balance sheets of the world’s banks, investment houses, hedge funds and mutual funds. In total there are 2,500 different sub-prime bond issues. Not all of them are bad. And even the bad ones will have some value. Most of this paper was issued in 2005-6. We won't know for several years how bad or how good some of it is until there is a better track record of defaults. The average sub-prime issue has 2.5 percent of its mortgages repossessed, another 5 percent in foreclosure and another 12 percent 60 days overdue. Some are doing better, others worse. That will change over time, the fear is that falling housing prices will only make this worse as it takes away any incentive to keep paying the mortgage.

Future scenarios
All of this is going to take time to work out. And during that time, the credit creation function of the banking system is encumbered in a way that hurts growth. Loans don't get made, terms and conditions are tightened. All of which leaves us with three possible scenarios, ranked by their probability:

Commercial Paper OutstandingEconomic hiccup : Much like 1998, all of this gets worked out fairly quickly. We have a flurry of bank bankruptcies and workouts but the financial system absorbs these losses and the credit creation process is quickly re-established with tighter credit. The result is a short period of weak consumer spending growth, perhaps a negative GDP number for Q4 2007.

Traditional recession: Much like 1990-91 with a Resolution Trust Corp set up to help homeowners stay in the homes and banks get their balance sheets back in place. The result is 2-3 down quarters for consumer spending.

Japan-like recession: Much like Japan in the early 1990s, unable to figure out just what assets are bad and which institutions are tainted, the whole system grinds on slowly working through these problems. The result being slow to negative growth lasts for several years with home prices falling, consumer spending weak and domestic business investment in decline. 

While financial markets are driven by a combination of greed and fear, grief is probably a better model for gauging the progress of the economy through a recession. Recessions are not unlike deaths in the family. In this context, the business cycle is just another dimension of the life cycle. Homeowners potentially face trillions of dollars in lost home equity over the next several years. The reverse wealth effect from that loss should shave billions off of consumer spending. That drop alone should be enough to prompt plenty of grief in the retail sector.

The benefit of recessions
While we would all like for the economy to grow forever, they never do. Recessions are a healthy and an integral part of a market economy. They clean out the excesses in the financial markets. They reward the well-run businesses by ridding them of competition from poorly run ones. They free up resources to be more efficiently used elsewhere. They help to keep inflation in check. And fortunately, they don’t last very long. The average recession lasts just 11 months. With little inflation and strong growth overseas, this recession should be short lived.

About Carl Steidtmann
Carl Steidtmann is Deloitte Research's chief economist and a director of Consumer Business Research.  In 2003 Consulting Magazine selected Dr. Steidtmann as one of the 25 most influential consultants for his work in consumer spending forecasting. He earned his Ph.D., master's and bachelor's degrees from the University of Colorado. He is based in New York.

About Deloitte Research
Operating through a network of research professionals, senior consulting and accounting practitioners, academics and technology partners, Deloitte Research delivers innovative, practical insights companies can use to improve their overall business performance. Through its in-depth publications, surveys, reports and commentary, Deloitte Research identifies, analyzes and explains major issues that drive today's business dynamics and shape tomorrow's marketplace.

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