Cost of "Risk" Soars; Economy Threatened

The last few weeks have been eventful ones in financial markets and for economic news. We've started to write to you several times about it and were afraid we were getting bogged down in the technicalities. We'll try again here; some of the "technicalities" are important for everyone, not just financial market specialists.

Investors Suddenly Realize Their Assets Are Risky!
We talked to you in early August about how subprime mortgage lenders got "carried away" with their lending. Other investors were also quite exuberant. The spreads between the interest rates on risky assets, for instance, low-grade ["high yield"] corporate bonds, and US Treasury securities were at all-time lows from 2004 through the middle of this year. Similarly, securities backed by credit-card debt also had narrow spreads to Treasuries until very recently. As the severity of the mortgage crisis came to light, investors dumped their risky holdings and switched to more of the safest asset, the Treasury notes and bonds. This demand drove down Treasury interest rates and pushed up rates on other debt. The suddenness of this move – within just a couple of weeks – caught many investors and bond issuers off guard.

Some issuers of debt occasionally utilize bridge loans while they are preparing a more permanent bond issue. These bridge loans are not usually bank loans, but short-term market instruments called commercial paper. This paper has had shorter and shorter maturities over the years, so now more than half comes due in 4 days or less. During early and mid-August, as markets were in turmoil, some funders of commercial paper withdrew this financing, leaving would-be issuers in the lurch. Their plans were incomplete, but they couldn't proceed without the interim funding. Some "deals" were cancelled, postponed or had their prices reduced.

The Fed Helps Out
The Federal Reserve provided some limited help to prevent these disruptions from spreading through the banking system. It added billions of dollars in short-term funds to the money markets and it reduced the discount rate, the rate it charges for loans it makes to banks. The infusions of cash were the largest since the aftermath of 9/11, when Wall Street shut down briefly. The Fed further encouraged banks to borrow from it, an action banks are loath to take, because they believe it shows they cannot manage their business properly. Not many are borrowing even now, although the quantities they are borrowing are the largest in years. The Fed is anxious not to be seen "rescuing" or "bailing out" bankers and investors who made poor decisions, but the Fed needs to try to protect the underlying health of the financial system.

But Jobs Post a Surprising Decline in August
Until this past Friday, we thought most of the damage from these dislocations was going to be confined to housing markets and to financial institutions. But then the Labor Department reported that the number of jobs in the US decreased in August by 4,000. This is a tiny number when there are 138 million total jobs, but an outright decline has historically been a signal of genuine weakness, at least bordering on recession. Some of the decline was related to varying dates of school openings across the country, which cut government jobs reported in education. This should reverse shortly. But employment in construction fell 22,000, accounted for mainly in residential contractors, and there were small declines in manufacturing of wood products, furniture and electrical machinery and appliances, all products related to home-building. In contrast, a number of service industries, especially retailing and hotels and restaurants, had nearly offsetting gains. But the handwriting is on the wall: the disruption in housing finance is great enough that it could impair the actual performance of the economy. Those laid-off construction workers can't spend as much on themselves, so strength in retailing and restaurants might not last for long . . . .

The Federal Reserve will hold one of its regular policy-setting meetings next Tuesday, September 18. They are likely to do what they had hoped to avoid, cut their key short-term interest rate, the "federal funds rate". This has the effect of lowering costs throughout the financial markets. While some had argued for this move earlier, it may have been seen as the bail-out no one really wanted. To a degree, the markets themselves have already effected some easing through the lower rates they have engineered on Treasury securities. But the Fed's action would affirm their judgment and hopefully relieve some tension and nervousness.

Can Fed Action Limit the Fall-Out Enough?
Notice here that we have not once mentioned the stock market. As we explained in an earlier article on this situation, the rest of the economy has so far held firm and the vast majority of businesses are maintaining their profitability. So while the stock market has been highly volatile in the midst of the uncertainty, it has not broken down. The companies who make it up are not the source of the problem. They and their stocks may suffer, but other sectors of the financial system are where it started. Possibly – possibly – if the financial turmoil can be contained with the corrective actions already being taken, that spillover won't result in a self-reinforcing economic contraction. Stay tuned and hang on: it may not be a roller-coaster, but it's certainly a very rough ride.

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Clearly there are lots more features to this story. We will follow soon with further comments about housing and homeownership in particular. Also, our entire explication above centers on "risk". We need to talk about that, why it's important and how people are compensated for bearing it. And who is the amorphous group we keep referring to, "investors"? What do they do and does it matter to me?

Entirely separately, in a preview of a different coming attraction, we got asked a pointed question by Matt the Web-Dude about the propriety of Mrs. Astor using her money to fund art projects. Wasn't there some higher use for the funds, he argued. This will bring us to the value of art. It indeed has value and even economists can talk about it in their own language. Stay tuned, as well, for this divertissement!