Uncharted Waters

Several months ago, midst great fanfare, a local developer announced plans for a massive, mixed-use building diagonally across the street from where I live in Brooklyn. Sixty-five stories, with retail stores on the street, then classrooms for the local college, then umpteen floors of condo apartments. Ten days ago, as reported well inside the New York Daily News, the deal between the college and the developer came unraveled due to "cost overruns". The big talk has disappeared, along with 55 stories of the envisioned Tower, and the college will proceed to build the utilitarian, ten-story classroom building it really needs.

Thank goodness.

It's "deals" just like this that have the U.S. economy in considerable trouble and canceling them beforehand will prevent some more trouble down the road. The housing and development bubble has burst, and contrary to one media assessment the other day that its effects are merely "lingering" and a credit-rating firm's comment just today that much of the bad news is already out, it seems to us that those effects have just begun. We don't really know how this will play out.

The Financial Waters Are Always "Uncharted"
"This time is different", economists are fond of saying when they can't explain or predict. Yes, this time is different, and we can describe that, but every recession is different from every other, so that's no excuse for expressing bewilderment at the unexpected path this one is taking. The new wrinkle now is the tiered financing schemes that financed the house price surge – and the financing schemes that funded those and other financing schemes, which in turn are funded by still other schemes, and on and on. For example, we are intrigued to learn that the "buyout firms" which issue debt to buy up the equity in various companies are not the ones liable for the interest and principal payments on that debt; those companies are. So if the management policy changes imposed by the buyout firm don't generate enough extra profit to cover the debt cost, the bought-out company will be in trouble. If interest rates go up, the situation is worse. Several well-known firms face just such consequences today.

Fed Tries To Shore Up Monetary Policy
In the risky financing markets, investors are shying away from many forms of private debt. This means that even though the Federal Reserve has cut base interest rates substantially in the last few months, rates on much debt have not seen much relief, as risk premiums have widened considerably. The Fed is seeking different ways to help in this increasingly tenuous situation where its standard policy tools have less impact than their historical norms. In December, it altered the way it supplies new money to the banking system, increasing the size of individual injections and lengthening their maturity. This is good if you're a bank. But another distinctive feature of the current experience is the greater roles being taken by firms and funds that are outside the banking system and have no account at the Fed that can be credited with new reserve money. So doing that has more limited impact than would have been the case historically. Tuesday the Fed announced a new system, where it will lend some of its holdings of US Government securities to stock and bond dealers, and they, in turn, can put up mortgage securities as collateral. This plan can help support the market for mortgage securities and reduce the greater risk now prevalent there, letting the lower base interest rates do more of the work they're supposed to.

Historically, financing of day-to-day economic activity was centered in commercial banks, and thrift institutions handled most mortgage financing. These two institutions were heavily regulated. Before you say that we should revert to this seemingly simpler financial organization, we'll point out that recessions, when they came in those days, could prove deep and prolonged, due at least in part to a lack of flexibility among lenders and also businesses. In contrast, the last two recessions, in 1990-91 and 2001, followed considerable deregulation of financial institutions along with the computerization of business, and these down-cycles traced a more saucer-like path, with the economy sliding gradually and climbing out slowly. And other recent scary episodes, such as the stock market crash in 1987 and the Russian debt default in 1998, did not produce generalized recessionary conditions at all. Now, though, the involvement is much broader, with U.S. consumers (that's us!) and businesses feeling restraint from crimped credit conditions as well as surging energy costs.

Which Way Is the Shore? Can We Get Back There?
Last Friday's February employment report from the Labor Department showed jobs contracting for a second consecutive month. Other basic indicators of activity, such as industrial production and retail sales, have been flat to down for the last three or four months. So the overall economy appears to be "dead-in-the-water", but hardly in a steep decline. Surely, home-building has pulled way back, but sustained growth in exports has basically offset that downward pull. So in all, evidence is presently inconclusive on how hard or long the economy's fall will be. Surely we have said enough here to imply that we're pretty concerned because it's not clear how much negative force might come as a financial house-of-cards continues folding in on itself even as rising food and energy costs eat into consumers' discretionary income. Still, growth persists in some sectors and also in other countries, and with active, creative monetary policy, that may stave off further worsening.

Meantime, what can you do? There's our usual mantra: pay down your credit card debt. In fact, that's exactly what you can do with the extra tax rebate you'll soon receive from the IRS. And there's another avenue of caution. With the plethora of complex financial instruments floating around, make sure you understand the terms of loans and other credit agreements you have and that you understand all the features of the financial assets you own. One of the sorry stories of these times was the loss by two brothers of the better part of an inheritance. As explained in the Wall Street Journal about a month ago, their funds were invested in supposedly safe "short-term" securities. But those bonds had their own wrinkle, and they not only turned out to have an actual maturity several years out, but in nervous markets to face lack of any trading outlet. No one would cash the brothers out of their bonds, which dropped half their value almost overnight. This week, too, with one of the country's major hedge funds having its assets seized by lenders, note that "hedge fund" is a complete misnomer: they aren't hedged at all, they're full of debt-laden risk. Things aren't what they seem: the sea's waves break where and when you're not looking.