"America faces day of reckoning with debt"

This grim headline appears in the UK’s Telegaph in an article by Ambrose Evans-Pritchard (hat tip Financial Armageddon) which is well reasoned, once you get past its fire and brimestone tone.

It argues that the countries with chronic balance of payments deficits are all in dubious shape and can no longer serve as demand engines. Thus the fate of the global economy is entwined with how these countries, and the US in particular, fare, which in turn hinges on the severity of the US credit crunch. And Evans-Pritchard is not sanguine on that front. Note that his article discusses downgrade risk for MBIA, which at least for now, thanks to a $1 billion investment by Warburg Pincus, has been forestalled (although some believe more capital infusions will be necessary).

Evans-Pritchard explicitly disagrees with the “decoupling” thesis, which says that even if the US has a sharp contraction, the rest of the world need not be affected. Nouriel Roubini has taken issue with this idea since 2006 and updates his views here.

From the Telegraph:

The rising economies of Asia are too small and deformed to save world growth as America, Britain, Australia and Club Med face their day of debt reckoning. China may make matters worse, not better.

The seven pillars of global demand over the last year – measured by current account deficits – have been the United States ($793bn), Spain ($126bn), UK ($87bn), Australia ($50bn), Italy ($48bn), Greece ($42bn), and Turkey ($34bn). Most are facing a housing bust. All are in trouble.

China cannot possibly step into the breach. Jahangir Aziz and Xiangming Li argue in a new IMF paper that China’s economy is now so geared to the US and EU markets that a 1pc fall in external demand will lead to a 4.5pc slide in exports and 0.75pc fall in GDP. Assumptions that it will weather a global shock are “likely to be wrong, perhaps dramatically”.

China is gobbling up iron ore, soy beans and crude oil, but it accounts for less than 4pc of global consumption and is no longer adding to total demand. Imports have been flat since April. China is boosting GDP at the world’s expense, by snatching markets with a cheap yuan. It is beggar-thy-neighbour growth.

Note that Goldman Sachs, Morgan Stanley, and Lehman Brothers have all begun to tear up the “decoupling” manual – the pre-crunch script assuring us that the world could get along fine as the US buckled. “What began as a US-specific shock is morphing into a global shock,” said Peter Berezin, a Goldman Sachs strategist. “There is a clear risk that some of the hot housing markets in Europe and some emerging markets will cool dramatically.”

In Europe, not a single junk bond has been issued since August. Spreads on Euribor – the rate used to price mortgages in Spain, France, Italy, and Ireland – reached 93 basis points last week, a new record. This is tantamount to four rate rises.

Thomas Mayer, Europe economist for Deutsche Bank, said the European Central Bank must cut rates immediately, regardless of the lingering inflation threat. “This could go beyond just a normal recession. It could turn into a real economy-wide crunch that we cannot stop,” he said.

Four months after the global credit system suffered its August heart attack, nothing has been resolved. The US market for Asset Backed Commercial Paper shed another $23bn last week. The outstanding volume has fallen for 17 weeks in a row as lenders refuse to roll over loans, cutting off $393bn in funding since August.

For now, the consensus view is that sub-prime losses will total $500bn and crimp lending by $2 trillion as bank multiples kick into reverse.

This assumes there are no more shoes to drop. Yet shoes are dangling precariously across the global credit system. We may soon have to add the terms HELOCs and “monoline insurers” to our crunch lexicon.

HELOCs are home equity loans, the money extracted from houses. Many borrowers pushed their debt to as much as 110pc of house values.

Moody’s says 16.5pc of these loans are in arrears beyond 60 days. The HELOC market is roughly $600bn, so add another $100bn to the funeral pyre. These niches add up.

Monoliners are specialist insurers who earn fees by lending their AAA ratings to US states, counties, and cities for bond issues – the safest corner of the credit industry. The nasty twist is that most have ventured into mortgage debt to spice returns. They now face enough losses to threaten their AAA standing.

A downgrade means that every bond bearing their guarantee must be downgraded pari passu. Pension funds and institutions will be forced to liquidate sub-AAA holdings. A fresh cascade of distress sales will ravage the $2,400bn “muni” market.

The unthinkable now looms. Moody’s said it was “somewhat likely” that top insurer MBIA would fall below the AAA capital requirement: Fitch warns of a “high probability” that CIFG Guaranty and Financial Guaranty will be placed on negative watch. Both agencies are poised to issue verdicts. The insurers will then have a month to raise capital, no easy task after a 70pc crash in share prices.

US Treasury Secretary Hank Paulson can be forgiven for pushing through a rescue plan last week that amounts to a flagrant abuse of contract law and capitalist principles. His sub-prime rate freeze is undoubtedly a stinker. The reckless are bailed-out. Those who scrimped to amass a little equity get stiffed. Moral hazard runs amok. But bankruptcy settlements are always ugly.

Mr Paulson’s New Deal may at least reduce systemic risk. Frozen rates concentrate losses in the lower tiers of mortgage debt but rescue the upper tiers, which is where the threat lies for the financial system. Would free marketeers rather see the whole edifice of capitalism burned to the ground to make their point?

The root cause of this debacle lies in errors made by the Federal Reserve and fellow sinners. They inflated the credit bubble by holding interest rates too low for too long and lulled nations into suicidal levels of debt.

The strategic failure of a whole generation of economists, bankers, and policy-makers has been so enormous that it may now take a strong draught of socialism to save the Western democracies. We start – but may not end – with the nationalisation of Northern Rock.

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3 comments

  1. a

    “They [the Federal Reserve and fellow sinners] inflated the credit bubble by holding interest rates too low for too long and lulled nations into suicidal levels of debt.”

    By all means whack the Fed, but let’s not forget mainstream American economists (Larry Summers, Brad DeLong) whose answer to every weakness in the economy was to cut interest rates and have people go into more debt to keep consuming. That’s the root of all our problems – the idea that, come Hell or high water, the consumer must keep consuming. Until these economists and their bankrupt theories are run out of town, we will never understand what hit us, or what we need to do in the future.

  2. Anonymous

    This was not a strategic failure but rather benign neglect by the horde of bankers etc. Everyone was getting rich and couldn’t afford not to be “dancing.” Talk to anyone on Wall Street over the past several years and the average comment would have been waiting for the trainwreck. Sad but true.

    Well it is almost here. And yet, we have people out there saying the market is going to 1700? Maybe? For all the doom and gloom why hasn’t the equity market fallen? Maybe because while pockets/sectors have been hit the market is a self feeding mechanism and constantly reinventing reasons (decoupling, BRIC,sub prime ring fenced, debt paradgim shift, low interest rates forever etc..) for why certain sectors are relativily better. The “market” has turned into a casino and the government has perpetuated this with its interest rate policies and the evolution of the 401K industry – i.e. the capital markets gulog (partial jest). The gov’t knows there is too much “wealth” at risk and hence will take out all stops to avoid this end. There is this palpable feeling on the Street that the shell game is fatigued. I think this time will be different epecially when we look at this in the context of the geopolitical sphere.

  3. foesskewered

    Anonymous – been reading Das on the ft?

    Well, let’s just say the wealthy seem to have it so much better even in bad times, see Matthew Lynn’s piece on Branson in Bloomberg.

    It’s just that attitude to debt that’s worrying, it’s like reaganomics never went away.

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