Caught in a Downdraft and Starting to Panic
By Steven Pearlstein Wednesday, January 16, 2008; D01
Are we having fun yet?
Okay, so maybe the economy has fallen into recession. Maybe house prices are going to decline 12 percent by the time it's all done, as Fannie Mae's chief executive said last week. Maybe this won't be the year for that 13 percent stock-price rebound that Goldman Sachs's crack investment strategist, Abby Joseph Cohen, predicted only last month. Maybe nearly a million workers were added to the unemployment rolls in the past nine months and a million more will be added before it's all over. And maybe there's really not much that the Federal Reserve can -- or should -- do to prevent this painful adjustment.
But, hey, look on the bright side: The country and Wall Street have already made great progress in moving through the stages of economic grief:
Willful blindness. ("Bubble, what bubble?")
Denial. ("House prices never fall. It's only those speculators in Las Vegas and the Gulf Coast.")
Rationalization. ("Maybe subprime did get out of hand, but it's really a small part of the market.")
Fantasy. ("Things should be pretty much back to normal by the second half of '08.")
Anger. ("If it weren't for those yahoos up in structured finance . . . ")
Capitulation. ("We might as well take these write-downs now and get it over with.")
Depression. ("This is going to get worse before it gets better.")
Now we're entering a new stage: Panic.
. . . Despite the brave exhortations from the CNBC Squawk Box, we are nowhere near the end of the financial unraveling that is necessary for an economic bottom to be reached.
. . . Looking ahead, the final phase of this unraveling is likely to implicate the giant market in credit-default swaps. Those swaps are essentially contracts that allow sophisticated investors to bet on whether a company, a government entity, or even a securitized package of loans will default on its debt obligations.
. . . Because these contracts trade on unregulated derivatives markets, nobody knows who holds the losing side of the bets. But it's a good guess that if defaults rise even to historically normal levels, a big hit will be taken by highly leveraged hedge funds, some of which may be unable to pay off on their bets and simply collapse. That, in turn, would trigger even further losses by banks and other investors that, unlike pure speculators, rely on those instruments to insure against default.
The credit-default swap has become so central to modern global finance that its size -- the amount insured, in effect -- is estimated at $43 trillion. If the losing side is unable to make good on even a fraction of a percent of those contracts, it could set in motion a financial chain reaction that could easily rival the subprime debacle.
Steven Pearstein is a business columnist of such clarity and lack of hubris as to be almost unknown among the high-priests of glib econospeak who usually advise investment bankers and handle the punditry on CNN. He presents financial news with the simplicity of my old daddy's iconic two nails on the wall--one for what is owed you and one for what you owe. Daddy understood capitalism.
To its chagrin, capitalism no longer understands daddy.
Daddy and Pearlstein don't have Harvard Business School degrees, but they might have saved Wall Street (and you and I) the grief that is surely coming our way. The producer nations are doing what they can for our failed consumer nation but, ultimately, they probably haven't the cash. $43,000 billion is a lot of dough.
America, for all its faults, has a symbiotic relationship to the rest of the world. We remain the planet's largest buyer of goods. Once producer to the world, Marshall Plan white knight and mecca to the hopeful, we're currently the broke and dissolute (but well armed) uncle, thrashing around in hallucinatory memory of former greatness.
Creditor turned debtor; China, India, Saudi and Japan hope to steer us toward a 12-step program that will keep us from unraveling the world economy. God knows we are raveled. It may be too late.
The planet sucks in its breath and hopes not.