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Keeping Things in Perspective, Part II

Posted by: Dean Foust on August 14, 2007

I’ve been chided by readers of this blog for a posting I made late last week, using some statistics to make the case that subprime loans are a much smaller share of the overall mortgage market that you might believe by the scary headlines. These readers take the view that there’s a credit crunch building that could take down the markets and the economy.

Even though I noted (probably too briefly) that the real issue was not just subprime, but also “Alt A” loans, Option Arm loans, traditional ARM loans, home equity loans, as well as the extraordinary amounts of leverage that hedge fund managers took on when buying these mortgage securities, I still got whacked by readers for taking too lightly the potential of a contagion that takes down other markets like dominoes.

Having the weekend to think through the potential risks myself, I acknowledge that you can’t lightly dismiss the risks posed by the subprime fallout. As just mentioned, subprime is but one of myriad different credit products that, we now realize, that either should never have been made, or weren’t priced to reflect the risk (and I haven’t even mentioned credit card debt). And the proverbial chickens are coming home to roost now, with growing defaults and the beginnings of what could become a full-blown credit crunch. The Federal Reserve, for instance, revealed in its latest survey of bank lending standards that banks have tightened lending standards on nontraditional mortgage products (though interestingly, it notes that it hasn’t seen any tightening in other consumer or commercial loans.)

Roubini_-_for_Website.jpgAre things going to get worse? Nouriel Roubini, a highly respected economics professor at New York University’s Stern School of Business (who is also runs RGE Monitor, an economic consulting firm) makes the case on his blog that the current mess has the potential to be worse than the fallout from the crash of Long Term Capital Management in 1998. At present, he argues, we have not only a liquidity crisis, but a credit crisis. His academic argument is well-reasoned and worth reading and can be found by clicking here.

dalio.jpgYet I surprised when I opened my morning email and found the daily market commentary from Bridgewater Associates, a hedge fund run by the highly regarded Ray Dalio (and Bridgewater is no johnny-come-lately fund run by 29-year-old Wall Street rocket scientists—the fund is an “old school” fund that has been around since 1975, and thus has seen it all, and now manages $165 billion in assets for clients. I found this link that provides Dalio’s bio and his investment philosophy.) In this morning’s missive, Dalio—whose firm has been very bearish on the markets for most of this year—argues, to my surprise, that the current situation won’t be as bad as some fear. I can’t provide a link—the research is provided solely to clients and select media—but I’ll quote from passages:

“Because this dynamic is taking place in an environment of abundant and growing liquidity, we believe that the contagion will be contained. In other words, because there are lots of investors with a lot of money to invest (i.e., institutional investors with big surpluses) who have lived the past couple of years hearing the investment mantra that “one has to jump on opportunities that come when other investors are afraid,” the spreads will not blow out in the same way as when money is tight. In fact, it is a reflection of the times that we are now seeing investment managers who have lost money going to flush investors to “allow” these investors to participate in “the recapitalization of funds to take advantage of great values due to mispricings.”

“We don’t know how far this contagion will reach, but we are inclined to think that it will be less severe than the one in 1998 ... The 1998 financial market contagion was preceded by lots of serious stuff, and even that contagion did not damage the real economy. The big difference between now and back then is that the U.S. balance of payments situation now looks like those of the deficit countries that had problems (though the foreign debt is in our currency).”

“So, my guess is that the financial market contagion will continue, but it won’t sink the economy, and it won’t be as bad as the one in 1998 (until the tightening comes along).”

I agree with Dalio. There's so much cash sloshing around the world, that it seems improbable that liquidity can really dry up.

Reader Comments


August 14, 2007 12:57 PM

The problem is that even supposedly sophisticated hedge fund managers like Dalio are thinking in terms of "contagion" when they should be thinking in terms of strength or weakness. You can contain contagion, but you can't eliminate weakness -- debtors who can't repay, hedge funds that are far too overleveraged, yen carry trade that is far too overblown, and companies that can't maintain double-digit earnings growth in a weakening economy.

The real problem is that everyone has become too short-term focused. Look beyond the current crisis du jour, and the next and the next. Tell me if you see any enduring signs of strength in the U.S. economy. I see...

Social Security/Medicare that needs to be fixed fast.

Health care cost crisis that needs to be fixed.

15 million barrels of imported oil a day at $70-100 a barrel.

Global warming problems that will cost trillions to fix.

Credit card debt crisis in the making.

Student loand debt crisis in the making.

Domestic manufacturing sector going bust.

Massive overbuilding in every category of commercial real estate.

Massive labor force unproductivity that will be weeded out, job by job.

A trillion dollar war that has been paid for 100% with borrowed money.


August 14, 2007 1:35 PM


There is not a lot of cash sloshing around in the world. If there were, banks wouldn't be so hungry for cash right now.

There is a lot of debt and leverage sloshing around in the world.

All debt must eventually must be repaid or defaulted.

All leverage eventually unwinds when the pendulum swings to deflation.

Jim D

August 14, 2007 8:18 PM

Stocks have reached what looks like a permanently high plateau.

- Irving Fisher, Professor of Economics, Yale University, October 16, 1929.

Beware of the false confidence of experts who are a little too close to the problem.

All the same, I'm really hoping you are right. But I don't think you are. I suspect you know the reasons I believe differently than you - I'd love to hear the reasons you beleive differently than me - and I do hope it's not "there's so much cash laying around", since as a previous poster mentioned, it's not cash, it's debt.


August 14, 2007 10:28 PM

If we are heading into "deep deflation," what is the best move you could make? I have given that question a lot of thought lately.

I think the answer is: buy as much crude oil as you can get your hands on. There is no way that any government or financial trend can debase oil. Oil rules. It has become the currency that nobody in the modern world can do without.

Fortunately, there is a simple way to sock away oil in your IRA or 401(k). It is USO.


August 16, 2007 4:52 AM

My biggest worry is that leverage has become so accepted as a transactional product, and has become so laundered throughout the wide and varied financial agencies, that leverage itself has become confused with currency ... that even someone as savvy as Ray Dalio (and do not mean that facetiously, I do respect his opinion) cannot distinguish the difference.

Again, it's not because Dalio isn't a smart man, it's just that some earlier shell-game up the pipe (and well beyond Dalio's line of sight) got the leverage thrown in with the money, and now nobody can tell which is which.

All this leverage, then, becomes a kind of secret fiat currency -- one who's value is based solely on the collusion of independent actors who's perception of reality is based solely on what they tell each other. But what happens to this pricing scheme when someone outside this privy sphere waltzes in and demands what's owed him?

Remember Parmalat? Remember how crude and blatant those guys were with their schemes, and still able to get away with it for so long? Hell, at the rate they were going, if you guys had reported that they were hand-scribbling crudely drawn Euro notes in crayon and trying to pass it off as hush-money, I'd just about believe it.

The lack of visibility in this market is astonishing, worrying, and deeply weird. For most of us, it's like being a passenger in a car going down the Interstate at 80 miles per hour.

... and it's midnight.

... and raining.

... and both headlights are broken.

... and you can't remember if the last sign you passed said "35W" or "E" on it.

But, hey, at least the driver's experienced. And swears he's been down this road a thousand times before. So why the heck not trust the guy?

Oh, and we've gotta pull over and get some gas pretty soon -- you gotta couple of bucks to spare a brother in need?

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BusinessWeek editors Chris Palmeri, Prashant Gopal and Peter Coy chronicle the highs and lows of the housing and mortgage markets on their Hot Property blog. In print and online, the Hot Property team first wrote about the potential downside of lenders pushing riskier, "option ARM" mortgages and the rise in mortgage fraud back in 2005—well ahead of many other media outlets. In 2008, Hot Property bloggers finished #1 in a ranking of the world's top 100 "most powerful property people" by the British real estate website Global edge. Hot Property was named among the 25 most influential real estate blogs of 2007 by Inman News.

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