Australian Lefty on Politics, Governance, Science and Info Management

Sub-prime problems are minor by comparison…

Posted by Dave Bath on 2008-01-19

The risk-hiding dodginess that elevated the sub-prime failures into a global problem, affected those borrowing from banks. Some risk-hiding in the bond markets (both government and corporate) could be even more disastrous for the world economy according to an article in this week’s The Economist.

Be afraid, be very afraid.

Bond insurers All fall down? (2008-01-18) explains the current fragility of bond insurers, and hints at the knock-on effects.

Bonds are used by governments and corporates to raise capital in a way that costs less than borrowing from banks. In exchange for the reliability of bonds, guaranteed by bond insurers, investors accept modest returns.  Issuing bonds is an important way that responsible companies raise capital for investment and thus important for economic activity.

Yet some bond insurers are looking vulnerable. If the bond investors (an ultra-cautious bunch) lose confidence in the bond markets, it will have nasty knock-on effects with the "good guys", not just irresponsible lenders and borrowers. If even the "good guys" cannot raise moderately-priced capital for sensible investments, the risk of recession, or at least a long-term slump, becomes significant.

Together with the other economic fragilities and vulnerabilities of countries like the US and Australia that rely on borrowing huge amounts of cash to maintain the illusion of growth that has led to (unjustified) confidence, my own bearish feelings of the last few years are looking mild, if not overly optimistic.

If Rudd and company were dejected after the last chat with the Reserve Bank of Australia about the economic outlook, and the disastrous results of 10 years of Howard mismanagement, yet still managed to put on a brave face to the cameras, hoping to maintain business confidence, they’ll have a harder time soon. Even experienced politicians won’t be able to sound bouyant – their body language will show the truth.

There’s not much any politician can do in short or medium terms to overcome this – apart from perhaps communist states where the government can direct corporate activities.

The last paragraph of the article highlights the significance of these woes:

There are already signs that the insurers’ woes are contagious. On Thursday Merrill Lynch wrote down $3.1 billion on debt securities that it had hedged with ACA and other bond insurers. Other banks have also made writedowns to reflect their lack of confidence in ACA’s ability to meet its commitments. The full extent of the “counterparty risk” banks face in dealing with bond insurers is only now becoming apparent Jamie Dimon, the boss of JP Morgan Chase, has said that the fallout from the bond-insurer crisis could be “pretty terrible” for the debt markets. If a big insurer such as Ambac or MBIA were to take a tumble, that could look like an understatement.


2 Responses to “Sub-prime problems are minor by comparison…”

  1. Raf said

    Well we are on the verge of a 1929 type collapse here. Last night saw major falls in not just the US but global markets. The financial system itself is at risk because with globalised markets and instruments everything is connected.

    The best that can happen is a genuine deflating of asset prices: land and equities. The issue is one of systemic risk. How can these prices deflate without causing major institutions to go out of business and unemployment to rise, people to lose their homes etc.

    Investors should be the big losers and not ordinary folk. What I mean by that is losses will have to be taken but people shouldn’t be kicked out of their homes. A completely different approach needs to be taken in handling this crisis.

    I’m not holding my breath though.

  2. Dave Bath said

    I’ll actually be writing soon that a proper recession (in Oz at least) will be a good and necessary thing if it can fix the current account problems. Whether or not the pollies are capable of managing this correctly and explaining it to the electors is another matter.

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