December 22, 2007

A lump of coal in your stocking courtesy of the dismal science

Paul Krugman is a smart guy but he's no performer. He writes so lucidly on economic matters that I'm always brought up short when witnessing one of his talks. I imagine being in one of his classes at Princeton must be daunting for the student trying to follow the quicksilver coursings of his expressed ideas, which are congenitally cogent but when he speaks ex tempore rush from his mind to his his mouth unmediated by the the customary attention a public speaker pays to the formal requirements of being readily followed by a given audience.

Shifting from one stated thought to another is a tricky business in public speech, and is best attempted by any speaker only after being preceded by sufficient warning to the audience in some brief but comprehensible suggestion that now we're on to something else, accompanied by a fond farewell to the idea that's just now being left.

As he speaks, Krugman's mind seems constantly torn between saying the words coming from his mouth and evaluating the words coming from his mouth, and then instantly offering up a reformulation, emendation, verbal footnote or other bye the bye to almost anything he's just uttered, although it must be admitted that he resists as much as he can the temptation to completely drop what he was originally saying to follow along the trail of the interceding idea and its sequalia which is ever-receding end of so much of this kind of talk.

Which is not to say that this is not the way people speak. This is the way people speak. In conversation, people flit from one thing they've just said to some other whatever it may suggest as a matter of course, irrespective of the tangentiality of the suggested matter. When there's only one person speaking, this inclination can be policed, but in Krugman's case, alone there in front of his listeners, it is not.

He's worth listening to because he manages to convey, pace the disorderly delivery, real, informed alarm about the health of global financial institutions today as they grapple with the catastophic effects of the subprime mortgage meltdown.

He describes the current situation as unique, contrasting it with earlier episodes of instability — the Savings and Loan debacle of the late 80's, the economic collapses in Russia and East Asia, the bursting of the internet bubble at the turn of the millennium among the recent episodes which seemed to indicate as they played out that global financial institutions had the tools at hand to mitigate every foreseeable shock to the system. Krugman notes that the tactics used so successfully earlier simply don't seem to apply to this situation, which isn't a liquidity crisis — lenders unwilling to lend, drying up available capital, although there's a lot of that going on in an understandably skittish environment— so much as it is a solvency crisis brought on by a tidal wave of worthlessness settling in on a vast array of securities backed by subprime mortgages.

Krugman says that housing prices must fall by up to 30% if they are to return to historic costs relative to other parts of the economy. In that eventuality, housing bought at the height of the market, when customers were being shoehorned in to new homes or convinced to refinance using one of these vehicles, is now and for years to come worth less than the paper that must be paid off on it.

In a rising market, the usurious rate adjustment built in to the most liberal of these sub-prime instruments, which kicked in after a specified period of time in which the borrower paid some laughably small amount against the debt, could be easily eluded by the simple expedient of refinancing using the collateral of a house now worth more than the original loan to pay off that first loan, and rinse and repeat as needed to avoid the consequences of the unsupportable mortgage payment required when that loan's rate adjustment kicks in. The market slows, steadies, falls. Houses bought with sub-prime loans are now worth less than what is being paid for them by their owners. The chances to avoid the rate adjustment dry up. Borrowers are squeezed to pay more than than the house is worth, and at a faster rate, more's the pity. Foreclosures skyrocket.

And the market isn't really sure who owns all that bad debt, who'll be stuck with the payable bill for it all. Currently it's just sort of materializing out of the vaporous realm of serial securitizations which sought to leverage the collateral of the now thoroughly sunken value of those subprime mortgages into vaster and vaster loan arrangements, which according to best practices in business come due just as the monthly mortgage statement comes due for the homeowner, and must by the ineluctable laws of accounting properly materialize on the balance sheets of financial institutions left holding the bag, payable in full, at the end of a given reporting period.

Bear Stearns, whatever other irregularity it may have indulged in over the past 80 years, has never failed to show a profit for its investors, but this year reports a multi-billion dollar loss. Merrill Lynch, of the famous bull on Wall Street commercial, exposed itself to its first loss in almost three quarters of a century and made Bear Stearn look like it got off easy. Citigroup? … well, jayz. Who knows how far into the future they'll be paying for it? And the insurance bought by prudent investors to mitigate risk should the market go bad, as markets sometimes do, appears more and more to be worthless itself, being carried by insurers who, like the owners of those unpayable mortgages, cannot themselves meet their obligation to pay up in full for their share of the same failed investment in subprime-backed securitizations owed by Bear Sterns and Citigroup and Merrill Lynch and all.

When Paul Krugman says he's alarmed, listen.

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