What’s really going on? What’s going on is that perhaps $6T of
mortgages with a duration of a decade that had been priced at a 1% per
year chance of default (with a 1/3 value haircut in the event of
default) are now being priced at a 4% per year chance of default.
That’s a loss of $600B in market value–and if your share of that $600B
is greater than your capital, or is thought to be greater than your
capital and so impedes your operations, you are gone.But truth be told it is a zero-sum game–not a real destruction of
wealth. The real rates at which cash flows of constant risk are being
discounted haven’t changed much: there hasn’t been a big redistribution
of wealth between the present and the future. What has happened was
that a bunch of people believed that the default risk was 1% when it
was actually 2% and reported gains of $200B (of which they took
2-and-20 on the hedge fund slice, perhaps $20B, for themselves), and
that now a bunch of people believe that the default risk is 4% when it
is actually still 2% (unless, of course, the assembled central banks of
the world fail and unemployment heads rapidly upward). So in aggregate
hedge fund partners have gained $20B, hedge fund investors have
paid$20B to their money managers for the privilege of losing another
$200B that they never had, and there are $400B of transitory paper
losses that will turn into real losses for those overleveraged and
caught by the credit crunch and so forced into fire sales, and into
real gains for those with steel nerves and liquidity.Unless, of course, Ben Bernanke and company fail to contain the
crisis, and we wind up in a severe depression. But then we would have
much, much bigger things to worry about than $600B of missing paper
mortgage value. 4 years x 3 percent excess unemployment x Okun’s Law
coefficient of 2 x $13T economy means a $3.1T cumulative Okun gap in
lost real wages, salaries, and profits. That’s the thing to worry about.
That’s Brad DeLong, here is the link.
I describe to my friends as a roll of the dice sometime in the near future. If it comes up as a one through five, the global markets will stabilize, and all values will quickly go back up to their long-term multiples. If it comes up a six, the Fed and other central banks have failed to contain the credit crises, and the global financial markets collapse.
Right now, stocks somewhere between the values associated with long-term multiples and total collapse. The current volatility we’re seeing is due to new information coming along that supports or contradicts the likelihood of rolling a six, which is a lot more than the volatility associated with normal economic news, like interest rate changes or earnings projections.
Allow me to offer
Those paper losses may be transitory, but not as transitory as the comments of those who disagree with Mr. DeLong!
What are you saying Dirk, that libertarians and laissez-faire economists approve of bailouts? *Nobody* is disapproving?
What if the default rate climbs above 4%? And which class of mortgage is Brad DeLong referring to? Some mortgage stats via CR:
“As of the end of last year, 5.82% (!) of all mortgages were
delinquent, the highest level in 23 years. 0.83% were in the process of foreclosure, also
an all-time high. When you look at just subprime mortgages, you find that 20% are
delinquent (the number is rising rapidly), and almost 6% were in foreclosure… Given Burn’s forecast for prices, as well as that of T2 Partners, all these statistics
are going to get worse.”
http://www.frontlinethoughts.com/pdf/mwo032808.pdf
But truth be told it is a zero-sum game–not a real destruction of wealth.
The truth is that the destruction of wealth already happened when these houses were built. Now the question is if it should be admitted or not. Obviously, some people still believe that if you don’t admit the problem it disappears – while the opposite is true. If you don’t admit the problem now, you’ll have to admit it later. If you don’t admit that you are running out of money, you will have to admit it in the moment you won’t have any money to pay your bills. You cannot deny reality forever.
Unless, of course, Ben Bernanke and company fail to contain the crisis, and we wind up in a severe depression.
Ben the great, the best economist in the world…except that nobody has a clue how is he supposed to ‘contain the crises’. The sentence above should be read: Unless Ben Bernanke fails to use dark magic and attain the impossible, we wind up in a severe depression.
That is why I have been accumulating stocks of beat up financial companies.
Isn’t the whole issue of “wealth destruction” interesting if we look at it from an individual’s point of view?
When housing prices were rising to bubble levels — wasn’t part of my 26 year old, schoolteacher daughter’s wealth being destroyed because there’s no way she could afford to buy a house. So she rented
Now that housing prices are coming down, they may decline to a level at which she would be prudent to buy as a means of enhancing her wealth.
And, in terms of destruction of wealth, what about my 84 year old father, living off CD’s that now are paying 2.5% or so? That’s half the income he was getting when they were paying 5%. That strikes him as wealth destruction, it’s a direct result of the actions to deal with the crisis, but nobody much talks about that.
These both seem to be cases that aren’t being considered in (what seem to me to be esoteric) arguments about wealth creation.
I liked Andy’s comment about Ben B needing magical powers.
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