Bottom line

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.