A Sequel to the Subprime Mess?

There's a pyramiding effect; the economy has become more vulnerable to credit setbacks. In theory, one investor's CDS losses should be offset by another's gains. In practice, Seides expects some CDS investors themselves to default, creating net losses that would further erode trust and confidence. The capital and loss reserves of banks and investment houses would suffer, limiting their ability to lend to business and consumers. Banks originate about two fifths of CDS, says Seides.

What ultimately matters is the connection between the financial economy and the real economy. In housing, that's clear. Subprime losses reduced mortgage lending, which has contributed to lower housing construction, sales and prices. In some other markets, a similar retrenchment has occurred. If too many junk bonds were sold at foolishly low interest rates to finance "private equity" deals—buyouts of companies—then the process had to reverse someday through higher rates and fewer bonds being sold. That's not turmoil so much as the distasteful reality of recognizing losses on dubious loans and investments.

Despite all the bluster, evidence of a widespread credit crunch is so far scant. Though credit standards have tightened, bank lending is still increasing; indeed, banks (last week Citigroup) are absorbing some securitized loans and bonds that can't be financed in the open market. Many U.S. companies have paid down short-term debt over the past five years, and corporate cash flow is running at a respectable $1.2 trillion annual rate. This insulates many firms from strains in credit markets.

The obvious danger is another wave of large losses and a chain reaction of fear that paralyzes and cripples investors, particularly banks. The Federal Reserve last week acted to forestall that possibility by creating a new lending procedure by which banks can borrow from the Fed using some of their existing investments as collateral. This provides an escape valve if the interbank market remains too unforgiving. The Fed seeks to maintain confidence without bailing out lenders from bad decisions. It's also trying to avoid recession while cutting inflation. The difficulty of reconciling all these worthy goals may well explain the great perception gap.

© 2007