A Crisis Of Confidence, Or A, B, C ?

Some analysts think that the current credit crisis is not much more than a tempest in a teapot - a large teapot, to be sure, but a teapot nonetheless. They call it a "crisis of confidence", as if all that is missing to make things right is the belief that it will be all right, i.e. the financial engineer's version of "all you have to fear is fear itself". This type of crisis may be a step up in urgency from "a simple re-pricing of risk", as Mr. Secretary Paulson so cleverly undersates it, but the warning light is supposedly still a pale yellow.

Overlooking for a moment the simple fact that our credit and asset economy is by definition based on confidence and that such a crisis is therefore nothing to sneeze at, let's observe some other hard facts to dispel the notion of "just a confidence crisis", a wording that implies that all is taking place inside the cerebellums of panicky speculators and can thus be promptly cured by swallowing a Blue Pill of Confidence, also known as Ben & Hankie's Market Virility Enhancer.

Fact A - Record Total Debt

The total amount of debt in the US has reached $46 trillion dollars, or 338% of GDP - an all time record. Choosing 10% as a semi-arbitrary percentage for annual debt service (interest and principal), we see that it translates into 34% of GDP. This huge amount clearly cannot be met from the "income statement" side of the economy and goes straight to the "balance sheet". This means that debt has reached an exponential growth phase connected with pyramiding, or servicing debt by issuing more debt. Some call this a Ponzi scheme and as with all cons, confidence is, indeed, crucial.

Fact B - Record Debt in The Financial Sector

One third of that total debt, or 110% of GDP, is now debt of the financial sector, up from just 60% 10 years ago. Regular corporate debt has remained steady at ~40% for decades (see previous post of August 18), implying the rapid leveraging of the US economy is channeled towards the purchase of "assets" and the consumption of "services" and imported goods. To put it simply, America has borrowed to its eyes to buy suburban homes and all kinds of financial assets, watch movies and buy imported goods. (A book on the current US economy could be titled "We Also Make Planes").

Fact C - The Fall of Assets

Asset prices are dropping because irrational over-valuation is evaporating, not because some fund manager is lacking the proper levels of testosterone to buy them. For example, real estate prices got way out of hand when speculators jumped in and created the well-known bubble. We can observe the results in the Census data relating to vacant non-seasonal houses that are for-sale-only: in 2Q2007 such vacancies rose to a record 15.6% (see chart below, click to enlarge). Naturally, mortgages packaged into CDO's and other financially engineered permutations are also getting into trouble - not because of some nebulous lack of confidence, but because borrowers can't service the debt and can't sell the houses, either. RealtyTrac just announced that foreclosures jumped 93% from last year.

Data: US Census Bureau

However, there is an instance where "lack of confidence" is the appropriate term to use, if somewhat mild for what is actually happening: today, Standard and Poor's downgraded the ratings of two mortgage-related funds from AAA to CCC and may cut them further, as they said. If you count the downgrade steps, those are 17 degrees of separation between prince and pauper and they happened in one go. Yes, I would call that a lack of confidence. In spades.