Wednesday, August 22, 2007

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.


  1. Good real estate info. Thanks for the read!

    As far as the real estate bubble goes, it looks worse in San Diego.
    I came across a San Diego real estate broker's blog post that is to be the only one I've seen that does not spout the 'industry line: "It's always a good time to buy real estate." This broker calls it like it is. No it's not PC, but it is amazingly informative and insightful.
    Bob Schwartz, the San Diego real estate broker who publishes the blog, wrote a great article back in 2005 that predicted today's huge home deprecation. You can read this article at: San Diego real estate the url is:

  2. not to be reductive, but what follows from what you have described is that we are about to enter the fearsome land of pushing on a string, yes. That's my bias at present.

  3. The stock market doesn't seem to have much of a head for hard data about problems in the credit/debt markets; it seems to react more to the tabloid headlines in the popular finance press. Today, borrowing from the discount window was spun as good news, even though common sense would seem to suggest the opposite.


  4. As ussual, a fine comment, concise and to the point.

    I'm so glad to see the use of the word "insolvency". This is a term that is avoided by the mainstream media. Insolvency, leaves no "wiggle" room. No room for "price adjustment", "re-pricing" if you will.

    Enron, was an insovency event and the result was, Poof. It just disapeared from the face of the earth, it was sucked up by the gravity of a financial black hole. Granted this was caused by fraud, or was it....?

    Reading your recent comments, causes me to be alarmed, as I find it dangerous to my dilignce to have my views affirmed. In other words, I hate to think that I'm "too right" in my analysis as it is always the devlish little detail that causes me so much pain. Therefore, I ask the question, have we missed anything....?

    Is there another asset class out there someplace that can be leveraged into the mix...? Is "superconductivity" around the corner and can we borrow against the future productivity of a new unprooven technology and securitize it as an asset class...? Is there any form of collateral out there that has not reached the saturation point of extinction.

    I have had the good fortune to have acted without fullfilling my exacting demands for detail. The markets usually don't alow us the time to complete and execute the totality of our diligence.

    Having said that, I can only say "THANK YOU" BB and HP. Thank you for the postponement of the feeding frenzy. This is one shark that is studying the menu and I think that, I'll have the shark.

    Best regards,


  5. to anonymous:

    health insurance.

    I read an article not long ago that some smart minds are coming up with new ideas to package the medical insurance probability as an asset on the basis of statistical data of illness/major health issues.

    Not sure how true but I guess there are people who are smarter financial quants than rest of the population to come up with such fleeting tricks.

  6. So, in order to make debt manageable /serviceable, the total amount of debt must shrink a lot, maybe to 100% of GDP.

    If this is the case, the crisis will be deep, long, and painful. I cannot really even imagine the effects of such debt destruction.