Friday, August 10, 2007

4th Scenario

This is the final scenario of the series of four scenarios that I am offering on what the turmoil in the credit and mortgage markets could mean. This is a scary case scenario, and I'll start off with a chunk from Paul Krugman's most recent column (via Economist's Views)

What’s been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in ... financial instruments backed by home mortgages ... have shut down because there are no buyers.

This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults.

Right now no one is really sure what their portfolio is worth even if they know that their portfolio has absolutely no direct MBS or CDO exposure because everything else that they are investing in has at least second order if not primary exposure. Since no one has a good idea exactly what the value of the MBS and CDOs are because they are so illiquid and no one wants to set the price for fear of taking on unanticipated losses, this starts crippling decision making.

When liquidity dries up ... it can produce a chain reaction of defaults. Financial institution A can’t sell its mortgage-backed securities, so it can’t raise enough cash to make the payment it owes to institution B, which then doesn’t have the cash to pay institution C...

When that happens, everyone holds onto their cash and their highly valuable and liquid investments in a fiscal version of Gresham's Law --- people hold on to their good and known cash for the times that they really, really, really need to spend it. In this scenario, the liquidity crisis inspired by mass risk aversion starts to cascade throughout the economy as no credit means no investment, and no investment means no new job growth, and no new job growth means wage and job cuts... rinse and repeat for while.

I don't think this scenario is that likely, but it is out there as a non-zero potentiality. The biggest reason why I don't think this is likely is that the Fed and ECB have a willingness to open up floodgates of cheap liquidity if need be, and that should ease the risk aversion of most people.

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