Tuesday, August 07, 2007

One scenario of a few

John Cole at Balloon Juice is reading the papers and throws up his hands in acknowledged and very rational ignorance as he reads the stories about the credit markets' wild gyrations over the past couple of weeks. He raises a good question:

There are a number of you who have been following this issue far more closely than I am, and might be able to fill in the gaps. how bad is this/ Am I being chicken little? Is this just the market correcting itself? Or is this the sign of something catastrophic on the horizon?

Over the next day or two, I'm going to offer a couple of scenarios that play out a Pollyanna-ish view, a muddling through perspective, a sideways period and then a severe reaction. These scenarios have different assumptions and believe that the variables involved interact in different ways. I'll start off with a best case scenario.

The best case scenario assumes that the problems at Bear Stearns' hedge funds, major Alt-A mortgage origination companies and home owners are isolated and unique events. There is no systemic problem with previous appraisals, most mark to model systems, and the CDOs and MBS are fundamentally sound and reasonably accurately valued. There may be a proviso in there that the accurate valuation is only accurate when the assets are slowly sold off.

Furthermore the American consumer is seeing some real wage growth for the first time in years, and this extra money should allow the consumers to start building up a cushion. We are also acclimated to the impact of $3.00 gasoline on our budget now so this is no longer a shock. The rate resets that are coming in the near term (next three to six months) will be dealt with by refinancing and the spare cash flow consumers are now generating.

Thus there is little to worry about. Bad decisions and models are facing reality and getting kicked around as they should in an efficient market system, and their assets are available to be picked up cheaply by more effective competitors. The rise in foreclosures should be tailing off soon as consumers are seeing more cash in their pocket, and most importantly, the large institutional investors and credit funders should be taking a deep breath soon and realizing that everything is in pretty good shape after this midsummer episode of creative destruction.

This view has little to recommend for policy changes and prescriptions. There may be a decent argument for the Fed to mirror the Fed future rates and throw in a quarter point decrease in the next couple of months as some insurance, but beyond that everything is in pretty good shape and the American economy will come out stronger as the fundamentals are strong.

This is the rose-tinted glasses scenario. Next is a muddle on through scenario.

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