I was still digesting the Wolf piece in yesterday's FT. Naked Capitalism's input was helping greatly. Basically, Wolf, usually measured is freaking out and the numbers he throws around, inspired by Roubini dwarf the numbers I had at the end of my previous blog arguing for "enough liquidity?". Nouriel Roubini of RGE monitor now puts the damage of the crisis in the $3T. A trillion here and a trillion there and soon enough it is real money.
From the FT cover
There is deep concern that banks are pulling back on capital at risk, drawing liquidity from the markets and triggering contagion at hedge funds. This has caused fresh turmoil in the market for mortgage-backed securities, intensifying the pressure on housing.
"You have three vicious cycles going on simultaneously," said Lawrence Summers, a former US Treasury secretary.
"A liquidity vicious cycle - in which asset prices fall, people sell and therefore prices fall more; a Keynesian vicious cycle - where people's incomes go down, so they spend less, so other people's income falls and they spend less; and a credit accelerator, where economic losses cause financial problems that cause more real economy problems."
Fed officials insist the US will not end up like Japan, not because economics could not possibly deliver such an outcome, but because the US system will not allow problems to fester, and policymakers will take whatever steps are necessary to avoid a Japan-style recession.
Of course the FED action is designed to provide relief to the banks for them to work through their sub-prime losses (in the 700bn). The FED can cover that on reserves alone without printing money and adding to inflation. They are short of buying the stricken securities themselves. They are not printing money (yet).
Talking about the process of debt deleveraging El-Erian says in "Investors must decide how to avoid tumbling dominoes"
Initial losses occurred in sectors, such as US subprime, where market activities had clearly deviated from fundamentals. In trying to get back on side, the affected financial institutions had three choices: allow the losses to eat up their regulatory capital, raise new capital, and/or cut exposure to other areas that utilised balance sheets. Several institutions executed on the first two; yet they could not avoid the third. As liquidity dried up in the "tainted asset classes", they had to reduce other positions. In some cases, this was done through sales and the withdrawal of credit lines, including those extended to hedge funds. In other cases, it was done through imperfect hedging.
Whatever the approach, the result was a wave of falling prices that, in a manner that is reminiscent of past episodes of "market contagion", sequentially moved from tainted assets to those further up the quality curve.
As the liquidity goes down, the contagion spread up "the quality curve". The "frantic" FED injection is there to backstop the withdrawal of liquidity, it seems the relief is percieved as temporary. The liquidity injection euphoria quickly died yesterday. It seems it wasn't enough to float the other boats. The market deeped steeply after a sharp rally, showing the market is not buying that the FED has done "enough"..
It is also not surprising that US policymakers are now frantically looking for measures to contain the damage. Interest rate cuts and cash handouts to consumers are now being accompanied by larger direct injections of liquidity into the financial system and an attempt, albeit still modest, to target housing.
The fat lady won't sing until housing clears. The problem with housing is that, unlike stocks, there is tremendous inertia in the pricing. Loss aversion is very strong in individuals and therefore the housing market adapts with timescale in YEARS. Not hours or days like securities. In other words, no one KNOWS HOW TOXIC the securitized mortgages are and that is a self-feeding negative loop. There is no market for the subprime, the temporary liquid relief will need to go beyond 28 days, expect this facility to roll-over. So we are in it for the long haul. To this he says
Second, it will take time for the deleveraging process to abate unless policies are supported more forcefully by measures that target housing directly.
Fourth, when markets become more liquid it will be felt first by assets that are closest to the official funding windows. This speaks to possible opportunities in swaps, high-quality mortgages, bank capital and municipals.
However when the liquidity catches up, and housing is solved, closely monitor the above assets, they should be the first ones to get "better".