Recent global market tremors are a disturbing commentary on the power of fear
THE job of an economist, among many other duties, is to put things into perspective. So, because I am an economist, among other duties, here is a little perspective on the recent turmoil in the stock and bond markets.
Financial mayhem: Foreign stocks, especially in developing countries, have taken a major blow, likely due to a 'repricing of risk' in connection with the sub-prime mortgage crisis in the US. But markets may be over-reacting as emerging economies are very strong and liquid First, when the story of this turbulence is reported, the usual explanation mainly has to do with some new loss in the sub-prime mortgage world - the universe of mortgages and mortgage-backed instruments related to buyers with poor credit histories or none at all.
Here is the first instance in which proportion tells us that something is out of whack: The total mortgage market in the United States is roughly US$10.4 trillion. Of that, a little over 13 per cent, or about US$1.35 trillion, is sub-prime - certainly a large sum. Of this, nearly 14 per cent is delinquent, meaning late in payment or in foreclosure. Of this amount, about 5 per cent is actually in foreclosure, or about US$67 billion. Of this amount, according to my friends in real estate, at least about half will be recovered in foreclosure. So now we are down to losses of about US$33 billion to US$34 billion.
The rate of loss in sub-prime mortgages keeps climbing. In time, perhaps it will double, maybe back to US$67 billion. This is a large sum by absolute standards, and I would sure like to have it in my bank account.
But by the metrics of a large economy, it is nothing. The total wealth of the United States is about US$70 trillion. The value of the stocks listed in the United States is very roughly US$15 trillion to US$20 trillion. The bond market is even larger.
Much more to the point, the fears and terrors about sub-prime mortgages have helped knock off about 6 per cent of the stock market's value in recent weeks. This amounts to about US$1.1 trillion or more than 30 times the losses so far in the sub-prime market. In other words, these sub-prime losses are wildly out of all proportion to the likely damage to the economy from the sub-prime problems.
The disconnect goes even further. The Dow Jones industrial average has been heavily moved by fears about the sub-prime market. But how are most of the Dow 30 affected by sub-prime mortgages in any meaningful way? No Dow company is short of liquidity, and consumer spending is still strong.
Foreign stocks, especially in developing countries, have been hard hit, and this is supposedly connected with a 'repricing of risk', which in turn is connected with sub-prime mortgages. But how are the risks in Thailand or Brazil or Indonesia closely related to problems in a housing tract in Las Vegas? The developing countries are fantastically strong and liquid.
Why would problems at a mortgage company in Long Island have anything to do with them? European stocks have also been hard hit, and this has to do with relatively small amounts of sub-prime in some European banks. On a global scale, the numbers in Germany and France are minuscule for sub-prime exposure. For European markets to fall on sub-prime issues makes no sense.
News last Thursday that a small amount of unpriceable sub-prime mortgages was in a BNP Paribas fund in France sent the markets in Europe and the US sharply lower. Why? The losses in France are at most in the single billions, while the losses in US markets alone were in the hundreds of billions on the BNP news.
Then there is the supposed 'drying up' of credit for private equity deals because of fears of risk. But this is also puzzling. I can't think of a single recent major private equity deal in which the bonds have defaulted.
Major hits
More to the point, suppose that all private equity deals were stalled for a year. Why would this affect the Dow? None of companies in the Dow 30 is having trouble raising cash. And suppose that all private equity deals went away for good.
Taken together, they are not all that big a piece of the US economy. Why should they put the markets of the richest nation in the world, as well as all of the world's other markets, into turmoil? Then let's take a peek at Bear Stearns. This venerable and clever financial house has taken some major hits on sub-prime mortgages lately. That is sad for the stockholders (I am a very small stockholder), and the price of Bear Stearns stock has tumbled.
A little over a week ago, news about Bear Stearns' liquidity issues lowered the market value by more than US$1.2 billion.
That is a big hit to a single company, to be sure, but then came the shocker: that news also helped wipe out hundreds of billions of dollars off the total value of US stocks.
My point is this: I don't know where the bottom is on sub-prime. I don't know how bad the problems are at Bear. Yet I do know that the market reactions are wildly out of proportion to the real problems that have been revealed or even hinted at. Maybe there is some giant thing hiding in the closet that might rationalise the market's fears.
But if it's hidden, how can the market be reacting to it in the first place? More will be revealed, as the saying goes. But recently investors have been selling out of all relation to what we know.
Reassurances in word and deed from Ben Bernanke, chairman of the Federal Reserve, helped calm the markets on Friday.
But recent events are a disturbing commentary on the power of fear.
This economy is extremely strong. Profits are superb. The world economy is exploding with growth. To be sure, terrible problems lurk in the future: a slow-motion dollar crisis, huge Medicare deficits and energy shortages. But for now, the sell-off seems extreme, not to say nutty.
Some smart, brave people will make a fortune buying in these days, and then we'll all wonder what the scare was about. -- NYT
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