Saturday, August 18, 2007

Welcome Rumblings in the World Economy

Home loan lending excesses of the past are coming home to roost, but there may be a heartening side to these rumblings.

The past few weeks have seen major tremors reverberating through world financial markets. The Dow Jones Industrial Average fell precipitously on July 26th , and again on on August 14th. It continued to fall for the next two days. Merril Lynch said Countrywide Financial, the largest US mortgage lender, could go bankrupt. Hedge funds operated by Bear Stearns were said to be teetering dangerously. BNP Paribas caused a flutter by announcing that it was halting redemptions from 3 securities funds, effectively freezing a total of $2.2 Billion in assets.

All these developments were traceable to the subprime home lending excesses that have been happening for years. The US Federal Reserve, which had maintained that the subprime issue did not need its intervention, cut its discount rate on August 17th, signalling that it was worried and willing to act to contain the damage.

Why are these admittedly bleak developments welcome?
As I wrote here in March, risk is being underpriced in the world economy. These developments may be an indicator of that situation beginning to get corrected. Hank Paulson called the July 26th fall of global markets a "repricing of risk"*. Lenders all over the world are waking up to the fact that there have been excesses in lending, particularly on the home loan front, and these excesses need to be corrected.

Another reason for "cheer" is that the extent of these rumblings are showing just how far-flung the effects of the subprime excesses had spread. Few expected that the first bank to go under would be a German bank (IKB Deutsche Industriebank), and a French bank (BNP Paribas) would be among the first to press the panic button by freezing its funds. This global spread of risk was suspected, but now there is data to confirm it, and that can only be good - at least it will encourage more diligence and discipline in financial matters.

A third reason why these events may be positive is that they may indicate that the subprime excesses have happened worldwide, and are not just a US phenomenon, they are apparently thought to be.

Large risks remain - the subprime mortgage mess in the US is still far from over, the fragility of the Chinese financial system is a cause for concern, and much of the mechanics of the world economy remain poorly understood. So, a widespread appreciation of the extent and magnitude of risk in the world economy can scarcely be anything but welcome.

All this also goes to show that nasty surprises are not always a bad thing. As long as the rumblings are just the sound of risk being more realistically assessed, we should be happy to hear them. They're just the sound of a soft landing.

* he also said subprime was nothing to worry about, a statement which was belied on August 17th when the Fed cut its discount rate.