Sometimes, Blog Posts Write Themselves: Cleaning up a hard drive of old files, I ran across these two articles from the middle of last year.
First, the WSJ, arbiter of business sanity and purveyor of a positive meme whenever one is to be found, on 28 July 2007—nine months after the general supply of securitizable mortgage loans went away, at least six months after even those with their own origination capacity realised the game was over, and about two weeks before Bear Stearns would issue bonds at the then-junk-bond-area yield of 245 over:
The economy grew at an annual rate of 3.4% in the quarter, reversing the anemic 0.6% growth in the first quarter, the Commerce Department said. Increases in exports and government spending drove much of the improvement. A rise in commercial construction spending and building of inventories offset a drag from housing and sluggish consumer spending.
But the positive drivers aren’t expected to persist, and recent indicators cast a darkening shadow over the rest of the year. The latest readings for spending on plant and equipment, which grew at a tepid 2.3% pace in the quarter, are disappointing. Rising inventories of unsold homes, falling prices and tighter lending terms on subprime loans for marginal borrowers offer little hope that housing is stabilizing. The downturn in stocks crimps Americans’ wealth, and turbulence in credit markets is sparking fears that loans will be costlier or harder to get….
Some business executives expect things to get worse. “This idea that there’s been no spillover from housing into other segments is just faulty,” Mike Jackson, chief executive of auto dealer AutoNation Inc., said in a conference call. “I think it’s extreme economic distress out there right now. It’s one of the toughest environments I’ve ever seen since I’ve been in the business.”…
Some forecasters say the gloom is overdone. As long as businesses continue to hire, the jobless rate remains near its current low 4.5% and energy prices don’t go higher, they say overall consumer incomes should be strong enough to support a healthy level of consumer spending. In a favorable sign, the University of Michigan said Friday its consumer confidence index rose to 90.4 in July from 85.3 in June.
Corporate earnings outside of financial services remain robust, although companies have been worrying for months about higher input costs crimping profit margins. “The real risk for consumer spending is if for some reason companies slam on the brakes and stop hiring,” said Brian Bethune, an economist at Global Insight. “The employment market is still reasonably solid.”…
“The big picture is that you’ve got an inventory problem in both markets — you’ve got too many homes for sale and too many bonds for sale,” says Mr. Kiesel. “So prices need to adjust: You need lower house prices and much bigger credit spreads. It means the economy is going to slow.”
Downward revisions to growth from the first quarter of 2004 through the first quarter of 2007 added to concerns because they offer more evidence that the pace of productivity growth has slowed, and with it estimates of the speed at which the economy can grow without higher inflation. Economists at Bear Stearns, for instance, said that estimates of the economy’s potential growth rate are likely to fall below 2.5% a year.
Let’s ignore for the moment the delusion that it was All About Subprime—even though some idiot on CBC was making exactly that claim Friday, trying to explain Why Canada is Different. (I’ll take Stephen Gordon’s analysis, instead.) This is an attempt at being positive: in the wake of an annualized 3.4% growth rate, that should have been much easier. But the harbingers had landed by then.
Next, the guy who keeps getting slammed in comments here and elsewhere, often for no good reason (or, in the case of Stanley Fish, in the throes of full hypocrisy). Larry Summers about a month later, 27 August 2007, in the LA Times. First, he gives the lie to the “once a century” meme:
Over the last two decades, major financial disruptions have taken place roughly every three years — the 1987 stock market crash, the savings and loan collapse and credit crunch of the early 1990s, the 1994 Mexican peso devaluation, the Asian financial crises of 1997, the Russian default and Long Term Capital Management implosion of 1998, the bursting of the technology bubble in 2000, the disruptions of 9/11 and the 2002 post-Enron deflationary scare in the credit markets.
This record suggests that, by the beginning of 2007, the world was long overdue for a major financial disruption. And sure enough, the difficulties around sub-prime mortgages “went systemic” in the last month as the market seemed to doubt the creditworthiness of even the strongest institutions and rushed to buy Treasury debt.
Soon, he gets to the heart of the matter:
[A]s investors rush for the exits, the focus of risk analysis shifts from fundamentals to investor behavior. As some liquidate, prices fall, then others are forced to liquidate, driving prices down further. The anticipation of cascading liquidation leads to still more liquidation, creating price movements that seemed inconceivable only a few weeks before. Reduced credit feeds back negatively on the real economy.
Eventually — sometimes in a few months, as in the U.S. in 1987 and 1998; sometimes in a decade, as in Japan during the 1990s — there is enough liquidation and price adjustment to make extraordinary fear give way to ordinary greed, and the process of repair begins.
It is too soon to draw policy lessons from the current crisis or to determine exactly where in the cycle we are now. But it is not too soon to highlight the questions it points up. Three stand out.
From that point on, the article goes downhill:
First, the current crisis has been propelled by a loss of confidence in rating agencies, as large amounts of debt that had been very highly rated has instead headed toward default….But there is no doubt that, as in previous financial crises, the rating agencies have dropped the ball.
In light of this, should bank capital standards, Federal Reserve discounting policy and countless investment guidelines still be based on credit ratings? What is the alternative? What if any legislative response is appropriate?
It seems more likely to assume that rating agencies are lagging, not leading, indicators of credit crises, as investment products develop based on iterative variations of current products, whose risk profile is therefore (definitionally) somewhat less well defined, and (again definitionally) are likely to have thicker tails that will not be captured by standard modeling. (See Robert’s discussion here.)
Second, how should policy respond to financial crises centered on nonfinancial institutions? A premise of our system is that banks accept much closer supervision from public authorities in return for privileged access to the Federal Reserve payments system and its “discount window,” which allows banks to borrow directly from the Federal Reserve. The problem this time is not that banks lack capital. It’s that the solvency of a range of non-banks is in question because of cascading liquidations and doubts about their fundamentals. In an old-fashioned phrase, central banks that seek to instill financial confidence by lending to banks or even by reducing their cost of borrowing may well be pushing on a string.
With the admission of insolvency of the financial institutions still at least six months away, Summers was already discussing the limits of liquidity provision.
His third point is only slightly less prescient:
Third, what is the right public role in supporting credit to the housing sector? The lesson learned from the S&L debacle was that it is catastrophic to finance home ownership through insured institutions that borrow short term and then offer long-term fixed-rate mortgages. Now a system reliant on adjustable-rate mortgages and non-insured institutions has broken down.
I might argue Summers took the wrong lesson from the S&L crisis, which grew in large part from primarily Texas-based S&Ls that loaned large amounts of money based on the idea that some barren desert land was valuable because it had oil under it. It does not seem coincident that the first wave of housing market collapses (ca. mid-to-late 2006) were all in similarly-desert areas—Phoenix, Lost Wages, the tracts of land near I-5 between LA and SF. But at least he knew what not to do:
[I]f there is ever a moment when [Fannie and Freddie] should expand their activities, it is now, when mortgage liquidity is drying up. No doubt, credit standards in the sub-prime market were way too low for way too long. But now, as borrowers face the reset of adjustable mortgages, it is not the time for authorities to get religion and encourage the denial of credit.
The next time someone tells you that “no one predicted” this phase of the current crisis, point them to Larry Summers fifteen months ago. Or even, in broad outline, the WSJ.