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Keeping Things in Perspective, Part II

I’ve been chided by readers of this blog for a posting I made late last week, using some statistics to make the case that subprime loans are a much smaller share of the overall mortgage market that you might believe by the scary headlines. These readers take the view that there’s a credit crunch building that could take down the markets and the economy.

Even though I noted (probably too briefly) that the real issue was not just subprime, but also “Alt A” loans, Option Arm loans, traditional ARM loans, home equity loans, as well as the extraordinary amounts of leverage that hedge fund managers took on when buying these mortgage securities, I still got whacked by readers for taking too lightly the potential of a contagion that takes down other markets like dominoes.

Having the weekend to think through the potential risks myself, I acknowledge that you can’t lightly dismiss the risks posed by the subprime fallout. As just mentioned, subprime is but one of myriad different credit products that, we now realize, that either should never have been made, or weren’t priced to reflect the risk (and I haven’t even mentioned credit card debt). And the proverbial chickens are coming home to roost now, with growing defaults and the beginnings of what could become a full-blown credit crunch. The Federal Reserve, for instance, revealed in its latest survey of bank lending standards that banks have tightened lending standards on nontraditional mortgage products (though interestingly, it notes that it hasn’t seen any tightening in other consumer or commercial loans.)

Are things going to get worse? Nouriel Roubini, a highly respected economics professor at New York University’s Stern School of Business (who is also runs RGE Monitor, an economic consulting firm) makes the case on his blog that the current mess has the potential to be worse than the fallout from the crash of Long Term Capital Management in 1998. At present, he argues, we have not only a liquidity crisis, but a credit crisis. His academic argument is well-reasoned and worth reading and can be found by clicking here.

Yet I surprised when I opened my morning email and found the daily market commentary from Bridgewater Associates, a hedge fund run by the highly regarded Ray Dalio (and Bridgewater is no johnny-come-lately fund run by 29-year-old Wall Street rocket scientists—the fund is an “old school” fund that has been around since 1975, and thus has seen it all, and now manages $165 billion in assets for clients. I found this link that provides Dalio’s bio and his investment philosophy.) In this morning’s missive, Dalio—whose firm has been very bearish on the markets for most of this year—argues, to my surprise, that the current situation won’t be as bad as some fear. I can’t provide a link—the research is provided solely to clients and select media—but I’ll quote from passages:

“Because this dynamic is taking place in an environment of abundant and growing liquidity, we believe that the contagion will be contained. In other words, because there are lots of investors with a lot of money to invest (i.e., institutional investors with big surpluses) who have lived the past couple of years hearing the investment mantra that “one has to jump on opportunities that come when other investors are afraid,” the spreads will not blow out in the same way as when money is tight. In fact, it is a reflection of the times that we are now seeing investment managers who have lost money going to flush investors to “allow” these investors to participate in “the recapitalization of funds to take advantage of great values due to mispricings.”

“We don’t know how far this contagion will reach, but we are inclined to think that it will be less severe than the one in 1998 ... The 1998 financial market contagion was preceded by lots of serious stuff, and even that contagion did not damage the real economy. The big difference between now and back then is that the U.S. balance of payments situation now looks like those of the deficit countries that had problems (though the foreign debt is in our currency).”

“So, my guess is that the financial market contagion will continue, but it won’t sink the economy, and it won’t be as bad as the one in 1998 (until the tightening comes along).”

I agree with Dalio. There's so much cash sloshing around the world, that it seems improbable that liquidity can really dry up.

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