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Wednesday, 11 June 2008

Of mice, men... and recession

Playing it safe may not be the best thing todo during times of economic turmoil

THE chief information officer of a large US bank said his boss told him: 'Please hold off on new software purchases for the next six months.

'The bank has decided to wait until the US economic outlook is clearer.'

Many US firms are taking a 'wait and see' approach. Consumers are too.

That attitude could trigger a recession. It is called a self-fulfilling prophecy.

First, fear leads to caution. It reduces spending. The economy slows. It produces more caution, less spending, more caution, less spending...

The next thing you know, you've got a recession.

On Friday, fear got the upper hand when the US stock market took its second biggest plunge of the year. That is what the Singapore and other Asian markets are looking at today.

Could things go from bad to worse? Yes. Here's how:

1) STOCK AND HOME PRICES

US and Asian stock markets hit their highs last October.

Now, the US market is 20 per cent off its highs. Our Straits Times Index is 30 per cent lower.

Home prices have levelled off here, but are dropping fast in the US. During October to December, US home prices fell 9 per cent, the biggest three-month drop in history.

When stock and home prices fall, people see their wealth evaporate. They feel poorer and spend less. It accelerates the economic decline.

Next stop: Recession.

2) CREDIT LOSSES

Most stem from US housing defaults, which seem to be never ending.

Last week's shock came from insurer AIG, parent of AIA. It had an incredible $800 billion of debt insurance called 'credit default swaps'. Of that, it wrote down $15 billion that it doesn't expect will be repaid.

UBS bank estimated on Friday that credit losses will total $840 billion. Of that, it estimates that $615b has not been disclosed yet. It is a huge number.

Next stop: Recession.

3) LESS BORROWING

At the centre of the storm is a new debt type, called CDOs, some of which hold shaky US home loans.

High defaults have made CDOs difficult to sell. There have been no new sales since November.

That's a problem since banks used to re-sell their home loans as CDOs. It made US bankers sales agents instead of lenders. They invested no capital and took no risks. Life was good.

Now, without CDOs, banks are back to old-fashioned lending that puts their own money at risk. It means fewer mortgages get made and at higher interest rates.

Of course, when money isn't borrowed, it isn't spent. The economy slows.

Next stop: Recession.

4) FEAR

Fear keeps interest rates high. A remarkable study by stock broker Merrill Lynch showed the interest rate cuts of the US Federal Reserve (central bank) aren't doing the job.

Consider this: The US Fed reduced its key interest rate from 5.25 to 3.0 per cent in the last five months. Such a big drop would normally encourage borrowing and spending.

This time, however, home loan rates haven't budged. They fell from 5.90 per cent in September to 5.88 per cent today. It's almost no change.

The same for car loans: A five-year car loan was 6.91 percent in September. It is now 6.95 per cent, which is slightly higher.

Things are a little better for all consumer loans. On average, they fell 0.45 percentage points since September compared with the Fed's interest rate cuts of 2.25 percentage points.

This means only one-fifth of the rate cuts (0.45/2.25) have reached the man on the street. It's no wonder the US economy has not perked up.

Next stop: Recession.

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