In a macroeconomic sense, recessions aren't bad things; they're adjustments. In a broad sense, they result when inventories have built up to the point that production has to decrease until the inventories come down to a reasonable level. The problem is that when production declines, then demand declines, and then it takes longer to reduce the inventories. When there are rising prices on, say, corn, farmers readjust their capacity to grow more corn. Over time, the supply and demand balance shift, but people who have grown corn with certain price expectations are reluctant to take losses. Especially when the incremental capacity comes at higher average fixed cost. Prices will eventually go down, but some of the capacity will have to be shut down and investments written off. Social costs follow, with dislocated farmers and farm workers.
In this particular case, a bunch of people assumed that residential real estate prices would continue to rise and markets remain liquid, thereby assuring value of the collateral of loans made to people who might otherwise default. Investors underestimated the risk of the assets and priced them incorrectly.
When I tell people it's all a pricing issue, they typically disagree with me. No, they say, the problem was that people got loans who weren't supposed to.
I'm still right, but with a rub I'll get back to in a moment.
The price of a loan is the interest rate. The more uncertainty there is with a loan, the higher the price should be. There are two sources of uncertainty: the probability that the debtor will not be able to meet the obligations of the loan, with the extreme case being a default; and that the value of the collateral will not cover the value of the loan if the default and foreclosure should occur. The less you know about a debtor, the more uncertainty there is; and the more dramatic the growth in real estate values, the more likely the values are in for a downward adjustment.
Here's the rub: a creditor will also increase the risk of the loan by increasing the price. Which is why it's not just about pricing, but also making a simple yes/no decision on whether to offer a loan, at any price. In other words, someone can't buy a house they can't afford simply by offering to pay a much higher interest rate on the mortgage. The solution instead is to opt for a less expensive house they can finance with a reasonable interest rate.
If we look at this in hugely simplistic economic terms, what has happened is this: the financial markets have realized that their portfolios of residential real estate loans - whether held as loans or securities - are worth far less than they thought. They have to write down the value of these assets against their income statements and balance sheet.
How much to write off, though?
Investors are happy to write off enough to give them a tax advantage, and this is an incentive to be very conservative and take a big hit. But they don't want to take such a big hit that their own solvency is questioned, because this would lead their own cost of capital to go up. Which would make it harder for them to make money.
The economy will go into a deep recession or worse if the banks are unable to issue or obtain credit at interest rates they can afford, and if they can not set an efficient market price for the assets that they hold. And if companies can't obtain credit, they can't fund growth, or even working capital.
All this because houses in California, Florida, and other places were sold for more than they were worth to people who really couldn't afford them.
Now, the securitization of assets (e.g., mortgages) that previously were relatively illiquid should, in theory, have mitigated some of this. If you own mortgage-backed securities that you thought were worth $100 million but you think might only be worth $90 million, you can sell them for what you can get on the market, perhaps $92 million; and then take the $8 million loss. You don't have to hold any bags that you think smell - you can sell them at a price.
This doesn't seem to be holding up, for two reasons:
One is that the value of mortgage-backed securities all of a sudden is uncertain. Investors don't know what the right assumptions about default, foreclosure, etc., are anymore, so they are uneasy about pricing.
The other is that too many investors funded their investments with loans against a) the value of the securities that now have uncertain value, and b) their own credit worthiness. Just like the homeowners who took up loans on hopelessly optimistic assumptions.
More to come...