Financial Crisis 101 - 10/16/08

PHILADELPHIA - October 16, 2008 Producers here at Action News often complain about my tendency to write and produce stories that are too long, especially when I'm reporting from a remote location, like a political convention. But I'm really going to show 'em today. This will be mercifully brief for a couple of reasons: I don't want to spoil the mood created by the Phillies' big win and their upcoming trip to the World Series, and time restrictions are preventing me from authoring an expository tome on this particular day. (Could that sound any more pompous?)

We do have to note that the stock market experienced another extraordinarily volatile day with the Dow down almost 400 points at the open, but up about 400 at the close. One expert put it this way: the market is overreacting to bad news, in this case, poor reports about industrial production, sending the market plummeting. Then the buyers come in like hungry lions and over-activate the market to the upside. We might as well get used to these wild swings. Wait a minute, I guess we already are.

But what really is impressive is the continuing slide in the price of oil. The price of light, sweet crude oil for delivery in November was down another 3 dollars by early afternoon, at 71 dollars. That's less than half of the high price of $147.00 per barrel reached in July. Of course the price of oil is tumbling because fears of a recession suggest that people will be using less energy. reports that the Energy Information Administration says the country's stockpiles of crude oil grew by 5.6 million barrels in the week ending October 10th. Analysts had been expecting an increase of 3.1 million. We know the equation by now. When there's more of something than expected, it usually means demand is down, and you've got the scenario for lower prices. It may reflect a weakness in the economy, and in this case it does, but the plunging price of oil seems like a very positive unintended consequence. We'll take it!

Another silver lining in the financial crisis, inflation is down. Excluding food and energy, wholesale prices were up just 0.1% last month. Here too, what seems like a good thing is a result of bad economic conditions. Then again, maybe it's not such a good thing, because it brings us closer to the possibility of deflation, and that could be part of an ominous scenario. That brings to mind an economist at NYU, Nouriel Roubini, whose name is virtually synonymous with the term doomsday. In fact, he's sometimes called Dr. Death. Here's a reprint of a quote from Roubini from A lot of it is technical, but it's easy to get the gist: POTENTIAL GLOBAL DEPRESSION.

"The US and advanced economies' financial system is now headed towards a near-term systemic financial meltdown as day after day stock markets are in free fall, money markets have shut down while their spreads are skyrocketing, and credit spreads are surging through the roof. There is now the beginning of a generalized run on the banking system of these economies; a collapse of the shadow banking system, i.e. those non-banks (broker dealers, non-bank mortgage lenders, SIV and conduits, hedge funds, money market funds, private equity firms) that, like banks, borrow short and liquid, are highly leveraged and lend and invest long and illiquid and are thus at risk of a run on their short-term liabilities; and now a roll-off of the short term liabilities of the corporate sectors that may lead to widespread bankruptcies of solvent but illiquid financial and non-financial firms.

The crisis was caused by the largest leveraged asset bubble and credit bubble in the history of humanity were excessive leveraging and bubbles were not limited to housing in the US but also to housing in many other countries and excessive borrowing by financial institutions and some segments of the corporate sector and of the public sector in many and different economies: an housing bubble, a mortgage bubble, an equity bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, a hedge funds bubble are all now bursting at once in the biggest real sector and financial sector deleveraging since the Great Depression.

And in a world where there is a glut and excess capacity of goods while aggregate demand is falling soon enough we will start to worry about deflation, debt deflation, liquidity traps and what monetary policy makers should do to fight deflation when policy rates get dangerously close to zero.

At this point the risk of an imminent stock market crash – like the one-day collapse of 20% plus in US stock prices in 1987 – cannot be ruled out as the financial system is breaking down, panic and lack of confidence in any counterparty is sharply rising and the investors have totally lost faith in the ability of policy authorities to control this meltdown.

When in markets that are clearly way oversold even the most radical policy actions don't provide rallies or relief to market participants you know that you are one step away from a market crack and a systemic financial sector and corporate sector collapse. A vicious circle of deleveraging, asset collapses, margin calls, cascading falls in asset prices well below falling fundamentals and panic is now underway.

At this point severe damage is done and one cannot rule out a systemic collapse and a global depression."

By the way, for you investors, Professor Roubini also predicts the Dow will go down to 7000. But hey, the NYU professor is a worst case scenario kind of guy, and what the heck, the Phillies are in the World Series. Remember, I said I didn't want to spoil the mood, so...never mind.

Jim Gardner

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