Monday, March 31, 2008

Trough of the US debt crisis?

Financial commentators show some optimism that asset bubbles would be by-gone. The latest, the bursting of the house prices, may only just be spreading to Europe – Spain and the UK in the forefront, not to forget Estonia in the fringe.

The decline of the high yielding corporate bond prices since their July 2007 high – what was 120 then is 100 today –seems not to entitle to a bubble burst, presumably because their total market is small in respect of the residential mortgages.

But, problems in the latter are spreading into commercial. Prices are also down in commercial properties in which my source of intelligence is David E. Witt, Witt Ventures LLC in Atlanta, Georgia. He has 38 years’ experience in real estate development and investment and saw the 1974 - 1975 melt down of commercial property prices.

“The commercial debt market has come almost to a standstill with the exception of 60 percent to 65 percent loan-to-value mortgages. “ As a wider consequence of the collapse of Bear Stearns, he adds: “no lenders are writing CMBS (commercial mortgage backed securities) debt anymore. That particular market is totally dead.”

Problems in commercial mortgage markets will endogenously feedback the downturn in the residential markets, intensifying the process of debt deflation as shortly described in my previous blog.

But, there still remains the biggest bubble of all, the huge market of the U.S. treasuries, to be punctured. The prices of Treasury notes and bonds have elevated to that infamous level of irrational exuberance. Last Friday’s yields varied from 1.6 percent on the maturity of 2 years to 2.5 percent on the 5 year’s maturity which are well below any estimate of the trend growth rate of the US economy plus the Fed’s implicit medium term inflation target.

After last week’s blunt cut of the steering rate, the Fed’s most important task is to get the inflation expectations quickly anchored so that they will not threaten its goal of price stability in the medium term, by preventing inflation expectations from feeding into the second-round effects in price and wage setting.

The yields on the U.S. Treasuries are bound to rise and their market prices to decline irrespective of whether the steering rate will descend or ascend and whether the Fed succeeds or fails in delivering price stability.

It means massive losses to the investors in the most volatile medium term maturities, in particular. The trough of the debt crisis is yet to be seen.

The financial system is able to cover its losses only from the cash flows of its basic business. Hence over a longer period of time considerably higher risk premiums and higher interest rates on all private sector loans will be needed than experienced during the run up to the liquidity bubble.

Therefore the U.S. economy will recover slowly from its current mayhem – and Europe will pay its share of the costs of the almost global mispricing of risks.

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