Is The Political World Ignoring The Economy?

A well-connected Democrat with a background in economics worries that the Democratic presidntial candidates are paying too little attention to the prospect of a recession. They're nibbling at the edges -- Hillary Clinton has a plan to solve what she sees as a national housing crisis -- but none of the candidates seem remotely prepared for a credit crunch, a market crash, a sudden GDP decline and a marked decline in consumer spending.

One theory is that Democrats don't want to be accused of talking down the economy in the way that the Republicans accuse them of talking down the surge.

This Democrat e-mails:

The Fed and European Central Bank last week intervened in a big way (the ECB pumped substantially more money into the financial system in a single day last week than they did the day after 9/11) to inject liquidity and get the markets on their feet. Probably a good thing, unless you worry about moral hazard problems, but they don't intervene unless things are getting dicey. And things are getting dicey – and things are likely to get much, much worse before they get better. I don’t think the political world understands just how harrowing the last two weeks have been in the financial markets. How and why did we get here?

Mortgage problems are spreading beyond subprime, which had already been an obvious and growing problem – Countrywide, a large mortgage originator reported in July that the delinquency rate on prime (not subprime) home equity loans was 3.7%, up from 1.5% a year before. Jumbo loans (above $417,000) are being priced 1.5% higher than non-jumbos, if they can be found at all. As recently as 2 weeks ago, the rate for a jumbo was almost equal to a non-jumbo, things have shifted that quickly. To give you a sense of why this matters, in the San Francisco Bay Area, 61.9% of mortgages are of the jumbo variety. If the housing market was already bad, it's just going to get worse as mortgage lenders stop the flow of easy money and housing gets decidedly more expensive, especially in large urban areas. (This perhaps will be a blue-state phenomenon more than a red state phenomenon).

The mortgage market mess has had a contagion effect in the broader credit markets. Appetite for the junk offerings being thrown off by multi-billion dollar private equity deals has disappeared as risk is getting re-priced. Here again there has been contagion beyond high-yield. Case in point, the LIBOR (London interbank offered rate, which banks charge to each other) jumped by 1.5% in a single day last week. That just doesn't happen. Today, there are signs that a bunch of banks in Canada are cutting back on lending to commercial paper issuers, ostensibly borrowers that are relatively safe bets. And a company that manages money funds for hedge funds today asked for permission to suspend redemptions. Counterparties that for years have lent to each other on very generous terms are suddenly extremely suspicious of each other.

A lot of the big investment banks are going to have ugly Augusts and Septembers as these private equity deals come home to roost and more losses emerge among the hedge funds they manage. This will lead to further turmoil in the banking sector, creating a downward spiral.

Where does it end? I’m not sure. I would say that the odds of a significant recession in the next 18 months are materially greater than 60%. If I were to venture a guess, I would bet that “it’s the economy stupid” is going to be right up there with “bring them home” when it comes to sloganeering on the campaign trial next year.