Thursday, August 09, 2007

Sanguine or stupid?

Apropos the latest chapter in the subprime saga, Felix Salmon asks what's the big deal about BNP Pariba's announcement that its freezing some funds with investments in bonds backed by subprime mortgages. After all, the money involved belongs to others (unless the bank feels compelled to bail out investors).

He has a point, although in full-blown panics these fine distinctions tend to get lost in the rush for the exits. In this type of situation, it's worth keeping a cool head and listing the possible scenarios:

1) Systemic crisis due to the collapse of a large, well-known financial institution. Very unlikely, but not impossible. After all, the virtue of securitization is that risk is spread more widely. Just imagine how bad it would be if banks had held on to these securities.

2) Credit crunch caused by panic among lenders. This would mainly affect the US (and UK) economy, leading to further losses in the credit and stock markets and perhaps a recession. However, given the strength of the world economy, wide availibility of capital and a starting point of low risk spreads, it probably wouldn't be too bad.

3) Full collapse of house prices in the U.S., consumer retrenchment and recession if a vicious circle between asset value losses and spending establishes itself.

My take is that scenario 3) is the one we should really worry about, yet its been largely ignored. In that sense, Felix's instincts are correct; the collapse of a few funds is mostly a sideshow whose consequences are psychological. But, needless to say, psychology does play a role in the markets. If the gloom bug jumps from them to home owners, then we're in deep doo doo.