No nonsense economics: what’s gone wrong in credit markets, why it was predictable and what lessons investors should learn 
Economics matter to wealth managers like No Monkey Business. To plan household finances and manage portfolios, we model financial market behaviour. How we model it requires some implicit views of how economies behave. At the heart of our views are some old-fashioned, let’s say orthodox, ideas about banking practice and its impact on the business cycle and asset price cycles.
Bankers can be relied on to screw things up. They have again. Lax lending (including to non-bank investment funds who were effectively taking over their lending function but without the discipline of banking regulations and capital adequacy) has created unsustainable pricing of credits, credit derivatives, residential and commercial property and equity securities. ‘Unsustainable’ does not necessarily mean ‘overvalued’. It means the levels will come under pressure when liquidity stops expanding or shrinks. If the underlying assets are impaired, as is bound to be the case for home loans and some heavily-leveraged companies and investment structures, the first stage of disappearing liquidity, which can be eased by central bank intervention, will be followed by bad debts, which can’t. Balance sheets in the expansion phase therefore hold the clue to the likely severity (if not timing) of the next recession.
With the exception of Japan in the 1990s, central banks in liberal democracies have responded to recessions by renewed monetary inflation. If history repeats itself, the recession will hold the clue to longer-run inflation. A difference this time is that America’s public and foreign financial position is already so bad that inflation may not be an option. The Japanese example may therefore be the relevant one.
Household finances, including investment portfolios, always need to be organised to withstand intolerable outcomes, however low their probability. It looks like many advisers forgot this priority in managing family wealth.
Stuart Fowler on 08.15.07 @ 04:50 PM GMT [">more..]
Kids’ stuff
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