WASHINGTON (MarketWatch) -- Could the turmoil in the markets in the past few weeks be the precursor of a full-blown credit crunch that could force the U.S. and global economies into a recession?
Some observers think that the markets are exhibiting classic signs of a so-called "Minsky moment," when overleveraged borrowers must finally pay the piper for their euphoria. The result, they say, will be a credit shortage that could bring down even innocent bystanders in their wake.
Academics, economists and money managers are all sounding the alarm. Financial markets are counting on the Federal Reserve to drop interest rates to cushion the fall, and yet senior officials at the central bank have insisted that the markets must discipline themselves.
The S&P 500 index is now pricing in a recession starting in late 2007 and lasting for most of 2008, led by the financial sector, said David Bianco, chief equity strategist at UBS. "We believe the market expects this recession to slash S&P 500 [earnings per share] by about 10%," Bianco said.
A growth recession, with rising unemployment along with slow growth in output and sales, "is a certainty," said Dimitri Papadimitriou, president of the Levy Economics Institute, a think tank at Bard College. That's where economist Hyman Minsky fleshed out his theories of a credit-business cycle, which emphasized a close connection between the creation and destruction of asset bubbles in financial markets and the timing of economic expansions and recessions.
The last two recessions, Papadimitriou said, follow the Minsky analysis to a "T." In the current cycle, he said, "economic activity will decline.
Minsky theorized that an asset bubble has three stages. In the first, so-called "hedge" investors can pay off the interest and principal from their cash flow. Healthy returns push up prices, attracting the "speculative" investors of the second stage, who can meet their interest payments from cash flow with the help of liquid capital markets, but would have to sell off assets to pay off the principal. In the third stage, "Ponzi" investors rush in, relying on the continual appreciation of the value of the asset to pay the interest or the principal.
If the asset loses value, Ponzi investors lose everything and speculative investors get squeezed. That's the Minsky moment.
Even the stodgiest economics institution in the world, the Bank of International Settlements, has a Minskyan analysis of the current situation: "There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking," the group said in its annual report last month. Such cycles inevitably end when fundamentals have been overpriced.
The Ponzi investors didn't stop with mortgages, as we now know.
Early signs of an impending credit crunch are everywhere:
- Mortgage lenders going out of business, and the lenders left standing are closing their subprime and Alt-A origination channels.
- The spread between corporate debt and riskless Treasurys has widened dramatically. Standard & Poor's has said most corporate debt is now speculative grade.
- Credit for leveraged buyouts has dried up, with dozens of deals canceled, postponed or repriced. The market for complex derivatives such as collateralized debt obligations has shut down like a "constipated owl," according to bond fund manager Bill Gross.
- The price of insuring asset-backed securities against default has soared.
