Tuesday, August 14, 2007

State of the Economy

I am not an economist nor a financial guru, but I'm pretty sure our economy is about to hit the crapper any time now. I'm waiting for the day that there are six or seven firms who all simultaneously decide to announce bankruptcy or a halt on withdrawals (which pretty much signals bankruptcy is near).

I'm going to give you my take on why our economy is about to tank, and please let me know if I am crazy. So the past few years of economic growth have been driven by easy credit. Not just for homeowners, but for corporations too. Hedge funds have been doing well by buying securitized debt and things seemed to be going well. Except we have this problem where the debt underlying a lot of these securities had underrated risk (i.e. they are riskier than they were sold at). In top of that, several hedge funds have been levering up the wazoo so that their initial capital makes up only a small percentage of their actual investments. It was as if debt were crack cocaine. They got a taste of it and only wanted more and more, so it could feed their addiction to use that money. But that means if their investors start asking for some of their money back (which all the smart ones are doing now), then they have a serious problem. The debt is like cocaine, remember! It's in their blood and they've already used that loaned money to make some investments. The expectations are that those investments will pay off much better than their debt rates. But to secure the necessary returns, these funds need time to implement their investment strategy. Well they don't have time with their investors demanding their money back. So their investments are not paying off at high enough rates to cover their debt. Now these hedge funds have no time, no money, and pretty much don't have anything besides an addiction.

How does this all lead to an economic downturn? Well this is not a small problem. It's a HUGE problem at EVERY bank on Wall Street. Everyone on Wall Street is sitting around with a finger on their nose hoping it will all go away. These announcements about hedge fund stalls and bankruptcies are an early indicator of what the real problem is. Well if you remember that all that debt was riskier than it actually was...the big trigger will be when all that debt gets re-rated at its true risk value (i.e. higher interest rates and lower value). The current run on hedge fund money by investors asking for their money back is just people who are trying to get something back before this huge debt-rating correction happens. Once that happens, the value of a lot of money will suddenly drop. So imagine if you were living a lifestyle with an income of $100K. Maybe you weren't too thrifty and spent everything you made. Well then one day someone comes along and tells you that you now will be making $50K. Now you are going to have trouble paying down your car lease, your mortgage payments, and that totally unnecessary habit of buying items out of the Sharper Image catalog. That's pretty much what is going to happen when all that debt gets re-rated, but at a much larger scale. No more car, no house, and definitely no more $500 Ionic Sonic Breeze air purifiers. The pains will be felt everywhere. The people to feel it first will be the banks. Then corporations who were expecting to get easy loans will be hit hard. These corporations will get tight with their spending, so service firms will have no business. And pretty much it ripples through the economy.

I'm pretty worried about recruiting for my classmates in business school. It looks like it is going to be a pretty craptastic recruiting year.

What can do you about this? Probably nothing, unless if your name is Bernard Bernanke. I definitely would take a look at any of your investment allocations. Move them out of any companies that are highly-levered and issuing junk bonds (e.g. GM). You might want to look at putting the money in a corporate bond mutual fund that focuses on high-quality corporate bonds.

I hope I'm wrong about the economy. But the more I think about it, the more I realize we are headed for a couple years of a tough economy. That might just be the nail in the coffin for the Republicans in the 2008 elections.


Melby said...

I don't know if I agree with all of that. Maybe I'm just more of an optimist.

Being at a start up I may just have a different perspective. I've been seeing a good number of VC's closing large funds and funding quite a few start-ups. That gives me a lot of confidence in entrepreneurship which creates 80% of all new jobs in the US and drives our growth. As long as the government stays out of the way (low taxes), I think small companies will continue to spring up, raise money, create jobs and fuel the economy.

The risky debt out there will get re-priced, but it will only create a correction (like the 10% haircut the market just saw) and banks will be a little more careful in the debt they take on. The people who will be hurt are those who would have been able to get housing loans before and can't any longer - but they probably shouldn't have been getting the loan in the first place.

I'm still liking my chances in this economy.

bizQuirk said...

The reference to the Sharper Image catalog is so right on. Oh, the sadness and emptiness that must permeate some folk's lives to get them to buy such crap.

Up and down University ave and all over mountain view, I see whole rafts of disenchanted family units desperately looking for distraction through consumption. Is this what their two-income slavery has bought them?