The subprime crisis has arrived. Yes, many anticipated so. That’s what happens when economy depends on expectations. They take some time to change and, when they change, they do it abruptly. Like those subprime mortgages that have transformed from “hot products” to “hot potatoes”.
Overall is not a matter of solvency but liquidity. I agree, tell that to those that will not be able to afford the mortgages, maybe up to 500.000 people in the US. But investors do not worry much about them. Investors just get scared and they stop pouring endless capital… until they start to do the same somewhere else.
Because companies still report record earnings and the price of gold has been rising non-stop. That means that the machine is still working.
But let’s not be too complacent. A wider crisis can still arise. If gold is “hot”, ABS are cooler than ever. ABS are asset-backed securities, financial products made up of mortgages and things alike that are covered by a real asset, such as your home. These are a way for banks to get cheap financing and externalise risks, because the default risk is transmitted by the ABS, while it wouldn’t be with debt, for instance.
If banks get increasingly difficult to finance, they will transmit this additional cost to companies and consumers. And that’s an entry point to generate a widespread crisis. Central banks should add additional liquidity to the system by lowering rates, but that seems unlikely given their current policies.
But, what about private equity? Now it will be more difficult for them to get cheap capital to finance, that’s for sure. But that doesn’t mean they have no future. On the contrary, they are now more needed than ever, because they are the ones to provide that leaning, that additional shakedown that companies needed in times of more expensive credit.
Remember, there’s much more to private equity than leveraged buy-outs, they have an important role in the markets, and that means they have an important role to play in this new situation.
PD: I read this morning in “The Economist” that the US were thinking of “relief measures” for the crisis. Then I changed to a Spanish newspaper and read about the Popular Party (centre-right and opposition and presumed liberal) to propose the right not to pay mortgages during a year for the unemployed. Alarmed by both news I couldn’t help the thought: regulation must ensure that the system is not abused but, let the market regulate itself. Although some regulations will be painful, it’s the most effective way we’ve come to know.