Taking Stock of Bonds

January 10, 2008

Truth Serum

In recent years Wall Street - and some of the investors that bought its securities - engaged in some interesting language games and plenty of wishful thinking. Second lien debt, better known as home equity loans, and lines of credit somehow got mixed in with first lien mortgage loans to less credit-worthy customers and these were all labeled subprime mortgage securities. This was sort of interesting because we now have learned that the recovery on second lien paper is very different than it is for first lien mortgage debt.

But the sophistry about mortgage debt and housing didn't end there. Until last fall some economists and market observers even believed that the housing crisis somehow would not impact the broader economy. How they came to this conclusion is unclear. Did anyone believe that the steady decline in home sales so well documented by the broader media would go unnoticed? Did anyone believe that the notable failures of mortgage lenders would go unnoticed by the broader public or that the bad news about home sales and prices would not prompt the average consumer to rethink their spending habits? The steady drum beat of reports about falling home sales and the declines in home prices had to impact consumer sentiment and it probably did, just in time for Christmas.

It should not take much imagination to realize that spending will also be impacted by rising energy costs which not only make basic goods more expensive, they make commuting to that new home more costly and they make it more expensive to heat that home.

A report on Tuesday from economists at Goldman Sachs that calls for a recession this year noted that consumer spending is expected to see an outright decline, though small, because of the housing industry's woes.

"Over the past few months, we have become increasingly concerned that the US housing and credit market downturn would trigger not just a growth slowdown and substantial Fed easing -- our long standing view -- but also an outright recession,” the Goldman report says. "The latest data suggest the recession has now arrived, or will shortly."

As they say, the truth shall set you free.