Credit Market's Weight Puts Economy on Shaky Ground

By Steven Pearlstein
Wednesday, August 1, 2007

The fundamentals of the economy remain strong.

The problems are largely confined to subprime mortgages.

A great buying opportunity.

* * *

It's hard to know whether the people peddling this optimistic blather are trying to delude themselves or us. Either way, it's dangerously wrongheaded.

Yes, the U.S. economy looks pretty strong. Why wouldn't it? We're borrowing the equivalent of 6 percent of our national income each year and using it for consumption and to bid up real estate, stocks and other assets to prices that make us feel richer than we really are.

Broad economic factors are not driving the markets right now. At the same time, what's going on in the markets could significantly affect the real economy. The mortgage mess is already shaving as much as a percentage point off economic growth. And now that other forms of credit have become more expensive -- anywhere from a quarter of a percentage point for the best corporate borrowers to several percentage points for the riskiest -- the economy could find itself fighting strong financial head winds.

The higher cost and tighter availability of credit is being felt worldwide, with impacts on Australian hedge funds, German banks, Russian oil companies, commodity prices in Africa and the government budget in Argentina.

As this so-called repricing of risk unfolds, don't pay too much attention to the stock market. Stock prices are collateral damage. The real action is in credit markets where bonds, bank loans, financial futures and all sorts of newfangled derivative instruments are traded.

Market bulls are quick to point out that default rates on these loans are still at historic lows. Have they forgotten that bonds tied to subprime mortgages fell even before the foreclosures began? And is there any reason to think the same thing won't happen with the credit extended to hedge funds for their speculative investments and to private-equity funds for their overpriced acquisitions?

One reason that default and bankruptcy rates have been so low is that borrowers could easily cover the problems by getting new loans to pay off old loans that may have been going sour. As Warren Buffett quipped recently: "A rolling loan gathers no loss."

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