Tetris finance. In the computer game Tetris, it's a good thing to collapse a column. In finance, it's not. There were warnings (as early as 2004) about yields not fully pricing in risk, but with the stock market setting records, the warnings fell on deaf ears. Then the Federal Reserve began hiking interest rates as the economy seemed poised to send inflation higher - belatedly, according to some. That exposed adjustable mortgage rates. That set off problems in the housing market.

A mortgage is a liability. The lender therefore has an asset. And financial firms borrowed heavily against such assets. This is called leveraging. The financial firms lent money based on mortgage assets, therefore they had assets they could borrow against. So when a mortgage went into default, it exposed loan problems for the mortgage lender, which exposed loan problems for the financial firm lending to the mortgage lender. Tetris finance.

This would be a problem limited to the financial markets except that it exposed risk, limiting lending altogether. The credit freeze-up slows an already weak economy. There is a chance that overall economic growth may not slow much more. After all, with consumption and investment so weak, loan demand isn't strong. Otherwise, the credit squeeze would be biting much deeper. But adding the degree of financial distress to an already weak economy could mean it will take longer to climb out of this hole. The most optimistic think it could all quickly begin to reverse, perhaps by the second quarter of 2009. The most pessimistic think it might take until the second quarter of 2010. Split the difference and all of this mess is finally in the rearview mirror by the summer of 2009. Between now and then, one clear signal to watch is when credit spreads narrow. The financial market and the economy won't begin to recover until that happens.

Thursday, September 25

8:30am Advance Report for Durable Goods (Bureau of the Census)

The ordering rate has been relatively strong, surprisingly so, given how soft the economy is. It should be no surprise, then, if the ordering rate edged a little lower in August. That might continue over the next half year or so.

Friday, September 26

8:30am Gross Domestic Product & Corporate Profits (2Q — 2008) (Bureau of Economic Analysis)

After a surprisingly sharp upward revision (to a 3.3 percent annual rate), GDP estimates for the second quarter probably did not undergo another substantial revision. Far more important, growth in the third quarter - with less impact from rebate checks and perhaps not quite as strong a rise in productivity, and a financial panic late in the quarter - will show only a minimal increase (less than 0.5 percent). Finally, profits are very likely to fall again in the third quarter, the 5th straight quarterly decrease.

BY THE END OF THE WEEK

Financial turmoil and the credit squeeze are taking their toll across the globe. The Leading Economic Indicators for all the countries measured have been declining since May. Economic forecasts for almost all industrial countries have been revised down and very easily could be further revised after the cataclysm in stock markets across the globe this week. How weak? For how long? There are no answers and there will not be any answers until the first step in the recovery process is in place. And that would be a return to more normal spreads in borrowing rates. There have been unusually wide spreads for the past year, a major reason why financial markets remain in such disarray. Efficient market theory suggests such panics are not sustainable. Let's hope the theory works.