Crikey

What we’ve learned recently is that, yes, it might be wise to have a few sandbags at the ready. The problem that was in subprime loans before has now spread into prime US housing loans, which are 85% of the market. Delinquencies and defaults have begun to rise in these loans.

The problem is that we are no longer talking about tens of billions of dollars of loans. We’re talking about trillions of dollars of loans. And it’s the deterioration in the prime loan sector which has generated a second wave to this crisis. That’s only started to happen in the last two months.

During that period the risk premium on the prime 30 year, long term, what they term “plain vanilla” housing loan has deteriorated by 70 basis points. It’s gone up by 0.7% relative to the long bond, and that means that all of the cuts in the Fed funds rate that have occurred up until the last one have entirely been absorbed by the increase in the risk premium. Therefore, there is no stimulus getting through to the US housing sector. All of the efforts the Fed has made since early August have barely been enough to stabilise the market. They have in no way improved the market. It’s that realisation that is starting to dawn upon people in the financial markets.

To be blunt about it, the problem is vastly larger than previously thought, because we now know it’s not limited to the subprime area. Now it’s in the prime area, it has become a genuine threat to US demand growth.

So what’s the forecast? Well, we think the US economy will grow by 0% in this quarter. Real net exports are running in the positive to about 1%. The US current account deficit is actually improving. So when you look at domestic demand for this quarter it’s probably falling at about a 1% annual rate. On a demand basis the US economy is already in recession and we expect about the same next year.

Alan Greenspan said: “We’ve got a 50% chance of a recession.” What’s remarkable is that it wasn’t 70%. The only thing that’s saving the US economy right now from being in genuine recession this quarter and next quarter is that exports are recovering because of the low level of the US dollar. But with the continued deterioration in the prime home loan market, the US economy can easily push itself over into recession from here.

Nobody knows how much further this might spread, and that’s why the US and Australian equities markets have taken fright. We actually faced a similar situation in the 2001 in the tech-crash. The Fed now has to cut funds much lower before it will be able to turn the US housing market around. This is definitely the biggest disturbance we’ve seen in financial markets in seven years.

So, although his quote made reference to China, is this part of the financial tsunami that Peter Costello warned voters of during the election campaign? It would be useful to start building arks.