The Economist has an interesting article on the Credit Default Swap marketplace ("Swap Shop"). I've written about this market before, but it is one that is even more important today than it was just a 18 months ago. Credit Default Swaps are essentially bets that anyone (well, any financial institution) can place on another credit instrument (e.g. a corporate bond). You can buy or issue a CDS without being a party to the underlying credit instrument, though often the participants in the CDS market use these vehicles to hedge their risks as parties to credit issuance. CDSs are different from the current black sheep of the finance family, the Collateralized Debt Obligation (CDOs: basically a pool of mortgages or other debt that is bundled, chopped up ("securitized"), and then re-sold). While the current "Credit Crunch" is largely a result of a meltdown in the CDO market due to mispricing of risk and other negligent/reckless lending practices in home loans, the CDS market is prospering. It grew from $34.4 Trillion in 2006 to $62.2 Trillion in 2007 and continues to grow rapidly (yes, you read those numbers correctly--the CDS market is many times larger than the entire US economy, even if most people have never heard of it). Here's the rub: this vibrant CDS marketplace will actually rescue us from the "Credit Crunch," unless of course it manages to cause the entire global economy to implode in the meantime. Fortunately, that unless isn't very likely. Yet. The CDS marketplace is like a safety net. As it grows more dense, more complex, more perfectly optimized as a risk-management tool, it also becomes more rigid--losing the very flexibility that it needs to perform its function. Currently, firms use the CDS marketplace as a network of insurance policies. When something goes wrong, as long as those firms that are obligated to pay under the CDS system have the spare change to do so, the safety net functions admirably. Of course, as a largely unregulated world shrouded in the fog of murky and non-transparent accounting practices (or worse, overly rigid ones like the new Basel-II standards), it isn't really possible to tell when a firm has over-committed themselves in this CDS shadow-world. Because CDS providers make money by issuing these swaps, and because at the right price there is a virtually unlimited market to purchase said swaps, the ratio of committed reserves to actual reserves of the financial industry in aggregate is rapidly accelerating. This makes the CDS marketplace increasingly "rigid"--where rather than absorb a shock, it spreads through the network without dissipating.
At any given point--such as now--it is much more likely that the system absorbs whatever shock it receives. But, as every moment passes, the CDS system becomes more optimized, and therefore less flexible and more brittle (there are historical precedents for this). Over time it will become increasingly likely that the any given shock shatters an increasing inflexible CDS system, but, in my opinion, we're not there yet. There is still lots of room for optimization in the system--for example, this CDS-style risk-management notion really hasn't spread to the retail level. When that happens--when I can buy a CDS on my neighbors mortgage to protect myself from the decline their bankruptcy and resultant foreclosure will cause in my home value, then I'll think we've crossed the Rubicon. Coincidentally, that's a really good business idea... (note: only partial sarcasm... I've long thought that there is a huge and untapped market for retail hedging of risk exposure far beyond life, car, and home insurance: why don't more individuals hedge exposure to volatile energy costs, food costs, housing values, job markets, etc.??)
So am I just saying that, most likely, we'll recover from our current economic mess? Not quite. What I am saying is that the current economic problems are caused by a very curable problem--poor credit practices. They are, admittedly, being exacerbated by the onset of the next source of economic problems, Peak Oil, but that is not yet the underlying cause of what's happening. I must admit, the media does seem fixated on telling us how there really is a depression, right now, in America--in my opinion because they have to talk about something, and because you don't get ratings for saying "nothing particularly striking to report today, Bob." Parts of the broader media complex--blogs and websites mainly--do nothing but cherrypick news that supports their view that we're one wake-up away from a "Mad Max" apocalyptic future. All this motivates me, at times, to defend my prediction that we aren't in a recession, and that we won't see a real recession this year at all. Of course, this conflicts starkly with my other prediction that we are currently experiencing a "slow crash." Am I schizophrenic? I don't think so (who does?)--rather, I suggest that these two views are compatible provided that the differing time periods are kept in mind.
I maintain my prediction that we won't enter a recession this year. Of course, I take that narrow-minded position that a recession should actually have to conform to the definition of recession before it counts--if people are allowed to go about willy-nilly and define what a recession is and then tell me that I'm wrong when I say the current data doesn't meet the definition, more power to them. Just for completeness, US Q1 2008 GDP growth = 0.6%, and a recession is officially defined as two consecutive quarters of zero or negative GDP growth. Contrast this with the incessant ranting of the media that "7 out of 10 Americans think we're already in recession" (and the unspoken data point: 9.9 out of 10 Americans can't actually define the threshold for recession, but the media still reports their opinion... kind of like "7 out of 10 Americans think the Surge in Iraq is working" while "9.9+ out of 10 Americans don't have the data to reach an informed opinion on the topic"), the current economic figures suggest that we are NOT in a recession.
So there's nothing but smooth sailing on the horizon and I'm transitioning my oil call options into suburban homebuilders? No. There are some grey swans that could create a true recession or depression: actual and sharp decline in oil production is one of them. I don't care how high oil prices go ($300/barrel, $500/barrel), as long as it's just a bidding war for plateauing, but not yet declining supplies, this won't cause a true recession in my opinion. Our very ability to bid prices to such heights will be reflective our our economic strength. But once actual energy supplies begin to decline substantially (say, 5% from peak), then this will cause economic damage.
Net oil exports are one key data point to watch--and they may already be showing substantial declines (in the 5% range). However, to the extent that oil exporting countries are increasing domestic demand by stepping up purchases of consumables and durables from the West, this may temporarily postpone the impact of net oil export declines. No telling, yet, whether net oil export declines or actual net production declines will be the first to start to impact the global economy, but I think we'll have time for one more bout of partying before either one puts the permanent kaybash on the festivities...