Knowing what we don’t know

Question marks right.jpgAt a time of uncertainty, its sometimes helpful just to frame the questions that need to be answered about the future. Pimco, the world’s largest bond fund managers, have done just this in two separate analyses. Their answers mirror those advanced by former Treasury Secretary Nicholas Brady, and make good sense to the blog:
Q1. How bad could this get?
Answer: “No one knows for sure, but common sense would provide a good guess. If the government cannot substitute credit to the same extent that it is disappearing from the private system, then the U.S. and global economies will retreat. If the economy is viewed as a bathtub filled with water (credit), then draining it back down might reduce economic activity proportionately. Liquidate credit to 2003 totals and you just might reduce economic activity (GDP) to 2003 numbers as well. Whoops! That would mean a 10%+ contraction in the US economy with unemployment approaching the teens.”
Q2. What can be done?
Answer: “Keeping the tub sufficiently full means advancing policies in content and magnitude never contemplated since the days of FDR. The U.S. and global financial systems require credit creation and foreclosure prevention, not bank nationalization as currently contemplated by some. Trillions will be required in the U.S. alone and it is critical that there be a high degree of policy coordination among all nations, which avoids protectionist measures reflective of failed policies in the 1930s.”
Q3. What is the new credit paradigm?
Answer: “Expect to see lower levels of liquidity (making price discovery harder), more corporate defaults (and restructurings), and lower recovery values. You can no longer assume a 40% recovery rate as a bond investor. Government bailouts will likely be based on political parameters, rather than commercial reasoning.”

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