What\’s really going on? What\’s going on is that perhaps $6T of mortgages with a duration of a decade that had been priced at a 1% per year chance of default (with a 1/3 value haircut in the event of default) are now being priced at a 4% per year chance of default. That\’s a loss of $600B in market value–and if your share of that $600B is greater than your capital, or is thought to be greater than your capital and so impedes your operations, you are gone.
But truth be told it is a zero-sum game–not a real destruction of wealth. The real rates at which cash flows of constant risk are being discounted haven\’t changed much: there hasn\’t been a big redistribution of wealth between the present and the future. What has happened was that a bunch of people believed that the default risk was 1% when it was actually 2% and reported gains of $200B (of which they took 2-and-20 on the hedge fund slice, perhaps $20B, for themselves), and that now a bunch of people believe that the default risk is 4% when it is actually still 2% (unless, of course, the assembled central banks of the world fail and unemployment heads rapidly upward). So in aggregate hedge fund partners have gained $20B, hedge fund investors have paid$20B to their money managers for the privilege of losing another $200B that they never had, and there are $400B of transitory paper losses that will turn into real losses for those overleveraged and caught by the credit crunch and so forced into fire sales, and into real gains for those with steel nerves and liquidity.
Unless, of course, Ben Bernanke and company fail to contain the crisis, and we wind up in a severe depression. But then we would have much, much bigger things to worry about than $600B of missing paper mortgage value. 4 years x 3 percent excess unemployment x Okun\’s Law coefficient of 2 x $13T economy means a $3.1T cumulative Okun gap in lost real wages, salaries, and profits. That\’s the thing to worry about.