An important distinction

Last week was a week of enormous consequence in the financial world. The events were so dramatic that they will be analyzed, discussed and debated literally for decades. It is no exaggeration to say that Wall Street as we knew it is no more, with the news today that Morgan Stanley and Goldman Sachs agreed last night to be converted into traditional bank holding companies.*

Across America and indeed the world, last week's turmoil is being seen as final proof that we really are in the greatest disaster since the Great Depression.

But there is a very important distinction to be made between the crisis on Wall Street and the economy at large.

This distinction is one that most observers are overlooking. They are tending to "conflate" or blend together the situation on Wall Street, where one venerable firm after another fell like dominoes last week, and the situation in the economy in general. They are not one and the same and should not be confused with one another.

It was not weakness in the broader economy that caused real estate related assets on the balance sheets of firms to plummet in value. Yes, there have been loan defaults and home foreclosures, particularly on loans that clearly were irresponsible. But the rate of foreclosure and default did not jump off the charts and drive Wall Street into bankruptcy. The latest data from the Mortgage Bankers Association shows the current foreclosure rate at 2.75% (up 1.35% from a year before) and the delinquency rate at 6.41% (up 1.29% from a year before). It should be noted that in the Great Depression the delinquency rate for homes which had a first mortgage was 43.8% (in 1934) and for homes with a second or a third mortgage the rate was 54.4%, according to statistics reported in the Federal Reserve Bank of St. Louis Review for May/June 2008.

The main catalyst for the financial meltdown, which has been brewing for over a year, was the effect mark-to-market accounting had on the balance sheets, credit ratings, and borrowing capabilities of financial firms, as we pointed out in a previous post. Economist Brian Wesbury uses a great analogy in his outlook for this week, in which he asks you to imagine that your neighbor has to sell his home under exigent circumstances at a fire-sale price, and because of that your banker declares that you must now mark your own home's value to the "new market" and that you must immediately give the bank $80,000 in new capital in order to keep yourself at the loan-to-value percentage set by the bank.

But that is a Wall Street problem, and although it is true that the financial sector impacts every other business that uses financial instruments (such as currency and credit cards and money market funds and bank accounts), it does not mean that the economy is in the same state of affairs. Most businesses not in the financial industry are not impacted by these specific mark-to-market rules, because businesses outside of the financial sector do not generally need to "borrow short and lend long" as part of their business model.

It may be hard to believe, but the true situation is that the underlying economy is actually solid. We have been saying that for months, and the numbers continue to bear it out. Recently, the Bureau of Labor Statistics released revised productivity data for the second quarter of 2008 which determined that non-farm productivity increased at an annual rate of 4.3% sequentially and 3.4% year-over-year.

Productivity is one of the most important economic measurements there is, although this healthy productivity number did not get much media attention this month. In a 2003 speech, Federal Reserve official Cathy Minehan noted that "rising standards of living are almost solely a function of productivity growth."

The fact that productivity is currently increasing at 3.4% is significant. From 1947 through 1986, for example, productivity grew at an average annual rate of 2.3%.

You won't hear too many commentators in the media explaining to you that, based on numbers such as corporate earnings, GDP, and productivity, it is reasonable to believe that the economy is fundamentally sound, despite the financial sector turmoil. But that is because very few of them are aware of the important distinction between the situation on Wall Street and the economy at large.

* The principals of Taylor Frigon Capital Management do not own securities issued by Morgan Stanley (MS), Goldman Sachs (GS), AIG (AIG) or Lehman Brothers (LEH).


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