June 28, 2002
Macroeconomic Effects of WorldCom

Richard Berner of Morgan Stanley thinks that WorldCom's accounting fraud will have little effect on financial markets--raise risk premia by 5 basis points (that is, 0.05%), but not have much of an additional effect on confidence or capital supply. If he is right, than the net effect will be stimulative, for the fear that WorldCom's accounting fraud will have bigger effects will cause the Federal Reserve to wait-and-see: to delay any raising of interest rates until the reliability-of-accounts situation becomes clearer.


Morgan Stanley

Investors fear that WorldCom's alleged fraud and presumed other lurking corporate blowups threaten the economy and financial markets. By escalating capital-market risk premiums, this and other shocks might further depress stock prices and trigger a broader-based credit crunch. In my view, that's unlikely. But the threat is likely to postpone Fed action to adjust monetary policy until late this year. Dave Greenlaw and I now expect that the Fed will remain on hold until November, and that officials will raise rates by just 50 basis points by year-end...

Is this event a tipping point for a broader escalation of risk premiums in the capital markets?  That depends not just on whether another event is news, but perhaps more important, whether this event has the critical mass to change both perception and reality for investors.  On the first point, WorldCom's woes in particular and corporate malfeasance in general are hardly news.  Few days have passed without new revelations that have depressed equity prices and widened telecommunications debt spreads.  Investors have long viewed the telecom industry as the poster child for excess and abuse, contrasting it with better corporate stewardship in other sectors.  But there is less clarity regarding the new threat of a WorldCom bankruptcy and the uncertainty it creates for the telecom industry, its suppliers, and its customers; it could threaten broader economic dislocation and financial contagion.

Risks Appear Contained

In my view, however, this threat remains largely sector- and name-specific rather than systemic.  Price action following the announcement in both debt and equity markets suggests that broad-based credit ripples are unlikely.  Corporate spreads generally widened by 10-20 bp initially and have ended up perhaps 5 bp wider some 48 hours after the announcement.  Corporate bond investors, frustrated by the fact that spreads on quality companies have been rich, seem to have welcomed the event as an opportunity to buy their debt at modest discounts.  And equity investors seem to be sending the same message: While there is concern over financial intermediaries' credit exposures to WorldCom or related parties, the shares of other telecom services providers closed up yesterday.

That issuers have largely securitized telecom debt and distributed it widely suggests that default will not cascade broadly into institutional problems, in contrast with the real-estate-induced credit woes of the late 1980s and early 1990s.  That does not, of course, rule out a credit crunch.  Indeed, I concede that the WorldCom fraud changes the balance of risks for the moment; whatever the chances of credit dislocations before, they are somewhat higher now.  But in my view, a credit crunch is defined by the inability of good, creditworthy companies to borrow.  There is scant evidence of such difficulties.  Instead, markets are facilitating "capital exit," as they reallocate credit from those companies who created excess to those who focus on ROIC.  Indeed, telecom bankruptcy over the longer term likely will be a positive credit event: Although the process may take years, if it truly reduces industry capacity, it will improve telecom sector credit quality.

Policy Response to Possible Headwinds

Two kinds of financial headwinds might concern markets and policy makers. Were a liquidity crunch to emerge, the Fed could avert it without easing monetary policy.  The pre-Y2K and post-September 11 experiences demonstrate that officials can flood financial markets with liquidity while holding short-term interest rates constant.  But in the event of a true credit crunch, additional ease would be likely. The current and perhaps forthcoming decline in market rates and a weaker dollar should offset the restraining impact of new financial headwinds. 

Against the backdrop of an "uncertain" recovery, the threat of a liquidity or credit crunch likely will keep the Fed on hold longer to insure against it, probably until late this year.  Futures already anticipate prolonged accommodation, suggesting that the market is working to cushion the shock; Fed funds futures this morning were even pricing in a slight chance of Fed ease at the September meeting.  Duration matters, however.  If the WorldCom fraud leaves no immediate aftershocks, market participants may quickly refocus on the emerging reacceleration in the economy, begin to embrace risky assets, and anticipate the eventual recalibration of monetary policy toward neutrality.

Posted by DeLong at June 28, 2002 10:16 PM

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