Is it possible that a few small towns near the Arctic Circle in Norway cannot pay their municipal employees because of the subprime credit crisis in the U.S.?  Apparently so. 

A Norwegian brokerage firm recently filed for bankruptcy after losing its license for selling collateralized debt obligations (CDOs), created by Citigroup, to four small Norwegian towns near the Arctic Circle.  The brokerage firm allegedly failed to inform the towns - the largest of which boasts 18,000 inhabitants - of the risks inherent in the CDOs, assuming the brokerage firm itself understood the risk issues.  Since the purchase of the CDOs, the four Norwegian towns have watched the value of their investments fall to less than 55% of original value - a loss of $64 million dollars.  Couple the paper loss with the absence of liquidity, and it's easy to understand why employee salaries are in jeopardy.

Where does it end?  It's really hard to say.  If nothing else, the fact that Norwegian villages near the Arctic Circle cannot pay municipal employees because of defaults on residential mortgages in Ohio or California attests to the extent of global financial integration.

There is a very interesting comment in the November 17th – November 23rd edition of The Economist to the effect that “…most economists do not forecast a recession in America, but the profession’s pitiful forecasting record offers little comfort.  Our latest assessment (see page 80) suggests that the United States may well be headed for recession.”

If you have a chance, please do read page 80 – and page 81 and page 82.  The Economist suggests seven forces contributing to – and one opposing – a possible recession.  The seven negative forces and factors are listed below:

• A collapse in housing construction;
• A drop in corporate profits;
• A steep and continuing drop in housing prices;
• An emerging drop in stock market prices;
• A sharp increase in oil and, subsequently, gasoline prices;
• A softening labor market; and
• An existing – and likely accelerating – credit crisis.

The collapse in housing construction ripples through various associated economic sectors, impacting output, employment, and ultimately consumer spending.  Declining corporate profits usually point to declining corporate investment, which has similar ripple effects.

The drop in housing prices and stock market values, increasing gasoline prices, a softer labor market, and an accelerating credit crisis directed primarily at the consumer all add up to heavy restraints on consumer spending – whose household debt has mushroomed from 80% of disposable income in the early 1990s to 130% of disposable income today.  Consumer spending largely explains the phenomenal economic growth over that period.  It accounts for roughly 70% of our gross domestic product (GDP).  If it stumbles, so, too, will the economy.

The one bright spot in the economy is export activity, which has been helped greatly in recent months by the rather dramatic fall in the dollar vis-à-vis every major currency.  Accounting for approximately 12% of GDP, the increase in exports has more than offset the drop in construction activity, which amounted to roughly 6% of GDP at its peak in 2006.

It’s obviously hard to say what it all really means but, then, we’ll find out soon enough.

Floyd Norris had a very interesting article in the November 2, 2007 edition of the New York Times – A Debacle That Has Wall Street In the Dark. He commented that every financial disaster deserves its very own scapegoat. The major accounting firms endured in that capacity – some successfully so and some not – following Enron, Worldcom, and a legion of other public humiliations.   Equity analysts had their turn after the dot.com melt down. Now the credit rating agencies may be in for an interesting few months. 

“This time it could be the credit rating agencies. The Securities and Exchange Commission is now investigating them to see if their ratings complied with their own published standards. 

It is hard to know which conclusion would be worse. It the agencies violated their own policies, they will be vilified for the conflicts of interest inherent in their being paid by the issuers of the securities. If they did not, they will be derided as fools who could not see how risky the securities clearly were…”

So long as the rating agencies are paid by the issuer, i.e., paid by the party seeking the credit rating, it seems likely the conflict of interest and associated questionable ratings will only continue. Further, unless market requirements have changed, an issuer needs credit ratings from two recognized agencies. Since there are three such agencies – Moody’s, Standard & Poor’s, and Fitch – it stands to reason that the issuer can shop around a bit if market scuttlebutt suggests one agency is too tough on certain securities or, more likely, conveniently lenient.

One possible resolution to the problem, mentioned in the Norris article, is to allow investors access to information given to the rating agencies by the parties seeking credit ratings, prevented presently by rating agencies’ exemption from Regulation FD. If such information were made public, investors could then make their own credit assessment and avoid reliance on third parties burdened with a possible conflict of interest. However it plays out, it will be interesting to watch.