Page 1 of
5 CREDIT BUBBLE
BULLETIN Crunch time By
Doug Noland
COMMENTARY
November 16 – Financial Times (Gillian
Tett): “Another week, another memorable encounter
with a nervous financial beast. This time,
however, the animal in question is Royal Bank of
Scotland…Last week, RBS raised eyebrows when it
was widely reported that one of its highly
respected credit analysts had predicted that
subprime losses could
eventually rise to between $250bn and $500bn - or
twice previous estimates… behind the scenes - and
occasionally in public view - the credit analyst
community remains distinctly divided about just
how big the final hit might be… Thus while some
observers project a $100bn hit, others talk about
$500bn… A decade ago, I covered the Japanese bank
crisis and became embroiled in a bad-loan guessing
game that continued for many years. The tally of
Japanese bad loans was estimated to be about $100m
at the start of the 1990s, but by 1999 had risen
to 1,000 times that size. I am told that a similar
game occurred during the Latin American debt
crisis in the 1980s and the Savings and Loans
crisis - or indeed in almost every other recent
banking shock.”
November 16 – Bloomberg
(Kabir Chibber): “The slump in global credit
markets will force banks, brokerages and hedge
funds to cut lending by $2 trillion, triggering
the risk of a ‘substantial recession’ in the U.S.,
according to Goldman Sachs Group Inc. Losses
related to record U.S. home foreclosures using a
‘back-of-the-envelope’ calculation may be as high
as $400 billion for financial companies, Jan
Hatzius, chief economist at Goldman…wrote… The
effects may be amplified tenfold as companies that
borrowed to finance their investments scale back
lending, the report said. ‘The likely mortgage
credit losses pose a significantly bigger
macroeconomic risk than generally recognized,’
Hatzius wrote. ‘It is easy to see how such a shock
could produce a substantial recession’ or ‘a long
period of very sluggish growth,’ he wrote.”
I commend Mr. Hatzius for his informed and
forthright analysis, and certainly appreciate Ms.
Tett’s insight. The adept and well-informed are
coming to recognize the gravity of the situation.
Meanwhile, most analysts and economists remain
steadfast in the “economic fundamentals are sound
and the risk of recession low” camp. Listening to
commentators on CNBC, one might be tempted to
believe that things are bound to quickly return to
normal after traversing the subprime speed bump
(“a bit of a Credit problem,” according to one
analyst). Goldman’s Hatzius recognizes both the
fundamental role that Credit plays in economic
development and that we are in the midst of an
extraordinary Credit Crunch.
Mr. Hatzius
throws out a $2.0 TN number in an attempt to
quantify the scope of curtailed lending. He goes
on to suggest that a “substantial recession” is in
order if this Crunch unfolds quickly, or a period
of protracted stagnation if it materializes over
time. I’ll let Mr. Hatzius speak for himself, but
my observations and analysis make it patently
clear that this historic Credit Crunch has passed
the point of no return and will now escalate
hastily.
The general economy has reacted
only moderately thus far. Most analysts mistake
this as further indication of the resiliency of
the U.S. economy and additional confirmation of
“sound” underpinnings. I take exceptions on both
counts, and see the general economy’s fortitude in
an altogether different light.
Central to
the bull case today is the financial strength of
the U.S. business sector. Granted, the
non-financial corporate balance sheet is today
heavier on cash and lighter on short-term debt
(perhaps significantly) than would typically have
been the case at this stage of the cycle. In stark
contrast to the technology sector’s (“Ponzi”)
vulnerability to the abrupt change in financial
conditions back in 2000, much of our
(non-financial) corporate sector can these days
contemplate Credit market tumult with assured
poise and, practically, indifference. Outside of
housing, few face an immediate cash-Crunch that
would necessitate terminating projects and firing
workers. I believe this general invulnerability to
short-term market liquidity issues helps to
explain today’s complacency in the face of a
momentous deterioration in Financial Conditions. I
believe this complacency is not only unjustified,
but also creates the “hook” that has corporate
managements and stock market bulls alike
confidently staying the course in the face of
terribly ominous developments.
Importantly, the other side of the
ostensibly robust non-financial corporate balance
sheet is the troubled financial sector’s. Keep in
mind that since the beginning of 2001, financial
sector borrowings (from the Fed’s Z.1 report) have
inflated 83% to $14.9 TN. Moreover, during this
six and one-half year period Total Mortgage Debt
jumped 106% to $14.0 TN. It was, after all, the
massive expansion of household and financial
balance sheets (and, in particular, their
liabilities) that created the “cash-flows” that
accumulated in unusual quantities in the
non-financial corporate sector. The bulls are wont
to fixate on the wherewithal of corporate America,
yet the source of this seeming financial
well-being is in reality at the root of Acute
Systemic Fragilities.
November 16 –
Bloomberg (Bryan Keogh and Shannon D. Harrington):
“For the first time in at least a decade, the
world’s biggest financial institutions are paying
more to borrow in the corporate bond market than
the average company. Bonds of banks, brokerages
and insurance companies yield 1.49 percentage
points more than U.S. Treasuries, matching a
record high set in October 2002… The average
industrial company bond trades at a yield premium
of 1.34 percentage points.”
The widening
spread differential between the financial and
industrial sectors is telling and it’s not
speaking bullishly. And financial sector spreads
widened notably this week. Residential Capital LLC
(“Rescap”), the residential lending arm of GMAC,
saw pricing its Credit risk widen an astounding
2,800 basis points this week (see Market
Dislocation Watch above) to 4,500. The market is
now pricing Rescap Credit insurance for likely
default. Its bonds are trading at 55 cents on the
dollar.
Rescap ended September 30th with a
$114bn balance sheet. Total Liabilities of $107bn
included $38.2bn “Collateralized Borrowings in
Securitization Trusts”, $14.5bn deposit
liabilities, $10.5bn FHLB Advances, almost $7.0bn
in repurchase agreements, $15.5bn in senior notes,
$1.0bn in subordinated notes, $1.8bn in “third
party Credit facilities” and another $10bn or so
of other liabilities. A Rescap default would have
far-reaching ramifications and would certainly be
a major blow for mortgage finance overall.
According to their website, Rescap is the
“7th largest originator of residential mortgage
loans in the U.S., producing $161.6 billion in
loan origination volume; the 7th largest servicer
of residential mortgage loans in the U.S., with a
primary portfolio covering 3.2 million loans
valued at $412.4 billion; No. 1 warehouse lender
in the U.S. with $13.2 billion in commitments; 3rd
largest non-agency issuer of mortgage-backed and
mortgage related asset-backed securities in the
U.S. with issuance of $71.1 billion.” Rescap has
been a leading subprime lender, and we’re all
familiar with the silly commercials from their
Ditech lending unit. Rescap, a unit of GMAC, is
owned jointly by GM and Cerberus Capital
Management, and the markets now fear that the
parent companies will be forced to choose
bankruptcy over funding a festering financial
black hole.
GMAC (one-year) Credit Default
Swap prices widened about 240 bps this week to 975
basis points. GM and Ford CDS widened notably as
well. Clearly, a Rescap default would be a major
event for the troubled Credit Default Swap
marketplace. Whether it would prove catastrophic,
I simply just don’t know. But I will assume that
Rescap, GMAC, GM and related risk exposures are a
meaningful component in a multitude of structured
products, including synthetic collateralized debt
obligations (CDOs of CDS). Those on the wrong side
of these rapidly widening spreads face acute
market illiquidity and few avenues to hedge
exposures. This is precisely the backdrop
conducive to panic and market accidents.
Between the CDS market and heightened GSE
angst, it was another rough week for “structured
finance.” Expect it to deteriorate further.
Freddie tightened lending standards this week, and
with a tidal wave of Credit losses building, I
don’t see how the GSEs don’t implement
meaningfully tighter lending standards throughout
the “conventional” mortgage arena. And with major
lenders such as Wells Fargo, Countrywide, and
Rescap moving to tighter lending, it appears we
are at the brink of only worsening Credit
Availability and resulting housing market
pressure.
And in regard to mortgage Credit
tightening, it is worth noting recent operational
data from Countrywide. Despite the subprime crisis
from earlier in the year, Purchase Mortgage
Fundings actually remained quite strong at $18.7bn
through the month of July. Purchase Fundings were
down only marginally to $17.2bn during August. But
these fundings then shank to $9.6bn in September
and to $9.3bn in October. By October, Purchase
Fundings were down 55% from July’s levels. Other
categories were even worse. Countrywide’s ARM
fundings were down 75% in three months; Home
Equity Fundings were down 64%; and Subprime
Fundings were down 98% to $42 million.
The
point I’m drawing from the data is that we are now
only a few months into the general mortgage Credit
Crunch - and Credit is about to get even tighter.
Housing markets, especially in California, are at
the brink of some very serious trouble. Moreover,
a severe Credit crunch is just now taking hold in
commercial real estate, a sector notorious for
punishing boom and bust cycles. While not commonly
appreciated, commercial real estate is today
acutely vulnerable to the downside of “Ponzi
Finance” dynamics. Keep in mind, also, that
commercial mortgage debt expanded 15% over the
past year (through the first half), playing a
meaningful role in system Credit and liquidity
creation. Now, through Rescap, GMAC, the CDS and
CDO markets, “leveraged lending,” M&A finance,
derivatives, and the securitization markets in
general, the system has reached the brink of an
historic Credit Crunch.
With the
securitization market severely impaired and Wall
Street reeling, the Banking sector balance sheet
has now ballooned $550bn (21% annualized) over the
past 16 weeks. How can this not be a disaster? How
can it be sustainable?
The bottom line is
that we have now entered a financial environment
prone to serious accidents. The financial sector
generally is under heightened strain, and I expect
this
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
