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5 Mortgage crisis to corporate debt
crisis By Doug Noland
COMMENTARY
The financial system
fell under intense stress on Wednesday. The
epicenter of the crisis was in the credit default
swap, or CDS, market, and contagion fears were
building quite a head of steam. The pricing for
Countrywide Financial default protection
(five-year CDS) surged a huge 469 basis points
(bps)to a record 1,610 bps (it would cost
US$16,100 annually for five years to insure
$100,000 of Countrywide debt
against default).
For perspective,
Countrywide default protection was priced at a
mere 30 bps one year ago and didn't even trade
above 600 during the subprime crisis this past
summer and autumn. Rescap CDS surged an astounding
1,360 bps on Wednesday to 3,746. This was up from
the year earlier 95 bps. MBIA CDS increased 85bps
to 849 (year ago 87) and Ambac 89 bps to 841 (year
ago 70 bps). Washington Mutual CDS increased 61
bps to 611 (year ago 54 bps). Many indices of
corporate debt spreads rose to their widest levels
in years.
In the old Alan Greenspan days,
Wednesday's circumstance would have most-likely
beckoned a "surprise" inter-meeting Fed rate cut.
There were rumors for as much. And while chairman
Ben Bernanke did not ease rates, on Thursday
morning he provided the markets the next best
thing: "We stand ready to take substantive
additional action as needed to support growth and
to provide adequate insurance against downside
risks."
Bernanke didn't plan on rambling
down the Greenspan path. Actually, I believe he
and other members of the Federal Open Market
Committee would have preferred to avoid it -
resist responding directly to Wall Street pleas
for aggressive Federal Reserve accommodation. "Let
the chips fall ...", as they say.
But the
Fed now knows what many on Wall Street have
understood since this summer: the US credit system
and economy are extraordinarily fragile and the
Fed simply will not risk sitting back and watching
an implosion without resorting to extreme
measures. If nothing else, inter-meeting
"surprise" rates cuts are back on the table. Wall
Street must be quite relieved to know this
mechanism is available in the event market selling
pressure turns unwieldy.
The week brought
back memories of the 2002 debt crisis. Weighed
down by the telecom debt collapse, Enron, and
other frauds, intensifying corporate debt problems
late in the year were at risk of smothering the
consumer sector. The nexus at the time was the
auto finance subsidiaries and Household
International. Consumer finance corporate debt
spreads were widening significantly, and
Household, in particular, was facing a liquidity
crisis in early November. The failure of a major
financial institution at that juncture would have
created a major systemic issue.
Well, on
November 14 HSBC agreed to buy (bail out)
Household International. A week later, FOMC
governor Bernanke gave his now (in)famous
"Deflation: making sure 'it' doesn't happen here"
speech. With rates at 1.0% (until June 2004!), the
Fed was now publicly discussing "electronic
printing presses", "helicopters" and other
"unconventional measures". Wall Street was
trumpeting deflation risk. Sure enough, the crisis
was soon resolved and Wall Street was emboldened
to perpetuate history's greatest credit inflation
and mortgage fiasco.
The tables have been
turned these days, with the mortgage crisis now
evolving into a full-fledged corporate debt
crisis. The key nexus this time around has been
Wall Street structured finance, especially as it
relates to the major mortgage lenders (certainly
including Countrywide, Rescap/GMAC, and Washington
Mutual) and the financial guarantors (in
particular, MBIA and Ambac). The unfolding
mortgage implosion has destroyed the value of
innumerable structured products; has annihilated
legions of mortgage companies; has impaired scores
of major lenders; has severely battered general
market confidence; and last week was in the
process of taking down a few huge mortgage
companies. Institutions with enormous liabilities
to the money, repo, securitization and derivative
markets - not to mention large borrowings from the
FHLB system - were in serious jeopardy. The risk
of a domino implosion in the credit default market
and the financial guarantor industry had become a
very real possibility. System disk intermediation
was in peril.
The Fed responded with what
the market has interpreted as a promise of
aggressive rate cuts, while Bank of America has
apparently for now resolved the Countrywide debt
issue. Citigroup's stock rallied on rumors of a
major new investment from Prince Alwaleed and
others. Washington Mutual's stock price rallied
sharply on rumors of merger talks with JPMorgan.
Countrywide's stock surged as CDS prices
collapsed, a dynamic sure to have caused
considerable grief to those shorting the stock to
hedge against default protection written.
Curiously, the general market took little
comfort from developments. A case can be made that
the rally in CDS and financial stocks was
destabilizing for much of the leveraged
speculating community (including market neutral
and quants) keen to short financial stocks against
(now sinking) technology shares. Overall, the
market was hammered, while MBIA and Ambac CDS
prices barely budged from record levels. Friday's
market was one of those that surely caused havoc
for numerous sophisticated trading strategies. And
it is worth noting that an index of junk bond
spreads to Treasuries actually widened an
additional 4 basis points to 603 bps, rising this
week above 600 for the first time since - not
coincidently - the 2002 debt crisis.
But
the general environment is nothing like 2002, and
I don't expect Fed words and actions - in concert
with financial bailouts - to have similar effects.
For one, 13% household mortgage debt growth in
2002 provided powerful financial and economic
stimulus that will not be forthcoming in 2008.
With consumer credit relatively stable, 2002's
corporate debt crisis was not a serious systemic
issue. Moreover, "Wall Street finance" was in an
aggressive expansionary mode and the global
banking community was developing quite a hankering
to participate in the US credit bubble. The
economy was emerging from a shallow recession.
The world is a much different place today.
The mortgage finance bubble is a bust, Wall Street
finance is imploding, and foreign financial
institutions are keen to cut and run from the
business of providing US credit. Countrywide's
mortgage problems will be absorbed - along with so
many other risks - by our own highly vulnerable
domestic banking system. Worse yet, the economy is
quickly succumbing to recessionary forces. With a
high degree of confidence we can proclaim that the
Mortgage Crisis has now evolved into a Corporate
Debt Crisis - and this crisis will not be resolved
anytime soon - by rates, by helicopters, or by
bailouts.
Unlike 2002, today's credit
crisis is systemic. Consumer and financial sector
fragilities - the heart of our credit system - are
now impaired to the point of imperiling the
capacity of the credit system to finance business
spending and intermediate corporate lending risk.
To be sure, prospects for a faltering US consumer
sector, massive financial sector credit losses,
and an imminent economic downturn have quite
negative ramifications for business lending and
valuations. In particular, unfolding dislocation
in the CDS and credit insurance markets will
severely restrict credit availability for small,
medium and large firms - especially those less
than top-tier borrowers.
I'll go further
and suggest that a severe tightening of financial
conditions has abruptly made many business
borrowing plans unviable; many a balance sheet and
debt load untenable; and vast numbers of business
strategies - crafted in altogether different
financial and economic times - much less viable.
Some companies will make the necessary adjustments
and many will not. The unfolding backdrop
definitely makes a lot of stock buyback plans
imprudent and growth strategies highly risky. The
aggressive risk-taking business manager - having
previously capitalized on the protracted boom -
will now be at a similar handicap to that which
afflicted the zealous home buyer and lender.
For those searching for explanations
behind the stock market's dismal start to the New
Year, I suggest contemplating the many serious
ramifications of the mortgage crisis having now
evolved into an Incurable corporate debt crisis.
This week, the bursting credit bubble passed
another significant inflection point - one perhaps
subtle but with major economic consequences.
WEEKLY WRAP
It was another tense
week in the markets. For the week, the Dow
declined 1.5% (down 5.0% y-t-d) and the S&P500
0.8% (down 4.6%). Pressure continued on the
economically-sensitive sectors. The Morgan Stanley
Cyclical index sank 2.7% (down 8.7%), and the
Transports fell 1.7% (down 8.4%). The more
defensive Morgan Stanley Consumer index added 0.1%
(down 3.3%), and the Utilities increased 2.3% (up
1.8%). The small cap Russell 2000 dropped 2.3%
(down 8.0%), and the S&P400 Mid-Caps declined
2.6% (7.2%). Last year's favorites are off to a
bad start. The NASDAQ100 dropped 2.6% (down 8.3%),
and the Morgan Stanley High Tech index sank 4.1%
(down 10.1%). Continuing last year's trend, the
Semiconductors were hit for 5.1% (down 13.3%). The
Street.com Internet Index sank 3.6% (down 8.9%),
and the NASDAQ Telecommunications index dropped
2.9% (down 8.6%). The Biotechs jumped 4.4% (up
2.7%). With Bullion surging $35.80 to close at
$895.40, the HUI Gold index jumped 7.1% (up
16.1%).
The Treasury melt-up runs
unabated. Three-month Treasury bill rates declined
12 bps the past week to 3.09%. Two-year government
yields sank 18 bps to 2.56%. Five-year T-Note
yields fell 14 bps to 3.04%, and ten-year yields
dropped 9 bps to 3.785%. Long-bond yields were
unchanged at 4.37%. The 2yr/10yr spread ended the
week at 122.5 bps. The implied yield on 3-month
December ’08 Eurodollars sank 20 bps to 2.88%.
Benchmark Fannie MBS yields dropped 14 bps to
5.16%, this week again outperforming Treasuries.
The spread on Fannie’s 5% 2017 note was one
narrower at 49 bps and Freddie’s 5% 2017 note one
narrower at 50 bps. The 10-year dollar swap spread
declined 2.6 to 60.2, the low since early October.
Most corporate bond spreads were wider, with the
spread on an index of junk bonds ending the week a
notable 49 bps wider.
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