Page 1 of 5 CREDIT BUBBLE BULLETIN The breakdown of Wall Street alchemy Commentary and weekly review by Doug Noland
Last week provided further confirmation of ongoing momentous credit market
developments. From an article last week by the Financial Times’ Michael
Mackenzie:
The auction-rate securities market, a US$330 billion slice
of the municipal bond sector, could disappear if the credit squeeze remains
entrenched, analysts warn. 'The auction-rate securities market is unwinding and
most of the market will enter a failed state,’ said Alex Roever, fixed-income
strategist at JPMorgan. 'The lack of confidence is the contributing factor and
there is a risk this type of structure will go away.' Like the asset-backed
commercial paper market that was popular with structured investment vehicles
until last summer, auction-rate securities, a form of rolling short-term
funding for long-term municipal commitments, have become fashionable in recent
years.
Auction-rate securities have joined the beleaguered
ranks of subprime, asset-backed commercial paper, SIVs, and the monolines -
financial structures that flourished during the prolonged credit bubble but no
longer pass market muster in today's post-bubble risk revulsion backdrop. This
week's unwinding of the auction-rate market and the blowing out of credit
spreads should be seen as an escalation of the ongoing unwind of contemporary
finance and its many avenues of risk intermediation.
On numerous fronts, the markets and economy confront a highly problematic
breakdown in Wall Street alchemy - the disintegration of key processes that had
for some time transformed ever-increasing quantities of risky loans into
perceived safe and liquid debt instruments that enjoyed insatiable demand in
the marketplace. In the case of the auction-rate securities, it was a clever
restyling of long-term and generally illiquid municipal debt (as well as
student loans and other borrowings) into perceived liquid securities that could
be easily sold at regularly recurring auctions (every one to a few weeks).
With scores of flush corporate treasury departments and wealthy clients
(managing huge credit bubble-induced cash-flows) keen to earn extra (after-tax)
yield on "cash equivalents", the Wall Street firms had been diligent in
ensuring (making markets for clients, when necessary) a highly liquid and
enticing marketplace. Now, with the onset of risk revulsion and acute financial
sector balance sheet pressures, investors are running for cover and Wall Street
firms are shunning the use of their own capital to support this and other
markets. Market liquidity has evaporated, confidence has been shattered, and we
are witnessing yet another run on a previously popular risk market/asset class.
The music has stopped for another game of musical chairs.
Heightened stress
The week saw heightened systemic stress stampede toward the epicenter of the US
credit system. It certainly didn't help that insurance behemoth AIG Group
reported an almost $5 billion writedown of its credit default swap portfolio or
that international securities dealer behemoth UBS reported massive losses on
its US credit positions. Confidence was further shaken by huge losses reported
by mortgage insurers, as well the twists and turns of the monoline bust turned
apparent bailout. In the markets, various indices of investment grade credits
widened sharply to record levels. The key dollar swap (interest-rate derivative
hedging) market saw spreads widen sharply. Agency spreads also widened
significantly. Benchmark Fannie Mae mortgage-backed securities (MBS) spreads
widened a remarkable 20 basis points (bps) against 10-year Treasuries, while
agency debt spreads widened a noteworthy 12.5 bps to 69.5 bps (high since
November). The breakdown of Wall Street alchemy is now pushing the credit
market dislocation uncomfortably close to the core of our monetary system.
I'll return to financial aspects of this crisis, but I definitely feel the
economic ramifications of the unfolding credit crisis are receiving short
shrift in the media. The week saw parts of the municipal debt market grind to a
virtual halt and the corporate debt market take another significant blow.
Investment grade debt issuance has now slowed markedly after beginning the year
at near record pace. At this point, the junk, collateralized debt obligation
(CDO), asset-backed security (ABS), private-label MBS, municipal bond (muni),
and even investment grade debt markets are all somewhere between impaired,
dislocated and completely dysfunctional. There is no mystery behind the recent
string of abysmal economic reports.
The preliminary reading on February University of Michigan Consumer Confidence
dropped 8.8 points to the lowest level since the 1992 recession. The Economic
Conditions index sank and the Economic Outlook index plunged, while one-year
Inflation Expectations rose from 3.4% to 3.7%. The Economic Outlook has sunk a
remarkable 22 points since July. Falling national home prices are clearly
wearing on confidence. Dataquick reported that home sales throughout much of
California have collapsed to more than 20-year lows, while home price declines
accelerate. This is a huge unfolding issue/debacle for the MBS, agency,
mortgage insurance, CDO and credit derivatives markets, not to mention the US
banking system and real economy. Countrywide Financial reported delinquencies
on its $1.5 trillion mortgage servicing portfolio had jumped to 7.47%, up from
the year ago 4.32%. The New York "Empire" Manufacturing index sank to the
lowest levels since April 2003.
The economy is now faltering badly and there is every reason to expect the
downturn to gather pace - negative real interest rates compliments of the Fed
and stimulus package compliments of the federal government notwithstanding.
While fourth quarter data is not yet available, one can look to the first nine
months of 2007 to gain important perspective. Despite the dislocation in the
subprime mortgage market, non-financial debt growth accelerated from Q2's 7.2%
to Q3's 8.9% (from the Fed's Z.1 report). And while household debt growth had
slowed to a 6.9% pace, business borrowings accelerated to a blistering 11.9%
annualized rate in the third quarter. This was the strongest corporate debt
growth since the tech/telecom boom in the late nineties. Importantly, total
(financial and non-financial) corporate debt expanded at an 11.1% rate during
the first three quarters of 2007, followed by 9.3% growth in State & Local
government borrowings. And while residential mortgage debt was slowing
meaningfully, commercial mortgage debt was expanding at an almost 13% rate.
Total (financial and non-financial) credit expanded a seasonally-adjusted and
annualized record $5.0 trillion during the third quarter - as nominal GDP
expanded at a 6% pace. While many trumpeted the "resiliency" of the US economy
in the face of mortgage and housing woes - more adept analysis would have
focused on the massive credit creation that had come to be required to sustain
the bubble economy. Importantly, the faltering subprime market initially
instigated only greater excesses throughout commercial real estate, municipal
finance, merger and acquisition finance, and corporate lending more generally.
The credit bubble was sustained at the great cost of heightened instability and
weakened structures - especially throughout leveraged lending, state and local
finance, and investment-grade corporate borrowings.
Coming home to roost
Keep in mind that through the third quarter CDO issuance was actually running
ahead of 2006's record pace. Until the fourth quarter, record credit growth
continued to fuel the finance-driven economy. This is all now coming home to
roost.
Today, with bursting bubbles in corporate and municipal finance joining the
mortgage bust, the US bubble economy has quickly fallen desperately short of
sufficient credit and liquidity. And the greater the credit market dislocation
and broad-based tightness of credit, the bleaker become economic prospects and
the more intense the revulsion to Wall Street's credit instruments. The days of
free-flowing cheap finance for home buyers, state and local governments,
leveraged buy-out firms, commercial real estate speculators, college students,
risky auto buyers, and high-risk credit card holders are over - and they will
not be returning for some time to come.
When I have previously underestimated the resilience of the US credit bubble
and economy, it was in each instance a failure to appreciate the capability of
Wall Street finance to expand to ever greater degrees of bubble excess. Today,
with contemporary finance mired in a historic collapse, I am confident that the
credit system is today only in a position to surprise on the downside. It is
this framework that shapes my view of a rapidly escalating credit crisis
feeding an arduous economic adjustment period.
And while it could undoubtedly prod a highly speculative stock market, there is
no resolution to the monoline dilemma that would meaningfully influence the
trajectory of the unfolding credit and economic bust. As we've been saying for
awhile now, confidence in Wall Street finance has been irreparably shattered.
Trust has been broken in AAA ratings, mark-to-model, CDO structures, myriad
risk models, credit insurance, counter-party risk, and various instruments and
vehicles for intermediating risk in the markets. Moreover, old-fashioned
lending will not come close to meeting the demands of a highly imbalanced
bubble economy, especially with bankers nervous and retrenching. Again, we're
witnessing nothing less than the breakdown of Wall Street alchemy - one that
took a turn for the worst this week.
Escalating contagion
Disconcertingly, recent market developments seem to confirm that the leveraged
speculating community and the government-sponsored enterprises (GSEs - such as
mortgage buyers Fannie Mae and Freddie Mac) are poised as the next shoes to
drop - the next dominoes in an escalating contagion. Along with the monolines
and mortgage insurers, the credit default swap market and GSE mortgage risk
intermediation were at the epicenter of the most egregious systemic risk
distortions and accumulations. They are now quickly moving to the forefront of
current acute fragilities.
Simplifying highly complex circumstances, the various risk models that
empowered the greatest leveraging of risk in the history of finance no longer
function as expected - or as required to maintain highly leveraged exposures to
a multitude of escalating risks. And it was all just only a matter of time.
The
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
