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4 CREDIT BUBBLE
BULLETIN The worst-case scenario -
live Commentary and weekly
watch by Doug Noland
This week offered
further disconcerting confirmation that the
20-Year Experiment in "Wall Street finance" is
failing miserably. On Tuesday, the Federal Reserve
was compelled to announce the implementation of an
extraordinary US$200 billion liquidity facility
for the Wall Street "primary dealer" community.
Despite this action, it was necessary before the
weekend for our central bank to orchestrate
emergency funding for troubled Bear Stearns. We’re
now clearly in the midst of a precarious systemic
crisis. I concur with the characterization made on
Friday by former Treasury Secretary Robert Rubin:
We’re in "uncharted waters".
To be sure,
the credit crisis has accelerated to a ferocious
clip. Last week it was a "white shoe" (ie
long-established professional
services firm) hedge fund
leveraged in AAA securities that imploded. Earlier
this week, a white shoe firm listed (in Europe)
fund that had been leveraging in AAA Fannie and
Freddie securities imploded. This week, one of
Wall Street’s white shoe firms required a
Fed-assisted bailout to at least temporarily ward
off implosion. It is neither hyperbole nor fear
mongering to warn that scores of players
throughout the expansive US financial sector are
now in jeopardy of finding themselves engulfed in
liquidity crisis.
I found the opening
question from Friday afternoon’s Bear Stearns
conference call quite telling: "What is your
current gross notional non-exchange traded
derivative exposure?" The executive’s response -
"To be honest with you, I don’t know this number
off the top of my head …" - was not comforting.
But to be fair, the company’s derivative
obligations are not the most pressing issue facing
management. It is, however, a deep concern for an
increasingly panicked marketplace.
The
Bear Stearns funding crisis certainly brings
somewhat to a head the market’s festering worries
with regard to the daisy-chain of derivative and
counter-party exposures, liquidity risk, and a
complete lack of transparency. Bear Stearns’
management was quick to blame "false rumors and
innuendo" for the funding crisis. Yet, how sound
are the underpinnings for Bear Stearns, the US
credit system, or the markets overall when market
chatter can have such destabilizing effects?
Candidly, I wish I had another of the Fed’s Z1 "Flow of Funds"
reports to grind through this evening -
conveniently providing the opportunity to keep
most of my thoughts and fears to myself. Most
unfortunately, we’ve been witnessing the
worst-case scenario unfold before our very eyes -
and it all imparts a bad feeling deep in my gut.
Of course, marketplace liquidity is everything
about confidence. Confidence that held sway so
reliably for years turned so fleeting. And once
revulsion takes hold, it tends to linger.
That Tuesday’s Fed announcement did not
forestall a run on Bear Stearns suggests to me
that this unfolding crisis has attained alarming
momentum. At this point, confidence in leveraged
securities finance appears to have been
irreparably damaged.
I’ll assume that two
of the critical fault lines for the rapidly
escalating crisis reside in the securities
financing repo market and the credit default swap
(CDS) marketplace. Leading the list of companies
that saw the prices of their CDS (default
protection) surge significantly this week were
GMAC, Bear Stearns, Ford, Sallie Mae, Countrywide,
and Lehman Brothers. These six companies combine
for (as of their most recent financial statements)
total assets of almost $2.0 trillion, supported by
shareholders equity of about $75 billion. Or,
stated differently, these six companies were
leveraged (mostly in financial assets) to
"capital" at a ratio in the neighborhood of 25 to
1. Moreover, derivative and other off-balance
sheet guarantees and commitments would surely run
in a multiple of hundreds of times the combined
assets for these firms.
In the context of
the current backdrop, fear of default for such
highly leveraged companies is more than justified.
Expectations for contagion effects throughout the
securities lending arena are similarly
well-grounded. We can safely assume that the
marketplace has accumulated enormous CDS positions
protecting against default for all six of these
companies (and scores of others). I’ll also
presume that a default by any one of these
companies (or from any number players) would pose
a severe problem for the CDS market and for
systemic stability overall. It is also likely that
heightened counterparty fears will add a
problematic dimension to those managing large
"books" of offsetting credit exposures. Evidence
mounts by the day supporting the view of a
problematic unfolding dislocation in the acutely
fragile and untested CDS marketplace.
The
Fed is in a real quagmire here. Because of the
daisy-chain nature of contemporary risk
intermediation (specifically in the derivatives
and securities financing marketplaces), a failure
these days in one of any number of institutions
would quickly reverberate throughout the entire
(frail) system. As such, today virtually any
player of significant presence in the derivatives
and/or repo markets is likely to be perceived by
the Fed as too big to fail.
The dollar
sank to a record low against the euro and to the
weakest level against the Japanese yen since 1995.
As far as I’m concerned, the currency markets this
week "officially" attained the status
"disorderly". Not surprisingly, the dollar
responded quite poorly to the Fed’s (so-called
"ingenious") plan to accept $200 billion of risky
collateral from the "primary dealer" community, as
it did Friday’s financing arrangement for Bear
Stearns. The $200 billion is certainly only an
opening "ante" and Bear the first of many
bailouts.
Undoubtedly, currency markets
have begun to increasingly discount the
nationalization of US credit risk - both by the
Federal Reserve and our federal government. The
Fed may plan on 28-day terms for its exchange of
Treasuries for other "street" collateral. Yet, the
way things are developing, I see little prospect
anytime soon for an environment conducive to the
Fed reversing course and transferring such risk
back to Wall Street. Indeed, this week likely
marks a key inflection point for what will soon
evolve into a huge expansion of Fed holdings (and
various guarantees) of US risk assets. And, at
some point, the federal government will be
similarly forced into accepting trillions of
"financial guarantee" obligations - for mortgages,
municipal debt, student loans, various "deposits"
and who knows what.
In past analysis, I
have differentiated between the financial sphere
and the economic sphere. At the Fed and throughout
the markets, the current focus is on financial
sphere developments and possible policy responses.
Even assuming that the funding crisis at Bear
Stearns and elsewhere is resolved in short order
(a huge assumption at this point), I doubt even
this would restrain the headwinds now buffeting
the economic sphere. Understandably, the focus now
will be on inter-bank and securities financing
markets. Meanwhile, recent developments will
ensure a further tightening in already taut
mortgage, municipal, and corporate lending
markets. The vulnerable economy will suffer
mightily.
The release this week of
Dataquick’s California housing data (see
"California Watch" above) provided strong support
for our view that the Golden State housing market
is crashing. Anecdotal accounts have markets
throughout the state basically shut-down because
of the inability to obtain mortgage credit (not to
mention housing revulsion). And with liquidity
quickly drying up for various endeavors including
student loans, auto finance, small business
lending, and business finance more generally, our
dire economic prognosis is regrettably coming to
fruition.
There are now forecasts for a
100 basis point cut in the Fed funds rate for
Tuesday. Many are arguing that financial and
economic developments support even more aggressive
Fed rate slashing. I am reminded of the joke of
the entrepreneur that loses money on every sale
but is determined to make it up on volume. At this
point, it should be apparent that rate cuts are
destabilizing the system. They not only damage
Federal Reserve credibility, they are battering
confidence in the dollar and US financial assets
more generally. With the financial crisis having
reached the core of the US credit system and the
currency markets having turned disorderly, we’re
now on dollar crisis watch. One of my greatest
fears has always been an unwieldy dislocation in
the currency derivatives market.
WEEKLY
WATCH For the week, the Dow was up 0.5%,
while the S&P500 declined 0.4%. Stating the
obvious, these minor index changes don't do
justice to daily wild volatility. The NYSE
Financial Index declined 2.2% Monday,surged 6.1%
Tuesday, declined 1.1% Wednesday, was little
changed Thursday, and was hit for 3.5% today. The
Transports (down 1.4% y-t-d) and Utilities (down
11.3%) both rallied 0.4% this week. The Morgan
Stanley Consumer index was little changed (down
9.9%), while the Morgan Stanley Cyclical index
gained 1.2% (down 9.1%). The NASDAQ100 recovered
0.4% (down 18%), while the Morgan Stanley High
Tech index declined 0.9% (down 17.4%). The
Street.com Internet Index was unchanged (down
14%); the NASDAQ Telecommunications index slipped
0.6% (down 13.2%); and the Semiconductors fell
1.8% (down 17%). With Bear Stearns plummeting, the
Broker/Dealers were clobbered for 7.2% (down
24.5%). The Banks were little changed (down
13.1%). With Bullion surging $27.40 to surpass
$1,000, the HUI Gold index jumped 5.7% (up 25.8%).
Three-month Treasury bill rates sank 30
bps this past week to 1.17%. Two-year government
yields declined 3 bps to 1.49%. Five-year T-note
yields fell 3 bps to 2.40%, and ten-year yields
dropped 9 bps to 3.45%. Long-bond yields sank 18
bps to 4.36%. The 2yr/10yr spread ended the week
at 196 bps. The implied yield on 3-month December
’08 Eurodollars dropped 20 bps to 2.035%.
Benchmark Fannie MBS yields dropped 27 bps to
5.45%. The spread between MBS and Treasuries
narrowed 18 to a still extraordinary 200 bps.
Widening further, the spread on Fannie’s 5% 2017
note jumped 11 to 99 bps and the spread on
Freddie’s 5% 2017 note surged 10 to 98 bps. The
10-year dollar swap spread narrowed 15.2 to 70.80.
Corporate bond spreads were volatile and ended
wider. An index of investment grade bonds spreads
widened to record levels this week, ending up 11
to 190. An index of junk bond spreads widened 13
to 636 bps.
Investment grade issuance
included American Express $3.0bn, Medco Health
Solutions $1.5bn, PPG Industies $1.55bn, Marathon
Oil $1.0bn, General Mills $750 million, Burlington
Northern $650 million, Lockheed Martin $500
million, Northern States Power $500 million,
MassMutual $400 million, Equitable Resources $500
million, PPL Energy Supplies $400 million,
Carolina P&L $325 million, Georgia Power $250
million and Consumers Energy $250 million.
Junk issuance included Stillwater Mining
$180 million.
Convert issuance included
Coeur D'alene Mining $200 million.
International dollar bond issuance
included BP Capital $1.0bn.
German 10-year
bund yields declined 5.5 bps to 3.73%, as the DAX
equities index dipped 0.5% (down 18.1% y-t-d).
Japanese "JGB" yields dropped 9 bps to 1.26%. The
Nikkei 225 sank 4.2% (down 20% y-t-d and 26.6%
y-o-y). Emerging markets were mostly lower.
Brazil’s benchmark dollar bond yields rose 11 bps
to 5.87%. Brazil’s Bovespa equities index added
0.2% (down 3.0% y-t-d). The Mexican Bolsa gained
1.5% (down 1.7% y-t-d). Mexico’s 10-year $ yields
fell 5 bps to 5.12%. Russia’s RTS equities index
increased 0.7% (down 9.9% y-t-d). India’s Sensex
equities index declined 1.3%, boosting y-t-d
losses to 22.3%. China’s Shanghai Exchange sank
7.9% this week, with 2008 losses now at 24.7%.
Freddie Mac 30-year fixed mortgage rates
jumped 10 bps this week to 6.13%, with rates down
only one basis point from a year earlier.
Fifteen-year fixed rates rose 13 bps to 5.60%
(down 28bps y-o-y). One-year adjustable rates
surged 20 bps to 5.14% (down 28 bps y-o-y).
Bank Credit surged $45.3bn (3-wk gain of
$102.1bn) during the most recent reporting period
(3/5) to a record $9.414 TN. Bank Credit increased
$201bn y-t-d, or 11.3% annualized. Bank Credit
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