Page 1 of 5 CREDIT BUBBLE BULLETIN A changed financial landscape
Commentary and weekly watch by Doug Noland
For our country's sake, I hope our Washington politicians worked out a mindful
financial sector bailout package over the weekend. Not that I am pro-bailout or
for government intervention. It's just that our financial system is teetering
at the precipice. The federal takeover and "sale" of Washington Mutual, our
nation's largest bank failure to date, was yet another major body blow.
Confidence has now been shaken so brutally that our policymakers can do little
to repair the damage. Yet at this point, stop-gap measures to restrain collapse
seem more appealing to me than no measures at all.
The financial structure that fueled myriad credit bubbles, asset bubbles,
economic bubbles and overliquefied the entire world is today no longer viable.
Wall Street finance is at this point an unmitigated bust, with a few of the
"holdout" sectors (ie the credit
default market and the hedge fund community) now succumbing. The great
financial alchemy of transforming endless risky loans into perceived safe and
liquid "money"-like instruments has run its historic course.
And with risky loans - household, financial sector, business, municipal and
speculator - having come to play such a prominent role in the nature of
spending and "output", the near elimination of risky lending will prove a
momentous financial and economic development. The US bubble economy is today in
dire straits.
We've reached the point where it has become difficult to secure new borrowing
unless one is of quite sound credit standing. This is the case for individuals
seeking to buy automobiles and homes; to afford myriad discretionary and luxury
goods and services; to finance educations; or to make the types of big ticket
purchases that had been bolstering our bubble economy. Lenders are now moving
aggressively to cut home equity and credit card lines. And, importantly, recent
developments have significantly tightened credit availability for businesses of
all sizes. Securitization markets have been largely shut down for awhile now.
Now acute stress has incapacitated the money markets.
Unless some dramatic development reverses the current course, it will not be
long before a self-reinforcing cycle of company payroll and spending cutbacks
takes hold. At the same time, the municipal bond market is in disarray. The
economic impact from major cutbacks in state and local government spending will
be significant. Today's finance-related economic headwinds are Cat-4 (and
gaining) Hurricane Systemic Credit Seizure, compared with last year's Tropical
Storm Subprime. Federal Reserve-dictated interest rates are extremely low - and
the Fed and global central bankers have injected unfathomable amounts of
liquidity - yet credit conditions have turned the tightest they've been in
decades.
The Lehman Brothers bankruptcy marked a major inflection point in the
confidence of contemporary "money". It was a decisive blow against trust in
various money market instruments - the very foundation of our monetary system.
"Money" has now tightened significantly for virtually all players that had
previously enjoyed cheap short-term financings. This list certainly includes
the hedge fund community.
The Lehman bankruptcy also marked a major inflection point in confidence for
the various "daisy chain" players involved in intermediating risky loans into
contemporary "money". The market was convinced Lehman was "too big to fail".
Its failure inflicted thousands of market participants with losses - from
investors in the Reserve Primary money fund caught with short-term Lehman paper
to holders of Lehman's long-term bonds. Investors all over the world were
impacted. The hedge fund community suffered mightily. The status of hundreds of
billions of derivatives and counterparty obligations was suddenly up in the air
or in the hands of the bankruptcy court. And, importantly, huge losses were
suffered in the credit default swap marketplace - the marrow of one of
history's most spectacular speculative manias.
Trying to add a bit of simplicity to the complexity of a credit market
breakdown, I'll say the Lehman collapse marked a critical inflection point in
at least five major respects:
First, the crisis of confidence jumped the "firebreak" from risk assets to
contemporary "money," shattering trust in various facets of contemporary
finance that was forged over decades.
Second, it required the marketplace to reexamine exposures to various direct
and indirect counterparty risks, a terminal blow for derivatives markets.
Third, it pushed the credit default swap marketplace into full-fledged
dislocation and instigated a long-overdue regulator onslaught.
Fourth, it decisively burst the "leveraged speculating community"/hedge fund
bubble. This has ushered in another round of problematic de-leveraging and
accelerated the reversal of Ponzi finance dynamics.
Fifth, it instilled global fear with respect to the risks of participating in
the inter-bank lending market with American institutions.
Basically, the Lehman collapse marked the end of Wall Street risk
intermediation as a significant component of system financial intermediation.
Going forward, credit growth will be chiefly generated by the banking system,
supported by various forms of government backing (Federal Reserve, Federal
Deposit Insurance Corporation, Washington bailouts/recapitalizations, and so
forth), the now government-operated government-sponsired enterprises (GSEs),
and various forms of federal government debt issuance.
Importantly, this new financial structure will ensure minimal risky lending as
well as significantly reduced risk-taking. And from a global perspective, I
believe newfound fears of lending to the American financial sector marks the
beginning of the end of our economy's capacity for trading new financial claims
for imports of energy and goods.
Over time the changed financial landscape will have a profound impact on the
underlying economic structure. Our economy will have no alternative than to get
by on less credit, less risk intermediation, and fewer imports. In the
near-term, the effects will be a rapid and pronounced slowdown of our economy's
"output". And while we'll only know over time, I'd bet this new financial
structure will allocate much less finance to entrepreneurial activities,
productive endeavors and the asset markets - while at the same time providing
ample (government-directed) purchasing power to ensure stubborn consumer price
inflation.
WEEKLY WATCH
The stock market was almost a sideshow ... For the week, the Dow dropped 2.2%
(down 16% y-t-d), and the S&P500 was hit for 3.3% (down 17.4%).
Economically sensitive stocks were under pressure. The Transports sank 6.9% (up
3.9%), and the Morgan Stanley Cyclicals dropped 7.3% (down 19.4%). The
Utilities declined 1.4% (down 18.7%) and the Morgan Stanley Consumer index fell
1.6% (down 8.9%). The broader market gave back a chunk of recent gains. The
small cap Russell 2000 dropped 6.5% (down 8.0%), and the S&P400 Mid-Caps
sank 6.4% (down 12.2%). The NASDAQ100 fell 4.2% (down 19.8%), and the Morgan
Stanley High Tech index dropped 4.5% (down 20.1%). The Semiconductors declined
3.7% (down 21.2%); The Street.com Internet Index fell 3.9% (down 13.9%); and
the NASDAQ Telecommunications index sank 8.5% (down 17.4%). The resilient
Biotechs dipped 0.6% (up 2.2%). The Broker/Dealers dropped 9.1% (down 37.3%),
and the Banks fell 10.5% (down 16.6%). With Bullion gaining another $6.20, the
HUI Gold index rose 1.6% (down 19.6%).
One-month Treasury bill rates dropped to 0.16%, and three-month yields dropped
to 0.84%. Two-year government yields ended the week down 5 bps to 2.12%. At the
same time, five-year T-note yields added 3 bps this week to 3.07%, and 10-year
yields rose 4 bps to 3.85%. Long-bond yields dipped 2 bps to 4.37%. The
2yr/10yr spread increased 10 to 173 bps. The implied yield on 3-month December
'09 Eurodollars jumped 18 bps to 3.555%. Benchmark Fannie MBS yields rose 7 bps
to 5.475%. The spread between benchmark MBS and 10-year T-notes widened 3 to
162 bps. Agency 10-yr debt spreads were 13 wider at 77.3 bps. The 2-year dollar
swap spread increased a notable 21.5 to 140, and the 10-year dollar swap spread
added 0.75 to 67. Corporate bond spreads were mostly wider. An index of
investment grade bond spreads ended 7 wider at 170 bps, while junk bond indices
were mixed.
September 24 - Bloomberg (Daniel Kruger and Kyoungwha Kim): "Investors outside
the US , who own more than half of all Treasuries outstanding, say the
government's $700 billion plan to revive the banking system will diminish the
appeal of the nation's bonds. Treasury Secretary Henry Paulson's proposal ...
would drive the country's debt to more than 70% of GDP. The last time taxpayers
owed as much was in 1954, when the US was paying down costs from World War II.
'The image of US Treasuries as a safe haven has been tainted by the ongoing
financial debacle,' said Kwag Dae Hwan, head of global investment ... with
South Korea's $220 billion National Pension Fund ... 'A big question mark hangs
over whether the US can deal with an unprecedented amount of debt. That is
unnerving all the investors, including me.'"
Investment-grade debt issuance included Caterpillar $1.3bn, American Honda
$1.25bn, EOG Resources $750 million, Peco Energy $300 million, South Carolina
E&G $300 million, Wisconsin Electric Power $300 million, Stanley Works $250
million, and UGI Utilities $100 million.
Junk issuance included Perkins & Marie $130 million.
September 24 - Bloomberg (Pierre Paulden): "Prices of high-risk, high-yield
loans fell to record lows ... The price of the average actively traded
leveraged loan fell 0.42 cent to 83.74 cents on the dollar, according to
S&P ... Prices have slumped 3.84 cents since Sept. 11 ... "
September 25 - Bloomberg (Emma O'Brien): "[Russia's] benchmark 30-year
sovereign bond has slipped this month, pushing the yield 118 basis points to
6.91% yesterday. The yield on OAO Gazprom's 6.95% note due 2009 has surged 295
bps to a record 10.5%, since Sept. 1."
German 10-year bund yields fell 4 bps to 4.16%. The German
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