Page 1 of 5 CREDIT BUBBLE BULLETIN History's biggest margin call
Commentary and weekly watch by Doug Noland
The entire world was seemingly positioned for a particular financial backdrop
and received an altogether different one. Some years ago I wrote something to
the effect that "financial crisis is like Christmas". After all, during the
Alan Greenspan era at the Federal Reserve, periods of heightened financial
and/or economic pressures were almost cause for celebration within the
leveraged speculating community. Aggressive rate cuts and "easy money" were the
trumpeted solution to any problem, which equated to easy financial fortunes for
the savvy market operators. Over time this culture of leveraging, speculation
and financial shenanigans
fanned out across the globe - throughout finance, commerce and government
endeavors.
This mindset was firmly ingrained when the US's subprime crisis erupted in the
spring of 2007. The whole world apparently was of the view that the unfolding
US mortgage and housing crisis ensured "easy money" as far as eyes could see.
"Helicopter Ben" Bernanke was at the controls; dollar devaluation was in full
force; dollar liquidity was barreling out of the US credit system; financial
systems across the globe had succumbed to credit bubble dynamics; inflationary
fires blazed everywhere; and speculative finance was literally inundating the
world. In most places, making "money" had never been so easy.
This backdrop created epic price distortions and some incredibly maligned
market perceptions. It's now clear that unprecedented leverage became deeply
embedded in markets and economies everywhere. These excesses had been unfolding
over a longer period of time, but terminal speculative "blow off" dynamics
really engulfed the global economy when US housing vulnerability began to
emerge. A confluence of many extraordinary and related dynamics was severely
undermining the global system.
The US financial sector was desperately overheated, the US mortgage/housing
bubble was bursting, the expansive international bubble in leveraged
speculation was in "blow-off" mode, global imbalances were at dangerous
extremes, and inflationary psychology took hold throughout global financial
systems, asset markets and real economies. It was an unparalleled period of
synchronized global credit, asset market and economic bubbles.
Only today is it readily apparent what a mess the global pricing system had
become. Think in terms of a net trillion-plus US dollars inflating the world
each year, of which a large part was recycled through Chinese and Asian
purchases of US securities (inflating domestic credit systems and demand in the
process). Think in terms of rapidly inflating economies with several billion
consumers (Brazil, Russia, India and China). Think in terms of the surge of
inflation that forced thoughtful policymakers in economies such as Australia,
New Zealand and elsewhere to significantly tighten monetary policy. Rising
rates, however, only enticed more disruptive speculative finance flowing
loosely from (low-yielding) credit systems including the US, Japan, and
Switzerland.
Speculation could have been as simple as shorting a low-yielding security any
place to finance a higher-returning asset anywhere. Or, why not structure a
complex leveraged derivative transaction that, say, borrowed in a cheap
currency (such as yen or Swiss francs), played the upside of rising emerging
equities markets, and at the same time had triggers to hedge underlying
currency and/or market exposure. And the counterparty exposure for a lot hedges
could be wrapped up in collateralized debt obligations (CDOs).
And the more loose global finance inflated the world, the more the leveraged
speculating community inundated "commodity" economies such as Australia,
Canada, Brazil, South Africa and Russia. Of course, speculative inflows ignited
domestic asset market and credit systems, in the process fostering dangerous
bubbles. And in concert with the deflating dollar, speculating on virtually any
emerging market or commodity was immediately profitable.
The more leverage the stronger the returns, and the world was introduced to the
concept of the billionaire hedge fund manager. In commodities markets, wild
price inflation and volatility forced both producers and commodity buyers to
employ aggressive hedging strategies. More often than not, derivatives employed
trend-following trading mechanisms. These "hedging" mechanisms covertly created
huge buying with leverage on the upside and, more recently, liquidation and a
collapse of prices and leverage on the downside.
It was Hyman Minsky "Ponzi Finance" on a grand scale. It was also a bout of
George Soros "Reflexivity" of epic proportions. The more markets perceived a
new era of endless cheap finance and rising asset and commodities prices, the
more US and global credit systems created the necessary inflationary fuel to
perpetuate the bubble. Markets believed the hedge fund and private equity game
could go on indefinitely. Participants thought that Wall Street would
securitize loans and be in a position to expand finance forever. Prime brokers
would always be willing outlets to finance leveraged securities holdings on the
cheap.
The derivatives market would always provide an efficient and effective
marketplace for placing bets, as well as for hedging myriad risks. Why not
speculate aggressively when insurance was so easy to obtain? At the same time,
contemporary "repo" and money markets were viewed as an endless source of
inexpensive finance. And, in the event of anything unexpected, the US Federal
Reserve (and global central bankers) would always ensure liquid markets - and
inflate as required. Again, why not speculate? The markets had unwavering faith
in enlightened contemporary finance and central banking.
But it was all part of the greatest mania in human history. As it turned out,
the markets could not have been more wrong on the sustainability of the
financial backdrop, the economic environment, asset price inflation, and all
types of sophisticated financial structures and strategies. Markets were not
only absolutely wrong, they were absolutely wrong on so many things on such an
unprecedented global basis. Now things are blowing up. In the thick of it all,
confidence in the securitization, "repo" and derivatives markets has been
broken.
As a result, Wall Street simply no longer has the wherewithal to apportion
ample finance for securities speculation. Without speculative demand for
high-yielding loans and securities, bubble economies are starved of sufficient
finance. And with asset markets bursting everywhere, this has quickly evolved
into history's biggest margin call.
Scores of derivative structures used to speculate in the asset bubbles have
collapsed - because of counterparty issues, illiquidity, or the structures just
didn't make any sense to begin with.
Moreover, the whole notion that derivatives would provide an effective hedging
mechanism is proving a fallacy. Again, counterparty issues and illiquidity are
the culprits. Markets can't hedge themselves, as there is no one with the
wherewithal to take the other side of the trade (especially during devastating
bear markets). In particular, the credit default swap structure is proving an
unmitigated disaster - for bond, equities and currency markets. Hopefully this
period of liquidation and deleveraging will be over very soon.
WEEKLY
WATCH
What a vicious crisis. For the week, the Dow was hammered for 5.3% (down 36.8%
y-t-d) and the S&P500 6.8% (down 40.3%). Economically-sensitive issues
were, again, hammered. The Morgan Stanley Cyclical index dropped 12.0% (down
50.9%). The Transports fell 6.6% (down 24.6%), while the Utilities dipped 0.4%
(down 34.4%). "Defensive" stocks weren't much help, as the Morgan Stanley
Consumer index declined 6.1% (down 28%). The broader market was under heavy
liquidation. The small cap Russell 2000 dropped 10.5% (down 38.5%), and the
S&P400 Mid-Caps sank 9.6% (down 41.6%). The NASDAQ100 fell 8.3% (down
42.3%), and the Morgan Stanley High Tech index was hit for 8.4% (down 45.4%).
The Semiconductors dropped 11.2% (down 48%), The Street.com Internet Index 8.8%
(down 39%), and the NASDAQ Telecommunications index 13.3% (down 44.3%). The
Biotechs declined 4.3% (down 21.2%). The Broker/Dealers sank 17.4% (down
60.7%), and the Banks fell 10.2% (down 42%). With Bullion sinking $51, the HUI
Gold index dropped 17.2% (down 58.8%).
One-month Treasury bill rates declined 8 bps to 0.24% and three-month yields
fell 12 bps to 0.86%. Two-year government yields dropped 10 bps to 1.52%.
Five-year T-note yields sank 25 bps this week to 2.59%, and 10-year yields fell
24 bps to 3.69%. Long-bond yields dropped 28 bps to 4.06%. The 2yr/10yr spread
declined 14 to 217 bps. The implied yield on 3-month December '09 Eurodollars
rose 4 bps to 2.65%. Benchmark Fannie MBS yields declined only 4 bps to 5.75%.
The spread between benchmark MBS and 10-year T-notes widened a notable 20 to
205 bps. Agency 10-yr debt spreads widened 17 to a new high 115 bps. The 2-year
dollar swap spread increased 1.5 to 125.5, while the 10-year dollar swap spread
declined 6.5 to 47.5. Corporate bond spreads were wider. An index of investment
grade bond spreads widened 26 to 242 bps, and an index of junk bond spreads
widened 16 to 840 bps.
Investment-grade debt issuance included Pepsico $2.0bn, Bottling Group PLC
$1.3bn, Baker Hughes $1.25bn, National Rural Utility Cooperative $1.0bn, CSX
Transportation $575 million, and Illinois Power $400 million.
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