Great Depression Not Imminent, But Inevitable

Includes: AIG, DIA, EEM, QQQ, SPY
by: Rakesh Saxena

At the root of domestic and global growth in the previous decade lies the substantial expansion of the business of risk insurance. And, as the facts are now rapidly unfolding, the exponential rise in the provision of coverage mechanisms for corporate bond default risks, sovereign debt risks, trade credit risks and political risks became the single biggest contributor to the unprecedented levels of debt and leverage exposed this October.

Today, it is becoming evident that the “non-actuarial” segment of the insurance marketplace is in sustained decline; fast-retreating risk insurance underwriters are laying the basis for the next Great Depression, succinctly identified by a widespread and comprehensive collapse in asset valuations. And, since the numerous stimulus plans have not even started to identify the methodologies being applied, or to be applied, to such valuations, the near-term and medium-term case for the S&P 500 to consolidate somewhere below 700 in 2009 remains compelling. Here is a short list of the behaviour of certain lead indicators which need to be recognized, and which are prompting this writer to reiterate a short-equity-index (DIA, QQQQ, SPY) call regardless of Wall Street’s immediate response to the Fed rate cuts on Tuesday.

Credit default swap providers have already suffered significant losses due to sharply widening spreads on Russia, Argentina, Pakistan, Ecuador, Iceland and Hungary, to name just a few examples. And as CDS spreads for industrialized countries like Greece and Italy breach 270 and 200 basis points respectively this week, there is every reason to believe that those pricing sovereign risks have nowhere to go to hedge their positions. The problem is that, despite what some on Wall Street have been claiming, non-actuarial insurance classes (e.g. coverage of embedded risks in credit default swaps and collateral debt obligations transactions) cannot be hedged in any credible manner. The crisis at American International Group (NYSE:AIG) can best be explained by the elite insurer’s decision to depart from its mainstream life and non-life businesses into sectors which do not lend themselves to any systematic mathematical and statistical risk assessments.

Precise information on which counterparty priced which corporate bond risk, and how much CDS-type risk (bought and sold), particularly in pricing terms, pervades the global corporate spectrum, is largely unavailable. But it is common knowledge that CDS price-makers have been using probability and option driven models which are increasingly proving to be divorced from reality. On whose books are the losses on widening CDS spreads being reflected?

The CDX investment-grade index (North America) has moved from 160 bps in early October to 245 bps, after touching a high of 285 bps in late November. During the same period, the high yield index rose from 925 bps to 1410 bps. This writer’s view is that, though there is broad array of quotes available from CDS and CDO brokers on a daily basis, actual deals are extremely limited; and, in a few short weeks, as more negative data on the global economy is published, debt default insurance providers will go into hiding.

As things stand, the reluctance of Lloyd’s syndicates to cover political risks is having a significant impact on investments in the third world. Calls to the Berne Group for export credit insurance are being met with “we’ll get back to you” messages. And forfaiting (discounting trade paper) companies in London and Europe have now priced themselves out of the market altogether. In fact, the diminishing trade credit insurance matrix is one of the primary reasons for this writer’s short call on the emerging markets (NYSEARCA:EEM).

It is difficult to predict when this strong “no-insurance” undercurrent will emerge, and be acknowledged, as a dominating factor in determining the status of the global economy. But, quite clearly, the ongoing dramatic reduction in the size of the risk insurance business will start to erode the quality of credit (higher yield spreads and higher upfront fees) within the first half of 2009; that erosion will, in turn, result in depressed asset values (even from this juncture), and in historical business contractions in the US and elsewhere. The basic ingredient (i.e. the end of non-actuarial risk underwriting) of another Great Depression is firmly in place.

Disclosure: Author holds short positions in EEM, SPY