The Tide Goes Out on Debt and Credit Deflation

Some may conclude that I have become obsessed with this issue since the death of securitisation in May 2007, given my Breton stubbornness in focusing on debt deflation, which has nonetheless proven to be a very useful look-out during these past two and a half years of turbulence.

As the unfolding of this process appears as implacable as ever, I am beginning this note with eurozone credit statistics and will then discuss the "sovereign" events (Dubai, Greece, dollar) which are now further heightening market anxiety.

First, money supply as measured by M3, the ECB's famous thermometer used to gauge price stability and credit liquidity for which the central bank has set an annual growth target of 4.5%, came in at an annual +0.3% for October.

This new disappointment, especially compared to the market's very low growth forecast of +0.8%, reveals once again an ECB slow on the uptake.

As you can see in the graph, below, not only did the central bank pursue its tight money policy until July 2008, when all credit indicators (M3, lending to non-financial businesses and households) had already turned steeply downward, but, above all, it refused to carry out its later monetary and quantitative easing.

Without falling into (the very tempting) ECB-bashing, we are still waiting for Mr Trichet to answer the question asked of him at a recent press conferences: Why is it dangerous to lower short-term interest rates to 0%?.

His dismissive response, reflecting a real deficit in democratic accountability, consisted of simply stating that that was the ECB board analysis and that no further explanation was needed…

I am leaving aside, for the time being, the new, quasi-schizophrenic insistence to feed daily the "exit-plan" debate, as Mr Weber-Pignon did again this morning.

If it were simply a matter of a poor understanding of the mechanisms of these processes, the damage would be limited to the extent that officials can be replaced, but imagine that the designated heir to Mr T's position says:

• We should not be too optimistic in our future forecasts.
• Germany is on the brink of a self-propelled recovery.
• I will not express myself on ECB policy; we are in a period of radio silence (‘Purdah’).
• It is time to think about exit strategy.
• We must end the stimulus plan polemic.
• We cannot wait indefinitely before exiting (from overly accommodating policy).

This leaves me speechless…

Given the hike in the price of gold (about which no one really cares, except a few hedge funds), are they going to make the same mistake they made in the summer of 2008, when oil prices were rising, and accelerate the depreciation of the dollar (which hardly needs it at this time) and, thus, fuel commodity prices (safe haven investments) just that much more?

On the other hand, the end result would give them additional arguments for hiking interest rates.

In any case, the simultaneous release of M3 figures and statistics on household loans on the eurozone, with another annual contraction, -0.1% sur un an, were a bitter pill. This may seem trivial, but this is unprecedented in the history of this series. In the pits of the recession of 2001, they continued to grow at annual pace of +5%.

Loans to what is otherwise known as the "real economy", non-financial businesses, declined by an annual -1.20%, another "record", which compares to +15% in the spring of 2008.

Bear in mind that, in the debt deflation process, the credit contraction phase stems from the:

• Reticence of credit-worthy borrowers to take on more debt at prohibitively high real interest rates, given the low returns of investment projects; and
• Reticence of banks with low core capital in the midst of de-leveraging to grant loans to clients who are now viewed as suspect.

Central banks and governments can demand that banks do their job as much as they want: that is precisely what they are doing today, and probably better than they were two years ago.

Eurozone: Loans to households and non-financials, and M3.

There's a green shoot for ya…

Speaking of banks' core capital, the Finance Minister from Rhineland-Westphalia, Helmut Lissen, says that WestLb should be sold in the first six months of 2010. With a more complex balance sheet, it will require help from a Bad Bank as the regional bank sector experiences a wave of M&A activity. Good luck!

Dare I also mention that the current widening in debt spreads on the eurozone and the ECB's pre-announcement of its determination to shut of the spigot aren't going to help matters, given certain banks' reputation for being load with carry trade?

If we account for the turbulence in peripheral countries (the Baltics, Central Europe, UC Rusal case) and the end of the guarantee on bank bond issues by governments in 2010, the credit outlook in Europe looks pretty gloomy.

Lost decade? There we have it!

Following the USA, China, EU, UK and Japan, Indian RBI Governor, Duvvuri Subbarao, has just demanded that banks boost their capital reserves.

In the meantime, in the United States, where the latest GDP figures prove that the economy remains under total government perfusion, new worries have been raised about the residential real estate outlook, despite the predictions of greenshooters of imminent resurrection.

First, there is the old story of ARM subprime mortgage options, the toxic instruments which enabled borrowers to put off until later the payment of both interest and principal, based on a much higher interest rate.

The grace period for the wave of debt issues in late 2004 comes to an end at year-end 2009: the average value of all these homes is so much lower than the remaining principal to be paid that it does not take a rocket scientist to see what will happen.

Oh, and here's an announcement likely to make waves: Fannie Mae (FNM) has warned that it plans to toughen home lending terms next month, both in terms of "credit scores" and loan amounts granted relating to the revenue of borrowers.

Check out this in detail, which constitutes only one of the episodes in the Cornelian choices with which the US administration must contend since the real estate credit market became quasi-Soviet.

Fannie and Freddie will continue to be caught between the hammer, represented by the search for earnings needed to re-privatise these structures, and the anvil, represented by the political need to support a residential real estate market that remains under perfusion whatever the costs.

As for Dubai, I don't have much to add to IB Bloomberg alerts we have already sent on the matter about which you can now read in the press (this evening's edition of Le Monde).

Our longstanding readers may recall our text almost a year to the day, on 12 November 2008.

Does anyone remember the name of the wise man who said that when a country starts building the highest building in the world, it is time to disinvest quickly?

Especially, given the surrounding area (desert), they really had no need to build toward the sky!

Perhaps with oil going at $50 per barrel, some buildings will go unfinished.

In this context, Mr Buffett's comment, quoted frequently in the wake of the Madoff revelations, comes to mind: When the tide goes out you can tell who is swimming naked.

In another symptom of the tulip syndrome affecting the gold market with Sri Lanka joining the gold ingot camp (India, Mauritius Island, Russia, China and just about all the world's major hedge funds), I recommend that following WSJ article, which reports that there is now so much demand for the physical stoking of gold in safe vaults from institutional investors that HSBC, the leading bank in this field in New York, is asking its retail clients to stock their gold elsewhere …

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A whole lot of options activity here in the past few days, with huge hedges via Dec09 put ladders on the Eurostoxx (29/27/26.50 at 42.50, delta -29%) and purchases of January gamma volatility on the Bund, thanks to the gift made by the massive seller in the past 15 days of puts and, then, calls, from 6.30% to 5.2% volatility!

Disclosure : Long 20 years OAT 0% Coupons, EDF Corp 5 Years 4.5%.

Comments

[conceptwizard]

The Fed and key central banks agreed to lend “virtual monies” to the “too big to fail” global banks at zero or near zero interest rate and these banks in turn would “deposit” these monies with the Fed and other central banks at agreed interest rates. These transactions are all mere book entries. Other “loans” from the Fed and central banks (again at zero or near zero interest rates) are used to purchase government debts, these debts being the stimulus monies needed to revive the real economy and create jobs for the growing unemployed. So in essence, these banks are given “free money” to lend to the government at prior agreed interest rates with no risks at all. It is a hoax!

These “monies” are not even the dollar bills, but mere book entries created out of thin air.

2009 Nov 29 12:22 PM

[tripleblack]

Mr. Mahe, do you see the ECB reversing this policy anytime soon? Or will they further accelerate the process, and raise rates?

2009 Nov 29 02:00 PM

[Northern Dancer]

With sentiment on the dollar recently at 98% bearish, my view is that the fuse has probably been lit on an explosive resurgence in the dollar. It looks to me like we're entering a scenario where basically everything commodity related is about to tank, except gold.

We're probably about to see the dollar and gold rising at the same time. As illogical as that sounds, it's a very real possibility. Both are likely to rise relative to everything else, while the relationship between gold and the dollar will probably remain relatively stable. Any pullback in gold therefore is likely to be minimal or conversely, any surge in the price of gold would also likely be minimal in dollar terms.

But for basically everything else, including the equities markets, I think it's watch out below time.

.

2009 Nov 29 02:24 PM

[Freya]

Iran's latest news release regarding the escalation in the building of uranium enrichment facilities should impact the USD, Gold, and Oil related instruments favorably.

A really interesting turn of events.

The Dubai default possibility becomes a Non-issue.

The USD, Gold, Oil all rise.

2009 Nov 29 03:43 PM

[tripleblack]

Yes, in particular if the Russian government's comments in Pravda are more than just political posturing.

Dubai may actually do something to pressure the situation we are talking about here, ie, the policies of the European central banks.

Oil in particular is likely to see an initial reaction, and be easiest to move, since it is already in play and relatively close to a support level value. Meant to point out, if the Emirates have to move investments around to support Dubai, they may elect to pump just a tad more oil than they are supposed to out of the ground...

Gold will move less, in percentage terms, than oil.


On Nov 29 03:43 PM Freya wrote:

> Iran's latest news release regarding the escalation in the building
> of uranium enrichment facilities should impact the USD, Gold, and
> Oil related instruments favorably.
>
> A really interesting turn of events.
>
> The Dubai default possibility becomes a Non-issue.
>
> The USD, Gold, Oil all rise.

2009 Nov 29 03:52 PM

[Donald Ingram]

I recommend that you step back from your statistics and charts and take a deep breath, then have a good look around you. Talk to people like the convenience store clerk, the old man on the bench, your neighbor, the guy standing in line behind you, or how about the kid stocking shelves at the grocery store.
"quasi-schizophrenic"? Is that something like being a little bit pregnant?
Some think that this economic stuff is only understood by rocket scientry. Just go for a walk-a-bout and talk to people.
Things are bad and they are not getting better.

2009 Nov 29 08:26 PM

[whidbey]

Lot of noise about the obvious. Yes, there is a form of madness to drives markets; It called having an opinion, or trading orientation. It can ruin or make the holder. Right now too many balls in the air to predict the outcome. Iran is obviously disbursing it enrichment, Israel obviously must rethink its strike strategy. In the meanwhile the markets will sell stocks, and buy PMs.

The question is how long can this happen before it become to preposterous for anyone to believe. I think is its a long while. Then what comes next?

2009 Nov 30 02:23 PM

[Michael Clark]

The next we'll hear is that we don't need to worry because the depression is just a 'virtual' depression since personal debts no longer have to be marked to market. That should make us all feel better about the illusions we're living with.


On Nov 29 12:22 PM conceptwizard wrote:

> The Fed and key central banks agreed to lend “virtual monies” to
> the “too big to fail” global banks at zero or near zero interest
> rate and these banks in turn would “deposit” these monies with the
> Fed and other central banks at agreed interest rates. These transactions
> are all mere book entries. Other “loans” from the Fed and central
> banks (again at zero or near zero interest rates) are used to purchase
> government debts, these debts being the stimulus monies needed to
> revive the real economy and create jobs for the growing unemployed.
> So in essence, these banks are given “free money” to lend to the
> government at prior agreed interest rates with no risks at all. It
> is a hoax!
>
> These “monies” are not even the dollar bills, but mere book entries
> created out of thin air.

2009 Dec 20 03:25 AM