The global markets are just now, yes just now, realizing they are the next line of infantrymen to get cut down in this credit debacle. While I’ve been saying the global story is strong, I was looking out five years into the future. In the short term (six months to a year) there is no way the rest of the world will avoid a recession alongside the U.S. despite all the talk about decoupling and the ECB still talking inflation. I’m sidestepping this market, running into the hills, and watching from above until the carnage stops.
I want to discuss how this complex CDO mess finally makes sense to me, and how much further we have to fall. But first, my short rundown of why the world can’t decouple in the short term, even with China, India, Europe, Mid-East, and South America running strong. Just as China has been growing like a weed by being the manufacturer of the world’s goods, selling to everyone, America is the flip side of that, and is the ultimate consumer. A lot of people argue that exports to the U.S. as a percentage of China’s sales is much smaller now, so China’s damage by the U.S. will be contained.$U.S. -> ChinaOk sure, that’s the first link in the sales chain. But why couldn’t analysts go just one or two steps further? China also has a lot of exports going to the growing European Union, but a main driver of the EU’s ability to buy stuff from China is because the EU has benefited to some degree from business in the U.S.$US -> EU -> China
The point is, the U.S. is the stilts upon which the world is built. Wherever you are in the world, some town in Hungary or a city in Korea, you may not have a direct line of sight to see the U.S. below you…but it’s below you. The termites called CDOs just have to eat through one of these stilts, and you’ll probably have further to fall than the U.S.
And, aside from the EU’s business in the U.S., the EU’s banking system has been smacked by the mortgage crisis just as U.S. banks have. EU Central Banker Trichet can talk inflation all he wants, but the central bank’s action speaks louder than words as they keep pumping in more liquidity than Uncle Ben Bernanke is willing to.This brings us to why I’ve finally given in to the bearish scenario and flipped on the negativity switch. It took Ambac’s potential downgrade by Moody’s, Merrill Lynch’s earnings, and Uncle Ben’s testimony on Thursday together to make me understand what this crisis is all about and how much further down we have to go. I may be wrong, but most market players are wrong more than they are right, so read into this as much as you want. This is just my understanding.First, the monoline insurers such as Ambac are down more than 90% year-over-year on what? Maybe SOME calls on the mortgages they insured for loans made in 2005, 2006, and some 2007? What about the rest of the neighborhood in California or Arizona whose value’s getting floored by the defaults down the street? What about the defaults to come as the mortgages resets in February?
Ok, so count these monoline insurers gone. That’s not the end of the story, however. Ambac was providing insurance on something, and just like your home or car, if your insurance doesn’t pay for the damages well, youyou're gonna have to eat the bill. In this case, it’ll be the banks and brokerages, U.S. and international banks alike, who got caught with their hands in the cookie jar. So what does this mean? The banks and brokerages become their own insurers and have to probably write down even more than they already have, because they have been valuing the write-downs based on insured values. Ooops! Safety net’s gone!
The value is likely to be closer to ground zero than not. I believe this explains why Merrill Lynch’s new CEO John Thain continues to look for investors and capital infusions from sovereign funds all over the world. Merrill, like other banks, must keep hoarding cash as they have become their own insurers and have to pay for what the insurers would have. Ambac may say they don’t need any more capital, but I’m with John Thain. Thain is one smart cookie. As he continues to hoard cash to build up his bomb shelter, I’m staying pessimistic about this market.
If I had to summarize Uncle Bernanke’s testimony on Thursday, it would be, he’s not doing anything, not cutting rates, not pumping in more lending more like the EU is doing, because he doesn't know what to do. As Chief Klough said to Lt. Tyler in the movie U571, “You’re the skipper now. And the skipper always knows what to do, whether he does or not.” I believe most market participants heard the same thing, which is why the market got clotheslined on Thursday after the testimony.
I had a whole schpeel to complain about Bernanke, but I threw it away because it seems pointless now. He may be right in trying to look for alternatives to a interest rate cut. The rate cuts so far have not worked, and it may not be because he didn’t cut enough or raised rates one time too many in ‘06. Banks continue NOT to lend, freezing the banking system, regardless of how much liquidity is pumped in from rate cuts, TAFy auctions, etc.
Why? Because all the banks are doing what John Thain is doing, hoarding cash, building their reserves, for when ALL the monoline insurers become dust in the wind AND the bulk of the bad mortgages from the last several years are dealt with. The first condition, the executions of the monoline insurers might be closer than ever. The faster these insurers give up, the sooner the banks can value their CDOs for what their REALLY worth, and we can all put this behind us.
But these insurers refuse to just close up shop and go work at the docks like in the 1930s. Still, the rating agencies can quickly end everyone’s suffering when they downgrade the insurers holdings push them under.The second condition, writing down the bulk of the bad mortgages from 2005-2007 might be a little harder to do, as it’ll take time for people to make decisions, take the defaults and run, etc. In any case, the sooner we write down these CDO’s completely, the safer the economy will be.
The economy is in a recession now. Even though the last few years have been great for the economy, leaving the corporate balance sheets as pretty as they’ve ever been, we are starting to burn through that cash, and fast. Each day we drag this on and the banks can’t write down their CDOs completely, the longer and deeper the recession will be. Until both these conditions are met so the banks are able to know their full CDO exposure, interest rate cuts will mean little as banks will just stuff that cash away under the bed.
This isn’t the Nasdaq in 2000 when companies were worth nothing, but a lot of the banks as well as businesses that need loans to stay alive, are worth a lot less than the numbers on Yahoo! finance.With that, I’ll begin a recession quote of the day, starting with:“Sorry Johnny, Daddy gets the bread because daddy has to go looking for work tomorrow. Go melt some snow and drink that.” At least in the 1930s, this dollar I have left would sure have gone a lot further.
Disclosure: no positions in the stocks mentioned.