Bracing for Another Round of Credit Related Woes

By Eric Roseman

I still like U.S. stocks compared to most foreign markets over the next 12 months.

In theory, a competitive currency makes American assets one of the best bargains in the world this year. Plus, a strengthening dollar is bullish for overall markets because it encourages cash-heavy global investors to assume more risk-taking.

But despite holding U.S. equities and several investment-grade corporate debt instruments, I'm still bracing for another round of credit related woes. Credit market indices continue to deteriorate this summer. A host of developments are revealing a fractured market that simply won't stabilize.

Credit spreads can tell a whole story. This matrix compares interest rates on riskier debt instruments vis-à-vis Treasury bonds. That picture here has been deteriorating since late May with high yield, investment grade, mortgage-backed and emerging market debt spreads all rising to their highest levels since the credit squeeze emerged.

What really irks me is that despite massive central bank liquidity injections into the financial systems since last December, interbank lending rates remain elevated. LIBOR, or overnight lending rates, are still too high. Right now, they're 81 basis points above the Federal Funds target 2% rate.

It's the same story in Europe. Banks aren't lending.

And the credit squeeze is not just affecting subprime or troubled borrowers. It's also affecting prime borrowers.

On Monday night I had dinner with one of the most successful real estate investors in Montreal. Despite his AAA-track record and bulging portfolio of income producing properties in Canada, this gentleman can't secure financing to buy distressed assets in the United States. Even hedge funds - which traditionally have been surrogate lenders to speculators - won't pony up the cash.

This tells me that we've got serious problems. If a prime borrower can't get funds to secure a bargain-basement real estate deal, then you've got to believe credit is tight. And tight credit is deflationary.

There's no doubt this has been a tough year for investors - the toughest I've had to navigate since 1998. Every time you think it's safe to put your toes back into the water, you get whipsawed by another panicked sell-off. Unless you've been over-weighted Treasury bonds and oil futures since mid-2007 the odds are pretty high you're losing money.

The market has not bottomed. Until signs of credit stress are finally alleviated investors should remain heavily parked in cash, alternative investments and reverse index funds. Another big shoe has yet to drop.

Comments

[Pauly B:]

With massive infusions by governments to bail out banks it seems on the surface that it would fix the problem. However it takes risk out of the equation and that is not helpful to capital markets.

It would be a nice perk if my checkbook would be balanced by an outsider if I were not responsible. Why should I invest in a financial when the reward is so poor and there are no consequences for these financial institutions?

I agree, we will test the lows in the S&P this fall.

2008 Aug 31 08:33 AM

[copesetic:]

Even the loan sharks are not lending right now, I know because I got turned down by all of them recently.Yet I have numerous concluded transactions and a perfect record with them. :( I may have to sell some silver to fund my latest project and save the usury that I was going to pay for the "privilege" of using their money to do it.

2008 Aug 31 08:38 AM

[OldLimey:]

"Every time you think it's safe to put your toes back into the water, you get whipsawed by another panicked sell-off."

This market has already had more bottoms than a herd of wilderbeest. If the PPT would let the market finds its own level there might be something meaningful to build on. Having said that, it's difficult to see how things can improve on a sustainable basis until investors are able to have a reasoned stab at estimating the true value of financials' balance sheets. Spreads suggest we're still some way from that point. The author's caution is well-founded.

2008 Aug 31 08:48 AM

[venividivici:]

"I still like US stocks compared to most foreign markets....." Boy, you are easy to please. Where has the S&P gone over the past 9 years? My understanding is NOWHERE! Wow you are very easy to please man.

2008 Aug 31 09:05 AM

[ain't no fo...:]

The author's quote:

"What really irks me is that despite massive central bank liquidity injections into the financial systems since last December, interbank lending rates remain elevated. LIBOR, or overnight lending rates, are still too high. Right now, they're 81 basis points above the Federal Funds target 2% rate.

It's the same story in Europe. Banks aren't lending"

But what people don't understand is, these injections were NEVER about LENDING... they were about TRADING, specifically using the house (taxpayer) money to keep a bid under the major indices at a critical time - the pre-election months.

How to do that? Why, give the major financials an incentive, namely vast sums of cash to trade these markets with, and let them run amok jacking the markets up and down, trading the volatility, making huge profits on both sides, but only as long as they kept it stable, steady, flat, because we can't have any crashes now, can we boys?

When the FED threw open the discount window to the investment banks (read that stock brokers) for the first time since at least the Great Depression, they knew the money wasn't going to get lent out, but rather that it would go into the trading accounts of the brokers and thence to the hedge funds they had spawned. Which was just what the FED and Treasury wanted, and I would submit the word got quietly passed to that effect through the good old boy's clubs on Wall Street loud and clear.

And anyone who has watched the volatility ever since has seen dozens of multi-hundred point up AND down days in the markets, many in consecutive days, generating huge trading profits on the long and short side for the world's largest day traders - the brokers and hedge funds.

But where are the markets after all this incredible, historical volatility? DEAD FLAT EVEN. And still the credit markets scream for relief.

Take this week... we had a 240 point down day, a 212 point up day, and a 170 point down day in what is supposedly the quietest week of the year. Yet vast amounts of money were made by those trading (and influencing) the swings. And yet the net change in the averages was virtually nil: Dow and Wilshire down 84 and 60 points respectively, SPX, NYSE Composite, Russell 2000 and Mid Cap 400 basically flat.

Shakespeare comes to mind... "All sound and fury, and signifying nothing"... which is just what the powers that be want.

And the vig on those "loans"? As Old Limey inferred, keep the PPT and the Invisible Hand stabilizing the markets, its an election year, the republicans are in deep trouble, and a crash in the markets just before the election would be their final disaster.

The huge injections of liquidity by the FED never went to business, consumer or even overnight lending, capital repair, or any sound economic purpose whatsoever.

But they were never supposed to.

2008 Aug 31 10:15 AM

[irondoor91:]

"This tells me that we've got serious problems. If a prime borrower can't get funds to secure a bargain-basement real estate deal, then you've got to believe credit is tight. And tight credit is deflationary."

Right you are. The reason the banks aren't lending on "bargain basement real estate deals" is that they have plenty of them as collateral on their balance sheets already and the prospects of owning more are increasing daily. They need the cash to invest in low-cost Fed funds and they need to get the current crop of loans off the reservation before they deteroriate any more.

Your real estate friend should hunker down, manage his cash flow , pay down his debt and let the momentary fit of greed pass on by. There will be even greater "bargain basement" opportunitues ahead.

2008 Aug 31 10:30 AM

[venividivici:]

Great post wpdragon. Those that run this casino have to keep their high rollers happy and engaged

2008 Aug 31 10:38 AM

[ain't no fo...:]

Thanks VVV...

"Those that run this casino have to keep their high rollers happy and engaged"

AT ALL COSTS... after all, its still all about the Benjamins

2008 Aug 31 11:13 AM

[nukldrager:]

So what we have is casinoism and the house is owned by a few of the gamblers

2008 Aug 31 11:49 AM

[farmer448:]

You want to look at a similar time, look at the runup to th 72 elections where the fed pumped the economy. Commodities were inflationary and stagflation was born as a term. I believe while studying the oracles bones that this will not be a short recession.

2008 Aug 31 12:32 PM

[Maryocon:]

The Real Estate market is bottoming at least in most of California. I am not sure about the hardest hit areas but I sure see the bottom here in Sonoma county. It will take awhile, probably a couple of years before it completly turns and starts heading up again, but if someone wants to get in on the bottom now is the time to do it. This is my third Real Estate downturn and the end is finally in sight.

2008 Aug 31 01:06 PM

[whidbey:]

Your point on the impact of tight credit is important; it will hurt small businesses and employment which will in turn pull down P/Es and the equities. I think it insane for the Californians to babble about a bottom in sight in their market. It is merely the pause before the final plunge. Abandon Hope all who enter the Golden State, maybe the US too.

2008 Aug 31 01:57 PM

[wagman:]

As deleveraging of massive leveraged credit inflation continues things will get much worse. Deflation is the operative force now and PPT will not be able to stop this. I agree with the excellent post by wpdragon that the FED and U.S. Treasury actions are designed to prevent collapse prior to the election and definitely for the benefit of their insider cronies. Whidbey is also spot-on. The end for collapsing real estate prices in CA and elsewhere in U.S and Europe is not anywhere near in sight. History shows that bailout actions in bear markets bring lower stock prices vs bull markets where they do the opposite. This bear market has so far given us the Bear-Stearns bailout, opening of the FED discount window and several "suprise" target rate decreases. My guess is the Fannie & Freddie bailout will be the next shoe to drop and kick the banks, stock and real estate markets much further down.

2008 Aug 31 02:35 PM

[woodsey:]

Did I hear "usury"? So, what else is new? We must take care of our buddies must we not? Someone mentioned 72; I would add 80. Sam is not our friend.

2008 Aug 31 03:15 PM

[madmilker:]

a Mason fruit jar gives a better return than the market now!

2008 Aug 31 06:14 PM

[brianoh:]

One major point is that the Fed Rate of 2% improves bank's profitability, or at least reduces their losses. The spread between what they pay and what they receive on mortgages is very high. This means that those with cash are paying for their losses on bad loans. As for stocks, it is a question of what are reasonable PE ratios. Based on historical rates stocks are at least 30% overpriced and the Fed and Treasury are fighting like mad to keep them there - hence the housing bubble caused by Greenspan. The whole FIAT money system is at risk as a result of printing too much money and inflating asset prices.

2008 Aug 31 06:45 PM

[Dirtt:]

The final wave of foreclosures has yet to pound the market. The most dubious and most sinister mortgages were made at peak prices. Housing inventories are about to swell.

"Unless you've been over-weighted Treasury bonds and oil futures since mid-2007 the odds are pretty high you're losing money"

Ultra short etf's are nice snacks.

2008 Aug 31 08:09 PM

[frugal:]

to maryocon: Why do you believe California real estate has hit bottom?

2008 Aug 31 09:58 PM

[frugal:]

maryocon: Why do think the market has hit bottom?

2008 Aug 31 10:05 PM

[trader_murf:]

Perhaps I digress a bit but here in Brooklyn at least where I live the prices on co-ops and houses still seem to be gaining value at an insane speed. I remember '89 and '90 in Brooklyn as well. I don't remember the term "short sale" but I do remember people turning in keys to co-ops with bad underlying fundamental mortgages and also people who had to sell taking a loss. I also was a dump newbie trader in 1998. All stocks come down. My point is, is it really possible to get through this credit mess and inflated housing prices (not to mention home equity loans, over extended credit cards, car loans, student loans, etc.) without the house of cards, so to speak collapsing in all areas to one extent or another? How can all of this be cleared out with foreclosures and excess inventory in Florida, California, Ohio, Nevada and even upstate New York but a housing tree grows to the sky in Brooklyn? I know they say all real estate is local but I just don't buy it, it reminds me of no not Cisco at 100, just hold on. I think to get this whole thing right more has to get shaken out. Judging from the recent sales around here get out the popcorn and crash helmets, sit back and watch the show. Or maybe snack on those ultra short etf's mentioned above.

2008 Sep 01 12:41 AM

[investor 101:]

"And tight credit is deflationary."
Yes, but the interest rate is negative and THAT is highly inflationary!!

2008 Sep 01 10:24 AM

[Kunst:]

When the RE market finally does "reach bottom", it isn't going to go right out and bounce back to the sky. The last bottom, in the early 90's, was pretty much flat for about 4 years, with only modest appreciation over a decade's time.

2008 Sep 02 01:40 AM

[peterthepai...:]

watch the 'flation man. be it DE or be it IN?
we aint seen nuthin yet!

2008 Sep 02 03:43 AM