The Real Credit Crunch

A lot has been written since the recent acceleration of turmoil in the credit markets. All sorts of analysts ranging from small time bloggers to the talking heads on CNBC have covered everything from bonds and credit derivatives to commodities and equities. Everyone has an opinion, and I feel like I’ve listened to or read almost all of them. Unfortunately, the overwhelming majority of what I’ve been exposed to has been pretty poor. Some analysts get bits and pieces right, but most lack the ability to really see the big picture.

I would like to take a step back and look at that big picture. I will be discussing the current financial climate, where we’ve come from, and where we’re going. Before we go on, I would like to say one thing. If you don’t think, or you’re even slightly skeptical, that I fall in line with the other pundits who put the word ‘analyst’ after their name, please refer back to some of my prior articles in Bourbon & Bayonets. You will see that as this process has panned out, not only my analysis, but my ability to foresee what’s to come has been spot on throughout the turmoil, but don’t take my word for it…look for yourself

Credit Suicide

Dear Reader, you’ve all read the headlines. Whether it be “Credit Derivatives Unwind,” or “Speculators Erase Retirement Funds,” if you read or listen to any financial media, you’ve heard it all. What we need to do is distinguish between fact and fiction, and start from day one. If I went to my grave today, and my readers could take only one thing from my analysis, it would be this:

Every issue we are facing today is either directly, or indirectly the fault of monetary inflation. When I say monetary inflation, I’m referring to the growth in the money supply (both paper money and credit growth). When you have excess money and credit, it attempts to find a home, and monetary / fiscal policy can influence the direction of the liquidity flows.

Without getting into too many details (you can email me with any questions you may have about any of the details in this piece), we rolled excess liquidity from the “Dot Com” bubble to the housing bubble. In order for the housing bubble to expand, there needed to be new lending stipulations and exotic debt (credit derivatives) instruments to absorb the excesses.

The end game of this process was a massive leveraged mispricing of risk. I’m sure that is another phrase you’ve been hearing a lot of over the past couple of weeks: mispricing of risk. What that really means is that interest rates weren’t properly set to represent the risk involved.

This mispricing of risk was represented in mortgage backed bonds, municipal bonds, corporate debt, and basically every other form of borrowing and lending practice. The enabler of this process was the rating agencies. By rating these toxic securities, many of which were marked to magic (marked to model) and marked to market, as investment grade, a massive market was created. Not only was the risk mispriced, but it was leveraged upon massively via the credit derivatives market.

Credit Markets Seized Up

Encroaching the present, the housing market began to deflate. Many of these credit analysts thought a deflating housing market was impossible. Obviously they were wrong. As the deemed impossible became reality, the assets backing many of these debt instruments began to not perform and enter default.

The funds (investment banks, hedge funds, pension funds, private equity) that were holding the non performing debt began to see balance books weaken. Adding fuel to the fire was the fact that these firms were leveraged out 10x, 15x, or even 20x over.

All of the sudden, capital to debt ratios were encroaching dangerous levels. Enter stage left, private equity and the Sovereign Wealth Funds. These entities began taking large stakes in the struggling companies in order to sure up balance sheets. Well, it didn’t take long for the SWFs’ money to be all but wiped out. Now when these failing firms need it the most, they can’t get a dime out of the foreign money pools. As the adage goes: Fools me once, shame on you. Fool me twice, shame on me.

Where’s the Capital?

The leveraged mispricing of risk has come home to roost in recent events. What has happened is that capital to debt ratios have gotten so poor that the rating agencies have been FORCED to call into question the ability for these firms to repay debt. Therefore, S&P, Fitch, and Moody’s cut the debt ratings and threatened more cuts if capital ratios didn’t improve.

If the firms can’t raise capital, the rating agencies will be forced into additional ratings cuts. Let’s not forget that the firms are massively leveraged out. This means that if their debt ratings fall, the firms will be forced to keep a higher debt to capital ratio as the ability for the investment firms to repay their debt is now looking to be more suspect.

Let’s look at it this way: When capital declines, the firms’ capital to debt ratio declines. If the ratio gets too low, the rating agencies cut. If the ratings agencies cut, the firms need to keep more capital on hand compared to their liabilities. If the firm can’t raise the necessary capital, a margin call is instituted.

With private funding and public offerings all but off the table, the firms needed to raise capital. They were forced to take their assets to the market in order to sure up balance sheets. To the firms’ surprise, there was barely a market to speak of. This resulted in massive illiquidity of these leveraged assets that were now worth pennies on the dollar. The more these firms needed to liquidate, the more illiquid the market got. It had a snowballing effect.

This is what happens when you mark assets to magic. In order to liquidate the asset you have to take it to market and see what the counter party is willing to pay. What was found out is that the counter party was willing to pay significantly less than the initial values.

Margin Calls & Negative Equity

Now the firms are facing margin calls because of their declining capital to debt ratios. What we found out in the past week and a half is that private funding, both foreign and domestic, is off the table. This directly resulted in ratings cuts and forced liquidation of assets. What the firms were finding out is that not only were their Tier 3 assets (marked to magic) worthless, but their Tier 2 (marked to market) and Tier 1 (equities, treasuries, etc.) were also worth significantly less than expected. Now what?

The best metaphor I can use to describe America’s investment banks is that they are like a house with negative equity. If the investment banks, and I’m talking about EVERY ONE of them, were to sell their balance books on the market, they would not have enough cash on hand after the liquidation to cover their margin loans. Hence, they have more debt than their assets are worth.

This is a very interesting and little known piece of information. Please remember this when speculators are continually bashed on a daily basis for causing this mess. Listen here, short sellers, myself included, simply saw balance sheets that didn’t match share prices. At BEST, these institutions are worth pennies a share. What has gone on in the past two weeks has been the free market trying to put a fair price on the financials. By outlawing short sales, regulators have removed a large part of the free market. Short sellers aren’t the problem, they are the truth.

Regardless, the options that the firms are left with are a declaration of bankruptcy or government assistance. We have seen examples of both, and my view points on these issues are very passionate and can be read in my most recent issues of Bourbon & Bayonets. For that reason and the sake of time, I will not reiterate them here, but the cost of this government should not be underestimated.

Bailout: Traits & Consequences

The U.S. Treasury and the Federal Reserve have two goals in mind. They are trying to orchestrate a soft landing and they want to prevent deflation at all costs. Here’s what Washington has in mind:

I mentioned above that if the investment banks were to take their assets to the market they would have ‘negative equity’ and would need to declare bankruptcy. What Hank and Ben would like to do is prevent the firms from ever having to take those assets to the market. If they can do that, they can hopefully prevent some of the inevitable bankruptcies, takeovers, and bail outs. Basically our government has taken up the policy that if federal money is needed to bridge the troubled firms to safety in order to prevent more mass liquidation, they will do it. Who they decided to bail and who they let fail is a topic for another date.

The other item to keep in mind is the election in November. I’m not saying either way, but I wouldn’t at all be surprised if authorities were simply trying to keep this thing patched together with wood glue and duct tape until after the election. Regardless, the more companies that are forced to file chapter 11 or otherwise, the more deflationary pressure our economy will experience.

Let’s discuss the macro picture regarding the government bailout of the large investment firms’ mispriced leverage of risk. With a couple of signatures, the government will approve a bailout that could cost $700 billion dollars. I need to say a couple of important things about this.

The $700 billion is not a limit. It is what the Treasury is estimating as a potential cost. Those estimates are based on today’s credit market climate. That is a climate that will only be getting much worse over the next 12-18 months. It is for that reason that I KNOW this will cost several hundred billion more than the initial estimates.

To put this into perspective; the U.S. has spent approximately $700 billion in on the Iraqi war in a 5 year span. Congress will have managed to match that massive sum during a couple days of session. Let’s not forget that HIGH END initial estimates of the war’s cost were around $100 billion. I have no reason to believe any of the government’s ‘initial estimates’ on the cost of this bailout.

This leads us into the final issue I would like to discuss: deflation. It’s this issue that is probably the most pressing issue regulators are facing. Deflation will be prevented at all costs. If it isn’t, you can expect deflation that would dwarf that seen in the 1930s. This will never be allowed, because that’s when politicians get tarred and feathered. The only way to prevent such deflation is to hyper inflate the monetary base. Dear reader, this is the ONLY outcome, and please don’t be naïve and think otherwise. I’ve always been bluntly honest with you, and to prepare your finances for anything otherwise is financial suicide. I’m not the only one who thinks so…

Note: The author and publisher do not hold positions in the securities mentioned.

Comments

[Reddenbacher:]

What you call deflation is what most of us refer to as a deep recession or indeed a depression. This means massive job losses and wealth losses across society. Of course it must be prevented at all costs. And after it is prevented a new regime of appropriate regulation and enforcement needs to be put in place so that the surviving financial firms serve their societal purpose of helping to finance the real economy while earning a very nice return for their effort. Contrast this to what has happened over the last dozen years where the financial firms chased after ever greater profits through the great paper shuffling gambling casino they built atop their traditional busiess of financing the real economy. We'll (us taxpayers) will have to save some of them but in return "appropriate" regulation and "vigorous" enforcement must be put in place.

2008 Sep 23 12:19 PM

[Smarty_Pants:]

Good description of how and why the process broke down.

Errors were made everywhere chasing quick profits throughout the process.

1) Widespread use of 'stated income' loans and lending to truly unqualified buyers via option-ARMs, etc. provided the fuel for the fire. Once rates reset these buyers couldn't afford to make payments on houses that were worth less than the loan value.

2) Artificially low interest rates at 1% for far too long drove housing prices to the moon as everyone scrambled to buy.

3) Unbridled real-estate speculation on a shoestring budget.

4) As you mentioned, absurdley excessive leverage by big banks and hedge funds.

5) Risk mispricing via CDO "insurance" payments that were woefully inadequate to cover the actual risk of the position. These were then multiplied to beyond absurd levels via the leveraging mentioned earlier.

How can any company CEO expose his business (AIG) to a potential $80 Billion in CDO payouts when the company balance sheet nets out to only $100 Billion of mostly illiquid assets? This is more than poor risk management, it's negligence.

What these people deserve is to fail miserably. What they will get is some form of government bailout and all the stings that are attached, just to stay in the game.

Meanwhile, the taxpayer will be saddled with Trillions of bad MBS on the books that will wind up losing money for them AND the onset of some serious inflationary pressure on price levels as the bailout money works its way through the economy.

Expect the dollar to go lower, interest rates to rise, and the market to sink over the long term. If the Chinese or Japanese decide to drop the dollar as a reserve then look out below.

2008 Sep 23 04:11 PM