Credit trading got very ugly late last night. Sellers were showing up in force, buyers were all but extinct, the street was taking its reward and leaving. Here are a few sample quotes from traders describing the afternoon's trading conditions:

• "Wheels coming off in finance spreads"
• "Retail flows skewed 70% to the sell side"
• "We're testing the liquidity thesis"
• "Liquidity non-existent"
• "Market clearing spread levels uncertain as sellers unable to find buyers"

Is this an inflection point? Are spreads headed wider? I'd like to think so. My models are pointing as bearish as they've been all year and I've thus moved into a bearish credit stance. However I have to admit, we've been here before. Several times over the last 6-months we've suffered through a day or two of real ugliness only to snap back. The real money back bid has (so far) always been there.

With most of the big banks having reported 3Q earnings I wanted to take a look at how we're progressing with loss reserves. Unfortunately, I did not find good news.

Here's what I did. I took a look at Wells Fargo, J.P. Morgan and Bank of America. All three reported a decent breakdown of their loan exposures by type. (Click on each name above for their earnings presentation). I then took the loan loss estimates used by the Fed in the stress test and multiplied each bank's exposures by the loss estimates. Note that the Fed basically had four loss estimates. They had a "Baseline" and a "Adverse" scenario, then they had a high and a low estimate within each of those.

Here is my take on bank earnings reports. I'm coming at this from a bond guy's perspective, so I'm a little less worried about whether certain revenues are recurring or not. By this I mean, JPM's fixed income trading revenues were probably higher than what we can realistically expect in the future. That being said, JP will probably have robust trading revenues in future quarters, just maybe not this robust. Same with the elevated NIM. Remember, bond guys don't care whether EPS is $1.5 or $1.55/share. We care about ticking time bombs.

So I'm more interested in whether banks are working through their problems. We know it will be a while before loan losses start falling, but at some point, banks will have actually provisioned enough. I don't think we're there now, nor do I think we'll be there in the next couple quarters. So what I want to see banks doing is using this period of elevated NIM/trading gains to build reserves against future.

I received numerous e-mails and comments in response to Friday’s piece, many of which were very reasonable critiques, all of which I appreciated. One basic question which was asked multiple times was why I make a distinction between what the Fed is currently doing (quantitative easing) and debt monetization. I’m going to try to answer this question below. As always, please feel free to comment and/or write me an e-mail if you have further questions. I welcome the debate. If however you start an e-mail with, “You idiot!” I am somewhat less likely to respond.

First, let’s frame the discussion. If one defines debt monetization as simply the creation of money for purpose of buying government debt, then there isn’t a distinction between the Fed’s quantitative easing program and debt monetization. In fact, by that simple definition, there is no difference between the Fed’s normal open market operations, which often involve doing repos with Treasury collateral, and debt monetization. But as a trader, I don’t give a dewback's tail what you call it. I care what the effect is. Clearly there is some distinction to be drawn between old-school open market operations, today’s quantitative easing program, and full scale debt monetization, at least in terms of degrees. So let’s agree that there is no utility in turning this into a discussion of semantics.

I switched from positive to negative on credit spreads on Wednesday of last week. Since then, we had a big sell-off in spreads on Thursday on the Jobless claims number. Friday we started out with a mini panic in credit spreads after the payrolls number, and I was feeling pretty good about my call. But the afternoon saw credit spreads rally hard to where most names were flat to slightly tighter. Today (Monday) we're rallying hard. Bank/finance is 10-15 tighter across the board.

I'm sticking by my models and remaining short credit. But it's worthwhile to note that there is a massive back bid in the corporate bond market. It's flowing from a number of sources. The most obvious is that fact that mutual fund flows are dominated by bond flows. A typical core taxable bond fund is going to be 50-80% corporate bonds (vs. about 20% of the overall investment-grade universe) and thus every dollar that comes into bond funds tends to hit the corporate bond market disproportionately.

What should we take away from the Countrywide (CFC)/Bank of America (BAC) deal?

First, it's obviously good for market liquidity that Countrywide won't wind up in bankruptcy. While I think the economy could have handled a Countrywide liquidation, it would have been painful and messy. I'm sure Ben Bernanke is happy about this turn of events. Notice that Fannie Mae (FNM) and Freddie Mac (FRE) stock were both up solidly Friday.

First let me say that I'm not surprised the market rallied strong Wednesday. Like I said just a day earlier, we knew Countrywide (CFC) was in serious trouble. We've known this for months. Why does the market sell off 200 points on news that was widely expected? With the market taking about 2/3 of it back Thursday, I'd say that sell-off was mostly fast money driven.

That doesn't mean we won't keep going lower. As I discussed the other day, it sure seems like the corporate bond market is set up for a much worse economic outcome than the stock market. Corporate bond spreads are as wide or wider than the last 2 recessions, and yet the stock market valuations seem sanguine on the topic.

Yesterday, rumors were rampant that Countrywide (CFC) was to declare bankruptcy sometime this week. The company denied the rumors, saying in an e-mail to major media outlets: "I feel happeeeeeee!"

Here is what I find particularly interesting about today's market.

I don't comment about the stock market very often, but something isn't right. Take a look at the chart below. The S&P 500 is in red, charted on the left axis. Corporate bond spreads are blue and are inverted on the right hand axis. Thus when the blue line "falls" that should mean the economic picture is deteriorating (click to enlarge):

Words have the power to both destroy and heal. -The Buddha

In thinking about where the economy, Fed, and markets will be going in 2008, I find my thoughts dominated by considerations of liquidity. Readers have heard me use the term "liquidity crisis" or "credit crunch" during 2007, but have rarely (if ever) seen me use "credit crisis" or "solvency crisis." This is purposeful.

The subprime woes of 2007 have thrust bond insurers into the spotlight, and, for the first time, really call into question the utility of municipal bond insurance. I have received a number of e-mails and comments from municipal bond investors expressing concern over the quality of their portfolio. I thought it would therefore be useful to discuss how muni insurance works, and what the decline of any municipal insurer would mean for municipal credit quality.

Municipal?
First a couple notes about municipal bonds. The term "municipal" is a bit of a misnomer, since any tax-exempt bond is generally considered a "municipal." That includes not only states, counties, and cities, but also government-related entities (such as a public university) and non-profit organizations (such as a hospital or private university). States, cities, counties and school district bonds which have pledged their full taxing power to bond holders are called general obligation. All other issues are called revenue bonds. Readers should note that governmental authorities are often not funded out of the state's general revenue, but out of their own revenue stream. For example, the Maryland Transportation Authority's revenues come from tolls and the state fuel tax. It would be theoretically possible for the Transportation Authority to be bankrupt without the state defaulting on anything.

Berkshire Hathaway (BRK.A) is starting its own municipal bond insurer, Berkshire Hathaway Assurance Corp. This immediately raises three questions. First, what impact will this have on the muni market? Second, what impact will this have on other monoline insurers? And third, what will muni guys call the new insurer? BHAC? (Pronounced like Be Hock? Maybe the old Oracle should have thought about that a bit more).

The answer to the first question is: It's great news. For more, see below.

What is a TOB? A tender option bond (from now on TOB) is the municipal bond market's answer to the classic borrow short and invest long. As with many types of leveraged strategies, this one has been getting hit very hard in 2007. It also has some disturbing parallels with the SIV problem which has rocked the money markets.

What exactly is it?

There is a piece on this new blog (which is trying to create a sort of independent stock research center where the reports are written by users) about iStar Financial (SFI). Fair disclosure, I'm considering a debt investment in iStar.

Anyway, toward the end of the report, the author goes into a bit about how financial stocks are in the unenviable position of proving a negative. I want to explore this idea a bit more.

When I started college, I wanted to be in politics. I was already of a Libertarian mindset, and had it in my mind that I could change the world. I picked economics as a major to learn about setting policy, not because I wanted to get into investments. Suffice to say I've fallen from the true faith and am now little more than a money grubbing trader.

Anyway, early in my college career I wrote a paper on budget deficits. Having a Libertarian bias to begin with, I set out to find sources which would conclude that budget deficits were evil. Lawyering? Hey, I wanted to get into politics at the time. Cut me some slack.

However, we can prevent the problems in housing from spiraling out of control. We can do this by providing liquidity to the system, in whatever form is most effective. Ideally, the Fed would find a way to provide liquidity where it's needed, but not where it's not. In other words, find a way to throw cash into the problem areas of the financial system without creating any more inflation pressure than necessary.

That's exactly what the Fed is trying to do with this new Term Auction Facility. I think James Hamilton has it right, in that it's nothing more than the discount window with another name and an uncertain interest rate. The idea is to give banks a temporary avenue for raising liquidity at a time when liquidity is dear. It's nothing that banks couldn't do through the discount window anyway, but without the stigma.

I only hope that when the data is analyzed, a strength can be found. Or at least, that's FGIC's only hope. Moody's (MCO) placed the erstwhile GE (GE) subsidiary on negative watch late on Friday. When I first started my career, FGIC had the reputation for being the most conservative of the major insurers. Now they are the one in the most trouble. Moody's also put XLCA [subsidiary of SCA (SCA)] on negative watch as well. Both will need to raise capital over the next couple months if they want to keep their gilt-edged rating.

We've speculated before on this blog about FGIC, which seemed particularly vulnerable given the fact that majority owner PMI (PMI) is having their own capital problems. But it's not over yet. Moody's didn't give a number to how much capital FGIC might need, but I suspect they've given such a number to FGIC management. So the odds are good that FGIC is already working on a capital plan.

Apparently Washington Mutual (WM) is not as well capitalized as we were lead to believe. As recently as November 7, Washington Mutual management was intimating that it thought its capital was adequate. Now it is saying it needs to raise $2.5 billion in new capital through a convertible preferred issue, and will cut its dividend by 75%. The combination of dividend cut and preferred offering will increase capital by $3.9 billion.

Let's put that into perspective. WaMu had $20.4 billion in Tier 1 capital, according to data supplied at its Investor Day on November 7. Increasing capital by $3.9 billion would be 19% of its total Tier 1 capital. Again, as of November 7, WaMu claimed (coincidence?) to be about $3.9 billion over the "Well Capitalized Minimum" dictated by banking regulations. I think we must assume that WaMu is concerned that it will fall below this minimum without additional capital.

I'm a believer in two things when it comes to monetary policy. First, it is in the best interests of everyone that long-term inflation remains contained. Therefore the Fed should be primarily focused on inflation most of the time.

Second, debt deflation is extremely dangerous for modern economies. I believe (and Ben Bernanke believes) this is what caused the Great Depression, and if we were to experience another Depression, debt deflation is the likely culprit.