Monday, October 27, 2008

A Little Credit

That really is all that is available in the debt markets today and the consequences are obvious. At the same time, we'd like to claim a little credit for calling the direction and - to some extent the magnitude of this crisis. We felt that these (then pending) consequences were obvious 18-24 months ago. In fact, one of the first posts on this blog in August 2007 noted:

Today's actions by the European Central Bank and the Federal Reserve confirm that the real threat is DEFLATION - not inflation. Central Banks don't pump $150 billion dollars into the banking system because they are afraid of creating too much money.

Again this June:

That is where we are now. The Fed has failed. The Great Oz has been exposed a just a man behind the curtain. Prepare for severe credit deflation and falling asset prices in markets that traditionally use leverage to purchase or hold positions.

For years massive credit inflation raged unchecked and asset prices soared as the pool of buying power increased far faster than the assets available to absorb it. As the debt machine began to break down and collapse under its own weight, credit creation proved insufficient to continue propping up all asset prices. At this point the Universal Debt Bubble (UDB) began to falter selectively. First housing, then junk bonds, asset-backed securities, commercial real estate, equities, corporate bonds and sovereign debt all fell off the wagon in turn. By early 2008, the one asset class that had not yet been hammered was commodities - though in reality, that was also a fragmented market with the highest profile stuff still going up while nearly everything else was down.

Selected commodities proved to be the final bastion of credit-driven asset inflation - leading many analysts to mistakenly call for inflation when the exact opposite was looming. Credit creation has now fallen to such a low level that asset inflation is now dead virtually everywhere. Grains, metals and oil were the last holdouts of the UDB and they are now being hammered into the ground. The WSJ provides us with evidence and a salutary example of how demand destruction works in Metals Meltdown Burns Scrap Dealers:

Now demand and price are in a freefall. Does the Miami businessman sell his now high-priced inventory at basement prices, or wait for the market to recover?


But in the last six weeks, scrap steel prices have fallen nearly 60% to about $400 a ton. Prices for aluminum scrap has dropped 33%, copper 25% and nickel about 15%. Peter Marcus, metals analyst for World Steel Dynamics, says, "We aren't near the bottom yet."

For a while, the trend in price seemed to be in favor of commodity inflation. The reality was that the huge amount of "money" (really credit) created during the UDB has been running around looking for someplace, anyplace to hide and commodities were the last asset bubble it ran towards. But the economic function of bubbles is draw in such phantom "capital" and destroy it as if it had never been. The trend-followers and and performance chasers will never understand this as they are always late by definition. One has to take a systems analysis approach to understand how pulling a lever over here can impact things that have no obvious connection to the original stimulus.

The last bubble is over. Oil has collapsed from nearly $150 to less than half that. Grains are down 60% or more. Industrial metals are in worse shape than that. Deflation is now the order of the day. Governments will try to stop it but will fail repeatedly. They do possess the power to stop it before deflation runs its full, natural course but the price will be self-destruction and national suicide via devaluation and hyper-inflation. In this case the cure is much, much worse than the disease.

Thursday, October 2, 2008


The commercial paper market certainly appears to be critically wounded. The seasonally-adjusted amount of CP has fallen dramatically since mid-September. Per the Federal Reserve the declines over the last three weeks:

September 17: -$52.1 billion
September 24: - $61.0 billion
October 1: -$94.9 billion

Headlines emphasizing funding cutoffs to companies in the real economy, like Caterpillar and A&T are highly misleading. Non-financial CP took a single hit of $18 billion ($217 billion to $199 billion) two weeks ago and has hardly budged since. The REAL story is the collapse of CP issued by banks and other financial companies. Domestic financial paper is down by $93 billion ($590 billion to $497 billion); foreign financial paper fell $40 billion ($225 billion to $185 billion, down 20%!); asset-backed paper is off $55 billion ($780 billion to $725 billion).

We have seen record withdrawals from money market recently, which has led to falling demand for commercial paper - which is usually purchased by these funds. In order to stem the flight from MM funds and hide the losses in asset-backed CP, the Fed recently extended their alphabet soup yet again. The "Asset-backed commercial paper money market mutual fund liquidity facility" or ABCPM3FLC for short was instituted just two weeks ago. It's gone from zero to $152 billion in just days - $22 billion average last week, to $122 billion average this week, to $152 billion by 10/2/08. All data are from the
Fed's H.4.1 release.

Panic Lending

Actions of this magnitude clearly indicate that a major crisis is unfolding behind the scenes. The freeze in interbank lending, the explosion of LIBOR loan rates, the collapse of financial commercial paper and counter-measures taken by CBs around the world indicate that the final act of the Universal Debt Bubble may be upon us. The UDB rested entirely on confidence - and badly misplaced confidence at that. It allowed credit to be extended to those who were manifestly NOT credit-worthy and the temporarily elevated economic activity created the illusion of prosperity.

All of that is going in reverse now and the politicos don't like it. Well, unfortunately this is all necessary to return to a stable economic structure after the bankers deliberately destabilized it. One of our first blog entries was Legions of the Damned - wherein we pointed out:

Over the last several weeks, there has been a collective recognition of the inherent riskiness of using illiquid, volatile and hard to value paper as collateral for lending. The lenders are requiring either much more (paper) or better (cash) collateral to secure the loans. The result is the global "Dash for Cash" that we've seen recently. Cash is King again and the scramble to come up with it resulted in huge spikes in overnight lending rates. The injection of $150 billion into the system was designed to bring the rates back down to the ECB and Fed targets of 5.25% and 4.0% respectively.

Had the CBs not acted, there would have been massive forced selling of the illiquid paper, demonstrating it to be nearly worthless. Now that would only formally recognize a situation that already exists in reality but as long as the banks can pretend that it's worth face value, they can continue to make loans and prop up consumption. This is a classic example of Gresham's Law - to oversimplify "Bad money drives out good money." When dodgy paper assets are treated nearly the same as cash, nobody is going to put up cash.

As we surmised well over a year ago, the repricing of risk is ongoing and the current crisis is simply the big brother of the one we experienced last summer. The clearest indication of risk recognition is the explosion of spreads. Once again, according to the Fed's Commercial Paper Report, yield differentials between high-quality (AA) and lower-quality (A2/P2) commercial paper have blown out enormously - from 80 basis points (0.80%) just a few weeks ago to over 400 bp today. Then there is the spread due to implied higher risk just for being a financial company. The spread on financial vs non-financial paper has widened from 30 bp to 160 bp in just weeks. A risk that Financial Jenga readers have known about for a long time is now confirmed by the market.

Inability to borrow in the US money markets helps to explain the severe dollar starvation overseas. It is this problem that the Fed is trying to fix with the their massive dollar loans (mischaracterized as "swaps") to foreign CBs. Less than a week ago, the Fed announced a
$330 billion expansion of these loans.

The results of the dollar starvation are manifest across Europe. Huge institutions like Dexia, Fortis and Bradford & Bingley have been fully or partially nationalized within the last few days. It does not help that the leverage ratios of European commercial banks are typically much higher than their American counterparts. Not only are the commercial paper markets closing to such banks but elevated LIBOR rates cut those same banks off from cheap dollar loans from other banks. The squeeze to dress up balance sheets to make them look good for the quarter-end reports undoubtedly contributed to it but the fact that pressures have not abated much yesterday and today indicates that much more than a seasonal problem is at work here.

The "dash for cash" is on. Despite the Fed lending as fast as it can, commercial credit is being drained from risky financial institutions faster than the Fed and other CBs can pump it in. Having seen Wachovia, WaMu and a half-dozen European banks fail in the last week, we see no near-term end to the pressures or the bank failures.