Mayday

We turn to Europe in this commentary as important events are occurring there behind the scenes and Asia has gotten the lion's share of the attention recently. The mariner's distress call actually comes from French, where "m'aidez" simply means "help me." We thought that would be a particularly appropriate title as Europe's financial system is starting to show signs of severe distress. From the actions of the CBs over there, we can infer that the problems there may be significantly worse than here in the US. Current open market operations show that the ECB has 451 billion Euros (about $640 billion) outstanding. This dwarfs the Fed total of just over $300 billion - including all liquidity facilities. It's pretty clear that there are many European banks in deep, deep trouble.

Starving for Dollars
It is also becoming increasingly clear that the European financial system has a desperate shortage of dollars. Since much of the debt outstanding is denominated in dollars and many European banks have taken in dollar deposits as well, there is a need for them to transact in our currency that is not reciprocated. When the Fed and foreign CBs set up the currency swaps, there was some suggestion that the purpose was to give the Fed enough Euros to intervene in the currency markets. That really didn't make much sense as the Treasury and the Fed have conducted a sub rosa weak-dollar policy for years. The logical and obvious explanation is now coming to the fore - Europe is seriously short of dollars and if they were forced to go out into the market and buy dollars, our currency would strengthen too much for the planners at the Fed who have been attempting to devalue it.

The bid to cover ratios from recent auctions make the point quite forcefully. The last set of TAF auctions in the US produced ratios of 1.51 and 2.19 (for the initial 84-day facility). The comparable ECB auctions in Euros had a bid to cover of 1.58. But ECB dollar auctions were bid at 4.56 and 3.85. US banks' demand for dollars appears to be roughly equal to Eurozone banks' demand for Euros. But Eurozone demand for dollars is twice as great as either one. This trend is confirmed by the result of the Swiss dollar auctions. Those had bid to cover ratios of 2.90 and 4.90. Finally, note that the Fed is not auctioning off Euros or Swiss Francs to anxious American bankers.

In addition, the high-yield bond market in Europe is completely frozen. Not one junk issue of any size has come out of Europe this year or for quite a few months of 2007. Retail sales there are falling farther and faster than in the US and the housing bust there has barely begun. Granted that theoretically the ECB had more room to cut rates than the Fed but the strength of unions and the social program costs make a wage-price spiral much more likely in the Eurozone, which seems to be constraining the actions of the ECB.

Ongoing Credit Implosion

The rate of implosion in the credit markets continues to accelerate. In fact, the process seems to be proceeding very rapidly and the only element missing is mass bond defaults. According to Bloomberg, the asset-backed commercial paper (ABCP) market has shrunk by 20% in a mere three weeks and the total CP market is 11% smaller over that period. This type of credit has contracted by $244 billion in a very short time. For those who think the Fed can simply "print money" to revive asset inflation, $244 billion is roughly 4x the $68 billion total of all US currency in circulation today. And of course, the CP market is just one of many credit markets undergoing a buyers' strike.

Private label MBS of any kind is very hard to sell right now, which is why even Countrywide is doing almost nothing but conforming loans.

[Countrywide] says that soon about 90% of its originations will conform to either bank loan or such so-called "Government Sponsored Enterprises" standards.

The corporate junk market is nearly frozen right now. As far as I can tell only one junk deal of any size has been done in eight weeks. Other than debt issued or guaranteed by governments, very little is being sold in the bond markets anywhere right now. Unless you are a "natural" AAA or AA-rated entity, you can only issue debt at punitively high interest rates.

There is complete distrust of credit ratings for any sort of structured debt. Of course that's what happens when BBB-rated "investment grade" structured bonds lose over half their value. More confirmation of just how bogus the ratings were and how badly standards had slipped came recently. S&P cut their rating on some structured investment vehicles (SIVs) from the gold standard AAA to near-default CCC in one fell swoop. As we previously mentioned in Fed Actions and Terrorist Attacks, the ratings agencies got paid three times as much on structured bonds but I'm sure that had nothing to do with the generous ratings. Surely, they are only correcting an inadvertent previous oversight.

Of course, when the ratings are that badly wrong, no one cares what about motives or excuses. All such ratings become suspect. Nothing the Fed can do will restore trust in the ratings agencies. Only the agencies themselves can do that and only with time and hard work. Similarly, much of the credit that was extended should never have happened. Since the creditors have been burned by dumb mistakes, those won't be repeated - regardless of how many unsustainable investment structures depend on the them.

The Fed cannot recreate the naivete, the wild optimism and the frenzy that drove much of structured finance over the last several years. The illusion of permanently lower risk has been broken and cannot be recreated. Much of the recent "financial innovation" was utterly dependent upon this illusion and so those products must simply disappear. The UDB has burst and the Fed just needs to get over it. Efforts by the CBs to halt this process will meet with the same success as King Canute's command to halt the tides.