More Credit Deflation

It is critically important to understand the decline in overall credit levels in order see just how powerful the emerging deflationary trend is. One of my favorite analysts is Doug Noland of Prudent Bear. His Credit Bubble Bulletin is an indispensable tool for anyone hoping to fully understand what is happening. From his latest edition:

Total Commercial Paper increased $1.1bn to $1.753 TN. CP has declined $471bn over the past 46 weeks. Asset-backed CP fell another $5.0bn last week (46-wk drop of $447bn) to $748bn. Over the past year, total CP has contracted $390bn, or 18.2%, with ABCP down $412bn, or 35.5%.

So there is a hole roughly $400 billion wide of destroyed credit in the shadow banking system of SIVs and other off-balance sheet entities. That would be pretty tough to fill. And in the immortal words of Ronco "But wait, there's more!" Bloomberg reported yesterday that CDO defaults since October now total 200, with a face value of $220 billion. Given the performance of the ABX and CMBX indexes, it seems safe to value the defaulted CDOs at 50% of face value or less. So add at least $110 billion to that already deep hole of vanishing commercial paper. This is all on top of whatever enormous losses emerge in the official banking sector.

So what new credit is being created to counteract all of this credit destruction? No help from the official banking sector, including the Fed. Back to our friend Doug Noland:

Bank Credit dropped $24.8bn to $9.339 TN (week of 6/18). Bank Credit has now expanded only $126bn y-t-d, or 2.9% annualized.
Fed Credit has increased $1.1bn y-t-d and $27bn y-o-y (3.2%).

There is very little ability to create new shadow credit now that the inherent riskiness of these absurdly complex vehicles has been exposed. A lot of investors are learning the hard way that if you can't understand it, you shouldn't buy it - a lesson that goes all the way back to the Mississippi Company and South Sea Bubbles of the early 18th century. The entire panoply of complex derivative securities is being revealed for the severely under capitalized pyramid scheme that it always was: SIVs, conduits, auction-rate securities, CDOs, CDS, asset-backed commercial paper and more.

The Universal Debt Bubble was a massive confidence scheme but the marks are now wise to the game. A whole new generation of "investors" with no memory of the current scandals will have to grow up before such a thing can be attempted again. We are witnessing the slow-motion collapse of the multi-trillion dollar shadow banking sector. With (commercial) bank credit also beginning to drop and Fed credit nearly stagnant, the supply of credit to support asset inflation is shrinking outright.

Expect more pain across all major asset classes that are typically purchased in highly leveraged transactions.

No Credit for You!

As the Universal Debt Bubble has begun to collapse under its own weight, various portions of the shadow banking sector have come under enormous pressure. These are the non-bank lenders that have magnified a credit bubble into the UDB. Starting last summer, the initial push shattered the most egregiously complex and levered structures - the CDOs. In the Fall of 2007, the conduits and SIVs joined the tankage - along with asset-backed commercial paper, their primary funding mechanism. The worst of the hedge funds have been closing their doors at an increasing rate.

Now we are beginning to see simpler securitized products being shunned as well. From Prudent Bear's Doug Noland:

Asset-Backed Securities (ABS) issuance slowed this week to $3.3bn. Year-to-date total US ABS issuance of $104bn (tallied by JPMorgan's Christopher Flanagan) is running at 27% of the comparable level from 2007. Home Equity ABS issuance of $303 million compares with 2007's $191bn. Year-to-date CDO issuance of $14bn compares to the year ago $217bn.

Over the past year, total CP has contracted $381bn, or 17.9%, with ABCP down $402bn, or 34.8%.

Credit Bubble Bulletin

As I read it, ABS (mostly credit card and auto loans) are down 73% from last year. Securitized home equity is down 99.8%. CDOs have fallen 93%. These were key shadow banking sectors that provided trillion during the last leg as the credit bubble mutated into the UDB. Because the structures were kept off the banks' balance sheets, they almost never had proper reserve structures. With leverage ratios of 30, 50 or even 100:1, the inherent risk was high. At 30:1, your valuation assumptions only have to be wrong by 3% for the whole thing to blow up - as they are now duly exploding.

Any hope that the Fed and other central banks had of keeping the asset bubble intact is fading along with the excess credit that has supported absurd asset prices for so long. The disappearance of the shadow banks is critical to the process of deflating the bubbles. At the same time as this illegitimate source of funding is drying up, the commercial banks are being forced to recognize large losses. Now the banks must lend within the restrictions of their required reserves and capital. At the same time, that capital is being wiped away by losses far faster than it can be replaced.

The math virtually guarantees that there will be a lot less credit available for the foreseeable future. Assets and goods that are dependent on the availability of credit are likely to see sharp further price declines.

A Child's Perspective

The UDB grew until it encompassed virtually all asset classes and nearly every nation around the world. Many markets and countries have now fallen off the former trend but the consequences are just starting. In covering something this large and complex, we tend to use a lot of statistical analysis here at Financial Jenga. But occasionally, a simpler perspective can be really helpful.

I occasionally play babysitter for my young nieces on weekdays and they sometimes overhear my phone conversations with friends and colleagues. Yesterday, they were here and overheard me ranting about the bankers' attempt to get even looser accounting treatment. Right afterwards, the 5 year old said: "Those must be really bad people if they lie so much."

She made me think a bit. We've always known that the only way to offset a bubble bursting is to inflate an even bigger bubble somewhere else. And most of us learned from our parents that if you lie, you'll just have to make up bigger lies to cover it up too. I'd just never made the connection before but a child did.

At the heart of every bubble is a lie, often multiple lies. At a minimum, there is extraordinary mis-valuation and mal-investment. But usually, it is much worse than that - deliberate fraud and orchestrated deception on a large scale. One of the earliest was the South Seas Bubble, which rested on visions of wealth from commerce with exotic countries when in fact there was little basis and certainly no profit from such activities. In much the same way, the tech bubble produced fantasies of fabulous profits from commerce using exotic technologies. Both visions were fed to credulous "investors" by a whole host of con men and by the belief that the herd must be stampeding to rich pastures.

Every bubble has its (many) victims and its villains. The best way to avoid them is to remember something else your parents probably told you: "If it sounds too good to be true, it probably is."

Fed Deception Wears Thin

Two critical events in the last 24 hours:

1) AIG reports an enormous loss
This is very important since insurance is the largest financial sub-sector which does not have access to the Fed's discount window, which has been used to conceal the losses or the various swap programs designed maintain the fraud that some banks are not insolvent. Given that, an honest report from AIG gives us some insight into what the REAL situation looks like in the financial industry and it's not pretty. With the strains imposed on the Fed's balance sheet by their past actions there is essentially zero chance that the insurance industry as a whole will get access.

Yesterday's selloff was triggered by an SEC announcement that greater disclosure would be required in the balance sheets of investment banks. Financials dropped hard. Essentially anything that interferes with the ability of the banks to commit fraud is going to tank the sector since fraud is the only thing between some of them and bankruptcy. The follow through from AIG just reinforces this as the look behind the curtain revealed loses of nearly $8 billion this quarter and there's no end in sight. They will raise $12 billion in new capital and also (weirdly) raise the dividend. So they bought back stock when it was expensive a year or two ago. Now they're selling when it's cheap. Buy high, sell low is not a good way to make money. We saw this trend coming back in November and wrote about it in Tactical Nukes

"Liquidity" has been removed. LBOs of any real size are dead. Instead of buying back shares to reduce the supply, corporations are starting to issue more stock and increase supply just as demand is falling. It looks to me as if the even the tactical bull case has been nuked at this point. The strategic case is long-dead. What is the reason to still own stocks today?

Also they are raising cash but will increase the rate at which they burn it by paying out higher dividends. Hello? Earth to AIG, anybody home?

2) Citigroup to sell half a trillion dollars of assets
$500 billion - that is a big number. Just for perspective, that is twice as large as all of the Fed's uncommitted assets. Like I've said before, Citigroup is too big for the Fed to save and this at least shows that management is taking action to control the damage on their own. For that I applaud them.

The flip side is going to be truly problematic for the financial sector though. Most of the Fed's actions have been aimed at preventing everyone from finding out what these assets are really worth. They've loaned out a bunch of money specifically so that banks could hold the assets instead of selling them - thereby establishing a market price for them. This announcement from Citi indicates that the game of hide the garbage may be over finally. Since the asset base involved is so big, there is no entity on the planet with enough money to allow them to hold on indefinitely. Once market prices for the assets are established, balance sheets across the financial world will have to be adjusted to the new valuation levels. This should result in another big round of writeoffs and losses.

Smaller and more nimble players may choose to get out quickly, before this enormous wave of selling. The selling itself will drive down prices, especially when it occurs on this scale. Just as the buying induced by the credit bubble drove asset prices up. If I were a manager in the banking sector (which thankfully I am not), I would front-run the sale of Citigroup assets so as to get the best price NOW. Sometimes he who panics first, panics best.


My major concerns at this point are where to put my money to keep it safe. The Fed games have ensured that we have little information on which to base our analysis. JP Morgan and Bank of America seem to be the "designated survivors" in the banking sector. Lending directly to the Federal government via Treasuries and small community banks with very high lending standards seem like the only other viable options. I am hopeful the these latest revelations bring the equity indicies back to more rational levels so that we can avoid the severe crash that a sudden recognition event would cause.

Consumer Co-dependency

It appears that the abused average American has finally had enough. Target reported that Christmas sales were very weak and lowered their revenue growth numbers for December quite a bit. Add in the margin pressure from discounting and earnings in that sector should be a mess. The problems seem to be widespread and for once, stocks actually seem to be reacting to obvious fundamental problems. This should really be no surprise at all but sadly, equities have ignored fundamentals for so long that it's a shock when reality intrudes on the feeding frenzy.

Here at Financial Jenga, we've been documenting the many pressures facing consumers for some time now. Housing and mortgage debt were covered in Where to Start? We wrote about the deteriorating employment situation and failure of government statistics to reflect it in Behind the Numbers. The collapse of personal savings and explosion of total household debt was the theme of First Principles. Why is anyone surprised that a consumer sector with no savings, huge debts and fewer jobs would decide that reducing spending the the right course? "When you're in a hole, quit digging" is just common sense.

Of course, common sense has been in short supply for years. Americans have been able to get away with all sorts of foolishness and the banks and other lenders have been their enablers. It is simply human nature to slip into wishful thinking that there really IS a free lunch out there somewhere. Mark Twain once described a banker as "a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain." Former uber-banker and CEO of Citigroup, Chuck Prince pretty much confirmed Twain's characterization back in July when he said:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.

Apparently, Chuck has stopped dancing and wants his umbrella back - except that he's no longer CEO. The reason he's not CEO now is because he waited too long to grab the umbrella and it looks as if he was right that "things will be complicated."

Banks are always willing to lend when they think there's little risk. That doesn't mean they are right in their risk assessment. Consumers have proven willing to borrow as long as they think they can make the payments. They are often overconfident on that front. The confidence of both is being pressured by the weak job market. Banker's willingness to lend is also falling with the value of the loan collateral - especially housing. Consumer confidence faces additional challenges due to higher food and energy prices. They were both wrong to be confident because they confused cyclical and secular economic forces. They also failed to recognize that their own behavior was the cause of the spike in asset prices. They borrowed and lent money used to buy the assets and prices quite naturally rose. Then they all congratulated each other on how smart they all were to "get in on a rising market." Now the prices are falling and the debt will still be the same size.

Consumers have a co-dependent relationship with their bankers - who have enabled destructive behavior for years. It appears that both sides are ready to walk away now that the relationship serves the needs of neither side.

Tactical Nukes

The fundamental case for a bull market died a long time ago and has not terribly sound in a long, given the combination of high valuations, slowing growth and a significant portion of earnings that were an outright illusion. Strategically speaking, the last time the bull case made any sense was in early 2006. That has not prevented tactical factors from pushing an overvalued market still higher in the interim. The primary tactical focus has been "liquidity" which readers of this blog will recognize as simply a synonym for growing debt.

The UDB threw off a tremendous amount of this "liquidity" as debt expanded rapidly. The serial collapse of mortgage finance, CDOs, MBS, asset-backed CP and other debt markets has reversed the flow as outstanding debt/credit shrinks. But how is this affecting stocks, you might ask? Well, there is the obvious collapse of profits in the building and financial sector as well as similar impending action in the consumer sector. But these are indirect effects and failed to knock down the indexes for long until recently.

There is now a much more direct impact on supply and demand for stocks and the financial pressures are affecting both sides of the equation. On the supply side, many distressed financial firms will be forced to issue new equity to bolster their crumbling capital base. Two major sources of "greater fool" demand for stocks have essentially disappeared - leveraged buyouts and corporate buybacks financed with debt. Lenders are no longer willing to finance such foolishness now that it has been exposed as such. The WSJ has this to say:

Driven by billions of dollars in share buybacks, record-setting buyouts and a wave of mergers, the amount of stock in the market shrank by hundreds of billions of dollars in the past four years.

With the supply of stock down and demand strong, the market rallied. Now, as the economy slows and credit markets buckle, high-profile companies are cutting back on buybacks, and some wish they held on to the cash they gave back to shareholders.

The reversal of the trend exposes a flaw in the buyback strategy -- many companies bought high and are selling low.

Big Buybacks Begin to Haunt Firms

"Liquidity" has been removed. LBOs of any real size are dead. Instead of buying back shares to reduce the supply, corporations are starting to issue more stock and increase supply just as demand is falling. It looks to me as if the even the tactical bull case has been nuked at this point. The strategic case is long-dead. What is the reason to still own stocks today?

Sea Change on the Street

Guys, there was a huge change of tone over the last two weeks and especially this week. The denial that has ruled Wall Street for so long is beginning to show major cracks. We're finally seeing grudging admissions that this is a much bigger problem than they were willing to admit. What used to be just a "subprime" crisis is now a "mortgage" crisis.

The terrible reports from major retailers like Pennys, Macys, Kohls and the spectrum of apparel shops along with restaurants like Starbucks, PF Chang, Chipotle, Brinker and Panera are causing the Street to question the "resilient consumer" thesis. They should since it is based on the ability of the consumer to dig themselves into an every deeper hole of debt. But McDonalds and Target did well and Walmart OK. What does it tell you when spending is switching from department stores to discounters and from premium or sit down restaurants to the golden arches?

We don't hear the word "contained" much anymore do we?


Smacking Fannie
Fannie Mae is messing with their accounting to hide rapidly rising losses. They snuck in the accounting change that cut reported losses by almost half. This sort of game has been very common at financial companies in the last few years. They usually get away with it but this time investors noticed and slammed the stock down 20% in just a few sessions. The executives at Fannie must feel like Mike Leach when one of his OLinemen gets called for holding. We're going to see a LOT more of this simply because there is so much out there to find.
More doubts about Fannie Mae's disclosures


Commercial Divers
Next, we get the first real world confirmation that commercial real estate pricing is now falling. Synthetic indexes like the CMBX and credit indicators have been indicating decline for many months. The MIT index covers CRE owned by large pension funds and showed a decline of 2.5% for Q3. That would imply that prices rolled over either during Q2 or early in Q3. Commercial joins residential and commercial construction spending should follow shortly.
MIT index shows first drop in commercial property value since '03

Just incidentally, the subtitle "Indicates housing woes, credit crunch 'may be spreading' " trips one of my pet peeves. There is not a housing crisis spreading to other sectors like a contagious disease. This is more like a genetic heart defect inherited by a group of brothers from the Credit family. One, let's call him "Bob Residential" has a near-fatal heart attack. Another, named "Joe Consumer" is in the hospital for major symptoms but nothing life-threatening yet. "Jim Commercial" and "John Corporate" are having chest pains. The media wants to blame Bob for everybody's problems but the reality is they were all flawed from birth (of the current crop of loans).


Goldman Shocker
Goldman Sachs, which had previously been very bullish, is now calling for $400 billion in direct losses from the crisis in mortgages, plus $2 trillion in withdrawn credit as bank reserves shrink. Well, at least they've got the right number of zeros now but they still fail to account for anything beyond residential real estate.
U.S. could face $2 trillion lending shock

Quote:

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"The macroeconomic consequences could be quite dramatic," Hatzius said in the note to clients. "If leveraged investors see $200 billion of the $400 billion aggregate credit loss, they might need to scale back their lending by $2 trillion."

Hatzius said such a shock could produce a "substantial recession" if it occurred over one year, or a long period of sluggish growth if it occurred over two-to-four years.

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The related article in Forbes made me roll my eyes and mumble "nice job Goldman, what took you so long?" This was obvious to anyone who bothered to do elementary analysis even a year ago. It's also why the Ben Stein's of the world have always been full of it. His "analysis" failed to account for how much the losses would push down the price of everyone else's houses or how the damaged financial system would be forced to cut lending. Duh!
Cost Of The Crunch? $2 Trillion, Says Goldman

Quote:

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In July, for example, Fed Chairman Ben Bernanke put subprime-related losses at $50 billion to $100 billion. "Even at the time, these numbers seemed quite optimistic," wrote Goldman economist Jan Hatzius, in a note Friday. "Now it is clear to most observers that they are far too low."

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So it looks as if the new bull case is huge losses and probable deep recession. Goldman has been a constant cheerleader since they have a lot to lose from this scenario. IMO, they have simply calculated that the loss of credibility from continuing to spew slanted nonsense now outweighs the loss of business if the economy and market fall a little sooner. Make no mistake, they would be extremely unlikely to make such a change unless they felt the events were already on the doorstep.


The Bleeding Edge
Of course, Hatzius at Goldman is just catching up to David Rosenberg at Merrill, who turned quite bearish 6 months. The guys who had this right from the beginning are Paul Kasriel at Northern Trust and a pair of academics - Nouriel Roubini at NYU and Robert Shiller at Yale. Notice that none of them work for investment or money center banks. Earlier, I linked the Bloomberg interview with Morgan Stanley's head of credit strategy, calling for a greater than 50% chance of the credit markets coming to a "grinding halt." The scary thing is that Roubini is now going further and saying the "risks of such a generalized systemic financial meltdown are now rising."
Nouriel Roubini's Global EconoMonitor

This is obviously not something I've foreseen. My expectation has been for severe and widespread losses, with a few major firms failing. Roubini has not yet published his full analysis but I pray that his conclusions are wrong though I will consider them with an open mind. Just as I've prayed that my own conclusions were wrong despite believing in them wholeheartedly. The problems seem inescapable. Hope for the best, prepare for the worst.