Australia Leads the Way

The race to the bottom in financial responsibility reached a new milestone today. The Reserve Bank of Australia - their equivalent to the Fed agreed to take asset-backed debt paper as collateral for repo loans to commercial banks. The Wall Street Journal reports this morning:

Banks that may be forced to assume assets from the conduits that have financing coming due could themselves face shortages of capital.

To head off such a problem, Australia's central bank, the Reserve Bank of Australia, has relaxed rules on collateral it will accept for short-term funding. This would enable banks to take more time to evaluate which portions of the asset-backed commercial-paper market are most affected by ailing subprime mortgages.

In doing so the Australians went beyond the Federal Reserve, which doesn't accept such paper as collateral in repo operations but did recently clarify it was willing to accept a wide variety of such paper for its lesser-used, and costlier, "discount window" loans to banks.

Basically, the RBA is willing to accept asset backed paper as collateral for loans now. The Fed will apparently do the same but only at the discount window where distressed banks come to borrow, hat in hand.

Conduits and structured investment vehicles (SIV) enabled banks to move assets off the balance sheet, where they would no longer count against their required capital. By providing these entities with a guaranteed line of credit, the bank was on the hook if investors who normally provide funding got cold feet. Of course, it was assumed that the high times would last forever so such a thing could never happen but naturally it did.

In hindsight, it can be seen that the conduits and SIVs were an attempt to evade the reserve requirements and banking regulations. These things traded on the credit and the good name of the bank but never appeared anywhere in the financial statements. Simply another clever, legalized fraud. Taxpayers should not be on the hook for this sort of gamesmanship.

Behind the Numbers

Today we hear that 4,000 fewer people had jobs in the USA in August than in July. Don't believe that - the losses are much worse than just 4k.

The numbers of losses have just gotten too big for the statistical "adjustments" to hide. The actual employer survey data showed job losses throughout the second quarter and minimal gains in the first quarter. The Birth/Death Model added 120k jobs in August. That is the assumed net addition from startup businesses, less the losses from existing firms folding. Does anybody actually believe that number should be positive instead of negative given the number of small business failures? The actual employer survey showed 124k losses. The reality is likely to be worse than that once the actual net jobs from business startups and failures is measured.

The household survey has been flashing danger even longer. No jobs created since November of last year. August household survey shows 316k jobs lost. The unemployment number stayed flat because they just took nearly 600k people out of the workforce for no apparent reason. The household survey captures people not considered employees - sole proprietors and independent contractors mostly. That would describe a lot of building subcontractors, realtors, mortgage brokers, etc. With what's happening in the housing sector, you should expect large discrepencies for a while as many such people lose their jobs.

August Employment Report

BLS Birth/Death Model

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.

First Principles

Well, it's been one heck of a week. With all of the insanity going on around us, sometimes it's best to take a step back and return to first principles. One of those is the Business Cycle - you know that thing that the Fed has supposedly abolished? The two questions that come to mind immediately are "why did the cycle exist?" and "how did the Fed get rid of it?"


The first one is easy. Economic cycles have existed throughout our history and always will exist as long as emotional humans are making economic decisions. The National Bureau of Economic Research has tracked US economic cycles going back to the mid-19th century. In the immediate postwar period, the cycles became more predictable as the Fed began to regulate them and induce the occasional recession to purge excesses before the market did it for them. During this period, it was discovered that the cycle could be manipulated though not controlled. The typical pattern was roughly three years of expansion, followed by a 12 month recession. The only major exception was the long expansion which lasted through most of the 1960s. The excesses from that one contributed to the really ugly decade that followed - and I'm not just talking about disco and afros for white guys either.

Unfortunately, other than Paul Volcker the Fed seemingly learned little from that experience. After Saint Paul imposed a painful but effective remedy for inflation, his successor Alan Greenspan embarked on a policy of continuous credit expansion. This has "worked" in the sense that economic growth was sustained over a long period, few setbacks were encountered and those were short and shallow. But the price was a crumbling economic foundation. Consumption became the dominant basis of the economy. Consumption growth was funded first with falling savings, then with growing debt. The major collapses in the savings rate came during the 1990s as it fell from 7% to 2% and again after 2002 when it went from 2% to negative.

We essentially outsourced the necessary but burdensome job of saving to Asia. Few economists seem to have drawn any connection between the outsourcing of manufacturing and of savings. Manufacturing requires investment and investment requires savings. It would seem reasonable that the nations which save and invest in the real economy (not just financial paper) would increase their manufacturing and that seems to be the case. The US is left with little savings, heavy debt, bad loans and a weakened manufacturing base. The cycle has not been abolished. It has simply been stretched and distorted beyond all recognition.

Fed Actions and Terrorist Attacks

We are beginning to see severe impairment of credit functions - the fruits of massive and long standing frauds that have recently come to light. By now, many of you are familiar with the 'mark to model' fraud, where the imaginary prices generated by a computer model are preferred over the actual prices which are being paid by actual people - especially when using the former allows firms to report gains rather than the losses they have suffered in reality. With some 'investment grade' paper trading at huge discounts to par, the rating services have a lot of explaining to do. The fee structures for structured finance create serious conflicts of interest.

"S&P, Moody's and Fitch have made more money from evaluating structured finance--which includes CDOs and asset-backed securities--than from rating anything else, including corporate and municipal bonds, according to their financial reports. The companies charge as much as three times more to rate CDOs than to analyze bonds, published cost listings show."

Then there are the garden-variety frauds that occur in every credit cycle and are endorsed or at least accepted by the accountants. Low losses in good times are assumed to be permanent and provisions for losses are small - inflating reported bank profits. This is often compounded by banks which drain their pre-existing reserves to inflate profits further. When combined with loose credit standards, nastiness is practically guaranteed to ensue since the low losses will be followed by very large losses once the weaker borrowers come under pressure. Financial 'innovation' simply adds to the problems since it is nearly always used to take on more risk, not reduce risk.

At the end of a massive credit cycle like the one we have just experienced, financial earnings are wildly overstated, assets are significantly overstated, credit quality is very bad and it is very difficult to distinguish the banks with some troubled assets from those that are insolvent. Under these conditions, it only makes sense to be very cautious when making loans.

Uber cautious lending is exactly what is happening today. Spreads on risky bonds have widened dramatically as investors demand to be compensated for risk again. New issuance of junk bonds has been virtually nil for eight weeks. More ominously, about half of the commercial paper (CP) market seems to be in the process of going away. There is almost no interest in asset-backed CP except at punitively high interest rates. In fact, this market judged the Fed's discount rate cut to be about as useful as a terrorist attack.

"Even the Fed's decision to cut the discount rate that it charges banks failed to revive demand. The rate for overnight borrowing in the asset-backed commercial paper market soared 0.39 percentage points to that price on Aug. 17, the biggest rise since the Sept. 11 terrorist attacks."

The bizarre rally in stocks is especially puzzling in light of the continued deterioration in credit quality and availability. This is way beyond 'whistling past the graveyard' by the equity markets; it's more like cramming fingers in their ears, kicking and screaming "lalalalalala I can't hear you!"

Humpty Dumpty Repair

It appears that the CBs have managed to stave of an immediate disaster in the financial markets - at least for the moment. Yet any hope of a material turnaround in market conditions seems distant indeed. The entire system was built on an ever-rising tide of debt and confidence. Debt served to expand the money supply and confidence ensured that the larger pool of money would move through the economy at accelerating velocity.

Now, fears of default have undermined the willingness to lend and borrow - undermining the psychological conditions necessary to sustain debt growth. At the same time, confidence has been crushed, slowing the headlong rush of money around the globe. The sale of CDOs has fallen dramatically - 35% from June to July. These instruments epitomize both trends; they serve to direct capital into new debt deals quickly while simultaneously taking out loans themselves to leverage the profits from those deals.


Confidence has not merely broken, it is shattered. The Fed and other CBs can do nothing to restore this confidence but that hasn't kept them from trying to put Humpty Dumpty back together again. The massive and fully justified loss of confidence has nothing to do with the Fed; it is in the credibility of Wall Street, housing collateral, ratings agencies, credit derivatives and complex financial structures generally. During the boom, the opaque, complex vehicles didn't matter as everything was going up. As things got shaky, the lack of transparency served as a smokescreen to hide the losses and keep the public in the dark.


As the scale of the problem has come to light, trust and confidence in everyone involved has tanked as it should. They have sustained or abetted a fraud against investors and should not be trusted. Given the reluctance to lend, it's clear that many financial institutions don't trust each other. The Fed can flood the markets with credit to temporarily stabilize the system but they can't undo the series of frauds and resulting rational distrust that has spread through the financial world like a virus.


The alphabet soup of complex and opaque credit derivatives helped to hide the damage for a long time. They continue to mask the full extent of the losses and the identity of the losers. But belated recognition by investors has changed the default setting. Previously, they assumed everything was fine unless specific problems were identified. Now, the problems are known if not truly understood, so the assumption is that risk portfolios are in trouble unless proven otherwise. The lack of transparency that was previously helpful is now a gigantic ball and chain.

It can't be undone now. It will take months to find who is holding all of the toxic waste and how much they are holding. Until then, all financial institutions are guilty until proven innocent. Lending will continue to be frozen by the high risk of losses. Humpty Dumpty can't be repaired even by "all the king's horses and all the king's men."

Legions of the Damned

In Leverage and Its Uses, we discussed the large and growing cohort of companies with shaky credit and bond ratings in the CCC to C range. Many of these firms are effectively bankrupt already, borrowing just to pay the interest on existing debt. Such a practice was only possible in the loose money conditions of the UDB (Universal Debt Bubble), which is now bursting with shocking speed. These companies form one one cohort within the Legions of the Damned.

Today's actions by the European Central Bank and the Federal Reserve cofirm 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.
Central banks move to counter liquidity crunch

Central banks no longer expand the money supply by literally printing currency. They create new money by expanding credit through the financial system - mostly the banks but with other financial institutions playing an increasingly important role. Quasi-banks like hedge funds and CDOs take in money (investments instead of deposits) and use it to fund the purchase of assets, while introducing additional credit in the form of leverage as part of the process. These hedge fund and CDO positions have been used as collateral for further loans, increasing total debt in the system to absurd levels.

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.

We are reverting from this state to more normal relative valuation. As part of that process, the value of cash - as measured by interest rates is rising. The CB action is intended to suppress this normal market mechanism and keep cheap credit flowing. Unfortunately for their plan, market participants have correctly diagnosed this as a last-ditch effort born of panic. The price of money (the interest rate) has risen dramatically in commercial paper, where the free market still largely determines prices.
Commercial Paper Yields Soar to Highest Since 2001

Which brings us back to the Legions of the Damned. The commercial paper market which is tightening up is part of the same bond market that has kept these companies on life support for several years. The same bond market that is refusing to fund risky mortgages and risky leveraged buyouts. The plug has been pulled and the life support is shutting down. Is anyone listening?