Years of loose monetary policy - not just in the United States - have fuelled a credit bubble that, more so than is generally understood, exposes world economies to substantial risks. These risks are not limited to financial markets. They will spill over into the “real economy”. The subprime crisis is but the first sign of a larger credit crunch and economic crisis.
In essence, the last decade or so of Easy Money has made EVERYTHING more available than it used to be. Liquidity was found at all levels: money, capital, goods, services and consumption…So far, so good; wonderful, indeed. However, the true problem emerges when that liquidity is accessible to all without an adequate price tag attached to it – a justified RISK PREMIUM. The result is MIS-ALLOCATION. When the risk premium is too low, the quality of money allocation DROPS. The quality of capital investment, goods, services, and consumption deteriorates. That is the big picture issue of Easy Money.
Note: This article was originally published in the Mountain Vision Newsletter in early September of 2007. We are posting this article as part of our blog’s “Mountain Vision Classics” series. After all, history might not repeat itself, but it does rhyme. While a few years old, we feel that this article is worth revisiting, as it accurately reflects where we stand today – if anything, once again getting closer to a market meltdown!
As Dr. Konrad Hummler of Wegelin & Co. [Editor’s note: Wegelin, a private bank that no longer exists, one of the victims of America’s “War on Tax Evasion”] asks correctly in his Investment Commentary No. 250: “The question here is: Are risks less serious when they are spread over more shoulders by means of derivatives and the like? Have the ever-greater possibilities to acquire risk – for which one is paid – basically just resulted in a downwards movement in its price, or is there perhaps a mechanism in the system that inherently results in an excessive appetite for acquiring risk?”
The August events are but one symptom of the underlying Easy Money issues, or the tip of the iceberg so to speak. Be assured, the crunching sound of ice, i.e. the screeching sound of stalling credit markets, has been heard by all, loud and clear. To say today that credit markets are frozen is actually an understatement.
At this point, the problem is that nobody will enter a debt transaction that they do not completely understand. While in spring an allocation toward AAA-rated asset backed bonds (more on asset backed securities below) was still a safe decision, doing the same today could quickly end the career of an institutional bond investor if it goes wrong. Buying a problem bond today will be seen as his fault, not merely an unforeseeable event.
The confidence in the overall system is shattered. No longer is the quick and efficient allocation toward securitized debt considered safe and standard business. This does throw a considerable wrench in the wheels of what was widely considered a well-tuned and efficient global money machine.
The Problem with Creating “Wealth” out of Thin Air
A key driver and factor in the creation of “wealth” during the past decade was liquidity. And that liquidity was to some extent the result of so-called credit derivatives. Their creation has added huge sums to financial markets.
As a result, the past 25 years have been a feast for investment bankers worldwide. As new money was being lent into existence out of thin air, huge sums flowed into financial assets of all descriptions. Stock markets boomed, bond markets boomed, and bigger and bigger tranches of “debt obligations” (collateralized or not) composed of the aforementioned credit derivatives of less and less creditworthy borrowers spread like a fungus over it all.
The Potpourri of Credit Derivatives – CDO, CMBS, RMBS, CLO and more…
Obviously, if you are not an investment banker, the myriad of abbreviations recently found in the press may well be confusing. Most people are not familiar with the world of structured finance and, therefore, find it difficult to understand the subprime mess. However, rest assured, you needn’t know it all to understand what’s going on. Here is our attempt to summarize, in plain “Swissenglish”, the core elements and logic of it all.
Once upon a time, investors who wanted a loan to buy a property would go downtown, meet with their banker, and negotiate the terms – face to face. Assuming the investor had the required capital and was considered a dependable counterparty, the papers were signed. The property was pledged and the banker kept an eye on the state and value of the property, while you paid the interest on the mortgage; a simple, clear and arms-length transaction.
This “old way” was arms-length, involving “tangible collateral” and requiring strict, ongoing discipline at selecting and monitoring credit risks. The disadvantage of the old-fashioned way of doing business was in its inefficiency. Contrary thereto, stock markets and currency markets were already being used globally to move large amounts of capital to corporations in an efficient manner.
So, in the early 90’s, a number of investment bankers saw the opportunity to create similarly efficient markets with real estate and other real assets. They created a new type of security called an Asset Backed Security (ABS). Essentially, investment banks would pool a large number of mortgages or bank loans and wrap them into a security. All kinds of securities were created in this manner: Residential Mortgage Backed Securities (RMBS), Commercial Mortgage Backed Securities (CMBS), Collateralized Debt Obligations (CDO), etc.
In order to find buyers for these securities, the investment bankers would go to the well-known and respected rating agencies. They rated tranches of the pools as investment grade (AAA to BBB), non-investment grade and unrated. These ratings were based on the well-established statistics in the credit markets. Long years of experience had provided solid knowledge of typical default rates. These were applied to the pools. Obviously, the unrated grade paid the highest interest and bore the highest risk of default. The highest grade (AAA-rated) provided lower interest but was considered AAA, in other words, SAFE.
The above graph, courtesy of BIS, should give you an idea of the magnitude and complexity of this money game. Over the past few years the latest generation of CDOs was created: synthetic CDOs. These are CDOs of CDOs! You get the picture.
Investment bankers started putting together all kinds of asset-backed paper (emphasis on ‘paper’). Car loans, business loans, credit card debt and more. It worked! Huge banking profits were realized. Debtors were given convenient and quick access to money. And, investors (creditors) were able to benefit from the convenient access to financing. Particularly, institutional investors (including hedge funds) were now able to allocate money toward a new asset class in front of their computer screen. After all, the securities were rated by well-known rating agencies. So, they would mix and match the different securities to fit the specifically sought risk and return profile.
Initially, subprime loans were still made the “traditional” way. The debtor had to prove he had a job. A down payment was required. And, the debtor had to prove he could pay the interest and eventually repay the mortgage. Over the past few years, particularly in America, loan practices changed and debtors were signed up that would not have been considered as counterparties in the “traditional world of lending” - zero down-payment loans and adjustable-rate mortgages (ARMs) everywhere. Meanwhile, the rating agencies were still applying their tested and proven statistics to rate the new asset-backed securities issued.
Generally, around 80% of the pools were rated at AAA! Only a small portion of around 5% would be rated subprime, despite the fact that default rates in the real world were starting to rise. The financial world had in essence been decoupled from reality. This has been going on “unnoticed” for some years. It accelerated over the past 5 years. And now, it has been noticed by ALL! Today, trust in the ratings and the credit industry has been lost.
Obviously, the above explanation is but an oversimplified description of that wonderful easy money world of ABS. However, it should cover what you need to know.
What Happened – A Synopsis of August Events
In August, the credit derivative problem reared its ugly head and worked its way into the commercial paper market. Within weeks, more than US$ 100 billion were lost. On August 16th, the commercial paper market all but shut down.
“The market for US assets has just disappeared”, said Alain Papiasse, Head of BNP Paribas's asset management services division. “Since the start of this week, there are NO PRICES for instruments that carry, directly or indirectly, some types of US assets. The 'contaminant' was and is US assets!”
A market with "no prices" is a DEAD market. On August 17th, the Fed had its back to the wall when the run away from risk began. If the Fed had acted directly to try to rebalance the short-term US Treasury market, it would have put its seal of approval on the perception that ONLY US Treasury debt was “safe”. This would almost surely have caused a broadening sell-off of all other forms of US financial paper. With no willing buyers, such a collapse would have been catastrophic. So instead, the US Fed lowered its discount rate, the interest rate that it charges to make direct loans to banks.
The European Central Bank (ECB) added 211.3 Billion Euros of extra cash to the EU money market between August 9th and August 14th to avert a credit crunch. On August 22nd, the ECB indicated that it may still raise interest rates in September and announced an additional 40 Billion Euro three-month loan to ease lending between commercial banks. This is the key to fully understanding lending between banks.
The People’s Bank of China lifted the deposit rate by 27 basis points and its lending rate by only 18 basis points, a differential, which signaled the bank’s priorities. China lifted its interest rates for the fourth time this year on Tuesday, August 21st in a move underlining the government’s concern over rising inflation, which reached a 10-year high of 5.6 percent in July. The Bank of Japan stood pat on its rate of 0.50 percent, saying that it would not want to roil the international financial markets any further than they already were. But by not raising its rates, Japan is allowing the “carry trade” to continue.
On Monday, August 20th, at the height (so far) of a huge run away from risk, the yield on the one-month Treasury bill fell by 160 basis points to 1.34 percent in early trading. The yield on three-month US Treasury Bills tumbled to 2.51 percent, 123 basis points below Friday’s close. These yields rose in later trading, but the three-month Treasury yield had still fallen by 81 basis points to 3.07 percent by the close of trading.
This one-day fall in three-month Treasury yields almost matched the fall on October 20, 1987, the day the Dow crashed 508 points, when the yield fell 85 basis points. It far exceeded the 39 basis-point fall on September 13, 2001, the day the Treasury market reopened after the 9/11 attacks.
The common sequence of events in times of market crises: Panic leads to a flight to safety into fixed income and government paper. The higher demand pushes down the yields as the prices for fixed income and government paper rise. There was no stock market crash this time, nor was there a terrorist attack. Yet yields on short-term Treasury debt paper had their biggest intraday fall EVER. This is a measure of the magnitude of fear.
The Next Phase of the Credit Crunch
The opposite of any credit expansion is a contraction. This is, or it should be, standard economic knowledge. The greater the credit expansion is, the more significant the subsequent contraction will be. The latest credit expansion we have witnessed was huge. One should expect the subsequent contraction to be too.
A credit expansion of the magnitude we are witnessing today will inescapably lead to large-scale misallocation and, consequently, to a false economic upswing. Later, when loans start failing and lenders start curtailing their lending because of concerns over their own solvency, the result will be a credit contraction, followed by an economic downswing.
The business cycle is always led by the credit cycle - in both directions. In our view, the potential for a substantial credit contraction is real and imminent. Such a contraction would be followed by an unavoidable economic recession or depression. The US Federal Reserve can do what it likes, but if lenders are too scared to lend (because they are worried about their own solvency) and borrowers are too scared to borrow, the US Fed is hamstrung. It can cut any and all interest rates to “zero” and it will still not be able to re-start the US credit expansion machine. The Fed will be PUSHING ON A STRING.
At the Federal Open Market Committee (FOMC) Meeting on September 18th, everyone expects the FED to lower its rates, ideally by 50 basis points. And, they probably will. Markets are already betting on lower rates and therefore more inflation. Gold is already benefiting from the market’s recognition of this fact. As we write, Gold has passed US$ 700!
Not lowering rates would send the fickle stock markets tumbling. The expectation of lower rates, today, is in fact already built into the markets. Wall Street has gotten used to Easy Money. And they count on their hero to provide them with quick fix remedies: Just like taking a Tylenol at the slightest sign of a headache, financial markets crave for a little more liquidity.
Mr. Bernanke is a savvy economist (although he was possibly not so smart to take on Mr. Greenspan’s legacy of bubbles…). He knows that lowering rates will do nothing to cure the true underlying issues. Lower rates will again only postpone the pains just a little longer, possibly. But, on the other hand, should the rates NOT be lowered in the next FED meeting, markets will be disappointed, and they will react accordingly.
For investors worldwide, and Americans in particular, closely watching every little blip on the Dow's screen and gauging their self-confidence by it, the next immediate crisis is programmed. Once again, the FED is tiptoeing on an economic tightrope and faces a dilemma: inflation vs. recession.
Yes, the official line is: “Inflation in the US is no problem.” But, the large past increase in the money supply has led to (now visible to all) price inflation. US producer prices rose by 0.6 percent in July. US food and beverage prices climbed 1.6 percent in July and were up 9.8 percent in the 12 months to July. That was the biggest year-over-year gain since 1995.
Prices of foreign goods imported into the US rose more than forecast in July. The 1.5 percent increase, the biggest since March, followed a revised 0.9 percent gain in June, the Labor Department reported. The US Dollar has fallen more than 10 percent since the beginning of last year against a trade-weighted basket of currencies of major US trading partners. The inverse of a falling currency is higher prices for imports.
As imports climb in price, inescapably, all internal prices also start to climb. But, economic growth in the US has been slowing and the obvious credit crunch is asking for rapid measures. So, it appears that the Fed must choose between greater inflation or immediate market turmoil and recession.