The Credit Crunch is Dead! Long Live the Credit Crunch!

What a difference five weeks makes.

Around the ides of March, we had the mind-focusing spectacle of the possible implosion of Bear Stearns, which was feared to take down a lot of the financial system. But Fed and JP Morgan to the rescue, Lehman presents earnings that depend entirely on accounting rather than business activity, namely, widening credit spreads that made its own outstanding debt worth less, and everything is hunky dory. Oh, yes, UBS announces losses equal to 5% of Swiss GDP, but that too is rationalized as a sign that the Swiss giant has gotten past its bad patch. And while the earnings reports from Bank of America and National City were less than stellar, the Bank of England has thrown in the towel, and following the Fed, will accept £50 billion of mortgage debt as collateral (actually, they are on-upping the Fed; the BoE’s loans have an one-year term). And while critics in the UK say this program won’t revive the housing market, that may not be the point of this exercise.

Most observers have deemed the credit crisis to be over, and are now focusing on such pressing questions as how fast the recovery will be and how bad inflation might get.

Perhaps I am inflexible and unable to adapt to new information, but I don’t see what has been accomplished beyond kicking the can down the road three to nine months. As reader Scott noted:

Basically what’s happened is that we’ve moved bad paper from the banks, where it needed to get marked to market, at least at some point, to the Fed, where that doesn’t have to happen. It’s a sort of out of sight out of mind phenomenon. But all those CDOs and MBS and CLOs are made up of individual mortgages, and of hung LBO loans. They will either be paid off in the end, or they’ll go into default. Assuming, as I think seems right, that some of them default, the Fed will have another line item on its balance sheet, REO. So as I see it, it’s absurd to say the credit risk has been “disappeared”; it’s just been moved from the banks to the public.

Let’s consider just a few unpleasant realities. The Journal today points out that banks are increasing reserves, which means they need more capital (um, guess regulators are riding them to provide for likely losses ex ante rather than when they can no longer avoid taking them). The US consumer at some point is going to have to reduce spending as a percent of GDP; the open question is whether that happens in time to avert a dollar crisis (given the Fed determination to reflate assets and preserve demand, we seem to have an answer as far as the intent of policy is concerned). But then again, as reader Steve pointed out, Fed governor Frederic Mishkin testified before Congress last week that small businesses, the big engine of job growth, are starting to have trouble getting credit (they are heavily dependent on loans collaeralized by real estate and credit card borrowing, both of which are scarce and costly now).

And our old litany of woes has merely retreated from the fore rather than gone away: we still have the monolines almost destined to come apart at some point, the fact (as John Dizard pointed out) bigger GSEs are systemically destabilizing due to their pro-cyclical hedging, the not trivial problem that the housing market won’t bottom till 2010 at the earliest, with more writedowns resulting, and my pet worry, CDS. As I understand it (and better informed readers can chide me if I am wrong), the CDS market basically has to keep growing to stand still. Again, perhaps I am too old school, but with inadequate margining/equity provisions, it seems guaranteed to go into crisis. You don’t get happy endings with ever mushrooming bets on underlying equity that fails to show corresponding growth.

Today, we had the biggest bank fundraising announced to date, RBS’s hugely dilutive £12 billion equity sale (and that’s in addition to £4 billion of asset sales). Reader Steve pointed us to a key item from the press release: the Scottish bank’s writedowns are markedly deeper than those taken by US banks to date, suggesting that the worst is not over on this side of the Atlantic. They have marked their US Alt-As at 50% of face, subprime at 38%, and CMBS at 83%.

Eeek. Steve’s remarks:

{The] RBS summary is damn sobering and is likely the first example of the greater transparency that BOE/Treasury are demanding from UK banks in exchange for the new borrowing facility. RBS may have exaggerated the marks to give themselves wiggle room, since they really can’t go back to the cap markets for a while. But still, the difference from marks at US banks (particularly commercial banks) is sobering and a sign that the crisis is going to drag on `in full opacity’ in the US for quite some time.

With this prelude, we came across some wide-ranging forecasts that we thought we’d share, just in case readers wanted to hear different points of view.

There is one at the Financial Times, which I sadly can’t re-access now (the FT server is not responding) but I believe I can recount reasonably accurately. The gist is that the credit crisis is an Anglo-Saxon, credit markets phenomenon. Neither Asia nor Europe is big on capital market intermediation, hence they will not be affected much, if at all, by the credit crisis. Thus emerging markets will be unscathed, making inflation the far bigger risk.

While the risk of inflation may well be underestimated, I have trouble with the notion that the credit crisis is as contained as the authors suggest. Spain and Germany are seeing more than a wee bit of banking stress; Eastern Europe, my sources tell me, is having a serious real estate contraction which is certain to have an impact on credit availability and the economy. We have reader Scott’s comments on emerging markets, which seem sound to me:

[]n a very broad sense that emerging economies will at some point be stronger than developed ones. But I expect them to suffer a bunch of pain–at least as much, and perhaps more, than we do–before they rebound more strongly than we will. I see China in a more or less analogous spot to where, say, the semi manufacturers were at the end of the tech bubble. They were way down the supply chain, far removed from the ultimate customers, so they didn’t see the slowdown until it clobbered them in the face. In the same way, China’s been building capacity sufficient for a world with limitless credit and capital at its disposal, and we’re now in a world very different from that.

Loyal Prudent Bear readers no doubt caught Doug Noland’s weekly article; I usually prefer the Asia Times version simply because they edit it a tad. Noland is predictably pessimistic; he now thinks we are going to enter an inflationary crisis that will lead to an even more wrenching (but not fully spelled out) ending than if the authorities had not intervened. The whole piece is worth reading, but here are some key bits:

….we live in a unique world of unregulated credit. Excess has evolved to the point of being endemic to an apparatus that operates without any mechanism for adjustment or self-correction. There is, of course, no gold reserve system to restrain domestic monetary expansions. Some years back, the dollar-based Bretton Woods global monetary regime lost its relevance. And, importantly, the market-based disciplining mechanism (“king dollar”) that emerged at times to ruthlessly punish financial profligacy around the globe throughout the nineties has morphed into a dysfunctional dynamic that these days nurtures self-reinforcing excesses.

The “recycling” of our “bubble dollars” (in the process inflating local credit systems, asset markets, commodities and economies across the globe) directly back into our securities markets rests at the epicenter of global monetary dysfunction.

A historic inflation in dollar financial claims was the undoing of anything resembling a global monetary system, and now this anchorless “system” of wildcat finance is the bane of financial and economic stability. To be sure, massive and unrelenting US current account deficits and resulting dollar impairment have unleashed domestic credit systems around the globe to expand uncontrollably. Today, virtually any major credit system can and does inflate domestic credit to create the purchasing power to procure inflating global food, energy, and commodities prices….

….there are reasons to expect this uninhibited global credit bubble to instead run to precarious extremes, and for resulting monetary disorder to become increasingly problematic. Destabilizing price movements and myriad inflationary effects are poised to worsen. The specter of yet another year of near $800 billion current account deficits coupled with huge speculative outflows of dollars is just too much for an acutely overheated and unstable global currency and economic system to cope with.
in the face of a rapidly weakening economic backdrop, global inflation dynamics coupled with our highly maladjusted economy ensure intractable trade deficits. I would further argue that the current inflationary backdrop will prove an impetus to credit creation that then begets only more heightened inflationary pressures.

There are certainly indications that the over-liquefied global system is not well situated today to handle more dollar liquidity (akin to throwing gas on a fire). Inflation and its consequences have quickly become major issues around the world.

With crude hitting a record $117 at the end of last week, there is every reason to expect that newly created global liquidity will further inflate energy, food, and commodity prices generally. The Goldman Sachs Commodities index has gained 21% already this year. But when it comes to monetary instability, our financial markets might just prove the unappreciated wildcard.

When the Fed and Washington radically altered the rules of US finance last month, they placed in jeopardy huge positions that had been put in place to hedge against and profit from systemic crisis. With the end of stage one arises a major short squeeze in the credit, equities, and derivatives markets. And when it comes to contemplating the scope and ramifications of today’s hedging activities, we’re clearly in uncharted waters. It is not beyond reason that a disorderly unwind of bearish credit market positions could incite a mini bout of liquidity, speculation, and credit excess that exacerbates global monetary instability while setting the backdrop for stage two of the crisis.

Last but not least, we have a fact filled, very informative, and somewhat curious piece from the Financial Times, “Road to ruin? America ponders the depth of its downturn.”

The article goes through the cases for whether the US will have a V, U, or L shaped recession. The Fed believes in the V, based on its rate cuts and the stimulus package (gee, when it was proposed, most respectable economists viewed it as costly window dressing), but the “great unknown” is what happens to housing (really?).

What is striking about the piece is the number and range of not-positive views and factoids. A sampling:

Alan Blinder, a professor of economics at Princeton and a former Fed vice-chairman, says the economy will struggle to return to normal growth in the face of “super-headwinds” emanating from the financial sector.

With banks under balance-sheet pressure and the financial system as a whole deleveraging, the credit squeeze on the real economy could continue even after the risk of a systemic crisis in the banking sector recedes.

Moreover, the impact of the tightening to date is only now beginning to be felt in the economy. Richard Berner, chief US economist at Morgan Stanley, who expects a lacklustre recovery, says that “given the time lags between when financial conditions tighten and when it shows up in the economy we still have a long way to go.”….

“The trillion-dollar question is what happens to consumption – is the US household going to rein back its spending?” says Raghu Rajan, a professor at the University of Chicago’s Graduate School of Business. As results from US retailers indicate, the consumer is already pulling back. “But the real question is has it got much further to go?”

Mr Rajan says economists do not fully understand why the savings rate collapsed from the early 1980s, making it hard to be sure at what rate it might rise again. Most explanations suggest some combination of increasing wealth (first from equities, then housing) and financial innovation, which made it easier to access the wealth represented, for instance, by home equity.

Kenneth Rogoff, a professor at Harvard, says US consumer spending would have to adjust following the reversal in house prices, even if there had been no accompanying credit crisis. As things stand, “even if we take away the immediate financial crisis, we are still left with a story where the whole credit structure that propagated the housing boom and credit boom has been seriously compromised,” he says.

Most experts believe the US savings rate will rise as households start to repair their balance sheets, but that this will happen gradually, muting rather than derailing economic recovery. There is a risk, however, that under stress this adjustment could be more abrupt.

Moreover, the longer an economic downturn lasts, the greater the strain on the financial system. The IMF already estimates that losses and writedowns on all debt and securities – not just subprime mortgages – could total $945bn.

Nouriel Roubini, a professor at New York University and chairman of RGE Monitor, an economic research firm, argues that underwriting standards deteriorated across a wide range of credit products during the boom, and that economic stress will result in a sharp rise in defaults and delinquencies on non-mortgage debt such as car loans, credit cards and leveraged loans.

The part I found the most surprising was when it acknowledged that a doomsday scenario seemed less likely given aggressive central bank action, but then started undercutting even that idea:

Policy activism is not a guarantee of success. The US’s large current account deficit increases the risk of a dollar crisis and a sudden pick-up in inflation expectations – a threat that has looked worryingly real at moments in recent months.

Moreover, there are some financial risks – such as multiple ruptures in the credit default swaps market, which banks and other financial institutions use to trade and hedge credit risk with each other – that would be very difficult for the Fed and Treasury to contain even if they wanted to.

The US government is also in a worse fiscal position than it was in 2001, making it harder to sustain an aggressive fiscal policy such as the Bush tax cuts and increased government spending that helped pull the US out of recession last time. Yet the likelihood is that the US – with even its external debts denominated in its own currency – has both the economic capacity and political will to prevent an L-shaped recession taking hold. In an election year, the pressure is for action.

The US should manage to avoid an L-shaped recession – and may even escape with a short V-shaped recession. The danger is that the extreme measures taken – already including the extension of the safety net to investment banks and the loosening of constraints on government-sponsored enterprises to support the housing market – could lay the seeds for the next financial and economic crisis.

If you believe Noland, that next crisis is waiting in the wings.