Credit as a Source of Market Instability

Banks are far more speculative endeavors than market prices reflect (perhaps until now). They always have been and could continue to be. Banks are the primary participants of market credit and credit is typically collateralized. Collateral is the speculative fever of the era. Nearly by definition. According to the Webster Dictionary collateral is "property (as securities) pledged by a borrower to protect the interests of the lender". Americans have typically held the majority of their wealth in the speculative collateral of that period. Weren't you in tech stocks in the late 90's, aren't you currently cutting spending to cover your mortgage? Don't blame congress, don't blame speculative sellers, blame the market's tolerance for credit. Credit has been the speculative class that is always revived. Not real estate, not equities, not commodities, not technological innovation.... Credit was extended to the tulip connoisseurs of the mid 17th century, credit was extended to the investors of the Japanese commercial real estate bubble, credit was extended to the "tigers", credit was extended in phenomenal portions to the American working class. Hence the reason why I am surprised that economists say the market will bounce back when housing prices bottom. The market will bounce back when the credit markets find a new source of collateral. And this time, I don't anticipate it will be the average American Consumer.

Fannie and Freddie Bailout: Politics and Financial Implications

Here we are on the cusp of a government led financial bailout for Fannie Mae and Freddie Mac. If credit markets reached a pinnacle of potential massive structural change, now is that peak. Freddie and Fannie are the current mortgage market. With the collapse of the "shadow banking system" Government Sponsored Enterprises are the only firms lending. Where does all of this money come from? Overwhelmingly, the Chinese. The Chinese are the largest buyers of Agency bonds. Agency bonds provide a better rate than T-Bills and they are "Government Sponsored", but not Government backed, I should add. The Chinese investment in US Agency Bonds fueled the housing boom. But now, the boom has gone bust along with the equity of the GSEs. The bonds have severely deteriorated in value, thereby eroding the lender's asset valuations. So how much is needed to bail out these enormous financial institutions? Paulson has proposed a $300 Billion bail out plan. Let me say that again...$300 Billion. Paulson will extend both a line of credit and allow the Treasury to purchase equity in Freddie and Fannie may. Clearly, Paulson's plan created new demand for GSE stock in the midst of a total collapse. A plan, not necessarily a congressional approval is shoring in its own right. I think the US Government lacks the resources for a bail-out of this size. It can lend to the GSEs and continue to pay the Chinese interest on non-performing mortgage backed bonds. I suspect the demand for such bonds will fall sharply considering the public knowledge agency debt is only backed by the Government and not performing assets. As bonds are dumped on the market interest rates will rise as they react inversely to the value of the paper. I see a flight of capital from the US, a continued fall in the dollar, the eventual de-pegging of the Chinese and Middle East Currencies (including the Yuan and Riyal), and higher interest rates as bidding for loans gets more competitive. The question is, where will all of the "conservative" quality capital go?

Securitized Debt Issuance 2006, 2007, 2008

Let's project the current pace of global securitized debt issuance from the first half performance of 2008 until the end of year. According to the July 4, 2008 edition of Asset Backed Securities; $510.3 Billion worth of asset backed securities including Mortgage, Credit Cards, Student Loans, Auto, and others have been issued so far this year. Assuming issuance remains at the same pace for H2 as H1 issuance would total $1.2 Trillion Dollars.

2006 ABS Issuance: $2,600,000,000,000
2007 ABS Issuance: $2,200,000,000,000
2008 ABS Issuance: $1,200,000,000,000 (Extrapolated $510BX2)

Initial estimates for the beginning of the year were far too optimistic as many analyst expected only a 30% decline from 2006 levels (i.e. $1.8T). Clearly, we are in much worse shape.

As far as U.S. Securitized Debt is concerns the figures are as follows:

H1 2008: $113,700,000,000

2006 ABS Issuance: $906,500,000,000
2007 ABS Issuance: $594,200,000,000
2008 ABS Issuance: $227,500,000,000 (Extrapolated $113.7BX2)

Here are some more interesting figures:

2006 U.S. GDP $13,194,000,000,000
2007 U.S. GDP $13,841,000,000,000
2008 U.S. GDP $13,979,000,000,000 (at 1% Growth)

Asset Backed Securities as a Percentage of U.S. Gross Domestic Product

2006: 6.87%
2007: 4.29%
2008: 1.62%

Considering that $679 Billion and $1.4 Trillion of credit has been removed from the US and global market respectively between 2006 and 2008 I expect a dramatic reduction in consumer spending.