The US economic crisis is different. The current credit crisis, more cleverly titled "Dis-intermediation Crisis" by Roubini, is an endogenous and central event emerging from the epicenter of the financial system. The periphery was supported by the inherent leverage and risk taking behavior of the deregulated financial system. In an all out search for yield the Western advanced economy speculators went abroad. The retraction of excessive risk taking behavior has brought us back to the fundamental elements of keeping our own financial house in order...i.e. holding U.S. dollars. This trend is particularly concerning to the authorities. Hoarding cash will be a self-reinforcing feed back process that will further destroy local and foreign economies. Macro-economic systems rely on transaction, credit, trust, confidence, consumption, and earnings. Simply put, the mammoth client in the room (the U.S. consumer) has stopped spending.
The exposure foreign economies have to the U.S. credit scenario will jar the central banks. Countries throughout Eastern Europe, South America, the Middle East, and across the globe have had a rude awakening to their global financial exposure. They will respond. Protectionist measures will prove to be a hard pill to swallow. Foreign economies have clustered industries, expertise, and policies that facilitate global trade. Try telling Brazil (a commodities based export economy) that they need to develop an advanced consumption based economy overnight. It simply will not happen. However, I suspect that surplus economies including the Middle East, China, and Russia will start spending their reserves domestically rather than abroad. Watch for a wave of global infrastructure developments, localized banking systems, and diversification amongst developing nations.
I'm hopeful that foreign measures to self develop will include localized banking regulations and impetus sufficient for broad financial propagation. Global de-centralization may be the unanticipated outcome of unregulated Western centralized capitalism. The tipping point of diffusion has been reached. This process, however, will most likely be seriously regulated. The next cycle of global finance could prove to be more hostile, protectionist, localized, regulated, politically driven, and government sponsored.
Wednesday, November 12, 2008
Sunday, November 2, 2008
Are the credit markets revived?
I've been watching quite closely the unfolding of the current economic crisis and it has been a series of staggering financial events. The core of the problem has been free market excesses that promoted self interest above the overall good. Financial engineering including the invention of structured credit products by JP Morgan in 1995 allowed banks to create off balance sheet credit conduits. Off balance sheet financing created a clear incentive for banks to pump volume rather than quality lending. The volumes were staggering. According to the Securities Industry Markets Association since 2001 more than $27 trillion dollars of structured finance products have been sold.
Issuance for 2008 is substantially lower. As of May 9, 2008 only $204.1 Billion has been issued in comparison to $434.9 Billion in the same period of 2007. Quite frankly, the system of securitization has come to a standstill. Money market managers are now fleeing the market. The only substantial volume left in the market is credit card securitization which is likely to suffer widening default spreads considering its tight correlation to unemployment. The reasons for the fall of structured finance are now well known.... conflicts of interests with rating agencies responsible for tranche categorization, risk managers unwilling to allow their firm to lose fees on trades, and market psychology that assumed housing prices never decline. The more important question is what will follow?
The red hot market concern should be what will replace the current American credit structure? Instead, the Fed is rushing to support the most fundamental money market mechanism that have been severely impacted from the collateral damage of the credit crisis. When I say fundamental market mechanisms I am referring to interbank lending and commercial paper issuance. It is no surprise that an implosion in structured finance has shaken the money markets to their core processes. It was the very nature of structured finance to leverage money markets to their greatest extent possible. In fact, we should all be proponents of structured finance because of its ability to maximize the efficiency of capital.
How will the credit market resolve? Ideally, these structured products become transparent, subject to objective credit quality analysis from truly independent third parties, and exchanged on accessible markets (i.e. NYSE, Chicago Mercantile Exchange, Chicago Board of Exchange). Markit.com offers tranched pricing for asset backed securities. But the quality of the credit is unknown and seriously questioned as evidence of the current pricing. Until the process is standardized and the credit quality of its contents completely understood I fear that structured finance will remain at a complete standstill.
Furthermore, the positive feedback mechanism is in place populating a very negative trend. Less credit, means less consumption, lower earnings, depressed housing prices etc. The wealth effect feeds on itself. As consumers feel the effect of $10.5 trillion being wiped from world wide equity markets in October, you can guarantee that it is not going to be a record holiday season. These lower earnings will perpetuate themselves the same way they reinforced themselves in the boom years. The market is pricing in a 2 year recession, although a nasty one.
In short, I'm not at all convinced that the credit markets have been resolved. In 2006 the US Asset Backed Securities market underwrote an astounding $2.3 Trillion of securitized debt. What will a $13.5 Trillion GDP do when the underpinnings of a $2.3 Trillion credit market evaporate? I suspect, it will decline continually until an innovative and trust worthy credit mechanism is revived.
Issuance for 2008 is substantially lower. As of May 9, 2008 only $204.1 Billion has been issued in comparison to $434.9 Billion in the same period of 2007. Quite frankly, the system of securitization has come to a standstill. Money market managers are now fleeing the market. The only substantial volume left in the market is credit card securitization which is likely to suffer widening default spreads considering its tight correlation to unemployment. The reasons for the fall of structured finance are now well known.... conflicts of interests with rating agencies responsible for tranche categorization, risk managers unwilling to allow their firm to lose fees on trades, and market psychology that assumed housing prices never decline. The more important question is what will follow?
The red hot market concern should be what will replace the current American credit structure? Instead, the Fed is rushing to support the most fundamental money market mechanism that have been severely impacted from the collateral damage of the credit crisis. When I say fundamental market mechanisms I am referring to interbank lending and commercial paper issuance. It is no surprise that an implosion in structured finance has shaken the money markets to their core processes. It was the very nature of structured finance to leverage money markets to their greatest extent possible. In fact, we should all be proponents of structured finance because of its ability to maximize the efficiency of capital.
How will the credit market resolve? Ideally, these structured products become transparent, subject to objective credit quality analysis from truly independent third parties, and exchanged on accessible markets (i.e. NYSE, Chicago Mercantile Exchange, Chicago Board of Exchange). Markit.com offers tranched pricing for asset backed securities. But the quality of the credit is unknown and seriously questioned as evidence of the current pricing. Until the process is standardized and the credit quality of its contents completely understood I fear that structured finance will remain at a complete standstill.
Furthermore, the positive feedback mechanism is in place populating a very negative trend. Less credit, means less consumption, lower earnings, depressed housing prices etc. The wealth effect feeds on itself. As consumers feel the effect of $10.5 trillion being wiped from world wide equity markets in October, you can guarantee that it is not going to be a record holiday season. These lower earnings will perpetuate themselves the same way they reinforced themselves in the boom years. The market is pricing in a 2 year recession, although a nasty one.
In short, I'm not at all convinced that the credit markets have been resolved. In 2006 the US Asset Backed Securities market underwrote an astounding $2.3 Trillion of securitized debt. What will a $13.5 Trillion GDP do when the underpinnings of a $2.3 Trillion credit market evaporate? I suspect, it will decline continually until an innovative and trust worthy credit mechanism is revived.
Saturday, November 1, 2008
All Clear or a Pause in the Deleveraging Trend
The Human mind looks for patterns. It can't help itself. Patterns allow our brain to bundle, classify, interpret, and store an enormous complexity of information. Market psychology is incredibly prone to this mode of thinking. Truly analyzing the data from international finance, currency relationships, inflationary causes or trends, economic fundamentals, etc. will likely puzzle even the brightest minds. Patterns or narratives take the center stage in market psychology. A misapplication of particular patterns can lead to valuations far from fundamentals. Consider the common market psychology from 2000 to present that housing prices always appreciate. Or consider the parabolic rise in oil prices despite the fact that commodity bubbles often are the last to crash in periods of credit contraction. A narrative, a pattern, a synopsis often drive market trends.
The panicked wave of selling that hit all markets (currencies, commodities, equity, emerging markets, leveraged loans, corporate debt, municipal debt, asset backed securities, etc.) in October was quite alarming. The narrative and pattern that has captivated the market is de-leveraging. De-leveraging, is simply a process where highly levered balance sheets sell assets in an effort to reduce their asset to debt ratio. This kind of selling is chaotic and subject to market panic because there is a race to get out as fast as possible considering that everyone knows which direction prices are moving. The narrative is inherently unstable and fearful. The other aspect to this story that the market is well aware of is that a market wide de-leveraging process implies that there is no balance sheet left to buy assets.
I am not arguing that the fundamentals of all market narratives are inherently flawed. Our unique human ability to select the apt pattern is the primary cause for our success as a species. But, when these narratives are shared or mutated within a group, a movement, a market trend, a political movement, or other social contexts they can lead to ridiculous extremes. Case in point genocide.
So when do these extremes resolve or more importantly turn the tides? Typically when the self reinforcing elements of the narrative lose footing. I fear that the self reinforcing nature of the current panic hasn't fully played out. The US government has cleared nearly $1 Trillion dollars of balance sheet, but the US consumer, banks, hedge funds, and municipalities have not been resolved. More scary, is that another wave of selling could be faster and appear more bottomless considering that nearly all central bank efforts have been expended. A narrative of no relief. A narrative of zombie banks. A narrative of Japan's lost decade. A narrative of no lender of last resort. A narrative of defaulting sovereignty and the fall of the American empire. A narrative of selling that cannot be stopped.
The panicked wave of selling that hit all markets (currencies, commodities, equity, emerging markets, leveraged loans, corporate debt, municipal debt, asset backed securities, etc.) in October was quite alarming. The narrative and pattern that has captivated the market is de-leveraging. De-leveraging, is simply a process where highly levered balance sheets sell assets in an effort to reduce their asset to debt ratio. This kind of selling is chaotic and subject to market panic because there is a race to get out as fast as possible considering that everyone knows which direction prices are moving. The narrative is inherently unstable and fearful. The other aspect to this story that the market is well aware of is that a market wide de-leveraging process implies that there is no balance sheet left to buy assets.
I am not arguing that the fundamentals of all market narratives are inherently flawed. Our unique human ability to select the apt pattern is the primary cause for our success as a species. But, when these narratives are shared or mutated within a group, a movement, a market trend, a political movement, or other social contexts they can lead to ridiculous extremes. Case in point genocide.
So when do these extremes resolve or more importantly turn the tides? Typically when the self reinforcing elements of the narrative lose footing. I fear that the self reinforcing nature of the current panic hasn't fully played out. The US government has cleared nearly $1 Trillion dollars of balance sheet, but the US consumer, banks, hedge funds, and municipalities have not been resolved. More scary, is that another wave of selling could be faster and appear more bottomless considering that nearly all central bank efforts have been expended. A narrative of no relief. A narrative of zombie banks. A narrative of Japan's lost decade. A narrative of no lender of last resort. A narrative of defaulting sovereignty and the fall of the American empire. A narrative of selling that cannot be stopped.
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