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). 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.

No comments: