WRFest 1Mar08(Credit Markets): Credit Contagion, the Fed and Outlook
The elephant in the room is the fundamental breakdown in the structure of the credit markets which is leading to wave after wave off cross-instrument and cross-market disruptions. About the time we think that one set of ripples from a single rock toppling into the credit pond has died down or been contained another and bigger rock (or boulder or ...) topples into and the ripples get bigger and bigger. As you may have gathered it's my habit to softclip interesting stories and keep them around to buildup a timeline. In tracking the credit markets it was really only necessary to track a core, usually Treasuries and the yield curve, because the relationship of those markets was the engine that drove everything else. Now every instrument and every market has its' own unique characteristics depending on how much structure, synthesis, leverage and perversity is embodied in that market. While we don't know the size of the problem or the linkages the best we can project is that it will continue, and we don't have any real clues as to all the myriad inter-connects. Tech guys talk about network structure where everything links to everything else talke about the N-squared problem. In other words it's not just about A <--> B links but A <--> C, C <--> Z, Z <--> who knows.
Earlier this past week we put up a long riff on the nature of this Ebolasized credit contagion which
falls under the heading "Minsky Moment"; unfortunately the N-Squared problem means that there were and are many major Minsky Moments hiding under the covers. You might want to go back and review that because it collected several of the readings from the last several months that provide an in-depth analysis of the situation.[$Trillion Losses: the Minsky Moment Continues].
We also put up another post reviewing how the Fed and the Central Banks are struggline to deal with this and why traditional monetary policy tools are limited. And why and where the breakdowns in the institutional management systems and governance of the financial firms created and are spreading this problem. One could say and defend the label sociopathic malfeasance with a straight face or just leave it at the horrible synergies of greed, arrogance and blind ignorance. Again a post worth reviewing [The Chairman's Testimonies: Listen to What He Really Said].
Now in some ways this all comes together in the multi-part charts (click to enlarge). The first two parts show various rate spreads. A flattening yield curve (FF-10Yr = FedFunds-10Yr Treasuries) shows a slowing economy while the jump in credit spreads (AA-T = 3Mo AA - 3 MoTreasuries) was the result of the credit crisis. Which seems to be getting better. Though the spread in corporate (BASpred=Baa-Aaa spread) shows that some rational risk re-pricing is underway. But while the structural factors are showing short-term improvements that consequences are worsening. The final sub-chart shows the YOY% growth in the inflation-adjusted monetary base. An interesting and rather arcance statistic which shows how much real money/credit/liquidity is out there to keep the economic engine turning over.And that's been negative since last summer as banks and financial institutions started re-thinking the craziness - and look where it's at now.
Barry Ritholz had an interesting riff this week that's worth quoting:
Why the Fed is Compelled to Lie to Congress I had an interesting conversation yesterday about Ben Bernanke's testimony with a person upset over the obvious understatements, spin, and happy talk -- even as the Fed Chair quite soberly discussed the US slowdown. If the Fed were to come clean about the present circumstances, it would cause a market panic. That's why we get this very gradual shift in assessments, all designed to be somewhat reassuring as it slowly feeds measured dollops of reality into the marketplace.
While we agree with the details and analysis of Barry's post we differ slightly on the interpretation, but only slightly. We think, as our earlier post shows, that the Fed is being candid, honest, reasonably accurate and complete. They just aren't phrasing what they're saying so bluntly that any idiot is shocked out of denial. Rather like the doctor telling you that you have cancer and at best a few months. What would your prefer - "wrap it up sucker, it's real bad, it's incurable and you got six months" ? Or "we think you have serious cancer that will be difficult to treat though there are some things we can try that should help. But we'd suggest now might be a good time to put your affairs in order" ? Both are true and accurate but the first is likely to add dysfunction and the last might help you cope as best you can. You don't shout fire in a crowded theatre you start guiding people calmly to the exit. The Fed is doing the best it can to control and palliate and then treat a bad situation it didn't create. But is responsible for coping with.
The first step is to listen to what they're really saying and not escape into denial. Which the readings after the break should help with. Most of them are concerned with particular stories about big new boulders toppling as the result of major tsunamic ripples from prior problems.
Credit Market Readings
More credit costs seen weighing on banks, brokers Analysts at Goldman Sachs cut estimates for the nation's top banks and brokers Monday and said these major institutions would likely report write-downs of between $1 billion and $12 billion for soured real-estate loans and related exposures. Goldman's estimates of new write-downs ranged from $1.4 billion it expects for Bear Stearns Cosall the way up to a whopping $12 billion projected for Citigroup Inc. "Although many of the write-downs in the back half of 2007 focused primarily on subprime and CDOs, we expect first-quarter 2008 write-downs to be spread across all aspects of residential mortgage-backed securities including subprime, Alt-A and prime, commercial mortgage-backed securities and leveraged loans. We forecast first quarter write-downs of approximately $1 billion to $12 billion for each of our large-cap companies across all of these categories," the Goldman analysts concluded. Goldman cut estimates for Morgan Stanley, Merrill Lynch & Co., Lehman Bros. and J.P. Morgan Chase & Co., along with Citigroup and Bear Stearns. Perhaps most notably, Goldman reduced Citigroup's first-quarter profit estimate to 15 cents a share from 40 cents and pared its full-year forecast to $2.50 a share from $2.75 previously. Also Monday, Citigroup's profit forecast was slashed by Oppenheimer & Co. "Our new estimate assumes about $12 billion of additional write-downs across leveraged loans, residential mortgage-backed securities and commercial mortgage-backed securities. We believe write-downs from its asset-backed CDOs will account for the largest percentage of the overall write-down. Citigroup has also been one of the least aggressive in terms of its write-down of these assets, in our view," Goldman's analysts said. Meanwhile, they cut J.P. Morgan Chase's earnings outlook to 70 cents a share from 96 cents for the quarter and to $3.44 a share from $3.70 for the full year.
- The "Warren Buffett rally": What happened? Stocks jumped this week on hopes that Warren Buffett would rescue troubled bond insurers. But after a look at the details, the market fell back. Buffett’s lowball offer to reinsure muni bonds was a bet that desperate insurers will get even more desperate, says MSN Money’s Jim Jubak.
· Forced CDO Sales of $150 Billion Foreseen by RBS From Fitch's Rating Plan Investors could be forced to unwind as much as $150 billion of collateralized debt obligations if Moody's Investors Service and Standard & Poor's follow proposals made by Fitch Ratings on the way it grades the securities, according to a Royal Bank of Scotland Group Plc report. Fitch is considering changing its criteria for CDOs backed by company debt to reflect higher risks of default and lower recovery rates. CDOs that package credit-default swaps, known as collateralized synthetic obligations, may have their ratings cut by about five levels under the proposals, potentially forcing investors to unwind the trades at a loss. ABX: Trending Lower, FDIC Releases Quarterly Report
· Freddie Mac Has Record $2.45 Billion Loss on Housing, Credit-Market Slump
· Deutsche Bank Chief Ackermann Forecasts More Subprime Writedowns by Banks
· UBS sets off market Bank's disclosure of exposure to certain loans leads to frantic moves in mortgage sector. Margin calls at Thornburg
Auction-Rate Bond Failures Saddle States, Cities With `Predatory' Yields determine the rate on more than $45 billion of bonds didn't attract enough buyers last week, according to JPMorgan Chase & Co. research. Even some successful auctions resulted in rates that were twice what borrowers paid in January, as investors who submitted bids demanded higher yields. ``The market right now is very predatory,'' said Marcia Maurer, chief financial officer of the Sacramento Regional County Sanitation District. The agency's weekly expense on $250 million of debt more than doubled to $343,000 from last month. Investors enticed by rates that jumped as high as 20 percent are seeking opportunities in the $330 billion market no longer supported by dealers from Goldman Sachs Group Inc. to Citigroup Inc. and UBS AG that for years committed their capital to prevent failures. Thousands of unsuccessful auctions have driven up taxpayers' borrowing costs and left investors in the securities unable to get their money.
Muni-Bond Yields See Historic Highs Yields on debt from municipalities and other tax-exempt issuers jumped to their highest levels in history Friday as hedge funds were forced to unwind complicated bets and in the process dump billions of dollars of the securities. Months of turmoil in the municipal-bond market, long a placid haven for individual investors, reached a boiling point Friday -- as hedge funds were forced to unwind complicated bets and in the process dump billions of dollars of the securities. As a result of that surprising forced selling, yields on debt from municipalities and other tax-exempt issuers jumped to their highest levels in history, when compared with safe debt issued by the U.S. government. The average AAA-rated, 30-year municipal bond yielded 5.14% Friday afternoon, compared with 4.42% on a U.S. Treasury 30-year bond. In normal times, municipal-bond yields are much lower than Treasurys, because investors don't have to pay taxes on municipal bonds. Typically, municipal bonds are the domain of the retail investors who are attracted by their tax-exempt status. But in recent years, hedge funds and foreign investors have become ever-bigger participants in the municipal-bond market. Several factors are behind the market's current dislocation. Some of these securities are backed by bond insurers -- meaning the insurers guarantee to investors repayment of principal and interest. But the bond insurers -- firms including Ambac Financial Group Inc. and MBIA Inc. -- have been hit by insurance written on subprime-mortgage debt, reducing investors' faith in other debt the insurers back. Hedge funds are a new source of trouble. Many hedge funds made bad bets on the direction of U.S. Treasury bonds in recent weeks. Treasury bonds have rallied because of economic worries, and some hedge funds expected them to sink because of inflation. With the hedge-fund trades going wrong, lenders to the hedge funds demanded capital -- something called a margin call -- forcing the hedge funds to dump municipal bonds to raise money.
FDIC Readies for Bank Failures The Federal Deposit Insurance Corp. is taking steps to brace for an increase in failed financial institutions as the nation's housing and credit markets continue to worsen. The FDIC is looking to bring back 25 retirees from its division of resolutions and receiverships. Many of these agency veterans likely worked for the FDIC during the late 1980s and early 1990s, when more than 1,000 financial institutions failed amid the savings-and-loan crisis. FDIC spokesman Andrew Gray said the agency was looking to bulk up "for preparedness purposes." The division now has 223 employees, mostly based in Dallas. The agency, which insures accounts at more than 8,000 financial institutions, is also seeking to hire an outside firm that would help manage mortgages and other assets at insolvent banks, according to a newspaper advertisement. In public, policy makers are debating what role the government should play in trying to stabilize the housing market and minimize foreclosures. Meanwhile, regulators have worked discreetly behind the scenes to closely monitor the growing number of troubled banks and thrifts considered at risk. Look Under the Banks' Hoods