Cramer's Anniversary: Continuing Credit Metastasis and Economic Outlook
We've crossed the one-year anniversary of Cramer's famous "rant that shook the world" and
despite the amusement factor we need to ask how it played out ? More importantly how is it going to play out ? Aside from watching Mr. Cool loose it completely a deeper amusement can had by contemplating the gap between the catastrophe created by the financial community and their willingness to blame everyone but themselves and look for rescue from the Fed and the government. A rescue necessitated by the catastrophic risks of the complete collapse of the markets and seizing up of the world economy. While Cramer's Rant first brought these "technical" issue to broader awareness the problems escalated from their and are on-going. The saving grace is that the Fed was finally able to find a set of innovative instruments that got the machinery working again - obviously not something they did overnight but had been thinking about for years. As was the Treasury under Paulson. Hats off to both those institutions and their leadership. Nonetheless they've "only" averted collapse - not done away with the need to rework and manage the credit crisis. For your listening pleasure and a look back check out the vidclip.
The point remains that we are barely thru the early part of this re-pricing of risks, de-leveraging and the resulting destruction of specious financial business models and dealing with the vicious feedback cycle between a slowing economy, loan losses, tight credit and more writeoffs. After the break you'll find a short selection of excerpts that reinforce these points - the most important of which is that months after many of us have been shouting out about it and years after the truly knowledgeable began warning the tsunami is beginning...beginning we say...to be apparent more broadly. Here we're going to walk thru several of the elements you need to keep in mind graphically. We do recommend reviewing Red Sky Mornings, Investor Take Warning: More Finance Industry for a discussion of the Finance Industry and its' broken business models.
Loan Situation
The place to start is with the level of activity in loans. The chart below shows the most recent Fed banking activity statistics for several loan types. You might want to read it clockwise starting in the UL where total Loans & Leases plus Loans & Investments are shown on the left with the YoY% change in Loans on the right since 1980, giving you a good view of the cyclic relationships. The UR shows Commercial loans just lipping over, Consumer loans not doing badly and Real Estate loans nose-diving. As we'd expect for the latter. The next two charts show all the major types and the aggregate compare since 1980 and 1998. On our reading a bubble we didn't know about in Business Loans is beginning to pop.
Credit Tightening and Money
A natural consequences of banks drawing down their reserves is that they have much less to lend. Which should in turn be reflected in loans but so far not much. Where it is beginning to show up is in the inflation-adjusted monetary base, i.e. the effective money supply that lubricates the whole massive economic engine. As you can see below, and we've discussed before, real growth in Money has been and continues to be negative. And has been declining rather rapidly for some time. The Fed can lower short-term rates all it wants but markets are markets and will tighten as standards are increasingly tightened. What the Fed can do is keep the wheels from falling off but it can't force them to turn.
The middle sub-chart shows real money growth as -3% while the other charts wrap some bigger picture monetary and rate indicators around it. The top shows various spreads with the 3Mo-Treasury spread showing continued fear and weakness, the AA-Bas commercial spread showing quality fears and the 10Yr-FF spread showing a steeping yield curve. The latter is normally a sign of either inflation fears or a growing economy yet the bottom sub-chart shows inflation and TIP spreads. While headline inflation has been painful the worldwide slowdown is likely to do exactly what the Fed anticipates and lower commodity prices. Hence the TIP spread over non-inflation-protected bonds is around 2.5%. Inflation aint' the problem - fear, uncertainty and doubt are. Otherwise known as a metastasizing credit crisis that continues to be ever-present in the markets.
More Rocks in the Pond
The credit crisis was started by problems in sub-prime mortgages and related synthetic debt instruments but it was just a catastrophe waiting to happen. Now we're beginning to see other problems succumb to the same pressures, starting with Alt-A quality mortgage loans as well as Option ARM resets. Lined up behind those private real estate loans are all the commercial real estate loans, then various consumer and business loans and so on. Consider the graphic below which tries to conceptualize what the continued tremors roiling thru the market mean for more asset class rocks to topple into the credit pond and keep it churning.
As one "rock" toppled it rippled up the entire chain of instruments built by leverage, greed and bad business practices and destroyed the underlying asset base. When the process works in reverse that's de-leveraging. Worse the ripples from one chain's breakdowns immediately spread to other credit markets, even ones that weren't necessarily adjacent in the sense of being technically linked. The Fed's new instruments appear to have prevented these topplings that would turn into a tsunami that drowned all us "innocent" bystanders but hasn't stopped the process. And the reverberations impacted other assets classes, each with their own sub-components, e.g. bonds, equities, etc. We didn't really realize how bad it could be until Bear-Stearns collapsed but now with Merrill and Lehman almost aground on the rocks it's clear what the consequences are.
An Example: Option ARM resets.
Just as one small example consider the next wave when Option ARMs, adjustable rate mortgages where the loanee has the option of deferring part or all of the payment until a cap is reached, are likely to do as they reset. Reset meaning that that rates are going higher so payments will and the expectation is that defaults are going to rise unmercifully. The lefthand shows just resets. And they aren't really going to start hitting until early '09 and then they build and build thru '09, '10, '11 and into early '12. Yet insiders and, now, the financial press are seriously worried about the default levels we're seeing now. The right-hand side shows the increase in payments - and if nothing else - what's that going to do to consumer budgets ? And therefore consumer demand. Recovery, schmovery. Thain was interviewed on CNBC and let slip one telling quote: "if there are not more problems there wont' be any more writedowns and we won't need to raise more capital. but if....". You know the rest.
Ripples and Credit Metastasis
As a closing note we leave you with this graphic which tries to trace some of the links between various instruments coming under pressure, bank writeoffs and the resulting tightening of credit. And then link it back into the economic consequences to establish a feedback process. Yes, judging by the readership stats, you've seen and looked at it before. But if Option Arms are just one tiny piece of a piece in the chart below what happens then ?
The final reading is Jim Jubak's most recent column discussing how Merrill's recent stock sale to raise capital destroyed the investment positions of everybody, especially the multitude of small stockholders, except Temesek. He's right but what's he's forgetting is that without capital MER was going to run aground and nobody would get anything. Put the pieces together - more rocks, more ripples, more write-offs, fewer loans, tighter credit, slower economy. Whaddya get ? And where's that leave MER, LEH, and so on and so on.
READINGS
Long view: Jim Cramer's TV outburst that will last for ages Cramer Day is upon us. This weekend marks the anniversary of former hedge fund manager Jim Cramer's outburst on CNBC that the Federal Reserve was "asleep" and that there was "Armageddon" in the fixed income markets. It was possibly the most entertaining five minutes of financial television ever broadcast. Those who do not work in a Wall Street trading room and have not watched the excerpt repeatedly over the past year, can watch it on YouTube (search for Cramer, Bernanke and Burnett) where it is a popular view. Even for those not amused by the sight of Cramer losing his cool on live television, the incident has significance.The outburst signalled for the first time to the general public in the US that the largely technical problems for the credit market could have serious repercussions for them. A week later, continental Europe woke up to the problems in the money markets when BNP Paribas halted redemptions on money market funds and the European Central Bank intervened. By the end of the month, the UK had its first bank run in more than a century as Northern Rock fell victim to frozen money markets. Reviewing the rant, we can see it set the template for all that followed.
Housing Prices Could Skid Another 33%, Analyst Says Housing prices will fall more than 30 percent before the market recovers and banks will continue their reluctance to lend until the credit crisis clears up, Oppenheimer analyst Meredith Whitney said on CNBC.In a wide-ranging interview, Whitney said the housing deterioration will be worse than even the doom-and-gloom predictions that already have circulated regarding the market. "There's one obvious area where the bad news isn't all out yet, and that's with home prices ... Home prices are going to fall much more than people expect," she said. "I think it's going to be well worse than 33 percent, and here's why: If you look at the futures market, it's indicating a range right around between 2002-2003 levels, when home ownership rates were actually higher, but fewer people can qualify for a mortgage because you've got to put 20 percent down, and that's a lot of money for people," she continued. "Furthermore, then you've got to find a bank to lend to you, because, Countrywide's not lending to you." Video: Click Here to Watch Whitney's Interview
Housing Lenders Fear Bigger Wave of Loan Defaults The first wave of Americans to default on their home mortgages appears to be cresting, but a second, far larger one is quickly building. Homeowners with good credit are falling behind on their payments in growing numbers, even as the problems with mortgages made to people with weak, or subprime, credit are showing their first, tentative signs of leveling off after two years of spiraling defaults. The percentage of mortgages in arrears in the category of loans one rung above subprime, so-called alternative-A mortgages, quadrupled to 12 percent in April from a year earlier. Delinquencies among prime loans, which account for most of the $12 trillion market, doubled to 2.7 percent in that time. The mortgage troubles have been exacerbated by an economy that is still struggling. Reports last week showed another drop in home prices, slower-than-expected economic growth and a huge loss at General Motors. On Friday, the Labor Department reported that the unemployment rate in July climbed to a four-year high. While it is difficult to draw precise parallels among various segments of the mortgage market, the arc of the crisis in subprime loans suggests that the problems in the broader market may not peak for another year or two, analysts said. Defaults are likely to accelerate because many homeowners’ monthly payments are rising rapidly. The higher bills come as home prices continue to decline and banks tighten their lending standards, making it harder for people to refinance loans or sell their homes. Of particular concern are “alt-A” loans, many of which were made to people with good credit scores without proof of their income or assets. “Subprime was the tip of the iceberg,” said Thomas H. Atteberry, president of First Pacific Advisors, a investment firm in Los Angeles that trades mortgage securities. “Prime will be far bigger in its impact.”
FirstFed Grapples With Fallout From Payment Option Mortgages Like many mortgage lenders, FirstFed Financial Corp. is struggling with rising losses. The bank posted a loss of nearly $70 million in the first quarter -- reversing years of profit. Forty percent of its borrowers became at least 30 days delinquent after the payments on their adjustable-rate mortgages were recast. The number of foreclosed homes held by the bank doubled in the second quarter from the first quarter. But FirstFed isn't another bank grappling with the fallout from subprime mortgages that went to less-creditworthy borrowers. In fact, FirstFed was ranked last year as one of the top five banks in the nation by a trade publication, partly because it appeared to have pared back on risky mortgage loans. Yet this year, the Los Angeles bank is on the front lines of what could be the next big mortgage debacle: payment option mortgages. These loans went mainly to people with good credit, but they are likely to experience defaults that are nearly as high as -- in some cases higher than -- those for subprime.Barclays Capital estimates that as many as 45% of option ARMs, as they are often called, originated in 2006 and 2007 could wind up in default. Another analysis, by UBS AG, suggests that defaults on option ARMs originated in 2006 could be as high as 48%, slightly higher than its estimate for defaults on subprime loans. Both studies looked at loans that were packaged into securities.
Only Ben Bernanke Knows When General Mills Sells Credit Like Its Cheerios Before credit markets from New York to London seized up a year ago, investment-grade companies could sell record amounts of debt in days. It took Tyco Electronics Ltd. Treasurer Mario Calastri 12 months to complete the bond sale he began last July. Issuers are paying about the highest borrowing costs since the last recession in 2001, according to Merrill Lynch & Co.'s U.S. Corporate & High Yield Master Index, as the lowest Federal funds rate in four years does little to pump up credit. The bond- market headwinds buffeting companies from Tyco to General Mills Inc. may thwart efforts by Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson to keep the economy out of recession with interest-rate cuts, stimulus checks and increased housing cash. U.S. corporate-bond sales have dropped 11 percent to $640 billion in the past year as the number of issuers shrank almost a third to about 660, according to Bloomberg data. At least 60 borrowers pulled debt sales since credit markets froze, according to data compiled by Bloomberg. The yield gap between companies' debt and U.S. Treasuries soared as high as 421 basis points, the most in almost six years, according to Merrill Lynch's index. Companies are defaulting at the highest rate in more than two years, according to credit-rating company Standard & Poor's.
Credit losses aren't done Merrill Lynch's fire sale of toxic mortgage debt last week has generated hopeful discussion about the beginning of the end of the credit crisis being at hand. But a review of some lesser-noticed events of late suggests that the pain is far from over. For starters, Societe Generale, the big French bank, on Tuesday announced an $890 million write-down for mortgage-related debt in its latest earnings report. The charge comes as the bank shops a big block of mortgage-backed securities known as collateralized debt obligations - described by one participant in the trade as "over $5 billion" - to clean up its balance sheet. SG's total writedowns of subprime mortgage and CDO-related assets have already amounted to about $7.3 billion. Then there's Lehman Bros. (LEH, Fortune 500), which has suffered as much as any Wall Street player from the housing downturn. But now the commercial real estate market is suffering too as economic growth slows to a crawl. And Lehman is a big player there. The New York Post reported last week that the bank is shopping its entire $29.4 billion commercial mortgage-backed security portfolio.
How Merrill trampled the little guys I don't care how cheap Merrill Lynch (MER, news, msgs) shares get. Why would any individual investor in his or her right mind buy even one after the scam that CEO John Thain just pulled? I thought the idea of common stock is that everyone buying a share gets an equal piece of the appreciation, if any, and takes an equal piece of the loss. But Merrill has just paid out $2.5 billion to make one great big shareholder, the Singaporean state investment fund Temasek, happier. At the same time, in order to raise $8.5 billion in new capital -- part of it to pay off Temasek -- Merrill's other investors are going to see their holdings diluted by 38%. So on top of the punishment the market has dished out to Merrill shareholders this year -- the stock was down 49% for 2008 as of the close on July 30 -- Thain has just dished out a 38% haircut. After the deal is done, existing shareholders will own 38% less of the shrunken company.
Comments
Wow has it been a year since the rant heard around the world? That was as good as any a marker for the beginning of the credit crisis. Happy Anniversary.
Posted by: Michael Donnelly | August 6, 2008 09:33 PM