Brace yourself for the insolvency crunch
Tags: Economics, Markets, Insolvency crunch, Subprime crisis
The liquidity crunch is not yet over: the insolvency crunch has hardly begun.
Repercussions will follow for the man on the street
Yes,investors are jumping back into the stock markets, hoping this is justanother routine shake-out - much like February 2007, or May 2006 -before the rally resumes. The `buy-on-dips’ orthodoxy dies hard.
Andyes, speculators have renewed their leveraged bets on the yen and Swissfranc carry trades, borrowing cheap in Tokyo and Zurich to play globalassets. The core belief is that nothing has really changed, that theworld economy is still in rude good health.
Be very careful.Interest rates in Europe and Asia are that much higher now, withdelayed effects starting to bite hard. Japan’s economy has stalled to0.1pc growth in Q2; the euro-zone has slowed to 0.3pc; and China’srefusal to import (by currency manipulation) makes it a drain on worlddemand. Above all, the credit bubble that perpetuated the rally of thelast eighteen months beyond its natural life has definitively burst.
Creditspreads on the iTraxx Crossover (a good barometer of corporate bonds)have ballooned 180 basis points since February. The cost of borrowingfor most firms in Europe and North America has jumped from circa 6.5pcto 8.3pc, if they can get it.
Many cannot. Germany’s Chamber ofIndustry told me yesterday that it had been flooded with distress callsfrom family Mittlestand firms unable to roll over credit lines. InCanada and Australia, junior mining finance has dried up almostentirely.
Global junk bond issuance has been frozen for two months. Fresh sales of collateralized debt obligations – the CDOs of subprimenotoriety: a $1 trillion sold last year - have all but stopped. Bankshave yet to off-load $300bn of debt from leveraged buy-out deals,forcing them to keep the liabilities on their books. They are allsnake-bitten now.
The private equity buy-out premium – whichpushed up the price/earnings ratio on the MSCI-600 of “median” stocksto a record high of 20 in May - has vanished. The P/E ratios on theDOW 30 big stocks are much lower – because they are too big even forthe big cat predators, KKR and Carlysle – but they are not low, giventhe late stage of the cycle. In reality, an earnings bubble andultra-cheap credit have flattered profits.
So no, the world haschanged, dramatically. Whether this means a protracted global downturnand a “profits recession” depends on how quickly the central bankschoose to respond, and how far they are willing to go.
BenBernanke is looking hawkish to me, given the shock of what happened onMonday when yields on 3-month US Treasury notes plunged at the fastestpace ever recorded, a panic flight to safety that no living trader hadever seen before.
Why? Because trust had collapsed to such adegree that players with a lot of cash no longer believed it safe toleave wealth in bank accounts, or the money market funds of brokeragecompanies - (exposed as they are to short-term commercial paper andsubprime CDOs). This did not occur after 9/11, or in the heat of theOctober 1987 crash. Nor did was there such a banking panic in October1929. (it hit in August 1931). If you think this is of no importance,or that this will pass swiftly, you have a strong nerve.
“Whenyou have a run on the money markets like this, it is bound to spillover into the real economy,” said Albert Edwards, global strategist atDresdner Kleinwort.
“We already thought there was a 40pc chanceof a US recession before all this happened, but the risks are now muchhigher and don’t forget that rates on adjustable mortgages will keeprising until a peak next March, so the maximum pain will be in thesecond and third quarters of 2008,” he said
“There will belarge bankruptcies, and liquidity is not going to help because too manypeople bet the farm at the top of the cycle, and they’re now insolvent.A lot more bodies are going to be floating to the surface before thisis over,” he said.
The belief that Europe would somehow beinsulated has been tested over the last two weeks. Two German bankshave required bail-outs on subprime bets – Sachsen LB for Eu 17.3bn,IKB for Eu 8.1bn.
Alexander Stuhlmann, boss of WestLB, confessedthat the German banking system was in a "not uncritical situation".Jochen Sanio, head of the German regulator BaFin, said a few daysearlier that the country faced the worst banking crisis 1931.
Hencethe continued actions of the European Central Bank, which has quietlyinjected 85bn euros in extra liquidity so far this week, almost as muchas it did on the first day of emergency stimulus in early August.
“Banksare still thirsty for credit, and the spreads have been amazing. Thisis not business as usual at all,” said Julian Callow, chief Eurozoneeconomist for Barclays Capital and an expert in the arcane field ofcentral bank operations. (He used to work for the Bank of England.)
Toclarify: the ECB allotted an extra Eu 45bn extra through a `weeklyrefi’ on Tuesday; and then Eu 40bn in a 3-month offer on Wednesday tostop the short-term commercial paper market seizing up.
What weknow is that 146 banks bid for loans on Wednesday, some clearly in suchdistress that they were willing to pay up to 5pc interest – a full 1pcabove the ECB’s benchmark rate.
Just like the dotcom bust: when the US sneezes, Europe catches… you know the rest.
Ina warped sense, one has to admire the cool way that Americans – whosave nothing, in aggregate – tapped into the vast savings pool ofthrifty Germans to finance their speculative excesses, and then leftthe creditors holding a chunk of the subprime losses.
Was itsharp practice, in the same way that foreigners were recruited byLloyds of London in 1986 and 1987 – before the impending asbestoslosses were known – and place like cannon fodder on “spiral syndicates”to absorb crippling losses? (Lloyds denies this occurred).
I amendebted to Randall W.Forsyth from Barron’s for this delicious quotefrom a hedge-fund operator, recounting with disgust what happened thistime in a letter to clients.
'Real money' (U.S.insurance companies, pension funds, etc.) accounts had stoppedpurchasing mezzanine tranches of U.S. subprime debt in late 2003 and[Wall Street] needed a mechanism that could enable them to 'mark up'these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISKTO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!!
"These CDOswere the only way to get rid of the riskiest tranches of subprime debt.Interestingly enough, these buyers (mainland Chinese banks, the ChineseGovernment, Taiwanese banks, Korean banks, German banks, French banks,U.K. banks) possess the 'excess' pools of liquidity around the globe.These pools are basically derived from two sources: 1) massive tradesurpluses with the U.S. in U.S. dollars, 2) petrodollar recyclers.These two pools of excess capital are U.S. dollar-denominated and havehad a virtually insatiable demand for U.S. dollar-denominated debt . .. until now.
Shameless.
