The Credit Markets Get Tighter (Mauldin)

The Credit Markets Get Tighter

While space does not permit, notice that it is not just residential mortgages that have become a problem. Home equity, credit cards, auto loans are all seeing a serious rise in delinquencies and foreclosures. Banks are having to eat into their capital base in order to reserve for growing losses. And that means they have less money to lend. And indeed, every survey I have seen for the past few months points to ever-tightening credit conditions for both business and consumers.

Let's take a few instances to look at what is happening. HSBC has had to take back $45 billion of investments in two Structured Investment Vehicles (SIVs) that it sponsored, called Cullinan and Asscher. Michael Lewitt of HCM writes:

"Moody's Investor Service ('Moody's') reported in early November that Cullinan's net asset value had declined to 69 percent of capital while Asscher's had dropped to 71 percent. HSBC said it does not expect any "material impact" on its earnings or capital strength from this transaction. A senior HSBC official tried to spin the bank's move as one that would "set a benchmark and restore a degree of confidence in the SIV sector." For anybody who is prepared to believe that palaver, HCM would only respond with the adage, "Fool me once, shame on you. Fool me twice, shame on me." There is no confidence to restore in the SIV sector because there is no viable SIV sector anymore. Cullinan and Asscher are a case in point since their assets are being removed from that very sector with this transaction! HSBC's SIVs have more than $34 billion of senior debt according to Moody's, making it the second largest bank sponsor of these ill-begotten vehicles after Citigroup (which is facing the prospect of adding about $40 billion of SIV assets back onto its balance sheet). Some observers viewed HSBC's move as a negative since it meant HSBC would not be participating in the Super-SIV, but HSBC would seem to be doing more than its part by assuming $45 billion of the estimated $300 billion problem."

If Moody's is right, that would suggest there are about $12.5 billion in losses at today's mark to market. While the equity investors in the SIVs will share a potion of that, typically that would be no more than about half the 30% loss, and often a lot less, depending on how aggressively the SIVs were constructed. That would mean anywhere from $7.5-10 billion in losses to HSBC. While the bank can certainly deal with a loss of that size, it will affect the capital structure.

HSBC is a well-run bank. It is not unreasonable to think that there are major losses in the other $255 billion in SIVs. The Super-SIV being put together by Citi, JP Morgan, and Bank of America will take some of that paper, but a lot of the rest is going to end back up on the books of the banks which sponsored them, or investors are going to take serious losses in what they thought was short-term AAA commercial paper.

And it is not just SIVs. A money market fund run by the state of Florida for its various pension funds, county governments, schools, and other government enterprises has suspended redemptions after $27 billion of a 42-billion-dollar fund has been redeemed in just 30 days, as news of problems spread. The fund has invested $2 billion in structured investment vehicles and other subprime-tainted debt, state records show. About 20% of the pool is in asset-backed commercial paper, said executive director of the State Board of Administration, Coleman Stipanovich, this week. "There is no liquidity out there, there are no bids" for those securities.

It was not clear whether the fund started with 20% in asset-backed commercial paper or that was the end result after redemptions. But it does mean there is the potential for large losses. And this is a fund where various governments hold their short-term cash, which will be needed to fund current obligations.

There are similar problems in all parts of the world, from Australia to Norway. Yet another German bank is in serious trouble, after it was thought to have been fixed. The European Central Bank pushed $70 billion (50 billion euros) into money markets on Wednesday, even as lending rates rose to new highs. And from Bloomberg:

"The cost of borrowing dollars for one month jumped the most in more than a decade as banks sought funds to cover their commitments through the start of next year. The one-month London interbank offered rate [LIBOR] for dollars surged 40 basis points to 5.34%." (Thanks to Bill King for sending me the above information.)

Pushing on a String - the LIBOR Conundrum

And that is a major concern, as there is a large disconnect in the market. Notice in the graph below how close a connection there is between the two-year Treasury note and 30-day LIBOR rates. (courtesy again of Greg Weldon, www.weldononline.com)

That is, until recently, as two-year rates have plunged to 3.01% and LIBOR has risen to the above noted 5.34%. This is a major fire alarm, telling us there is something wrong in the building. And what is wrong is that banks are in trouble. And we are not talking just US banks, we are talking about banks all over the world. They are having to bring SIVs and other products onto their books, make provisions for larger losses, and so on. But as Greg points out, the growth in "assets" that came from deposits was only about 10% of the total growth, meaning the rest is loans outstanding.

Where are they getting their capital? Buried in the text of the FDIC report, Greg found this line: "Insured institutions increased their reliance on wholesale funding sources." They are having to borrow money at a much higher level than normal, sending rates up.

The structured security market is in a freeze, which is the funding source for much of the credit in the US and the world for such everyday things as car loans, credit cards, student loans, commercial bank loans, commercial mortgages, and construction. The CLO (mostly bank loans) market is reeling. There is no effective subprime mortgage market. Now, maybe the world settles down after the holidays. But right now, there is nothing to suggest that.

Indeed, Greenspan warned in 2005 of exactly the scenario we are seeing today. He was talking about the rise in housing prices and other assets, and then concluded (emphasis mine):

"Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."

So, even as the Fed cuts rate, the cost of financing and credit is going up. The odds for a 50-basis-point cut at the next meeting are rising with the arrival of each new fire truck.

But what about inflation? If (and it is if) we get into a real debt (credit) spiral, that is hugely deflationary. Massively so. The Fed will once again be facing deflation of a kind that will be far, far worse than what we thought we faced in 2002. This one will be brought on by a deflation in the credit markets.

The Fed needs to act preemptively, and the sooner the better. Remember Greenspan's speech a few years ago, in which he opined that the Fed needed to focus on avoiding the truly dangerous long-term situations rather than smaller near-term problems? The truly dangerous problem is a credit crunch. Lower rates in a credit crunch will be like pushing on a string. Think about Japan in the '90s. Even zero rates did not help.

This current credit crunch has the potential for growing into a full-blown credit crisis, the likes of which we have not seen in the modern world. It is not altogether clear that cutting rates at 25 basis points per meeting is going to do anything to help, if the cost of borrowing does not come down. We are in an entirely different type of crisis than we have ever seen. It is not for certain that the old tools, the fire sprinklers, if you will, will be enough. We may need to adapt to a new, interconnected world.

The real problem is not one of credit or even liquidity, but of confidence in the assets you are purchasing. If you cannot trust an AAA-rated piece of paper in a state-run money market fund, you get very concerned about where to put your money. Until the markets start offering investment products with full transparency and real guarantees for the higher-rated tranches, it is going to be difficult to restart the asset-backed security markets.

(And with credit insurers being threatened with a drop in their credit ratings due to inadequate capitalization for the mortgage guarantees they provided, even insurance is no longer seen as a solid back-up. That is a major fire truck parking next to the building, but one that is being ignored. Talk about a threat to the entire system.)