27 September 2008

Our Financial System is Teetering at the Precipice

For our country's sake, I hope our Washington politicians can work out a mindful financial sector bailout package over the weekend. Not that I am pro-bailout or for government intervention. It's just that our financial system is teetering at the precipice. Last night's federal takeover and “sale” of Washington Mutual, our nation's largest bank failure to date, was yet another major body blow. Confidence has now been shaken so brutally that our policymakers can do little to repair the damage. Yet at this point, stop-gap measures to restrain collapse seem more appealing to me than no measures at all.

The Financial Structure that fueled myriad Credit Bubbles, asset Bubbles, economic Bubbles and overliquefied the entire world is today no longer viable. Wall Street finance is at this point an unmitigated bust, with a few of the “holdout” sectors (i.e. the Credit default market and the hedge fund community) now succumbing. The great Financial Alchemy of transforming endless risky loans into perceived safe and liquid “money”-like instruments has run its historic course. And with risky loans – household, financial sector, business, municipal and speculator – having come to play such a prominent role in the nature of spending and “output”, the near elimination of risky lending will prove a momentous financial and economic development. The U.S. Bubble economy is today in dire straits.

We've reached the point where it has become difficult to secure new borrowing unless one is of quite sound Credit standing. This is the case for individuals seeking to buy automobiles and homes; to afford myriad discretionary and luxury goods and services; to finance educations; or to make the types of big ticket purchases that had been bolstering our Bubble Economy. Lenders are now moving aggressively to cut home equity and Credit card lines. And, importantly, recent developments have significantly tightened Credit Availability for businesses of all sizes. Securitization markets have been largely shut down for awhile now. Now acute stress has incapacitated the money markets.

Unless some dramatic development reverses the current course, it will not be long before a self-reinforcing cycle of company payroll and spending cutbacks takes hold. At the same time, the municipal bond market is in disarray. The economic impact from major cutbacks in state and local government spending will be significant. Today's finance-related economic headwinds are Cat-4 (and gaining) Hurricane Systemic Credit Seizure, compared to last year's Tropical Storm Subprime. Federal Reserve dictated interest rates are extremely low – and the Fed and global central bankers have injected unfathomable amounts of liquidity – yet Credit Conditions have turned the tightest they've been in decades.

Lehman was Major Inflection Point

The Lehman bankruptcy marked a major inflection point in the confidence of contemporary “money.” It was a decisive blow against confidence of money market instruments – the very foundation of our monetary system. “Money” has now tightened significantly for virtually all players that had previously enjoyed cheap short-term financings. This list certainly includes the hedge fund community.

The Lehman bankruptcy also marked a major inflection point in confidence for the various “daisy chain” players involved in intermediating risky loans into contemporary “money.” The market was convinced Lehman was “too big to fail.” Its failure inflicted thousands of market participants with losses – from Primary Reserve Money Fund investors caught with short-term Lehman paper to holders of Lehman's long-term bonds. Investors all over the world were impacted. The hedge fund community suffered mightily. The status of hundreds of billions of derivatives and counterparty obligations was suddenly up in the air or in the hands of the bankruptcy court. And, importantly, huge losses were suffered in the Credit Default Swap marketplace – the marrow of one of history's most spectacular speculative manias.

Trying to add a bit of simplicity to the Complexity of a Credit Market Breakdown, I'll say the Lehman collapse marked a critical inflection point in at least five major respects:

First, the Crisis of Confidence jumped the “firebreak” from risk assets to contemporary “money,” shattering trust in various facets of contemporary finance that were built over decades.

Second, it required the marketplace to reexamine exposures to various direct and indirect counterparty risks, a terminal blow for derivatives markets.

Third, it pushed the Credit default swap marketplace into full-fledged dislocation and instigated a long-overdue regulator onslaught.

Fourth, it decisively burst the “leveraged speculating community”/hedge fund Bubble. This has ushered in another round of problematic de-leveraging and accelerated the reversal of “Ponzi Finance” dynamics.

Fifth, it instilled global fear with respect to the risks of participating in the inter-bank lending market with American institutions.

Basically, the Lehman collapse marked the end of “Wall Street” risk intermediation as a significant component of system financial intermediation. Going forward, Credit growth will be chiefly generated by the banking system, supported by various forms of government backing (Fed, FDIC, Washington bailouts/recapitalizations, etc.), the government-operated GSEs, and various forms of federal government debt issuance. Importantly, this new financial structure will ensure minimal risky lending as well as significantly reduced risk taking. And from a global perspective, I believe newfound fears of lending to the American financial sector marks the beginning of the end of our economy's capacity for trading new financial claims for imports of energy and goods.

Over time the Changed Financial Landscape will have a profound impact on the underlying economic structure. Our economy will have no alternative than to get by on less Credit, less risk intermediation, and fewer imports. In the near-term, the effects will be a rapid and pronounced slowdown our economy's “output.” And while we'll only know over time, I'd bet this new financial structure will allocate much less finance to entrepreneurial activities, productive endeavors and the asset markets – while at the same time providing ample (government-directed) purchasing power to ensure stubborn consumer price inflation.

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