17 January 2009

Credit Bubble bulletin ~ Nolan's analysis

A Divergence:

The 2009 stock market has quickly come face-to-face with the reality that the worst of our banking system’s problems have yet to pass. Today, Citigroup reported an $8.3bn fourth quarter loss, about double what was expected. Bank of America posted a quarterly loss of $1.8bn (its first loss since 1991). In both cases, huge additional governmental support has been required.

The breakup of the great global “financial supermarket” is now moving briskly. Citi management this morning announced a plan to create a new entity (“bad bank”?) to aggregate “non-core” assets. This entity - including Citi Financial, Citi Mortgage, the company’s asset management business and a pool of securities - will account for approximately $850bn of Citi’s $1.95 TN of total assets. The government has directly invested $45 billion in the bank and is now backing $301bn of Citi’s real estate loans and securities.

From Bank of America came the news of additional “emergency” governmental support necessary to consummate the acquisition of troubled Merrill Lynch. The government will inject an additional $20 billion of “capital” into the deal (on top of an earlier $25bn), along with guarantees on an $118bn pool of risk assets (said to include mostly Merrill residential and commercial mortgage-backed securities, and Credit default swaps).

Bill Gross’s current investment thesis “buy what they [the government] buy” seems only to apply to fixed income. In the stock market, investors are scurrying away from the banking sector where it has become apparent that the government will be taking an ever-increasing role in ownership and Credit Policy.

It remains my view that our maladjusted economy is in the earliest stage of what will prove a grueling and protracted adjustment period. And with Wall Street finance incapacitated, there will be no alternative than for the banking system to aggressively expand Credit. In rough terms, Bank Credit will need to expand in the Trillion dollar range (10% growth) this year if there is any hope of stemming depressionary forces and stabilizing the system. The way I see it, system-wide Credit expansion of $2.0 TN or so will likely be required, of which about half will be forthcoming from federal borrowings.

Keep in mind, however, that while Washington stimulus would be expected to support general spending throughout the economy, it will be the almost sole responsibility of the banking system (with governmental support) to extend the necessary Credit to reverse the downward spiral in our nation’s troubled asset markets. This will be no small feat. Yet it may be a case that the banks are today in such awful shape that they have no option but to accept massive federal government aid and, along with it, a likely new mandate to get out and lend. Expect the new Administration to hit the ground running.

Candidly, the current environment presents the most difficult macro analysis of my career. The collapse of Lehman was a seminal event in U.S. and global finance. Overnight, Trillions of Wall Street’s financial claims lost their “moneyness.” Trust in history’s most powerful mechanism of Credit expansion was shattered – and for years to come will remain shuttered. Near- and long-term ramifications are momentous, especially when it comes to the performance of asset markets. But, at the same time, the collapse of the historic Credit Bubble has also granted global policymakers an unprecedented mandate to inflate governmental debt and obligations. The promise of basically unlimited deficits and Credit guarantees is required to shore up the “moneyness” of the core of monetary systems both at home and abroad.

Will these deficits and guarantees be sufficient to stabilize financial and economic systems? What are the inflationary ramifications of such policymaking? How long will the markets so contently accommodate the unmatched expansion of government obligations – and along with it governmental intrusion into all things financial and economic? There is no easy analysis or clear answer. Is the renewed collapse in bank stocks a harbinger of a dramatic worsening of economic prospects? Or could it perhaps be more a case of stock declines discounting future shareholder dilution and other issue related to larger governmental ownership and control?

As gloomy as economic reports and news headlines have been, there have actually been scattered hopeful signs of system stabilization. Corporate debt markets are showing unequivocal signs of life. January is on pace for the strongest month of corporate debt issuance since May. And even the junk bond market is showing a dim pulse. At the same time, municipal debt issuance this past week was the most robust since the Lehman collapse.

It is worth noting that many key debt spreads remain significantly below the levels from the dark days of November. At about 220 bps, investment grade spreads are 60 bps below November highs. Junk spreads narrowed 30 bps this week. And Credit Default Swap pricing for many topping The List of Credit Problem Children – including MBIA, Ambac, MGIC, Sears, GMAC, Ford Motor Credit, and ResCap – are today significantly below the crisis levels from a couple months back.

At 93 bps, agency debt spreads are about half the level of the November spike. Agency long-term borrowing costs have sunk from above 5% during the fourth quarter to today’s 3.25%. It is also worth noting that benchmark agency MBS yields are now below 4.0% after surpassing 6.0% in November. While mortgage rates are no longer the invaluable indicator they were during the mortgage finance Bubble, I don’t want to completely discount them either. There has already been a meaningful jump in mortgage refinancings. I would also expect these rates to somewhat support housing transactions, although the weak stock market and a barrage of job cut announcements weigh further on confidence.

In short, it is not so easy to discern an area of acute systemic crisis commensurate with the pounding taken this past week or so by the banks and financials. I’ll this evening label this dynamic “A Divergence.” It is possible that there is acute stress out there not visible to the naked eye. Perhaps the major banks are in worse shape than they appear. And housing and the economy could be taking additional legs down, although this would be a surprising development considering the current financing environment. The international backdrop remains problematic. And one should assume there are more hedge fund shoes to drop. Reasonable analysis would see speculator de-leveraging and liquidation overhanging the markets for some time to come. So, it’s an especially tough call - and A Divergence that beckons for analytical focus.

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