Credit Keeps Contracting–Watch Out For CDS

 

1/15/08

The foundation of the global economy is credit. With unanchored fiat currencies as a base, and an intermediary infrastructure that can instantaneously direct and leverage billions of dollars, euros, or rubles of excess liquidity into speculations and investments ranging from subprime mortgage derivatives to treasury bills, the financial system and the economy rest on the capacity of creditors to lend and the willingness of borrowers to borrow. Every transaction, every price, rests on credit. When credit flows towards an asset class, its price rises; take it away, as we’ve seen with housing, and its price falls.

The situation most analogous to the present credit contraction was the S&L and junk bond crisis of the late 1980s and early 1990s. Then, as now, credit directed towards those assets shrunk as their values declined, economic activity slowed, the stocks of financial firms were hammered, the Federal Reserve lowered interest rates, and a man named Bush was in the White House. After some pain and the government assuming bad S&L debt, we emerged from that downturn and we shall do so this time as well, the optimists argue. However, that argument ignores the history of that time and the severity of the current situation. The federal funds rate was cut 750 basis points, from 10 percent in March of 1988 to 2.50 percent in December of 1991, to keep the economy going and to provide a steep yield curve so that a depleted banking system could borrow short and lend long, replenishing capital. The government socialized $250 billion in write offs on bad debt. Even with such extraordinary measures, fear of economic and financial collapse was widespread. Shades of today, Citicorp traded at a split adjusted $1.39, attracting Arab capital. The economy eventually turned up, but it was a slow, “jobless” recovery that doomed George Bush Senior’s reelection campaign.

The current credit contraction is more severe than that episode. Even after adjustment for inflation, losses in just the subprime sector will exceed those of the S&Ls. Collateral credit damage, or contagion, is also much more extensive. The earlier crisis stayed for the most part confined to the U.S. banking system because bad loans stayed with the banks and S&L’s that made them. The subprime crisis has hit a far wider swath of borrowers, and with securitization and collateralized debt obligations, the associated debt is globally dispersed. As losses have been recognized, capital of lending institutions has been impaired and lending activity has been reduced across all sectors, not just mortgages. The overall economy is far more leveraged now than it was twenty years ago, especially in the consumer sector, where debt service-to-income ratios are at an all time high. A viscous cycle has begun to feed on itself. As lenders cut lending borrowers must cut their borrowing and consumption. Economic activity slows, further diminishing the flow of credit. The latest employment and industrial production statistics confirm the slowing economy and American Express’ report of rising delinquency and default rates for affluent consumers suggests weakness is moving up the food chain.

The failure to recognize the economic centrality of credit has resulted in huge losses and will ultimately result in billions more. People pin their hopes on the Fed, but it took 750 basis points to save the system from that less severe crisis twenty years ago. The current Fed has only 425 left. There’s talk of fiscal stimulus, but even making the heroic assumption that democrats and republicans can set aside their differences and adopt a package, it will probably be too little, too late. The recession may already be here, and the same crowd who never saw the subprime crisis coming until it arrived, who then assured us it would stay confined with no larger financial system ramifications, and then assured us that those unseen ramifications would have no economic impact, are now telling us we might see a quarter or two of slow growth, but by the second half of this year things will be hunky dory.

If the foundation of a house is undermined, don’t expect the damage to be confined to a few rooms. The two quarters and done forecast is the kind of wishful thinking, fantasy actually, which pervades financial markets. Bank of America, hailed last fall for putting $2 billion into Countrywide at $18 a share, is again hailed for averaging down at $7 and change and buying the entire company. How is paying $4 billion for a company likely headed towards bankruptcy smart? MBIA borrows at 14 percent to preserve its AAA. How can an entity that must pay almost a thousand basis points over benchmarks be AAA?

Our award for the biggest fantasy is the entire credit default swaps, or CDS, market. This $45 trillion market, bigger than the U.S. housing and bond market combined, is the ultimate repository of credit risk. A CDS allows the purchasing party to insure against a default by the issuer of an underlying credit obligation. Both corporate bonds and CDO’s are insured in the CDS market. The basis point spread on the CDS is the cost of insurance, and spreads rise as an issuer’s credit quality deteriorates. If the underlying instrument goes into default, the CDS seller pays the buyer the par amount that has been insured. The interesting feature of this market is that while buyers of the insurance require sellers to post increased collateral against their obligation as the spread widens, nobody is required to set aside reserves against potential defaults.  The risk that a seller of insurance can’t make good is called counterparty risk. Structured Credit Company wrote default protection on $5 billion worth of credit risk with just $200 million in capital. It couldn’t make good and last month settled with its counterparties—the usual Wall Street players, for five cents on the dollar. Pimco’s Bill Gross recently estimated that counterparty losses in the CDS market will be about $250 billion if the corporate default rate merely trends to normal from its current abnormally low level. If the recession is severe the default rate will be far higher than normal. At $45 trillion, the systemic risk posed by CDS has the potential to be far greater than that of subprime, and the CDS market is our leading candidate for a 2008 credit blow up. We continue to see the glass as half empty—not because we’re congenital pessimists but because we’re inveterate realists. Be very careful; it’s dangerous out there.