The Sky Has ALREADY Fallen

The Sky Has ALREADY Fallen [¹]

By Ambrose Evans-Pritchard, Telegraph.uk | 25 October 2007

If you are a bear, you must accept that you will always be wrong in polite society, and you will continue to be wrong all the way down to the bottom of recession. That is the cross that bears must bear.

Over the last three months we have seen a rolling collapse of speculative debt and real estate across half the global economy, yet friends still come over to my desk at the Telegraph, with that maddening look of commiseration on their faces, and jab: "so when is the sky going to fall then, eh"?

Well, excuse me. The sky HAS fallen. The median price of US houses has crashed from a peak of $262,600 in March to $211,700 in September. This is an 18% drop nationwide. Yes, the year-on-year slide is still just 4.2%, but that will soon change as the base effect catches up. Merrill Lynch has just confessed to a $7.9bn write down on CDO subprime debt and assorted follies, nearly double what it suggested three weeks ago. This is what happens when a bank values its CDO debt at "mark-to-market" rather than "mark-to-myth", as some of Merrill’s rivals are still trying to do. Merrill’s Q3 loss of $3.5bn has cut the group’s equity capital by a fifth. This has consequences. The bank’s lending multiples will have to shrink. In Britain, we have had the first bank run since the City of Glasgow Bank collapsed in 1878. The Fed has cut the interest rates a half point and vastly increased the pool of eligible collateral for Discount operations. The European Central Bank has injected over €400bn of liquidity in the biggest intervention since the euro was created. Japan is in recession. Housing starts fell 23.4% in July and 43.4% in August. The US dollar has fallen below parity with the Canadian Loonie for the first time since 1976, and to all-time lows on the global dollar index.

All it will take now for a full-fledged rout is a move by the Saudi and Gulf states to break their dollar pegs, which they may have to do to prevent imported US inflation causing havoc; or for the Asian banks to stop buying US Treasuries— as Vietnam, Singapore, Korea, and Taiwan, have gingerly begun to do.

And for good measure, the Bank of England has just warned in its Financial Stability Report that lenders are still in serious trouble, that there is a risk of commercial property crash, and that equities are "particularly vulnerable" to a downturn. It is said there may well be a repeat of the summer crisis, "potentially on an even larger scale."

What more do you want?

It is true that stock markets have once again decoupled from the realities of the debt markets. But they did this in the early summer, when the Bear Stearns debacle was already well under way. They caught up famously in August.

Nobody I talk to in the City credit trenches believes for one moment that the crunch is safely over. Indeed, they think that we are edging back to extreme stress levels, and the longer it goes on, the worse the damage.

Yes, Blue Chip companies can borrow money, but most of them don’t need to do so because they have bloated cash reserves.

Once you go down the chain, the picture changes fast. The iTraxx Crossover index measuring spreads on mid to low-grade corporate debt has jumped 100 basis points or so in the last week to around 360. It costs companies 1.8% more to borrow than it did in the halcyon days of the credit bubble in February, if they can borrow at all.

The ABX indexes measuring subprime debt— those infamous CDO packages of mortgages sliced and diced, and sold to German pension funds and Japanese insurers with a lot of lipstick— are still falling to record lows.

As Goldman Sachs strategist Peter Berezin put it: "It’s the summer that won’t end,"

"We continue to learn that it pays to respect the sell-offs in ABX and housing-related credit. This has elements of the February and August sell-offs, where credit markets signalled problems," he said.

From a par of 100, these indexes have fallen to (depending on the vintage):

AAA grade: 90
AA:        64
A          33
BBB        21

This means that the toxic BBB tier has lost almost four fifths of its value. Even the AA has lost a third.

Now, remember that the total stock of subprime and Alt-A (close kin) debt issued from early 2005 to early 2007 amounts to $2 trillion. Ben Bernanke’s estimate that losses would be $100bn looks wildly optimistic.

Not to labour the point, but three-month Euribor rates are still at 62 basis points over the ECB’s 4% rate. This amounts to a de facto half point rise since the crunch for all those in the euro-zone with floating mortgage rates— 98% of the total in Spain, the biggest property bubble of them all.

Asset-backed security (ABS) issuance peaked at €78bn in March, fell to €52bn in July, €9.8bn in August, €5.6bn in September, and €2.5bn in October. It has died. Banks no longer dare to hawk the stuff of fear of a humiliating rebuff.

As for asset-backed commercial paper in the US, it has contracted every week since August as the lenders refuse to roll over short-term loans. Roughly 25% of the market has been closed down, cutting off almost $300bn of funding for SIVs.

These SIVs (structured investment vehicles) are `conduits’— in City argot— that allow banks to juice profits by speculating off books on high-risk debt. They borrow short (three to six months) to invest long (five years of so), making money on the interest arbitrage. Until the game blows up, of course. Some $370bn still needs to be rolled over, and there lies the rub. The strong suspicion is that Hank Paulson’s $75bn SIV rescue for the big four US banks is intended to cover up the problem by feeding out losses slowly, rather than allowing firesales to cause a cascade. As the Bank of England warned, the Super-SIV should not be used to prop up fictitious valuations.

"It stinks, as does the Treasury’s sponsorship of the scheme. It seems designed to prevent price discovery." says Bernard Connolly, global strategist for Banque AIG.

Connolly says it resembles the slippery practices at the start of the Bear Stearns debacle, when creditors quickly abandoned attempts to force CDO sales by the Bear Stearns hedge funds as soon as they realized that prices were collapsing— exposing the awful truth that hundreds of billions were falsely valued on everyone's books.

Nauseating though Paulson’s M-LEC— `Master Liquidity Enhancement Conduit’— may be, it probably has to be done.

Connolly says the Fed-led pack of central banks have made such a mess of capitalism by blowing credit bubbles (with low rates in the late 1990s and 2003-2006) that they now have no alternative other than to relaunch the "Ponzi Scheme", or risk depression.

This will have political consequences, of course. "The looming threat on the horizon, or just over it, is that the socialization of risk will be accompanied, in many countries, by the socialization of wealth," he said. Indeed. The investors now baying for bail-outs had better be careful what they wish for. Democracy will have its way of making them pay. One recalls the 98% tax rate on dividends in Britain in the late 1970s. Haircut now, or haircut later.

In any case, the Paulson Super-SIV has failed to calm the horses. "This rescue has back-fired. The central banks don’t want anything to do with it. There is a fear that the big four US banks are trying to hide their debts," said Hans Redeker, currency chief at BNP Paribas.

The DOW is down 500 points or so since peaking in early October, and it looks wobbly.

Even so, equities have not begun to reflect the reality that the 2006-2007 credit bubble has popped [[and with it the principal engine of the world economy: normxxx]] and cannot easily be reflated at a time of stubborn, lingering inflation. Spare me the mantra that the "fundamentals" are sound. Credit is the ultimate fundamental.

Woe betide Wall Street if the Fed fails to slash rates dramatically over the Winter, starting on October 31.

Woe betide the dollar if it does.

Normxxx    
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