By Christopher_Laird | 18 November 2007
Present contraction of credit
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So far, equity markets have barely reflected this turmoil to the degree it should. That is going to rapidly change. Central banks have been doing backflips to stem the crisis, and I think, things are rapidly spinning out of control. They have barely been able to stem a collapse in interbank lending, which would [immediately] halt credit markets. The damage a paralyzed credit system will do to our credit dependent economies is going to be staggering. It would appear that much of the crisis is hidden from view, but the way it will inevitably reveal itself will be in falling corporate earnings, and collapsing consumer and business spending. In a few short months, we will see if I am right. So far, stock markets have not priced in falling earnings that we expect to appear in coming months, as contracting credit markets constrain all manner of spending and investment.
Genesis of collapsing credit
As late as July of this year, a crashing housing market appeared to be something that could be weathered by other growing sectors of the US/Western economies. Then, the inevitable credit dominoes started to fall, after the first one— the mortgage delinquencies— fell. Next we entered a scary August and September world credit crisis, as huge forms of liquidity, formerly seeming of endless supply, rapidly dropped to nothing. That was the securitized credit [mostly subprime mortgage backed bonds/securities, quickly spreading to all MBBs and MBSs] markets.
Rapidly, the emerging losses in securitized credit, from CDOs, MBSs and such (packages of loans such as mortgages sold off as securities and derivatives) caused a cascade of falling confidence in elements of the banking sectors (in particular, the SIVs, which are stuffed with MBSs abd CDOs). The credit crisis spread from the mortgage derivatives markets to the commercial paper markets almost instantaneously (mostly no one wanted to buy the commercial paper offered by the SIVs), after BNP Paribas, France's largest bank, had to freeze redemptions on two hedge funds that had losses in mortgage derivatives. In about a week from that announcement, the entire European commercial paper market froze, as banks were afraid to roll over each other's commercial paper, not knowing who else had $billions worth of exposure to the huge mortgage derivatives market. This was in August.
The credit market damage is so severe that the largest banks in the US are at risk of losing much of their capital. Citibank alone said it needs to raise $30 billion in capital. If the 5 largest banks in the US are already in crisis mode, and other major banks in the EU too, and don't forget Canada, England and so on, things look incredibly negative. And the losses have only just begun to pile up. There [is much] more to come, as we will partly discuss. Bernanke stated that 450,000 mortgages will reset each quarter in the US in the coming year. But this is not all about just mortgage resets and the housing market. This is about the spreading damage to other key sectors of the credit markets.
Since July, the West's commercial paper markets (CP) have contracted by hundreds of $billions worth, as banks and investors refused to roll over CP of 270 days or less maturity. The ECB (European Central Bank), the US Fed, and other western central banks had to step in and offer short term money to cover the shortfalls, or else a massive world banking liquidity crisis would have resulted.
As it is, interbank lending is quite bad, and Central banks have not been able to stop either the continued shrinking of the CP markets, nor the ever increasing losses stemming from a collapse of the securitized debt markets. Central banks have had to step in as lenders of last resort to keep the banking and financial system from imploding, and there is little relief on this front to date. The $75 billion SIV bailouts 'arranged' by the US Treasury department is on again and off again. The key banks involved may not be able or wish to complete it. Citi, for example has to raise $30 billion in capital to cover the mess that has emerged since July.
Next big credit domino
Now, other huge credit markets are about to fall in turn. Next, is the credit insurance market. Credit insurance is an essential part of any credit market. Lenders use credit insurance to help cover the risk of loss when they make loans or buy bonds. Credit insurance is a key component that rating agencies use to assess credit risk of bonds and such; assuming that if any covered bonds default, the credit insurers will pay off.
But, the amount of securitized credit loss is so huge at this time, with losses on CDOs, MBS, and other securitized credit vehicles, that the viability of credit insurers is now in question. Credit insurers will have to start paying off in the next several months. They will be reporting big losses. Their solvency risk will affect the credit ratings of every security they insure.
This means that all the securities these credit insurers insure will be downgraded by rating agencies— if the credit insurer becomes insolvent, or even has solvency problems.
This crisis has spread to Money Market funds. First, many money market funds have a large part of their capital invested in short term commercial paper that provided a slight yield bonus. Since much CP is not rolling over, MMFs are having trouble rolling forward those maturities. Also, some MMFs have invested in securitized debt (mortgage derivatives like MBS and CDOs) or SIV commercial paper, all of which are in some degree of trouble.
I have had readers email me stories of being put off from redemptions from many money market funds since August. These are from major name institutions. I have been told of games like telling people to fill out forms and not executing what people wanted to do in their fund. Those stories still come in as I write this. It is very important that you read the disclosures about your MMFs, and know that these are generally not FDIC insured. The same goes for other nations MMFs and their deposit insurance.
How this crisis develops
First, US mortgages default, Jan to June 07. Second, the credit securities back of them collapse in value July 07 to present. Third, the banks and others holding these have to take huge losses/writedowns. Fourth, those institutions have to raise more capital. Fifth, credit insurers have to pay off (coming in the next several months). Sixth, as they go bankrupt (or near bankrupt), all of the rated securities they insure will be downgraded. Seventh, a new cycle of losses results as the values of the newly downgraded credit securities are marked down.
Finally… here is the rub— banks and such have to slow or stop lending for lack of funds, and you get a system wide contraction or freeze of new credit. We are right in the middle of this part. HSBC, for example, has stated they are going to pull back lending in the US, as they have been badly hit in the mortgage markets. Consider this, and you may anticipate credit contraction in the US increasing across all lenders. As I said, Citi alone stated they need to raise $30 billion of capital to cover losses.
Main source of credit now totally dead
What's more, the cornucopia of credit in the last 5 years, securitized credit, is fast vanishing. As that entire sector becomes discredited, the source of most of the money coming into the world's bubble economies, securitized debt, is drying up.
As banks are forced to raise capital and slow lending, consumers find new credit hard to get or not available at all. The same goes for businesses, so eventually there is a collapse in economic growth. And if no recovery is made quickly, you get a depression. Not a recession, a depression, due to the spiralling collapse of economic demand.
Gold in a real world stock collapse
So far this year, we have had about four world stock sell offs. Gold has sold off in these, but rapidly recovered later. It is not clear how gold will react if we saw a real world stock crash however, on the order of 50%.
Gold showed two types of behavior this year in stock sell offs. The first was a drop as institutions had to cover margins and sold gold to raise cash during stock drops. But, also, at one point in the August-Sept credit crisis, flight to safety caused gold to rise, even in the midst of the stock declines.
So, we know that in this kind of environment, gold has shown resiliency.
That would not likely be the case with other commodities however. In spite of the new paradigm Asia growth model, I don't think Asia will escape major economic contraction should the West have a severe economic recession. Since China is the largest consumer of many commodities, any significant contraction by them will cause commodity prices to plummet. Gold should be less affected because it is seen as a form of money, unlike other commodities.
New Chinese Foreign investment restrictions
Just consider that many Chinese economic sectors have huge overinvestment, and that China just instituted economic restrictions on new foreign investment in many sectors they consider over invested. That being the case, they would not do well if a large part of their export markets contracted, should the west (EU,US, etc) have a severe economic contraction.
Gold right now is in a very speculative phase with a lot of volatility. Japanese speculators are all over it, and it is said that when Japanese speculators get into gold, it is late in that particular bull run.
We at Prudent Squirrel are long term gold bullish, as Western central banks will likely attempt to flood money to keep markets afloat, and are lenders of last resort to the credit/banking system. The US fiscal prospects are terrible in coming years, and we expect gold to be well over $1000 in coming years. The rest of the West, EU, Japan, are not much better off.
However, in the intervening time, if financial markets finally recognize the damage to the credit markets, and consumer spending and corporate earnings finally reflect economic contraction, stocks will fall precipitously. Gold likely would sell off quite a bit initially in that. But longer term, we believe gold is still the best place to have part of your liquidity.
Stocks at this time are presently recovering somewhat, but we feel that the potential for a systemic banking crisis and the contracting credit will soon be reflected in stock markets. So far they have not reflected the severity of the credit situation as much as they should.
The Prudent Squirrel newsletter is our financial and gold commentary. Subscribers get email market alerts mid week as needed. We put out an alert Oct 30 that a general market selloff was imminent. Stocks sold off hard soon after worldwide. So far, we have predicted four major world stock sell offs by up to two days in advance this year. We also predicted the USD was about to bounce in Sunday's newsletter, which it did Monday. The USD is still shaky though.
Normxxx
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