Monday, October 13, 2008

It's the Credit Markets, Stupid

To Paraphrase Bill Clinton, “It’s the credit markets, stupid!”

We are in uncharted waters. Never before has there been a total global collapse of the credit markets. Past crashes, such as 1929 and 1907, did not involve instantaneous responses by computer programs and the instant flow of information over the global internet.

It’s always darker better the sun comes out, but we haven’t reached bottom yet. Don’t watch the Dow Jones; watch the credit markets. Credit is the lifeblood our economy. The current crisis is one of confidence, or more precisely, a lack of confidence by creditors.

Creditors lack confidence not in the underlying economy, which is still strong, but in the ability of debtors to repay their debts. Too much leverage, inadequately secured by mortgages is the catalyst. If Bear Stearns, Lehman Brothers and AIG can fail, any company can. Government’s no better off. Indeed, the Country of Iceland is apparently bankrupt as is Vallejo, California. Jefferson County, Alabama (Birmingham) just experienced a near bankruptcy death experience. They are but the first.

European, Russian, and South American markets are in chaos. Banks are failing around the world. Russia, flush with petro dollars, is watching the collapse of its banks, which are already owned by the government

Car purchasers have defaulted on $25 billion in auto loans. Holders of debt issued by Bear Stearns, Lehman Brothers, and WaMu have incurred large losses. Some courts won’t approve mortgage foreclosures and sheriffs won’t enforce evictions. Governments are talking about cramming down mortgages.

Keep in mind that Bear Stearns and Lehman both had liabilities of over $30 for every dollar of capital. Leverage is great on the upside, but devastating on the decline. Lehman further made the mistake of investing long in non-liquid real estate, while borrowing short.

Deleveraging will be painful.

We have lived off cheap credit since the 1990 S&L failures. The Fed partially bailed out banks by driving interest rates down to almost zero. Remember when your passbook savings accounts paid 5%? Now what does your savings account pay?


9% was historically a good rate for mortgages, but after 1990 rates dropped substantially. Cheap money allowed for 0% down, interest only loans as well as subprime loans. 9% will return shortly.

Wall Street may determine our IRA’s, 401K’s and other retirement plans, but the credit market defines our quality of life. No credit, no economy! It's that simple. No mortgages, no home equity loans, no car loans, no inventory financing, no lines of credit, no bridge loans, no bonds, no commercial paper, no payroll loans, no student loans, no credit cards, no factoring, no nothing.

Large lenders, such as insurance companies were willing to purchase somewhat risky bonds and other debt instruments as long as they received insurance for the debts, often in the form of credit default swaps. Thus, if the debtor defaulted, another party would pay off the loans. AIG was one of the large debt insurers. Derivatives jumped from $106 trillion in 2002 to $531 trillion today, a tremendous leap of blind faith in a novel debt instrument.

We don’t even know who the counter parties are to these deals as lobbyists, Alan Greenspan, Robert Rubin, Lawrence Summers and others successfully convinced Congress to bar the SEC from regulating these instruments.

Now that it’s clear that these insurers, including AIG, lacked sufficient reserves to cover defaulting loans, creditors face a double whammy. First, they will lose billions on outstanding loans, crippling their ability to make new loans. Indeed, some large insurers, including Allstate, Metropolitan Life and the Hartford, are rumored to be in cash flow difficulty, and are raising capital. They will not be the last.

Potential lenders, with ample case holdings, are also unwilling, to loan any additional funds to any but the highest credit worthy applicants.

Thus, even governments, such as the State of California, which had little difficulty in the past obtaining bridge loans, can’t find any. It’s looking for $7 billion in revenue anticipation loans until tax receipts come in. That California has been living beyond its fiscal means for years, and just passed another budget held together by smoke and mirrors, does not help its cause.

That the Treasury is considering following London’s lead in acquiring equity stakes in our banks is a revolutionary idea, but truly remarkable is that no one, not even dyed in the wool conservative Republicans, have expressed outrage- so desperate is the crisis.

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