by David Stanowski
07 April 2008
There is little doubt that the credit markets are currently in the most serious financial crisis since 1929. They find themselves in this predicament for two reasons: the unprecedented use of leverage, and the creation of a large number of derivative instruments (futures, options, swaps, etcetera) that are not traded on public exchanges.
When highly-leveraged instruments are traded on an exchange, the exchange controls the amount of leverage that can be used, and it marks the positions to market at the close each day. If any positions have moved substantially against a particular trader, he is forced to put up more margin, or close out the positions. This process keeps things relatively "under control".
This use of extraordinary amounts of leverage, and off-exchange derivatives really accelerated after the FED flooded the system with cheap money in 2001-2003, in their attempt to prevent a financial meltdown, in the aftermath of the NASDAQ bubble. However, this move only delayed the inevitable, and made conditions much worse! Things began to unravel quickly, in the summer of 2007, as the housing bubble deflated.
When the stock market reached a "panic bottom" on 16 August 2007, the FED stepped in with the first in a series of moves to lower interest rates, as it had done after the NASDAQ bubble. At first, this action helped traders push the stock market to new highs in October, but they had not addressed the underlying problem.
By this time there was about $500 Trillion in off-exchange derivatives trading world wide that were not being marked to market, so their value was unknown. As the months went by, the derivatives on residential mortgages declined dramatically in value, so that many of the institutions that held them became insolvent.
Rumors that many, if not all, of the so-called investment banks were insolvent swirled as the new year began. On 10 March 2008, the CEO of Bear Stearns appeared on CNBC to tell investors that everything was fine at Bear. However, after the close on 13 March, Bear Stearns called the FED and told them that they were insolvent, and would have to file bankruptcy the next day.
The FED panicked! Normally, the failure of one investment bank would have little impact on the economy as a whole, but the FED was afraid of the one thing that most people did not consider. If Bear went into bankruptcy court, the trustee would have to set a value on all of its off-exchange derivatives in order to liquidate the firm. If these were valued accurately, using a mark-to-market criteria, the holdings at many other firms would be shown to contain dramatic losses, too.
With a nominal value of about $500 Trillion, if these derivatives were marked down just 5%, i.e. $25 Trillion, this would cause a financial tsunami that could swamp the U.S. economy which produces about $13 Trillion of goods and services each year! Since many of the mortgage-related derivatives were known to be under water by 70-90%, the potential fallout was unimaginable!
This is why the FED worked from the first notice by Bear Stearns on 13 March, throughout the weekend until Monday 17 March, to devise a plan where Bear would not have to go into bankruptcy court; it would be "acquired" by J.P. Morgan with a $29 Billion guarantee from U.S. taxpayers. As it turned out, the paper at Bear Stearns was so bad, J.P. Morgan would not do the deal without this guarantee. However, by doing this, the FED acted well beyond their legal authority.
These four days in March were much like a Cuban Missile Crisis in the financial markets. Few knew what was going on, at the time, but as the days and weeks pass, more and more leaks out about how close we came to financial Armageddon! In fact, many of the players testified before Congress that they had to act beyond their legal authority to "save the system".
Unfortunately, unlike the Cuban Missile Crisis, the FED's actions during those four days still did not address, or correct the underlying problems, which continue to persist. We are merely waiting for the next insolvency to force itself into public view.
The best way to monitor the condition of the credit markets is through the use of spreads. This is the difference in the interest rate charged on lower quality debt versus the interest rate charged on higher quality debt. The greater the difference, the greater the risk the market sees.
For many months prior to the 16 August 2007 panic low, in the stock market, the spread between the Bloomberg Corporate Investment-Grade bonds, and their High-Yield bonds was about 2.00-2.50. By 16 August 2007 the spread had risen 58% to 3.56, which confirmed that there was indeed a crisis in the credit markets.
Notice how much worse the crisis has become since the FED "fixed it" in August. That is when they said it was "contained to sub-prime". The spread climbed all the way up to 6.28 on 17 March 2008, when the FED "saved the system". By this measure, the crisis is 76% worse than it was last August! The spread has declined since then, but since the underlying conditions have not changed, this will probably prove to be a temporary respite.
The safest debt in the world is the U.S. Treasury's 13 Week TBill. As traders began to learn why the FED had prevented a Bear Stearns bankruptcy filing, a flight to quality panic began that drove yields down on TBills to the point where they hit 50-year lows on 19 March!
The spreads between TBills and Eurodollars can often best be understood, if considered on a percentage basis, due to the very low interest rates currently offered on TBills. As far back as 1989, this spread had never exceeded 20%, until 2007.
Early in 2007, the spread was less than 10%. As the summer wore on, it moved into the 20-30% range, and finally peaked two trading days after the 16 August stock market low at 80%. The near financial meltdown, just after the Bear Stearns deal, drove the spread to an unprecedented 350%! Since then it has dropped down into the 100% range, but consider where it was one year ago, and its long-term history.
Since the four days in March ended, the debate in the mainstream financial media has centered on the question of whether or not the crisis is over. The problem that most perma-bulls ignore is two fold. First, the FED is the institution that is most responsible for creating the current mess, and yet they have over reached their legal authority to "fix it", and use this as an argument to lobby for even more power. This is hardly good news.
Second, the extreme leverage and Trillions of Dollars worth of off-exchange derivatives are still out there, and they still have not been marked-to-market. Most of the financial world is in a total state of denial, because they simply don't want to face this reality. The FED has consistently ignored these issues, and pretended that what they needed to do was to lower interest rates, and provide liquidity. Interest rates and liquidity are not the problems; solvency is.
The spreads confirm that what we have is a continuing crisis of confidence in the credit markets. The only thing that can restore confidence, quickly, is to force a mark-to-market of all holdings, immediately. However, the FED and the Treasury Department have consistently demonstrated that they do not want to do this, so they will try to drag it out for years, as they did in the 1930's. That worked very well that time, too!
Late last year, the FDIC put in a request for more staff, because they foresee 50-150 bank failures in the next two years, which puts depositors and investors in a tough position. Theoretically, all bank deposits less than $100,000 are "insured", but the FDIC does not have nearly enough money to cover widespread failures. This means that deposits could be "frozen" indefinitely while the government considers a taxpayer-funded bailout.
TBills and TBill-only Money Market Funds remain the best choice for the safe return of principal. Even Money Market Funds that invest in "government agency" paper, such as FHA, GNMA, GSA, Maritime Administration, FNMA, Freddie Mac, Federal Home Loan Bank, TVA, SLMA, and the Federal Farm Credit Bank are now at a much higher risk of default, and should be avoided.
Agency paper as well as corporate bonds and commercial paper, and, of course, private-sector debt related to real estate carries the much higher risk shown by the spreads. High-risk debt has infected mutual funds, pension plans, 401K's, and many insurance products like whole-life insurance and annuities.
With de-leveraging underway, now is the time to save money and reduce debt. Funds that are available to save or invest should be held in only the highest quality paper (TBills), if possible.
The other shoe hasn't dropped, YET.
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