Credit Crisis

In yet another in our series of taxpayer-funded Federal Reserve research that has achieved so much over the years, the New York Fed blog has released its perspectives on the Tulip-mania bubble of 1633-37. Hot on the heels of SF Fed's Williams comments that bubbles can only be seen in rear view mirror and then of course - and that there's always an exogenous factor to blame' - in the case of tulips, the New York Fed cites "beers" as the catalyst since 'shares' were exchanged in pubs... Ironically then, it seems even 380 years ago, the only thing that mattered was liquidity.

Just as natural selection selects for traits that improve the odds of success/survival in the natural world, Economic Darwinism advances people and policies that boost profits and power within the dominant environment. If there was one phrase that summarized the current malaise, it would be "The Federal Reserve's 20-year policy of easy money created an environment virtually assured to select bankers, bureaucrats, educators, and elected officials who least understood the consequences of a credit crisis." In other words, a hyper-financialized environment of near-zero interest and abundant credit rewarded those people and policies that succeed in that environment.

Despite trillions of dollars of interventions and zero interest rates by the Federal Reserve, combined with numerous bailouts, supports and assistance from the Federal Government, the economy has yet to gain any real traction particularly on "Main Street."  Are we currently experiencing the second "Great Depression?"  That is a question that we can continue to debate currently, however, it will only be answered for certain when future historians judge this period. One thing is for sure.  With the lowest rate of annualized economic growth on record there is a problem currently that is not being adequately recognized. The depression may indeed be on "Main Street" once again with the only difference being that the "breadlines" are formed in the mailbox rather than on street corners. And while many are quick to dismiss comparisons to the Great Depression, there is one important difference: the rate of population growth which, as opposed to the depression era, has been on a steady and consistent decline since the 1950's.

That China faces a number of serious economic (and potentially social) problems is no surprise and as Guggenheim's Scott Minerd notes, trying to predict when persistent structural problems will lead to a shock for markets is extremely difficult (as we noted here). However, from a symbiotic collapse in the previously 'virtuous' bond-market-to-banking-system relationship, to the drying up of easy credit for all but the largest (and least over-capacity) firms, it appears that China's private sector leverage has crossed the tipping point that signalled crises in the US, UK, Japan and South Korea. Although the recent data (believe it or not) show signs of a stabilization in the Chinese economy, the elevated debt burden should continue to cast doubt over its growth sustainability and the "childish" and non-transparent nature of China's bond market offers little or no hope for a free market solution.

Draghi is a clever man in charge of a pretend central bank (for it’s only equipped to fight inflation, not a banking-turned-sovereign-debt-and-unemployment crisis). He must guess that bond investors will soon figure out that a stateless central bank defending a stateless currency is so hamstrung politically that it carries far less firepower than, say, the Federal Reserve has over the US economy and US dollar. If his outright-monetary-transactions bluff collapses, he may well have other tricks ready to suppress yields on struggling sovereign debt and save the euro (without which there is no need for the ECB). If Draghi is out of surprises, he can be thanked for buying time for politicians to come up with durable solutions to the eurozone’s woes. Oh, that’s another flaw with Draghi’s scheme; it removed the pressure for politicians to act. So they haven’t.

There are real-world consequences to over-issuing credit and currency. Eventually this leads to a bidding war for trust: Whose credit/cash will be trusted to retain its purchasing power? There is a grand irony here, of course; as issuers of credit/cash attempt to debase their currency to boost their exports, their debased currency buys fewer real-world resources.

It is well-known that as part of the S&P500's ascent to new records, investor margin debt has also surged to all time highs, surpassing for the past three months previous records set during both prior, the dot com and the housing, stock market bubbles. And as more attention has shifted to the topic of speculator leverage once more, inquiries into the correlation between bets upon bets and stock performance are popping up once more, in this case in a study by Deutsche Bank titled "Red Flag! - The curious case of NYSE margin debt." Of particular note here is a historical comparison of margin-debt warnings that have recurred throughout history but especially just before major stock bubble crashes, such as in the period 1999/2000, 2007/2008 and of course today, which have time and again been ignored. Here is what was said then, what is being said now, and what is ignored always.

President Obama said yesterday that he wouldn't support restoring FNMA and Freddie Mac to the status they enjoyed before the credit crisis, which let Fannie and Freddie make profits during good times, "knowing that if their bets went bad, taxpayers would be left holding the bag." The implications loom large not just for property owners but for investors if there will not be any "implicitly guaranteed" Agencies. For home owners it is likely to mean that their cost of mortgage products will rise and perhaps significantly if this task is left totally to the private sector. We suspect that in times of trouble then no one will lend and the volatility in the housing sector will increase dramatically.

The rapid pace of China credit expansion since the Global Financial Crisis, increasingly sourced from the inherently more risky and less transparent "shadow banking" sector, has become a critical concern for the global markets. From the end of 2008 until the end of 2013, Chinese banking sector assets will have increased about $14 trillion. As Fitch notes, that's the size of the entire US commercial banking sector. So in a span of five years China will have replicated the whole US banking system. What we're seeing in China is one of the largest monetary stimuli on record. People are focused on QE in the US, but given the scale of credit growth in China Fitch believes that any cutback could be just as significant as US tapering, if not more. Goldman adds that China stands to lose up to a stunning RMB 18.6trn/$US 3trn. should this bubble pop. That seems like a big enough number to warrant digging deeper...

Information overload and cognitive dissonance often hide the facts from right under one's nose. Sometimes, as in the case of the following image, a picture paints a thousand words; and in this case, any doubt about where the world's 'most-bust-prone' nations are in the post-crisis new normal should be instantly (and visually) dismissed (as we noted here, here, and here).

Wall Street bankers, Washington politicians, economists and the media trumpet a substantial rebound in the U.S. economy, in the second half of 2013 and beyond, as a result of the Federal Reserve’s continued and open ended use of $85 billion dollars a month in quantitative easing. Learn why this is wishful thinking.  Rather than do want is necessary to solve the ongoing 2008 credit crisis, those in power stoop to public relations tricks and propaganda.

Many high profile investors, economists and companies got burned during China's recent woes. We look at the errors they made and what you can learn from them.

Greed; corporate arrogance; lobbying influence; excessive leverage; accounting tricks to hide debt; lack of transparency; off balance sheet obligations; mark to market accounting; short-term focus on profit to drive compensation; failure of corporate governance; as well as auditors, analysts, rating agencies and regulators who were either lax, ignorant or complicit. This laundry list of causes has often been used to describe what went wrong in the credit crunch crisis of 2008-2010. Actually these terms were equally used to describe what went wrong with Enron more than twenty years ago. Both crises resulted in what at the time was the biggest bankruptcy in U.S. history — Enron in December 2001 and Lehman Brothers in September 2008. Naturally, this leads to the question that despite all the righteous indignation in the wake of Enron's failure did we really learn or change anything?

The heart of any con is winning the trust of the mark, and the heart of counterfeiting is persuading the mark that a facsimile of value is real. What happens when trust in the counterfeiters is lost? What happens when the assets presented as zero-risk lose value? What happens when "the Fed has our back" doesn't stop the stock market from careening off the cliff of a global credit crisis, which is another term for a crisis of faith that the system is as stable and resilient as it is presented? Trust is a fragile creature. It is a most ephemeral yet powerful force. Once lost, it can never be fully regained; it can only be earned back, one step at a time. We are fast approaching the moment when the value of the counterfeit trust, the counterfeit assets and the counterfeit promises are revealed as fakes.

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