Dec

15

Gordon HaaveWhat is a credit crunch?  At least in simplistic terms, one would think that it is a situation where credit is hard to come by.  Yet, per this graph prepared by the St. Louis Fed, bank lending is holding up just fine, despite a brief dip a few months ago. Yet, we hear constantly about a credit crunch, and the difficulty in borrowing money.

Let me explain something very, very clearly: If you put a lot of money on your credit cards, and default on them, you are going to have a hard time borrowing money shortly thereafter. That is not a credit crunch. Similarly, if you borrow a lot of money in order to lend to unworthy credits, you are going to have a hard time borrowing money shortly thereafter. That is not a credit crunch, it is the most basic works of a free market system, where capital is moved rapidly from productive uses to non-productive uses.

The capital markets have realized that it was a mistake to allocate vast amounts of capital to SIVs and hedge funds who added no value, but merely leveraged up loans to risky borrowers and/or sliced up assets a million different ways and passed them around in a daisy chain, while adding on a huge fees for their "genius".

Their losses have caused dislocations in the credit markets, and there me be worse things yet to come.  But, entities that don't actually add any value in the world should have a hard time borrowing money, that does not mean there is a credit crunch.

Alston Mabry explains:

A credit crunch is when I have trouble covering my action.

Anything else is natural market forces, clearing prices, etc., etc.

Russ Humbert writes:

While agreeing with much of what Prof. Haave said, there is a credit crunch of sorts, a loss of confidence in the rating agencies. A quick look at the investment grade ratings credit spreads confirms this. Going from year lows OAS spreads of 33, 54, 74, 104 for credits AAA, AA, A to Baa. (9 year lows ); Jumping to 84, 153, 179, 222 at end of 11/30, with AA reaching record spreads; higher than 2000 and 2002. The AA to Baa spreads seem to be moving in parallel while this occured. Hence rather than simply fleeing from poor credit, the risk premium has increased for most of the investment bonds equally. It would be as if, in your analogy, many deadbeats found how to sneak in an raise themselves to a very high FICO score — ruining your high credit rating.

Ken Smith ruminates:

Seems to me no one in government is producing a graph that extrapolates the above data to the future. What about that? Kurt Vonnegut inquired aloud "Why is there never a Secretary of the Future?" Government has Secretary of Defense, Secretary of Agriculture, etc. but no Secretary of the Future.

In short, no one is dedicated to plan for the future; every bureaucrat and every CEO and every householder is dedicated to short-term goals.

You might chime in to say everyone in the financial industry is dedicated to the future; with due respect I decline that argument. Yes savings are now in the form of 401k and IRA funds, these purportedly are future-thinking instruments. Purportedly. That's the joke. None of them have calculated taxes and inflation that occur in the future.

Taxes and inflation wipe out all gains that purportedly will occur in the future. A simple experiment with extrapolation will prove this to any and all who take on the task of proof. We cannot escape three things in life: taxes, inflation, death.

Three things. But of course there is more. Health, for one thing. A health issue can and does and provedly wipe people out — financially. Who can plan an individual future with such an issue? We don't know ahead of time if we will wake up one morning with dementia. 

Greg Van Kipnis critiques:

I am not sure who Prof. Haave is debating or criticizing, however,…

… a credit crunch usually can be defined by the result of a general drying up of short-term credit such that the yield curve inverts. Many things can cause such an outcome, but they are all destructive to economic activity in the near-term.

In the current situation we have something different happening which I am calling a mal-distribution of credit. Obviously the yield curve is not inverted in the treasury market, but it seems to be for poor credits as evidenced by the widening of credit spreads at the short end.

The leading issuers of credit are hemorrhaging equity due to mortgage-related asset write-downs more rapidly than new sources of equity are being tapped to create credit to satisfy the needs of traditional borrowers. Good credits are still able to offset lost access to money markets, e.g. witness the shrinking CP market, by raising money by other means, which currently are lumped by the Fed into the C&I category. As your graph shows that category is exploding. Poor credits are getting rationed out. Many anecdotes are showing up in recent weeks to underscore that development.

If everything happened simultaneously the negative effects of the mal-distribution would show up immediately. The squeeze is likely to intensify as more financial institutions are credit downgraded. To head this off the brighter firms are doing what UBS did and the rest will wither. The 4-fold Fed/Treasury actions of the past month (MLEC , mortgage-terms jawboning, FF/ Discount rate drop, TAF/Swap-Lines) are all attempt to speed the restoration of the mal-distribution of equity. Collectively these are unprecedented historical developments.

So far no one has been "bailed out", whether they are stupid derivative issuers or investors, or stupid mortgagees or mortgagors. There will be bankruptcies, shot-gun marriages, and arrangement of necessity before this is over. The key for the monetary/fiscal authorities is to replace destroyed credit with new credit so the general economy will not be crippled. To pull this off successfully will require extraordinary good luck and judgement.

Gordon Haave responds: 

I wasn't debating anyone in particular, but rather the global meme that the financial system is in collapse.  It's not. Credit is being denied to people who are bad risks.  Because those people tend to be somewhat powerful, they have created this credit crunch meme in order to try to get bailed out. So, I agree with almost everything that you wrote, except that I disagree re: the monetary and fiscal authorities having to replace destroyed credit with good credit.  They don't need to do anything. All they need to do is let the markets clear.  

A few months ago,everyone said that the monetary authorities needed to do something, meanwhile the markets have been clearing, the prices have been set (as seen by the equity injections into the banks).  There is nothing to do except let the markets clear.

There is a market rate for credit.  It reflects time preferences.  If the Fed creates extra credit, it distorts the markets, it makes it appear that people are demanding more investment than they really are (hence the real estate boom).  When it becomes clear that was not the case, that investment gets cleared out. The answer is not to keep distorting the market, but simply to let it clear.

Carlos Nikros remarks:

Like the definition of an asset price bubble, there's much subjectivity in the definition of crunchiness. Although I mostly agree with Prof. Haave, some aspects of the current economic backdrop are not favorable for borrowers with good credit, as opposed to impeccable credit. For instance, A2/P2 commercial paper isn't an easy sale right now. Yes, the corporate bond market is open for business, but if an issuer is not a well-known credit, it has to fight for attention in order to get its deals done smoothly.

Gregory van Kipnis concludes:

Amish BuggyFor an analogy for how we can be of the same moral-philosophic persuasion yet have significant differences, consider different 'sects' of Amish. One splinter group was called the 'motor-Amish' and another the 'electric Amish' and the third the 'mirror' or 'image Amish'. The first believed that using motor vehicles for certain applications was OK, the second condoned the use of refrigeration and phones for a subset of the congregation to satisfy the FDA rules for milk or getting emergency help, the third did not ban mirrors or any reflective metals from the household. They were all still Amish, but they fought like heck on Biblical interpretation.

Well, I do believe that markets will clear and should be left to clear. But, just as a winding mountain road without guardrails will clear itself of many foolish divers who will go off the cliff, many innocents will be carried away as well. If the damage were only limited to single drivers I'd be content to leave things as they are. Even the most ardent Austrian School adherents understand social costs and the proper limited role of government to address them, however. If markets were atomized with numerous buyer and sellers, no impediments to entry and exist, and wide distribution of information, the 'clearing' process would be swift and fair. Our markets are semi-rigid and relatively concentrated due to complex institutional arrangements. They won't clear neatly. Many innocents will be carried away.

So when I spoke of replacing destroyed credit with new credit, I had in mind the lessons learned and taught by Friedman and Bernanke (among others) in their studies of the causes of the Great Depression. They were clear that many stupid things were done to trip the economy into recession, but when credit was extinguished, partly due to loans' being called in to meet runs on banks, and was not temporarily replaced by some Governmental agency, the recessions cumulated into a disaster.

I know, I know, I can already hear a response from someone that "once you start with regulations to protect people in the name of the people (men united in councils), then lies and deceptions will begin" (I badly paraphrase Tolstoy and Leonard Read). That is the risk we take when we create government. If we are led by men of high standards, who vote their conscience and willingly take personal responsibility for their decisions, the risks are small. I believe the Fed, at least, is governed that way today.

Stefan Jovanovich voices his dissenting view:

The revised standard version of 20th century American history that Dr. van Kipnis is preaching is very much the current gospel. It is what William Poole means when he says that "(m)acroeconomists today do not believe that policies to stabilize the price level and aggregate economic activity create a hazard. Federal Reserve policy that yields greater stability has not and will not protect from loss those who invest in failed strategies, financial or otherwise. Investors and entrepreneurs have as much incentive as they ever had to manage risk appropriately. What they do not have to deal with is macroeconomic risk of the magnitude experienced all too often in the past." Poole quotes a passage from David Cannadine's recent biography of Mellon as an indication of how truly awful things once were before we had professional economic management. "Mellon constantly lectured the president on the importance of letting things be. The secretary belonged (as Hoover would recall) to the "leave it alone, liquidationist school," and his formula was "liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate."

Alas, what Governor Poole fails to note is that this is very much Hoover's version of history. To the end of his life Hoover blamed Mellon for questioning Hoover's presumption that he could "re-engineer" the American economy in the same way that he planned food relief to Belgium and Holland after World War I. Governor Poole and Gregory would seem to share the former President's abiding faith that the application of science could domesticate the feral wildness that results from unregulated buying and selling. What they also share is a complete absence of any skepticism about the unintended effects of allowing "some Governmental agency" to "temporarily replace" "extinguished credit". When the government tries to manage economic risk, it either debases the currency by handing out far more money or promises of money than it can reasonably expect to take in or it establishes a world where prices are administered, not negotiated. In either case, the efforts of "men of high standards" (sic) to "stabilize the price level and aggregate economic activity" create a hazard that is far greater than any credit crisis. They destroy growth and pricing itself, and they risk turning nearly every citizen into a lobbyist or (worse) a lawyer. Friedman and Anna Schwartz are quite clear that the primary causes of the Depression were (1) the passage of the Smoot-Hawley Tariff (which Mellon literally begged Hoover to veto) and (2) the Federal government's attempt to administer the economy through the NRA, etc. Compared to Mellon's prescription (which was to let the markets find out on their own what stocks and farm land were worth), the Hoover-Roosevelt solution was the one that truly ended in liquidation.

There is no way that limited or unlimited government can "address" the problem we have right now without creating greater harm. The mountains of imaginary wealth created by loans against the security of 1800 sq. ft. stick and stucco 1950s bungalows in Pacoima are simply not worth what people thought they were - just as RCA stock was not worth what call loan supported buyers bid it up to in 1928. One does not have to be an economic fundamentalist to believe that common stock valuations usually have some discernible relationship to companies' cash flows from operations. It is also more than a matter of faith to think that, as wonderful as California real estate is, its prices most of the time have at least some distant connection to the ability of their owners to pay their mortgages. Until the homes in Pacoima once again have some vague relationship to what new buyers can afford to pay, the crisis will continue; but it will end - just as past real estate slumps have ended. But, if the wise men (and occasional women) of the Federal Reserve, the Treasury and the Federal government decide that they can "fix" the problem by legislating price levels for the paper issued on the security of those California bungalows and New York condos, we may see the People's Republic of Santa Monica bring the rent control to Iowa. "Credit creation" that tries to restore former unrealistic price levels in the midst of a panic is a bit like having alcohol for breakfast as a cure for hangover. It will - temporarily - take the edge off, but it only makes matters much worse later on.

Dec

11

Handles
The bond move the last three days is down three full handles from 117 3/4 to 114 3/4. That's the greatest three day move down before a FOMC meeting in history, I believe (my data cover only the last 94 FOMC meetings from 1996). The closest contender was March 17, 2003 where a decline of 2 3/4 occurred. The bond market must not like price controls.

Anatoly Veltman writes:

Both the up-swing (to 12/4 118′22 high) and the down-swing (to 12/10 114′12 low) were on reduced Open Interest, allowing me to play reversals with greater impunity. O.I. tipped covering: it meant that fewer stop-loss orders have remained resting; a factor that substantially cushioned risk for the near-term value-picker. More interesting, both reversal trades were obvious to me in real-time; and the slight O.I. data lag was not hindrance.

The top was a double-top in price of the 10-year (and a secondary top in all Treasuries, from 2-30year); while O.I. displayed Bearish Divergence.

The ensuing chart decline was symmetrical to November's chart rally (the chart “symmetry play” piqued Victor’s interest on 12/4), and pointed to low-volume, thin chart space all the way down into the 114 handle. At the minute 114′12 traded, for 10 consecutive futures sessions O.I. cumulatively slid over 100,000 lots (10% of the exchange total)!

So, .25 on Fed Funds and .50 at the discount window — or any other combination, plus “all-important” Paragraph Three FOMC mumbling — the trade here is technically solid. My analysis is performed discretionarily in real-time; I suspect 21-century black boxes execute these trades quite ahead of me, unfortunately!

Carlos Nikros adds:

I suspect that lots of fixed income securities just became substantially longer in duration last week, as well, necessitating the usual hedging and pruning.

Andrea Ravano observes:

I think the fear factor that pushed bond prices to their limit is fading. If we consider yield moves instead of prices we get the following picture :

Mat./1week ago/Yesterday/Difference

2 Yr. 2.87 3.20 +0.33

5 Yr. 3.28 3.60 +0.32

10Yr 3.93 4.18 +0.25

The data along with the collapsing spread between Tips and vanilla Treasuries points to a "normalisation" of the bond market to pre-subprime panic levels.Which, of course, does not mean one should not be worrying about inflation in the long run, but short term wise, the move in bonds might be explained with year end book squaring and the end of the worst in the sell off of the stock autumn bear market move.

Alan Millhone remarks:

I wonder how many other UBS types will fall victim to the subprime debacle before the dust finally settles? May be a long and cold winter for builders/investors/developers. Investors look to the Feds to step in to stabilize. Fed intervention to me looks like a form of price controls, much like price freezes and rationing in the Second World War.

Victor Niederhoffer offers a postscript:

One can now see what the purpose of the four point drop in bonds in the previous three days before the Open Market meeting was: to vigilantly control the Governors from overly inflationary activities.

SP

Barry Gitarts adds:

The equity sell-off today at 2:15 was almost expected to happen as it did when the Fed cut rates last time. What's unexpected was that the market kept going down and did not stage a turnaround at 2:30 - 3:00 pm. Maybe it became too obvious and the daytraders with their one hole located at 4:00 pm got cornered. Maybe the market will resume its upward course tomorrow after feeding the big fish today.

Nov

12

E*tradeSo, it's finally come to this. The financial community is chatting seriously about the prospect of a run on a bank. E*trade Bank, specifically. From the standpoint of one who has an account with them (a modest sum, and it's not where my paycheck or regular savings goes) what are the ramifications for an insured bank failure or the bankruptcy of the bank holding company?

I will probably close my account (which is the fashionable thing to do), but strictly speaking, what is the timeline of events between a bank failure and the return of my insured funds via the FDIC? Does the FDIC encourage other institutions to assume the deposits? Do I just get a check? How long does it take? Do modern banks and thrifts have provisions to restrict or delay deposits in order to forestall a run? (I remember when I was a mere lad that my first passbook savings account had a notice on the deposit slips that the savings bank had a right to delay paying withdrawal requests for up to 90 days.)

On the topic of E*trade bank specifically, they went through a rapid ramp-up during which they paid among the highest rates of interest in the country, subsidized almost all of their routine fees, and had their customer service people pick up the phones promptly. Then, presumably when they reached some level of critical mass, all of the coddling ceased (a sort of bait and switch, I suppose). And hence, despite the convenient interface, we decided several months ago to move almost all of our money elsewhere.

ETFC

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