Enzio's Clock

Background

1. Prof. Kindleberger's anatomy of a crisis

We are so thrilled with Prof. Kindleberger's clarity that we want to show you his cycle yet again. Here is our summary first given you on 8th June, 2007:

"Prof. Kindleberger wrote a marvelous anatomy of a crisis:

o Displacement happens when the economic outlook is altered by changing profit opportunities. (currently: China and India’s emergence is propelling commodities markets as well as corporate profits thanks to improvement in lifestyles)

o A boom ensues. Bank credit and personal credit expands significantly. This results in Adam Smith’s “over trading”: pure speculation, overestimation of profits and excessive gearing step forward. (currently: sub prime lending, exchange traded funds (ETFs) that are based on air). Bubbles occur. Economists define bubbles as “deviations from fundamentals”. Back to my Economic Clock: the only big markets that have such deviations from fundamentals are the USA and Japan. However, the current mania (Mr. Greenspan’s "irrational exuberance") will keep feeding on itself. We are in the latter stage this boom phase now and, excluding America and Japan, there is no bubble – markets are in line with fundamentals, with their respective Economic Time.

o Distress sets in. The smart money starts selling. One event is the tripwire; Prof. Kindleberger calls it a "causa proxima". More recently, for instance, I thought that the sub prime mortgage matter might be such a tripwire to crisis, but I was wrong, alas! He also says that "causa remota" is due to an excess demand for money (EDM). “Revulsion” rears its ugly head: revulsion against commodities or securities leads banks to stop lending on the collateral of such assets.

o Panic sets in. Everyone bolts for the exits. Then, one of three things happens. Either prices fall so lowly that people load back up (currently: that is what February was about), market “circuit breakers” are established, i.e. trading is stopped if certain price limits are reached, or a lender of last resort stabilizes confidence,"

We wrote on 8th June 2007 that "...we are in the latter phases of the boom phase".

Here is what we have been writing of late (we cite bits below in italics and, for your convenience, double-click on the italicized part to read article). Below, we juxtaposition our blathering to Prof. Kindleberger's marvelous framework:

2. How assets combust into liabilities

Earlier on we suggest that assets must morph into liabilities. In medical terms, a derivative has the "...power to draw off fluid from a diseased part of the body", according to the New "Shorter" (3,700 page!) Oxford Dictionary. In the FT of 19th/20th January, the lead editorial states that "...the aftershocks of the earthquake have revealed that thousands of financial structures were fragile and poorly-built."

What follows relies heavily on said FT, particularly the insights gleaned from pages 6 and 8, and from page 1 of the FT of 18th January, 2007. We also refer extensively to your Collateral Damage (1), referred to below as "CD1", and urge you to review this - for your own financial safety!

We want to reveal the symbiotic, i.e. co-dependent nature of the sickness of "assets" and how that kills ratings - and deepens an unwillingness to lend. Forgive the swamp of acronyms that you are going to have to wade through - but avoid wading through this swamp at your financial peril!

First, let's find out remotely what we are talking about. Here is an acronym strudel. I make no bones about not commanding my subject, so if there are any constructive corrections, I am very open-minded. As my respected mother in law has taught me: "I know my opinion, so tell me yours."

• Credit default swaps (CDSs): These allow bond holders to insure against default. Those who sell such protection collect premiums. This is the business of monoline insurers.
• Monoline insurer. "A company that insures against the risk of a bond or other security defaulting." A specialist bond insurer who issues credit default swaps (CDSs). Crucially, the bond issuer - not the buyer of the bond! - purchases the insurance of the monoline, As monolines hitherto have enjoyed great credit ratings, "monolines essentially lend their credit rating for a fee." This means that especially the little guys with poor credit ratings can issue bonds and then in their sales pitch tell potential suckers - ardon me, "investors" -that their third-rate bond is backed by the guarantee of a AAA-rated bond insurers, and
• Structured investment vehicles (SIVs): These cover a variety of banking sins. Of late, we have had to learn fast about the following members of financial sin tribe:
• Collateralized debt obligations (CDOs): "complex debt instruments backed by payments from other bonds, loans or other assets.", and
  
• Collateralized mortgage obligations (CMOs):debt instruments backed by mortgages, often of sub-prime nature.
• Securitized mortgage debts (SMDs): big banks bundle thousands of individual mortgages owed by the Ma and Pa Kettles of this world. The big banks then create CDOs or CMOs out of these, and sell various tranches, depending on their quality. Often the worst of the lot, the ones backed by sub-prime mortgages, are insured by monoline insurers in the form of credit default swaps.

Here is the chain of events unfolding in front of unwilling eyes. We reckon that this distress will go through until August of this year...

• Rotting assets...: In our first piece in this series, we told you how banks bundle mortgages into securitised mortgage debts (SMDs) and sell various tranches of them as collateralised mortgage obligations (CMOs) or Collateralised Debt Obligations (CDOs) to pension funds or individual investors (suckers?) wanting more than what Treasury bills yield. But, all that glitters is not gold. We suggested in CD1 that the big banks that have issued the created the SMDs cannot just foreclose on the homes of people who have fallen behind on their mortgage payments. But ultimately, it is these "Ma and Pa Kettles", the mortgage-paying public at large, who are paying the interest which goes to the buyers of CMOs/CDOs. So, if Ma and Pa Kettle default, the whole system craters - fluid leaves the diseased body...
• ... lead to monoline downgrades...: The big banks who create these SMDs and issue various tranches of CDOs/CMOs, of course, want to ensure that their interest gets paid - even if Ma and Pa Kettles cannot. So they pay a company, a AAA-rated "monoline", to make sure that the bonds are safe: both sides create a credit default swap (CDS). The issuer of CDOs/CMOs, the "protection buyer" gives a premium to the monoline and gets from the monoline "protection seller" the purported safety of insuring the principal and interest payments accruing from said CDO/CMO. But, as suggested in Collateral Damage (5), part II, these insurance policies are not legally binding - so, that market is unregulated. Of late, markets have worried that hitherto AAA-rated monolines are getting ratings downgrades themselves. ACA Capital, one such monoline, got its rating trashed to "CCC" last November, and stood on the brink of bankruptcy last Thursday;the ratings-fates of the world's two biggest bond insurers, MBIA and Ambac, are in limbo. So what if a monoline's rating is downgraded?
• First, banks get to ask the monoline to raise more cash as collateral in order to ensure that the "insurance" provided by the monoline actually is in place. Besides, with cash calls mounting from nervous investors, the monolines have to raise more money just to cover their obligations. So, monolines have to raise more capital. Tough to do when their ratings are wobbling and their share prices have been smacked. So who is now going to insure the bond if the monoline is out of the running?
• Secondly,with such bonds no longer enjoying the hitherto highly-rated backing of monolines, less CDOs/CMOs get issued, so ultimately, the cost of capital rises at the long end of the yield curve. Indeed, expect some of the monolines to cease existing, so down goes the supply of CDSs. But the long-term cost of capital also will rise because it is probable that Congress, in its stunted wisdom, will pass the "Emergency Home Ownership and Mortgage Equity Protection Act of 2007". Now how is that for Capitol Hill brevity? This Act will allow judges unilaterally to change the terms of a home owner's primary mortgage contract if he/she is bankrupt. Hitherto, judges only have been able to modify mortgages on second homes that are in bankruptcy court.
• Thirdly, with Ma and Pa Kettle defaulting on their mortgages, and with the monoline's "insurance" strength evaporating, banks have to raise their own reserves. Another reason that banks have to raise their reserves is that once the monoline's credit rating has been cut, credit rating agencies immediately downgrade the $2.4 trillion in bonds purportedly "insured" by the monolines.So, banks greedy enough to own such bonds have to increase the capital that they hold against such bonds. Think of this as "marking to market" of "counter party risk" and you are in the right ball park. Next to having to increase their reserves, don't forget that our wise bankers also have to cope with the billions of dollars of write downs on their CDOs and CMOs. With wilting markets forcing banks to keep more "rainy day" money, they have less money to lend into the economy, yet another nail in the coffin of an excess demand for money. Of course, this inability (forced increase in mandatory reserves) as well as unwillingness to lend (banks are just plain scared) ultimately means that the resulting excess demand for money morphs into an excess supply of goods. So how on earth can profits rise if demand falls?
• ... so banks must reduce lending:As we just saw, banks bnow stop lending because they are scared, and because they have less money to lend. After all, their write downs on such CMO "assets", coupled with having to increase their reserves, means that there is less money to lend. That, of course, creates an excess demand for money, and that means that stock markets have to crash: there is no gas in the tank with which to fuel asset markets.

Of course, as pointed out in CD1, this means that America's waning excess demand for goods will morph into an excess supply of goods - particularly until this August, by which times about $325bn of SMDs will have defaulted. By that time, U.S. consumption will shrink by $350 bn - or 1.7x China's 2006 exports to America. Auf Wiedersehen, de-coupling! So now we understand why the current crises (sub-prime, credit default swaps and the credit card crunch) have to ruin The Economic Time™ in America. Gosh, things just are not so different this time around, are they?

3. Can Bush's booster help the dead rooster?

Just now we illustrated the complexity of the mess. Pres. Bush's $150 billion booster cannot help the $1 trillion "dead rooster", these being the losses that we can expect once all three crises - sub-prime, collateralized debt swaps and credit card crunches - have worked themselves through the system. Here is why:

• "Paroles, paroles", an old song, or "Words, words": he only has launched proposals. Congress has to pass the package (or, the potato). I cannot imagine that the arrogance of Hank Paulsen is going to help him persuade Congresspeople to want to accept Bush's proposals: look at how he beats up so ignorantly on China. Besides, as pointed out in the FT of 19th/20th January, in Lex, "...There are also obstacles to rebates actually boosting consumption. The last time it was tried, in 2001, two thirds of the rebate was spent within six months. Back then, though, the savings rate was 1.5% of disposable personal income. Today, it is about 1/2%. Cheques mailed now might simply be used to pay down credit card bills bloated by the holiday season."
• No excess supply of money: we suggested in mid-December that Central Bank "easing" was not creating an excess supply of money - just somewhat easier access to it, and
• The private financial sector is in the driving seat - but wants to stay in the garage: the vital bit is that in this cycle, it is the private sector - NOT THE CENTRAL BANK - that is creating the excess demand for money: banks just don't want to lend to each other. No Central Bank or indeed tax authority can change the lending moods of private sector banks, as such public authorities cannot tell them what to do. (Of course, as we suggested earlier, the gains are privatized, but the losses are socialized...) This has to be why such credit crunches give us longer recessions: the Central Bank cannot "step on the gas" as the private financial sector simply does not want to leave the garage!! So what, then, if the Fed cuts another 50 basis points on 30th January - or moves Fed Funds down to 3%, as pundits predict? The fact is: banks are gun shy. Full stop.
  
• No creation of an excess demand for goods. If banks don't want to lend, the lifeblood of the economy - consumption - dies. We calculated that all three crises - sub-prime, collateralised debt swaps and the looming credit card crunch - will wipe out about $350 billion in US consumption this year.( That is nearly twice the amount that China exported to America back in 2006!) Besides, when the "panic" stage sets in by this June, plenty of over-extended consumers will be selling their stocks like mad just to re-pay their debts
• Hence, tax cuts could not prevent recession last time, either. Said FT Lex concludes that "...even the stimulus applied towards the start of the George W. Bush presidency, along with interest rate cuts, did not avert recession. If anything, the problems look more deep-rooted..." Remember that when German banks cleaned up their balance sheets, that place went through a recession lasting fifteen quarters - or 2 3/4 years- in the early 1990's!! They did not want to lend, either.

4. How to Make Money Off This Idea

1. Always consult your financial adviser first.
2. On 14th January, we gave you 14 ways to earn off the coming panic, including shorting the finance and consumer discretionary.
3. One day later, we gave you eight ways to make money off this mess.
   
4. Sell into the feigned strength of the market deluding itself that "Fed funds cuts help out." By definition, they cannot: banks don't want to lend, as we discuss in the third bullet point of part 3 above.
5. We re-iterate: buy more of the ETF through which you can short the US market, the "UltraShort S&P500 ProShares" (SDS:US). Buy particularly when it weakens during market strength in America this Monday. And even if the market falls, just keep buying. "Panic" has yet to set in. Since we recommended this to our subscribers on 16th November, this instrument has risen 15.1%! That represents an annualized return of 441%!!