Yesterday I talked about how bond auctions were falling apart at the seams this week. For the first time in memory, bond auctions were failing and government entities that had borrowed based on those bonds (and paying 4-5%) were now paying up to 20% interest or more.
Today there’s plenty more bad news, including the most compelling evidence yet that the credit markets are on the verge of collapse.
The cost of protecting corporate bonds from default soared to a record as investors purchased credit-default swaps to hedge against mounting losses in the $2 trillion market for collateralized debt obligations.
“The market is full of rumors of unwinding of CDOs, and the price action suggests that people believe the rumors,” said Peter Duenas-Brckovitch, head of European credit trading at Lehman Brothers Holdings Inc. in London. “It sort of has that Armageddon feel, and the market is feeding on itself.”
In other words, in order to bail out of the collapsing CDO market, the banks are turning to credit default swaps en masse. A $2 trillion market is about to unbalance a $45 trillion market, just in the same way the $200 billion subprime collapse unbalanced the $2 trillion CDO market.
Guess what’s about to happen to credit default swaps as a result?
Securities known as constant proportion debt obligations that package indexes of credit-default swaps may be forced to unwind about $44 billion of assets because of a decline in the value of their holdings, UniCredit SpA analyst Tim Brunne in Munich said today. The value of the so-called CPDOs has fallen to as low as 40 percent of face value, according to Morgan Stanley.
Credit-default swaps on the Markit CDX North America Investment-Grade Index of 125 companies with investment-grade ratings jumped 13 basis points to 167.25 at 8:31 a.m. in New York, according to Deutsche Bank AG.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower fails to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.
The CDX index of credit-default swaps doubled this year as bank losses and writedowns on debt investments soared above $145 billion worldwide. The equivalent iTraxx index in Europe rose 16.5 basis points today to a record 134.5, according to JPMorgan Chase & Co., the biggest one-day move since the index started in 2004. The index was at 51 basis points on Jan. 2.
So, in the space of six weeks, the market for credit default swaps is going haywire. The same bubble mentality that burst subprimes is about to blow a hole in a multi-trillion dollar credit shell game.
CDOs package assets and use the income to pay investors. Securities made up of credit-default swaps are known as synthetic CDOs. The notes are losing money as the cost of credit-default swaps rises. CPDOs are based on the CDX and ITraxx indexes.
Moody’s Investors Service downgraded 1.1 billion euros ($1.62 billion) of CPDOs arranged by ABN Amro Holding NV, Lehman Brothers Holdings Inc. and BNP Paribas SA last week as asset values fell. CPDOs arranged in 2006 by banks including Amsterdam-based ABN Amro may be forced to unwind if the iTraxx Europe index rises another 5.5 basis points to 140, according to UniCredit’s Brunne.
“Different CPDOs have different trigger levels, but once one is triggered the negative technical pressure that is created may well cause other triggers to be hit,” Willem Sels, a credit analyst at Dresdner Kleinwort in London, said in note to investors today.
Because these arcane debt monstrosities are approaching these “trigger levels” they are going south. And the fact they were used as collateral to purchase credit default swaps is even worse…because the bubble on the default swaps now is so large that the triggers are kicking in on THOSE as well.
It’s a multi-trillion dollar train wreck.
Banks would seek to unwind CPDOs by buying credit-default swap indexes to offset their bets.
“What seems to be clear in both Europe and the U.S. is that the continued unwind of leverage and structured products has continued to lead to underperformance in investment grade,” Nick Burns, a London-based credit strategist at Deutsche Bank, wrote in a note today.
Contracts on U.K. mortgage lender Alliance & Leicester Plc jumped 40 basis points to 245 after the bank slashed its profit target for this year and next, citing rising borrowing costs and declining valuations on asset-backed securities because of the U.S. subprime mortgage slump.
A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.
Contracts on Standard Chartered Plc rose 3 basis points to 112 after the London-based bank abandoned a plan to refinance its $7.15 billion Whistlejacket Capital Ltd. structured investment vehicle, the largest SIV run by a bank to collapse.
Much larger SIVs and CDOs are going to collapse. The 7 billion dollar ones are the small ones. They represent a small fraction of the credit garbage the banks have and are now trying to get rid of by trading them in for credit default swaps…making this particular brand of garbage even more useless.
Meanwhile, inflation is getting even worse.
Annual consumer price inflation increased to an unexpectedly strong 4.3 percent in January from an already elevated rate of 4.1 percent in December, according to the Labor Department.
On a monthly basis, rising food costs helped push consumer prices up for a second straight month in January by 0.4 percent, more than offsetting a moderation in energy price rises.
Excluding volatile food and energy items, growth in core consumer prices accelerated to 2.5 percent from 2.4 percent in December, a level that is likely to make Fed policy-makers uncomfortable.
The bad news on inflation was coupled with more grim news from the housing market, with permits to break ground on new U.S. homes in January decreasing 3 percent to the lowest rate in more than 16 years.
With the housing market’s problems now well publicized, financial markets focused on the inflation, which could complicate the Federal Reserve’s efforts to shore up the economy through a continuation of aggressive interest rate cuts.
“The concern is on the inflation side. We are seeing an elevated trend, especially in the core,” said Kevin Flanagan, fixed income strategist for global wealth management at Morgan Stanley in Purchase, New York.
So rate cuts don’t work, because of the solvency and inflation problems. But there’s nothing else the Fed can do but to try to inflate their way out of this mess. They will come under strong pressure to do just that and punt the mess over to the next President in 2009.
If the core rate of 2.5% is making people uncomfortable, wait until it starts hitting double digit numbers later on as Fed rates continue to fall. They literally have no choice…and yet anything they do or don’t do at this point will make the situation worse. As it is, stagflation (if not stag-deflation) is almost upon us. When the rest of the credit market collapses, the dollar will deflate worldwide and with all the major commodities priced in dollars, the world’s going to go into a massive tailspin.
Hyper-inflation or stag-deflation…and the odds are the first will only speed up the onset of the second. That’s the Fed’s choice right now. People are still operating under the assumption that the Fed can stabilize the economy.
As long as the banks are still playing “pass the bubble” in the credit markets, things will continue to destabilize, if not break down completely.
In more dour housing news, U.S. mortgage applications plunged last week, and demand hit the lowest level since the start of the year as interest rates surged, an industry group said.
The Mortgage Bankers Association said its seasonally adjusted index of mortgage applications for the week ended Feb. 15 fell 22.6 percent to 822.8, the lowest level since the week ended Jan. 4.
Borrowing costs on 30-year fixed-rate mortgages, excluding fees, averaged 6.09 percent, up 0.37 percentage point from the previous week, the highest since late December.
Yep. And as people flock to 10-year treasury notes, the rates on them are jacking up. These notes are what mortgage rates are based on, and at a time where housing is in a deep depression, mortgage rates are jumping up. That means more people are going to default on mortgages, and not just the 2 million subprime people, but millions and millions more will default on regular mortgages as well.
Inflation and the housing depression will collide, causing a massive collapse in the real estate market. Trillions will vanish, this will finish off banks, and the coming destruction will dismantle the global financial system.
But don’t just take my word for it.
So how bad might this downturn get? To answer this question we should ask a true bear. My favourite one is Nouriel Roubini of New York University’s Stern School of Business, founder of RGE monitor.
Recently, Professor Roubini’s scenarios have been dire enough to make the flesh creep. But his thinking deserves to be taken seriously. He first predicted a US recession in July 2006*. At that time, his view was extremely controversial. It is so no longer. Now he states that there is “a rising probability of a `catastrophic’ financial and economic outcome”. The characteristics of this scenario are, he argues: “A vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe.”
If the Financial Times is bringing up Nouriel Roubini’s theories as plausible, we’re in a whole metric fuckton of trouble. Roubini lists 12 steps to a disaster and right now we’re at about 4.
Is this kind of scenario at least plausible? It is. Furthermore, we can be confident that it would, if it came to pass, end all stories about “decoupling”. If it lasts six quarters, as Prof Roubini warns, offsetting policy action in the rest of the world would be too little, too late.
Can the Fed head this danger off? In a subsequent piece, Prof Roubini gives eight reasons why it cannot. (He really loves lists!) These are, in brief: US monetary easing is constrained by risks to the dollar and inflation; aggressive easing deals only with illiquidity, not insolvency; the monoline insurers will lose their credit ratings, with dire consequences; overall losses will be too large for sovereign wealth funds to deal with; public intervention is too small to stabilise housing losses; the Fed cannot address the problems of the shadow financial system; regulators cannot find a good middle way between transparency over losses and regulatory forbearance, both of which are needed; and, finally, the transactions-oriented financial system is itself in deep crisis.
The risks are indeed high and the ability of the authorities to deal with them more limited than most people hope. This is not to suggest that there are no ways out. Unfortunately, they are poisonous ones. In the last resort, governments resolve financial crises. This is an iron law. Rescues can occur via overt government assumption of bad debt, inflation, or both. Japan chose the first, much to the distaste of its ministry of finance. But Japan is a creditor country whose savers have complete confidence in the solvency of their government. The US, however, is a debtor. It must keep the trust of foreigners. Should it fail to do so, the inflationary solution becomes probable. This is quite enough to explain why gold costs $920 an ounce.
The connection between the bursting of the housing bubble and the fragility of the financial system has created huge dangers, for the US and the rest of the world. The US public sector is now coming to the rescue, led by the Fed. In the end, they will succeed. But the journey is likely to be wretchedly uncomfortable.
And yes, the FT believes there may indeed be something to Roubini’s theories.
Frankly, I think Roubini’s predictions here are somewhat optimistic.
