Friday, August 10, 2007


With the so-called subprime credit crunch spilling over into Europe and then the rest of the world, I think we need to take one step back to gain some perspective.

First, let's dispense with two common misconceptions - or outright lies, if you prefer:
  1. It is not a "US subprime credit crunch", but a credit crunch, period. The trouble surfaced first at low-quality mortgage loans because that was the weakest in a long series of weak links. The problem, taken as a whole, is too much debt assumed by too many borrowers who cannot hope to service it without relying on constantly higher asset prices. In other words, it is a classic asset-credit bubble, only this time it is not contained within one country but it spans nearly the entire globe.
  2. Liquidity is not a stash of cash sitting in an account, looking for assets to buy. Liquidity is (a) access to reasonably cheap credit and (b) the ability to sell assets at reasonable prices, quickly and in size.
The corollary from (1) above is that the current credit crunch is not a "spreading out" from sub-prime to other sectors, but the initial phase of what is likely to be a long, drawn-out process of declining debt and asset prices. It could happen in one fell swoop (aka Crash), but that's what central banks are for, as we saw yesterday. They cannot stop the process, but they can act as lenders of last resort to slow it down. However, even if there is a "sudden event", I expect it will be followed by many more years of aversion to debt and risk. There is simply too much reliance on debt and asset appreciation in the global economy for it to go away in one step, however severe.

The proof to (2) above has been brewing for weeks, but finally made headlines yesterday as the ECB, Fed and BOJ had to intervene to provide... liquidity (if there was so much to begin with, where did it all go?). Liquidity is directly connected to credit because if everyone demanded cash in exchange for all goods and services the economy would immediately collapse into Medieval mode. Credit is a function of trust, i.e. the expectation of repayment, and thus liquidity is a function of trust - or confidence, if you like.

Bubbles of all sorts are phenomena of excessive confidence vs. the cash generating capacity of the underlying assets that are being inflated and they pop when excess confidence evaporates. We are now in the first stages of a credit - liquidity - confidence crunch, brought upon by the final realization that asset prices have moved so high that they cannot satisfy their debt loads out of cash flow.

And thus, Fed's Fearsome Phantasm (I couldn't resist) is raising its ugly head: persistent deflation that cannot be cured by lower interest rates. A liquidity trap, as is known to central bankers. Most scoff at the idea that we could actually experience falling prices in the US, but they are clearly mistaken and the evidence is all around us, though usually misinterpreted by the casual observer. Just a couple of examples because I have to catch a boat (ah, summertime...):

(a) House prices are now dropping in absolute terms, the first time since the Great Depression. A quarter of US GDP is related to housing activity.

(b) Because of China's huge manufacturing overcapacity, most consumer goods are cheaper today than years ago. If final demand fails to keep up with production (already happening, look at retail sales) we will see even lower prices and business failures.

(c) Negative saving rates and no access to credit means purchases must be curtailed and/or assets sold. That's deflationary.

(d) ..and finally, if anyone still believes that modern-era fiat currencies can be inflated to kingdom come to avoid the trap, think of Japan.

Have an interesting weekend...though the Chinese would consider this a curse.


  1. Well, maybe even this cloud has a silver lining: reduced economic activity would mean less CO2-emissions and thus slow down the global warming.

    It might also just post pone the peak oil.

    On the other hand, we may have higher food prices (due to energy and erosion etc) and lower prices on other goods. I do not know what it would mean, or entail.

  2. "Liquidity is not a stash of cash sitting in an account, looking for assets to buy"

    Ah...but the Saudis and the Chinese DO have this cash(liquidity) from their reserve holdings! They will swoop in and buy the family jewels cheap!

  3. I agree with you about the deflation scenario. I don't understand why Fed Ben worries about a inflation. Businesses have many means to control wage inflation if it get too out of hand.

  4. Re: Chinese and Saudi "liquidity".

    Their reserves are mostly in dollar denominated bonds, agencies backed paper. We took their merchandise and gave them a bunch of IOU's. I very seriously doubt they will ever be able to collect on them, in the traditional sense.

  5. Mane wrote:

    "Well, maybe even this cloud has a silver lining: reduced economic activity would mean less CO2-emissions and thus slow down the global warming."

    Unfortunately, lower energy prices will likely just breed complacency about such things as PO.

    Hellasious wrote:

    "Their (The Chinese) reserves are mostly in dollar denominated bonds, agencies backed paper. We took their merchandise and gave them a bunch of IOU's. I very seriously doubt they will ever be able to collect on them, in the traditional sense."

    Now we need to ask and answer the 64 trillion dollar question, which is, what benefits the holders of massive quantities of dollar denominated assets the most, deflation or hyper-inflation and we will likely will have our answer as to what our financial future holds.

  6. In a deflationary environment, the only money that moves is debt payments. Regardless of the underlying strength of the US economy, a good portion of the world's debts are denominated in USD.

    As perverse as it sounds, the US dollar may strengthen as people sell down assets in other currencies to pay down debts denominated in USD.

  7. I see inflation not deflation. Inflation is already running very high in the US. Don't believe the CPI numbers, they are lies and don't include energy and food, the two most important goods. A weak dollar is causing inflation as oil prices increase in US$ terms as is food. Wal Mart is doing so well in the grocery market because many people can not afford to shop in other supermarkets anymore as food prices have increased at least 10% in the last year. We have a credit crunch and the fed cannot lower rates as the dollar would plunge and oil would hit $100 overnight and we are back in 1970's style stagflation.


    “(T)he vicious circle of a weakening US economy – with a housing recession getting worse and a fatigued consumer at the tipping point - and a generalized credit crunch has sharply increased the probability that the US economy will experience a hard landing.”
    New York, NY August 10th, 2007 – RGE Monitor chairman and NYU/Stern School of Business professor Nouriel Roubini has provided analysis of the current precipitous declines seen throughout the global markets in his blog posting, “Worse than LTCM: Not Just a Liquidity Crisis; Rather a Credit Crisis and Crunch.”

    Professor Roubini argues that the current market turmoil will be much worse than the crises of the late 1990s – such as the LTCM liquidity crunch - for several reasons. “Today we do not have only a liquidity crisis like in 1998; we also have a insolvency/debt crisis among a variety of borrowers that over-borrowed excessively during the boom,” Professor Roubini observes. “You have hundreds of thousands of US households who are insolvent on their mortgages. . . lots of insolvent mortgage lenders. . .(and) soon enough – plenty of insolvent home builders,” he adds. “We also have insolvent hedge funds and other funds exposed to subprime and other mortgages.” And even in the corporate sector default rates – that have been kept unusually low until now by excessively easy credit conditions – will sharply increased now that risk has been repriced and corporate yield spreads are much higher.

    Combined with other fundamental economic factors, Professor Roubini argues the result is likely to be a hard landing for the U.S. economy, most likely a “growth recession” where growth stagnates below 1% for several quarters. He concludes, “The risks of a systemic crisis are rising: liquidity injections and lender of last resort bail out of insolvent borrowers - however necessary and unavoidable during a liquidity panic – will not work; they will only postpone and exacerbate the eventual and unavoidable insolvencies.”

    The full posting follows below and can also be accessed at For commentary and analysis from Nouriel Roubini, RGE Monitor Chief Economist Brad Setser and numerous other well-known economists, please visit today.

  9. Get lost, Ryskamp.

    Hellacious - you must believe in the PPT now.

  10. I'd like to disagree, sort of, with one of the things you've been saying.

    You describe in detail the "various stages in securitizing and derivativizing a simple home mortgage up to the fourth degree (CDO, CDS, hybrids, funded vs. unfunded, etc). By that stage the resulting structured instrument is completely unrecognizable vs. the original mortgage and is impossible to price without a long list of assumptions about future default rates, the shape of the yield curve, volatilities, etc."

    You make the point that these derivative securities cannot be properly valuated, since there's no market for them. Of course I agree with that wholeheartedly.

    What I'm quibbling with is not what you say but what you imply: That somehow stocks have been valuated properly since there IS a market for them.

    In fact, no one is valuating stocks. If you do a real valuation, then the only possible "real" value is around Dow 5000 -- based on exponential growth forecasting and the Law of Mean Reversion applied to historical P/E ratios and historical corporate earnings.

    Instead, in the stock market we have what's known as trading based on "relative value."

    What this means is the following: You go to the grocery store to buy a pound of apples. You see that one kind of apple sells for $100 per pound, and another kind of apple sells for $200 per pound. So you make a decision to buy the first kind of apple based on "relative value," without worrying whether BOTH types of apples are overpriced, since you're going to charge to a credit card anyway.

    The point is that "mark-to-market" really isn't any better than "mark-to-model" when investors and financial managers are people from the promiscuous Boomer generation and Generation-X, practicing credit debauchery. Just as CDOs are being valuated by "mark-to-model," which is meaningless, stock market shares are being valuated by "mark-to-relative-value," which is just as meaningless as mark-to-model -- or mark-to-myth. In the end, rules and regulations don't matter much if you're dealing with entire generations of people who are profligate, licentious and corrupt.

    By the way, are you ready yet to "upgrade" the Panic of 1893 to a bigger panic?



    John J. Xenakis
    Web site:

  11. Hi,
    I wonder where I can find the TED spread? Do you know what it is?

  12. The TED spread is the difference in interest rates between eurodollar deposits and Treasury bills and is used as an indicator of systemic risk in the money markets. The wider the spread, the wider the perceived risk.

    Right now 3m LIBOR is at 5.58% and 3m bills at 4.54%, thus the TED spread is 1.04% or 104 basis points. It has widened out quite a bit in recent days and was even higher before the central banks intervened.

    To John Xenakis,

    I believe you somewhat misunderstand my views viz. the stockmarket. I too believe stocks are overvalued globally, along with other assets that have been caught in the ultimately destructive cycle of leverage - pump prices - more leverage.

    Pricing to model is as valid and useful as the data that goes into it - in other words, GIGO. This has become extremely apparent in the credit market and because it is now viscerally connected to stocks via the umbilical cord of CDS's, it won't be long before the various models start to flash red. Some of them are already breaking down, witness the abysmal results of a series of quant hedge funds that were supposed to perform well in any market environment.

    My 1893 reference was to the kind of environment we are in, i.e. the Gilded Age of Robber Barons, lax government oversight and tax policy towards business, etc.

    My belief is that we will be in for a long time of financial market weakness, even if we get a crash event. The problems run much deeper than simple overvaluation of stocks and bonds.


  13. Can you comment on the jump in the overnite US LIBOR from 5.35% to 5.86%? This is unprecedented. How can the Federal Reserve lower rates if the LIBOR is rising?...TIA...

  14. Re: Libor rise

    The interbank money market is the largest, most liquid market in the world. The fact that it seized up and caused O/N rates to jump so much is a very strong warning sign that the credit crunch is on, big time.

    There are two reasons this happened:

    a) Risk aversion - banks did not want to lend to some other, lesser quality banks.

    b) Cash hoarding. Banks with excess cash that would normally lend it out to other banks chose to keep it instead and forgo interest income, which is VERY telling. Why? Good question...some say they wanted to keep it at hand to satisfy cash calls from fund subsidiaries that were facing withdrawals, but this is nonsense, mostly. Such liquidations have value dates from one to five business days later and lending O/N would not have made a difference.

    On balance, I think banks are panicking and don't want to lend even to other banks. That's why the ECB and Fed HAD to step in, in unprecedented amounts. Otherwise we would have faced "fails", i.e. some banks not being able to come up with cash to settle previous deals.