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Thread: Collapsing Global Credit Bubble Churns up Financial "Whales"

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    Default Collapsing Global Credit Bubble Churns up Financial "Whales"

    Collapsing Global Credit Bubble Churns up Financial "Whales"

    As the Whales Hit the Beach, Don't Forget Where they Came From

    by Eric Janszen

    Editor's Note: We're fans of independent research and money management firm GaveKal and the writings of Charles Gave, Louis-Vincent Gave and Anatole Kaletsky based in Hong Kong. We've heard iTulip described as GaveKal's evil twin brother. Both firms strive to be rigorous and consistent, but where GaveKal surveys the financial markets scene and sees a glass half full, iTulip sees a glass of Kool-Aid.

    Louis-Vincent Gave, in his letter to subscribers today, continued with a metaphor to illuminate the global liquidity contraction, "in which the central banks keep throwing in sticks of dynamite until the ocean finally disgorges a huge dead whale," and listing as previous "whale" examples Continental Illinois, Chrysler, Brazil, Drexel Burnham, Kidder Peabody, Mexico, LTCM/Russia, and Enron/MCI/Argentina. The letter explores the idea that Northern Rock PLC, Britain’s fifth-biggest mortgage lender, may be it. We say Northern is a lead whale, and look for a lot more to hit the beach over the next year.

    Let's compare the US and UK situations as the credit crisis progresses. Bernanke rode into the Fed in 2006 on his reputation as an asset deflation fighter, the prefect man for the job as everyone from Wall Street to Washington knew the credit party had gone on so long and reached such extremes that only a person believed to be able to deal with the inevitable crisis was suitable.

    While Bernanke's famous 2002 "dropping money from helicopters" speech is frequently cited, he has been developing a reputation as a virtuoso in the subtle arts of deflation fighting for nearly 25 years, to wit: Bernanke, B. (1983) "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression," American Economic Review, Vol. 73, 257-276. The promise to supply copious liquidity at the drop of a hat was just the right cover for the much more prudent approach that was intended. Clearly, the actual fulfillment of that expectation would spell disaster for a Fed managing the aftermath of a nearly 20 year old credit bubble in the context of a dollar trading at 34 year lows and oil at all time highs.

    These antecedents, along with the seeds of the current credit crisis, are the legacy of Fed, Treasury Dept, and Congressional post-stock market bubble re-inflation policies 2001 - 2005: cut rates, cut taxes, debase the currency. Imagine US creditors' relief when the Fed merely changed discount window policies, as ex-Fed governor Larry Meyer told everyone they'd do (we heard it on a Goldman client call; Meyer's on the payroll) as CDOs were marked to market from mark to model. Setting such low expectations of prudence made the measures taken appear hawkish.

    The Bank of England made no such pre-crunch PR arrangements so is now stuck playing political catch-up, thus the hard line with banks in official statements that echo the words of President Hoover's Treasury secretary, Andrew Mellon, who advocated allowing the 1929 crash to "liquidate labor, liquidate stocks, liquidate the farmers and liquidate real estate." But the intention is to not take it that far. After some speculator's blood has been spilled, the necessary bailout measures will be taken. The risk, though, as the Japanese learned, is that these short term political decisions can morph into suboptimal long term monetary decisions. The politics are deterministic, so a repeat of the Japanese deflation cycle experience is possible if the hard line is maintained too long; the credit crunch may become self-reinforcing if the BoE doesn't soon start to get as creative as the Fed has been in the US. One factor holding them back is that the Brits have this class thing to deal with that makes the appearance of the BoE bailing out rich people more politically problematic than for the Fed. In the US there may be occasional noise about wealth inequality and socialism for bankers but it's restricted to academics and well-meaning journalists and isn't politically significant as long as the flat panel TVs keep flowing out of Asia and the credit keeps flowing to pay for them.

    The experience for net debtor versus net creditor nations is different in the circumstance of a debt deflation. In the case of the US in the 1930s and Japan in the 1990s, as net creditors debt deflations have a tendency to reinforce processes that increase the purchasing power of the currency, exacerbating asset and commodity price deflation. In the case of the US today, in its role as the world's largest debtor with massive military and entitlements bills still piling up, a self-reinforcing debt deflation could eventually lead to a repudiation of the currency unless arrangements can be worked out to sell assets to US creditors at very favorable prices, such as the oil and other resource companies that China desires above US Treasury bonds, but is blocked by Congress from purchasing.

    Whether Northrock is "a" whale of "the" whale remains to be seen, but I suspect the former will be proven in time. Recall that the current credit problems originated in the US housing market and that has a long way to go down. Greenspan admits in his new book "The Age of Turbulence" that might be better titled "Duh" that there was indeed a housing bubble and housing prices are still closer to a top than a bottom for the cycle. More importantly from a whale counting perspective, the housing bubble, while it gets lots of press today, is just the start. A similar fate awaits the US commercial real estate market, which financing via Commercial mortgage-backed securities was even more outlandish (see 1031 Exchanges: More FIRE Economy Hijinks and Curtains for Commercial Real Estate? iTulip Select, Sept. 16, 2007).

    Then there's the private equity deals funded by CLOs that have left many US companies with impaired balance sheets even in good times. A modest decline in demand, even without outright recession, will make many of those deals uneconomical (see Interview with John Challenger, CEO, Challenger, Gray & Christmas, iTulip Select, June 13, 2007). While the optimists opine that these deals are benignly re-negotiable, recent experience in the mortgage lending industry, which offered similar assurances as recently as Q1 2007, provides evidence that in practice when the money dries up, PE firms will need their cash flow as much as anyone else, and at the same time as everyone else.

    As duration of unemployment grows and fuel demand by air carriers declines along with freight shipping volumes, the US economy shows itself on a descent path into recession, which we modeled October 2006 as due to start in Q4 2007. The only serious questions are how fast and how far. Policy options are limited and raise further questions. What can the Fed do with one hand tied behind its back by inflation? What options are available for additional foreign borrowing given Treasury Dept. head Henry Paulson's recent unfruitful bond sales trips to Asia? And what kind of fiscal stimulus can be supplied by a Democratic Congress on the hook with voters to stop spending the US into oblivion so Hillary Clinton can get elected President in 2008. In fact, a recession in 2008 would probably seal a Clinton win.

    The whale metaphor in this context reminds me of the joke about the Bostonian who was stopped by an environmental activist at Logan Airport and asked, "Please, sir, will you help us save the whales?" The Bostonian replies, "Save the whales? How? I can see saving stamps and coins, but where am I gonna put a collection of whales?"

    Not a whale but a collection of whales is what we'll have before the credit bubble Greenspan made is finally unwound.

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    Last edited by FRED; 09-17-07 at 06:51 PM.



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