Don’t let the extreme volatility distract you from the potentially vicious stock market downtrend that is only in its early stages. The great global credit boom is over and the cleanup is under way. The layer upon layer of leverage that propelled the ponzi-like expansion is now operating in reverse and the leverage is being unwound—albeit at a reluctant pace since few are willing to admit as to how dire the financial and economic situation actually is. All great booms are followed by a bust, and this was one of the greatest booms in economic history. It won’t end with a few Fed rate cuts, a $150 billion stimulus plan and a relatively insignificant and brief drop in the stock market.
The global credit turmoil that became evident in August is a long way from over as additional writeoffs in the billions of dollars are announced almost every day. Yesterday UBS wrote off another $4 billion, its third writeoff in the last few months. Other major institutions have similarly announced sequential large writeoffs after indicating that the prior one was the last. The Wall Street Journal estimates that banks have now announced writeoffs of over $100 billion on subprime and CD-related loans with a lot more likely. Bill Gross of PIMCO calculates that $250 billion has already been lost on subprime loans and that losses on credit default swaps may result in additional losses of $500 billion.
Another source of great concern are the so-called monoline insurers that we first wrote about in our comment of December 20 called "Bond Insurers—the Next Crisis?" (see archives). The monolines use their own triple-A rating to insure up to $2 trillion of securities, which are then awarded their own triple-A rating on the basis of the insurance. Most of these monolines are now in major financial difficulty as a result of insuring various derivative products that have now gone bad.
Any downgrading of these monolines by the ratings agencies will force other financial institutions into another major round of writeoffs. Given the dire consequences, the rating companies have been reluctant to issue downgrades, although developing circumstance have begun to force their hand. Already, a few of the smaller monolines have had their ratings reduced while others are on watch lists for future downgrading. Today the market was cheered by MBIA’s assertion of confidence in its ability to maintain its triple-A rating. However, the company was already on Moody’s watch list, and today S&P as well put the company on its own list for possible future downgrading. There’s an old saying that any company that has to make an announcement that it is sound is invariably in trouble.
Additional credit turmoil is likely as a result of the continually deteriorating housing industry. Yale professor Robert Shiller, who has been so right on the housing mess, estimates that U.S. homeowners have lost $1 trillion and could lose up to three times that amount in the next few years. This would put even further pressure on the economy and on the balance sheets of financial institutions. The recession is likely to be deeper and longer than normal since the previous expansion was built on a house of cards that is now crumbling.
In our view the recent belated but frantic action of the Fed, the Administration and Congress confirms the dire outlook. The reduction of the funds rate by 125 basis points within the span of eight days is one of the biggest on record in such a short time. Furthermore, as we said last week, the unprecedented quick cooperation between George Bush and Nancy Pelosi is itself an indication of how seriously they view the situation. However, the current crisis was not caused by high interest rates, and lower rates are therefore not the cure. Indeed, the shrinking of bank balance sheets amounts to a tightening of credit that threatens to offset most of the effects of lower short-term rates. All in all we think it is far too soon to be looking for anything more than a temporary bottom in the market, and that there is a long way to go on the downside in terms of either magnitude or time.
