'Lehman Moment'

By: Doug Noland | Fri, Jun 17, 2011
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For the week, the S&P500 was little changed (up 1.1% y-t-d), while the Dow increased 0.4% (up 3.7%). The Banks rallied 1.5% (down 9.1%), while the Broker/Dealers slipped 0.1% (down 12.3%). The Morgan Stanley Cyclicals added 0.1% (down 2.6%), and the Transports jumped 1.9% (up 1.0%). The Morgan Stanley Consumer index gained 0.8% (up 0.5%), and the Utilities jumped 1.1% (up 5.0%). The S&P 400 Mid-Caps were little changed (up 2.8%), and the small cap Russell 2000 rallied 0.3% (down 0.2%). The Nasdaq100 declined 1.3% (down 1.1%), and the Morgan Stanley High Tech index sank 2.6% (down 6.3%). The Semiconductors dropped 3.6% (down 5.7%). The InteractiveWeek Internet index sank 2.8% (down 5.9%). The Biotechs fell 1.4% (up 7.4%). Although bullion gained $8, the HUI gold index dropped 2.3% (down 13.4%).

One-month Treasury bill rates ended the week at zero and three-month bills closed at 2.5 bps. Two-year government yields declined 2 bps to 0.37%. Five-year T-note yields ended the week down 4 bps to 1.52%. Ten-year yields declined 3 bps to 2.94%. Long bond yields added 2 bps to 4.20%. Benchmark Fannie MBS yields added a basis point to 3.91%. The spread between 10-year Treasury yields and benchmark MBS yields widened 4 to 97 bps. Agency 10-yr debt spreads increased 4 to negative one basis point. The implied yield on December 2011 eurodollar futures jumped 6.5 bps to 0.465%. The 10-year dollar swap spread increased 4 bps to 14.6 bps. The 30-year swap spread declined slightly to negative 26 bps. Corporate bond spreads were volatile but ended the week little changed. An index of investment grade bond risk was unchanged at 99 bps. An index of junk bond risk was little changed at a 7-month high 507 bps.

Debt issuance has slowed significantly. Investment-grade issuers included ABB Treasury $1.25bn, Fuel Trust $1.0bn, Discovery Communications $650 million Realty Income Corp $250 million, TC Pipelines $350 million, Hanover Insurance $300 million, Eaton $300 million, and Private Export Funding $300 million.

Junk bond funds saw outflows surged to $2.1bn (from EPFR), the second-highest level on record. Junk issuers included Goodman Network $225 million, and Universal Hospital Services $175 million.

Convertible debt issuers included Brookdale Senior Living $316 million.

International dollar bond issuers included Kaisa Group $650 million and Itau Unibanco $500 million.

German bund yields were unchanged at 2.96% (unchanged y-t-d), while U.K. 10-year gilt yields dipped 2 bps this week to 3.20% (down 31bps). After trading above 30% on an intraday basis, Greek two-year yields ended the week up 136 bps to 26.48% (up 1,424bps). Greek 10-year note yields increased 7 bps to 16.59% (up 413bps). Spain's 10-year yields rose 10 bps to 5.56% (up 12bps). Ten-year Portuguese yields surged 46 bps to 10.61 (up 403bps). Irish yields rise 15 bps to 11.15% (up 210bps). The German DAX equities index rallied 1.3% (up 3.6% y-t-d). Japanese 10-year "JGB" yields were down 2 bps to 1.115% (down one basis point). Japan's Nikkei declined 1.7% (down 8.6%). Emerging markets were under pressure. For the week, Brazil's Bovespa equities sank 2.6% (down 11.9%), while Mexico's Bolsa added 0.2% (down 9.1%). South Korea's Kospi index slipped 0.7% (down 0.9%). India's equities index declined 2.2% (down 12.9%). China's Shanghai Exchange dropped 2.3% (down 5.9%). Brazil's benchmark dollar bond yields declined 6 bps to 4.06%, while Mexico's benchmark bond yields were little changed at 4.01%.

Freddie Mac 30-year fixed mortgage rates added one basis point to 4.50% (down 25bps y-o-y). Fifteen-year fixed rates dipped one basis point to 3.67% (down 53bps y-o-y). One-year ARMs increased 2 bps to 2.97% (down 85bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down one basis point to 5.00% (down 57bps y-o-y).

Federal Reserve Credit jumped $25.5bn to a record $2.810 TN (32-wk gain of $529bn). Fed Credit was up $402bn y-t-d and $488bn from a year ago, or 21.0%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 6/15) increased $3.5bn to $3.447 TN. "Custody holdings" were up $96bn y-t-d and $367bn from a year ago, or 11.9%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg - were up $1.535 TN y-o-y, or 18.4%, to a record $9.8 TN. Over two years, reserves were $3.062 TN higher, for 45% growth.

M2 (narrow) "money" supply rose $7.9bn to a record $9.0 TN. "Narrow money" has expanded at a 4.9% pace y-t-d and 4.7% over the past year. For the week, Currency increased $1.6bn. Demand and Checkable Deposits dropped $23.4bn, while Savings Deposits jumped $36.5bn. Small Denominated Deposits declined $3.4bn. Retail Money Funds fell $3.4bn.

Total Money Fund assets declined $34bn last week to $2.708 TN. Money Fund assets were down $103bn y-t-d, with a decline of $99bn over the past year, or 3.5%.

Total Commercial Paper outstanding declined $14.7bn to $1.206 Trillion. CP was up $237bn y-t-d, or 44% annualized, with a one-year rise of $123bn.

Global Credit Market Watch:

June 17 - Bloomberg (Tony Czuczka and Helene Fouquet): "Chancellor Angela Merkel retreated from German demands that bondholders be forced to shoulder a 'substantial' share of a Greek rescue, saying she'll work with the European Central Bank to avoid disrupting markets. 'We would like to have a participation of private creditors on a voluntary basis,' Merkel told reporters... This 'should be worked out jointly with the ECB and there shouldn't be any dispute with the ECB on this.'"

June 17 - Bloomberg (Sapna Maheshwari): "Investors steering clear of the corporate bond market are driving down debt offerings to the least this year as European officials struggle to contain a Greek debt crisis that's sent relative yields to a five-month high. Bond sales from the U.S. to Europe to Asia declined 56% this week to $27.9 billion... Investors are demanding an extra 1.65 percentage points in yield over government debentures, the most since January..."

June 15 - Bloomberg (Boris Groendahl): "A 'disorderly' Greek default would spread contagion to Portugal, Ireland and beyond as Europe's inability to contain the debt crisis threatens the survival of the euro, Brown Brothers Harriman strategist Lena Komileva said. Estimates for the damage of an unmanaged default understate indirect effects on the European and global banking systems, said Komileva, Brown Brothers' Global Head of G10 Strategy... An unmanaged Greek credit event would cause liquidity to seize up, leaving banks around the world struggling to find funding, she said. 'Investors have largely prepared for the eventual certainty of a Greek credit event, but the markets remain vulnerable to a broader contagion... The real economic cost behind it is not so much the direct cost of Greek default, but the uncertainty surrounding broader financial stability the day after Greece defaults.'"

June 13 - Bloomberg (Jennifer Ryan): "Greece had its credit rating cut three levels by Standard & Poor's, which branded the nation with the world's lowest debt grade and said a restructuring looks 'increasingly likely.'"

June 16 - Bloomberg (Abigail Moses): "The cost of insuring against default on Greek, Irish and Portuguese government debt surged to records, driving a gauge of sovereign bond risk to an all-time high, on concern Europe's deficit crisis is worsening."

June 15 - Bloomberg (Helene Fouquet): "European Central Bank Governing Council member Christian Noyer said that the euro region's sovereign-debt crisis is 'contagious.' 'There is nothing more wrong than to say that this is a crisis of the euro,' Noyer said... 'What is true is that euro-zone economies are highly interdependent'. 'This crisis, shared among nations, is like a bad virus... It's contagious and transmissible.'"

June 15 - Bloomberg (Joe Brennan): "Irish Finance Minister Michael Noonan said senior bondholders should share in the losses of Anglo Irish Bank Corp. and Irish Nationwide Building Society, reversing a policy of protecting owners of senior securities. Noonan discussed sharing the cost of rescuing both lenders with senior bondholders at a meeting with the International Monetary Fund... The lenders have about 3.8 billion euros ($5.4bn) of the securities. 'We don't think the Irish taxpayer should redeem what has become speculative investment -- we don't believe it should be redeemed at par,' Noonan said."

June 15 - Bloomberg (Elisa Martinuzzi and Maria Petrakis): "Prime Minister George Papandreou vowed in 2009 to scrap an agreement to sell a stake in Greece's biggest phone company in a bid to get elected. This month, forced to raise cash, Greece triggered an option to sell 10% of Hellenic Telecommunications Organization... to Deutsche Telekom AG. The price: less than one-third of what Europe's largest phone company paid for shares when it last bought OTE stock in 2009. That deal underlines the challenge facing European countries such as Greece and Ireland, awash in debt, that are hoping to raise as much as 71.5 billion euros ($103bn) in the continent's largest yard sale of state assets in more than a decade... The threat of Greek default or euro breakup is scaring buyers and depressing prices..."

June 14 - New York Times (Stephen Castle): "With European governments divided over how to shape a new bailout for Greece, Mario Draghi, who is likely to become the next president of the European Central Bank, warned... against forcing private investors to take part. At a confirmation hearing at the European Parliament, Mr. Draghi... also highlighted the risk that a Greek default could set off a 'chain of contagion.' "All in all, the costs outweigh the benefits,' he said... The bank has been firmly against any restructuring of Greek debt, in part because of its own holdings. The Dutch finance minister, Jan Kees de Jager, told his Parliament in The Hague on Tuesday that the bank's total exposure to Greece might be 130 billion to 140 billion euros, or as much as $200 billion. In addition, the E.C.B. has provided 90 billion euros of liquidity to Greek banks, he said..."

June 15 - Bloomberg (Angeline Benoit): "Spain's 17 regions must abide by stricter fiscal rules and increase budget transparency to avoid derailing the nation's efforts to rein in the euro region's third-largest deficit, the Bank of Spain said. Efforts to control public finances are not being evenly shared between the central government and the regions, the... bank said... The regions hire half of public workers, control health and education spending, and together owe 115 billion euros ($165bn)."

June 15 - Bloomberg (Richard Bravo): "The wall of bonds and loans maturing through 2014 has been slashed by about $727 billion, or 60%, since 2009, reducing default risk and shoring up corporate balance sheets. The $473 billion of debt now coming due is down from $1.2 trillion two years ago, according to JPMorgan... About $209 billion matures over the next 2.5 years."

Global Bubble Watch:

June 16 - Bloomberg (Stephanie Bodoni): "The European Union must heed European Central Bank warnings about bondholder involvement in any new bailout package for Greece, Luxembourg's Jean-Claude Juncker said. 'We have to observe a certain number of red lines, mainly those mentioned by the ECB -- no default, no rating downgrades and the private-sector involvement has to be done on a voluntary basis... If we were to move to larger solutions, we have to take into account all the risks entailed.'"

June 17 - Bloomberg (Gavin Finch, Boris Groendahl and Liam Vaughan): "European Union stress tests on the region's banks are becoming 'irrelevant' because they ignore the possibility of a default by Greece. 'Everybody is so concerned about Greece defaulting and the effect that's going to have on banks, yet that's not something even being considered as part of the stress tests,' said Jane Coffey, head of U.K. equities at Royal London Asset Management... 'Greece defaulting isn't exactly a black swan event. There's a very good chance it will happen.'"

June 14 - Bloomberg: "China's May home sales transaction value rose 17% from April as developers marketed more residential projects during the Labor Day long weekend even as the government maintained its housing curbs."

June 15 - Bloomberg (John Dawson and Sophie Leung): "The world faces years of 'growth scares' as a weak recovery grinds on with little to cushion against periodic shocks, Morgan Stanley's Stephen Roach said. 'We had a growth scare last year about this time, we're having another growth scare this year, and I think we will have growth scares for several years to come,' said Roach.... 'When you have a weak recovery, you don't have a cushion that enables you to withstand those periodic shocks that always seem to come out and hit specific economies or the world... With oil prices up, the euro zone in trouble, the U.S. housing market having another leg down, and the problems in Japan, you've certainly had more than your normal fair share of shocks.'"

June 16 - Bloomberg (Crayton Harrison): "America Movil SAB Chief Financial Officer Carlos Garcia-Moreno said Mexican debt issuers are facing 'unprecedented' favorable conditions and demand in the market. 'We have a really unprecedented situation with extraordinarily low interest rates,' said Garcia-Moreno... 'The financial conditions today are viewed as very good. Not just the rates, but the conditions of access. Today there is appetite.'"

June 16 - Bloomberg (Gonzalo Vina and Thomas Penny): "Chancellor of the Exchequer George Osborne published draft legislation that will hand powers to the Bank of England to police Britain's banks in the biggest regulatory overhaul since 1997. The draft Financial Regulation Bill, which will now undergo pre-legislative scrutiny, will abolish the U.K.'s Financial Services Authority and transfer most of its powers to the central bank."

Currency Watch:

In a volatile week for the currency markets, the U.S. dollar index gained 0.3% to 75.99 (down 5.1% y-t-d). For the week on the upside, the Australian dollar increased 0.8%, the South African rand 0.7%, the Japanese yen 0.3%, the Singapore dollar 0.3%, and the Canadian dollar 0.1%. On the downside, the Swedish krona declined 1.4%, the New Zealand dollar 1.1%, the Norwegian krone 0.7%, the Taiwanese dollar 0.6%, the Swiss franc 0.6%, the South Korean won 0.3%, the euro 0.3%, the Danish krone 0.3%, the British poun 0.2%, and the Brazilian real 0.1%.

Commodities and Food Watch:

The CRB index dropped 3.6% (up 0.8% y-t-d). The Goldman Sachs Commodities Index was clobbered for 4.7% (up 5.9%). Spot Gold added 0.5% to $1,539 (up 8.4%). Silver declined 1.6% to $35.75 (up 16%). July Crude sank $6.28 to $93.01 (up 2%). July Gasoline fell 2.4% (up 20%), and July Natural Gas sank 9.1% (down 2%). July Copper rallied 1.1% (down 7%). July Wheat sank 11.5% (down 15%), and July Corn dropped 11.0% (up 11%).

China Bubble Watch:

June 15 - Bloomberg: "China's inflation pressures have yet to be contained by four interest-rate increases since September, underscoring the danger of any extended policy pause as bad weather threatens to further drive up food costs. The central bank yesterday increased banks' reserve requirements to drain cash from the economy after consumer prices rose 5.5% in May, the biggest gain since 2008. Inflation may reach 6 percent this month, according to banks from Societe Generale SA to UBS AG."

June 14 - Bloomberg: "China ordered lenders to set aside more cash as reserves after inflation accelerated to the fastest pace in almost three years in May... A half percentage point increase announced by the central bank... will take the ratio to a record 21.5% for the nation's biggest lenders. The announcement was hours after data showing the annual inflation rate climbed to 5.5%."

June 15 - Bloomberg: "China's macro-economic controls face risks this year including asset bubbles and inflationary pressure, the People's Bank of China said... The central bank reiterated a prudent monetary policy and a proactive fiscal policy for this year, according to the report."

June 15 - Bloomberg: "More than 18,000 corrupt Chinese officials have fled the country since the mid-1990s with about 800 billion yuan ($123bn) in embezzled funds, China National Radio said, citing a People's Bank of China report."

June 15 - Bloomberg: "Chinese developers' outlook was cut to 'negative' from 'stable' by Standard & Poor's, which said tighter credit and further government curbs may lead to rating downgrades in the next year... 'We haven't seen any encouraging news so far,' Bei Fu, an analyst at S&P, said... 'Inventory and sales pressure increased, government's policy is gradually showing effect, transactions have been curbed. Many companies issued bonds that will improve their liquidity but put pressure on gearing.'"

Japan Watch:

June 15 - Bloomberg (Monami Yui and Nobuyuki Akama): "Prospects for fiscal reform in the world's most-indebted nation are disappearing as Japanese Prime Minister Naoto Kan prepares to step down. When Kan took office a year ago, he pledged reforms that would balance the budget in 10 years and rein in a debt burden that's double the size of the economy."

India Watch:

June 16 - Bloomberg (Kartik Goyal): "India's central bank raised interest rates for the 10th time since the start of 2010... The Reserve Bank of India increased the repurchase rate to 7.50 percent from 7.25%..."

June 14 - Bloomberg (Unni Krishnan): "India's inflation accelerated in May, adding pressure on the central bank to extend the fastest round of interest-rate increases among Asia's major economies... The wholesale-price index rose 9.06% from a year earlier..."

June 16 - Bloomberg (Kartikay Mehrotra): "India's $400 billion plan to eliminate blackouts within five years is being imperiled in the credit markets. Loan growth for power projects is at a two-year low and bond sales by the industry slid 50% this year as rising interest rates, land acquisition delays and higher coal prices hamper electricity projects."

Asia Bubble Watch:

June 15 - Bloomberg (Eunkyung Seo): "South Korea's central bank signaled it will add to this year's three interest-rate increases as inflation and household debt remain elevated. 'We should normalize interest rates from their low level to reflect price and household debt levels,' Bank of Korea Governor Kim Choong Soo said..."

Unbalanced Global Economy Watch:

June 14 - Bloomberg (Svenja O'Donnell): "U.K. inflation held at the fastest pace since October 2008 last month... Consumer prices rose 4.5% in May from a year earlier..."

June 15 - Bloomberg (Emma Ross-Thomas): "Spanish home prices fell for the 12th quarter as unemployment remained above 20% and rising interest rates made mortgages more expensive. The average price of houses and apartments declined 4.1% in the three months through March from a year earlier..."

June 15 - Bloomberg (Dorota Bartyzel and Monika Rozlal): "Polish inflation accelerated in May to its fastest pace in almost a decade... Consumer prices rose an annual 5%, compared with 4.5% in April..."

U.S. Bubble Economy Watch:

June 15 - Bloomberg (Alex Kowalski): "The cost of living in the U.S. rose more than forecast in May as prices for everything from autos to hotel rooms climbed, signaling raw-material expenses are filtering through the economy. The consumer-price index increased 0.2% last month and was up 3.6% from May 2010, the biggest year-over-year advance since October 2008..."

June 15 - Bloomberg (Dan Levy): "A surge in wealth from technology stock sales and initial public offerings is spilling into the Silicon Valley real estate market as newly rich workers bid up home values in suburban cities south of San Francisco. The median price of single-family houses sold in Palo Alto, home of Facebook Inc., climbed 20% in May from a year earlier to $1.63 million, the biggest jump since 2008, according to... DataQuick."

Real Estate Watch:

June 13 - Bloomberg (Dan Levy): "Southern California home prices fell 8.2% last month as unemployment remained high and mortgages were hard to obtain, DataQuick said. The median paid in the six-county region was $280,000, down from $305,000 a year earlier..."

Fiscal Watch:

June 15 - Canadian Press: "It's not often a Canadian politician goes to the U.S. to offer advice publicly, but Finance Minister Jim Flaherty is taking that diplomatically risky chance. In candid language, the finance minister tells a New York business audience that the U.S. needs to get its fiscal house in order. ...Flaherty says the U.S. needs to outline a solid plan to eliminate the deficit and reduce debt -- not just for its sake, but for the world's. And he says there is no time to waste because the fate of the world's economy depends on the decisions being made in Washington."

June 13 - Bloomberg (Lorraine Woellert and Clea Benson): "Fannie Mae and Freddie Mac, the mortgage companies operating under U.S. control, are improving their financial condition but remain a risk to taxpayers, the companies' regulator reported. In its third annual report to Congress released today, the Federal Housing Finance Agency said improved underwriting on the loans that the companies package into mortgage-backed securities helped slow the agencies' losses to $28 billion in 2010, from $93.6 billion a year earlier... The government-run enterprises, which own or guarantee more than half of the $10 trillion U.S. mortgage market, operated as private companies before they were taken into government conservatorship in September 2008..."

Muni Watch:

June 14 - Bloomberg (James Kraus): "So-called conduit municipal bonds that allow private institutions to access low-cost municipal bonds that finance economic development have come under scrutiny because of the high ratio of their defaults and loss of tax revenue, the Los Angeles Times reported. The conduits account for about 20% of all municipal bonds and for about 70% of all municipal bond defaults in recent years... About $84 billion of such bonds were sold last year and growth in them has been three times faster than the overall municipal bond market, the Times reported..."


'Lehman Moment'

Isn't it incredible that the failure of one firm, Lehman Brothers, almost brought down the global financial system? It is equally incredible that, less than three years later, a small country of 11 million has the world teetering on the edge of another systemic crisis. Today's circumstance is a sad testament both to the instability of the international Credit "system" and to the lessons left unlearned from the previous crisis.

For about 15 months now my analysis has attempted to draw parallels between the initial subprime eruption and last year's Greek debt crisis. Both were the initial cracks in major Bubbles ("Mortgage/Wall Street Finance" and "Global Government Finance"). These two weakest links - due to their role as the marginal borrower exploiting a period of system market excess - were extremely poor Credits. On the one hand, the systemic vulnerabilities associated with a potential bursting of major Bubbles elicited aggressive policy responses to the initial subprime and Greek tumults. On the other hand, policy had no constructive impact on the underlying quality of the debt - while significantly inciting market excesses (market price distortions, Credit and speculative excess, etc.) that exacerbated systemic fragilities.

There was heightened fear this week that the "Greek" crisis was evolving into Europe's "Lehman Moment." Recalling back to 2008, the Lehman collapse was the catalyst for a crisis of confidence throughout the expansive universe of "Wall Street" risk intermediation. Importantly, market confidence in the willingness and capacity for policymakers to backstop this multifarious system held steady virtually until the moment the Lehman bankruptcy was announced. The marketplace appreciated the enormous risks associated with a potential crisis of confidence throughout the securitization and derivative marketplaces, yet assumed that policymakers would simply not tolerate a failure by one of the major players in this financial daisy chain. The global financial system almost imploded when this precarious "too big to fail" assumption was debunked.

I have posited that the global policy response to the 2008 crisis only expanded and solidified the market's notion of "too big to fail." Most in the marketplace believe that policymakers now recognize that allowing Lehman's failure was a major policy blunder. The expectation today is that the EU, ECB, IMF, Germany, China and the Fed will not tolerate a Greek debt default. This faith had better not be misplaced.

While the Lehman failure proved the catalyst for the 2008 crisis, it was definitely not the root cause. The problem was instead the Trillions of unsound debt underpinning Trillions of leverage, Credit insurance, and sophisticated risk intermediation that, through "Wall Street alchemy", had transformed really bad loans into seemingly appealing ("money-like") debt instruments. As soon as the market began to back away from these structures (commencing with subprime concerns), the downside of a (Hyman Minsky) "Ponzi Finance" scheme was set in motion. And as the Bubble began to falter, the market increasingly valued huge amounts of debt based on the perception of a system backstop rather than based on the fundamentals of the underlying debt instruments (largely, increasingly vulnerable mortgages).

If authorities had moved to save Lehman back in September of 2008, it would have bought some extra time - and would have changed little. Trillions of unsound debt, distorted asset and securities markets, and a severely maladjusted economic structure ensured a major crisis. It was only a matter of the timing and circumstances as to how the widening gulf between distorted market prices and the true underlying value of the debt was resolved. As we are witnessing with Greek, Portuguese and Irish debt (and CDS) prices, market troubles often manifest when unanticipated policy uncertainties force the marketplace to take a clearer look at the fundamentals underpinning a debt structure - only to grimace.

The problem today is not really Greece. A distorted global Credit "system" has created tens of Trillions of unsound debt - and rapidly counting. Aggressive "activist" policymaking has been at the heart of this unprecedented Credit inflation, and the markets today fully expect policymakers to ensure this Bubble's perpetuation. And, importantly, for better than two years now global fiscal and monetary policies have incited another huge round of global speculation and re-leveraging. This latest Bubble gained considerable momentum with last year's European Greek bailout and implementation of the Fed's QE2 program.

Policymaking gave a new - and egregiously profitable - lease on life to the "global leveraged speculating community." Given up for dead, hedge funds, proprietary trading desks and others have been able to exploit government-induced market distortions like never before. With confidence that massive fiscal and monetary stimulus would ensure economic expansion, abundant marketplace liquidity, and strong inflationary biases for global securities and commodities markets, the global "risk on" trade proliferated near and far. Re-risking and re-leveraging - through the creation of new market-based debt and attendant liquidity - fueled a self-reinforcing speculative boom. QE2 (and other central bank liquidity operations) coupled with re-leveraging dynamics bolstered the perception that the markets had commenced a cycle that would prosper in liquidity abundance for an extended period. Fragile underpinnings, especially in the U.S., seemed to ensure years of policy largess.

There is a big problem any time the leveraged speculating community begins to question core assumptions - certainly including the capacities of policymakers to sustain Credit booms, ensure liquid and continuous markets, and to contain Credit stress. Think of it this way: Enterprising market operators are incentivized into leveraged ("risk-on) trades when they discern that policymaking is providing both a trading edge (generally an inflationary bias or predictable spread) in the marketplace and a favorable liquidity backstop availing an easy exit when necessary. I would argue that huge speculative positions have accumulated over the past two years on assumptions that are increasingly in doubt. This has quickly become a major market issue, and largely explains recent market action.

The markets must now face the reality that policymakers don't, by any stretch, have the Greek crisis contained. Last year's big "fix" is now appreciated as a mere little band-aid. What appeared an incredible sum for the one-time bailout of an inconsequential economy is increasingly recognized as the tip of the iceberg for huge structural problems at Europe's periphery and beyond. The markets are beginning the process of recalibrating the potential costs - including financial, economic and social, along with myriad unknowable attendant risks - associated with festering Credit and market crises. The results are frightening.

My basic premise is that the sophisticated leveraged speculators have been operating as the marginal source of liquidity - fueling a highly speculative run throughout global risk markets. These players now appreciate that assumptions underlying their bullish positioning in various markets are now in jeopardy. No longer do the policymaking, liquidity and economic backdrops support their aggressive risk-taking posture. This effectively ends the latest cycle of speculative excess, as prospects would appear to dictate more self-reinforcing pressure to de-risk and de-leverage.

A speculative marketplace cannot easily accommodate a move by the marginal liquidity provider to unwind leveraged positions. This challenge becomes only more formidable when a meaningful segment of the speculating community would prefer to unwind long exposure and then go short various risk markets. It is exactly this type of dynamic that transforms what seemed to be highly liquid markets quite abruptly into illiquid problems.

It has been part of my bear thesis that the "moon and stars" were lining up for a bout of de-risking and de-leveraging right as QE2 was wrapping up. Market cracks have been forming for months now - emerging market equities, commodities and the gold stocks, the banks and the depleting energy sector come to mind. Hedge fund returns have been unimpressive, which equates to a lot of positions and leverage in potentially weak hands. And, importantly, the U.S. economy has performed dismally in the face of massive stimulus. Much of the marketplace has been caught poorly positioned. Still, many of the bullish persuasion are comparing the current soft-patch to last year's, missing the critical difference that recent weakness commenced in the midst of strong equities markets, booming debt issuance and $20bn or so of weekly quantitative easing.

It is certainly not a clear line from Athens to the U.S. markets and economy. And it's not an easy task to explain how financial conditions in our system have come to a large degree to be dictated by global market forces. But to appreciate the gravity of the situation one must first recognize the underlying fragility of our financial and economic systems.

If this were a sound recovery - fueled by balanced growth, strong capital investment and financed largely by relatively stable bank finance - I'd be a lot less worried. But we're instead in a quite shaky recovery incited by massive fiscal and monetary stimulus - which spurred excessive risk-taking, speculation and general financial excess. Real economic adjustment was put on hold; the system has been set up for disappointment. And with bank lending stagnant, the vast majority of system credit creation is coming these days from the issuance of marketable debt. The markets had already moved to impose austerity on the municipal bond arena, and it appears the booming corporate debt marketplace is now facing an abrupt shift in the liquidity backdrop.

"Extend and pretend" and "kicking the can down the road" are now bandied about when discussing the policy approach to the Greek crisis. Virtually everyone believes that policymakers will -heroically in the final hour - come together, end the brinksmanship and craft a policy response that avoids even a technical default. German Chancellor Merkel peaked into the abyss and saw the light - just as the markets presume politicians and central bankers will do. There will be no "significant" contribution (aka losses) to bondholders, with Ms. Merkel agreeing instead to a voluntary participation from private creditors.

The problem is the market has no appetite for Greek debt - and it doesn't want the debt of Ireland or Portugal either. And it wouldn't take all that much for the marketplace to take a cautious approach to debt altogether. At this point, there's little that can be done to make this problematic periphery debt appealing to the marketplace. Meanwhile, the Greek populace has taken a lot of pain - and will be told to endure worse - without seeing any positive results. The whole process has lost important credibility, which could mark an important inflection point for the markets.

Global markets have enjoyed a bountiful year of policy-induced gains. Policymakers, once again, emboldened those believing that governments can solve debt problems and easily intervene to bolster financial markets. This backdrop has, at the same time, provided quite an opportunity for market participants to hedge risk in Credit default swap (CDS) and myriad other derivatives markets. At the end of the day, the flurry of hedging and speculating that arose when subprime heated up in '07 embedded risk exposures that came back to haunt the system with Lehman's collapse. And, I'll wager, many of the institutions at the heart of today's booming global risk-intermediation and derivatives markets (including CDS) are heavily exposed to Greek and periphery debt.

Expanding debt impairment is becoming a major problem; there's no apparent default mechanism that wouldn't imperil many of the world's major financial institutions; and the tentacles of this potential crisis reach far out across the global system. "Extend and pretend" is the new normal, as global markets become a politicians and policymaking confidence game. Europe - and the world's - new "Lehman Moment" commences when the markets question the soundness of the global derivatives marketplace.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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