Monster Western Credit Crisis - Prelude to a Depression


By Chris Laird

Nov 14 2007 10:55AM

  • The present contraction of credit
  • Gold in this situation

Present contraction of credit

The West (US,EU, Canada) is in the midst of a gigantic and spreading credit crisis that may well to lead it into a depression, if it is not fixed soon. So far, Central bank infusions (Over $1trillion worth in a few months since July!)  have been the only thing that has stopped a massive bank liquidity crisis from shutting down commerce. But the damage to credit markets thus far is so huge, and worsening rapidly, that a very bad outcome seems assured. Gregory Peters of Morgan Stanley said there is a better than 50% chance of a systemic banking crisis that will hammer credit markets at this time.

So far, equity markets have barely reflected this turmoil to the degree it should. That is going to rapidly change. Central banks have been doing backflips to stem the crisis, and I think, things are rapidly spinning out of control. They have barely been able to stem a collapse in interbank lending, which would halt credit markets. The damage a paralyzed credit system will do to our credit dependent economies is going to be staggering. It would appear that much of the crisis is hidden from view, but the way it will inevitably reveal itself will be in falling corporate earnings, and collapsing consumer and business spending. In a few short months, we will see if I am right. So far, stock markets have not priced in falling earnings that we expect to appear in coming months, as contracting credit markets constrain all manner of spending and investment.

Genesis of collapsing credit

As late as July of this year, a crashing housing market appeared to be something that could be weathered by other growing sectors of the US/Western economies. Then, the inevitable credit dominoes started to fall, after the first one fell, the mortgage delinquencies. Next we entered a scary August and September world credit crisis, as huge forms of liquidity, formerly seeming of endless supply, rapidly dropped to nothing. That would be the securitized credit markets.

Rapidly, the emerging losses in securitized credit, from CDOs, MBS and such (packages of loans such as mortgages sold off as securities and derivatives) caused a cascade of falling confidence in our banking sectors. All of a sudden, the credit crisis spread from the mortgage derivatives markets to the commercial paper markets in an almost instantaneous fashion, after BNP Paribas, France’s largest bank, had to freeze redemptions on two hedge funds that had losses in mortgage derivatives . In about a week from that announcement, the entire European commercial paper market froze, as banks were afraid to roll over each other’s commercial paper, not knowing who else had $billions worth of exposure to the huge mortgage derivatives market. This was in August.

The credit market damage is so severe that the largest banks in the US are at risk of losing much of their capital. Citibank alone said it needs to raise $30 billion in capital. If the 5 largest banks in the US are already in crisis mode, and other major banks in the EU too, and don’t forget Canada, England and so on, things look incredibly negative. And the losses have only just begun to pile up. There are many more to come, as we will partly discuss. Bernanke stated that 450,000 mortgages reset each quarter in the US in the coming year. But this is not all about just mortgage resets and the housing market. This is about the spreading damage to other key sectors of the credit markets.

Since July, the West’s commercial paper markets (CP) have contracted by hundreds of $billions worth, as banks and investors refused to roll over CP of 270 days or less maturity. The ECB (European Central Bank), and US Fed, and other western central banks had to step in and offer short term money to cover the shortfalls, or else a massive world banking liquidity crisis would have emerged.

As it is, interbank lending is quite bad, and Central banks have not been able to stop either the continued shrinking of the CP markets, nor the ever increasing losses stemming from a collapse of the securitized debt markets. Central banks have had to step in as lenders of last resort to keep the banking and financial system from imploding, and there is little progress on this front to date. The $75 billion SIV bailouts arranged by the US Treasury department is on and off again. The key banks involved may not be able or wish to complete it. Citi, for example has to raise $30 billion in capital to cover the mess that has emerged since July.

Next big credit domino

Now, other huge credit markets are about to fall in turn. The next one is the credit insurance market. Credit insurance is an essential part of any credit market. Lenders can buy credit insurance to help cover the risk of loss when they lend. Credit insurance is a key component rating agencies use to asses credit risk of bonds and such, and assume that if any of the bonds that have credit insurance default, the credit insurers will pay off.

But, the amount of securitized credit loss is so huge at this time, losses on CDOs, MBS, and other securitized credit vehicles, that the viability of credit insurers is now in question. Credit insurers will have to start paying off in the next several months. They will be reporting big losses. That will affect the credit ratings of every security they insure.

This means that all the securities these credit insurers insure will be downgraded by rating agencies – if the credit insurer becomes insolvent.

This crisis has spread to Money Market funds for various reasons. First, many money market funds have a large part of their capital invested in short term commercial paper that provides a slight yield bonus. Since much CP is not rolling over, MMFs are having trouble rolling forward those maturities. Also, MMFs have invested heavily in the securitized debt (mortgage derivatives like MBS and SIVs and CDOs) all of which are in deep trouble.

I have had readers email me stories of being put off from redemptions from many money market funds since August. These are from major name institutions. I have been told of games like telling people to fill out forms and not executing what people wanted to do in their fund. Those stories still come in as I write this. It is very important that you read the disclosures about your MMFs, and know that these are generally not FDIC insured. The same goes for other nations MMFs and their deposit insurance.

How this crisis develops

First, US mortgages default, Jan to June 07. Then, the credit securities back of them collapse in value July 07 to present. Then the banks and others holding these have to take huge losses/writedowns. Then those institutions have to raise capital. Then credit insurers have to pay off (coming in the next several months). Then as they go bankrupt, all the rated securities they insure will be downgraded, as the supposed insurance that was purchased is now worthless, as the insurer is insolvent. Then a new cycle of losses as the newly downgraded credit securities have to be marked down.

Then…here is the rub – banks and such have to stop lending, and you get a system wide freeze of new credit. We are right in the middle of this part. HSBC, for example,  has stated they are going to pull back lending in the US, as they have been badly hit in the mortgage markets. Consider this, and see credit contraction in the US increasing across lenders. As I said, Citi stated they need to raise $30 billion of capital.

Main source of credit now totally dead

What’s more, the source of most of the credit in the last 5 years, securitized credit, is literally disappearing. As that entire sector becomes discredited, the source of most of the money coming into the world’s bubble economies, securitized debt, is drying up.

As banks are forced to raise capital and stop lending, consumers find new credit hard to get or not available at all. The same goes for businesses. You then get system wide credit collapse, and the resultant collapse in economic growth. And if no recovery is made quickly, you get a depression. Not a recession, a depression, due to collapsing economic demand.

Gold in a real world stock collapse

So far this year, we have had about 4 major world stock sell offs. Gold has sold off in these, but rapidly recovered later. It is not clear how gold will react if we saw a real world stock crash however, on the order of 50%.

Gold showed two types of behavior this year in stock sell offs. The first was flight to cash, and as institutions had to cover margins, sold gold in stock drops. But, also, at one point in the August-Sept credit crisis, flight to safety caused gold to rise, even in the midst of the stock declines.

So, we know that in this kind of environment, gold has shown resiliency.

That would not likely be the case of other commodities however. In spite of the new paradigm Asia growth model, I don’t think Asia will escape major economic contraction should the West have a severe economic recession. Since China is the largest consumer of many commodities, any significant contraction by them will cause high commodity prices to plummet. Gold should be excepted because it is a central bank reserve asset, unlike your other commodities.

New Chinese Foreign investment restrictions

Just consider that many Chinese economic sectors have huge overinvestment, and that China just instituted economic restrictions on new foreign investment in many sectors they consider over invested. That being the case, they would not do well if a large part of their export markets contracted, should the west (EU,US, etc) have a severe economic contraction.

Gold right now is in a very speculative phase with a lot of volatility. Japanese speculators are all over it, and it is said that when Japanese speculators get into gold, it is late in that particular bull run.

We at Prudent Squirrel are long term gold bullish, as Western central banks will likely attempt to flood money to keep markets afloat, and are lenders of last resort to the credit/banking system. The US fiscal prospects are terrible in coming years, and we expect gold to be well over $1000 in coming years. The rest of the West, EU, Japan, are not much better off.

However, in the intervening time, if financial markets finally recognize the damage to the credit markets, and consumer spending and corporate earnings finally reflect economic contraction, stocks will fall precipitously. Gold likely would sell off quite a bit initially in that. But longer term, we believe gold is still the best place to have part of your liquidity.

Stocks at this time are presently recovering (one day since Tuesday, anyway), but we feel that the potential for a systemic banking crisis and the contracting credit will soon be reflected in stock markets. So far they have not reflected the severity of the credit situation as much as they should.

The Prudent Squirrel newsletter is our financial and gold commentary. Subscribers get email market alerts mid week as needed. We put out an alert Oct 30 that a general market selloff was imminent. Stocks sold off hard soon after worldwide. So far, we have predicted 4 major world stock sell offs by up to two days this year.  We also predicted the USD was about to bounce in Sunday’s newsletter, which it did Monday. The USD is still shaky though.

Stop by and have a look.

Christopher Laird


Chris Laird is not an investment advisor/professional. This article, and the PrudentSquirrel newsletter, is general market commentary only. It is not intended as specific advice. You should talk to your own investment professionals for specific advice.

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