Jul 27 2007
The Great Credit Unwind
If you read our associated 2007 Wealth Report (From Ernharth Group Wealth Management), you knew it was only a matter of time before the house of cards that is the global credit system would find itself over extended to where it could no longer support itself. That is the nature of any massive credit / money supply expansion. The economy is so badly perverted by easy money and the associated mentality, that caution goes to the wind as newfangled justifications for the formerly unjustifiable become commonplace replace the timeless truisms.
Our favorite is probably this one: you don’t create wealth by saving; you create it by expanding debt. That’s a corollary to the soon to be (hopefully) discredited “paradox of thrift”, where Keynes and many generations of ideologically related schools of economics theorized that too much savings is a problem because the very act of savings ends up slowing the velocity of money — no one is buying or selling, to the point of recession and depression — a theory not terribly comfortable with the free market purpose of prices in relation to interest rates. (For more on that, see our recent post “The Dollar Sinks Amid Systematic Credit Risk“) Based on such a foundation, credit has been ginned up to the stratosphere — as have the asset prices it supports. But with it, so went common sense and good old fashioned measured risk taking — as one might have learned from Benjamin Graham or Warren Buffet.
So here we sit today with one of the consequences of underpriced and ever-expanding credit: a credit unwind and contraction. Consider:
“Bloomberg Radio reported this morning that the monthly issuance of Collateralized Debt Obligations (CDOs), or packages of debt instruments bundled together to form a “portfolio” of debt, dropped from $42 billion to $3 billion in the latest month. That 93% drop represents a significant tightening of liquidity that is starting to ripple throughout the credit markets. The fixed-income markets appear to be starting to understand that the days of free-flowing liquidity are likely to be behind us. Most credit spreads are widening.”
That’s Merrill’s Richard Bernstein discussing a drop we mentioned a few weeks ago. That’s a severe contraction that’s causing many deals to fall apart. Just the same, existing CDOs are getting repriced at a rapid pace — which ain’t pretty. Barry Ritholzt has some great charts documenting how the supposed good stuff — the AAA to A CDOs are feeling the wrath of finally being marked to market in an environment that truly is coming to terms with the rot beneath the surface.
It’s not pretty, and anyone thinking this is not going to bleed further into other areas of the market needs to get on top of the situation. As we stated two days ago, this is not just a credit market issue — this is a fundamental problem of massive dislocations in the economy. A massive perversion of dislocation built upon dislocation built upon dislocation.
The only question remaining is, will the ultimate end game be temporarily papered over with another blast of money supply? That’s a tool that grows less effective with each blast, and as such, the consequent price inflation is spilling out of the financial markets and into the general economy — never mind the nearly laughable indicator that CPI has become.
As for the market swings of the past few days, keep your head low. Always remember, though, that those in the policy seat are terrified of a massive contraction and are ready to open the MZM spigots as far as they are needed. In such an environment, all bets are off — expect wild volatility — including even new equity market highs time and again until the dust ultimately settles. But, as we’ve been saying for over a year now, measure your returns not in terms of dollars or relative to CPI, but against other currencies and hard assets — the latter which cannot be printed so easily as fiat currencies that are used by all governments across the world.
