We have officially started year 2 of the credit crunch. Some could argue that the actual start was in late May or June of 2007 when the first signs of widening credit spreads were observed. In real time that was a difficult conclusion to reach since those early warning signs then were within the normal trading ranges and seemed to be nothing more than ordinary volatility.
We believe the first apparent sign was the Bear Stearns (BSC) announcement in July 2007. BSC admitted problems with their hedge fund construction and indicated they would have to add funds and recognize losses. At that time no one believed that this first chapter in the Bear Stearns saga would end eight months later, with the final chapter in March 2008. BSC disappeared in a remarkable application of the Federal Reserve’s power and emergency funding tools.
So where are we now?
We are watching a massive adjustment in finance. The next generation of textbooks will have chapters devoted to Bear Stearns, JPMorgan Chase, and the Fed-financed weekend shotgun merger. There will be whole sections on the Federal Reserve and how it has hugely altered its balance sheet and is reconstructing its role.
Fannie and Freddie will require a treatise on the largest de facto nationalization in American history. Bank failures will be examined to determine how and why they happened. IndyMac is also a chapter in this new book. How is it that a $32 billion failure is deemed adequately capitalized in March and fails 100 days later? I will stop this listing of what we know, so we can articulate what we don’t know.
We don’t know if the stock market correction is finished or if there is another serious decline ahead. We don’t know if the Treasury bond market faces a sustained upward movement in yields or will rally to lower yields. We don’t know if we are going to see the deflationary forces of falling housing, collapsing autos, and distressed consumers prevail over the inflationary forces of commodities and a weaker currency.
We don’t know if the 2009 fiscal condition of the US and its 50 states and local governments will break the limit on deficits. It is starting to appear that the public sector total borrowing requirement in the United States will exceed $600 billion in fiscal 2009. And please remember that is the cash borrowing portion, not the accrual. With the accrual it is likely to exceed $1 trillion. If the US reported its liabilities the way it requires every private company to report, we would be routinely seeing this trillion appendage to the national numbers.
In the corrective actions taken by the Congress and the Treasury Secretary and the Federal Reserve Chairman, we are witnessing a massive expansion of leverage. And we witness a growing intervention of the government into finance, economics, and markets. Some argue this is for the better. Maybe so? Others argue for the laissez faire ways of yesteryear. They are in the distinct minority, and their arguments are not persuasive to the majority. Like it or not, the outcome of the credit crunch is more and bigger government intervention into the economy and the financial structure of the country.
That means the seeds of the next crises are being sown right now, as these fixes of the past problems are enacted. The very same folks who planted the soil in the breeding ground of housing finance or leverage loans are now fertilizing the successor crisis during this rocky period.
Where will we look for the unintended consequences? Is the entire federal bank deposit insurance structure being realigned so that risk is shifted to the uninsured depositor in an unprecedented way? We think so. Who is the uninsured depositor? Mostly independent businesses and smaller institutions are taking on this risk. Many of them do not even understand it.
Have we marked up the retirement system unfunded liabilities and therefore added to the risk of the federal government’s guarantee of insured pensions? Will Pension Benefit Guarantee Corporation be the next crisis? Or will the crisis erupt from a run on securities firms because of suspicions about SIPC insurance protection?
We do not know where the next explosion will occur. We do know it is coming. In the global market, the credit default swap (CDS) on the United States has doubled in price since the Fannie-Freddie nationalization (10-yr CDS from 8 basis points to 16). This security trades in euro because dollar pricing makes no sense when measuring credit risk on the primary issuer of dollar denominated debt. Likewise the credit default swap on Germany trades in dollars because the German home currency is the euro. The US is now priced at double the credit risk of Germany. Both are still low compared to other countries. Most importantly, the US trend is clearly negative. At Cumberland, we view credit default swap pricing as one of the single most important market based indicators of risk. Watching the credit default swap price on the United States widen is a warning signal of higher interest rates to come, if it persists. We must give commendation to Howard Simons of Bianco Research for excellent comments on this technical subject.
At Cumberland we will continue to use scenario strategies and attempt to manage clients’ funds around these risks. Sometimes that means selling something at an early stage and before the risk materializes. Often that early move is anticipatory and the event does not happen. There are many times when a cure is put in place before the loss occurs.
Is it better to run early and then miss a move because the loss didn’t happen? We think so. The alternative is to wait until it does happen, and that is often too late. On our website, www.cumber.com, in the right corner, are three commentaries from the past. In them we discussed the growing risk in Fannie and Freddie and in the mortgage sector. One of them (December 17, 2004) suggested that investors in Fannie Mae were heading for trouble. We wrote: “…the stock is still near 70 bucks. Oh, well. These folks once bought Cisco and Microsoft at $100 a share. They are each a more responsible reporting company than FNMA.” We were ridiculed when we published it three and a half years ago.
This weekend we are off to the annual economic-finance retreat at a fishing camp in Maine.
Each year we organize this event by invitation only. Finance and market professionals and economists gather privately at Leen’s Lodge in the village of Grand Lake Stream, Maine. Some of the discussions are private. Other comments become public as attendees write about them. Quotation is allowed but only with the permission of the speaker.
This year CNBC is sending a live truck to the fishing camp. My interview is scheduled for 6:30 AM on Friday, August 1. There will be other interviews of attendees, and the panel discussion of the 8:30 AM employment report release will be conducted from the location in Maine.
When we gathered last year, the first chapter of the Bear Stearns saga was very fresh. The Fed Funds rate was 5-1⁄4%. There were few concerns about bank failures or bear stock markets or $140 oil. There were numerous AAA rated municipal bond insurers a year ago and student loan paper was viewed as a cash equivalent. I expect this year’s discussions will be quite robust.