Sunday, January 27, 2008


What Follows A Credit Bubble Implosion

Some are now debating whether the earlier than scheduled rate cut by the Fed was prompted by the SocGen losses. More have been arguing that the Fed is kowtowing to Wall Street by cutting more than 50 basis points and earlier than planned. We must be be certain that the Federal Reserve is not there to ensure an always strong stock market.

Morgan Stanley's Stephen Roach counters that the decision was ``dangerous, reckless and irresponsible,'' and Nobel Prize winner Joseph Stiglitz says it resulted from ``bad economic management.'' To me, the Fed's aggressive rate cuts mirrors the mistakes Greenspan made the last few years by keeping rates low for too long and printing too much money.

By easing aggressively on the basis of no new information, they're sending a message that they have to protect and defend the markets. Traders anticipate a further half-point rate cut at the Fed's meeting Jan. 29-30. That would put the overnight interbank lending rate at 3 percent and bring the cumulative reduction to 2.25 percentage points in less than five months, the deepest cut since 2001, when the U.S. entered its last recession. What is clear is why does the Fed bring forward the rate cut move, if it wasn't responding to some external market implications. Monetary policy is a strategic lever which works itself into the real economy: an additional week during the official FOMC meeting should not change things. Obviously Bernanke acted because of some additional news. It could be the SocGen situation or the free falling global equity markets.

Although this sounds far-fetched and opinionated, it looks like the Fed just didn't recognize the severity of this crisis.

The Fed's unscheduled move has been a frequent topic of discussions in Davos. George Soros said the Fed is ``doing the right thing,'' just not quickly enough. ``I think the Fed is well behind the curve, and has been reacting instead of being proactive,'' he said. The Fed rate cut showed that the Fed can be pushed around by the markets,'' says Nick Parsons, head of market strategy at National Australia Bank Ltd.'s NabCapital unit in London. ``The Fed is a follower and not a leader. In an attempt to gain control, the Fed has lost credibility.''

If the Fed reacted the way it did when the stock markets fell, what will the Fed do when the credit bubble implosion hits the consumer debt, another rate cut? What about the forthcoming bust in home equity financing? Another rate cut? How many rate cuts will be needed? Its like applying more Vicks Vapourub everytime the person coughs. It feels like some relief but does nothing to address the core condition.

This is a credit bubble implosion due to over exuberant money supply growth for the past 5-6 years. A lot of people would not be aware that you can print as much money as you like, but there are consequences - if not, every central banker would continue to print as fast as they can. This is simplistic but its the reality. When central banks print more money, it offers to the banks, or lend to the banks at cheap rates. Hence the money is "owed" and must be paid back. Its not like the central banks print money and GIVE it free to the banks to lend out. The central banks cannot circumvent the cycle by saying to the banks "OK, don't have to pay that amount, I will just write it off" - although technically they can, its called a bailout but they do it by lending more money with even lower rates or zero rates to bail out ailing banks. The Fed could bail out the Citigroups and Merrill Lynchs by offering a "superfund" to do something like that, but that is tantamount to covering the mistakes in the market place.

Back to the money supply growth issue. Banks with more funds can then lend to the companies and consumers to inject economic activity. Owing to the loose money supply side, the lending has not been all productive. Credit card debts globally is a problem. Especially in the US, home equity refinancing is a huge problem. As property prices surge, many continue to tap on the additional equity for cash: most of it went to holidays, refurbishment, down payment for another property, etc. On the commercial side, the lending went into aggressive repackaging of home lending.

This is the end result of excessive money supply growth. Of course many have been saying that for the last 2 years but you needed a proper catalyst for the credit bubble to be pricked. Failing which, this merry go around could go on for a few more years. The catalyst was the sub prime implosion. The accumulation of sub prime related bad news finally tipped the scales when Citigroup not only wrote down US$18bn in sub prime but also provided an additional US$4bn for anticipated consumer debt problems.

Looking forward, there could be more "bad news" related to sub prime write downs from European banks. Most of the bad news for the past 3 months had been from American banks. However European banks only reported half yearly results, unlike the quarterly reporting in the US. It is plausible that there should be much more "bad news" from the European side in the coming weeks.

The credit bubble implosion, if there was to be a progression, would be something like this:
Money Supply Excessive Growth = Reckless Lending = Reckless Consumption = Reckless Leverage = Assets Driven Up Beyond Fair Value = More Leverage On Inflated Assets = Sub prime Mess = Commercial Debt Tightening = Reassessment of Risk = Only a portion of Global Investors Realise Credit Bubble Imploded = Assets Correcting Back To Fair Value = Consumer Dent Implosion = Damage Control By Fed (too late) = Assets Fall Some More = Central Banks Coordinate Even More Rate Cuts = Banks Continue To Write Down = More Bankruptcies and Foreclosures = Everybody Knows Credit Bubble Imploded = Everybody Starts To Tighten Spending = Consumer Confidence Dips = Market Starts To Rise After Prolonged Falling & Recovers Even While All Consumers Feel The Pain Because Markets Are Forward Discounting & Not A Snapshot Of Reality In Present Tense

If you look at the chain of events above, where we are NOW is the RED coloured portion.


2 comments:

solomon said...

I still blame Alan for this debacle and Ben for his poor leadership. No matter what the Fed does now and later, it will to the liking of Street traders because there is not much ammunition left in the coffer ie. 3.25%. Hopefully the vulture funds did not fix the market now, or else it will be more disaster.

They have not stop / fully accountable the leaking from the financial system.

US should also relook at their employment issues, of which in these recent years too much outsourcing have been done to the name of "Cost leadership".

We may need at least 2 years, taking account that the year after the Presidential election normally the market is soft.

Only time will tell.

Edmund said...

Hi dali

I am a staunch follower of your blog and I must say you are one of the better ones around.

I'd like to be the devil here and bring you back several weeks on the outset of the infancy of the subprime crisis.

Together with most other analysts, you have been quick to brush off the subprime being an insignificant % of the total loans in the US system and that it will only cause a blip.

Fast forward now, like the others, you are pressing the panic button frantically and calling for a total stampede out of equities.

I know the financial markets are fluid and far from blaming you for making such calls, would you hold a contrarian view now ala Marc Faber in bull markets or when Warren Buffet took short positions in the USD (which has proven to be correct and his net worth would have multiplied had he continued to rollover those positions) in the think of a wall street boom.

What is your argument on China and India being a potential saviour for the rest of the world?

And why is it that even when the subprime loans were identified to be an insignificant % of the financial system (and thus, confidently brushed aside by all and sundry), never did i hear of one analyst then predicting it to be the ultimate downturn of the wall street and global equities?

I mean, what changed?