Wednesday, April 23, 2008
a reconsideration of easing
at this point, my eyes turn to china. would a stock market collapse end the inflationary mania that has helped to keep the united states afloat? i think quite possibly so. many chinese companies are doing what american companies did in the 1920s to improve profits -- that is, ignoring their lines of production to borrow and speculate in equities. dumb money had of course already been piling in at record rates. a crash and rapid exit of foreign speculative capital could have massive ramifications across corporate and banking sectors, with banking having been acknowledged for some time as a potential weakness. (more on the subject from brad setser.) and the pattern frankly looks very pessimistic, with chinese 'A' shares down 27% from their highs three months ago and still making new lows.
'a' shares are now down 50% in what is becoming one of the great stock market collapses of the past century. does it now threaten to end the debt supercycle by cutting the united states off from further financing of its current account deficits?
perhaps. foreign pressure to support the dollar is becoming more aggressive in considerable part due to the no-longer-deniable ill effects of american monetary easing on dollar-peg economies as runaway inflation results in food riots. the blame is being squared up on america.
The global food crisis is a monetary phenomenon, an unintended consequence of America's attempt to inflate its way out of a market failure. There are long-term reasons for food prices to rise, but the unprecedented spike in grain prices during the past year stems from the weakness of the American dollar. Washington's economic misery now threatens to become a geopolitical catastrophe.
the premise involved -- that international dollars are seeking stores of value in commodities -- strikes me as an overstatement. but speculative capital, overlaying a general increase in resource demand, is definitely driving the commodities boom. and the search for a scapegoat in china and elsewhere over simultaneous stock market collapses and incipient starvation will be powerful political incentive for governments to reduce dollar recycling and allow currency appreciation while employing the benefits of trade instead to help domestic policy.
the leverage that underlies the boom is, however, being attacked by the global credit contraction now underway. the price explosion that has resulted from speculation should be a relatively transient phenomena, even as recessionary periods are generally characterized by the collapse of the prices of finished goods and assets as compared to raw materials (which is exactly what we're seeing, and in an extreme way). and even the underlying demand may well moderate if a global slowdown isn't avoided. the pressure that results from political instability over food prices may be short-lived if deleveraging and asset collapses continue to deepen.
regardless, the food crisis should be the paramount concern of all involved; there is no motivation for revolution as compelling as hunger, and the governments of dollar-peg economies know it. they must take remediative action. if the dollar continues to decline, i would expect the pressure on the united states to ratchet higher and eventually some sort of multinational currency intervention to take place. in a deflationary environment, it may be more successful than anyone now presumes it could be.
in the long run, though, that doesn't fix the problem. even if the dollar can stage a rally, the solution must be for the united states to stop borrowing against its future, accept a lower standard of living and close its current account deficit. yves smith brings up the possibility of the united states being forced to borrow in another currency, shifting the exchange-rate risk back onto the united states. i wouldn't at all be surprised if foreign creditors, seeking no longer to devalue their own currencies, began to seek exactly that remedy.
There are two commonly referenced effects whose underlying mechanics I have been unable to find satisfactory details on, and this is one of them.
If I as an American sell my Chinese stocks, I then exchange the resulting yuan for dollars, but someone else is left with the yuan. If their propensity to invest in stocks is on average expected to be similar to mine, then they are as likely to buy Chinese stocks with the money as anything else (or if they don't, the next person down the line of monetary exchange might be). Money should flow across all asset classes proportionately based on perceived relative value. So shifts in foreign versus domestic investment seems to be meaningless for asset class prices denominated in a single currency, though it clearly affects exchange rates. Unless propensity to leverage is different between American and Chinese holders of yuan (more leverage giving a higher impact on prices)... but that seems unlikely to have been quantified.
The second common and related statement is that if foreigners fled US treasuries, long term rates would rise. Same deal -- whoever they sell the dollars to has to do something with them, so treasuries are as likely a target as anything. If there is an expectation of continued dollar debasement and import-driven price inflation, that would lower the propensity for holders of dollars to buy bonds versus other asset classes, but that expectation shouldn't persist too long once the flight has occurred. If 70s style cost push inflation took hold the fed would likely have to raise rates to fight it, but can that really be considered an inevitable outcome of any flight from US treasuries by foreigners, given that import prices (impacted by exchange rates) are only a small percentage of our economy?
What am I missing, or which assumption here is wrong?
P.S., I reread your comments on sale of loans in a fractional reserve system and now it's all clear, thanks!
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looking like a bull trap
deteriorating momentum of a kind seen at many short-term tops. maybe the longer-period momentum is signalling a potential extension of the run, but then maybe not.
hi/lo data are not more encouraging. again the 65d measures are more optimistic -- but the 20d are not.
mcclellan is diverging down as well, as are issues over 10dma, net advancers, net volume... just not encouraging.
these same patterns are evident elsewhere too. they're blatant enough in the financials that i initiated a position in SKF yesterday. but i would also note that they are not as plain in the s&p.
again, there may be an extension of the rally -- all these trends can extend a bit further in time before a reversal becomes likely, and there's always the possibility that further strong gains nominally reverse the trends themselves. i wouldn't be surprised to see divergences build in the 65d highs and longer-term demand-supply line before any cutback.
dramatic slowing in economy
These results reflected a noticeable tradedown in service levels from express to saver, saver to deferred, and deferred to ground. As customers worked hard to reduce their costs. Tradedown was evident across all customer sectors but was most prevalent in retail. This is a tell tale sign of a progressively worsening economic environment.
it seems to be getting clearer that the united states, on the cusp of recession a few months ago, has since slowed considerably and is currently in a deepening recession. whether it becomes the kind of recession that joseph stiglitz and nouriel roubini are calling for is another question, of course.
but yves smith notes the disconcerting results of the TAF is causing anxiety even in traditionally optimistic corners. risk aversion, if mildly improved, still remains quite high with markets not responding the central bank initiatives in the manner which was hoped -- and this is driving economic contraction.
We offer this final note. Various measure of spread based risk premiums have been at extraordinary levels since last June when the turmoil started. These widened spreads are taking an economic toll. We expect that the Fed will persist until it gets them to narrow.
If the Fed fails, we will have a difficult and protracted deflationary recession. If the Fed succeeds, the slowdown will be shorter and shallower....But we must admit that when we see a TAF auction result like we just saw, we become just a little more worried.
Tuesday, April 22, 2008
american political life has become deeply absurd and unserious
Illustrating the candidates' efforts to reach every possible voter, Obama, Clinton and Arizona Senator John McCain, who has locked up the Republican nomination, made taped appearances on the World Wrestling Entertainment Inc. program ``Monday Night RAW'' on the cable channel USA Network.
The WWE says the weekly program draws 5 million viewers, and all three candidates used wrestling themes for their messages.
``Tonight, in honor of the WWE, you can call me Hillrod,'' Clinton, 60, said in her segment. ``This election is starting to feel a lot like `King of the Ring.' The only difference? The last man standing may just be a woman.''
Obama, 46, said, ``this is a historic time for America. It's not just that the reign of Randy Orton may soon be coming to an end.'' Orton is the reigning WWE champion.
just look at this. VERY presidential. and these people would ostensibly be sending american men and women to their deaths in iraq and afghanistan? one of this lot assuming the ostentatious title of 'leader of the free world'? or am i the only one who has a difficult time imagining dwight eisenhower humiliating himself by taking second billing to verne gagne and the crusher?
in any previous age of american politics, such antics would've meant a swift and rightful political death. it would've been the equivalent of commodus dressing up as hercules and walking the streets of rome. now, all the candidates are queueing for a chance to deliver wincing lines like, "can you smell what barack is cookin'?"
but then, this is the country that elected both jesse ventura and arnold schwartzenegger to governorships with no prior political experience whatsoever, isn't it?
this on the cultural dynamics of professional wrestling.
S&P originally defined its loan-loss assumptions in the mid-1970s – it rated the first private MBS in 1977. ... To develop a worst-case, benchmark scenario of mortgage foreclosures and losses, the company had to look back to the Great Depression.
Although data was very limited by contemporary standards, S&P was able to derive base foreclosure-frequency assumptions from a study of the behavior of urban mortgage loans originated by 24 life insurance companies between 1920 and 1946 (published by the NBER). Based on this study, S&P defined a AAA depression as one in which 15 percent of all borrowers in the lowest risk category will default, a AA depression as one in which 10 percent will default. (In other words, to be rated AAA, a bond would require credit support that would withstand a number of iterations of the AAA depression scenario.)
The benchmark loan is a first-lien mortgage on an owner-occupied, single-family, detached house with an original LTV of 80 percent or less. ... Foreclosure frequencies would be adjusted higher for loans with additional risk factors, including historical delinquencies and severities, lien type, loan type, geographic concentrations and borrower quality.
The other component of the loss formula is loss severity, as most in the industry know. Again, S&P’s original benchmark for market value losses was the Great Depression. In an extreme stress scenario, market value declines would be a major component of loss. (Other components include unpaid accrued interest, legal and selling costs, property maintenance, and so forth. The severity of these vary from state to state as well as with economic conditions.) Based on Depression experience, S&P had determined the market value of single-family detached properties would decline by 37 percent under the AAA depression scenario, 32 percent under the AA scenario.
fifteeen percent of prime borrowers in default, 37% decline in housing prices -- with the trends in place, even in prime mortgages, these are eminently believable destinations in the next few years. this is a reminder that what we are experiencing in housing today is very much in line with the bust seen in the great depression. as was the texas experience on a regional level:
Texas/Oil Belt experience is of particular interest in the present crisis. The Fannie study indicated lifetime default rates of 8.5 percent on Texas loans originated in 1981-1983, while other data indicated foreclosures in Houston between 1980 and 1989 amounted to 16 percent of housing stock. Houston home prices declined about 30 percent. Likewise, S&P found loss severities reported by Fannie (and largely attributed to the Oil Belt states) were easily in the ball park of Depression-based assumptions: the GSE charged off 25 percent of aggregate principal balances of foreclosed loans in 1987, 28 percent in 1988 and 31 percent in 1989.
one can certainly make the case that what we're today experiencing, while not common, is also not exactly rare and certainly not unprecedented. and considering the incredibly easy terms of the 21st century mortgage -- little if any money down, teaser rates, even negative amortization -- i think it perfectly rational to expect something greater than that, to expect the worst housing bust in american history bar none.
Monday, April 21, 2008
i can't find the will to disagree with any of this. i do think stocks have put in at least a meaningful intermediate-term low. possibly if unimaginably, it is really the all-clear on the great credit crisis of 2008. it's critical to realize that the low always is unimaginable when it comes -- that in fact the existence of a low point is predicated on the bleakest possibly outlook being dominant. this looks very much like such a time.
rather than simply fire-and-forget, though, i'll be monitoring the outlook as we go. i rather concur with dr. steenbarger at this point -- at or approaching overbought with minor correction probable.
and i'll do that because of a good point made by jim stack that was passed on to me by a friend in conversation. the stock market has managed to trade lower in spite of eight fed rate cuts. the only two precedents on the books: 2001 and 1930. it's generally fatal in my view to lean on "it's different this time" -- but the fact remains that, sometimes, it IS different. one cannot ignore the housing bust and its economic implications as part of a larger leverage bubble. an honest-to-god deflationary unwind is a real possibility here, and if it came to pass a lot of sentiment indicators would be rendered useless. (can one imagine what the consumer sentiment chart of the early 1930s looked like?)
Friday, April 18, 2008
the most bullish price action in months
the nasdaq 100.
the nasdaq composite.
the s&p -- the only one of the four not to break the downsloping line dating back to the october highs. all, however, seem to have broken out over resistance that has persisted at the top of the range in place since the january 22/23 low.
there have been some concerns about volume particularly since the mid-march low point which may have established the final and successful retest -- bonddad's view is not uncommon. i attached this comment.
i don't think the lack of volume is a problem, and here's why.
i nervously kept out of the initial stages of the 2003 launch in large part because, for much of the huge rally from march 2003 to march 2004, i felt volume was unimpressive. looking back statistically, the 21-week average of volume in the s&p was below the 50-week virtually the entire time. both the 21-day and 50-day averages of index volume traded at or below the 200-day.
a similar pattern can be found following the breakout from the range which ended in july 2006.
and i think that comports well with reason -- rallies from deeply pessimistic lows will by nature be underparticipated in the early going as general skepticism remains very high.
just an anecdotal observation, but i have noted that this rationale appears at the beginning of virtually all large rallies. that's not to say that THIS must be a large rally, of course -- just that i don't think a shyness in volume in the early stages of a rally necessarily says much about its character in the intermediate run.
i will, however, be watching breadth characteristics on this rally closely. this is, after all, probably just a bear market rally which will fizzle well before new highs or anything of the kind are put in place. more updates on that later.
Hi I enjoy reading your blog. I wonder whether you can make any view / remark on the threat of global central bankers on their existing policy instruments and function. I think the subprime/securitization situation simply a tip of what is much larger concern-international monetary system. Thanks EMT
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the death of the misconception of market fundamentalism
soros sees the pragmatic trend -- credit expansion -- to have seemed to many to have validated an ideological misconception -- that markets can be left to their own devices and will function in the best possible manner if left to do so -- in a series of crises which, having been survived more or less accidentally, reinforced both the trend and the misconception.
at about 11 minutes, soros admits to having been wrong on the timing of this crisis -- he believed the acute phase would have been over months ago, which has instead lingered over (he believes) counterparty risk even as the fed has closed the possibility of a 1930s replay by stepping into bear stearns. a well-capitalized exchange is the solution, he avers.
but he goes on to say (15 minutes) that the error of the current paradigm has not yet been recognized -- and will not be until authroities acknowledge the need of regulation to moderate the supply of credit and therefore the degree of asset bubbles, something which would indeed involve a paradigm shift away from the (mis)conception of market fundamentalism.
more on soros and reflexivity here via barry ritholtz. i have a great deal of intuitional empathy for soros' view -- it is clear that the episteme of equilibrium economics is very far from being universally applicable or even correct. it is but a paradigm from which we (that is, our society) will eventually suffer as greatly as we have heretofore profited, ensuring a profound paradigm shift. as i have said, i cannot know if we have reached the end of this paradigm, which i might call 'keynesian' and trace to the post-depression period which set the stage for the emergence of what soros identifies as market fundamentalism in the 1980s (which was indeed when indebtedness began its accelerated march, cumulating in the ludicrous period of 2002-2007). but i do suspect and sincerely expect that we have in fact reached the paradigm shift, perhaps heralded by the end of the precession of the simulacra.
But I don't understand why you would call such market fundamentalism 'keynesian'.
My postKeynesian view says that true Keynesian thought (as interpreted by Hyman Minsky and followers) is anything but fundamentalist and tracks well with Soros views.
Am I missing something?
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but i do also think that this lot, being men of their times, are inherently keynesian in their worldview (though they would surely try to deny it). the way in which 'market fundamentalism' has manifested in practice has not been a movement of actual laissez-faire economics but a trend of ever greater government involvement in markets characterized by a sharp bias toward business -- making government the passive party rather than the assertive. as such, i really consider it an outgrowth of the keynesian paradigm -- maybe 'bastard child' captures it better. :)
in the end, i think what must come a cropper is not actual laissez-faire -- in my view, that came a cropper in 1929 after an extended 19th c run and what remains is largely propaganda leftovers -- but that fundament of keynesianism which believes that demand can and should always be stimulated by government to beneficial effect. the idea is axiomatic on both sides of the aisle and throughout respectable academia -- but i think the reality is that the moral hazard so generated is cumulative and supporting many of the outrageous imbalances we see in the united states and indeed globally.
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i suppose what i'm really saying is that i feel the division between keynesian and neoclassical economics in practice is not as sharp as is professed ideologically. i can think of very few public proponents of say's law/supply-side economics -- the 'market fundamentalists' -- who do not shill for demand stimulus when the chips are down (or even threatened). but then few practicing keynesians anymore remain immune to the ideology of the marketplace as the best arbiter of price -- who anymore calls for price controls in the face of inflation?
these two groups are linked in the substratum, though, by the forms of equilibrium economics. say's law more obviously and famously, of course, but keynesian economics no less -- where keynes supposes the equilibria but advocates action to alter them rather than waiting until "we are all dead".
i would suggest instead that there is no actual equilibrium, at least not beyond any discrete moment -- and that instead economic systems are complex and chaotic, unknowable and moving between states violently, always traversing the middle ground between extremes but rarely stopping to rest there.
THAT is rather what i mean by the inviability of equilibrium economics -- until we recognize that we cannot understand much less safely control economic systems and that they will always defeat the controls we devise for them because of precepts like reflexivity, we will hazard too much on presumed comprehension and implied stability, neither of which actually exist.
perhaps that recognition is the next paradigm? :)
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And I agree with pretty much all of what you say above, including the idea that most mainstream economists have gravitated to a bastardized form of Keynesian thought.
I have wondered these last few years, along with others what Keynes would have been saying in these latter times -- what Hyman Minsky would have been saying.
That is why I've been championing Minsky/Keynes notions at my Econ Dream - Nightmares site, along with the idea of far-from equilibrium-systems.
But we will never know what Keynes or Minsky might have said in the face of the creeping-fascism we've witnessed. Instead we have too many economists and pundits acting like Free Market Screechmonkeys -- Market Fundamentalists.
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movement toward CDS exchange
In particular, the banks are tying to develop a scheme that would only allow institutions with strong capital bases and credible trading histories to clear trades in the credit default swap markets with a central counterparty.
The aim is to ensure that members of this clearing house club would be more protected from the risk of a trader or investor failing to meet their obligations.
not exactly salvation for hedge funds -- more of a move to build a catbird's seat for intermediation (for a fee, thank you).
These discussions mark a striking new twist in the development of the credit derivatives industry that has lacked any central clearing mechanism and has fiercely resisted any suggestions that banks should move their current private or “over-the-counter” trading activity on to regulated exchanges.
The proposals to create this type of clearing house are set to be extremely controversial within the industry, not least because some bankers fear it could presage an eventual shift towards greater regulation of the CDS sector.
whatever the motivation, this must be regarded as a good step, particularly if the exchange is well regulated. (the recent american experience in lightly or essentially unregulated exchanges dominated by a small cabal is not so good -- though it's very interesting to revisit the zeitgeist of late 2001 just before the collapse of that corrupt entity, which is so much different than what came just weeks later.) hardly foolproof, mind you -- exchanges are so weakly regulated in the united states by an underfunded SEC that little impedes the suicidally reckless. but even a pretense of standardized reporting and a supported mechanism to determine counterparty exposure could be of some benefit in one of the most opaque of all marketplaces.
more from yves smith. as noted in the comments, a move to exchange will probably make CDS far less profitable and attractive -- the reasons they aren't cleared now -- though that may well not be a bad thing, is indeed perhaps quite the point.
Thursday, April 17, 2008
jpmorgan raising capital
The hush-hush plans to raise capital at the Wall Street bank would certainly seem to contrast against remarks made by JPMorgan CEO Jamie Dimon earlier Wednesday, who had said that the credit mess was “working itself out.” No mention was made on the earnings call about raising $6 billion, and a source that spoke with HW reacted to the news with stunned silence upon hearing of the plan.
“I can’t imagine that a $6 billion capital raise would just have slipped the minds of the execs [at JPMorgan],” said one source, who asked not to be named. “I really don’t know what to say.”
Lehman sold $4 billion of preferred shares earlier this month. Citi has raised capital via preferred shares as well, paying 8.13 percent on stock it sold back in January. There are others, obviously. But none had the apparent audacity to file a preliminary prospectus only hours after an important quarterly earnings call, without so much as mentioning anything about a plan to do so during the call.
“It just takes all of the steam out of things,” said the same source. “I mean, most of us had taken the earnings report as a half-good thing, after all, with Dimon’s remarks. Now what are we supposed to think?”
questions about jpmorgan's exposure to commercial real estate are already in the air. federal reserve board member donald kohn reiterated yesterday the concern of the government generally for regional and smaller banks, but what few talk about is the fact that jpmorgan chase is also more heavily exposed in this area. the distribution of assets has served it pretty well in the residential housing bust; but now that a commerical bust is underway, jpmorgan would seem to be in more trouble than most suspect.
and with an unwind in the CDS market lurking in the growing shadows of this credit crisis, one might soon with the benefit of retrospect wonder why anyone thought jpmorgan was in a position of strength the day they bailed out bear stearns.
UPDATE: what's worse, jpmorgan appears to be dissembling, per felix salmon.
UPDATE: more from ft, which speculates that bear stearns is just that toxic.
Wednesday, April 16, 2008
credit default swap market still growing
The total volume of outstanding credit derivatives contracts stood at $62,200bn at the end of last year, up from $34,500bn a year earlier, the International Swaps and Derivatives Association will announce at its annual conference in Vienna today. This is 10 times the level of four years ago.
these are incredible figures -- $62tn is several multiples the size of the corporate debt market in total, and four times the gdp of the united states. but most shocking should be the underlined -- this is a highly leveraged speculative market which is completely untested at anything like its current size in an actual cycle of recession and accelerating real bankruptcies.
this -- and not housing, amazingly enough -- looks to this observer to be the true dark heart of the leverage boom that appears to be ending now. when this market is finally tested later this year, when corporate bankruptcies spike as the credit crisis overtakes weak balance sheets dependent on easy refinancing and rising asset prices, when a significant player beyond even the new expanded envelope of protection offered by the federal reserve goes bust and cannot pay -- only then will we really be made to realize just how incredibly excessive the credit boom that began in 1982 had become in its late stages.
as institutional risk analytics well said two days ago as part of an intelligent polemic against fair value accounting in a world of highly irrational markets:
For some months now, we've been pondering what happens to all of those net short credit default swap portfolios at dozens upon dozens of hedge funds that will be going out of business this year due to the Great Unwind. Hedge funds have no permanent capital, thus there are no assets available to support the defeasance of a book of net-short OTC derivatives positions should the fund be forced into involuntary liquidation.
In such a scenario, you can forget about netting; won't be nothing left to net, in or out of bankruptcy. And since the old habit of simply writing more CDS contracts is not available once the fund starts liquidating, we wonder if leading CDS dealers like JPMorgan (NYSE:JPM) won't be forced to take these trades back as hedge funds expire. What's the "fair value" of a book of short OTC derivative positions taken by a dealer in payment of other debts?
Indeed, if you think of BSC not as a broker dealer, but instead as a clearing customer of JPM, then the logic of the acquisition makes perfect sense. JPM could not let BSC go into Chapter 11 because doing so might have started a chain reaction among the OTC derivative counterparties of both firms.
Between JPM, BSC and BSC's customers there were three levels of leverage, making the ratio of Economic Capital to Tier One Risk Based Capital computed by The IRA Bank Monitor (4.7:1) for JPM at the top of the leverage pyramid seem entirely too generous! If you impute even a fraction of the downstream leverage residing with clearing customers to JPM, the giant bank's capital shortfall becomes alarming.
A bank holding company, after all, is thinly capitalized and in many ways was the precursor of the hedge fund model. On a parent-only basis, JPM's $314 billion asset balance sheet includes $200 billion representing investments in its subsidiary banks and non-bank units, supported by half as much equity and more than $200 billion in debt.
And remember that JPM's on-balance sheet capital does not even partially support the counterparty risk of its vast OTC derivatives businesses, thus the BSC acquisition was a "must do" deal for Mr. Dimon. Think of it this way: JPM is essentially an uncapitalized, $76 trillion OTC derivatives exchange with a $1.3 trillion asset bank appendage. By the way, we are working to include factors for OBS securitizations in the next iteration of our Economic Capital simulation in The IRA Bank Monitor.
But you understand that Fed officials still believe, even today, that the US markets are not over-leveraged.
when one begins to understand that some hedge funds have made a living over the last few years by doing little more than collecting premium from selling CDS and magnifying that into big steady returns by operating over huge leverage -- and that very probably some are still doing so, to judge by the reckless pace of expansion in the market -- it becomes obvious that, in a real recession with real bankruptcies, counterparty risk is not a potential hazard but an inescapable and imminent eventuality.
a month ago questions started to surface about jpmorgan chase in relation to its commerical banking exposure. but a far more central threat to it is its status at the single biggest player in credit default swaps. i don't know where it ends for the house of morgan when the CDS market finally is faced with deleveraging and forced liquidation. but i suspect its implied status as one of the banks simply "too big to fail" will be tested to the fullest.
One thing I don't understand is how leverage is applied to the CDS market... is it that the party selling the swaps is borrowing money to meet whatever capital requirements are required to issue the swaps, so that they can issue more of them?
A more general question about fractional reserve lending that I haven't found an answer to: When a loan is made by a federal reserve bank, the loaned money is "created" (with reserve set aside). How are loans sold (whether securitized/packaged or not)? Is the selling price the value of the future interest payments PLUS the principle, or just the value of the future interest payments? When a borrower defaults on a loan that has been sold, whose money is "destroyed" to compensate? When a borrower pays down principle, is the principle "destroyed" still -- i.e., the effect of fractional reserve lending transfers to the buyer of the loan and the buyer is at risk for much more than the face value of the loan?
I can't find any articles discussing this, but I'll understand if you (or other readers) don't want to play the role of educator :)
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i think that's a good general view of how leverage underlies CDS. a capital pool (eg hedge fund) uses its capital as collateral against a much larger loan, which enables it to support a large balance sheet. that balance sheet can be expanded to post collateral against CDS that are moving against the fund -- up to a point.
however, if the pool is faced with redemptions, it may be forced into rapid balance sheet contraction and indeed may not be able to post collateral. creditors may also pare or call lines to the pool, forcing sales into an illiquid market. a pool could also be overexposed to a rash of credit events and fail outright.
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the fed is also engaging in asset swaps -- that is, loaning treasuries in exchange for other, lower-quality assets like ABS. this too has no money-creating effect.
the result has been a steady monetary base.
if the fed gets into the inflationary business of creating cash -- "quantitative easing" -- it would simply make loans (ie increase assets) and, rather than sell other assets, increase that all-important liability of the fed, cash. this would have the side effect of driving the fed funds rate down to near-zero.
alternatively, it could expand its balance sheet by creating as a liability not cash but federal reserve bonds, which would be sold to the public or the treasury.
that hasn't happened yet. if it happened, the fed would likely sell them at a discount and redeem them at some future point at par (the difference being the return to the investor).
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I think you answered my first question, but unfortunately I think I misphrased my second question. I was referring to loans made by federal reserve chartered commercial banks -- i.e., the textbook scenario of how money is created via lending. And I'm trying to determine how the creation and destruction of money via that mechanism translates into a world where loans are routinely packaged and sold to other parties.
Your explanation of the Fed's monetary actions are a great concise summary but I think I already had a grasp of that side of things :)
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when a deposit-taking bank makes a loan, it effectively shifts cash (which was booked to balance the liability of the deposits) to accounts receivable. it can regain cash by then selling the loan.
loans are sold in all kinds of ways. sometimes they are sold whole -- sometimes stripped into principal-only and interest-only components -- sometimes pooled and tranched into ABS. the cash that can be received in exchange has everything to do with the marketplace, depending on perceptions of interest-rate risk, default risk, prepayment risk -- very complex, particularly in the case of mortgages.
when the borrower defaults, the creditor does effectively see his asset "destroyed", at least in part. if the loan is secured, he gets something tangible (a car or house) to try to redeem. if the loan has been sold, whomever is holding the principal-only slice is an injured party. if the loan has been pooled and tranched, it's whomever is next in line to take the loss.
if the borrower prepays rather than defaults, obviously the principal is repaid and there's no injury (it's the interest-only slice that's hurt exclusively, as there won't be any more interest payments).
in the abstract, whether or not money is destroyed in this instance is up to the now-repaid creditor -- if he makes/buys another loan, then no; if he uses his returned capital to pay down an obligation of his own (ie, reduce the size of his balance sheet by offsetting a liability with cash), then yes. this isn't optional in case of default, obviously -- the balance sheet is reduced, with the loss of the asset being paired with a loss of equity.
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Part of why I'm curious is I'm trying to form my own opinion/understanding of the feasibility of the fed preventing broad money supply (and consequently asset prices in general) from significantly contracting, even if it monetizes newly issued treasury or federal reserve debt. It seems like the answer should be knowable but yet there is so much disagreement out there on inflation/deflation/etc.
Sorry, I haven't used blogging software otherwise I'd try to help on the RSS question (from a previous post), as I am technical.
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it's the $64 question, to be sure. the other day i posted this, which i think gets close to the heart of things. it really does come down to reducing claims (that is, dollars of credit/debt) per base dollar (what the fed controls) to a less dangerous level as painlessly as possible.
the ratio contracted meaningfully from 1990-94 as the savings and loan bust played out. this was less a deleveraging than simply a stagnation of lending while monetary base grew beneath as a pretty healthy clip. that same dynamic, over a longer period, *could* be our fate this time too -- a "malaise".
but i obviously fear that the amount of debt -- particularly financial sector debt -- has gotten so large as to make deleveraging a more dangerous process, prone to financial earthquakes. moreover, i think we're restricted in how much we can expand monetary base vs gdp because, as an international debtor nation, a really aggressive devaluation may result in a dollar crisis and repudiation resulting in a severe "standard of living adjustment" (read: depression).
i do, though, think the muddle-through possibility is a strong case, and too much attention (including here) is paid to the less likely extremes.
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My intuition tells me muddle through is improbable based on the seemingly large gap over the last several decades between money creation (along with asset appreciation) and underlying productivity growth (the only truly sustainable driver of wealth creation over the long term) plus demographic changes, and that inflation may reverse and send us down a path like Japan's or worse, but I'm trying to understand the actual facts. Your blog is a great source of thoughtful commentary -- keep it up!
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hbl, i would say that a 37% increase in money supply is a *big* deal. consider that, looking back, that's the move from 1998 to today -- ten years of money supply growth in what many would consider a regime of quite high (if officially suppressed) inflation (much of it due, though, to credit growth of course). and that only to get the ratio back to 40 in a period of credit stagnation, which is still an elevated level. such a period would probably see raw input prices rise dramatically in relative terms to leveraged asset classes, which would be punished by higher interest rates, higher input costs and slow economic activity -- but overall asset prices would hopefully rise as debt remained stagnant, giving a nominal deleveraging.
you'd also be explicitly signalling to a lot of dollar claimants that you were going to pay them back in significantly devalued currency -- which has its own dangers.
in 1990-94, inflation moderated as lending slowed but remained positive -- and as monetary base was expanded 56% over the four years. the system didn't actually deleverage in aggregate (though some parts of it, centered around savings and loans, did) -- therefore, national equity was not seriously consumed. but a deleveraging of sorts was effected. this was a difficult period for banking.
claims over base is really just an approximation of leverage in the system -- the higher the ratio, the less of a decline in asset prices is needed to wipe out equity.
that leverage must come off if chronic disasters are to be avoided. periods of asset price declines are survivable when leverage is modest. but when leverage is THIS high, a modest spark can be enough to consume all the equity in the financial system and leave little to support any debt at all.
that's the fear i share with you, i think. unlike the 1990s, we now have massive private leveraged entities both central to the system and outside the system beyond the fed's purview. i'm not at all sure that an orderly period of stagnation as inflation corrodes real debt loading is possible. investors in that sphere won't patiently wait out subpar profits in the way that capitalized banks can.
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I think I did not understand the significance of a 37% increase in base money because I was thinking it was changes in broad money supply rather than base money supply that would ultimately drive inflation (with a lag of course) -- probably in part because it seems like excessive credit expansion since the early 1980s has been a major contributor to the high but underreported price inflation appearing in recent years. $320 billion is only a ~3% increase on $11+ billion of M3, for example, verus the 37% increase relative to base money supply. I need to find some more good economics texts and fill in more of the gaps in my knowledge. Thanks for your patience. There is another question that has been bothering me for years but I'll spare you for now ;)
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Tuesday, April 15, 2008
ug99 and food riots
new scientist a year ago ran this article about a fungal strain puccinia graminis tritici (or stem rust) which attacks wheat, called TTKS or race ug99.
Since the Green Revolution, farmers everywhere have grown wheat varieties that resist stem rust, but Ug99 has evolved to take advantage of those varieties, and almost no wheat crops anywhere are resistant to it.
The strain has spread slowly across east Africa, but in January this year spores blew across to Yemen, and north into Sudan (see Map). Scientists who have tracked similar airborne spores in this part of the world say it will now blow into Egypt, Turkey and the Middle East, and on to India, lands where a billion people depend on wheat.
There is hope: this week scientists are assessing the first Ug99-resistant varieties of wheat that might be used for crops. However, it will take another five to eight years to breed up enough seed to plant all our wheat fields.
The threat couldn't have come at a worse time. Consumption has outstripped production in six of the last seven years, and stocks are at their lowest since 1972. Wheat prices jumped 14 per cent last year.
Black stem rust itself is nothing new. It has been a major blight on wheat production since the rise of agriculture, and the Romans even prayed to a stem rust god, Robigus. It can reduce a field of ripening grain to a dead, tangled mass, and vast outbreaks regularly used to rip through wheat regions. The last to hit the North American breadbasket, in 1954, wiped out 40 per cent of the crop. In the cold war both the US and the Soviet Union stockpiled stem rust spores as a biological weapon.
After the 1954 epidemic, [Norman] Borlaug began work in Mexico on developing wheat that resisted stem rust. The project grew into the International Maize and Wheat Improvement Center, known by its Spanish acronym CIMMYT. The rust-resistant, high-yielding wheat it developed banished chronic hunger in much of the world, ended stem rust outbreaks, and won Borlaug the Nobel peace prize in 1970.
Yet once again Borlaug - now 93 and fighting cancer - is leading the charge against his old enemy. When Ug99 turned up in Kenya in 2002, he sounded the alarm. "Too many years had gone by and no one was taking Ug99 seriously," he says. He blames complacency, and the dismantling of training and wheat testing programmes, after 40 years without outbreaks.
... fears grow in rich wheat-growing countries, but meanwhile Ug99 has got worse. It was first noticed because it started appearing on wheat previously protected by a gene complex called Sr31, the backbone of stem rust resistance in most wheat farmed worldwide. Then last year it acquired the ability to defeat another widely used complex, Sr24. "Of the 50 genes we know for resistance to stem rust, only 10 work even partially against Ug99," says Ward. Those are present in less than 1 per cent of the crop.
The first line of defence is fungicide, but the poor farmers who stand to lose most from the blight generally cannot afford it, or don't have the equipment or know-how to apply it. CIMMYT is considering "fire brigade" spray teams armed with cheap, generic fungicides in poor areas. However, they will be competing with the rich for fungicide, and depending on where Ug99 strikes, stocks could be limited.
Even rich countries face problems. The US has been fighting soybean rust with fungicide ever since spores blew in on hurricane Ivan in 2004. If Ug99 arrives as well, the US could be in trouble because it doesn't make enough fungicide for both crops. Kitty Cardwell of the US Department of Agriculture says there might be enough if the US fights Ug99 the same way as it is tackling soya rust: spotting outbreaks with a fast DNA-based field test and posting the results on an interactive website (www.sbrusa.net), so farmers spray only when danger looms. Ultimately, says Ward, the only real answer "is to get new, resistant varieties out there".
So it's a race, and who wins depends on what Ug99 does now. Stem rust can arrive in a new area and lurk for years before it gets the right conditions for an outbreak. "It won't suddenly explode everywhere. It will be like a moving storm," says Dowswell.
However, Ug99 has another ace up its sleeve. The spores blowing in the wind now are from the asexual stage that grows on wheat. If any blow onto the leaves of its other host, the barberry bush (Berberis vulgaris), they will change into the sexual form and swap genes with whatever other stem rusts they find. Barberry is native to west Asia. "As if it wasn't challenging enough breeding varieties that resist this thing," laments Ward. "All I know is that what blows into Iran will not be the same as what blows out."
now this from the united nations a month ago.
A dangerous new fungus with the ability to destroy entire wheat fields has been detected in Iran, the United Nations Food and Agriculture Organization (FAO) reported today.
The wheat stem rust, whose spores are carried by wind across continents, was previously found in East Africa and Yemen and has moved to Iran, which said that laboratory tests have confirmed its presence in some localities in Broujerd and Hamedan in the country’s west.
Up to 80 per cent of all Asian and African wheat varieties are susceptible to the fungus, and major wheat-producing nations to Iran’s east – such as Afghanistan, India, Pakistan, Turkmenistan, Uzbekistan and Kazakhstan – should be on high alert, FAO warned.
“The fungus is spreading rapidly and could seriously lower wheat production in countries at direct risk,” said Shivaji Pandey, Director of FAO’s Plant Production and Protection Division.
massively rising food prices -- a side effect of both the western world's dollar-liquidity binge transmitted as inflation through currency pegs to much of the third world, and demand increases for the oil which is processed into fertilizer even as supply cannot rise correspondingly -- are already triggering food riots across the globe -- what may represent one of the greatest threats to third world stability in decades. there is no motive for violence quite as compelling as hunger.
"This is the world's big story," said Jeffrey Sachs, director of Columbia University's Earth Institute.
"The finance ministers were in shock, almost in panic this weekend," he said on CNN's "American Morning," in a reference to top economic officials who gathered in Washington. "There are riots all over the world in the poor countries ... and, of course, our own poor are feeling it in the United States."
World Bank President Robert Zoellick has said the surging costs could mean "seven lost years" in the fight against worldwide poverty.
"While many are worrying about filling their gas tanks, many others around the world are struggling to fill their stomachs, and it is getting more and more difficult every day," Zoellick said late last week in a speech opening meetings with finance ministers.
if these largely-demand-driven pressures were to receive a supply shock in the form of a wheat epidemic, what would follow is unthinkable.
but there's a different dynamic to consider as well. "commodities as an asset class" has become a mantra in recent years, and there can be little doubt htat huge amounts of speculative capital have poured into commodities. to some extent, this must have the effect of "artificially" raising prices. more than one oil industry observer in the last few years, for example, has been made a fool of by rising prices which have seemed to levitate over normal supply-demand modeling.
as noted in comments at calculated risk, this is not without precedent.
What were the economic diseases from which business was suffering? A few of them may be listed categorically.
... 2. Artificial commodity prices. During 1929, as David Friday has pointed out, the prices of many products had been stabilized at high levels by pools. There were pools, for example, in copper and cotton; there was a wheat pool in Canada, a coffee pool in Brazil, a sugar pool in Cuba, a wool pool in Australia. The prices artificially maintained by these pools had led to overproduction, which became the more dangerous the longer it remained concealed. Stocks of these commodities accumulated at a rate out of all proportion to consumption; eventually the pools could no longer support the markets, and when the inevitable day of reckoning came, prices fell disastrously.
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putting a dent in peak oil
Haroldo Lima [head of the National Petroleum Agency] told reporters the find, known as Carioca, could contain 33 billion barrels of oil equivalent, five times the recent giant Tupi discovery. That would further boost Brazil's prospects as an important world oil province and the source of new crude in the Americas.
... “It could be the world's biggest discovery in the past 30 years, and the world's third-biggest currently active field,” Mr. Lima, head of the government's oil and fuel market regulator, told reporters at an industry event in Rio de Janeiro.
... Analysts said the estimate was probably still preliminary, although it did not contrast with some geologists' forecasts made in the past.
“It's a very relevant number, basically triples the reserves. But it still seems a little premature to have a precise number while they are drilling a second well,” said Felipe Cunha, an analyst with Brascan bank in Rio de Janeiro.
The Carioca area lies west of Tupi in the prolific Santos basin, off the coast of Sao Paulo state. BG has a 30 per cent stake in the project and Repsol 25 per cent.
“It's subsalt, and we knew there were big expectations for the subsalt cluster in addition to Tupi. But, if this is confirmed, it's really huge,” said Sophie Aldebert, associate director with Cambridge Energy Research Association in Brazil.
“With that size, you'd have plenty of gains of scale that could easily offset the subsalt geological challenges,” she added. The challenges include shifting salt clusters that require reinforced piping and producing in deep waters from huge depths under the ocean floor.
... Most of Petrobras crude comes from heavy-oil Campos basin fields, but recent subsalt discoveries could make Brazil a major producer of higher quality oil.
this find emerges even as oil is hitting new record highs at $112 on news that russia -- now the world's largest oil producer (not saudi arabia, you read that right, since 2006 -- though saudi is the largest exporter of oil) and one of the few major oil-exporters to be consistently increasing oil for export in recent years -- actually saw production decline in the first quarter, seeming to verify many fears that russian oil production is at or past peak.
to be sure, even 33bn barrels won't change this dynamic. but perhaps it will buy some time.
Monday, April 14, 2008
a demon of our own design
Interestingly enough, New Scientist cites the subprime mortgage crisis--I wrote here about the weird connections it was revealing--as a prime example of sheep-lopping. Instead of spreading the risk in the sense of dividing it up and minimizing it, our financial system is now so tightly wound that it spreads risk like a contagion--and if one segment of the American mortgage market gets sick, there is a worldwide credit crunch.
richard bookstaber makes this observation at length in his excellent systemic view of financialization. (his erstwhile blog here.) bookstaber recommends climbing off the ledge through regulation, but a part of me wonders if such tightly coupled specialization isn't an inevitable outgrowth of systemic behavior which makes crisis and collapse similarly unavoidable, in civilizations the same as markets.
the nervous dollar watch
I fully appreciate the current policy dilemma Bernanke & Co. face – this is not your garden variety Keynesian slowdown. The yawning current account deficit represents consumption in excess of productive capabilities, and we are resolving that imbalance. The resolution entails accepting some moderation of domestic demand in concert with expansion of external demand that will be consistent with a new constellation of interest rates, exchange rates, and prices. It is not obvious, a priori, that we know the monetary policy consistent with that new equilibrium. But policymakers should realize that implications of that adjustment when setting policy.
My concern remains that the Fed has panicked in setting a rate policy that treats the external sector – and therefore, the current account adjustment – as a mere curiosity, giving little thought to their role in supporting the adjustment. In effect, policy, both monetary and fiscal, has degraded into an effort to dig the economy out of a hole by shoveling deeper. We built the most recent expansion on the back of debt financing, driving consumption gains while real median incomes stagnated on the theory that you can borrow your way to prosperity. That theory has proven ill-advised at best; the inability to continuously fuel the borrowing binge through housing provided the initial blow to the consumer. The second blow was the softening job market due to the first blow. The third blow was the inflation driven by the policy response designed to minimize the impact of the first two blows. The question now is: does the Fed read the increased pain of consumers as a reason to cut rates 50bp at the next outing of the FOMC? I hope not – but I cannot rule it out.
Then again – perhaps we are simply at the point where inflation is the only politically palatable option. The Bear Sterns rescue is the basis for a massive, fully monetized bailout of the financial sector…and Congress and the next President would oblige. If that is where we are headed, somebody needs to start thinking about capital controls before the rest of the world realizes the US intends to repay its obligations with very devalued Dollars.
Bottom Line: As has been the case for months, I would be much less concerned about the path of monetary policy in the absence of rapidly increasing commodity prices and a declining Dollar. I do not believe it is advisable to let the Dollar completely disintegrate. And given the increasingly clear link between monetary policy, the Dollar, and commodity prices, the Fed would be best to served to moderate the pace of easing. I think they understand this, but I remain worried that fundamentally, they only have one tool, and they will feel a need to keep using it if only to look like they are doing something. This is especially worrisome given that low interest rates are apparently not providing much of a fix for Wall Street – for that, the Fed needs to focus on reducing counterparty risk.
as previously noted, the currency consequences of a negative real policy rate may, from this precarious setup, put the fed exactly where it was in 1931 -- compelled to raise rates in order to defend the currency despite the knowledge that raising rates will deepen the depression.
the fed may well be about to take the other road this time -- as noted in dupuy's link, to the second option mentioned by brad delong for a third order financial crisis -- a general inflation. the wall street journal editorial page is already bleating for it.
but i remain doubtful that such an outcome is really possible. again, with a credit bubble of something on the order of $50tn -- as shown in the fed's most recent quarterly z.1 report table d.3, total outstanding financial and non-financial debt was estimated at $47.0tn -- now potentially on the brink of deflating, can the fed really print enough money on a monetary base of $850bn? and if it tries, would it not force a repudiation of dollar-denominated instruments globally -- something dupuy suggests could force the institution of "capital controls"?
it's a question that's impossible to answer yet (and hopefully remains so). but one way or another, these graphs have to be resolved. the first is a plot (in blue) back to 1984 of the total financial and nonfinancial claims reported in the z.1 table d.3 divided by the monetary base as reported through the saint louis fed. the second (green) is the year-over-year growth rate of that ratio. recessions are in red -- and as you can see essentially amount to a contraction in the amount of claims on the monetary base. the mild 2001 recession of course was mild in large part because the contraction of the ratio was itself mild; the 1990-1 recession more severe correspondingly.
these suggest that a "normalization" of the ratio can be achieved by driving the ratio back under 40 -- representing either i) a fall of the claims from $47tn to something closer to $34tn, a 27% collapse in credit; or ii) a rise in monetary base from $855bn to $1175bn, a 37% growth; or iii) some combination.
using nonfinancial outstanding debt, one can paint this picture back to 1959 using FRED data. one must recall that 1986-1994 was a period of difficulty for american banking which encompassed the savings and loan disaster, considered by many to be a forerunner writ small of the current housing collapse. one can see how monetary base expanded much faster than nonfinancial debt during the period.
furthermore, the spectacular divergence of total against nonfinancial debt since 1995 is more visible here -- the gap between the two plots is by and large financial sector debt. i strongly suspect a similar (qualitatively, at least) divergence probably was visible in the 1920s. the birth of the financial sector boom notably corresponded to the first explicit efforts to repeal the glass-steagall act of 1933 -- see articles here and here -- which led to the gramm-leach-bliley act. this was viewed by some at the time as a serious mistake in deregulation, and still is seen as so by many critics of financialization. seems to me that's exactly what it has been.
again this is the YoY growth. periods of zero or near-zero expansion -- as well as periods of the highest rate of contraction -- have marked economic weakness. the magic data for comparisons to the great depression are not here available; as one can see, this entire period is essentially a long, great leveraging of the monetary base.
Friday, April 11, 2008
israel sinking toward war?
In truth, all of this may dissolve into nothing much. In intelligence analysis, however, sometimes a set of not-fully-coherent facts must be reported, and that is what we are doing now. There is no clear pattern; there is no obvious direction this is taking. Nevertheless, when we string together events from February until now, we see a persistently escalating pattern of behavior. In fact, what we can say most clearly is that there is escalation, without being able to say what is the clear direction of the escalation or the purpose.
We would like to wrap this up with a crystal clear explanation and forecast. But we can't. The motives of the various actors are opaque; and taken separately, the individual events all have quite innocent explanations. We are not prepared to say war is imminent, nor even what sort of war there would be. We are simply prepared to say that the course of events since February — and really since the September 2007 attack on Syria — have been startling, and they appear to be reaching some sort of hard-to-understand crescendo.
The bombing of Syria symbolizes our confusion. Why would Syria want a nuclear reactor and why put it on the border of Turkey, a country the Syrians aren't particularly friendly with? If the Syrians had a nuclear reactor, why would the Israelis be coy about it? Why would the Americans? Having said nothing for months apart from careful leaks, why are the Israelis going to speak publicly now? And if what they are going to say is simply that the North Koreans provided the equipment, what's the big deal? That was leaked months ago.
The events of September 2007 make no sense and have never made any sense. The events we have seen since February make no sense either. That is noteworthy, and we bring it to your attention. We are not saying that the events are meaningless. We are saying that we do not know their meaning. But we can't help but regard them as ominous.
dr. steenbarger further links to local and very informed opinion that war is imminent.
Claude Salhani: What is your perception of the current situation in the Middle East?
Dory Chamoun: The situation in the Middle East is not going to remain as it is. There is a peace process going on between Syria and Israel, which is on track. How to achieve it remains the question. It is a fact that the Golan Heights is to be divided. Israel wants part of the Golan Heights. This is something the old [former President Hafez] Assad refused.
Now, to achieve that part; they will not be able to achieve it through peace, because Mr. Assad who represents a minority regime cannot say, 'okay, I will give what my father did not give.'
There will be a mock-up war between Syria and Israel. And at the same time Israel will take the advantage to beat up Hezbollah. This time they will fight in the Bekaa Valley. This is a scenario that I see unfolding.
CDS market deterioration?
I happened to meet with a hedge fund yesterday (unlevered, BTW) and it comments in passing were telling. They are seeing very large volumes of mortgage paper even though, this fund has not bought a single mortgage and expect that there is even more that would be offered if buyers were stepping forward. In addition, credit default swaps traders tell them that that market is in perilous shape. A great deal of the protection was written by hedge funds, who were typically levered. When they get into trouble, their problems will redound to the investment banks, both through their exposure as CDS counterparties and as lenders to failed hedge funds.
The fact that CDS traders are discussing such a grim viewpoint with people outside their firms (let's fact it, most businesspeople don't go around saying their product is about to implode) suggests that it is a common knowledge in the dealer community. I wonder if this topic is getting short shrift for a reason. The media has been known to overlook the foibles and failings of public figures until they are on the ropes. There may be similar self-censorship operating here, since the press probably does not want to be accused of fomenting panic.
then ben bittrolff looks more analytically at the pricing in the marketplace in the aftermath of further downgrades of several monolines.
i have no particular window onto the CDS market -- all my perspective comes secondhand. but i think this much is apparent: the federal reserve bank has gone to war in large part to protect the CDS market. there are certainly other, very good macro reasons for the fed to be cutting policy rates; but there is essentially no compelling macro reason to have stepped into the bear stearns situation, nor to have extended the envelope of de facto discount window protection to all primary dealers, except to have staved off the unwinding of this immensely important and extremely leveraged market in an intensely chaotic manner.
the question of the hour is whether or not the fed, in this new supercharged role -- one which not all of its advocates think appropriate, mind you -- can quell the fears of traders. and i have sincere doubts as to whether they can, because of the structure of the CDS market.
when bear was on the brink of failure, there was some intense speculation that the ibank was being pushed to its destruction by none other than the commercial banks which serviced it. after all, with banks badly needing collateral to take to the window, one of the ways they can obtain collateral is to see an ibank default. some opined that jpmorgan was not so much the savior of bear stearns as the fed drove a pile of collateral to jpmorgan for a bargain-basement price in an effort to shore up the commerical bank, which is the single largest player in the CDS market and heavily invested in the commercial and CRE loans that are only now starting to run into difficulty with the onset of recession.
by extending discount window protection to the major ibanks, however, the fed has less solved the problem than shoved the same incentives one layer further out into the shadow banking system -- now it is commercial and investment banks both who are incentivized to cut off the parties left just outside the fence, which is the hedge fund community. unlike the ibanks, no one will be making much of a case to salvage hedge funds in this environment. this isn't 1998 with one large firm in trouble; now, many funds are being squeezed and not all of them can be helped.
what's more, there looks to be a surefire trigger in the wings -- recession, and what it means for actual bankruptcies. after years of progressively easier corporate credit which kept weak companies in business and drove bankruptcies to all-time lows, the piper has come calling for his due. already we're seeing conspicuous bankruptices in the airlines.
sooner or later, a large bankruptcy with a massive presence in the CDS market is going to push a significant hedge fund player to insolvency and it will not be able to meet its claims. many other players will suddenly find that their CDS book is unbalanced -- and, in a high fear environment that expensively precludes going out and writing new contracts to rebalance, books will be balanced by forced sales, sending more hedge funds to the wall, and so it goes. the fed may be able to salvage the banks in such a scenario, but not without severe losses -- and they will be essentially powerless to prevent the unwind in the international hedge fund universe.
this scenario is why CDS spreads have widened and will persistently stay wide until either it becomes clear that the economy has traversed the recession of 2008 without a disaster unfolding in the CDS market -- or until the disaster actually does unfold.
Thursday, April 10, 2008
Yet you delight more in breaking them.
Like children playing by the ocean who build sand-towers with constancy and then destroy them with laughter.
But while you build your sand-towers the ocean brings more sand to the shore,
And when you destroy them the ocean laughs with you.
Verily the ocean laughs always with the innocent.
But what of those to whom life is not an ocean, and man-made laws are not sandtowers,
But to whom life is a rock, and the law a chisel with which they would carve it in their own likeness?
What of the cripple who hates dancers?
What of the ox who loves his yoke and deems the elk and deer of the forest stray and vagrant things?
What of the old serpent who cannot shed his skin, and calls all others naked and shameless?
And of him who comes early to the wedding-feast, and when over-fed and tired goes his way saying that all feasts are violation and all feasters lawbreakers?
What shall I say of these save that they too stand in the sunlight, but with their backs to the sun?
They see only their shadows, and their shadows are their laws.
And what is the sun to them but a caster of shadows?
And what is it to acknowledge the laws but to stoop down and trace their shadows upon the earth?
But you who walk facing the sun, what images drawn on the earth can hold you?
You who travel with the wind, what weather-vane shall direct your course?
What man's law shall bind you if you break your yoke but upon no man's prison door?
What laws shall you fear if you dance but stumble against no man's iron chains?
And who is he that shall bring you to judgment if you tear off your garment yet leave it in no man's path?
People of Orphalese, you can muffle the drum, and you can loosen the strings of the lyre, but who shall command the skylark not to sing?
thank you, tanta.
Wednesday, April 09, 2008
credit crisis loss estimates still growing
Tuesday, April 08, 2008
the credit crisis going forward
second -- and more interestingly -- institutional risk analytics offers this interview with jonathan rosner (via yves smith).
The IRA: So what is the Rosner view of the world? The party line in Washington and on Wall Street is that everything's fine and we'll return to normal growth in the second half of 2008.
Rosner: I see troubles radiating outward. What I mean specifically is that there is no functional change in the problems in the mortgage markets. What is really making us feel OK, at the moment, is the fact that banks are destroying shareholder capital and that they are raising new money. That's all well and good, but we still have not changed the underlying reality, namely that most of the losses taken so far are due to mark to market issues. We have not yet really seen the bulk of the underlying credit losses.
The IRA: Ditto. We have been talking about this for six months, but there seems to be a refusal on the part of many observers to accept that the losses reported to date have been primary trading book write downs vs. actual charge offs of loan losses. Citigroup (NYSE:C), for example, did just 120bp in aggregate charge offs in 2007.
Rosner: There is a lack of appreciation or maybe a lack of understanding between these two issues, mark to market losses and actual credit losses, and we need to distinguish between these two issues. I continue to believe that we are going to see further downward pressure on home prices -- regardless of what the Congress believes or intends or manipulates. Unless we actually nationalize the housing industry, there is not much we can do to avoid the downward correction in home values.
The IRA: ... But let's get back to the current mess. How do you assess the state of the real estate market and the implications of this for financials?
Rosner: We are starting to see an acceleration of the delinquencies and loss rates moving from subprime through alt-a through the prime market. GSEs like Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) are in no position frankly to do much to save themselves let along save the market. ... They are already visible in the home equity line of credit market. The HELOCs are typically committed lines and frankly people often forget that in some respects, at least in this cycle, the consumer lenders, revolving lenders, credit card lenders, are in a better place that the HELOC lenders. The revolving and credit card lenders can change your available lines overnight and change your rate terms with the same speed. The HELOC lenders cannot.
what follows is important, and puts a knife in some of the arguments surrounding walkaways.
Rosner: ... What I mean by that is that the last asset which a borrowed defaults on is the primary mortgage…
The IRA: At least it used to be. The FT reported a while back that the 2006 production was the reverse, with borrowers defaulting on mortgages before credit cards or auto loans.
Rosner: No, the mortgage still is the last thing to go into default. The borrowers we've see default already are those with no other resources. Where I think we see the next leg and what I am watching carefully now is that we are seeing the drawdown of committed but undrawn lines of credit by distressed borrowers who are taking cash out of the line to pay first their primary mortgage and then revolving lines of credit. At some point we reach a terminal period where they default on their credit card and then their primary mortgage. I'm not sure it does not go in the other order, but we'll see. That is the reason, I believe, that we've seen a little bit of a slowdown, a respite from a massive spike in defaults, because the borrower who is Alt-A and prime largely, even with the decline in home values, still has access to credit. Consumers do not give up spending of their own volition. They do so only after they have exhausted all other options.
The IRA: Suggesting that we could be headed to a huge uptick in default experience in unsecured and mortgage loans in the not too distant future?
Rosner: Yes, we will see the drawdown of HELOCs until they are exhausted, resulting in an eventual upsurge in defaults on mortgage-related and revolving credit. ... I would be very wary of institutions that have HELOC exposure. For the time being, I would be less concerned with the credit card companies. And then there is the situation in commercial real estate, where the wheels are starting to shake and even fall off the wagon.
the interview covers a good deal more ground than this, but in terms of the depth and breadth of any subsequent recession this is central. it is hard to conceptualize, given the turmoil we've already seen, that banks in the main have not yet even begun to take the economic losses that are surely coming. and rosner here is only ancillarily referring to the commercial side, awareness of which is only now beginning to materialize.
Monday, April 07, 2008
action against iran closer?
"Petraeus is going to go very hard on Iran as the source of attacks on the American effort in Iraq," a British official said. "Iran is waging a war in Iraq. The idea that America can't fight a war on two fronts is wrong, there can be airstrikes and other moves," he said.
"Petraeus has put emphasis on America having to fight the battle on behalf of Iraq. In his report he can frame it in terms of our soldiers killed and diplomats dead in attacks on the Green Zone."
perhaps this is just so much posturing, the use of rhetoric to try to influence iranian behavior. but i'm inclined to think that the still-prideful administration and their handpicked generals are in over their heads and continue to refuse to understand either the limitations of american power or the same of iranian power.
iran is not a monolithic block. it is probable that the united states has both potential allies and potential enemies inside iran as they do in iraq, and that only some few are involved in the regional arms trade that sees iranian weapons show up across borders. it is also probable that, rather like the drug trade into the united states, there's little the iranian government could do about it even if it were deeply motivated. as juan cole notes, the mahdi army is not a destitute organization. i wouldn't be at all surprised if (unmentioned in the news, of course) american soldiers are finding not only iranian- but american-made weapons being fired at them, weapons which transited the black market either overseas or within iraq itself.
this may be clear to many on the american side as well. the administration in an election year, however, would find utility in a scapegoat to blame for its failings in iraq -- and this then amounts to another classic example of empires having their foreign policy driven by domestic politics.
strategically, the united states is left having upset the balance of power in the mideast by overturning the iraqi applecart, handing iran a regionally dominant position by empowering iraqi shi'ites, some sympathetic to iran. contrived efforts to now rebalance the situation by weakening iran are not going to be materially aided by a few airstrikes. it would take the construction of a durable american client state in iraq. this is no small undertaking, and it isn't kind generally to shia empowerment -- there's a reason some select sunnis have so consistently been installed by europeans atop the power structures of states carved from the former ottoman empire along the persian borderlands. this dissonance of american goals -- the utopian desire for decentralization and democratization on the one hand, the realistic need of a client state to preserve regional order in favor of america on the other -- is likely to be expressed in frustrated fits, the physcial manifestation of which is an airstrike, in lieu of anything like a real solution.
one should be wary, then, as ever. paranoid proclamations like this are flowing from the mouths of the more bloodyminded israeli politicians, and some questionably-sourced reports foresee a joint american-israeli action regionwide. while i imagine that to be too brash a move for all but the most evangelical neoconservatives, there's no doubting that the elevated propaganda in both israel and the united states is intended to evoke popular fear and hatred of iran -- a necessary preliminary condition of any military move.
on the other hand, i can't see pro-iranian elements within iraq sitting idly by while the u.s. or u.s./israel mounts attacks on iran. i doubt these sects could be bought off with greenbacks. so, it would appear to be about the worst possible move to act against iran in the near future.
perhaps a useful barometer would be to lexis/nexis fox news transcripts month by month and see if they are ratcheting up the propaganda like they did a year before the iraq invasion.
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Friday, April 04, 2008
march price declines in chicago
Asking prices fell at the fastest rate in Chicago — down 3.9 percent during March — driven by a large increase in for-sale property inventory of 12.3 percent, the companies said. The largest quarterly declines occurred in San Francisco and Las Vegas, however, which were off 5.3 percent and 5.2 percent, respectively, during the month.
“As the typically strong spring selling season gets underway, we are seeing sellers marking down prices to move their homes,” said Michael Simonsen, CEO and co-founder of Altos Research. “The seasonal inventory buildup is only going to exacerbate the near-term supply-demand imbalance and put more pressure on sellers to reduce their price expectations.”
i've analyzed the altos/realiq report before here with respect to listing times. now we're seeing what i had hoped we would -- average listing times decreasing slightly (though still very high at 131 days) and faster price declines. the spring inventory build looks to be more impressive than ever in the early going, in part due to chicago becoming an american foreclosure capital, and that bodes yet more poorly still for pricing.
that dovetails with affordability metrics, which indicate chicago pricing has a long way to go. as i commented at menzie chinn's blog:
i'd be happy to chime in as a current-renter-future-buyer as well, nominating myself to speak for millions. there's nothing "affordable" about housing right now.
i'm in northwest suburban chicago, renting a wonderfully rehabbed four-bedroom house for $2000/mo. taxes come to $550/mo, so my equivalent mortgage payment would be just $1450/mo. using a 30y fixed @ 6%, what kind of mortgage can a guy carry with that? about $220k, funding a $270k purchase with 20% down.
the property was bought by the current owner in 2005 for $459k. the place across the street is currently listed at $419k.
paul mcculley recently made an excellent point about what must broadly happen to compel cash-heavy buyers into the housing market again -- and that is "positive carry". that's where housing busts normally find a price bottom -- when the capacity for an investor to rent the property out for more than he must pay to service the underlying debt is restored. that's where buying makes a lot of sense.
we are a long way from that point in chicagoland. i wouldn't at all be surprised if menzie has the eventuality ballparked at 40-50%.
i've seen no meaningful fiscal action yet from the government to stem the tide here, and i'm not sure any is really feasible. barring that, this promises to be a very painful summer for home sellers in chicagoland.
Lenders who allow owners to stay in their homes are distorting the record foreclosure rate and delaying the worst of the housing decline, said Mark Zandi, chief economist at Moody's Economy.com, a unit of New York-based Moody's Corp. These borrowers will eventually push the number of delinquencies even higher and send more homes onto an already glutted market. "We don't have a sense of the magnitude of what's really going on because the whole process is being delayed,'' Zandi said in an interview. "Looking at the data, we see the problems, but they are probably measurably greater than we think.''
it was earlier this week point out by barry ritholtz that banks, when they do foreclose, are sometimes not even bothering to take title (incidentally highlighting again chicago as one of the nation's foreclosure capitals).
this matches up well with anecdotes and common sense. servicers in the most blighted areas must be beyond overwhelmed by now. there simply isn't enough manpower to process what is happening, and banks are not in a position to take on more REO. one would have to expect banks to price REO even more aggressively in coming months in an effort to get through the inventory.
Thursday, April 03, 2008
why deflation is probable from here
Over-indebted individuals have just three choices: reduce spending below income, sell assets they own to somebody else or, if the worst comes to the worst, default. But one person’s debt is another person’s asset, one person’s expenditure is another person’s income; one person’s sale is another person’s purchase and one person’s default is another person’s loss.
If very many individuals reduce their spending, in order to pay down their debt, the economy slumps. If many try to sell assets they own, their prices crash. If many default on their debts, financial intermediaries implode. The economics of an entire economy are not the same as the economics of a single household. That was perhaps the most important point John Maynard Keynes made.
Thus, argues Mr Magnus, “there is a quite serious risk that the de-leveraging downturn could run amok: credit contraction causes economic contraction, which causes further write-downs and capital destruction, which leads to more credit contraction and so on”. On the upside, the fairy government-mother stood on the sidelines, applauding the enthusiasm of her charges. On the downside, she is dragged in, as risk-addiction turns into risk-aversion.
the bottom line:
Neither households nor the financial sector, as a whole, can de-leverage swiftly, other than via a calamitous mass default or by shifting their debt elsewhere, usually on to the government. For an entire economy, particularly a huge one, to recover from debt-addiction is hard. However much one may loathe the idea, a private-sector financial mania will finish up as public-sector pain.
i have personally questioned in the past the government's capacity to inflate from debt levels as high as this -- monetary base is so small in comparison to the size of the debt being written down that it cannot stand against the tide to make an inflation go. this is, it seems to me, the great lesson of not only japan but the nordic financial crises. again yves smith and his trenchant critique of some other views:
We are witnessing liquidity hoarding in the interbank markets. I already have economically literate readers who tell me that they are holding large cash balances at home our of fear of a bank holiday and are trying to find a bank they deem to be safe. A couple of bank failures and we could be well on the way enough withdrawals from banks to generate a money supply contraction, no matter what the Fed does with the monetary base.
many economists consider these deflationary events "mistakes". as i commented earlier at naked capitalism:
one of the most consistent features of the modern period is the conceit of the current -- a sort of background of antipathy for all that came before. it frequently presumes earlier incarnations of ourselves to have been some combination of stupid, uneducated and inexperienced. it isn't difficult to imagine why the prejudice is popular.
but i think a more nuanced reading of history backs a different view -- that eras are defined by philosophies and paradigms that are over time pushed, thanks to the positive reinforcement or earlier successes, to their breaking points and then beyond. the people operating within the paradigm are neither stupid nor uneducated nor inexperienced -- but they are operating under a set of assumptions that have succeeded heretofore in accordance with the paradigm of the era, and (it is taken as self-evident) will continue to work as expected ad infinitum.
they ignore (or perhaps are really incapable of properly interpreting, given the deeply-reinforced prejudices of the paradigm) that every imperfect paradigm must eventually fail because the imbalances that are part of its maintenance are at least fractionally cumulative -- and that the cumulative imbalance is ultimately unsustainable.
i have no idea if we've reached that point -- the end of the keynesian economic paradigm, as it were, for lack of a better label.
but prof. delong would seem here to deny that there is a paradigm at all -- that modern economics are not so much a set of temporarily-operable assumptions accruing imbalances that will ultimately undo the paradigm as simply Correct (capital C, to denote its holiness), subject only to the virtue of its high priests.
i would note that mainstream social thinkers in all previous periods believed exactly in the same manner of their contemporary paradigm. all considered it to be extremely sensible, generally invulnerable if properly managed, indeed the height of human achievement.
yet not one such paradigm has avoided its fate -- not as the result of "errors" but in spite of actions taken by authorities in harmony with the assumptions of the paradigm. nor will this one avoid a similar fate, i think it's safe to say -- because, as ever, too few appreciate the complexity of social systems and their ability to defy and destroy our necessarily simplistic assumptions about it and render everything we now believe we know about it null. *there* is where the error lies, i suspect.
UPDATE: a note (via bloomberg) from banking analyst meredith whitney articulates the severity of the contraction now underway.
UPDATE: more japan comparisons via yves smith. i have to admit, i find the similarities extremely compelling, even at some level of detail, such as the reluctance of japanese banking to get sucked into the american vortex. of course, rogoff and reinhart have made the commonalities clear to many now.
i further tend to agree with socgen's edwards -- the disbelief in the united states that things could be "that bad" is simply a form of denial without much basis in fact. it very certainly could be "that bad". some will point out the health of megacap corporate balance sheets in america today as compared to japan then, and i agree. but consumer debt in japan was absolutely nothing like the problem we have in the united states -- the first big difference between japan then and america now is that then it was a corporate/financial services debt and property bubble, whereas today it is a household/financial services debt and property bubble. i wonder which is worse, but it may not matter -- edwards is utterly correct to point out that the position of the united states today is aggravated by its heavy dependence on foreign capital inflows, whereas japan then was in the opposite situation. that is the second big difference, and it compounds and complicates our more mundane insolvency and deleveraging problems with a first-class currency crisis.
I'm impressed by your blog overall but can't find an RSS/atom feed -- if you have one it is well hidden...?
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Really? At what point in the aggregation of individual actions does the magical pixie dust enter the equation?
The irresistible urge to aggregate and then imbue the aggregate with special characteristics not found in any of the individuals or groups within it is the worst sort of unthinking metaphysical claptrap and why Keynesian economics and all its progeny has led to nothing but grief and confusion.
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an household taken strictly by itself would be in a similar situation. but in a network of households, any individual household caught out in the rain can reduce leverage by selling to other, liquid households at something very like current prices. in this way, an individual deleveraging is possible without delivering a systemic shock. this sort of activity is what drives creative destruction in the best sense.
but when the entire network -- the economy -- is trying to reduce leverage simultaneously, there is no one to sell to. illiquidity becomes a problem, and liquidation can then only proceed by real price reduction -- which means insolvencies and defaults, which (when the defaults are nominal) means forced sales, which means yet lower prices, and so forth.
this dynamic does not present itself when a single household in a deep network of households is in trouble -- or, if it does, it tends to be a passing phenomena.
that is, unfortunately and thanks to the excesses of the credit boom from 1980 to 2007, not the situation we find ourselves in now.
perhaps wolf would do better to suggest that the economics of an entity enmeshed in a deep network are different from the economics of either the entity or the network in isolation.
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the coming corporate bankruptcy boom?
If the debt markets are to be believed, companies could be in at least as much trouble as they were in the previous two downturns, in the early 1990s and at the start of this decade, after the dotcom bubble burst. A leading indicator is the spread between yields on speculative “junk” bonds and American Treasury bonds. A year ago, the spread was only about 280 basis points; the long-term average is around 500 points. This month the spread exceeded 800 points for the first time since March 2003, reaching 862 on March 17th.
FridsonVision, a research firm, publishes a default-rate predictor based on the percentage of bonds trading with a spread of at least 1,000 basis points. On March 19th this was forecasting a default rate on high-yielding American corporate bonds of 8.55% by the end of February 2009, compared with Moody's forecast for American bonds of 6.8% for that date.
Martin Fridson, the firm's founder, admits this forecast is risky, because it relies on prices set in a market that has been hit by the liquidity crisis. Indeed, some contrarians believe that today's corporate-bond spreads say more about the shaky health of the financial markets than they do about the condition of corporate borrowers. As liquidity returns, they predict, corporate-bond prices will soar, making this the buying opportunity of a lifetime.
Mr Fridson concedes that the difference between corporate-bond spreads and actual default rates is unusual and hard to explain: on the previous occasions when spreads have exceeded 800 points, the default rate was already 9.43% in 1990 and 5.44% in 2000. That said, the huge amounts of “covenant lite” debt issued in the credit boom of 2005-07, which gives lenders much less power to demand their money back than in the past, may have delayed the moment of default for many underperforming firms. So FridsonVision looked at the ten firms in which spreads exceeded 1,000 points by the smallest amounts. If these were merely victims of irrational pessimism in the market, they ought to be in relatively good shape. In fact, the analysts found plenty of reasons to worry. The companies included household names such as Beazer Homes, Ford and Rite Aid, all of which are “exhibiting classically distressed behaviour of downsizing amid recurring losses.”
A look at the firms with distressed debt shows that problems are rapidly moving beyond the long-term sick (airlines, cars) and the industries immediately affected by the crisis (home builders, mortgage lenders, monoline insurers). Craig Dean of AEG Partners, a restructuring-advisory firm, says he is now seeing troubled companies in retailing, restaurants, manufacturing and food processing.
more from yves smith. a surge in corporate bankruptcies comports well with my impression of the last few years of very low corporate bankruptcy rates. questionable operations were sustained by the same evaporation of underwriting standards in lending as was seen in residential mortgages (though perhaps to a lesser excess). allowed to pile on more and more low-interest-rate debt, rather than be driven to bankruptcy by nervous creditors, these companies are now a backlog of defaults held back by a dam of easy credit. that dam is now broken, and recession is imminent -- ergo, a flood is coming.
recent improvement in corporate credit default swap metrics have been explained a massive short squeeze, noting that:
... cash bond indices had barely moved in recent weeks, with many bonds still trading at very wide spreads.
Illiquidity in cash bond markets may contribute to their divergence from credit derivatives, but some analysts say these bonds may still give a truer picture of investor appetite for risk....
but accrued interest notes that things have, for whatever reason, thawed a bit in credit markets for the first time in months. to be sure, it was seen earlier that things had got overdone and a rally was overdue. if there is a considerable liquidity-driven mispricing in debt instruments, it should become evident fairly soon as something like liquidity returns.
this situation is very different from the mega-caps in general, many of whom are carrying massive cash balances and are in little danger (though some, like ford, are in a boatload of trouble). rather, the bulk of the danger lays in the mid- and small-cap sectors. in some ways, while growth has not been nearly so spectacular as the financial and household varieties as ft's martin wolf notes in this important article, corporate debt seems to have concentrated at the lower-quality end of the corporate scale.
as the economist's graph shows, there may be a lag of a few quarters before defaults amass in earnest. but, when they do, i suspect the rate will quickly jump to double digits and unemployment become a serious problem in the united states.