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Wednesday, November 12, 2008


the corporate bond collapse

mish offers evidence of debt deflation in examining corporate bond spreads, which includes this shocking chart of Baa spreads to Aaa and t-bills dating back to 1934. this echoes the horrifying plight of western capital markets, where levered finance of all manners -- hedge funds, investment banks, institutional investors, commerical banks -- is being hammered and forced to liquidate in the first balance sheet recession in the west since the collapse of the roaring twenties. and the reality of defaults is onrushing if tardy, per the ft.

as an aside, mish's further evidenciary proceedings at minyanville -- attempting to correct for the owners equivalent rent (OER) contribution to CPI measurement using the case-shiller home price index -- is also worthwhile.

jim rogers for one (via naked capitalism) believes western debt instruments are "going to be a terrible place to be for the next 10, 20 years" as the great unwind proceeds. prudent bear's martin hutchinson is looking out to a great bond market crash of 2009 to resonate with a similar feature of 1931.

... {N]ext year, while it may avoid more than moderate stock market mayhem, is likely to produce the worst bond market carnage in US history.

Treasury borrowed over $1 trillion in the year to September 2008; it is expected to borrow close to $2 trillion in the year to September 2009. That’s 13% of US Gross Domestic Product. ... in terms of GDP that’s far more debt than the US capital market has ever been asked to absorb, other than during World War II. At some point, “crowding out” must occur; we certainly cannot assume that Asian central banks will want to take the entire load, at interest rates less than zero in real terms.

Treasury bond and other prime bond yields can be expected to rise sharply in 2009. This will cause losses to their holders. To the extent that such holders are foreign central banks, the United States probably doesn’t need to worry. ... However domestic holders are a more serious problem. To the extent that pension funds have losses on their holdings of bonds, they will need to raise contributions; to the extent that insurance companies have such losses they will need to raise premiums.

Assuming the $30 trillion state, mortgage and private corporate debt outstanding has an average duration of 5 years, a fairly conservative assumption, and neither the shape of the yield curve nor the premiums payable for risk alter significantly by the end of 2009, a 1% rise to 4.74% in Treasury bond rates by December 2009 would cause a total loss to investors in the $30 trillion of Federal, agency, mortgage and prime corporate debt of 3.9% of the debt’s principal amount, or $1.17 trillion. Not as bad as the credit losses.

However once rates start rising, they are likely to rise much more than 1%. To cause a loss of $3 trillion, the same as the estimated credit losses, 10 year Treasury bond yields would have to rise to 6.43%. Hardly an excessive assumption; 10-year Treasuries yielded 6.44% on average during 1996, at the beginning of the Fed’s money bubble, in which year inflation was 3.4%.

of course that won't stop equities from tanking, as albert edwards will tell you.

both rogers and hutchinson presume the outcome of rising inflation within the next two years, rather than the deflation we are currently experiencing as exampled by mish. this presumes a successful devaluation of the dollar on the part of the fed and move to some measure of credit creation -- a monetary inflation backed by quantitative easing, if not one initially backed by wage increases.

whether that comes to pass -- or whether an asset collapse and capital flight from the united states forces interest rate increases and a defense of a freefalling currency, a la iceland, where civil order is beginning to come apart as economic activity and wages collapse while import prices skyrocket, leading up to a third of the population to consider emigration -- it is possible that the pain in corporate bonds, deep as it has already been, will only spread up the capital structure to more highly-rated securities as depression unfolds.

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from perrone: see, gm, that's what I mean -- a la _Iceland_? the United States? can we really imagine how even theoretically, given the structure of the world economy, they might somehow wind up analagous in practice? well, I can't. what am I missing?

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a refutation of the reserve currency is pretty hard to imagine, perrone -- but give the fed a chance to run some trillions off their printing presses and we might see exactly that. that's all that has really happened in iceland -- a rejection of the krona.

there are massive differences of course, particularly the united states being a low-interest-rate country and therefore a funding source for the carry trade. but there is more than one path to currency destruction.

fwiw, it's almost impossible for me to wrap my mind around the idea. but is it possible? unfortunately, i think yes.

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Iceland's debt-to-GDP ratio in domestic currency is 530% versus 350% of GDP in the US.

It seems like their problems so far are due to other factors related to exchange rate and interest rate dynamics, extreme levels of foreign borrowing, etc.

I've been wondering whether their domestic money supply would enter its own deflationary debt collapse of the sort the US has begun, despite high imported inflation. Or is it already contracting?

I have yet to see meaningful discussion of this.

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