Thursday, June 19, 2008

Will the fat lady sing already?

It seems that as my economic posts get a bit more technical many of you "disconnect", you all seemed to respond better to generic posts. Truth is, while I apologize for the details, they are important in understanding what the frak is going on in this current financial crisis. However today I will try to fly a bit at "10,000ft".

So, we are facing $350B of losses to the financial sector due to subprime, due to falling prices on defaulted assets with jingle mail phenomenas. House prices are STILL falling down. So the losses are going to increase. Let's say it will be $500B on subprime alone when all is said and nothing sold. The banks have already recapitalized to the tune of $250B. And it is going on with a vengeance. Dividends are being cut, capital is being raised (latest: Fifth Third, with $2B announcement this morning). The financial sector is in dire straits but I am ready to go long on it, well at least by selling puts :) My banker refused to do such a trade on my behalf yesterday. I believe that at the rate they are going we may be see the final shoe drop this summer (hence the puts, but he is right it may be a little aggressive and i am very conservative). We may be at a good 60-70% through this financial crisis. And with the headline SO negative I will be taking a contrarian view in 2 mo.

But the mother of all meltdowns is still moving under the water: the CDS spaghetti plate of Credit Default Swaps. With 60T (yes T!!!) under-written, the whole economy is insured but given the losses in the banking sector, an almost certainty is that the counter-party risk is material just not observed. Also it is REALLY hard to observe it since most of these contracts are Over the Counter (OTC) and thus private. See calls to create markets for OTC (which would cease to be OTC then :). The whiff of radio-activity from this decomposing pile of dunk was enough to trigger the bear-stern rescue on the theory that settling the CDS mess would grind the financial system to a halt and since we are fighting a stupid war at the other end of the world, there would be no one to enforce martial law. Not kidding on this one. However nothing to worry about, move on... the radio-active mountain is still there, and we had better not look to close and hope it holds :)

The credit crisis is alive and kicking, and will continue to do so through the summer. I am long on it with bonds, I like fixed income, I avoid fund of bonds (you get hit on paper value) and try to hold on short and mid-term securities. Inflation be damned, at least I am principal protected, which is more than I can say for equities.

So what with the connection to the "real" economy, and its derivative the stock market, what are the knock on effects of the financial crisis. Well the most obvious variable is the soaring inflation which poses real limits for the central banks. In a nutshell: Stock market dive at the beginning of 08, the FED cut the rates like mad (debated heavily by academic bloggers), save the day for now, debase the dollar currency in so doing, the oil price spikes (crude is priced in dollars, with other demand factors and speculation included) and that has a knock on effect on everything as we use oil well... for everything from medicine production, to farming to transport to ... everything. The problem with inflation is that the central banks feel the need to raise interest rates, see Trichet and his BIG FRENCH MOUTH spouting last week that he would raise the EU interest rates, sending tremors through the markets. The FED are STUCK: they can't lower to stimulate and they can't raise to combat inflation. They will do something but there is NO CLEAR PATH. Recession is "slipping in" according to the official recession indicators, and has been here for the past 3 mo.

Credit contraction could have kept inflation under control, it seems it hasn't, theory is that the inflationary dam isn't breached as there is no wage pressure. So the wage-price inflationary spiral of the 70's, which did nothing but erode cash and increase numbers on paper, will not take hold. We will all get poorer since prices will go up but not income, but there will be no real inflation long term... we will see how well THIS theory holds up.

Speculation on the biggest assets we have (houses) had to have nasty consequences. A part of me sits in contemplation enjoying the spanking the ignorant real estate agents are taking (God! do I despise that kind), another part of me is genuinely worried that credit is evaporating as a consequence with real macro consequences on investment, while the final part says "so what, we will survive this flood, bring it on! Kids let's go to the swimming pool! Time for your lessons!"

So I am teaching my kids survival skills: mathematics and swimming. Matt Asay would insist on Bible teachings, I let Nathalie take care of it.

6 comments:

Andrew Meyer said...

Marc,

I really enjoy your financial pieces, however there are two things to remember about financial analysis:

1. It has correctly predicted five out of the two financial crises.

2. There's a great line from a 1970's Woody Allen movie: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray we have the wisdom to choose correctly.”

I admire you teaching your kids swimming and math, after they start doing financial analysis, people usually invest in canned peas and shotguns...

Don Busch said...

I had never heard of these things before today. Here's a good article from Bloomberg (found it in the Wikipedia entry).

http://www.bloomberg.com/apps/news?pid=20601109&sid=aCFGw7GYxY14

Crazy!

Marc, thanks for the education!

Marcf said...

andrew LOL

We need a good woody Allen satire of the investment world , kind of a modern and kosher version of bonfire of the vanities.

Marcf said...

don when you say you had never heard of the crisis, you are joking right ? If not just move along nothing to see here. No need to thank me just buy me a beer one day!

Don Busch said...

Marc,

No, I'd never heard of Credit Default Swaps. Sorry to be unclear. The financial crisis, I'm well aware. We're in the housing market right now, and prices are shifting a lot.

Much of the financial stuff you post forces me to go to Wikipedia and try to learn something. Which is definitely not a bad thing.

Thanks!

Army No Va said...

Best Housing Blog...

http://thehousingbubbleblog.com/index.html

My guess is 2 years more down. Maybe 3. Would mirror previous busts. This one moving a bit faster in some ways, but it also is bigger.

I told one of my best friends who made a lot of money in Orlando FLA real estate over the past 20+ years that when he says it's a terrible investment, I'm in! He's working towards that now slowly (he has a house for sale and won't cut the price much), but not there yet - probably 2 more years!!