A credit crater too big to fill – Nov. 5, 2008

You can read the attached lengthy article from MSN Money based on input from Satyajit Das, a name you might remember from one of my own articles. Satyajit, a banking expert, wrote a 4,000 page text on derivatives (structured financial instruments). Or, instead, you can read his quotation below which sums up the article and is the most chilling analysis I’ve yet heard.


Nov. 5, 2008

“Governments are not really trying to save the system anymore,” said Satyajit Das, a banking expert in Sydney, Australia. “They now realize that’s impossible. They are just trying to manage the decline.”

A credit crater too big to fill?

“As the movement of money across borders comes to a grinding halt, governments can only manage the decline. Don’t be surprised to see markets roll back to 1995 levels — or lower.”

By Jon Markman   MSN Money Nov 5, 2008 

“Despite a weeklong surge in stocks, it’s becoming increasingly clear that credit has suffered a catastrophic setback.” 

“It’s as if a set of asteroids hit Manhattan, London and Tokyo, carving a massive hole in the architecture of finance. The initial buildings in the impact crater, Lehman Bros. (LEHMQ, news, msgs), Bear Stearns and Northern Rock, were quickly incinerated. But now the toxic rain and tsunamis that were kicked up are rolling onto the survivors in waves and cutting off their air supply.”

“New data from world money centers suggest the movement of money around the globe has simply ground to a halt, as institutions in the United States, Europe and Asia that are receiving taxpayer dollars from governments are socking it away to shore up their balance sheets, reserve against liabilities expected in the near future and sustain their unprofitable operations.”

“Governments are not really trying to save the system anymore,” said Satyajit Das, a banking expert in Sydney, Australia. “They now realize that’s impossible. They are just trying to manage the decline.”

How low will it go?

“As a result, once the current rally interlude is over, it’s not hard to see the Dow Jones Industrial Average ($INDU) sinking to around 4,000 — a level it last hit in 1995, before debt started to play such a large role in corporate and personal finance.” 

“That would entail a decline of 70% from its 2007 peak, or about the same amount the Japanese stock market has fallen since 1990 in the wake of its own debt unwinding. Or the amount the Nasdaq Composite Index ($COMPX) dropped from 2000 to 2002. Or the amount the Russian market has plunged since June.”

“If that seems too harsh, well, the math is pretty easy to explain. Figure you have a well-regarded multinational company that earns $10 a share and sports a price-earnings multiple of 25 when the U.S. economy is rolling along at its long-term trend rate of 4%, or about twice its normal growth rate.” 

“Multiply 25 times 10 and the stock is worth $250. But now take away half the financing of customers, the stock buybacks done with borrowed money, the high-yield cash-management systems of the corporate treasury, the leveraging that allows raw materials to be bought with borrowed money and the leveraging that allows its customers to buy with credit cards and layaway plans.”

“Then ratchet back U.S. economic growth to 0%, which is about the best forecast now for 2009. Figure the company now earns 25% less than at peak (an optimistic estimate), or around $7.50 per share. Because of the slowing growth environment, the market is likely to take the price-earnings multiple down to around 10, which is still more than twice the company’s forecast growth rate. Now multiply $7.50 by 10, and the stock is projected to trade at $75, or around 70% lower than the peak.”

“The problem is that this scenario might be too sunny. The economy is losing around 200,000 jobs a month. Just last week Yahoo (YHOO, news, msgs), Merck (MRK, news, msgs), Chrysler, Xerox (XRX, news, msgs), Goldman Sachs Group (GS, news, msgs) and National City (NCC, news, msgs) announced layoffs.”

“Unemployment, now skimming along at a relatively tame 6.5%, is expected to mushroom at least to 8.5% if not 9% or higher by the end of next year. With stock and home prices in a tailspin, consumer net worth is already on track to decline 14.7% year over year this quarter, a record plunge.”

“Credit card revenues have sunk to their lowest level in five years, and a JPMorgan Chase (JPM, news, msgs) official was quoted this week as stating that “loan volume will keep going down as we continue to tighten credit.”

“Holiday sales are expected to be weak, with same-store sales in November and December projected to sink 2.2% from last year. The lone good news: A decline in the price of gasoline of nearly 50% since June, to around $2.15 per gallon nationwide, will roughly equal a $210 billion tax cut.” 

“ISI Group analysts said that when these factors are totaled and sifted, corporate profits are on track to decline 10% in 2008, and that if U.S. gross domestic product stays flat next year, corporate profits are likely to fall 13% more in 2009. That would be the first back-to-back decline in profits in the post-World War II period.”

“Meanwhile, Europe, which is responsible for a third of world GDP, is in no better shape, with manufacturing falling off a cliff. Volvo (VOLVY, news, msgs) reported last week that truck orders are off 55%. Greece is staggering as rental rates for its key shipping industry are down 90% since June. Emerging East European countries such as Ukraine and Serbia are seeing their currencies blow up along with their economies. Ditto India, Argentina, Brazil and even China, where growth is slowing from the low double digits to around 7%.”

Trying to fill an expanding hole

“To counter all these effects of credit extinction, the United States, Japan and the European Central Bank are cutting short-term interest rates, injecting taxpayer money directly into the capital structure of banks, providing hundreds of billions in low-interest loans, guaranteeing deposits and more, on an unprecedented scale.”

“So why isn’t it working? A couple of reasons. First, early in this debacle, the Federal Reserve and Treasury Department apparently decided that they would declare war on the so-called shadow banking system. These were the hedge funds, structured investment vehicles (SIVs) and other nonbank entities that had grown up since around 1995 to create, leverage, re-leverage and distribute roughly $10 trillion in debt.”

“Pimco co-chief Mohamed El-Erian has called this the ‘global liquidity factory,’ but no matter the name, these unregulated entities created oceans of money that flowed luxuriantly to everyone from credit card users in North Dakota to bankers in Iceland and builders in Thailand”.

“The shadow banking system worked so long as everyone at the base of the system paid their loans on time, but economic stresses of the past year have tested that concept, and it has flunked. Governments have closed the liquidity factory by ordering the SIVs and conduits onto banks’ books, smothering the hedge funds by extinguishing their key prime brokers, Bear Stearns and Lehman Bros., and through the September short-selling ban that led to mind-blowing losses.” 

“This may have seemed like a good idea at the time, but the government has now been forced to spend taxpayer money to fill in the gaps where private money used to rule. And as it does so, banks are so concerned that they will not have enough money to meet the demands of angry customers of leveraged products wielding return receipts that they’re hoarding it.”

“Example: Imagine that a Mr. Watanabe in Tokyo was sold a high-yield collateralized debt obligation in 2007 at $10 million by Merrill Lynch (MER, news, msgs). Since other similar CDOs have traded lower, he’s now carrying it on his books at $8 million. But if he were to sell it on the open market he could probably get only $2 million or less.”

“Pressured by his own regulators to button up, he tells Merrill to buy it back or never expect to get any business from him again. Merrill then agrees to buy it at $4 million. Now new Merrill owner Bank of America (BAC, news, msgs) has to both pay the cost and reserve bank capital against it.”

“There are hundreds of Watanabes and as much as $3 trillion to $5 trillion in similar deals coming back onto bank balance sheets from CDOs, SIVs, currency swaps and the like, according to banking expert Das, so you can see that governments’ effort to recapitalize banks experiencing a run of deleveraging is not trivial. They will back up banks to the minimum required for solvency, but not anywhere close to their previous free-lending glory. This is why capital is at a standstill and why any business plan dependent on credit is now suspect.” 

‘Forcing them to pay through the nose’

“Credit analyst Brian Reynolds offered a few shocking examples from recent bond deals. Coca-Cola Bottling (COKE, news, msgs) issued debt in July at a spread of 1.69 percentage points over Treasurys. By this week, the spread had widened out to around 3.40 points, a move of historic proportions, Reynolds said.”

“When the company wanted to make another deal this week, bond investors made the bottler pay a stunning 4.68 percentage points over Treasurys.” 

“Reynolds notes that the same has happened with telephone giant Verizon Communications (VZ, news, msgs). In April 2007, it issued 10-year debt at 0.95 percentage point over Treasurys. In April of this year, it issued 10-year debt at a spread of 2.60 points, a historic move considering the worst spread for a big phone company had been 3.00 points in 2002. That record was shattered last week, when bond investors made Verizon pay 4.88 points over Treasurys.”

“And the kicker: Reynolds said the bond community was speculating that troubled MGM Mirage (MGM, news, msgs) would have to pay as much as 12% for a bond deal this week, but when it was priced, demand was so weak that the company was forced to pay 15%. And the deal was secured by the company’s New York-New York hotel and casino in Las Vegas. Moreover, Reynolds said, the company isn’t using the proceeds for growth but instead to pay down another credit facility.” 

“In other words, loan shark bond investors are forcing them to pay through the nose and put up collateral just to keep the balls in the air,” he told clients in a note Friday. It’s like a consumer who uses a credit card costing 15% a year to pay off a debt owed at 9%.”

“This is the new world companies face — and you wouldn’t know it by just looking at stocks.”

“Das said the bottom line is that deleveraging is like an epic flood. Governments can’t hold it back; they can only channel it. The public expects them to actually save the day just as they did after the 1987 equity crash, the 1991 real-estate crash and the 1994 junk-bond crash, yet none of those blowups involved an equity, credit, commodity and currency crash all rolled up in one.”

“It will literally take a miracle to solve this mess. Cross your fingers, and hope that a rollback to 1995 is as bad as it gets.”

Disclaimer: I’m not an investment advisor and these articles are for commentary only. For specific advice you should consult your own investment professional.

Your comments are WELCOME! Lengthy comments may time-out before you’re finished so consider doing them in a word doc first then copy and paste to “Leave a Reply” below.

About gerold

I have a bit of financial experience having invested in stocks in the 1960s & 70s, commodities in the 80s & commercial real estate in the 90s (I sold in 2005.) I'm back in stocks. I am appalled at our rapidly deteriorating global condition so I've written articles for family, friends & colleagues since 2007; warning them and doing my best to explain what's happening, what we can expect in the future and what you can do to prepare and mitigate the worst of the economic, social, political and nuclear fallout. As a public service in 2010 I decided to create a blog accessible to a larger number of people because I believe that knowledge not shared is wasted.
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