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Will Credit Crunch Crisis Calm Down Before The Real Stock Market Crash ?

Stock-Markets / Financial Crash Aug 23, 2007 - 08:33 PM GMT

By: Christopher_Laird

After basically being up on and off 24/7 for two weeks – I am amazed at the speed of the onset of the credit crisis. I also had a feeling last night, thinking about all this chaos, that it is rather bizarre. Weird and eerie is another view. There is no doubt that we have seen real fear like never since 1929 in credit markets. That almost spread to equities, with some scary drops – like 600 and 800 point down days in the Hang Seng and the Nikkei.

As happened in the February 27 crashes, the US markets were the ones that more or less held ground- So far. As that seemed to continue to be the case, again, the Asian markets seemed to calm, and also the European markets. Now, I would also suggest that the US ‘Working Group on Markets' and the BOJ market management teams both put serious floors under equities. Many times in the past two weeks we would see the Dow headed for a really bad day, but all of a sudden a serious reversal. I particularly remember that day when the Dow was rapidly down 150 points, but made most of that up in the last hour and ended down something like a few points. You are not going to tell me that the traders really did that one. A floor was put in.

I am not really one of these people who believe in conspiracies, but that does not mean that the Working Group on Markets is not what is seriously mitigating things. Hey, they admit they do it. They certainly have the horsepower and brains to pull it off, with Paulson and so on, market traders par excellence.

The only trouble is, how many times can this work? I think it is rather clear that, now that mortgage derivatives have been scattered world wide, and are being written down to 10 cents on the dollar, some more anarchy must ensue. We may have sort of weathered the first real test, but at great cost, and likely many hidden losses out there. We are not out of the woods yet by any imagination. The bad derivatives are about $2trillion worth of subprime and Alt A (one level higher). 20% of these are in arrears. Then we have the trouble spreading to even good mortgage derivatives, as investors flee these regardless of quality. That has caused jumbo loans (exceeding 400k US) to become hard to get and at 9%! Good luck to the high end real estate market.

Obviously, mortgages are not all going to lose 90% of their value, or are they? Maybe, if we have a real depression, and that is quite possible given the scope of this credit crisis – way larger than the LTCM episode – maybe if we have a real depression most mortgage derivatives will lose 90% value. We are talking something in the range of $10 trillion worth of new mortgages in the last 5 years that are becoming a big weight around all the holders of the paper.

Crisis has spread everywhere

Now, we get into the issue that the credit crisis spread to other areas and hammered confidence. The Fed used the discount rate to encourage lenders to loosen up. They lowered the rate .5% to 5.75, and allowed 30 days, instead of overnight – plus the option to roll forward as needed. That should have helped the situation. However, not too many took the Fed up on the deal, so we had an orchestrated campaign, where Citi, Morgan, Wachovia and another borrowed $500 million apiece Wednesday from the Fed under those terms.

Then, this is supposed to encourage others to take advantage of the discount rate. The trouble is, banks and institutions are not. Why is that? Because they don't want to lend the credit to others in trouble, and then assume the risk. So, it does little good to lower the rate, and even have campaigns to take advantage of it, if lenders have lost confidence in the liquidity of the system, and that is a real problem.

So, unless central banks are willing to just underwrite the entire credit system, and cover all impending mortgage losses, (buyers of everything as last resort, like MBS – Fed) we will likely not see any confidence return to credit markets. This is the thing the ECB has been quite afraid of. So has the Fed. The trouble is, if the CBs do underwrite all the losses (monetize them) then the only healthy market left, sovereign debt like US treasuries, will collapse too. Then we are in total disaster, as the USD might just let go finally…and we now go to a combination of a liquidity crisis followed by a collapsing USD – that is if the Fed wanted to monetize all these trillions of losses. So that can't happen. People who think central banks will totally cover all these trillions of losses and hold up equity markets overestimate their power and willingness to do that.

The ONLY solution that has done anything so far, is to prevent a real equity sell off. That is another problem. We already have hedge funds and banks going under. New revelations of these instantly hit stocks. This is likely to continue

Flight to safety in a panic

The episode in the US treasury market early this week, where yields dropped 1 to 2% in a panic flight to safety in US T bills/bonds/notes was quite something. In fact, it was almost never seen before. Well, as stocks seem to calm down, that is not a good sign at all that things are done unwinding. Rather, it just shows the fragility of the situation. 

One quote in an article stated, as I recall, ‘people just wanted to get out of Money Market Funds and into Treasuries'. I don't remember the link. It's been a big rush of data and articles, and I have been a very busy bee trying to keep up. I'm sure that you have too, as have the banks and Fed and ECB and practically everyone.

I want to comment on the UST market and stocks, but first another thing about how bad this credit crisis is. It is NOT over. The commercial paper market (short term credit for companies like 30 to 90 days) is swapped between banks and companies and institutions to cover short term funding needs. The market in the US alone is $2trillon. $50 billion has to roll over each week. 

Well, in the last two weeks, a backlog of $90 trillion has accumulated and NOT rolled over. This is the next set of dominoes to fall. The EU is having similar trouble, and one German banker said there is the making of a serious German banking crisis – because short term paper is not rolling over. So what does everyone do now? The system is collapsing right before our eyes.

If a company, bank, whoever, cannot roll over their short term paper, they are insolvent. This is a very big deal. I could go on and on about other sectors of the credit market being dead in the water right now. The efforts of the Fed to save things with the discount window appear not to be working. I have said before that Central banks are really trying to get ahead of this mess, but they are not really succeeding. Get ready for phase two of the developing liquidity/credit crisis. One guy said the unwinding will not be denied. Probably, we have only seen the beginning of it, and what a beginning it was/is. The scale of this is just huge.

Not working

So, the Fed gets the three biggest US banks to borrow a measly $500 million apiece in the discount window, but that is peanuts, and clearly there are few takers – if the Fed had to do this big hullabaloo about those small potatoes, Wednesday afternoon in an announcement through those banks.

Treasuries and stocks

Now we get to Treasuries and stocks. The episode early this week when treasuries dropped indicated many things. One is the lack of confidence overall in the evolving credit mess/crisis. Another is lack of confidence in Money Market Funds. 

I have put out alerts and public articles talking about how money market funds (MMFs) have grown vast since their invention in the 70's. The idea was to have some safe money in a fund where you can park short term money, but not have to lock it up say in a CD. It was to be a pool of liquid capital, but get a bit more interest. The creator of the idea recently said that MMFs have lost their original focus and are NOT what he created then.

Rather, MMFs now compete against each other, and so, take on more risk to get better yields. People mistakenly think most of these are FDIC insured, but they are not. Well, guess what? MMFs have gone heavily into the CP market and mortgage derivatives to boost yields. And we all know what is happening to that sector. 

You think, well, but that is probably only like 5% of what they have. Wrong. It is more like 20 to 30%. Does that scare you? It should. There are going to be some very big surprises in MMFs going forward when they reveal what their capital losses are. They are all praying the credit markets calm down before they have to report the bad news.

The same goes for Hedge funds. There is a big pool of redemptions that have to be accomplished. Hedge funds are hoping that equity markets recover so they can unload all the built up redemptions. I have seen stories how MMFs and Hedge funds have been putting off investors from redemptions, by many devices, such as saying they had to fill out papers. The people get them in the mail, fill them out, then wait. Two weeks after they started this process with the fund, they call, having heard nothing. The fund tells them they filled out the papers wrong. Or they filled out the wrong papers. So they get to start all over again. This buys the funds about a month…..See how this goes?

So, naturally, people lose faith in funds. The thing that scares people the most is NOT being able to get their money. Perhaps the fund will freeze redemptions – that is happening all too frequently right now. I also believe we have seen nothing yet.

It gets worse. I just put out an alert to subscribers that your retirement funds, pension funds, and so on, are all into – guess what? MBS, CDOs, (mortgage derivatives) and are in the same boat as the MMFs, and everyone else who played with this toxic mess that is only about $2 to $5 trillion…. The list goes on and on. You need to check out your pension funds and MMFs. 

Now, I have only written so far about the $2 to $5 trillion of mortgage derivatives in trouble. I can't cover all the other areas of pending trillions of losses and make this article less than book size.

Treasuries and Stocks

A bit of panic, wouldn't you say? People fled to US Treasuries and out of MMFs and other funds. There are good reasons for them to do so.

Now let's look at this picture over a longer timeline.

Here we see that when there is flight to liquidity/safety like this, the DJW (Dow Jones World stock index) dropped like a stone last time. I expect the same or worse this time, particularly considering how BAD the emerging liquidity crisis is. That was not the case back then. That one was due to 911 and the NASDAQ crash prior. And remember, this world equity bubble is a liquidity/credit driven one, and based a lot on derivatives which are turning out to be a very bad mechanism, to say the least.

When the real unwinding comes this time, we will really see something. So far, stocks have only barely reflected the critical situation in credit/liquidity right now. I expect this to change soon. 

By Christopher Laird
PrudentSquirrel.com

Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.

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Comments

Rumple Stilskin 29 Aug 07, 13:05	word up, dude In other words, yuppies in business suits will be dumpster-diving for breakfast; all the while dodging colleagues jumping out windows. The poor people will laugh, having lost everything long ago before already.
Ellen 29 Aug 07, 14:18	Money market funds Are you saying that my mother's MMFs in several large banks are NOT insured by the FDIC? I believe she was told they were but I urgently need to know so I can protect her in her old age. Thanks so much, Ellen
Zekewolf 29 Aug 07, 17:59	Dark Ages ? Given the catastrophic collapse of everything, it's safe to assume that we will be entering a new era of the dark ages. Civilizations will fall to ruin, as there worthless paper money is exposed for what it is. There will be no FDIC. Contrary to Chimpy in the white house, there will be no United States, as the only thing holding it toghther now is a corrupt tax base. The old and the sick will die immediately, the young and able will seek a warmer climate, to try and survive.There is no escape this time. Only the elite in their maximum security tunnels will survive. And when the elite re-surface, they will set up the phoney debt pyramid all over again.
R. Schulz 29 Aug 07, 18:07	The end of the line. The end of the usury cycle comes when the income of the victims can't even pay the interest on the debt. We are there now. Expect expensive homes to fall 90% and ordinary homes to fall 50%. The collapse has barely begun and will probably last more then a decade.Expect your stocks,pension funds, insurance policies etc to fall 50% to 90%. If the government tries to print enough money to bail out the bankrupt system then the dollar will collapse to nothing and our troubles will really start. This is the end of the line for the Usury System. The end that was inevitable from the start.
jonnyb 29 Aug 07, 18:10	Money for nothing Why's this such a surprise? All "systems" are inherintly doomed to failiure due to the unsustainability of fiat currencies used to fund them and the obviously stupid notion of an ever increasing economy. Those that get burnt have succumbed to the notion of growth without risk. Sorry, no such thing. Sell stocks, derivatives et al. Buy seeds - you,re going to need them if you want to eat.
Anthony 29 Aug 07, 18:49	money market I have money in MMF's and would like to close it out. What should I put it in? a regular interest bearing bank account?
K. Harlow, Silver Sand Financial, Inc. 29 Aug 07, 19:29	Ellen, please check Please check if your mothers funds are FDIC insured. If she has over $100,000 tied into the MMF she may be out of luck. I know that very few MMFs are FDIC insured, as the insurance usually leads to lower rates of return on money. I hope everything goes well. Another option I have been eyeing for my money is in I Bonds. I Bonds (inflation bonds) are tied to the rate of the consumer price index (CPI). This may be the only good way out for savvy investors, as the index is rising. The I bonds return rates are based on the percentage of the CPI. With food and everything going up, this may be a wise alternative for your mothers money. Let me know what you think. God Bless. Karl Harlow Silver Sand Financial, Inc kharlow@silversand.bz
Mike 29 Aug 07, 20:11	Yikes! Start a garden, learn how to can food, get solar / wind / geothermal power and get off the grid if you can, buy a diesel automobile that can run on used filtered cooking oil, use grey water in your garden, drill a well if you can...
RICH L. 29 Aug 07, 22:18	THE DOLLAR SO IF THE DOLLAR DROPS TO NOTHING THEN WHAT BECOMES OF THE MONEY YOU HOLD? ANY INPUTS ON THIS. I HAVE HEARD THAT EVENTUALLY CIVILIZATION WILL RETURN TO THE GOLD STANDARD
Alan 29 Aug 07, 23:28	Worthless Money "IF THE DOLLAR DROPS TO NOTHING THEN WHAT BECOMES OF THE MONEY YOU HOLD?" It becomes worth nothing, if it is dollars. Hold something else: food, factory-boxed ammo, silver,gold, shoes, booze, razor blades... ANYTHING. ANYTHING BUT DOLLARS.
Scott 30 Aug 07, 04:26	FDIC Insured FDIC Insured means little because there isn't enough money to cover everyones deposits, in fact, the amount that funds the FDIC is less than 10 percent of all accounts.
John 31 Aug 07, 12:43	More debts than available money There is worse than the 10 percent... Since all money is created from debts. And that created money come with interest to pay on.. It's easy to understand that debts will grow faster than the money supply... Were do we get the money for the interest if all money is created from debts? Gold standard is no better for many reasons. One is that it's possible to grind small amounts of gold on coins to be sell again on the market. Then gold coin loose value and/or the amount of gold in coin is lowered and then one day war arrive and fiat money too.
Ray Proffitt 31 Aug 07, 19:58	New Paradigm - We need to wake up We’re entering a new paradigm in our civilizations. The Earth will not continue to give ever increasing yields. Financial manipulators have no real purpose in the grand scheme of things. What we need to do: 1.- Start taxing EVERY financial transaction (1% internal, 3% external) 2.- ½ the military budget, and invest the other ½ in energy research (conventional and unconventional) 3.- Encourage space exploration, this will have a flow on effect for preserving Earths natural resources. 4.- Retrain financial manipulators in science and engineering. 5.- Spend on education. 6.- Adopt true democracy. The money days must come to an end. Discovery, science and engineering are more useful to a civilization than people playing with numbers representing a unit of transaction.
craig 02 Sep 07, 11:33	owner financed real estate everybody should mind their own business !!!!! its funny because nobody does.. FDIC...scam hedge funds...scam...mutual funds...scam... take your money out fast...by a house.. hold a mortgage... option a property.. thats all for now kids.... peace THE PROFIT
L.Hamilton 19 Dec 08, 23:14	Marry Christmas & Happy New Year "to thouse who are saved by God" ...We will se a 3/4 fall in value of shares,real-estate and all government's in the Western World is likely to nationalise all cash-deposits above a certain limit set by the government.