Financial Markets in Denial of Collapsing Credit Markets

By: Christopher_Laird

The ECB just lent out an astounding half $Trillion worth of money to 390 banks in only one day this week. It was to combat the lending freeze in Europe where banks are refusing to lend to each other over concerns about the mortgage losses this year. The demand was so high it caused alarm.

The question that comes to mind is, ‘Hey, we have a first class financial emergency here, when are the stock markets going to react accordingly?'

Consider this comment: “Commentators joke about banks and financial institutions "going to the confessional," meaning that they admit that a percentage of their assets are mortgage-backed securities that are now near-worthless.

The fact is that very few institutions have gone to the confessional. Probably 99.9% of even the world's financial institutions are hiding vast amounts of near-worthless securities, and that doesn't even touch upon investments by non-financial companies (such as investment pools in state and local governments like those in Florida and Montana.”… Link

"What has become evident is that banks are concerned about the capital position of other banks. They do not know where the losses resulting from the array of derivative financial instruments will finally come to rest, and I think in the last four weeks we've also seen a more disturbing development, which is that the banks themselves are worried that the impact of their reluctance to lend collectively will lead to a sharper downturn in the United States, and perhaps elsewhere, thus generating further losses outside the housing and financial sectors, which will feed back onto balance sheets and reinforce their reluctance to lend, because of the need to generate more capital." Mervyn King, Governor Bank of England

It is hoped that the EU banks will bring to light the extent of their losses by first quarter 08. If not, the crisis continues unabated. The main problem is that they don't know who is hiding losses.

Another huge market in trouble

Also consider that there is a major crisis building right now in the $2.5 trillion municipal bond market in the US. The bond insurers such as MBIA are at risk of having their AAA ratings pulled (they already are probably not AAA but the rating agencies know if they pull that, the tens of thousands of securities they guarantee will lose their ratings, and result in fire sales, the kind of problem that started the huge credit crisis with Bear Stearns before Summer.)

There were comments several months ago that the ‘subprime' credit crisis would blow over. Rather it is mushrooming out of control into other huge credit markets, and leading to new $billions of losses and a collapse of lending and confidence in banks in the EU and US.

Rather than talking about the ‘subprime ‘ crisis, one would do better to now realize this is a pan credit crisis, spreading to other major credit sectors. The ARM resets are only beginning, they include about half of all mortgages made since 2003, and all levels of credit. We have only seen the beginning of the mortgage problems in 07, not its ending. Try 08, 09 for prospects. One huge amount of new ARM resets.

What US rate freeze plan?

Oh and that US mortgage freeze plan? I estimate it's only going to affect about 4% of the problem mortgages, as the criteria to qualify are quite restrictive. That plan was mere window dressing. No real effort was made to avoid the nasty wave of pending resets coming in 08 and beyond.

Of course the US and other stock markets rallied when the news came out on that so called mortgage rate freeze plan.

A whole LOT of CB money

Then the US Fed and ECB and other central banks got together last week to discuss a plan to infuse a lot of money into credit markets. The stock markets rallied. Then, come this week the ECB has to loan out an astounding $500 billion worth of money because banks won't lend to each other. The Stock markets yawned that off. 

I read an interesting quote where a hedge fund manager said, if someone would take him out of all his positions right now, he would gladly go to 100% cash. He is only a reluctant participant.

I have a feeling that kind of thinking is one reason the markets are not reacting as of yet to this incredible credit crisis. But how long can that last? The stock markets are clearly in denial, they are down, but are not even closely reflecting the severity of this world financial market.

One thing is sure, world economic activity will contract due to very difficult credit markets. That will affect profits in 08 in the US, EU and other major economies. Then we will see a significant reaction to this mushrooming credit disaster. So far, massive central bank interventions have done just about zero to lower credit spreads in the troubled 3 month short term money.

Monetization when?

The only thing central banks have been able to do is basically loan ‘unlimited' amounts of money out for collateral of all types. The central banks don't want to appear to be monetizing the mess, but they may eventually have to do that. Gold would go out of sight.

Right now, central banks are not just ‘printing' money and throwing it around, they are taking collateral against that. But, if the collateral turns sour, central banks will have to face the choice of taking those losses off financial institutions books, or else face this crisis for years. Just taking the bad assets as collateral does not take losses off bank's books. That is the status quo now. Banks are nursing big losses, and have no way to get out of them, without fire sales.

There has been no meaningful movement on the credit situation, and it is rapidly spiraling out of control. So far, stock markets have been in denial for the most part. That has to change for the worse. Eventually, the mushrooming damage from the collapsing credit markets will cause a world stock detonation. The central banks have few options and are not sure what to do. Worse, it appears that the only thing that could work to free the banks it to take those losing assets off their books, which would effectively be monetization of all the losses. So far , those losses are estimated to be up to $1 trillion worth. It could easily end up being perhaps 5 or more $Trillion.

And now, with other huge and important markets in trouble ($2.5 trillion muni bond markets) unless a solution is found soon, we will be looking at a tumultuous 08 in all markets. If that happens, gold would be pulled in different directions. First, gold would want to sell off due to liquidity problems, second, gold would want to rise due to flight to financial safety. 

But just about everything else other than precious metals will get killed next year if the markets ever do react to the collapsing credit markets.

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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