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Page 1 of 5 CREDIT BUBBLE BULLETIN History's biggest margin call Commentary and weekly watch by Doug Noland The entire world was seemingly positioned for a particular financial backdrop and received an altogether different one. Some years ago I wrote something to the effect that "financial crisis is like Christmas". After all, during the Alan Greenspan era at the Federal Reserve, periods of heightened financial and/or economic pressures were almost cause for celebration within the leveraged speculating community. Aggressive rate cuts and "easy money" were the trumpeted solution to any problem, which equated to easy financial fortunes for the savvy market operators. Over time this culture of leveraging, speculation and financial shenanigans      fanned out across the globe - throughout finance, commerce and government endeavors.  This mindset was firmly ingrained when the US's subprime crisis erupted in the spring of 2007. The whole world apparently was of the view that the unfolding US mortgage and housing crisis ensured "easy money" as far as eyes could see. "Helicopter Ben" Bernanke was at the controls; dollar devaluation was in full force; dollar liquidity was barreling out of the US credit system; financial systems across the globe had succumbed to credit bubble dynamics; inflationary fires blazed everywhere; and speculative finance was literally inundating the world. In most places, making "money" had never been so easy.  This backdrop created epic price distortions and some incredibly maligned market perceptions. It's now clear that unprecedented leverage became deeply embedded in markets and economies everywhere. These excesses had been unfolding over a longer period of time, but terminal speculative "blow off" dynamics really engulfed the global economy when US housing vulnerability began to emerge. A confluence of many extraordinary and related dynamics was severely undermining the global system.  The US financial sector was desperately overheated, the US mortgage/housing bubble was bursting, the expansive international bubble in leveraged speculation was in "blow-off" mode, global imbalances were at dangerous extremes, and inflationary psychology took hold throughout global financial systems, asset markets and real economies. It was an unparalleled period of synchronized global credit, asset market and economic bubbles.  Only today is it readily apparent what a mess the global pricing system had become. Think in terms of a net trillion-plus US dollars inflating the world each year, of which a large part was recycled through Chinese and Asian purchases of US securities (inflating domestic credit systems and demand in the process). Think in terms of rapidly inflating economies with several billion consumers (Brazil, Russia, India and China). Think in terms of the surge of inflation that forced thoughtful policymakers in economies such as Australia, New Zealand and elsewhere to significantly tighten monetary policy. Rising rates, however, only enticed more disruptive speculative finance flowing loosely from (low-yielding) credit systems including the US, Japan, and Switzerland.  Speculation could have been as simple as shorting a low-yielding security any place to finance a higher-returning asset anywhere. Or, why not structure a complex leveraged derivative transaction that, say, borrowed in a cheap currency (such as yen or Swiss francs), played the upside of rising emerging equities markets, and at the same time had triggers to hedge underlying currency and/or market exposure. And the counterparty exposure for a lot hedges could be wrapped up in collateralized debt obligations (CDOs).  And the more loose global finance inflated the world, the more the leveraged speculating community inundated "commodity" economies such as Australia, Canada, Brazil, South Africa and Russia. Of course, speculative inflows ignited domestic asset market and credit systems, in the process fostering dangerous bubbles. And in concert with the deflating dollar, speculating on virtually any emerging market or commodity was immediately profitable.  The more leverage the stronger the returns, and the world was introduced to the concept of the billionaire hedge fund manager. In commodities markets, wild price inflation and volatility forced both producers and commodity buyers to employ aggressive hedging strategies. More often than not, derivatives employed trend-following trading mechanisms. These "hedging" mechanisms covertly created huge buying with leverage on the upside and, more recently, liquidation and a collapse of prices and leverage on the downside.  It was Hyman Minsky "Ponzi Finance" on a grand scale. It was also a bout of George Soros "Reflexivity" of epic proportions. The more markets perceived a new era of endless cheap finance and rising asset and commodities prices, the more US and global credit systems created the necessary inflationary fuel to perpetuate the bubble. Markets believed the hedge fund and private equity game could go on indefinitely. Participants thought that Wall Street would securitize loans and be in a position to expand finance forever. Prime brokers would always be willing outlets to finance leveraged securities holdings on the cheap.  The derivatives market would always provide an efficient and effective marketplace for placing bets, as well as for hedging myriad risks. Why not speculate aggressively when insurance was so easy to obtain? At the same time, contemporary "repo" and money markets were viewed as an endless source of inexpensive finance. And, in the event of anything unexpected, the US Federal Reserve (and global central bankers) would always ensure liquid markets - and inflate as required. Again, why not speculate? The markets had unwavering faith in enlightened contemporary finance and central banking.  But it was all part of the greatest mania in human history. As it turned out, the markets could not have been more wrong on the sustainability of the financial backdrop, the economic environment, asset price inflation, and all types of sophisticated financial structures and strategies. Markets were not only absolutely wrong, they were absolutely wrong on so many things on such an unprecedented global basis. Now things are blowing up. In the thick of it all, confidence in the securitization, "repo" and derivatives markets has been broken.  As a result, Wall Street simply no longer has the wherewithal to apportion ample finance for securities speculation. Without speculative demand for high-yielding loans and securities, bubble economies are starved of sufficient finance. And with asset markets bursting everywhere, this has quickly evolved into history's biggest margin call.  Scores of derivative structures used to speculate in the asset bubbles have collapsed - because of counterparty issues, illiquidity, or the structures just didn't make any sense to begin with.  Moreover, the whole notion that derivatives would provide an effective hedging mechanism is proving a fallacy. Again, counterparty issues and illiquidity are the culprits. Markets can't hedge themselves, as there is no one with the wherewithal to take the other side of the trade (especially during devastating bear markets). In particular, the credit default swap structure is proving an unmitigated disaster - for bond, equities and currency markets. Hopefully this period of liquidation and deleveraging will be over very soon.  WEEKLY WATCH  What a vicious crisis. For the week, the Dow was hammered for 5.3% (down 36.8% y-t-d) and the S&P500 6.8% (down 40.3%). Economically-sensitive issues were, again, hammered. The Morgan Stanley Cyclical index dropped 12.0% (down 50.9%). The Transports fell 6.6% (down 24.6%), while the Utilities dipped 0.4% (down 34.4%). "Defensive" stocks weren't much help, as the Morgan Stanley Consumer index declined 6.1% (down 28%). The broader market was under heavy liquidation. The small cap Russell 2000 dropped 10.5% (down 38.5%), and the S&P400 Mid-Caps sank 9.6% (down 41.6%). The NASDAQ100 fell 8.3% (down 42.3%), and the Morgan Stanley High Tech index was hit for 8.4% (down 45.4%). The Semiconductors dropped 11.2% (down 48%), The Street.com Internet Index 8.8% (down 39%), and the NASDAQ Telecommunications index 13.3% (down 44.3%). The Biotechs declined 4.3% (down 21.2%). The Broker/Dealers sank 17.4% (down 60.7%), and the Banks fell 10.2% (down 42%). With Bullion sinking $51, the HUI Gold index dropped 17.2% (down 58.8%).  One-month Treasury bill rates declined 8 bps to 0.24% and three-month yields fell 12 bps to 0.86%. Two-year government yields dropped 10 bps to 1.52%. Five-year T-note yields sank 25 bps this week to 2.59%, and 10-year yields fell 24 bps to 3.69%. Long-bond yields dropped 28 bps to 4.06%. The 2yr/10yr spread declined 14 to 217 bps. The implied yield on 3-month December '09 Eurodollars rose 4 bps to 2.65%. Benchmark Fannie MBS yields declined only 4 bps to 5.75%. The spread between benchmark MBS and 10-year T-notes widened a notable 20 to 205 bps. Agency 10-yr debt spreads widened 17 to a new high 115 bps. The 2-year dollar swap spread increased 1.5 to 125.5, while the 10-year dollar swap spread declined 6.5 to 47.5. Corporate bond spreads were wider. An index of investment grade bond spreads widened 26 to 242 bps, and an index of junk bond spreads widened 16 to 840 bps.  Investment-grade debt issuance included Pepsico $2.0bn, Bottling Group PLC $1.3bn, Baker Hughes $1.25bn, National Rural Utility Cooperative $1.0bn, CSX Transportation $575 million, and Illinois Power $400 million.  Continued 1 2 3 4 5