Credit Bubble Bulletin, by Doug Noland

[LA_Renter]

Given the amount of conversation we have been having regarding the mortgage market meltdown, I thought this was a very excellent commentary from Doug Noland at Prudent Bear. He has been a reasonable bear throughout this correction. He really brings home the gravity of the current set of circumstances.

I’m never comfortable with the idea of “yelling ‘fire’ in a crowded theater.” But Jim Cramer already did as much late this afternoon on CNBC. His “we’re in Armageddon” tirade (available at CNBC.com) was made moments after Bear Stearns’ CFO Samuel Molinaro offered a disconcerting assessment of market conditions during the company’s hastily called conference call: “I’ve been out here for 22 years, and this is as bad as I’ve seen it in the fixed-income markets.” A highly-aroused Mr. Cramer, volunteering to speak on behalf of Wall Street, called for the Fed to aggressively cut rates and “open the discount window.”

The Credit Market has Dislocated, liquidity has evaporated, and our academically-inclined new Fed chairman is in store for a historically challenging real world first test. Wall Street has been conditioned over the years to expect “bailouts.” Only months on the job, Alan Greenspan stepped up and assured the markets that the Fed was ready to add liquidity after the ’87 stock market crash. The Greenspan Fed acted aggressively during the LTCM crisis and, later, Dr. (“Helicopter”) Bernanke played an instrumental role in the Fed talking the risk markets higher in late 2002. To be sure, Fed “reliquefications” played a conspicuous role in fostering ever greater and more unwieldy Bubbles – and this will remain in the back of FOMC members’ minds. The Bernanke Fed today would likely prefer to maintain a “hands off” approach for as long as possible – which has already been too long for an acutely fragile “Wall Street.”

And let’s not forget the (unsung hero) GSE “backstop bid.” The GSE’s ballooned their balance sheets $150bn to absorb speculative de-leveraging during the 1994 de-leveraging and bond market rout – about double 1993’s at the time record asset expansion. GSE balance sheets (chiefly holdings of mortgages and MBS) ballooned $305bn during tumultuous 1998, $317bn during 1999, $238bn in 2000, and $344bn during liquidity challenged 2001. Agency balance sheets mustered growth of $37bn last year. Importantly, the GSE’s are definitely in no position these days to aggressively create marketplace liquidity by expanding their (money-like) liabilities to aggressively purchase MBS – in the process stabilizing market prices (especially for the leveraged speculators). Wall Street must all of the sudden feel short of friends.

Appearing this evening with Larry Kudlow, Larry Lindsey called upon Fannie and Freddie to loosen lending standards to help ameliorate the rapidly accelerating Mortgage Credit Crunch. I was immediately reminded of how Washington nurtured the $200bn (or so) S&L bailout from what should have been resolved years earlier at a fraction of the cost to taxpayers. The GSE tab is today running out of control. Keep in mind that Fannie and Freddie already have combined “Books of Business” (MBS holdings and guarantees) of almost $4.0 TN supported (in the best case) by stockholders’ equity in the neighborhood of $60bn (current financial statements not available!). The thinly-capitalized Federal Home Loan Bank System has another $1.0 TN of assets. Before all is said and done, taxpayer GSE exposure will likely reach the trillions – to add to other untenable ballooning federal contingent liabilities.

This week, the unfolding financial crisis reached a problematic stage on several fronts. For one, illiquidity hit the gigantic “AAA” market for “private-label mortgage-backed securities.” The booming market for non-agency MBS has played an instrumental role in ensuring abundant cheap mortgage Credit – on the one hand filling the liquidity void created by the constrained GSEs (balance sheets) and, on the other, providing virtually unlimited inexpensive “jumbo” mortgage finance to inflate upper-end housing Bubbles in California and the most desirable locations and neighborhoods across the country.

While the subprime implosion was a major marketplace development, in reality only a small segment of the mortgage marketplace was actually impacted by significantly tighter Credit conditions. Today, we are in the throes of a dramatic, broad-based and momentous tightening of mortgage Credit. Importantly, key players and sectors throughout the mortgage risk intermediation process are increasingly impaired and now in full retreat. This includes entities such as the mortgage insurers, MGIC’s and Radian’s faltering C-BASS securitization unit, REITs such as failed American Home Mortgage and others, hedge funds such those that failed at Bears Stearns and many more, the broker/dealer community and the expansive mortgage derivatives market generally. There is also the issue of exposed mutual funds, money market funds, pension funds and the banking system in general. Just like NASDAQ went to unimaginable extremes than then doubled during a fateful “blow-off” – total mortgage Credit doubled subsequent to the Greenspan Fed’s reckless post-tech Bubble “reflation.” Risky mortgage exposure now permeates the (global) system and is highly susceptible to “Ponzi Finance” dynamics.

[LA_Renter]

(cont)
The process of transforming risky mortgage loans into coveted perceived safe and liquid (“money”-like) Credit instruments has broken down on several fronts. Not only is the risk intermediation community impaired, marketplace confidence and trust in the quality, safety, and liquidity of mortgage (and mortgage-related) securities is being shattered. There are apparently serious problems developing throughout the massive marketplace for (“repo”) financing MBS. And it is precisely the market for financing the top-rated mortgage securitizations – where the perceived risk was minimal – where I suspect the greatest abuses of leverage occurred. The marketplace is now experiencing forced de-leveraging and a liquidity Dislocation – with major systemic ramifications.

I mostly downplayed the marketplace liquidity and economic impact of the housing downturn last fall and the subprime implosion this past February. For the system as a whole, the Credit spigot remained wide open. My view of current developments is markedly different. I cannot this evening overstate the dire ramifications for the unfolding Credit Market Dislocation. There is today serious risk of U.S. financial markets – distorted by years of accumulated leverage and derivative-related risk distortions – of “seizing up.” A system so highly leveraged is acutely vulnerable to speculative de-leveraging and a catastrophic “run” from risk markets. At the same time, the Bubble Economy and inflated asset markets – by their nature – require uninterrupted abundant liquidity. The backdrop could not be more conducive to a historic crisis, yet most maintain unwavering confidence that underlying fundamentals are sound.

I am this evening unclear how the enormous ongoing demand for new California mortgage Credit will be financed going forward. With the market having lost all appetite for “jumbo” MBS, mortgages must now be priced generally in accordance with the standards of increasingly cautious loan officers willing to live with these loans on their banks’ balance sheets (a radical departure from pricing set by originators selling loans immediately in an overheated MBS market). And, let there be no doubt, the prospective Credit tightening will hit grossly inflated and highly susceptible “Golden State” housing prices hard – a scenario that will force lenders to incorporate significantly higher Credit losses into their loan pricing terms (perhaps Cramer was speaking to CA homeowners when he jingled house keys in front of the camera during Wednesday’s show and suggested it was perfectly rational to mail your keys to the bank). Furthermore, I expect the pricing and availability of Credit required to refinance millions of rate-reset mortgages in California and elsewhere to turn prohibitive for many. And the home equity well is about to run dry – from a combination of sharply tightened Credit conditions and accelerating home price declines.

A severe tightening in mortgage Credit is in itself sufficient to pierce a vulnerable U.S. Bubble Economy. But there is as well an abruptly brutal tightening in corporate Credit. The junk bond market has basically closed for business. The leveraged loan marketplace is in turmoil and scores (46 – see WSJ above) of debt deals have been pulled. And, more ominously, the previously booming ABS and CDO markets have slowed to a crawl. Perhaps not immediately, but it will not be long before the economy succumbs to recession.

Credit Market Dislocation now dictates the assumption that Federal Reserve liqudity assurances and rates cuts are on the near horizon. And while they will likely incite the expected knee jerk response in the equities market, I don’t expect they will have much lasting effect on our impaired Credit system. Current issues are much more complex and serious than ’87, ’98, 2000, or 2002. The dilemma today is that confidence in “Wall Street finance” has been shattered. The manic Bubble in Credit insurance, derivatives, and guarantees is bursting. The manic Bubble in leveraged speculation is in serious jeopardy. The currency markets are a derivative accident in waiting. Fed rates cuts risk a dollar dislocation and/or a further destabilizing (for spreads) Treasury melt-up.

[LA_Renter]

(cont)
The process of transforming risky mortgage loans into coveted perceived safe and liquid (“money”-like) Credit instruments has broken down on several fronts. Not only is the risk intermediation community impaired, marketplace confidence and trust in the quality, safety, and liquidity of mortgage (and mortgage-related) securities is being shattered. There are apparently serious problems developing throughout the massive marketplace for (“repo”) financing MBS. And it is precisely the market for financing the top-rated mortgage securitizations – where the perceived risk was minimal – where I suspect the greatest abuses of leverage occurred. The marketplace is now experiencing forced de-leveraging and a liquidity Dislocation – with major systemic ramifications.

I mostly downplayed the marketplace liquidity and economic impact of the housing downturn last fall and the subprime implosion this past February. For the system as a whole, the Credit spigot remained wide open. My view of current developments is markedly different. I cannot this evening overstate the dire ramifications for the unfolding Credit Market Dislocation. There is today serious risk of U.S. financial markets – distorted by years of accumulated leverage and derivative-related risk distortions – of “seizing up.” A system so highly leveraged is acutely vulnerable to speculative de-leveraging and a catastrophic “run” from risk markets. At the same time, the Bubble Economy and inflated asset markets – by their nature – require uninterrupted abundant liquidity. The backdrop could not be more conducive to a historic crisis, yet most maintain unwavering confidence that underlying fundamentals are sound.

I am this evening unclear how the enormous ongoing demand for new California mortgage Credit will be financed going forward. With the market having lost all appetite for “jumbo” MBS, mortgages must now be priced generally in accordance with the standards of increasingly cautious loan officers willing to live with these loans on their banks’ balance sheets (a radical departure from pricing set by originators selling loans immediately in an overheated MBS market). And, let there be no doubt, the prospective Credit tightening will hit grossly inflated and highly susceptible “Golden State” housing prices hard – a scenario that will force lenders to incorporate significantly higher Credit losses into their loan pricing terms (perhaps Cramer was speaking to CA homeowners when he jingled house keys in front of the camera during Wednesday’s show and suggested it was perfectly rational to mail your keys to the bank). Furthermore, I expect the pricing and availability of Credit required to refinance millions of rate-reset mortgages in California and elsewhere to turn prohibitive for many. And the home equity well is about to run dry – from a combination of sharply tightened Credit conditions and accelerating home price declines.

A severe tightening in mortgage Credit is in itself sufficient to pierce a vulnerable U.S. Bubble Economy. But there is as well an abruptly brutal tightening in corporate Credit. The junk bond market has basically closed for business. The leveraged loan marketplace is in turmoil and scores (46 – see WSJ above) of debt deals have been pulled. And, more ominously, the previously booming ABS and CDO markets have slowed to a crawl. Perhaps not immediately, but it will not be long before the economy succumbs to recession.

Credit Market Dislocation now dictates the assumption that Federal Reserve liqudity assurances and rates cuts are on the near horizon. And while they will likely incite the expected knee jerk response in the equities market, I don’t expect they will have much lasting effect on our impaired Credit system. Current issues are much more complex and serious than ’87, ’98, 2000, or 2002. The dilemma today is that confidence in “Wall Street finance” has been shattered. The manic Bubble in Credit insurance, derivatives, and guarantees is bursting. The manic Bubble in leveraged speculation is in serious jeopardy. The currency markets are a derivative accident in waiting. Fed rates cuts risk a dollar dislocation and/or a further destabilizing (for spreads) Treasury melt-up.

[LA_Renter]

(cont)
A focal point of my Macro Credit Analysis has for some time been the grave risks posed to markets and economies commanded by the seductive elixir of speculative liquidity. I have compared the current backdrop to that of 1929. For too long our Bubble Economy and Bubble Asset Markets have luxuriated in liquidity created in the process of leveraging speculative securities positions (especially in the Credit market). We are now witnessing how abruptly euphoric boom-time liquidity abundance can transform to a liquidity crisis.

I apologize for appearing overly dramatic. But this evening I have nagging feelings that for me recall the disturbing emotions following the terrible 9/11 tragedy. I know the world has changed and changed for the worse – yet I recognize that I don’t know how and to what extent. I fear for our markets, our economy, our currency and our system. I received an email this week on my Bloomberg that said something to the effect, “You all must be happy in Dallas.” I can tell you we’re instead sickened by what has transpired during the late-stages of this senseless Credit and specualtive orgy. The Great Credit Bubble has been pierced, and there will now be a very, very heavy price to pay. And, as always, I hope I am proved absolutely wrong.

[LA_Renter]

(cont)
A focal point of my Macro Credit Analysis has for some time been the grave risks posed to markets and economies commanded by the seductive elixir of speculative liquidity. I have compared the current backdrop to that of 1929. For too long our Bubble Economy and Bubble Asset Markets have luxuriated in liquidity created in the process of leveraging speculative securities positions (especially in the Credit market). We are now witnessing how abruptly euphoric boom-time liquidity abundance can transform to a liquidity crisis.

I apologize for appearing overly dramatic. But this evening I have nagging feelings that for me recall the disturbing emotions following the terrible 9/11 tragedy. I know the world has changed and changed for the worse – yet I recognize that I don’t know how and to what extent. I fear for our markets, our economy, our currency and our system. I received an email this week on my Bloomberg that said something to the effect, “You all must be happy in Dallas.” I can tell you we’re instead sickened by what has transpired during the late-stages of this senseless Credit and specualtive orgy. The Great Credit Bubble has been pierced, and there will now be a very, very heavy price to pay. And, as always, I hope I am proved absolutely wrong.

[Allan from Fallbrook]

LA_Renter: Don’t think you are. Wrong, that is. While someone of us are perceived as being overly bearish, the sobering words from a variety of sources, including Bear Stearns, would indicate that we are in for a bumpy ride.

I think the worst is yet to happen, especially when the valuation models used for CDOs, CDSs and other derivative instruments are tested in the real world. Leverage is averaging somewhere between 10x and 20x, and paraphrasing the old saying: “Leverage in reverse is a female dog”.

One thing that really strikes me when people compare this bust to the one endured during the 1990s is that the median price for a home now is probably three times higher than back then. A much greater distance to fall, especially when you have little to no equity cushion. The banks carrying these loans are going to get hit very hard when they begin the process of clearing their REO portfolios.

[Allan from Fallbrook]

LA_Renter: Don’t think you are. Wrong, that is. While someone of us are perceived as being overly bearish, the sobering words from a variety of sources, including Bear Stearns, would indicate that we are in for a bumpy ride.

I think the worst is yet to happen, especially when the valuation models used for CDOs, CDSs and other derivative instruments are tested in the real world. Leverage is averaging somewhere between 10x and 20x, and paraphrasing the old saying: “Leverage in reverse is a female dog”.

One thing that really strikes me when people compare this bust to the one endured during the 1990s is that the median price for a home now is probably three times higher than back then. A much greater distance to fall, especially when you have little to no equity cushion. The banks carrying these loans are going to get hit very hard when they begin the process of clearing their REO portfolios.

[JWM in SD]

Allen, think the macro credit issues are what a lot of posters here still do not understand. I am in a very good position financially right now and the events in the past three weeks scare the hell out of me.

The candle is burning at boths as we speak and there are dimwits still coming to this site to ask about getting loans and buying overpriced property.

To all of those doubters who read this and think we are a bunch of loons. Good luck in the next 5 years suckers. Go buy a house right now and a 100%, no doc mortgage if you can still get it. Live it up now because you won’t be solvent in a few years.

[JWM in SD]

Allen, think the macro credit issues are what a lot of posters here still do not understand. I am in a very good position financially right now and the events in the past three weeks scare the hell out of me.

The candle is burning at boths as we speak and there are dimwits still coming to this site to ask about getting loans and buying overpriced property.

To all of those doubters who read this and think we are a bunch of loons. Good luck in the next 5 years suckers. Go buy a house right now and a 100%, no doc mortgage if you can still get it. Live it up now because you won’t be solvent in a few years.

[Allan from Fallbrook]

JWM: While I’m self-employed now, my background is corporate accounting with a very large insurance brokerage (Willis Corroon PLC). When I was there, they were British owned and had been in business roughly 400 years (no lie). They were bought up in recent years by KKR and renamed Willis.

I offer this background because I come from a conservative discipline (accounting) and a conservative industry (surety/insurance). While I don’t profess to be an expert in finance issues, or credit or the stock market, I used to work with quite a few people from those industries and stay in contact with them to this day. By and large, every one of them is either “concerned” (on the optimistic end) or “worried as hell” (pessimistic). These are MBAs from good B-schools, accountants with Big 4 backgrounds and attorneys.

In insurance we referred to shifting liability as “passing a burning match”. This resembles a lit stick of dynamite and those in the know, both industry insiders and pundits are beginning to ring the bell – loudly.

I agree about events scaring the hell out of you. Same here and mainly because that gut instinct that tells you when things are bad, bad wrong is going off – loudly.

[Allan from Fallbrook]

JWM: While I’m self-employed now, my background is corporate accounting with a very large insurance brokerage (Willis Corroon PLC). When I was there, they were British owned and had been in business roughly 400 years (no lie). They were bought up in recent years by KKR and renamed Willis.

I offer this background because I come from a conservative discipline (accounting) and a conservative industry (surety/insurance). While I don’t profess to be an expert in finance issues, or credit or the stock market, I used to work with quite a few people from those industries and stay in contact with them to this day. By and large, every one of them is either “concerned” (on the optimistic end) or “worried as hell” (pessimistic). These are MBAs from good B-schools, accountants with Big 4 backgrounds and attorneys.

In insurance we referred to shifting liability as “passing a burning match”. This resembles a lit stick of dynamite and those in the know, both industry insiders and pundits are beginning to ring the bell – loudly.

I agree about events scaring the hell out of you. Same here and mainly because that gut instinct that tells you when things are bad, bad wrong is going off – loudly.

[HereWeGo]

I wish I could disagree with some part of that post. The only aspect he does not cover is the deflationary impact on the equity markets (and probably other asset classes as well), as funds scramble to cover bond losses by selling equities (or maybe I missed that part of the post.)

I haven’t agreed with the whole “bottom up” Bear Scare scenario, but this top down thing is a big concern.

As the author implies, California real estate just took a sudden and grievous blow. The seemingly overnight precipitous shift in the availability for mortgage credit (especially jumbo) can be summed up in one phrase:

Game Over, Man. Game Over.

[HereWeGo]

I wish I could disagree with some part of that post. The only aspect he does not cover is the deflationary impact on the equity markets (and probably other asset classes as well), as funds scramble to cover bond losses by selling equities (or maybe I missed that part of the post.)

I haven’t agreed with the whole “bottom up” Bear Scare scenario, but this top down thing is a big concern.

As the author implies, California real estate just took a sudden and grievous blow. The seemingly overnight precipitous shift in the availability for mortgage credit (especially jumbo) can be summed up in one phrase:

Game Over, Man. Game Over.

[HereWeGo]

I wish I could disagree with some part of that post. The only aspect he does not cover is the deflationary impact on the equity markets (and probably other asset classes as well), as funds scramble to cover bond losses by selling equities (or maybe I missed that part of the post.)

I haven’t agreed with the whole “bottom up” Bear Scare scenario, but this top down thing is a big concern.

As the author implies, California real estate just took a sudden and grievous blow. The seemingly overnight precipitous shift in the availability for mortgage credit (especially jumbo) can be summed up in one phrase:

Game Over, Man. Game Over.

[POZ]

LA_RENTER,

I am neither a PHD economist, Investment banker, nor financial guru by any stretch of the imagination and I have the same feeling in my gut. I am simply your average (non-kool-aid drinking) consumer being squeezed out of every cent. If you dont mind my asking, what is your background and experience in finance and economics that leads to make such dire predictions?

Regards,

Paulo

[Author]

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