Revulsion and Discredit
By Frank Barbera CMT. August 14, 2007
We hear each day the idle prattle of Wall Street “Buy Side” investors, discussing whether the recent decline in stock prices is just a correction in a healthy market, or whether this is the start of a bear market. Not surprisingly, to a man these ‘experts’ seem to unanimously agree that this is just a correction, and that a bottom is close at hand, not to mention the John Chambers quote that “this is the strongest global economy I’ve ever seen.” In our view, these guys need to have lunch with the Housing Market economists who have been saying the same thing over the last 18 months -- still no bottom there either! Clearly, the admissions coming out of BNP Paribas, Goldman Sachs (and its Alpha Fund), Macquarie Bank and its Fortress Funds, last week implied a larger series of financial problems is at work. Rob Kirby put it very well in his commentary on Monday,
“Losses being reported by Citibank are inconsistent with observable, comparable, already reported data from both Bear Stearns and Goldman Sachs. We have yet to hear from either J.P. Morgan Chase or B of A.” The financial system is, shall we say, fragile.”
Macquarie Bank of Australia hit by US loan woes
In our view, the ‘pundits’ arguing that this is just a ‘correction’ are absolutely kidding themselves as there is an overwhelming argument to be made that prices are headed much lower, and within relatively short order. The mistake being made is a complete lack of understanding of the opaque nature of the credit derivatives market. This has been perhaps the greatest bubble mankind has ever conceived with the notional value of Credit Derivatives running into the Trillions. Yes, of course, only a small portion of those numbers is perhaps at risk, but even using small percentages, the numbers get very staggering, very quickly. We are seeing the end of the Credit Bubble, and the beginning of the Credit Crunch. Last week overnight rates shot higher in the Libor Market and overseas Fed Funds. Central Banks quickly moved to inject liquidity on an unprecedented scale. Unmasked in the crisis are the ‘black box’ models of the quants, now unable to cope with three sigma events. Unmasked in the crisis are the highly leveraged strategies and failed ‘risk containment’ strategies that were supposed to prevent huge losses. For CDO’s and other Structured Products, the serious flaws in risk assumptions based on false estimates on the levels of liquidity now comes to the fore, and with it, the risk of an ongoing contagion that could spread around the global financial system. Years ago, the talented economist and author, Charles Kindelberger wrote about credit bubbles and how they tend to evolve into a speculative episode.
“The boom is fed by an expansion of bank credit that enlarges the total money supply. Banks typically can expand money, whether by the issue of bank’s notes under earlier institutional arrangements or by lending in the form of addictions to bank deposits. Additional means of payment to fuel a speculative mania were available in the virtually infinitely expansible nature of personal credit. For a given banking system at a given time, monetary means of payment may be expanded not only within the existing system of banks but also by the formation of new banks, the development of new credit instruments, and the expansion of personal credit outside of banks.
In a number of his works, Kindelberger discussed the works of the great Hyman P. Minsky and then goes on to discuss how credit bubbles often foster a ‘speculative episode’ and how once kick started, bubbles will often implode upon themselves.
“There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich. When the number of firms and households indulging in these practices grows large, bringing in segments of the population that are normally aloof from such ventures, speculation for profit leads away from normal, rational behavior to what has been described as "manias" or "bubbles." ”
As we shall see in the next chapter the object of speculation may vary widely from one mania or bubble to the next. It may involve primary products, especially those imported from afar, or goods manufactured for export to distant markets, domestic and foreign securities of various kinds, contracts to buy or sell goods or securities, land in the country or city, houses, office buildings, shopping centers, condominiums, foreign exchange. At a late stage, speculation tends to detach itself from really valuable objects and turn to delusive ones. A larger and larger group of people seeks to become rich without a real understanding of the processes involved. Not surprisingly, swindlers and catchpenny schemes flourish.
Although Minsky’s model is limited to single country, bubbles have historically tended to spread from one country to another (ed. leading to the impression of Mr. Chambers boundless economic growth). The conduits are many. Internationally traded commodities and assets that go up in price in one market will rise in others through arbitrage. The foreign-trade multiplier communicates income changes in a given country to others through increased or decreased imports. Capital flows constitute a third link. Money flows of foreign exchange are a fourth. And there are purely psychological connections, as when investor euphoria or pessimism in one country infects investors in others. The declines in prices on October 24 and 29, 1929, and October 19, 1987, were practically instantaneous in all financial markets (except Japan), far faster than can be accounted for by arbitrage, income changes, capital flows, or money movements.
As the speculative boom continues, interest rates, velocity of circulation, and prices all continue to mount. At some stage, a few insiders decide to take their profits and sell out. At the top of the market there is hesitation, as new recruits to speculation are balanced by insiders who withdraw. Prices begin to level off. There may then ensue an uneasy period of "financial distress." The term comes from corporate finance, where a firm is said to be in financial distress when it must contemplate the possibility, perhaps only a remote one, that it will not be able to meet its liabilities. For an economy as a whole, the equivalent is the awareness on the part of a considerable segment of the speculating community that a rush for liquidity---to get out of other assets and into money---may develop, with disastrous consequences for the prices of goods and securities, and leaving some speculative borrowers unable to pay off their loans. As distress persists, speculators realize, gradually or suddenly, that the market cannot go higher. It is time to withdraw. The race out of real or long-term financial assets and into money may turn into a stampede.
The specific signal that precipitates the crisis may be the failure of a bank or firm stretched too tight, the revelation of a swindle or defalcation by someone who sought to escape distress by dishonest means, or a fall in the price of the primary object of speculation as it, at first alone, is seen to be overpriced. In any case, the rush is on. Prices decline. Bankruptcies increase. Liquidation sometimes is orderly but may degenerate into panic as the realization spreads that there is only so much money, not enough to enable everyone to sell out at the top. The word for this state is revulsion. Revulsion against commodities or securities leads banks to cease lending on the collateral of such assets. In the early nineteenth century this condition was known as ‘discredit’. Overtrading, revulsion and discredit - all these terms have a musty, old-fashion flavor. They are imprecise, but they do convey a graphic picture.
Revulsion and discredit may go so far as to lead to panic (or as the Germans put it, Torschlusspanik. "door-shut-panic"), with people crowding to get through the door before it slams shut. The panic feeds on itself, as did the speculation, until one or more of three things happen: (1) prices fall so low that people are again tempted to move back into less liquid assets; (2) trade is cut off by setting limits on price declines, shutting down exchanges, or otherwise closing trading; or (3) a lender of last resort succeeds in convincing the market that money will be made available in sufficient volume to meet the demand for cash. Confidence may be restored even if a large volume of money is not issued against other assets; the mere knowledge that one can get money is frequently sufficient to moderate or eliminate the desire.
… And so it is, as once again, we see “Revolution and Discredit” with there ‘musty, old fashion flavor,’ painting a graphic picture of an implosion as history repeats. In this context, we grow increasingly concerned by the cascading series of negative announcements that seem to ‘blow up’ on markets each day.
Take today’s announcement from Thornburg Mortgage, a Wall Street darling, which is now collapsing under the weight of its mortgage portfolio. In this case, the company isn’t going down without a fight, as insiders have been trying to instill confidence by purchasing common equity shares even as the bond prices have moved steadily lower. Normally a fool’s errand, the insiders at Thornburg pressed on in an attempt to instill confidence in the underlying bonds with a brave gesture. In one of his recent commentaries, Jim Cramer of CNBC, who I believe attempts to do a credible job, discussed Thornburg for what it could be --the near death of the US Mortgage Lending Industry.
NEW YORK, Aug 14 (Reuters) - Bonds of Thornburg Mortgage () fell sharply on Tuesday after several analysts lowered their ratings on the mortgage lender, citing liquidity concerns.Thornburg's 8 percent notes due in 2013 fell to 61.5 cents on the dollar, down from 82.5 cents on Friday, their previous significant trade, according to MarketAxess.
Above: Thornburg Mortgage (TMA) — a disastrous day.
In either event, we must step back and wonder, “Are we now seeing the unmistakable signs of Minsky’s Acute Financial Fragility?” - the unmistakable signs of a global credit bust, perhaps of epic proportions? Could this be unfolding now before our very eyes? As I am a technician, when faced with chart breakdowns of this sort, my first instinct is fear, as the ‘bombshell’ type patterns which have so dominated the financial sector in recent weeks likely carry very negative implications. Take a good look at some of the other institutions which have exposure to Sub-Prime, and other toxic debt obligations. WAMU, Countrywide, Downey, Wachovia, all are breaking down hard out of major top formations. Hard to believe this represents any type of bottom. Instead, these breakdowns have all come on high volume and high downside momentum, and appear to be suggesting that the ‘problems’ have only just begun. In last week's update of the Credit Bubble Bulletin, Credit Analyst Doug Noland summed things up by stating,
“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 rate cuts risk a dollar dislocation and/or a further destabilizing (for spreads) Treasury melt-up.”
Above: A major breakdown in Downey Financial S&L (DSL)
Above: a Major Breakdown from a Double Top in Washington Mutual S&L (WM)
Above: Wachovia, breaks down from a major Double Top. Wachovia purchased Golden West Financial for $25 Billion last May, 2006. Golden West was loaded up with Adjustable Rate Mortgages.
Above: Countrywide Financial (CFC) — a massive breakdown from a broadening top formation... Signals a very powerful trend reversal, possibly a meltdown underway.
Above: a huge complex Head and Shoulder formation on Capital One (COF) -- perhaps the reports from Wal-Mart and Home Depot today indicating a slowing economy will be bad news for Credit Card companies as consumers pull back on spending.
Above: Americredit (ACF) — another massive Head and Shoulder reversal top breaking down at Americredit… and this is a bottom? Give me a break!
Other signs are also far from encouraging. Take today’s stock market, for example. During the day, the market attempted to rally on several occasions, with each attempt overwhelmed by aggressive selling. With the S&P closing down 26.38 index points at 1426.54, the index has now decisively closed BELOW its important 200 day moving average which ended today at a reading of 1454.07. On a technical basis, there is almost no way this type of action can be construed as anything but extremely bearish, with “mechanical” fund liquidation often kicking in after the break of key moving averages like the 200 day.
Unfortunately, the technical negatives do not end there. Let’s take a brief stroll back through time to 1929 and 1987, two episodes where the market experienced a major crash. In both cases, markets began the entire negative episode by (1) breaking a well defined medium term rising trendline, then (2) experiencing a snap-back rally followed by (3) a price decline to below the 200 day moving average that accelerated downward into the crash.
Above: S&P 500 thru today’s close… poised for a big decline.
Over the last few weeks, the action of the S&P 500 has, to date, followed the prior path of both the 1987 and 1929 markets quite closely with the sell off below the 200 day average today, suggesting that rather than finding a low, we are looking at a building contagion that is finding downside acceleration. If so, then we paraphrase Doug Noland (at Prudent Bear) who may have asked the most important question when he said, “If the highly leveraged Wall Street firms will struggle to ‘rein in’ risk on myriad fronts and likely be forced to fight mightily for survival, for how long will the American public hold its nerve -- that is a major question. They have been conditioned to believe that their holdings in the stock, bond, and “money” market are safe and secure.” With the permeation of high-risk credit throughout the entire credit system, these assumptions may come under a severe test in the days and weeks ahead. Volatility is now rising and is only back to the middle range of its historic trading bands. Those arguing for a major low should realize that we are still a long, long way from “real fear;” the collapse of Thornburg Mortgage today is an ominous development, reminding us that it is real fear that defines major market bottoms.
Above: the long term view of the OEX VIX Index, which tracks volatility. Risk premiums are still a long way from being excessive, implying markets could be a long way from a major low.
Markets once again ended the day sharply lower with the DJIA ending down 207.61, or 1/57% at 13,028.92. The S&P 500 ended lower by 26.38 index points or 1.82% to finish at 1426.54, while the NASDAQ Composite ended lower at 2499.89, down 42.35 index points or 1.67%. The 10 Year Bond Yield ended at 4.73%, down 5 basis points with nearby Dec Gold finishing at $680.20, down $.70.
That’s all for now,
© 2007 Frank Barbera