GSE Woes and More Fed Easing Ahead
By Frank Barbera CMT. August 19, 2008
It is hard to comprehend how far off the mark the official GDP numbers are at the present time. So far, with virtually all “non major” headline numbers moving into recession, we have seen the government statisticians skillfully manipulating the GDP figures higher by systematically understating inflation, and thereby overstating growth. At 1.80% growth in Q2, the GDP number was a charade steeped in the one time spending data of government stimulus checks. Yet, the effect of such a limited ‘one-off’ jolt is akin to a receding tide, with any positive affects wearing off in record time.
A simple glance at the chart below really speaks volumes about the directional trend of the US Economy, and has been unwaveringly accurate for years and years. The chart shows the rising trend of Continued Jobless Claims which reached a reading of 3.417 million in July, soaring 114,000 in the last week. Looking back we find that this reading of 3.417 million is the highest figure seen since October 2003, and is rapidly closing in on the peak figure of 3.76 million seen in May 2003. Any move above that high would place this gauge at the highest reading since 1982, a 26 year high. At present, with continued claims jumping by 320,000 during just the last three weeks, all that is required to reach that 26 year high are gains of 345,000 in the weeks just ahead. Given what is happening in the financial sphere and the housing sphere, these types of future gains in continued claims are all but a shoe in between now and late September. Over the long haul, we have inked in two horizontal lines on the chart below, one at 3.40 million and the other at 3.50 million. In our view, readings above 3.40 million have unwaveringly defined recessions, while readings above 3.50 million have identified powerful recessions. In this case, we would not be surprised to see this gauge move to new all time highs even above the twin 1974 and 1979-80 recession peaks seen in May 1975 (4.637 million) and November 1982 (4.713 million) before this down-cycle is complete.
In the face of this type of data, how can recession be plausibly denied? For those looking for still more proof of the economy's wayward bias, we once again update the last few months of Non-Farm Payrolls. In the table below, we show the BLS figures as reported, and then the corresponding Birth Death Model Adjustment. On the far right column we update the monthly data adjusting back for the phantom jobs. Again, what we see is 5 straight months of larger than 200K per month job losses. This is a hemorrhaging of jobs, something which has never happened before in the history of this data series. Looking at the “As Reported” data, the three month moving average of Non-Farm Payrolls is a rocky –64,500. However, re-stating the data to compensate for the huge positive bias of the BLS Birth Death Model, we find that restated, or properly stated, the 3 month moving average is now at –221K and falling. In the past, anytime this three month moving average has been below –200k, the economy has been in full blown recession as illustrated by the average falling below the lower horizontal line.
|BLS Reported||Birth Death||NET Affect|
|Non-Farm Payrolls||Adjustment||or Real Payrolls|
Above: the “As Reported” data by BLS which shows the economy still above the –200k recession boundary and lower clip: the restated result taking away Birth Death, revealing a 3 month average plunging heavily into recession. Which one do you believe?
Above: Temporary Employment – 3 Month Moving Average of Monthly Change
In addition to the Non-Farm Payroll gauges, we also note that the trend for Temporary Help Services, often an excellent and very sensitive gauge of the labor markets, continues to move virtually straight down. All of this continues to suggest that there is no sign of a bottom in terms of the current economic contraction. At the same time, we also do not see any sign that the massive credit collapse is in any way leveling off. As most market watchers are aware, the trend over the last few days has been strongly down in the stock market with the financials once again leading the way lower.
In the case of both Fannie Mae (FNM) and Freddie Mac (FRE), new closing lows for the entire decline were registered today. In both cases, the daily charts are littered with breakaway and extension gaps, implying some very bad days could be dead ahead. In this vein, it appears that the GSE’s have entered their final death throes and that a major problem could be just ahead, as any further large down gaps would be indicative of the kind of full scale panic that could send these shares to under $1.00, indeed, toward zero.
At the same time we note that AIG International (AIG), long a bastion of blue chip stability, joined Fannie and Freddie at new life of cycle lows in today’s trade. In our view, there appears to be a greater tide of crisis building in the area of Credit Default Swaps, which in our view is likely the next major shoe to fall.
In the aggregate, this suggests that the current bear market in equities, which is likely only in the 2nd or 3rd inning, could be among the most severe seen in many years, perhaps going all the way back to the Great Depression. We say this because the credit bubble that is now unwinding represents the unwinding of 25 years worth of excess credit build up in the financial economy. Going back to the beginning of the secular bull market in August 1982, with the DJIA just under 800, the US embarked on a grand movement within the economy to a financial economy, wherein all sorts of new products were consistently brought to market. For much of that time, the progress was constructive and much of the financial economy fairly sound. Yet, in recent years, as perhaps is the nature with long term trends, everything seemed to move in the direction of gross excess, with debt levels rising dramatically just as a plethora of new, complex and illiquid securities were brought to market. It is now in the down-wave corrective phase that the bright spotlight of reality is being shined on many of these securities, with CDO’s, Mortgage Backed Securities and many asset backed securities running into severe problems in recent months. In our view, Credit Default Swaps are likely to become yet another category of new-fangled securities destined for the financial trash heep. Unfortunately, Credit Default Swaps are a very illiquid and opaque market, which has never been put to the test of a strong economic contraction. Originally envisioned as a kind of insurance policy purchased by banks and brokers as protection for times when companies fail to pay their debts, the CDS market has grown in over the last eight years from a notional value of $900 billion dollars to a current notional value of more then $45 TRILLION dollars.
Put another way, the CDS market currently has a notional value that is greater than the combined value of the US Equity Market ($21.50 Trillion), Government Bond Market ($.4 Trillion) and Mortgage market ($7.1 Trillion) combined. Within the CDS Market, commercial banks are among the major players, with the top 25 banks holding more than $13 Trillion in Credit Default Swaps. Among the top four banks, JP Morgan Chase ($7.80 Trillion), Citibank ($3 Trillion), Bank of America ($3 Trillion) and Wachovia ($1.6 Trillion). To better understand Credit Default Swaps (CDS), assume that Party 1 bought credit default insurance from Party 2 to protect himself from a default on a bond, or as a bet on a company's health. In the case of actual default, Party 2 would pay the bonds full value to Party 1. However, and here is where things go seriously awry, the CDS market is not regulated, and Party 2 often has the right to assign the insurance contract to yet another party, Party 3. Party 3 can then assign the contract to Party 4, and Party 4 may assign it further to Party 5. In this instance, in the case of an actual default, Party 1 may have to find and track down the ultimate party responsible, who may or may not be in a position to actually pay the bond's value. Are you getting the idea that this is a not a kosher market?
In the New York Times back in February of this year, they did an article on this subject and quoted Mr. Harvey Miller, a senior partner at Weil, Gotshal and Manges. “It could be another – I hate to use the expression nail in the coffin (referring to the country's credit crisis) as an original CDS, can go through ‘15 to 20 trades’ such that “when a default occurs, the so-called insured party or hedged party doesn’t know who is actually responsible for making up the default and if that end player actually has the resources to cover the default.” One of the biggest problems now facing participants in this market is that the market value of CDS contracts now far exceeds the $5.7 trillion in value of Corporate Bonds, whose ‘defaults’ the swaps were created to protect against. This has created a huge imbalance and like CDO’s, CDS contracts have no exchange where they are traded and their prices are not reported to the public. Institutions typically value these contracts on computer models rather then prices set by the market. Does this sound familiar? In a default, if the party obligated to make good on the insurance is unable to pay, then the counter-party, the one who thought they were insured, will have to record the default on its books. For Banks, who own a great number of these securities, this could be another source of massive losses in the next 12 to 24 months, with many banks already in bad shape and possibly unable to handle a final straw.
Over the last few years, the face value of these CDS contracts has been growing at an exponential rate, roughly doubling every year. This alone is frightening, as if only a small portion of these contracts actually collapsed (only 5% o these contracts going sour would be a 2 Trillion dollar problem), it would probably mean that the US Banking system will face a systemic crisis unlike anything the nation has seen since the last Great Depression. To many, these contracts seem like a financial innovation that simply got ahead of itself, and ahead of the regulators ability to track and monitor. Quoting the New York Times, “it would be as if homeowners, facing losses after a hurricane, could not identify the insurance companies to pay on their claims. Or, if they could, they discover that their insurer had transferred the policy to another company and that company could not cover the claim.”
Without pressing the panic button, I hope I have at least made it clear why we are concerned. Unfortunately, large players in the CDS Market including AIG International, General Motors and Ford would all seem to sport very substantial downside risk, and in the case of the two auto makers, it seems that crushing combination of both lousy auto sales and now a lousy finance arm, (which for years has been the only profit center, GMAC LLC and Ford Credit) will lead to a situation where push inexorably comes to shove. At GM, the Residential Capital LLC unit alone has 16 billion in CDS Swaps, which have likely been pyramided several times over and over. Consequently, a default at RESCAP, which seems to have one foot in the grave, could be a trigger mechanism for a cascading default, a contagion that once unleashed may be very difficult to arrest. What’s more, in addition to CDS risk, the two GSE’s, Fannie Mae and Freddie Mac are also likely mortally wounded with both of these financial corpses holding up to 2 Trillion in interest rate derivatives.
Again, the downside risk to the US Financial System is far greater than the miniscule remaining value of these equities. A collapse in the GSE’s could very easily be a trigger mechanism for foreign capital to put the brakes on any new investments in US Debt, forcing a further credit contraction and yet another round of credit downgrades in the months ahead. The global black eye would be brutal, and a sharp reduction of foreign capital flows INTO the US would likely trigger a massive current account adjustment and potentially a very serious Dollar Crisis.
For now, the problem at hand remains the Housing Crisis and the Banking–Credit Crisis, but in our view, as time passes, the odds will continue to grow that all of these problems morph into an even more serious Currency Crisis. In this vein, we view the current strength in the US Dollar as ultra transitory, and opening the door for the Federal Reserve to begin its next wave of interest rate cuts aimed at supporting the banking system and Wall Street. As more defaults are seen in coming months, the Fed in our view will have little choice but to begin monetizing these problems and creating fresh doses of digital dollars, all out of thin air. For Helicopter Ben, the new Super-Duper Helo is about ready to lift off, with one mission and one mission only -- paper over all of the bad debts and keep the system from bursting at the seams. For the US Dollar, the path of least resistance will once again be a relentless slide to new lows, this time likely accompanied by rising long-term interest rates as foreign capital abandons the long ensconced patterns of mercantilism and vendor finance. The torpedo explosions now resonating throughout the bulkheads of the sinking GSE’s cannot be ignored, as the unwinding of derivative positions at these institutions could well be the trigger event to place foreign capital into full retreat. With balance sheet impairment and collapse, will follow debt downgrades and the beginning of a potential exodus – a run from US GSE Agency paper. Fingers have been plugging up the damn thus far, but the pressure behind the walls appears ready to burst. For those who think the markets have been volatile in the last few weeks, get ready, cause we believe you haven’t seen anything yet.
That’s all for now,
© 2008 Frank Barbera