Key Signals and the CDS Cascade
By Frank Barbera CMT. October 7, 2008
As close observers of market behavior, we continue to view with great alarm the ferocity of what appears to be a still building credit market contagion. With a potency of almost biblical dimensions, this 100 year flood continues to amass, forming a tidal wave which is carving out an intercept course with some of Wall Street's most acutely fragile derivative instruments. At the moment, the $54 Trillion Dollar Credit Default Swap market is directly in the cross-hairs, with this month featuring several major settlement days for institutions like Lehman, AIG, and Washington Mutual. Dates include Lehman CDS deals on October 10th, and WaMu deals on October 23rd. For many insurance companies, these CDS Contract settlement dates could be a kind of ‘waterloo,’ where billions of dollars in losses could come home to roost. A gander at the destruction wreaked on insurance company share prices shows a steep downside acceleration in the last few weeks with names like Conseco Inc (CNO), Allianz SE (AZ), Progressive (PGR), Hartford Financial (HIG), CAN Financial (CNA), MetLife (MET), Prudential Financial (PRU), Sun Life (SLF), Lincoln National (LNC) and Aegon (AEG) all falling sharply. While the true potential exposure remains unclear in most cases, the deep seated distrust that now prevails within capital markets seems to be a "shoot first and ask questions later” mentality where the equities are involved. Likewise, we continue to see bearish chart configurations on a number of leading CDS players including General Motors and Ford, which we have pointed out in several prior comments. Just look at the downside acceleration in these equity prices which show the same type of exponential declines seen during the demise of so many other institutions in recent months.
Above: GMAC LLC (GMA)
Above: Ford Motor (F) breaking down to fresh multi – year new lows, and down nearly 17% just today.
In addition, as was the case with AIG, and WaMu and Lehman, the Credit Default Swap rates for both auto makers have been moving exponentially higher with the GM rate above 4000% and the Ford rate closing on 3000%. In my view, this spells humogous trouble dead ahead. In his book, “Manias, Panics and Crashes,” Charles Kindleberger alludes to ‘acute panic, crisis and danger' the point of recognition and virtual epicenter of a financial storm. In my view, we are in the very heart, the very ‘eye’ of the storm, with the CDS market packing Category 5 force winds.
As we see it, not only is trouble swirling around the banks, the insurance companies and the large auto makers, but in our view, names we are already know about may still be major stories still in the process of unfolding. To that end, I would not be surprised to find out that the ripple affect of AIG demise is a story that is still having far reaching untold consequences. Like Credit Ansalt of the 1930’s, AIG was such a huge player with so many counter-parties in its business, it is hard to believe that the AIG CDS issues have been put to rest. In looking at the stock chart over the last two to three weeks, we see a classic five wave (a,b,c,d,e) symmetrical triangle, which is virtually always a downside continuation pattern. The implication from this chart is for another powerful downside thrust – most likely, already getting under way. Would we be surprised if shareholders are completely wiped out? Would anyone be truly surprised?
With the Federal Reserve now ballooning its balance sheet in parabolic fashion, one can only wonder where the crisis will finally end. For the last few months, the debt bomb has been primarily affecting the credit markets, more recently spilling into the equity markets. In my view, the risk from here continues to build that vanishing credit, and vanishing confidence unleashes this contagion into the currency markets which have been torn between an interventionist money printing Fed on the one hand, and a static, unable to see eye to eye, European Central Bank on the other. While the talk in most circles has been about little more then deflation in recent days, if the credit market contagion goes airborne and infects the currency markets, then the outcome could rapidly reach an inflection point in which it could pivot on a dime, and morph into an inflationary nightmare virtually overnight. While many are applauding the Federal Reserves move to prop up the Commercial paper market at ‘all costs,’ this may be one of those times where the phrase “at all costs’ is more telling than most would really believe. How does the Fed plan a reverse exit strategy once CP is weaned to life support? And with other lifelines drawing more and more capital by the day, at what point does the Central Banks deteriorating credit quality become the over-arching focal point? What then?
For several years, we have maintained that the final ‘end game’ phase of this credit bubble/ depression would begin when credit market problems permeated into the currency markets, and when a falling Dollar forced UP long term yields. For those who might have missed it yesterday, the Fed announced it would be buying unsecured commercial paper, and today, stocks tanked, the dollar tanked, gold moved up and most importantly, Bond yields moved up. In the past, 99% of the time with the stock market down big, bond yields would have fallen sharply. Today, it was “the turn” in the Dollar market that ruled the roost, with the flight to quality trade targeting precious metals, not bonds. OK, one more time in case anyone missed it: Stocks down big, and no rally in bonds. Shades of things to come and an indicator that Problem A is now potentially morphing into Problem B.
Problem B is a Shakespearian tragedy on a grand scale, a potential “reflationary” global currency crisis, which once unleashed could make the problems of falling home values and declining 401K’s seem positively mild in comparison. Think acute shortages of basic goods; think hourly pricing. Think increasing scarcity and rationing. To be sure, there would be nothing deflationary about any of this, if this crisis jumps the tracks. On second thought, maybe best not to think about this at all as the outcomes are just too depressing.
In any event, in closing we recap on this Tuesday, the raging bear market continues with no end in sight. Stocks ended in virtual ‘free fall’ with major indices like the S&P 500, DJIA, and NASDAQ Composite outside all major trading bands. While some technical gauges for the market are ‘oversold,’ many others are still not oversold, and not down to the kind of levels that would even remotely indicate an important bear market low. Thus, the rule of the day is that of the falling knife, namely -- don’t try catching one! For Bonds, the action is ominous as if bonds can’t rally on a 500 point decline in the DJIA, then when will they? Perhaps Bonds – those “recycle” trade aficionado’s know a lot more about what is truly on the way, and perhaps this is a key signal most of us will be well advised to heed. This situation is a mess, and on this Tuesday, one can only lament at the potential untold costs these problems will have for so many who were but innocent victims of circumstance. From ‘Pulp Fiction’ and Ezekial 17, it seems that “the path of the (many) righteous men” has truly been beset on all sides by the inequities of the selfish, and the tyranny of evil men.”
That’s all for now,
© 2008 Frank Barbera