Fragility: What Has the Watchers Worried In the US Debt Markets

As you know I am on the lookout for a 'trigger event' that might spark another financial crisis, given the composition of the economy and the financial markets. 

In the last financial crisis 2008, it was the failure of the two Bear Stearns hedge funds that exposed the grossly mispriced risks in mortgage backed financial assets, and the generally flawed nature of the market's collateralized debt obligations.  This led to a cascade of failures in fraudulently priced assets, and resulted in increasingly large institutional failures, including the collapse of Lehman Brothers.

One can draw some parallels with the financial crisis before that, which was the gross mispricing of risk and inflated values of internet-related tech companies that had grown to obviously epic proportions by 2000. A failure of several key tech bellwethers to make their numbers, and some negative results in the economy, showed the flaws in the underlying assumptions in what was clearly an asset bubble. And once the selling started, it was Katy-bar-the-door.

 

The failure of two relatively minor hedge funds was not a great event. The failure of a tech bellwether to make its quarterly numbers is not either. But their interconnectedness to the other portions of the world markets through the financial institutions on Wall Street, and more importantly, the fragile nature of the entire pyramid scheme of fraudulently constructed and mispriced risk of financial assets, caused an inherently shaky system to fall apart.  What was most shocking was how quickly it happened once the dominos started falling.

The debt market in the US, with its deep ties to private equities, is probably not a trigger event, the fuse itself.  But it well might serve as the powder keg that will transmit the effects of some more individual event throughout the world's markets and economies.

The gross mispricing of risks in financial paper, again, and the lack of reform in the financial system along with excessive leverage and mispricing of risk, the fragility of long distorted markets if you will, has certainly risen to impressive levels again.

 

It is a familiar template of recklessness, fraud, and  then reckoning.  Afterward there is the usual attempt to blame the government officials which have been corrupted, and the people who have been duped and swindled.  Quite often some scapegoat will be found to be demonized.

 

I am thinking that this time the problem will arise overseas, with the failure of some major financial institutions there.  Perhaps Greece will provide the spark.  Or the Ukraine, or Mideast, or something yet unforeseen.  The failure of some major European bank certainly has historical precedent.

 

And if we do experience another crisis, do not be surprised if the moguls of finance come to the Congress through their proxies again, with a sheet of paper in hand demanding hundreds of billions of dollars, or else.

Last time it was a bail-out, which was the printing of money by the Fed to monetize the banking losses and shift them to the public.  This time they are thinking of something more direct, talking about a bail-in.   What if they eliminated cash, and started utilizing and redploying financial assets like savings and pensions.   The uber-wealthy already have their wealth parked in hard income-producing assets and offshore tax havens.  Who would stop them?

Like war, there will be an end to this kleptocratic economy of bubble economics and financial crises when the costs are borne by those responsible for it, and who so far are benefitting from it, enormously.

 

Tell us why you think it might be different this time.   What has really changed?  From what I can tell, it has not only stayed the same for the most part under the cosmetics of change, and significant portions of the financial landscape have gotten decidedly more dangerous, larger, and more leveraged.

 

Wall Street On Parade

Here Is What’s Fraying Nerves Among the Financial Stability Folks at Treasury

By Pam Martens and Russ Martens

June 10, 2015

On Monday, Richard Berner worried aloud at the Brookings Institution about what’s troubling the smartest guys in the room about today’s markets.

Berner is the Director of the Office of Financial Research (OFR) at the Treasury Department. That’s the agency created under the Dodd-Frank financial reform legislation to, according to their web site, “shine a light in the dark corners of the financial system to see where risks are going, assess how much of a threat they might pose,” and, ideally, provide the analysis to the folks sitting on the Financial Stability Oversight Council in time to prevent another 2008-style financial collapse on Wall Street.

Two notable concerns stood out in Berner’s talk. First was a concern about liquidity in bond markets evaporating rapidly for reasons they don’t yet “sufficiently understand.”

...Another major concern are the bond mutual funds and ETFs that have mushroomed since the 2008 crisis and are stuffed full of illiquid assets or assets which might become illiquid in a financial panic.

Read the entire article here.

The Moral Hazard of the Fed's Current Policy: The Resurgence of Fraudulent Paper

"As a dog returns to its vomit, so a fool returns to his folly."

Proverbs 26:11

A reader who works in commercial real estate finance shared a warning, informed by his own private industry perspective today. This was in response to my post this morning on the Fed's policy error of indiscriminately pumping money into an unreformed banking system, without adding safeguards and provisions for its employment in productive investment rather than wealth transfer control frauds.

It is almost tragically funny to see the economic principles learned from the Great Depression applied so blindly and haphazardly as advocated by some economists and policy makers. 

It is hard to explain the realities of things to people who see the rough world of the markets through the abstractions of their theory and models.

Yes, the approach used by the government in the Great Depression favoured the stimulus of government work and investment programs for a depression and liquidity trap, and a certain amount of financial security to ease the pain.  But it would have never been so wilfully complacent about the underlying fraud that caused it in the first place as the government is today.

And austerity without reform is a form of economic suicide.  FDR came right at Wall Street and the Banks with serious reform that saved capitalism from itself, and worked for a generation to hold back its darker impulses.  This is a lesson that we have apparently forgotten.

If the Fed attempts their old fix once again, they may do what I thought was almost inconceivable, and go a step beyond mere stagflation which is bad enough, and cause an actual break in confidence, and the bond of their word, the currency. The people of the world will not be fooled forever.

As Hyman Minsky once said, and the moderns seem to have forgotten, "Anyone can create money; the problem is in getting it accepted." He should have added, except by force.

Reform goes hand in hand with recovery.

From a reader:

CDO Resurgence Could Meet Resistance From RE Investors
Law360

A recent bump in demand for collateralized debt obligations has some experts predicting an onslaught of new deals in the coming months, but real estate attorneys caution that even with a more conservative structure, CDOs could be a hard sell with those still reeling from their role in the 2008 crash.

Also, Commercial Mortgage Alerts reflected commercial mortgage backed securities issuance of $48 billion last year (2012) - up from about $33 billion (2011). Remember the Fed is buying up to $45 billion in mortgage backed bonds per month!

"I believe the Fed has succeeded in provide the banks the incentive to begin issuing fraudulent paper again, the infamous CDO's. That's the only way the banks can meet the demand for higher yielding paper given their reluctance to engage in productive investments.

They know the game now, despite the real estate lawyers who are either wrong or just propagandizing. Open-ended QE.

The banks will issue large amounts of the CMBS paper and CDO paper and probably come up with other bond schemes and even LBO's that are fraudulent and probably worthless.

They'll sell them to whomever, because if the fraud is ever revealed, it will get charged to the Fed who will buy the paper from the investors or off the banks' books for near 100 cents on the dollar.

The great fraud machine is stirring. The debt bubble is reflating.

There is no underlying strength in the economy, so the loans being securitized will not be repaid in real terms and the banks and the investors will ultimately offer them to the Fed, who will buy them at non-market prices.

What's to stop this? There's nothing stopping it.

There is no threat of prosecution for fraud. There is no shame or sense of morality.

There is only a ton of money to be earned by the banks/hedge funds/private equity with no threat of punishment for engaging in massive fraud."

This later from another reader.  To be fair, CDO's are not in and of themselves bad assets, but they do tend to operate nicely in lending themselves as a vehicle for misstating risks because of their complexity and sometimes convoluted terms.  Therefore in that spirit, Deutschebank Selling CDO's to Meet Its Capital Goals.  And Private Equity Getting Deeper into Debt as Multiples Rise as well as Hampton's Average Home Price Hits Record.  

If this is productive debt with risks well-priced then no worries.  But I wonder if we will see a return to the LBO's, bond abuses, and dodgy IPO's of the past given the current climate of loose regulation and increased pressure to make easy money.

SP 500 and NDX September Futures Daily Charts; Gold Daily Chart; Corporate Bonds

The stock market was hit by a double whammy with the miss in revenue by bellwether Cisco after the bell last night, and then the dreadful unemployment claims number this morning, with 484,000 more people unemployed versus 465,000 expected.

Stocks opened much lower as expected, but as the selling subsided they managed to climb back regaining much of the losses in a low volume trading day.

I think the Street, dominated as it is by the big TBTF banks, will rally around this pivot point of support on the major indices until the General Motors IPO comes out, which should be next week at the latest. CEO Ed Whitacre announced today that he will be stepping down to make way for someone that will stay with the company for a longer time horizon, to give investors confidence in the new share offering as GM becomes a public company again.

So while volumes remain light and 'nothing happens' to trigger hard selling, I would expect these down days to be met with the purchase of the SP futures in particular to give it support. While the SP futures may see unusually high volumes as a fellow blogger noted yesterday, this is indicative of organized Street support to prop the market keying in on the SP 500 futures in the style endorsed by Robert Rubin, and not legitimate investor interest in buying the dip.

There are not many investors in these markets at these prices; the market is primarily consists of speculation and momentum trading, and therefore prone to sharp sell offs like the recent flash crash. This is why I have put out the 'black diamond' sign even though I do not anticipate a serious downleg until the IPO of GM is priced and put out to market. If it is withdrawn that will be a deadly sign that the Street believes there is insufficient liquidity to get it out to market, even though the government wants it to happen, and badly.

By the way, I was just thinking today how fortunate that Bush Jr's proposal to 'privatize Social Security' by investing it in the stock market was turned down, even by Alan Greenspan who never met a pedigreed Wall Street scam he couldn't support.

SP 500



Nasdaq 100

Cisco's weak results (for them) and their weaker forecast sent tech into a tailspin last night. It managed to hold itself together today for the reasons cited above.



Gold appears to have recovered from its FOMC-inspired smackdown and has resumed its uptrend. Do not expect this to be straightforward or easy, and you will not be disappointed.

But anyone who says that gold is a bubble is either talking their book or operating on a badly mistaken theory of money and value. This undeniable bull market in gold and silver is a direct reflection of the well deserved and justified deterioration in the financial system and the currency, the perception that Wall Street is rife with fraud, cronyism and corruption, and hidden counterparty risks.

The way to fix the problem is not by engaging in further fraud and market manipulation, like trying to silence the smoke alarm to keep everyone calm and confident. It takes a particularly perverse Madoff-like view of the world to write that prescription. The way to repair confidence is to reform the markets and weed out the crime, and establish a more equitable and self-governing system of global trade, because the current dollar reserve regime is no longer sustainable.

Failure to reform is gold's best friend. And this is why the crooks hate it publicly, while stuffing their personal vaults with it privately.

Gold



A Sign of a Top in Corporate Bonds

US corporations are issuing large amounts of new debt to take advantage of the exceptionally low rates created by quantitative easing. IBM recently did a major issue of three year notes that went out at one percent. Johnson and Johnson came out today with ten and thirty year notes at record lows.

Johnson & Johnson sold $1.1 billion of debt at the lowest interest rates on record for 10-year and 30-year securities amid surging investor demand for corporate debt.

The drugmaker, in the first offering by a nonfinancial AAA rated company in 15 months, sold $550 million of 2.95 percent, 10-year notes and the same amount of 4.5 percent, 30-year bonds, according to data compiled by Bloomberg. That’s the lowest coupons for those maturities on record, according to Citigroup Inc. data going back to 1981.

Great deal, if you wish to have record low returns in a depreciating currency with counter party risk correlated to an economic recovery. No risk in corporates, right? Maybe less for J&J, but most of the others will be promises writ on water if a major Depression ensues. But perhaps the Fed can buy them.

I obviously cannot predict when and if it will happen with certainty. But if the economy turns down and a dollar currency crisis ensues these corporate bonds will suffer a meltdown between foreign selling and corporate defaults.

Nassim Taleb believes that government bonds will collapse and is betting on it. I think corporates are a better bet, because a business slump and corporate failures could do the trick, even while the dollar and the short end of the curve is viewed as a safe haven.

But if there is a fear of hyperinflation and a greater dollar crisis, even the relative safety of Treasuries will melt down, and the longer end of the curve will drop in value faster than you can say "Sell."