Chance This Is The Bottom? Zero.
Basic Thesis: The subprime burst was just a prelude to the real disaster, that of cascading counterparty defaults and capital base destruction of bank parties, due to normal default rates in a typical recession. If you believe we are not trending into recession, read no further. This argument runs on the basis we dip into one. The Bear Stearns asset bailout served as a beacon. The estimate of 45 trillion outstanding notional credit default swap contracts, insuring bond holders from default, holds an enormous latent pressure over the financial sector and possibly the rest of the markets. The New York Fed took it seriously, and so should you.
Capital erosion from losses, even amidst Fed and Government sanctioned capital injections, still results in destruction of capital and thus book value. This destruction will still undermine stock prices, no matter how much the fed prevents the "cascade." (Click images to enlarge.)
Here we see default rates have barely moved off of expansionary period levels. Notice default rates in the '91 and '01-02 recession periods hit the 10% range.
Moody's is forecasting defaults in this cycle that look to repeat past patterns.
What follows is corporate default counts. I picked the period surrounding the Great Depression and the last two recessions, both of which involved substantial default rates. Notice that even in the Great Depression, the defaults did not occur en masse until several years following the market crash of 1929. Is this credit crisis in subprime comparable, even if of lesser amplitude, to this dynamic?
It''s important to also take note that most defaults are in the speculative grade (high yield) category. Notice even during the Great Depression relatively few investment grade defaults. But even in the relatively light recession of 2002, there is a substantial amount of investment grade defaults. This is most worrisome since a credit default swap disaster will likely occur on the heals of a AAA US Corporation going belly up. Like I've illustrated in previous talks on CDS with my example of GE credit default swaps, it only takes one black swan high yield blowup to unearth the possible cascade the New York Fed took great effort to prevent. There lies a possibility that the Citis, JPMs, and Goldmans of the world are using credit default swap short positions on AAA debt levered to unbelievable levels to amp earnings.
Finally, here is the notional amount the recent defaults represented:
Notice the actual amount of money these defaults represent is relatively little, spread across all debt holders in the system. This isn't where the risk lies. The lack of any visibility on possible liabilities that might result from a magnification of losses that never before existed is the current problem.
With that said, we are still quite early in the cycle, as we haven't yet had our first negative GDP number. Even job losses have barely budged. Defaults are still relatively low. This says to me a long and steady period of continual downwards pressure before we hit bottom. During the last recession, the equities started their recovery off bottom when the default rate started quickly trending down. Even without the unknowns associated with outstanding derivative liabilities, the better risk/reward trade is to wait to buy equity indexes until we get a down trending default rate.
You can access this default data directly in the Moody's annual paper entitled Corporate Default and Recovery Rates, 1920-2007.
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This article has 23 comments:
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ItsJustMe
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38 Comments
Apr 04 09:33 AMToday they budged. Big time.
And discount rate spreads are blowing out again like they did last summer and a couple of months ago. Check out the chart at the Federal Reserve site:
www.federalreserve.gov.../
Now I know why Bernanke seemed especially nervous on Wednesday and the congressmen seemed concerned. They know Bernanke is running low on ammo. This isn't good...
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ratpyan
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1 Comment
Apr 04 09:35 AM-
andrewpmk
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14 Comments
Apr 04 09:58 AM-
Pent up demand
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115 Comments
Apr 04 10:01 AMThe perma-bulls have had many days in the sun. Unfortunately for them the "expansion" of the last 5 years is turning out to have been largely smoke(credit) and mirrors(leverage). Pay no attention to that man behind the curtain Mr. perma-bull.
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NPM
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2 Comments
Apr 04 10:36 AM-
Michael B. Krause
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68 Comments
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Apr 04 10:57 AM-
Michael B. Krause
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68 Comments
My Website
Apr 04 10:57 AMscriabinop23.blogspot....
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helplessobserver
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413 Comments
Apr 04 03:27 PM-
blue skies and lollipops
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1 Comment
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Apr 04 04:34 PM-
robert99
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127 Comments
Apr 04 06:15 PM-
pockyclips 2020
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154 Comments
Apr 05 11:16 AMThanks to no appreciation in the average portfolio so far this decade, and real inflation in the double digits, boomers better think again about retiring in the next 10 to 15 years off of their 401Ks. Unless you have a good pension to supplement your income.
In the late '90s, people were serious about retiring in their late 50s.
Where are the "Thank ya, W" stickers now? He will go down in history as the Calvin Coolidge of the 21st century. And this is one boomer that won't be working 'till the day he dies, unlike most of us.
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flatout
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1 Comment
Apr 05 01:54 PM-
Dan Schmeidler
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47 Comments
Apr 05 03:16 PM-
BrucePile
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95 Comments
Apr 05 05:06 PMYou can hold the good stocks in the time it's going to take to unwind the problems (a lot of them will climb), but bear markets typically have sudden, hard to predict sell-offs that grow in intensity gradually dragging even the strongest areas of the market into them untill a capitulation phase is reached. It's going to get more and more dangerous both long and short stocks. The Fed will continue to throw bail-out money making a short portfolio a mine field, and sudden fits of market anxiety over debt's lack of visibility will probably make a long portfolio a constant struggle.
A commodity portfolio may be the best area as it will benefit from the flooding of the money supply no matter what kind of problems are created or solved in the stock market. You won't have to be right about the next big gyration of stocks. We are likely into a long market cold spell like '68 to '82 associated with the mega financial/hard asset inflation cycle where commodities will be outperforming a dangerous stock market for quite awhile as we are only about 4 years into the upswing of the hard asset bull market, not even reverted to the historical mean yet (not really "bubble" territory).
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johnthebear
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259 Comments
Apr 06 12:25 AMIt will be very interesting to see the earnings reports of the REITs that begin on April 23 to the end of the month. I suspect that there will be a lot of "prime" properties that are marked to market due to higher interest rates on the "interest only" loans they have been enjoying. Higher capitalization rates will come into play as well as the coming vacancy rate allowances. Sharply lower real estate values could really upset the apple cart on a world wide basis. It could really get tough going forward, regardless of the spin the talking heads put on the story.
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end of the world
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2 Comments
Apr 06 12:39 AM-
curious cat
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136 Comments
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Apr 06 01:21 AMin case you were confused by your leftist readings, the rich pay most of the taxes and invest most of their money, which creates jobs. it isn't their fault that the iron curtain came down and there are billions of people willing to work for a nickle a day. american workers are very fortunate to have jobs at all, at this point.
we have to continue to support small business, because they create jobs and innovate. a free market, with less tax and less regulation, allows risk capital to work. higher tax and more regs mean fewer people invest in business, fewer jobs are created and america suffers.
i know you'll vote democrat if they pay you enough, but remember they are paying you with my tax dollars, not yours. when you cash that rebate check, have a drink on me.
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stkinvestor
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4 Comments
Apr 06 02:22 AM-
I'm a Sucker
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6 Comments
Apr 06 04:21 AMwww.comedycentral.com/...
Watch 4:30 seconds into the clip. Greenspan is a thief!!!!
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mslasky
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21 Comments
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Apr 06 07:18 AM-
vaduz
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109 Comments
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Apr 06 10:24 AM-
analogdog
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1 Comment
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Apr 06 10:32 PMThe relief check coming to the American consumer will be eaten up quickly by the rising gas and food prices. The ethanol dream will continue to increase the starvation in the world... and the shrinking dollar is threatened further by the push to remove it from the oil standard. Not sure I want to be conscious that day....
Money can be made in this market. I'm short financials... but not enough to get destroyed if America drinks more Kool Aid being served up by CNBC and the rest of the media... "opiate for the masses".
We'll need it... pain is ahead. Live within your means, avoid credit debt, and find the real value that is out there.
Read the data for yourself... not just opinions. Decide for yourself... but staying in cash might not be good enough.
oh... and learn how to trade Forex... LOL it's been amazing.
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curious cat
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136 Comments
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May 07 11:51 PMuser 173580, you make an excellent point regarding the republicans not managing to live up to their campaign promises of spending less. they decided to spend on our freedom and the freedom of the enslaved iraquis. it could have been worse though. they might have given all those displaced new orleans katrina victims a lot of money to make up for the fact that they did not buy flood insurance. oh, wait, they did do that. too. idiots....
user, it does take a lot to raise a family and if i were poor, which i was, i would not have a lot of kids, because they might starve and i would not want that. if i were poor, which i was, i would bother to read and work hard and save, instead of spending every dime i made, and learn to invest for the future. gee, i wish this were america, where everyone were free to work hard and learn and save. stop blaming the government for not doing what you should do. stop watching tv. stop buying five dollar cups of coffee, stop going to the movies, buying michael jordan's underwear and shoes, pay tv, lottery tickets, doing your hair and nails, drinking booze, smoking cigarettes, doing drugs. exercise a little restraint. try telling your neighbors that you appreciate them and tell your kids that they need to listen to their teachers. wash behind your ears while you're at it, ok?