Sunday, July 29, 2007

We're doomed

What happened? Just a few weeks ago, the bond market was flush with liquidity and sub-prime was an isolated problem. Now that seems like a long time ago and a market far, far away.

First, let's review some facts.

  • The economy is still growing at a fairly strong pace outside of housing. Excluding bond market activity, there is little evidence that housing is causing problems in other areas of the economy.
  • The only segment of the bond market where there have been actual disruption of cash flows remains the sub-prime ABS and ABS CDO markets.
  • Both corporate defaults and corporate leverage remain low by historic standards.
  • The factors causing liquidity to be so plentiful are still in tact, particularly over savings in Asia, easy money from Japan and China, and large cash flows to hedge funds and private equity.

Given these three facts, there are two logical explanations of for the violent collapse of credit spreads.

First, the bond market is anticipating that some or all of these factors will change for the worse. Consumer spending will finally slow, corporate defaults will rise, and foreigners will find U.S. investments less attractive.

Alternatively, you could argue that this is mostly technical. There is an extremely heavy high-yield calendar over the next several weeks. That coupled with a general discomfort with historically tight spreads and fear over sub-prime contagion causes real money accounts to back off corporate bonds entirely. Each basis point of widening seems to confirm the theory that spreads are "returning to normal" and causes more people to sell corporates.

I'm working through which scenario I find more credible. My instinct is the later, but the former can't be dismissed. Anyway, a key thing to remember is that corporate spreads will not rebound as quickly as they widened out. No matter what scenario you side with. Because corporate bonds are negatively skewed (i.e., your potential loss is always greater than your potential gain) fear will always linger in that market. This is as opposed to stocks, where greed can cause a more rapid rebound. More on this idea soon.

So I'd say the best case scenario for the short-term, meaning next couple weeks, is that corporate traders manage to feel out where there is an actual market, some bidders emerge, and the corporate market stabilizes. If this happens, and the stock market also rebounds, then corporates become a buy, on the theory that corps will catch up with stocks.

The worst case scenario? Uhhh...


Robert said...


Are you planning on posting regarding the market conditions as they develop? For instance, would you agree with the comment made by "the cds trader" to your last post as to Friday's action?

I agree with your point that this event may have been more technical in nature. With average earnings gains nearly double analysts' forecasts, how can the sky be falling in the long run? I suppose, as you point out in your post, the fixed income markets are discounting some major changes in the future, but it seems hard to believe.

It would take a near seismic shift from the current conditions to produce a situation that warrants this level of disruption. This feels like 1998 all over again, but the events leading up to the current crisis just don't seem to be as serious as the conditions that existed at that time.

Anonymous said...

Wouldn't you say that until Bernanke matches Japanese interest rates, everything goes up?

Nobody seems to need collateral for loans anymore. All that is needed is cheap money.

Leverage can stretch to the sky as long as the spread between Japanese rates and US rates stays the same.

Anonymous said...

For anyone who serious studies economic history, it's naive to think that any housing recession, let along one this deep, won't spill over into the general economy. It always has before. Why shouldn't it this time?

Oh, you must believe in a new paradigm.

Wake up! Housing is a leading indicator and real estate (housing + commerical) is the most powerful front-edge driver of economic cycles. Just because you can't see spillover yet in the published data doesn't mean it's not there.

You don't have to twist your brain so hard. Just let the history of economic cycles 101 be your guide.

Accrued Interest said...

Anon #1:

Can't agree entirely. Japanese easy money keeps liquidity high here in the U.S., yes. But for the moment, the easy loan terms are unavailable.

Anon #2:

I hear people make this arguement before, but please show me where we've had a generalized recession **caused** by a housing recession. I am a student of economic history and don't know of any instances of this happening. I know of times where aggregate demand became weak and that caused housing prices to stagnate. But not where housing prices declines causing a recession. I think we're in uncharted territory here.

I'm open to someone proving me wrong, but so far, no one has.

Accrued Interest said...


Yes I agree with CDS that Friday was worse than Thursday. I wish I could post more often, but I don't always have the time.

It feels A LOT like 1998, doesn't it? Generalized panic, failing hedge funds, massive and sudden flight to quality...

Will Bernanke act like Greenspan did then? AG cut rates 3 times, once inter-meeting, early on in the LTCM crisis.

Robert said...


I recognize that you have a job to do and this blog comes way, way behind your task at hand. So thank you for taking the time to post. I really enjoy your blog and make a stop each day to check for new posts.

Quick question: What is your opinion on today's action? Are you still busy being liquidity provider?

On another note: Has the continuing price action affected your generally bullish view of MBS? Doesn't this situation potentially lead to the possibility that some investors will get burned by the most toxic of MBS and therefore many other investors are put off to all MBS for a period of time? Or will the smoke eventually clear and the cream of the MBS world rise to the top?

Thanks in advance for taking the time to post and reply to comments. Keep up the good work.

Accrued Interest said...

I play in a few odd-ball, high quality sectors, like taxable municipals, GNMA Project Loans, SBAs, and others. Those sectors were not well-bid, despite the strong quality, last week. I'm feeling out where it is today. I just put a bid on something which, if I win it, would be like 2 points below where it should be. I did win some stuff on Friday at that same differential. For readers who trade AAA assets regularly, you know what that means in terms of how bad liquidity is.

On MBS, I still like it fundamentally. If there is any "mistake" I regularly make as a trader its getting into sectors too early, or when they are relatively tight, because the fundamental story is so strong. I'm certain that my MBS positions will produce excess return over time, but honestly its hard to say how long it might take for them to come back. I'm planning to regularly revisit the MBS story on this site, so stay tuned.

Anyway, for a quck take, I don't think people will eschew MBS for too long. Agency MBS are about 35% of the Lehman Agg, so most money managers will remain active in the sector. I think the speed of the come back depends on swap spreads. If swaps tighten, MBS will tighten.

Anonymous said...

Trying to be more articulate and focussed:

Isn't the key the American consumer?

If he sneezes everyone catches cold.

And isn't he running out of "wealth" fast?

Anonymous said...

It's not housing price declines that traditionally have contributed to recessions. It's primarily the spillover that comes from weakness in building houses and creating new households (and all the things purchased in the process).

I don't know why smart people (including you) can't get this. It's basic economics. Most people in the U.S. spend "big money" on two basic things in life, aside from ongoing essentials: cars and housing. When you have sharp downturns in economic activity in both areas at the same time, it sends out ripples in many directions. I can see those ripples right now in countless ways: earnings announcements, store traffic, consumer confidence etc. History teaches that the ripples get a lot bigger and wider as they go.

People are confused, in part, because they think the U.S. has transitioned to a "service economy" that can somehow withstand sharp downturns in manufacturing (cars and housing). But millions of service jobs are created to meet demand, and they will be destroyed as demand dries up. That's the nature of a service economy. People don't know this, in part, because there has never before such a huge economy totally dominated by services.

P.S. "Japanese liquidity" has served mainly to let hedge funds ramp up risk for all investors. You may be shocked to see how fast part of the liquidity can shift from net long to net short, in which case ordinary investors will be burned and lose confidence in the market and economy. There's no law that says leverage has to be invested long. That's the other new dangerous dynamic, in addition to service economy: hedge funds, their fluidity, and lack of loyalty to anything in particular.

flow5 said...

Why 2007 is different than 1987.

Black Monday Oct 19 1987.

On Sept. 4 the Fed raised (1) the discount rate 1/2 percent to 6, and (2) the federal funds rate 1/2 percent to 7.25 (up from 5.875 percent in Jan). On Sept. 30 fed funds spiked at 8.38; fell to 7.30 by Oct. 7; then rose to a peak of 7.61 Oct 19 (Black Monday).

At the same time, (Sept. & Oct 87), the decline in the proxy for real-gdp (its rate of change) plummeted (a record since its inception in 1918). The quantity of legal reserves bottomed in the bi-weekly period ending 10/21/87. This was the trigger.

At the time, the 30 year conventional mortgage yielded 11.26 percent, up from 8.49 percent in Jan. 87, and moody's 30 year AAA corporate bonds yielded 11.06 percent on 10/19/87, up from 9.37 in Jan. 87.

The preceding tight monetary policy and the sharp reduction in legal reserves, had forced all interest rates up in the short run (when inflation and real gdp were subsiding). And the banks scrambled for reserves at the end of their maintenance period - to support their loans-deposits (contemporaneous reserve requirements were in effect exacerbating the shortfall and response time). A significant number of banks, or large banks with large reserve deficiencies, tried to settle their obligations at the last moment, and ignored any consequences.

Black Monday's trigger was obscured because the decline in monetary flows (MVt) overlapped Qtr3 & Qtr4 GDP (quarterly reports are used by the Bureau of Economic Analysis to measure gross domestic producd - not monthly reports).

The Fed quickly reversed their policy when the markets panicked, i.e., they brought the volume legal reserves back into alignment.

"The United States has the largest national economy in the world - with a GDP of 2006 of $13,755.9 trillion dollars. If the U.S. hiccups - it resonates around the world.

Fed 27, 2007 didn't start in China, it started here. That's why the Shanghai market dropped 6.5% May 30 2007 without affecting other world markets.

Real-gdp & inflation both bottom in OCT this year. It should be a period of market weakness. Even so, 4qtr economic activity sharply rebounds.

flow5 said...

Ben Bernanke is a scholar. We have never had a Chairman as competent. He should be appointed to a life-time position as Federal Reserve Chairman. Do not underestimate him.

Anonymous said...

There appears to be little new left to loan against that does not carry significant default risk.

Accrued Interest said...

Anon #1:

The key is the American consumer. The question is, will mortgage defaults and reduced MEW overwhelm otherwise solid economic fundamentals. The majority of consumers do not have a mortgage problem: i.e., they have a fixed-rate mortgage they can afford. But say you have 10% of consumers cut their spending by 50%. That's a 5% reduction in spending and that's a recession. (Real numbers aren't that large, but you see my point.)

So far, solid job growth seems to have overwhelmed this housing-related problem. I find it compelling to think this will continue.

Anon #2

In my mind, we're talking about two different ideas. On one hand you can argue that we've seen large job losses in certain industries ripple out and cause a recession. Absolutely. So now you argue that the housing industry can cause a recession. Why not? Then the debate is whether the job losses will be large enough and how quickly those jobs can flow to some other area of the economy. That's a perfectly reasonable debate.

If you want to argue that home price declines cause a recession, I can't agree. Especially if you want to claim that this has happened in the past. We've never really had a bubble burst in home prices quite like we're having now. So I guess my position is that history is a poor guide in this instance. But either way, home prices decline for a reason. I'd argue that home prices are a symptom of some other economic problem, at least in the past.

I think if we have a recession, it will be because of a credit crunch. The crunch may well be related to sub-prime problems. So in that way, you could argue that home price declines were a contribting factor, but really it was poor lending standards that will have "caused" the recession.

Accrued Interest said...

Also, Flow5 needs to start his own blog.