Satyajit Das is author of Traders, Guns and Money: Knowns and unknowns in the dazzling world of derivatives (August 2006) and Extreme Money: The Masters of the Universe and the Cult of Risk (August 2011)
~~~

In Crosstown Traffic, Jimi Hendrix sang: “can’t you see my signals turn from green to red / And with you I can see a traffic jam straight up ahead.” In global financial markets, the signals have changed from green to red. But rather than a simple traffic jam, a full scale credit crash may be ahead.

In financial markets, facts never matter until they do but there are worrying indications.

Fact 1 – The European debt crisis has taken a turn for the worse.

There is a serious risk that even the half-baked bailout plan announced on 21 July 2011 cannot be implemented.

The sticking point is a demand for collateral for the second bailout package. Finland demanded and got Euro 500 million in cash as security against their Euro 1,400 million share of the second bailout package. Hearing of the ill-advised side deal between Greece and Finland, Austria, the Netherlands and Slovakia also are now demanding collateral, arguing that their banks were less exposed to Greece than their counterparts in Germany and France entitling them to special treatment. At least, one German parliamentarian has also asked the logical question, why Germany is not receiving similar collateral.

Of course, Greece, which does not have two Euros to rub together, doesn’t have this collateral and would need to borrow it.

Compounding the problem is Greece’s fall in Gross Domestic Production (“GDP”) was worse than forecast, even before the latest austerity measures become effective. The Greek economy has shrunk by around 15% since the crisis began. 2-year borrowing costs for Greece are now over 40%, pawnbroker levels. The next installment of Greece’s first bailout package is due to be released as at end September. Some members of the International Monetary Fund (“IMF”) are already expressing deep misgivings about further assistance to Greece, in the light of the seeming inability of the country to meet its end of the bargain.

A disorderly unwind of the Greek debt problem cannot be ruled out. Ireland and Portugal remain in difficulty. Spain and Italy also remain embattled with only European Central Bank (“ECB”) purchases of their bonds keeping their interest rates down. Concern about the effect of these bailouts on France and Germany is also intensifying.

Concerns about US and Japanese government debt are also increasing.

Official forecasts show that America’s national debt will increase by $3.5 trillion from its existing $14.5 trillion over the next decade. These forecasts are unlikely to be met unless the political deadlock over the budget is overcome and economic growth recovers. Japan was downgraded to AA- and its longer-term economic prognosis continues to be poor.

Facts 2 – Problems with banks have re-emerged.

Banks globally, especially European banks, are seen as increasingly vulnerable to European debt problems. The total exposure of the global banking system to Greece, Ireland, Portugal, Spain and Italy is over $2 trillion. French and Germany banks have very large exposures.

If there are defaults, then these banks will need capital, most likely from their sovereigns. As they are increasingly themselves under pressure, their ability to support the banking system is unclear. The pressure is evident in the share prices of French banks; Societe Generale’s share price has fallen by nearly 50% in a relatively short period of time.

In the US, concerns about Bank of America (“BA”) have emerged, with analysts suggesting that the bank requires significant infusions of capital. The major concerns relate to BA’s investment in US mortgage originator Countrywide including continuing litigation losses, exposure to European banks, loans to commercial real estate and the quality of other assets, such as mortgage servicing rights and goodwill resulting from its acquisition of Merrill Lynch.

BA claims that its exposure of $17 billion to European sovereigns was hedged. As the world discovered in 2008, it wasn’t whether you were hedged but who you were hedged with and whether they were financially able to perform that was the issue.

BA shares have fallen by roughly 40% price over the past month, compared to a 15% decline in the S&P 500. The cost of credit insurance on BA risk has also increased sharply.

BA decision to issue $5 billion in preference shares to Warren Buffett’s Berkshire Hathaway, now confirmed as the market’s lender of last resort, at distressed prices was not a statement of strength but weakness. BA needs more capital in any case and Buffett is betting on both BA and if things go wrong that the US taxpayer will bail him out as they did with his investment in Goldman Sachs.

BA’s woes confirm that problems in the banking system exist globally, not only in Europe.

Fact 3 – Money markets are seizing up

Banks and financial institutions are finding it increasingly difficult to raise funds. Costs have risen sharply.

Spanish and Italian banks have limited access to international commercial funding. Like Greek, Irish and Portuguese banks, they are heavily reliant on funding from local investors and central banks, including the ECB.

American money market funds, which manage around $1.6 trillion, historically invested around 40-45% ($600-700 billion) with European financial institutions. Over the last few months, the money market funds have reduced their exposure to European entities, especially Spanish and Italian banks. The funds have also decreased the term of their loans to the European entities that they are willing deal with to as little as 7 days at a time, in an effort to limit risk.

European banks are having to pay higher interest rates, if they can attract funds. The problems are not confined to European financial institutions. Despite limited known direct exposure to European sovereigns and their relatively strong financial positions, Australian banks’ credit costs in international money markets have increased by more than 1.00% in less than 3 months.

As a result, non-financial institutions are finding finance less readily available and more expensive. Anecdotal evidence suggest that businesses are having difficulty financing normal commercial transactions, recalling the credit problems of late 2008/ early 2009.

Banks are increasingly following Tennessee Williams’ advice for survival: “We have to distrust each other. It is our only defense against betrayal.”

Fact 4 – The broader economic environment is deteriorating.

The global economic recovery is stalling. The risk of a recession or minimal growth is significant.

The favourable stock market reaction to the latest report of growth in orders for durable goods in America misses an essential point. At around $200 billion an month, it is still around 20% below its peak in 2007 and only at 2000 levels.

Germany and emerging market economies, like China and India, which have contributed the bulk of global growth since 2008, are showing signs of slowing. The effects of the excessive credit expansion in China and India are showing up in bank bad debts.

Then there are pernicious feedback loops. Tighter money market conditions feed into lower growth, increasing the problems of government finances. Falling tax revenues and rising expenditures push up budget deficits, requiring greater borrowing. Lower growth feeds into greater business failures that increase bank bad debts, feeding further tightening in lending conditions and the cost of finance.

The rapid and marked deterioration in economic and financial conditions means that the risk of a serious disruption is now significant.

If market seize up again, then “this time it will be different. There might just not be enough money to bail out everyone and every country that may need rescuing.

Government policy options are severely restricted. Government support is restricted because of excessive debt levels and the reluctance of investors to finance indebted sovereigns. Interest rates in most developed countries are low or zero, restricting the ability to stimulate the economy by cutting borrowing cost. Unconventional monetary strategies – namely printing money or quantitative easing – have been tried with limited success. Further doses, while eagerly anticipated by market participants, may not be effective.

The global economy may muddle through, but a second credit crash is now distinctly possible. But the trigger and timing is unknown. As John Maynard Keynes remarked: “The expected never happens; it is the unexpected always.”

~~~

-Satyajit Das
August 27, 2011

Category: Bailouts

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

29 Responses to “From Green to Red – Is Credit Crunch 2.0 Imminent?”

  1. bullionaire says:

    Oh, but they do have the ultimate in collateral, in fact all the PIGS do….its called gold.

    To think this small but essential detail was overlooked by the author suggests he may think he knows what he’s talking about, but really doesn’t (like any Keynesian), or he’s simply a shill trying to divert attention away from the one universally recognized store of wealth.

    Some have speculated that the gold these countries think they own has largely been sold by their central banks (via bullion banks using a fractional reserve basis – selling 100 ozs of paper gold for every ounce of physical that exists) to keep gold prices (& central banks perceived inflation fighting skills) in check, so perhaps the author wishes to obfuscate this speculation or is simply ignorant, but in either case, his subsequent analysis offers nothing.

  2. ilsm says:

    Banks (aka bubble machines) all over must be liquidated.

  3. When the screaming gets loud enough they will just start printing again. They always do

  4. DeDude says:

    Not solving Greece and demanding that Greece should fix itself will turn out to be a costly mistake.

  5. stonedwino says:

    The banks that are largely responsible for this mess and credit crunch, were bailed out at taxpayer expense, yet here we are again at the edge of another precipice and nothing has changed. The banks are still not really lending and doing much of anything to fix the housing problem with so many underwater and continue to be a drag on the economy…we should have gone Swedish on them. I don’t see another bailout of TBTF….therefore the only option will be to start nationalizing them….if we don’t the privatizing of profits and socializing the losses will only continue…neither the banks, nor our wallets can afford that…game over.

  6. Concerned Neighbour says:

    An excellent piece. I’ve been raising these same points since the so-called recovery began, but this is the “goldfish market”. Your average market participant has either a very short-term memory or the wisdom of coral (or great ignorance – take your pick).

    Of course the most infuriating aspect of all this is banker bonuses are still stratospheric. Bonuses no longer have any relationship to performance, and if they do, the performance metrics are strikingly in error. I saw a chart somewhere the other day that pointed out how bonuses have soared over the last decade plus, despite real returns on the S&P 500 being negative over time. The gall of our Wall Street Overlords – including the hideously inept boards of directors – is something to behold.

    All this so-called recovery has done is shift stress from the private to the public sector. And due to previous poor management (I’m looking primarily at you, George), the public sector wasn’t in a position to do what was called for (that is, massive fiscal stimulus). The little that it mustered was even misallocated.

    That the banks are still stressed after their massive bailouts and near-record bonuses over the last couple years speaks volumes as to their utterly incompetent management. In my opinion, the only practical and moral option at this point is for a temporary government takeover and re-organisation, followed by hiving off smaller chunks to the market when conditions improve. It’s what should have been done last time, and has a great track record in other coutries. Of course, the “government killed my first-born” camp in this country will be completely against it.

  7. Concerned Neighbour says:

    As an aside, I was was AFK for much of the week. But in perusing the headlines, I see the Tuesday rally of 3.5% was attributed by our wise media to optimism over Jackson Hole. Then on Friday when the anticipated QE3 announcement was not forthcoming, the market rallied an additional 1.5%. A fascinating development to be sure.

    Bernanke is an excellent puppet master. Of this there can be no doubt. By simply stating the September meeting will be two days rather than one, he maintains hope that somehow he will soon pull salvation from where the sun doesn’t shine. In this goldfish market, I’m curious to see how long he can pull this off. Perhaps he should simply postpone his decision one month every time he opens his mouth, without actually doing anything.

  8. ToNYC says:

    After trying everything that doesn’t work, the richest contiguous land mass inhabited by a people with a living document for independent people, will do the right thing.
    Professor William K. Black’s tested method using the FDIC for a sane banking system is still ready when people get tired of tasting what the king of depression scholar Bernank’s allowing the gangrene of the Dual-Mandate of Full Employment to drive haircuts away from his private corporation member banks using Federal as if we were all GEICOs.
    Anachronisms ruin the movie, and suspension of disbelief is an art that has lasts until it doesn’t.

  9. zell says:

    The question is whether muddle through policies will be able to overcome the alienation of citizenry here and in Europe which no longer identifies with the ” greater good.” There is a deep resentment at the muddle throughers and a oppositional feeling that the crooks were never punished, the remediation hasn’t worked, and it’s time to let it rip. The Arab spring seems a precursor to the Western winter.

  10. MayorQuimby says:

    ilsm- Re: “bubble machines”…Nicely stated. I’m going to borrow that one.

  11. dead hobo says:

    Satyajit Das has massive street cred with the professional experience to back it up. He doesn’t waste your time and he isn’t selling anything. I’ve been a big fan since reading Traders, Guns and Money and my only complaint is that he does not write more.

    Most others, excluding Invictus and probably 1 or 2 others who guest post here may be Wall Street luminaries, but all they write are ponderous opinion pieces. I’m rarely able to finish one since each could easily be condensed down to a few concise paragraphs of financial opinion, however that would look far less impressive. Most I never read past the first paragraphs since their opinions, ultimately, would have the same predictive quality as a barking dog with an english translator if I could find something that translates dog bark to english.

    But Satyajit Das is the real deal and a world resource. I plan to invest accordingly.

  12. ilsm says:

    MayorQuimby,

    Thank you.

  13. carleric says:

    Great and intelligent commentary….more Das…less Krugman speak alikes. Cut Greece loss…their culture nad governmental ineptitude precludes any fix, implement the Swedish solution here at home and lets just move on. Oh and cancel Bernanke’s credit cards.

  14. Winston Munn says:

    Ideology Default Swap, anyone?

  15. atandon says:

    I am not sure but does following concept exist in this real world? :-)

    Concept : “Sovereign as collateral”

    Countries that are not able to pay up their debts (Greece for example) should offer senate/parliament seats to the lending country representatives as collateral. This way lending countries can have say in governance, business and politics internals and may steer to stabilize the country. However, once the country is stable and is able to pay up, reps should leave immediately and let son of the soils to manage themselves.

    This may help with long term globalization as well where world is steered towards a common governance model where world leaders are joined in a common senate and people of the world have developed tolerance to accept “right” leadership from people from other regions as well.

  16. dead hobo says:

    atandon Says:
    August 28th, 2011 at 11:31 am

    I am not sure but does following concept exist in this real world? :-)

    Concept : “Sovereign as collateral”

    reply:
    ———-
    You might have something here. If you eat at a restaurant and forget your wallet, some let you work it off in the kitchen. Perhaps Greece could offer to indenture some of the Greek populace to go to other countries and work off debt they enjoyed the benefits of but now don’t want to pay for. Who wouldn’t want to import a hard working Greek indentured servant? I can think of hundreds of uses. This could only be an economic stimulant. I see a win-win here.

  17. “…Satyajit Das is the real deal…”

    x2
    ~~~~~

    I think it’s *funny, that his first Book was published in ’006, yet, when the first, “House of Cards” blew over..”No One saw it coming../Woocoodanode?” was resounding down, near, every Lane..
    ~~~~~

    People, now that it’s, seemingly, ‘safe’ to talk about ‘going Swedish’ (with the Banks), need to start understanding the “Icelandic-model” ….

  18. Patrick Neid says:

    The historical narrative continues to rule despite the best efforts of mice and men. Pick your champion, no matter who, had they been in charge with a blank canvas and untold powers we would still be where we are today. Humpty Dumpty…

  19. DrungoHazewood says:

    I’ve been reading Das since 07. One of the best, and he flies under the radar. The bearishness is getting pretty heavy, and its coming from people with excellent track records.

  20. atandon says:

    reply @ dead hobo :

    Countries of good servants will rarely go in so bad state as Greece. What they really need is good leadership that can motivate them and teach them to serve their own country well. They should seriously consider adopting barter system internally (instead of borrowing more money from outside) :) until their economy stabilizes and they are able to produce something really valuable that they can export to other countries to come out of their debt.

  21. paloo says:

    At Jackson Hold this week, IMF’s Lagarde states:

    “In the US, she called for new action on housing, such as writing off more of the principal on mortgages, intervention by government housing finance agencies such as Fannie Mae and Freddie Mac, or steps to help homeowners refinance their mortgages at lower rates.”

    http://www.ft.com/cms/s/0/9f857244-d0d0-11e0-8891-00144feab49a.html#ixzz1WLStZK00

    Also some crazy bank recapitalization stuff which won’t fly politically here, but otherwise is this part of a recognition at official levels that part of the challenge is that the American Consumer is TBTF?

    Hey, this is an election year. Watch for this as a central part of Obama’s re-election strategy – based on a tardy realization that banks don’t vote.

  22. mathman says:

    More of the same info here:

    http://triplecrisis.com/how-to-turn-a-continent-into-a-subprime-cdo/

    Hope everyone came away from Irene with bearable to little damage/power outages.
    It’s finally breakin’ up here in PA – good stiff breeze yet with amazing gusts now and then.
    Lotta pickin’ up to do in back yard. Wife says “get on it.” See yas later.

  23. kbuytaert says:

    Please note that under strong EU pressure, Finland agreed to no no longer ask an underlaying guarantee for the Risk it takes when borrowing to Greece:
    http://www.presseurop.eu/en/content/article/888681-poor-accounting-helsinki
    Finlands’ international political influence is now damaged. A lesson for all other country’s.
    Nevertheless I can imagine that the risk for a Credit Crunch 2.0 remains present.

  24. wally says:

    “If market seize up again, then “this time it will be different“. There might just not be enough money to bail out everyone and every country that may need rescuing.”

    OK, fine. Since money and debt are flip sides of a coin, all this statement translates to is: somebody won’t get paid. Since that is exactly the thing that many persons insist should have happened long ago, I guess we’ll see better days ahead.

  25. endorendil says:

    On point #2. You mention that the potentially toxic assets total more than 2 trillion USD. That is comparable to the amount of toxic assets that set of Credit Crunch 1.0 (the subprime mortgages), but is tiny compared to the assets that made 1.0 such a globally pervasive and hard to disentangle mess: the CDS/MBS that spread the losses in unpredictable ways. Is there a similar multiplier at this point, i.e. are there correspondingly vast financial instruments that slice and dice and hedge the government debts of these countries? If there isn’t, the cleanup should be much easier, no?

  26. Darkness says:

    >As John Maynard Keynes remarked: “The expected never happens; it is the unexpected always.”

    Keynes admits he was always wrong?