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Generational Dynamics Web Log for 16-Oct-2008
Market selloff resumes savagely, as markets collapse around the world

Web Log - October, 2008

Market selloff resumes savagely, as markets collapse around the world

Commentary on Wednesday has been the most negative I've ever heard, although it's framed in terms of a "severe recession." Still, I believe I've heard the words "1929" and "depression" more often on Wednesday than I ever have (since I was in school in the 1950s).

Market summary, 15-Oct-2008
Market summary, 15-Oct-2008

Wall Street indexes fell sharply at the open, and continued to fall throughout the day. Markets in Asia and Europe also fell sharply, and as I write this on Wednesday evening ET, Tokyo's Nikkei index has fallen another 11% in the last two hours.

The market seems to be reacting to the drunken orgy on Monday, where the market went up 11%, following the incredible worldwide fantasy bailout over the weekend. Now, the market seems to have resumed its path for the preceding three weeks, where the market fell 25%.

A major problem is that interest rates are not falling fast enough. This was apparent yesterday from the quote from Rick Santelli that I posted yesterday.

On Tuesday afternoon, after the Fed auction, CNBC reporter Rick Santelli reported that interest rates causing the credit crisis were not easing, despite Monday's fantasy bailout announcement. He made the point that interest rates for GSE bonds (bonds offered by Freddie Mac and Fannie Mae) continue to be much higher than interest rates for US government Treasury bills. Here are his words:

"Some of us are disappointed in the thaw, and I'll tell you why. If the government is basically underwriting the GSE's, and they've ramped up all of their coverage, like FDIC, tell me why it is that the 3 and 6 month bill for the auction today garnered a yield of .5 and 1.10 respectively?

Yet, when Freddie went to the market with 3 and 6 month bills, their 3 month bill was at 1.95, and their 6 month was at 2.70.

This is living proof that, for whatever reason, we're not seeing this money that's been thrown into the banking system do exactly what it is we want it to do. And somebody at Treasury or Fed, or the banking regulators, have to go pound some heads, because the T-bill rate should be coming up, and the GSE rate should be coming down, and it's NOT HAPPENING."

On Wednesday, the credit crisis still showed little or no sign of easing. The news services tried to put the best face on it. Here's a a news story from Wednesday morning:

"Libor for Dollars Drops as Central Banks Offer Unlimited Cash

By Gavin Finch and Nate Hosoda

Oct. 15 (Bloomberg) -- Dollar money-market rates fell after the European Central Bank, Bank of England and Swiss National Bank offered lenders unlimited U.S. currency for the first time in a coordinated effort to unlock credit markets.

The London interbank offered rate, or Libor, that banks charge each other for three-month dollar loans dropped for a third day, its longest sequence of declines in seven weeks, according to the British Bankers' Association. It slid 9 basis points to 4.55 percent today. The comparable euro rate declined to 5.18 percent. Asian rates also decreased."

That sounds pretty good, until you read several paragraphs later:

"While the cost of three-month dollar loans has dropped in the wake of the measures, it's still 305 basis points more than the Fed's target rate. The difference was a record 332 basis points on Oct. 10. It was 82 basis points on Sept. 15, the day Lehman Brothers Holdings Inc. filed for bankruptcy and 11 basis points on July 31, 2007, just before the start of the credit squeeze."

And so, if you look at interest rate spreads in the past year (where 100 basis points equals 1%):

    Date                   Basis points
    ---------------------  ------------
    July 31, 2007           11
    Sept 15, 2008           82
    Oct 10                 332
    Oct 15                 305

In other words, the Libor spread has fallen a tiny amount, compared to where it was even just a month ago.

This is just one major cause of the huge pessimism among investors that was evident on Wednesday.

This was buttressed by a slew of disastrous data: The U.S. retail sales report revealed big September sales declines, and the U.S. Empire State manufacturing index plunged the greatest amount in its history.

This afternoon, Ben Bernanke gave a speech, in which he attempted to defend Fed policy, adding that the recession is going to last a long time.

The market fell sharply after that speech. Well-known financier Mort Zuckerman commented on Bloomberg television after the speech. Zuckerman is normally a pretty upbeat guy, but on Wednesday afternoon, he was bitter and angry:

Mort Zuckerman <font face=Arial size=-2>(Source: Bloomberg)</font>
Mort Zuckerman (Source: Bloomberg)

"I think that the economy is not only bad now, but it's going to get worse. The fact is the credit crunch is not over, and it's not going to be over.

What they just did for the banks is to make sure that no major financial institution is going to fall down a trap door and disappear in 72 hours, but it is not going to dramatically change the credit crunch.

And so we're in for a very, very weak period in the economy, and who knows how far that will go? Nobody knows, because there are unknown factors in our economy that we've never had to deal with before, one of them being plummeting house prices, which has a good ways to go. They're off about 20% and may go down another 15%.

And another is these toxic securities and credit default swaps, and nobody knows how bad they're going to be."

This is a real statement of despair, but it's realistic. I've been commenting on the issue of real estate prices and mortgage-backed securities (CDOs) for a long time, and I've mocked and ridiculed analysts on CNBC, in WSJ and elsewhere, who said that the real estate crash was near the bottom, or that the mortgage-backed securities was a small, "contained" problem.

My thoughts go back to a year ago, when pundits were talking about a "kitchen sink" quarter. This meant that corporations would take as many writedowns as possible in the third quarter, so that they'd be completely rid of them.

We heard the same thing every quarter since then. Even those who thought that the problem would go on for a while longer were absolutely certain that it would be over by now, near the end of 2008.

But you could hear the bitterness in Zuckerman's voice when he said that falling home prices, toxic securities, and failing credit default swaps will go on for an indefinite time. He expressed no hope whatsoever.

He was asked, "Ben Bernanke, who's studied the Great Depression, says that it won't happen again. Do you agree?"

"Well, we won't have a similar kind of depression. We won't have the Treasury and the Federal Reserve not providing the liquidity to the financial system. We won't have a balanced budget - we're gonna have a huge deficit. We won't have trade dropping because of Smoot Hawley and similar things like that.

But we have different things that may be just as serious. For example, we their $52 trillion in credit default swaps out there -- nobody knows how good they are.

When they came [to rescue] AIG, AIG thought they needed $40 billion to get out of the hole. The government said $85 billion. They're already up to $121 billion. So who knows how bad it would be?"

The AIG bailout is less than a month old, and it appears to be spiraling out of control.

However, his answer is inconsistent. He says that the Fed will continue providing liquidity, but he's already shown that the Fed can't possibly provide enough liquidity to matter. The new Depression will be much worse than the last one.

(For a description of the AIG bailout, see "The Fed will loan American International Group (AIG) an $85 billion bridge loan." For a discussion of credit default swap (CDS) counterparty risk, see "Brilliant Nobel Prize winners in Economics blame credit bubble on 'the news.'")

"With Lehman Brothers, which was THE fundamental mistake the Fed's made -- they now are apparently exposing the financial world to $360 billion of losses on credit default swaps that were guaranteeing Lehman papers.

So I don't know where this ends. Nobody knows where it ends."

This is another fundamental mistake. He talks as if the crisis BEGAN only five weeks ago when Lehman Brothers collapsed, and he implies that if only that one mistake hadn't been made, then we'd all be OK today. This is wishful thinking.

These are dark days, and they're going to get darker very soon.

(Comments: For reader comments, as well as more frequent updates on this subject, see the Financial Topics thread of the Generational Dynamics forum. Read the entire thread for discussions on how to protect your money.) (16-Oct-2008) Permanent Link
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