October 2007

I am deeply confused by today GDP numbers. I was expecting that the masters of the universe will prepare GDP report to be a good excuse for today rate cut (or a good tool to pressure for a cut, because Feds do not participate in statistical exercises).

Why did they put the chain deflator at 0.8%??? To say that inflation is over and we can safely cut? But the games with decreasing chain deflator made GDP growth at 3.9% rate, definitely not a good number for a cut. It will be revised down and inflation revised up, later on.

The only possible answer I see is that the numbers were not cooked and we do have a chain deflator at 0.8%. If you look at the chart it’s scary (today number is not plotted yet):

The last time the chain deflator was at 1% it was in 1998 (green line), it never happened even during the deflationary scare of the last recession. We just fell off the cliff straight to the off-the-chart record, below LTCM and Asian Currency crisis deflation scare. The last time the chain deflator was below 1% it was in 1954, we’ve just made a 53-year record.

That means all the pricing power is quickly evaporating and while there is a lot of production in the pipeline the final consumption has to be showed in by the lower prices.

We got a flat tire while driving in the left line on the highway, at full speed. I think Feds must cut today but it won’t help


Look at one of the junk bond indices:

junk october

It is forming some kind of triangle with a decision point set to tomorrow. Sometimes I wonder how beautiful the chart dances are. The chart is just pointing into Fed decision day and then we’ll see a breakout either up or down and this move will be significant. I recommend watching junk bonds tomorrow – HYG, AFBIX, SHIAX. Whatever they do stocks will follow later.

It is pretty much given that Feds will cut 25bp tomorrow. The action in oil was orchestrated to give Feds the excuse to cut without being accused to disregard the high earl prices. But even as we know what will happen it is absolutely impossible to predict what the market will do. The only thing I know is that tomorrow the smart money team will make a good damage to stupid money.

As I think the smart money are very well aware of what is happening with various SIVs in the lite of recent action in ABX and asset-based commercial papers they will probably play bear. If not then I’m likely to lose some money as I’m a bear

If it will never happen again then October 26 and 29 of 2007 will be recorded in history books like the Biggest Bloody Butchery (BBB) of collaterized debt obligations.

In two days, the AAA-rated credit default swaps protecting the papers linked to non-agency mortgage tranches declined by about 10%. This usually means that corresponding paper loss across the board was roughly the same.

The total outstanding amount of those CDOs is about 1.5-1.6 trillion, where the AAA slice is about 80%, or 1.2 trillion dollars.

The wipe-out of 10% is probably translating into $100-$120 billion in just two days, and papers with that rating are usually sitting in highly leveraged SIVs and various “low-risk” funds. This is not the same as the stock market losses of $100 billion, which happens pretty often. The stock losses are usually spread over millions of accounts where everyone lost few bucks. The CDO losses will hit just couple of involved institutions, few $billions each.

Like I’ve said before, there is a lot of dead fish deep in the waters, just give it a week before everybody will feel that smell…

Today we had a first grade panic in credit default swaps ABX-HE-AAA 07-2, ABX-HE-AAA 07-1 and second grade panic in CMBX-NA-AAA 3.

In the past two occasions that kind of panic was a very reliable indicator that the chain reaction will happen. The next thing to happen before the stock market starts moving down is the decline of junk bonds. For the next 2-3 weeks I see only 3 possible outcomes:

  1. Major market crash
  2. Feds will cut 50bps
  3. All of the above

As I don’t see any hint so far that Feds may cut 50bp I would put the probability of the outcome #1 at over 50%

Update: I don’t know how important it is but back Thursday someone charged someone else 15% for overnight Fed Funds loan. The comments from “Calculated Risk” discussion:

The 15% for the Fed funds rate as the “high” shows that some member institution has to pay 15% due to the poor quality of assets that they are using for the FED Repo (TOMO operations).

O yeah, while I’m at it, I don’t think the 15% was in a Fed Repo operation ( http://www.newyorkfed.org/market…?SHOWMORE=TRUE)

The FFR is “the federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight”. The TOMO is done to influence these operations in the aggregate. So the 15% we saw was some institution charging some OTHER institution for overnight lending against its crappy assets. Wouldn’t I love to know who it was.

For 10 months already I am posting articles about credit crunch. Back then pretty much nobody was using the credit crunch words, now they are everywhere. My very first post about credit crunch is titled “The recession call“. I wrote it back in January and gave my expected timeline of events, from January to October with expected recession starting around October. While my timeline was only partially correct it seems to me that it was better than any prediction that you’ve heard on TV back then. Well, it’s never late to praise myself 🙂

Now it’s probably time to ask what’s next, because my prediction is ending this month, the future finally came.

I think the very last step that is left before everything falls apart is called “pull the plug”. What’s that?

At this point many lenders and borrowers are suffering losses and there is a lot of talks that this or that company is a good candidate for bankruptcy. So far lenders are not only extending the credit but are also expanding it. Look at this. The outstanding banking credit is exploding from 8 trillion a year ago to 9 trillion now, with $350 billion of new loans since July. The banking credit is replacing the commercial paper market and bond market. Of course the interest on banking loans is pretty high. I would say there is still a lot of trust in the system when banks are lending more and more even in the face of the evolving problems.

There is a great deal of what is called a “moral hazard”, or a believe that any major bank or corporation will be bailed out by taxpayer’s money. They are too big to fail. Maybe. But Bernspan can’t save anyone, he will have to chose.

I imagine the current situation as a standoff between a group of cowboys with arms ready waiting who will pull the plug first. At some point someone will deny a credit to someone, and someone will default on the credit, sending a big wave through the credit market. We already had so many bail-outs recently that at some point the bail-out limit will be exceeded.

I’m not ready to put a timeline on this yet. It can happen any moment, even this week. Or maybe next year. But it will happen and it will be a good firework. Have your popcorn ready.

The question that was asked at least twice:

“How often do you speak with regulators? What regulators say?”

“We think this is not an appropriate question. We do not speak with regulators. We don’t have any questions to discuss with regulators”

Ok, understood.

Just checking what’s going on before I’m going to sleep: Nikkei is down 3%+, China down 1.6%, $/Yen 113.8. Oh-oh, not a nice way to start the week. It’s probably not the “Universal Margin Call” I’ve mentioned half a year ago but it is very close. That time (back in March) it did not happen.

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