Mortgage Crisis to Corporate Debt Crisis:
The financial system fell under intense stress Wednesday. Theepicenter of the crisis was in the “Credit default swap,” or CDSmarket, and “contagion” fears were building quite a head of steam. Thepricing for Countrywide Financial default protection (5-yr CDS) surgeda huge 469 basis points to a record 1,610 bps (it would cost $16,100annually to insure $100,000 of Countrywide debt against default). Forperspective, Countrywide default protection was priced at a mere 30 bpsone year ago and didn’t even trade above 600 during the subprime crisisthis past summer and autumn. Rescap CDS surged an astounding 1,360 bps Wednesday to 3,746. This was up from the year earlier 95 bps. MBIA CDS increased 85bps to 849 (year ago 87) and Ambac 89 bps to 841 (year ago 70bps). Washington Mutual CDS increased 61 bps to 611 (year ago 54bps). Many indices of corporate debt spreads rose to their widest levels in years.
In the old Greenspan days, Wednesday’s circumstance would have most-likely beckoned a “surprise” inter-meeting Fed rate cut. There were rumors for as much. And while chairman Bernanke did not ease rates, Thursday morning he provided the markets the next best thing: “Westand ready to take substantive additional action as needed to supportgrowth and to provide adequate insurance against downside risks.”
Bernanke didn’t plan on rambling down the Greenspan path. Actually,I believe he and other members of the FOMC would have preferred toavoid it – resist responding directly to Wall Street pleas foraggressive Federal Reserve accommodation. “Let the chips fall…”, as they say. But the Fed now knows what many on Wall Street have understood since this summer: TheU.S. Credit system is extraordinarily fragile and the Fed simply willnot risk sitting back and watching an implosion without resorting toextreme measures. If nothing else, inter-meeting “surprise” rates cuts are back on the table. Wall Street must be quite relieved to know this mechanism is available in the event market selling pressure turns unwieldy.
This week brought back memories of the 2002 Debt Crisis. Weigheddown by the telecom debt collapse, Enron, and other frauds,intensifying Corporate Debt problems late in the year were at risk ofsmothering the consumer sector. The nexus at the time was the auto finance subsidiaries and Household International. Consumerfinance Corporate Debt spreads were widening significantly, andHousehold, in particular, was facing a liquidity crisis in earlyNovember. The failure of a major financial institution at that juncture would have created a major systemic issue.
Well, on November 14 HSBC agreed to buy (bailout) Household International. A week later, FOMC governor Bernanke gave his now (in)famous “Deflation: Making sure ‘it’ doesn't happen here” speech. Withrates at 1.0% (until June 2004!), the Fed was now publicly discussing“electronic printing presses,” “helicopters” and other “unconventionalmeasures.” Wall Street was trumpeting “deflation” risk. Sureenough, the crisis was soon resolved and Wall Street was emboldened toperpetuate history’s greatest Credit inflation and Mortgage fiasco.
The tables have been turned these days, with the Mortgage Crisis now evolving into a full-fledged Corporate Debt Crisis. Thekey nexus this time around has been Wall Street “structured finance,”especially as it relates to the major Mortgage lenders (certainlyincluding Countrywide, Rescap/GMAC, and Washington Mutual) and the“financial guarantors (in particular, MBIA and Ambac). Theunfolding Mortgage implosion has destroyed the value of innumerable“structured products;” has annihilated legions of mortgage companies;has impaired scores of major lenders; and this week was in the processof taking down a few huge mortgage companies. Institutionswith huge liabilities to the “money,” “repo,” securitization, andderivative markets – not to mention huge borrowings from the FHLB -were in serious jeopardy. The risk of a domino implosionin the Credit default market and the “financial guarantor” industry hadbecome a very real possibility. System Risk Intermediation was in peril.
TheFed responded with what the market has interpreted as a promise ofaggressive rate cuts, while Bank of America has apparently for nowresolved the Countrywide debt issue. Citigroup’s stock rallied on rumors of a major new investment from Prince Alwaleed and others. Washington Mutual’s stock price rallied sharply on rumors of merger talks with JPMorgan. Countrywide’sstock surged as CDS prices collapsed, a dynamic sure to have causedconsiderable grief to those shorting the stock to hedge against defaultprotection written.
Curiously, the general market took little comfort from developments. Acase can be made that the rally in CDS and financial stocks wasdestabilizing for much of the leveraged speculating community(including “market neutral” and “quants”) keen to short financialstocks against (now sinking) technology shares. Overall, the market was hammered, while MBIA and Ambac CDS prices barely budged from record levels. Anindex of Junk bond spreads to Treasuries actually widened an additional4 basis points today to 603 bps, this week above 600 for the first timesince – not coincidently - the 2002 Debt Crisis.
Butthe general environment is nothing like 2002, and I don’t expect Fedwords and actions – in concert with financial bailouts - to havesimilar effects. For one, household mortgage debt expanded 13% in 2002, proving powerful financial and economic stimulus. With consumer Credit relatively stable, 2002’s Corporate Debt Crisis was not a serious systemic issue. Moreover,“Wall Street finance” was in an aggressive expansionary mode and theglobal banking community was developing quite a hankering toparticipate in the U.S. Credit Bubble. The economy was emerging from a shallow recession.
The world is a much different place today. TheMortgage Finance Bubble is a bust, Wall Street finance is imploding,and foreign financial institutions are keen to cut and run from thebusiness of providing U.S. Credit. Countrywide’s mortgage problems will be absorbed – along with so many other risks – by our domestic banking system. Worse yet, the economy is quickly succumbing to recessionary forces. Witha high degree of confidence we can proclaim that the Mortgage Crisishas now evolved into a Corporate Debt Crisis – and this crisis will notbe resolved anytime soon – by rates, by helicopters, or by bailouts.
Unlike 2002, today’s Credit crisis is systemic. Consumerand financial sector fragilities – the heart of our Credit system - arenow impaired to the point of imperiling the capacity of the Creditsystem to finance business spending and intermediate corporate lendingrisk. To be sure, prospects for a faltering U.S. consumersector, massive financial sector Credit losses, and an imminenteconomic downturn have quite negative ramifications for businesslending and valuations. In particular, unfoldingdislocation in the CDS and Credit “insurance” markets will severelyrestrict Credit Availability for small, medium and large firms –especially those less than top-tier borrowers.
I’llgo further and suggest that a severe tightening of Financial Conditionshas abruptly made many business borrowing plans unviable; many abalance sheet and debt load untenable; and vast numbers of businessstrategies - crafted in altogether different financial and economictimes - much less viable. Some companies will make the necessary adjustments and many will not. The unfolding backdrop definitely makes a lot of stock buyback plans imprudent and growth strategies highly risky. Theaggressive risk-taking business manager – having previously capitalizedon the protracted boom - will now be at a similar handicap to thatwhich afflicted the zealous home buyer and lender banker.
Forthose searching for explanations behind the stock market’s dismal startto the New Year, I suggest contemplating the many serious ramificationsof the Mortgage Crisis having now evolved into an Incurable CorporateDebt Crisis. This week, the Bursting Credit Bubblepassed another significant inflection point – one perhaps subtle butwith major economic consequences.
