Long term outlook

The Singular Problem With Credit

Posted by Karl Denninger in Musings

I keep getting "pushback" from people in the mortgage industry and elsewhere, especially related to my Youtube Videos, with all sorts of claims that "we can't go after all the fraud in the mortgage business - get over it", along with similar missives.

Folks, you need to understand something very clearly, because Bernnake and the rest of the policymakers have laid out the truth for you - if you care to listen.

Fully 2/3rds of credit provided in our economic system is non-bank lending.

That is, it is hedge funds, sovereign wealth funds, pension funds, insurance companies and both foreign and domestic private investors who have extra capital they do not need at the moment, and they are willing to lend that money into the economy.

These are the buyers of securitized debt instruments.

This market is closed.

Both ASF (American Securitization Forum) and Federal Reserve statistics say that there has been essentially no securitized debt issuance over the last six months.

None.

That market is closed because this class of investors was gang raped by the pernicious and outrageous fraud up and down the line within the market.

Arguing over whether the banks are responsible for not verifying information provided (they are), automated approvals are responsible (they are), ratings agencies are responsible for being essentially purchased rubber stamps (they are) or borrowers who fraudulently overstated income and understated debt (they are) misses the point.

The point is that all of these factors are in fact elements of fraud.

All of these are willful and knowing misrepresentation - either by omission or commission - of the risks and true credit profile of the collateral, borrower's character and capacity, market assumptions used in modeling or all of the above.

The fact of the matter is that this 2/3rds of the credit provided to our market has left and is not coming back until the misrepresentation ends and they can be assured that it will not happen again.

That is, these people are demanding their pound of flesh using the most powerful weapon they have - their checkbook.

As just one of many examples:

Feb. 20 (Bloomberg) -- Asian investors won’t buy debt and mortgage-backed securities from Fannie Mae and Freddie Mac until they carry explicit U.S. guarantees, similar to those given on bonds issued by Bank of America Corp. or Citigroup Inc.

And why should they?

These investors got boned. Repeatedly. In the non-agency market they didn't just get boned they got gang-raped, with losses in some cases on CDOs and similar being 100%.

These events are not supposed to happen, according to risk modeling. And if the risk model actually had put into it the quality of underwriting (none), the verification of income and assets (none), a realistic model of credit growth and asset prices (ha!) and similar, it wouldn't have - because there would have been no competitive market for those securities at the prices asked.

The argument that this was all "the bank's fault" is simply not true. The blame is spread across the curve - the fact that your local bank has no guard does not give license to someone that desires to come in and rob it; in that case we penalize the bank but we still lock up the bank robber.

But all of this belies the underlying problem: in the attempt to divert attention from one group or another - and all of the guilty parties are engaged in it at this point, including Congress and our other regulatory agencies such as The Fed - we are forgetting that the private capital is still gone and until we find a way to guarantee that another assault will not happen that capital will not return.

As I listen to Bernanke's testimony in front of both the House and Senate, and as I watched President Obama's speech last night, I remain stunned by the lack of recognition of the above facts.

While lawmakers and policymakers such as Bernanke continue to blame "understaffing" (code in DC for "we want more money") and the lack of fully-formed plans, the fact remains that unless private capital can be convinced to return, and soon, we are headed for an economic depression worse than the 1930s.

This is not some manner of conjecture or fear-mongering - it is a fact that there is absolutely no way we can maintain our standard of living or economic output at anywhere near former levels with 2/3rds of credit capacity gone, nor can we replace that 2/3rds of the former capacity via other means.

To put this in perspective we are talking about a $50 trillion (roughly) credit universe for the United States; 2/3rds of that is ~$30 trillion dollars. It is simply not possible for the government or Fed to replace this, which is why even with a commitment of $9 trillion as has been made thus far the economy is not responding; 2/3rds of what disappeared is still gone and yet trying to actually fund $9 trillion through T-bond sales would cause an immediate implosion in the Treasury market.

We therefore have two choices, and if we do not pick #1 we will get #2:

Stop "the bezzle" - right here and now - punishing the fraudsters across the board and clamping down on all manner of fraud in the future with enforcement of the law both looking back and forward being the primary driver of policy.
Accept that we will have an economic Depression worse than the 1930s, as the continued absence of private credit provision will guarantee a contraction in GDP of at least 30%. This will result in the bankruptcy of about 20% of the S&P 500, 25-30% unemployment, half of all private businesses in the United States going under and general economic malaise at least equivalent to the 1930s and quite possibly far worse.
Those are the only choices ladies and gentlemen. All the handwaving in the world will not convince private capital to come back and you cannot force that private capital to return.

We can only convince private capital to return by guaranteeing that the rule of law will be upheld, that those who screwed them this time will be punished in accordance with the law and that anyone who attempts to screw them in the future will be immediately dealt with under the same provisions.

Those are the choices folks, and if we do not accept this and adopt it as policy within a very short period of time the economic contraction will continue and, once it reaches a critical point, the collapse in the equity and credit markets will accelerate and be impossible to stop until liquidation has run its course.

We are very close to reaching that tipping point and the reaction today in the markets, after being filled with "hope" yesterday, is a direct consequence of the administration's failure to follow through with concrete steps to restore trust, transparency, and the rule of law.

Until and unless you hear that message come out of Washington DC your wisest course of action is to be prepared for economic conditions at least as bad as those during the 1930s, because unless policy changes that is exactly what we are going to get.

The math is never wrong.