Saturday, April 12, 2008

Best Current Explanation of Credit Crunch

Reprinted in its entirety. Click title to go to source.

Payback Time
By Eric J. Fry

Never in the history of the vibrant US economy have so many owed so much in so many different ways. So now that credit is fleeing from the U.S. economy like finance CEOs from responsibility, the economy is certain to struggle. Slumping home values won't help.

Get ready for the "Era of De-Leveraging."

The U.S. economy is leveraged...too leveraged, which is not a good thing to be when credit becomes scarce. Without fresh access to borrowed capital, a leveraged entity will struggle to survive...and often perish. (Bear Stearns illustrates the point).

Leverage is a bipolar financial creature. During boom times, it provides delicious pleasures. But when economic activity contracts, leverage breaks out a whip and doles out misery. Here in the 50 States of America, the whip-cracking/misery stage has arrived...and the U.S. economy is ill-prepared for the abuse. The US economy, led by its imprudent financial sector, is over-leveraged...painfully over-leveraged.

Even using generous assumptions about the value of assets on bank balance sheets, the leaders of the US financial sector owe $40 for every dollar of assets they own. And let's not forget WHAT they own: bad loans, impaired derivatives, and a "Love Canal" of complex financial assets that carry mark-to-imagination pricing. And let's not forget either that even after all the Fed's regulation-bending bailouts and desperate rate cuts and backroom M&A deals, the US financial sector is still carrying about twice the leverage it carried three years ago and about triple the leverage it carried one decade ago.

So what's the point? Just this: All bubbles deflate... and America's credit bubble will be no different.

The "Era of Excess Leverage" perished sometime last summer; the Era of De-leveraging has arrived. This new era will be much less fun than its predecessor. During the last five years, American finance companies and individuals embarked on a frenzied borrowing binge. They levered-up big time. The banks and brokerage companies leveraged themselves to better fulfill their corporate mandate: maximizing returns to management. And individuals leveraged themselves to add square footage, leased SUVs and Himalayan yoga retreats to the standard-issue American dream.

That was lots of fun.

But now, home prices are falling, which means that the prices of the mortgage-backed exotica littering bank balance sheets are also falling. Therefore, leveraged banks and individuals must now de-lever, which will be no fun at all.

As America de-levers, the American economy will certainly stumble. Banks will sell whatever they can sell – including parts of themselves – to raise cash. Individuals will sell whatever they can sell – including the roofs over their heads – to raise cash. The weakest members of both contingents will go bankrupt, which will further depress prices of the assets that the leveraged survivors will still be trying to sell.

Best case, dear investor, asset values will continue grinding lower. More likely, asset values will drop rapidly, as credit drains from the economy. This process of credit contraction is almost certain to hobble economic growth and to imperil the survival of every leveraged financial institution and individual.

Contracting credit annihilated Bear Stearns in less than one week. Contracting credit will invite similar hardships upon the entire US economy, notwithstanding the Federal Reserve's desperate maneuvers to prevent them. No doubt, the Fed will continue combating the credit contraction with an endless barrage of rate cuts, bailouts and "temporary" loans. But immediate victory seems improbable. The forces of deleveraging are simply too large and too powerful...and these forces have already gathered considerable momentum.

Therefore, in the new era that has just begun, many investments will struggle. But do not despair; the Federal Reserve has wrapped a bow around the commodity sector. Ben Bernanke's gift to investors will be an unimaginably robust and durable commodity rally. Yes, there will be large, severe selloffs in this sector, but the Fed's frenetic efforts to "save the markets" have set in motion an inflationary storm surge that seems likely to drown the US dollar, while whisking commodity prices to much higher ground.

Oil is the new dollar. By extension, so is wheat...and cocoa...and aluminum. "I have the growing sense that paper money - any paper money - isn't a good store of value," observes Dan Denning, editor of the Australian Daily Reckoning. "I think investors are realizing that they can't move their wealth from one currency to another and preserve they are doing the next best paper wealth for claims on tangible assets."

Meanwhile, demand for commodities continues to swamp supply. So the commodity sector looks like a pretty friendly place for investors, despite the ever-present risk of severe selloffs. But the investor who tries to avoid these short-term selloffs could easily miss a very long-term bull market. In other words, today's commodity markets might resemble the S&P 500 of August 1987, but probably not the S&P of March 2000.

I don't "know" anything, of course. I'm just guessing that commodities are still a "buy." Therefore, my historical frame of reference for today's commodity market is not the S&P 500 of 1987 or of 2000; it is the S&P of 1994.

In February 1994, the S&P 500 had more than doubled off of its 1987 lows and seemed very richly priced at about 25 times earnings, especially considering the fact that Greenspan had just initiated a new tightening cycle. Over the next 12 months, the Fed Funds rate DOUBLED from 3% to 6%.

So what happened next?

The stock market sold off just like it was "supposed to"...for about 9 months. The S&P slumped about 10%. But then the market spent the next six years skyrocketing. From its 1994 peak to its 2000 peak, the S&P would TRIPLE. The Nasdaq would soar 7-fold over the same timeframe.

In other words, I think it's too early to be a seller of commodities. Sell the financials and buy commodities...once more with feeling.

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