Two primary factors that we had introduced to our Significant Event watch list earlier this year -- "Liquidity Watch" and a "Credit Event Watch" -- have been triggered. As such, the salient question of the day is "What next? We identify four possible scenarios -- Minsky, Mini, Minor and More. (The first is named after Dr. Hyman Minsky, the famed theorist of the three credit modes ... the last being Ponzi-finance, the most unstable.) We hazard to estimate the probabilities. Currently, from all indications, a Mini -- a Mini Minsky, really -- has begun. Will it get worse?
But first, a brief retrospective. We venture to conclude that most market participants do not fully understand the full import of the dynamics and mechanisms at play presently. After all, there has been a tremendous and rapid evolution in financial structures in recent years, both domestically and around the world. As we will describe, the banking system has become the small cousin to a gigantic array of nonbank, credit-generating institutions. Given this extremely rapid growth, the stability of these systems have yet to be fully tested. And, unlike banks, these sectors operate outside of the reserve system. As such, central banks are really not well equipped to fix liquidity (much less solvency) problems in the non-bank financial world. That's exactly where the major crises are hitting.
The scale of these changes in financial structures, at least partly, are certainly indicated by the boom in the positional value of financialized vehicles (mostly in the form of securities) relative to economic activity. The graph on this page provides a sense of the scale of this shift in recent years. As already said: It is unprecedented; its underlying structures untested through any significant financial storm. This will make things more top-heavy than seems to be widely assumed.
Why Stock Market Trends Are Misleading at Present. Financial tremors experienced recently did not include a crash in the stock market (though certainly generating the highest volatility in years), nor an upside-explosion in the longer-term bond market nor a bust in broader commodity markets. There surely were large movements in all of these market areas.
The main specter was elsewhere: It was a crash in "credit" ... the most insidious of types. And here, looking at the various credit indicators, there can be no doubt that there was a crash as has not been seen in at least 75 years ... maybe more. For lack of a better description, it has been pandemonium.
Therefore, just observing stock markets trends of late, it would be understandable to believe that there has been no real financial crash and that whatever tremors there were, would not likely affect real economies. Most major stock indices are still showing gains year-to-date, despite market declines from the 2007 peaks. Typically, a six-month decline of the major stock market indices is usually considered a precursor to economic recession. This has not yet occurred. As such, more than a few analysts are pooh-poohing any concerns that a recession, or a more typical equity bear market may be bearing down upon us.
Not surprisingly therefore -- as already is obvious -- there still remains a very healthy appetite to buy all the dips. The assuaging words of Bush and Bernanke, such as this past week, are eagerly received.
Unfortunately, the wrong indicator is being observed. The crash was in credit markets, not equities. Assuredly, the effects of this crunch are now working their way into the real economy. As in a tsunami, the after waves must be anticipated. Usually, the second and third waves are the largest. Equity markets at present are therefore falsely comforted during this quiet period in between, even as the backwash has already carried out its first victims.
Important to realize is that the financial market topography is very different from that which present-generation analysts are accustomed. To assume that just because stock markets may not have crashed as perhaps in October 1987, that therefore significant damage has not occurred to financial markets and future economic prospects is likely to be wrong.
No doubt, it will be difficult to assess the unfolding financial ramifications yet to come and their likely delayed impact on the real economy. Credit developments and its related liquidity effect are not as observable as are the stock market indices that are published every few seconds. In fact, there is strong reason to suggest that the very opaqueness of the credit providers in the non-bank sector means that many emerging problems are actually hidden from view (and can be hidden for a time longer).
We have already commented upon the fact that much of North America's financial system now lies outside of the official monetary system. This trend was already observed by the Bank of International Settlement (BIS) research more than two decades ago. Non-bank players have grown rapidly in recent decades (i.e. pensions funds, finance companies, brokerage firms, and funds of all types, for instance) and securitization of loans and mortgages has boomed. The sky is the limit and so it was.
Therefore, the powers of the "lender of last resort" -- a central bank -- during a period of liquidity crisis are greatly diminished. Today, the member commercial banks of the 12 reserve districts of the US central monetary system represent only a small portion of total credit assets (now well less than a third.) Most credit, therefore, is manufactured outside of the banking system and is not subject to fractional reserve constraints. It is only banks that have access to the credit window of the Federal Reserve System.
The last time that banks were in a contraction mode due to bad credits on the asset side of their balance sheets (early 2000s) and were suffering from burgeoning loan losses, the US Federal Reserve helped them out quite handily. It simply dropped short-term rates to 1.00% and invited the banks to load up on treasury bonds and earn a very huge and low-risk spread. Soon enough, other financial players joined the game, eventually employing huge leverage and launching "The Trade" as it was known (carry-trade, borrowing in low yield currencies and going long high-yielding bonds).
In time, this program worked. But, today, we have an entirely different situation. The major banks are considered to have strong balance sheets (high equity to asset ratio) and seem to be riding through the recent tremors in steady shape. But that is just the point. The eye of the credit storm, for the most part, is in the non-bank finance areas. This is not the world of bank loans but rather of securities and leverage (not that various units of banks are not involved in these areas). Banks, of course, have been willing complicitors in this shift as they have been the primary agents in securitization trends.
So how then to prop up the securities markets ... particularly the credit security markets? Conditions of excessive leverage or Ponzi finance that might exist in the non-bank sector, are largely beyond the direct protective net of the central bank should they begin to unwind or hit a wall of "illiquidity" (i.e. lack of financing sources). The vast non-bank world is "constipated" and must rely upon capital infusions or the indirect effects of central bank actions.
To this point, events to-date have not represented a crippling, direct hit upon bank balance sheets ... for now. That's one reason why the Fed "discount window" is a rather impotent tool at present. However, in time, the flotsam in the non-bank subsidiaries, prime brokerage hiccups ... etc. will come back to bite the banks in different ways.
Four Scenarios: Pick One. Looking ahead, we divide possible outcomes into four main scenarios, each with two sub-sets. Here, in reverse order, are described the four sets -- Minsky, Mini, Minor or More.
1A. More: Return to Previous. The Fed and other central banks around the world are successful in quelling fears and clearing liquidity blockages. Faith and confidence in the coordinated powers (illusory or otherwise) of the global central banking systems quickly results in "business as usual." A return to Ponzi finance conditions occurs. There remains little collateral damage as even many overextended speculators are skated onside. Market participants not only return to employing leverage, they continue the previous rate of new debt growth (which is a minimum required condition for this scenario!). There is no material impact upon economic growth or corporate profit growth. (Very low probability ... perhaps only 5%.)
1B. Minor Impact: Stabilization. The Fed and other central banks around the world are successful in quelling fears and liquidity blockages. A further collapse is forestalled, however, a chastened financial system continues to de-leverage, rebalance and write-off losses. As finance conditions stabilize, and a steeper yield curve returns (as well as risk spreads) many financial institutions are able to maintain earnings sufficient to at least cover increased loan losses and any impairment of capital. Economic growth and corporate profit growth slows modestly for 2 to 6 quarters. (Probability? We guestimate 25% at present.)
2A. Mini Liquidation. Despite accommodative Fed posturing and temporary actions of central banks around the world, a sentiment swing to risk aversion gains momentum and cannot be reversed. Deleveraging continues. Lenders continue to tighten lending standards. Numerous financial mergers occur. Bank holding companies, though flush with sufficient capital, are forced to bail-out their non-bank subsidiaries. A US economic recession takes place, primarily driven by consumer deleveraging and a stagnant investment environment. Corporate earnings growth stalls out, yet remains supported by a relative strong overseas economy. The US dollar trends flat, or perhaps slightly stronger. Equity markets, after an interim recovery, now respond negatively to deteriorating business conditions. (Probability? 40%. Actually, this scenario seems to be unfolding at this very time.)
2B. Minsky Liquidation: Critical and Unstable. Despite accommodative Fed posturing and temporary actions of central banks and governments around the world, a sentiment swing to risk aversion gains momentum across the full spectrum and cannot be reversed. Deleveraging continues. Lenders continue to tighten lending standards and rating agencies reverse "ratings creep." Speculators converge upon a new belief set -- avoidance of risk, safety and hoarding of liquidity. Market volatility remains above average, confounding the quantitative machinery behind trillions in financial instruments and products. Collateral values continue to deteriorate. An accumulation of these factors cause additional non-bank entities to fail. A marked economic slowdown in the US as well as internationally then begins to broadly undermine corporate profits. A more substantial decline in US equity markets ensues, also internationally. An abrupt homebias effect which triggers a sizable repatriation of foreign investment positions along with a deflationary consumption trend, boosts the US dollar for a time. This last dynamic is most unwelcome as it sets off a further self-reinforcing loop of additional repatriation and lower US corporate profits due also to exchange translation losses. (Probability? Forbid as high as 25%. We are of course "hoping" things turn out more fortuitously.)
Each of the above scenarios would have one additional variation -- inflationary or non-inflationary. This would have to do with the nature of central bank actions. If central banks and governments do indeed differentiate their resuscitative actions between speculative and responsible financial players in the chain (i.e. emphasize the discount window), this would bring a stronger and more stable foundation to any following recovery (both financial and economic) when this finally occurs. Conversely, if central banks and governments introduce programs that indiscriminately reward irresponsible players in the financial chain, an elevated environment of moral hazard and crony capitalism will unfold. Inflation will rise sharply. Everyone overboard and fend for yourselves.
Of course, the above subsets are simplified scenarios and do not take account of low probability occurrences nor geopolitical or other exogenous factors. Viewing the grid of outcomes and insipient indicators, we assign our current probabilities in the table on page 2.
Final Conclusions: To this point, at least, the general attitude amongst institutional equity investors is that the sudden equity market correction to date was more of a "godsend" than the start of longer-running tremors or the beginning collapse of a "Ponzi finance" phase. It seems to be the "ole' dog returns to his vomit" theorem at work. After markets have vomited, many players now still only see a warmed-up opportunity.
To be sure, risks to any worsening scenarios are not insignificant. However, while many indicators document our central premise of excessive leverage and a Ponzi-type financial regime, in the interest of balance and unbiased research, we must look closely to the causal and structural factors that will play a role.
Given that we cannot have perfect foreknowledge as to the next events, we have assembled a long list of "diagnostic indicators" that will help us gauge ongoing probabilities and potential trigger points to any of the potential future scenarios as we go forward.
At the present time, virtually all indicators continue to confirm not only a continuing deleveraging process but also a broad-based consumer retrenchment. Coincident with the broader impact upon securitized credit structures, is a compression of the household sector balance sheet in the US. It is highly unlikely that this latter development is anywhere near ending in the foreseeable future.
This is not a third-world debt situation. For now, at its very epicenter are the deteriorating balance sheets of the richest households in the world, who happen to live mostly in the largest economy in the world.
We also conclude that complacency and confidence are still far too high. Given the nature of the forces at play and the extent of the damage to credit markets over the past month or so, it would be a serious error to gloss over realities with simple and optimistic "happy talk."
We continue to retain above-average cash levels and as much as possible seek to emphasize assets that can exhibit an inverse correlation to any further market tremors.
