No Credit for You!

As the Universal Debt Bubble has begun to collapse under its own weight, various portions of the shadow banking sector have come under enormous pressure. These are the non-bank lenders that have magnified a credit bubble into the UDB. Starting last summer, the initial push shattered the most egregiously complex and levered structures - the CDOs. In the Fall of 2007, the conduits and SIVs joined the tankage - along with asset-backed commercial paper, their primary funding mechanism. The worst of the hedge funds have been closing their doors at an increasing rate.

Now we are beginning to see simpler securitized products being shunned as well. From Prudent Bear's Doug Noland:

Asset-Backed Securities (ABS) issuance slowed this week to $3.3bn. Year-to-date total US ABS issuance of $104bn (tallied by JPMorgan's Christopher Flanagan) is running at 27% of the comparable level from 2007. Home Equity ABS issuance of $303 million compares with 2007's $191bn. Year-to-date CDO issuance of $14bn compares to the year ago $217bn.

Over the past year, total CP has contracted $381bn, or 17.9%, with ABCP down $402bn, or 34.8%.

Credit Bubble Bulletin

As I read it, ABS (mostly credit card and auto loans) are down 73% from last year. Securitized home equity is down 99.8%. CDOs have fallen 93%. These were key shadow banking sectors that provided trillion during the last leg as the credit bubble mutated into the UDB. Because the structures were kept off the banks' balance sheets, they almost never had proper reserve structures. With leverage ratios of 30, 50 or even 100:1, the inherent risk was high. At 30:1, your valuation assumptions only have to be wrong by 3% for the whole thing to blow up - as they are now duly exploding.

Any hope that the Fed and other central banks had of keeping the asset bubble intact is fading along with the excess credit that has supported absurd asset prices for so long. The disappearance of the shadow banks is critical to the process of deflating the bubbles. At the same time as this illegitimate source of funding is drying up, the commercial banks are being forced to recognize large losses. Now the banks must lend within the restrictions of their required reserves and capital. At the same time, that capital is being wiped away by losses far faster than it can be replaced.

The math virtually guarantees that there will be a lot less credit available for the foreseeable future. Assets and goods that are dependent on the availability of credit are likely to see sharp further price declines.

Australia Leads the Way

The race to the bottom in financial responsibility reached a new milestone today. The Reserve Bank of Australia - their equivalent to the Fed agreed to take asset-backed debt paper as collateral for repo loans to commercial banks. The Wall Street Journal reports this morning:

Banks that may be forced to assume assets from the conduits that have financing coming due could themselves face shortages of capital.

To head off such a problem, Australia's central bank, the Reserve Bank of Australia, has relaxed rules on collateral it will accept for short-term funding. This would enable banks to take more time to evaluate which portions of the asset-backed commercial-paper market are most affected by ailing subprime mortgages.

In doing so the Australians went beyond the Federal Reserve, which doesn't accept such paper as collateral in repo operations but did recently clarify it was willing to accept a wide variety of such paper for its lesser-used, and costlier, "discount window" loans to banks.

Basically, the RBA is willing to accept asset backed paper as collateral for loans now. The Fed will apparently do the same but only at the discount window where distressed banks come to borrow, hat in hand.

Conduits and structured investment vehicles (SIV) enabled banks to move assets off the balance sheet, where they would no longer count against their required capital. By providing these entities with a guaranteed line of credit, the bank was on the hook if investors who normally provide funding got cold feet. Of course, it was assumed that the high times would last forever so such a thing could never happen but naturally it did.

In hindsight, it can be seen that the conduits and SIVs were an attempt to evade the reserve requirements and banking regulations. These things traded on the credit and the good name of the bank but never appeared anywhere in the financial statements. Simply another clever, legalized fraud. Taxpayers should not be on the hook for this sort of gamesmanship.

Ongoing Credit Implosion

The rate of implosion in the credit markets continues to accelerate. In fact, the process seems to be proceeding very rapidly and the only element missing is mass bond defaults. According to Bloomberg, the asset-backed commercial paper (ABCP) market has shrunk by 20% in a mere three weeks and the total CP market is 11% smaller over that period. This type of credit has contracted by $244 billion in a very short time. For those who think the Fed can simply "print money" to revive asset inflation, $244 billion is roughly 4x the $68 billion total of all US currency in circulation today. And of course, the CP market is just one of many credit markets undergoing a buyers' strike.

Private label MBS of any kind is very hard to sell right now, which is why even Countrywide is doing almost nothing but conforming loans.

[Countrywide] says that soon about 90% of its originations will conform to either bank loan or such so-called "Government Sponsored Enterprises" standards.

The corporate junk market is nearly frozen right now. As far as I can tell only one junk deal of any size has been done in eight weeks. Other than debt issued or guaranteed by governments, very little is being sold in the bond markets anywhere right now. Unless you are a "natural" AAA or AA-rated entity, you can only issue debt at punitively high interest rates.

There is complete distrust of credit ratings for any sort of structured debt. Of course that's what happens when BBB-rated "investment grade" structured bonds lose over half their value. More confirmation of just how bogus the ratings were and how badly standards had slipped came recently. S&P cut their rating on some structured investment vehicles (SIVs) from the gold standard AAA to near-default CCC in one fell swoop. As we previously mentioned in Fed Actions and Terrorist Attacks, the ratings agencies got paid three times as much on structured bonds but I'm sure that had nothing to do with the generous ratings. Surely, they are only correcting an inadvertent previous oversight.

Of course, when the ratings are that badly wrong, no one cares what about motives or excuses. All such ratings become suspect. Nothing the Fed can do will restore trust in the ratings agencies. Only the agencies themselves can do that and only with time and hard work. Similarly, much of the credit that was extended should never have happened. Since the creditors have been burned by dumb mistakes, those won't be repeated - regardless of how many unsustainable investment structures depend on the them.

The Fed cannot recreate the naivete, the wild optimism and the frenzy that drove much of structured finance over the last several years. The illusion of permanently lower risk has been broken and cannot be recreated. Much of the recent "financial innovation" was utterly dependent upon this illusion and so those products must simply disappear. The UDB has burst and the Fed just needs to get over it. Efforts by the CBs to halt this process will meet with the same success as King Canute's command to halt the tides.