It certainly appears as if the credit crisis is well and truly over or, at the very least, the light which most of us think we can see at the end of the tunnel is no longer that of an oncoming freight train.

No wonder equities are currently enjoying one of their best spells ever. And while equities continue to go up and up, most of us are left scratching our heads. Is this the real thing or will it go down in history as ‘just’ another bear market rally? Not so long ago, the entire financial system stared Armageddon in the face. Now, only a few months later, equity markets behave as if all the worries of yesterday have been washed away. How is that possible?

“Never in the history of the world has there been a situation so bad that the government can’t make it worse.”

-Unknown

The great bank illusion

The current bull market began in earnest in the second week of March, but what really got everyone going were the surprisingly good Q1 US bank earnings which were reported during the first half of April. Most commentators interpreted the numbers as the clearest piece of evidence yet that we are now firmly on the road to recovery.

Of course US banks made good money in Q1. The environment created for them is the equivalent of the US government reducing the cost of goods to zero for its embattled car manufacturers and then going on to buy – courtesy of the US tax payer – a couple of million cars that nobody really needs. Even Detroit would make money given those conditions!

Liquidity is trapped

The problem for the rest of us is that the banks are not sharing the candy they have been handed. Much of the liquidity created by the central banks remains trapped in the financial sector (see chart 1). Quite simply, the multiplier is not doing its job, as many banks prefer to hoard cash rather than increase lending at this juncture.

This is both good and bad news at the same time. Good because it implies that we probably do not have to worry too much about the inflationary effect of the aggressive monetary easing currently taking place; bad because it means that the economy is not going to kick back to life as quickly as everyone would like – and expect.

Meanwhile investors are growing cautiously optimistic about the GDP outlook for the second half of the year with many now forecasting modest growth – at least in the United States. Only a fool would suggest that GDP would shrink by 5-10% per quarter in perpetuity, as has been the case over the past two quarters. The economic slowdown is now decelerating and, as I pointed out last month, there are good reasons why we may see a temporary lift in economic activity later this year, but it will almost certainly prove transitory.

We are still in a bear market

The dangerous conclusion to draw from the experience of the past few weeks is that all is now well and dandy and it is time to load up on stocks again. I cannot emphasize it strongly enough: The bull market of March-April 2009 is almost certainly a bear market rally but, as one of my partners pointed out the other day, NYSE saw four 20%+ rallies between 1929 and 1932 (see chart 2). Bear market rallies can be extremely powerful and hence deceiving.

The problems are not over yet. Not by a long stretch. It will take longer than 18 months to unwind the excesses of the past 25 years. Analysts at Morgan Stanley reckon that the 15 largest banks which between them have shrunk their balance sheets by about $3,600 billion so far in this crisis, will shed another $2,000 billion in 2009¹. If you do not share my pessimism, please take a quick look at chart 3 below. The US financial sector debt load (as a % of GDP) is now 117%. In the early days of the great bull market in 1982, the same number was 22%. Households are not much better off with total household debt now at 96% of GDP vs. 47% in 1982.

Further write-offs to come

The IMF reckons that both European and US banks – but in particular the European ones – are well behind the curve in terms of recognizing their credit crunch related losses. According to the IMF, there is at least another $1,500 billion to come. So when the US banks reported surprisingly good numbers for Q1 it was certainly not because the economy had suddenly and miraculously revived itself, but because some of the oldest tricks in the book were used to gloss over much bigger problems².

As the recession bites into the lives of ordinary people, banks will face losses not only on sub-prime mortgages but on all loan products. As you can see from chart 4, sub-prime is indeed a small fraction of the total loan book for the US banking sector.

Delinquencies are on the rise

And that is precisely what is beginning to happen as illustrated in chart 5. Delinquencies are now on the rise on all mortgage products; however, whereas sub-prime started to deteriorate as early as 2007, it is only recently that delinquencies related to Alt-A and adjustable rate mortgages have taken off, and prime and jumbo loans are only now starting to suffer.

These are all temporary problems, though, however bad they may appear. By far my biggest concern at the moment is the enormity of the debt problem facing most OECD countries. In the March issue of the Absolute Return Letter I referred to an important study conducted by Carmen Reinhart and Kenneth Rogoff back in December of last year³ which I would like to re-visit (see chart 6).

Banking crises run and run

Reinhart and Rogoff studied every banking crisis of the past generation and made some startling observations. One in particular caught my attention. It has to do with the subsequent rise in government debt which, according to Reinhart and Rogoff, has been “… a defining characteristic of the aftermath of banking crises for over a century”. According to the authors, governments inevitably underestimate the ultimate cost of a banking crisis, because the indirect costs (such as falling tax revenue in subsequent years) end up much higher than predicted.

The IMF estimates that the cost of the current crisis to the United States will eventually reach 34% of GDP or close to $5 trillion. However, the Obama administration, through its various implicit and explicit guarantees, is already using a number close to $9 trillion⁴. And Reinhart and Rogoff’s historical average of 86% of GDP implies an ultimate cost of over $12 trillion!

The IMF is too optimistic

I have a lot of respect for all the good work being produced by the people at the IMF; however, they are sometimes too politically correct for my taste; maybe too afraid of stepping on someone’s toes. So when they go public, as they did recently, with an estimate of how much the current crisis would ultimately cost, their projection will more than likely prove hopelessly inadequate.

The true cost is important, because it has to be financed through new bond issuance, and it is my thesis that the sheer size of this tsunami will eventually overwhelm the world’s bond markets. As you can see from chart 7, using the official IMF estimates, the twelve most industrialised of the world’s G20 countries (in my book known as the Dirty Dozen) will have to issue about $10 trillion worth of new bonds to cover the cost of the current crisis.

The final cost will be enormous

However, if you (like me) believe that IMF underestimates the true cost of this crisis, Reinhart and Rogoff offer a more realistic approach (see chart 8). Using their least costly case study (Malaysia 1997) as our best case scenario, the true cost comes to $15 trillion. If one uses the average of 86% instead, the cost jumps to a whopping $33 trillion. I didn’t even bother to produce a worst case scenario – it all got too depressing!

I need to put the $33 trillion into perspective, because it is so big that it is almost incomprehensible. According to Wikipedia (see chart 9), total private wealth across the world today is about $37 trillion less the losses incurred in 2007-09, so the real number is probably closer to $30 trillion now. Total global savings (loosely adjusted for the big losses in 2008) are probably somewhere in the region of $100 trillion. In other words, financing this crisis could absorb one-third of total global savings. No wonder Gordon Brown looks tired!

Where do we find the money?

Obviously, governments may buy a portion of these bonds themselves, but they cannot afford more than a fraction of the total unless they want to challenge Mugabe as the ultimate master of illusion. Neither should investors hold out for sovereign wealth funds to do the dirty work. As is clear from chart 9, the total amount of wealth accumulated in these funds is pocket money when compared to the projected bond issuance over the next few years.

Hence it comes down to the price at which governments can attract sufficient demand from people like you and me. One of two things may happen. Either this crisis will ignite such a bout of deflation that investors will happily own government bonds yielding 2-3% or the deflation scare goes away ultimately, the global economy recovers and bond investors demand much higher yields for taking sovereign risk. I am not yet sure which scenario will prevail, but I do know that both are quite bad for equities longer term. Take your profits!

Source: The $33,000,000,000,000 Question

With both Chuck and Frank out of the office, I fielded the calls from reporters after the FOMC cut, and the most popular question asked was what the near zero interest rates would mean for the man on the street. Well it was great news for those on Wall Street, but I told the reporters that the rate cut really wouldn’t have much of an impact on US consumers. After all, interest rates at 1% weren’t stimulating the banks to start lending so why would .25% rates cause any change?

Fed Funds have been trading at around .25% for some time, so this move by the Fed simply moved their target rate closer to the actual market. In addition, the Fed can’t really impact the Libor rates, which most loans are now tied to. So yesterdays interest rate move was largely for cosmetic purposes. Chuck was sick with the flu yesterday, but sent me a quick note after seeing the news from the Fed.

“So… The Fed goes 75 BPS… Japan now has higher interest rates than the U.S.! How is that possible? How many times must I repeat that it’s not the COST OF THE CREDIT… IT’S THE AVAILABILITY OF THE CREDIT! That’s causing the Credit Crisis!

Well… I saw yen trading below 90 yesterday, less than 5 whole figures from the 85 that I said yen could trade to 2 years ago… I know, I’m always early on these things! There was good news from the Japanese Ministry of Finance (MOF) yesterday… Seems they are not interested in intervening right now… The MOF’s head guy, Nakagawa, had this to say…

“We’re not considering intervention at all at this time,” Nakagawa told reporters in Tokyo today. I’m not that concerned about today’s yen moves.”

When I woke up last night to look at the currencies… And what to my wondering eyes did appear, but the euro trading very close to 1.41! Oh, those of little faith and patience that sold into the weakness, like catching a falling knife!”

Yes, all of the WorldMarket investors who claimed to be ‘long-term’ but bailed out after the dramatic dollar rally are probably kicking themselves right about now. Markets like these are a great illustration of why investors need to stick to their diversification strategies, and not try to time the markets.

So Chairman Bernanke has used up all of his remaining ammunition for the main weapon against the economic crisis, and now has to move to other less proven methods to combat the crisis. These ‘quantitative’ easing methods which the Fed will now use are unproven, but they are all that they have left. The Fed pulled the first new weapon out yesterday with a pledge to buy unlimited quantities of mortgage backed securities. They hope that by purchasing these securities, they will be able to force mortgage rates lower. But as Chuck points out above, it isn’t the cost of credit, but the availability that is the big problem.

The problem with these new untested financial weapons is that their longer term impacts are not known. I can assure you of one thing, the new methods suggested by the FOMC will all lead to higher inflation. Most of the press surrounding the announcement suggested that inflation is no longer a problem. And the data released yesterday supports this view, as CPI fell 1.7% MOM in November, bringing the annual change in core prices to just 2%. So US policy makers have decided to concentrate on getting the US economy growing again, with no consideration of the long term inflationary effects of their policies. The Fed is pushing the printing presses to their limit, and while oil prices have kept prices down for now, inflation is still alive, and is waiting just around the corner.

The value of the dollar fell across the board yesterday, but the yen was the biggest mover falling to 88 yen/dollar. The latest move puts the total yearly appreciation of the yen at 26% vs. the US$. Japan’s Finance Minister threw water on the yen’s rally said the government is prepared to take steps to help their economy. But we haven’t seen any intervention this morning, so the yen has held onto its gains.

Australia’s dollar rose to a two month high and the kiwi gained on purchases by investors looking for higher yields. Currency markets are starting to return to trading on fundamentals, and interest rate differentials are one factor which traditionally determines currency rates. It looks like the AUD$ has a green light to move back toward .75 while the kiwi will probably move above .60 before year end.

The currency markets rallied dramatically as they seem to have finally come to the realization that the US dollar is not the ’safe haven’ which they thought. Many of the stories and opinions which are now coming across my desk suddenly agree with what we have been saying for some time, that the fundamentals of the US dollar are very weak.

Currencies today 12/17/08: A$ .6915, kiwi .5788, C$ .8263, euro 1.4060, sterling 1.5285, Swiss .8971, ISK 177.82, rand 9.9574, krone 6.7496, SEK 7.8235, forint 189.35, zloty 2.9103, koruna 18.718, yen 88.79, baht 34.57, sing 1.4575, HKD 7.7501, INR 47.6575, China 6.8357, pesos 13.01, BRL 2.346, dollar index 80.20, Oil $44.02, Silver $10.98, and Gold… $855.05

Source: Fed Brings Rates Down to Near Zero

But there’s a damn good indicator that will show us the way – the London Interbank Offer Rate, usually referred to as LIBOR.

And right now LIBOR tells us that this financial mess still has room to run.

As indicators go, recent developments have demonstrated that the LIBOR system is arguably corrupt. Until now, LIBOR always has been constructed by industry insiders – with little in the way of oversight or regulation. It drives billions of dollars of trades and transactions a day. And it’s publicly available at 11:30 a.m. (London time) each business day.

Now regulatory authorities are investigating the entire LIBOR process, and that makes it as close to insider information as we’re going to get.

LIBOR is calculated entirely using data provided by insiders from 16 banks and reflects the daily borrowing rate in U.S. dollars, European euros and Japanese yen that banks extend to their best customers – each other.

Theoretically, it’s a measure of what the banks must charge for money and that’s how the rest of the world uses the LIBOR rate.

But as we’ve hinted, there’s a far darker side and, as usual, we’ll tell you about it even though other insiders won’t.

Interest rates are not really a cost of borrowing – even though that’s how they are portrayed to the public. To insiders, interest rates are a measure of risk. So even though banks and financial institutions use the daily LIBOR rate to “price” billions of dollars worth of financial instruments, what these institutions are really doing when they post their LIBOR rates is to look at each other’s credit quality and assign a risk premium.

Thus, if LIBOR rates are rising, one way to interpret that fact is to conclude that the risk of doing business with other financial institutions is going up to. That creates an incentive for banks to “fib” when they submit information on the rates at which deposits were being offered.

That’s because – as my colleague Martin Hutchinson noted way back on April 18 – “any whisper of trouble over a bank makes other banks’ dealers not want to place money with them.”

This is true even when the financial markets are healthy and in good shape. But it’s even truer when – as now – the markets are rattled and facing severe inflationary pressures.

Here’s why: The higher the LIBOR rate goes, the greater the risk of perceived default and the poorer the credit quality associated with the 16 banking heavyweights that submit the rates used to calculate LIBOR. What’s more, those negative perceptions work their way through the balance of the world’s financial system as a giant cascade of interlinked financial instruments.

If this doesn’t make sense, think of it this way: What happens with LIBOR is not any different from what happens with rates assigned to home mortgages and credit cards – just on a far larger scale. If you’re a good credit risk, you get low rates. If you’re a bad credit risk, or are a high-risk borrower, you must pay higher interest rates because banks and other potential creditors view you as more likely to default on your obligations.

The bottom line is that LIBOR can actually be viewed as a kind of leading indicator.

In fact, I suggested as much back on May 8, when I correctly warned readers that the dollar rally under way at the time was nothing more than a “head fake of legendary proportions.” At that point, the consensus view was that the dollar was finally emerging from a decline that had taken it down to record lows against key world currencies.

But when I noted that LIBOR was rising in concert with the dollar’s embryonic rebound, it was clear to me that something was rotten in Denmark – or, in this case, London. Given that realization, I was able to conclude that the dollar’s strength was nothing more than a temporary aberration and that the greenback would resume its decline once the inevitable new round of problems emanated from the financial-services sector.

And that’s exactly what happened.

Since Money Morning published my “head fake” prediction, the “dollar rally” sputtered and died and the greenback resumed its downward spiral. And the catalyst for that dour turnabout was just what I’d predicted – a whole new round of financial write-downs and headlines about banks and investment banks facing major problems. Indeed, just this week there’s been bad news surrounding Lehman Brothers Holdings Inc. (LEH), which wrote down another $3.7 billion in mortgage-backed assets.

So what’s LIBOR telling us now?

That’s simple. First, it’s telling us that this mess is far from over. And second (and potentially even worse), it’s making it very clear that inflationary worries are escalating.

It’s also clear to me that the distrust between banks is growing. The three-month LIBOR rate recently jumped 10 basis points to reach 2.79%, representing the biggest LIBOR increase since August and the highest LIBOR level since April 30.

Which is why it would seem that there are more financial shenanigans to come. Indeed, I feel a bit like the announcer on the old Batman TV series, asking in my best, scene-setting baritone voice:

“Could it be that we’ll see another round of financial house cleaning in the next 90 days? Or are there additional credit-induced write-downs and earnings disappointments headed our way? To find out… tune in next week at the same Bat Time, and the same Bat Channel…”

LIBOR seems to be telling us that there’s enough drama for several more episodes.

[Editor’s note: Since this article was prepared, word has escaped from London that the biggest banks in England may be preparing to swap nearly £90 billion pounds sterling worth of mortgage-backed assets for U.S Treasury Bills with the Bank England. And, judging from how globally linked banks are these days, where there’s smoke, odds are good that there’s fire, too. That means we could see everything from higher interest rates globally to increasing defaults and heightened personal consumer financial trauma. Although that will create fear in the market place, it’s important to note that with fear, comes opportunity.]

Source: How Will We Know the Credit Crisis and Banking Fiasco Are Truly Over?

It seems the Federal Reserve and other global central banks have successfully tempered the credit crisis since mid-March. The Fed’s effective bailout of the now defunct Bear Stearns created a floor under the sub-prime wreckage.

The good news is that a host of high-risk credit indices have posted big rallies over the last eight weeks. That includes a blizzard of new fixed-income issues as companies return en masse to fund their operations.

But don’t get too excited…The debt crisis is far from over.

LIBOR Rates Barely Budge Lower

While several indicators have improved recently, other important sources of funding remain under pressure. This tells me the sub-prime crisis is now spreading from the mortgage-backed securitization market to consumer installment debt.

Also, inter-bank lending rates have yet to fully recover from their pre-July 2007 levels while bank credit is contracting, not expanding – an ominous sign as the United States struggles to escape a slowdown.

Three-month London Inter-Bank Borrowing Rates (LIBOR) has barely budged since the Fed rescued Bear Stearns. The majority of financial institutions continues to hoard cash and refuses to trust overnight lending facilities.

The Main Sub-Prime Fear Factor:
Overnight Lending Rates Barely Move

While it’s safe to assume that some areas of the credit markets have not stabilized, other areas of the credit markets have indeed started to breathe easier. Among those normalizing this spring is the sub-prime market.

Sub-prime is Finally Tamed

According to Fitch, the international credit-rating agency, banks have probably written off approximately 80% of their bad loans through mid-May.

It’s not over for every bank. Some banks, including Switzerland’s Union Bank of Switzerland (UBS) continue to surprise the markets on a weekly basis with a host of spectacular losses tied to real estate, sub-prime, leveraged loans, and auction rate securities.

But for the most part, however, the sub-prime crisis is past its inflection point. What matters now is how and when other credit indicators normalize.

As of yesterday, the sub-prime crisis has resulted in approximately US$200 billion worth of write-downs for global banks. The lion’s share of those losses came from UBS and others in the United States and the United Kingdom.

For the most part, Asia and Latin America have escaped the crisis. Their banks remain highly liquid compared to their peers in North America and parts of Western Europe.

The securitization model (aka rolling sub-prime mortgages into securities and selling them) is still alive and kicking overseas, but it was NOT a primary investment source for Asian and Latin banks. Therefore these savvy banks avoided most toxic sub-prime products like collateralized debt obligations or CDOs.

Credit Spreads Narrow

As I continue to track the normalization of credit markets, I’m encouraged by the narrowing credit spreads across several markets – a bullish development.

One key indicator I follow – the spread between three-month Treasury bills and the three-month LIBOR – has narrowed considerably since March to 0.85% from 1.83% back in early April.

That tells me that the “safe haven” trade on short-term Treasury bills since the sub-prime crisis first erupted last summer is reversing. It also means that risk is gradually returning to the credit markets. Prior to mid-April, three-month T-bills plunged way below the Federal Funds rate to a low of 0.81% – severely overbought as investors scrambled for safety.

Another bullish indicator now flashing green is the yield spread between 30-year municipal bonds and 30-year Treasury bonds.

Prior to mid-March, the yield differential between 30-year municipal bonds and long-term T-bonds ballooned to their highest in history as investors fled municipal debt. The average yield on high quality municipal bonds has plummeted 70 basis points (0.70%) after reaching a peak on February 29.

Earlier last winter, as yields soared, savvy investors like Bill Gross of PIMCO and venture capital investor, Wilbur Ross, scooped-up those fat yields. In hindsight, that was a great speculation as yields have plunged versus T-bonds.

Also, some mortgage and financial companies, including non-financial issuers, are successfully raising capital again since April. Though financing remains much more expensive compared to 12 months ago, it’s nevertheless a positive development for global capital markets.

Beware of High-Risk Debt Markets

High-yield bond indexes and preferred securities have also rallied since late March.

Preferred securities, which provide stock and income-like features, have also rallied. But financial service companies that most issue these preferred securities and write-downs are far from done. I would avoid preferred securities and those juicy, but dangerous yields.

The same is true for high-yield bonds and other busted credits, including sub-prime securities as the economy continues to slow.

High-yield or junk bond defaults remain historically low at just below 2% of all outstanding issues. Previous recessions have seen defaults surge almost three times this level.

In my view, the recent rally is nothing more than a dead-cat bounce. More junk bonds will default over the next 6-12 months.

The Next Credit Crisis: Consumer Installment Debt

I’m still highly dubious that credit markets have bottomed. Sub-prime is now largely history. But other segments of the credit spectrum that have a far more profound impact on the American consumer are just beginning to unravel.

The consumer is now threatened by a liquidity crisis. Housing values continue to heavily contract and revolving credit installment debt is becoming harder to secure.

The culprit is less the write-downs themselves and more the virtual “shutdown” in the securitization market. At its height, the securitization market provided 66% of household borrowings in the first quarter of 2007. Without this market, consumer credit losses may be far worse than currently estimated.

Auto loans, personal loans, mortgage loans, and other segments of installment debt are still contracting. Auto loans are especially vulnerable with defaults recently hitting a 10-year high of 3.4% in March. And more Americans are dropping their house keys to their local lenders as housing values continue to plunge below the cost of their mortgages.

Consumer deflation has arrived at the absolute worst time as savings rates are barely positive. Soaring energy and food prices, declining home values, surging auto delinquency loans and gradually rising unemployment depict a growing liquidity crisis now underway for the consumer. Also, most, if not all, installment debt is structured to finance domestic consumption. It’s not a pretty picture.

Stay defensive and avoid most debt markets, except high quality short-term Treasuries and investment-grade bonds. The consumer credit bear-market is underway.

ERIC ROSEMAN, Investment Director

EDITOR’S NOTE: As of today, our Sovereign Society research team is working on a special report to give you the information you need to protect yourself from this second coming of sub-prime – when it hits the real economy – including your personal credit report. Please look for this special report coming to your email inbox this weekendSource: Is Sub-Prime Finally Over? Yes and No

Source: Is Sub-Prime Finally Over? Yes and No