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Saturday, July 21, 2007

What's Going On In The Credit Markets

Well, plausible deniability is fading fast. The commercial loan indexes are moving almost in concert with MBS indexes. The bottom line is that the money bag is closing fast, and the long forecast credit contraction is well underway. The week's trading produced broad-based declines in financial stocks because of expected losses.

It seems very likely that non-prime loans written over the last few months will have trouble finding buyers except at a discount. Commercial loans will probably encounter a similar fate, meaning that another wave of bankruptcies in mortgage companies is pending. In effect the game of musical loans has just about stopped; everyone's going to be stuck with what they have, and what happens from here is a function of how irresponsible the originator was. This includes leveraged buyout debt, commercial and industrial loans, commercial mortgages and even those reams of auto loans for 15-20% more than the car securing the loan is worth.

Even the Fed has stopped claiming that the problem is limited to subprime loans. The Fed remains delusional, at least in public, about the effect on the economy though.

This is the list of states reporting increases in initial claims of over 1,000 in the latest weekly unemployment report:
ND +1,156 Layoffs in the manufacturing industry.
WA +1,250 No comment.
PR +1,422 No comment.
MN +1,431 Layoffs in the construction and manufacturing industries.
OK +1,698 No comment.
TN +1,709 Layoffs in the rubber/plastics, industrial machinery, transportation equipment, and fabricated metals industries.
KS +1,725 Layoffs in the manufacturing industry.
AL +1,880 Layoffs in the transportation equipment and service industries.
CA +2,023 Layoffs in the service industry.
OR +2,220 No comment.
AR +2,264 Layoffs in the manufacturing industry.
GA +2,854 Layoffs in the service industry.
MO +3,361 Layoffs in the transportation, warehousing, and manufacturing industries.
IL +3,504 Layoffs in the trade, service, and manufacturing industries.
IA +4,047 Layoffs in the manufacturing industry.
IN +5,855 Layoffs in the automobile industry.
PA +6,721 Layoffs in the food, chemical, leather goods, and fabricated metals industries.
WI +11,835 Layoffs in the construction, service, transportation, warehousing, and manufacturing industries.
NY +12,223 Layoffs in the transportation, service, and public administration industries.
OH +12,830 Layoffs in the automobile industry.
MI +31,282 Layoffs in the automobile industry.
This is the list from the prior week:
CA +1,161 Layoffs in the service industry.
NC +1,170 Layoffs in the transportation equipment and furniture industries.
CT +1,375 No comment.
MI +1,813 Layoffs in the automobile industry.
IN +1,993 Layoffs in the automobile industry.
NJ +2,127 Layoffs in the transportation, warehousing, public administration, construction, trade, and service industries.
KY +2,416 Layoffs in the automobile and manufacturing industries.
NY +3,974 Layoffs in the transportation and service industries.
Poor auto and truck sales are leading to another round of auto layoffs, but what is happening is a wide-spread phenomenon. Spending is tightening up fast for businesses and consumers.

Bloomberg has had some pretty good coverage of events as they unfold.

Defaults on all consumer and business debt will start moving up pretty rapidly.. Younger people should pay a lot of attention to this. Watch what is happening where you live; a credit bust such as this one is pretty rare and a remarkable phenomenon. The effects seem to appear almost overnight, although the causes of those effects always build for years beforehand. These events are very predictable, but so ugly that no one wants to tell the truth about what is going to happen.

Inflation will tend to start dropping now.

The cause of the recession following a bubbly credit expansion is the inevitable credit contraction. The credit contraction occurs because bad debts have to be written off, so the effective supply of free money sharply contracts. The result is that the monetary circulatory system gets blocked at the top (large banks and financial companies). Because the top level institutions are not buying nearly as much debt (they can't monetize it), the mid-level banks and other lenders are forced to become overcautious in lending, and finally, the smaller creditors become desperate for cash and begin to call in pretty good loans. The real beginning of this credit contraction appeared to be just a couple of weeks ago, and it will be in full swing by fall.

I will be out of touch for another week, week and a half. Partly I'm wandering around and talking to people, especially bankers in the smaller banks. I was quite surprised by the signs of recession in the Carolinas, and now I'm in the NJ/PA/NY on walkabout. In general, things seem better in comparison, but there are a lot of houses for sale, many of them advertised as FSBO. The first "For Rent" signs are beginning to crop up too. You can see the cracks beginning to appear.

The amount of total debt (Federal Reserve commercial paper outstanding) is unbelievable; some of this is just pure junk that will never be paid back. Over the next couple of months watch these curves take a drop:

And this is just commercial debt; residential mortgages have ballooned upward too. Mortgage rates continued to rise last week. Treasury yields dropped as T-Bills became more attractive, but it's unlikely that the risks in the mortgage marketplace will allow mortgage rates to follow treasury yields down. Competition for loans is still pushing mortgage rates below what they should be in this environment; they should be about 50 basis points higher in most areas according to the way I calculate it.

Lord only knows what is happening at the GSE's (FNMA, etc). They do handle (and have bought in the past) a lot of subprime and adjustable loans, and prime loans in some areas will probably have increased default rates over the next few years.

Comments:
I'm watching car dealers show signs of hurt. A local Ford dealer who has been in business since all Fords were black has consolidated into half their land and put the free half up for sale. A couple others have gone out of business entirely.

They are not selling cars and I'll bet some of their financing deals are as shaky as subprime mortgages. They're selling to the same people, with the same loose terms, right?

This is not a contained problem.
 
> Inflation will tend to start dropping now.

I know falling inflation is typical for recessionary periods as companies trade margin for survival (i.e., volume).

However, with the increased use of corn for ethanol 'locked in' for political reasons, I wonder if this time it will be different across the broad range of affected items. I.e., anything using corn syrup (!), food animals which did eat corn but now will need to be fed something else more expensive, etc.

I think the downstream effects of the politically-motivated ethanol scam are going to prove to be a pretty unyielding inflationary force at the mass market level. This will result in people having less remaining discretionary income to take advantage of reduced prices for optional purchases, which will retard recovery and require even further cuts on those optional items.
 
I work for a local internet service company. I talk to a fair number of folks in my area (once timber, now mostly recreational in PNW). I wish I had a dollar for everyone that tells me they are trying to sell their house. I could probably afford one now ;)

My neighbor has his place (and it's nice but not fancy)up for sale. It has five acres and he wants 370,000+. We live ten miles from the nearest town and it does not have a real store to speak of. It's 45 miles to the largest town. They are selling their place because gas for him and his teenagers is running over 1k a month. And no, it does not seem like they considered getting rid of the SUVs.
 
I have been buying puts on Alt A lenders, like FED, DSL, FHN, IMB and have expanded to medium sized banks. I sounds like your research would provide great opportunities for deciding which banks to short/buy puts.
 
Anon - exactamundo. It's the very opposite of contained. A better way to describe it is that the floodgate has been opened. The only thing preventing a correction before was deranged lending. These things can only continue for so long.

Frank, inflation will be suppressed by people's inability to buy stuff, but you are correct in commenting that it will continue higher than it normally would because of the international situation.

One thing to remember - India and China have their own problems, and most of the globe has seen similar trends in lending. Everyone had better hope that India and China keep pushing up, because there will be considerable global downdrafts forming.

Teri, I was aghast at how many people are trying to sell in NJ, and how delusional they are about sales prices. Part of the problem seems to be that property assessments are very high, and the would-be sellers seem to confuse that with market price.
 
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