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Monday, September 17, 2007

Diffusion, Not Containment

I hope the Fed does gather its wits enough to drop 50 basis points this week.

Take a look at this graph from the Fed's Commercial Paper release (these are Friday's figures):

This shows the spread between different categories of debt. Of course asset-backed is worst, but look at A2/P2 non-financial, especially between 30-90 days. A2/P2 is poorer quality debt.

Now we come to the volume statistics. If you will look at this link, you will see that the volume of A2/P2 is now dropping significantly. This means that credit for poorer quality non-financial corporations is being withdrawn, and that they will have to seek other ways to cover it, or repay it. Since these are non-financial businesses, this marks a strong diffusion into the overall economy.

The total volume of A2/P2 non-financial by year, in millions:
2005: 3,311
2006: 4,986
2007: 6,275
By 2007 monthly average:
Apr: 5,578
May: 5,842
Jun: 7,409
Jul: 7,287
Aug: 7,343
Sep: 6,464
By 2007 recent weekly average:
08/17: 8,744
08/24: 7,196
08/31: 6,299
09/07: 6,836
09/14: 6,166
Volume drops of this magnitude indicate that the problem is significant, and the trajectory shows that it increasing as this wears on. While the volume for A2/P2 is dropping, the volume for AA non-financial appears now to be increasing, indicating that this is not a liquidity problem but a confidence problem. What's going on for these businesses is quite equivalent to the relative price increases for poorer quality mortgages in comparison to prime mortgages, and as with mortgages, it means that the poorest quality businesses are probably being cut off.

I hope this provides some background to these paragraphs in this Bloomberg article:
A Fed report last week showed output at U.S. factories fell for the first time in six months during August, suggesting businesses may be scaling back as consumer spending slows.

The Commerce Department on Sept. 14 said business inventories rose 0.5 in July. That was more than forecast and a sign companies won't need to ramp up production to replenish supplies in coming months, economists said. Retail inventories jumped, led by a surge at auto dealers.

Prospects for slower growth are already taking a toll on manufacturing jobs. A government report on Sept. 7 showed factory payrolls dropped by 46,000 in August, more than economists had forecast and the most since July 2003.

Chief financial officers this quarter are the most pessimistic since at least the last recession, an industry survey showed. Concern over consumer demand, higher labor costs and credit-market turmoil will cause hiring and investment to ``stagnate,'' according to the September Duke University/CFO Magazine Business Outlook, released Sept. 11.
In general, in such an environment the worst credit gets cut off, and the so-so credit sees higher rates. If you will look at the volume link above and study the monthly for AA non-financial, you will note that it fluctuates quite a bit. This stat is one I use for a manufacturing proxy, but A2/P2 also has some relationship to industrial activity, although more, I believe to services.

I don't think the moral hazard people seem so worried about exists; the resurgence of risk recognition seems firmly embedded into the financial system. The hazard that exists is rapid diffusion into healthy or relatively healthy business, which would be an economic disaster. I have relatively good anecdotal evidence that this is already occurring to some extent. Sitting around for another six weeks to see how far that will go is probably one of the least safe and sound financial tactics imaginable.


The Flow of Funds data was released today for the 2nd quarter.

I have put up new charts in my blog.

The Physics of Home Mortgage Debt - 2007 - Q2
I'm scared, we disagree. You want to call the police to shoot gophers. Sure they can shoot 'em but if they shoot 'em fer you they'll have to shoot 'em for everybody and soon run out of bullets vwhen sumptin' bad happens. 'Taint their job ta cover the bets when they go again' the house. Sur' enough they gotta step in when the house goes bankrupt but this'in ain't that. Is it?

A slowdown in commercial lending is two things; cyclical velocity and repricing risk. Do you want to try and break the business cycle or do you want to subsidize risk AND socialize it as well?

We disagree as to moral hazard. I know, I know you are smarter and more experienced and better spoken and nicer than me. Okay, conceeded. Now, given the lending standards of the last few years and who availed themselves of loose credit, who is the recent borrower? Smart, ethical MOM or the Dawg?

[N.B. I am, in realworld, a conservative savvy person with my childrens' tuition and inhiertance.]
Dawg & Mark - The riskiest stuff is still going to lie like roadkill on the Street; we are now concerned with viable operations getting funding. A Fed cut won't restore health to the bad mortgages, and won't even ease credit much for pretty good mortgages. It will have the effect of making more funding available for businesses that are creditworthy.

It may not look like much, but this is a heck of a financial crisis.

I'm obviously not doing a very good job of explaining this. The world of commercial credit is one in which your mortgage could be called to cover Casey Serin's default. This is a real, genuine threat.
This is a real, genuine threat.

I don't doubt it. The real, geniune threats are coming from all directions (inflationary, deflationary, greenspanary, bankofamericary, ...).

The Flow of Funds Data I used today is already over two months old (which is an eternitity during times of crisis). I probably should have put more disclaimers on what I wrote. It's all rear view mirror stuff.

The Fed is boxed and I am glad I'm not Bernanke. If I see one more chart showing how tame inflation has been year over year while completely ignoring that much of the reason was LAST year's commodity selloff so help me I'm going to have a cow.

If Bernanke cuts rates and inflation is not under control, heaven help us all.
I should probably add that we should already know how bad it is if the bulls are predicting a stock market collapse if they don't get 25 basis points.

Good grief. That's a LOT of implied leverage.
Mark - yeah, the Fed is in a very tight box. It's a no-win situation politically. Parts of inflation are structural and determined internationally.

The Empire survey showed a pretty hefty one-month drop. I think the Feds will look at the cp and mfrg data and pull the trigger.
I'm obviously not doing a very good job of explaining this. - MOM

No you're doing a fine job explaining ... you are just too early. The Fed might cut tomorrow but I feel they will be too early too.

They need at least one more month worth of data - consumption, employment, inflation - before they pull the trigger. Confirm the data, measure twice & cut once, etc.

If Stag Mark is right and the market tanks so be it. It wouldn't be the end of the world.

Disclaimer - I am about the only person over at CR who ISN'T short so I see no gain from a market tank.

BTW - I like your blog. I stop in from time to time & read but don't often comment.
The riskiest stuff is still going to...

And who is going to make that call? The missing mortgare payment goes straight to FC? Don't scoff. Who says risky? Why? Fact is the first will be coddled and anyone late to the category will be crucified. Risk has nothing to do with clearing out a problem caused by not understaqnding risk.

You aren't the only one who isn't short. It seems a bit too much like shorting inflation to me. The relative sidelines are just fine by me.

I'm not predicting that the market would collapse if the Fed doesn't cut. It just seems that more than a few people out there think it is true.

If I was Bernanke this is what I would do.


I guess that's just one of the many reasons that I'm not the Fed Chairman, lol.

Fed Rate Decision: Greater Chance of a 50bp Cut?
The consequences of unchanged rates would be severe. The entire yield curve would be repriced and the stock market would collapse. Therefore the more important question is: will the Fed deliver a 25 basis point cut or a 50 basis point cut?

If 25 basis points means the difference between financial armageddon and safety, we are in serious trouble.
Rob - this is no longer about mortgages at all, not even commercial ones. It's about funding for business activity. No one but a lunatic (the lunatics are mostly out of business) is going to pick up the junk mortgages for anything but steep discounts.

Dryfly - I don't short on principle, but I frankly don't believe that equities will collapse, even if the Fed raised. I mean, what the heck are most people going to put their money in? I think there is a lot of nonsense and jabber floating about.

But one thing that isn't nonsense and jabber is the sharp turn this summer in the business, especially the b-to-b climate. A rate cut will provide some margin there. We had some sort of expansion going on. If possible, that needs to keep going.
The Fed's job is not to bolster up risky business activity, but it is to make sure that liquidity exists so that good businesses are not forced to contract for no other reason but the need to become their own bankers. That it should do.
Rob - the way the risk thang for businesses will work is this. Businesses that don't have problems are in some cases getting their loans called because the bank which extended them the credit now desperately needs to cover cash shortages caused by the bad loans they made. The Fed can't stop this. Instead, the Fed needs to ease enough that these businesses can go to a bank that didn't behave recklessly and get replacement funding at reasonable rates.
Thank you MOM.I know a lot more about the real estate end than the rest,having been around it my whole life.real estate in california is toast no matter how low the rates go,or how high the conforming limit gets because we now have underwriting and people can not afford 10x earnings as a mortgage amount.game over.I very much appreciate your data and comments on the commercial paper market,and also agree that A) the good choices are gone,and B) the best bet is a 50 or even 75 basis point cut to avoid a complete freeze of the credit market.I do not consider it a desirable choice,but it is the best choice available,and the alternative is very ugly indeed.I appreciate the quality of your Data,and your approach to analysis as well.
Tom - I think one thing everyone can agree on is that these stupid, stupid loans are non-saveable. Toast, as you say. The stupid, stupid companies that got into them heavily are likewise frying on the griddle. Quite a few banks who got into it are up for a nice quick sale. A fine example of that is FINB, who I had written about earlier.

The Fed's real problem was that it couldn't afford to get rates much lower than the BofE, but I think the BofE is going to have to cut now. Certainly they woke up today and realized that they would have to cover Northern Rock's depositors, or chance A&L and/or B&B following in its footsteps.

So now the Fed has a little more room on rates, and a 25 bps cut is likely to do very little. I think 50. Regardless, if it doesn't do it this time it will have to do it the next time.

I think there is enough drag introduced into the system to moderate inflation TO THE DEGREE it can be moderated. That is not saying much.
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