To Big to Suffer a Loss - By Doug Noland

<blockquote>"The last thing the crippled leveraged speculating community needs right now is dislocation in the CDS marketplace. Again, the attention this week was on Lehman, while I believe a much more unwieldy facet of today’s crisis mounts with the bursting of the historic hedge fund Bubble. Perhaps Sunday we’ll read news of BofA acquiring Lehman – and perhaps the markets will rally big on such news. But such a transaction would have little if any impact on crisis dynamics that have engulfed the leveraged speculating community. The various markets – global equities, real estate, mortgages, energy and commodities, currencies, CDS and risk assets generally – have all become an absolute and unmitigated mess. Money is being lost in waves; scores of favorite trades are being unwound; redemptions are gathering pace; and the ugly side of Ponzi Finance Dynamics has taken firm control.


Importantly, there is today no magical cure – no government bailout – that is going to rejuvenate robust speculator returns. The Credit Bubble burst, and now the speculator Bubble is bursting. As we have been witnessing of late, stock market rallies tend to show their greatest force in the sectors where the speculators are short. Meanwhile, stock market declines tend to see the favored sectors lead on the downside. Worse yet, astonishing volatility throughout the markets has created a backdrop where it has become too easy to “get your face ripped off.” Repeated government interventions have only exacerbated market instability and vulnerability."</blockquote>


To Big to Suffer a Loss

By Doug Noland
September 07, 2008
Source

This will be another captivating weekend, with focus on both Ike and Lehman. The experts are anticipating that Ike may be the worst hurricane to hit Texas in 50 years. Today’s financial storm is a once-in-a-lifetime, ongoing event. Indeed, it is my sense this evening that this financial maelstrom has now reached a new erratic and highly uncertain stage. That the Fed would respond to the collapsing U.S. Credit Bubble with a string of rapid rate cuts was no surprise. That the Fed would step up and bail out Bear Stearns, while at the same time providing liquidity facilities to the Wall Street firms, was similarly predictable. It was like clockwork when the GSEs responded to market tumult and the mortgage collapse by heedlessly expanding their obligations. And while I was surprised that the likes of OFHEO’s Lockhart and the gents at Pimco proved key enablers for the GSE’s last gasp of recklessness, that the federal government would be forced to step up and nationalize Fannie and Freddie should have been anything but a bombshell development. Only the timing of the “bazooka” blast was up in the air.

Washington has certainly brought out the big guns – resorting to them so early in the crisis but to alarmingly limited avail. Negative real interest rates and even unprecedented bailouts do little to address the deep structural deficiencies that have developed over many years. Sustaining inflated U.S. asset markets requires massive ongoing growth in Credit and speculative trading. The deeply maladjusted U.S. “services” Bubble economy is sustained only through ongoing Credit excess. To be sure, the heart of today’s predicament lies in the reality that a heavily impaired U.S. financial sector is simply incapable of partaking in the degree of Credit excess required to sustain inflated assets prices, incomes, corporate profits, government receipts and much needed (restructuring-related) investment spending. The problem is systemic. Bailouts and other government measures have minimal impact because they are not inciting heightened Credit expansion.

And while the media directed its attention to Lehman, the pricing of AIG Credit Default Swaps (CDS) exploded this week. This is a company with a Trillion dollar balance sheet and enormous exposure to the CDS market and other derivatives. And although its balance sheet is only about a third the size of AIG’s, Washington Mutual also saw its CDS blow out. And while most holders of Fannie and Freddie obligations have come out of the GSE fiasco unscathed (or better), one can see how this crisis going forward will see more pain meted out to the corporate bondholder - not just the poor lowly equity owner. Perhaps the prospect of Lehman debt holders suffering losses has pushed the acutely vulnerable CDS market to the edge.

The last thing the crippled leveraged speculating community needs right now is dislocation in the CDS marketplace. Again, the attention this week was on Lehman, while I believe a much more unwieldy facet of today’s crisis mounts with the bursting of the historic hedge fund Bubble. Perhaps Sunday we’ll read news of BofA acquiring Lehman – and perhaps the markets will rally big on such news. But such a transaction would have little if any impact on crisis dynamics that have engulfed the leveraged speculating community. The various markets – global equities, real estate, mortgages, energy and commodities, currencies, CDS and risk assets generally – have all become an absolute and unmitigated mess. Money is being lost in waves; scores of favorite trades are being unwound; redemptions are gathering pace; and the ugly side of Ponzi Finance Dynamics has taken firm control.

Importantly, there is today no magical cure – no government bailout – that is going to rejuvenate robust speculator returns. The Credit Bubble burst, and now the speculator Bubble is bursting. As we have been witnessing of late, stock market rallies tend to show their greatest force in the sectors where the speculators are short. Meanwhile, stock market declines tend to see the favored sectors lead on the downside. Worse yet, astonishing volatility throughout the markets has created a backdrop where it has become too easy to “get your face ripped off.” Repeated government interventions have only exacerbated market instability and vulnerability.

I find it rather odd that Secretary Paulson and the Administration were keen to boast that Fannie and Freddie shareholders would not benefit at the expense of the U.S. taxpayer. Yet it’s not as if there were moral hazard issues that had incentivized these shareholders into risky speculative activities at the expense of systemic stability. On the other hand, moral hazard played a fundamental role in Pimco’s and others’ speculative endeavors in agency debt and MBS obligations (enabling the GSEs’ reckless expansion of risk). And, what do you know, The Enablers came out the big winners.

There’s a lot of talk these days about institutions that are Too Big to Fail. But this misses the more important point. The heart of the problem is systemic throughout the Credit system, and I’ll refer to it as Too Big to Suffer a Loss. The entire financial system would have come unglued if agency debt and MBS holders suffered losses – losses that could have triggered another round of speculative deleveraging – that could have triggered outflows from “bond” funds – that could have triggered losses in “money” funds and/or a flight from the dollar.

“Moneyness of Credit” remains an invaluable analytical concept. Despite acute vulnerability, the U.S. Credit system – hence the American economy – has resisted implosion specifically because the heart of the monetary system has retained its “Moneyness.” Indeed, nationalizing Fannie and Freddie was seen as necessary to retain confidence in the core of contemporary “money” – agency obligations, “repos” and money fund assets. This highly inflated supply of “money” has become so large as to almost on its own shoulder the entire U.S. (global?) financial system and economy. “Money” has become Too Big and Consequential to Suffer a Loss.

Pimco and others savvy players appreciated this dynamic and exploited it for all it was worth. Ironically, with all the losses being suffered throughout the markets, the moral hazard issue has never been as precarious. The government “printing press” now includes agency debt and MBS. The incentives to enable the continued rampant inflation of contemporary “money” have never been stronger, with the consequences of these obligations losing their “Moneyness” never even remotely as consequential. Perhaps Treasury and the Administration will stick to their word and not provide taxpayer funds to save Lehman and others. Yet why do I feel the next step of government intervention will be to bolster the “repo” market. Looks like the days of easy government interventions have run their course.