Ambrose Evans-Pritchard: Here comes the insolvency crunch


By Ambrose Evans-Pritchard
The Telegraph, London
Thursday, August 23, 2007

The liquidity crunch is not yet over. The insolvency crunch has hardly begun.

Yes, investors are jumping back into the stock markets, hoping this is just another routine shake-out -- much like February 2007, or May 2006 -- before the rally resumes. The "buy-on-dips" orthodoxy dies hard.

And yes, speculators have renewed their leveraged bets on the yen and Swiss franc carry trades, borrowing cheap in Tokyo and Zurich to play global assets. The core belief is that nothing has really changed, that the world economy is still in rude good health.

Be very careful. Interest rates in Europe and Asia are that much higher now, with delayed effects starting to bite hard. Japan's economy has stalled to 0.1 percent growth in Q2; the euro-zone has slowed to 0.3 percent; and China's refusal to import (by currency manipulation) makes it a drain on world demand. Above all, the credit bubble that perpetuated the rally of the last eighteen months beyond its natural life has definitively burst.

Credit spreads on the iTraxx Crossover (a good barometer of corporate bonds) have ballooned 180 basis points since February. The cost of borrowing for most firms in Europe and North America has jumped from circa 6.5 to 8.3 percent, if they can get it.

Many cannot. Germany's Chamber of Industry told me yesterday that it had been flooded with distress calls from family Mittlestand firms unable to roll over credit lines. In Canada and Australia junior mining finance has dried up almost entirely.

Global junk bond issuance has been frozen for two months. Fresh sales of collateralized debt obligations -- the CDOs of subprime notoriety: a $1 trillion sold last year -- have all but stopped. Banks have yet to offload $300 billion of debt from leveraged buyout deals, forcing them to keep the liabilities on their books. They are all snake-bitten now.

The private equity buyout premium -- which pushed up the price/earnings ratio on the MSCI-600 of "median" stocks to a record high of 20 in May -- has vanished. The P/E ratios on the DOW 30 big stocks are much lower -- because they are too big even for the big-cat predators, KKR and Carlysle -- but they are not low, given the late stage of the cycle. In reality, an earnings bubble and ultra-cheap credit have flattered profits.

So no, the world has changed, dramatically. Whether this means a protracted global downturn and a "profits recession" depends on how quickly the central banks choose to respond, and how far they are willing to go.

Ben Bernanke is looking hawkish to me, given the shock of what happened on Monday when yields on 3-month US Treasury notes plunged at the fastest pace ever recorded, a panic flight to safety that no living trader had ever seen before.

Why? Because trust had collapsed to such a degree that players with a lot of cash no longer believed it safe to leave wealth in bank accounts, or the money market funds of brokerage companies (exposed as they are to short-term commercial paper and subprime CDOs). This did not occur after 9/11, or in the heat of the October 1987 crash. Nor did was there such a banking panic in October 1929. (It hit in August 1931.) If you think this is of no importance, or that this will pass swiftly, you have a strong nerve.

"When you have a run on the money markets like this, it is bound to spill over into the real economy," said Albert Edwards, global strategist at Dresdner Kleinwort.

"We already thought there was a 40 percent chance of a US recession before all this happened, but the risks are now much higher, and don't forget that rates on adjustable mortgages will keep rising until a peak next March, so the maximum pain will be in the second and third quarters of 2008," he said.

"There will be large bankruptcies, and liquidity is not going to help because too many people bet the farm at the top of the cycle, and they're now insolvent. A lot more bodies are going to be floating to the surface before this is over," he said.

The belief that Europe would somehow be insulated has been tested over the last two weeks. Two German banks have required bail-outs on subprime bets -- Sachsen LB for E17.3 billion, IKB for E8.1 billion.

Alexander Stuhlmann, boss of WestLB, confessed that the German banking system was in a "not uncritical situation." Jochen Sanio, head of the German regulator BaFin, said a few days earlier that the country faced the worst banking crisis 1931.

Hence the continued actions of the European Central Bank, which has quietly injected E85 billion in extra liquidity so far this week, almost as much as it did on the first day of emergency stimulus in early August.

"Banks are still thirsty for credit, and the spreads have been amazing. This is not business as usual at all," said Julian Callow, chief Eurozone economist for Barclays Capital and an expert in the arcane field of central bank operations. (He used to work for the Bank of England.)

To clarify: the ECB allotted an extra E45 billion through a "weekly refi" on Tuesday; and then E40 billion in a three-month offer on Wednesday to stop the short-term commercial paper market from seizing up.

What we know is that 146 banks bid for loans on Wednesday, some clearly in such distress that they were willing to pay up to 5 percent interest -- a full 1 percent above the ECB's benchmark rate.

Just like the dotcom bust: When the US sneezes, Europe catches. ... You know the rest.

In a warped sense, one has to admire the cool way that Americans -- who save nothing, in aggregate -- tapped into the vast savings pool of thrifty Germans to finance their speculative excesses and then left the creditors holding a chunk of the subprime losses.

Was it sharp practice, in the same way foreigners were recruited by Lloyds of London in 1986 and 1987 -- before the impending asbestos losses were known -- and placed like cannon fodder on "spiral syndicates" to absorb crippling losses? (Lloyds denies this occurred.)

I am endebted to Randall W.Forsyth from Barron's for this delicious quote from a hedge-fund operator, recounting with disgust what happened this time in a letter to clients.

"'Real money' (U.S. insurance companies, pension funds, etc.) accounts had stopped purchasing mezzanine tranches of U.S. subprime debt in late 2003 and [Wall Street] needed a mechanism that could enable them to 'mark up' these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!!

"These CDOs were the only way to get rid of the riskiest tranches of subprime debt. Interestingly enough, these buyers (mainland Chinese banks, the Chinese government, Taiwanese banks, Korean banks, German banks, French banks, U.K. banks) possess the 'excess' pools of liquidity around the globe. These pools are basically derived from two sources: 1) massive trade surpluses with the U.S. in U.S. dollars, and 2) petrodollar recyclers. These two pools of excess capital are U.S. dollar-denominated and have had a virtually insatiable demand for U.S. dollar-denominated debt ... until now."



Ambrose Evans-Pritchard is international business editor for The Telegraph.

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