Monday, October 6, 2008

Is this what is going on?

The story is the banks won't lend to each other. The truth is probably that loan quality across the board has been deteriorating and banks realize they need more reserves themselves. It is clear that this is more than a subprime problem and it is also clear that many in the business probably looked at this as an opportunity to pick up some good customers until probably May. Bear was really at that time only an exceptional casualty and Citi had gotten plenty of money as had the brokers.

I don't believe many realize how much income Citi has been claiming over the past few years. They have done this in a climate where they haven't even begun to cover their lending with retail and commercial deposits, making them beholden to the system for massive funds. Citi had $400 billion in fed funds liabilities in summer of 2007 and the entire Fed balance sheet at that time was less than $900 billion, so massive amounts of money had to go in that direction. Then we get into the brokers, who were carrying massive leverage, probably in the trillions between them and all this needs to be unwound. But, I doubt it can.

I don't think it takes a genius to realize that credit has to shrink. That is what deleveraging means, selling enough assets to move your debt/capital ratio downward. Being that the leverage is in the financial and real estate markets, this means selling assets in these areas. I believe the financial mess is worse than the real estate mess, as it permeates the entire economy. LEH going bust set off a massive liquidation of assets. Some think this is a derivatives play, but I suspect the derivatives model was more of something that allowed all this credit structure to be built and not so much what is taking it down. The truth is the derivative market is capital neutral for the system, only punative on the players on the losing side. Clearly there were operations that were heavily on the wrong side of these trades, the brokers, monolines and AIG to name some majors, but the banks are also on the wrong side of the trade.

The fashion that the banks are on the wrong side of the trade is that financial growth was supported and encouraged by the derivative structures. Credit has to expand or there becomes a shortage of liquidity. There isn't anything out there to replace the leverage created by the derivatives market, which has gone from a structured market to a pure and simple casino with the CDS's over the past year. I can see where mark to market has wrecked havoc in this market, as traders have driven up premiums on everything, including a swap on the credit of the US. Absent the efficient use of these instruments, I highly doubt we could have carried the world economy past 2000 had these instruments not been there to allow for much lending.
I know I am going to have charges that I don't have a clue, but I am not sure anyone can put into words what is going on. I don't view this as a derivatives situation so much as a situation where the world debtor group has run out of the capacity to pay. Banks aren't lending because there is a hole in their cash machine, not because they have good loans to be made out there. Most banks are conservative, lend locally and attempt to make good loans. But, most money in the system has been loaned by wild west financiers and banks geared to attempt to maximize size and profit growth, mainly concentrated in NYC and comprising the largest players in the game. The banks that have expanded their balance sheets with little local knowledge, using market insurance are the ones that are insolvent.

So many are watching the VIX, but the VIX doesn't really matter now. It might matter at some point, but there are 900 stocks you can't short, which means that put options now have to be naked or hedged through the SPX, which creates a complex derivative model. The real situation is we are in a liquidation, a deleveraging event where the economy, the financial system and consumer balance sheets have reached maximum leverage potential. I don't know where you can move the housing market beyond 100% or even 125% LTV(remember the Ditech commercials), the broker balance sheets beyond 30 to 1. Or for that matter, the forward use of derivatives to create immediate capital for banks out of future income on debt they create.
The use of derivatives has allowed the finacial industry to paint a wishful picture, the reality that the massive piles of credit could be paid or insured. Of course, this is what is defined as a delusion. I have wondered how much totally synthetic stuff was created out there to allow for locking in and swapping these instruments of mass destruction that are now coming unwound. But, I propose the real damage was done on the way up and showing up now in a burst bubble.
One might note that these aren't the little banks going under here, but the largest. I feel that the ones that are giving the appearance of having avoided this mess, JPM, GS, WFC and a few others just haven't owned up to what they have lost. LEH had about $700 billion in liabilities and I don't know of that includes the deficit in their CDS accounts. FNM and FRE were trillion dollar outfits. I would venture that Bear was about the same size as LEH. I don't know how big WB is, but I venture it is pretty large. Some idiot said it was worth $60 billion right now, which goes to the point of how much speculation is still in the system.

What happens when large institutions deleverage? Clearly the money supply is destroyed. The Fed is trying to prop this mess by replacing the funds removed from the system with interbank credit. But, now the real picture is coming into view and there can't be any real lift to the banking system by changing the nature of its liabilities. It is very clear that every dollar of deleveraging most likely comes from the same over extended banks originated the debt. If bank A lends Hedge Fund B $1 billion and hedge fund B sells stock to get the $1 billion back, it has to come from somewhere, or some account. It likely comes from the bank that finances the buyer of the instuments, but in retirement of debt it goes into the black hole on the other end.
I am sure there are plenty of bankers that know how this thing works, thus the NY banks are financing the brokers who are, through the Fed, financing the liquidations. Of course these guys have to find someone with cash to off load this stuff. Unless this offloading is financed, the result will be a decline in account balances.

The end result is we have run out of people to take out credit to pass the bags to. Bags include housing in hot areas, bags in stock, bags in financial instruments, bags in derivatives. Deleveraging doesn't mean taking out more loans, but instead liquidating assets. Any fool in the banking business knows this and I think they also know that there isn't much in lending that doesn't carry extreme risks. Why would a bank risk their money to another bank at some kind of minimal rate when they can buy other junk yielding 10%? I will leave the derivative figuring to guys like Ras and stick to my idea that the lead horse in this game is credit generation and quality and not the lube on the axle.

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