Debtor's Prison

Greetings fellow inmates:

A few days ago the IMF released its July update to the Global Financial Stability Report (GSFR). The updates are short documents that supplement the much heftier reports that are chocked full of great information about financial systems across the globe. As we could have expected, this update is more sanguine about the risks to the global financial system than the April GSFR. In particular the report states that unprecedented policy actions by governments and central banks have succeeded in stabilizing the financial condition of banks, reducing funding pressures and CP risk concerns, supporting aggregate demand and reducing the tail-risk of another systemic failure similar to Lehman. Naturally, the size and extremity of the plethora of bailouts, public guarantees and interventions have propitiated improved conditions in several markets and a return of some risk appetite. Simultaneously however, many of the fundamental problems and vulnerabilities remain and the interventions have created new ones. Amongst the many lessons the GCC should teach us is that risk should be realistically and consistently assessed. For that reason, we will focus on the remaining downside risks as per the report, supplemented with our own views.

In spite of the liquidity improvements in the interbank markets due to the gargantuan pools of artificial liquidity injected by central banks, financial conditions remain tight in general. Growth in bank credit continues to decline in the advanced economies. We often discuss this very topic. The prevalent view is that credit growth needs to resume for economies to fully recover around the world. As you are well aware, we have an inherent objection to debt and to a credit-money based economy. Therefore, a reduction in credit growth is actually a welcome result of the crisis in our view, and a necessary correction. The problem we see is that the liquidity (ie, credit/debt) has in fact been injected into the base of the system, it just hasn’t coursed through it yet due to broken transmission channels. Securitization markets are currently shut down except for the government-supported ones, like Uncle Benny’s propping up of MBS issuance (below is a chart to this effect in the US and Europe). As Tyler Durden at Zero Hedge reported yesterday, there is the possibility that a pending legal case could put the final nail in securitization’s coffin. Securitization itself is a worthwhile development, the problem was that it was much more extremely concentrated than was believed and it fuelled the excessive leverage that led to the GCC. So, while we take comfort in the strong deleveraging process we’ve experienced thus far, we remain very concerned about the fact that while some of the pipes of the financial system have burst and some of the debt-water pressure has eased in parts of the system, the pipes themselves have not been fixed. Instead, governing bodies have resorted to pumping more water into the debt-reservoir.

Bank capitalization remains a very serious concern for a variety of reasons, despite massive government guarantees and commitments. In the past few months we have seen banks undergo a charade of a stress test, raise private capital and pay back some of the government bailouts. All this however belies the fact that loan losses will continue to increase due to further deterioration in a variety of debt classes. Mortgage defaults continue to rise, commercial real estate is still deteriorating and has plenty to go. Credit card default rates are not only rising rapidly, but will continue to get exacerbated by the onslaught of job losses. Commercial and industrial loans will also create further losses, especially at smaller banks. All of this is referring purely to what is on bank balance sheets. On top of that, we must consider the enormous amount of bad assets that remain parked in off-balance sheet vehicles, SIVs, SPVs, etc. As we have said before, we are extremely concerned with the fact that these have not been dealt with and continue to fester outside the public view. These are not accounted for in the standard loss reports, though the banks certainly have exposure to them. All accounting tricks notwithstanding, the fact that all this toxic debt continues to stagnate poses a huge systemic risk.

Cross-border flows continue to pose a risk, especially for emerging economies which are more dependent on external financing for growth. The epic proportion of capital outflows from emerging economies has been somewhat ameliorated by the tentative resumption of some risk appetite of late. The chart below illustrates the precipitous dive in external claims on emerging economies as well as the reduction in external loan issuance. This problem has been especially damaging for emerging European countries with extreme imbalances and that heavily depended on external capital. As a result, they have not enjoyed some of the apparent economic stabilization of other parts of the world.

The IMF update also discusses the developing risks in the sovereign debt markets. Globally, sovereign yield curves have steepened, allegedly due to improved growth prospects and reduced deflation concerns. As the report candidly admits however, rising long-term yields could also be due to worries about the market’s inability to absorb the immense expected issuance. Below is a chart of the expected issuance as well as 5YR CDS spreads for selected sovereign debt. Notice that CDS spreads remain significantly above their pre-crisis levels in spite of having fallen from their highs in February. This indicates that some of the private-sector credit risk has been transferred to the public sector as would be expected from the slew of interventions and government support. Sovereign debt issuance is one of the major risks for the next 2-3 years in our view. As we have said before, the solution to such a major debt problem is not to swap one kind of debt for another, which is what effectively has happened. This transfer of risk to the sovereign is extremely dangerous as it threatens the viability of the last recourse that the world is currently tapping into. The end-game of this global debt glut is far from over.

May your capital be safe and your investments prosperous,

MAAA