Friday, June 27, 2008

More Credit Deflation

It is critically important to understand the decline in overall credit levels in order see just how powerful the emerging deflationary trend is. One of my favorite analysts is Doug Noland of Prudent Bear. His Credit Bubble Bulletin is an indispensable tool for anyone hoping to fully understand what is happening. From his latest edition:

Total Commercial Paper increased $1.1bn to $1.753 TN. CP has declined $471bn over the past 46 weeks. Asset-backed CP fell another $5.0bn last week (46-wk drop of $447bn) to $748bn. Over the past year, total CP has contracted $390bn, or 18.2%, with ABCP down $412bn, or 35.5%.
So there is a hole roughly $400 billion wide of destroyed credit in the shadow banking system of SIVs and other off-balance sheet entities. That would be pretty tough to fill. And in the immortal words of Ronco "But wait, there's more!" Bloomberg reported yesterday that CDO defaults since October now total 200, with a face value of $220 billion. Given the performance of the ABX and CMBX indexes, it seems safe to value the defaulted CDOs at 50% of face value or less. So add at least $110 billion to that already deep hole of vanishing commercial paper. This is all on top of whatever enormous losses emerge in the official banking sector.

So what new credit is being created to counteract all of this credit destruction? No help from the official banking sector, including the Fed. Back to our friend Doug Noland:

Bank Credit dropped $24.8bn to $9.339 TN (week of 6/18). Bank Credit has now expanded only $126bn y-t-d, or 2.9% annualized.
Fed Credit has increased $1.1bn y-t-d and $27bn y-o-y (3.2%).
There is very little ability to create new shadow credit now that the inherent riskiness of these absurdly complex vehicles has been exposed. A lot of investors are learning the hard way that if you can't understand it, you shouldn't buy it - a lesson that goes all the way back to the Mississippi Company and South Sea Bubbles of the early 18th century. The entire panoply of complex derivative securities is being revealed for the severely under capitalized pyramid scheme that it always was: SIVs, conduits, auction-rate securities, CDOs, CDS, asset-backed commercial paper and more.

The Universal Debt Bubble was a massive confidence scheme but the marks are now wise to the game. A whole new generation of "investors" with no memory of the current scandals will have to grow up before such a thing can be attempted again. We are witnessing the slow-motion collapse of the multi-trillion dollar shadow banking sector. With (commercial) bank credit also beginning to drop and Fed credit nearly stagnant, the supply of credit to support asset inflation is shrinking outright.

Expect more pain across all major asset classes that are typically purchased in highly leveraged transactions.