Saturday Morning Coffee - Who Has Your Back?

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Our job is to see the market as it is, not as we think it 'should' be. And maybe the rules have changed.


My son asked yesterday how many people truly understand what is happening with US market structure. He understands far better than I, as a significant part of what he does is understanding credit derivatives.

Let's review.

• The US had a massive housing market rally for years, based on an asset bubble, fueled by market speculation encouraged by easy credit launched and promoted by Alan Greenspan.
• Many 'investors' got interest only loans with little or no verification of credit worthiness
• This occurred because loan originators were interested primarily in making the loans (capturing fees) and then selling the loans
• Loan buyers didn't hold them either
• They securitized the loans, structuring them in such a way to attract yield-seeking investors from AROUND THE WORLD
• This got done with the tacit blessing of the credit rating agencies, who extracted larger than normal fees for loans (structured finance) that had a higher default rating than conventional 'bonds' of similar rating
• Many financial institutions carried these products on their books as marked-to-model, instead of marked-to-market (actual market value)
• Eventually, the products began to fail (as you would expect), and these products became worth less or just worthless
• The access to credit for the general market (even credit worthy individuals and institutions) therefore diminished, with higher origination standards, higher down payment requirements, and higher interest rates
• The 'subprime' market for loans essentially disappeared
  
• The broader market showed increased spreads (less liquidity)
• Less liquidity shows up as increased volatility
• Existing homes don't sell (for example my father-in-law's and my next door neighbors), and new construction further increases inventory
• Increased housing inventory results in softer prices (buyer's market)
• Mortgage resets stress consumers further
  
• Increased inventory also results in lower margins on construction
• Softer construction/housing means fewer higher paying construction jobs
• Construction job weakness means reductions in consumer spending, both from those in the industry, and consumers no longer able to use mortgage equity withdrawal as their piggy bank

So what's a Federal Reserve to do? The BLS shows softer inflation numbers (deflation) but the Federal Reserve pounds money into the market (above, inflationary). Professor Bernanke elects to target the credit markets, instead of the general market, as the Federal Reserve opts to accept ABCP (asset-backed commercial paper).

The market sees an opportunity, with a 'backer' of their bets. If I go to Vegas with a backer, who says "I will cover your losses", then I am a fool not to bet, and bet big.

With liquidity being restored through coordinated global monetary infusion and the government's (socialization of risk) taking on the risk for commercial paper...calling a spade a spade), volatility collapses.
__________________________________________________________________________________Meanwhile, the bond market, represented by the Ten Year Yield above, has voted 5.25% off the island. It says the US economy is slowing, you must cut rates.
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So with the equity markets within sniffing distance (five percent) of all-time highs, the markets demand rate cuts, not for the preservation of the integrity of the system (a good reason) but to allow price expansion (speculation).

The problem remains that US economic growth has become dependent on massive credit infusion, with each dollar of GDP growth requiring almost four dollars of debt. This elephant in the room isn't sustainable, but recession or even the existence of the business cycle has become politically unacceptable.

The captains of the corporate boardroom relocate to the government, so the foxes now run the henhouse. And most Americans only know the reality of price increase of what they need (food, energy, tuition, insurance) and deflation of what they have (their home equity constituting their principal asset).

And Wall Street says 'trust us'. We've got your back.

Good trading and great risk management.

Educational use only. Never intended as investment advice.