Money Sage (archive)

Regrettably, we believe this to be the case.

Forthcoming hits to the banking system are, in our judgment, likely to be as follows:

1. Commercial mortgage-backed securities. (CMBS). The bear market in commercial real estate, which we have predicted for some time, is now solidly underway, in our judgment. Prices have started to decline from their current stratospheric levels -- from where they receive grossly inadequate support from the rental income generated by the underlying properties. The market value and salability of commercial mortgage-backeds is poised to sink -- possibly severely -- with attendant damage to bank balance sheets and the banking system's lendable capital. Multiplying signs of distress among multi-billion dollar borrowers among real estate moguls is suggestive of the developing downward pressure on commerical property prices. The contraction of lendable bank capital -- attributable to other factors -- constricts the availability, and raises the cost of bank capital still extendable to commercial real estate property owners. The price of CMBS will follow the price trend of the more familiar, now well-hated, bear trend in the price of residential mortgage-backeds, we judge.

2. Credit card, automobile, and other asset-backed securities. As the vicious downward cycle of house prices, home equity levels, prices of mortgage-backeds, and availability of lendable bank capital continues to feed upon itself, and each of its components -- with the possibility of an ACCELERATION of this downward spiral -- the ability of credit card borrowers, and borrowers who have used loans to purchase autos, appliances, finance vacations, etc etc -- to service their debt obligations will shrink. (This, indeed, is already occurring). The income streams produced by the large quantity of SECURITIZED LOANS -- the little brother to the securitized mortgage loans which have already wreaked horrific havoc -- will diminish. This will generate a replay in this NEW ARENA of what we have already seen in the residential real estate mortgage-backeds -- an APPROPRIATE DECLINE IN VALUE OF THE SECURITIES (many of which the banks and other important financial institutions hold). As these securities decline in price, the falls will likely OUTPACE the actual decline in income streams, as FEAR SPREADS and APPROPRIATE UNCERTAINTY about the ultimate payout of these securitized loans manifests itself. The buyer's strike we have seen in the residential mortgage-backed market will likely spread to these other securities, further reducing the lendable capital of the banking system, raising the price of credit for those few who can still borrow, and moving the banks another sizable step in the direction of DE FACTO INSOLVENCY.

We are concerned over whether the FED can move fast enough -- faster than the approaching tsunami. The lack of a full bore government bail-out is a mounting concern, as the financial implosion threatens to intensify.

We have one additional area of concern, we are sorry to say. If the FED proceeds with a massive liquidity creation effort (which we have YET TO SEE), there is a risk of a sell-off at the long end of the Treasury market. If Treasury investors become concerned that the FED's measures could lead to a rise in inflation down the road, they will sell, forcing long term yields higher. This would serve to at least partially neutralize the FED's re-liquefying efforts. A combination of the FED's grave 1970s error of monetizing the inflation of that era, and the central bank's endless harping, in recent years, on the so-called "inflation threat" in an environment where the primary threat has for a long time been DEFLATIONARY may have the ironic consequence of driving long-dated yields temporarily higher at precisely the wrong moment -- the moment when the deflationary and contractionary forces are at their most powerful.

One final observation. The FED is NOT, repeat NOT, to blame for this potential "ultimate dilemma." We have taken the FED to task repeatedly when we judged its monetary policy to be erroneous and when we found its method of forecasting to be deficient. We do NOT retract these criticisms.

However, in confronting the "ultimate dilemma" the FED is reaping the whirlwind produced by government policies which have created, nurtured, and extended to the breaking point an economy built upon an apparently endless cycle of borrowing and spending. This, to be sure, has many positive benefits. Now, however, we are face to face with the prospect of having to pay the piper. We maintain a cautious hopefulness that a combination of timely FED and US government bailout moves will prevent a true puncture of the credit bubble. As we have said in the past, the objective must be not to allow the bubble to burst, reap the whirlwind, and then rebuild on a "sounder" basis. This would entail horrific suffering and could permanently damage America's economic strength and future. We need to manage the bubble, nor burst it.