Money Sage (archive)

Regrettably, the answer to this question we pose in the title is: Affirmative.

New landmines are now surfacing, with the probable consequence of WORSENING the CONTINUING DETERIORATION of the capital position of the banking system, the ability/willingness to lend, and the ability of increasingly hardpressed borrowers to roll over their loans, increase them, or improve the terms of borrowing.

Without repeating what we have said again and again, we wish to UNDERLINE that there is in effect a MUTUALLY REINFORCING DYNAMIC between the deepening bear market in real estate (which is now spreading to NEW sectors of the real estate market and the securitized loans this sector supports -- viz., COMMERCIAL real estate), the falling value and marketability of an INCREASINGLY BROAD SPECTRUM of real estate backed loans, the consequent deterioration in the liquidity/solvency of the banking system, AND the concomitantly DECLINING OF THE BANKS TO ROLL OVER existing customer loans, make new loans, or improve lending terms. This, in turn drives the generality of borrowers (i.e., homeowners, consumers, major property owners, businesses of all classes) into an endlessly deteriorating liquidity situation with ever-more serious threat of insolvency to an ever-growing number of borrowers/homeowners/consumers.

It hardly requires a financial wizard to infer the implications of this vicious cycle for the overall economy.

Now, new problems have been added to this existing witches' brew. In the last several days a freezing up of the auction-rate securities market has occurred. This market accounts for more than $300 billion in bonds issued by a variety of issuers. The bonds reset their interest rates via bank-managed auctions every 1-5 weeks (depending on the terms of each bond indenture). Issuers are typical highly reliable borrowers -- such as municipalities, student-loan authorities, museums, etc. The long-term bonds they issue are "normally" a highly liquid security, which is frequently purchased by those seeking to park their cash in a safe place. The creditors purchase these securities in lieu of totally liquid, totally safe short-term Treasuries because of the EXTRA YIELD. These investors are engaging in the all-too-familiar "reaching for yield" -- a behavior which, as we have noted in a prior post, may have produced greater loss for investors than all the stock market losses in history.

Now, the buyers have disappeared, and hundreds of auctions in recent days have failed. What this means is that creditors who need the cash ARE UNABLE TO SELL THEIR SECURITIES. In the past, when banks were flush, they would frequently purchase these securities from those who had to sell if there was not enough buying interest. Banks, however, ARE NOT REQUIRED to bail out those needing liquidity -- and THEY ARE NOT DOING SO. (Note-- banks are not required to bail out money market funds they sponsor either if these money markets hold securities they cannot sell or which have dropped drastically in price. Thus far the banks HAVE bailed out these funds, both out of calculations of overriding self-interest, and because their capital position was STRONGER than it is TODAY).

There are two immediate consequences of the auction failures. The first is that the issuer must pay a penalty rate of interest to holders of their securities until the next auction. This, of course, reduces the capital of the issuers, and their ability to service other debts or proceed full-bore on projects to which they have committed or would otherwise launch. The consequences for the economy of a continuing failure of auctions -- itself in part an indirect consequence of the growing impairment of bank capital, and in part a consequence of the pandemic of fear -- are clear.

The second consequence is that a continuation of these failures will INTENSIFY FEAR and WILL BROADEN the category of risk-averse securities, with further contractionary implications for an economy already facing a possible downward vortex.

A second problem area, which has not yet materialized but which may, is the category of tender-option bonds. Certain financial firms -- BANKS among them, for a change -- have reportedly set up off-balance sheet entities (remember the SIVs?) to issue debt securities and employ the funds they thereby raise to purchase longer-term municipal bonds. The risk here is that creditors may choose NOT to roll over their loans to these bank-sponsored entities, threatening the entities with bankruptcy ( a la SIVs), with grave damage to the banks' reputation and ability to conduct business, or, more likely, force the banks to move the assets held by the off-balance sheet entities onto their own balance sheets. This would constrict further the banks' ability to lend to their own customers and to the generality of borrowers.

In sum, we will freely own that we are somewhat hardpressed to see where the second half economic growth Dr.Bernanke, the FED, and the Administration are predicting will materialize from. With surveys indicating that only a small percentage of recipients of stimulus plan largesse intend to spend their rebate checks, with the lending capability of the banks in ever greater question, with home prices continuing to decline and mortgage resets, defaults, and foreclosures rising, we admit that we lack the insight apparently possessed by the FED and the Administration.