Threat to Global Markets: Credit Contraction or Liquidity Shrinkage

``What deflation is, is falling prices precipitated by a credit contraction—by the inability or unwillingness of lenders to lend and borrowers to borrow…But, for now, a superabundance of money and credit is financing a leap in asset prices across markets and time zones.” Jim Grant, Grant’s Interest Rate Observer

Nonetheless, there are several differences between that of February’s volatility and today’s carnage.

One is that as a function of market internals, as we pointed out in our June 18 to 22 edition (see Introspection on the US Markets and the Phisix, Deterioration in US Market Internals), the deterioration in the US has gone broad based, as shown in Figure 2.

Figure 2: Barry Ritholtz: Weekly Performance of Dow Subcomponents

Courtesy of one of our favorite analyst Barry Ritholtz, Figure 2 shows that even the previously buoyant sectors of Basic Materials, Energy and the Industrials responsible for the elevation of the main indices in the past has now degenerated. So instead of an interim recovery, which proved to be ephemeral, almost all of the industry groups have presently joined in the selloff. In short, what we are seeing today is a broad market decline in investor sentiment and this does not bode well for the US markets.

Second, credit markets are manifesting signs of a contagion…

Figure 3: Paul Kasriel of Northern Trust: Recent Spike in Yields still Low compared to yesteryears

Since one of the main pillars ascribed to as having boosted US markets of late has been the de-equitization process or “equity supply shortages for investment” mainly as a consequence to a combination of corporate share buybacks plus leverage buyouts or private equity deals (which accounted for more than a third of all acquisitions in the US in the first half of the year-Economist), the sudden rise of risk aversion as shown by the rising yield spreads has effectively reduced the incentives for such activities.

To quote another favorite analyst of ours Mr. Paul Kasriel of Northern Trust (highlight mine), ``But now, credit to fund de-equitization is getting more expensive. Since June 12, the yield spread between high yield (aka junk) bonds and 10-year U.S. Treasury securities has increased by 150 basis points. Even with this recent widening, corporate credit-risk spreads still are relatively low. But should they continue to widen, this de-equitization factor that has been driving up stock prices will wane.”

With the ongoing housing recession spilling over to the subprime mortgages, which during its heyday have been then packaged and rated in different forms of structured finance instruments, and sold or distributed to a diverse class of investors, the present re-ratings or change in risk assessment has likewise affected institutional holders in far corners of the globe. For instance, two Australian hedge funds were reportedly affected; Absolute Capital Group (suspended withdrawals) and Basis Capital Fund Management (hired Blackstone to negotiate with bankers to limit losses).

Even credit default swaps or contracts used to speculate on a third party’s ability to pay on our domestic sovereign bonds were recently repriced, according to Oliver Biggadike of Bloomberg, ``The perceived risk of owning Philippine and Indonesian notes rose to the highest in a year. Contracts based on $10 million each of Philippine and Indonesian dollar-denominated debt increased $55,000 to $205,000, according to prices from JPMorgan Chase & Co. The difference in yield on the nations' 10-year dollar- denominated benchmark notes compared with similar-maturity U.S. Treasuries increased to 2.08 percentage points and 2 percentage points respectively. Both countries' credit ratings are below investment grade. High-yield, or junk bonds, are rated below Baa3 at Moody's Investors Service and BBB- by Standard & Poor's.” Subsequently, the sharp rise in yields has evidently boosted the US dollar relative to the Peso (the latter had a precipitous drop over the week down by 2.05% from 44.8 to 45.72 pesos against a US dollar).

While Japan’s banking system is said to have little exposure on US subprime mortgages, according to the International Herald Tribune (emphasis mine) ``Japan's nine biggest banking groups have more than ¥1 trillion of combined holdings in products backed by U.S. subprime mortgages, the Nikkei English News reported.” That’s still equivalent to about a hefty US $8.418 billion but nonetheless a short change compared to the $600 billion subprime mortgage loans (as of 2006) in the US.

So with tighter credit standards self-imposed by the US financial entities arising from the subprime mortgage crisis, rising yield spreads have led investors to shy away from present deals, where according to the Economist (highlights mine), ``The mortgage malaise has, in short, led to a broader reassessment of risk. Until recently, issuers of high-yield (junk) bonds and loans were able to borrow at wafer-thin spreads over blue-chip credits. That gap is now widening by the day. As a result, more than 40 companies—many the targets of leveraged buyouts—have had to cancel, postpone or sweeten bond or loan offerings this month. This week banks pulled the sale of $12 billion in loans to finance the leveraged takeover of Chrysler. This has left some wondering if the golden age of private equity may be over. Shares in Blackstone, a private-equity firm that went public last month, are languishing 17% below their offer price.”

Effectively all these translate to one thing: Credit Constriction. If in the past liquidity or the availability to create, access and intermediate funds came with no apparent limit, today’s subprime busts have spurred a change in risk appetite which has reversed the course of investor’s expectations: investors now demand higher yields for commensurate risks taken.

Figure 4: Dr. Ed Yardeni: Assets of US Households

Lastly, the recent realignment in investor’s expectation could also affect the spending patterns of the US households which constitute about 75% of GDP.

Where total financial assets of the US households totaled US $42.522 trillion for the first quarter according to the Federal Reserve’s Flow of Funds, direct and indirect exposures to equities or via mutual funds and the real estate industry constitutes about 50% of the said assets, as shown in Figure 4 courtesy of Dr. Ed Yardeni of Yardeni.com. A broad deterioration in both asset classes could further restrict the financing options for the highly levered US households in the face of a contracting credit environment.