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Are We Heading for Another 2008?

Intervention ultimately leads to greater instability
Wednesday, April 11, 2012, 11:44 AM

We all know that central banks and governments have been actively intervening in markets since the 2007 subprime mortgage meltdown destabilized the leveraged-debt-dependent global economy. We also know that unprecedented intervention is now the de facto institutionalized policy of central banks and governments. In some cases, the financial authorities have explicitly stated their intention to “stabilize markets” (translation: reinflate credit-driven speculative bubbles) by whatever means are necessary, while in others the interventions are performed by proxies so the policy remains implicit. 

All through the waning months of 2007 and the first two quarters of 2008, the market gyrated as the Federal Reserve and other central banks issued reassurances that the subprime mortgage meltdown was “contained” and posed no threat to the global economy. The equity market turned to its standard-issue reassurance: “Don’t fight the Fed,” a maxim that elevated the Federal Reserve’s power to goose markets to godlike status.

But alas, the global financial meltdown of late 2008 showed that hubris should not be confused with godlike power. Despite the “impossibility” of the market disobeying the Fed’s commands (“Away with thee, oh tides, for we are the Federal Reserve!”) and the “sure-fire” cycle of stocks always rising in an election year, global markets imploded as the usual bag of central bank and Sovereign State tricks failed in spectacular fashion.

Keep Doing More of What Has Failed Spectacularly

Central banks and states responded by doing more of what had already failed spectacularly. In the ensuing years 2009-2012, they increased money supply and liquidity and lowered interest rates to zero or near-zero. And sovereign states borrowed vast sums to squander on “stimulus spending.” This “doing more of what has failed spectacularly” earned the apt moniker of “extend and pretend.” Nothing was actually fixed, but we were encouraged to believe it had been fixed with a flurry of absurdly complex “reforms” that only increased the power of the central states and banks without actually addressing the underlying causes of the meltdown: extremes of leveraged debt, extreme concentrations of financial wealth that then bought political power, shadow banking and opaque markets for hundreds of trillions of dollars in notional derivatives, systemic fraud and embezzlement, phony valuations assigned to assets and liabilities, and various schemes to misprice risk, among others.

If we had to distill the entire global crisis into the simplest possible statement, we might say that the collateral that supported this great inverted pyramid of leveraged debt vanished, and as a result the entire pyramid crumbled.

Since the global housing bubble was at the heart of the crisis, let’s use housing to explain this simple summarization. If a house that was owned free and clear (no mortgage debt) rose in value from $200,000 to $500,000 during the bubble, the collateral of that asset was valued at $500,000 at the peak. If the house has fallen to $250,000 in the post-bubble decline, the collateral is now $250,000.

Since there was no debt leveraged off of that collateral, the owner experienced no leveraged consequence of that decline. His assets fell, and he felt the “reverse wealth effect,” so he feels poorer even though his asset is nominally worth more than it was prior to the bubble. (Adjusted for inflation, that nominal gain might well vanish into a decline in purchasing power, but that’s another story.)

Compare that to the home purchased for $500,000 with a highly leveraged subprime mortgage in which 3% of actual cash collateral ($15,000) was leveraged into a mortgage of $500,000. (For simplicity’s sake I am leaving out the transaction costs.)

The collateral was leveraged 33-to-1. This is delightfully advantageous if the house continues rising in value to $600,000, as that increase generates a six-fold return on the cash invested ($15,000 in, $90,000 out). But once the house prices slipped 10% to $450,000, then not only did the 3% cash collateral vanish, the collateral supporting the mortgage also declined. The mortgage was no longer “worth” $500,000.

Since Wall Street securitized the mortgage into mortgage-backed securities (MBS) and sold these instruments to investors, then the value of those MBS also fell as the collateral was impaired. And since various derivatives were sold against the collateral of the MBS, then the value of those derivatives was also suspect.

If $1 of collateral is supporting an inverted pyramid of $33 of leveraged debt, which is then the collateral supporting an even larger pyramid of derivatives, then when that $1 of collateral vanishes, the entire edifice has lost its base.

And that's at the heart of current central bank policy: “Extend and pretend” is all about keeping the market value of various assets high enough that there appears to be some collateral present. 

In our example, the mortgage is still valued on the books at $450,000, but the actual collateral — the house — is only worth $250,000. The idea being pursued by central banks around the world is that if they pump enough free money and liquidity into the system, and buy up impaired debt (i.e., debt in which the collateral has vanished), then the illusion that there is still some actual collateral holding up the market can be maintained. 

Subprime Mortgages Have Given Way to Subprime Sovereign Debt

The implosion of overleveraged subprime mortgages triggered the 2008 global meltdown because the market awoke to the fact that the collateral supporting all sorts of debt-based “assets” had vanished into thin air. Four years later, we have another similar moment of recognition: The collateral supporting mountains of sovereign debt in Europe has vanished. The value of the debt — in this case, sovereign bonds — is now suspect.

The European Central Bank (ECB) has played the same hand as the Federal Reserve: Do more of what has failed spectacularly. Expand the money supply, pump in more liquidity and buy up the impaired debt all in the hope that the market will believe that there is still some collateral holding up the leveraged-debt pyramid.

The ultimate collateral supporting the stock market is the book value of the assets owned by the company, but the notional collateral is corporate profits: equities are claims on the future free cash flow generated by the corporation.

There are all sorts of inputs into this calculation, and markets are supposed to reflect these various inputs: currency valuations, sales, profit margins, costs of labor and raw materials, inflation and so on. Now that markets are manipulated to maintain the illusion that there is enough collateral out there somewhere to support the inverted pyramid of leveraged debt, it’s difficult to know what’s real and what’s illusion.

One of the few ways we have to discern the difference is to compare various markets and look for divergences. If a spectrum of markets and indicators is pointing one way and another market is pointing the other way, we then have a basis for asking which one is reflecting illusion and which one is reflecting reality.

In 2008, the central banks and governments lost control of the illusion that there was sufficient collateral to support a stupendous mountain of leveraged debt. By doing more of what failed spectacularly then, they have laboriously reconstructed the illusion that they control the markets (“Away, tides, for we are the ECB!”) and thus the valuation of collateral.

Once again we are sternly warned not to “fight the Fed,” as if the Fed had the financial equivalent of the Death Star (“You don’t know the power of the Dark Side!”). Once again, we are in an election year where the four-year cycle is supposed to “guarantee” an up year in stocks.

Or maybe 2012 is shaping up to reprise 2008, and the market will wake up to the fact that intervention doesn’t create collateral, it only creates the temporary illusion of collateral. 

In Part II: Why A Near-Term Market Rollover is Probable, we will look at key technical indicators that suggest the Fed’s Death Star may not be the ultimate financial weapon in the Universe after all. There is a growing series of global data that suggest the run-up in the equity markets has reached its peak, and that the economic sickness the central banks had hoped to "cure" with all of their money printing is metastasing. 

Click here to access Part II of this report (free executive summary; enrollment required for full access).

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5 Comments

Dirk Campbell's picture
Dirk Campbell
Status: Member (Offline)
Joined: Dec 4 2009
Posts: 17
Are we Heading For Another 2008?

The crash of 2008 was confidently foretold in the media, people could see it coming. The creation of money with unacceptably risky loans was an obvious disaster that could be clearly observed working through the system. I don't see any such thing in the papers or on the news now. Why would that be? Probably because the financial journalists who saw the 2008 crash coming are not seeing a 2012 crash coming.

Rehearsing all the same sub-prime mortgage arguments in a restrospective attempt to predict the same thing happening again on a bigger scale is not very impressive. Did this guy predict the 2008 crash? Not really. He looked at the current financial imbalance but was unable to say what it would actually lead to. Lots of maybes and probables, nothing about banks collapsing and having to be bailed out by massive government borrowing.

I am not saying he is wrong, just that hedging one's bets is a city financier's approach and doesn't invite trust. If the analysis is sound, the conclusion is incontrovertible. Analysts having been rehearsing all these same arguments for years, and still the only thing that can be said with any certainty is that 'the next twenty years will be entirely unlike the last twenty years'. Appreciate your consistency, Chris! Or 'during a time of uncertainty the gold price performs better than anything else' after which the gold price began an overall downward trajectory which it still maintains.

Issuing prophecies which turn out to be wrong - including ones disguised as questions - pisses people off and stops them listening after a while.

Dr No's picture
Dr No
Status: Member (Offline)
Joined: Jun 18 2011
Posts: 2
Why forecasters are unreliable

 Reliable forcasters are impossiblebecause the forcaster can´t possibly be privy to enough information about the present to get a line on the future.

Next months Dow Jones average will reflect billions of seperate decisions-which themselves are the outgrowth of the desires, intentions, and actions of hundreds of millions of people of all kinds, not just investors.

Not even the worlds biggest computer can read the minds of millions of people and thus it can´t obtain and analyze the data necessary to know the future. S investors try shortcuts. They use fundamental analysis- such as guessing how politicians will try to manipulate interestrates and what the manipulations will lead to. Or they alpply technical analysis-such as watching the trends of particular indicators, thinking that the cause-and-effect pattern of yesterday will apply again tomorrow.

Almost any method works at first, because the analyzer chooses the methods that are working. But no forcasting system holds up long enough to make you rich. And when it stops working, you lose money-because the one thing that you certainly can´t forcast is the occasion when a forcasting method will fail.

eugene12's picture
eugene12
Status: Member (Offline)
Joined: Jan 11 2012
Posts: 3
I wonder where I was when

I wonder where I was when the media was forecasting the collapse in 2008?  Sure wasn't here!!  I've never heard the US media forecast anything but things are picking up.  In fact, I've yet to see a media person with enough knowledge to do anything other than read off the monitor.  They're actors pure and simple.  Nearly half of America either can't or can barely read and write so one can't say anything too complicated. 

As far as forecasts, I don't think it takes a genius to see we're in deep, deep shit here.  Course when you're a member of the smartest, brightest and god's chosen few, you believe you're carrying a big, big shovel.  But then we did elect a leader who believed god spoke directly to him.  When you live in the land of religious fantasy, anything can happen!!

 

 

 

 

 

 

 

 

 

 

 

raydescm's picture
raydescm
Status: Member (Offline)
Joined: Apr 13 2010
Posts: 1
2 cents

Since when is gold trending down? I look at that price every day. I guess if you bought in March 2012 you might be thinking that but look at the longer view and it is still going up (and I think will continue to do so when the next sovereign debt disaster revelation hits the news). I also don't remember any confidently foretold predictions of a crash in the media in 2008 besides maybe Peter Schiff and one or two others, and they were being laughed at until Lehman Brothers tanked. In principle I agree that the world is fantastically complex and hindsight is 20:20. But history does repeat itself and many warning lights are blinking red. We ignore these at our peril.

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