Download The Bursting Bubble

The Bursting of the Credit Bubble
By Daryl Montgomery
Sept 18, 2007
What Has Happened Since Last Meeting
• Drop in house sales Aug 2006 to Aug 2007:
Los Angeles, CA
Orlando, FL
Phoenix, AZ
Las Vegas, NV
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•
•
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- 50%
- 40%
- 40%
- 37%
In some cases, prices are still rising (statistically bogus).
Foreclosures up 115% year over year (36% from July).
US Dollar hit an all-time low against Euro (inflationary)
Oil hit an all-time high (inflationary)
Wheat hit multi-year high (inflationary)
Two Fed governors gave speeches saying inflation is under
control (2007 Q2 inflation was 4.2% annual rate).
Bernake bails out the big banks in the future’s market.
Bush announces a non-bailout bailout for subprime
borrowers with good credit (huh?)
Banc Paribas, Country Wide Financial, Northern Rock
(known for its 125% mortgages).
The Federal Reserve’s Actions
• Pumped huge amounts of liquidity into the
financial system to stabilize the bond market.
• Cut the Discount Rate 50 basis points on
August 17th, one hour before future’s expiration –
in an effort to prevent a stock market crash.
• Today, Sept 18th:
Fed Funds Cut by 50 basis points
Discount Cut by 50 basis points
Bubble, Bubble, Toil and Trouble
• The US Fed has created 2 back to back bubbles:
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•
•
•
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1. Equity: 1995 to 2000
2. Credit: 2001 to 2007 (much worse by far)
Declining yields combined with an excess of capital,
lack of regulation, and political corruption are the breeding
grounds for Bubbles.
Innovation, either financial, technical, or both also needed
to create a major Bubble.
Bubbles have circular feed-back mechanisms, where
growth continually creates new growth (process reverses
when Bubble bursts and becomes an anti-Bubble).
Valuations become absurd, Fraud widespread.
Once a Bubble starts to burst it can NOT be
Re-Inflated for many years, sometimes never again.
It’s a Credit Bubble –
Problems First Showed up in Sub-Prime
• Financial Innovation/Feedback mechanism behind current Bubble:
Packaging consumer loans into bonds (Securitization) sold to financial
institutions and hedge funds.
• This Bubble Includes almost ALL Credit :
1. Consumer credit:
Residential Mortgages, Credit Cards, Car Loans
2. Business credit
Private equity, stock buy backs, commercial mortgages,
small business loans
3. U.S. Government Debt
• Beneficiaries of the Financial Asset Bubble:
1. Direct:
Brokers, Banks, Homebuilders, Retail, Autos, Defense
any stock which was a potential Buyout candidate
2. Indirect (subsidiary bubbles):
China-US trade, Commodities, Emerging Markets
Why the Bursting of the Credit Bubble
Will Have Serious Consequences
• Growth in the U.S. Economy is based on ever increasing
Consumption (this makes as much sense as a family trying
to spend itself rich), not Production.
• Consumer Spending represents 70% of GDP.
• Growth in Consumer Spending has exceeded personal
income growth and GDP growth for many years.
• This has only been possible for this rate of growth in US
Consumer Spending to take place because of massive
borrowing and decreased savings (now negative).
• Any significant reduction in US Consumer’s ability to
borrow will have seriously negative economic
consequences, both in the US and throughout the world.
Comparison to Previous Crises
• The current Financial Asset Bubble is similar to the
Savings and Loan Crises and LBO/Junk Bond collapse in
the late 80’s/early 90’s.
• During this period a major stock market crash took place in
’87, a mini-crash in ’89 and a bear market/ recession in
‘90-’91.
• The government bailout cost U.S. taxpayers $200 billion.
• Moral Hazard theory states that bailouts shouldn’t be done
because the problem will only repeat and get worse.
• An equivalent bailout for the current crises would
probably cost $2 trillion (this will not happen only because
the highly indebted US government can’t afford it).
The U.S. Fed is Caught Between
‘Northern Rock’ and a Hard Place
• The only solution for our current debt crises is to create
Inflation since Debtors benefit from inflation and Lenders
lose (our foreign creditors will not like this).
• The Fed lowering interest rates will cause the US Dollar to
drop further and inflation to get out of hand.
• Problem: No one wants to hold a currency or bonds from a
country with a lot of inflation. This will really damage our
economy because we are dependent on borrowing.
• Inflation de-stabilizes an economy and getting rid of it and
strengthening the US Dollar would take economydestroying high interest rates.
Effects on the Markets
• There is a possibility of a stock market crash until the end
of October.
• There is a possibility of a US Dollar collapse, if US
interest rates approach/fall below Euro zone rates.
• A Bear Market in US Equities is almost certain. This Bear
Market will spread to other countries (a global expansion
must invariably be followed by a global contraction).
• Lower Fed rates mean a weaker US Dollar and higher Oil
and Gold prices.
• Consumer staples do best in a Recession/Depression.
• Generally, the more non-US Dollar earnings for a stock,
the better.
• Big caps better than small caps.
US Dollar – 1971 to 2006
NASDAQ - 3 Month Daily
High Volume Sell Off, Low Volume Rally
DJIA – 3 Month Daily
High Volume Sell Off, Low Volume Rally
Russell 2000 – 3 Month Daily
50 Day Trading Below 200 Day Moving Average
Gold – 3 Year Weekly
Trading Near Breakout Point
Consumer Staples – 3 Year Weekly
Trading Near Breakout Point