Credit Default Swaps Soar

Bloomberg is reporting Credit Swaps Top $62 Trillion in Rush to Hedge Losses.

Credit-default swaps worldwide expanded to cover $62.2 trillion of debt in 2007 as investors rushed to protect against losses triggered by the collapse of the U.S. subprime mortgage market. Contracts outstanding rose 37 percent in the second half of 2007 from $45.5 trillion in the first half, the New York-based International Swaps and Derivatives Association said today.

Postponed Is Not Prevented

I agree with Noland that an immediate deflationary collapse was prevented when the Fed bailed out JP Morgan. However, that does not negate the ongoing deterioration of bank balance sheets and a slow deflationary process, just like happened in Japan.

Citigroup is coming to market with an 8 3/8% preferred. Merrill Lynch (MER) announced an 8 5/8% preferred. That capital is being raised for one reason only: They have to, over and over. Credit is rapidly being destroyed and Bernanke cannot prevent it.

Too Big To Bail

Professor Sedacca made some interesting comments in The Moral Hazard Club.

When you add up all the Level II assets by just the eight largest holders in the U.S: JP Morgan (JPM), Citibank (C), Bank of America (BAC), Merrill Lynch (MER), Goldman Sachs (GS), Bear, Morgan Stanley (MS) and Lehman Brothers (LEH), it comes to a staggering $5 trillion - nearly half the size of the economy. Level III assets are nearly $600 billion.


What Cannot Be Paid Back Will Default

Debt that cannot be paid back will be defaulted on. And if one believes like I do, that the above article describes a situation that is too big to bail, then default it is. Although I believe the Fed is willing to break the rules to the point of taking illegal actions, (See Fed Uncertainty Principle Corollary Number Four) it would be a mistake to think the Fed would purposefully cause hyperinflation.

The reason is simple: Hyperinflation would end the game and whatever power the Fed had. With that backdrop, there are huge constraints on the Fed. One of them is the U.S. dollar. Another one is wages. It does no good to force home prices up if people are out of work and cannot pay the bills.

Besides, the Fed clearly cannot force home prices up. If it could, it would've done so already. Yes, the Fed can cheapen the dollar, but the Fed cannot force banks to lend or force companies to hire. Without jobs and without rising wages, the Fed can lower interest rates to 0% and it will not stop a destruction of credit.

Noland gives far too much credit to the Fed. Postponed Is not prevented.

It took three lending facilities, interest rates at 2.25%, and a rescue of JP Morgan to stabilize the markets. The cost was zombification of banks. Bernanke will soon have to face option arms, increasing numbers of walk-aways, a commercial real estate implosion, rising unemployment, mounting global tensions, and European displeasure over the Euro.

What will Bernanke do for an encore? Some suggest the answer will be to print. On that score I actually agree. But where will the money go? Will zombified banks be willing to lend? To who? I will address the issue of printing in a followup post.

In the meantime I am sticking with my story right now. The Fed is clearly not printing, and marked to market destruction of capital and credit is happening at a stunning rate. That combination equals deflation regardless of what the price of commodities is.

The mad scramble by some corporations to raise capital, the scramble by others to play "hide and seek" with level 3 assets, and the scramble by virtually everyone to play swap-o-rama with the Fed supposedly just to prove the process works tells the real story. The real story is deflation.

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