Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Street Sees Recession, Or Something Worse?


...seemingly marginal data can morph into a driving force if enough people start focusing upon it.


On December 21 I wondered whether the employment numbers were indeed trending toward something consistent with a recession. I hedged myself a bit by saying that my analysis used rather rudimentary data, and that of course the economy is far more complex than what can be described by some statistical changes as interpreted by yours truly.

The funny thing about markets however, is that seemingly marginal data can morph into a driving force if enough people start focusing upon it. That's why I found it interesting that on January 4 Barry Ritholtz' excellent blog also discussed the Birth-Death issue I raised in my December piece. In Saturday's edition of John Mauldin's "Thoughts From The Frontline", Mauldin too revisits the same topic. Lastly, on Friday, during one of his reports from the floor, CNBC's Rick Santelli noted that the Birth-Death Model numbers were catching the attention of traders. Again, by itself the issues raised by the B-D Model are just one piece of the puzzle, unless of course the crowds make it the piece of the puzzle.

I note this because a far more ominous potential problem is beginning to bubble to the surface. That is the issue of who is on the hook for having underwritten Credit Default Swaps (CDS) for many multiples of the underlying debt, and how these entities will make good on these CDS. For those new to CDS, they are basically put options on debt. If a corporate bond (or other debt obligation) covered by a CDS defaults, those who underwrote (read: Sold) the CDS must pay off those who bought the CDS.

We have discussed this before in the 'Ville, but notably, it was prominently featured in yesterday's newsletter by Mauldin; and as I chat with traders the same worries come up more and more frequently.

Again, just to make sure we are clear on the potential size of the problem, it is estimated that market players around the world – including everyone from hedge funds to life insurance companies, to reinsurers, to investment banks – are on the hook for 5-10 times the total amount of outstanding corporate bonds. That means that even if only 5% of corporate bonds were to default, the economic consequences would be roughly equal to:

  • The amount of issuer's debt outstanding
  • Minus the recovery on the debt
  • Times a multiple between likely between 5 and 10
  • If we assume even a 5% corporate bond default rate, and a recovery rate of 50% on those bonds, it means that after the CDS on those bonds are paid off, the impact to the financial system would be tantamount to a 12.5%-25% default rate on all outstanding corporate bonds; enough to put the entire financial system on the brink.

Why raise this apocalyptic scenario now, considering that corporate bond default rates in 2007 were at historic lows, well under 1%? In a Friday Buzz I pondered if the behavior of the financials is hinting to a "nuclear size cockroach" about to jump out of the woodwork. This is a weekly chart of the Banking Index (BKX) going back to 1999.

Click to enlarge

(You can see many other similar charts in Prof. Shedlock's piece An Asymmetrical Unwind of the Credit Bubble)

Forget about support and resistance levels, retracements, entry points/stops, overbought/oversold, and all the other technical stuff, and just look at the picture. The stocks of the largest financial institutions on the planet, Citigroup (C), Bank of America (BAC), Wachovia (WB), Wells Fargo (WFC), JP Morgan Chase (JPM) – the institutions where money for our finance-based economy lives – are showing extreme distress, more so than at any other time including '02, when the market was in free fall; and back then, debt derivatives (CDS) outstanding were a fraction of what exists today. What's even more worrisome is that the CDS on these banks' debt seem to be confirming such level of distress.

I understand if some readers might dismiss my concern (not belief yet – but definitely concern) that we may be on the verge of something worse than just a recession. But once you have dismissed my worries, please do yourself a favor: listen to Friday's video interview with UBS' Art Cashin. For those unfamiliar with Cashin, he is the NYSE floor director for UBS, a man with decades of experience, and whose commentary consistently adds more to my financial education than just about any of the reams of research I read every day. Watch the whole thing (it's only 3-4 minutes), but listen carefully to what he says from the 2:20 mark on.

Then store his words in your memory bank, and put your antennas up to hear if his worries are expressed in other circles. As I said at the beginning of this piece, crowds can take a "piece of the puzzle" and make it "the piece of the puzzle". If Cashin's fears start spreading, the real "fun" is still ahead of us.

< Previous
  • 1
Next >
Position in XLF, IAI
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Featured Videos