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What Future Does the Credit Crunch Bring?


When you have too much debt, how can you be confident?

As the general public is fed old financial news day in and day out by TV, news of what happened already, let's look at some forward-looking current facts.

The most important data release yesterday was the weekly Federal Reserve commercial paper outstanding number. Asset-backed commercial paper fell a further 3.1% for the week to $966.7 bln. Overall commercial paper outstanding fell by $54.1 bln. Total commercial paper outstanding has fallen 13.4% in one month. During the 2001 downturn, commercial paper peaked in November 2000 and slid through to December 2003. Over that three-year period it declined by only 22%.

15-day commercial paper is yielding 6.3%, 90 basis points higher than a month ago. Treasuries are 200 basis points below these levels.

Credit in the system is contracting fast. As a result, signs of weakness in the economy will appear fast.

Libor rates remain at extremely elevated levels, also suggesting that the credit crunch in debt markets is as bad as it has been despite more liquidity injections from the ECB. Something is very wrong in the financial system. Does that not have vast implications to an economy that is built on the financial industry with over 30% of all S&P 500 earnings based on financial companies?

Weekly initial jobless claims dropped from 337K to 318K (normal volatility but the 4-week moving average is in a steady uptrend) while continuing claims were worse than expected. The labor market is slowly weakening from the very bogus numbers we are fed by the BLS: birth death adjustments and total employment "assumptions" have severely distorted the employment picture.

In August in the U.S., one-third of agreed mortgages failed to close. Either the borrower walked away or the lender didn't like what he saw. On top of the pending home sales numbers released on Wednesday this should add up to home sales data that are truly shocking when released late September. A huge portion of the past five years' economic growth has been based on the housing and mortgage industries. It is not hard to see the implications.

Harley-Davidson (HOG), the biggest U.S. motorcycle maker, scaled back its forecast for deliveries amid a "difficult time" in the U.S.

Harley-Davidson expects to ship 86,000 to 88,000 motorcycles of its main brand in the third quarter instead of a previous forecast of 91,000 to 95,000 units, the Milwaukee, Wisconsin-based company said today in a PR Newswire statement. The company expects a "modest'' decline in 2007 revenue and earnings per share to fall to between $3.69 and $3.77 from last year's $3.93 per share, Harley-Davidson said. Full-year deliveries will total 328,000 to 332,000 motorcycles. Shipments are coming down 7%; EPS being cut by 10%.

Harley-Davidson is a nearly perfect example of a business benefiting from the credit boom on the way up and suffering on the way down. The telling thing is the speed with which they are being affected: this credit contraction which began in the beginning of August is already affecting the big end consumer market (Harley-Davidson bikes are definitely discretionary items for the middle and high end consumer, statistically speaking).

Adding to discomfort on Wall Street, former Fed Chairman Alan Greenspan said turmoil in the market in the past seven weeks is "identical" in many ways to what happened in the stock market crash of 1987 and the 1998 dislocation triggered by the collapse of the $100 bln hedge fund Long-Term Capital Management, the Wall Street Journal reported in its online edition.

"Having gone through both those periods, it is eerily familiar, I have to agree with him," said Rick Meckler, president of investment firm Liberty View Capital Management, Jersey City, New Jersey.

Unfortunately, I disagree. Both episodes were liquidity events for sure, but the solution Mr. Greenspan came up with was to create "artificial" liquidity through credit creation. The infusion of debt-stabilized asset prices (more "money" chasing the same volume of assets). But in both cases Mr. Greenspan never had the gumption to mop up that debt and allowed it to grow and grow and grow. Today we have the culmination of that debt. This "liquidity event" is much larger than either of these two previous episodes.

The same solution is being used, but this time it is only slowing down a much bigger problem.

Three month LIBOR is a touch higher than yesterday, but way higher than a week ago reflecting banks need for dollar cash.

HSBC Chief Executive Michael Geoghegan said it is hard to say whether the worst of the global credit crunch is over yet, the Hong Kong Economic Times reported Friday.

Geoghegan added that the credit problem was a matter of market confidence and might not be resolved by slashing interest rates.

This is what they who own all that debt (this bank is really at risk) would have you believe. It is only a matter of confidence. Well, confidence is born of value. If you know you can swing a golf club, you are confident.

When you have too much debt, how can you be confident?

And the London Times reports that Barclay's (BCS) could be on the hook for another of its ABCP SIVs (special investment vehicle) - Barclays is offering to underwrite the $1 bln rescue of another highly geared fund that got into trouble because of the liquidity squeeze. Mainsail II, a $4.5 bln (£2.2 bln) structured investment vehicle designed by Barclays Capital and managed by the hedge fund group Solent Capital, had been forced to start selling assets as it struggled to roll over finance in the commercial paper market. The plan is to pay out CP investors at par without the Barclays line.

For those of you not up on SIVs, they are just off-balance pockets of debt that banks have created to borrow short term and lend longer term. They do it off-balance so as not to require much capital, thus throwing off huge margins at huge risk. That risk is now coming due.

If we assume that the last five years of economic growth is almost all credit-induced, and now that credit is contracting, we must conclude that future economic growth is clearly in danger. The problem with recession is that the enormous debt that exists must be serviced still. If it can't be serviced, it must be destroyed through default. That is deflation.
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