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U.S. Banking System on the Fritz


Debt outweighs savings, income.

Yesterday S&P released its new assumptions for default rates for securitized debt obligation, all those fancy new derivatives being blamed for the easy lending that fueled the mortgage bubble:

April 28, 2008: Standard & Poor's Ratings Services today announced that it has revised its recovery-upon-default assumptions for collateralized debt obligation (CDO) securities backed by certain U.S. residential mortgage-backed securities (RMBS) collateral, including Alternative-A (Alt-A), subprime, home equity loan, and tax-lien RMBS issued in the U.S. during and after the fourth quarter of 2005 ("the affected U.S. RMBS"). (From S&P)

And the blame is warranted. I've described 100 ways in which too faulty assumptions in recovery rates and cash flow allowed this paper to be sold to investors, thus lending money to people who couldn't pay it back. The market realized it, prices went down, and the banking system went broke. Let me say this clearly: the U.S. banking system is not functioning. It's getting all of its capital from the government in various forms. Even if somehow the Fed and its cronies take on more and more credit risk through some form of nationalization, future lending as illustrated by these new default rates will be severely curtailed. As you can see these are not minor adjustments.

The market didn't care much when these numbers were released, but then short covering doesn't care much about anything when they're covering. The adjustments were enough to assure that the current $300 billion in bank write-downs (debt destruction) will eventually be more like $1 trillion rather than the more sanguine numbers published by Wall Street along with the cries of "the worst is over" by "those that benefit the most". As this process unfolds we'll see that the $1 trillion number is low as well. You'll see the dollar actually strengthen as more and more debt is destroyed that is denominated in the dollar.

We're still very early in this process. You can choose to listen to the assurances of those that never saw this coming, or worse, denied it all along saying that the worst is over. Or you can use logic in understanding that there is six times normal the amount of debt in the system and the level of actual savings and income in the economy cannot support half of that. And this is where I diverge from some middle of the road analysis that I have seen where the conclusion is mild recession and muddle through: that analysis never mentions the extremely high levels of debt, extremely low household income relative to that debt, and the extremely high notional real estate capitalization relative to GDP. All these levels indicate the unique nature of the problem and the likely negative effects it will have.

Risk is high.
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