Proof The Credit Squeeze is Not Over

A: Just a lot going on under the surface here folks that could lead to another round of credit woes when it reaches the top; that is mass media and consumers. Let me just get right into the three reasons why the credit squeeze is not over: ABX markets plunging, Bank of America's Earnings Miss, & Cheyne Finance's PLC insolvency issue.

ABX MARKETS PLUNGING


In a sign that investor sentiment is plunging for mortgage backed securities, the ABX markets are getting whacked again. Take a look at the two charts over on the right here. The TOP chart shows what is going on with "AA" while the bottom chart shows the "BBB" markets. Notice the steep selloff in the past week! For "AA", we are now at the same level we were when this credit squeeze first hit the surface back in early August!

We virtually erased the rebound entirely showing an utter lack of confidence in the secondary mortgage markets. Recall that these ABX indexes are a series of credit-default swaps based on 20 bonds that consist of subprime mortgages. Some show what is going on in higher quality bonds ("AA" or "AAA" rated) while others show what is going on in riskier markets ("BBB" rated). In this case, forget the rating's as its clear the same sickness has infected most of the ABX markets. When you see a steep selloff like this, it's an indication of a decline in sentiment in the mortgage backed securities (mbs) markets. It's entirely possible that this leads to another round of seizing up of the secondary mortgage markets. The link works like this:

INVESTOR SENTIMENT FOR MORTGAGE BACKED SECURITIES (MBS) FALLS ---> ABX INDEXES PLUNGE ---> SECONDARY MARKETS CANT FIND BIDS ---> HOLDERS OF MBS ASSETS CAN'T SELL ---> CAPITAL GETS TIED UP AS LENDERS CAN'T SELL MBS ON SECONDARY MARKETS FOR DESIRABLE PRICE ---> LENDERS HAVE LESS CAPITAL TO LEND OUT ---> TIGHTER LENDING STANDARDS ---> HIGHER RATES AS RISK RE-ENTERS THE MARKET

Again, this happened in late July right before the first credit wave hit which resulted in all the headlines, stock selloff, uncertainty of who holds what assets, and ultimately much tighter lending standards and a pop in lending rates as risk was repriced. Well, its happening again! All you have to do is look at the demand, or lack thereof in this case, for mortgage backed securities.

BANK OF AMERICA MISSES BIG TIME

In a sign that the worst is obviously not over for the major banks, Bank of America (BAC - stock down 3.5%) reported earnings that missed consensus estimates by some $0.26!

From Yahoo Finance:

Bank of America Corp., the nation's second-largest bank, said Thursday its profit fell 32 percent in the third quarter as trading losses and write-downs on a wide variety of loans offset solid revenue growth in most businesses. Earnings from its global corporate and investment bank fell by $1.33 billion, or 93%, as a result of the disruption in the financial markets during the quarter.

"While the significant dislocations in the capital markets have hurt most participants, we are still very disappointed in our third-quarter performance," Chairman and Chief Executive Kenneth D. Lewis said in a statement.

n the bank's largest consumer unit, which includes America's biggest credit-card business and bank-branch network, net income dropped 16 percent to $2.45 billion.

The structured credit markets, fixed income markets, and secondary mortgage markets (anything to do with credit basically) remains dysfunctional! My concern was how widespread the problem is and whether it will carry over into future earnings of company's exposes. I just don't see how it won't. Expect more bad news from banks, lenders, hedge funds, and brokerages with exposure to the credit markets.


CHEYNE FINANCE PLC BECOMES INSOLVENT

Thanks to Calculated Risk, who is always on top of this stuff, we get a glimpse of the first insolvency case. According to CR (via Bloomberg's article "Cheyne Finance SIV Won't Pay Debt as it Falls Due"):

Cheyne Finance Plc, the structured investment vehicle managed by hedge fund Cheyne Capital Management Ltd., will stop paying its debts, a receiver from Deloitte & Touche LLP said. Cheyne issued $8 billion of short-term debt to buy securities linked to home loans, according Moody's Investors Service.

The receivers declared an "insolvency event," Deloitte said. That means the SIV is unable to pay its debts when they are due, according to its prospectus.

SIV's are Structured Investment Vehicles.

SIVs, with $320 billion of assets, invest in securities from mortgage-backed debt to bank bonds. They finance their investments by selling commercial paper, debt that comes due in 270 days or less, and medium term notes, which mature in nine months or longer.

Investors in the past three months have avoided asset-backed commercial paper on concern that delinquency rates on home loans to people with bad credit will continue to rise and hurt the value of mortgage bonds held by SIVs.

Only two days ago did I write my most recent post about lagging concerns I have; credit restrictions, solvency issues, global inflation, and higher rates. But that wasn't when I started talking about it.

SEPT 10th, 2007 ---> The two biggest threats to housing I now see are:

1. Global Growth Slowdown Amid Credit/Liquidity Crisis
2. Insolvency Crisis - Inability to pay back debts; assets no longer exceed liabilities

SEPT 13th, 2007 ---> Lets be frank, America does have a debt problem and both mortgage debt and credit debt has been getting more costly to the holder of late! That means more money out of the pocket of the consumer that could be going towards spending, that is now going towards living.

If there just isn't enough money to pay this off, well then, the debtor becomes insolvent! An insolvency crisis has been brewing for some time and now that risk is causing the rates on loans and other debts to cost more, I worry that the game may end in a rough way down the road. What happens when these debts can't be paid off? What happens when the corporation can't raise enough money to pay its creditors? What happens when assets no longer exceed liabilities

SEPT 16th, 2007 ---> Well the news out of American Home Mortgage on Friday could be signs of the beginning of that insolvency (assets no longer exceed liabilities; inability to pay debts) as a very real concern and that there are a number of classes that could be effected including the consumer, corporations, hedge funds, and any other highly leveraged entity.

This credit story is NOT OVER! We are also yet to see any actual evidence in US economic data that the credit squeeze is hitting the wallets of consumers. I think it's a matter of time. I only hope that the mature and proven resilient US economy will be able to absorb this shakeout like a mild case of fleas!