Credit Easing or Credit Short Covering?

A: Sorry for the lack of content lately as I have been very busy with buyer/seller clients in the field, and working on the new charting system for you guys! Since Manhattan real estate does not change day to day, I want to discuss something that I have talked about with those I know on the front lines of the credit markets earlier this week. Reality is, that when the credit storm really got rolling many hedge firms and brokerages became risk averse and hedged their long positions by going short on the credit markets; a logical move. While it was a profitable trade for months, when the fed bailed out Bear Stearns they basically removed the systemic crisis that these trades were meant to profit from. Upon this realization, there has been a major short squeeze in the credit markets to cover some of these hedges, causing bids to come in on what otherwise were illiquid markets. What we hear as signs of easing in the credit markets via bids coming in, may simply be short covering! Add on to that the usual speculative in-the-know crowd riding the wave and we may have some false signs of hope.

The motivation to write about this came when I read Yves post on Naked Capitalism this morning, that included an excerpt from Doug Noland's article in the Asia Times, who hits it perfectly:

"When the Fed and Washington radically altered the rules of US finance last month, they placed in jeopardy huge positions that had been put in place to hedge against and profit from systemic crisis. With the end of stage one arises a major short squeeze in the credit, equities, and derivatives markets. And when it comes to contemplating the scope and ramifications of today’s hedging activities, we’re clearly in uncharted waters. It is not beyond reason that a disorderly unwind of bearish credit market positions could incite a mini bout of liquidity, speculation, and credit excess that exacerbates global monetary instability while setting the backdrop for stage two of the crisis."

Lets go back to basics. What got us in this mess in the first place was irresponsible lending + buying that led to the busting of the housing bubble. That resulted in the seizing up of the secondary mortgage markets which led to distress in other credit markets. What started as subprime, quickly spread to auction rate securities, alt-a, student loans, etc..It is still spreading and losses and write-downs continue to mount. Through funky accounting and creative fed swap programs, much of the garbage is either being hidden or transferred from balance sheets to the fed.

Here are some of the recent headlines in creditville, where fund raising (as I discussed April 9th) is the name of the game!

RBS To Sell $24 Billion in Shares To Shore Up Capital

Citigroup Sells $6 Billion in Preferred Shares

National City Follows Wachovia, WaMu in Rush For Cash

Why raise cash? Because loan loss reserves are dwindling and regulators require at least a 7.5% reserve in Tier 1 Capital! As Mish accurately points out in regards to Citigroup's Tier 1:

Citigroup raised capital in December and January by selling stakes to investment funds controlled by foreign governments including Abu Dhabi, Korea and Kuwait. The infusion helped boost Citigroup's Tier 1 ratio to 8.8 percent by Jan. 22 from 7.1 percent at the end of the year. Citigroup's so-called Tier 1 capital ratio -- a measure of its ability to withstand loan losses -- fell to 7.7 percent at the end of March, the New York-based bank said yesterday. Citigroup says it needs a 7.5 percent ratio to provide a margin of safety and preserve its credit ratings.

Mish's Comment: 8.8% is now 7.7% and shrinking. Citigroup will soon need to sell more assets or cut its dividend or both. I predict both.

Mish was right and the very next day Citigroup announced a $6Bln preferred share sale! Look at it this way, why borrow cash if you don't need it? If you need the money, then you MUST raise cash, and right now there is massive capital raising going on reflecting the weak state of balance sheets; if it were any other way they wouldn't need to dilute by issuing more shares!

Housing is still correcting, the consumer is tapped out, credit is being withdrawn as evidence by the pulling of lines of credit (HELOC's), homeowner equity is declining and unable to be accessed as an ATM anymore, credit costs have risen, and we are likely in a recession that will cause job losses. Since 70% of the US economy is driven by the consumer, its hard to discount all these macro stresses that the consumer must deal with. If the recession hits, how in the world will there be enough buyers to take down housing inventory?

So, it is just illogical and wrong to accurately predict how or when this credit crisis will end at this point in time. You can't have decades of debt building and very poor lending standards leading to the sharpest 5-6 year rise in housing prices nationwide unwind in a 8-month period of time! It will take time to heal these wounds, and right now I strongly believe in what Doug Nolan is saying and have discussed this exact scenario with friends that I consider to be very smart on the front lines of the credit markets. If the credit markets were fully healed, LIBOR wouldn't be so much higher than our fed funds rate! Time will tell.

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