Credit Crunch: Credit crunches are usually considered to be an extension of recessions. A credit crunch makes it nearly impossible for companies to borrow because lenders are scared of bankruptcies or defaults, which result in higher rates. The consequence is a prolonged recession (or slower recovery) resulting from the supply of credit having shrunk.
Keith Shaughnessy, president of Foundation Mortgage Corp., declared today that the credit crunch has arrived. Who is Keith Shaughnessy? No one particularly important, and therefore his declaration wouldn't be significant...except that the CFO of investment bank Bear Stearns pretty much echoed this claim when he said, "It's been as bad as I've seen it in 22 years. The fixed-income market environment we've seen in the last eight weeks has been pretty extreme."
There were no junk bond issuances this past week. None at all. There were no international dollar bond issuances either. Nada.
In the years I've been watching the markets I can't say that I've ever seen that happen.
Major players in the field of the bond market are saying things like:
"It's mind-boggling. This last week, the velocity of losses has picked up dramatically. The models work when they look at history, but not when history is all new."
'The market for mortgage bonds has become "very panicked and illiquid."'
But probably the most memorable comment wasn't even made in America. It was made in an emergency meeting called by Germany's finance minister.
According to people who took part in the conference call, Jochen Sanio, head of Germany's financial regulator, is said to have warned of the worst banking crisis since 1931.
I find that comment specifically interesting for two reasons:
#1) That the financial troubles aren't limited to American shores. The rest of the world has been buying our mortgage-backed securities for years
#2) That the banking troubles for Germany are even worse than the early years of Hitler and WWII
An Economic Katrina
So what does a credit crunch mean, in the short-term? It means deals don't get made.
The big chill gripping global credit markets has caused 46 leveraged financing deals around the world to be pulled since June 22, representing more than $60 billion in funding that companies had planned for mergers and acquisitions. The number of deals pulled last year: zero.
And another example:
Analysts estimate large banks have underwritten loans worth $300bn to finance deals not yet been completed.
Modern business requires cash flow. Cash flow requires credit. If no one is lending then there is no credit. Business doesn't happen. Economies stop.
What is the cause of all this? The mortgage market. Specifically, America's real estate bust. The implosion of the speculative bubble that was America's real estate market is having ripple effects around the world.
Let me throw a couple graphs at you so it is easier to understand what is happening and why.
Without mortgage equity withdraws (MEW) America's economy would hardly have even moved these past few years.
The problem is that so much equity was withdrawn from homes (to pay for lifestyles that people couldn't afford) that despite an unprecedented housing boom, people now own less of their homes than before the housing boom.
And here's the real problem (in $billions):
Monthly Mortgage Resets
A huge percentage of homeowners bought homes with low "teaser" rates for 2 or 3 years, which then get reset to higher market rates. Those mortgages are resetting now. Hence the huge rise in defaults and foreclosures when monthly mortgage rates double and triple.
Foreclosure percentage
The problem, is that we have not seen the worst of it yet. Not even close.
We have just seen $197 billion of mortgage resets so far this year. That is less than we will see in two months (February and March) of next year. The first six months of next year will see more than the total for 2007 or $521 billion. This suggests to me that the number of foreclosures is due to rise dramatically from the already high current levels, putting more homes into a weak housing environment.
The direct effect of all this real estate implosion is leaking out onto the rest of the bond market in the form of higher interest rates.
To give you an idea of just how bad it is, watch this video of economic pundit and salesman Jim Cramer have a nervous meltdown on CNBC yesterday. The terms he used were "Armageddon" to describe the economic environment on Wall Street, and claimed that 7 million homeowners were going to lose their homes.
Cramer's solution is for the Federal Reserve to cut interest rates. That may indeed help the bond market, and by extension the housing market, but it also has another negative side effect.
You see, the dollar has been rather unhealthy recently.
If the Fed starts cutting interest rates (while the rest of the world is raising rates) then that will discourage the rest of the world to loan us money, since they will get less return on investment. Since America no longer saves money, and in fact must borrow $2 Billion every day from the rest of the world just to maintain our lifestyle, a rate cut could cause the dollar to tumble. Which would make those imported cars, electronic goods, and oil much more expensive.