 INSTITUTIONAL ADVISORS
Financial Contagion
Bob Hoye snippet
Institutional Advisors
Jul 27, 2007
The first crash in subprime
mortgage bonds wasn't noticed until the price had plunged to
73 in late February. When it was discovered by Wall Street strategists
it was quickly judged to be an isolated event. Then, with the
rebound to 84.60 in late May it lost its focus even as an event,
let alone a contagious one.
Then the price of the mortgage
bond again turned down to take out the February low in late June,
when a number of Fed spokesmen argued that "the pain
from the subprime mess will be contained."
The breakdown was at 73 and
the plunge took it to yesterday's 51.62, which decline seemed
to prompt yet more observations that the distress could be isolated.
History provides reliable instruction
on credit expansions and credit contractions. One causes the
other, and the corruption of central banking from the
duty of providing a sound currency to being the bender of last
resort has exacerbated the booms, which in turn will exacerbate
the inevitable contraction.
Those armed with interventionist
theories rather than with the evidence of financial history seem
compelled to deny a natural turn towards a credit contraction,
when its time has come.
This occurred with the culmination
of the tech-mania in 1Q 2000. Pundits stayed with the theme that
you had to buy the stock market because "there was no
inflation". One of the features of that boom was that
it did not include commodity price inflation - mainly inflation
of stock prices.
Today's story has been remarkably
different as "you have to buy equities because there
is inflation in commodity prices." However, although
the pitch is opposite to that of 1Q 2000, a boom is a boom and
the actual stories, while interesting, have been controlled by
the credit markets. Typically near the culmination of huge speculative
action the yield curve will turn from inversion to steepening,
at which time usually the wheels begin to fall off the most egregious
speculations.
Recent examples would include
nickel's 40% plunge and the subprime "mess" becoming
more acute as it afflicts the traditional corporate bond market.
Describing the problem as a
"mess" implies that it is isolated and eligible for
fixing.
This was the case with the
"Asian Crisis" that started with the Thai baht on July
1, 1997. The problem followed excessive local speculation blowing
out and on the usual liquidity crisis the central bank suffered
a shocking loss of reserves. The financial media overlooked the
real problem and described it as "currency turmoil,"
with the implication that it could be fixed by wise policy. The
other reporting blunder was the insistence that credit distress
would be isolated to Thailand.
Then when it afflicted the
Philippines, media still insisted that it could be contained.
Well, as the world discovered, the distress couldn't be contained
and despite the affliction, spreading U.S. corporate spreads
did not adjust for risk until it was too late and in October
suffered the worst hit in a decade.
All the way down the slide
the establishment insisted that it was currency turmoil and that
it could be contained.
The current subprime "mess"
turned acute earlier in the year, and traditional corporate spreads
remained immune until mid June. After basking in splendid isolation
at record narrow spreads, widening has taken junk from 418 bps
over treasuries to 595 bps. With this the yield has jumped from
9.50% to almost 11%, which would knock some 13 points off a representative
junk-bond.
Usually junk-bonds and the
stock market go up and down together. Given the nature of credit
the stock market will get in line with the building liquidity
crisis.
As with the end of previous
credit inflations, the contraction is progressing from sector
to sector. This time around it started with subprime mortgage
bonds and has now taken out junk which most of the time acts
like a stock.
This is likely the biggest
train wreck in financial history and until today, in looking
at the senior stock indexes the bulls are getting aboard the
last train into Dodge City.
July 26, 2007
-Bob Hoye
Institutional Advisors
email: bobhoye@institutionaladvisors.com
website: www.institutionaladvisors.com
Hoye Archives
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