Monday, April 13, 2009

Dead Cat Bounce

    Dow, last 12 months

The markets are up and Obama is talking about glimmers of hope.  Had the situation turned?  Is the crisis abating?  Nope.  its a dead cat bounce. Even a dead cat bounces if dropped from sufficient high.

Although specific causes like the US sub-prime mortgage market were recognized before hand, almost nobody foresaw the tremendous complexity and global nature of the coming crisis.  Even they didn't see many significant consequences.  The crisis so-far has had several important themes.
  1. The US housing bubble.  Asset bubbles always burst, leaving those who borrowed against bubble prices in a ruinous position.  
  2. The tremendous over leveraging by countries like Iceland, Ireland and The Ukraine.  This one is significant because it shook up the currency markets.  
  3. The uncontrolled growth of European banks.  Iceland, Ireland, Switzerland, The Netherlands, France and UK have banks who's combined liabilities greater than GDP.  Iceland would have to spend all its tax dollars for the next 19 years to pay off the commitments of its failed banks. 
  4. The stunning over borrowing by consumers in many key economies, especially the US.  This over-borrowing, combined with housing deflation, means a consumer-led recovery is not on.
  5. Blatantly illegal activities by US banks.  These people should be charged under organized crime laws rather than bailed out.  Its also worth mentioning the fraud by US ratings agencies like Moody's.  
  6. The Bush administration's spectacular corruption.  This may have been the most corrupt US administration of all time.  They pissed away trillions enriching themselves and their friends.  Regulation first became a joke, then a memory.
  7. The US' move away from traditional debt instruments that everyone understood, to derivatives that nobody understood.  Important because the traditional instruments have withered.  Reconstituting them will take years and imply an economy with far less available debt (i.e. less growth). 
  8. The unexpectedly global reaction to the crisis.  Nobody expected such swift or far-reaching consequences in so many different places.
  9. The complexity of the debt instruments at the core of the crisis.  Its almost impossible to take them apart to determine the status of the individual loans. Take a lemon, a lime and an orange.  Put them in a blender for 1 minute on high.  Now reconstitute the three original pieces of fruit.
You may notice the overarching theme of debt.  Debt is great, especially in business.  It allows you to rent money to buy an asset.  You pay back the money but still own the asset.   What nobody foresaw was the that providing debt would become so profitable that people would start manufacturing it outright.  US investment banks, became debt factories, manufacturing derivatives like toasters.  Too  much debt pouring into consumer markets creates bubbles.

So the fundamental problem is too much debt.  This is not just a US problem, because of globalization, everyone is involved.  The solution to the crisis is for asset prices to return to sustainable values, for all the bad debt created by the asset bubble to be wound down and for new mechanisms for financing debt. Asset prices have spectacularly re-adjusted over the last year, so that's already underway. What has not happened at all is the resolution of all the bad debt or the restructuring of the debt mechanisms. Hundreds of banks around the world are sitting on piles of worthless debt.  They are like a person on life-support.  The body functions, but they are not viable.  Thus the financial crisis persists.  Obama and the rest of the G20 are frantically engineering a soft landing.  No matter what, winding up all the bad debt will take years, with lots more pain on the way.  Likewise, the re-invention of debt mechanisms will take years.

The currency impact of so much government debt has yet to become apparent.  Europe's restructuring of its banking system to be less vulnerable has not yet begun.  The decision of China and India to re-orient resources on building their domestic markets has yet to be felt in global markets.  So I'm calling recent news a dead cat bounce rather than a recovery.