The Great Credit Contraction of 2007

What is the inter-relationship between Housing, LBOs & Stock Buybacks?

Last month, I noted 6 reasons why rising yields were a threat to equity prices:

The M&A/LBO Put
Share buybacks
Consumer spending

As of late, we have seen the threat of two of these issues increase dramatically: The M&A/LBO Put and
Share buybacks are being pressured by the increasingly expensive credit. 

Much of this is derived from the mess in Housing: As many of the ARM/liar loans in the Sub-prime and Alt-A mortgage group increase their default rates, the residential mortgae backed securities (RMBS) that were packaged into CDOs have begun to unravel (See WTF is going on in the ABX Markets?). All told, the many variations of these were a prime source of cheap financing. This was what has been driving private equity buying frenzy and many share buybacks. That financing source is rapidly fading. 

How much is the credit drying up?  According Merrill’s Richard Bernstein:

"Bloomberg Radio reported this morning that the monthly issuance of Collateralized Debt Obligations (CDOs), or packages of debt instruments bundled together to form a "portfolio" of debt, dropped from $42 billion to $3 billion in the latest month. That 93% drop represents a significant tightening of liquidity that is starting to ripple throughout the credit markets. The fixed-income markets appear to be starting to understand that the days of free-flowing liquidity are likely to be behind us. Most credit spreads are widening."

See Bill Gross latest for further discussion of the great credit contraction of 2007. 

Lastly, for those hoping this marks the bottom of the Housing derived credit crunch, according to the UK Telegraph, "some $2 trillion of subprime and ‘Alt A’  mortgage debt is falsely priced on the books of banks and funds worldwide.” 

And to imagine: Some tv pundits — cretins of the lowest order — actually have been insisting that the Housing market would have absolutely zero impact on credit, the economy, markets and retail.   What a bunch of tools . . .


UPDATE July 25, 2007 10:47am

Both CNN/Money and Reuters are confirming what the WSJ reported this morning, that Chrysler’s bankers could not sell the $12B in loans for the auto business and they are getting stuck with $10B of it with Daimler and Cerberus likely responsible for the balance.

The expectation is that the finance unit will eventually get done — but at terms that are considerably more attractive to investors. Bloomie is reporting that KKR was forced to accept much higher loan costs on the Alliance Boots deal.

Expect more term deals to falter like this in the near future . . .

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  1. rubberbandman commented on Jul 25

    I would like some of what Poole is smoking!!!!!

    Poole Says Moderating Inflation Doesn’t Need Quick Fed Response

    By Anthony Massucci and Vivien Lou Chen

    William Poole of the the Federal Reserve Bank of St. Louis July 24 (Bloomberg) — Federal Reserve Bank of St. Louis President William Poole said he sees signs that inflation is “moderating just a bit” and suggested the central bank can afford to wait before lowering interest rates.

    “Given that the real economy is doing quite well, there is certainly no reason to believe we have to quickly respond to signs of moderation in inflation,” Poole said in response to questions from reporters following a speech in Wilmington, Delaware.

    Poole, 70, voted with all other members of the Federal Open Market Committee last month to leave the benchmark lending rate at 5.25 percent. Fed Chairman Ben S. Bernanke last week told Congress that economic growth will pick up slightly next year and inflation will recede.

    “There is no necessity to make any tradeoffs at this time,” Poole said. “That clearly would be more difficult if the economy were to stall out.”

    In his speech to the Wilmington Club, Poole said the U.S. economy has “performed well” in the face of rising energy prices and inflation remains “contained.”

    “Consumers have reduced their consumption of more expensive energy,” he said. “Yet they have been able to maintain strong overall demand for consumption goods.”

    Oil Futures

    Crude oil futures on the New York Mercantile Exchange reached $76.13 on July 20, the highest intraday price for a front-month contract since Aug. 10. Prices are up 20 percent this year. A report tomorrow may show refineries operated at 91.6 percent of capacity, a 10-month high, according to a Bloomberg News survey.

    “Although economists are a bit nervous about this situation, the U.S. economy has performed well despite the oil price increases,” Poole said. “We are nervous because those of us of a certain age remember well how different the situation was in the 1970s.”

    The recent increases are “roughly comparable” in percentage terms to those in the 1970s that led to recession, Poole said. This time, though, “overall inflation has remained relatively contained” and “energy in the United States remains quite inexpensive” relative to the cost of other goods, he said.

    “The impact has been real, but the magnitude small enough that price increases have not disrupted the normal processes of economic growth,” the bank president said.

    “There are certainly strains from the high price of energy,” Poole said. “However, there is no energy crisis and households and firms are adjusting in a sensible way to price increases.”

    “In my judgment, markets will continue to handle energy problems well and the future for the U.S. economy is bright.”

    Subprime Mortgages

    In reply to another question from reporters, Poole said he doesn’t expect losses from defaults on subprime mortgages to spread beyond the real estate industry.

    “The damage, I think, is going to remain primarily in the real estate sector,” he said. “We do not have a bank involvement and therefore bank lending for the normal sort of economic projects is alive and well.”

    The bank president is a former economics professor at Brown University in Providence, Rhode Island. He joined the St. Louis Fed as its president in 1998.

    To contact the reporters on this story: Vivien Lou Chen in San Francisco at ; Anthony Massucci in Wilmington

  2. sid falco commented on Jul 25

    Go Barry!

    Does this have any implications for purchasers of high yield debt in the coming 6 months. I don’t want to miss out since the 2002-2003 period when junk debt was a value play.

  3. Craig commented on Jul 25

    Truly, what is Poole smoking?

    How would the St. Louis Fed know the severity of this yet undefined problem when the principals don’t?

    There isn’t anyone that yet understands how deep this problem is, most especially the Fed. who would lie or jawbone it anyway.

  4. tjofpa commented on Jul 25

    So, what are we going to find after we drain the swamp?

    The creature was really a Zombie all along.

  5. tjofpa commented on Jul 25

    …and how are those CPDO monsters doin’ right about now? Anybody got the balls to double down?

  6. Groty commented on Jul 25

    Per an article in the UK Telegraph, Morgan Stanley points out that every equity market correction of 10% or more in the past 20 years was preceded by a widening of credit spreads.

  7. D. commented on Jul 25

    A top banker told me a couple of years ago that if you added up all the accounting gains and losses from derivatives you’d end up with a positive value while we all know that derivatives are supposed to be a zero sum game.

  8. Philippe commented on Jul 25

    The new FED is saying do not expect lower interest rate (it has accomplished silently an incredible task which commands great respect)
    “Vox populi vow Dei” is the finance industry, where LBO’s is the carrot stick (who cares if Chrisler is going to compete with an undervalued yen as long as Chrisler buy out is funded,has anyone read the Chrisler’s engineering and business plan?, the same for KKR Boots?)Has someone stood up and explained that where Daimler has failed the new owners will succeed?

  9. Neal commented on Jul 25

    According to Moodys (via Bloomberg this morning), the biggest danger from the subprime mortgage issue is that it will be so easily overcome that the ease of overcoming may lead to over-confidence when we come to face more serious threats to the economy!!

  10. bullb commented on Jul 25

    The Fed does not care, and will not. They have been saying it out loud for quite awhile that risk is mis priced in the credit markets. What you see now is not the problem, but the solution to what they have been repeatedly asserting was the problem.

  11. curmudgeonly troll commented on Jul 25

    Enjoyed reading Bill Gross… OMG I can’t live in a world where Ken Griffin (or Jim Cayne) doesn’t work as hard as he does today!

  12. michael schumacher commented on Jul 25

    all this and a morning buy program to get our gap up and then fade it back about halfway and then take it back up again.

    This market has ADD is the worst way…..

    With what is seeping through the cracks (it’s not flowing)and we still get the morning push by the fools who continue to be in total and utter denial. Credit spreads?? nope…..foreclosures getting worse??….nope.

    What happened to the earnings driven market??

    We are just exchanging one bubble for another.


  13. jkw commented on Jul 25

    Derivatives aren’t a zero-sum game any more than stocks are. Stocks are zero-sum only if you include the companies issuing the stocks. Derivatives are zero-sum only if you leave out the arbitrage trades. Arbitrage trades can either lose or make money on the derivatives side, so it is difficult to determine whether the pure derivatives trades have net losses or net gains. I would guess the arbitrage trades lose money on the derivatives more often than they make money on them.

  14. m3 commented on Jul 25

    great points, barry.

    but the question remains, is credit really tight, or just merely tighter?

    the buybacks are still going through, the LBOs are still going through; they’re just on less favorable terms.

    it’ll be interesting to see if this does turn into an inflection point… but it’s too early to tell.

    good post.

  15. jrf commented on Jul 25

    As reported on CNBC:

    “Cerberus Withdrawing $12 Billion Financing Deal for Automotive Portion of Chrysler Buyout”

    Fun stuff

  16. mhm commented on Jul 25

    The only real problem is the over-leverage on some instruments isn’t it?

    Yen carry unwinding caused the drop yesterday after 3PM (due to BRL/JPY). Just now was the drop in the DAX, forcing EUR/JPY, which forces USD/JPY which in turn forces some desperate liquidation on the US markets.

    Prices are in a role coaster by the VIX is not going much higher… why?

  17. Fred commented on Jul 25

    Oh really?…look past the headline.

    This deal will be done….that’s why the mkt’s rebounding.

    What happens when the Unions agree to more reasonable comp packages? The banks will be able to sell these commitments at much higher prices.

    Emotional trading is unhealthy to one’s portfolio performance. Fear is your friend.

    Here’s a great quote from “Since the bull market began in March 2003, the (sentiment) score has reached this kind of extreme 26 times, and the S&P 500 reacted positively the next day 70% of the time. The 8 times that it showed a negative return the next day, then the day following that was positive all 8 times by an even larger average return. Meaning that if the signal “fails” today and the S&P declines again, then it’s an even higher-odds buy signal for tomorrow.”

  18. Stuart commented on Jul 25

    The Chrysler deal is a bellweather deal. If it falls through, Katie bar the door.

  19. michael schumacher commented on Jul 25

    March 2003……hmmmmmmm I wonder what went on during that month???? and more importantly what was discontinued that month followed by who got jobs during that time frame as well.

    you can talk statistics all you want however the underlying reason for said bull market is all too apparent once the “other” factors that you chose to ignore are thrown at it.


  20. Fred commented on Jul 25

    Yes MS, you’re right…””other factors”…I didn’t mention that Earnings have driven this bull market.

    S&P EARNINGS have gone from $54.15 (2003) to $81.96 (2006) and is estimated to be north on $100 in 2007…lol

  21. Bill commented on Jul 25

    Earnings have not driven this bull market. It is all about cheap debt and a devalued dollar.

  22. michael schumacher commented on Jul 25

    earnings…..yea there’s a wonderful story. Don’t you think the dollar collapsing has anything to do with that???? Especially in the face of the Bush Admin. wanting a “strong dollar” for the last three years???

    The only winner in that scenario is profits however I will agree that they exist but in financial engineering terms only. They are not organic and have not been for quite some time.

    Earnings…..nice try…

    Where are those precious earnings now???

    and while you’re at it I really want to know how come international earnings (that you’ve offered up as a catalyst several times) do not seem to matter at YUM, HOG, and several other high profile stocks.


  23. Fred commented on Jul 25

    Hey, we agree to disagree! News flash!

    Money market since ’03 has been a very safe investment.

  24. TexasHippie commented on Jul 25

    Sold my MERFX holdings in my 401(k) which I held purely based on credit expansion. I’m with Fred in expecting capex to improve due to tech productivity improvements, and I recently bought AKAM and CSCO. I am banking on organic growth and real earnings now.

  25. Fred commented on Jul 25

    RVBD is a great buy right here, TH…

    Good luck.

  26. michael schumacher commented on Jul 25

    agree to disagree??? no you’re (as usual) backed into a corner with no way out and you just ignore the issue.

    Just like the (several) other questions you can’t or won’t answer.

    Typical and expected….


  27. slapshot57 commented on Jul 25

    what impact is the tightening of credit have on some of the private equity buyouts that have yet to be finalized? I have a decent stake in alltel, should I be worried that the buyout may fall through?

  28. michael schumacher commented on Jul 25

    slapshot (one of my alltime favorite movies-who own da chiefs????

    the deals will still get done but at terms more favorable to the debt buyers. A few billion here or there won’t stop it from happening however the repercussions of taking on that debt…well….we have some great examples of it in the last few weeks don’t we??

    specific examples need to be looked at pretty hard to see where the risk is placed, even that’s hard to do with the entire debt market playing “hide the losses” so to speak.

    Bottom line: the deals will go through but on much less borrowed $$ and at higher rates, this “may” kill deals but these bankers still want that Y/E bonus…..


  29. MarkTX commented on Jul 25

    there goes the move higher…

    way too easy…

    all news is good

  30. sungster commented on Jul 25

    if a credit crunch is coming, what asset class or sectors would benefit?

  31. Winston Munn commented on Jul 25

    This from Kevin Depew at Minyanville:

    “First, Chrysler (DCX) said this morning it is scrapping a planned sale of $12 billion of loans for its automotive business.
    Chrysler was to use the financing to help fund its buyout by Cerberus Capital Management.
    The company still intends to move ahead with a plan to raise $8 billion for its financing division… probably because the company has no choice.
    Kohlberg Kravis Roberts & Co.’s banks, led by Deutsche Bank (DB) , failed to sell $10 billion of senior loans to fund the leveraged buyout of Alliance Boots, according to Bloomberg.
    What does this mean?
    In both cases, the financing plans were scrapped due to a lack of buyers.
    They simply couldn’t find anyone willing to offer credit for the terms they were seeking.
    What do you call a situation where investment capital is increasingly difficult to obtain as banks and investors become more risk averse, perhaps wary of lending money to corporations and firms and consequently driving up the cost of debt products for borrowers?
    Oh yeah, that’s called a credit crunch.”

    It might be a good time to reflect on the consequences of a credit squeeze. Here are some possibilities: 1) reduced share buybacks – earnings will not be increased by the expediency of borrowing to reduce shares. 2) A decline in buy outs – buy out expectations won’t be a factor in stock prices.

    Seeing that the past few months increases in the markets have been driven almost entirely by buybacks and buyout speculation, it is hard to imagine a continued runup on nothing but earnings power. Especially when you realize that the entire scheme is contingent upon debt financing additional debt: Mr. Ponzi, meet Mr. Reality.

  32. ali commented on Nov 17
  33. Ben Kloosterman commented on Mar 17

    Interesting this was 8 months ago…. And now things seem to be really going down the toilet.. Unless the reserve gives us a quick and painfull recession with some tight fiscal discipline we will prob get a Depression .

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