The Great Unwind Has Begun

The credit markets had a seizure on Wednesday. To recap the mind-numbing events:

Three month T-bills finished at a two basis point yield, and may even have traded at negative yields. Signs of ZIRP.

Gold rose $68 and is still going up in Asia. The dollar fell against the yen, a sign of continued carry trade unwinds.

Credit default swaps on financials blew out, with Morgan Stanley hard hit: Spreads on protection for its bonds rose 220 basis points to over 900.

The TED spread, an indicator of stress in the interbank lending markets, shot upwards to 238 basis points.

CDS spreads on Treasuries rose to 30 basis points. Nine months ago, CDS on Treasuries were an oddity rather than an actively written contract, and the spread was 2 basis points.

Swap spreads widened considerably.

Today’s TSLf auction was, as Alea put it, a “disaster” with prices and bid to cover up big time.

And the commentary was far from cheery. Kenneth Rogoff, in a Financial Times commentary, said that the US needed a trillon to two trillion dollar bailout. That may seem like a made-up number, and any estimate of the outcomes of an eruption this large is bound to be plenty approximate. However, Rogoff has made an extensive study of financial crises, so it would be a mistake to assume that he made this estimate casually. From the Financial Times:

Were the financial crisis to end today, the costs would be painful but manageable…. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn to $2,000bn…..

It is hard to predict exactly how and when the mega-bail-out will evolve. At some point, we are likely to see a broadening and deepening of deposit insurance, much as the UK did in the case of Northern Rock. Probably, at some point, the government will aim to have a better established algorithm for making bridge loans and for triggering the effective liquidation of troubled firms and assets, although the task is far more difficult than was the case in the 1980s, when the Resolution Trust Corporation was formed to help clean up the saving and loan mess.

Of course, there also needs to be better regulation. It is incredible that the transparency-challenged credit default swap market was allowed to swell to a notional value of $6,200bn during 2008 even as it became obvious that any collapse of this market could lead to an even bigger mess than the fallout from subprime mortgage debt.

It may prove to be possible to fix the system for far less than $1,000bn- $2,000bn. The tough stance taken by regulators this past weekend with the investment banks Lehman and Merrill Lynch certainly helps.

Yet I fear that the American political system will ultimately drive the cost of saving the financial system well up into that higher territory.

An interesting observation in comments at Nouriel Roubini (hat tip Megan):

….the situation in the markets right now reminds me a lot of the time back in 1987 before the big October crash. At that time, during Sep and Oct there were some big swings in volatility in the Dow. The swings came about because investors were very nervous about a possible collapse, then every so often the market would decide that “everything is alright” and bounce up again. We’re seeing that phenomenon again now. Back in 1987 one of the big drivers of the crash was “portfolio insurance”. Brokers had implemented a scheme whereby stock portfolio’s were supposedly insured in value through hedging transactions in the futures markets. Of course, the whole scheme only works if losses can be kept modest and predictable in nature. The market tore apart initially in the Chicago futures markets when the scheme began to break down. This time in 2008 the issue is not stock insurance … it’s bond insurance. The market is now very nervous about a possible collapse in the CDS market. Different asset – but the same underlying issue. The insurance on bond values just can’t be paid up when losses become large and unpredictable in the system. (Pete)CA)

From Ambrose Evans-Pritchard at the Telegraph:

Bernard Connolly, global strategist at Banque AIG, said the Fed and the Treasury were doing too little, too late, to stave off disaster. Interest rates need to be cut immediately and dramatically, while Washington must prepare for a wholesale takeover of large parts of the lending system along the lines of the Scandinavian bank rescues in the early 1990s.

“Unless there is a very rapid change of mind, depression – with all its horrors and consequences – will be inevitable. The judgment that letting Lehmans go would not create systemic risk depended, if it was ever going to be anything other than ludicrous, on very rapid action to shore up the financial system. Instead, Hank Paulson seems to be adding to the risk in the system,” he said.

“We fear that a virtual nationalisation of the financial system will now be necessary,” he said….

Albert Edwards, global strategist at Société Générale, said Washington’s serial bail-outs are the inevitable result of the credit bubble of preceding years. “This was all baked in the cake long ago. What we have seen so far is just a dress rehearsal for the deep recession that is coming. America is going to be losing 500,000 jobs a months. That is when we will see interest rates go to zero. The deficit will be covered with printed money as it was in Japan. The endgame will be helicopters full of cash dropped by Ben Bernanke,” he said.

And from the Financial Times:

Andrew Brenner, co-head of structured products and emerging markets at MF Global, said: “It feels like no one wants to take anyone’s credit…it feels like we are on a precipice.”

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  1. Cash Mundy

    U.S. Meltdown Reflects Regulators’ Failures, China’s Wu Says

    Paulson said last year that China risked wasting trillions of dollars in resources and lost economic potential unless it rapidly opened its capital markets.

    `Better Than Intervention’

    “An open, competitive and liberalized financial market can effectively allocate scarcer resources in a manner that promotes stability and prosperity far better than government intervention,” Paulson said in Shanghai in March last year. “Time is of the essence.”

    Asian stocks tumbled to the lowest in three years today while gold and U.S. Treasuries surged as concerns mounted that more financial firms will collapse.


    Nice try, Hank, but the Chinese haven’t stayed in business for 5000 years by falling for your kind of schtick.

    CTMM: War? Obama’s ahead 2 points, oil is still below 100, and by the election (if there is one) the US will be too broke to invade Fire Island. If the ziocons can’t force an Iran attack soon, it may never happen.

    So, did it never occur to these financial geniuses that the conditions that would trigger the credit default swaps would also more than likely render the counterparty unable to perform?

    Here’s an idea: let the Supreme Court decide that CDSs lack contractual validity, and let the parties work them out without legal recourse. Then let them make a law that a contract of any kind, mortgage or whatever, cannot be transferred without the consent of all parties, specifically barring prior consent.

    The experts say it can’t work? What, like they have any credibility at this point (other than Nouriel Roubini)?

  2. Anonymous

    A better question of when will the war break out -in my opinion borrowing to pay for war costs is an inevitable “cure” for deflationary woes-is which warriors will fight?

    Will it be America and:

    1. Russia
    2. Iran
    3. Pakistan
    4. Aliens

    I expect China will be out of the mix as we will need to “throw them a bone” by letting them supply the other side…


  3. Anonymous

    There is only one way out of this mess. Don’t talk about Treasury or the Fed. Don’t talk about Bush, Obamam or McCain (as presidential candidates). All they can do is rearrange the chairs on the deck of the Titanic.

    Congress has the constitutional authority to create US currency and maintain a system national credit. Congress can make a new ship, and transfer all the passengers (that’s us folks) off the Titanic to it.

  4. Anonymous

    It’ll take a full blown depression with blood in the streets to effect any meaningful change and the bankers will kick and scream the whole way against trying to prevent their cash cow of fractional reserve banking with its compounding interest.

    (Or the cycle ends and begins again)

  5. bg

    If I am not missing all of this war talk, I think it comes from the high correlation between economic shocks and later wars.

    If wars are derived from national will to attack a percieved enemy during economic insecurity – then there first must be economic insecurity. Despite a 10% ‘correction’ in the market, I don’t sense the populace is yet mad enough to bomb some bogeyman. We are still high off the fumes from the bubble.

  6. mmckinl

    Insolvency is the problem and you can’t fight insolvency with more debt.

    The next president should get permission to print 1 to 2 trillion dollars through the treasury without borrowing from the Federal Reserve. These monies could then be used to unwind all these debt positions.

    Of course the bankers will never allow any exception to their money making monopoly through debt. They would crash the whole system first.

  7. eh

    Nonetheless the market may yet have one more monster snapback rally should any not as bad as usual news come out. The Fed appears to be a non-factor at this point; I was quite surprised that they did not cut given the slump in commodity prices, e.g. oil. Compare e.g. to their ’emergency’ cut back in January. Their behavior is definitely peculiar

  8. doc holiday

    Re: "The tough stance taken by regulators this past weekend with the investment banks Lehman and Merrill Lynch certainly helps."

    >> I'm not sure what is meant by tough stance, was that the bailout or the bonuses given to the CEOs, or was it for the latest round of option grants for insiders and board directors, or perhaps some cash advances to lobby groups like SIFMA?

  9. Anonymous

    The Government is saving its last bullets (more like blanks) per the interest cuts since they have projected a housing recovery in 2010 so they have plenty of time to go to absolute zero.

  10. peterthepainter

    oh what a tangled web we weave!.. when we first practice to deceive…

    puleeese, next time, lets just keep it simple eh?

    I know!…fat chance!

  11. doc holiday

    One vast mistake here is for some to zero in on shorts as some mythical part of this realistic crisis, when in fact, the shorts did not grant options to CEOs, as in giving Fuld $71 Milion for a heck of a job burning Leh to the ground. It isnt hard to see the full swing corruption at work on wall street with the bonus structures linked to the casino mentality that brought about this result, where taking ultimate risks has resulted in ultimate failure. The shorts didnt take part in setting compensation structures, just as they did not take part in paying off accounting firms and auditors and regulators; the shorts didnt take part in the culture of fraud that was nurtured, mentored and supercharged to the excessive levels of greed that these fat corporate pigs are still in denial about! These pigs that are too BIG to fail, should fall into the swill, and IMHO, let America fail if it can’t be honest, let Americans live in filth in our new third world sewer, where our third rate citizens can lie in gutters, since they can’t stand up for justice!

    See CEO Compensation link:

  12. Anonymous

    Yea, crisis over, they solved this with money; how obvious! Full faith restored and everyone is ready to live happily ever after!!

    …coordinated measures Thursday to inject $360 billion worth of liquidity into frozen short-term credit markets.

  13. Anonymous

    If $360 billion doesn’t un-freeze this market, then by damn, let’s try $900 Billion or $5 Trillion, we have to keep the markets running efficiently, no matter the cost!!!

  14. Anonymous

    September 18, 2008

    Uhh…In a 180 turn from my “lighter side” comments of the last two days (I’ll catch up on those later) it seems that some of our blooger compatriots and their “war” comments are following the more polite route that was referred to as “character” recently, and bravo for that. It is also possible that they have been sheltered and/or isolated from the more radical sub culture views that our always on the alert government sponsored disinformation network quickly labels as “conspiracy theorists” as it has done for years with a passion, beginning soon after WII.

    Personally I’ve always taken note of the “conspiracy theorists” views on “staged wars” without building a bunker, and laying in a stock of $7.00 AK-47’s, or really worrying about it. And then I got to see one unfold right before my eyes with the most recent invasion of Iraq. You all know the story by now so I won’t bother you with the details. And if you happened to have missed that one, and would like to see how it’s done from the inside, have a good laugh, and be entertained at the same time, just rent a copy of the movie “Wag the Dog”.

    Here’s the current operable “conspiracy theory” that has been in play for about 3 to 4 years of how Chaney, Rumsfield, Ashcroft, Wolfowitz, (yes they’re still around) and all of their Neo-Con buddies at the AEI think tank will avoid losing the White House. Surprise! They will cook up something like another war since Afghanistan and Iraq have now gone stale, Iran’s a good target, or hey, how about a complete melt down of the USA financial system? And the punch line is “anything that would ‘justify’ the declaration of Marshall Law before the November 6, 2008 presidential election”.

    So that’s it. Conspiracy theorists, what a wild and crazy bunch of guys and gals! Hmm, on the other hand if you were looking for a reason for all of Hank’s, Ben’s et al’s questionable decisions of late, and were also wondering why in the world they would be making them, then maybe, just maybe, there’s some kind of match here. Just a thought, but be careful you wouldn’t want to be branded as “one of those”. Let’s see Sept. 18 to Nov. 6 equals 50 days. World created in 7 days. Who knows?

    By the way George Jr., the long time White House punching bag, can’t wait to get back to the ranch. They’ll probably have to lock him in the Oval Office.

    Best regards dear hearts,

    Earl L. Crockett
    On the Beach, Santa Cruz, CA

  15. Anonymous

    Just to put it in perspective, a 2 basis point yield on a $10,000 3-month T-bill means that you earn … FIFTY CENTS in interest for the period.

    Unless you can trade commission-free, the nominal yield is sure to be negative. And the government may still tax you 15 cents on your interest “earnings.” Which they will use to bail out the next victim.

  16. David Habakkuk

    Anonymous at 6.17:

    ZIRP means ‘Zero Interest Rate Policy’.

    An interesting paper advocating a ZIRP was produced a year ago by Chris P. Dialynas, Managing Director of PIMCO, and Marshall Auerback, whose commentaries on international economics, and in particular on the interrelationship of international economics and geopolitics, used to be one of the highlights on

    Entitled ‘Renegade Economics: The Bretton Woods II Fiction’, the paper recommended a ZIRP as part of a comprehensive policy designed to eliminate global imbalances the authors argued were radically unstable. The paper contains interesting arguments about the nature of the instabilities — stressing among things the long term sustainability of a situation China funds an American military machine whose use an instrument of energy policy is liable it is at some point used against China or Chinese interests.


    The ‘Renegade Economics’ paper followed an earlier paper co-authored by Dialynas, also advocating a ZIRP as a remedy to global imbalances.

    A summary and link are at

  17. dd

    In one sense the old canard that derivatives are a “zero sum” game is proved true: the end result is zero dollars for everyone.
    Perhaps the better better game analogy or even a whole new “game theory” will now be disseminated: Old maid played with an entire deck of old maids.

  18. Stuart

    “..coordinated measures Thursday to inject $360 billion worth of liquidity into frozen short-term credit markets.”

    And exactly where do they get this $360 Billion from?

  19. dd

    Odds are increasing for a bank holiday or at least a market halt. Tomorrow is the quad witch but the day before has a lot of unwind action. The market might get overwhelmed here.

  20. Matthew Dubuque

    Matthew Dubuque

    Roubini is a little off the mark here.

    I was completely short the market 6 weeks before the 1987 crash, while I was entered in the National Trading Championships audited by Arthur Andersen.

    What was obvious a major cause of the crash at the time (and caused me to be extraordinarily bearish 6 weeks before anyone else), was the collapse in the Japanese bond market. NOBODY discusses that to this day, but it was obviously a trigger. The Fed should do a paper on it; maybe KC would be up to it.

    That’s what I relied on, I was 100% right and ahead of everyone else. Rogoff does not understand what happened in 1987 fully.

    Matthew Dubuque

  21. Aaron Krowne

    Gosh, why would PIMCO advocate ZIRP?

    In seriousness, folks, I don’t know how anyone can advocate ZIRP. What has ZIRP + quantitative easing done for Japan? Certainly not improved their situation. They’re still stuck in the malaise they have been for almost twenty years, and all that liquidity is zooming around the globe for carry trades.

    Am I missing something?

  22. Flow5

    Roubini doesn't know what he is talking about. The FED pulled the trigger both times, just a little harder in 87.

    Matthew Dubuque: "collapse in the Japanese bond market…but it was obviously a trigger"

    No that was the effect, not the cause. & there were others that forcast the drop who participated in those sponsored championships, i.e., Robert Prechter

    What caused the 87 drop was an excessively tight monetary policy. In fact, real gdp dropped further & faster than at anytime since the Great Depression.

  23. mxq

    Does anybody care that CDS markets are totally unregulated?

    Via Jim Cramer on TSC ($):

    “OK, we immediately need to change the rules on these credit default swaps. This is a market — not unlike the old options markets, or stocks before federal regulations were created — where there is no regulation whatsoever. I believe this market needs to have sunlight shining on it to disinfect it. I believe that institutions should not be allowed to take this insurance if they don’t have an economic stake. That just should not be allowed. These transactions should be closed out and from now on, all trades must be posted on an exchange for scrutiny, an exchange like the New York Stock Exchange. Any non-disclosed contract should be cancelled going forward.

    These rules should be made immediate going forward. That way, these insurance contracts cannot be used to destroy the underlying security or company. Right now, this stuff us like taking a life insurance policy out on someone you hate, and it is legal to murder them. That’s not sound policy. Obviously these contracts, even if there is an economic interest, need a regulatory body, an SEC of their own.”

  24. Yves Smith

    The problem with Cramer’s idea is that there are all sort of boring technical reasons why existing contracts can’t be put on an exchange. In fact, they aren’t traded in the normal sense; hedges and position adjustments are done via entering into new agreements.

    But there is still every reason to have all new CDS be exchange traded. But that requires standardization of contracts and terms, which takes time to implement.

    I’m all in favor of the idea and in previous discussions have advocated forcing more instruments to be exchange traded. But it takes time, unfortunately.

  25. foesskewered

    Hmm, the short sq1ueeze seems to have been re-enacted, see the dow return to 11,000. Problem is, there aren’t (apart from the independent funds and alpha chasers) that many investment banks who have been distant enough from the crisis to take advantage of the cannabalistic chort selling, obvious suspicion going the way of GS and perhaps even the crew over at citi. Hmm, wonder if the cannabalism will rebound on them?

    as for the seemingly whimsical way lehman was abandoned, aig rescued, was wondering if the fed thought that MS probably needed a lifeline and therefore sacrificed no4 to leave hands free for no2?

    as for exchange traded as discussed by Yves, would that reveal even uglier skeletons in the closet? in the long term, sure it’s viable but could the move result in those little nuggets of information that have been kept away from the market for their own good?! (that was sarcasm, btw)

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