Bernanke the Dove

In his recent testimony to Congress, Federal Reserve (Fed) Chairman Ben Bernanke painted a rosy picture of the U.S. economy. If the Fed were satisfied with the economy, it could afford to be blunt about challenges ahead; instead, the Fed is working very hard to appease the markets.

What is Bernanke worried about? Why is he so dovish?

Our economy is hooked on access to easy money. Until about a year ago, consumers were able to print their own money by extracting equity out of their homes. Since then, record low volatility across most asset classes has encouraged speculators to increase the leverage in their bets on investments; increasing leverage, directly or through derivatives, increases money supply. As a result of these forces, control of money supply has shifted from the Fed to the marketplace.

There have been ominous signs that the credit bubble is bursting. In the mortgage industry, we have seen an implosion of sub-prime lenders. Sub-prime lenders had been churning out mortgages to anyone who they could reach with their aggressive advertising campaigns, no matter how bad their credit rating was. Originators of mortgages sell off their loan portoflio to intermediaries; they in turn sell mortgages tranches or derivatives to the marketplace. Everyone was happy: aggressive lending practices increased the demand for homes, pushing up home prices; some investment banks loved the business so much that they started buying sub-prime lenders for billions of dollars, so that they could be ‘closer to the source’. This game is ending, and it is ending fast. Now, few investors want to touch these once prized mortgages as it has become apparent that many borrowers cannot even make their second payment (they have to make the first payment when they sign the mortgage). As intermediaries cry foul, mortgages are returned to the originators. In the meantime, sub-prime lenders are better at selling than at managing mortgages; they lack the capitalization to hold any significant inventory of bad debt and have to declare bankruptcy. We are talking about big numbers: HSBC announced this month it is increasing to $10.6 billion the allocation to cover losses in the sub-prime lending market. Both Morgan Stanley and Merrill Lynch were amongst the premier investment banks that have spent billions in recent years acquiring sub-prime lenders.

As this weakest link of the credit market is imploding, the fear is that any fallout may spread. While many investors are cheery about the “soft-landing” and are under the illusion that we have seen the worst from the housing market fallout, we believe Bernanke is gravely concerned that we might just be at the beginning of a treacherous unwinding that is long overdue. Any credit contraction might spill over to the debt-laden and thus interest-rate sensitive consumer.

Trouble in housing and with it in the mortgage industry are symptoms of a much broader credit debacle: the risk of an implosion in the credit derivatives market. A popular segment of this market is credit default swaps (CDS); with a CDS, a periodic fee is paid in return for a contingent payment upon a credit event, such as a default. What may sound like an obscure market is huge: easy credit has allowed this market to mushroom to $26,000 billion. In this market, you can insure against the risk of a security defaulting without entering into an agreement with the issuer of the security. The problem is that if the security vanishes, the derivatives may become worthless. As an example, two global steel conglomerates, Tata Steel & Corus, are in currently in merger discussion. Corus currently has over $1.5 billion in bonds, but CDS contracts written by unaffiliated parties linked to Corus debt are estimated to be between five and ten times as large. If the merger does take place, Tata Steel has made it clear that they might retire the existing debt; that may render the credit derivatives worthless.

Optimists say that any trouble in the credit markets will be confined to hedge funds who are on the wrong side of a bet. But even if that was the case, imploding hedge funds must liquidate other holdings as they receive margin calls. In a best case scenario, we believe volatility will pick up in most asset classes; this would induce speculators to pare down their bets; such monetary contraction would likely weigh on asset prices.

Does this imply the Fed may bail out a failing hedge fund? As long as the financial system as a whole is not in jeopardy, the Fed will unlikely jump to the rescue of an imploding hedge fund. However, the reason why the Fed is trying to be pre-emptive is to mitigate the spillover effect trouble in the credit markets could have to the consumer. The U.S. consumer is far more interest rate sensitive now that in the past; with over two thirds of the U.S. economy driven by consumption, it may prove to be simply too important an area to collapse.

In our assessment, Bernanke’s benign outlook is a message to banks not to cut the lifeline to sub-prime lenders, to keep the party going. Bernanke working hard to increase money supply just as market force demand a contraction may have very negative implications for the U.S. dollar.