The End of Extend & Pretend?

The S&P500 dropped 0.9% in a holiday shortened week.  Volume was light, but it had less meaning due to the shorter week.  Interestingly, and ominously, the VIX (or fear) index spiked over 23% in a sign of possible turmoil hidden beneath the surface.  It seems like many traders suddenly decided to take out an insurance policy to protect against downside price movements.

The macro data were mixed to weak.  Although the second estimate of the third quarter GDP growth was slightly better than expected (at 2.5%), more than half of that growth came from inventory builds, builds that are clearly unsustainable.  Housing, already showing signs of deteriorating months ago, is dropping like a rock.  Existing home sales fell in October; they were expected to be flat.  New home sales plunged; they were expected to rise.  Personal spending rose less than expected; personal income did slightly better than expected.  Durable goods orders collapsed; economists estimated that they would be flat.  Initial jobless claims improved to 407,000, BUT only because the government twisted the number higher with a huge seasonal adjustment; without this adjustment, claims would have risen. 

Technically, the S&P has formed a downward sloping channel on the daily charts.  And many of the momentum, oscillator, and breadth indicators are pointing to more downside potential.  The weekly charts are painting a possible double top formation where the first top peaked in April and the latest one in early November.  If the S&P drops meaningfully over the next two weeks, then the weekly charts would turn decisively bearish.

It looks like the global policy of extend and pretend may be finally ending.  The policy, in a nutshell, is one where private bank losses–with the help and cooperation of national governments–are hidden from public view.  The hope is that if banks delay the recognition of their old losses, they could earn their way out with current profits, profits often subsidized by central bank support.  The goal is to protect the capital structure of the banks, specifically the debt holders;  senior debt holders (often the largest source of bank funding, next to depositors) have yet to take any major losses virtually anywhere in the world during this Great Recession.

Japan has been struggling with this policy for over 20 years.  It’s still not out of the woods today.

The US adopted the same approach in 2008 when the banking system began to implode.  Over two years later, the US banks are still stuck with this policy, with most of the losses still hidden on the too-big-to-fail bank balance sheets.

So where is the change in policy coming from?

Europe, and specifically Germany.  The Eurozone nations, specifically the PIIGS, are slowly but surely falling like dominos.  Greece fell in May.  Ireland is falling today.  Portugal and Spain–judging by their sovereign debt yields and CDS rates–are soon to follow. 

The key, or the trigger, is an announcement by Angela Merkel of Germany, that Germany will not be able to continue supporting the wounded PIIGS much longer UNLESS the senior debt holders of the banks that lent funds to the PIIGS also share in the pain.  In other words, Merkel and Germany are hinting that the taxpayers of the Eurozone nations should not ALONE continue to bail out the banking sector, the very same banking sector that made the risky loans in the first place, and specifically, the senior bond holders (to the banking sector) who–unlike depositors–fully understood that they invested with the expectation that they were incurring a risk of loss.

This would change everything.

Up till now, the global credit markets have been operating under the assumption that the banksters–who’ve so far successfully controlled the politicians–would NOT have to suffer by taking losses on most of their debt investments. 

But what Merkel is saying–even if she really wanted to make the banksters whole–is that she and her political leadership are at risk of a popular (and in Germany’s case, constitutional) revolt.  She may not be able to force the German taxpayers to further protect the European banksters.

And the same thing is happening in Ireland.  There is a strong chance that the people will reject the European so-called bailout.  Iceland did so about a year ago, but Iceland was not on the Euro.

What does this mean?  The shock effect to the capital markets could be devastating.  In essence, the markets would be staring a hundreds of billions of dollars in losses.  But more importantly, the markets would lose confidence, confidence that the world’s governments and their taxpayers would always be there to protect them against major losses.

To put this into context, the psychological effect could be larger than the shock from the Lehman Brothers collapse.

In fact, it could be ten times larger.

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