Pressure on global financial system is still simmering away

April 28th, 2008

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One of the financial veterans you have to respect is Peter Bernstein. As this Wall Street Journal article, One Guy Who Has Seen It All Doesn’t Like What He Sees Now said,

Peter Bernstein has witnessed just about every financial crisis of the past century.

As a boy, he watched his father, a money manager, navigate the Depression. As a financial manager, consultant and financial historian, he personally dealt with the recession of 1958, the bear markets of the 1970s, the 1987 crash, the savings-and-loan crisis of the late 1980s and the 2000-2002 bear market that followed the tech-stock bubble.

Today’s trouble, the 89-year-old Mr. Bernstein says, is worse than he has seen since the Depression and threatens to roil markets into 2009 and beyond — longer than many people expect.

If you look at the financial press today, you will find that the market is ‘optimistic’ that the credit crisis is turning for the better. It has hope that the situation will get better. Consequently, you get to see some recovery of financial stocks and the US dollar. But Peter Bernstein is not so hopeful. As he said,

If China goes into a recession, God knows. The Iraq war and the whole situation with terrorism, we really don’t know where that is going to come out. There are so many things that have got to get buttoned down before you say that the future looks good enough to take a risk.

In other words, there are too many unknown unknown lurking around (see Failure to understand Black Swan leads to fallacious thinking). We share his concern about China and had written a long article about it in Can China really ?de-couple? from a US recession?. Peter Bernstein will only start to get hopeful when he sees that

… housing trouble has to at least flatten out. As long as that is going on, I think the pressure on the credit system is going to persist. It is kind of the leading indicator. It is where the trouble started. We have to underpin the consumer. That is why this is different. That is why this is like nothing we have had before.

This brings us to the Credit Default Swaps (CDS). As we said before in Potential global economic black hole: credit default swaps (CDS),

What happens if these waves of bad debts trigger the contingent obligations of CDS sellers to honour these mass of credit defaults? If these CDS sellers default themselves, what will happen to those who depend on CDS to remain solvent in the event of defaults?

As long as the house price deflation is still under way, the solvency of the financial system will be under pressure, which in turn will lead to further deflation and contagion of credit default. That will test the CDS. As this Economist article said, Swap shop,

However, many market participants were equally reassuring about the health of the CDO market in early 2007?and look how that turned out. Independent observers will not be really reassured until the system survives the test of a big, juicy default. Given the weakness of the American economy and the scale of the credit crunch, it probably will not be long before that test comes along.

If the CDS time bomb explodes (and some will argue that it is a matter of when), the first share market casualty will be the financial stocks. Just as the Germans did not know when and where D-Day will occur (though they knew it was a matter of time), so will the day of CDS reckoning be.

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