We are beginning to see severe impairment of credit functions - the fruits of massive and long standing frauds that have recently come to light. By now, many of you are familiar with the 'mark to model' fraud, where the imaginary prices generated by a computer model are preferred over the actual prices which are being paid by actual people - especially when using the former allows firms to report gains rather than the losses they have suffered in reality. With some 'investment grade' paper trading at huge discounts to par, the rating services have a lot of explaining to do. The fee structures for structured finance create serious conflicts of interest.
"S&P, Moody's and Fitch have made more money from evaluating structured finance--which includes CDOs and asset-backed securities--than from rating anything else, including corporate and municipal bonds, according to their financial reports. The companies charge as much as three times more to rate CDOs than to analyze bonds, published cost listings show."
Then there are the garden-variety frauds that occur in every credit cycle and are endorsed or at least accepted by the accountants. Low losses in good times are assumed to be permanent and provisions for losses are small - inflating reported bank profits. This is often compounded by banks which drain their pre-existing reserves to inflate profits further. When combined with loose credit standards, nastiness is practically guaranteed to ensue since the low losses will be followed by very large losses once the weaker borrowers come under pressure. Financial 'innovation' simply adds to the problems since it is nearly always used to take on more risk, not reduce risk.
At the end of a massive credit cycle like the one we have just experienced, financial earnings are wildly overstated, assets are significantly overstated, credit quality is very bad and it is very difficult to distinguish the banks with some troubled assets from those that are insolvent. Under these conditions, it only makes sense to be very cautious when making loans.
Uber cautious lending is exactly what is happening today. Spreads on risky bonds have widened dramatically as investors demand to be compensated for risk again. New issuance of junk bonds has been virtually nil for eight weeks. More ominously, about half of the commercial paper (CP) market seems to be in the process of going away. There is almost no interest in asset-backed CP except at punitively high interest rates. In fact, this market judged the Fed's discount rate cut to be about as useful as a terrorist attack.
"Even the Fed's decision to cut the discount rate that it charges banks failed to revive demand. The rate for overnight borrowing in the asset-backed commercial paper market soared 0.39 percentage points to that price on Aug. 17, the biggest rise since the Sept. 11 terrorist attacks."
The bizarre rally in stocks is especially puzzling in light of the continued deterioration in credit quality and availability. This is way beyond 'whistling past the graveyard' by the equity markets; it's more like cramming fingers in their ears, kicking and screaming "lalalalalala I can't hear you!"