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ON THE EDGE OF A PRECIPICE: The US stock market collapse could trigger the biggest global recession since the 1930s

Friday, 8/2 Market Wrapup
Still Watching The Banks
With Brazil now on the ropes, the IMF is considering giving the country more time to repay its $11 billion in loan payments due next year. We now see bankruptcies rising, companies as well as countries defaulting on their debt, credit spreads widening, and one has to wonder, Who is next? There is too much debt and the growth in derivatives has only compounded this situation. Over the last few weeks, worries and concern has started to spread over the nation’s top three banks and their exposure to derivatives. The current exposure exceeds J.P. Morgan Chase’s net equity. Even as large as Citigroup is, their current exposure could cause severe problems for the banks, especially if systemic risks throughout the world’s monetary system start to multiply as we are now starting to see unfold. In fact, given the extent of their derivative book and considering that they are in all of the wrong places, it is hard not to imagine that one of these three banks are headed for trouble, if not all three. The banks are supposed to have risk control measures in place. Yet with derivative books this large, it doesn’t seem possible they can avoid the occurrence of future problems. In the case of JPM, their derivative book of $23.4 trillion and equity base of $40 billion is all that covers $51 billion in potential credit risk, not mentioning the $68.8 billion in derivative risk exposure. These three banks are in all of the wrong places -- corporate loans, loans to emerging markets, and counterparties to a Titanic-size derivative book. Add to this the fact that most of the derivative books of these major banks are of the OTC variety -- which means they are far riskier and less liquid -- it isn’t too imaginative to envision more problems occurring. A lot of the derivative business is based on blind faith and assumptions. These are the assumptions that are built into the derivative risk models that provide the theoretical pricing for much of these complex instruments.

"It's So Derivative"
Bank	Derivative Contracts' Total Value	Current Exposure
J. P. MorganChase	$23.4 Trillion	$68.8 Billion
Bank of America	$9.8 Trillion	$6.9 Billion
Citigroup	$6.6 Trillion	$22.4 Billion
Source: Office of the Comptroller of the Currency as of March 31, 2002 Table courtesy of Matthew Goldstein, "Bank Derivatives Back on Radar," 8/2/2002

It is the complexity of these instruments and the prevalence of problems in the international system that is now causing central bankers and investors to worry. As I said above, someone somewhere is going to come up on the wrong side of these trades. At this time we don’t know who. We just have clues.

Looking Like A Double-Dip Recession
The economic numbers this week are showing the economy is starting to slow down again and that the recession was much deeper than originally thought. On Friday the government reported the economy created fewer jobs than expected and that the unemployment rate remains stubbornly high. Factory orders fell 2.4% in June and many more companies are reporting a slowdown in sales and profits. The economic numbers this week have already caused one major Wall Street firm to predict the threat of recession will cause the Fed to lower interest rates again. Goldman Sachs, which predicted a rate hike because of a strong economy only five weeks ago, is now calling for the Fed to lower interest rates again in order to thwart another recession. Some question this move given the large contingent of foreign ownership in our financial markets. Lower interest rates would now be considered an act of desperation that could cause foreign investors to panic and exit our markets. Currently, interest rates are more attractive overseas, especially in Europe.

This week Trim Tabs reported that money flowed into equity funds in a delayed reaction to a jump in stock prices. Last week $20.5 billion flew out of stock funds. For the month of July nearly $48 billion flowed out of stock equity funds. This follows outflows last month that were close to a record $48 billion.

What we have seen this week and this quarter is a number of clues on the economy and on earnings that call into question a second half recovery. The economy was much weaker than originally thought and shows signs of new weakness. Corporations continue to report weak sales and profits and there are new signs of retrenchment in spending on the consumer front. It is hard to make a case at this point for a second half recovery. In fact, it is much easier to predict the economy will lapse back into a recession instead of a strong recovery. In summary, the primary trend is for the bear market to continue and for the economy to head back into recession. In addition, there is even a greater risk that the Perfect Financial Storm is coming closer to fruition as barometric gauges in the financial system have taken a sudden drop.