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Stimulus Maximus

The recovery in corporate credit markets is a fake...

US STOCKS advanced to fresh 11-month highs yesterday, writes Eric Fry in the Rude Awakening.

But don't bother looking for a rational rationale; you won't find it. Stocks are going up because stocks are going up.

That's a nice thing, even though it may not be an entirely logical thing.

Some 550,000 Americans filed for unemployment benefits in the first week of September. That's good, we are told, because the number could have been higher. Such is the analysis that, for several weeks, has been filling headlines, shaping investors perceptions and begetting "Buy" orders.

Again, we've got no quarrel with these pleasant results; just don't ask us to embrace the dubious logic that is producing these pleasant results.

Repeatedly, hopeful investors, bullish analysts and self-serving politicians assert that the US economy is recovering. This glass- half-full contingent typically cites less-bad data to support its assertion...while not forgetting to mention that share prices are rising a lot. (The obvious implication being that nothing could be so bad if the stock market is darn good.)

Maybe the bulls are right to be bullish, both about the stock market and the economy. But we can't escape our nagging doubts. Sure, we can observe that share prices are rising. And we can easily see that the US economy has not fallen off a cliff. But we cannot seem to detect any signs of genuine economic recovery out in the real world, where real people are trying to keep their jobs and not lose their homes.

More to the point, we cannot seem to detect any sign that individuals and small businesses have regained access to credit. Despite many top-down indications that the credit markets have "returned to normal", the bottom-up anecdotes tell a very different tale.

This apparent contradiction has been bugging us for weeks. Yes, credit spreads are narrowing, which suggests a renewed appetite for risk-taking in the fixed-income markets. And yes, large companies sold a record $926 billion of new debt issues through the first eight months of this year.

And yet...and yet...financing remains very difficult to obtain for anyone who has not retained an investment banker. Mr. and Mrs. Average cannot obtain financing very easily.

"How could this be?" we have been asking ourselves. "How could the credit markets exhibit the characteristics of normalcy while, simultaneously, most Americans are unable to get a loan for anything?"

We have no answer, but we have developed a theory: The credit markets aren't really recovering, they are merely playing at it.

Two very visible trends are unfolding in the credit markets at the same time...and they seem to contradict one another. First, credit spreads are contracting. In other words, the yields on high-risk debt, relative to Treasury yields, have fallen dramatically since last fall.

Taken at face value, this phenomenon means that creditors have become increasingly willing to finance high-risk borrowers. But here's the problem: credit spreads merely depict the pricing of bonds that ALREADY exist; spreads tell you nothing about the volume or terms of new issuance. Bank balance sheets tell that story. And when balance sheets are expanding, lending is expanding. When balance sheets are contracting, so is lending.

Guess what? Bank balance sheets are contracting. In part, this contraction has resulted from events like foreclosures and write-offs. But this contraction has also resulted from the simple fact that banks are not their own admission.

"Banks tightened standards on all types of loans last quarter," Bloomberg News reported recently, "and said they expect to maintain strict criteria on lending until at least the second half of 2010, the Fed said in its quarterly Senior Loan Officer survey published on Aug. 17.

"Most banks cited reduced risk tolerance and 'a more uncertain economic outlook' as the main reasons for restricting credit to businesses, with 35.2 percent saying they 'tightened somewhat'."

For example, the amount of leveraged loans – the kind private-equity firms use to finance company purchases – has shrunk to $67.7 billion this year from $311.2bn in 2008 and $962.9bn in 2007.

Ditto, every category of consumer loan. Credit is scarce. But even if the banks had not admitted to restricting lending, we would have been able to see it for ourselves.

The quantity of loans and leases on the balance sheets of US banks have been declining for months. At the same time, however, credit spreads have been narrowing. How cold this be?

Here's our guess: Investment banks like Goldman Sachs and J.P.Morgan, along with numerous large hedge funds, are borrowing money at very low rates of interest and buying higher-yielding corporate debt. As this leveraged buying proceeds, the prices of high-yield bonds rise and their yields fall.

It is a simple "carry trade" – turning low-cost credit into higher-yielding investment – but it is a carry trade that causes credit spreads to narrow...and causes Wall Street analysts to declare that the fixed income markets are functioning normally.

This simplistic deduction may be too simplistic...and wrong. Spreads are narrowing because speculators are speculating and arbitrageurs are arbitraging. At the end of all this speculating and arbitraging, Goldman Sachs reports robust profits but Mr. and Mrs. Average still can't get a car loan.

In other words, the credit markets may not be functioning as normally as they would appear to be.

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Eric J.Fry has been a specialist in international equities since the early 1980s. A professional portfolio manager for more than 10 years, he wrote the first comprehensive guide to American Depositary Receipts, International Investing with ADRs. Today he reports on Wall Street from California for the renowned Daily Reckoning email service.

See full archive of Eric Fry articles

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