Moody’s appears to be evaluating credit risk from behind the looking glass, somewhere in Wonderland. I base that statement on the reasons Moody’s is giving for raising the credit ratings on large US banks. Please consider the Bloomberg article JPMorgan Chase, Large U.S. Banks Have Ratings Raised by Moody’s.

JPMorgan Chase & Co., Bank of New York Co. and State Street Bank & Trust Co. gained higher credit ratings from Moody’s Investors Service Inc., which said the U.S. government would back the banks if they faced default.

Moody’s announced new guidelines for bank credit ratings last month that consider financial strength along with any support companies may get from government and financial institutions if they get into serious trouble.

Moody’s gave JPMorgan, of New York, and State Street, of Boston, ratings of Aa2, a level higher than their prior Aa3. Bank of New York rose two notches to the highest rating, Aaa, from Aa2. A higher credit rating can lower a company’s cost of raising money by signaling to lenders and investors that they face less risk.

Moody’s made the switch to make its ratings reflect reality, said Gary Bauer, Moody’s managing director for banks in the Americas.

“Too Big to Fail”

“People already feel like they’re too big to fail,” said Jonathan Hatcher, senior research analyst for corporate bonds at Delaware Investments, which holds $98 billion in corporate bonds.

The new policy has the potential to produce “really interesting” upgrades in Japan, where government support helped banks stay solvent during the 1990s, Hatcher said.

In a stunning display of twisted logic, Moody’s has made it a blessing to have rising default risk.
By raising credit ratings, Moody’s lowered big bank’s borrowing costs with the likely consequence of ensuring that when the bailout comes it will be larger than it would have been otherwise. Gary Bauer at Moody’s says this “reflects reality”. Meanwhile Jonathan Hatcher of Delaware Investments points to Japan as the model and says “they’re too big to fail”.

Earlier today, speaking from behind the magic mirror somewhere in Wonderland, Greenspan proclaimed “A bottom has been hit in the decline of U.S. home sales“.

Planet Earth Perspective

Reporting from planet earth on the other hand is Mr. Practical with this perspective on the economy.

The relatively small sell-off in global stocks has the media scrambling for reasons and apologists regurgitating their normal excuses. The Wall-Street machine churns out bull after bull to assure us that “the bottom of the housing slump has been reached” and “stocks have no more downside.”

There is a reason for the sell-off, although none has been touched on by mainstream sources. Does anyone remember Japan raising rates? For nearly a week nothing happened, so the connection was lost. Even marginally higher interest rates are death to the massive structural problems that exist. The fact that they will take years to correct is something that most do not want to contemplate. Central bankers assure us everything is fine. This is, if I can identify one thing, the problem.

A market economy works because its participants are entrepreneurs. The economy rewards their production and mercilessly punishes their sloth. The economy should provide its own liquidity through production and then savings. In its self-interest it seeks the best value and destroys the worst. It tightens liquidity when debt gets too high and loosens it when it’s too low. Government steps in with some regulation to ensure fair play. Fine.

But when government grows too big and through its hubris believes its bureaucracy knows more than the market, the seeds of eventual deflation are sewn. I am not talking about the re-distribution of income through taxes (that is another story); I am talking about direct intervention in the supply of credit to “ensure price stability.” That lie is due to the political refusal to allow the market to tighten.

The problem becomes worse when big government aligns itself with big business (the extinction of entrepreneurs) to affect the natural self-correction processes of the market.

Years of debt accumulation are not cured by a 5% correction in stocks as Wall-Street wants you to believe. A major debt correction, one that the market has been trying to accomplish for years but is rejected time and time again by Fed policy, is necessary to correct the huge imbalances that exist. To deny the necessity of this eventuality is human.

Total U.S. debt is now 3.6 times GDP and continues to grow. But new debt is having less and less effect in driving economic growth: more income is going to service that debt and less to creating production, the stuff that generates income. The second highest U.S. debt has ever been was 2.9 times in 1929. Despite Mr. Bernanke’s false recollections of Fed actions back then, they created an immense amount of liquidity (credit) trying to cure the stock market crash. The market did rally back temporarily as a result, then slowly crashed much worse as that new credit just went to short term speculation in stocks. The new money did no real good because there was already too much capacity, so the credit never went to creating production. The same thing is happening today. It now takes $7 of new debt to make $1 of GDP where it only took $1 in 1980 and $3 in 2000.

And the consumer, which is most of the economy, is in trouble too. Today household debt is now 130% of income. That is up from 100% just in 2001, 70% in 1986, and 40% in 1953. How quaint we were back then.

So step back from the TV and take a good long look. The US’ problems are not solved by a 5% correction in stocks and the coming debt correction won’t take a week and then go away. We do not know how it manifests nor do we know the timing of it. But you should know the nature of the beast and the only way to fight it: reduce risk before everyone else does.

Best Regards,
Mr. Practical

Thank to Professor Succo at Minyanville for practical advice to those living on planet earth: “reduce risk before everyone else does”. It is only in Wonderland (and/or the Twilight Zone) that it make sense to upgrade banks because there is a 98% chance of a government bailout if things go bad. OK, perhaps the “reality” is that the Fed won’t let any big banks fail. But does anyone remember the zombie companies in Japan that resulted from similar actions?

I discussed some of this previously in Malinvestments, Predatory Lending, and Demagogues

Instead of taking a hit in 2002, Greenspan and Bernanke made matters worse by creating the mother of all housing bubbles. Instead of allowing people to go bankrupt, we passed laws making it harder, and those laws have already started to backfire. Instead of stopping subprime lending earlier, institutions repeatedly dropped lending standards to meet growth requirements. Instead of taking writeoffs now, lenders are refusing to admit mistakes hoping on a wing and a prayer that these bad home loans will cure themselves. Those loans will not be paid off either. We are following in the footsteps of Japan except that our consumer debt loads will make it worse. The Fed has learned nothing every step of the way.

For some reason Moody’s and others seem to be a mad rush to join Greenspan, Bernanke, and Lereah in Wonderland. Then again, perhaps all of them have discovered a new dimension entirely and are evaluating things from the Twilight Zone. Could it be that the reality of planet earth is simply too much for any of them to handle right now?

Mike Shedlock / Mish/