Wrote this new blog based on some Moody's data. In the future I'll do a more indepth analysis correlating default rates to market bottoms and recessions. That way we can substantially conclude that these somewhat obvious implications are de facto correlated, thus the argument is valid. And of preliminary interest might be the constant default rate, but not boom/bust like of the mid 70s to early 80s period: perhaps some characteristics inherent in the credit cycle and recession type led to no peak, but constant, default rates. http://scriabinop23.blogspot.com/2008/04/end-game-0-chance-this-is-bottom.html Basic Thesis: subprime burst was just a prelude to the real disaster, that of cascading counterparty defaults and capital base destruction of bank parties, due to normal default rates in a <em>typical</em> recession. If you believe we are not trending into recession, read no further. This argument runs on the basis we dip into one. The Bear Stearns asset bailout served as a beacon. The estimate of 45 trillion outstanding notional credit default swap contracts, insuring bond holders from default, holds an enormous latent pressure over the financial sector and possibly the rest of the markets. The New York Fed took it seriously, and so should you. Capital erosion from losses, even amidst Fed and Government sanctioned capital injections, still results in destruction of capital and thus book value. This destruction will still undermine stock prices, no matter how much the fed prevents the "cascade." Here we see default rates have barely moved off of expansionary period levels. Notice default rates in the '91 and '01-02 recession periods hit the 10% range. Moody's is forecasting defaults in this cycle that look to repeat past patterns. What follows is corporate default counts. I picked the period surrounding the Great Depression and the last two recessions, both of which involved substantial default rates. Notice that even in the Great Depression, the defaults did not occur en masse until several years following the market crash of 1929. Is this credit crisis in subprime comparable, even if of lesser amplitude, to this dynamic? Its important to also take note that most defaults are in the speculative grade (high yield) category. Notice even during the Great Depression relatively few investment grade defaults. But even in the relatively light recession of 2002, there is a substantial amount of investment grade defaults. This is most worrisome since a credit default swap disaster will likely occur on the heals of a AAA US Corporation going belly up. Like I've illustrated in previous talks on CDS with my <a href="http://scriabinop23.blogspot.com/2008/01/credit-default-swaps-keep-your-eye-on.html">example of GE credit default swaps</a>, it only takes one black swan high yield blowup to unearth the possible cascade the New York Fed took great effort to prevent. There lies a possibility that the Citis, JPM, and Goldmans of the world are using credit default swap short positions on AAA debt levered to unbelievable levels to amp earnings. Finally, here is the notional amount the recent defaults represented: Notice the actual amount of money these defaults represent is relatively little, spread across all debt holders in the system. <em>This isn't where the risk lies.</em> The lack of any visibility on possible liabilities that might result from a magnification of losses that never before existed is the current problem. With that said, we are still quite early in the cycle, as we haven't yet had our first negative GDP number. Even job losses have barely budged. Defaults are still relatively low. This says to me a long and steady period of continual downwards pressure before we hit bottom. During the last recession, the equities started their recovery off bottom when the default rate started quickly trending down. Even without the unknowns associated with outstanding derivative liabilities, the better risk/reward trade is to wait to buy equity indexes until we get a down trending default rate. You can access this default data directly in the Moody's annual paper entitled <a href="http://www.moodys.com/cust/content/content.ashx?source=StaticContent/Free%20Pages/Credit%20Policy%20Research/documents/current/2007000000474979.pdf">Corporate Default and Recovery Rates, 1920-2007</a>.