Future credit cycle scenarios: Ayers Rock or Matterhorn?

Put simply, Bank of America is debating the depth — and structure — of the credit cycle. Specifically, whether we’ll see a ‘classical’ version of accelerating defaults followed by rapid improvement (the Matterhorn) or an Ayers Rock scenario, in which government intervention to stave off bankruptcy ends up prolonging the credit adjustment.

Despite its headline figure of 30% cumulative default rates across 09-11, the “Matterhorn” scenario should be hoped for as the economic implication of “Ayers Rock” increases cumulative defaults to 50%.

The historical perspective suggests that Matterhorns are much more likely than Ayers Rocks — but, then again, we’ve never seen government intervention on this scale before. We’d also note that a prime criticism of quantitative easing in Japan was that it ended up postponing the structural change that many argued was necessary for the country’s banking system. That the US is embarking on something similar could end up tilting the balance in favour of an Ayers Rock situation.

Given the government's efforts to prop up an overleveraged financial system (a system that will inevitably succumb to massive defaults and consumer retrenchment) I believe we are in store for an Ayers rock credit cycle. Thx Greenspan, Paulson, Bernanke, and Bush!!!

Hat tip to FT Alphaville for the find.