Saturday, August 30, 2014

02/25/2000 - The Quality of Financial Sector Assets *

The historic divergence only widens between the blue-chips and surging prices for the more speculative areas of the stock market. For the week, the NASDAQ100 surged more than 5%, increasing its year-to-date gain to 13%. The semiconductors gained more than 10% and the AMEX Biotech index 5%, increasing 1999 gains to 46% and 70%. The small caps continue to rally with the Russell 2000 gaining more than 2%, increasing its year-to-date gain to 10%. The Internet index jumped 7% and the Morgan Stanley High Tech and the NASDAQ Telecommunications indices advanced 4%. No doubt about it, the bulls came after us bears hard this week. For the blue-chips, the Dow declined 3% and the S&P500 about 1%. The economically sensitive issues were under pressure with the Transports and Morgan Stanley Cyclical indices dropping 3%, the Morgan Stanley Consumer index 4% and the Utilities 6%. The financial stocks continue to suffer with the S&P Bank and the Bloomberg Wall Street indices declining about 2%. It was a tough week, but we made it through and look forward to next week.

Certainly, fundamentals continue to point toward an unfolding bear market in the credit market as well as for equities. Importantly, systemic stress only intensified with spreads widening another few basis points again this week as bond market conditions continue to be quite unsettled. Currency markets have turned volatile as well, with the dollar surging against the Euro and Swiss frank. We don’t view this as related to fundamentals. Fundamentals also played no role in the metals market as gold was hit hard this week. Meanwhile, crude oil continues its march higher, gaining almost $2 this week. Putting it all together, it continues to be an extraordinary period in the financial markets.

Mr. Greenspan had a few interesting things to say during this week’s Humphrey-Hawkins testimony, although we certainly sensed a much more “dovish” demeanor, likely a response to heightened systemic stress emanating in the credit market. Unfortunately, he once again completely failed to articulate the case that it is a necessity for the Federal Reserve to move aggressively to rein in dangerous financial and economic excesses. One thing for sure, Greenspan does not ride on the “Straight Talk Express.” He rarely utters the word “credit” and never makes reference to money and credit excess. He artfully ducks questions about the money supply. As well, he conveniently ignores a discussion of the damaging consequences to our financial system and economy that mount daily from reckless speculation in both the credit market and stock market. We are certain that he possesses a sound understanding of these issues, yet chooses to remain silent. At the same time, he is quick to trumpet the latest productivity data and ramble on and on regarding the wonders of technology and the new economy. Once again, his words provide powerful fodder for the technology stock mania. Moreover, while continuing to espouse the view that inflation is the only significant risk posed by the current environment, he at the same time states that he cannot see inflation anywhere outside of crude oil. He warns about wealth effect-induced excess demand, while also making it clear that he is not targeting stock prices. He talks increasing about imbalances and distortions, while stating that he sees no reason that the longest US expansion on record cannot run indefinitely.

American policymakers and its citizens deserve much more from the chairman of the Federal Reserve. Certainly, this is no time for doubletalk – no time for Greenspeak. For the good of the country, it is time for Greenspan to give up all the “spin” and take seriously the responsibility bestowed to him to protect the soundness of our financial system. It is simply negligent not to act against what is so obviously an historic financial and economic bubble, for he understands clearly the ugly consequences of bubbles and wild speculative manias. Importantly, Greenspan “baby step” gradualism works only to encourage greater financial and economic distortions as dangerous credit excess and speculation run unabated. Importantly, as was the case in the US in the late 1920’s, Japan in the late 80’s and SE Asia in the 1990’s, it is during the final manic episode of bubble excess that immense and irreparable damage is inflicted on both the financial system and economy. We refer to this period as the “terminal phase of credit and speculative excess,” and believe that damage essentially grows exponentially during the “terminal phase”. Today, Greenspan surely recognizes that egregious credit and speculative excesses are maligning the financial system and economy but he nonetheless looks the other way.

From his Q&A last week with Dr. Ron Paul, a couple of things in particular caught our attention. Quoting from Greenspan, “So our problem is not that we do not believe in sound money. We do. We very much believe that, if you have a debased currency, that you will have a debased economy.” We could not agree more with this comment – that a “debased currency” leads to a “debased economy.” This has, of course, been proven time and time again throughout history, and precisely why we focus so keenly on the monetary system. If Greenspan recognizes this, then why has he accommodated the greatest increase in money and credit in history? Looking at the data, during the six-year period beginning in 1995 and concluding at the end of the decade, broad money supply (M-3) expanded almost $2.2 trillion, or 50%. We would strongly argue that such excessive money growth has led to a “debased” financial system and economy.

If one wants to ignore the financial wreck that was the inevitable consequence of 1920’s financial excess, one should at least recognize the decimation of the banking systems in Japan and South Korea after the bursting of their financial bubbles. Importantly, in both cases reckless lending and dangerous speculation created highly vulnerable financial systems. With the inevitable piercing of these respective bubbles, these powerful economies were brought to their knees as their financial systems buckled under a mountain of bad debts. During the boom, excessive credit creation fueled higher asset prices, over-borrowing and consumption by the consumer sector, and immense debt and wasteful investment from the corporate sector. These were classic credit-induced booms and busts, regardless of productivity and technological advancement.

Importantly, it is critical to recognize that the quality of the financial sector assets increasingly wanes as a boom progresses. In the later stages of a boom, excessive money and credit creation finance inflated asset prices and too much money and credit fuels uneconomic investments. As good as the economy looks at the peak of the boom, the real story develops as the soundness of the underlying financial sector becomes increasingly jeopardized by the creation of poor quality financial sector assets. Eventually, a point is reached where the financial sector is unable to create enough new credit to keep the bubble expanding. When asset prices reverse and the economic bubble succumbs, the financial system is impaired with poor balance sheets. Those who focused on the Japanese economic miracle in 1989 and the South Korean industrial powerhouse in 1996 without looking at the underlying financial systems were absolutely blind to imminent crisis.

With this in mind, we want to come back again to another Greenspan comment regarding the Fed and money supply targets: “We have never done M-3 per se because it largely reflects the extent of expansion of the banking industry. And when in effect banks expand, in and of itself, it doesn’t tell you terribly much about what the real money is.”

Actually, we take strong issue with Greenspan’s assertions that M-3 “largely reflects the extent of expansion of the banking industry” That may have been the case traditionally, but in the contemporary US financial system non-banks have come to play a critical role in money and credit creation. Importantly, money market funds have evolved to be at the epicenter of what has been unfettered money growth. Contrasted to Greenspan, we would say that broad money supply (M-3) largely reflects the extent of expansion of the financial sector, including both banks and non-banks. And the key to recognizing the developing US crisis lies in appreciating the vulnerability of a highly imbalanced financial sector after years of reckless expansion and speculation. We would strongly argue that excessive and misdirected lending has come to increasingly impair the quality of financial sector assets. Keep in mind that over the past six years bank credit has expanded by about $1.5 trillion, or 44%. Of this amount, only $357 billion, or 24%, were for commercial and industrial loans. Real estate loans were the leading category of bank credit growth, increasing $460 billion, while security holdings and lending accounted for $407 billion. Clearly, this surge in bank assets (bank credit) directed to real estate and securities, fully 58% of bank credit growth, has fueled the US asset bubble. However, we strongly argue that these bank assets are now acutely vulnerable and pose great risk come the inevitable bursting of the US bubble.

We also have growing conviction that significant financial sector risk lies unrecognized outside of the banking system. Parting company with virtually everyone, and mindful of “yelling fire in a crowded theater,” we nonetheless view money market funds as quite vulnerable going forward. Over the past six years money market fund assets surged almost $1 trillion, or almost 160%. After beginning 1995 at $630 billion, money market fund assets ended the decade at $1.625 trillion. In fact, fully 46% of total M-3 money supply growth is explained by the unprecedented rise in money market fund assets. For comparison, over this same period currency in circulation increased $166 billion, large time deposits $342 billion and savings deposits $589 billion. Interestingly, the narrow definition of money (M1 – generally currency and checking accounts) actually declined slightly over the past six years. Over this same period, Federal Reserve credit expanded about $190 billion.

Indeed, it is our view that the explosion of money market fund assets has been at the epicenter of the US financial and economic bubble. Money market funds have been the key conduit for non-bank lenders, particularly the GSE’s, Wall Street firms, and captive finance companies. Free from reserve requirements, money market funds have teamed with these aggressive non-bank financial institutions for what has been an historic bout of unfettered money and credit growth. Moreover, this mechanism proved particularly effective in sustaining rapid credit growth during past bouts of systemic stress and faltering financial system liquidity. During five key months of financial crisis in 1998 money market funds expanded more than $200 billion, or at a 40% annualized rate. Then throughout last year’s second half, money market funds again expanded by almost $200 billion, a rate of 28%. We strongly argue that this rampant money growth was critical fuel for extending the stock market and economic bubble and we don’t think one can overstate the dominant role of these funds have come to play during this historic period. Today, however, the key issue becomes the soundness of these funds. Has the immense growth in money funds and the concomitant surge in asset prices come to jeopardize the quality of fund assets? If these funds have been a key source fueling asset inflation in both the equity and real estate markets, are these funds now vulnerable? Unfortunately, we must answer both questions strongly affirmative.

We have recently been taking a closer look at a few money market funds and are alarmed by what we see. One fund from a major US brokerage had 40% of its assets in repurchase agreements. Repurchase agreements, or “Repos”, are a key financing arrangement used by the leveraged speculating community. Looking at another major brokerage’s money market fund, it had 37% of its assets in “Repos”, and 24% in commercial paper from the likes of Aegon Funding Corp, Old Line Funding Corp, Greenwich Funding Corp, Tulip Funding Corp, and several Wall Street firms. We looked at another large fund that held significant commercial paper holdings from a long list of “Funding Corps” including Central Capital Corp, Corporate Asset Funding, Amsterdam Funding Corp, Park Avenue Receivables Corp, Delaware Funding, Edison Asset Securitization, International Nederland Funding Corp, and General International Funding, to name a few. These funds also have large exposure to Fannie Mae, Freddie Mac, the Federal Home Loan Bank System, GE Capital and the major brokerage firms.

Last week we made the case that the US financial sector is one massive and precarious interest rate arbitrage. Well, it is clear to us that money market funds are the key source of liquidity for this historic speculation. Instead of the expected reasonable role of funding the short-term borrowing requirements for businesses involved in actual commerce, money funds are predominantly lending to holders of securities, most likely mortgage, credit card and auto receivables. With insufficient investor demand for the now nearly $1 trillion annual increase in mortgage, agency and corporate securities, Wall Street has created a structure where conduit “funding corporations” purchase much of the long-dated loans with liquidity created through the money market funds. This is a powerful new twist to the age-old game of borrowing short and lending long. It has worked like magic as the expansion of money market fund assets has created a virtually unlimited source of loanable funds for the financial sector. If one ever wonders how our economy functions so marvelously with little savings, able at the same time to so easily accommodate an unending flood of new credit creation, we think the answer lies in the uncontrolled expansion of money market assets. The downside, however, lies in acute systemic vulnerability from the truly unprecedented leverage and related use of derivatives, as well as historic distortions and imbalances to the real economy.

Interestingly, Greenspan and, generally, the economic community remain focused almost exclusively on the banking system, ignoring rampant money and credit creation by institutions outside the banking industry. This is a critical error. We understand why this is the case for Greenspan; clearly he does not want to admit that the Fed has lost control of money creation to non-bank enterprises. Why the economic community ignores the explosion of money market funds and non-bank lenders remains a mystery, although this is obviously a very sensitive subject for Wall Street. As we have said in the past, this bubble will not work well in reverse. We are of the view that the credit bubble is in the process of being pierced with the faltering of our highly leveraged and vulnerable financial sector. We believe liquidity is faltering, and that key sectors of the stock market are indicating as much.

Curiously, NASDAQ and the more speculative areas of the stock market have thus far proved immune to the deteriorating financial market environment, much to the delight of the New Paradigmers and “momentum players.” However, we suspect recent divergences have little to do with fundamentals but, instead, have likely been exacerbated by an unfolding dislocation in the leveraged speculating community. We suspect that many players hit with losses in the credit markets have been forced to also cover short positions in the stock market. Moreover, significant capital in the leveraged speculating community is dedicated to some version of a “market neutral” strategy. This entails buying good companies and shorting bad companies. Ironically, this strategy has been a near disaster as the blue-chips have been hit while at the same time other sectors are in a virtual melt up. We also believe that the proliferation of derivatives has also likely played a role in what is now clearly a dislocated stock market. We will not venture into predicting the stock market but we strongly reiterate our view that the credit market bubble is in serious jeopardy and the ramifications of this momentous development are significant for the stock market and economy going forward.