Ominously, the spread on the 10-year dollar swap increased another 6 basis points today and seven for the week, ending today at 135. Agency and mortgage spreads, however, generally narrowed slightly this week, although they remain at extreme levels.
Over the weekend, pundits will certainly be in full force attempting to explain the causes behind the sinking stock market. Likely, the bulls will say this is little more than a “normal” correction. Already, and not surprisingly, they are calling this a great buying opportunity. We doubt, however, that there will be any substantive discussion as to the true forces behind recent financial market tumult. Indeed, we continue to be amazed at the lack of recognition or appreciation for the unfolding dynamics. Importantly, recent market turbulence has everything to do with the natural and inevitable consequences of endemic leveraging and speculation throughout the financial system, and there will be no quick fix, from Greenspan or elsewhere. This is and will continue to be about “deleveraging.”
In our March 24th commentary, "Hear No Evil, See No Evil, Speak No Evil", we discussed how the unfolding credit market dislocation was alarmingly reminiscent of the initial break in the Thai baht back in the summer of 1997, an event that proved the catalyst for the worst global financial and economic crisis in decades. It continues to be our view that the unfolding dislocation in the derivatives marketplace, the linchpin for the money and credit bubble, is a similarly seminal development. Yet, we would be very surprised this weekend if any of the commentators “connect the dots” between the dislocation in the credit market and troubled stock market. It was, however, the dramatic widening of spreads that signaled faltering liquidity and a changing landscape for the highly leveraged credit system and acutely vulnerable financial system. Here we clearly see derivative problems as the catalyst for the piercing of the US bubble, as it has precipitated losses for the leveraged speculating community and forced the unwind of leveraged bets throughout the credit market and, increasingly, the stock market.
As we wrote on March 24th, like Thailand, SE Asia and emerging markets back in 1997, there is a series of “dominos” lined up precariously, seemingly waiting to be knocked down. At the same time, few in the marketplace recognize the importance of what is now rapidly unfolding. In this regard, we have always been big fans of Morgan Stanley Chief global strategist Barton Biggs. He is not afraid to “call them as he sees them,” and he has for some time been rightfully skeptical of the US bull market. It caught our attention yesterday morning, however, when he told a Bloomberg television audience that that the sell-off in technology sector could actually be a positive for the rest of the stock market. Apparently, the consensus view has been that a sinking NASDAQ will take the pressure off of the Federal Reserve to raise interest rates. And while we can’t disagree that what is developing will almost certainly lessen the need for aggressive Fed tightening going forward, we strongly part company with respect to the ramifications for the rest of the market. Indeed, we view the piercing of the technology speculative bubble as another seminal event for the US financial and economic bubble. Actually, the technology sector has for quite awhile been one big “domino” in waiting.
We believe it is virtually impossible to overstate the importance of what is now unfolding. In past commentaries, we have often focused on mortgage and consumer credit excess. The GSEs, with their balance sheets ballooning with residential mortgage loans, have championed egregious credit growth, leading to housing inflation, a dangerous misallocation of resources, and momentous distortions to the real economy. This almost monopolizing of the conventional mortgage marketplace has only worked to exacerbate the banking and financial sector’s drift into increasingly risky lending. Indeed, an over-zealous US banking system and Wall Street have for some time joined forces to incite an historic corporate debt bubble, with technology and telecommunications lending at the heart of unprecedented lending excess. We now see the corporate debt bubble as the next key “domino” in jeopardy, with quite troubling ramifications for a financial sector with extraordinarily high exposure.
Importantly, what is now developing is clearly much more than a correction for technology stocks. Instead, we are witnessing the piercing of the historic technology financial bubble that has grown to monstrous proportions for both the stock market and credit market, not to mention the economy. Technology is truly at the epicenter of a massively leveraged financial sector. Be it the day-traders who purchased Internet stocks on margin, or the hedge funds that had made big leveraged technology bets in the derivatives market, or the egregious lending to Internet and telecommunications companies by the financial sector and capital markets, the tech bubble is all about credit excess.
We adhere to the “Austrian” economics dictum that the pain and dislocation to be suffered with an inevitable downturn is directly proportional to the excesses of the preceding boom. With this in mind, it is helpful to recognize and appreciate the significance of the truly historic nature of previous bubble excess. For starters, during 1999, companies around the globe issued a total of $3.23 trillion of new stocks and bonds, with technology and telecom issues leading the charge. Debt issuance increased 13% from 1998’s heady issuance, while equity and equity-linked security issuance surged 40%. Sales of stock jumped 51% in the US to $174 billion. IPOs increased 88% to $69 billion. And, importantly, 54% of stock offerings were from technology and communications companies. 1999 was also a booming year for junk debt. Not surprisingly, borrowing was led by the telecommunications sector. During the fourth quarter, almost 400 companies tapped the junk-bond market to borrow $112 billion.
With money and credit growth running out of control late last year, there was certainly plenty to fuel wild financial excess throughout the first quarter. Global equity sales increased more than 100% from last year to $130 billion. Global mergers surged more than 30% to $1.18 trillion. Wall Street sold 123 separate IPO deals valued at $22.6 billion during the first quarter. A record 66 convertible bond deals totaling $21.6 billion were issued, almost one-half of last year’s record $44.2 billion of offerings. For comparison, $5.4 billion of converts were sold during 1999’s first quarter. Also during this year’s first quarter, more than $20 billion of junk debt was issued, with more than half issued by media and telecommunications companies. During the first quarter, $90 billion flowed into mutual funds, this compared to $11 billion for last year’s first quarter. Amazingly, it seemed as if virtually everyone was compelled to participate in the tech mania for the final speculative blow off. This week Ameritrade reported that it signed up 306,000 new accounts during the first quarter compared to 134,000 during the 4th quarter. E-Trade signed up 603,000 new accounts, versus 330,000. E-Trade also reported that transactions increased 73% from the 4th quarter. In short, it was a “textbook” speculative frenzy to end an historic mania.
Quickly, the game has changed. Investment banks originally scheduled 108 IPOs for April hoping to raise $12.7 billion. After today, add five more companies to make a total of 28 that have shelved plans for IPOs, and many more will follow. Of the 24 companies that have completed deals, more than half reduced the size of the offerings. From the Bloomberg IPO index of 452 companies, the majority now trade below offering prices. And with speculators, particularly the leveraged speculating community, getting hammered and now forced to reduce holdings, the capital markets money spigot has been effectively turned off. At the same time, this will put additional pressure on the banking sector to continue funding risky credits. Abruptly, however, the appetite for such credits is likely disappearing. Believing the financial sector is already over-exposed, we don’t see the banks as a reliable source of additional credits. In this regard, we came across an interesting quote from the head of global loans at Morgan Stanley within a January Bloomberg story. “The growth in leveraged lending has been fueled by telecom companies and their rapacious need for capital. Telecom companies need money for network expansion. If the bond market isn’t there, they’ll go to the bank market for cash.” Also from this story comes a troubling quote, “A reluctance by high yield bond investors to buy bonds of some telecommunications companies, such as GlobeNet Communications Group and ICG communications, led them to the loan market.”
Going forward, it is our sense that the syndicated loan market is key. With capital markets faltering, will the banks continue to loan aggressively and, importantly, will there be demand for these loans in syndication? Or will lenders, investors and speculators all back away from technology and telecommunications credits? For sure, if bankers follow the capital markets in restricting lending to risky credits, this could prove fatal for a plethora of companies with poor balance sheets and negative cash flow. Amazingly, $1.035 trillion of syndicated loans were issued during 1999. In fact, syndicated lending has grown to represent just over one-half of total corporate financings. And of 1999’s total, an astonishing $391 billion were categorized as “leveraged lending,” or higher risk credits. This amount was 19% above 1998 and almost 80% above 1997. During 1998, leveraged lending increased 45%.
For a bit of color, we will include a paragraph from Chase Manhattan’s 1999 10-K. “Chase has been the world’s leading arranger of syndicated loan financing for eight consecutive years. The syndicated loan market is the world’s largest new-issue corporate capital market. During 1999, Chase was book manager of 34% of U.S. syndicated credit facilities, up significantly from 26% in 1998. This represented $357 billion in 1999, a volume increase of 31% over the prior year. Chase has led numerous benchmark syndicated loan transactions in 1999, including those for New Economy companies, non-U.S. borrowers and acquisition-related financings.” During the historic money and credit fiasco in the fourth quarter, Chase led on $123 billion in syndicated loans, while Bank of America contributed $122 billion. During an historic December, 569 deals totaling $195 billion were issued.
As the New Year began, apparently everyone believed this lending boom could last forever. During January, 522 syndicated loan deals totaling $119 billion were issued. Syndicated lending was going gangbusters through mid-March, with almost $34 billion lent for the week ending March 17th. By the end of March, however, volume had slowed to just under $20 billion. Over each of the past two weeks syndicated bank-lending volume has dropped to about $14 billion. We certainly expect that derivative and credit market problems will restrict demand for loan syndications. Over the past few years, Wall Street has been quite industrious in creating numerous conduits and sophisticated vehicles that then became major buyers of new loan credits. These are exactly the type of mechanisms that we highlighted last week when we discussed the key role of derivatives and intermediaries in turning risky loans into “safe” money. While there is very little transparency and information available, it is our sense that many of these conduits and structures rely heavily on leverage, as well as interest rate and credit protection in the derivatives marketplace. With this in mind, we certainly see cause for concern and will follow this closely. And with hundreds of billions of risky technology and telecommunications credits permeating the entire financial sector, we must admit to believing that this house of cards is increasingly in serious jeopardy.
In conclusion, we would not be surprised to hear the pundits claim that the slowdown in money supply growth is a significant cause behind stock market weakness. Slowing money supply is, in fact, a key development. Most, however, will mistake cause and effect. With the capital markets having come to be the dominant source for money and credit creation, it is only natural that this process falters with the deterioration in financial markets. As the “dominos” now start to fall, the inevitable consequences will be a destabilizing collapse of credit. What began in the derivative and credit markets has now quickly moved to the highly leveraged technology sector. Leveraged players in one market are forced to sell and reduce leverage, which reduces liquidity for players elsewhere, who are forced to sell and reduce their leverage, and so on. Quickly, financial sector liquidity disappears, confidence wanes and markets stumble badly. Unfortunately, the problems were created with previous egregious speculative and credit excess, and we just don’t see much in the way of medicine for getting out of this mess.
A special thanks to the outstanding bank analyst Charles W. Peabody of Mitchell Securities for his excellent analysis, including work on syndicated bank lending.