Wow, another wild week, with the global financial environment seemingly turning more precarious by the day. The blue chips, however, continue to demonstrate considerable resiliency, with the Dow unchanged for the week and the S&P500 declining about 1%. The Morgan Stanley Consumer index rose 2%, the Utilities were unchanged and the Morgan Stanley Cyclical index had a slight decline. The strong advance in the Transports came to an abrupt end, with this index dropping 4% this week. After gains early in the week, the small cap Russell 2000 ended the week with a loss of about 2%. Year-to-date, the Russell 2000 has declined about 5%. Technology stocks came under heavy selling pressure the past two sessions, with the NASDAQ100 ending the week down 4%, the Semiconductors 3%, and the Morgan Stanley High Tech index 2%. Year-to-date, the NASDAQ100 has declined 12%, and the Morgan Stanley High Tech index 5%. The Semiconductors still have a year-to-date gain of 35%. The Internets dropped 2% this week, while the NASDAQ telecom index sunk 6%. The financial stocks, although coming under pressure today, performed well under the circumstances, with the S&P Bank index unchanged and the Bloomberg Wall Street index adding 1%.
It was another unsettled week in the credit market. Yields were largely unchanged, with shorter maturities outperforming the long-bond. It was, however, “the dog that didn’t bark” that has us pondering next week. Spreads barely budged, remaining unusually wide and indicative of extraordinary systemic stress. The 10-year dollar swap narrowed 1 basis point to 133, mortgage-back spreads generally narrowed about 2 basis points, and agency spreads were largely unchanged. In Europe, yields remain near 5-year highs. German 2-year yields surged 18 basis points this week to the levels not seen since August 1995. Italian bond yields rose to the highest level in 2 and one-half years, and the spread between German and Italian bonds moved to the widest levels since the launch of the euro. Interestingly, unusual things now appear to be developing with European yield curves and spreads. We suspect this could be related to an unwind of leveraged trades and will be something to watch carefully over the coming days and weeks. This week also saw considerable dislocation in global currency markets with many currencies faltering badly. Interestingly, with all the focus on the strength of the dollar, the yen made a big move today and ended the week at the strongest level versus the dollar since last month.
The credit market has turned quite illiquid for virtually all but the best credits. Corporate issuance is down considerably year-to-date, and the securitization market is struggling. Forced to keep loans on their balance sheets, bank credit has expanded by about 18% over the past four weeks. Year-to-date, bank credit has expanded at a rate of 11%. Year-to-date, bank credit has expanded $174 billion. Interestingly, real estate loans have increased $83 billion, commercial and industrial loans $46 billion and consumer loans $21 billion. Money market fund asset growth and the money supply have both slowed markedly. This should not be surprising with the contraction of margin debt and the slowdown in the growth of GSE balance sheets. This slowdown, not surprisingly, has led to an almost immediate faltering of credit market liquidity.
“Financial market participants will always push risk taking to the marginal edge, unless prevented from doing so. This is because the marginal edge holds special appeals, for it is there that competition is least, profit margins are greatest, fees are most lucrative, and ancillary business is easiest to line up.” Dr. Henry Kaufman
“Financial institutions have a crucial public responsibility, one that sets them apart from other business enterprises… As repositories of large pools of savings, banks (and indeed many other financial institutions) possess an awesome fiduciary responsibility – one that should temper the institutions’ entrepreneurial drive…by their very nature they are leveraged heavily, and for them to survive and succeed, they must balance their fiduciary responsibility with their entrepreneurial drive.” Dr. Henry Kaufman
History should provide us a very strong warning against the excessive concentration of financial power. Indeed, the story of the devastating boom and bust of the “Roaring ‘20s” was one of flagrant financial excess and abuse by some or our country’s largest and most important banks and financial institutions. Of course, politicians were happy to look the other way as the stock market ran to dizzying heights, the economy boomed, and leading financiers and economists were seduced into the notion of “new eras” and “permanent prosperity.” When this delusion vanished and was then abruptly replaced by the harsh reality of the Great Depression, Washington was forced into action to clean up what was widely perceived as a financial system that had gone terribly wrong.
Believing that there are strong parallels between the current environment and that of the 1920’s, it is insightful to examine the logic behind the financial reforms pushed through during the depression. Pulled from the 1996 book The New Finance, by Franklin R. Edwards:
“The financial structure in the United States is a product of our unique political, cultural, and economic history, all of which came together in the 1930’s to create by legislative decree a highly segmented financial system. Reforms enacted in the 1930’s were motivated largely by the collapse in the stock market in 1929 and by the depression that followed. While interpretations differ as to the causes and effects of those cataclysmic events, they unquestionably occupied center stage in the thinking of financial reformers at the time.
Four significant themes emerged from the legislative reforms adopted during the 1930s. First, commercial banks, as the main providers of money and liquidity to the economy, were seen as key, or unique, financial intermediaries, requiring special protections. The widespread failure of banks and the concurrent economic depression during the 1930s undoubtedly encouraged such a view. Second, legislation discouraged large size among financial institutions, especially banks. Branch and affiliate operations were restricted, and severe restrictions were imposed on bank’s activities. Third, banking and securities activities were viewed as particularly incompatible and, if intermingled, a threat to economic stability. Finally, to reduce speculative activity and make security markets more efficient, legislation required issuers of public securities to disclose more information and imposed curbs on the provision of credit for speculative purposes.”
Over the years, however, memories have faded, while the revisionists have been amazingly successful in pinning responsibility for the Great Depression on the Federal Reserve; not for allowing, and even fostering the boom, but for not “printing enough money,” after the fact, during the early 1930’s. The true villain, the enormous and abusive credit and speculative excesses of the boom, is conveniently forgotten and virtually erased from economic history. This will prove a most costly distortion of the facts. Presently, the overwhelming faith in the Fed engenders unwavering confidence that such a monumental blunder could never be repeated. As such, the financial structures, regulations and oversight deemed so necessary during the depression to ensure both future soundness of the financial system and the stability of the economy, are today viewed as outdated and unnecessary.
Apparently, with Greenspan at the helm, it has become just a fine idea for our most important banks to acquire large holdings of stocks, while also dedicating billions to “new economy” venture capital. There is also no problem, supposedly, with our largest depository institutions engaging in investment banking activities, nor is there a concern that some of our country’s largest financial “intermediaries” combine traditional deposit banking, high-risk lending, insurance, security underwriting, and investment management services. Apparently, it is also okay that the largest investment banks not only lend aggressively, but also work diligently to create sophisticated securities and funding vehicles to “package” these loans into marketable instruments, while also operating major money market, mutual funds, and investment advisory services. And, it must make sense that our largest depository institutions have become leading players in what should be considered a momentous derivatives experiment, as traders and writers of risky contracts. Moreover, the current environment has seen the investment banks, with tight relationships with company insiders, execute company stock buy-back programs, while at the same time developing sophisticated derivative trading schemes to profit from writing put options and other derivatives. It does not require a wild imagination to see the enormous power attained by intermingling all these functions under one financial services umbrella. It also should not take much to see how such an arrangement is inherently rife with conflicts of interest and incentives to manipulate markets. Inarguably, these arrangements nurture reckless leveraging and speculation, hence creating a highly unstable and acutely fragile financial system. And, certainly, such arrangements run strongly in the face of the public interest.
If one takes a step back, it is truly astounding (and enormously disconcerting) to see what has been allowed to transpire within the U.S. financial system. Today, the three largest U.S. “banks” - Citigroup, Bank of America and Chase Manhattan - have come to hold combined assets of almost $1.8 trillion. The three largest “securities firms,” Morgan Stanley Dean Witter, Merrill Lynch and Goldman Sachs have combined assets of $1.05 trillion, having increased $182 billion (21%) during the past 12-months.
The “Big Three GSEs,” Fannie Mae, Freddie Mac and the Federal Home Loan Banks have combined assets of almost $1.6 trillion, having increased $302 billion (24%) during the past 12-months and a stunning $562 billion (55%) during the past 7 quarters. Total agency securities ended 1999 at $3.9 trillion, an increase of $905 billion in just 18 months. Even the largest “industrial” firm, General Electric, continues to aggressively expand its financial services business as its total assets have grown to $422 billion. Combined, these 10 institutions have balance sheets with total assets of $4.8 trillion, supported by shareholders’ equity of $ 280 billion.
But in the present period of “wild cat” finance, an institution’s power is certainly not limited by the size of its security holdings or balance sheet. Indeed, we don’t think one can overstate the influence derivatives and the key derivative players have come to exert over the financial markets, and the financial system generally. At the end of 1999, the seven commercial banks with the largest derivative positions combined for a whopping $33 trillion of derivative positions, or 95% of total bank exposure. The proliferation of money management services has also certainly augmented these firm’s power, dominance that is attained with balance sheets bloated with securities and loans and, of course, massive derivative books. The three largest brokers have combined assets “under management,” largely client accounts and funds within money management operations, of a staggering $3 trillion. Elsewhere, the largest private money management firm now manages over $1 trillion in assets.
Such an enormous concentration of power is not conducive to free and efficient markets. Instead, it is clearly much to the contrary, as increasing size begets additional influence over market mechanisms. With this in mind, it is now becoming apparent that this unprecedented concentration of financial power is having an important influence on the character of the developing financial crisis. As we have stated, it is our view that - as opposed to the 1997/98 crises that originated at the periphery in the emerging markets - Wall Street is this time the “epicenter” for what we expect to be a return to global financial crisis. With the piercing of the momentous US credit bubble, it is now our expectation that the US stock market and economic bubbles are in grave danger. It has also been our view that the piercing of the US credit bubble would commence a bear market in the dollar. In regard to the dollar, our analysis has not yet been proven accurate. We believe, however, that the most powerful forces recently propelling the dollar are anything but bullish for the intermediate and long-term.
We continue to believe that the most powerful, if not recognized, dynamic in the US financial system is the forced unwind of leveraged interest rate speculations – the deleveraging of what developed into an historic interest-rate arbitrage (borrowing short and lending long and play the “yield curve,” or shorting quality and going long risk and playing “credit spreads”). With these trades now faltering badly, the forced liquidation is creating an enormous supply of credit market instruments searching for demand. The consequence is much higher interest rates. And, not surprisingly, the most significant jump in interest rates has transpired in the sectors that had come to be dominated by the leveraged players – mortgage-backs and agency securities.
The deleveraging and resultant surge in rates has led to two negative, but not widely appreciated, major developments for the global financial system. First, higher US interest rates and increasingly dramatic interest rate differentials (especially to European and Japanese securities), is working like a magnet attracting global funds. This is particularly the case today as the powerful US financial institutions, armed with top credit ratings, can go overseas to obtain virtually unlimited funding. We believe all of the major US financial institutions – and clearly Fannie Mae and Freddie Mac - are major borrowers internationally, a powerful force recycling the flood of dollars back to the help sustain the faltering US credit market. And ironically, as the deleveraging US credit system sucks global capital from other industrialized economies and emerging markets, a strong and destabilizing feedback mechanism develops. Indeed, faltering currencies and financial markets globally leads to heightened risk and risk aversion. The immediate result is an even more pronounced flight to “high-grade” US securities. These dynamics are today unusually precarious, as most emerging markets, especially those in Asia and Latin America, remain very frail with economies and financial systems acutely vulnerable to any capital outflows or financial disturbance.
There is also a second major development now in play. The piercing of the US credit and technology bubbles is in the early stages of what will create a momentous global technology credit crunch. For some time, US and international speculators, investors and investment bankers have canvassed the globe for “new economy” plays, particularly in the telecom and Internet areas. The resulting speculative and credit excess were extreme. In time, the amount of “hot money” involved and the extent and consequences of historic malinvestment and economic distortions will become apparent. Now, however, this momentous bubble is in the process of imploding, and players are beginning to run for cover. Since much of the “hot money” likely originated from the US, the bursting of overseas bubbles is first forcing a repatriation of “hot money” back to the US.
And while these unusual forces have supported the dollar up to this point, our mountain of foreign obligations is allowed to grow by the month. During March our trade deficit surpassed $30 billion for the first time. The first quarter deficit was a disastrous $86.3 billion, an increase of 60% from last year. Going forward, there are two important questions to ponder with regard to the dollar. First, how much foreign capital flowed into the US from overseas, particularly to play the US high tech economic miracle? Second, how aggressively will the major US financial institutions continue to borrow from overseas? And, importantly, what will be the ramifications for these institutions, US financial markets, and the dollar when it becomes appreciated that the epicenter of the global crisis is, in fact, the US financial system?
As the week came to an end, financial markets were looking quite ominous. Stock markets were coming under heavy pressure globally, as both technology and financial stocks were being sold here at home, and the dollar was hit hard against the Japanese yen. For sure, it appears investors are beginning to “connect the dots” and recognize the seriousness of developments. Still, few appreciate that the ramifications for the crisis now unfolding go deep and broad. How this all plays out depends considerably on how long confidence holds in the soundness of what we believe is an acutely vulnerable US financial system. Certainly, the extraordinary concentration of power within the US financial system has played a major role in exacerbating and perpetuating the US boom. This, however, has only exacerbated credit and speculative excess and fostered devastating imbalances and distortions to the US economy. The unavoidable downside is that when confidence wanes the consequences are historic and not easily rectified. Let there be no doubt that the unprecedented concentration of financial power today greatly heightens systemic risk.