It was another unsettled week for financial markets. For the week, the Dow dropped 3%, and the S&P500 declined 2%. Perceptions as to the direction of the U.S. economy began to darken, with the Morgan Stanley Cyclical index sinking 6% as the Utilities added 2%. The more defensive stocks outperformed with the Morgan Stanley Consumer index unchanged for the week and the Transports dropping about 2%. Technology stocks were weak, with continued selling in Microsoft leading the NASDAQ100 lower by 5%, while the Morgan Stanley High Tech index suffered a less serious 2% decline. The Semiconductors dropped 4%, the NASDAQ Telecommunications index 7%, and The Street.com Internet index 8%. The small cap Russell 2000 declined 4%. There was an unusual divergence in the financial sector, with the S&P Bank index advancing 5%, and the Bloomberg Wall Street index sinking 5%.
With the view of a slowing economy taking hold as the week progressed, Treasury yields dropped noticeably. The key 10-year Treasury yield declined almost 18 basis points and two-year rates dropped 11 basis points. Spreads moved only slightly, with the 10-year dollar swap spread narrowing almost two basis points and mortgage-back spreads generally unchanged. Agency spreads generally narrowed one basis point. Elsewhere, in what could have been an important inflection point, the dollar weakened abruptly - falling almost 2% today against the euro and Swiss franc. For the week, the euro rallied more than 3% to close today above 93.
“The shift toward speculative and even Ponzi finance is evident in the financial statistics of the United States as collected in the Flow of Funds accounts. The movement to ”bought money” by large multinational banks throughout the world is evidence that there are degrees of speculative finance: all banks engage in speculative finance but some banks are more speculative than others. Only a thorough cash flow analysis of an economy can indicate the extent to which finance is speculative and where the critical point at which the ability to meet contractual commitments can break down is located.” Hyman Minsky
“The theory developed here argues that the structural characteristics of the financial system change during periods of prolonged expansion and economic boom and that these changes cumulate to decrease the domain of stability of the system. Thus, after an expansion has been in progress for some time, an event that is not of unusual size or duration can trigger a sharp financial reaction. Displacements may be the result of system behavior or human error. Once the sharp financial reaction occurs, institutional deficiencies will be evident.” Hyman Minsky
Back in early February we posted a commentary titled “If Hyman Minsky Were Alive Today.” Well, considering the enormity of recent developments we thought it appropriate to attempt to expand on the view of the world through the brilliance of Dr. Minsky. Minsky placed great importance on debt structures and, hence, was always focused on the dynamics of the financial sector. In particular, he was keenly aware of the character and systemic significance of debt created through the act of leveraging speculative assets. For Minsky, it was the deterioration in the quality of debt over the life of the boom that created the inevitability of the bust. At the later stages of a boom, general euphoria created an environment conducive to the over issuance of increasingly low-quality credits. And with rapidly expanding debt supported by assets with increasingly dubious future cash flows, the result was an increasingly fragile financial system. Importantly, a boom-time mentality by both borrowers and lenders – with money and credit excess engendering a strong feedback mechanism - created a vulnerable financial structure made up of mountains of weak debt supported by increasingly uneconomic enterprises.
Minsky’s model has three categories of debt structures: Sound “hedge finance” - where “cash flows are expected to exceed the cash flow commitments on liabilities for every period.” Less sound “speculative finance” - where cash flows, although inadequate to fully service debt in the short-run, are generally sufficient over the longer-term. And, unsound “Ponzi finance” - “cash flows from assets in the near-term fall short of cash payment commitments” and only with some future “bonanza” will cash flows ever be sufficient to service debts and provide any realistic hope of generating profits. Importantly, “a ‘Ponzi’ finance unit must increase its outstanding debt in order to meet its financial obligations.” New money and credit are a necessity for perpetuating the game.
The greater the ratio of speculative and Ponzi finance, the greater the fragility of the financial sector to rising interest rates and/or other shocks. Ponzi financed assets, in particular, are highly sensitive to both changing perceptions and higher interest rates. Higher rates are injurious as debt service costs rise at the same time the present value of future cash flows drops precipitously. Quoting Minsky, “the rise in long term interest rates and the decline in expected profits play particular havoc with Ponzi units, for the present value of the hoped for future bonanza falls sharply.”
“It can be shown that if hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system…Over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.”
Minsky also held the view that “a stock market boom feeds upon and feeds an investment boom.” In what he described under the heading “the economics of euphoria,” he writes about the exuberant 1960’s bullish period where “political leaders and official economists announced that the economic system had entered upon a new era that was to be characterized by the end of the business cycle…” Such optimism takes on a powerful role, especially as a protracted period of prosperity ingrains over confidence within the financial community. “Financial institutions are simultaneously demanders in one and suppliers in another set of financial markets. Once euphoria sets in, they accept liability structures – their own and those of borrowers – that, in a more sober expectational climate, they would have rejected…The shift to euphoria increases the willingness of financial institutions to acquire assets by engaging in liquidity-decreasing portfolio transformations…The result is a combination of cash flow commitments inherited from the burst of euphoria and of cash flow receipts based upon lower-than-expected income.”
We believe the “Minsky model” is invaluable in making sense out of the present extraordinary environment, one with a global financial system locked in its perilous proclivity of breeding devastating booms and busts. Be that as it may, American economists have been quick to pin the blame for overseas crises on “crony capitalism.” This, while convenient, ignores the true but “too close to home” culprit – massive credit and speculative excess, and the proliferation of “Ponzi finance.” Undeniably, Japan remains mired in a quagmire of bad debts and financial paralysis more than a decade since the piercing of its financial and economic bubble. These are the ugly but unavoidable remnants of a euphoric period where reckless credit and speculative excess fostered delusions of permanent prosperity and resulting endemic malinvestment. The Japanese debt explosion was directed primarily at inflating stock and real estate prices, fostering an enormous misallocation of resources to projects with minimal true economic value. Come the inevitable piercing of the stock market bubble, confidence waned and the credit system buckled. A painful bust was unavoidable - the consequence of asset prices and capital investment becoming completely detached from underlying cash flows. Fortunately, the Japanese are major savers and run perpetual trade surpluses, factors that have thus far helped to avert financial collapse.
The 1995 Mexican crisis is another prime example of fragile financial structures developing from an unsound boom. Again, the boom was financed with excessive credit growth, but this time much of it provided by aggressive US financiers. The term “Ponzi” is everywhere applicable to the strategy of aggressively borrowing in the US money markets to finance holdings of Mexican debt – a game that became very popular within the blossoming leveraged speculating community. But when the Fed raised rates in early 1994 after a long period of extreme accommodation, credit market conditions in the US quickly faltered, liquidity for markets closely linked to the US disappeared, and expectations as to the sustainability of the Mexican boom evaporated. Foreign capital headed for the exits, leveraged trades were unwound, and the acute vulnerability of the Mexican financial sector exposed. Financial and economic collapse was quickly set in motion, halted only by the Federal Reserve and Treasury’s dramatic rescue.
The SE Asia boom and bust also powerfully illustrated Minsky dynamics. After all, how could these so-called “miracle” Tiger economies go from years of extraordinary growth to near financial meltdown in a period of several months? Well, specifically because this spectacular boom - particularly during the final rabid outburst of euphoria - and resulting bust had everything to do with acutely fragile debt structures that had increasingly come to dominate these financial systems and economies. Specifically, endemic credit excess came to (Ponzi) finance increasingly risky and ill-advised endeavors – projects without sufficient underlying cash flows to service heavy debt loads. Importantly, the region’s rapidly expanding financial sectors became increasingly frail, aggressively expanding dubious credits with external borrowings in an unsustainable boom. At the same time, and unrecognized by bullish analysts, the Tigers came to be highly exposed to the vagaries of the leveraged speculating community, with their aggressive use of borrowed “hot money” and derivative strategies. Actually, “Ponzi finance” increasingly became the lifeline – the marginal source of credit growth - for these bubble economies.
Surreptitiously, acute financial fragility developed with the proliferation of sophisticated currency and interest rate arbitrage plays by both the speculators and the individual domestic financial sectors. Still, it was largely the foreign capital flows that fostered the perception of endless capital. These perceptions increasingly nurtured precarious imbalances and distortions such as overheated demand, misallocation of resources and deteriorating trade positions. Unbeknownst to these economies, the resulting addiction to foreign capital flows became the weak link in extremely fragile financial structures that imploded immediately as the “hot money” headed for the exits. The region’s financial and economic collapse was averted only through unprecedented IMF bailout packages, a spectacular export boom to satisfy US bubble-induced over consumption, and a resumption of foreign inflows (also directly related to the U.S. bubble).
A similar boom/bust dynamic played out in the egregious Russian (Ponzi) financial bubble that imploded with the first exit of “hot money.” The vulnerable US financial system nearly followed emerging markets into meltdown, only to be given a reprieve through an historic period of unprecedented money and credit excess, with the resulting historic manic boom. Now, however, the reprieve has run its course and crisis is back at the front door. And if the booms in Japan, Mexico, SE Asia and Russia were completely misinterpreted at the time, the bullish analysis of the US boom is a momentous analytical blunder. The present bullish focus on GDP growth, technology advancement, and productivity improvements blindly ignores the key development: the historic rise in financial fragility and the unsustainibility of the U.S. boom.
Quit simply, the recent US bubble is truly unprecedented in respect to the endemic degree of “Ponzi finance.” First, the most obvious example is the Internet bubble where the majority of enterprises have no economic value whatsoever without perpetual financing. Underlying business cash flows and economic profits are nonexistent, and the underlying fragility of these enterprises is becoming obvious with this sector’s recent implosion. Minsky would also certainly view much of the enormous credit advanced to fund the “telecommunications arms race” as “Ponzi finance” - weak credits vulnerable to changing perceptions and higher interest rates. Certainly, this mountain of telecom debt is acutely vulnerable to any systemic dislocation that leads to a discontinuance of additional financing, a situation we see unfolding today. A case could be made that a preponderance of the U.S. technology bubble fits within Minsky’s definition of “Ponzi finance.”
Following dangerous parallels to the emerging market bubbles, the US bubble has been financed by unprecedented foreign capital flows. And more specifically – and uncomfortably similar to SE Asia – it is our belief that the proliferation of “sophisticated” interest rate and currency strategies used by the leveraged speculating community have played a crucial and unappreciated role in financing the US boom. This, in itself, creates acute vulnerability to changing perceptions and capital flight. Leveraged “hot money” is highly unstable, and it is certainly our view that derivatives feed instability.
According to most recent Bank for International Settlements reports, global OTC interest rate contracts increased to $60 trillion, and increase of 42% for the six quarters ended 12/31/99. The interest rate swap market now totals $44 trillion. Importantly, this explosion in interest rate derivatives closely parallels the enormous growth in US agency and mortgage debt. Over the same 18-month period, total assets of the government-sponsored enterprises increased 45% to $1.72 trillion, while total US financial sector debt increased 28% to $7.6 trillion. Not surprisingly, such enormous credit growth fueled an asset bubble, with surging stock and real estate prices fueling overheated demand. In what should be recognized as a disaster, our current account deficit exploded to $400 billion annually. It is right here where one can find the necessary ingredients for systemic Minsky financial instability.
There is a strong, yet misguided, bullish perception of a healthy situation where a flood of foreign capital has been making direct investments in the wondrous U.S. “new economy.” Unrecognized, is that enormous foreign capital flows have instead largely directly and indirectly financed inflation in US securities and real estate markets. Somehow unappreciated, the powerful US mortgage finance superstructure has been a leading provider of “Ponzi” finance, recklessly inflating home prices - assets noteworthy for their lack of underlying cash flow. This game becomes even more precarious as the financial sector, aggressively extending this increasingly dubious credit, resorts to ever more risky liability structures. Here, ballooning balance sheets are financed with significant short-term borrowings, while supposedly much of this risk is shifted to the “derivatives market.” At the same time, the mortgage sector has increasingly borrowed aggressively from foreign sources. If this not precarious enough in itself, the leveraged speculating community - relying on sophisticated models and strategies - is a major holder of mortgage-back and agency securities. In this regard, we do not believe the present structures within the mortgage finance superstructure could today be more vulnerable. Indeed, we see this sector as a prime catalyst for the developing systemic dislocation.
First, as we have highlighted previously, the models used extensively within the mortgage and speculating communities no longer function properly. In a structural development, spreads have “blown out” as risk-free government securities have dramatically outperformed mortgage-related securities. This is self-destabilizing as wider spreads work to heighten systemic risk perceptions. As well, the U.S. yield curve has inverted, further rendering previous relationships and hedging programs inadequate. Inarguably, the swaps market is in dislocation, and we do not believe one can overstate the importance of this development. The swaps market will be key going forward. And, importantly, it is our “hunch” that there will be a close relationship between the mortgage/agency market, the swaps market, and the stability of the dollar.
At the minimum, there is an unprecedented and unstable currency mismatch as foreign funding sources have accumulated enormous holdings of dollar denominated securities. If, for any reason, dollar confidence wanes these holders could move to “hedge” or liquidate holdings. This creates a very tenuous situation – clear and present financial fragility. At the same time, it is our belief that the great, although unrecognized, “secret” is that there is an enormous “carry trade,” where “hot money” speculators have borrowed at low foreign interest rates to take leveraged positions in higher yielding U.S. securities. Quite likely, agency and mortgage-backs are at the epicenter of these “plays,” and we would suspect that sophisticated strategies involving the swaps market are also paramount. Not only have these “hot money” flows artificially inflated American asset prices and perpetuated the bubble economy, they have also been the key “recycling” mechanism for our massive current account deficits. This should be patently recognizable as “Ponzi finance” at its truest form.
And while this year’s surging interest rates have hurt such “carry” trades, losses have been greatly mitigated by the strength of the dollar. Now, however, with the great US technology bubble bursting and the resulting tottering perceptions as to the soundness of the U.S boom, dollar dynamics are changing rapidly. Quite likely, foreign investors have begun to liquidate American technology stocks and to repatriate funds back home. This, combined with the faltering U.S. credit market, provides a strong catalyst and certainly solidifies our belief that the dollar is now acutely vulnerable to a sharp reversal. And recognizing the acute nature of U.S. financial fragility, we see a not insignificant probability that this will manifest into a self-reinforcing and destabilizing capital flight. Moreover, with the leveraged speculating community increasingly impaired, we expect dollar weakness to lead to a problematic deleveraging and an unwind of the foreign “carry trade”, with negative ramifications for the dollar, global derivatives markets, and the US financial system and economy. Reiterating what we have said recently, the U.S. credit bubble has been pierced with profound ramifications.
Although we certainly don’t expect anything comparable to the devastating collapse of SE Asian currencies back in 1997, we do see some disconcerting similarities. Unprecedented leverage and the unimaginable derivative positions create acutely fragile financial structures. One only need to remember back to December 1997 when the South Korean won lost almost 40% of its value in a matter of days to appreciate the danger posed by the proliferation of leveraged speculation and dynamic hedging derivative programs. Here at home, things are now moving quickly, and the possibility of a dollar break could further exacerbate the unfolding dislocation in the US credit and stock markets. Already faltering, the U.S. credit system could quickly be pushed over the edge by an abrupt decline in the greenback, which would only force further liquidation of dollar denominated security holdings.
In many respects, what is developing is similar to the environment where the U.S. credit market virtually froze in the fall of 1998. In the unfolding environment, the institutional deficiencies of the U.S. financial sector will become evident, and the degree of speculative activities exposed. Unfortunately, we see the U.S. financial and economic bubble as history’s greatest episode of Minsky’s “Ponzi finance.” Importantly, “a ‘Ponzi’ finance unit must increase its outstanding debt in order to meet its financial obligations.” Such a structure is patently unsustainable. And with the U.S. now running a current account deficit of more than $1 billion daily, there is “no room for error.” Foreign lenders must remain highly confident in the soundness of the U.S. financial system and economy. Unfortunately, we just don’t see how such confidence can be maintained. When foreign source creditors are unable or unwilling to continue to finance our boom – either due to a change in perceptions or the forced unwind of faltering leveraged speculations – the game is over. If our invoking Minsky “Ponzi finance” analysis is indeed the correct analysis for the U.S. bubble, the prognosis is increasingly perilous.