06/01/2000 Banks Take the Reins of Credit Excess-Wall Street is Ecstatic *

It was another truly extraordinary day to end an historic week. Today, the Semiconductors gained 8%, the AMEX Broker/Dealer index 9%, and The Street.com Internet index 11%. In just four sessions, the Philadelphia Semiconductor index rocketed 27%, the NASDAQ100 21%, The Street.com Internet index 26%, the NASDAQ Telecommunications index 23%, the S&P Bank index 7%, and the AMEX Security Broker/Dealer index 20%. Year-to-date, the Semiconductors have gained 64% and the Bloomberg Wall Street index 13%. Both the NASDAQ100 and the S&P500 are back to positive for the year, while the Morgan Stanley High Tech index has added 10%. The 52-week gains for the NASDAQ100 and the Morgan Stanley High Tech index are 78% and 93%. The Semiconductors have added 183% and The Street.com Internet index 71% during the past year. For the week, the Dow gained 5% and the S&P500 advanced 7%. The Transports added 5% and the Morgan Stanley Cyclical index 6%. The Utilities actually declined 2% and the Morgan Stanley Consumer index had a small decline. The small cap Russell 2000 surged 12%, the Bloomberg Wall Street index 15% and the S&P Bank index 9%.

What is all the excitement about? Well, the bulls are clearly crafting the perception of an omnipotent Federal Reserve orchestrating a perfect “soft-landing.” Today’s weaker than expected employment report is going to be sold zealously as strong evidence of such a wonderful scenario. Interestingly, the bullish melee/buyers’ panic/short squeeze in the stock market overshadowed an unimpressive performance in the credit market. After this morning’s 2-point surge on the release, the bond market closed the day down a tick. For the week, long-bond yields dropped about 12 basis points and 10-year yields about 16 basis points. Spreads did narrow, with the key 10-year dollar swap spread ending the week 5 lower at 127. Mortgage-back spreads generally narrowed about 5 basis points, with agency spread narrowing as much as 9 basis points. The exception was the TED spread that widened 14 basis points this week as Treasury bills rates declined much more than borrowing rates in the Eurodollar and other short-term funding instruments. Ominously, the dollar traded poorly today, dropping more than 1% against the euro and Swiss franc.

Back in the fall of 1998, I had what regressed into a “heated” email debate with Bloomberg’s Caroline Baum. It was my contention that the extraordinary expansion in GSE balance sheets (asset growth from mortgage and other debt purchases) was a major factor driving the rapid growth in money market fund assets (hence broad money supply). It was also my belief that this enormous GSE credit creation binge was a driving force in the move to “reliquefy” US (global?) financial markets. Ms. Baum fervently argued the consensus view: that only banks have the ability to create money and credit, hence the GSE’s are but “intermediaries” playing no role whatsoever in money or credit creation. I recalled this “debate” last week when I read Ms. Baum’s column “Banks Ride to the Rescue in More Ways Than One”

Quoting from her column:

“Remember the fall of 1998, when the capital markets ``seized up,' borrowing from Federal Reserve chairman Alan Greenspan's phrase book, and prompted forecasts of an economic dark winter?

What everyone -- including the Fed but excluding the monetarists -- missed was that banks were lending in spades. Unable to raise money in the new issue stock and bond markets, corporations tapped their bank credit lines.

The result was soaring growth in the money supply and bank credit. The economy defied its skeptics, never skipping a beat and growing at a 5.9 percent rate in the fourth quarter of 1998.”

Well, that’s pretty convenient analysis - and fits neatly with Wall Street bullish spin. And, clearly, there is another “reliquefication” in the works. But parting company with Ms. Baum, we see this as a high-risk operation likely to fail this time around. Importantly, we have our own analysis of 1998, one that leads us to have much different expectations for how this situation will develop going forward. First, in respect to 1998, what everyone -- including the Fed, the monetarists and Ms. Baum -- missed was that the GSE’s were lending in spades. It is again insightful to look back at the data. During the second-half of 1998, broad money supply (M3) expanded $390 billion, or at a 14% annualized rate. Of this, $183 billion, or almost half of the expansion, was the result of a surge in money fund assets that grew at an annualized rate of 31%. This surge in money market assets was consistent with ballooning GSE balance sheets. During 1998’s final six months – a period of acute systemic stress with the Russian collapse and failure of LTCM - total assets held by Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System expanded by an astonishing $210 billion, or at a 38% annualized rate. A significant portion of this lending was funded in the money markets, as Fannie and Freddie short-term borrowings rose by $113 billion during this six-month period, expanding at an annualized rate of 40%.

It is insightful to contrast the extraordinary GSE expansion during this period with that of the so-called “rescuers” – the banks. During the second half of 1998, banks expanded commercial and industrial loans by $55 billion, or at a 12% rate, real estate loans by $50 billion, or at an annualized rate of 8%, and consumer loans by $4 billion, or at a rate of 1%. These three bank credit categories increased $109 billion, or about one-half GSE asset/lending growth. Granted, bank credit expansion over this period was at a rate of almost 14%, but nearly 40% of this related to security purchases. Indeed, commercial, industrial, real estate, and consumer loans combined to account for only about 37% of bank credit growth. These numbers certainly support our view that the GSE’s held the reins of credit excess and were the most powerful players in the 1998 “reliquefication.”

Now, lets try to make sense of what is presently unfolding. In some key facets, it is a much different environment. After a problematic dislocation in the credit market with an inverted yield curve and a blow-out of swap spreads – not to mention increased public scrutiny – previous GSE runaway credit excesses have seemingly given way to moderate growth. Indeed, the days of unlimited growth for the GSEs appear over. During the first quarter, total assets for the “Big Three GSEs” increased $39 billion, or at a 10% annualized rate. This trend continued in April, with Fannie Mae mortgage portfolio growth declining to less than 1% annualized. Not surprisingly, the GSE slowdown corresponds closely with tempered growth in money market fund assets. During the first 20 weeks of 2000, money market fund assets have increased $58 billion, or at a 9% annualized rate. It is certainly our view that this dramatic slowdown in GSE asset growth is an important factor responsible for faltering liquidity throughout the credit system.

But with the GSE seemingly on the ropes and capital market liquidity faltering, other players in the financial sector are forced to take up the slack. By default, the huge onus to perpetuate credit excess has fallen squarely on shoulders of the US banking sector. This, we believe, has particularly become the case since security issuance slowed sharply in late March. Moreover, dislocations in key security and derivatives markets have fed increasing systemic stress on an almost weekly basis. Now, and certainly with Wall Street cheering them on, the bankers have taken the reins of credit excess and are working frenetically to keep the game going. During the past nine weeks, commercial and industrial loans have increased $36 billion, or at an annualized rate of 20%. Real estate loans have expanded $42 billion, or at a 16% rate, while consumer loans increased $6 billion, or 7% annualized. And in contrast to the second half of 1998 where these three key categories of lending comprise just 37% of bank credit growth, during the past 10-weeks it has been 62%. Keep in mind that a considerable portion of 1998’s bank credit was directed at the faltering securities market (where the financial sector was increasing its leverage to provide a deleveraging mechanism for many speculators that got into trouble), the majority of today’s credit fuel is fed directly to the economy.

This past week, however, banks both aggressively lent and bought securities. Bank credit for the week ended May 24th expanded a remarkable $31 billion in what equates to a 30% annualized rate. Wow…There was a $13 billion increase in security holdings, increasing the 9-week rate of growth to 19%. And in what now appears a key development for the credit system, syndicated bank loans expanded last week by $43.648 billion (volumes reported by Bloomberg). Of this amount, almost 30% represented funding arrangements for three major Wall Street firms. For comparison, syndicated loan volumes were $13.805 billion the week of April 7th, $14.419 the week of April 14th, $21.294 billion the week of April 21st, $17.219 the week of May 12th, and $23.339 billion the week of May 19th.

Notably, despite such extraordinary growth in bank credit, money supply growth is expanding at a 13-week average of 7.7%, strong but considerably below the 26-week average of 10.1%. So far, the aggressive lending by the banking sector has not yet worked to lessen the tight liquidity conditions in the credit market. But here we will again part company with the consensus. Pulling another quote from Baum’s article:

“From the borrower's point of view, it doesn't matter one whit whether he gets a loan from the bank or in the credit market. All he cares about is the most favorable rate. It does matter in a macro sense, however, because all credit is not created equal. Banks create credit (they expand the money supply); markets merely allocate it. Dollar for dollar a bank loan is more expansionary than borrowing from a non-bank.”

Well, we disagree completely as we see no credit creation mechanism more powerful and a better mechanism to “reliquefy” the credit system than the “infinite multiplier” available to the GSEs when they balloon their balance sheet with money market borrowings (see past commentaries). Importantly, we believe the current “reliquefication” will prove much more onerous for the U.S. financial system as banks are forced to compete for deposits and funding necessary for continued egregious credit growth. Actually, we view recent moves by the banking sector as resembling an act of desperation.

It is certainly our expectation that despite recent bullishness at the prospect of lower interest rates, intense pressures will only mount in the money markets as banks are forced to bid for funding. Already, we think this is a significant factor underlying higher Eurodollar interest rates and leading to a sharp widening in the TED spread. Moreover, funding pressures could quite easily be exacerbated by any break in dollar confidence. Sure, the enormous quantities of dollars that flood the global financial system have provided the appearance of an endless source of funding for the US financial sector. This dangerous game, however, could end abruptly. Today, certainly, there is heightened systemic risk associated with our disastrous trade position. Presently, we are running $30 billion monthly trade deficits. Our current account deficit could easily reach $125 billion quarterly. For comparison, during the 1998 crisis and financial sector “reliquefication,” our country ran trade deficits of almost $90 billion during the entire second half of the year. The current account deficit during the second-half of 1998 was $125 billion, which was actually 60% greater than during the second-half of 1997.

Today, like 1998, an unfolding financial dislocation spurs the financial sector into only more aggressive credit excess. And while a week like the one just ended gives the appearance that they have succeeded, such measures only postpone the inevitable and lead to only more problematic distortions and imbalances both for the financial sector and economy. One major advantage for the 1998 “reliquefication” was the deflationary global backdrop and some slack in our manufacturing sector and labor markets. Today, industrialized economies are booming globally, inflationary pressures are rising, bottlenecks have developed in key domestic manufacturing sectors, and the labor market is tight as a drum with wages rising smartly. Another significant advantage during 1998 was that there was a global flight to the safety of U.S. dollar assets. This will not be repeated in 2000, with Wall Street at the epicenter of the unfolding crisis.

There is an additional factor that we believe played a key role during 1998’s “reliquefication:” The GSEs were “off the radar screen.” Economist and analysts alike, with their focus on banks, were oblivious to these institution’s enormous credit excesses. For “reliquefication 2000,” however, all discerning eyes will see the obvious excesses in bank credit (although the banks’ many “off-balance sheet” vehicles certainly lack transparency!). With this in mind, we just don’t see how serious analysts will be anything but alarmed by recent bank credit developments. Certainly, we expect foreign investors will be monitoring developments closely, and we do not expect them to take comfort in what they see – runaway bank credit at the late stage of an historic financial and economic boom. And while the Wall Street spinmeisters will create the enticing illusion of “a jumbo jet landing softly in a sea of marshmallows,” it isn’t going to happen. All the might of our powerful financial sector is working diligently to keep the U.S. supertanker bubble from sinking, but I am reminded of a quote that went something like this: “Three hours after the Titanic collided with the iceberg partygoers are still merrily enjoying martinis at the bar. That’s all well and good, but this ship won’t make port.”

The bottom line remains that we have a financial system and economy hopelessly addicted to credit excess. The cure will not be found with one more wild binge.