06/22/2000 Chinks in the Armor of 'New Era Finance' *

A week that began with the bulls confidently positioning for a continued summer rally, ended with indications of a return of the bearish sentiment. If nothing else, it was once again extraordinarily volatile. For the week, the Semiconductors gained 5% and the Biotechs advanced 4%, while the Street.com Internet index sunk more than 6% and Morgan Stanley Cyclical index dropped 5%. The Dow finished largely unchanged, while the S&P 500 dropped about 1%. The Utilities and Morgan Stanley Consumer index declined about 2%, and the Transports lost 1%. The small caps gave up earlier big gains to finish 1% higher for the week. Technology stocks were all over the map, with the NASDAQ100 declining more than 2%, the Morgan Stanley Technology index unchanged, and the NASDAQ Telecommunications index dropping 3%. The financial stocks generally outperformed, with the S&P Bank index advancing 2%, and the Bloomberg Wall Street index ending unchanged.

It certainly appears that the bear market has return to fixed income. For the week, 2-year yields jumped 19 basis points, 5-year yields 18 basis points, and the key 10-year yield 21 basis points. Mortgage-backed securities performed poorly with spreads widening and yields surging about 25 basis points for the week. Spread generally widened a couple basis points, with more severe widening for agency securities. The implied yield on the September Agency futures contract jumped 23 basis points this week. Across the Atlantic, European bonds suffered their worst week of the year. With investors increasingly mindful of increasing inflationary pressures, yields on the benchmark 10-year German bund jumped 15 basis points this week. In the UK, 10-year gilt yields surged 19 basis points, its worst performance since January. Increasingly, signs of dislocation appear in the British credit and currency market, and speculation mounts as to the exposure of U.K domiciled entities to mainland borrowings. Oil ended the week with a gain of more than $2.

This afternoon we see that bank credit expanded $18 billion (loans and leases expanded by $20 billion!) last week, this after yesterday’s report that broad money (M3) supply expanded by another $10 billion during the most recent weekly reporting period. During the past 5 weeks, broad money supply has increased $59 billion, or 9% annualized. With M2 expanding only $11 billion during this period, the preponderance of money creation has been in the “institutional” area. Indeed, almost half of broad money supply growth over the past 5-weeks can be explained in two categories, “institutional money market funds” that expanded at a 27% annualized rate, and “large bank deposits” growing at a rate of 19%.

Clearly, the financial sector remains locked in a desperate addiction to money and credit creation excess. But, then again, this is precisely what is necessary to keep the game going. During the past 9 months, broad money supply (M3) has expanded by an astounding $463 billion, or at a 10% annualized rate. And with M1 (currency and checking deposits – “traditional money”) increasing by about $5 billion over this period, one is left to search outside of traditional bank money and credit creation mechanisms for the source of additional fuel powering the great U.S. bubble. As we have highlighted in previous commentaries, the commercial paper market – conveniently unfettered by either capital or reserve requirements – is a hotbed of money and credit excess.

Indeed, last summer when spreads widened sharply, the gold market dislocated, and liquidity waned in the capital markets (the “Stealth Crisis”), more of the onus of credit creation fell on the money market. During the nine-month period August 1999 through the end of May, total commercial paper outstanding jumped $240 billion, or at an annualized rate of 25%. Non-financial commercial paper borrowings increased $54 billion to $311 billion, while total financial sector commercial paper borrowings surged $186 billion, or 25%, to almost $1.2 trillion. Within the financial classification, “Asset-Backed Commercial Paper” expanded by almost $104 billion, or at 31% annualized rate, during this nine-month period. Asset-backed commercial paper is a key component in “New Era Finance,” a critical mechanism whereby the financial sector creates its own liquidity.

Six years ago, at the end of June 1994, there was about $50 billion of “asset-backed” commercial paper outstanding. Since then, outstandings have exploded to $551 billion, or growth of 1,100%. Most of this paper is purchased by the money market funds. Asset-backed commercial paper is issued by entities that are generally only conduits, referred to as “funding corporations.” As stated in the documentation, these entities are obscure “special purpose bankruptcy-remote Delaware corporations,” without typical SEC reporting requirements. The primary purpose of such vehicles is to issue commercial paper and use the proceeds to purchase various higher-yielding financial assets. If one looks at the holdings of major money market funds (especially those managed by the major Wall Street firms), one will see that the funds have large holdings of commercial paper issued by a myriad of “funding corporations,” including Greyhawk Funding, Equipment Funding, Asset Securitization Corp., Thunder Bay Funding, Tulip Funding, Strategic Asset Funding, Park Avenue Receivables Corp., Octagon Funding, and MOAT Funding, to name just a few. There have been more than 200 of these vehicles created over the past several years.

These conduits are created (sponsored) by commercial banks, finance companies and securities firms, both domestic and international. There are several explanations for the keen popularity of these conduits. For one, it allows lenders to remove loans from bloated balance sheets where capital adequacy is an issue. This benefit is referred to as “balance sheet relief,” or, our favorite, “capital arbitrage.” It is no coincidence that the largest and most aggressive lenders are also the leading sponsors of these types of conduits. Furthermore, during periods of heightened systemic stress and faltering liquidity in the capital market, these aggressive lenders turn to these vehicles as funding sources for their cash-strapped clients. Indeed, when junk bonds and risky securitization issues go wanting, such risky loans are increasingly funneled through asset-backed conduit programs. We certainly believe this to be particularly the case over the past nine months.

Accordingly, these entities have been godsends for Wall Street investment bankers. With these funding corporations and other vehicles of “New Era Finance” providing what has been to this point virtually unlimited liquidity, fearless investment bankers have had carte blanche to lend without regard to either investor appetite for such loans or the condition of the capital markets generally. As such, we certainly see these vehicles as a very critical factor in sustaining the U.S. financial and economic bubble when, in the past, traditional risk aversion and market discipline would have long ago dictated otherwise. In this respect, it truly is a “New Era,” but not the way the bulls perceive. We certainly suspect that these entities have been convenient dumping grounds for high risk leveraged syndicated bank loans, particularly for the telecommunications industry. There is no way to know, however, as transparency is nonexistent for these programs. They do not file public statements detailing their holdings or financial position, nor are there disclosures by the sponsoring banks that create these vehicles. And as is the case for many of the financial vehicles created for “New Era Finance,” many asset-backed entities are operated out of the Cayman Islands. We are very disturbed that these questionable entities have become such an integral part of our credit system and money supply. The lack of transparency works fine and dandy when sentiment is bullish, it can come back to haunt the marketplace when perceptions turn negative.

The magic of these programs is that they convert risky loans that few investors would touch into the highest-rated commercial paper attractive to even the risk-averse money market fund investor. “New Era” financial alchemy, no doubt about it! The risky loans presently purchased by the funding corps include credit card receivables, auto loans and leases, insurance receivables, health care receivables, student loans, home equity loans, sub-prime mortgages and other residential mortgages, commercial loans and other real estate assets, equipment leases, trade receivables, junk, and other corporate loans, and, importantly, syndicated bank loans. Additionally, many asset-backed conduits purchase financial assets already securitized by other funding corporations. These can run the gamut of financial instruments, including sophisticated mortgage securities, structured corporate obligations, as well as credit and other derivatives.

Beyond “capital arbitrage,” these conduits are also popular with the aggressive financial institutions seeking to speculate on interest-rate arbitrage opportunities. Actually, these programs provide a new twist to the traditional “borrow short, lend long” strategy. As such, we certainly see this mechanism as a significant component of what is an historic system-wide interest-rate arbitrage that has become endemic to the U.S. financial sector. Such strategies are much more profitable with low short-term interest-rates and a steep yield curve, prevalent in the past but not today. The amount of assets now involved with these strategies certainly raises the possibility that they have been factors in this year’s credit market and derivatives dislocation. At the same time, these vehicles also provide credit arbitrage. It is immediately profitable to borrow at interest-rates available to only the highest-rated institutions, while taking a spread by lending to risky credits.

However, the concoction for this “New Era” financial alchemy – turning risky, often long-term loans into pristine short-term commercial paper – must overcome inconvenient issues such credit risk, interest-rate risk, and liquidity. Money market funds, of course, will generally only purchase the highest-rated, short-term liquid securities. No problem, as right here we see the very best that contemporary finance has to offer. First, to “hedge” against interest-rate risk, these entities enter into swap agreements or other interest rate derivatives (usually directly with the entity’s sponsor – also the major derivative players!). To “hedge” against credit risk, the sponsor provides “credit enhancements.” These can include over-collateralization, recourse to the sponsor, or “third-party” guarantees such as credit insurance and credit derivatives. And to ensure sufficient liquidity in the event of market disruptions and/or the vehicle’s inability to roll its commercial paper, the sponsor will typically provide a letter of credit or an asset purchase agreement. Voila! Water into wine!

And while these entities are the joy of cash-burning companies, investment bankers, and derivative dealers alike, there are also more subtle advantages that have of late worked to the advantage of the financial sector’s efforts to perpetuate the boom. Importantly, “mark to market” is apparently not an issue for these entities. If the market value of risky loans has declined, no need to recognize the loss. If the hedge funds, on the other hand, were the “repositories” for risky securities such as mortgages and/or corporate securities (as they had been in the past), rising rates would lead to losses and necessitate a liquidation of positions. Such liquidations are the Achilles Heel of credit bubbles. As was the case during 1994 and again with the Russia/LTCM crisis in 1998, marked-to-market losses in a highly leveraged financial sector quickly lead to a self-reinforcing general financial market dislocation. We certainly surmise that Wall Street’s creativity in structuring these types of financial entities has been a critical factor that has thus far found this rising rate cycle much less tumultuous than that of 1994. And while the music plays on, the ugly fact remains that such bubble-induced credit excess distorts the market pricing mechanism and nullifies market discipline.

Indeed, mechanisms and structures that perpetuate market distortions only create ever greater and more damaging maladjustments and imbalances. The momentous danger inherent with credit bubbles is that systemic risks grow exponentially during the final “terminal” stage of money and credit expansion. At the late stages of a credit cycle “Ponzi finance” (see May 26th commentary) dominates, with excessive credit financing increasingly dubious enterprises and asset inflation. Accordingly, such ill-advised lending leads inevitably to severe credit losses down the road, although there are already strong indications that this process has begun in earnest. We expect this to prove a troublesome vulnerability for the plethora of “funding companies” and other sophisticated “New Era” structures created over this prolonged boom. These entities are, in fact, “weak links” in the U.S. credit system and certainly create additional fragility for what has for some time been a highly vulnerable U.S. financial system.

It is certainly our view that a confluence of issues now places “New Era Finance” in grave jeopardy. To begin with, we don’t believe the dislocation in the swaps market and other interest-rates derivatives has been resolved. Increasingly, however, it appears that the more pressing issue for the market could prove to be credit issues. As such, nothing will cause greater problems for the plethora or sophisticated “New Era” structures and strategies than the onset of credit problems. Indeed, the entire U.S. credit system is built on confidence; investor confidence that it can purchase asset-backed and mortgage securities and remain immune to credit losses; confidence that holdings in money market funds are immune to credit issues. But such confidence of immunity is an illusion, as there is absolutely no way that investors can remain protected against credit losses when the bubble bursts.

Unfortunately, the U.S. credit system is built on a foundation of false assumptions. First, despite bullish claims otherwise, the derivatives market cannot protect the entire credit system from higher interest rates – the grand illusion of “New Era Finance.” Derivatives simply shift risk between parties, and usually to parties with less wherewithal to manage risk in a difficult environment. Second, there are literally trillions of dollars of credit guarantees that have been created in this melee of reckless credit creation, supposedly ensuring against investor losses. But the fact remains that these entities providing credit insurance are not capitalized sufficiently to provide meaningful protection in the case of a serious downturn. While the thinly capitalized GSEs have guaranteed more than $1.5 trillion of mortgage-back securities, the largest guarantor of bonds as well as asset and mortgage-backed securities now has gross exposure of $745 billion. Subtracting the amount reinsured, this company’s net exposure on insurance written is $636 billion. Yet, it has shareholder’s equity of less than $4 billion. Granted, during the boom credit losses are minimal and all this insurance appears viable. But if investors come to ponder the possibility of a “hard landing,” today’s credit insurance quagmire will look increasingly suspect. Without unwavering confidence in credit insurance, derivatives and other structures that apparently protect investors, “New Era Finance” runs aground, and the institutions involved stumble. And if this wonderful alchemy of converting risky loans into securities palatable to risk conscious investors falters, the music stops.

We certainly see the potential for much less bullish perceptions to have a major impact on these asset-backed “funding corporations,” as well as the securitization marketplace generally. Actually, we see such structures as boom-time phenomena, now acutely vulnerable to what we perceive as a marketplace increasingly sensitive to risk. Such a development becomes even more consequential because the commercial paper and securitization markets have been forced to play such a major role in the credit creation process. This prominent role became necessary after previous egregious credit creators (notably the hedge funds and GSEs) came under heightened market discipline. If market sentiment turns against these vehicles of “New Era Finance,” the U.S. credit machine will quickly sputter.

The bottom line remains that tens of trillions of interest rate derivatives and trillions of dollars of credit insurance have dramatically increased the quantity of credit created. This, combined with the gross deterioration of loan quality, creates an enormous increase in risk for the U.S. financial system and economy. Most unfortunately, our largest financial institutions have been among the most aggressive to adopt “New Era” concepts, instruments, vehicles, and strategies. As market confidence in such things wanes, the ramifications are quite dismal for the U.S. financial system, the U.S. economy, and the U.S. dollar. We certainly sense serious chinks in the armor.