06/29/2000 The Impossibility of a Soft-Landing *

The stock market remains highly unsettled, but the bulls were able to hold things together for quarter-end. For the week, the S&P500 gained almost 1%, and the Dow rose slightly less. The Morgan Stanley Consumer index jumped almost 4%, while the Utilities dropped almost 5%. The Transports posted a marginal advance, while the Morgan Stanley Cyclical index declined about 1%. The NASDAQ100 gained about 2%, although the technology sector was mixed. The Morgan Stanley High Tech index added 2%, yet the Semiconductors sank 6%. The NASDAQ Telecommunications index jumped 4%, and Street.com Internet index had a small gain. The Biotechs were largely unchanged, and the small cap Russell 2000 added about 1%. The financial stocks were mixed with the AMEX Broker/Dealer index gaining 1%, while the banks were slammed for 4%. We certainly see the poor performance of the banking sector as an ominous sign for the general market.

It was a surprisingly good week for the credit market, although we must admit a bit of skepticism as to the role quarter-end trading played. All the same, yields on the 30-year bond dropped 15 basis points, 10-year yields 16 basis points, 5-year 19 basis points, and 2-year Treasury yields sank 15 basis points. According to Bloomberg News, the 30-year bond had its best half-year performance since 1995. For the week, spreads were relatively quiet, with the key 10-year dollar swap spread 2 wider for the week, while agency spreads were 1 to 2 wider and mortgage-back spreads were largely unchanged. The dollar had another unimpressive week, dropping about 2% against the euro and Swiss franc. The dollar index declined about 1% for the week.

Today we see that bank credit expanded by a whopping $29 billion during the latest weekly reporting period. This expansion was across all categories with real estate loans jumping $9 billion, consumer loans $7 billion, security credit $5 billion, and “other” $6 billion. As is often the case, loans for commerce and industry lagged, increasing only $2 billion. During the past eight weeks, real estate loans have surged $41 billion, while commercial and industrial loans have increased almost $23 billion. Over this period, total bank credit has expanded by $95 billion, or an annualized rate of 13%. Year-to-date, bank credit is expanding at a rate of about 11%. This past week broad money (M3) supply increased $14 billion and has now surged $74 billion during the past 6 weeks (9.6% annualized rate). During the past 3-months, M3 has expanded at a rate of 8.3%; 9.1% for 6-months; and 8.4% for 12-months. M3 expanded by almost $26 billion during the past two weeks, with institutional money market funds and large time deposits combining to grow almost $30 billion. So much for “tighter” monetary policy.

Now that May data is available, we see that Fannie Mae and Freddie Mac sharply increased credit creation. For the month of May, these two powerful credit creators had gross mortgage purchases of $32 billion, this compared to $17.5 billion during April. In fact, May was the most aggressive month of mortgage purchases since September. Perhaps it is coincidence that these two periods of aggressive purchases coincided with bouts of considerable financial stress. Remembering back to September, spreads were widening substantially, liquidity was disappearing in the credit market, and the gold derivatives market dislocated spectacularly. Jumping forward, during the first half of May spreads spiked to historical extremes, credit market liquidity faltered, and NASDAQ was at the brink of a crash. Yet, in a replay of last September’s reliquefication, liquidity miraculously returned to the financial system in late May, with NASDAQ commencing a major rally and spreads narrowing sharply. During May, Freddie Mac expanded its “retained portfolio” (the vast majority of total assets) at an annualized rate of 29%, while Fannie grew its “average investment balance” (approximating total assets) at a rate of 15%.

The fact that the GSE’s returned to rampant credit creation (joining the banking system!) the same month that the Fed moved “aggressively” to increase interest-rates 50 basis points, reinforces our contention that Federal Reserve monetary policy has become largely irrelevant. In the contemporary financial landscape dominated by Wall Street and the capital market, it is the financial sector that calls the shots, not the Fed. Sure, Mr. Greenspan can increase the cost of short-term funds at the margin, but this has little if any impact on the availability of credit. Surely, the cost of funds is not dampening demand for mortgage credit. But, then again, why would it when inflationary psychology has become so entrenched in the asset markets. Indeed, rising asset prices create additional demand for credit in self-reinforcing and destabilizing bubble dynamics. Apparently unappreciated by the Fed, it is the nature of credit availability, and not the price of credit, that has become the key issue for the great U.S. financial and economic bubble.

A few months ago, a noted financial journalist made a statement that I found rather stunning at the time. I will try to paraphrase: “In the past, the big mistake in monetary policy was taking the punchbowl away from the party too quickly. Fortunately, with an enlightened and omnipotent Greenspan at the helm, there is little risk of such an occurrence during this cycle.” Talk about turning William McChesney Martin’s great maxim on its head! The truth of the matter is that it is not the speed that liquor is removed from the party that causes problems. The great policy blunder, recognized clearly by Mr. Martin, is leaving the spiked punchbowl at the party too long and allowing the guests to get drunk and obnoxious. Refusing to remove the punchbowl, either because of cowardice or because one can create “New Paradigm” justification, is but perpetuating failed policy, as well allowing greater damage to the system.

To any serious analyst, it is patently obvious that the U.S. “party” has been out of control for some time. Yet, bullish pundits would like us to believe that all is well – that this is “business as usual” with the Fed in complete control for this, the first “tightening cycle” for the “New Economy.” This nonsense simply could not be more detached from reality. The harsh and unappreciated reality is that over this long boom the Fed has lost control of the financial system, just as the financial sector has forged head first into reckless lending, unprecedented leveraging and speculation, derivatives, and sophisticated structures and vehicles. This “New Era Finance” has fostered unprecedented money and credit growth, the fuel for historic speculation in the asset markets and a bubble economy. And while discussion of overheated asset prices is generally directed at stock prices, the asset bubble includes financial assets (stock, corporate bonds, mortgage-backs, securitizations, etc.), residential and commercial real estate, radio/tv/cable/media franchises, fine art, etc. This historic asset bubble is truly endemic and all encompassing – not fodder for “soft landings.” And, of course, over the years the financial infrastructure developed to profit from credit creation and asset inflation has grown to possess immense power.

All the same, the bullish consensus views a soft-landing as virtually a sure thing. Our analysis, on the other hand, leads us to view a soft-landing as an absolute impossibility. Why such a pessimistic view? Well, the key to our analysis rests upon the concept that money and credit excess set in motion processes that corrupt market pricing mechanisms. And the longer such excesses are accommodated (by the chief financial system regulator, the central bank), the greater and more problematic the imbalances to both the financial system and real economy. The greater the system diverges from equilibrium, or lets call it “reality.” Importantly, distortions beget greater distortions; financial excess breeds economic maladjustments, and the consequence is financial and economic instability. Unfortunately, the U.S. system has experienced so many years of credit excess that destructive processes have left our financial and economic system terribly maladjusted, dysfunctional and acutely unstable. For too many years the system has allowed the consumer, corporate, and financials sectors to take on too much leverage; leverage that will prove unmanageable come the next downturn. For too long processes have led the system toward ever-greater misallocation of resources, and an alarming increase in risky credits. And, obviously, at this very late stage in the boom, interest rates are certainly not a magical elixir that will cure the patient of disease after years of binging on bubble excess.

It was enlightening to study analyses of the 1980s commercial real estate boom/bust and S&L debacle. This boom arrived first in the oil patch and then blossomed along both coasts. In hindsight, it was clear that new structures, particularly office buildings, were being constructed despite rising vacancies and spectacular overbuilding. The nonsense of it all should have been obvious. Interestingly, and clearly pertinent today, higher interest rates (particularly in the case of the late 1980’s) had little if any impact on tempering new construction. How could this have been? Well, throughout the boom, an enormous financial “infrastructure” evolved to profit handsomely by directing funding to new projects and financial products. New commercial mortgage securities were introduced, and other enticing high-yielding vehicles such as REITs and real estate partnerships were created. And then there were the reckless S&Ls, many forced to seek alternative lending venues in an attempt to grow their way out of trouble after being crushed in home mortgage lending earlier in the decade.

As the commercial real estate boom progressed, initial above-market returns enticed huge flows of speculative capital. These speculative flows incited rising asset prices, which only exacerbated the construction boom. Rising asset prices emboldened lenders, speculators and investors, and the financial infrastructure to attract additional capital expanded aggressively. Real estate lending was “the game.” Importantly, over time the flow of speculative capital and resultant asset inflation dictated the projects to be developed (the allocation of resources), instead of underlying project fundamentals. What’s more, one would have expected that rising rates would have discouraged marginal new projects. Instead, the key dynamic was an increasingly speculative/distorted marketplace, with the power and influence of investment bankers, investment managers and S&L executives growing by the month and year. Indeed, the massive infrastructure worked diligently and finally desperately to perpetuate the boom. Ironically, rising interest-rates for some time only provided additional incentive for greater speculative flows, regardless of “cap rates,” cash flows, or expected returns on the underlying projects. Once the party got out of hand, the market only became more dysfunctional over time. When market forces eventually returned, the end-results were near calamitous - massive misallocation of resources, the S&L debacle, a severe banking crisis and recession.

Presently, we see several situations where enormously powerful infrastructures, having developed during the boom, now forcefully perpetuate credit excess, much to the detriment of our financial system and economy. As we have highlighted previously, there is an historic bubble in mortgage finance. While this is clearly a national bubble, particularly on the upper-end, the situation in California is an unfolding financial debacle. This week the California Association of Realtors reported that both existing home sales volume and prices reached new records during May. Sales volume rose 18% from April and the median price increased 2.3%. Quoting the association’s president: “Despite expectations that the housing market could cool off in a higher interest-rate environment, home sales accelerated to new heights.” Year over year sales volume throughout the state increased 7.7%, with the median price increasing almost 12% ($26,010) to $246,420. Quoting the association’s VP and economist, “The inventory of homes available for sale continues to contract throughout the state. This has to put upward pressure on the median price of a home in nearly every region of California.”

Interestingly, although volume was a record for the month, it would have been even stronger had key regions such as Santa Clara and “Wine Country” not experienced a decline of sales due to a severe lack of available inventory. This acute supply and demand imbalance led to year over year price increases of 29% in “wine country” and 34% in the Santa Clara region. Elsewhere, prices surged 17% in Orange Country, 19% in Northern California, 21% in the San Diego region, and 34% in Monterey. Clearly, this has developed into a precarious statewide housing bubble.

Amazingly, we hear not a word of concern about what is a major systemic risk to the U.S. financial system. And, importantly, the Fed’s decision to let the party continue allows the great California real estate bubble to run to even more devastating extremes. Who is minding the store? Most unfortunately, this is a replay of the 80’s real estate fiasco but at a much grander scale – actually the proverbial “mountain versus a molehill” applies. Yet, amazingly, no one dare say “enough is enough,” and instead the dysfunctional marketplace continues to fund the boom despite the obviousness of the unsound bubble. Massive credit excess feed asset inflation and a major misallocation of resources, as the Fed tinkers with rates. What a fiasco.

Tinkering with interest rates will also not alter the behavior of aggressive money managers that have risen to the top during this protracted bull market. After all, today’s leading money managers have come to be masters of the universe controlling enormous amounts of assets. This position has not been attained by purchasing stocks based on conservative principles such as analysis of future cash-flows, economic profits, and underlying value; but instead by speculating on the high flyers. This type of “investing,” however, has fostered an historic misallocation of resources. Monetary policy is not going to resurrect sound investment practices, wasted capital will not magically reappear, and resources will not immediately be redirected back to more economic enterprises. Somewhat higher short-term rates are also not going to facilitate the closure of the hundreds of venture capital funds that today suffer from delusions of permanent prosperity. Moreover, present interest rates will not dissuade the powerful coterie of investment banks from their unrelenting quest for negative cash flow enterprises, entities providing endless borrowings to securitize. Nor will the massive and destabilizing derivative industry be tempered by 6.5% short-term rates. Clearly, the infrastructure, both financial and commercial, that has developed over this historic period of excess is like a bureaucracy that takes on a life of its own. With the Fed impotent, it will be the markets that bring this fiasco to a close. Nothing about this inevitable process will be “soft.”

A funny thing happened on the way to subverting market forces… Actually, we think a very important lesson about the power of markets waits just around the corner. Sure, market forces can be distorted by credit excesses and the proliferation of derivatives, as well as being subverted by immensely powerful financial institutions. And months can go by while the Fed can tinkers with interest rates and hopes and prays that there really is such a thing as a “New Paradigm.” Over on Wall Street, the bulls can run the propaganda machine, play “business as usual,” and dream of permanent prosperity. But at the end of the day, market forces will, as they always do, prevail. When this inevitable day of reckoning arrives, “soft landing” will not be an apt metaphor.

Judging by the recent performance of many of the leading financial institutions – especially some of the most aggressive adherents to “New Era Finance” – we certainly sense that market discipline is in the process of reemerging. Pondering what is behind the poor performance of the financials, the list of potential hotspots is long and wide. There could be “behind the scenes” derivative problems, both interest rate and credit. Clearly, credit problems are unfolding in corporate finance. With hundreds of billions of leveraged loans (telecom in particular) created over the past few years, there are certainly flocks of accidents waiting to happen. And as we highlighted last week, we certainly expect unpleasant issues to emerge from “structured finance.” Many of these vehicles and entities created by the aggressive lending community have mechanisms whereby problem credits can be put back to the lender. With perceptions changing, the market will look with askance at such a possibility, and perhaps the market is beginning to recognize the danger of such structures. Or, maybe at this point, it is simply that the imbalance between supply and demand for risky credits is becoming increasingly problematic.

There is, indeed, insatiable demand for mortgage and corporate borrowings, credits necessary to keep these respective bubbles from imploding. And if lenders are losing their ability to pass this risk onto the marketplace, they either have to cut back on lending or balloon their balance sheets with risky credits. No doubt about it, the game was much more fun for the lenders when they could easily offload risky credits. We suspect that the recent extraordinary growth of bank credit may be related to difficulties in distributing credits to other entities or the capital markets. Could liquidity be waning in the securitiztion marketplace? Well, only time will tell, but any nasty development within the financial sector will only add to an already vulnerable dollar. For now, we will leave it at “something’s up” and watch things carefully next week.

In closing, it has been suggested that I use logarithmic charts for money and credit growth. I specifically do not use logarithmic charts, as I believe they simply provide a convenient mechanism for conventional analysts to downplay the extreme nature of this historic monetary expansion. An apt analogy would be the hopelessly obese individual saying, “hey, look at the logarithmic chart of my weight gain…it really doesn’t look all that bad!” I won’t be playing that game. Besides, if, as the bulls claim, we are in a stable price environment, why is it not appropriate to chart nominal money and credit growth?