10/19/2000 Here We Go Again... *

With negative news from super-heavyweights IBM and Chase Manhattan, in addition to a collapsing junk bond market and faltering stocks and currencies throughout Asia, as well as globally, Wednesday was a critical juncture for financial markets. The euro traded in an increasingly dislocated manner, energy markets were again moving higher, and spreads began to widen significantly here at home, in Latin America and throughout emerging debt markets. The Dow opened down nearly 450 points and the NASDAQ100 had broken through the key 3000 level. No mistake about it, a serious financial event was in process; derivative players were certainly in dire straights, especially as they were forced to hedge put options in a collapsing market just two days before option expiration. They needed a rally; they got it in a big way. From Wednesday’s low to today’s highs, the NASDAQ100 surged 18%, the Semiconductors 28%, the AMEX Broker/Dealer index 13%, and the S&P Bank index 9%. Microsoft surged 35% from Wednesday’s low, while other key derivative stocks such as Dell, Yahoo, and Intel jumped between 20% and 45%. This wild surge cut year-to-date losses to 7% for the NASDAQ100 (52-week gain of 40%) and 5% for the S&P500. With the proliferation of equity derivative trading, the relative outperformance of these two key indices has been most opportune for the financial system. At the same time, it is truly frightening to ponder the harsh reality that this out of control marketplace has come to occupy such a critical role in our nation’s economy, as well as the global economy.

For the week, the NASDAQ100 and the Morgan Stanley High Tech indices jumped nearly 6%, with The Street.com Internet index also adding 6%. The AMEX Biotech index surged 8%, increasing its year-to-date gain to 86%. The Dow was largely unchanged, while the S&P500 gained 2%. The Transports added 2%, and the Morgan Stanley Cyclical index gained 1%. The Morgan Stanley Consumer index had a slight gain, while the Utilities declined 1%. The small cap Russell 2000 increased more than 1%, and the S&P400 Mid-cap index advanced 3%. The NASDAQ Telecommunications index added 1%. The financial stocks made a strong showing, with the AMEX Security Broker/Dealer index surging 5%, and the S&P Bank index increasing 2%. Gold stocks dropped 5%.

Treasuries once again benefited from tumultuous financial markets. For the week, 2-year yields declined 2 basis points, 5-year 5 basis points, 10-year 9 basis points, and long-bond yields dropped 8 basis points. It was a stunning week in the agency market, with news of a “settlement” between the duo Fannie Mae and Freddie Mac and Washington helping yields drop about 18 basis points. The yield on the benchmark Fannie Mae mortgage-back security declined 13 basis points to 7.40%. The spread on the 10-year dollar swap narrowed 5 to 114. However, in a dramatic continuing collapse, the Bloomberg junk bond spread widened 35 basis points to 636. Investment grade corporates under performed, with the double-A corporate spread widening 4 basis points. In continued global currency tumult, the dollar generally added 1% this week.

Responding yesterday to a question from CNBC’s Ron Insana, “if you were President, what would you do in response to a financial crisis?” Governor Bush stated that he would immediately “call Alan Greenspan” and “talk about liquidity.” For good reason, Wall Street, Washington, and the media have come to believe with religious fervor that any financial problem can be quickly resolved by the largess of the Federal Reserve liquidity machine. This perception has certainly played a major role in the great U.S. bubble – a truly historic episode of “moral hazard.” In fact, behind the scenes I am sure there is indeed a movement afoot to create additional liquidity to keep financial markets afloat.

There is, however, a critical aspect of contemporary financial systems and economies that goes unappreciated by U.S. central bankers and the bullish consensus, and we see this dynamic both globally and certainly within the highly speculative U.S. financial system:

Liquidity seeks out inflation, while avoiding deflation like the plague. This dynamic was made clear back in 1994/95 when the Japanese central bank moved aggressively to create liquidity in hopes of stemming accelerating deflationary conditions. Strong action was taken to stimulate the economy and stabilize asset values as well as the general price level. There was, however, a major unexpected consequence: much of the liquidity avoided the deflationary spiral in Japan, choosing instead to flee the country in search of asset inflation overseas. Exactly such a circumstance was found in the burgeoning (and infamous) “yen carry trade,” or borrowing at near zero interest rates to take leveraged positions in higher-yielding securities in the U.S. and Europe. A more recent example of liquidity’s preference would be the flight out of PC and Internet stocks and into subprime and biotech issues. Sophisticated “hot money” speculators recognize that PC companies are operating in a deflationary environment, while inflation remains very prevalent in drug pricing, high-risk lending and consumer finance generally.

The fact that liquidity seeks out inflation, while avoiding deflation like the plague, poses an enormous, and I suspect largely unrecognized, dilemma for central bankers, particularly in the present environment. Clearly, Greenspan and Wall Street have come to believe that any crisis can be averted by stoking securities prices with a greater flow of liquidity – additional money and credit/purchasing power. Certainly, Wall Street is aggressively positioned with the “Greenspan Put” in mind. And with our recklessly over leveraged and speculative financial sector “hanging in the balance,” the presumption today is clearly “easy money” as far as the eye can see. Yes, the Fed will feel increasing pressure to mitigate the grave systemic stress developing after the bursting of the technology bubble. The major consequence of continued credit excess, however, will be more liquidity, or inflationary fuel, to sectors outside of the cash-strapped telecom and leveraged-lending areas.

Sure, additional money supply and financial credit growth increases demand for debt securities. Today, however, this additional purchasing power avoids faltering companies and sectors in dire need of financing, choosing instead Treasuries and securities from sectors where inflationary pressures are still prevalent, such as mortgage-back and agency securities. More buying of Treasuries only exacerbates market dislocations, posing considerable problems for the leveraged speculators and derivative players. Also, additional liquidity will avoid companies like Xerox, and will instead go directly to the likes of Fannie Mae and Freddie Mac – that are still aggressively expanding credit and, accordingly, with underlying assets (mortgage loans and residential real estate) remaining with a strong inflationary bias. While the telecom sector increasingly struggles with what will be a devastating credit crunch, the residential real estate market is awash in inflationary “easy money.” While many Internet companies will collapse as funding runs dry, lenders will certainly line up to fund what will likely be the $1 billion sale of the Bank of America building in San Francisco. For now, office rents are inflating and liquidity seeks out inflation. This is precisely what we mean by a distorted and unbalanced economy.

Yes, the Fed and the financial sector can “reliquefy.” But what they and Wall Street do not appreciate is that, by its very nature and certainly with the leveraged speculating community having come to play such a dominant role throughout our financial system, this “hot money” will gravitate to sectors where it will only exacerbate already problematic distortions and imbalances. Liquidity can be created. But, it will have a strong proclivity against going where the Fed wants it to go – it will, instead, prove destabilizing. Throwing only more liquidity at the household sector in this environment of heightened inflationary pressures and an unfolding energy crisis is a dangerous game. At a minimum, it will add fuel for higher energy prices and only greater and inevitably destabilizing trade deficits, with great risk to the dollar. Stating the major dilemma in anther way: one big problem currently is that the enormous tech/Internet/telecom sector, the previous bastion for credit and speculative excess (“inflation”), is in a serious liquidity crunch (“deflation”). A second big and complicating problem is that we remain in the midst of an historic credit-induced real estate bubble, with the real estate finance superstructure presently the leading instigator of money and credit excess (“inflation”). If you were liquidity, where would you go?

On another subject, we have to take exception to last week’s Current Yield column in Barron’s:

“Is it Fall 1998 all over again? Bond market participants couldn’t help but wonder last week as Wall Street’s simmering credit squeeze began to pinch. Corporate-bond spreads in the U.S. and Europe widened sharply amid concerns over deteriorating credit quality. And speculation about big losses in junk bond trading slammed bank and brokerage stocks, including those of marquee-caliber firms like Morgan Stanley Dean Witter, Goldman Sachs and Merrill Lynch.

Things aren’t nearly as bad as they were two years ago, however. For one thing, there’s far less leverage in the financial system. In late 1998, Russia’s meltdown caught hedge funds in over their heads, prompting the Federal Reserve to cut rates and Wall Street giants to bail out Long-Term Capital Management. And the global economy isn’t on the verge of recession. Asia’s economies are healthier, as are Latin America’s. That means there’s less reason to think today’s volatility in the credit markets pose a systemic risk.”

Actually, I strongly disagree with the analysis that today “things aren’t nearly as bad” or that “there is far less leverage in the financial system” than in 1998. In fact, this statement could not be further from reality – things are, regrettably, much worse. First, let’s dig into the leverage issue. Looking at Federal Reserve data, total outstanding credit market debt has surged $4.4 trillion (20%) in the two-year period since June 30th 1998. Marketable debt issued by the corporate sector increased by 30% to $4.6 trillion, while household sector debt increased 19% to $6.7 trillion. Total outstanding mortgage debt has surged $1.6 trillion, or 32%. And more specific to financial system leverage, the financial sector increased credit market borrowings by a whopping $2 trillion, or 34%, to almost $8 trillion. Within the financial sector, we see that commercial banks have increased total liabilities (marketable debt and deposits) by $933 billion, or 18%. Security Broker/Dealers increased total assets by $270 billion, or 32%. Finance companies increased holdings by $265 billion, or 34%. And, importantly, the government-sponsored enterprises expanded assets by an astounding $518 billion, or 44%. Not bad for two years.

Perhaps there are no acutely fragile hedge funds that have incorporated outrageous leverage like LTCM, but make no mistake, there is unprecedented leverage in our financial system – endemic over-leveraging that has gone to a new extreme since the near meltdown in 1998. The security brokers have much greater exposure today than they did two years ago and the derivatives marketplace is much larger. Moreover, I actually see the GSEs in the same vein as LTCM. They both have strategies that superficially seem reasonable – they certainly “talk a good story” and masterfully sell the concepts of New Era finance, derivatives, “risk management,” and sophisticated strategies. But the bottom line is that these reckless strategies revolve around interest rate arbitrage and absolutely egregious leveraging. Looking at September 30th data from Fannie Mae and Freddie Mac, we see that $33 billion of shareholder’s equity now supports total assets of $1.07 trillion. This, however, is not the extent of these companies’ exposure. Fannie and Freddie also have enormous off-balance sheet liabilities as they have guaranteed the “timely payment of principle and interest” on another $1.26 trillion of mortgage-back securities not held in their immense mortgage portfolios. So, for every $70 of (mostly mortgage) exposure, they have $1 of shareholder’s equity. And, since June 30th 1998, Fannie and Freddie have ballooned total assets by $507 billion (90%!), while shareholder’s equity has increased $12 billion. Including off-balance sheet guarantees, total exposure has increased $712 billion.

And while Wall Street and Washington trumpet how wonderfully these companies are managed, I have come to the conclusion that this GSE credit explosion is little more than a sophisticated scheme – a current manifestation uncomfortably on the lines of the infamous “South Sea Bubble” or the “Mississippi Bubble.” With this in mind, I have absolutely no doubt that this apparatus of financial engineering and wanton credit excess will at some point collapse; they always do. And the more monstrous these institutions are allowed to become, the greater the risk that their eventual collapse brings down the entire global financial system. This is no exaggeration – these institutions make LTCM look miniscule. It is absolutely appalling that these institutions are allowed to run unchecked as risk grows by the week. There is also no doubt that continued GSE excess exacerbates problematic distortions and imbalances to the real economy and, eventually, to the American taxpayer who will be left holding the bag. After all, the only way this scheme remains viable, especially during times of heightened market stress, is because of the implied guarantee from the U.S. government. It is only with the assumption that the U.S. government would never allow the failure of their sponsored enterprises that these institutions command top debt ratings - no matter how egregiously over leveraged. It is only because these institutions are assembly lines for triple-A rated securities that they have unprecedented free rein to in the marketplace to instigate bubble excess.

So, Here We Go Again… In what is becoming increasingly reminiscent of 1998, we see that Freddie Mac increased assets by almost $21 billion during the third-quarter, a 20% annual rate. This compares to expansion of less than $7 billion, or 7% rate, during the second quarter. Similar to Fannie, Freddie increased (non-mortgage loan) “investments” by $9 billion (25%!) during the quarter to $44 billion. During the past year, Freddie has almost doubled the size of its “investments.” For the third-quarter, Fannie and Freddie combined to expand total assets by $50 billion (20% growth rate), compared to $29 billion during the second-quarter (12% growth rate). (It is no coincidence that money market fund asset growth has accelerated over the past 15 weeks, expanded by $104 billion, or at a 21% rate) This was the largest expansion since the turbulent fourth-quarter of 1998. Year to date, “investments” have expanded at an annualized rate of 50% to $99 billion. With these institutions now forcefully purchasing mortgages, there should be little mystery behind the collapse of mortgage yields to below 7.5% from almost 8.5% during May, potent fuel for already overheated real estate markets. Clearly, as goes the growth rate of GSE balance sheets, as goes credit market liquidity.

We are not surprised that our politicians buckled and failed to take any action to rein in the reckless activities of the Government-Sponsored Enterprises. After all, Fannie Mae and Freddie Mac are said to have the most powerful lobbies in the world. It is difficult, however, to sit back quietly when members of congress “spin” the situation and claim victory with yesterday’s announcement of a voluntary agreement with Fannie Mae and Freddie Mac. And many in Washington and New York are claiming this resolves the situation…unbelievable.

Pulling an excerpt from the companies’ release: “The companies said they will hold more than three months' worth of liquidity so their operations won't be disrupted during a financial crisis. They've also agreed to implement a risk-based capital stress test on an interim basis until a permanent capital standard be put in place by its regulator, the Office of Federal Housing Enterprise Oversight. The companies also agreed to publicly disclose results of their analysis of interest rate risk sensitivity and publicly disclose credit risk sensitivity analyses.”

The “mood” in Washington was captured by comments from Texas Congressman Ken Bentsen: “I think this proposal now completes what has become a three-legged stool of regulation of these two hybrid financial institutions – these two GSEs. You have HUD, which has had regulatory authority over mission; you have OFHEO, which was created in the ’92 act in establishing a portfolio regulation and capital risk standards regulation. And now through this agreement you have market regulation, which in large part should be predominant with financial institutions. And these two financial institutions – which are congressionally created – have become much more market oriented than perhaps they were in the past. So I think this is a very good step for them. And I would just say, I think this very well could lay to rest any questions about whether or not there is proper oversight of the GSEs. Obviously, Congress will have to continue to look at this. But it should also lay to rest the issue that it is necessary for Congress to kill the goose that laid the golden egg with respect to providing a very stable secondary mortgage market in the United States, in order to insure that there is not systemic risk. So I think Richard (Louisiana Congressman Richard Baker) and Paul (Pennsylvania Congressman Paul Kanjorski) have done a particularly good job of working with the GSEs, and in doing so in a way that doesn’t interfere with the ability to continue to provide a stable mortgage product to the American consumer. So I am quite hopeful that what is being done today will be well accepted by the market and will work.”

“Lay to rest” that there is “proper oversight,” you’ve got to be kidding! First of all, these companies can absolutely not be trusted to rein in reckless excess with some voluntary agreement – NO WAY! They have proven time and again that they are beholden to Wall Street and the perpetuation of the bubble, not the American taxpayer. Indeed, and as we are seeing again presently, it should be noted that they expand their leverage most aggressively specifically during times of acute financial instability. They are much too leveraged to take this liberty. This is a dangerous game of financial Russian roulette, and one of these days one or all of these institutions will “take a bullet.” Moreover, Congressman Bensten is most incorrect that there is market regulation at work here. There is anything but. These institutions, with their implied government guarantee, operate specifically outside of market discipline. And it is complete nonsense to look to Wall Street to discipline these lenders – the leading instigators of credit excess and the critical liquidity backdrop for the leveraged speculating community. It’s like asking addicts to regulate the drug pushers. Yea, that will be a success. The bottom line remains, Wall Street and the GSEs are a dangerous combination, and politicians are complicit…financial historians will not be kind.

In regard to regulation, we did note a troubling passage from an article back in the June issue of Bloomberg Magazine – Fannie Takes on Its Foes – written by David Gillen: “His (Armando Falcon, director of Office of Federal Housing Enterprise Oversight/OFHEO) office has worked up a test that uses assumptions about interest rates and mortgage defaults to determine if Fannie and Freddie have adequate capital. Using 1997 financial statements, it found that Freddie Mac was adequately capitalized but that Fannie Mae came up $3.7 billion short of Falcon’s standard. He promises an updated report this year, but he says he can’t get the money he needs from Congress to keep up with the galloping companies…Fannie Mae argues Falcon’s test is confusing and riddled with errors. ‘It simply doesn’t work,’ Raines say. Fannie and Freddie have suggested ways to improve it. Not surprisingly, many of those proposals would reduce the amount of capital the companies must hold.” Publicly, Mr. Raines like to trumpet that Fannie Mae is closely regulated. Right…and the taxpayer should take comfort from a voluntary agreement.

It is an absolute outrage that Congress fails to provide OFHEO’s Mr. Falcon funding to update his stress test. Keep in mind that since 1997, total GSE assets have mushroomed by more than $750 billion, with off-balance sheet increases putting total increased exposure easily over $1 trillion. These institutions have also developed into major derivative players, another ill-advised experiment that will not end well. All considering, the American taxpayer deserves at least an updated stress test, and it is not either in Mr. Raines’ or Freddie Mac’s Mr. Brendsel’s place to decide if the test is to his liking.

The voluntary agreement also calls for the two companies “to strengthen their capital cushion against sudden losses by issuing publicly traded subordinated debt on a semi-annual basis. This debt issuance will allow the companies to have core capital and subordinated debt to equal or exceed 4 percent of their assets after a three-year phase-in period.” Well, to begin with, why don’t we give a bit more protection to the American taxpayer with a moratorium on stock buybacks? Fannie Mae purchased another 5.4 million shares during the third quarter. This makes for a total of 25.2 million shares repurchased during just the past three quarters – “more than three times the number of shares repurchased during the comparable period in 1999.”

Since I am critical of Washington on this issue, I am compelled to offer up 10 initiatives that I recommend be put in place immediately. I won’t hold my breath.

1) Limit asset growth rates, to say 5% annualized (20% is patently reckless!)

2) Match assets and liabilities – (don’t finance mortgages with commercial paper!)

3) Do not use derivatives – (no counterparty risk for the U.S. taxpayer!)

4) Terminate stock buyback programs

5) The Federal government should immediately and completely disavow the implied guarantee (give market discipline a chance!)

6) Terminate all non-mortgage loan assets (stick to their charters!)

7) Terminate subprime and ultra-low down payment lending (too risky for the American taxpayer!)

8) Limit the use of mortgage insurance – (only a façade of meaningful protection)

9) Provide absolute transparency, on a timely basis, on what is being purchased in the marketplace (protect the integrity of U.S. financial markets!)

10) Give Mr. Falcon at OFHEO requested resources so he can do his job!

On another subject, it is worth underscoring the unfolding debacle in the high-yield bond market, and we believe high-risk lending generally, and how investors and speculators are fleeing the sector. Included above are charts from three major high-yield funds, not to highlight individual fund performance, but to illustrate the nature of the current liquidation. Last Friday Heartland Advisors marked down the value of two their high-yield municipal bond funds. The net asset value of the High-Yield Municipal Bond Fund was reduced 70% after management revalued security holdings.

From today’s San Francisco Chronicle (Harsh Lesson in Muni-Bond Funds): “Here's what happened: Last Friday, Heartland changed the way it values bonds in its two high-yield muni funds. Instead of relying solely on an outside pricing service -- Interactive Data/Financial Times, the same one many other funds use -- Heartland said it would ‘consider factors and information in addition to prices’ provided by Interactive, formerly called Muller Data. This change resulted in a drastic markdown of the share price of two Heartland funds…In a supplement to its prospectus, Heartland said it made the change ‘because of a current lack of liquidity in the high-yield municipal bond markets generally, and because of credit quality concerns and a lack of marketmakers, market bids’ and comparable trades.”

With the high-yield sector faltering generally, the fund began to mark down the prices of some of its bonds. Then, “to meet redemptions, the fund had to sell some of its bonds and found out they weren't worth as much as they thought.” What had been considered market prices for the calculation of investors’ wealth were nowhere close to where the actual securities could be sold in the marketplace. This is quite pertinent for financial markets generally, as when funds are flowing into an asset class the entire sector can be valued based on “last sale” and liquidity conveniently assumed. The situation changes abruptly, however, when fund flows reverse and liquidity comes at a great premium. Stock investors take note…

Well, in conclusion, this week the leveraged players definitely found themselves in “hot water” once again. Typically, that means it’s time for, Here We Go Again – “reliquefication.” Yet, we don’t see it working this time, especially after the last episode was allowed to run so out of control as to create unprecedented liquidity for a final wild speculative blow-off encompassing the Internet/telecom/technology bubbles. Today, the consequences of previous excess are a great and escalating burden. We actually do agree with the Barron’s columnist in one area; the global economy is not today heading for recession, while economies throughout Asia and Latin America are booming, for now. But, let us not for one second forget that the underlying financial systems are extremely fragile at best, and likely hopelessly impaired. While economies boom, the financial foundation could not be more precarious. In a critical difference from 1998, our domestic financial system is in the midst of an unfolding credit debacle. Importantly, the crisis here at home in 1998 was mainly due to forced liquidations in the leveraged speculating community and resulting systemic illiquidity. Such a crisis could (and was) resolved through aggressive reliquification (particularly from the GSEs) and lower interest rates from the Federal Reserve – shift the leverage away from the troubled speculators, and then make the environment conducive for the leveraged community to continue to play. The environment was made “right” for leveraged speculation, and the game was set in motion for a final wild fiasco. It will not be possible to “right” the unfolding credit debacle, only exacerbate it.

There is another key aspect that made the 1998 environment conducive to a system-wide “reliquefication.” Importantly, to achieve credit excess takes both willing borrowers and lenders. For liquidity to “stick,” it must get in the hands of aggressive spenders. Don’t underestimate the role played in the 1998 “reliquefication” process by having hundreds and even thousands of individuals and companies with pie-in-the-sky ideas to create enterprises from the Internet and telecom “revolution.” They were like mountains of tinder waiting for a match – more than willing to borrow and spend in historic proportions. On the other side, liquidity found a similar tinderbox with manic behavior overwhelming a bloated banking, investing, and speculating community who absolutely fell over themselves to provide capital and speculate like there was no tomorrow. It was an extraordinary confluence of unprecedented liquidity, exciting new technologies, and raw unadulterated emotion. It was a once in a lifetime phenomenon – an historic mania. Those days are over. Investors’ confidence has been irreparably broken in the Internet and telecommunications sectors, and I have no doubt that herein lies the catalyst for the piercing of the Great U.S. Bubble.

Quoting from Charles Kindleberger’s masterpiece “Manias, Panics, and Crashes:” “Causa remota of the crisis is speculation and extended credit; causa proxima is some incident that snaps the confidence of the system, makes people think of the dangers of failure, and leads them to move from commodities, stocks, real estate, bills of exchange, promissory notes, foreign exchange – whatever it may be – back into cash…To the extent that speculators are leveraged with borrowed money, the decline in prices leads to further calls on them for margin or cash and to further liquidation. As prices fall further, bank loans turn sour, and one or more mercantile houses, banks, discount houses, or brokerages fail. The credit system itself appears shaky, and the race for liquidity is on.” (Thanks Gary!).