Stocks are out of the 2003 blocks quickly. For the week, the Dow and S&P500 were up 4%. The Transports gained 3% and the Utilities 4%. The Morgan Stanley Consumer and Morgan Stanley Cyclical indices increased 4%. The small cap Russell 2000 gained 2%, and the S&P400 Mid-Cap index added 3%. The technology sector was strong, with the NASDAQ100 gaining better than 3%. The Morgan Stanley High Tech index added 5% and the Semiconductors 6%. The Street.com Internet index advanced 5% and the NASDAQ telecommunications index 4%. The Biotechs were up about 2%. The financial stocks rallied as well, with the Securities Broker/Dealer index up 6% and the Banks 4%. With the mighty bullion up another $1.90, the HUI gold index added 2%. The CRB (commodity) index added 1% this week, after finishing 2002 up 23%.
The Credit market is reacting negatively to mounting inflationary pressures. For the week, two-year Treasury yields jumped 15 basis points to 1.75%. Five-year yields surged 23 basis points to 2.97%, while the 10-year saw its yield jump 21 basis points to 4.02%. The long-bond yield rose 17 basis points to 4.95%. Benchmark Fannie Mae mortgage-back yields popped 23 basis points, while the implied yield on agency futures increased 19 basis points. The spread on Fannie’s 5 3/8% 2011 note narrowed one to 40, while the benchmark 10-year dollar swap spread was unchanged at 45. Corporate Credit spreads widened marginally. The dollar was about unchanged for the week.
With the exception of yesterday’s surprisingly strong ISM manufacturing survey, economic reports were almost universally dismal as 2002 came to its conclusion. The four-week average for Initial Jobless Claims rose to the highest level in three months. With forecasts at 86 (up two points from November), the Conference Board’s December Consumer Confidence index was reported at 80.3 (its sixth drop in seven months). Importantly, the Present Situation index dropped 8.4 points to 69.9. This index has now dropped 41.3 points since May to the lowest level since January 1994. Those believing jobs were plentiful dropped to the lowest level since early 1994, while those viewing jobs as hard to find surged to the highest level since mid-1994. And while the percentage of respondents that expect to purchase a home ticked up slightly, it is worth noting that figure remains well below the year ago level. Notably, Consumer Confidence declined in all regions, with the 20.2 point drop in New England the largest.
The New York Purchasing Managers index sank almost 15 points to a contractionary 41.4, the lowest reading since January. While remaining above 50, the Chicago Purchasing Managers index declined a more-than-expected three points to 51.3. Curiously, the Chicago New Orders index dropped almost eight points to 53, while Prices Paid jumped about five points to 62.1 (the highest level since August). November Durable Goods Orders dipped 1.4% (expectations of up 0.8%), with Unfilled Orders declining to the lowest level since 1996.
New Home Sales came in at a record rate of 1.069 million (up 14% y-o-y). Interestingly, however, we see that the national median price dropped $11,600 to $167.300, the lowest in 14 months. In a sign of a slowdown at the upper-end, the median New Homes price is down $23,300 since June. And while it garners little attention, the number of new homes for sale continues to ratchet up. At 335,000 units, the inventory of new homes is up 9% y-o-y to the highest level since August 1996. Elsewhere, Existing Home Sales were reported at a somewhat weaker but still strong 5.56 million rate (up 6% y-o-y). With average (mean) prices for Existing Home sales up 11.2% ($20,400) y-o-y, and sales volumes up 6%, annualized Calculated Transaction Volume jumped almost 18% ($170 billion) to $1.13 Trillion. Y-o-y, average (mean) prices were up 15.6% in the Northeast, 16% in the Midwest, 7.8% in the South, and 9.3% in the West. It is also worth noting that outside of the 12.7% jump in the West, home sales levels slowed noticeably. The national inventory of existing homes increased to 2.34 million, up 12% to the highest level since June 1998.
One word rather succinctly describes the economy’s 2002 performance: unbalanced. And while many an economist is quick to underscore the year’s ballpark 3% GDP growth, the financial markets clearly began to appreciate the poor quality of “output” growth. This is an important development for the dollar.
To set the stage for Issues 2003, it is helpful to briefly review key developments from last year. Credit system stress began to build in the spring after a flurry of major bankruptcies, including Global Crossing, K-Mart, NTL, and Adelphia. The dollar began to come under significant selling pressure in April, with widening Credit spreads and faltering corporate liquidity soon to follow. Then in late June and early July, with the revelation of massive fraud and the subsequent implosion at WorldCom, systemic stress took a rather dramatic turn for the worse. Stocks were in near free-fall, the dollar was sinking precipitously, and spreads were widening sharply. But with rates collapsing and the GSE’s struggling to keep their gargantuan balance sheets and derivative books in balance, the latest imperious round of “reliquefication” fell squarely upon the banks.
With an historic mortgage refi boom in full bloom during the third quarter, the Commercial Banking sector expanded holdings of Financial Assets at a record annualized pace of $698 billion, a rate double that from 2001. During the second and third quarters, Commercial Banking sector mortgage lending averaged an annualized $323 billion, compared to full-year 2001’s $130 billion. Bank consumer lending averaged $58 billion, versus 2001’s $16.6 billion. Over a 34-week period commencing in April, Commercial Banking sector Total Assets surged an unprecedented $629 billion, or 15% annualized. During this period, Commercial and Industrial loans dropped $50 billion. The liquidity surge did stabilize equities and the dollar, but was insufficient to arrest ballooning Credit spreads. The corporate bond market was slipping into a precarious state of illiquidity and dislocation. Hedge funds began to come under fire for shorting corporate bonds, while speculative activity in the Credit default swap arena mushroomed. Elsewhere, impaired European insurance companies and financial conglomerates were in full international retreat. The global “risk” market was at the brink.
Quietly, worsening Credit conditions at home began spreading from the corporate to the consumer sector. There were revelations of serious issues at Capital One (with bond yields widening to 10%), ongoing problems at Household International (with its $125 billion of managed assets) and Conseco was in dire straits. Heightened liquidity concerns saw Household bond spreads widen to almost 800 basis points by late October. Spreads also ballooned for major consumer lenders Ford and Sears, as well as others. Fannie responded to heightened systemic stress in October by expanding its Book of Business at a 21% annualized rate (strongest since March). The Fed’s surprise 50 basis point cut on November 6th (Dr. Bernanke gave a speech commemorating Milton Friedman’s birthday on the 8th), followed the next week by HSBC’s surprise acquisition of moribund Household International, were sufficient to resolve the marketplace dislocation, with spreads, stocks and the dollar abruptly reversing course. Those caught on the wrong side of systemic dislocation hedges and speculations ran for cover. For American households, it was refi madness.
Broad money supply surged $255 billion over a 10-week period commencing in early October, a 16% annualized rate. Rampant reliquefication was exceedingly successful in inflating Treasury and agency prices, while liquidity meandered back to the corporate bond market. In a noteworthy change from the past, these measures had quite modest affects on equities while they undercut the dollar. Gold, energy, and commodity prices, in general, surged and finished 2002 with the strongest price gains in years.
With the general financial market backdrop in mind, let’s now analyze some of 2002’s monetary developments. Broad money supply (M3) expanded by $465.4 billion, or about 6% during the past year. Over two years, M3 ballooned an historic $1.46 Trillion, or almost 21%. It is instructive to dig a bit deeper and make comparisons. During 2001, broad money supply surged $990 billion, or about 14%. Institutional Money funds were actually that year’s fastest growing component, surging $406 billion, or 52%. The financing of GSE balance sheets played no small part in 2001’s expansion of Money Market Fund assets (Freddie Mac, for example, increased short-term borrowings by 36% to $250 billion for the year; the FHLB 30% to $122 billion; and Fannie Mae 23% to $343 billion). But the GSE’s may have in combination actually reduced short-term borrowings during 2002. Therefore, we should not be surprised to see that the growth rate for Institutional Money Fund assets dropped to 5%, while Retail Money Fund assets declined 4% during the past year. For 2002, the expansion of Savings Deposits accounted for the vast majority of money supply growth, jumping $462 billion, or 20%. The fastest growing money supply component, however, was Repurchase Agreements (“issued by depository institutions”) that surged 25% to $476 billion.
The untold story of 2002 is the surge in Primary Dealer Repurchase Agreements (repos). Twelve-month gains of almost $400 billion, or 20%, put outstanding repos at about $2.4 Trillion. This enigmatic financing vehicle played a critical role in financing the past year’s unprecedented mortgage debt growth. First, repos surely financed GSE balance sheet growth; an expansion this time financed primarily by long-term (“agency”) bond issuance. Second, the repo market has come to play a major role in financing speculative holdings of mortgage-backed securities. We are left to ponder the degree of leveraged speculation the repo market has come to finance, though it does appears to have developed into THE key liquidity mechanism. Financing Treasuries, agencies, and mortgage-backs in the Repo market (borrowing short, lending long) provides virtually free speculative profits in a collapsing rate environment like 2002. Thus, last year’s extraordinary growth was supported by an unusually hospitable financing environment. Things won’t always be so good.
To be sure, and despite some close calls, it was another banner year for Wall Street Structured Finance. While December’s numbers have yet to be included (from Bloomberg data), annualized agency mortgage-backed security issuance of $1.36 Trillion was up 26% from 2001. CMO (“collateralized mortgage obligations”) issuance jumped 47% for the year to $806 billion. The asset-backed securities (ABS) marketplace enjoyed another record year, with issuance up 14% to $429 billion. Home equity-backed ABS issuance jumped 40% to $142 billion (up from 2000’s $49 billion).
Annualizing Fed data (after three quarters) for ‘02, we see that combined structured finance (GSE balance sheet growth, agency mortgage-backs, and asset-backed securities) expanded at a 10.7% rate ($780 billion) to $7.84 Trillion (up 92% over 19 quarters). GSE growth was at an annualized 9% ($208b), agency mortgage-backs 12% ($339b), and ABS 11% ($233b). The “structured finance ratio” (combined GSE, MBS and ABS growth, divided by total non-financial/non-federal Credit growth) averaged 77% during the first three quarters, compared to 54% in ’97 and 56% in 2000.
Amazingly, third quarter Total Mortgage Credit growth of $941 billion (annualized) was 88% of total non-finance/non-federal Credit growth, while averaging 82% over the first three quarters. This compares to 39% during 1997, 49% during 2000, and 63% during 2001. Annualized 2002 non-financial Corporate debt growth collapsed to 3.8% of total non-financial/non-federal debt growth. This compares to 1997’s 37% and 2000’s 34.8%. These ratios help to illuminate an extremely unbalanced Credit system, and one need look no further for an explanation of the extraordinarily imbalanced U.S. economy.
In last year’s “Issues 2002,” I questioned whether the Great Credit Bubble would survive another year. It did. The Credit system was sustained by truly unbelievable (and conspicuous) lending and speculative excess running rampant throughout real estate finance. In a normal environment, one would have expected consternation from prudent central bankers. Yet the Greenspan Fed not only refused to restrain the dangerous, out of control excesses, it acted specifically to bolster the Great Mortgage Finance Bubble. Indeed, in the midst of an unprecedented lending and speculative frenzy, the Fed was trumpeting its capacity to use the “printing press” to ward off any fledgling risk of a “deflationary” bust. In a normal environment, one would have expected consternation from the “bond market vigilantes.” Yet the largest bond management house in the world is outspoken in its support for the “Bernanke Put” and “a devaluation of all paper currencies.” Truly, the financial world has been turned completely upside down, and as challenging as it is, we must factor this into our analysis.
I strongly recommend a careful reading of the latest missive from Pimco’s Paul McCulley. His piece certainly changed the direction I was heading for this week’s Bulletin. From McCulley (his underlines): “Over thirty years ago, America was forced to bust up the Bretton Woods arrangements, because America didn’t want to deflate sufficiently to keep gold from rising above $35 an ounce. Today, just the opposite problem exists: America needs to inflate the money stock, while devaluing it against gold, so as to keep private sector debt obligations from sinking into a deflationary abyss. And the world needs the same thing: a broad based, wholesale devaluation of all paper currencies versus a basket of globally-traded “stuff.” Mr. McCulley also wrote that the “ditching” of Bretton Woods was a “regime shift, not just a cyclical wiggle in monetary affairs.”
That the Pimco bond family fully supports the inflationist perspective trumpeted by Milton Friedman, Alan Greenspan, and Ben Bernanke is both fascinating and worth pondering. Sure, the “debate” is couched in terms of the risks of “inflation” and “deflation.” But I believe the heart of the matter lies elsewhere. Hyman Minsky analyzed contemporary finance and economics in term of “Wall Street Finance,” and the “Wall Street Paradigm.” “Ditching” the Bretton Woods gold anchor cut loose the U.S. monetary system. And (agreeing with Mr. McCulley) it ushered in an historic (and experimental) monetary regime paradigm shift. Over time, especially following aggressive financial deregulation and the rise of the pro-Wall Street Greenspan dynasty, the Wall Street Paradigm took full control of the monetary reins.
McCulley and others are today calling for the Fed and Treasury to use all inflationary means to fight some nebulous evil with the fully loaded label “deflation.” In my mind, however, it is increasingly clear that the overriding objective is to preserve the Wall Street Paradigm - the Structured Finance Monetary Regime. And, importantly, there is overwhelming evidence that the Greenspan Fed and Washington are fully behind Wall Street in its determination to reign supreme over the U.S. money and Credit system (while disregarding attendant risks and costs). The alternative is deemed unacceptable.
This is not a tirade as much as it is setting the backdrop for our analysis for Issues 2003. We learned during 2002 that uncontrolled mortgage lending excess is more than acceptable to our central bankers. Wall Street, once again, proved there isn’t a speculative Bubble it won’t fall head-over-heals in love with (Are we to place society’s financial system and economy in the trust of The Street’s capricious heart?). The Mortgage Finance Bubble was nurtured to dangerous extremes, and we should at this point assume that all efforts will be made to sustain this inflationary Credit and speculative Bubble. The alternative will be deemed unacceptable. The consequences going forward include a continuation of 2002’s unprecedented non-productive debt growth and Current Account deficits. Financial fragility will be an ongoing issue, as will dollar weakness. To sustain the Wall Street Paradigm will require massive, unrelenting creation of new dollar claims - Credit to support levitated asset prices and a debt-ridden, maladjusted economy. That the endemic asset Bubble today includes tens of Trillions of equity, real estate, and Credit market instruments ensures that the inflationary path will be a treacherous obstacle course, quite likely insurmountable.
How much money and Credit will be required to sustain myriad and endemic domestic asset Bubbles with $500 billion (Current Account deficits) exiting annually to the rest of the world? How will so much monetary fuel somehow flow evenly and to where it is most needed? Well, it can’t and won’t. Commodity Speculator Paradise? And how long will it make sense for global players and the leveraged speculating community to hold low-yielding dollar assets? After a very difficult 2002, will scores of impetuous hedge funds prove to have weak hands when it comes to their dollar and U.S. Credit market speculations? When others are printing money playing gold, crude and euros? To what extent have global players hedged dollar exposure in the swaps and derivatives market? What is the risk of a derivative/speculative unwind dollar crisis along the lines of SE Asia, Russia, or Argentina? Are currency crises a permanent fixture in the unharnessed, endemic Credit and speculative excess, post-Bretton Woods Wall Street Monetary Regime? Why would the dollar be immune to these dynamics? Issues 2003.
In his most recent contribution to the Inflation vs. Deflation debate, Jim Grant made an interesting pronouncement: “Inflation is a monetary phenomenon. Deflation is a credit phenomenon.” Well, as reasonable as Jim’s analysis appears, a strong case can be made for the exact opposite. In contemporary finance, there is a fine line between “money” and Credit. During a Credit-induced boom, a wide swath of companies and financial institutions can procure purchasing power (for investing, spending, or speculating) through the issuance of myriad liabilities/IOUs (securities, book entries, either paper, electronic or otherwise). Good times find lenders content to hold Enron “trade paper,” WorldCom notes, telecom junk bonds, Conseco manufactured housing securitizations, National Century healthcare asset-backs, risky CDO tranches, and AmeriCredit securitizations (as long as they are wrapped in AAA Credit insurance!). Credit growth (liability creation) creates purchasing power, the inflationary fuel so easily husbanded during prosperous times (much of it seductively inflating asset prices!). Perceived safe, secure, stores of nominal value, monetary liabilities – Money – are a sideshow, at best (“Cash is Trash”). But when the glorious boom eventually turns confounding bust - and greed gives way to fear, sleepless nights, and risk aversion - the limelight returns to the safety and liquidity of money, as it has for centuries. This is no anachronistic intellectual sermonizing, but a truism of finance and economics of potentially momentous importance for 2003.
The Great Credit Bubble survived 2002 specifically because the liabilities created throughout the Wall Street “Structured Finance” Monetary Regime maintained their “moneyness.” At key inflection points, there is a thin line between “safe haven” status and a crisis of confidence. The prices of GSE liabilities (debt and mortgage-backs) surged, despite being issued in incredible quantities. The prices of bonds insured by MBIA, Ambac, and the other Credit insures rose as if these risky, thinly capitalized insurers hadn’t a care in the (uncertain, hostile) world. GE maintained its pristine Credit ratings and continued to enjoy basically unlimited access to new finance. The marketplace even accommodated troubled companies such as Capital One and Sears, transforming risky consumer loans into perceived safe asset-backs. Increasingly risky mortgage loans were converted into safe “money” like never before. I often ponder how much this entire amazing process should be taken for granted. And, for the first time, 2002 saw some skepticism as to the soundness and consequences of the massive GSE Bubble. The year also saw some discussion regarding the appropriateness of top ratings for key monetary players such as GE and MBIA. J.P. Morgan, a key player in transforming risky loans into safe “money,” found itself in trouble. These types of issues are not going away and concerns will only harden over the year.
As we contemplate Issues 2003, we fully expect the spotlight to shine brightly on J.P. Morgan, Fannie, Freddie, GE, MBIA, Ambac, the other money center banks, the Wall Street firms, the mortgage insurers, and the other risk players. These institutions are now accepting an exponential rise in risk through their aggressive risk intermediation operations (transforming larger quantities of increasingly risky loans into perceived safe securities). That international risk players are in retreat only increases the amount of risk that must be absorbed by the U.S. financial sector.
To this point, however, the Structured Finance Monetary Regime maintains its capacity to create “money” in unlimited quantities and the U.S. economy retains is primary competitive advantage (issuing top-rated securities). But Credit Bubble dynamics now dictate that enormous and unrelenting Credit inflation will be necessary to forestall the undoing of the likes of Fannie, Freddie, MBIA, JP Morgan, GE, - the entire Monetary Regime. Inflate or Die. Accordingly, as long as the Wall Street Structured Finance Paradigm retains its Supreme Reign over the Power of Money, we should expect an incessant flood of dollar balances wreaking financial havoc at home and abroad. This is a U.S. systemic problem, a dollar problem, an economic problem, and a global problem.
At this point, we are forced to assume that it is the goal of the Federal Reserve, the White House, the GSEs, Pimco, (global central bankers?) and Wall Street to preserve at all cost the Wall Street Structured Finance Monetary Regime. This is quite a formidable cabal that is today as focused as it is determined. We no longer contemplate the possibility that Greenspan and Washington are oblivious to acute financial and economic fragility. They’re on the case and, especially after 2002, there is no turning back. Again, the alternative is simply unacceptable. A breakdown of the Structured Finance Monetary Regime would mean an end to unlimited “money” creation and a (deflationary) collapse in the divergent U.S. asset Bubbles (real and financial) and hopelessly distorted economy.
It is my view that inflation is largely a Credit phenomenon. A savage deflation, as was witnessed in the thirties, is a phenomenon of monetary regime breakdowns. We are living at an historical crossroads in 2003. Unstable financial markets and a vulnerable dollar are assured. The risk of expanding inflationary manifestations from a deranged U.S. Credit system is rising by the week, especially for commodities with inelastic supplies (gold and oil!).
But always lurking out there will be the risk that conspicuous cracks widen in the foundation of the Wall Street Paradigm. There are clearly vulnerable players, and if one institution winds up in serious trouble, the daisy chain of risk intermediaries and speculators becomes acutely frail. Yet, the dollar is the greatest wild card for the Wall Street Monetary Regime. If the dollar decline becomes disorderly and currency derivative markets dislocate, all bets are off. Thus far, dollar weakness has had no impact on spreads (especially for agency bonds) or interest rates. We don’t expect this curious aberration to last. The Fed and U.S. financial sector are hopelessly locked in Credit Bubble dynamics, with inflating dollar balances devaluing claims held by our foreign Creditors. The rubber meets the road when expected currency losses overwhelm gains from inflating dollar asset prices, especially agencies and Treasuries.
Recall the old slogan, “You are What You Eat.” Well, we believe “An Economy is How it Lends” (and how is speculates!). Minsky used the terminology “Money Manager Capitalism” in his cogent analysis of finance’s keen influence on the real economy. I have in the past expanded this analysis while coining the phrase “Financial Arbitrage Capitalism.” “Structured Finance” can be read “speculative finance,” and the contemporary Wall Street Paradigm can be viewed as a Regime of Leveraged Speculation. There is today no separating the speculators or asset Bubbles from monetary matters. Regrettably, debt financing business investment and actual goods producing enterprise is deficient for the speculating arbiters and financial engineers, while only becoming more unsatisfactory as the size of the speculative pool of finance balloons. The leveraged players treasure the characteristics and liquidity of GSE and top-rate “structured instruments,” with this mechanism becoming the commanding Monetary Process injecting finance into the real economy. These processes became rather discernable during 2002, with non-productive mortgage and consumption-related debt the order of the day. Issues 2003 and beyond should recognize the ramifications from a monstrous leveraged speculating community (and consequent unfathomable securities holdings) becoming the linchpin of the Wall Street Paradigm. You can joyfully eat Big Mac’s and fries daily for years until one day an unseen clogged artery reminds one of the cost of being a junk food junkie.
Leveraged speculation certainly played a momentous role in supporting the Wall Street Paradigm and the U.S. economy throughout 2002. Heroic perhaps, but it will prove in the end self-defeating. Endemic leveraged speculating is fueling real estate inflation, over-consumption, and untenable trade deficits. And importantly, if surreptitiously, mushrooming non-productive debt is exacerbating financial fragility and economic maladjustments. Inflation will not convert these specious financial claims into sound Credits (or make right a maladjusted economy!), but will instead create only weaker claims in larger quantities. This is a central facet of Credit Bubble analysis. Both of these Credit inflation manifestations – financial fragility and economic maladjustments - were clearly revealed during 2002, and we expect them to become even more prominent during 2003.
To nurture inflation today is to stoke the attendant Bubbles in leveraged speculation and Mortgage Finance. As neat and tidy as it may sound, it is simply impossible to provide a little goosing to global goods prices without throwing additional fuel on destabilizing U.S. asset inflation. And this gets to the heart of the matter: Indelible Monetary Processes at the core of the Wall Street Monetary Paradigm assure destabilizing lending and speculative excess. This is a reality of contemporary finance and economics that absolutely destroys the efficacy of the inflationists’ policies propagated by the likes of McCulley, Bernanke, Greenspan, and Friedman. They should all go back and study John Law’s Mississippi Bubble experience. Dr. Friedman in the past has made the ridiculous claim that there is no such thing as destabilizing speculation. Mr. McCulley goes so far as to aver that both debtors and creditors can benefit today from inflation. Who then, might we ask, is losing out to the bevy of speculators? And what are the consequences when these financial arbiters move to cash in their dollar chips?
The inescapable dilemma posed by enormous Credit-induced speculations is that they eventually must unwind. Such a circumstance will lead to sinking assets prices and a Credit collapse, the question is only from what levels. It is a speculative dynamics issue, not an issue of monetary deflation. Bursting Bubbles may certainly lead to a collapse in the underlying Credit that financed the asset inflation, but monetary inflation cannot make right a speculative Bubble (as John Law and the French learned the hard way). Our greatest criticism of the Greenspan Fed has been its coddling of the leveraged speculators. Never before had central bankers enjoyed such a powerful and instantaneous monetary mechanism. This expedient was negligently abused and is now largely impotent. The residual is truly frightening.
We are today left with untenable financial and economic Bubbles addicted to Credit excess, over-liquefied financial markets, and ultra-low interest rates. It is tempting for those involved to couch the risk of a collapsing speculative Bubble in terms of a general risk of deflation. But prolonging speculative Bubbles only postpones the inevitable painful day of reckoning. The best that can be hoped for, at least from a 2003 financial markets point of view, is a scenario where rampant liquidity extends the life of this historic Bubble. We are all left to hope our currency suffers no more than an orderly decline.
And, the strange thing is, as long as the Wall Street Money Machine churns out massive additional dollar claims, the wildly distorted service-sector economy can muddle through and things really won’t seem so bad. But the wildness lurks beneath. The less arcane issues such as mounting local, state and federal government deficits may this year become important issues. If a major Credit insurer falters (perhaps in CDOs or Credit default swaps), muni finance immediately becomes a major issue. Then there’s the unmitigated financial disaster unfolding out in California (How much Credit inflation/“currency devaluation” would suffice to reignite the technology Bubble?) The dire consequence of a California housing bust is a not insignificant justification for more of the inflationists’ stew. And while pundits have their eyes on the spectacular housing inflations in California and the Northeast, we would expect serious problems to manifest first in the “marginal” housing markets in places like Dallas, Atlanta, Denver, Phoenix, and Las Vegas (similar to the signal missed when the small caps put in highs and began their descent while everyone was transfixed by the tech and Internet moonshots). And speaking of (exporting) real estate inflation, it is interesting to read this week of housing Bubble concerns in South Korea and China.
Meaningful U.S. mortgage problems may perhaps still be some time away (the system remains in the midst of feverish lending excess). But we see no escaping consumer Credit problems this year. Importantly, we expect tightening Credit availability to blow headwinds on the consumption-based economy. And the day ultra-easy Credit availability begins to tighten in mortgage and auto land will prove a major inflection point for the U.S. economy. We’ll have our eyes keenly focused on the marginal mortgage-backs (home equity and subprime) and the entire asset-backed marketplace. We have been waiting for the marketplace to impose some discipline, but we’ve witnessed the opposite. This is but one more testament to the dysfunctional nature of the Wall Street Monetary Regime (and a distinct contrast to a gold standard). Excesses are not self-correcting but instead reinforcing. As we saw with the technology, Internet and telecom debt Bubbles, things go to gross excess before ending in spectacular busts.
After three years of stock market losses, most would surely consider such a pessimistic view for 2003 as indicative of a “permabear” mentality. But I would like to be very clear about this: From my analytical framework, 2002 basically followed what I consider a worst-case scenario. Mortgage Credit excess went to unprecedented extremes, Credit market leveraged speculation appears to have gone to unprecedented extremes, trades deficits went to unprecedented extremes, and a highly imbalanced Bubble economy suffered only further debilitating distortions. The Fed used its bullets sustaining the Credit Bubble and, despite assurances to the contrary, has little ammunition remaining for when it’s desperately needed.
The good news is that the economy did muddle through 2002. The bad news is that cost of muddling was high and is today rising sharply. If the latest reliquefication’s tempered influence on stocks and dreadful impact on the dollar were ominous, the economy’s performance in the face of unprecedented liquidity and mortgage refis was darn right alarming. How much money and Credit would be required today to reignite the boom, and what would be the consequences? Or perhaps the more relevant question would concern where and how sufficient systemic Credit creation will be garnered when this protracted refi boom finally comes to an end.
Broad money supply surged $255 billion over a 10-week period commencing in early October, a 16% annualized rate. Rampant reliquefication was exceedingly successful in inflating Treasury and agency prices, while liquidity meandered back to the corporate bond market. In a noteworthy change from the past, these measures had quite modest affects on equities while they undercut the dollar. Gold, energy, and commodity prices, in general, surged and finished 2002 with the strongest price gains in years.
With the general financial market backdrop in mind, let’s now analyze some of 2002’s monetary developments. Broad money supply (M3) expanded by $465.4 billion, or about 6% during the past year. Over two years, M3 ballooned an historic $1.46 Trillion, or almost 21%. It is instructive to dig a bit deeper and make comparisons. During 2001, broad money supply surged $990 billion, or about 14%. Institutional Money funds were actually that year’s fastest growing component, surging $406 billion, or 52%. The financing of GSE balance sheets played no small part in 2001’s expansion of Money Market Fund assets (Freddie Mac, for example, increased short-term borrowings by 36% to $250 billion for the year; the FHLB 30% to $122 billion; and Fannie Mae 23% to $343 billion). But the GSE’s may have in combination actually reduced short-term borrowings during 2002. Therefore, we should not be surprised to see that the growth rate for Institutional Money Fund assets dropped to 5%, while Retail Money Fund assets declined 4% during the past year. For 2002, the expansion of Savings Deposits accounted for the vast majority of money supply growth, jumping $462 billion, or 20%. The fastest growing money supply component, however, was Repurchase Agreements (“issued by depository institutions”) that surged 25% to $476 billion.
The untold story of 2002 is the surge in Primary Dealer Repurchase Agreements (repos). Twelve-month gains of almost $400 billion, or 20%, put outstanding repos at about $2.4 Trillion. This enigmatic financing vehicle played a critical role in financing the past year’s unprecedented mortgage debt growth. First, repos surely financed GSE balance sheet growth; an expansion this time financed primarily by long-term (“agency”) bond issuance. Second, the repo market has come to play a major role in financing speculative holdings of mortgage-backed securities. We are left to ponder the degree of leveraged speculation the repo market has come to finance, though it does appears to have developed into THE key liquidity mechanism. Financing Treasuries, agencies, and mortgage-backs in the Repo market (borrowing short, lending long) provides virtually free speculative profits in a collapsing rate environment like 2002. Thus, last year’s extraordinary growth was supported by an unusually hospitable financing environment. Things won’t always be so good.
To be sure, and despite some close calls, it was another banner year for Wall Street Structured Finance. While December’s numbers have yet to be included (from Bloomberg data), annualized agency mortgage-backed security issuance of $1.36 Trillion was up 26% from 2001. CMO (“collateralized mortgage obligations”) issuance jumped 47% for the year to $806 billion. The asset-backed securities (ABS) marketplace enjoyed another record year, with issuance up 14% to $429 billion. Home equity-backed ABS issuance jumped 40% to $142 billion (up from 2000’s $49 billion).
Annualizing Fed data (after three quarters) for ‘02, we see that combined structured finance (GSE balance sheet growth, agency mortgage-backs, and asset-backed securities) expanded at a 10.7% rate ($780 billion) to $7.84 Trillion (up 92% over 19 quarters). GSE growth was at an annualized 9% ($208b), agency mortgage-backs 12% ($339b), and ABS 11% ($233b). The “structured finance ratio” (combined GSE, MBS and ABS growth, divided by total non-financial/non-federal Credit growth) averaged 77% during the first three quarters, compared to 54% in ’97 and 56% in 2000.
Amazingly, third quarter Total Mortgage Credit growth of $941 billion (annualized) was 88% of total non-finance/non-federal Credit growth, while averaging 82% over the first three quarters. This compares to 39% during 1997, 49% during 2000, and 63% during 2001. Annualized 2002 non-financial Corporate debt growth collapsed to 3.8% of total non-financial/non-federal debt growth. This compares to 1997’s 37% and 2000’s 34.8%. These ratios help to illuminate an extremely unbalanced Credit system, and one need look no further for an explanation of the extraordinarily imbalanced U.S. economy.
In last year’s “Issues 2002,” I questioned whether the Great Credit Bubble would survive another year. It did. The Credit system was sustained by truly unbelievable (and conspicuous) lending and speculative excess running rampant throughout real estate finance. In a normal environment, one would have expected consternation from prudent central bankers. Yet the Greenspan Fed not only refused to restrain the dangerous, out of control excesses, it acted specifically to bolster the Great Mortgage Finance Bubble. Indeed, in the midst of an unprecedented lending and speculative frenzy, the Fed was trumpeting its capacity to use the “printing press” to ward off any fledgling risk of a “deflationary” bust. In a normal environment, one would have expected consternation from the “bond market vigilantes.” Yet the largest bond management house in the world is outspoken in its support for the “Bernanke Put” and “a devaluation of all paper currencies.” Truly, the financial world has been turned completely upside down, and as challenging as it is, we must factor this into our analysis.
I strongly recommend a careful reading of the latest missive from Pimco’s Paul McCulley. His piece certainly changed the direction I was heading for this week’s Bulletin. From McCulley (his underlines): “Over thirty years ago, America was forced to bust up the Bretton Woods arrangements, because America didn’t want to deflate sufficiently to keep gold from rising above $35 an ounce. Today, just the opposite problem exists: America needs to inflate the money stock, while devaluing it against gold, so as to keep private sector debt obligations from sinking into a deflationary abyss. And the world needs the same thing: a broad based, wholesale devaluation of all paper currencies versus a basket of globally-traded “stuff.” Mr. McCulley also wrote that the “ditching” of Bretton Woods was a “regime shift, not just a cyclical wiggle in monetary affairs.”
That the Pimco bond family fully supports the inflationist perspective trumpeted by Milton Friedman, Alan Greenspan, and Ben Bernanke is both fascinating and worth pondering. Sure, the “debate” is couched in terms of the risks of “inflation” and “deflation.” But I believe the heart of the matter lies elsewhere. Hyman Minsky analyzed contemporary finance and economics in term of “Wall Street Finance,” and the “Wall Street Paradigm.” “Ditching” the Bretton Woods gold anchor cut loose the U.S. monetary system. And (agreeing with Mr. McCulley) it ushered in an historic (and experimental) monetary regime paradigm shift. Over time, especially following aggressive financial deregulation and the rise of the pro-Wall Street Greenspan dynasty, the Wall Street Paradigm took full control of the monetary reins.
McCulley and others are today calling for the Fed and Treasury to use all inflationary means to fight some nebulous evil with the fully loaded label “deflation.” In my mind, however, it is increasingly clear that the overriding objective is to preserve the Wall Street Paradigm - the Structured Finance Monetary Regime. And, importantly, there is overwhelming evidence that the Greenspan Fed and Washington are fully behind Wall Street in its determination to reign supreme over the U.S. money and Credit system (while disregarding attendant risks and costs). The alternative is deemed unacceptable.
This is not a tirade as much as it is setting the backdrop for our analysis for Issues 2003. We learned during 2002 that uncontrolled mortgage lending excess is more than acceptable to our central bankers. Wall Street, once again, proved there isn’t a speculative Bubble it won’t fall head-over-heals in love with (Are we to place society’s financial system and economy in the trust of The Street’s capricious heart?). The Mortgage Finance Bubble was nurtured to dangerous extremes, and we should at this point assume that all efforts will be made to sustain this inflationary Credit and speculative Bubble. The alternative will be deemed unacceptable. The consequences going forward include a continuation of 2002’s unprecedented non-productive debt growth and Current Account deficits. Financial fragility will be an ongoing issue, as will dollar weakness. To sustain the Wall Street Paradigm will require massive, unrelenting creation of new dollar claims - Credit to support levitated asset prices and a debt-ridden, maladjusted economy. That the endemic asset Bubble today includes tens of Trillions of equity, real estate, and Credit market instruments ensures that the inflationary path will be a treacherous obstacle course, quite likely insurmountable.
How much money and Credit will be required to sustain myriad and endemic domestic asset Bubbles with $500 billion (Current Account deficits) exiting annually to the rest of the world? How will so much monetary fuel somehow flow evenly and to where it is most needed? Well, it can’t and won’t. Commodity Speculator Paradise? And how long will it make sense for global players and the leveraged speculating community to hold low-yielding dollar assets? After a very difficult 2002, will scores of impetuous hedge funds prove to have weak hands when it comes to their dollar and U.S. Credit market speculations? When others are printing money playing gold, crude and euros? To what extent have global players hedged dollar exposure in the swaps and derivatives market? What is the risk of a derivative/speculative unwind dollar crisis along the lines of SE Asia, Russia, or Argentina? Are currency crises a permanent fixture in the unharnessed, endemic Credit and speculative excess, post-Bretton Woods Wall Street Monetary Regime? Why would the dollar be immune to these dynamics? Issues 2003.
In his most recent contribution to the Inflation vs. Deflation debate, Jim Grant made an interesting pronouncement: “Inflation is a monetary phenomenon. Deflation is a credit phenomenon.” Well, as reasonable as Jim’s analysis appears, a strong case can be made for the exact opposite. In contemporary finance, there is a fine line between “money” and Credit. During a Credit-induced boom, a wide swath of companies and financial institutions can procure purchasing power (for investing, spending, or speculating) through the issuance of myriad liabilities/IOUs (securities, book entries, either paper, electronic or otherwise). Good times find lenders content to hold Enron “trade paper,” WorldCom notes, telecom junk bonds, Conseco manufactured housing securitizations, National Century healthcare asset-backs, risky CDO tranches, and AmeriCredit securitizations (as long as they are wrapped in AAA Credit insurance!). Credit growth (liability creation) creates purchasing power, the inflationary fuel so easily husbanded during prosperous times (much of it seductively inflating asset prices!). Perceived safe, secure, stores of nominal value, monetary liabilities – Money – are a sideshow, at best (“Cash is Trash”). But when the glorious boom eventually turns confounding bust - and greed gives way to fear, sleepless nights, and risk aversion - the limelight returns to the safety and liquidity of money, as it has for centuries. This is no anachronistic intellectual sermonizing, but a truism of finance and economics of potentially momentous importance for 2003.
The Great Credit Bubble survived 2002 specifically because the liabilities created throughout the Wall Street “Structured Finance” Monetary Regime maintained their “moneyness.” At key inflection points, there is a thin line between “safe haven” status and a crisis of confidence. The prices of GSE liabilities (debt and mortgage-backs) surged, despite being issued in incredible quantities. The prices of bonds insured by MBIA, Ambac, and the other Credit insures rose as if these risky, thinly capitalized insurers hadn’t a care in the (uncertain, hostile) world. GE maintained its pristine Credit ratings and continued to enjoy basically unlimited access to new finance. The marketplace even accommodated troubled companies such as Capital One and Sears, transforming risky consumer loans into perceived safe asset-backs. Increasingly risky mortgage loans were converted into safe “money” like never before. I often ponder how much this entire amazing process should be taken for granted. And, for the first time, 2002 saw some skepticism as to the soundness and consequences of the massive GSE Bubble. The year also saw some discussion regarding the appropriateness of top ratings for key monetary players such as GE and MBIA. J.P. Morgan, a key player in transforming risky loans into safe “money,” found itself in trouble. These types of issues are not going away and concerns will only harden over the year.
As we contemplate Issues 2003, we fully expect the spotlight to shine brightly on J.P. Morgan, Fannie, Freddie, GE, MBIA, Ambac, the other money center banks, the Wall Street firms, the mortgage insurers, and the other risk players. These institutions are now accepting an exponential rise in risk through their aggressive risk intermediation operations (transforming larger quantities of increasingly risky loans into perceived safe securities). That international risk players are in retreat only increases the amount of risk that must be absorbed by the U.S. financial sector.
To this point, however, the Structured Finance Monetary Regime maintains its capacity to create “money” in unlimited quantities and the U.S. economy retains is primary competitive advantage (issuing top-rated securities). But Credit Bubble dynamics now dictate that enormous and unrelenting Credit inflation will be necessary to forestall the undoing of the likes of Fannie, Freddie, MBIA, JP Morgan, GE, - the entire Monetary Regime. Inflate or Die. Accordingly, as long as the Wall Street Structured Finance Paradigm retains its Supreme Reign over the Power of Money, we should expect an incessant flood of dollar balances wreaking financial havoc at home and abroad. This is a U.S. systemic problem, a dollar problem, an economic problem, and a global problem.
At this point, we are forced to assume that it is the goal of the Federal Reserve, the White House, the GSEs, Pimco, (global central bankers?) and Wall Street to preserve at all cost the Wall Street Structured Finance Monetary Regime. This is quite a formidable cabal that is today as focused as it is determined. We no longer contemplate the possibility that Greenspan and Washington are oblivious to acute financial and economic fragility. They’re on the case and, especially after 2002, there is no turning back. Again, the alternative is simply unacceptable. A breakdown of the Structured Finance Monetary Regime would mean an end to unlimited “money” creation and a (deflationary) collapse in the divergent U.S. asset Bubbles (real and financial) and hopelessly distorted economy.
It is my view that inflation is largely a Credit phenomenon. A savage deflation, as was witnessed in the thirties, is a phenomenon of monetary regime breakdowns. We are living at an historical crossroads in 2003. Unstable financial markets and a vulnerable dollar are assured. The risk of expanding inflationary manifestations from a deranged U.S. Credit system is rising by the week, especially for commodities with inelastic supplies (gold and oil!).
But always lurking out there will be the risk that conspicuous cracks widen in the foundation of the Wall Street Paradigm. There are clearly vulnerable players, and if one institution winds up in serious trouble, the daisy chain of risk intermediaries and speculators becomes acutely frail. Yet, the dollar is the greatest wild card for the Wall Street Monetary Regime. If the dollar decline becomes disorderly and currency derivative markets dislocate, all bets are off. Thus far, dollar weakness has had no impact on spreads (especially for agency bonds) or interest rates. We don’t expect this curious aberration to last. The Fed and U.S. financial sector are hopelessly locked in Credit Bubble dynamics, with inflating dollar balances devaluing claims held by our foreign Creditors. The rubber meets the road when expected currency losses overwhelm gains from inflating dollar asset prices, especially agencies and Treasuries.
Recall the old slogan, “You are What You Eat.” Well, we believe “An Economy is How it Lends” (and how is speculates!). Minsky used the terminology “Money Manager Capitalism” in his cogent analysis of finance’s keen influence on the real economy. I have in the past expanded this analysis while coining the phrase “Financial Arbitrage Capitalism.” “Structured Finance” can be read “speculative finance,” and the contemporary Wall Street Paradigm can be viewed as a Regime of Leveraged Speculation. There is today no separating the speculators or asset Bubbles from monetary matters. Regrettably, debt financing business investment and actual goods producing enterprise is deficient for the speculating arbiters and financial engineers, while only becoming more unsatisfactory as the size of the speculative pool of finance balloons. The leveraged players treasure the characteristics and liquidity of GSE and top-rate “structured instruments,” with this mechanism becoming the commanding Monetary Process injecting finance into the real economy. These processes became rather discernable during 2002, with non-productive mortgage and consumption-related debt the order of the day. Issues 2003 and beyond should recognize the ramifications from a monstrous leveraged speculating community (and consequent unfathomable securities holdings) becoming the linchpin of the Wall Street Paradigm. You can joyfully eat Big Mac’s and fries daily for years until one day an unseen clogged artery reminds one of the cost of being a junk food junkie.
Leveraged speculation certainly played a momentous role in supporting the Wall Street Paradigm and the U.S. economy throughout 2002. Heroic perhaps, but it will prove in the end self-defeating. Endemic leveraged speculating is fueling real estate inflation, over-consumption, and untenable trade deficits. And importantly, if surreptitiously, mushrooming non-productive debt is exacerbating financial fragility and economic maladjustments. Inflation will not convert these specious financial claims into sound Credits (or make right a maladjusted economy!), but will instead create only weaker claims in larger quantities. This is a central facet of Credit Bubble analysis. Both of these Credit inflation manifestations – financial fragility and economic maladjustments - were clearly revealed during 2002, and we expect them to become even more prominent during 2003.
To nurture inflation today is to stoke the attendant Bubbles in leveraged speculation and Mortgage Finance. As neat and tidy as it may sound, it is simply impossible to provide a little goosing to global goods prices without throwing additional fuel on destabilizing U.S. asset inflation. And this gets to the heart of the matter: Indelible Monetary Processes at the core of the Wall Street Monetary Paradigm assure destabilizing lending and speculative excess. This is a reality of contemporary finance and economics that absolutely destroys the efficacy of the inflationists’ policies propagated by the likes of McCulley, Bernanke, Greenspan, and Friedman. They should all go back and study John Law’s Mississippi Bubble experience. Dr. Friedman in the past has made the ridiculous claim that there is no such thing as destabilizing speculation. Mr. McCulley goes so far as to aver that both debtors and creditors can benefit today from inflation. Who then, might we ask, is losing out to the bevy of speculators? And what are the consequences when these financial arbiters move to cash in their dollar chips?
The inescapable dilemma posed by enormous Credit-induced speculations is that they eventually must unwind. Such a circumstance will lead to sinking assets prices and a Credit collapse, the question is only from what levels. It is a speculative dynamics issue, not an issue of monetary deflation. Bursting Bubbles may certainly lead to a collapse in the underlying Credit that financed the asset inflation, but monetary inflation cannot make right a speculative Bubble (as John Law and the French learned the hard way). Our greatest criticism of the Greenspan Fed has been its coddling of the leveraged speculators. Never before had central bankers enjoyed such a powerful and instantaneous monetary mechanism. This expedient was negligently abused and is now largely impotent. The residual is truly frightening.
We are today left with untenable financial and economic Bubbles addicted to Credit excess, over-liquefied financial markets, and ultra-low interest rates. It is tempting for those involved to couch the risk of a collapsing speculative Bubble in terms of a general risk of deflation. But prolonging speculative Bubbles only postpones the inevitable painful day of reckoning. The best that can be hoped for, at least from a 2003 financial markets point of view, is a scenario where rampant liquidity extends the life of this historic Bubble. We are all left to hope our currency suffers no more than an orderly decline.
And, the strange thing is, as long as the Wall Street Money Machine churns out massive additional dollar claims, the wildly distorted service-sector economy can muddle through and things really won’t seem so bad. But the wildness lurks beneath. The less arcane issues such as mounting local, state and federal government deficits may this year become important issues. If a major Credit insurer falters (perhaps in CDOs or Credit default swaps), muni finance immediately becomes a major issue. Then there’s the unmitigated financial disaster unfolding out in California (How much Credit inflation/“currency devaluation” would suffice to reignite the technology Bubble?) The dire consequence of a California housing bust is a not insignificant justification for more of the inflationists’ stew. And while pundits have their eyes on the spectacular housing inflations in California and the Northeast, we would expect serious problems to manifest first in the “marginal” housing markets in places like Dallas, Atlanta, Denver, Phoenix, and Las Vegas (similar to the signal missed when the small caps put in highs and began their descent while everyone was transfixed by the tech and Internet moonshots). And speaking of (exporting) real estate inflation, it is interesting to read this week of housing Bubble concerns in South Korea and China.
Meaningful U.S. mortgage problems may perhaps still be some time away (the system remains in the midst of feverish lending excess). But we see no escaping consumer Credit problems this year. Importantly, we expect tightening Credit availability to blow headwinds on the consumption-based economy. And the day ultra-easy Credit availability begins to tighten in mortgage and auto land will prove a major inflection point for the U.S. economy. We’ll have our eyes keenly focused on the marginal mortgage-backs (home equity and subprime) and the entire asset-backed marketplace. We have been waiting for the marketplace to impose some discipline, but we’ve witnessed the opposite. This is but one more testament to the dysfunctional nature of the Wall Street Monetary Regime (and a distinct contrast to a gold standard). Excesses are not self-correcting but instead reinforcing. As we saw with the technology, Internet and telecom debt Bubbles, things go to gross excess before ending in spectacular busts.
After three years of stock market losses, most would surely consider such a pessimistic view for 2003 as indicative of a “permabear” mentality. But I would like to be very clear about this: From my analytical framework, 2002 basically followed what I consider a worst-case scenario. Mortgage Credit excess went to unprecedented extremes, Credit market leveraged speculation appears to have gone to unprecedented extremes, trades deficits went to unprecedented extremes, and a highly imbalanced Bubble economy suffered only further debilitating distortions. The Fed used its bullets sustaining the Credit Bubble and, despite assurances to the contrary, has little ammunition remaining for when it’s desperately needed.
The good news is that the economy did muddle through 2002. The bad news is that cost of muddling was high and is today rising sharply. If the latest reliquefication’s tempered influence on stocks and dreadful impact on the dollar were ominous, the economy’s performance in the face of unprecedented liquidity and mortgage refis was darn right alarming. How much money and Credit would be required today to reignite the boom, and what would be the consequences? Or perhaps the more relevant question would concern where and how sufficient systemic Credit creation will be garnered when this protracted refi boom finally comes to an end.
