It was generally another positive week for the financial markets. For the week, the Dow and S&P500 gained 2%, while the Transports, Utilities, and Morgan Stanley Consumer indices added 1%. The Morgan Stanley Cyclical index rose 3%. The broader market continues to perform well, with the small cap Russell 2000 adding almost 2% and the S&P400 Mid-Cap index increasing 1%. The technology sector has gained a head of steam. For the week, the NASDAQ100 added 5% and the Morgan Stanley Technology index jumped 7%. The Semiconductors and The Street.com Internet indices surged 8%, while the NASDAQ Telecommunications index jumped 9%. The Biotechs added 3%. The financial stocks continue to rally, with the Securities Broker/Dealer index gaining 4% and the Banks 3%. And while bullion gained $3.30, the HUI gold index slipped 2%.
The Treasury market suffered. For the week, two-year yields actually rose only one basis point to 1.77%, while the implied yield on March 3-month Eurodollars declined one basis point to 1.36%. The five-year was a different story, with yields jumping 15 basis points to 3.12% (up almost 40 basis points in 2003’s seven trading sessions). The 10-year Treasury note saw its yield rise 11 basis points to 4.13%. The long-bond yield increased eight basis points to 5.04%. Mortgages performed quite well, with benchmark Fannie Mae mortgage-back spreads narrowing eight basis points. The implied yield on agency futures rose 12 basis points, about in line with Treasuries. The spread on Fannie’s 5 3/8 2011 notes narrowed one to 39, while the benchmark 10-year dollar swap spread was unchanged at 45.5. The S&P investment grade Credit spread index narrowed six to 228 (down from October’s high of 279). The S&P speculative grade Credit spread index narrowed 61 to 1209 (down from October’s 1570). Emerging market spreads narrowed as well, in what was a noteworthy narrowing of spreads throughout. The dollar index declined another one percent this week, dropping to a three-year low against the euro while losing ground to a widening list of currencies globally. It is also worth noting the recent weakness of the Mexican peso.
Broad money supply (M3) declined $4.3 billion last week. Savings Deposits declined $5.3 billion, and Retail Money Fund assets were down $2.8 billion. Institutional Money Fund assets dropped $7.1 billion, while Large Denominated Deposits added $2.2 billion. Repurchase Agreements jumped $10 billion, with six-week gains of $54.6 billion. While one week does not make a trend, the commercial paper (CP) market came to life last week. Total CP issuance jumped $17.2 billion, with financial CP borrowings increasing $11 billion to $1.180 Trillion. Non-financial CP was even up $6.2 billion (to $161.4 billion), the largest increase in about one year. By category, Asset-backed CP increased $14.8 billion to $740.5 billion, the highest level in 11 months (four-week gains of $26.9 billion). Asset-backed security issuance is said to be off to a “quick start,” with $7.2 billion sold this week.
Today’s dismal jobs report is further proof of economic weakness going into year-end, but it is arguably more valuable in providing clear evidence of an imbalanced economy becoming even more so. Over the past five months (August to December), the U.S. economy shed 81,000 jobs. The atrophying manufacturing sector lost an alarming 272,000 jobs. The overbuilt Retail sector has seen 101,000 positions lost since August, while the prospering Finance and Insurance sector has added 81,000. The economy has been supported by the continued expansion of “Services,” which added 258,000 jobs since August. Within “Services,” Health Services added 100,000 jobs, while employment increased 56,000 in Education in five months. The economy is also supported by continued growth in the government sector, where 151,000 jobs were added over five months. Since its peak in March 2000, Goods Producing jobs have declined 2.1 million to 23.6 million.
There is growing talk of the benefits the U.S. economy would receive from a weaker dollar (and its inflationary effect). Traditionally, one would expect a meaningful boost from the export sector. We instead see minimal help to a manufacturing base that has come to be a minor player in the maladjusted U.S. economy. In this regard, it is worth noting that the poor Argentine consumer saw prices jump 42% last year, after its currency (and economy) collapsed. Yes, the manufacturing-led economies of SE Asia recovered quickly on the basis of weak currencies and booming exports. But Argentina’s lack of a strong export sector is proving that benefits from currency weakness/crisis depend very much on the structure of the underlying economy.
Here at home, bond market issuance is on fire. According to Bloomberg, $27.8 billion of corporate bonds were issued this week, the strongest sales in 15 months. Combined U.S. corporate and agency debt surged to almost $65 billion this week (year-to-date issuance has already reached $81 billon). And, importantly, as money returns to junk bond funds - and as the crowd rushes back to higher yielding debt instruments - it’s not just top-tier borrowers now enjoying easy access to finance.
We’ll take Tyco’s $4.5 billion issue (raised from $3.75 billion) as a sign that life is returning to the convertible bond market. 2002 issuance was down 49% to $54.5 billion. Elsewhere, Household International sold $1.75 billion of notes (raised from $1.5 billion). The company’s 10-year notes were sold at 175 basis points above Treasuries. This compares to a spread of 250 necessary to sell 10-year notes in late November, and an almost 500 basis point spread on 10-year notes during the scary days of October. The spread is now at about 160. Elsewhere, Cendant doubled the size of its deal to $1.5 billion, Comcast raised $900 million, the Inter-American Development Bank sold $2 billion, DaimlerChrysler $2 billion, ASIF Global Financing (“a special-purpose entity with ties” to AIG) $1.1 billion, and Mexico $2 billion.
Today from Bloomberg: “Shares of Allegheny Energy Inc. rose as much as 18 percent after the Wall Street Journal reported the utility owner is near an agreement with creditors to restructure its debt and avoid bankruptcy.”
January 7 – Bloomberg: “Federal regulators dropped a proposal to require additional quarterly data from lenders that target people with histories of unpaid bills after agreeing with banks that there's no standard definition for such lenders. The Federal Reserve, Office of the Comptroller of the Currency, Federal Deposit Insurance Corp. and the Office of Thrift Supervision said current bank examinations are adequate to monitor the risks taken by so-called subprime lenders.”
On many fronts, things seem to be easing up. It is worth noting that the NASDAQ Telecommunications and Morgan Stanley Technology indices have year-to-date gains of 14%, The Street.com Internet index 15%, and the Philadelphia Semiconductor index 17%. Nextel is up 22% already, Capital One 31%. The weak, financially vulnerable companies are significantly outperforming.
Mixing “macro” analysis with playing the markets can be both fascinating and profitable. It can also be especially dangerous, as the more parlous the macro environment the more likely that inflationary efforts will be undertaken to “reliquefy” the system and stimulate lending and speculating. We reached another of these key inflection points during the fourth quarter and it is becoming increasingly clear that this latest inflationary “reliquefication” is today beginning to take hold. It may not last; it could easily be derailed by a faltering dollar, rising yields, or a myriad of other risks; and it will inevitably prove unsuccessful. But for now, importantly, financing conditions are improving markedly, and this is a major development with respect to company and industry analysis. Such a circumstance has, potentially, the greatest ramifications for the weakest, most leveraged companies and sectors – the marginal borrowers. That many of these marginal companies’ stocks, bonds, and Credit default swaps have attracted over-sized short positions is a dynamic of the current speculative marketplace that makes things all the more volatile and uncertain. And with the market appearing happy to ignore poor earnings releases – while completely dismissing today’s dismal jobs report – we see further evidence the market wants to believe in the unfolding “reflation.”
Yet, unrelenting inflation are the watchwords for the Mortgage Finance Bubble. The Mortgage Bankers Association’s (MBA) weekly Refi application index jumped 29.1% to the highest level in seven weeks (up 245% from the year ago level). Amazingly, this historic refi boom is now in its 29th week and shows little sign of waning. For comparison, both the major refi booms from ‘98 and ’99 lasted about three months. The MBA’s Purchase index remains strong as well, increasing 13% to about equal the year ago elevated level.
Today from Countrywide: “Total fundings of $35.2 billion in December marked another monthly record for Countrywide. Total fundings of $102.1 billion in the fourth quarter produced the first $100 billion quarter in the history of the company. More importantly, year-to-date fundings eclipsed the $250 billion level, 82 percent higher than the $138.2 billion produced in 2001. Total purchase fundings in December grew 71 percent over last year to $8.8 billion, our second best month for purchase mortgages ever. For the full year, purchase fundings reached $86.4 billion, rising 65 percent over last year…Average daily applications remained brisk at $1.9 billion and maintained the pipeline of applications at $49.1 billion. It is noteworthy that these strong operational results were achieved during December, which was affected by the holidays and other seasonal Factors.” Year over year, December e-Commerce fundings were up 79% to $14.7 billion, home equity fundings jumped 64% to $1.2 billion and subprime funds rose 46% to $1.2 billion.
New Age subprime mortgage lender New Century originated a record $1.74 billion of mortgages during December, up 132% y-o-y. Fourth-quarter fundings of $4.47 billion were up 123% y-o-y. The company also stated that it “sees meeting 2003 production estimate of $16 billion,” while also announcing that its credit facilities had been raised to $3.47 billion.
Tuesday the Mortgage Bankers Association (MBA) released their third-quarter National Delinquency Survey. As was widely reported, the number of loans in foreclosure rose from 1.13% to a record 1.15%. “Total Past Due” declined 11 basis points nationally to 4.66%, although “90 days or more” delinquencies added four basis points to an elevated 0.82%. From the MBA: “There’s some good news in this survey. We believe that delinquencies have peaked and, as the economy continues its recovery, the housing market will continue to make its contribution. We believe going forward there will be fewer households facing the harsh economic reality of unemployment that helped to drive up delinquencies and foreclosures in the first two quarters of 2002. Certainly, that could change with any unforeseen circumstances, but all indicators are pointing toward a growing economy and ultimately an improving job market.”
The MBA is almost surely too optimistic. We’ll continue to aver that the data is especially unimpressive considering the record lending volumes and attendant housing inflation. We fully expect things to only get worse going forward. Keep in mind that Home Mortgage debt increased at an annualized rate of $786 billion during the third quarter. This compares to an average of $165 billion annually during the recessionary years 1991 to 1993. When today’s period of extreme Credit profligacy eventually subsides, expect unprecedented foreclosures and losses commensurate with boom-time lending excesses. The real trouble commences when the lending spigot turns from the current gusher to even a previously normal Credit flow.
In a clear sign of serious unfolding problems, the MBA survey reports that 12% of Federal Housing Administration (FHA) loans are either in foreclosure or delinquent. And for the first time, the MBA broke out subprime data, although warning that the 1.2 million unit universe should “not be considered representative of the total subprime market.” All the same, the delinquency and foreclosure numbers are quite alarming and indicative (along with FHA data) of fundamental systemic lending shortcomings. For the nation overall, 14.78% of conventional subprime mortgages were past due, with 8.58% in foreclosure. Some of the worst performing states in terms of total delinquencies include Pennsylvania (17.19%), Indiana (17.16%), Michigan (16.84%), Ohio (16.52%), Iowa (17.3%), Missouri (17.09%), Georgia (16.45%), North Carolina (19.54%), South Carolina (23.12%), West Virginia (17.36%), Alabama (19.76%), Mississippi (23.66%), Arkansas (17.21%), Louisiana (20.64%), Oklahoma (17.04%), Texas (16.45%), and New Mexico (19.05%). Wow…
We continue to be surprised by the degree of deterioration in the face of continued housing inflation and unparalleled Credit availability. Major mortgage insurer MGIC this week reported that total Insured Loans Delinquent increase 41 basis points during the quarter to 4.45%. This compares to 3.46% for 4th quarter 2001 and 2.58% for 4th quarter 2000. Subprime delinquencies increased 30 basis points to 12.68%, compared to 4th Q 2001’s 11.60% and 4th Q 2000’s 9.34%. Year-over-year, Total Loans Delinquent jumped 35%, while Losses Incurred surged from $51.7 million to $140.5 million. The stock surged on what was a dismal earnings report.
And while mortgage Credit inflation runs unabated, the structural nature of the dilemma posed by previous general Credit inflation is becoming more conspicuous.
January 7 – Bloomberg: “Texas, with a budget deficit of $12 billion, has surpassed New York’s $10 billion shortfall to have the second-largest budget gap among U.S. states behind California… State deficits nationwide now total almost $90 billion, the American Legislative Council reported. The council, a bipartisan group of more than 2,400 legislators from all states, predicted two years ago that states would have huge shortfalls, said Bob Adams, council spokesman. ‘The states boosted spending at unsustainable rates during the 1990s,’ Adams said. ‘Budgets increased faster than inflation and faster than the rate of population growth.’ The end of the '90s economic boom left states unable to finance government, he said.”
New York Governor George Patake from his “State of the State” address: “We face a fiscal crisis today of a magnitude that we have not faced in our lifetime.” With personal income tax receipts sinking 14.8% between last April and October, forecasts now call for a state deficit as high as $10 billion over the next 15 months (according to Bloomberg). New York City is facing a $3 billion deficit for the next year.
California Governor Gray Davis from his State of the State Address: “Tonight, I come before you with a challenge as great as any in our state’s history – and a real plan to meet that challenge… On Friday, I will send you one of the toughest budgets ever presented. It will be balanced. It will be responsible. It will make significant cuts in nearly every program. And it will return this state to sound financial footing…my budget will erase the $35-billion shortfall and eliminate the structural deficit… Our current fiscal structure has not been updated in 25 years to reflect either our changing economy or demographics. Our budgets have become painfully dependent upon extremely volatile sources of revenue, constraining our ability to make long-term vital public investments. It’s high time to shake free of this boom-bust syndrome… State government will need to do more with less – and we will. But we also need to do more to create new jobs now and to stimulate our economy… My goal is to help create 500,000 new jobs over the next four years. I’m proposing a new California Jobs plan that will put more Californians to work – not in years, but in weeks. We’ll begin with “Build California” – a new initiative to accelerate the flow of billions of dollars into our economy. Last November, the voters of this state did their part by approving $18 billion in bond measures for better schools, affordable housing and new water projects. In December, I asked the State Allocation Board to expedite $5.5 billion from our new School bond… These funds will finance 1,000 new schools… We will also fast-track our $2.1 billion housing bond… I will also direct my agencies to accelerate freeway and public transit projects by one full year… Moreover, I will recommend that the UC Board of Regents Pension Fund invest in California housing…” (Perhaps this CA deficit problem is not as restrictive on spending as I first imagined…)
Today from Bloomberg: “California, confronting a record $35 billion budget deficit, may borrow for the first time to cover obligations to employee pension funds. Governor Gray Davis and Assembly Speaker Herb Wesson are considering selling pension bonds to raise about $800 million owed to retirement funds for state teachers and other employees, said spokeswomen for Davis and Wesson. States such as New Jersey have used pension bonds to raise money pledged to worker retirement accounts without raising taxes. The borrowers are betting returns achieved by the funds will exceed the cost of the debt and reduce the need to contribute more to the plans later. The risk is that returns lag, leaving the states paying interest on the debt while still having to pump money into the funds.”
Well, the much-coveted “reflation” elixir appears to be off to a gangbusters start. And with the corporate bond market coming to life, the mortgage Credit system continuing to fire on all cylinders, and government borrowing poised for a record year, Team Reflation should be careful for what they wish for. Indeed, the Economic Cycle Research Institute's future inflation gauge monthly index rose to 116.6 in December (up from Dec. 2001's 96.4), the highest level since October 2000.
Recent historic speeches by Ben Bernanke and Alan Greenspan have paid tribute to Milton Friedman’s revisionist analysis that the Fed’s derelict failure to create adequate money supply was a major cause of the Great Depression. Dr. Bernanke noted Friedman’s premise that if (Governor of the New York Federal Reserve Bank) Benjamin Strong would not have died in 1928, it is quite likely that he would have held the “bubble poppers” at bay, while adding sufficient liquidity to thwart deflationary forces: “Friedman and Schwartz argues in their book that if Strong had lived, many of the mistakes of the Great Depression would have been avoided.” I have argued that such post-Bubble policy analysis is generally misdirected, and there’s no need to rehash yet again this week. But I would like to share some interesting (and hopefully pertinent) material found reading through Lester V. Chandler’s 1958 biography – Benjamin Strong Central Banker.
“Never forget that (the Federal Reserve) was created to serve the employer and the working man, the producer and the consumer, the importer and the exporter, the creditor and the debtor; all in the interest of the country as a whole.” (“A reminder written by Benjamin Strong and always kept in the top drawer of his desk.) (page 1)
“The original theory of the Federal Reserve was that it would make money available primarily by rediscounting for its members ‘short-term, self-liquidating commercial paper arising out of the production, distribution, and sale of goods and services.’ …Thus the emphasis was often placed on the quality of paper discounted rather than its quantity… Emphasis shifted inevitably, though slowly, from the quality of paper discounted to its quantity, and from passive accommodation to positive regulation.”
“What no one could foresee, and what would have displeased the Democrats who sponsored the (Federal Reserve) act and so greatly distrusted 'Wall Street,' was that leadership in the System would soon be exercised by an official not even mentioned by title in the act – the Governor of the Federal Reserve Bank of New York, who was a former Wall Street banker.” (page 12)
Reading through Chandler’s detailed account of the creation and early years of the Federal Reserve, I was reminded of the major influence the rampant inflation of 1917-1920 and subsequent deflationary bust had on the young Federal Reserve System. It clearly had a profound effect on Benjamin Strong. I found it fascinating to follow the transformation of a cautious, prudent Strong to that of revolutionary and activist central banker (to the world). It was actually quite similar to the transformation we have witnessed of Alan Greenspan. Financial and economic innovation, rampant financial speculation, and truly extraordinary domestic and international developments made for sweeping, complex changes and issues. Experimental, activist central banking was thought by those in power as the answer. Businessmen, investors and, importantly, the speculators wanted to believe. But in the end the activists absolutely lost control of their experiment and it all ended in disaster.
Interestingly, the young Ben Strong used language such as “the heresies of Greenbackism and fiat money” and stated that “if the United States Government embarks once more upon the expedient or experiment of issuing fiat paper…the day will come when we will deeply regret it.” Strong, along with other founding members of the Fed, saw inflation as an evil that must be fought at considerable cost if necessary. The history of repeated inflationary booms and busts left little room for any other view. I found the following quotes regarding efforts to deal with an inflationary Bubble early after the Fed’s formation especially interesting considering current views on such matters.
During 1919, “everyone was talking about the speculative mania. Speculation there certainly was – speculation in the stock market and in commodities. But this was no mere speculative bubble confined to the surface of the economy. It was a rapid and insistent rise of spendings that penetrated almost every market for goods and services, raising not only prices for output but wages and other costs as well.” (page 136)
Federal Reserve inflation had played a key role in helping finance the war effort, but this inflation had taken on a life of its own. Fed leadership was resolved to conquer the beast.
Adolph C. Miller, economist and founding Federal Reserve Board Governor (served 22 years) in a letter dated February 26, 1919: “The most serious part of inflation is, after all, the aftermath. We sow the wind to reap the whirlwind. Somehow or other we have got to come down off the perch. But this is an uncomfortable process for nearly everybody and, for some, a very costly and ruinous one. We shall be fortunate in this country if we get off without some very serious financial trouble and some very serious political troubles growing out of the currency and credit disorders. That has always been true in the past and I am terribly afraid will be true in the present instance…I am satisfied that the expansion that has gone on throughout the year 1918 and that we shall undoubtedly have during the year 1919, is pretty nearly all pure inflation. On every side the evidence of the demoralization and the serious disturbance of established relationships that this unsettling of prices has brought is at hand… There has got to be liquidation, there can be no question of that.”
Benjamin Strong (letter dated February 6, 1919): “The day of deflation approaches. The process of deflation is a painful one, involving loss, unemployment, bankruptcy and social and political disorders, whereas the process of inflation brings in its train prosperity, employment, rising prices, a happy absence of bankruptcies and general state of contentment, all of which leads me to the point of this letter, namely, that mistakes by the present Treasury Administration from now on will bring retribution of a very certain and definite character which was not likely during the days of war excitement and expansion, but which is now beginning to loom up most definitely during the distasteful days of paying the damages… If inflation is arrested at its present level the readjustment of prices and the losses resulting will be no greater than that now fixed by the existing price level. If inflation continues…the liquidation will be arrested and our later troubles will be the greater. Notwithstanding the hardships and losses resulting, I believe you will agree that it is inevitably necessary that our banking position must be gradually deflated… Our policy in this country has so far been the soundest of any, we have avoided a debasement of our circulating media…”
“…In 1920-21 the Federal Reserve had not yet developed this concept of its functions – to use its powers continuously and positively to promote maximum employment, the highest sustainable rate of economy growth, and stable price levels. Almost unquestionably, it was still operating under a prewar theory of central banking in which the dominant guides to policy were financial rather than economic. The Federal Reserve Act, much influenced by foreign experience and assuming the continued function of an international gold standard, had not intended that a new System should manage money positively and continuously with the prime purpose of achieving some desired behavior of employment, business activity, and prices. Any such suggestion would have been considered heretical. Rather, its dominant purpose should be to assure ‘sound’ financial conditions, which meant first of all maintaining gold payments and avoiding financial crises. A central banker accepting this set of priorities naturally feared inflation more than deflation and insisted that on some occasions deflation was necessary for the attainment of primary financial objectives.” (page 183)
“In May, 1920, inflation gave way to deflation and depression.” It was, indeed, a painful experience and the young Fed came under intense criticism. “…The depression experience had a great influence on (Strong’s) thinking and on future Federal Reserve policies.” “Like most other Federal Reserve officials, he believed that some deflation of bank credit was essential and that some price reductions were inevitable and desirable. Within three years, Strong himself had rejected many of these ideas.” “All this (cautious, passive central banking) was soon to change when Strong and other Federal Reserve officials came to understand and use open-market operations as an instrument of policy… the old standards were soon to be rejected, partly because of the painful experience.”
“No other peacetime period in the history of the System has witnessed a faster development of both Federal Reserve thinking and policies than that starting around the end of 1921 and culminating in 1924… Theirs had now become a philosophy of positive regulation, and they were consciously using their powers to promote high and stable levels of business activity and employment, stability of price levels, and “European monetary reconstruction.” (page 189) “The year 1922 witnessed the first large-scale purchases (open-market purchases of government securities) and the beginning of the use of this instrument for policy purposes.”
From Ben Strong, November 1922: “Since the Federal Reserve System has found its position as a large lender it becomes one of the most important factors in the economic machine because it must, whether it wishes to or not, exercise control over the volume of credit, which in turn has such a far reaching effect upon prices, wages, etc… the Federal Reserve, as the central factor in the control of credit, must rely upon the application of wisdom and intelligence of the first order. There are no automatic penalties which would apply as in ordinary times to an orgy. In view of that, students of the System should watch it, criticize its affairs, protect it against invasion from political or other sources…” (page 199)
“From Ben Strong, July 1923: “Our job is credit. It makes no difference if it’s a deposit or a bank note. If we regulate and keep fairly constant the volume of this credit, - always with due regard to gold imports and exports…- we are doing our whole duty.” (page 202)
It would appear that Benjamin Strong’s heart was in the right place, but also fair to say he had no idea at the time how this powerful new mechanism would fuel asset inflation and foster a dangerous Wall Street speculative Bubble. How financial Credit, once unleashed, would prove impossible to contain. “The easy-money policy of 1924 was of historic importance. It was the first large and aggressive easing action deliberately taken by the Federal Reserve for the purposes of combating a decline of price levels and business activity and of encouraging international capital flows.” (page 241) Repeated interventions were deemed necessary, including the historic aggressive easing of monetary conditions to assist the Bank of England during 1927. With each liquidity injection, the flood of finance to New York only quickened. Each year the speculators become more emboldened and the maladjusted economy more distorted. By the arrival of 1929, the Fed was faced with a radically imbalanced system, with goods and commodity prices moving in one direction and asset prices in another; some sectors of the economy overheated, many turning very weak. The Fed attempted to manage systemic liquidity and the quantity of credit creation, but it had become hopelessly impotent in directing finance to productive purposes. Speculative finance had come to dominate. Benjamin Strong and the Fed, in their effort to do too much, had completely lost control.
Adolph Miller, in 1931, regarding the Fed's aggressive 1927 operations: “…it was the greatest and boldest operation ever undertaken by the Federal Reserve system, and, in my judgment, resulted in one of the most costly errors committed by it or any other banking system in the last 75 years. I am inclined to think that a different policy at that time would have left us with a different condition at this time.” (page 438)
Most Depression era economists and analysts held similar views to Miller: Fed operations had fueled a most dangerous strain of inflation and precarious speculative Bubble. Even Alan Greenspan in the sixties spoke of the Depression as a result of the Fed repeatedly putting “coins in the fuse box.” (The Transformation of Alan Greenspan.) Yet, Milton Friedman’s revisionist analysis pinning the blame on the post-Bubble Fed for not creating sufficient money supply was what people wanted to hear in the early sixties. It, today, clearly suits Greenspan, the Fed and Wall Street just fine.
“The philosophy of the American government of (Strong’s) day was not, of course, the classical one of laissez-faire, but it was certainly one of limited objectives and limited intervention in economic affairs. No government during the period would have seriously considered assuming the heavy responsibilities that have now become commonplace. Nor would it have expected the central bank to do so. Such ideas were alien to those responsible for the establishment of the Federal Reserve System. They assumed that the new System, like the government, would be one of limited objectives and limited intervention. Of course they expected it to prevent crises and panics and to reform the banking system in several other respects. But they foresaw neither the need nor the opportunity for any basic modification of the functioning of the international gold standard. They saw no need because they were pleased with the gold standard… Strong was among the first to recognize that the old rules of central banking, which implicitly assumed a smoothly functioning international gold standard, were obsolete and that radically new concepts of central banking would have to be developed.” (page 477)
The Transformation of Benjamin Strong, the transformation of monetary regimes, the transformation of economics, and the transformation to everlasting inflation.
On many fronts, things seem to be easing up. It is worth noting that the NASDAQ Telecommunications and Morgan Stanley Technology indices have year-to-date gains of 14%, The Street.com Internet index 15%, and the Philadelphia Semiconductor index 17%. Nextel is up 22% already, Capital One 31%. The weak, financially vulnerable companies are significantly outperforming.
Mixing “macro” analysis with playing the markets can be both fascinating and profitable. It can also be especially dangerous, as the more parlous the macro environment the more likely that inflationary efforts will be undertaken to “reliquefy” the system and stimulate lending and speculating. We reached another of these key inflection points during the fourth quarter and it is becoming increasingly clear that this latest inflationary “reliquefication” is today beginning to take hold. It may not last; it could easily be derailed by a faltering dollar, rising yields, or a myriad of other risks; and it will inevitably prove unsuccessful. But for now, importantly, financing conditions are improving markedly, and this is a major development with respect to company and industry analysis. Such a circumstance has, potentially, the greatest ramifications for the weakest, most leveraged companies and sectors – the marginal borrowers. That many of these marginal companies’ stocks, bonds, and Credit default swaps have attracted over-sized short positions is a dynamic of the current speculative marketplace that makes things all the more volatile and uncertain. And with the market appearing happy to ignore poor earnings releases – while completely dismissing today’s dismal jobs report – we see further evidence the market wants to believe in the unfolding “reflation.”
Yet, unrelenting inflation are the watchwords for the Mortgage Finance Bubble. The Mortgage Bankers Association’s (MBA) weekly Refi application index jumped 29.1% to the highest level in seven weeks (up 245% from the year ago level). Amazingly, this historic refi boom is now in its 29th week and shows little sign of waning. For comparison, both the major refi booms from ‘98 and ’99 lasted about three months. The MBA’s Purchase index remains strong as well, increasing 13% to about equal the year ago elevated level.
Today from Countrywide: “Total fundings of $35.2 billion in December marked another monthly record for Countrywide. Total fundings of $102.1 billion in the fourth quarter produced the first $100 billion quarter in the history of the company. More importantly, year-to-date fundings eclipsed the $250 billion level, 82 percent higher than the $138.2 billion produced in 2001. Total purchase fundings in December grew 71 percent over last year to $8.8 billion, our second best month for purchase mortgages ever. For the full year, purchase fundings reached $86.4 billion, rising 65 percent over last year…Average daily applications remained brisk at $1.9 billion and maintained the pipeline of applications at $49.1 billion. It is noteworthy that these strong operational results were achieved during December, which was affected by the holidays and other seasonal Factors.” Year over year, December e-Commerce fundings were up 79% to $14.7 billion, home equity fundings jumped 64% to $1.2 billion and subprime funds rose 46% to $1.2 billion.
New Age subprime mortgage lender New Century originated a record $1.74 billion of mortgages during December, up 132% y-o-y. Fourth-quarter fundings of $4.47 billion were up 123% y-o-y. The company also stated that it “sees meeting 2003 production estimate of $16 billion,” while also announcing that its credit facilities had been raised to $3.47 billion.
Tuesday the Mortgage Bankers Association (MBA) released their third-quarter National Delinquency Survey. As was widely reported, the number of loans in foreclosure rose from 1.13% to a record 1.15%. “Total Past Due” declined 11 basis points nationally to 4.66%, although “90 days or more” delinquencies added four basis points to an elevated 0.82%. From the MBA: “There’s some good news in this survey. We believe that delinquencies have peaked and, as the economy continues its recovery, the housing market will continue to make its contribution. We believe going forward there will be fewer households facing the harsh economic reality of unemployment that helped to drive up delinquencies and foreclosures in the first two quarters of 2002. Certainly, that could change with any unforeseen circumstances, but all indicators are pointing toward a growing economy and ultimately an improving job market.”
The MBA is almost surely too optimistic. We’ll continue to aver that the data is especially unimpressive considering the record lending volumes and attendant housing inflation. We fully expect things to only get worse going forward. Keep in mind that Home Mortgage debt increased at an annualized rate of $786 billion during the third quarter. This compares to an average of $165 billion annually during the recessionary years 1991 to 1993. When today’s period of extreme Credit profligacy eventually subsides, expect unprecedented foreclosures and losses commensurate with boom-time lending excesses. The real trouble commences when the lending spigot turns from the current gusher to even a previously normal Credit flow.
In a clear sign of serious unfolding problems, the MBA survey reports that 12% of Federal Housing Administration (FHA) loans are either in foreclosure or delinquent. And for the first time, the MBA broke out subprime data, although warning that the 1.2 million unit universe should “not be considered representative of the total subprime market.” All the same, the delinquency and foreclosure numbers are quite alarming and indicative (along with FHA data) of fundamental systemic lending shortcomings. For the nation overall, 14.78% of conventional subprime mortgages were past due, with 8.58% in foreclosure. Some of the worst performing states in terms of total delinquencies include Pennsylvania (17.19%), Indiana (17.16%), Michigan (16.84%), Ohio (16.52%), Iowa (17.3%), Missouri (17.09%), Georgia (16.45%), North Carolina (19.54%), South Carolina (23.12%), West Virginia (17.36%), Alabama (19.76%), Mississippi (23.66%), Arkansas (17.21%), Louisiana (20.64%), Oklahoma (17.04%), Texas (16.45%), and New Mexico (19.05%). Wow…
We continue to be surprised by the degree of deterioration in the face of continued housing inflation and unparalleled Credit availability. Major mortgage insurer MGIC this week reported that total Insured Loans Delinquent increase 41 basis points during the quarter to 4.45%. This compares to 3.46% for 4th quarter 2001 and 2.58% for 4th quarter 2000. Subprime delinquencies increased 30 basis points to 12.68%, compared to 4th Q 2001’s 11.60% and 4th Q 2000’s 9.34%. Year-over-year, Total Loans Delinquent jumped 35%, while Losses Incurred surged from $51.7 million to $140.5 million. The stock surged on what was a dismal earnings report.
And while mortgage Credit inflation runs unabated, the structural nature of the dilemma posed by previous general Credit inflation is becoming more conspicuous.
January 7 – Bloomberg: “Texas, with a budget deficit of $12 billion, has surpassed New York’s $10 billion shortfall to have the second-largest budget gap among U.S. states behind California… State deficits nationwide now total almost $90 billion, the American Legislative Council reported. The council, a bipartisan group of more than 2,400 legislators from all states, predicted two years ago that states would have huge shortfalls, said Bob Adams, council spokesman. ‘The states boosted spending at unsustainable rates during the 1990s,’ Adams said. ‘Budgets increased faster than inflation and faster than the rate of population growth.’ The end of the '90s economic boom left states unable to finance government, he said.”
New York Governor George Patake from his “State of the State” address: “We face a fiscal crisis today of a magnitude that we have not faced in our lifetime.” With personal income tax receipts sinking 14.8% between last April and October, forecasts now call for a state deficit as high as $10 billion over the next 15 months (according to Bloomberg). New York City is facing a $3 billion deficit for the next year.
California Governor Gray Davis from his State of the State Address: “Tonight, I come before you with a challenge as great as any in our state’s history – and a real plan to meet that challenge… On Friday, I will send you one of the toughest budgets ever presented. It will be balanced. It will be responsible. It will make significant cuts in nearly every program. And it will return this state to sound financial footing…my budget will erase the $35-billion shortfall and eliminate the structural deficit… Our current fiscal structure has not been updated in 25 years to reflect either our changing economy or demographics. Our budgets have become painfully dependent upon extremely volatile sources of revenue, constraining our ability to make long-term vital public investments. It’s high time to shake free of this boom-bust syndrome… State government will need to do more with less – and we will. But we also need to do more to create new jobs now and to stimulate our economy… My goal is to help create 500,000 new jobs over the next four years. I’m proposing a new California Jobs plan that will put more Californians to work – not in years, but in weeks. We’ll begin with “Build California” – a new initiative to accelerate the flow of billions of dollars into our economy. Last November, the voters of this state did their part by approving $18 billion in bond measures for better schools, affordable housing and new water projects. In December, I asked the State Allocation Board to expedite $5.5 billion from our new School bond… These funds will finance 1,000 new schools… We will also fast-track our $2.1 billion housing bond… I will also direct my agencies to accelerate freeway and public transit projects by one full year… Moreover, I will recommend that the UC Board of Regents Pension Fund invest in California housing…” (Perhaps this CA deficit problem is not as restrictive on spending as I first imagined…)
Today from Bloomberg: “California, confronting a record $35 billion budget deficit, may borrow for the first time to cover obligations to employee pension funds. Governor Gray Davis and Assembly Speaker Herb Wesson are considering selling pension bonds to raise about $800 million owed to retirement funds for state teachers and other employees, said spokeswomen for Davis and Wesson. States such as New Jersey have used pension bonds to raise money pledged to worker retirement accounts without raising taxes. The borrowers are betting returns achieved by the funds will exceed the cost of the debt and reduce the need to contribute more to the plans later. The risk is that returns lag, leaving the states paying interest on the debt while still having to pump money into the funds.”
Well, the much-coveted “reflation” elixir appears to be off to a gangbusters start. And with the corporate bond market coming to life, the mortgage Credit system continuing to fire on all cylinders, and government borrowing poised for a record year, Team Reflation should be careful for what they wish for. Indeed, the Economic Cycle Research Institute's future inflation gauge monthly index rose to 116.6 in December (up from Dec. 2001's 96.4), the highest level since October 2000.
Recent historic speeches by Ben Bernanke and Alan Greenspan have paid tribute to Milton Friedman’s revisionist analysis that the Fed’s derelict failure to create adequate money supply was a major cause of the Great Depression. Dr. Bernanke noted Friedman’s premise that if (Governor of the New York Federal Reserve Bank) Benjamin Strong would not have died in 1928, it is quite likely that he would have held the “bubble poppers” at bay, while adding sufficient liquidity to thwart deflationary forces: “Friedman and Schwartz argues in their book that if Strong had lived, many of the mistakes of the Great Depression would have been avoided.” I have argued that such post-Bubble policy analysis is generally misdirected, and there’s no need to rehash yet again this week. But I would like to share some interesting (and hopefully pertinent) material found reading through Lester V. Chandler’s 1958 biography – Benjamin Strong Central Banker.
“Never forget that (the Federal Reserve) was created to serve the employer and the working man, the producer and the consumer, the importer and the exporter, the creditor and the debtor; all in the interest of the country as a whole.” (“A reminder written by Benjamin Strong and always kept in the top drawer of his desk.) (page 1)
“The original theory of the Federal Reserve was that it would make money available primarily by rediscounting for its members ‘short-term, self-liquidating commercial paper arising out of the production, distribution, and sale of goods and services.’ …Thus the emphasis was often placed on the quality of paper discounted rather than its quantity… Emphasis shifted inevitably, though slowly, from the quality of paper discounted to its quantity, and from passive accommodation to positive regulation.”
“What no one could foresee, and what would have displeased the Democrats who sponsored the (Federal Reserve) act and so greatly distrusted 'Wall Street,' was that leadership in the System would soon be exercised by an official not even mentioned by title in the act – the Governor of the Federal Reserve Bank of New York, who was a former Wall Street banker.” (page 12)
Reading through Chandler’s detailed account of the creation and early years of the Federal Reserve, I was reminded of the major influence the rampant inflation of 1917-1920 and subsequent deflationary bust had on the young Federal Reserve System. It clearly had a profound effect on Benjamin Strong. I found it fascinating to follow the transformation of a cautious, prudent Strong to that of revolutionary and activist central banker (to the world). It was actually quite similar to the transformation we have witnessed of Alan Greenspan. Financial and economic innovation, rampant financial speculation, and truly extraordinary domestic and international developments made for sweeping, complex changes and issues. Experimental, activist central banking was thought by those in power as the answer. Businessmen, investors and, importantly, the speculators wanted to believe. But in the end the activists absolutely lost control of their experiment and it all ended in disaster.
Interestingly, the young Ben Strong used language such as “the heresies of Greenbackism and fiat money” and stated that “if the United States Government embarks once more upon the expedient or experiment of issuing fiat paper…the day will come when we will deeply regret it.” Strong, along with other founding members of the Fed, saw inflation as an evil that must be fought at considerable cost if necessary. The history of repeated inflationary booms and busts left little room for any other view. I found the following quotes regarding efforts to deal with an inflationary Bubble early after the Fed’s formation especially interesting considering current views on such matters.
During 1919, “everyone was talking about the speculative mania. Speculation there certainly was – speculation in the stock market and in commodities. But this was no mere speculative bubble confined to the surface of the economy. It was a rapid and insistent rise of spendings that penetrated almost every market for goods and services, raising not only prices for output but wages and other costs as well.” (page 136)
Federal Reserve inflation had played a key role in helping finance the war effort, but this inflation had taken on a life of its own. Fed leadership was resolved to conquer the beast.
Adolph C. Miller, economist and founding Federal Reserve Board Governor (served 22 years) in a letter dated February 26, 1919: “The most serious part of inflation is, after all, the aftermath. We sow the wind to reap the whirlwind. Somehow or other we have got to come down off the perch. But this is an uncomfortable process for nearly everybody and, for some, a very costly and ruinous one. We shall be fortunate in this country if we get off without some very serious financial trouble and some very serious political troubles growing out of the currency and credit disorders. That has always been true in the past and I am terribly afraid will be true in the present instance…I am satisfied that the expansion that has gone on throughout the year 1918 and that we shall undoubtedly have during the year 1919, is pretty nearly all pure inflation. On every side the evidence of the demoralization and the serious disturbance of established relationships that this unsettling of prices has brought is at hand… There has got to be liquidation, there can be no question of that.”
Benjamin Strong (letter dated February 6, 1919): “The day of deflation approaches. The process of deflation is a painful one, involving loss, unemployment, bankruptcy and social and political disorders, whereas the process of inflation brings in its train prosperity, employment, rising prices, a happy absence of bankruptcies and general state of contentment, all of which leads me to the point of this letter, namely, that mistakes by the present Treasury Administration from now on will bring retribution of a very certain and definite character which was not likely during the days of war excitement and expansion, but which is now beginning to loom up most definitely during the distasteful days of paying the damages… If inflation is arrested at its present level the readjustment of prices and the losses resulting will be no greater than that now fixed by the existing price level. If inflation continues…the liquidation will be arrested and our later troubles will be the greater. Notwithstanding the hardships and losses resulting, I believe you will agree that it is inevitably necessary that our banking position must be gradually deflated… Our policy in this country has so far been the soundest of any, we have avoided a debasement of our circulating media…”
“…In 1920-21 the Federal Reserve had not yet developed this concept of its functions – to use its powers continuously and positively to promote maximum employment, the highest sustainable rate of economy growth, and stable price levels. Almost unquestionably, it was still operating under a prewar theory of central banking in which the dominant guides to policy were financial rather than economic. The Federal Reserve Act, much influenced by foreign experience and assuming the continued function of an international gold standard, had not intended that a new System should manage money positively and continuously with the prime purpose of achieving some desired behavior of employment, business activity, and prices. Any such suggestion would have been considered heretical. Rather, its dominant purpose should be to assure ‘sound’ financial conditions, which meant first of all maintaining gold payments and avoiding financial crises. A central banker accepting this set of priorities naturally feared inflation more than deflation and insisted that on some occasions deflation was necessary for the attainment of primary financial objectives.” (page 183)
“In May, 1920, inflation gave way to deflation and depression.” It was, indeed, a painful experience and the young Fed came under intense criticism. “…The depression experience had a great influence on (Strong’s) thinking and on future Federal Reserve policies.” “Like most other Federal Reserve officials, he believed that some deflation of bank credit was essential and that some price reductions were inevitable and desirable. Within three years, Strong himself had rejected many of these ideas.” “All this (cautious, passive central banking) was soon to change when Strong and other Federal Reserve officials came to understand and use open-market operations as an instrument of policy… the old standards were soon to be rejected, partly because of the painful experience.”
“No other peacetime period in the history of the System has witnessed a faster development of both Federal Reserve thinking and policies than that starting around the end of 1921 and culminating in 1924… Theirs had now become a philosophy of positive regulation, and they were consciously using their powers to promote high and stable levels of business activity and employment, stability of price levels, and “European monetary reconstruction.” (page 189) “The year 1922 witnessed the first large-scale purchases (open-market purchases of government securities) and the beginning of the use of this instrument for policy purposes.”
From Ben Strong, November 1922: “Since the Federal Reserve System has found its position as a large lender it becomes one of the most important factors in the economic machine because it must, whether it wishes to or not, exercise control over the volume of credit, which in turn has such a far reaching effect upon prices, wages, etc… the Federal Reserve, as the central factor in the control of credit, must rely upon the application of wisdom and intelligence of the first order. There are no automatic penalties which would apply as in ordinary times to an orgy. In view of that, students of the System should watch it, criticize its affairs, protect it against invasion from political or other sources…” (page 199)
“From Ben Strong, July 1923: “Our job is credit. It makes no difference if it’s a deposit or a bank note. If we regulate and keep fairly constant the volume of this credit, - always with due regard to gold imports and exports…- we are doing our whole duty.” (page 202)
It would appear that Benjamin Strong’s heart was in the right place, but also fair to say he had no idea at the time how this powerful new mechanism would fuel asset inflation and foster a dangerous Wall Street speculative Bubble. How financial Credit, once unleashed, would prove impossible to contain. “The easy-money policy of 1924 was of historic importance. It was the first large and aggressive easing action deliberately taken by the Federal Reserve for the purposes of combating a decline of price levels and business activity and of encouraging international capital flows.” (page 241) Repeated interventions were deemed necessary, including the historic aggressive easing of monetary conditions to assist the Bank of England during 1927. With each liquidity injection, the flood of finance to New York only quickened. Each year the speculators become more emboldened and the maladjusted economy more distorted. By the arrival of 1929, the Fed was faced with a radically imbalanced system, with goods and commodity prices moving in one direction and asset prices in another; some sectors of the economy overheated, many turning very weak. The Fed attempted to manage systemic liquidity and the quantity of credit creation, but it had become hopelessly impotent in directing finance to productive purposes. Speculative finance had come to dominate. Benjamin Strong and the Fed, in their effort to do too much, had completely lost control.
Adolph Miller, in 1931, regarding the Fed's aggressive 1927 operations: “…it was the greatest and boldest operation ever undertaken by the Federal Reserve system, and, in my judgment, resulted in one of the most costly errors committed by it or any other banking system in the last 75 years. I am inclined to think that a different policy at that time would have left us with a different condition at this time.” (page 438)
Most Depression era economists and analysts held similar views to Miller: Fed operations had fueled a most dangerous strain of inflation and precarious speculative Bubble. Even Alan Greenspan in the sixties spoke of the Depression as a result of the Fed repeatedly putting “coins in the fuse box.” (The Transformation of Alan Greenspan.) Yet, Milton Friedman’s revisionist analysis pinning the blame on the post-Bubble Fed for not creating sufficient money supply was what people wanted to hear in the early sixties. It, today, clearly suits Greenspan, the Fed and Wall Street just fine.
“The philosophy of the American government of (Strong’s) day was not, of course, the classical one of laissez-faire, but it was certainly one of limited objectives and limited intervention in economic affairs. No government during the period would have seriously considered assuming the heavy responsibilities that have now become commonplace. Nor would it have expected the central bank to do so. Such ideas were alien to those responsible for the establishment of the Federal Reserve System. They assumed that the new System, like the government, would be one of limited objectives and limited intervention. Of course they expected it to prevent crises and panics and to reform the banking system in several other respects. But they foresaw neither the need nor the opportunity for any basic modification of the functioning of the international gold standard. They saw no need because they were pleased with the gold standard… Strong was among the first to recognize that the old rules of central banking, which implicitly assumed a smoothly functioning international gold standard, were obsolete and that radically new concepts of central banking would have to be developed.” (page 477)
The Transformation of Benjamin Strong, the transformation of monetary regimes, the transformation of economics, and the transformation to everlasting inflation.
