01/19/2001 There's a New Sheriff Making His Way to Town *

It was another week of destabilized financial markets. What else is new? For the week, the Dow gained 1% and the S&P500 added 2%. The Morgan Stanley Cyclical index was unchanged, the Morgan Stanley Consumer index dropped 1%, and the Transports declined 2%. The Utilities added 2%. Interestingly, the small cap Russell 2000 was unchanged and the S&P400 Mid-Cap index declined 1%. It was, of course, a big week for the technology sector with the NASDAQ100 adding 6%, the Morgan Stanley Technology index 9%, and the Semiconductors 7%. Year-to-date, these indices have gained 13%, 21%, and 25%. The Street.com Internet index gained 6% and the NASDAQ Telecommunications index added 5%, increasing year-to-date gains to 27% and 21%. The Biotechs have not been as fortunate, posting a loss of 1% this week. The financial stocks were unimpressive, with the S&P Bank index declining 1% and the Securities Broker/Dealers adding 1%. Gold stocks were generally unchanged.

It was another very volatile week in the credit market, with yields dropping considerably once again. Two and five year yields dropped 16 basis points, while the bellwether 10-year Treasury yield declined 8 basis points. The long-bond saw its yield drop 7 basis points to 5.55%. Mortgage yields declined in line with Treasuries, with the yield on the benchmark Fannie Mae mortgage-backs dropping 9 basis points to 6.78%. Agency yields generally declined 7 basis points, while the benchmark 10-year dollar swap spread was unchanged at 90. The dollar index enjoyed a rally of about one and one-half percent. Energy markets were wild again this week, with natural gas prices declining about $1 (to $7), while crude surged more than $2 to end the week back above $32. Broad money supply expanded another $15 billion last week, making its growth $176 billion in 7 weeks.

“A pathetic side of the manipulation of credit in modern times is that the owners of capital, especially the little capitalists, are swept into a pool of adventure, in which the actual lending of the capital is on a great scale and performed by central agencies alleged to be so expert in debt-trading that it is better to entrust all to them. In this way loans are made and debtors accommodated, representing risks that the owner of the money, were he lending directly, would never dream of taking. It is supposed that the great professional lenders are vastly experienced, and possess almost magical discretion. The truth is that these pompous egotists throw money around, in prosperous times, with as much abandon as though it were confetti.” Freeman Tilden, A World In Debt, 1935

“The modern world, however, boasts of the extent of its manipulation of “credit facilities,” and announces that one unit of actual coin or convertible currency can be made to support thirty or even forty units of credit. So that, soon after the depression began in 1929, the President of the United States, Mr. Hoover, was found begging his people not to hoard money, for by doing so they were destroying, for every dollar so hoarded, many dollars of invaluable credit. Of course they were. What did the great manipulators of credit suppose would happen when they had piled obligation upon obligation in an inverted pyramid that rested upon the final right of some original creditor to claim the wealth he had lent to his debtor? Did they think the time would never come when, from panic brought on by a sense of the topheaviness of the structure, the actual owners of the goods would suddenly say ‘Pay me’? Freeman Tilden, A World In Debt, 1935

“It is the fear of capital for its safety that precipitates a panic, and it is the attendant rush to cancel debt that brings about the ensuing depression. It follows that any scheme looking toward the avoidance of panics and depressions must deal with this cause; and any plan that does not do so is not only idle, but may be a dangerous adventure. Hence, the way to deal with a collapse of exchange is not to pretend that “prosperity” is merely in a temporary eclipse, to return again if everybody will act optimistically; but frankly to acknowledge that conditions were unsound, and permit the natural impulses of trade to rectify them. This prescribes a bitter medicine, which people do not like and politicians cannot collect upon; but quack remedies merely put off the final day of reckoning.

The natural remedies, if the credit-sickness be far advanced, will always include a redistribution of wealth: the further it is postpones, the more violent it will be. Every collapse of credit expansion is a bankruptcy, and the magnitude of the bankruptcy will be proportionate to the magnitude of the debt debauch. In bankruptcies, creditors must suffer.” Freeman Tilden, A World In Debt, 1935

“While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy. The bursting of the Japanese bubble a decade ago did not lead immediately to sharp contractions in output or a significant rise in unemployment. Arguably, it was the subsequent failure to address the damage to the financial system in a timely manner that caused Japan’s current economic problems. Likewise, while the stock market crash of 1929 was destabilizing, most analyst attribute the Great Depression to ensuing failures of policy. And certainly the crash of October 1987 left little lasting imprint on the American economy.” Alan Greenspan, June 17, 1999

There is not one paragraph from the volumes of Greenspan material that I have read that I ponder more than the above. Somehow, monetary policy has regressed to the point of complete disregard for financial and economic excess. Why worry about a boom, when there is always monetary policy to insure against a bust. Why worry about poor and excessive lending when monetary policy is always available to make the reckless lenders whole? Why worry about the type of investment funded by the lenders, when new lending capacity can be created as easy as “the Federal Reserve reduces interest rates by 50 basis points”? For Greenspan, as well as Wall Street, “the answer” can always be found with accommodative monetary policy. Lower rates, create a positive yield curve, and “free money” is created out of thin air. Keep the leveraged financial players in the game, credit remains available, and a perpetual boom is assured.

The foundation of this faith was laid with the monetary accommodation after the 1987 stock market crash. The cure for the early 1990s S&L debacle and severe bank problems (significantly exacerbated by late 80’s “easy money”) was a bout of extreme monetary accommodation, as well as the resulting boom in non-bank credit creation. The heavy cost of this policy was unprecedented leveraged speculation in the U.S. credit market (and emerging markets). 1994 ushered in the inevitable crisis of “deleveraging” in the credit market, the Orange County bankruptcy, and the Mexican collapse (direct consequences of previous “ultra easy money”) and the “answer” was found in truly negligent accommodation of egregious credit and speculative excess. That time around, the cost manifested into endemic leveraging, especially in emerging markets, as the global financial system was left as “free game” for the leveraged speculating community. This, of course, led us to the spectacular booms turned domino collapse throughout SE Asia, Russia, emerging markets generally, and LTCM. With the global economy and financial system at the greatest risk since in a generation, the “natural” response was to through caution to the wind. The consequence was the historic Internet/telecom/technology speculative bubble that burst last year. But, once again, “the consequences need not be catastrophic,” with lower interest rates and the accommodation of whatever credit growth Wall Street sees fit in creating to help to let the air out easily.

Well, it sure seems like we’ve witnessed a lifetime of financial crises over the past 13 or so years. And, ominously, each crisis only comes more quickly and in greater dimensions than the one before. Why is there no recognition that the Greenspan Fed is perpetrating an absolutely failed policy, and that this is culminating in what is clearly a potential disaster? Mr. Greenspan may believe that he is masterfully letting the air out of the tech bubble, but he apparently remains oblivious to a very precarious “big picture”: his policies continue to nurture a massive credit bubble that is being pumped up by the day to truly unprecedented dimensions. The questions to be considered now are how long this period of “reliquefication” continues, the character and degree of the manifestations from this credit inflation, and the scope of the inevitable bust.

The Internet/telecom bubble lasted about 18 months. One characteristic of contemporary finance is the alarming degree of excess and resulting financial and economic damage that can be propagated in a relatively short period of time. This fact apparently does not enter into Greenspan’s thinking as he is locked in a negligent strategy of “accommodating” the latest crisis, over and over and over. Today, he recklessly accommodates what we view as the terminal stage of consumer credit excess. And just as the bulls spouted nonsense during the ridiculous Internet/NASDAQ boom, they are right back at their favorite game. Listening to the bulls, one is left to believe that it is “business as usual” as an enlightened Federal Reserve again ensures Endless Summer - the next leg in a perpetual bull market in what is without a doubt Permanent Prosperity. Isn’t life a dream… But in reality there is no such thing as a “free lunch” from the Fed, only a more conspicuous and precarious bubble. While this highly effective mechanism does create astonishing “liquidity” to perpetuate this fateful credit bubble, this is only “debt piled on debt.” This tenuous structure is made only more fragile by the very poor quality of current lending.

For this “round,” of reliquefication, it should be recognized that it is the consumer that is now being buried as he/she adds to the mountain of mortgage and installment debt. The costs will be devastating for so many in what is an absolute tragedy. In the words of the brilliant Freeman Tilden, we are witnessing a very “pathetic side of the manipulation of credit…” Why has the Japanese experience of burying the consumer sector in mortgage debt been completely ignored by our policy makers? Despite extremely low interest rates, the cautious Japanese consumer saves and shuns debt more than a decade after the bursting of the Japanese bubble. This is overwhelmingly the key to understanding the protracted stagnation in Japan.

Fourth quarter numbers are in, and there is certainly no stagnation at Freddie Mac, as the government-sponsored enterprise (GSE) expanded its mortgage portfolio at a 29% annualized rate ($25.8 billion). As expected, it was Freddie’s most aggressive expansion since the historic fourth quarter (reliquefication) of 1998. Fannie and Freddie combined to expand assets during the fourth quarter by $63 billion, a 24% growth rate. These two behemoths increased assets by $113 billion during the second half (22% rate) compared to $60 billion during the first half (12%). Interestingly, money market fund assets expanded at about 8% during the first half and then accelerated to 21% during the second half. Could the close correlation between money fund assets and GSE balance sheets be mere coincidence? Nope.

There were interesting comments from a key Federal Reserve policy maker highlighted in an article yesterday by Deborah Lagomarsino of BridgeNews: “Turning to the issue of financial market soundness, (St. Louis Federal Reserve Bank President William) Poole repeated that the United States needs to ‘make clear the extent’ of federal guarantees for government sponsored enterprises (GSEs). Poole did not name them specifically, but these include such housing-related entities as Fannie Mae and Freddie Mac. While the debts of GSEs carry no explicit guarantee, the market prices these obligations ‘as if there is a federal guarantee,’ Poole said. ‘Should there be an unpredicted shock of some sort to one of these firms, the likely outcome is substantial market disruption as a consequence of the uncertainty over the government's role,’ he said. ‘Congress ought to examine carefully whether the GSEs are managing their affairs in a way that is consistent with the inherent risks they face,’ he said.” Is the Fed getting nervous? It ought to be.

Reckless lending, however, is anything but limited to the GSEs. MBNA, the largest publicly traded credit card lender, increased loans during the quarter by $4.1 billion, a 20% annualized rate. For the entire year, the company increased “managed loans” by a record $16.5 billion (23%) to $88.8 billion. Total assets (a large portion of loans are securitized and sold) increased 25% to almost $39 billion. MBNA added 2.2 million new accounts during the fourth quarter. From the earnings release: “Charlie Cawley, president of MBNA, said, ‘We have completed the best quarter in our history. MBNA has produced earnings increases, averaging 25%, in each of the 40 quarters since we became a public company…” It is sure a lot easier to produce earnings by lending money than it is by producing products…

Subprime credit card issued Providian increased loans by $3 billion during the fourth quarter, an annualized growth rate of 50%. “For the full year 2000, total managed credit card loans increased 42% over year-end 1999.” There were 1.3 million new accounts during the fourth quarter and for the year new accounts increased by 31% to 16.3 million. Importantly, however, there is now clear trouble on the horizon with charge-offs jumping to a rate of 8.48% compared to 7.61% during the third quarter and 6.78% during the year ago fourth quarter. All the same, the company continues to give guidance for 35% loan growth for 2001. Providian ended the year with total assets of $18.1 billion (up 26% for 2000) supported by shareholder’s equity of $2 billion. The bulls continue to trumpet the rates customers are willing to pay on Providian cards. We continue to suspect that Providian books a lot of revenues that it will never collect.

To fund a ballooning balance sheet of risky subprime credit card loans, Providian has raised $13 billion of deposits. From the company’s website: “Providian offers safe, FDIC-insured deposit accounts that consistently pay among the top rates available nationally. Open your account online and get started saving today…Providian CDs are a worry-free way to earn excellent returns and diversify your portfolio.” And for you big spenders, “Providian has two banks; your total deposits are insured up to $100,000 per accountholder, per bank.” FDIC insurance hard at work…

And then there’s Capital One. The company reported that it added 4.3 million net new accounts during the quarter – yes, the quarter. Adding on average more than 47,000 new accounts daily, CapOne ended the year with 33.8 million accounts. “Managed consumer loan balances” increased $5.4 billion during the quarter to $29.5 billion, about double estimates. This 22% increase for the quarter translates to an 88% annualized rate, yes, 88%. From a Wall Street research report: “COF noted that portfolio growth in the quarter was enjoyed in all three segments (superprime, prime and subprime), with a bias towards superprime on the strength of the company’s recently launched 0% purchase teaser program. Management also stated the prime segment increased “significantly” for the first time in the last few years. Also of note, management indicated that the recently formed alliance with K-Mart has already generated in excess of 1 million new accounts since mid-September.” I don’t make this stuff up…

Elsewhere, Household International added $4.2 billion of “managed receivables,” a growth rate of about 20%. For the year, receivables grew 22%. “Growth within the quarter was strong across all consumer product lines, most notably in real estate secured and MasterCard/Visa receivables.” New home equity loans totaled $1.3 billion.



And then there is AmeriCredit, “a sub-prime auto finance company headquartered in Fort Worth, Texas, which makes loans to consumers with blemished credit histories – a market with approximately $100 billion in annual originations. The company has developed proprietary scoring and collection tools that have enabled it to be the only sub-prime finance company to not miss an earnings estimate or have credit problems since entering the indirect auto finance business in 1992.” For the quarter, automobile loan purchases were almost $1.4 billion, an increase of 41% from the comparable period one year ago. Year over year, Americredit’s managed loan portfolio surged 55% to $8.2 billion.

Subprime lender Metris, with 4.5 million accounts, saw its total assets increase 82% over the past year to $3.7 billion. Metris added 300,000 new accounts during the quarter and expanded managed receivables at a 36% rate (branded as “tepid” by one Wall Street analyst!). Managed receivables have increased 27% over the past year.

Wild excess is, not surprisingly, also seen in student loans. Here USA Education/Sallie Mae (another GSE) acquired $2.4 billion of loans during the fourth quarter, a 40% increase from last year. For the entire year, Sallie Mae acquired $20.5 billion of loans, a 50% increase from 1999.

As we have stated before, consumer credit and “subprime” are where it’s at today on Wall Street, as firms tout these “growth stocks” and profit mightily by peddling their securitizations. As usual, a “hot” sector gets the full attention of the Street’s amazingly effective propaganda machine. The “apologists” for the consumer debt bubble are not unlike those that not all too many months ago manufactured “analysis” and New Age theories supporting the Internet bubble. The bursting of a bubble, “no problem,” we’ll create a new one.

“Now let’s look more closely at the U.S. savings rate. Our gross savings rate is 18%, so we’ve been able to tolerate a lower personal savings rate because the government savings rate has been so much higher. Some of the horror stories told about overextended consumers aren’t quite true. John (Neff) indicated we’re not at the upper limit of consumer debt to income, but consumers are in even better condition when you include installment debt, about 30% of which isn’t really debt at all. It’s cash management – using our credit cards instead of cash, getting our frequent-flyer miles and all the rest of it…Thirty percent of installment debt is paid off each month.” Abby Joseph Cohen, Barron’s (Roundtable discussion) 1/15/01

Ms. Cohen either doesn’t know what she is talking about or she is blatantly obfuscating the facts. First of all, the U.S. economy is on course to run an unprecedented current account deficit that will soon approach $450 billion (4.5% of GDP). Obviously, as an economy we are living grossly beyond our means, extreme money and credit growth run unabated, and any chatter that “our gross savings rate of 18%” is simply ridiculous. But then again, we had “analysis” justifying a $500 price target for Amazon.com. Second, to look at installment debt without recognizing the explosion of mortgage debt during this boom cycle is silly (how much home equity debt has been used to pay down credit card balances?). Still, during the past 12 months (data through November), total non-mortgage consumer debt has increased 10%, while the category “revolving debt” has jumped 12%. The issue is not how many purchases are made with plastic (credit or debit cards), but how much additional debt is accumulated each month. It matters greatly that the consumer is spending beyond her income, in what should be seen as clearly fostering unsustainable borrowing and spending. To not appreciate this predicament is an inexcusable analytical blunder.

Where the bulls really have it wrong is their focus on the ratio of debt service to income. Not only is this very poor analysis, it is quite dangerous. Actually, it is interesting (hopefully enlightening) to see how the numbers really work. Using one of the many “how much home can you afford” mortgage calculators now available online, one can certainly see the seductive power of leverage, as well as getting right to the heart of the bull’s (erroneous) argument. Let’s assume that a borrower has $5,000 a month gross income, $10,000 cash on hand, $500 per month other debt service (student loans, car payments, credit cards, etc.), and interest rates are at 8%. An “aggressive” estimate by the “calculator” using a 3% downpayment (quite popular today!) will allow for a $1,300 monthly mortgage payment (almost 30% of gross income). In this case, the “calculator” says that the borrowers can borrow $133,000 to purchase a home priced at $137,000 (with mortgage insurance, of course!). Now, let’s change the assumptions a bit. Let’s say this borrower lands a 10% increase in gross income (certainly reasonable in this environment of strong wage growth) and that interest rates drop to 7% (with the Fed lowering rates and a “whiff” of financial crisis in the air). The “calculator” now says that the borrower can obtain a loan of almost $172,000 on a home valued at $177,000. A veritable gift from god…time to step up to a better neighborhood! Importantly, in this example, the borrower can now take on 30% additional debt ($44,000) with exactly the same “debt to income” level. Everyone’s happy. Credit and asset bubbles are both insidious and very seductive.

In the hopelessly bloodshot eyes of the bulls, this extra 30% ($44,000) of debt just doesn’t matter – the consumer (or the economy for that matter) is not any more “overextended.” This is, of course, complete nonsense (working to keep the “G” rating on this commentary). Clearly, the consumer has increased his risk greatly, although it may not appear this way in the current age of rising home prices, 4% unemployment and the illusion of wage gains as far as the eye can see. The critical ramifications, however, are much more apparent when looking at this situation from a “macro” perspective. As has been precisely the case, if much of the household sector goes through this “calculation” in an environment of unlimited availability of mortgage lending, then there will be a gross increase in total mortgage debt. And, just as sound analysis would have projected, this gross expansion of mortgage credit has stoked a major surge in housing inflation (too much money chasing too few homes). This credit-induced asset bubble has been the major factor fueling the over borrowing and over consumption that continues to foster massive trade deficits and the accumulation of unthinkable foreign liabilities.

And as we go full circle on this line of thinking, it is precisely the unprecedented accumulation of foreign liabilities that will prove the Achilles heel for the sanguine views espoused by Greenspan and the bulls. It is only a matter of time until a faltering currency shatters the halcyon notion that monetary policy always provides the mechanism by which credit inflation resolves any crisis, financial or economic. Today, the bulls believe that debt burdens can continue to be lessoned by asset and wage inflation. And while there are many flaws in this line of wishful thinking, there is today a basic lack of appreciation that we do in fact live in a global economy. Wage inflation at home comes at the cost of an even greater loss of global competitiveness, as is undoubtedly one of the factors behind our faltering manufacturing sector (“no problem, lower interest rates!!!”). Granted, this hasn’t been much of an issue for sometime, with domestic demand booming and the dollar benefiting from what historians will likely identify as an extraordinary aberration in the face of an extreme deterioration in underlying fundamentals. However, it is becoming clear that perceptions are changing with respect to the greenback.

For years we have traded goods for “paper.” And with the price of our “paper” inflating, huge investment and speculative foreign flows have financed our profligacy. The dollar didn’t miss a beat. Having the world (and the speculators!) enamored with our “paper” has been one heck of a wonderful advantage – it makes domestic wage inflation and the loss of competitiveness for our goods-producing industries hardly an afterthought. The key to “success” rested with “a strong dollar is in the best interest of the United States,” a policy focused specifically and stridently on maintaining the price of our “paper.” And with a credit excess-induced asset bubble fueling surging demand for the New Age service sector economy, why even be concerned with producing goods anyway (besides, they pollute!)? The consequence of this brand of economic “success” is today an acutely fragile prosperity and an enormous gap between the current “value” of all this paper and the underlying capacity to create true economic wealth.

If demand for our “paper” wanes (as we believe has commenced), we are going to have to pull out and dust off the old “rulebook,” and the New Paradigmers will have to dispose of their playbook. Crazy as it may seem, we have a sneaking suspicion that the long-forgotten issue of “competitiveness” quickly moves right back to center stage. Such an event will mark the unfortunate confrontation between strong domestic wage growth and a fierce global business environment. This is also when this Wall Street game of justifying egregious consumer debt through the extrapolation of wage inflation breaks down. Furthermore, this when what is clearly an overvalued dollar becomes acutely highly suspect. And as much as it is taboo to even think of such a thing, one of these days our creditors may even say, “Pay me!”

So, if one stands back, takes a long look, and contemplates reality for a bit, it becomes perfectly reasonable to expect that there is one heck of an adjustment waiting around the bend. Going forward, the bottom line is that the U.S. economy is going to have to compete in the global market for goods and services – the days of “goods for paper” are running on borrowed time. Sure, the Fed and Wall Street are clearly determined to perpetuate this great credit inflation as the mechanism to sustain unsustainable demand, turn around the faltering manufacturing sector, and maintain this momentous consumer debt and financial bubble. The answer, in all cases, will not be found in more credit. I just can’t shake the notion that the sophisticated global players don’t see the writing on the wall. After all, any scheme that has gotten to the point of necessitating the burying of the consumer sector must be “at the end of its rope.” At least this wouldn’t be the first option.

So, it may be next week, next month or perhaps even a few months down the road. But everyone (including Mr. Greenspan) better well be prepared for The Wrath of Mr. Market. He hasn’t been around these parts in a spell and all the townsfolk, especially the drunken gamblers and gunslingers down at the Saloon, have long forgotten what a tough Son of a Bitch he can be. He doesn’t like troublemakers and has his own way of dishing out his own ferocious brand of punishment. Mr. Market does it on his terms, is unpredictable by nature. But boy can he be quick as lightening, with his punches landing with shocking force. We’ve been on the lookout for him but don’t see him quite yet. He uses the element of surprise as one of his best weapons. He’s on his way; make no mistake. We can already hear his intimidating voice now: “The raping and pillaging, the fun and games are over for all you wild cowboys, drunks and card sharks. All this BS has gone on for way too long and has gotten way out of hand, so I have no choice but to bring it all officially to an immediate end. From here on out, there’s going to be some law and order in this here town. I’m changin’ the rules and I’m going to enforce them with an iron fist. You might darn well get used to it. From now on, we’re going to do things with some discipline and respect. There’s a new sheriff in town…”