02/16/2001 Four Months of Respite *

The week certainly ended on an ominous note, with a new U.S. President authorizing bombings near Baghdad, ugly inflation data, and a faltering stock market. For the week, the Dow was unchanged, while the S&P500 declined about 1%. The Morgan Stanley Cyclical index added 1%, while the Transports and Utilities declined 1%, and the Morgan Stanley Consumer index dropped 2%. The broad market continues to hold up quite well, with the small cap Russell 2000 and the S&P 400 Mid-Cap indices both unchanged. Technology stocks remain hyper-volatile. For the week, the NASDAQ100 declined 2% and the Morgan Stanley High Tech index lost 1%. The Semiconductors outperformed, adding 6% and increasing year-to-date gains to 15%. The Street.com Internet index declined 1%, while earnings disasters pressured the NASDAQ Telecommunications index to a 7% decline. The Biotechs declined 3%. Financial stocks showed some vulnerability, with the S&P Bank and Bloomberg Wall Street indices declining 1%. Gold stocks added 2%, despite a better than $2 decline in the price of bullion.

On the back of generally stronger than expected economic news this week, 2-year Treasury yields increased 7 basis points, while the 5-year saw yields rise 9 basis points. The 10-year T-note and long-bond saw yields increase about 8 basis points. The yield on the benchmark Fannie Mae mortgage-back security jumped 12 basis points, while agency yields generally added 8 basis points. Spreads generally widened, with the key 10-year dollar swap adding 2 to 95. The currency markets were volatile, although the dollar ended the week with a small gain.

From the question and answer session – Alan Greenspan’s February 13th testimony, Federal Reserve Board’s semiannual monetary policy report to the Congress:

Delaware Senator Thomas Carper: My only other question is this; in my little state of Delaware, we cut taxes seven years in a row during my time as governor, sometimes rates at the top, sometimes rates at the bottom, sometimes in between; we cut taxes for businesses and individuals. We had a four-part litmus test for the tax cuts that we adopted. And one of the things that we're wrestling with within our own caucus, and I presume our Republican friends are as well, is a set of core principles on which tax cuts should be based; if you will, a litmus test.

The four that we used in my state were the following: one, the cuts should be fair; two, they should promote or enhance economic growth; three, to the extent that they can, we should simplify the tax code, not make it more complex; and the fourth is that the cuts should be consistent with a balanced budget and sustainable throughout the full business cycle. But those four things: fairness, promoting economic growth, simplicity, and sustainability throughout the full business cycle and consistent with a balanced budget are really the litmus test that we used.

Can you just give us a little guidance -- and I know my time has expired -- but just a little guidance on the kind of principles, whether we're Democrats or Republicans, that our tax-cut policy should be based on.

Chairman Greenspan: Well, I think in a very interesting way, it depends on where one starts. I mean, going back from, say, a purview of 1995, for example, with what appeared at that point to be about a 1-1/2 percent trend growth rate in productivity, it appeared as though the level of taxation was essentially consistent with a balanced budget over the longer run at full employment. And what has happened is that productivity growth has accelerated quite significantly, and so the existing set of tax rates has engendered a very much more rapid rise in revenues. As I said at the Senate Budget Committee, that productivity over the past five to seven years has risen at about a 3 percent rate, which is twice what it had been previously, and revenues have gone up 2-1/2 times; the difference being that the rise in the productivity has elevated earnings expectations and created a permanent higher level of asset values, which spilled over into tax liabilities when realized gains were involved or even when they weren't.

And so that what you have got at this point is, as a consequence of the acceleration in productivity, a much higher rate of receipts than one had anticipated. And so I think the Congress is confronted with the choice of whether in fact you give back what, in retrospect, turned out to be an unintended excessive level of receipts, or whether those are employed for other purposes. And these are the key judgments which I think in this particular debate are critical, and these are political judgments; these are judgments which only the Congress can make.

Senator Carper: Thank you so much

Alabama Senator Richard Shelby: Mr. Chairman, a lot of people seem to be a little hesitant regarding the economy as a whole, and I know it depends on how they're looking at it, but consumer confidence is very important. Is it time to hunker down, I believe that was the phrase that was used earlier, or is it a time to be a little cautious, or is it time to be bullish or what? Because what you say today and how you say it, as you well know, is going to be interpreted many, many ways, and people are looking for everything in the world out of your utterances.

Chairman Greenspan: Well, Senator –

Senator Shelby: What would you say to the American consumer looking at the economy today seeing layoffs here, layoffs here, and not in every sector, but in some?

Chairman Greenspan: Yeah. Senator, I think that it's always important to first start with what's the longer-term outlook.

Senator Shelby: Absolutely.

Chairman Greenspan: And the longer-term outlook, as I've reiterated many times, in my judgment is undiminished in the sense that by any measure that I can see, we are only partway through one of these most remarkable periods of technological advance which is crucial to productivity growth and, indeed, to all of the deliberations we are having with respect to the budget. It really gets back to that question.

What tends to happen, however, is that while the technologies change and it creates an accelerating environment for economic activity, as I point out in my prepared remarks, we human beings react in a somewhat negative way to change when it occurs in a pronounced way. And so it is perfectly credible to find, for example, as I think we see today, that there are a number of business people who fully perceive the longer-term profitability of these new high-tech investments as pretty much fairly accurate and achievable, but they are concerned about the uncertainty, and they develop concerns about the immediate future. And even though they perceive the future in a very positive way, they tend to pull back. It's a wholly human, normal reaction. And what that does is it brings the economy down.

But if, indeed, those underlying trends are still there, as I firmly believe, it is just a matter of time before that sort of malaise dissipates and the system comes back. If you look at American economic history, it always has those characteristics. And if we focus on the longer term, as a number of business people have, and have continued to invest right through this period, it's my impression that it is they who will end up at the end of the day with the best positions in their markets to exploit them over the longer run.

Senator Shelby: Mr. Chairman, could you, in a sense, perhaps look at the economy like a long-distance race and the runners, or some of the runners are going -- if the economy is the runner, is going to get its second wind because they're trained for the long haul, we're in it for the long haul, and those who are in it for the long haul, which is all of us, we're going to be rewarded if we stay the course?

Chairman Greenspan: Oh, I agree with that, Senator. I have no doubt that at a minimum, that the turgid economic growth which we experienced from the early 1970s through the, say, early 1990s, is not something that we're about to replicate, in any sense that I can envisage, over the next 10 years.”

Does Greenspan truly believe such nonsense? While he has professed (increasingly over recent years) some convoluted analysis, associating surging tax receipts with productivity improvements takes the cake. And he may hope that better than 20 years of “turgid” economic conditions has over the past six or so years given way to a New Paradigm, but this is no doubt some combination of wishful thinking, flawed analysis and obfuscation. The last six years will prove the aberration. Sure, the mid-nineties provided a momentous inflection point in financial and economic history, it just had very little to do with a so-called productivity miracle. Instead, it had almost everything to do with the manifestation of an historic Credit Bubble. This fact is conspicuous in any chart of U.S. money or credit growth. Specifically, one can pinpoint the “Reliquefication” concomitant with the Mexican bailout and Orange County bankruptcy in 1995. It was in 1995 that the buds of credit and speculative excess were nurtured instead of quashed. That round of rampant monetary expansion precipitated a spectacular boom both here and abroad (emerging markets) and subsequent ugly bust. The resulting 1998 “Reliquefication” ushered in an absolute money and credit “free for all.”

Since 1998, truly unprecedented money and credit expansion have been only briefly interrupted by respites of moderation. Yet, for a system hopelessly addicted to extreme monetary excess, moderation simply doesn’t work. This fact is a best-kept secret and something Wall Street and the Fed would prefer not to contemplate. Why do the GSE’s and Wall Street create credit so aggressively (the force behind exploding money supply)? Because it is precisely the requirement for sustaining the Great Credit Bubble.

We monitor credit market spreads closely, as an indication of liquidity pressures and systemic stress. Similar to previous episodes, spreads have narrowed sharply over the past four months. This is not surprising, and is purely a factor of the degree of monetary expansion. Look at it this way: while the GSE’s are aggressively purchasing credit market instruments and the enormous and always-enterprising leveraged speculating community goes along for the ride, this flood of liquidity fuels higher prices/lower interest rates, particularly for more risky (high-yielding) instruments and any class of securities aggressively sought by the speculators. The catch is that a U.S. system so incredibly leveraged, with negative household savings, and reliant on huge foreign flows to finance massive trade deficits, the entire financial and economic apparatus has become so “revved up” that massive liquidity injections must be maintained to keep asset prices levitated and financial markets liquid. But like the movie Speed, there are unfortunate circumstances for letting pressure off the accelerator. Any moderation in monetary expansion, like that experienced in mid-1999 and again in early 2000, leads quickly to sinking prices for the riskier securities, liquidation by the leveraged speculators, and faltering systemic liquidity that manifests into wider credit spreads and other financial disruptions. Leverage works like magic when prices are rising but can abruptly turn problematic with any move toward liquidation. Endemic over leveraging is an accident waiting to happen. We will return to this later.

As discussed repeatedly, since the mid-1990s the government-sponsored enterprises have been leading pushers of credit excess. Today, they are dealing more forcefully than ever. Fannie Mae’s January numbers are in and, not surprisingly, we see that Fannie expanded its mortgage portfolio at a 31% annual rate, to $621 billion. Averaging about $1 billion per business day, Fannie purchased a total $20.6 billion of mortgages in January at a net yield of 7.02%. To put this in perspective, Fannie Mae’s mortgage portfolio expanded in January by about the same amount ($14 billion) as the Federal Reserve’s holdings of securities increased during the entire past year. This is exactly why I focus on the GSEs and financial sector and pay less attention to Federal Reserve Open Market operations.

Fannie’s commitments to buy future mortgages (“mandatory commitments”) jumped to $27 billion in January (from December’s $20 billion), second only to the $30.5 billion at the height of the refinancing boom (“Reliquefication”) in October 1998. During the month, Fannie Mae purchased $1 billion of multifamily loans, almost 80% more than its previous record from the prior month. Fannie’s multifamily loan portfolio has expanded by 27% over the past twelve months. After expanding its total mortgage portfolio by 13% during the 12-months ended September 30, 2000, Fannie expanded its portfolio at a rate of 30% in October, 28% in November, and 25% in December, extraordinary growth only to be surpassed in January. It has been four months of intense “Reliquefication.”

Over the past four months, money market fund assets have surged $244 billion, or at an annualized rate of 40%. During just the past six weeks, assets in money funds have jumped an astonishing $144 billion. For comparison, money market fund assets increased $39 billion during the first half of 2000. These assets increased $43 billion last week alone. Broad money supply increased $35 billion last week and $118 billion during the past six weeks. Over the past four months, broad money supply (which includes money fund assets) has increased $301 billion, or at a rate of 13% (broad money supply increased about $260 billion for all of 1995). It should not be ignored that there are great costs associated with such rampant monetary inflation, and perhaps we saw a hint of what is in the offing with this morning’s much stronger than expected report on Producer Prices. January producer prices rose at the strongest pace since September 1990, confirming what I believe are the most potent general inflationary pressures since the late 1980’s. The bond market vigilantes may have succumbed to playing The Game, and the propaganda machine hyping the death of inflation may be running louder than ever, but it’s just not going to change fundamentals.

It is rather incredible that not a word of protest has accompanied the past four-month’s 13% rate of monetary inflation. This is actually a similar rate of growth to that at the height of 1998’s Reliquefication, although the inflationary consequences have all appearances of manifesting in a much different manner. In past commentaries I have made the point that “Liquidity Loves Inflation.” Sure, combining central bank accommodation with unfettered financial sector leveraging creates an extraordinarily virile liquidity generating mechanism for contemporary financial systems. But once created, this liquidity is virtually impossible to control and even has a propensity of gravitating directly to asset classes enjoying inflation (choosing a Fannie Mae security instead of a Lucent bond, for example). And while there were acute global deflationary pressures in 1998, there are today strong general domestic inflationary pressures that are certain to be augmented by current monetary excess. On the other hand, during 1998 there was the budding of an historic inflationary boom throughout the expansive Internet/telecom/technology sector that proved an incredibly powerful liquidity magnet. The present deflationary technology bust sees the magnet turned upside down. This is a key and intractable aspect of present financial fragility.

This is where economics gets wonderfully fascinating (unless one chooses to fixate on notions of a New Economy and a productivity miracle). Over years, as credit inflation gave way to runaway money and credit excess, our dysfunctional financial system has increasingly financed enormous numbers of enterprises with inadequate cash flows and little hope for true economic profits. “Ponzi Finance,” in the words of the great Hyman Minsky. This has been, of course, an historic speculative bubble captivating investors, bankers, speculators, central bankers and American business generally. Interestingly, of the few economists and analysts that correctly recognize that the U.S. has been in the midst of a major bubble, most actually believe that it has been in NASDAQ/technology stocks. Greenspan may even believe this, and has thus embarked on yet another round of extreme accommodation to lessen the economic impact collapsing tech stocks. The major issue today is not NASDAQ, an inventory overhang, or the unfolding severe capital equipment slowdown.

The fact of the matter is that the technology bubble is but one very critical component of the Great U.S. Credit Bubble. The key yet unappreciated point to recognize today is that years of reckless credit excess have created unprecedented leverage throughout the U.S. credit system and extremely weak debt structures. And while Wall Street and Greenspan obviously hope that another bout of monetary excess will do the trick and alleviate the spectacular technology collapse, the preponderance of new liquidity will avoid technology like the plague. Moreover, it is unavoidable that the most recent Reliquefication is and will continue to lead to inflation elsewhere, while it also creates greater consumer debt burdens, perilous financial sector leverage, and even more fragile debt structures.

It is certainly significant both financially and economically that the latest shot of extreme monetary expansion is avoiding the tech collapse to play the real estate bubble. Could this prove the catalyst for the marketplace finally recognizing the dysfunctional nature of the U.S. credit system? While Lucent and a myriad of technology companies fight for survival, credit availability could not be easier in mortgage finance. Could there be a more conspicuous example of a highly maladjusted financial system and economy?

This morning the Commerce Department announced that January housing starts jumped a much stronger than expected 5%, with single family starts running at the strongest rate in one year. Building permits jumped 13%, with multifamily permits surging 24%. The bursting of this unrelenting real estate bubble will wait for another day. Also, fourth quarter mortgage refinance data has been released by Freddie Mac. During the quarter, “78% of Freddie Mac-owned loans that were refinanced resulted in new mortgages at least five percent higher than the original mortgages…” Only 9% of refinanced loans were for amounts less than the original mortgage. Interestingly, on average, loans were refinanced at comparable interest rates, confirming that the overriding motive of borrowers was to extract equity (housing inflation). The “median appreciation of refinanced property” was 28% during the fourth quarter, down slightly from the third quarter’s 29%. However, the “median age of refinanced loan” dropped sharply from 6.6 years to 4.9 years. During the refinancing boom back in the fourth quarter of 1998, the median appreciation was 9%.

There should be no doubt that the current refinancing boom is greatly exacerbating the bubble in money market fund assets, a very dangerous financial distortion that runs unchecked. What are the ramifications today for a loss of investor confidence in the $2 trillion dollar money market fund industry? Astounding… Interestingly, yesterday’s American Banker carried a lead story titled “FDIC Said to Whisper Fund Premium Warning – The Federal Deposit Insurance Corp. has been quietly warning trade groups that it could start charging banks premiums again by yearend – in part because of fast-growing accounts at large firms such as Merrill Lynch & Co., industry sources said Wednesday.”

Also from the article: “Industry representatives said the FDIC has cited fast-growing and de novo institutions that have added billions of dollars to insured deposits without paying new premiums as one of the key reasons for the coverage ratios dilution…the poster children for the issue have become Merrill Lynch, which has moved nearly $50 billion from uninsured accounts into insured deposits at its banks in New Jersey and Utah during the past nine months, and Salomon Smith Barney, a Citigroup Inc. unit that started moving money from uninsured accounts into insured deposits last month.”

Apparently, Salomon Smith Barney is now aggressively moving client assets into FDIC insured deposits, with a structure that includes six separate banking entities providing up to $600,000 of FDIC insurance protection. Coincidently, from the pile of financial reports I read from the last year’s third quarter, the one sentence that sticks most clearly in my mind came from Citigroup – Salomon Smith Barney: “Total client assets in the Private Client business grew 24% from a year ago to $1.047 trillion while annualized gross production per Financial Consultant reached $526,000 in the first nine months of 2000…” It will be quite interesting to see how aggressively Wall Street moves to obtain FDIC insurance for all this “money” it has helped create. I know if I were either Sandy Weill or Bob Rubin (Citigroup chairmen) I would do my best to get my clients into FDIC insured accounts, and this current Reliquefication provides a convenient window of opportunity.

I can’t shake the notion that we are likely in the midst of what in hindsight will be seen as The Great Distribution. While the public remains quite bullish and (helped greatly by the mortgage refinancing boom) money continues to flow into mutual funds, the stock market just doesn’t react like it has in the past. Clearly, some are aggressively selling and we’ll assume it’s the insiders and sophisticated liquidating to the public. One of the unfortunate and problematic aspects of major asset bubbles is a redistribution of wealth.

I am also now anticipating some moderation from the unsustainable monetary expansion associated with the four-month old Reliquefication. As stated above, for a system hopelessly addicted to extreme monetary excess, moderation won’t work. With signs of general economic resiliency, endemic and increasingly problematic maladjustments, an historic real estate bubble, and heightened general price pressures, something has to give. And at what cost will Greenspan attempt to maintain confidence and sustain unsustainable consumer demand? Besides, it should be increasingly apparent that fighting this war with a flood of liquidity is not only not working, it’s greatly raising the stakes for potential financial catastrophe. Before today’s unusual recovery and rally in the credit market (perhaps related to U.S. bombing in Iraq) interest rates had been rather quickly moving higher. Spreads have also begun to widen. It does not take much imagination to see how this very fragile structure could rapidly turn sour. The bottom line is that already unprecedented leveraged speculation certainly became only more extreme with the speculating community aggressively playing for a faltering economy and aggressive Fed accommodation. Endemic over leveraging in the U.S. credit market is a ticking time bomb, and there does today appear acute risk to any significant move higher in rates or widening of spreads.

I have written before that we have been witnessing the absolute worst-case scenario develop methodically right in front of our eyes. Well, today I again believe we are entering a period of potentially extreme risk with the stock market, credit market and dollar all in the line of fire. It’s been Four Months of Respite. However, not only is the effectiveness of Reliquefication dissipating rapidly, the costs are growing exponentially. When the next crisis breaks, it will be significant.

I will conclude with what I believe are two pertinent quotes:

“The favor of the masses and of the writers and politicians eager for applause goes to inflation. With regard to these endeavors we must emphasize three points. First: Inflationary or expansionist policy must result in over consumption on the one hand and in malinvestment on the other. It thus squanders capital and impairs the future state of want-satisfaction. Second: The inflationary process does not remove the necessity of adjusting production and reallocating resources. It merely postpones it and thereby makes it more troublesome. Third: Inflation cannot be employed as a permanent policy because it must, when continued, finally result in a breakdown of the monetary system.

A retailer or innkeeper can easily fall prey to the illusion that all that is needed to make him and his colleagues more prosperous is more spending on the part of the public. In his eyes the main thing is to impel people to spend more. But it is amazing that this belief could be presented to the world as a new social philosophy. Lord Keynes and his disciples make the lack of the propensity to consume responsible for what they deem unsatisfactory in economic conditions. What is needed, in their eyes, to make men more prosperous is not an increase in production, but an increase in spending. In order to make it possible for people to spend more, an “expansionist” policy is recommended. This doctrine is as old as it is bad.” Ludwig von Mises, Human Action, 1949

“The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system.” Ludwig von Mises, Human Action, 1949

“…Minsky characterized the financial balance along a scale of running from ‘fragile’ to robust.’ ‘Fragile finance’ refers to states in which cash commitments are relatively heavy compared to cash flows, so that there is some danger of widespread failure to meet commitments, failure that might cause general breakdown in coherence. ‘Robust finance’ refers to states in which commitments are relatively light compared to cash flows, so that the danger of incoherence is relatively remote. The emphasis on the threat of incoherence is one way of reading the scale. Viewed more positively, what is so appealing about a state of ‘robust finance’ is that it leaves open many different possible future paths for subsequent social freedom. What is so tragic about a state of ‘fragile finance’ is that previous commitments leave open only very few possibilities for the future, and maybe no possibilities at all that are consistent with existing commitments. Fragile finance is a state of social constraint. The degree of fragility or robustness in the economy as a whole ultimately depends on the fragility or robustness of financing arrangements at the level of the constituent economic units.” Perry Mehrling, The Vision of Hyman P. Minsky, 1998

“What nobody saw, though some people may have felt it, was that those fundamental data from which diagnoses and prognoses were made, were themselves in a state of flux and that they would be swamped by the torrents of a process of readjustment corresponding in magnitude to the extent of the industrial revolution of the preceding 30 years. People, for the most part, stood their ground firmly. But that ground itself was about to give way.” Joseph A. Schumpeter, Business Cycles, 1939

P.S. From yesterday’s American Banker: “Sears Is Back as A Player In Cards - In the eight months since it starting issuing MasterCards to seven million of its inactive Sears cardholders, Sears Roebuck and Co. has broken into the rank of the top 25 bank card issuers, amassing $1.4 billion in receivables on the general purpose cards.”