03/15/2002 Random Thoughts *

Despite acutely unsettled financial markets, the Dow and S&P500 ended the week with fractional gains. The Transports dropped 2% and the Utilities declined 1%. The Morgan Stanley Consumer index added 1%, while the Morgan Stanley Cyclical index was unchanged. The broader market was volatile, although the small cap Russell 2000 and the S&P400 Mid-Cap indices ended unchanged. Chaotic trading in the technology sector continues, with heavy selling this week. For the week, the NASDAQ100 declined 4% and the Morgan Stanley High Tech index sank 7%. The Semiconductors dropped 7%, while the NASDAQ Telecommunications and The Street.com Internet indices were hit for 6%. Biotech stocks gained about 4%. Financial stocks were also generally strong, with the S&P Bank index adding 3%. The AMEX Securities Broker/Dealer index was largely unchanged. With bullion declining 20 cents for the week, the HUI gold index added 1%.

The Credit market was under pressure again this week, although today’s better than one and one-half point reversal in the bond market saved the day. After today’s rally, two-year yields were up only 2 basis points this week to 3.58%. Five-year yields increased one basis point to 4.71%, while 10-year yields were unchanged at 5.33%. The long-bond saw its yield increase four basis points to 5.76%. Benchmark Fannie Mae mortgage-back yields rose four basis points, while implied yields on agency futures increased three basis points. The spread to Treasuries on Fannie Mae’s 5 3/8% 2011 note widened 3 to 71. The benchmark 10-year dollar swap spread narrowed 2 to 69. The dollar continues to appear vulnerable, with the dollar index dropping less than 1% this week. Yields rose again this week throughout Europe, Canada, Australia and New Zealand. The CRB index added better than 1%, with crude oil enjoying another strong week.

Today’s preliminary University of Michigan consumer confidence index jumped to 95 from February’s 90.7. The index has now jumped 13 points from October’s lows to the highest level since December 2000. The expectations component jumped 5 points to 92.3, up almost 20 points since October to the highest reading since November 2000. Today also saw a better than expected report on industrial production. The 0.4% gain was the strongest performance since June 2000 and the first back-to-back increase in 18 months. The two weekly U.S. same-store retail sales reports - from Instinet Research Redbook and Bank of Tokyo-Mitsubishi - had sales up a strong 4.7% from year ago levels. Yesterday’s $98.83 billion fourth-quarter current account deficit was a slight increase over the third-quarter, although with retail sales and general demand recovering it will be interesting to watch the trade deficits over the coming months. For the year, the current account deficit of $417.4 billion was down from 2000’s monstrous $444.7 billion, but a major unavoidable adjustment waits for the future. The current account has deteriorated markedly since 1997’s $140 billion deficit, the obvious consequence of uncontrolled Credit excess.

This week’s $11 billion issuance from GE was the fourth largest bond sale on record, with the company finding itself in interesting company behind France Telecom’s $16.4 billion, Deutsche Telecom’s $14.47 billion, and WorldCom’s $11.9 billion. WorldCom debt continues to sink, with 10-year yields quickly approaching 10%. Bloomberg’s domestic debt issuance tally had $54.5 billion of new debt issuance last week, increasing year-to-date sales to $390.9 billion. Amazingly, y-t-d issuance is running up 9% above last year’s record issuance. There is no mystery behind so-called economic “resiliency.”

The convertible bond issuance boom runs unabated, with Lucent this week selling $1.75 billion of “convertible trust preferred shares.” These securities pay a 7.75% dividend, while providing convertibility into equity shares at $6.10. These types of securities have for some time provided fodder for sophisticated strategies employed by the leveraged speculating community, and we will thus continue to keep a keen eye on this area. Year-to-date convertible issuance of $26.4 billion is up 20% from 2001’s unprecedented issuance boom. This year’s deals include the recent $600 million issue from Computer Associates, a $2 billion deal from Merrill Lynch, GM’s $2.6 offering, Gap’s $1.38 billion, Ford’s $5 billion, Amgen’s $2.82 billion, and Williams Company’s $1.1 billion. It is not easy to make sense of the insatiable demand for these types of securities, especially from some very vulnerable issuers, outside of recognizing that there is one enormous pool of speculative finance searching for deals to play. For now, the convert boom remains a godsend to an impaired corporate America, but we do ponder the ramifications for this market in the event of any general dislocation within the leveraged speculating community. If the speculators turn sellers of these issues, it is not clear who will be the buyers. If this source of finance runs dry, desperate borrowers like Lucent will have no place to turn. There are very intriguing Bubble dynamics encompassing the convertible debt arena.

And while the convert market remains white hot, the key CDO (collateralized Debt Obligations) marketplace cooled noticeably. Year-to-date issuance of about $9.7 billion is running about two-thirds last year’s pace. With the Enron debacle putting offshore and “special purpose vehicles” uncomfortably under the bright spot light, this sector is almost sure to struggle going forward. Many issuers now feel pressure to provide additional disclosure as to off-balance sheet exposure, taking much of the “fun” away from these structures. The accounting regulators and accounting profession are also moving to make it more difficult to exclude many of these vehicles from consolidated financial reporting. At the same time, defaults continue to greatly surpass expectations, with the ratings agencies now scurrying to make up for their previous laxness. Importantly, if this source of finance turns down, the resulting Credit tightness will only further exacerbate Credit losses and defaults. Like converts, CDOs have been very popular with the leveraged speculating community and have, thus, provided a key source of finance during this period of acute corporate Credit problems (and resulting extreme monetary accommodation). The downside of Credit cycles are unavoidably problematic, which explains why central bankers, governments, and the financial sector work so diligently to sustain the fateful booms.

Looking at Fannie Mae’s February numbers leaves no doubt that the GSEs are acting frenetically to ensure the Credit Bubble survives. “Fannie Mae’s total business volume [total acquired mortgages] was $66.6 billion, the third highest on record.” The company’s retained mortgage portfolio grew at an imprudent compound annual rate of 27.0% ($14.4 billion for the month), while its total “book of business” expanded at a 20.1% pace (up from January’s 11.6%). Fannie’s “average investment yield” on held assets was stable at 6.48%, compared to 7.11% last February. This week, Freddie Mac’s posted 30-year fixed-rate mortgage averaged 7.08%, up from the week ago 6.87% (increasing 63 basis points from November’s low!). Freddie’s average mortgage rate has jumped 28 basis points in two weeks to the highest level since the first week of January. It is also worth noting that Freddie’s 30-year fixed-rate has surpassed the 6.96% rate from one year ago.

After last year’s record mortgage Credit creation, a prudent analyst would today question Fannie Mae and Freddie’s interest rate risk exposure. The American homeowner was afforded another great opportunity to borrow and/or refinance at rates considerably below today’s yields. Someone is on the losing side of this “trade,” although the GSEs assure us that they have carefully hedged their interest rate risk. But as we have discussed repeatedly, the GSEs have become such enormous monsters that it is no longer reasonable to pretend that they are able to hedge their interest rate exposure in the marketplace. With the appearance that we may now be heading into the first major Federal Reserve “tightening” cycle since 1994, this is quickly becoming much more than a case of intellectual theorizing.

Fannie Mae began 1994 with total assets of $217 billion and came into 2002 with total assets having surged to $800 billion. Freddie’s numbers are even more incredible, with about $84 billion ballooning to $617 billion. Not bad for eight years! Over this period, total GSE liabilities surged 266% to $2.25 trillion. According to The Bond Market Association, “short-term federal agency” debt outstanding increased 23% last year to $718 billion. In just 12 months, Freddie’s short-term debt surged 66% to $223 billion. Fannie’s short-term borrowings jumped 29% to $289 billion. For the system as a whole, it is impossible to get a handle on where interest rate risk resides or problems lurk. The derivatives market, alone, has destroyed any hope of transparency. But we do know that only $194 billion of the $1.4 trillion of outstanding commercial paper has been issued by “non-financial” borrowers. Financial sector commercial paper borrowings have surged from the $407 billion at the end of 1993 to the current $1.207 trillion. Total money market fund assets have increased from $583 billion at the end of 1993 to last week’s $2.351 trillion. It is impossible to feel comfortable with the knowledge that “non-financial” commercial paper outstanding is less than 10% of total money market assets. But, then again, this is “Financial Arbitrage Capitalism” run terribly amuck.

All one has to do is look at recent statements from the major money market funds to get a sense of the profound changes that have transformed finance (and “money”!) during this extraordinary cycle. The majority of fund assets can now be divided into three categories: short-term agency debt obligations; asset-backed commercial paper and financial institution (bank, brokerage, finance company) commercial paper borrowings; and repurchase agreements. In one manner or another, the vast majority of these borrowings are made by financial institutions or “special purpose vehicles” to finance holdings of higher-yielding loans. How this massive financial edifice would fare during the various stages of an extended tightening process is unclear, although such debt structures are patently vulnerable and we suspect highly unstable.

According to the New York Fed, total primary dealer repurchase agreements outstanding surged 24% last year to almost $1.8 trillion. Most recent data put outstanding repurchase agreements at almost $1.96 trillion. There were $766 billion of primary dealer “repos” outstanding at the end of 1993. And according to The Bond Market Association (referencing data from the Government Securities Clearing Corporation), “in excess of $187 trillion in repo trades were submitted by [Government Securities Clearing Corp] participants in 2001, with an average daily volume of approximately $748.1 billion.”

I wish I could make sense in my own mind of these colossal figures, and then muster a coherent analysis of the ramifications for such a system as it heads into a tightening cycle. But the numbers are unfathomable, as I ponder the $1.8 trillion of “repos” combined with the recklessly leveraged GSEs and their slivers of equity supporting $2.3 trillion of mostly mortgage assets. The Securities Broker/Dealers are major players in the repo market, having seen total liabilities increase from $442 billion at the end of 1993 to almost $1.4 trillion to end 2001. Over this same period, outstanding “federally-related” mortgage-backed securities have doubled from about $1.4 trillion to $2.8 trillion. If I had to pick just two sets of statistics that illuminate the enormity of this tireless Credit Bubble, it would be total outstanding Financial Sector borrowings (financial Credit creation) and “Rest of World” holdings of U.S. financial assets (accumulation of foreign liabilities). After beginning 1994 at $3.35 trillion, financial sector borrowings exploded to end 2001 at $9.37 trillion. Not coincidently, “Rest of World” holdings of U.S. financial assets began 1994 at $2.6 trillion and ended 2001 at $8.2 trillion. It is possible to find at least one set of data that has not ballooned since 1997. Total U.S. Reserve Assets ended January at $67.5 billion, down over $2 billion since 1997.

I do recognize the mechanism where financial sector leveraging creates the liquidity for its own liabilities. Nowhere is this mechanism more conspicuous than when Fed rate cuts and aggressive GSE purchases foment lower market rates and a self-feeding refinance boom. This is an especially powerful operation, as the GSEs finance ballooning mortgage holdings with money market fund borrowings (creation of new GSE liabilities in the money market). Such a process creates new liquidity/buying power that is transferred to the holders of old mortgages, which they then use to purchasing myriad other long-term securities such as CDOs, asset-backs, corporate bonds, etc. And as aggressive Fed rate cuts foster leveraged speculations in agency bonds, mortgage-backs, etc. (carry trades), it is again no mystery as to how the aggressive expansion of new financial sector liabilities - in this case repurchase agreements - creates its own liquidity/demand. We’ve seen the process in action repeatedly, but now what?

While we have barely commenced a “deleveraging” process (short rates remain at 1.75% with the first Fed increase not yet imminent!), it is already worth noting that, despite very aggressive GSE expansion over the past two months, money market fund assets and broad money supply are relatively unchanged. I think this may be explained by the GSEs financing little of their rampant growth through money market borrowings. It is certainly reasonable to assume that the cost and liquidity of placing new hedges would be an issue today, with the GSEs now keen to expand longer-term debt issuance. It is also likely that broad money supply stagnation is related to the abrupt halt in placing new leveraged bets (financed in the repo market?) in agency and other debt instruments. Certainly, with rates having moved sharply higher some speculators must be looking to pare a bit of risk, while the derivative players have commenced selling to dynamically hedge their derivative positions. As was the case during the 1994 Fed rate tightenings (and, under different circumstance, during the second half of 1998), GSE expansion becomes critically important to offset liquidations by the hedge funds and leveraged players, as well as derivative-related selling. Basically, leveraged positions are transferred from the speculators to the GSEs (“buyers of first and last resort”!), which is one critical aspect of this most extraordinary Credit system.

Thus far market rates have moved higher, but in an orderly manner with little indication of systemic liquidity issues. But, again, we are very early in the process, with enormous GSE purchases still supporting the marketplace. We also have no indication of any meaningful selling by impaired speculators, with most likely remaining confident in a cautious Greenspan as they salivate at gaping spreads. It does not, however, take a wildly bearish imagination to envisage how the derivative players (including the GSE counterparties) and the leveraged speculators could quickly find themselves competing for fleeting marketplace liquidity. Again, I understand how the Fed basically determines rates and the financial sector creates liquidity through leverage when rates are stable or declining, but I don’t believe these atypical supply/demand dynamics are sustainable in the face of any significant “deleveraging.” We would expect the move by the likes of the GSEs and GE (with short-term borrowings increasing from $119 billion to $153 billion during 2001!) to aggressively issue long-term debt that would speed the process of evaporating liquidity in long-term instruments.

The wild cards remain the size of leveraged speculative holdings and the amount of derivative hedging. That foreign sources have most certainly been tapped to finance leveraged holdings of US. debt securities and that derivative hedging of U.S. dollar positions is an integral aspect of the hedging of the massive accumulation of U.S. financial assets by foreigners, virtually assures that the dollar will be key going forward. The specter of an Arthur Anderson collapse following Enron cannot help dollar confidence. It is also worth noting that Enron debt was placed in 28 CDOs sold to European investors. Perhaps the perception of a sound U.S. economy, along with unlimited supplies of top-rated (GSE, GE, etc.) securities, will keep foreign attention away the issue of acute U.S. financial fragility. We wouldn’t want to count on it.

Yesterday Nebraska Senator Chuck Hagel called for hearings to discuss the GSEs: “Recent press accounts have raised some very serous concerns and questions as to the taxpayer liability and financial soundness of these government sponsored enterprises.” That what we would expect to be a much more circumspect view of these institutions comes coincidently with the beginning of what has all the makings for a problematic Fed tightening cycle, could prove tricky. GSE use of derivatives for interest rate protection - a critical weak link for these institutions and the U.S. financial system – is certain to get especially diligent attention. It appears to us a situation where more intense market scrutiny is highly unlikely to uncover anything inspiring confidence, although there are clearly issues that could unnerve already shaken investors. There will be no more separating the GSEs from the issue of the soundness of the U.S. financial system, but perhaps this will only solidify the perceived federal government backing of these institutions.

Any move by foreigners away from agency securities would, of course, be a huge development for U.S. financial market liquidity, the dollar and the economy. But right now we have our sights on anything that could hinder continued explosive growth of GSE balance sheets. During 1994, 1998, 1999, and 2000 these institutions performed their reliquefication miracles quietly and off the radar screen. This luxury is no longer available. The day the GSEs get their blank checkbooks taken away we’ve got a much different ballgame. For now, we’ll assume their operations remain outside of market discipline and they just keep borrowing and spending like there’s no tomorrow.

Alan Greenspan made some interesting comments this week before the Independent Community Bankers of America. While addressing “encouraging signs of strengthening underlying trends,” he also focused on “emerging longer-term challenges, particularly on the need to augment our domestic savings rate to facilitate the financing of the investment that will almost certainly be required as the baby boomers retire.” We share your concerns Mr. Greenspan, but your timing is troubling. After all, non-financial business borrowings increased 50% over the past four years to almost $10 trillion, with an unprecedented $2.25 trillion borrowed during 1998/99. Regrettably, under your watch much of this finance was pilfered and wasted. Most of the liabilities remain, but there’s just not much in the way of economic wealth producing assets to show for it. And while you may believe that the system can simply create another costless blizzard of money and Credit (and resulting financial wealth) and hope for better results in the upcoming “investment” boom, it’s just not going to be possible. Under your watch a financial sector like none previous has taken command of the Credit system’s monetary processes. For too long the incentives have strongly favored the tandem of aggressive lending and leveraged speculation. The financial sector and the speculators have come to basically govern who has access to borrowings, and the game is financing consumption and speculation, not productive investment. The Fed and GSEs have nurtured a system and environment that is wondrous to the entrenched financial players, and the game will not change until the incentives change. Clearly, the Fed has no intention of making the necessary changes to commence what will be an arduous adjustment process, so we’ll wait nervously to see what type of “accident” precipitates the unavoidable crisis.

In the “Roaring Twenties,” even with all the shenanigans, at least the game was financing real business investment. JP Morgan, the dominant U.S. financial institution during that era, was financing investments in transportation infrastructure, automobile manufacturing, mining and oil exploration, and various industrial enterprises. We may today wish that investment spending would fuel sound economic growth, and economists and analysts can, if they like, continue to pretend that business capital spending drives the U.S. Bubble economy. Yet, we are dealing with a very unusual services-based economy that is supported, levitated and driven by financial Credit creation. The key “sectors” for analysis are, on the economic side, the booming “service sector” and, on the financial side, the GSEs and the leveraged speculators. The game in this most sordid cycle is consumption, mortgage, and security finance. The dominant institutions are reckless mortgage lenders, asset-based lenders, financial engineers and securities speculators.

The key inflationary manifestation from reckless Credit excess directed narrowly to capital spending is eventual collapsing business profits. Such dynamics remain conspicuous throughout the technology sector. It is today, however, worth pondering the possibility that inflationary manifestations in “services” may be quite different than that from business investment and, importantly, not in the same way self-limiting. And the real danger of Credit-induced asset inflation is that excess only begets higher asset prices and additional self-feeding borrowing power. We may have good reason to view the U.S. consumer as nearing the end of her rope, but as her assets (and income) rise in value she acquires additional collateral to borrow and spend against. She is given more rope. The momentous question today is whether the financial sector can maintain its capacity to create the enormous Credit to keep the asset Bubble expanding. We need to appreciate that, in this maladjusted “service sector” economy, it is Credit excess that drives the cycle of financial wealth creation and resulting spending.

This historic Bubble is about perceived financial wealth not true economic wealth. The key monetary transmission mechanisms exist in mortgage and debt security finance. The key driver of economic activity is financial gain not traditional business profits. This is not what we have learned and it is certainly not how we would like things to be. In the short-run, a system having perceived financial wealth dictating activity provides the Fed and financial sector considerable advantage. When the Credit Bubble bursts the disaster will be uncovered, and we will be in desperate want for true economic wealth creating capacity.

During 2001, non-financial business borrowings increased $321 billion (3%), while household sector (including non-profit organizations) borrowings expanded $743 billion (7%). Total mortgage Credit growth was more than double non-financial business borrowings. And while an unrelenting consumption and financial Credit Bubbles provide the rose-colored glasses crowd (including our Fed Chairman) reason to celebrate the economy’s resiliency, it’s not going to do any good for our economic future. Sure, Credit excess directed at consumption and asset markets works wonders in keeping the economic wheels turning. There is, furthermore, even the illusion that the New Era economy has conquered the business cycle. But there will be no escaping the consequences for this unprecedented accumulation of non-productive debt by a contemporary system lacking any effective constraint on excess. Sometimes when I read Mr. Greenspan I do get the sense that he is fully deluded:

“Even a subdued recovery would constitute a truly remarkable performance for the American economy in the face of so severe a decline in equity asset values and an unprecedented blow from terrorists to the foundations of our market systems. For if the tentative indications that the contraction phase of this business cycle has drawn to a close are ultimately confirmed, we will have experienced a significantly milder downturn than the long history of business cycles would have led us to expect.

Although there are ample reasons to be cautious about the economic outlook, the recuperative powers of the U.S. economy in the recent past have been encouraging. One important ingredient in that resilience has been the performance of productivity. Even discounting somewhat the phenomenal strength of the growth of output per hour of late, one cannot help but be impressed with how well productivity has held up in the face of the abrupt slowing of the economy in late 2000 and in 2001.

That performance has been encouraging because the nation’s fortunes, to a very great degree, will depend on the evolution of the growth of productivity. In particular, productivity will play a central role in determining the nature of the economy’s response to the aging of the population soon upon us.”

Unfortunately, the continuing U.S. boom has everything to do with unrelenting Credit and speculative excess and little if anything to do with productivity. This myth will also be uncovered when the Bubble bursts. And at this point to have our Fed Chairman partake in wishful thinking that the GSEs, Wall Street firms, the leading “banks,” the “financial engineers” and speculators will now be transformed to prudent financiers of sound investment is a joke devoid of humor. The intractable dilemma is that powerful institutions and monetary processes have been created over this protracted cycle that are married to the consumption and asset Bubbles. These Bubbles then require the preponderance of the system’s financial resources to avoid collapse. And that’s why exactly they’re called Bubbles and why great care and diligence must be taken to ensure that they do not develop.

I arrived back to Sydney this morning and will work to have a piece next week with more insight and deeper analysis. Thanks for your understanding!