03/16/2001 Global System Instability *

With recognition of the seriousness of the unfolding global financial crisis beginning to take hold, the Dow ended the week with a loss of almost 8%, the largest decline since October 1989. Across the board, it was bear market action. For the week, the S&P500 dropped 7%, the Transports 10%, the Morgan Stanley Cyclical index 9%, and the Morgan Stanley Consumer index 8%. The Utilities declined 5%, while the small cap Russell 2,000 and the S&P400 Mid-Cap indices both declined 7%. Tech stocks were hammered once again, with the NASDAQ100, Morgan Stanley High Tech and Semiconductor indices all sinking 9%. The Street.com Internet index sank 13% and the NASDAQ Telecommunications index dropped 11%. Financial stocks generally outperformed, with the Bank and Securities Broker/Dealer indices declining 6%. The HUI gold index sank 11% this week.

The U.S. credit market is thus far the great beneficiary of mounting financial crisis. For the week, two-year Treasury yields sank 23 basis points to 4.27%. Five-year yields declined 22 basis points to 4.46%, while the key 10-year T-note saw its yield drop 16 basis points to 4.90%. Long-bond yields declined 5 basis points to 5.27%. The yield on the benchmark Fannie Mae mortgage-backed security declined 17 basis points to 6.48%, while agency securities somewhat under performed with yields dropping 14 basis points to 5.70%. The benchmark 10-year dollar swap was basically unchanged at 95. Junk and investment grade corporate debt spreads widened somewhat during the week. Gold reversed sharply this week, with bullion prices dropping better than $13. With global currency markets in disarray, the dollar won by default. The dollar index surged almost 4% this week.

The following paragraphs from Hyman Minsky’s "Inflation, Recession and Economic Policy" (1982) seem especially pertinent this week.

"All in all, the euphoric period has a short lifespan. Local and sectoral depressions and the fall in equity prices initiate doubts as to whether a new era really has been achieved. A hedging of portfolios and a reconsideration of investment programs takes place. However, the portfolio commitments of the short euphoric era are fixed in liability structures. The reconsideration of investment programs, the lagged effects upon other sectors from the resources shifting pressures, and the inelasticity of aggregative supply that leads to increases in costs combine to yield a shortfall of the income of investing units below the more optimistic of the euphoric expectations.

The result is a combination of cash flow commitments inherited from the burst of euphoria and of cash flow receipts based upon lower-than-expected income. Whether the now less-desirable financial positions will be unwound without generating significant shocks or whether a series of financial shocks will occur is not known. In either case, investment demand decreases from its euphoric levels. If the boom is unwound with little trouble, it becomes quite easy for the economy once again to enter a "new era"; on the other hand, if the unwinding involves financial instability, then there are prospects of deep depressions and stagnation." 124

"Financial vulnerability exists when the tolerance of the financial system to shocks has been decreased due to three phenomena that cumulate over a prolonged boom: (1) the growth of financial – balance sheet and portfolio – payments; (2) the decrease in the relative weight of outside (government) and guaranteed assets in the totality of financial asset values; (3) the building into the financial structure of asset prices that reflect boom or euphoric expectations. The triggering device in financial instability may be the financial distress of a particular unit.

In such a case, the initiating unit, after the event, will be adjudged guilty of poor management. However, the poor management of this unit, or even of many units, may not be the cause of System Instability. System instability occurs when the financial structure is such that the impact of the initiating units upon other units will lead to other units being placed in difficulty or becoming tightly pressed…

The liabilities of banks and nonbank financial intermediaries are considered by other units (1) as their reservoirs of cash for possible delays in income and financial receipts and (2) as an asset that will never depreciate in nominal value. Bank and financial intermediary failure has an impact upon many units – more units hold liabilities of these institutions than hold liabilities of other private sector organizations. In addition such failures, by calling into question the soundness of the asset structure of all units, tend to modify all desired portfolios. A key element in the escalation of financial distress to Systemwide Instability and crisis is the appearance of financial distress among financial institutions. Without the widespread losses and changes in desired portfolios that follow a disruption of the financial system, it is difficult for a financial crisis to occur…

From this analysis of uncertainty it appears that, even if effective action by the central bank aborts a full-scale crisis by sustaining otherwise insolvent or illiquid organizations, the situation that made such abortive activity necessary will cause private liability emitters, financial intermediaries, and the ultimate holders of assets now to desire more conservative balance sheet structures. The movement toward more conservative balance sheets will lead to a period of relative stagnation."

"Displacements may be the result of system behavior or human error. Once the sharp financial reaction occurs, institutional deficiencies will be evident. Thus, after a crisis it will always be possible to construct plausible arguments – by emphasizing the triggering events or institutional flaws – that accidents, mistakes, or easily corrected shortcomings were responsible for the disaster." 118

"Under these emerging circumstances there is a decrease in the size of the dislocation that can cause serious financial difficulties to a unit, and an increase in the likelihood that a unit in difficulty will set other units in difficulty. Also, even local or sectoral financial distress or market disruptions may induce widespread attempts to gain liquidity by running off or selling out positions in real or financial assets (inventory liquidation). This action in turn may depress incomes and market prices of real and financial assets. We may expect financial institutions to react to such developments by trying to clean up their balance sheets and to reverse the portfolio changes entered into during the recent euphoric period. The simultaneous attempt by financial institutions, consumers, and firms to improve their balance sheets may lead to a rupture of what had been normal as well as standby financing relations. As a result losses occur, and these, combined with the market disruptions, induce a more conservative view as to the desired liability structure." 140/141

"Jobless Surge as Dollar Hits New Depths" was the headline for the lead story in yesterday’s Sydney Morning Herald. "Japan banks on the edge – Japan’s banks headed for a crisis which threatens world currency stability…" also made the front page. Around the world, it is becoming apparent that global financial crisis has taken a decided turn for the worst. Today, the Brazilian real dropped almost 2% to its lowest level since March of 1999, this just one day after the Brazilian central bank intervened to support the real for the first time in 14 months. Concerns grow of the more than $140 billion of external debt borrowed by companies in Brazil. Fears are increasing of acute financial crisis in Argentina and Latin American bonds. The major markets in Brazil and Argentina trade poorly throughout. Argentina peso futures contracts trade with heightened premiums reflecting growing concern of a breakdown of the country’s currency board. Governments and corporations in Argentina have significant foreign denominated debt.

One can certainly get a feel for the global nature of the current crisis by scanning today’s headlines from Bloomberg News: "Canadian Dollar Drops Near Record Amid Concern about Stocks and Economy"; "Australian Dollar Falls on Concern Government Set to Lose Parliament Seat"; "Korean Won, Taiwan Dollar Decline as Weak Yen Curbs Demand for Exports"; "Thai Baht Falls to Three-Month Low as Central Bank Says It’s Not Worried"; "Venezuela Unemployment Rate Surges to 15.8% in January From December’s 10%"; "Philippine Unemployment Rate Rises in January to 11.4%, a Nine-Month High" "Argentine Bonds Plunge on Concern Economy Plan Won’t Get Political Support"; "Turkish Economic Program Hinges on Lenders Providing Up to $25 Billion"; and "Euro Suffers Worst Weekly Drop Against the Dollar." In the US, a disconcerting headline has "Edison, PG&E Stocks and Bonds Drop on Fear of Bankruptcy." With significant exposure to a California utility bankruptcy in money market funds, this situation should be monitored closely. At the same time, American credit data turns more ominous by the week.

Yesterday, the Mortgage Bankers Association reported a sharp and broad based increase in mortgage delinquencies. The delinquency rate for "one-to-four unit residential properties" jumped 50 basis points to 4.54% during the fourth quarter. "The increase in the delinquency rate is significant but not a surprise given the fourth-quarter economic slowdown," said Douglas G. Duncan, MBA's chief economist. "Real GDP growth was only 1.1 percent in the fourth quarter, the slowest pace in six years. And rising energy prices also cut into homeowners' disposable income and ability to pay." Importantly, the fourth quarter marked the third consecutive quarterly increase in delinquencies. "After falling 71 basis points from the first quarter of 1998 through the first quarter of 2000, the delinquency rate over the past three quarters has risen by 82 basis points."

I have made the case repeatedly that while there are spectacular examples of regional real estate bubbles, the critical aspect of this boom cycle has been the pervasive nationwide character of this bubble fueled by a national real estate financial superstructure and unprecedented mortgage lending excess. Hints of boom turning bust are becoming more conspicuous. Notably, delinquencies rose in all four regions during the fourth quarter. The Northeast saw 4.51% late on payments, an increase of 56 basis points for the quarter. In the North Central, it was 4.28%, up 59 basis points; in the South, 5.52% up 55 basis points; and 3.51% in the West, up 35 basis points. Year-over-year, delinquencies jumped 83 basis points in the Northeast, 75 basis points in the North Central, 81 basis points in the South, and 52 basis points in the West. And with unemployment remaining at historic lows and housing prices strong, it should be clear that this rise in delinquencies is thus far much the result of poor lending, with significantly greater problems guaranteed come a recessionary environment and declining home values. Yesterday Bloomberg News ran a story on declining apartment prices in New York City.

Also yesterday, the American Bankers Association (ABA) reported credit card delinquencies of 3.34% at the end of the year, a jump from the 3.21% at the end of the third quarter and 3.22 percent at the close of 1999. The quarterly average over the past five years is 3.38 percent. The ABA reported that 4.25% of total credit card receivables were at least 30 days late, an increase from 3.93 percent in the third quarter. We expect a surge in credit card delinquencies going forward.

And while consumer debt problems are in the very early stages, the unfolding corporate debt debacle seems to worsen by the month. It is worth mentioning an article yesterday from BusinessWire: "Fitch: One For History Books; 1st Qtr Defaults To Exceed $20B. On the heels of a record setting $27.9 billion in default volume for the year 2000, high yield defaults soared to $12.8 billion for the first two months of 2001. February produced $9.4 billion in defaults, driving the LTM high yield default rate to 6.7% compared to 5.3% in January. Prominent defaults for the month of February included satellite telecommunication provider, Globalstar, banana producer, Chiquita Brands, and California utility giant, Southern California Edison. Excluding SoCal Edison and its precipitous fall from investment grade to high yield to default in less than three months, default volume for February totaled $4.4 billion. An unprecedented string of defaults by fallen angels (companies rated investment grade one year prior to default) including SoCal Edison began to unfold in 2000 and, as forecast by Fitch, is continuing this year. In the first week of March, fallen angel Finova Capital filed for Chapter 11 protection, placing an additional $6 billion of bonds in default. Excluding fallen angels, the LTM high yield default rate through February stood at 5.4% compared to 4.6% for full year 2000. Finova and additional defaults through the second week of March, suggest that the first quarter of 2001 will mark the biggest cluster of defaults ever witnessed by the U.S. corporate bond market, surpassing $20 billion."

Yesterday’s current account report from the Commerce Department is another document for the "time capsule." For the year, the U.S. current account deficit surged 31% to $435.4 billion, more than 4% of GDP (for comparison, it was about $110 billion during 1995), up sharply from 2.5% of GDP as recently as 1998. For the year, the profligate US economy imported about $1.22 trillion of goods (19% year-over-year increase), almost $450 billion more than it exported. Yet, despite this massive deficit, "US owned assets abroad" jumped $553 billion (compared to $430 billion in 1999). By category, overseas "direct investment" totaled $162 billion, while "foreign securities" were purchased to the tune of $124 billion. Both categories were little changed from last year. Big increases, however, were reported in the categories "US claims on unaffiliated foreigners reported by US nonbanking concerns" and "US claims reported by US banks." The first category had a net increase of $157 billion (up 70% from 1999’s increase of $92 billion) and the second $124 billion (up 58% from 1999’s increase of $70 billion).

With huge foreign bound outflows and a truly massive current account deficit, the offsetting foreign source inflows have grown to simply unimaginable proportions. "Foreign-owned assets in the United States" increased $952 billion during the year 2000, up 26% from 1999’s increase of $754 billion. And while "foreign official assets in the United States" increased about $30 billion (compared to 1999’s $33 billion), "other foreign assets in the United States" ballooned a stunning $917 billion (up 29% from 1999’s $711 billion). During the fourth quarter alone, "other foreign assets in the US" increased $280 billion (up almost 80% from 1999’s Q4 increase of $157 billion). For year-2000 by category, direct investment totaled $317 billion (up 15% from 1999’s $276 billion); holdings of US Treasuries actually declined by $52 billion (compared to 1999’s decline of $20 billion) and US currency sent abroad increased $1 billion (compared to 1999’s increase of $22 billion). The key to this amazing story (trading securities for goods!) is the massive foreign purchases of "US securities other than US Treasury securities." At an astounding $466 billion for the year, these net purchases were up 41% from 1999’s record of $332 billion. For now, the worldwide flood of dollars flows right back into agency and other US securities. Also, importantly, "US liabilities to unaffiliated foreigners reported by US nonbanking concerns" jumped $106 billion (up 208% from 1999’s $34 billion increase), while "US liabilities reported by US banks" increased $79 billion (up 18% compared to 1999’s $67 billion).

This data is evidence of unprecedented financial credit excess. Further, capital movements of this magnitude and character are almost certainly "hot money" speculative flows emanating from credit excess at home, in Europe and, increasingly, from the UK and off-shore banking centers. With this in mind, the unfolding global financial crisis should come, unfortunately, as little surprise to serious analysts.

As such, the narrative to yesterday’s report contained some interesting language: "Sharply higher demand for credit in Caribbean banking centers and in Europe resulted in a sharp step-up in interbank transfers…In the fourth quarter, large inflows from Caribbean banking centers occurred partly in response to a pickup in demand for credit abroad and partly for yearend bookkeeping purposes…In 2000, U.S. banks borrowed heavily in the second and fourth quarters to meet surges in domestic and international credit demand and to accommodate yearend bookkeeping needs"

My work to this point has heavily focused on the Great US Credit Bubble. However, there is absolutely no doubt that the past few years have witnessed the most outrageous and reckless credit and speculative excess throughout the global financial system. The multinational investment banking houses, international money center banks and the ballooning hedge fund industry – the "leveraged speculating community" – have led this financial rampage. Surely, historians will see this period as little more than unadulterated "wildcat finance" – an unharnessed global financial structure virtually encouraged by global central bankers to run completely amok. Accordingly, it is impossible for me to read through the above current account data and ponder its momentous ramifications without coming back to the great analysis of Hyman Minsky. This is "Ponzi Finance" in its purest form; credit on credit; the "layering" of leverage on leverage and speculation on speculation. Most unfortunately, it is an historic example of how capitalist financial systems, as Minsky keenly appreciated, have a proclivity of running wildly off course. The costs today are layering of frail debt structures and problematic financial interrelationships; desperately distorted economies and financial systems; and an acutely fragile global financial regime. The "bill" for previous wa

nton excess has been delayed on several occasions but is now coming due in spades.

As George Soros so brilliantly articulated in his book "The Crisis of Global Capitalism," when the current global system comes under significant stress, countries at the periphery are the first to falter. Well, globally the "wheels are coming off" the system, and the currencies of the periphery countries are getting hammered. Sure, politician, pundits, and citizens of countries such as Canada, Australia, Brazil, South Korea, Taiwan, Argentina, Singapore, Thailand, and elsewhere can easily come up with domestic explanations for their currency and financial woes, but the root of the problem lies outside, with a dysfunctional global financial system. The earthquake (the "Big One") has now begun and, alarmingly, the foundation of the system is beginning to buckle after only the initial minor tremors. And just as earthquakes illuminate the previous lack of or disregard for building codes, along with sloppy engineering and shabby construction, there will be years and perhaps decades to ponder why more care, attention and discipline were not taken to nurture, develop and protect a sound and stable global financial architecture. For too long, too many have acted in total disregard for the greater good of a healthy global financial and economic system. There has been a complete lack of responsibility and accountability, and many innocents will now share in the costs.

There’s no doubt about it, all the "fun and games" has left an edifice of over indebtedness, shaky institutions and maladjusted economies – acute Global Financial Instability. And following Minskian analysis, "if the unwinding involves financial instability, then there are prospects of deep depressions and stagnation." We just don’t see any other way around it. Sure, global central bankers could look to another round of runaway credit and speculative excess like that which emanated from the post-98 global crisis "reliquefication." It is difficult though to see how something similar could be repeated. Back in 1998, the US consumer still held the potential to be the "locomotive" for global recovery, enjoying an inadequate but positive 4% savings rate. There was as well the "tinderbox" of the unfolding tech/Internet/communications bubble, as well as generally a great proclivity of accepting risk by American households and institutions. Today, the US consumer is at the end of his rope, risk aversion is taking hold, and the technology bubble is a complete bust. The most likely scenario going forward is retrenchment - severe retrenchment, whether global central bankers like it or not.

Indeed, it appears a major period of retrenchment is already in progress. It is very much international, multidimensional, and it is outside of the control of the Federal Reserve. Importantly, it is more specifically financial than economic, although economic downturn is a certain consequence of financial retrenchment. This is an atypical crisis, not easily understood by traditional analysis. As policymakers from Australia to Canada struggle with sinking currencies not justified by relative underlying economic fundamentals, the root cause of the unfolding global currency crisis is the increasing impairment of the global system itself, specifically the "leveraged speculating community." It has been the financial institutions that have been behind the global "euphoric era"/financial bubble, and it is the financial players that are today caught heavily exposed, are suffering heavy losses, and now have little alternative outside of aggressive risk control. This is a sea change for the global economy and asset markets. The major dilemma, however, is that with the leveraged speculating community having come to quite dominate international financial markets, it is an arduous (impossible?) process to locate participants willing to accept the market risk that they are desperately seeking to unload. Bull markets create their own liquidity and bear markets, by definition, destroy liquidity. Bear markets uncover problematic underlying leverage. This is very much a global liquidity crisis in the works, with unprecedented leveraged speculation at the root of the unfolding financial debacle. There will be no cure but a protracted workout period.

We also have little doubt that derivative players are and will continue to play a prominent role in the unfolding crisis. They have willingly become "receptacles" of enormous market risk – equity, currency, interest-rate, credit - in what will prove a great failed experiment with sophisticated "risk management" techniques and vehicles. If the true story is ever told about these derivative markets, the storyline will be much more about reckless leverage and speculations than managing risk. And with global positions surpassing $100 trillion, the derivative marketplace is very much a "weak link" in the acutely fragile global financial "daisy chain." If one major derivate player falters, perhaps a Japanese institution, then the entire frail system is in jeopardy. And as we have stated previously, the derivative players assume continuous markets and marketplace liquidity. Neither will be forthcoming as derivative traders look to offload the risk they have accumulated over this boom cycle. My favorite flood insurance analogy would today have torrential rains and a swelling river level leaving the flood insurance speculators in a panic as they rush to a reinsurance marketplace with no takers, in what they had always assumed would be liquid and functioning market. So much for making bold assumptions…

So far, the US dollar wins by default, with the periphery currencies under intense liquidation. For now, this is much more about market dynamics than underlying fundamentals. Still, there remains the strong but erroneous marketplace perception as to the soundness of the U.S. financial system. Sure, capital levels are high, especially compared to weakened institutions abroad. This comparison, however, is deceptive, with the US only recently seeing its historic asset bubble begin to falter. Even today, one can make a case that the Great US Credit Bubble lives on, with money market fund assets increasing $18 billion last week to $2.047 trillion (unbelievable!). Money market fund assets have now increased at a 33% annualized rate during the past 36 weeks (since the beginning of 2000’s second half). Broad money supply increased $14 billion last week to almost $7.3 trillion, and has now expanded almost $570 billion, a 12% rate, during the past 36 weeks. The U.S. financial sector is working diligently to protect itself and sustain the boom, but these efforts will be futile. February numbers are in for Fannie Mae, with the mortgage lending behemoth expanding its mortgage portfolio at a 19% rate during the month. And while this is reduced from January’s expansion, it is worth noting that Fannie Mae’s "average investment balance" increased $15 billion during February, a 27% growth rate, to $682 billion.

So, especially with a faltering yen and the Japanese financial system in tatters, the great global leveraged speculating community is even more comfortable with the US credit market as the "place to play." Moreover, a confluence of factors including the crowd behavior of the speculators, heightened global risk aversion leading to a liquidation of "periphery" assets, and a massive derivative position overhang exacerbating market direction – whatever that direction might be, finds us today in the midst of a severe global currency market dislocation. It’s a dollar "meltup." And while this dislocation has thus far worked to the great benefit of the dollar and, importantly, agency and credit market instruments, the unfolding financial crisis is anything but a sanguine development for the vulnerable U.S. financial sector. The U.S. stock market is beginning to appreciate the seriousness of the unfolding crisis, but this again ironically only provides greater fuel for the speculative bubble in the U.S. credit market. The day of reckoning approaches… Thus far, however, the major deficiencies of the leading U.S. institutions (and financial system generally) have remained unexposed (specifically due to continued rampant money and credit excess). This will not last. With the expectation of an inevitable break in confidence for the powerful U.S. financial sector, the potential for outright financial collapse is absolutely terrifying.