05/17/2001 Feeding the Financial Beast *

The Fed moved aggressively again this week, having now reduced rates by 250 basis points in less than five months. The only somewhat reasonable comparison would the 18-month period spanning January 1991 to September 1992, where rates were lowered from 6.75% to 3%. It is interesting to compare some key economic data between these periods. While it is commonly accepted that the U.S. experienced only a mild recession during the early 1990’s, the Fed’s extreme accommodation occurred during a period where unemployment rates rose from 6.4% (1/91) to 7.8% (6/92). So far this year, unemployment has increased from 4.2% to 4.5%. Currently, the household sector is running a negative savings rates compared to a positive savings of between 8% and 9% during 1991/92. The U.S. actually ran a current account surplus during the first-half of 1991, but will run a massive current account deficit approaching $450 billion this year. The current 1.6 million rate of housing starts is about 60% above starts during 1991. While the U.S. economy was immersed in a stubborn recession during the early 1990s, the Fed has recently responded aggressively although the U.S economy has yet to experience a single quarter of negative growth.

The Greenspan Fed was forced to respond aggressively in the early 1990’s to a U.S. financial system in acute crisis. Severe impairment was the consequence of previous reckless lending and financial excess, including the S&L crisis, wildcat finance in the "oil patch," the junk bond fiasco, and regional (particularly the North East and California) real estate booms turned bust. The solvency of major U.S. banks (including Citibank) was in question, and an unfolding real estate collapse in California had clear potential to push the system over the edge. A severe credit crunch was taking hold and the Fed acted to stem what had potential to develop into the first U.S. depression since the 1930s. Greenspan responded aggressively and history’s greatest Credit Bubble and bull market were launched.

So what has the Federal Reserve so spooked today?

Perhaps, Greenspan has come to appreciate the acute fragility of the dysfunctional U.S. financial system and an incredibly maladjusted economy. In the early ‘90s some fretted when he was slow to come to grips with the dire condition of the U.S. financial system. Well, years of training have obviously had quite an impact: Dr. Greenspan has gone from "baby steps" to holding a world record in the triple jump. It has been a truly remarkable transformation, from guarded central banker to assertive financial ringleader. He has apparently come to believe that it is much better to act early to forestall crisis and come with full guns blazing. Shoot first, ask questions and take count of collateral damage much later. After all, this approach did prove decisive in arresting the global financial and economic crisis back in 1998. The Fed and U.S. financial sector stimulated a U.S. consumption boom (that continues to this day) that did wonders for the struggling global economy. This accommodation, however, also proved decisive for pushing the evolving U.S. credit-induced boom into a full-fledged historic bubble economy. Importantly, an enormous "reliquefication" provided unprecedented liquidity for the unfolding technology/Internet/telecommunications bubble. Even more significant were the indelible imprints left on an emboldened and much mightier financial sector.

While others have commented on the interesting language in the Fed’s policy directive, I will highlight this as well: "A significant reduction in excess inventories seems well advanced. Consumption and housing expenditures have held up reasonably well, though activity in these areas has flattened recently. Investment in capital equipment, however, has continued to decline. The erosion in current and prospective profitability, in combination with considerable uncertainty about the business outlook, seems likely to hold down capital spending going forward. This potential restraint, together with the possible effects of earlier reductions in equity wealth on consumption and the risk of slower growth abroad, continues to weigh on the economy."

If the Fed is truly targeting faltering capital spending and profitability, especially within the highly maladjusted technology sector, it is making a major policy error. It was specifically the enormous financial bubble that developed post-1998 that led to massive and unsustainable over spending throughout the expansive high tech industry. It is also worth again addressing (as somewhat of a follow-up to last week’s commentary) the powerful interplay between financial and technological innovation that has certainly not been given its proper due elsewhere. The unusually large margins afforded new and innovative products and services throughout the technology sector not surprisingly garnered extreme business and speculative interest. This keen attraction, combined with a contemporary credit system with a newfound capability and penchant for creating virtually unlimited money and credit, provided an absolute financing and spending powder keg. Consequently, a flood of money was available to throw at virtually any technology enterprise. This, not surprisingly, led to scores of negative cash flow and hopelessly unprofitable ventures receiving funding, whose expenditures provided enormous revenues that sustained artificially outsized industry revenue and profit growth. The more profits, the larger the flood of finance, and the greater the over spending. It was a textbook bubble, with monetary excesses fueling the boom through funding both uneconomic enterprises (that would not survive come the bursting of the financing bubble) and over investment that would ensure an abrupt margin (profitability) collapse at the first sign of business slowdown. A bust in proportion to the historic excesses of the previous boom was unavoidable. In sum, increasingly dysfunctional monetary processes that were both creating and directing massive financial excess at the sector assured its eventual collapse.

Most unfortunately, the Greenspan Fed absolutely fails to address the true and clearly potentially disastrous underlying dilemma for the U.S. system: entrenched monetary processes that hopelessly perpetuate financial excess, self-reinforcing market distortions and dangerous economic maladjustments. The Federal Reserve simply refuses to govern a dysfunctional wildcat financial sector that has grown to momentous size and power, and whose self-serving pursuits propagate unrelenting and increasingly precarious lending and speculative excess. The great danger comes not from a slowdown in capital spending or a consumer who wisely chooses to temper his unsustainable borrowing and spending after many years of binge, but to the gross financial excess that runs unabated with the acquiescence and extreme accommodation of the Federal Reserve. Instead of moving to harness an out of control credit system that assures recurring credit-induced booms and busts, failed Fed policy only Feeds the Financial Beast. Indeed, this is a financial system, and leveraged speculating community especially, that blossomed directly from the Fed’s early 1990s accommodation and hasn’t looked back since. The resulting enormous speculative and banking profits afforded the financial players in the early 1990s, however, looked like a pittance compared to the windfall following the Fed’s 1998’s "reliquefication." Not only is the Fed loath to control this monster that it has been so instrumental in nurturing, it has now reached the point where the Fed is granting additional rewards for previous reckless excess. This has gone much beyond an issue of moral hazard. This is outright negligence.

It is now simply a sad case of waiting to see when, where and how big and destabilizing the next bust; unrelenting monetary excess assures it. Certainly, nowhere are the excesses more pronounced than throughout the real estate sector. And like the gas that was thrown on the smoldering technology boom back in 1998/99, the Fed today fosters even more outrageous excess throughout mortgage finance. It is certainly worth noting that with the adopted Greenspan strategy of cutting rates early and quickly, there will be few bullets left when the massive real estate bubble bursts, taking consumer spending and the general economy down with it. We are today in the quite early stages of what will eventually prove a protracted period of economic decline.

For now, the contemporary mortgage finance sector and real estate markets with ingrained inflationary expectations provide the Fed a powerful policy tool. Countrywide Credit made the following release Tuesday afternoon: "Countrywide Home Loans national call centers have seen a 400 percent spike in calls from consumers immediately following the Federal Reserve’s announcement this morning. This is the fifth rate drop by the Federal Reserve this year. Recent rate decreases have generated significant interest from consumers who are purchasing or refinancing their homes. In addition, many homeowners see this as a chance to open home equity lines of credit many of which are based on the declining Prime Rate."

Borrowing against home equity is clearly playing a critical role in sustaining the consumer-spending boom. Today’s larger than expected trade deficit of $31.2 billion saw record consumer goods imports. MarketNews International reported that March imports into the Port of Los Angeles were up 15% year over year. Quoting the port’s director of business development: "I’ve been to the shopping centers and everybody still has bags and bags -- at least in Southern California." The article continued, "His retail clients have already suggested that the port should prepare for strong activity in the third and fourth quarters. (The director) argues that whatever consumer spending has been lost to higher energy prices may well be offset by the recent surge in mortgage refinancings. ‘Unfortunately, all that does is give consumers a second chance to get into debt since they don’t stop spending.’"

April numbers are in from Fannie and Freddie. With a major mortgage refinancing boom circulating through the system, for the month Fannie purchased a record $53.5 billion of mortgages (surpassing the previous record of $51.6 billion set in December 1998). Its total book of business (portfolio purchases and Fannie Mae mortgage-backs held in the marketplace) expanded at a rate of almost 22% ($22.7 billion), compared to about 9% last year. Freddie Mac made total purchases of $41 billion during April, while expanding its mortgage portfolio at a rate of almost 27% ($9.3 billion). The continued credit excess instigated by the GSEs is as incredible as it is reckless. Importantly, the GSEs are providing massive liquidity to the old holders of refinanced mortgages ("reliquefication"), which they then use to absorb surging issuance of corporate debt, credit-card, auto and other asset backs, commercial mortgage-backs, CDOs (collateralized debt obligations), CLOs (collateralized loan obligations), junk and myriad other debt instruments.

Extracted from an article by Dow Jones’ Joe Niedzielski: "Wider credit spreads on bonds and loans led to a doubling of the cash-flow-structured fixed-income vehicles that Standard & Poor’s rated in the first quarter. (S&P managing director David) Tesher said traditional asset-backed investors are turning to the CDO market to increase assets under management and to escape from the volatility of having to mark to market their holdings of asset-backed securities. Issuance of these vehicles also gives these investors increased capacity to buy more asset-backed securities, he said. ‘Often there are illiquid marks and they can do a CDO of asset-backeds and no longer have to mark to market the underlying collateral,’ Tesher said. ‘That's a big motivation.’" Well, isn’t that special…

Wall Street and the leveraged speculating community are certainly hard at work, developing strategies, creating structures, and "doing deals," all the while benefiting handsomely from the extreme monetary accommodation. Acting together, the Fed and the powerful GSE "reliquefication" mechanism have created what is developing into an historic mortgage credit boom. From a Wall Street research report: "Total (Fannie Mae) new business volume of $53.5 billion implies $92 billion combined for Fannie and Freddie in the month, at least $250-$300 billion in the quarter, and perhaps $465 billion in US originations in the second quarter, representing a staggering $1.85 trillion annual rate of US originations." $465 billion of mortgage originations this quarter? $1.85 trillion for the year? Truly, utterly amazing.

So far, May is living up to expectations. In its weekly data, the Mortgage Bankers Association reported dollar volume of applications 86% above year ago levels. Purchase applications are running up 11% (dollar volume), with applications to refinance up 468%. It is certainly not just the GSEs that are aggressively playing the real estate bubble. This week GMAC announced a registration to sell $14 billion of mortgage-back securities and all the major Wall Street firms are participating. Bear Stearns reported the sale of almost $6 billion of mortgage-backs for FleetBoston. "Completion of this complex transaction depended heavily on the innovative work of Bear Stearns’ Financial Analytics and Structured Transactions Group. Through its proprietary analytics, its proprietary collateralized mortgage obligation arbitrage and proprietary loan-level prepayment models, Bear Stearns and its financial engineering capabilities optimized asset allocation, maximized Fleet’s asset value and created a multitude of structured securities. The resulting deal was the largest Agency re-securitization ever issued." It does sound impressive…

Along with fueling the real estate bubble, it has become apparent that this current bout of rampant money and credit excess will have a major impact on the energy sector. The unfolding energy crisis is very much a global phenomenon, with Brazil soon to begin rationing electricity and surging prices impacting consumers and businesses in Europe, Asia and elsewhere. Here at home, prices have jumped sharply and millions prepare for a summer of blackouts. The situation is turning desperate in California, with Governor Gray Davis announcing Wednesday that the State of California is moving aggressively into the energy production business. There is going to one heck of a capital-spending boom in the energy sector in California and likely throughout the country.

It is certainly to the point where one ignores the profound ramifications of the California energy crisis at one’s peril. First of all, the major spike in electricity prices provides a clear example of the degree to which extreme price unpredictability and volatility have become an unfortunate hallmark of the highly maladjusted U.S. bubble economy. We have witnessed unprecedented volatility in the U.S. stock market, surging rents and real estate values in key markets, rising prices in a broad list products and services, wild component and product price fluctuations throughout the technology sector, as well as extraordinary price movements and extreme volatility in currency, precious metals and energy markets globally. The Greenspan Fed and U.S. financial sector may have mastered the art of sustaining a financial bubble, but at the cost of extreme instability and acute system fragility.

Such an unstable environment is certainly anything but conducive to effective business planning or cost management. Furthermore, as was made painfully clear to the California utilities and now to State officials, the extreme nature of current price volatility can prove devastating for intermediaries. I was reading a Los Angeles Times article back from December that included an interesting quote from an Edison International vice president: "We are the only thing standing between the consumer and volatility. We have to remain financially healthy." Yes, they were the risk buffer. Unfortunately, an unforeseen surge in electricity prices over a period of months was enough to bankrupt PG&E and virtually do the same to Edison. Importantly, years of experience had convinced the utilities and seemingly everyone else that there was little risk in protecting the State’s electricity customers from swings in spot electricity prices. Recent history, however, has very little relevance to the current extraordinary bubble economy.

When the California electricity market was deregulated back in 1996, no one had any inkling of the bubble that would soon engulf the state. There actually was concern for a likely supply and demand imbalance, but the fear was that there would be major overcapacity in electricity generation. Things can sure change quickly and dramatically. Certainly, a gross underestimate of future demand is at the heart of today’s predicament. Furthermore, as explained in the Los Angeles Times article, "the notion was that (these) new companies would absorb the risk of volatile electricity prices, giving customers stable rates and they would keep prices low by competing among themselves." Not only was the degree of risk that would develop incomprehensible at the time, the basic premise regarding how risk would be absorbed proved completely erroneous. As the intermediaries between spot electricity prices and regulated customer rates, it was the utilities alone left to shoulder whatever risk developed. It is also likely that a belief existed that the utilities could hedge their exposure in the developing energy derivatives marketplace. But what players had the wherewithal to insure against potential energy losses for the entire State of California? And once the energy market became dislocated, who was supposed to have the resources to step up to the plate and absorb the massive losses that have since ravaged the powerful California utilities and now impair State finances? Outside of the government, no one.

Last week, I touched upon the boom-time "New Economy" delusions of a structural shift in productivity and profits. This week I would like to address the equally critical misconceptions regarding risk that have played a momentous role in fostering this historic bubble. The unfolding California energy crisis certainly illuminates some very fundamental and critical misunderstandings. First, the popular notion that the marketplace (almost like magic) creates stability and prices that tends toward equilibrium is patently false in an environment dictated by rampant money and credit excess. Indeed, credit-induced bubble economies are specifically dominated by forces cultivating disequilibrium. Second, the perception that the mechanisms and strategies of contemporary finance reduce risk is absolutely fallacious. Derivatives, in particular, provide a mechanism for individual players to mitigate/hedge risk. It is a completely different proposition, however, for the system as a whole ("fallacy of composition"). There is no way an entire market can hedge, as outside of the market there are no parties with the wherewithal to remunerate in the event of large system-wide losses.

The general perception (actively marketed by Wall Street) that risk can be mitigated by derivatives has and continues to play a major role in this bubble. As we have witnessed repeatedly in various markets, the availability of derivative "protection" changes behavior, inducing participants toward riskier activities that significantly augment risk for the system as a whole. Furthermore, credit bubbles foster exponential debt growth, asset inflation and resulting speculative excess, as well as severe marketplace and economic distortions that as well grow exponentially over time. It is critical today to appreciate that Credit Bubbles generate risk exponentially, and Fed policy is greatly exacerbating this process. And while there is much finger pointing today in California, the State’s energy crisis is very much the consequence of boom-time erroneous notions and credit bubble excess. It is as incredible as it is alarming to see how quickly California went from expecting huge budget surpluses, as far as the eye could see, to financial crisis.

With the previous paragraphs in mind, I would like to highlight a comment made in a recent Wall Street research report: "We view (Fannie Mae’s) risk profile as moderate because its implied government debt guarantee gives it the financial capacity to carefully hedge its risks while still generating a high return to shareholders."

While such "analysis" that Fannie Mae (and Freddie Mac) can "hedge its risk" is clearly the sanguine consensus view, it is patently fallacious and yet another example of the complete misconception of risk that has pervaded throughout this boom. Fannie Mae’s total book of business (its mortgage holdings and its guaranteed mortgage-backs held in the marketplace) has reached almost $1.4 trillion, with Freddie Mac not far behind at $1.0 trillion. The GSEs are rapidly becoming THE mortgage market, and as I stated above, a market cannot hedge itself. The extreme risk inherent in the GSE business model has become much too momentous for "hedging." Similar to the California utilities, the GSEs are the intermediaries "standing between the consumer and volatility." Like the utilities, when times get tough they will be on their own. The GSEs can make all the claims they want about how much "insurance" they have purchased, but the financial players that are on the other side of these trades will not have the liquidity nor the resources to "pay" in the not unlikely event of a significant financial and economic dislocation. For one moment, ponder the scope of the losses suffered in the California electricity market over the past several months and put them in context to the potential credit and interest-rate losses that could develop throughout the entire U.S. household real estate sector. Let’s end all the nonsensical talk of the GSEs having the "financial capacity to carefully hedge." It is truly an impossibility.

Sure, the historical models do support the silly claims that there is little in the way of interest-rate and default risk for the GSEs. Yet, the California utility fiasco provides irrefutable evidence of how abruptly the financial environment can turn hostile, and the extreme danger of relying on past experience as a predictor of the risk inherent in this bubble economy. Actually, it is at the minimum disingenuous to use recent data to claim minimal risk in mortgages financed at current inflated real estate prices, with unusually low mortgage rates, with the consumer sector highly over borrowed and having extracted unprecedented amounts of home equity, while the U.S. economy commences a downturn after years of extreme excess. The bottom line is that the continuing real estate bubble now poses considerably greater systemic risk than the technology bubble, and this risk expands by the day. It is furthermore just ridiculous that the Greenspan Fed is inciting further excess that is certain to create a major financial and economic disaster down the road.

It is worth addressing a key aspect of the current environment that, among other things, helps explain the extraordinary divergence between high and volatile energy prices and the low and relatively stable cost of money: there is a fundamental difference between derivative markets for intermediating commodity and financial risk. Central bankers are, of course, incapable of creating oil, natural gas, or electricity. For a critical commodity with the characteristics of electricity, buyers are at times disposed to paying what would normally be viewed as exorbitant prices to secure adequate supplies. The Fed is particularly impotent in such markets, where wildly modulating liquidity in the spot market (supply and demand imbalances) can lead to dramatic and destabilizing price movements. Similar results in interest-rate markets would today be catastrophic. Not to worry, however, as the Fed has tremendous influence in the massive financial derivatives marketplace. Not only can the Fed directly create liquidity in the "spot market," it has tremendous power (as we have seen repeatedly) to inspirit the creation of financial sector liquidity that quickly rectifies supply imbalances throughout the financial markets. In this regard, one cannot overstate the critical role now played by the Fed with its liquidity assurances. Greenspan has been seduced by such power.

Indeed, the viability of the $100 trillion plus derivative market is absolutely dependent on assurances of uninterrupted liquidity that only the Federal Reserve can effectively provide. And nowhere is the Fed’s role more critical than with the mammoth interest-rate swaps market. The swaps market, in particular, holds the key for the GSEs ability to endlessly balloon their balance sheets, with this unprecedented liquidity creating mechanism at the heart of the U.S. financial sector’s insatiable demand for securities. It is a ruse, however, to claim that the risk associated with this unmatched credit creation can be "hedged." This extraordinary (experimental) monetary regime that so effectively "transforms" mountains of risky loans into trillions of dollars of safe "money" is absolutely dependent on both GSE liquidity and the viability of the massive derivatives market. So, right here one can isolate the critical relationships at the heart of history’s greatest financial bubble.

While this cozy mutual dependence that has developed between the Greenspan Fed and the derivative players has been instrumental in fostering the U.S. bubble, it has become increasingly dysfunctional and precarious over time. Instead of providing a mechanism to isolate and disperse financial risk as advertised, the derivatives market has become a mechanism to disguise risk and perpetuate unprecedented credit excess. Clearly, the GSEs and Wall Street are abusing the common perception of derivatives as a risk management tool, as they recklessly perpetuate unimaginable leverage, endemic speculation and general financial excess. And with the system under considerable stress due to the collapsing of the technology bubble, the aggressive financial players have unwavering (and justified) confidence that the Federal Reserve will continue to accommodate history’s Greatest Credit Bubble. This is the Fed locked in policy disaster. Monetary policy has been left to court a dysfunctional relationship with the masters of financial excess, a circumstance that to this day fosters momentous financial and economic distortions that absolutely assures financial and economic crisis.

The GSE’s ability to balloon their balance sheets and fuel a real estate bubble is much dependent on the continued expansion of the interest-rate derivatives market. Indeed, the notion of derivatives providing a mechanism to mitigate risk is the key to the unfettered money and credit creation, hence the unlimited availability of credit. In truth, derivatives are but a convenient repository for risk, where crisis lurks whenever this risk rises to the surface. At some point, there will be a severe dislocation.

As such, it is certainly worth highlighting an article by Dow Jones’ Michael Mackenzie: "Swaps As A Benchmark Poses Systemic Risk Issues: CSFB – ‘Private sector benchmarks are fine and good except in the (unlikely) case of a systemic crisis,’ Credit Suisse First Boston analysts wrote in a research note Monday. ‘Systemic risk remains a factor in the pricing of swaps.’ On three occasions during the past three years, the swap market has experienced distinct bouts of illiquidity. These include the near bankruptcy of the hedge fund Long Term Capital Management in the aftermath of Russia's debt default in October 1998, the Y2K panic of summer 1999 and the burst of monetary tightening by the Federal Reserve in April-May 2000. During these periods, the interbank swap market closed the shutters, with the consequence that trades beyond even the standard size of $50 million became difficult to execute. The rationale for this inactivity lay in the overwhelming desire of market participants to pay fixed on a swap contract. The strong one-directional flows meant swap dealers were unable to accommodate the demand to pay fixed because very few participants were willing to sit on the other side of the contract and make floating rate payments when credit risks, and therefore private credit interest rates, were rising. Not surprisingly, CSFB said, swap spreads vaulted sharply higher during these periods as dealers ‘raised their offer levels to sharply ration flows... you could run, but you couldn't hedge.’ The dysfunctional nature of the swaps market in times of trouble is compounded by the ongoing consolidation of the banking industry, which is reducing the number of swap counterparties. The recent merger of Chase Manhattan and JP Morgan has created a giant that dwarfs other banks within the interest rate swaps sphere, a market that the Bank of International Settlements estimated at $48 trillion in June last year."

We have certainly not seen many public references to "the dysfunctional nature of the swaps market" or the "three occasions during the past three years" of "distinct bouts of illiquidity." As we watched these developments at the time, they were seemingly the best-kept secret around. The liquidity and dynamics of this key market in times of system stress is a critical issue that has been repeatedly "swept under the rug." We did observe that in each case of market distress the GSEs responded forcefully with aggressive balance sheet expansion, hence providing the liquidity to stem the crisis in the swaps market and sustain the Credit Bubble. While such measures have certainly proved effective thus far, this is a very dangerous game. The GSEs, providing the key liquidity that sustains the swaps market and credit market generally, are themselves dependent on the swaps market to sustain their massive balance sheet expansion. This is certainly not a virtuous circle. Instead, it has disconcerting similarities, although on a much grander scale, to some of the financial nonsense that inflated the technology bubble. That the Fed has become such an instrumental player in this game is quite troubling. As I have written repeatedly, this will not work well in reverse. One of these days interest-rates will surprise on the upside. Perhaps, the Fed will be forced to reverse course or the credit market will move on its own. We certainly see all the makings for a surprise on the inflation front, with continued money and credit excess being poured on an economy with the greatest predisposition to inflationary pressures in years.

A strong perception holds that there is little risk associated with the Greenspan Fed’s aggressive rate cuts. This is but one more example of the consensus view being way out in left field. We are certainly watching the price of gold carefully, with bullion rising almost $20 this week. While it is a very key commodity, it’s trading has for some time been distorted by aggressive central bank selling and untold supply created in the derivatives market. Such market dynamics, like those that pervade throughout financial derivatives, create great potential for speculative excess, instability and inevitable dislocation. We have expected that a rush to unwind derivative speculations would at some point create panic buying of the actual underlying metal. Has the Fed’s extreme aggressiveness set off this process? Will a dislocation in the gold derivatives market precipitate other derivative problems, perhaps in the swaps or currency markets? Is the dollar similarly vulnerable to a derivative market dislocation? It is certainly our view that the Fed is pursuing the course of greatest risk, the senseless perpetuation of the Great Credit Bubble.