The evolution of finance
Hyman Minsky, our favorite American economist, is most recognized for his maxim "stability breeds instability," as well as his path-breaking theoretical reflections on "Ponzi Finance," the "Financial Instability Hypothesis," and the "Wall Street Paradigm." While we have been heartened that Minsky has been attracting keener attention these days, too often we feel the very essence of his work, and certainly his most pertinent insights, have been either watered down or completely overlooked. We could not agree more with Minsky’s view that "an understanding of the American economy requires an understanding of how the financial structure is affected by and affects the behavior of the economy over time." Whether one pitches his or her tent in the bull or bear camp or somewhere in between, there should be little debate that we continue to witness historic evolution in both the nature of finance and the underlying structure of economic systems.
We believe the current backdrop, so rife with financial excess and nuance, has elevated a "Minskian" analytical framework to the standing of "invaluable." Never has finance had such a commanding impact on the real economy; never before has Wall Street finance enjoyed such power to dictate which sectors relish spectacular booms – including its own. At the same time, the bursting subprime bubble offers a vivid example of the nature and fundamental fragility of, in Minsky’s nomenclature, "Ponzi finance." We view subprime as only the latest in an ongoing – and at this point open-ended – series of booms and eventual busts. Yet despite the subprime meltdown and unfolding mortgage credit fiasco, the general backdrop remains decidedly in what Minsky referred to as the "economics of euphoria."
Look no further than the Federal Reserve’s own "flow of funds" data for evidence of unrelenting financial elation. Bank Credit expanded $906 billion, or 12.1%, during 2006, with a two-year gain of 24%. Strong, yes, although Wall Street has left the banking industry in its dust. For the year, broker/dealer assets expanded 29% to $2.742 trillion, with a two-year rise of $897 billion, or 49%. At $615 billion, 2006 broker/dealer asset growth was double the previous record set in 2005, and approached triple 2000’s level, then an all-time high.
In terms of financing Wall Street’s spectacular expansion, Fed statistics inform us that "federal funds and security repurchase agreements" (repos) surged $484 billion, or 24%, during 2006 to $2.491 trillion, with two-year growth of $800 billion, or 51%. This market almost doubled in just five years. Over the past year, outstanding commercial paper increased $370 billion, or 22%. Money market fund assets grew $400 billion, or 20%.
In the real economy, last year was notable for a housing-led economic moderation. After posting blistering 9.0% nominal GDP expansion through last year’s first quarter, nominal growth had more than halved, to 4.1%, by year end. Annual non-financial debt growth decelerated from 2005’s 9.4% to 7.9%. In nominal dollars, the expansion of non-financial debt slowed to $2.100 trillion from 2005’s record $2.279 trillion. Despite economic moderation – or more likely because of it – financial sector debt growth accelerated to 9.3% from 2005’s 8.7%. In nominal dollars, the growth in financial sector credit market borrowings increased from 2005’s $1.04 trillion to a record $1.20 trillion. Overall, total credit market borrowings (financial and non-financial) increased by a record $3.555 trillion. or 27% of GDP, and up from 2005’s increase of $3.403 trillion. For perspective, total credit market borrowings increased $2.348 trillion in 2002, $2.725 trillion in 2003, and $3.002 trillion in 2004.
It is worth highlighting a few of the more significant changes in the composition of debt created. Total mortgage debt expanded $1.172 trillion, or 9.7%, during 2006, down from 2005’s record $1.462 trillion, but still multiples of the annual average growth in the 1990s of $268 billion. Household mortgage debt growth slowed markedly from 13.8% to 8.9%, the slowest rate of expansion since 2000. As residential downshifted, the commercial real estate lending business went into overdrive. Commercial mortgage debt growth accelerated to 15.6%, with a notable two-year gain of 32%. Little wonder construction employment has held up so well.
Meanwhile, the corporate debt market was its most active since the telecommunications debt bubble. The pace of borrowings last year jumped to 8.3%, up sharply from 2005’s 4.9%, and its fastest annual pace since 1999’s 9.8%. This marked a notable reemergence of corporate debt bubble dynamics from what had been steadily rising debt growth from 2002’s 0.3%, 2003’s 1.9%, and 2004’s 3.4%. Suddenly reaching a frenetic pace, fourth quarter borrowings expanded an eye-opening 10.9% rate, the most intensive debt expansion since the pinnacle of corporate borrowing bubble excess during 2000’s second quarter. Keep in mind that this intensification was in the face of the real economy cooling.
It has been an unequivocal case of full speed ahead for "structured finance." Outstanding asset-backed securities (ABS) increased $533 billion, or 17.4%, last year. The ABS market expanded $1.12 trillion, or 50%, in only two years, and has ballooned more than 170% so far this decade. Collateralized debt obligations (CDOs) – the packaging of various types of loans, bonds, and derivatives into a multitude of securities – becomes a more prominent source of system credit and liquidity creation each year. Public CDO issuance surged to $918 billion last year, up almost 50% from a record 2005. Sales of "synthetic" CDOs – primarily bundling credit derivatives – doubled to $450 billion. And, according to the Financial Times’ Gillian Tett, total public and private "CDO issuance was probably around $2,800 billion last year, a threefold increase over 2005." Amazing.
Credit bubble is ongoing
There is as yet no sign of moderation from the ballooning derivatives sector. According to the Bank of International Settlements, total global derivatives positions grew 24% last year to $370 trillion. Foreign exchange derivatives grew 22% to $38 trillion, and interest-rate positions were up 24% to $262 trillion. Growing the most vigorously, credit derivatives surged 46% last year to $20.4 trillion, this after doubling in size during each of the previous two years. Here at home, U.S. bank derivatives holdings jumped 30% to end the year at $131 trillion, including credit derivatives which surged 55% to $9.0 trillion. Bank revenues from trading derivatives rose 31% to a record $18.8 billion, a vital driver of ongoing industry earnings growth during a period of waning profitability for traditional lending.
The theme that unfolded throughout 2006 – economic moderation abetting financial sector extremism – continued through 2007’s first quarter. Combined profits at Goldman Sachs, Lehman Brothers, Morgan Stanley, and Bear Stearns were up 34% from 2006’s first quarter to $1.9 billion. These earnings were the upshot of unparalleled balance sheet expansion, with assets at these four institutions up $239 billion, a 34% pace, during the quarter to surpass $3.0 trillion. At Merrill Lynch, 24% y-o-y net revenue growth led to a 31% increase in comparable first quarter earnings. And assets expanded $137 billion at Citigroup and $57 billion at JPMorgan Chase during the quarter.
While trading gains have somewhat hit a plateau recently, the investment banking business has never been hotter. According to Dealogic, first quarter global debt issuance rose another 3% from last year’s record pace to $1.73 trillion. Global issuance of corporate bonds jumped 22% to a record $700 billion. On the back of March’s $98.6 billion monthly record, first quarter U.S. high-grade bond issuance was up 13% y-o-y to $273 billion. Remarkably, the ballooning financial sector accounted for about 72% of total high-grade debt sales. Virtually insatiable demand for yield pushed U.S. junk bond issuance 33% higher to $39 billion. At $26 billion, first quarter convertible debt issuance more than doubled from the prior-year period. And while U.S. mortgage-backed securities issuance slipped 5% to $248 billion, federal agency debt issuance increased 25% to $215 billion. ABS issuance was about unchanged at a robust $289 billion. And apparently substituting commercial credits and M&A-related "leveraged loans" for subprime, year-to-date CDO issuance is, incredibly, running 20% ahead of last year’s record pace.
The global mergers and acquisitions boom shows every indication of going to only greater extremes. The value of corporate deals announced during the first quarter surpassed $1.1 trillion (from Thomson Financial), a record first quarter, and up 24% from comparable 2006. First-quarter U.S. merger volumes totaled $429 billion, up 21%. The value of announced leveraged buyouts jumped 40% to $188 billion. LBO firms are said to have raised more than $210 billion since the beginning of 2006. With typical leverage, this would provide in the neighborhood of $2 trillion of potential acquisition firepower. At the current pace, announced deals this year will surpass 2006’s record $3.8 trillion, which was 38% above the 2005 level. According to Bloomberg, "loans for LBOs jumped 65% to $1.4 trillion in the past year, and sales of bonds rated below investment grade climbed to $218 billion, up 73% from the previous 12 months."
In spite of slowing GDP, escalating financial excess ensures no let-up in U.S. economic distortions and imbalances. Bubble economy effects remain conspicuous in the household sector balance sheet. For the year, household assets jumped $4.9 trillion to $69 trillion, led by a $3.2 trillion increase in financial assets, followed by a $1.5 trillion increase in real estate. And as liabilities rose "only" $1.1 trillion (almost 9%), household net worth jumped $3.8 trillion to almost $56 trillion. Net worth has now inflated almost $16 trillion, or 40%, in just four years. According to research firm The Spectrum Group, the number of U.S. households with a net worth of at least $5 million jumped 23% last year, to surpass one million, with the number rising five-fold since 1996.
Further buoying the irrepressible consumer, personal income expanded a record $658 billion, or 6.3%, during 2006, the strongest pace since 2000. This was up from 2005’s $508 billion, or 5.2%, increase. Credit system bubble dynamics are at play. The housing slowdown-induced recalibration from mortgages to corporate finance has exacerbated already heightened inflationary pressures in compensation. These days, booming company cash flows and over-liquefied financial conditions fuel a bidding war for top talent, and, to only a lesser extent, for skilled workers throughout the economy. With tax receipts booming, fiscal first-half federal government revenues were 8% above the year ago level – this on top of fiscal 2006 receipts that were up 11.8% from 2005.
It’s our long-held view that intractable U.S. current account deficits provide the starkest evidence of bubble excesses. Thus far, there’s no indication of any meaningful improvement from last year’s record $860 billion – approaching 7% of GDP – current account deficit. This is despite the approaching three-year anniversary of the Fed’s "tightening" cycle, as well as today’s confluence of U.S. economic moderation, a booming global economy, and ongoing double-digit export gains. "Rest of world" (from the Fed’s "flow of funds") holdings of U.S. financial assets jumped a numbing $1.527 trillion last year to $12.552 trillion, up more than 50% from 2005’s $1.041 trillion increase. "Rest of World" holdings of U.S. financial assets expanded on average "just" $388 billion annually during the nineties.
Private overseas demand for our debt has become woefully inadequate in the context of recycling never-ending outbound U.S. financial flows. Forced to take up the slack, ballooning foreign central bank balance sheets now inflate with reckless abandon. Foreign reserves were up almost $950 billion over the past year, or 22%, to $5.233 trillion, almost doubling the pace of expansion from the preceding 12-month period. Chinese reserves surged an incredible $325 billion, or 37%, the past year to $1.20 trillion, with an epic two-year gain of 82%. In an eye-opening development, China’s reserves inflated a staggering $136 billion in the first three months of the year.
Central banks exchanging newly "minted" domestic finance for "bubble dollars," generally over-heated credit systems worldwide, and an international M&A boom go far in explaining the unprecedented global liquidity backdrop. The expansive international securities leveraging boom – certainly including the "yen carry" trade – plays a murky, yet surely prominent role as well. Despite a setback or two, the irrepressible liquidity onslaught has thus far ensured that global stock market inflation builds on last year’s extravaganza. Emerging stock markets carry on their parabolic rise, while emerging debt yields sink further into uncharted lows. Even the Japanese economy is registering an inflationary pulse, notably with bubble dynamics returning with a vengeance to metro real estate markets.
Inflation on the march
The current backdrop is one of lavish liquidity over-abundance, a robust global economy, synchronized highly speculative financial markets, and energy, metals and commodities prices all flashing troubling price pressures. The Fed may pay only lip service, but we do take at face value the ECB’s and a growing number of global central bankers’ warnings about inflation. We were struck by a clear change in tone in comments made in March by Chairman Bernanke: "When the offsetting effects of globalization on the prices of manufactured imports and on energy and commodity prices are considered together, there seems to be little basis for concluding that globalization overall has significantly reduced inflation… Indeed, the opposite may be true." We are in complete accord.
We’ve always believed it was only a matter of time before credit and liquidity excesses both at home and abroad manifested into more traditional inflation. The incredible expansion in Asian manufacturing capacity ("investment inflation") coupled with our own technology and "services" output booms (the so-called "productivity miracle") held traditional consumer price inflation at bay. Keep in mind, however, that inflation dynamics are ever-evolving and, considering the backdrop, should prove especially unwieldy. We suspect that these dynamics suggest less hospitable prospects for traditional consumer prices.
The tremendous inflation experienced throughout the global energy and resource sectors now pushes potent "second round" price effects to a broadening range of goods and services, recently including an array of staples such as corn and grains, meats, milk, eggs, cereals, chewing gum, and grocery items more generally. When it comes to heightened "core" inflationary pressures, industry experts now anticipate a year of double-digit residential rent increases nationally. We’ll also see how far into record territory gas prices climb this summer. And it’s safe to assume another typical year of bothersome price gains throughout healthcare and education. While it is difficult-to-impossible to accurately quantify, inflationary pressures throughout "services" continue to mount. To be sure, the conventional bullish view that a housing downturn would promptly quash inflation – if "globalization" hadn’t already – is today on thin ice.
Ponzi finance
Monetary disorder and heightened pricing pressures propagate worsening distortions throughout our maladjusted economy. Yet our nation’s real estate and mortgage finance markets remain at the epicenter of bubble-induced instability and fragility. Notwithstanding the much-trumpeted view that it simply could not happen, the majority of our nation’s real estate markets are now posting y-o-y price declines. An increasing number of housing markets are coming under intensifying downward price pressures. Portending greater stress over the coming months, first-quarter foreclosures were double the prior-year level. Golden State foreclosures are now running three times last year’s numbers, with the data emerging out of Southern California’s Inland Empire downright frightening. Perhaps in slow motion, but California real estate is an unmitigated disaster in the making.
Meanwhile, real estate market bubbles elsewhere persevere and would be pushed to only more dangerous extremes by lower interest-rates. Financial hub Greater Manhattan remains very much immersed in bubble excess, as do upper-end properties throughout the country – still fueled by the powerful confluence of booming incomes, securities market gains, and ultra-loose mortgage finance for prime borrowers. Some states have been reporting exceptional y-o-y price inflation: Prices in Utah were up 18%, Wyoming 14.3%, Idaho 14%, Washington 13.7%, and Oregon 13.5%. Commercial property prices still bubble in most markets, buttressed by tightened occupancy and expected double-digit gains in office rents. Illustrative of the current commercial real estate boom, private equity firm Blackstone recently won a feverish bidding war for Equity Office Properties Trust, "the nation’s largest landlord," for a cool $39 billion.
The subprime debacle
Bubble dynamics encompass commercial real estate and linger in pockets of residential, yet the subprime meltdown is the major financial and economic development so far this year. Despite developing efforts by federal and state politicians, the GSEs, and some of our major lending institutions, credit availability will be reduced rather dramatically for riskier borrowers going forward. Importantly, this marks a key inflection point for the mortgage finance bubble and, with perhaps more of a lag than one would normally expect, the bubble economy.
Some theory is in order. Minsky adopted an economic model whereby the character of finance evolves over time with the development of three relatively distinct – and progressively riskier – categories of debt structures. Initially, there is a "tranquil" backdrop supporting an expansion of sound "hedge" finance – where "cash flows are expected to exceed the cash flow commitments on liabilities for every period." Success and enlivened animal spirits breed less robust "speculative" finance, with cash flows initially and occasionally inadequate to fully service growing debt loads. Returns are, however, at least anticipated to be sufficient over the longer-term. Finally, deepening euphoria and a cutting edge financial apparatus rear unsound "Ponzi finance." Here, "cash flows from assets in the near-term fall short of cash payment commitments" and only with some future "bonanza" will cash flows cover rapidly mounting debt service and offer any realistic hope for profits. Importantly, and somewhat translating Minsky, "a ‘Ponzi finance unit’ is dependent upon forthcoming credit availability/marketplace liquidity as it expands outstanding debt in order to meet ongoing financial obligations."
The subprime mortgage bubble was classic "Ponzi finance." Several years of escalation were culminating into absolutely egregious excess. Only ever-expanding quantities of finance – unrelenting reckless lending and risk intermediation – would sustain housing inflation and hold the weakest credits imaginable above water. Millions of subprime borrowers had – knowingly and otherwise – taken the bait of zero-down, variable-rate, "teaser" and complex "exotic" mortgages. Untold numbers of financial players were aggressively acquiring – both directly and indirectly – risky mortgages for their enticing yields.
It all may have exuded an aura of normalcy and sustainability. In reality, only uninterrupted borrower access to the most favorable refinancing terms, coupled with unflinching speculator demand for increasingly vulnerable mortgage end-products, could possibly have held implosion at bay. The proverbial writing was on the wall by early 2006, as the ranks of the frothiest and most overbuilt housing locales began to succumb to the downside of market bubbles. Yet the desperate search for yield in the financial markets won the day, prolonging the insatiable appetite for the riskiest mortgage paper. The powerful interplay between hedge fund, CDO, derivatives and "Wall Street finance" booms was surely at the epicenter of this dynamic.
Enterprising and often unscrupulous originators obliged hordes of horrendous credits – too many filing flawed and fraudulent loan applications – who were desperate to refinance. In many cases, homeowners and property investors were intent on making monthly payments for only as long as housing inflation was forthcoming. For many, prices stopped rising. At this point the prolonged lending boom was only delaying the day of reckoning. Wall Street mortgage pool operators eventually began to panic, inciting a bank-run-like move to hastily scour portfolios and return "early payment default" mortgages back to the thinly-capitalized originators.
Underpinned by the most fragile debt structures, the bulk of the subprime origination industry imploded in a few short weeks. Contagion effects have moved quickly to the "Alt-A" market, though nationalization of much of the U.S. mortgage market by the various government-sponsored enterprises and programs has, for the time being, established an effective firewall.
Wall Street has thus far succeeded in downplaying the ramifications of the subprime implosion, wishful thinking empowered by ongoing historic excesses throughout the vast majority of credit systems at home and abroad. Anticipating the next easing cycle, heightened speculation throughout the debt markets has aggravated system over-liquidity and exacerbated excesses, notably in corporate debt issuance, M&A, and leveraged securities speculation. And while the circumstance and timing of Ponzi scheme breakdowns are notoriously uncertain, we confidently caution that the subprime experience provides a microcosm of overall U.S. credit system vulnerability.
Financial innovation and excess driving corporate profits
In Minsky’s meticulous study of financial history - including careful analysis of financial system operations and market dynamics during his lifetime – his focus remained with monetary aspects of financing business investment in capital assets. Later in his career his theorizing did turn to the system’s evolution to a phase of "money manager capitalism" commanded by a new breed of financiers with, at best, only secondary interest in the underlying real assets. But the focal point of Minsky’s work remained the dynamics of the interplay between financial innovation and the corporate profit and investment cycle. When it came to identifying "Ponzi finance units," it was still predominantly an exercise of scrutinizing the banking industry and ballooning corporate balance sheets. Minsky would look elsewhere these days.
The scope and character of "money manager capitalism" has evolved profoundly since Minsky’s untimely 1996 passing. Our Doug Noland has entitled this latest stage "financial arbitrage capitalism." Today, myriad and diverse financiers – predominantly non-bank institutions operating outside the purview of central bankers and financial regulators – largely disregard capital assets and real economic returns as they aggressively pursue "spread" profits chiefly through the leveraging of debt securities. As the subprime bubble has demonstrated, underlying economics are driven by profits generated through the origination, investment banking, and, especially, leveraged speculation in high-yielding loans and their securitizations. Real economy effects don’t enter into the equation until the onset of the bust.
Throughout the system, behavior is now dictated by the pursuit of speculative financial returns, in contrast to true economic profits. To be sure, this is not the Capitalism that, for most of the first 200 or so years of our republic cultivated the greatest economic powerhouse the world has ever known. The entire incentive structure has been recast and subverted.
Today, financial profits command system credit and liquidity creation – and financial flows in general – and in the process govern real economy development. Subtle as it may have been, this has radically altered both the financial and economic landscape. In the process, the expansion of bank and corporate balance sheets has become almost incidental in the context of ballooning "broker/dealers," hedge funds, "repos," "fed funds," ABS, MBS, money market funds, CDOs and, let’s not omit, foreign central bank holdings of U.S debt instruments.
In particular, contemporary Wall Street "structured finance" has afforded incomparably incentivized financiers the unparalleled capacity to choose their preferred yields, ratings and, increasingly, pricing for their asset holdings. On the funding side, there is unique flexibility in readily choosing the rates, terms and even currency denominations of borrowings. All the while, there is practical indifference with respect to the underlying soundness of the loans backing the structure – let alone the wealth-creating capacity of the economic assets underpinning the debt. Today’s incentive structure doesn’t differentiate profits from real investment from gains in financial assets. Worse yet, because the lending market for low-end housing can be exploited rapidly, in great size, and for long periods, finance is more likely to flow to endeavors such as tract housing in Palmdale rather than toward industrial capacity to produce goods for export. It may not be obvious to the exuberant crowd luxuriating in boom-time excesses, but the pricing mechanism – the lifeblood of free markets – has been severely corrupted.
At the core of marketplace distortions, derivative markets provide the opportunity to easily "hedge" or insure against various possible unfavorable outcomes, in the process emboldening speculation, leveraging, and the wholesale expansion of credit. The end result is a credit apparatus unlike any in history, with endless capacity to create "money"-like debt instruments for which there remains virtually insatiable demand. The nature of risk intermediation has been completely transformed, and the marketplace does not yet comprehend the new pressure points. But as long as each year brings with it greater credit creation, leveraged speculation, derivatives growth, and financial sector expansion – system liquidity will remain robust, securities prices will levitate, debt defaults will remain minimal and financial "spread" profits maximal – irrespective of underlying fundamental merits.
Lending without constraints
Importantly, system dynamics today governed predominantly by a speculative financial profits cycle are different from the traditional bank-financed capital investment-driven profit cycle. Fundamentally, the capacity to finance and speculate in unbounded new financial assets creates distinct dynamics. For one, traditional restraints on investment booms, in particular bank credit expansions restricted by capital/reserve requirements and other regulatory constraints, no longer apply. A financial profits boom is also not burdened by the issues of capital overinvestment, resource and productivity limitations, pressure on output prices and margins, or the variability of economic profits more generally. And especially pertinent to the current environment, central bankers potentially hold significantly more sway for longer periods over financial sector expansion and profitability than they do over real economy profitability.
The technology boom and bust is a case in point. Ponder the variability of profits during the relatively short-lived technology bubble period and contrast it to the ongoing multi-year Wall Street profits bonanza. In the former, progressive excess leading to massive overinvestment distorted and eventually induced a collapse in industry profitability, with rate cuts having little stimulating effect on perceived prospects or actual post-Bubble earnings. In the latter, at least so far, escalating excesses have created only ever-increasing profitability. Moreover, expectations run high that forthcoming rate reductions will stabilize robust financial earnings for some time to come. Quite simply, more finance equals more financial profits; and the markets today clearly perceive that policymakers will act aggressively to ensure the ongoing free-flow of credit and liquidity.
Minsky recognized that the Federal Reserve’s efforts to stabilize the system would – by nurturing a recursive cycle of risk-taking and financial permutation – prove inevitably destabilizing. In this era of unfettered Wall Street finance, such dynamics have become incomparably more perilous. With system profits now largely dictated by uninhibited financial sector expansion, Federal Reserve stabilization protocols have fundamentally and profoundly altered the dynamics of asset-market risk-taking, leveraged speculation, and system-wide credit and liquidity creation.
Corporate profits, household incomes, asset prices, and economic performance have all evolved to the point of acute dependency on ongoing leveraged speculation and rampant credit inflation. Worse yet, system frailty goes anything but unnoticed by the powerful cadre of sophisticated market players. These aggressive profit-seekers today pursue their outsized share of wildly inflated financial fortunes with confidence that policymakers have no alternative than to sustain the boom. We live these days in the gilded age of the billionaire financial operator.
In previous shareholder letters we referred to "blow-off" excesses. The combination of diligent system observation and laborious contemplation – and the simple truism that "blow-offs" are by nature of limited duration – have given us impetus to take a slightly different analytical tack. Minsky identified "Ponzi finance" as a "deviation amplifying system." After careful study of years of credit excess begetting only greater and increasingly diffusive excess, we’ve come to a conclusion: To better comprehend the dynamics of the present system, the entire U.S. – and, increasingly, the global – credit system should be analyzed as having evolved into one momentous "Ponzi finance unit."
One must look all the way back to the securities leveraging heyday of 1929 to find a comparable example of speculative financial profits and "Ponzi" dynamics taking such command over system credit and liquidity flows. We choose to sound alarmist only because we’ve become so alarmed by recent developments. And we keep waiting for an honorable statesman to step forward and pronounce that "enough is enough" – someone with the public stature to persuade "the powers that be" that restraint is not only in order but in the vital national interest. But clear thinking and moderation are anathemas to the nature of Ponzi schemes and Minsky’s "Ponzi finance units." Few will seriously contemplate the downside when there’s so much easy money there for the taking.
Returning to the theme "subprime as a microcosm of U.S. credit bubble dynamics," there are today ominous parallels. For one, the writing is again on the wall. Mortgage finance is tightening, with negative portents for inflated housing prices, the over-leveraged consumer, scores of exposed debt instruments and financial institutions, and the highly maladjusted U.S. bubble economy. The underpinnings of productivity and corporate profitability have deteriorated markedly, although the true scope of the decay is masked by the current monetary backdrop. Meanwhile, massive dollar outflows are increasingly overwhelming their capacity to be "recycled" without outwardly destabilizing effects. There are indications that foreign central bankers and our other foreign creditors are losing patience, while protectionist sentiments gather steam here at home.
Analogous to technology in 1999 and subprime in 2006, today over-liquefied and highly speculative markets display steadfast determination to disregard the storm clouds. The risk envelope is pushed to only more perilous extremes. For example, first quarter earnings reports confirm that the pursuit of financial profits has realized a new magnitude. We were struck that Citigroup, JPMorgan Chase, Goldman Sachs, Morgan Stanley, Lehman Brothers, and Bear Stearns financed record balance sheet growth with a combined $202 billion expansion of "fed funds and repo" liabilities. This almost 80% growth rate was an alarming escalation beyond last year’s unprecedented surge in securities-based finance.
Ponzi schemes inherently (and notoriously) experience their greatest and most destabilizing excesses late in the game. These include wild abnormalities in the scope and character of financial flows, along with the full-blown mismanagement and market misjudgment of risk. At some point, increasingly evident fallout from the mania sets in motion faltering confidence, a reversal of wayward flows and, typically, rather abrupt collapses. Again, technology stocks and subprime mortgages are illustrative.
Regarding the credit bubble these days hopelessly enmeshed in "Ponzi finance" dynamics, we’ll be the first to admit that there’s a thin line between our evidence of "mania fallout" and seeming confirmation of "The Golden Age of Capitalism" – as many see the current environment and, we’ll note, as some historical revisionists invoke with respect to the 1920’s. We’ll further accept that, atypically, today’s bubble is not evidenced at home by wild Roaring Twenties, 1989 Japan or Internet bubble-style stock price gains. Even conspicuous housing bubble inflation has largely subsided.
What has not subsided, however, is the massive expansion of credit instruments – large swaths of which have little to no transparency but have nonetheless evolved into the speculative instruments of choice for a monstrous global leveraged speculator community. Today, previously unimaginable "credit arbitrage" financial profits are doled out to the holders of myriad securitizations, CDOs, derivatives, and other "structured" instruments and products. It is within this peculiar mania in highly leveraged risk intermediation where we discern the type of acute fragility associated with Minsky’s "Ponzi finance."
Preparing for the inevitable
At this stage, to sustain what is really a multitude of inter-related bubbles will require massive and nonstop credit creation, along with imperturbable speculative fervor. From a Minskian perspective, years of financial sector innovation, permutations and gross excess have created exactly the infrastructure to give it a determined whirl. To be sure, the scope and character of current excesses create an incredibly challenging backdrop in which to manage shareholder funds. Market risk is exceptionally high, while the current trajectory of financial sector expansion virtually ensures wildly unpredictable and destabilizing financial flows. The bottom line is we foresee the near-term market environment as extraordinarily unsettled.
