05/31/2001 Risky Business *

It was a mixed week in the stock market, with technology stocks bouncing back after suffering heavy selling early in the week. For the week, the Dow was largely unchanged, while the S&P500 and Transports declined about 1%. The Morgan Stanley Consumer index added 1%, with Utilities largely unchanged. The broader market suffered marginal declines, with the Russell 2000 and the S&P400 Mid-Cap index declining about 1%. Financial stocks were mixed, with the AMEX Broker/Dealer index declining 5% and the S&P Bank index posting a small advance. The brunt of this week’s decline fell on the technology sector, with the NASDAQ100 and the Morgan Stanley High Tech index both dropping 6%. The Street.com Internet index declined 8%, with the Semiconductors and NASDAQ Telecommunications index sinking 6%. With gold plunging $9, the HUI gold index declined 5%.

The credit market remains unsettled, although rates dropped sharply this week. For the week, two-year Treasury yields dropped 11 basis points, with 5-year Treasury yields declining 8 basis points. The yield on the key 10-year T-note dropped 15 basis points to 5.36%. Long-bond yields also dropped 15 basis points, with yields closing the week at 5.70%. Mortgage-back and agency yields generally declined about 11 basis points. The benchmark 10-year dollar swap widened one basis point to 79. Global currency markets are in increasing disarray, with weakness in emerging markets from South America to Asia. The Taiwan dollar continues to trade poorly, as do currencies throughout Southeast Asia. The euro is at a six-month low against the dollar, and dropped 8% against a resurgent yen during the month of May.

Today’s economic data was certainly indicative of a highly imbalanced U.S. economy. On the jobs front, 129,000 manufacturing jobs were lost during May, while service sector employment increased by 70,000 and construction jobs added 31,000. The unemployment rate declined one-tenth to 4.4%. The Commerce Department reported record construction spending for April, with total spending up 5% year over year. . While residential construction increased 1% from a year ago, nonresidential spending was up almost 10%. Industrial construction spending was up 19%, with office and educational both up 11%. Compared to 1995, current construction spending is up more than 50%, with nonresidential construction rising about 70%. Auto sales were interesting as well, with Ford sales down 12% and Chrysler falling 8%. GM total vehicle sales actually increased 1%, with record truck sales up 10%. GM stated that the industry is on track for its "third-best year ever," while increasing its second-quarter production schedule due to stronger than expected demand. Toyota had its best month ever in the U.S., with sales of 166,000 more than 10,000 above its previous record. Lexus enjoyed its best May, with sales up 20%. BMW enjoyed its second-best month ever in the U.S., with sales up 32%. It was the best May on record for Mercedes-Benz. It was also a record May for Honda, with sales up 5%. Acura sales were almost 20% above last year. Audi had its best May since 1985, and Subaru had its best May since 1987. It was a record May for Volvo and Suzuki, while Volkswagen sales were up 4% from last year and Porsche sales increased 12%. Hyundai sales jumped 35%.

As the latest credit numbers begin to trickle in, it is clear that May was another extraordinary month for the U.S. credit system. Corporate bond issuance of $88 billion surpassed the previous record of $80 billion set in January. May corporate issuance was more than double the $37.9 billion issued during the same month last year. Bloomberg quoted a managing director from Salomon Smith Barney (the top-ranked underwriter this year): "I can't think of a friendlier environment for the corporate bond market." Well, as long as one ignores pesky fundamentals such as extreme corporate debt loads, deteriorating profits, and poor economic prospects, the environment is "friendly" indeed. With the continuing boom in real estate finance, it is worth highlighting the clear deterioration in some key sectors. According to Torto Wheaton, the national office vacancy rate increased to 9.5% during the first quarter, up from 8.3%. Hotel occupancy in New York is said to have dropped to 75% during the first quarter, a 7-point decline from last year. According to Cushman and Wakefield, 19% of total Silicon Valley office space is currently under construction.

In the future, curious minds will ponder why the commercial building boom continued despite an obvious sharp turn in underlying fundamentals. There’s one reason: the interplay of massive monetary expansion and speculative demand for securities. Monetary processes continue to provide abundant availability of credit. From Bloomberg: "The flood of sales came as the average yield spread between 10-year company debt and top-rated government bonds shrunk 0.17 percentage points to 1.29 points in May, and narrowed almost a full point this year, a Merrill Lynch & Co. index shows."

The asset-backed market continues to fire on all cylinders, with May’s issuance of $27 billion up 56% year-over-year. Total year-to-date asset-back sales of $116 billion have already handily surpassed total issuance for the entire year of 1995, while running 42% above year ago levels. Year-to-date credit card-backed issuance of $27 billion is up 79%. Auto-backed sales of $30.6 billion are also up 79%, while home equity-backed issuance of $30 billion is 63% above year-to-date figures from last year. Again, it is worth noting that this extreme issuance is coming in the face of rapidly deteriorating fundamentals. During the first 20 weeks of the year, there were a total of 581,105 bankruptcies, an increase of 23% year over year. From Moody’s: "In April 2001, deterioration in U.S. consumer credit quality accelerated, as measured by two key performance indicators of securitized pools of U.S. bank credit card loans. Both the bad loan write-off rate and late payment rate rose by over 13% from their year-earlier rates, a margin of increase which has not happened since the last negative credit cycle in 1995 - 1997."

Recognizing that "money" is created through the lending process, there is certainly no mystery behind the continued historic monetary expansion. The Great Credit Bubble runs unabated, with broad money supply (M3) expanding by almost $41 billion last week ($68 billion during the past two weeks). Broad money has surged a stunning (even if this is the "same old story," it remains "stunning" nonetheless!) $249 billion over the past 10 weeks, an annualized growth rate of 18%. Since the end of October - in what has been 29 weeks of unrelenting "reliquefication" - M3 has jumped $614 billion, a 16% annualized growth rate. This expansion is not limited to "broad money" components, with M2 growing at an annualized 11% rate over the past 29 weeks. By major category, currency outstanding has increased (since October 30th) $18 billion, or at a rate of 6%. Checkable deposits have actually contracted $11 billion, an annualized 4% rate of decline (M1 has increased only $4 billion since October 30th). Savings and small time deposits have increased $216 billion, a 14% rate, while retail money market fund assets have added $67 billion, growing at a rate of 13%. Of the broad money components, "repurchase agreements" have declined $8 billion, while "eurodollars" have increased $21 billion, or 19% annualized. Leading the monetary charge, institutional money market fund assets have surged $248 billion, or at an annualized rate of 61%. As discussed repeatedly in previous commentaries, the powerful deposit creating capability of money market fund intermediation is at the heart of the unprecedented GSE and Wall Street-led money and Credit Bubble.

And while it may sound "nutty" to the unwavering bullish consensus, we continue to believe that the late stage of the 1920’s bubble provides the most valuable comparison for garnering insights into the current extraordinary environment. If for no other reason, the 1920s period certainly was characterized by intense interplay between powerful financial and economic forces. Perhaps no economist offers a greater understanding of the 1920’s boom and bust than the brilliant Joseph Schumpeter. I stumbled across a rather succinct and pertinent passage from a book written by Eduard Marz: Joseph Schumpeter – Scholar, Teacher and Politician:

"The main emphasis in Schumpeter’s theory of development is on the sporadic emergence in history of the innovator… What does Schumpeter regard as the principal differences between the primitive stages of capitalism and the fully developed form of that system? He sees the differential specifica in the modern credit system. It is only with the introduction of institutions engaged in the ‘production’ of finance on a commercial basis that the transition to a more advanced stage of capitalism takes place; its most important feature is the perpetual, though discontinuous, transformation of the productive forces…

With the help of innovation, the entrepreneur manages to gain a – usually temporary – cost advantage over the greater number of traditionally oriented circular-flow producers. As long as his unit costs remain below the market price, he reaps a surplus from his entrepreneurial activity. But this advantage, which accrues to him from an innovative use of the factors of production, is sooner or later eroded in one of two ways: first, very soon imitators appear, causing pressure on the market price; and secondly, the cost of producing the new goods will rise sooner or later because of the increased demand for the factors of production…

Schumpeter’s concept of entrepreneurial profit is linked, of course, with a specific concept of capital and interest on capital. According to him, capital is only a fund of purchasing power enabling the entrepreneur to withdraw factors of production from their previous uses in order to employ them in a more profitable way. A certain sum of money thus makes it possible for its lucky owner to acquire temporary dominance over men and material…the question arises as to where an additional fund of purchasing power, making it possible to pursue new courses of production, is to come from. Schumpeter’s answer is that the commercial banks create investment credit out of thin air…The concept of credit creation is a focal point in Schumpeter’s theory of economic development.

In this way the banks help the entrepreneur to come into possession of additional financial resources, to which there is no corresponding supply of additional goods. The result is an inflationary process in which the purchasing power of the circulating monetary units is compressed and the entrepreneur thus enabled to enter into the process of production.

…according to Schumpeter’s model, innovations appear in ‘clusters.’ Schumpeter attributes this peculiar phenomenon essentially to two factors: first, the great number of imitators who follow hard on the heels of a successful entrepreneur; and secondly, the growing readiness of the public to accept innovations after the first great pioneering moves have succeeded. The jerky changes in a previously stationary situation lead to cyclical upswings which, after some time has elapsed, are superseded by a distinct downswing in the economy. The economic development under capitalistic premises thus proceeds in the form of cyclical fluctuation.

What, according to Schumpeter, is the cause of the cyclical ups and downs? …the abrupt onset of a wave of innovations is accompanied by a rise in prices. In the course of the cyclical upswings initiated by primary innovations, the well-known signs of a boom can be observed. The phase of prosperity contains, however, the seeds of its own destruction. We have seen that the rise in prices is caused by the disturbance of the equilibrium… As the new productive combinations become effective, the supply of goods increases. Shortages now increasingly give way to a partial over-saturation of the markets. As a result prices begin to fall. According to Schumpeter, the pattern of inflation succeeded by deflation is an element in the process of development… The transition from prosperity to recession is explained chiefly by two facts: the exhaustion of innovative activity and the increasing imbalance between different spheres of the economy during the phase of prosperity. Looked at from this angle, the phase of recession can be seen as a natural purging process, to which many of the less viable businesses founded during prosperity fall victim.

When I first began reading accounts and analyses of the "Roaring ‘20s" and the Great Depression that followed, it was always quite difficult for me to grasp how such a robust financial and economic system could have suddenly become so frail. Unfortunately, I no longer find the processes and circumstances involved all too confusing, recognizing how a façade of strength and stability can be supported by an increasingly fragile underlying financial and economic foundation. I also remember reading an analysis (only somewhat more "optimistic" than what has developed into the consensus view) that espoused the view that the Great Depression was caused by the failure of inept government policymakers to recapitalize the U.S. banking system. Following this reasoning, with total losses of "only" about $5 billion (this amount is from memory), the federal government could have easily made up this shortfall and kept the economy safe from the vicious spiral of loan losses, bank failures, sinking asset prices, general debt deflation and eventual economic collapse. And despite the fact that these losses were a significant portion of total banking industry capital, it did seem plausible that a bailout was both possible and reasonable. Could it be that simple – to sustain a boom entails only that the government "cut a check" to the troubled banks whenever they are hit with significant loan problems? Moreover, doesn’t the structure of this incredible contemporary financial system preclude the necessity of overt government bailouts - can’t the Federal Reserve just orchestrate financial sector profits through the inducement of positive interest rate differentials? Arguably, this is precisely how the bullish consensus on Wall Street views the world, and, admittedly, it has worked miraculously before! What’s wrong with this picture?

The "fly in the ointment" of the sanguine view lies specifically with the unappreciated nature of money and credit, and the deleterious effects of monetary excess and the resulting intractable monetary processes. Importantly, these consequences impact both the economy and the financial system. As such, it’s certainly our view that this week’s renewed weakness in the technology sector is indicative of the severity of the unfolding bust, as well as an early harbinger of what will prove the inevitable impotence of Federal Reserve policy generally. As discussed in previous commentaries, the developing technology collapse is the unavoidable consequence of previous historic credit, speculative, and spending excess. There has simply never been so much money and credit recklessly thrown at so many hopelessly uneconomic enterprises, and no amount of additional monetary excess is going to create strong cash-flow generating businesses out of these misguided ventures. Yes, more credit can provide a temporarily lifeline, but with the high cost of enormous additional debt and further imbalances in an already fragile system.

At the same time, the bullish consensus could not see things more differently. Here, the expression "rose colored glasses" does not come close to doing justice. For starters, the analysis that holds that the process of "purging previous excesses" is critical for the vitality of a capitalistic economy is today disdainfully viewed as having about as much merit as medieval medical practices of bloodletting and leeches. Apparently, in the age of wonder drugs, advances in monetary "science" and the unsurpassed skill of the Greenspan Federal Reserve assure that financial and economic sickness are today remedied with non-invasive treatments of heavy doses of central bank accommodation. Previously chronic and often terminal financial ills are today cured by painless outpatient procedures.

The bullish consensus simply could not be further from reality on this front, with a truly momentous misunderstanding of money and credit lying at the heart of today’s policy misadventure and ominous marketplace complacency. Schumpeter saw credit as "essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur." Interestingly, he generally disapproved of borrowings outside of financing entrepreneurship. Schumpeter’s brilliant analysis of the functioning of capitalistic economies provides a great foundation for appreciating the current environment, with particularly valuable insight garnered from a focus on his two key agents of capitalism: the entrepreneur and the credit system. Perhaps it is helpful to expand his definition to "credit is the creation of current purchasing power granted to a borrower in exchange for cash flows payable in the future." While a credit system creates purchasing power "out of thin air," the resulting cash flow commitments are very real with consequences for borrower and the lender alike.

Importantly, extreme money and credit excess are today stimulating little if any economic growth, much to the delight (relief) of the credit market. Where else can "entrepreneurs" create a truly massive supply of a wide assortment of "products" and watch their prices all increase? There is certainly no mystery behind the current unusual environment, and only the uninformed or hopelessly complacent can ignore the ramifications of this extreme divergence between credit growth and economic performance. As such, it is critical to appreciate that much of past credit excess was spent poorly, financing consumption, negative cash flow enterprises, and asset inflation. The consumer today is forced to increase borrowings (especially against inflated home equity) just to meet debt service requirements and sustain previous levels of consumption. But that is the nature of a negative savings rate, and why it is both inadvisable and unsustainable. For the scores of negative cash-flow businesses, additional borrowings are but a lifeline to the next borrowing (Minsky’s "Ponzi Finance"). And throughout corporate America, past borrowing excesses (often financing stock buybacks), increased costs, and stagnating revenues dictate continued heavy borrowing requirements.

Furthermore, it should be recognized that massive credit excess has for years been directed specifically to asset markets, especially the bubbles that developed in the equity, real estate, and credit markets. This process has worked like magic, fueling asset inflation, increased (perceived) financial wealth, and borrowing capacity. What a precarious game. The massive real estate sector, in particular, will entail enormous and uninterrupted new credits to sustain inflated prices, and when those additional credits are not forthcoming there is going to be one big problem. Thus, one can look at the massive accumulation of consumer, real estate and corporate debt as the continuing creation of unprecedented cash flow commitments, although importantly lacking of adequate true underlying economic wealth creation capability – the ability to generate cash flows - to service outstanding debt.

So getting back to the question, why couldn’t a $5 billion payment remedy the situation for the U.S. banking system back in the early 1930’s? Well, because the bank losses were not THE problem, but only a consequence/residual of the massive financial imbalances/debt accumulation and economic distortions that had developed over a period of many years. A $5 billion "grant" to the banking sector would have been inconsequential – the veritable "drop in the bucket - doing little but temporarily sustaining boom-time asset prices and spending, while having no impact whatsoever on the underlying soundness of the system outside of fostering additional debt accumulation (cash-flow commitments) and augmenting dangerous imbalances. As we are witnessing currently, Credit Bubbles create monetary processes leading to financial and economic distortions, and providing the capacity for the financial sector to perpetuate credit excess only exacerbates dangerous imbalances. Over the past year, almost $850 billion of additional broad money supply has been created and likely upwards of $2 trillion of additional borrowings, and what does the system have to show for it but heightened fragility? There is just no way around the inevitability of a "purging of previous excesses;" it is only a matter of from what degree of systemic fragility and how extreme the destabilization wrought by the necessary adjustment process. It has been our argument all along that the sooner this adjustment process is commenced the better for the system.

It is critical to recognize that the "entrepreneurial spirit" so revered throughout the technology sector has flourished to an even greater extent and with significant negative consequences within the financial services industry. Capitalism is about the pursuit of profits. But never before have so many, including some of the brightest and enterprising, gravitated to finance for this endeavor. Never has a group of individuals had access to such incredible financial resources and power. Schumpeter witnessed some of this with the Wall Street fiasco from the1920’s - the proliferation of equity trusts, holding companies, broker call loans, margin lending, and rampant speculation – and had strong opinions on the necessity of prudent banking. The ‘20s were, however, only a hint of what would culminate in the Roaring 90’s, where entrepreneurs and innovators in the real economy became merry bedfellows with innovators and "entrepreneurs" in the financial sector. Even throughout the wild market excesses of the 1920s, bankers and the Federal Reserve generally remained at the controls of the nation’s credit system. To begin to comprehend the extreme and complex nature of current economic and financial fragility, one must recognize how the leveraged speculating community’s role in credit creation has spawned gross excesses and misallocation of resources. The system will not begin the much needed recovery process until the reins of the credit system are returned to responsible bankers and true investors.

Clearly, a dysfunctional financial sector created and directed unprecedented purchasing power to the technology bubble. Too often, as we have witnessed, "entrepreneurs" expended these funds on ventures that have not generated adequate cash flows to repay debt obligations. The pursuit of profits played a critical role in this process. However, the focus was on immediate profits in the financial sphere with little regard for the underlying economic profit potential of the new enterprises. The lack of business profits has been due to a number of factors, including the weakness of or lack of viable business plans, "overinvestment" in the case of too many competing enterprises forcing down product prices, and rapidly changing business conditions (new products, volatile demand). In all cases, planned cash flows failed to materialize, and it should be apparent that the enormous over financing of this industry created "the seeds of its own destruction." Clearly, providing additional credits (and creating more commitments for future cash flows) today to uneconomic ventures is "throwing good money after bad" and only compounds systemic fragility. The "natural purging process, to which many of the less viable businesses founded during prosperity fall victim" is a critical aspect of capitalism and definitely anything but akin to bloodletting. Unfortunately, unprecedented credit excess from an aggressive and enterprising contemporary credit system fueled a technology bubble that got completely out of hand. Consequently, the financial system developed such extreme exposure to the tech/telecom industry that lenders have little alternative today than to continue to extend credits or deal with a full-fledged collapse.

Throughout this process, there is an overriding problem that is being ignored: it has been a "cluster of innovation," "animal spirits", and "entrepreneurs" that have been the driving force behind the U.S. boom, but these powerful forces have emanated from the financial sphere. Unlike entrepreneurship in business, where an influx of competitors drives down prices and excess profits, heightened competition in the financial arena incites self-reinforcing credit and speculative excess. If lending spreads narrow, just make it up with volume! Here, credit excess begets credit excess; financial bubble begets bubble economy. Moreover, the "animal spirits" of the financial "entrepreneur" and innovator actually ensures the impairment of the business entrepreneur, with endemic overfinancing creating an environment of wild price instability, fleeting profits, and general uncertainty. At the late stages of the boom, as we are seeing currently, the profits achieved by the financial sector come at the expense of the business sector and systemic stability.

Most unfortunately, there is no simple or painless manner of turning off these processes, as the aggressive financial "entrepreneur" has come to dominate the entire credit creating process. This fact and its disconcerting ramifications cannot be overstated. It is the financial player – and in too many cases the leveraged speculator – that is the true source of credit availability that is currently sustaining boom-time spending, inflated real estate and other asset prices, and financial system liquidity. It is the financial innovator that is the true master of the boom, with unrelenting credit availability owing its existence to contemporary Wall Street "structured finance." In the past we have noted the expansion of "funding corps" and asset-backed commercial paper issuance that has increased from about $65 billion in 1995 to more than $650 billion currently. Yesterday I was reading a Wall Street research report explaining the booming "CDO" marketplace. First, a definition: A CDO is "a securitization of corporate bonds, bank loans, ABS (asset-backed securities), RMBS (residential mortgage-backed securities), CMBS (commercial mortgage-backed securities), or almost any non-consumer obligation. CDO refers to the special purpose vehicle (SPV) that holds the asset portfolio and issues liabilities…" From the report: "Global CDO issuance has averaged $137 billion per year for the last three years. In the context of asset-backed securities, this figure is about one-half of public and private U.S issuance. This sustained level of activity is remarkable given that annual volume never exceeded $4 billion until 1996. We estimate outstanding CDO volume at $500 billion. The current status of CDOs is due to the acceptance of the product by investors and credit risk hedgers."

Whether it CDOs, asset-backed commercial paper and securities, sophisticated mortgage instruments, interest rate and credit derivatives, credit insurance, or GSE guarantees, the overriding motivation for the financial sector is to lend as much as possible and then create the sophisticated vehicles and structures necessary to disaggregate and offload the "risk." What has accumulated is a truly unprecedented edifice of debt in a complex web of contracts and structures that have yet to be tested in anything less than a hospitable economic environment. Total asset-backed securities are quickly approaching $2 trillion, with over $2.5 trillion of mortgage-backs securities, and over $2 trillion of GSE debt. At the end of the first quarter, there was a total of $27.5 trillion outstanding credit market debt, with the non-financial sector on the hook for over $18 trillion and the financial sector for $8.4 trillion.

Interestingly, Morgan Stanley’s Byron Wien recently wrote a piece titled "Increasing Demand for Money" where he stated "in a mature economy, even one with a high level of entrepreneurship and a well-educated and energetic work force, it may take more money to achieve a given level of growth than in the past." We certainly agree, and we believe we understand the dynamics. The business cycle has turned (despite the efforts of the Federal Reserve and U.S. financial sector), with debt-burdened businesspersons and households increasingly risk-averse. This comes, paradoxically, with the maladjusted U.S. economy’s massive and unrelenting borrowing requirements. The widening gap between the huge demand for credit and reduced tolerance for risk necessitates increased intermediation of riskier loans into "safe money." Thus far, this has proved but a mild challenge for the aggressive and resourceful U.S. financial sector. But let there be no doubt, this intermediation process is accumulating unprecedented risk throughout the financial system. We would strongly argue that the quality of credit created at this stage of this extraordinary cycle is extremely suspect. Combine exceedingly risky credits with today’s enormous issuance and it should be quite apparent that the U.S. financial sector is locked in some pretty Risky Business. In fact, a very strong case could be made that at this stage of the cycle and with current monetary processes, financial sector risk grows exponentially, while the overriding issue has become acute systemic fragility. Analyzing the environment in these terms, it should be clear that "cutting checks" and perpetuating bubbles are not only ineffective, they are very much a disastrous losing proposition. This is why governments should not be in the business of sustaining booms.