06/13/2002 A Few More Years *

Today’s stock market reversal was typical of this week’s wild action. After swinging triple digits intra-day Monday through Friday, the Dow ended 1.2% lower for the week. The S&P 500 lost 2%. The broader market fared worse with the Russell 2000 losing 2.5% and the S&P 400 Mid-Cap dropping 2.7%. The economically sensitive Dow Transports outperformed this week by losing 0.5%, but the Morgan Stanley Cyclical index dropped 2.3%. The Morgan Stanley Consumer index dropped 2.8%, and plunged 4.2% today after back-to-back reports of a weakening consumer. Utilities were the star performer, gaining 1.4% this week. Technology stocks were among the biggest losers with the Nasdaq losing 2% the NDX down 2.7%, the SOX down 3.4% and the Morgan Stanley High Tech index down 3.0%. Telecom stocks dropped 5.1% and biotechs sank 2.0%. Securities firms suffered through a week of grim news with the Broker/Dealer index losing 4.3%. Banks fared better, losing only 1.4%. Spot gold fell 1.4% this week, taking the HUI 5.2% lower.

Faltering stock prices and heightened financial tumult led to the largest decline in Treasury yields in five months. Two-year Treasury yields dropped 26 basis points to 2.89%, while 5-year yields declined 25 basis points to 4.07%. The 10-year Treasury yields sank 26 basis points to 4.80%, while the long-bond yield dropped 25 basis points to 5.41%. For the week, December 3-month Eurodollar yields collapsed 32 basis points to 2.49%. Implied yields on agency futures contracts dropped 25 basis points. It is worth noting that mortgage-backed securities underperformed, with spreads widening six basis points. Benchmark mortgage-backed spreads are now up 12 basis points in two weeks. The spread on Fannie Mae’s 5 3/8% 20011 note was unchanged at 53, while the benchmark 10-year dollar swap spread widened one to 55. The dollar index suffered a marginal decline for the week, while the dollar today touched 17-month lows against the euro. The Greenback traded at an 8-month low against the British pound and 27 month low against the Swiss franc.

Today from Bloomberg – “The Turkish lira fell to an eight-month low on concern the Treasury won’t find enough buyers to roll over $2.5 billion of bonds coming due next week, analysts said. The currency fell 3.2 percent to 1,583,000 per dollar in late afternoon trading. The lira has dropped 13 percent over the past six weeks as a series of illnesses have kept Prime Minister Bulent Ecevit away from work.”

Brazilian government bond yields surged as much as 150 basis points earlier in the week to 18.5%, as the real came under heavy selling pressure. The government is increasingly desperate to contain a developing panic out of Brazilian financial assets. From Bloomberg - “Brazil’s central bank raised the amount of money banks have to keep on reserve, in an effort to reduce cash available to buy dollars. The bank raised its reserve requirement to 15 percent from 10 percent, which will require the country’s banks to keep more term deposits in the central bank... Brazil is trying to brake a decline in its currency that has accelerated as investors worry the government won’t be able to make payments on its debt, which has ballooned to 929 billion reais ($344 billion), equivalent to about three-quarters of the gross domestic product.”

Broad money supply contracted $25.1 billion last week. Savings Deposits were down $16 billion, retail money market deposits declined $4 billion, and institutional money fund deposits were down $14.6 billion. Repurchase Agreements increased $3.8 billion. Year-to-date convertible security issuance of $40.7 billion is down 34% y-o-y.

The University of Michigan’s preliminary report on June consumer confidence was much weaker than expected. The reading of 90.8 was down from May’s 96.9, and the lowest level since February. The Economic Outlook component dropped from 92.7 to 86.2, the lowest reading since December. Although May retail sales were reported slightly weaker than expected, the weekly same-store sales reports indicate continued reasonably strong sales. The Bank of Tokyo-Mitsubishi survey had last week’s sales up 4.6% from one year ago, while Instinet Research Redbook had y-o-y sales up 3.9% last week. According to Bloomberg, May U.S. home appliance shipments of 6.10 million units was up 14% year-over-year. Year-to-date appliance shipments are up 7.3%.

The Mortgage Bankers Association weekly mortgage application index had purchase applications dropping 13% from the previous week’s surge to 359, up about 5% from year ago levels. The refi application index increased 6% to the highest level in five weeks. Countrywide Credit reported total mortgage fundings during May of $13.66 billion, up 26% y-o-y. Purchase fundings hit a new record $7.8 billion during the month, up 10 percent from April and 65 percent y-o-y. Refi fundings of $5.8 billion were down 5% y-o-y. Home Equity fundings of $950 million were up 89% y-o-y, while subprime fundings were up 32% to $614 million.

Freddie Mac reported that one-year adjustable mortgage rates sank to 4.67% last week, an 8-year low. Thirty-year fixed mortgage rates of 6.71% were at a six-month low. Fannie Mae’s June numbers are out. The mortgage-backed securities issuance boom continues, with outstanding MBS growing at a 21% annual rate, with year-to-date growth at 19.5%. Fannie’s total book of business grew 13% annualized, with its retained portfolio growing at 4%. Total business volume was a robust $50 billion for the month.

Today from Bloomberg – “Fannie Mae and Freddie Mac increased their use of derivatives last year to hedge against shifts in interest rates and other risks, the regulator for the two government-sponsored agencies said. The notional volume of derivatives used by Fannie Mae rose to $533.1 billion at the end of 2001 from $324.7 billion at the start of the year, the Office of Federal Housing Enterprise Oversight said in its annual report to Congress. The volume of derivatives used by Freddie Mac increased to $1.1 trillion from $474.5 billion.”

This week Prudential Securities’ Edward Yardeni issued an interesting report, “From Bubble to Bubble.” Extracted from the report: “The Next Bubble. While air is still coming out of the Nasdaq bubble, another bubble may be just starting. My recent European tour included London. I visited several global investors in the financial district, ‘The City.’ Britain has a housing bubble that may soon burst. I believe that the residential real estate market in the United States is just beginning to show signs of speculative activity. However, our housing bubble could last a few years. My guess is that it might burst just after Federal Reserve Chairman Alan Greenspan retires during June 2004, when his term expires.”

“Beginning to shows signs of speculative activity”? “Last A Few More Years”? We believe it is especially important today to recognize that the Bubble in mortgage finance has been inflating since 1998. It is also our view that we are now well into the “terminal stage” of mortgage finance excess, and hence would expect the termination of this Bubble to commence in the coming months, not years. We do not expect developing financial tumult will be conducive to financials Bubbles, U.S. mortgage finance not withstanding. A Credit system with such over-leverage and endemic speculative excess is prone to financial accident.

U.S. and global financial markets are now signaling that we have entered a more serious stage of the unfolding financial crisis. The structural problems are deep and wide. Importantly, participants are now beginning to appreciate the serious ramifications for the U.S. financial sector. Until recently, the market had successfully “circled the wagons” around many of the key Credit Bubble players. While the stocks of the Wall Street securities firms had been weak, the shares of Fannie Mae, Freddie Mac, the mortgage insurers, Credit insurers Ambac and MBIA, and many of the consumer lenders such as Household International and Capital One Financial were holding not far from all-time highs. This week these stocks came under heavy selling pressure, and this is not a bullish development.

Today, it is especially important to appreciate the parallels between the telecommunication Bubble that is now well into its collapse and the mortgage finance/consumer Credit Bubble that is in the midst of its “terminal stage” of excess. As long as Credit was expanding aggressively throughout the telecommunications arena, the industry expanded with all semblance of sustainability. At the late stages of the telecom Bubble, however, gross lending and speculative excess set the stage for inevitable collapse. The amount of borrowings necessary to sustain the industry Bubble became quite outsized, that there was simply no way it would be sustained. When Credit availability began to wane, the marginal companies lost access to new finance and began to fail. These marginal failures then exacerbated the reduction in Credit availability and speculative flight away from telecom junk bonds and equities. At a certain point, the reversal of speculative flows passed a critical juncture and the industry Bubble was doomed. Capital flight begat failures at the margin that begat a further contraction in Credit availability and more aggressive capital flight. “Virtuous cycle” was transformed to vicious downward spiral.

While there remain few signs that speculative flows have reversed in mortgage-back and asset-backed securities, the backdrop for such an occurrence is certainly evident. We believe that the stock market is beginning to discount what we expect to be such an inevitable development. We believe that a serious dislocation in the risk market is gaining momentum by the week. The corporate debt implosion runs unabated. The enormous and growing losses in telecom debt, corporate bonds, technology stocks, Credit derivatives, gold shorts, and the dollar have impaired key financial intermediaries, derivative operators, and speculative players. The risk Bubble is in serious jeopardy, and a derivatives market dislocation/accident is now a distinct possibility. The cost of derivative Credit default protection continues to surge, even for the likes of behemoth General Electric. We believe the weakness in the JPMorgan, Citigroup, Merrill Lynch, Goldman Sachs and other major financial intermediaries is confirmation of the rising probability of unfolding derivative and capital market dislocation.

Like the reversal of speculative flows into the telecom industry, at a certain point reversal of speculative “flows” in the risk market crosses the point of no return. We believe the stock market is now signaling that such a critical juncture has been passed, with major ramifications for U.S. financial assets, the dollar and, eventually, the U.S. mortgage finance/consumer Bubble and economy.

We are certainly now increasingly on the lookout for weakness and flight away from the marginal consumer lenders, and we believe that exactly this development gained momentum this week. We note the weakness in the stocks of Americredit, Metris, Household International, and Capital One Financial. These companies are both risky lenders and major operators in the securitization marketplace. It has been our expectation that the unfolding dislocation in the risk market (particularly Credit insurance and default swaps) would begin to impact the securitization marketplace at the margin (the most risky securitizations). Were these aggressive lenders to lose access to the capital markets, they would be forced to change their liberal lending policies and restrict additional lending to their most vulnerable borrowers. Such a circumstance would be quite problematic for borrower and lender alike.

It would certainly appear that this group of stocks is now beginning to discount an imminent reversal of speculative flows to risky consumer securitizations. The weakness in the Credit insurers is also worth noting, as it may further indicate what we have expected would be changing perceptions as to the risk profiles of these companies and the securitization marketplace generally. If market perceptions have begun to take a less sanguine view of the risky lenders and Credit insurers, our analysis would expect that this would mark a seminal inflection point for the great U.S. mortgage finance/consumer Credit Bubble.

But for now, the Treasury market is in a 1998-style meltup and dragging most of the Credit market along for the ride. Agency yields are paralleling Treasuries, with key spreads remaining especially narrow considering the circumstances. Since WTC, the marketplace is more confident than ever in the federal governments implicit guarantee of agency debt. But we will continue to look to 1998 for hints on how things might progress. Between September 15th and October 5th 1998, two-year Treasury yields sank 70 basis points to 4.03%, while 10-year yields dropped 70 basis points to 4.16%. This flight to quality and derivative/leverage-related dislocation set the state for October’s financial crisis. Interestingly, swap spreads were basically unchanged between September 15th and September 29th, but then widened sharply as the Credit market dislocated. During the past four weeks, two and 10-year Treasury yields have dropped about 45 basis points, while swap spreads are about unchanged. December Eurodollar rates have collapsed about 70 basis points over the past four weeks.

We will be watching the Credit market especially carefully over the coming days and weeks. It would appear we are entering a very critical period. Are we to the point where 1998-style hedge fund selling will force spreads wider and lead to self-feeding liquidations? Is there a serious financial problem underpinning the flight to Treasuries and dollar selling? Is the Credit market now vulnerable to any meaningful stock market rally, and could a reversal prove a critical inflection point with respect to marketplace liquidity? Is the agency market a speculative Bubble increasingly vulnerable because of the faltering dollar? How much marketplace leverage is there in agencies, mortgage-backs and asset-backed securities? How vulnerable are these key markets today to market reversal?

Well, we’ll be the first to admit that the character of recent stock market weakness raises many questions, and we are today short on answers. Movers arrived this week to transport my belongings back to Dallas. I will be catching a plane in a couple hours and returning home. I have enjoyed Sydney tremendously and am quite pleased with my productive year. It is a wonderful city in a very special country, and I said farewells to some dear friends. But I am excited to be coming home. Things could not be more interesting, and I hope to provide more insightful analysis next week and in the weeks to come in what is certain to be an extraordinary period in financial history.