07/12/2001 Comparative Advantage *

Argentina drifted into financial meltdown this week, with government bond yields surging to 36%, up from 13% just one month ago. Argentina’s borrowing costs now surpass those paid by Nigeria and Russia. Overnight peso borrowing rates surged to 400%, while the Argentine stock market has lost 18% of its value so far this month. In neighboring Brazil, the currency sank another 5% this week, as yields rose above 15%. The Mexican peso dropped about 2% this week, while the Bolsa stock index slid 4%. The JP Morgan Emerging Market Bond Spread Index widened 153 basis points this week to 962, the widest spreads since 1998. Spreads have widened significantly in perceived risky credits, including the Philippines, Malaysia, Russia, Ecuador and Turkey.

Nothing like global financial crisis to excite U.S. equity players. For the week, the Dow jumped almost 3%, with the S&P500 adding 2%. Economically sensitive issues shined, as the Transports surged 7% and the Morgan Stanley Cyclical index jumped 5%. The Morgan Stanley Cyclical index now sports a double-digit year-to-date gain. For the week, the Morgan Stanley Consumer index was unchanged and the Utilities declined 2%. The broader market enjoyed gains, with the small-cap Russell 2000 adding 2% and the S&P400 Mid-Cap index gaining 1%. Technology stocks rallied sharply, with the NASDAQ100 and Semiconductors jumping 5%, and the Morgan Stanley High Tech index adding 6%. The Street.com Internet and NASDAQ Telecommunications indices were up 1%. Biotech stocks came under heavy selling pressure, with the AMEX Biotechnology index dropping 5% for the week. Despite a late week rally, the S&P Bank and AMEX Securities Broker/Dealer indices ended largely unchanged. With bullion adding $1, the HUI Gold index gained 3%.

The U.S. credit market enjoyed gains, although they were unimpressive considering the global backdrop. For the week, two-year Treasury yields declined 5 basis points to 4.08%. The yield curve generally flattened this week, with 5-year yields declining 8 basis points (4.75%) and 10-year yields 13 basis points (5.22%). Long-bond yields declined 11 basis points to 5.62%. Mortgage-backs somewhat underperformed, with yields declining 10 basis points. Agency yields generally declined 12 basis points. The benchmark 10-year dollar swap spread added 1 to 88. Unstable global currency market conditions continue, although the dollar index gained only slightly this week.

Broad money supply surged $42.8 billion last week, making it $696.5 billion since the end of October, a 15% growth rate over 35 weeks. Institutional money market fund assets increased almost $18 billion last week, and have now expanded by $300 billion since October, a growth rate of 62%. This afternoon from Larry Kudlow: "There are not enough dollars being created by the Fed...it is incumbent that the Fed start expanding the monetary base. It should be growing closer to 10% than four and one-half percent…"

Standard and Poor’s reported that 101 companies defaulted on $57.9 billion of debt during the first half, easily surpassing the $42.3 billion for all of last year. Defaults are on pace for 3.81% of total S&P rated debt, already nearing record levels from 1991.

While the global debt crisis turns increasingly ugly, the Great Credit Bubble continues to inflate at home. MBNA, "the world’s largest publicly traded credit card company," this week reported a 35% year over year increase in company revenues. The company’s total managed loan portfolio jumped 18% (y-o-y) to $90.4 billion. MBNA also reported an 18% growth rate for customer purchase volume during the quarter, while adding 2.2 million new accounts (190,000 over the Internet). According to the company, "The typical new Customer has a $70,000 annual household income, has been employed for 11 years, owns a home, and has a 17-year history of paying bills promptly." While the company securitizes a large portion of its loans, it has nonetheless expanded its assets by 28% over the past year to $40.4 billion. Total assets have increased 137% since 1996. During the quarter, credit loses increased to 4.82%, compared to 4.35% the previous quarter and 3.95% last year. Elsewhere, J.P. Morgan’s weekly report on bankruptcies had about 25,000 new filings last week, 20% above year ago levels. Year-to-date, bankruptcy filings are running up 23%, with MasterCard International forecasting a 21% increase in bankruptcies to 1.5 million this year. Also catching my eye was the headline "Bank of Marin Reports Record Earnings Growth…" This California bank reported a 30% increase in loans for the year.

From company CEO Stanford L. Kurland: "Countrywide established new all-time records in June for all three key production benchmarks: fundings, applications and pipeline. Maintaining a trend, June fundings provided the fourth consecutive monthly record at $11.4 billion, 108 percent higher than in June 2000. Refinances are not the only driver as purchase fundings also set a new record at $5.9 billion and provided 52 percent of total fundings. Record average daily applications of $737 million were 104 percent higher than last year. The record pipeline of loans in process of $18.7 billion is 96 percent higher than last year. All-time highs for applications and pipeline are leading indicators that fundings should remain strong in the coming months." Along with surging refinancings, purchase fundings were up 29% and home equity fundings up 52% from last year.

Wednesday, the Mortgage Bankers Association reported a sharp drop in applications to refinance. The weekly index dropped 20% to the lowest level since December. Purchase applications continue to demonstrate resiliency, with the weekly index almost unchanged from one year ago. And while it does take weeks for the pipeline of funded mortgages to make its way onto the balance sheets of Fannie Mae and Freddie Mac, this historic refinancing boom with its powerful liquidity affect for the U.S. financial system has clearly passed its peak.

The impact of this liquidity surge has been evident in booming asset-backed security (ABS) issuance. According to Thompson financial services, year-to-date home-equity-backed issuance of $50 billion is up 35%, with $41.1 billion of auto-backed issuance up 39%. Credit card-backed issuance of $40.8 billion has surged 76%, and will soon surpass 1999’s total issuance of $41.6 billion. Total year-to-date ABS issuance of $187.4 billion is running 16% above last year. Of total ABS, home equity comprises 26.7%, auto 21.9%, credit card 21.8%, student loan 2.4%, manufactured housing 1.4%, equipment 1.4% and "other" 24.5%.

From Hedgeworld.com: "Convertible arbitrage, a stalwart strategy for many funds of funds, has suffered from sub-par performance over the last few months. Some industry observers, citing declining market volatility, shrinking convertible premiums, and a significant increase in new client assets, are calling for the strategy to earn less-than-stellar returns until market conditions become more favorable."

I was recently reading through Marcia Stigum’s popular book, The Money Market, where I came across an explanation of interest-rate derivatives that hits upon a misconception that is of utmost pertinence today (underlines mine):

"Often, a top credit, say a Morgan to pick a bank name, will find that its comparative advantage lies in borrowing medium-term, fixed-rate money, whereas what it really wants to borrow is variable-rate money. Meanwhile somewhere, some single B corporate will be saying, ‘The penalty I have to pay for borrowing medium term at fixed rate is awfully high, but fixed-rate money is what I really need.’ This sets the stage, realized a few prescient dealers in the early 1980s, for a liability swap. The triple-A credit borrows medium term at a fixed rate; the single-B credit borrows medium term at a variable rate; and then in effect, they swap liabilities – more precisely they swap on negotiated terms the future interest-rate payments each contracts to pay. Surprisingly, such a swap is not a zero-sum game. Far from it, the situation is a perfect example of the gains that can be realized from specialization along lines of comparative advantage (recall that Ricardo based his famous argument for free trade on differences in national comparative advantage, and the argument for free trade still stands today on the same ground). Triple A and single B can together reduce their joint costs of borrowing by each borrowing in the market where they get the best terms; then, using a swap, they can divvy up the savings they have realized and each end up with the type of liability they wanted in the first place. All this may sound a touch esoteric and theoretical, but it’s the basis in a nutshell of a business that grew, during the 1980s, from a zero base into one where outstandings are now measured in the hundreds of billions."

I agree, "it’s the basis in a nutshell of a business that grew" from a zero base to surpass $100 trillion of total outstanding derivative positions. Derivatives have been a central feature of the unchecked contemporary credit systems responsible for the explosion of credit and resulting destabilizing capital flows both domestically and globally. It is my view that there are very serious flaws in the "esoteric and theoretical" underpinnings of the derivatives market that today hold profound ramifications for the stability of the U.S. and global financial systems and economies. There remains the strong perception that derivatives have played a major role in creating a more effective U.S. system (Greenspan: "derivatives have enhanced the overall efficiency of financial markets and the economy"). We instead argue that the greater impact of the boom has been to foster historic credit and speculative excess. Rather than improving the functioning of the marketplace, derivatives in reality work covertly to impair the market pricing mechanism. Quite simply, the explosion of derivative trading has been a major factor striking monetary disorder, fostering financial and economic boom and bust dynamics. Somewhere along the line the whims of contemporary finance supplanted proven economic doctrine, with huge costs now waiting to be paid.

In many instances, critical economic concepts ("laws") applicable to real economy processes are conveniently ascribed to the financial sphere. Yet, financial processes often work with quite different supply and demand characteristics, as is made perfectly clear when rising securities prices impel significantly increased demand. It should have also been obvious that deregulation would impart very different consequences in the financial sector as compared to the, let’s say, the airline industry. Central bankers should have been especially on guard against financial excess. It is also worth noting the difference between the lending business and goods manufacturing, where lower product prices generally prompt a self-regulating reduction in production - as economics would suggest. But for the "manufacturer" of credit, lower margins often lead to increased "production" – lending in greater volume and to riskier credits. And, most importantly, an increased supply (credit availability) of credit only fosters additional demand – as excess begets greater excess. This is at the very core of Credit Bubble analysis.

So, back to the above example. It is claimed that the swap arrangement is better "than a zero sum game" – that there is wealth created through the reduction of combined borrowing costs for the "Triple-A" and risky credit. First of all, contemporary finance is fixated on funding costs and financial returns, with virtual disregard for the true underlying economics of lending and investment. What really occurred in the swapping of these cash payments? I would argue that the total funding cost issue is rather trivial, compared to the critical aspect of this (and most) derivative transaction being that credit has become more available to a risky borrower at below what would have been traditional market prices. This may not seem like much of a revelation, but it is critical for appreciating the endemic credit excess and market distortions that today leave U.S. and global systems vulnerable to crisis. The bulls have always trumpeted the flexibility and "risk management" aspects of derivatives, ignoring the much more significant issues of credit availability, speculative excess, and systemic fragility.

There are of course sound justifications for the market imposing an "awfully high" "penalty" for a risky credit to borrow "medium term at fixed rates." So, right there one should question the potential for the proliferation of derivatives to subvert market forces. There is absolutely no doubt that one major - if not the greatest - effect of this proliferation has been unprecedented (and now problematic) borrowing by risky credits both domestically and internationally. At the minimum, it is worth pondering the financial "magic" behind this seemingly mutually beneficial swapping arrangement. Unfortunately, there is no "magic" or wonderful financial alchemy, only the creation of counter-party risk with someone exposed to potential loss in the event the risky credit fails to make good on the derivative contract. There is certainly no reduction of risk, quite the opposite with the additional risky debts created. Moreover, too often this type of risk is transferred to a speculator or other financial player with limited wherewithal in the event of crisis. Sure, overt combined borrowing costs may have declined for the two borrowers (as proponents always make clear), but there is at the same time an increase in other less quantifiable costs including default risk.

There are as well important systemic issues, with real but indeterminate costs associated with risky credits obtaining greater access to funding. These include the issues of over and mal-investment (telecom/Internet), as well as the financial fragility concomitant with overborrowing and aggressive risk intermediation by the financial sector. The nature of these costs is at the same time particularly dangerous, as they go largely unrecognized throughout the boom. Funding negative cash flow borrowers (companies or countries) may appear relatively harmless, only to quickly become a major headache when the environment turns less hospitable. I would further argue that systemic costs grow exponentially at the late stages of a boom, and today pose a major if not recognized risk to the U.S. financial sector and economy.

Instead of addressing the critical issues of counter-party or systemic risks, it is popular for proponents to use alluring terminology such as Ricardo’s "comparative advantage" and Adam Smith’s "specialization" and "division of labor" when describing derivatives or contemporary finance generally. "Comparative advantage" – considered one of the "greatest laws in economics" – argues that the wealth of two countries can both be increased with specialization of production and mutually advantageous exchange of goods, even when one country possesses an absolute advantage in producing all goods. But is it reasonable that similar "laws" of wealth creation apply to borrowing money as they do for producing goods? Arguably, unfathomable amounts of debt and derivatives have been created based on the premise that they do! Well, I would strongly argue that not only is "Comparative Advantage" (and other economic "laws") generally not applicable to contemporary finance, it is an especially dangerous concept when used to justify credit expansion and financial excess.

With the U.S. possessing a "Comparative Advantage" in "producing" triple-A rated securities, does this mean it’s good economics to use this attribute to run massive trade deficits and accumulate unprecedented foreign liabilities? Is this, in the long run, a mutually advantageous arrangement for the U.S. and its trading partners? I would further argue that the entire U.S. Credit Bubble is built on a the erroneous theoretical foundation of financial "Comparative Advantage." The government-sponsored enterprises, with their implied government guarantees, have used this "advantage" to borrow $2 trillion in the marketplace and guarantee another trillion or so of mortgage securities. The financial sector has issued more than $1.2 trillion of commercial paper, using proceeds to fund more risky credits. And top credits such as GE aggressively use their funding advantage to expand risky lending, while the entire game of "structured finance" is converting risky credits into securities with the "Comparative Advantage" of being intermediated by money market funds into "safe" money.

It is not my desire to be an alarmist and I certainly take no satisfaction from "crying wolf." I began writing the Credit Bubble Bulletin specifically because of our view of the historic nature of the unsound boom and the inevitability of a major subsequent adjustment. My goal is to try to bring some understanding and perspective to what will be extraordinary financial and economic developments. And the more I work and study, the greater my conviction that we have experienced a highly unusual period where sound economics were tossed aside by a powerful wave of dubious and dangerous notions of "New Age" finance. Granted, history has other examples of such folly, but not many that compare to what we have witnessed.

Perhaps readers have noticed that I do not discuss price-to-earnings ratios, nor do I dwell on the stock market "mania" aspect of the bubble. The core of my analysis revolves around what I see as some very critical and fundamental flaws in contemporary finance and economics, as well as the development of a fragile global financial apparatus. I believe very strongly that financial historians will look back at the final breakdown of the Bretton Woods monetary regime in 1971 as ushering in 30 years of reckless and unsustainable global credit expansion, with resulting unprecedented distortions and imbalances to the global economy and financial system. I do see the developing crisis in the context of 30 years of gross monetary mismanagement.

I expect similar future derision for the (15 or so year) explosion in derivative positions, recognizing this as little more than a bull market phenomenon closely associated with extreme credit and speculative excess. I do find it interesting that there is now considerable attention and disdain for Wall Street equity analysts, yet little attention paid to their brethren derivative specialists in the office next door. This will not always be the case. In many ways, the derivative bubble has troubling characteristics all too similar to the nonsensical Internet propaganda, albeit with much greater systemic significance. I expect the unfolding crisis will eventually test the viability of the derivative marketplace, a prospect I find particularly disconcerting. The enormous expansion of credit insurance – from the GSE guarantees, to mortgage, municipal and corporate bond insurance – is also built on erroneous financial and economic foundations, and will be similarly discredited. The whole notion that risk can be neatly packaged, transformed, and managed will prove preposterous.

As for the protracted U.S. boom, future economists and analysts will unfortunately recognize it as one senseless failure in monetary and economic experimentation. How could the business of such a great economic power have turned so decisively to finance and speculation? I certainly expect analysts to question the reasonableness of the 20-year evolution in Federal Reserve monetary policy. No doubt many will struggle with making sense of the rationale for a central bank accommodating uncontrolled money, credit and speculative excess, while focusing exclusively on interest rate management. Such a one-dimensional approach only nurtures a booming industry for financial speculation. Besides, where was the precedent for such a risky adventure in central banking? It will never make sense that Wall Street, "structured finance," and the securities markets were afforded free rein to dominate the nation’s credit system, casting aside the mainstay of sound finance – the prudent banker. And what could Washington have been thinking to give such unprecedented power to the government-sponsored enterprises to be used for reckless credit excess? How could the Fed have accommodated an historic stock market bubble, and then further aggressively accommodated an historic real estate bubble in the face of a bursting NASDAQ? How, they will ask, could policy makers ever have supported the de-industrialization of an entire economy, and in the process allowed annual current account deficits to grow to $450 billion and household savings to turn negative? How could the great advantage and responsibility of possessing the world’s reserve currency not have been coveted and cautiously guarded? I view the unfolding financial and economic crisis in terms of the accumulated damage from 30 years of unprecedented monetary, financial, and economic misadventure.

Today, we are again in the midst of another round of unrelenting global financial crisis. Having "seen it all before," complacency does come easy, with most dismissive of very significant developments. I have argued that the global financial system is dysfunctional, and only in the U.S. do I suspect that such a view would today appear radical. In a recent commentary I questioned the source of the necessary new credit to sustain the U.S. Credit Bubble, intimating that the Greenspan Fed and U.S. financial sector are quickly running out of ammo. At the same time, the global crisis is running several steps ahead of the U.S., with options largely exhausted. This is a 1998-style crisis, but it is important today to recognize that a lot of bullets have been shot over the past few years, including a truly historic U.S. led global monetary reflation. The resulting financial bubble pushed American households to extreme and unsustainable consumption, giving a major boost to the global economy but at the great cost of even more precarious global imbalances and an acutely vulnerable U.S. economy and financial system. This U.S. Bubble, in concert with huge IMF bailouts, was wholly responsible for the renewed financial flows to emerging markets. But even this was not enough, and now this liquidity spigot is running dry. We’ve seen pegged currency regimes switch to floating; we’ve seen countries borrow in dollars; we’ve seen the adoption of currency boards. But we are right back in crisis, with little left in the arsenal.

For too many years "coins have been put in the fuse box" instead of addressing serious flaws in U.S. and global financial systems. The bottom line remains that these massive global capital flows, having become the hallmark of the contemporary global financial system, just don’t make sense. The game has regressed to a "wildcat" pursuit of speculative financial gain, with investment and economics playing little if any role. The predictable result has been wild currency and financial market instability, perhaps enticing to the speculative trader but unacceptable to true investors. As we have witnessed repeatedly, "money" floods into various markets only to wreak absolute havoc when it later decides to head for the exits. As I said, it just doesn’t make sense. International "investing" has regressed to something similar to equity investors buying index funds; It may work just swell during bull markets, but without any consideration for underlying value or economic prospects, investors lack the conviction necessary to ride out tough periods. Everything is just a trade. Why would anyone expect such a system to effectively allocate resources or demonstrate stability?

How could it have appeared reasonable to either borrower or lender for Argentina to accumulate $130 billion in dollar denominated debt? Did they believe that they could protect themselves by hedging? If so, where did they expect to find players with the wherewithal to make good on such "insurance" in case of collapse? Are derivative-related dynamic hedging strategies exacerbating the Argentine bond collapse? Were investors in Argentina because of economic prospects, or simply to speculate on spreads in higher-yielding dollar denominated assets? Was it perceived as a "Comparative Advantage" for others to borrow less expensively and then lend to Argentina and "play the arb"? If so, how did the "arbs" plan on getting out of their trades? Whatever happened, we are seeing one more disturbing example of the crowd heading for the exits, with marketplace liquidity and economic prospects quickly evaporating. It is really both pathetic and sad. A Bloomberg story yesterday had J.P. Morgan with a $16 billion estimate for total investor losses during the day in dollar-denominated Argentine debt. Argentina debt is said to comprise 25% of total tradable emerging market debt.

I have no idea as to the amount of exposure or losses suffered by the global "leveraged speculating community" in Argentina, Brazil, Russia, Turkey, or other emerging markets in tailspins. However, with the decline in the euro, faltering global equity markets, and general global currency dislocation throughout, probabilities are high that some players have been impaired. Clearly, the global financial system has experienced a severe body blow, and must now be considered acutely vulnerable. I would suspect that derivatives are a major factor in the tumult in Argentina, and if so, this would make this unfolding crisis even more prone to sparking global contagion effects. As we saw with LTCM, once derivative players run into trouble, problems in one market can quickly spread along the daisy chain to various other instruments, markets and countries. And, importantly, once the leveraged players begin to suffer significant losses and are forced to rein in risk – deleverage – we can expect the virus of faltering liquidity to spread through the system. Exactly this process is now taking a heavy toll throughout the emerging markets.

The $64,000 question: when do global crisis, "deleveraging," and illiquidity hit the fragile U.S. financial system? Well, if history is any guide, it is worth noting that the Russia collapse commenced in late August 1998. And while the U.S. market did suffer during this period, it recovered strongly during September. Things, however, came to a head during the first week of October. The U.S. financial system "seized up," as the financial sector buckled under the weight of a collapsing dollar and widening spreads. At this point, the U.S. credit system, while terribly fragile, retains its inflationary bias (capability to perpetuate monetary excess). So if the GSEs and financial sector continue their efforts to keep the system liquid, at the same time the dollar is buttressed by continued global tumult, the U.S. financial system could perhaps stave off crisis for the coming weeks. It is, however, a very dangerous game they play…with acute systemic vulnerability the upshot of the tight interplay between the U.S. credit market, dollar and derivative bubbles.

As money continues to pour in, I suppose that hedge fund community assets now approach an astounding $500 billion. Throw in the international money center banks and investment houses and such, and one appreciates the monstrosity of what I refer to as the "leveraged speculating community." I include the hedge fund phenomenon with derivatives, credit insurance, the GSEs, and "structured finance," as extraordinary features of this massive global Credit Bubble that may prove but remarkable "flashes in the pan" of financial history. One thing is sure, the destabilizing impact of these financial players and products has been ignored for too long. If not before, there should have been recognition back in 1996 when efforts by several SE Asian countries to cool their economies with higher interest rates only incited greater "Hot Money" flows that further destabilized these bubble economies. There is certainly no excuse for ignoring the systemic danger after the LTCM fiasco in 1998. There should have been further recognition in 1999/2000 with the historic NASDAQ speculative bubble. Yet we have not experienced another speculative stampede into U.S. credit market instruments.

Still, I don’t know when crisis will engulf the leveraged speculating community. It certainly seems long overdue. Markets are generally not as accommodating to the aggressive and leveraged but, then again, they have been playing with an ace in the hole (the Fed on their side). For some time, unprecedented flows have made their way to the hedge fund community because of the perception of a "Comparative Advantage." As many of you are well aware, hedge funds generally take 20% of fund profits, while afforded the luxury of not having to pay for losses – the old "heads I win, tails you lose". While it doesn’t get much attention, this is one more powerful factor of contemporary finance, and one more dangerous incentive structure. While most funds (estimated 5,000 in total) surely try to do a good job and manage responsibly, the opportunity to take 20% of profits in cash (on mark-to-market/unrealized gains) will naturally induce speculators to structure portfolios for outsized returns, and often in esoteric instruments not easily valued. Actually, outsized returns are not as difficult to play for as one might imagine, especially with the proliferation of derivative trading, sophisticated strategies and instruments, and, of course, easily available financing for leverage.

Think of an example of writing out of the money puts today on U.S. agency securities and/or the U.S. dollar. In this environment, the probabilities that such trades will end up profitable would be perceived as quite high. So why not do such trades "in size," play the probabilities, and enjoy 20% of profits, while choosing to disregard the seemingly low probability of a major "unexpected" market dislocation? Besides, if the trades do "blow up" the whole industry will be in trouble anyway. Certainly, speculators would have been mighty tempted with the heady trading profits available for betting against a collapse in Argentina (playing the "probabilities" and writing puts options on Argentine bonds and/or currency derivatives). And such trades even add to market "efficiency" most of the time, providing a supply of "insurance" for those seeking protection. We are all left to hope that the market never needs to call on this "insurance."

Today, however, it’s looking like "insurance" may be called upon in Argentina, a situation that must have the involved players in a panic. As such, there is now clear potential for an exponential increase in losses on presumed "low probability" trades. With players having made similar probability bets in various markets, these types of situations can quickly become a major systemic issue as a series of trades begins to falter in tandem. The domino effect leads one "low probability" market event into a series of "low probability" events (and potential catastrophic losses) that computer models had forecasted as having virtually no chance whatsoever of developing simultaneously. This is the unfortunate nature of a global system incorporating $10’s of trillions of derivatives, untold leverage and endemic speculation. There will be no mystery surrounding the eventual crisis, but we are nonetheless destined to hear more blather regarding "The Perfect Storm." We’ll plan on fighting the "revisionists" all the way.