07/18/2002 That's my story, and I'm sticking to it! *

The unfolding financial crisis hit the blue chips especially hard this week. For the week, the Dow and S&P500 were hit for 5%. The Transports dropped 6%, the Morgan Stanley Cyclical index 8%, and the Morgan Stanley Consumer index 10%. The Utilities continue their collapse, with the index down 10% this week. Losses were somewhat less dramatic for the broader market, as the small cap Russell 2000 declined 6% and the S&P400 Mid-Cap index declined 5%. Technology stocks generally outperformed, with the NASDAQ100 declining just over 3%. The Morgan Stanley High Tech index declined 5%, the Semiconductors 3%, the Street.com Internet index 4%, and the NASDAQ Telecommunications index held in there with a 2% decline. The major Biotech index actually gained 5% this week. The financial stocks were under heavy pressure, with the AMEX Securities Broker/Dealer index declining 5% and the S&P Bank index dropping 8%. Although bullion added $8, the HUI gold index dropped about 5%.

The collapse in Treasury yields continues, with 2 and 5-year yields dropping 11 basis points to 2.41% and 3.65%. The 10-year Treasury yield declined 5 basis points to 4.52%, while the long-bond yield was largely unchanged at 5.32%. Benchmark Fannie Mae mortgage-backs and agency yields generally declined 5 basis points. The spread on Fannie Mae’s 5 3/8 2001 note and the benchmark dollar swap spread both widened 2 to 54. The implied yield on December Eurodollar futures declined 3 basis points to 2.03%. The dollar index dropped better than 1% again this week. Corporate spreads continue to widen, with the financial sector seeing their spreads to Treasuries widen meaningfully.

The Treasury Department today reported a June surplus of $29.1 billion, down from last year’s $32 billion. Year-over-year June receipts were down 11%, while spending declined 8%. Fiscal year-to-date, our $118 billion deficits compares to last year’s $169 billion surplus (a $287 billion deterioration!). While it barely makes the headlines, today’s announcement of a record $37.6 billion trade deficit (estimates of $35.4 billion) is a disaster. For comparison, last May’s deficit was $30.148 billion, May 2000 $31.070, May 1999 $21.184, and May 1998 $14.444 billion. The pre-Bubble May 1997 trade deficit came in at large but manageable $8.6 billion. These perpetual deficits are now on the verge of spiraling out of control, and only a blind optimist would discount the potential for a serious dollar accident. Certainly, the news from the Port of Los Angeles and Port of Long Beach is not encouraging. Total container imports surged to about 528,000 during June, up sharply from May’s 506,000 (and up 21% y-o-y!). At the same time, container exports dropped to 171,000 from May’s 181,000 (up 3% y-o-y). Up 31% y-o-y, 256,000 containers left these two ports empty last month.

Broad money supply (M3) declined $8.2 billion last week, with a two-week drop of $37.4 billion. Demand deposits declined $14.1 billion, checkable deposits and small time deposits each dropped $3.2 billion, and repurchase agreements declined $9 billion. At the same time, savings deposits increased $10.7 billion, institutional money fund deposits gained $2.9 billion, retail money fund deposits added $3.5 billion, and Eurodollars increased $4.8 billion. It is also worth noting that asset-backed commercial paper outstanding declined $6.9 billion last week to $702.5 billion. When “money” supply declined earlier in the year, we argued that it was more related to “liability management” (companies issuing longer-term debt and paying down monetary liabilities) than a general decline in lending. We will no longer necessarily follow this line of analysis. Considering the current environment, we would now have a much more serious view of any meaningful decline in broad money supply as a problematic indication of systemic Credit tightening and faltering liquidity.

July 15, 2002 – “Looking for a safe haven from corporate ‘fallen angels,’ US money funds continue to purchase enormous amounts of Asset-Backed Commercial Paper (ABCP) according to a report issued by Moody’s Investors Service this week. Nearly a quarter of all money fund assets are now invested in ABCP conduits, according to the rating agency, continuing last year’s trend, when investment was at 22%. As of May 31, (the most recent month for which data is available) US money market funds held more than $343 billion, or over 48% of all outstanding ABCP. Most ABCP conduits are rated Prime-1, which indicates highest quality and credit losses among these P-1-rated programs have been almost non-existent, the agency said. ABCP outstanding in the US is now at $717 billion, representing 52% of all outstanding commercial paper, up from 37%, or $551 billion three years ago. Over the past year, ABCP outstanding has grown at a rate of over $4.7 billion per month.”

Housing construction remains on target for the strongest year since 1986. June housing starts were reported up 2.4% y-o-y, with single-family starts up 4.4% and multi-family starts up 5.3%. The South and Northeast were strongest, with y-o-y increases of 7.6% and 6.1%. New housing permits were issued at an annualized rate of 1.7 million units, up 5.1% y-o-y. For comparison, starts are up 8% from 2000 and 21% from pre-Bubble 1997. The Mortgage Bankers Association’s weekly application index was down slightly this week, although purchase applications were up 21.5% y-o-y and refi applications were almost double year ago levels. This week’s refi reading was the highest since January.

From yesterday’s American Banker: “In 1991, 21.4% of the prime mortgages insured by...MGIC Investment Corp., the nation’s largest mortgage insurer, were 95% LTV (loan to value) or higher; last year that rose to 60.1%... Underwriting ‘was a lot worse in the ‘80s than it is today,’ said Gary Gordon, an analyst with UBS Warburg. The loan designs a decade ago were way below par, he said. Automated underwriting is a ‘tremendous’ check, he added. ‘There are many more controls.’” We do not share Mr. Gordon’s sanguine view. “Bill Dallas, the founder and chairman of First Franklin Financial Corp. in Irvine, Calif., said, ‘You’d have to be an insolvent arsonist not to get a loan right now.’ He added that the appetite for mortgage-backed securities has helped fuel excessive lending.”

We are in a fascinating intellectual environment where weak analysis continues to dominate discourse. Amazingly, Alan Greenspan retains full support, and many steadfastly condone his perpetual easy money policies. But how can this be? In particular, what does our system have to show for the past year’s ultra-easy money other than unending “blow-off” excesses throughout consumer and mortgage finance? We have only more egregious trade deficits, a parabolic rise in problematic foreign liabilities, and an even more distorted “service sector”/consumption-based Bubble economy? Some now (it would have been valuable a few years ago when the fixation was the “new economy”) invoke the brilliant analysis of Hyman Minsky (“Financial Instability Hypothesis” and “The Wall Street Paradigm”), but the great Minsky neglected distortions to the real economy. The key unfolding story for the financial markets and dollar is the grossly distorted U.S. economy. Today, the most valuable analysis would combine the genius of Minsky with Mises and focus on fragile debt structures, dysfunctional monetary transmission mechanisms, and deep structural economic maladjustments.

By now, we should be well into what would be an arduous but unavoidable financial and economic adjustment process. But we remain stuck in hopeless denial, regrettably incapable of accepting what will be harsh medicine. Instead of treating the tumor, we have watched the cancer spread. Some pundits argue that we need to aggressively institute Keynesian policies, while forcing the banks to lend. As for the “Keynesian” analysis, this is especially dangerous today, as it ignores the fact that Keynes was espousing desperate interventionist policies to mitigate a deep global depression and financial collapse, not to perpetuate an historic Credit Bubble. Unfortunately, nowadays such interventions are little more than futile attempts to perpetuate unsustainable boom-time Credit and consumption excesses. There is absolutely no way around what will be a very difficult and protracted adjustment period.

It is worth repeating that household home mortgage Credit expanded at a 10.1% annualized rate during the first quarter, while the financial sector increased borrowings at a 9.9% annualized rate. This parlous divergence probably only widened during the second quarter. To be sure, there is plenty of lending going on, but the crowd today much prefers increasing Credit card limits and lending against inflating home prices. The marketplace despises financing U.S. corporations and is manic over consumer lending. In past analysis we have often used the terminology “Monetary Processes.” Well, today continued rampant Credit excess feeds gross overconsumption and mortgage finance excess, and it will continue doing so until there is a major financial accident.

We follow quarterly earnings reports from the financial sector carefully both from a micro and macro perspective. One can garner valuable insights from the lending activities of the major U.S. financial institutions. Thus far, enough companies have reported to confirm the ongoing trend of reducing commercial Credits while lending freely to the consumer and mortgage borrower. This is a major problem that should be recognized as a natural progression of an acutely unstable Credit system. From an individual company perspective, as well as from the system as a whole, troubled lenders (that maintain access to additional borrowings) will typically move aggressively to any “hot” sector in a desperate attempt to “grow” their way out of previous lending mistakes. It is incumbent upon the financial regulator/overseer to quash reckless lenders early before such practices become a systemic issue. An out of control Credit system will not stabilize with continued monetary over-stimulation, but will perpetuate repeated boom and bust cycles. From a systemic point of view, the risk is of only more extreme boom and bust episodes from an increasingly impaired system. At a certain point, a bust will challenge the viability of the financial system.

Looking at troubled commercial lender and derivative player JPMorganChase, “Cardmember Services” revenues were up 39% y-o-y to almost $1.5 billion, “Home Finance” revenues were up 87% to $772 million, and “Auto Finance” revenues were up 23% to $167 million. Managed “Cardmember” end of period outstandings were up 29% y-o-y to $49.5 billion. “Auto Finance” outstandings were up 12% y-o-y. Is there any wonder why consumer spending has held up so well?

Bank of America reported earnings-per-share up 13% y-o-y, led by strong consumer lending growth. The bank’s corporate loan book has now declined by almost 40% in two years to about $60 billion. “Average managed consumer credit card outstandings were up 12 percent from last year... Net charge-off were $888 million, or 1.06 percent of loans and leases, up from $787 million, or 0.82 percent, a year ago. The increase in charge-offs was primarily concentrated in the consumer bankcard portfolio due to a 29% increase in on-balance-sheet outstandings and the impact of the rise in unemployment and personal bankruptcy filings.” Over the past twelve months, “loans and leases” have declined $40 billion (11%), while “securities” have increased $28.6 billion (52%). Interestingly, “Global Corporate and Investment Banking” earnings were up 12% y-o-y. We will now see how exposed BAC is to the increasingly troubled asset-backed securities and “structured finance” marketplace.

FleetBoston reported a second-quarter loss of $386 million, with commercial loan outstandings “down by 15% in the past year as part of Fleet’s strategy to reduce risk.” The bank took total charges of $925 million for problem assets in Argentina. The company also took a large $950 million provision for losses, as well as a $388 million charge for the disposition of Robertson, Stephens.

Looking at Wells Fargo, total loans expanded at a 14% annualized rate during the quarter, and were up 12% year-over-year to $185 billion. The composition of lending growth tells the story. Commercial loans declined at a 1% annualized rate during the quarter, and were down 5% year-over-year. Consumer loans, on the other hand, expanded at a rapid 25% annualized rate. Residential first mortgage loans expanded at a 41% annualized rate during the quarter (up 51% y-o-y). “Junior” 1-to-4 family real estate (home equity) loans grew at a 45% rate during the quarter (up 51% y-o-y), while Credit card loans grew at a 2% rate (10% y-o-y). From the American Banker: “In late June, Wells had $48 billion in (mortgage) applications outstanding – the highest quarter-end level ever. And the surge is continuing.”

Aggressive consumer lending behemoth (“managed assets” of $119.7 billion!) Household International had another big lending quarter. “Owned assets” expanded at a 31% annualized rate to $97 billion (up 20% y-o-y). Total “managed assets” assets grew at a 28% rate to $120 billion (“investment securities” increased $3.2 billion to $8.2 billion). By major category, real estate loans increased at a 23% rate (also 23% y-o-y), auto finance at 16% (33% y-o-y), MasterCard/Visa 11% (down 2% y-o-y) , “private label” lending 5% (12% y-o-y), and “personal non-Credit card” 18% (12% y-o-y). Year-over-year, net charge-offs were up 34% to $766 million, while non-performing assets increased 20% to $3.6 billion. We don’t see how such aggressive lending at this stage of the cycle will come to anything good, with this company taking on huge exposure at the “fringe” of mortgage finance.

Subprime Credit card lender Metris is providing another example of how losses balloon when aggressive lenders eventually are forced to restrain growth. Over the past year, Credit card charge volume sunk 14%, while total net charge-offs jumped to a rate of 15%, up from 10.9% one year ago. For the quarter, the company reported a net loss of $36.4 million, compared to year ago’s net income of $54 million. How quickly things can turn sour...

The accident in wait Capital One hit its first guardrail this week. “Hats Off” to our bank regulators for moving to rein in this out of control lender. As most readers are by now aware, the company is in the process of entering into a “Memorandum of Understanding” with regulators over its subprime lending and overall systems. This should prove the beginning of the end. Interestingly, the company disclosed that its managed Credit card portfolio is comprised of almost 40% subprime loans, apparently about double the amount the market had been led to believe. Importantly, the company also announced that it was reducing its growth rate from the previous 30-35% to 20-25%. With net quarterly charge-offs up 68% y-o-y, we will now see if the company can grow new receivables fast enough to stay ahead of what will be mushrooming losses. The bond market is skeptical, with Capital One yields shooting as high as 10% on the news. During the past year, total assets surged 56% to $33.8 billion, while deposit liabilities have increased 60% to $16 billion. “Other Assets” were up 58% to $1.06 billion.

Wall Street appears determined to keep faith in its “darling.” From JPMorgan: “We continue to believe the company’s information based strategy will allow them to grow successfully and manage risks conservatively. We see no fundamental changes in the company’s strategy...” From CreditSuisse First Boston: “Regulatory Shocker Shouldn’t Derail One of Financial Services’ Best Success Stories.” This is no “success story,” and it is destined to be one interesting saga over the coming months. We have surely not heard the last from the regulators. But today investors were heartened with the news that Capital One’s CEO Richard Fairbank purchased $5 million of stock. We are not so impressed. From the American Banker: “Notably, Mr. Fairbank and president and chief operating officer Nigel Morris do not receive base salaries or bonuses, but are paid strictly in stock options which they are allowed to divest only if the stock prices rises 20% every year for a period of three years. Last year, Mr. Fairbank, who is 51, made $142.2 million, and Mr. Morris, 43, $89.5 million from the sale of options that they had held since 1994.” One more example of a sickening transfer of wealth.

This week, of course, Federal Reserve Chairman Greenspan spoke before both the House of Representatives Committee on Financial Services and the Senate Committee on Banking, Housing and Urban Affairs. It is amazing that he can maintain such a sanguine perspective. At this point, it seems rather clear that it’s the old, “That’s My Story and I’m Sticking to it.” Unfortunately, Greenspan’s “Story” is increasingly lacking of credibility.

From Tuesday’s appearance before the House: Congressman Kanjorski (Pennsylvania): “Mr. Greenspan, in the last several weeks, consumer confidence has shown some shift. And, of course, that was one of the two pillars that has been sustaining our economy over the last 18 months -- consumption of personal items. I’d like you to address the level of personal debt and whether or not its high amount could impinge on the ability for the consumer confidence and consumption to continue. And then interlace that with this discussion that we're hearing now about the potential of a real estate bubble. We’ve also had real estate as the second leg of the economy, which has been significantly high and to a large extent almost beyond understanding in a continuing growth pattern. Is it possible that the real estate bubble exists in the country as the stock market bubble existed? And if the real estate bubble disappears, and real estate adjustments occur, and consumer confidence continues to go down, what do you foresee for the American economy over the next 18 months to two years?”

Alan Greenspan: “Well, first of all, Congressman, let me say that it is certainly the case that the surveys of consumer confidence have gone down. And the reason they have gone down are many. But, consumer spending in retail markets has not. And indeed, our interest is actually what people do, not what they say. Indeed, as I point out in my written text, the same time that the indexes of consumer confidence fall -- fell, there’s been a big surge in motor vehicle sales in the early weeks of July. So that I think we have to be aware that on occasion, as good as these measures are of consumer confidence, they often don’t necessarily represent what people are going to do, where we care what they’re going to do as far as the economy is concerned. On the issue of debt, a goodly part of the rise in debt is mortgage debt, but that mortgage debt has not been going up faster than the rise in the market value of homes. Indeed, it’s been going up less, and that actual new equity is still increasing. So, a goodly part of the rise in debt is merely a reflection of the significant rise in home ownership, and the rise in the market

value of homes, which to a large extent is a function of one, the low interest rates, two, the shortage of buildable land, and three, and importantly, the incredible rise in immigration – a third of the rise in -- in the household formation is from immigration, and that's been a major factor holding the price level of homes up.

We’ve looked at the bubble question, and we’ve concluded that it is most unlikely mainly because, one, we have a very diverse real estate market throughout the country. We have so many different areas which don’t arbitrage one another as do stock prices. And the transaction costs in homes is very high. You cannot readily sell a home without a fairly large cost, and, perhaps even more importantly, you have to move, so that they type of underlying conditions that -- that creates bubbles are very difficult to initiate in the housing market. It’s actually easier in England where they have had bubbles because it’s a smaller geographical area. But there’s – we’ve seen no evidence that a national bubble in home values which would then collapse and create the type of problems you correctly identify are likely to happen.

So -- and indeed, I might say the evidence of the last few months is that the acceleration in prices which we saw earlier is beginning to phase down so that it is not an issue on the table at the moment. It is theoretically a concern. We do watch it, and if it changes, obviously we would try to conceive of actions we could take to change it, but that is not an issue that we think needs to be addressed by policy at this stage.”

Also from Greenspan: “Remember, our economy is remarkably efficient. It has developed a resiliency and a flexibility in recent years which makes it very difficult to understand how this is going on in the context of what clearly is many breaches of what appropriate corporate governance is. What it basically is saying is beneath all of the problems that we have, it’s still a very sound structure.”

As much as his words argue the contrary, I do not believe Dr. Greenspan is oblivious to the unfolding financial and economic crisis. He must appreciate that we stand today at the precipice of financial dislocation. But if he does, in fact, believe that our system is underpinned by a “sound structure,” he is about to receive the shock of his long career. The “structure” is instead frighteningly frail and vulnerable. And the reality of the situation is that the much-vaunted “resiliency” of the U.S. economy has been directly the upshot of the continuing Bubble in “structured finance.” It is now clear that this historic Bubble is in trouble.

It is difficult to know what to write tonight. Everything I look at – the things that I believe are the key determinates for the soundness of the financial system – signal to me that we are basically witnessing an unfolding implosion of the U.S. Credit system. This sounds extreme, but I am convinced of the acute fragility of underlying debt structures – I am convinced the crisis that has been held at bay for so long has now commenced. I am very fearful of systemic financial dislocation and a plunging dollar. It is time to have one’s house in order. The run on U.S. financial assets has commenced, although so far financial stress has buttressed the key Treasury, agency and mortgage-back markets. We continue to look at this as an unfolding dislocation in the “risk” market, with distress at the fringe having now clearly made it to the core of “structured finance.” This is an enormous problem. A WorldCom bankruptcy would be a problematic development for the impaired CDO (collateralized debt obligations) and Credit default swaps markets. Yet, the implosion of the stocks of some major borrowers such as AOL Time Warner leads us to fear we haven’t seen the last of major bankruptcies. At the same time, recent developments at the fringes of the consumer Credit Bubble signal that consumer lending problems must now also be factored into the equation. It appears the worst-case scenario is unfolding right before our eyes.

In the past, we have often used flood insurance as an analogy for the derivatives market. Inexpensive and readily available flood insurance led to a building boom along the river. A long drought made writing flood policies extremely profitable, and speculators rushed into the marketplace. The building boom along the river paralleled the Bubble in writing flood insurance. There were a few instances when rain started to come down pretty hard, and the speculators watched nervously as the local authorities constructed makeshift levees that held the floodwaters at bay. But as soon as the weather cleared the emboldened speculators became only more aggressive, and more luxurious structures were built, only closer to the waterway. The authorities were determined to do whatever necessary to sustain the building boom, and liked to trumpet how good it had become in building levees. They were ready to move into action with the first raindrops, and were adored by the insurance companies, speculators and homeowners.

Well, today torrential rain is falling, the dikes are giving way, and everyone is getting very nervous – homeowners and those that have been peddling insurance. The authorities maintain a brave face. The speculators always planned on going to the reinsurance market when the heavy rains began to fall, but that market now has a deluge of buyers and no willing writers of flood protection. The flood insurance market is “dislocated,” with players basically stuck with the exposure they have written. Various parties are all the sudden very interested in the financial wherewithal of the cadre of marketplace participants (counterparties). The “conservative” bankers that lent against the homes on the river are in a panic and won’t be financing anymore riverfront building. Confidence in the marketplace is waning rapidly, which only exacerbates the rush to dump exposure to a potential flood. With the flood insurance market in taters, the building boom is doomed.

The closer the scrutiny, the more apparent that, in the event of a flood, there is going to be a very serious problem – economic and financial. The bottom line is that incredible amounts of inadvisable building (“risk creation”) have occurred over the past few years, and there is nothing that can be done to reduce risk at this point. Unfortunately, the insurance “industry” has little in the way of the necessary financial resources in the event of a flood, and there is little that can be done about this either. It’s a severe structural problem – both for the financial system and the real economy. At the same time, the local authorities have continued to throw additional sandbags on top of fragile levees, with no one wanting to ponder the dire consequences if this frail structure gives way. They say everything is fine, as it always has been. The nervous homeowners are somewhat comforted, but those in the insurance market know otherwise. They are left to pray that it stops raining.