08/01/2002 The housing bubble loses some air *

It was another chaotic week in U.S. and global financial markets. Our heads are still spinning after a couple weeks of truly historic volatility. For the week, the Dow and S&P500 gained about 1%. The Morgan Stanley Consumer index added 1% and the Utilities jumped 4%. The economically sensitive issues suffered, with the Morgan Stanley Cyclical index and Transports declining 2%. The broader market was mixed. The small cap Russell 2000 declined about 1%, while the S&P400 Mid-Cap index gained about 1%. The technology stocks declined once again, with the NASDAQ100 and Morgan Stanley High Tech indices sinking 2%. The Semiconductors dropped 4%, while the NASDAQ Telecommunications index added 1%. The Biotech rally continues, with the major index up 6% this week. The financial stocks were mixed, with the S&P Bank index gaining 3%, while the Securities Broker/Dealer index declined 2%. With bullion up $3.80, the beaten down HUI Gold index jumped 19%.

The historic collapse in Treasury yields continued this week, no doubt exacerbated by abysmal economic news and problematic dislocation in other Credit market instruments. For the week, the 2-year Treasury yield dropped 22 basis points to a stunning 2.0%, with the 5-year yield sinking 18 basis points to 3.21%. The 10-year Treasury note saw its yield decline 9 basis points to 4.29%. The long-bond yield dropped 9 basis points to 5.22%. Mortgage-backs underperformed again this week, with yields declining 7 basis points. Meanwhile, the agency melt-up continued, as implied yields on agency futures sank 15 basis points. The spread to Treasuries on Fannie Mae’s 5 3/8% 2011 note narrowed 2 to 71, while the benchmark 5-year dollar swap spread increased 2 to 71. This spread traded at 41 in May. Corporate spreads again widened across the board to extreme levels. The big story this week is that the unfolding financial maelstrom has now hit the asset-backed securities market, with Credit card securitization spreads widening meaningfully. Faltering liquidity (and the loss of safe-haven status!) in this key market will be quite problematic for the real economy. The yield on December Eurodollar sank another 14 basis points this week to 1.70%. The dollar rally faded as the week ended, with the dollar index closing about unchanged for the week. A late week bond and currency rally rescued Brazil from what was looking increasingly like a major financial accident. Emerging markets throughout Latin America are in major trouble.

Yesterday from Bloomberg: “Marge Teller, who traded more than $100 billion of interest-rate futures a day at the Chicago Mercantile Exchange, called it quits last month. Making money in the market just got too difficult this year, she said. The 40-year-old Philadelphia native has no plans to return. Increased volatility, sparked by a slump in U.S. stocks, had made profits hard to come by, even for one of the biggest independent traders in the Eurodollar interest-rate futures pit, she said. ‘What I didn't want to do is stand in there every day in a market like this...It’s a very vicious market. If you're not going to make extraordinary amounts of money standing in there, it’s just not worth it.”

Broad money supply (M3) jumped $33.9 billion last week. Demand deposits gained $8.8 billion and retail money fund deposits increased $5.8 billion. Institutional money fund deposits expanded $7 billion, large time deposits $4.3 billion, and repurchase agreements increased $8.3 billion. We will be very surprised if the GSE’s are not now aggressively expanding their balance sheets (“reliquefication”). Commercial paper increased $7.3 billion last week, with a rise of $19.5 billion over two weeks. Not surprisingly, financial sector commercial paper borrowings comprised $16.3 billion of the increase. Financial sector commercial paper borrowings of $1.168 trillion compare to non-financial CP borrowings of $181 billion. We see plenty of securities leveraging in the banking data as well. Bank Credit expanded by $41.7 billion last week, with three-week gains at $84.7 billion. Most of the increase was in security holdings, with Treasury positions increasing $28.5 billion (to $917.4 billion) and other securities jumping $12.1 billion (to $698.6 billion). Commercial and Industrial loans increased $1 billion ($39 billion in three weeks), while Real Estate loans added $5.1 billion, Consumer Loans $3.5 billion, and Security loans $2.7 billion.

From Friday's American Banker (Rob Garver): "Peter Fisher, the under secretary for domestic finance, said lenders were lulled to inattention iby favorable economic conditions in the 1990s and largely abandoned the 'dirty-fingernail business of credit analysis.' They have become too reliant on risk models and other formulas to measure their credit exposure, he said, and are paying for it with the recent string of high-profile corporate defaults."

Aug. 1 Bloomberg: “Junk bonds are having their worst year on record as investors, scorched by bankruptcies and accounting frauds, sour on the riskiest corporate debt. Bonds of companies without investment-grade credit ratings have tumbled 9 percent this year, on pace for an annual decline of 15 percent, according to Merrill Lynch & Co. data. That would make it the worst year since Merrill started its junk bond index in 1986.” According to Merrill Lynch, Treasuries were the best performing sector during July with a 2.34% gain. Agencies returned 1.91%, Munis 1.62%, and Mortgage-backs 1.23%. Asset-backs showed returns of 0.87%, with investment-grade corporates returning 0.55%. Junk bonds lost 3.88% during the month, covertibles sank 5.36%, and emerging market bonds were hit for 6.60%. The past two months have been nasty for junk, emerging markets and, importantly, for the previously hot convertible sector.

The economic news this week has been dismal. With expectations for a 0.3% increase, June construction spending was reported down 2.2%. Spending was down 3.7% year-over-year, after being up 0.6% y-o-y during May and up 0.1% during April. Non-residential spending was down 20.1% y-o-y, compared to May’s y-o-y decline of 14.4%. Industrial spending was almost 46% below last June, Office 33%, and Hotels/Motels down 30.7%. Residential construction spending has now declined for three consecutive months, with June’s y-o-y increase of 3.9% compared to May’s 7.4%. Single-family construction was up 4.1% y-o-y, declining slightly from May. The hot multifamily residential sector saw spending drop 3.2% during the month, with May’s y-o-y increase of 17.9% dropping to June’s 9.8%. Interestingly, public sector construction spending slipped 3.1% during June, with y-o-y expenditures up only 1.3%. For comparison, May’s y-o-y increase was at 3.1% and April’s 6.8%. The construction slowdown is gaining momentum and it is broad-based.

Expectations had the June reading from the ISM index at 55, but the actual level was a barely expanding 50.5. This was down from May’s 56.2, and the weakest report since January. The key New Orders index sank an eye-opening 10.4 points to 50.4, the lowest level since November. Backlog of Orders dropped to 45.5, down 8 points from May and 17 points since March. Only one of ten ISM indices increased during the month, and, making things even worse, it was Prices Paid. This index increased 2.8 points to 68.3, the highest reading in 28 months. Could it be the weak dollar? The Chicago ISM index had New Orders declining 9 points to 52.4, with Prices Paid rising 6.3 points to 64.5.

Monday’s consumer confidence report from the Conference Board confirmed a steep drop in sentiment. June’s confidence was reported at 106.4, with expectations for July at 101. The actual number came in at 97, down a troubling 13 points in just two months to the lowest level since February. It is worth noting that this index was at 116.3 in July 2001 and 143 in July 2000. The index of future expectations sank 11.5 points to 95.7. All regions throughout the country experienced declining consumer confidence.

Second quarter GDP was reported up 1.1% versus expectations of up 2.3%. Consumer spending expanded at a rate of 1.9% (compared to the first quarter’s 3.1%), the slowest pace since last year’s third quarter. Non-durable production actually declined 0.6%, after the first quarters 7.9% rate expansion. Government spending continues to be strong, with Federal outlays growing at a 7.4% rate. Interestingly, and likely an issue with considerable importance down the road, state and local governments reduced outlays at a rate of 1.1% compared to the first quarter’s 4.6% rate of growth. The economy is now poised for negative growth during this quarter.

Today’s report on U.S. factory orders was also disappointing. Orders declined at a 2.4% rate, the weakest performance in seven months. New orders were down 2.4% y-o-y, with non-defense capital goods orders down an alarming 9.1%. Orders for consumer durables were down 4.1% and info-technology orders declined 5.3%. Once again, the story is abrupt and broad-based weakness. This will be no “capital goods recession,” but a broad-based economic downturn. Strong July auto sales are at this point a major exception to the poor economic news. We fear, however, that the industry continues to steal future sales through the use of ultra-aggressive financing deals. A Toyota executive stated the case succinctly: “The resumption of zero-percent financing and a wide range of discounts and sweet incentives have drawn buyers back into the market.” GM, the “price leader” of easy Credit, saw sales surge 24%.

GM is, as well, aggressively pumping the mortgage finance Bubble. Those of us having grown tired of the endless Ditech Funding commercials will not be surprised by Wednesday’s article in the American Banker: “Residential Funding Corp., better know as GMAC-RFC, said its issuance of mortgage-backed and asset-backed securities issuance was a record $18 billion in the first half. That included a record $6.8 billion of subprime securitizations for the General Motors unit, one of the nation’s largest MBS and ABS issuers. The company led all subprime issuers in the first half with a 12% market share and ranked first in home equity securitizations with a 13% share. GMAC-RFC’s second-quarter issuance totaled $7.7 billion, including $3 billion of subprime loans and a record $1.6 billion of alternative A products.” For comparison, GMAC-RFC issued $12 billion of ABS and MBS during last year’s first half. From Ditech’s website: “We are one of the few lenders to offer loans over-and-above the value of your property. The Freedom Loan puts you in the driver’s seat of your finances by letting you borrow up to 125% of your home’s value. Many use the Freedom Loan to eliminate high interest-rate credit card balances, pay for home improvements, or buy a new car - there aren’t any restrictions on how you use your money.” Nothing like cyclical industrial companies moving aggressively into subprime lending... For those hoping that we have witnessed the worst of corporate debt problems, keep in mind that GM and Ford combined for total assets of $627 billion with shareholder’s equity of about $37 billion at the end of June. Moreover, these aggressive financing deals virtually ensure problems down the road in auto loan securitizations. Were there no lessons learned from the huge losses suffered from the aggressive auto leasing programs?

July 31 Bloomberg – “Nortel Networks Corp. sold an office building in California’s Silicon Valley to South Bay Development Co. for about $23 million, the lowest price per square foot in the area since the mid-1990s. South Bay and partner Pacific Coast Capital Partners paid about $65 a square foot for Nortel's vacant 359,000-square-foot building in Santa Clara, said Mark Regoli, executive vice president of the Campbell, California-based real estate developer. Silicon Valley’s office vacancy rate has risen to 32 percent from 3.5 percent since the late 1990s Internet boom faded, and rents have fallen to an average of $33 a square foot from a high of $100. Nortel, North America’s second-biggest maker of telephone gear, spent about $40 million renovating the building and had it on the market earlier for $50 million, Regoli said. ‘It’s a good opportunity to take advantage of the absolute collapse in the commercial real estate market here,’ Regoli said. ‘This is one of the first sales reflecting a new pricing dynamic. There were tons of sellers who still wanted crazy numbers for their buildings.’”

From yesterday’s Wall Street Journal: “The Housing Bubble Loses Some Air - In Atlanta, the number of homes for sale priced at $750,000 and above now stands at more than a 20-month supply...compared with a four or five month supply in a more healthy market. The number of homes on the market in Denver has doubled to about 17,000 from January of last year... In Seattle...home sellers now outnumber buyers by four to one... The price drops and sales slowdown in some markets suggest that the residential real-estate bubble may finally be losing some air.”

From Wednesday’s American Banker (Michele Heller): “Nine months into his investigation of the role financial institutions may have played in the downfall of Enron Corp., Sen. Carl Levin said Tuesday that legislation may be needed to rein in the use of special purpose entities and ensure that equity analysts act independently. Sen. Levin, the chairman of the permanent subcommittee on investigations, said in an interview Tuesday that he is interested in exploring whether Congress should consider legislation that targets special-purpose entities.”

From the flap of the book, Stocks for the Long-Term: “Jeremy Siegel invites virtually all investors and savers of every age and income class to build wealth the historically proven way – in the stock market.” Dr. Siegel’s book made the case that stocks over time consistently provide a 7% return with lower overall risk than investment alternatives. I found it interesting (considering the environment) that he appeared on television the other night still trumpeting stocks as appropriate investments for the masses, while stating his view that stocks should be afforded a much higher multiple than the market has granted historically. He believes strongly that today’s policymakers will not repeat mistakes that in the past led to problematic unemployment and inflation, hence the S&P500 deserves a price-to-earnings ratio in the low twenties rather than the historical P/E of about 14. Unfortunately, Dr. Siegel and the Hassets and Glassmans (Dow 36000) of the world failed miserably at recognizing the extreme risk inherent in the financial landscape when they were so vocally promoting the stock market. Amazingly, I see no indication that they have moved up the learning curve.

The first step in accessing the risk in financial assets (stocks, Credit market instruments, and currencies) it to try to understand the nature of the underlying Credit system. The key issues are the quantity of financial claims being created, how the new finance is being spent (the quality of these claims), and the types of businesses/industries being financed. And, importantly, who is acquiring these claims – long-term investors or leveraged speculators? Is speculative finance a key facet of the monetary expansion? Are the flows stable? Is the Credit mechanism stable, or self-reinforcing? If there are reasons to suspect that the quantity of new finance directed at one industry is excessive and that the acquirers have a speculative bent, then one must consider the ramifications for an eventual reversal of flows and an abrupt contraction of Credit availability. If the Credit mechanism is unstable, then risk basically grows exponentially over time along with the expansion of suspect financial claims. The major flaw in the bullish stock market analyses was always that they – ignoring the key role of the Credit system - extrapolated unsustainable boom-time financial excess (and inflating financial asset prices) far into the future. They were walking blind to the approaching cliff - they were oblivious that an out of control Credit system was creating grossly excessive amounts of new finance and that the flows were exceedingly of a speculative nature. Credit creation was extreme and being poorly allocated. These dynamics applied to the telecom debt Bubble that ballooned from 1998 to 2000, and they apply to the ongoing mortgage finance Bubble.

I highly recommend that readers go back and read Bill Gross’ July and August writings (www.pimco.com). His past two pieces have been especially interesting, and what I read between the lines is absolutely fascinating. He sits in the “catbird’s” seat overlooking the Credit system, and he clearly appreciates the unfolding Credit system dislocation. His “quote de jour” regarding corporate bonds is that, “It’s a lousy business.” And since he stands high and mighty at the peak of the Mount Everest of agency and GSE mortgage-back securities, he enjoys the luxury of writing that, “The corporate market at the moment is close to full tilt (pin-ball machine analogy), half frozen, trading on price – not yield.” In other words, the market is virtually closed down for all but a few borrowers. The economy may not be far behind.

But what does it mean that Bill Gross prefers to hold mortgage-related securities rather than to lend to business? And since he is outperforming his competitors, he will attract more fund flows, while his competitors scamper to dump corporates and mimic his agency/mortgage-back portfolio. He clearly recognizes the problem of it all, and has encouraged banks to increase their lending to corporate America (while protesting the shorting of corporate bonds by the hedge funds), and is even now contemplating a potential role for the Fed in the worsening corporate Credit crunch. But the dilemma is that banks are more than happy doing the same thing Bill Gross is doing, making the easy money playing the (seemingly risk-free) mortgage finance Bubble. Interestingly, Mr. Gross makes reference to the banks (“levered sector”) off-loading corporate risk to the bond managers and insurance companies (“the unlevered sector”) through the Credit default swap market. Mr. Gross understands that Dr. Greenspan is “well pleased” with the stabilizing influence of this risk transfer, but warns him that the things are not going as well as Greenspan might have presumed. It would be interesting to know what Mr. Gross really thinks.

Which brings us to the heart of our concerns. We have for some time operated with an anchorless monetary and Credit system creating finance at a whim. And to throw historic Credit excess at an economy that produces so little of a tangible nature is simply asking for a Credit disaster. Furthermore, the contemporary Credit mechanism is dominated by the securities markets, where myriad instruments are aggressively managed by performance-chasing portfolio managers and leveraged speculators. This leads to excessive Credit creation too often inundating the hot sectors in manic bursts. Later, extreme Credit availability gives way to boom turned bust, impaired borrowers and lenders, market revulsion, and unavoidable Credit crunch. The bottom line is that the Credit system is only as stable as the ebb and flow (flood and drought) of contemporary markets. Throw on top of this an historic experiment developing a sophisticated market for trading and insuring Credit and other market risks (equity, currency, interest rate, etc.), which is about to be unveiled as an enormous failure. Yet, as long as the bull market held in securities and risk, the New Age system had all the appearances of a financial miracle. But the unfolding bear market in risk has seen buyers disappear and anxious sellers multiply, an imbalance that will not be rectified for years to come. Not only are the portfolio managers and speculators running for cover, many of the key players in the risk market are suddenly more interested in saving their hide and staying out of jail than they are in trying to book speculative trading “profits.” “Game Over.”

With the corporate debt market in taters and the risk markets dislocating, there is today no doubt that we are in a pickle like nothing seen in decades. Yet, the economic community is making the same critical mistake that the technology bulls made - extrapolating Credit Bubble-induced demand into the future. We fear the key issue going forward will be the bursting of the consumer and mortgage finance Bubbles. For too long, boom-time consumption has been sustained by reckless consumer and mortgage lending. The economic community is about to learn that what it believes is normal spending is, in reality, absolutely unsustainable. If the economy is as fragile as we suspect, it is time to ponder the ramifications of the other dominos lined up perilously throughout the Credit system. And then there is the issue of the dollar, which is acutely vulnerable to unfolding financial and economic dislocation. We’ll have to wait to see how the dollar reacts to what will likely be imminent Fed rate cuts. If the dollar buckles, we’ve got one heck of a mess. If the dollar holds, perhaps the mortgage finance Bubble will have enough remaining life to keep our impaired system liquid and the distorted economy stumbling along for a little longer. But if this unfolding storm hits the Agency and Mortgage-back Mountain, there’s going to be an avalanche. While Mr. Gross is not today suggesting that the Fed buy corporate bonds, we doubt he will protest when the Fed is forced to rescue the agency market.