08/22/2002 Accentuated Credit Cycles *

Despite today’s drubbing, stocks generally ended another unsettled week with gains. For the week, the Dow and S&P500 added 1%. The Transports and Morgan Stanley Cyclical indices gained 2%, while the Morgan Stanley Consumer index increased 1%. The Utilities jumped 4%. The broader market enjoyed small gains, with the small cap Russell 2000 and the S&P400 Mid-Cap indices rising 1%. The technology sector was especially wild, with atypical price divergences. The NASDAQ100 ended the week with a gain of 1% and the Morgan Stanley High Tech index added 2%. After today’s selling, the Semiconductors lost 3% for the week, while The Street.com Internet and the NASDAQ Telecommunications indices surged 7%. There was a definite upward bias for stocks with significant short positions. The Biotechs generally gained about 1%. The financial stocks also managed small gains this week, as the Securities Broker/Dealer and S&P Bank indices rose 1%. With gold sinking $7.10, the HUI Gold index dropped 5%.

Bloomberg this afternoon reported that investment-grade corporations issued $16.1 billion of new debt this week, the most since January. Interestingly, despite the stock market rally and much needed stabilization in the corporate bond arena, there was no respite in the Treasury/agency market melt-up. Yields actually declined during the week, with the benchmark 10-year Treasury yield declining 9 basis points this week to 4.24%. Two-year Treasury yields dropped 10 basis points to 2.15%, 5-year 12 basis points to 3.31%, and the long-bond 7 basis points to 5.02%. Benchmark mortgage-back yields dropped 12 basis points, while the continued melt-up in agencies saw implied futures yields sink 17 basis points. The spread on Fannie Mae’s 5 3/8% 2011 bond narrowed 6 basis points to 51, while the 10-year dollar swap spread dropped 5 to 52. While we suspect that there remains considerable underlying financial stress in the Credit system, it also appears that a weakening economy is supporting the Treasury market. This week’s Instinet Redbook retail survey had same store sales slightly below year ago levels. This is the first negative reading since last December, and down sharply from the peak reading of an almost 6% y-o-y increase bank in March. Even during the first four weeks of July, same store sales were averaging up 2.7% y-o-y. In addition, a lengthening list of key retailers has announced disappointing recent sales. That retail sales are faltering in the midst of a major mortgage refi boom is an especially noteworthy development.

The Mortgage Bankers Association application index jumped 11% to a new record this week. The refi index surged 14%, almost reaching November’s record level. The refi index is running up more than 200% from one year ago. The purchase index increased 5% for the week, and is up 26% year over year. While there are increasing signs of deceleration in many local housing markets, this historic mortgage Credit Bubble thus far runs unabated.

The Federal Home Loan Bank system (FHLB) recently released second-quarter financial statements. Total assets jumped $19.4 billion during the quarter, an 11% growth rate. Assets increased $52.6 billion, or 8%, during the past year. Over this period, the FHLB saw its holdings of mortgage loans jump from $19.6 billion to $38.3 billion. Combined with Fannie Mae and Freddie Mac, “Big Three GSE” total assets ballooned $248 billion during the past four quarters to $2.2 trillion, a 13% growth rate. Assets are up $550 billion over two years (33%), and $1.16 trillion over four years (113%). The FHLB ended June with $615 billion “total notional amount of interest-rate exchange agreements outstanding compared to $601 billion at December 31, 2001 and $546 billion at June 30, 2001.” The enormous interest-rate derivative positions of the FHLB, Fannie Mae, and Freddie Mac are surely a destabilizing (trend reinforcing) factor in today’s Credit system, as counter-parties are forced to aggressively hedge exposure to declining interest rates (acquiring Treasury and agency securities and futures positions). We also wouldn’t be surprised if recent dislocation (“melt-up”) in the Treasury and agency markets – which exacerbates spread problems in corporates, asset-backs, and mortgage-backs – is a factor in recent Fed comments downplaying the likelihood of imminent Fed rate cuts. Certainly, there is considerable risk of additional Credit market disruption in the event of a further drop in mortgage rates. Declining rates begets dynamic hedging related buying by derivative players, protecting the GSE from sinking rates (as yields on their assets drop relative to rates on long-term debt), as well as the enormous mortgage-back securities industry hedging against the shortening life of their mortgage holdings. This buying, then, leads to lower rates, additional refinancings, and only more hedging.

Comments Wednesday (quoted by Bloomberg) by Anthony Santomero, president of the Federal Reserve Bank of Philadelphia, on the issue of whether consumer credit was driving the economy: ‘I don’t think that consumer credit per se is driving the ability of increased consumer spending. It’s the liquefaction of home equity.” On the issue of a possible housing bubble: ‘At this point I don’t see it as problematic. Housing prices have gone up significantly over the last year. Much of this is driven by fundamentals.”

August 20 - American Banker (Erick Bergquist): “On the brink of bankruptcy, Conseco Inc. is jangling the nerves of its creditors as well as its competitors, particularly those in the manufactured-housing market. Because it is one of the largest originators and servicers of these loans, Conseco Finance plays a big role in everything from pricing to how repossessed homes are sold. As the market reacts to Conseco’s problems, companies that rely on asset-backed securities to finance their manufactured housing loan fundings face higher costs... Other competitors worry that to raise cash Conseco may try to sell its inventory of 16,700 repossessed homes...”

This week brought more dismal news on the ballooning Twin Deficits. The Treasury Department reported a July budget deficit of $29.2 billion, compared to the year ago $2.8 billion surplus. This was the largest July deficit since 1994. After the first 10 months of the fiscal year, the y-t-d $147.2 billion deficit compares to last year’s $171.8 billion surplus (a swing of $319 billion!). Year-to-date, total revenues are down 10.2%, with individual tax receipts declining 17.8% and corporate tax receipts sinking 16.3%. “Social Insurance” tax receipts are slightly positive for the year. On the spending side, year-to-date expenditures are up 9.4%. If not for the significant decline in interest expense, spending would have been up better than 11%. Year-to-date by major categories, Social Security payments are up 5.3%, National Defense 14.3%, Income Security 15.8%, Medicare 7.7%, and Health 14.8%, while interest payment are down 16.7%. Other areas include Transportation up 19.6%, Education, Social Welfare up 13.3%, and Veterans Benefits up 13.5%.

Over at the Commerce Department, June’s trade (goods and services) deficit of $37.2 billion is second only to May’s $37.8 billion. We imported $40.8 billion more goods than we exported, up 14% y-o-y. Total goods imports were up 3.1% y-o-y, with Consumer Goods jumping 10.0% (pharmaceuticals up 25.9%!). Automotive imports were up 6.3%, while Capital Goods imports were down 1.4% y-o-y. June goods exports were down 2.8% y-o-y, with Capital Goods shipments dropping 6.4% (telecom equipment down 29.3%!). Our first-half trade deficit of $206 billion is up 8% compared to last year. Interestingly, y-t-d imports from Canada, our largest trade partner, are down 9.1%, while shipments from China are up 15.4%. July data from the two large Southern California ports were not encouraging. While inbound containers declined 3% for the month (up 14% y-o-y), loaded outbound containers dropped 10% (down 6% y-o-y). Containers leaving empty rose 10% for the month to 282,940. This is up 29% from the year ago level, and fully 55% of total inbound containers. The weaker dollar is not helping.

Broad money supply increased $6.8 billion last week, with demand and checkable deposits declining $9.9 billion, while savings deposits increased $20.5 billion. Retail money fund deposits declined $5.0 billion and institutional money fund deposits dipped $2.0 billion. Eurodollars increased $3.3 billion and repurchase agreements added $5.1 billion. Repurchase agreements have now increased $24.2 billion over the past four weeks. The Federal Reserve also reported that official Foreign Holdings of US Debt increased $9.4 billion last week. Bank Credit jumped $34.1 billion last week, and is now up $50.1 billion over three weeks. Bank’s holdings of securities rose $11.7 billion last week, while Loans and Leases jumped $22.3 billion (real estate up $6.6 billion, loans for securities up $13.1 billion, and consumer loans up $3.1 billion). With “other assets” rising $17 billion, total bank assets surged $55.5 billion in a single week. Interestingly, commercial paper borrowings grew another $13.5 billion last week. During the past seven weeks, total commercial paper outstanding has jumped $53.9 billion (30% annualized growth rate) to $1.3759 trillion. Over this period, non-financial commercial paper has actually declined $1.3 billion to $178.3 billion. Financial sector commercial paper borrowings have increased at a 36% annualized rate over the past seven weeks. It is also worth noting that primary dealer repurchase agreement positions ended the week of July 24th at $2.247 trillion. Dealer repos began the year at $1.787 trillion and ended year-2000 at $1.440 trillion. The amount of financial leveraging in the system is truly incomprehensible.

One cannot overstate the dominant role now played by the Wall Street securities firms. With these firms and their questionable activities now under careful scrutiny, their rise to prominence over our nation’s Credit mechanism becomes a most critical issue. It is worth noting that the “Big Six” – Citigroup, JPMorgan, Morgan Stanley, Merrill Lynch, Goldman Sachs, and Lehman Brothers – expanded total assets by an eye-opening $148 billion during the second quarter to $3.38 trillion. This amounted to an 18% annualized growth rate. Whether this aggressive expansion was fueled by expanding securities holdings to profit from lower interest rates, related to derivative trading activities, or because these firms were forced to make markets as their clients sold – or some combination of the above – we simply do not know. But we do know it turned out to be an especially poor time to take on additional risk.

Morgan Stanley saw is balance sheet balloon an amazing $62.3 billion, or 51% annualized, to $554 billion during the second quarter. Assets include about $44 billion of “U.S. government and agency securities,” $30 billion “Other sovereign government obligations,” $53 billion “Corporate and Other Debt,” $22.9 billion of “Corporate Equities,” $30 billion “Derivative Contracts,” $79 billion “Securities purchased under agreements to resell,” $12 billion “Securities provided as collateral,” $144 billion “Securities Borrowed,” $51 billion “Receivables,” $22 billion “Cash and cash equivalents,” $46 billion segregated cash and securities, and another $20 billion of miscellaneous assets. Interestingly, more than two-thirds of the company’s second-quarter growth came from four assets classes – “Other sovereign government obligations,” “Corporate equities,” “Corporate and other debt,” and “Securities purchased under agreements to resell” – which surged $44 billion to $187 billion.

Over the past month money supply has surged, financial sector commercial paper borrowings have expanded rapidly, the banking system has been rapidly expanding securities holdings, and the GSEs have returned to ballooning their balance sheets. These are precisely the makings of the type of “reliquefication” with which we have become all too familiar over the past four years. The very good news is that the system has once more retreated after again approaching the edge of the cliff. The dollar’s reversal has played a key role in system stabilization. But the question then becomes how long is aggressive (reckless?) financial sector expansion consistent with a sound currency? It would appear to us a rather precarious Catch 22: The financial sector has today no alternative than to continue leveraging - creating the money and Credit necessary to sustain liquidity for our securities-based Credit system, while keeping asset prices inflated and the U.S. Bubble economy levitated. But won’t unrelenting monetary inflation eventually imperil the dollar? Even “bearish” analysts are quick to announce that the storm has passed, but we suspect it is much more a desperately needed break than a passing.

The systemic problems afflicting the U.S. Credit mechanism are of a structural nature. There will be no quick fix, no “reliquefication” rescue like we have seen in the past. Today “liquidity” is being thrown on a deeply distorted system in the midst of a bursting Bubble. Sure, “top-tier” borrowers such as GE Capital, GMAC, Fannie Mae and Freddie Mac will continue to enjoy virtually unlimited access to finance. Unfortunately, the nature of this Credit excess will ensure continued over consumption, massive trade deficits, and offer little in the way of the future wealth creating capacity we (and our creditors) are in desperate need. Importantly, we believe bullish psychology has been broken in the global risk market. We certainly expect the perception and willingness to accept market risk has been transformed for many key players, perhaps including J.P.Morgan, Citigroup, Merrill Lynch, and European insurance companies to name a few key risk operators.

While I am as guilty as the next analyst in focusing too much attention on daily market fluctuations and developments, I would like to stress that the key analysis today is that we have now commenced the downside of the consumer Credit cycle. I also would like to proffer that we have passed an important inflection point in this protracted cycle of financial speculation and leveraging. Ironically, the technology collapse (with the resulting historic Fed and GSE monetary easing) only ushered in a final speculative blow-off in Credit market speculation. Money flooded into the relative “safety” of the leveraged speculating community, Wall Street securities firms ballooned their balance sheets, virtually everyone in fixed-income was transformed into a “spread” trader, convertible arbitrage became the hottest ticket in town, and the burgeoning Credit default market became a favorite venue for trading for fun and profit. Each respective boom fostered Credit availability. All have created problems that will require necessary adjustments.

Only time will tell, but I would assume at this point that the game has changed: perceptions of risk have been altered in combination with heightened risk aversion. For one, we would not expect that market rates can move much lower from here, while the considerable risks involved with convertible arbitrage and trading Credit default swaps has been exposed. It will be very interesting to see if chastened investors pull money from the hedge fund industry as we approach yearend, and if large numbers of funds decide to close shop. This would prove a significant inflection point in financial history. While the collapse in market interest rates has done much to buttress industry returns to this point, we nonetheless would expect that losses throughout the industry have caught many sanguine investors by surprise. The perception that hedge funds will make money in virtually any environment has been broken. The true risk profile of the current environment has burst forth.

So, if I could leave readers with one thought this week, ponder the ramifications if we have, in fact, commenced the simultaneous downturn in the consumer Credit and financial speculation cycles.

A brief analogy:
Imagine you reside in a quiet town comprised of Traditional Bankers. An aggressive Non-Bank Lender arrives in town and offers Credit to those of less than prime status – borrowers previously shunned by prudent bankers. The local economy receives a boost from heightened Credit availability, as the marginal borrower previously denied finance now obtains purchasing power. The town’s Credit cycle, however, is tempered by the limited amount of finance that Traditional Bankers are willing to provide to the New Age Non-Bank Lender. Focused on micro Credit analysis of aggressive Non-Bank as well as recognizing the dangers of excessive Credit flowing throughout the community, Traditional Bankers would keep a tight leash on lending.

The scenario (and potential for the Credit cycle), however, changes rather markedly with the arrival of Securities Firm to the community. Securities Firm immediately moves to develop a close relationship with Non-Bank Lender, promising management a much more advantageous financing relationship. No longer would nervous loan officers limit Company growth, nor would earnings be limited by the spread between the yields on loans made and the cost of bank borrowings. Instead, Securities Firm will acquire loans from Non-Bank Lender, pool them, purchase some Credit insurance, get a top rating and sell them into the marketplace. (While also dangling the carrot of a hot IPO for Non-Bank Lender if they keep the lending spigots wide open)

It does not take long for exciting things to happen throughout the community. Not only are local merchants benefiting from the created purchasing power, a few savvy local investors enjoy the above-market yields offered by Non-Bank Lender’s asset-backed securities (NBLABS). As more investors clamor for these securities, Securities Firm encourages Non-Bank Lender to ratchet lending volume. Seeing great profit opportunities, Securities Firm and a few of their speculating clients decide to borrow money to take leveraged positions in NBLABS. It’s almost as good as free money.

The economic boom begins to take hold. Even the prudent bankers take notice that Non-Bank’s borrowers turned out to be better risks than they would have expected. The economy is certainly much “healthier” than anyone had forecast. Over time, many citizens throughout the community were enjoying higher paying jobs, more valuable securities holdings, and much more equity as the value of their homes rose nicely. Everyone seemed to have money and booming securities portfolios. Those that choose to take leveraged positions in NBLABS were becoming fabulously wealthy by the large spreads and very low Credit losses. Everyone soon wanted a piece of the action, with Credit becoming available for buying myriad consumer goods, automobiles, homes or borrowing against home equity. Demand for the loans necessary to create the marketable securities simply could not be satisfied. The more securities created – with a booming economy, negligible Credit losses, and more citizens with “money” to “invest” - the more valuable these marketable securities became. Boy was the securities boom seductive. A mania developed with the instruments and strategies only becoming more “sophisticated” by the year.

But it is anything but rocket science to recognize The Precariousness of Accentuated Credit Cycles – the confluence of a Credit induced economic boom with manic speculative interest in Marketable Securities. The obvious dilemma arises when the Credit-induced economic Bubble begins to lose air. After years of excess, businesses had over-borrowed and over-expanded. Easy money had nurtured silliness, poor judgment and worse. Less apparent but equally important, excesses and resulting price divergences (including seductive asset inflation and income growth) had distorted the nature of demand leading to heightened risk for local businesses. Not surprisingly, the resulting maladjusted economy would first impart pain on the marginal (and leveraged) business enterprise. When business was good – in the midst of the boom – financial speculators threw destabilizing finance at companies and industries. When things began to turn sour, the businessperson’s dilemma was immediately compounded as financial speculators ran for cover and Credit availability evaporated seemingly overnight. Interestingly, the local monetary authority retained considerable power to stimulate lending by lowering interest rates – one could argue possessing much greater influence over the pricing of marketable securities than its traditional sway over bank lending. But this is a two-edged sword. At this stage of the cycle, lower official rates do foster lending, although it heightens speculative interest in non-business, consumer and mortgage-related securities. Boom-time consumer borrowing and spending are prolonged, if only for a while and with considerable negative consequences to the structure of the economy and soundness of the financial system.

Eventually, even the consumer sector is impacted by the increasing lack of Credit availability to the business sector (“Credit crunch”). Rising Credit losses at the margin – for the weakest consumer borrowers – hits the returns to the holders of the subprime marketable securities. The speculators begin to move away from this asset class, while the local bankers determine that their foray into riskier lending was ill-advised. This reduction of Credit availability at the fringe of consumer spending is critical. It begins immediately to affect the general business environment, leading to surprising weakness in previously strong sectors. This then dampens the appeal of a new class of securities, especially the hitherto booming market in consumer receivables that begin to demonstrate deteriorating Credit performance. The unfolding Credit morass has jumped the fire line into the “meat” of the consumer sector.

Over time, the booming speculative market in consumer and mortgage-related securities had developed into the key driver of the community’s Credit system – the dominant mechanism for disseminating purchasing power throughout the economy. During the boom, this phenomenon had all appearances of a miracle. But the little secret is that Securities speculation was nurturing most extreme and atypical Credit excess. And as the boom began to give way, the extent that manic securities markets had distorted the nature of demand and the underlying structure of the economy began to be illuminated. As much as the speculative boom fed the Credit Bubble on the upside of the cycle, revulsion at the securities market would now have dire consequences. The extraordinary distortions created from the Accentuated boom were now to Accentuate the downside of the Credit bust.

Sure, it seems to make common sense that the Traditional Banker would be expected to step up to the plate and provide the local economy desperately needed Credit. But the big problem is that the economy has become so maladjusted and is in such an unstable state of flux. The economy requires constant and enormous injections of Credit, especially to the increasingly vulnerable consumer and mortgage Bubbles. While there are scores of very anxious borrowers, it is an environment where it has become exceedingly difficult to judge if they will remain sound Credits. This then becomes a very key, if complex issue. While expedient, “stepping up to the plate” and lending at this juncture poses significant risk to Traditional Banker. If they end up extending ample new Credits to the consumer and mortgage sector at the crest of an historic bursting Bubble, the consequences could be truly catastrophic. And if they don’t, there will be immediate financial and economic dislocation. That is, in a nutshell, the risk of a marketable securities-based Credit regime.

Moreover, the types of loans made by Non-Bank Lender, pooled and packaged by Securities Firm, and sold to the Speculators, are of a much different character than those viewed as appropriate to Traditional Banker. The speculators are interested in yield, and couldn’t care less if the underlying loans are funding future productive capacity, consumption/imports, or inflating home values. They are also willing to dump these securities at the first glimpse of trouble on the horizon, with little concern for the consequences of asset classes falling in and out of vogue, or the role their manic behavior plays in Credit booms and inevitable busts. The Traditional Bankers know all too well that they must live with their loans until they are repaid, carefully analyzing the cash flow characteristics of their underlying Credits. They monitor the quantity of Credits they are providing to the community, as well as the types of entities being financed and the consequences of their lending. History demonstrates that this does not alleviate Credit cycles, but it does tend to keep them from running completely out of control. The additional element of an unfettered speculative mania in Credit market instruments ensures the Accentuated Credit Cycle runs completely out of control.

My brief analogy certainly does not do justice to the extraordinary complexities of the current environment. But I hope readers will ponder the differences between a traditional bank lending-induced Credit cycle, and the speculative, securities market based cycle we have experienced. I would argue strongly that there is not only a difference in degree, but also a major and unappreciated difference in kind. The issue today is two-fold. Unprecedented securities speculation and leveraging has fueled historic economic and asset Bubbles. There is simply no way to transform a maladjusted Bubble economy to one of balance and soundness without an arduous adjustment period. Additional financial excess is clearly not the answer. At the same time, we are currently in the midst of the manic stage of speculative financial excess throughout consumer and mortgage-related finance. Not only will another round of “reliquefication” face the law of diminishing marginal returns, but keeping the game going at this juncture only feeds more egregious non-productive Credit excess. Not only does it require enormous Credit creation to sustain the system today, the reality of this being the very late stage of the cycle ensures that today’s new Credits are unusually suspect. There is just no way around this dilemma. For the system as a whole, risk continues to grow exponentially. If there was only a chart that illuminated the percentage of non-productive Credit to total Credit created.

As we have discusses many times previously, the contemporary U.S. financial sector does enjoy the capacity of creating its own liquidity. We are witnessing it once again. But the residual of such efforts is ever more dangerous financial sector leveraging, ballooning suspect financial claims, and a dangerous accumulation of foreign held liabilities. We’ll stick to our analysis that this will eventually manifest into a serious problem for our currency. It is when marketplace revulsion hits dollar denominated securities that we will experience the ugly downside of this Accentuated Credit Cycle.