09/12/2002 Liquidity Excess vs. Faltering 'Risk' Market *

The stock market demonstrated a rather mixed performance for the week. While the Dow declined about 1%, the S&P500 and Transports were about unchanged. The Utilities dropped 3%. The Morgan Stanley Consumer index added 1%, while the Morgan Stanley Cyclical index declined 2%. The broader market was mixed as well, with the small cap Russell 2000 about unchanged, as the S&P400 Mid-Cap index declined 1%. The NASDAQ100 was slightly positive, with the Morgan Stanley High Tech index declining 2%. The Street.com Internet index added 2%. The Semiconductors dipped 2%, and the NASDAQ Telecom index posted a slight advance. The Biotech index gained 2%. The financial sector was also mixed, with the Securities Broker/Dealer index gaining 2% while the Banks declined 3%. Although bullion gave back $3.40 of last week’s strong gains, the HUI Gold index nonetheless added 2%.

The Treasury market “melt-up” generally runs unabated. The 10-year Treasury note saw its yield drop 10 basis points to 3.91%, while the long-bond yield declined 9 basis points to 4.77%. Shorter-maturities were not as impressive, with 2-year yields unchanged at 2.04% and 5-year yields declining 7 basis points to 2.97%. Agency and benchmark mortgage-backs performed very well, with yields generally declining about 14 basis points. December Eurodollar yields increased 4 basis points to 1.77%. The spread to Treasuries for Fannie Mae’s 5 3/8% 2011 note was about unchanged at 51, while the benchmark 10-year dollar swap spread narrowed one to 55. Today’s strong gain put the dollar index up 1% for the week.

Commodities continue to trade very well. Yesterday the CRB index traded to the highest level since February 2001, with year-to-date gains of almost 19%. Crude oil prices are up about 50% for the year, with global supplies remaining unusually tight. Drought in the U.S., Canada, Australia and elsewhere is feeding higher grain prices. The U.S. Department of Agriculture this week lowered its forecast of corn production to the lowest level in seven years and soybeans to the lowest level in three years. So far this year, corn and soybean prices are up better than 35%, and wheat prices are up almost 40%. Yesterday cattle prices surged to a six-month high. Australian wool prices also jumped to a six-month high. Sugar today traded to a one-year high. Interestingly, today South Korea’s central bank governor Park Seung commented on fears of heightened inflation pressures: “I’m concerned about inflation next year because of rising oil and property prices.” From Bloomberg: “Park said low interest rates were partly responsible for pushing up home prices, adding he feels ‘guilty’ that cheaper borrowing cost pushed up the size of household loans and led to higher apartment prices.”

There are some very unusual things happening within the U.S. banking system. Total “Bank Credit” surged $47 billion last week, with security holdings increasing $33.6 billion. “Loans and leases” were up $13.4 billion. Real estate loans increased $14.2 billion, while commercial and industrial loans declined $1.4 billion. “Total Assets” surged an eye-opening $72.5 billion, with a two-week gain of $101.6 billion and four-week increase of $141.2 billion. Total bank assets have surged $428 billion during the past 22 weeks, expanding at a 16% annualized rate. Security holdings are up $43.4 billion over two weeks, while increasing $184.6 billion (18.5% annualized) so far this year. Commercial and industrial loans are unchanged over the past eight weeks, and have declined about $25 billion thus far during 2002. With the unfolding tumult in the securities markets, it is apparently the banking system’s turn to step up to the plate to sustain rampant Credit flows and an over-liquefied financial system. Clearly, such aggressive bank liquidity creation has played a major role in stabilizing the faltering U.S. Credit system. Such operations, however, are surely not conducive to the long-term soundness of our currency, or the stability of our financial system and economy.

At the same time, broad money (M3) supply declined $13.7 billion last week. Demand deposits increased $11.8 billion, retail money fund assets declined $9.9 billion, institutional money fund assets dropped $15 billion, and large time deposits declined $7.7 billion. Eurodollar deposits added $1.7 billion, while repurchase agreements increased $5.8 billion. Repos have now surged $45.9 billion over seven weeks to $411 billion. Importantly, outstanding commercial paper (CP) jumped $18.1 billion last week to $1.395 trillion, with financial sector CP increasing $16 billion to $1.221 trillion. Over the past ten weeks, total CP has increased $72.6 billion (29% annualized), with financial sector issuance up $78.3 billion, or 36% annualized. Non-financial sector commercial paper borrowings have declined $5.7 billion over 10 weeks. Asset-backed commercial paper issuance is up $10 billion over the past seven weeks to $711.8 billion.

The Mortgage Banker’s Associations weekly index of refi applications surged 19% to a new record high. The refi index was up 166% from year ago levels, while a strong purchase application index was up 29% y-o-y. Countrywide Credit’s August production was impressive. Average daily fundings jumped to almost $1.7 billion, up 24% from July and 125% above levels from last August. Purchase fundings were up 55% y-o-y, while refi/non-purchase fundings more than doubled. Home equity lending jumped 59% y-o-y. It is not only mortgage borrowings that are expanding rapidly. July (non-mortgage) consumer debt expanded by $10.8 billion, or 7.6% annualized, the largest increase since November. Recognizing that many mortgage borrowers (refis and home equity) are using some equity extraction to pay down more expensive Credit card balances, the continued rapid growth of consumer debt is especially noteworthy.

From the American Banker (W.A. Lee): “Anecdotal evidence has suggested that a good number of entrepreneurs and small businesses finance their operations by credit card, but a new report documenting at least part of this trend asserts that the phenomenon is probably even larger than most people thought. Small-business receivables owned by monoline card companies and by banks that did offer separate data for their card operations grew 17.3% in one year, to $140 billion at the end of June 2001, according to the Small Business Administration Office of Advocacy. (More recent figures were not available.)” The American Banker quoted a senior economist from the Small Business Administration: “‘For the past five years, banks have found that their credit scoring method for consumers is also pretty good for businesses where the individual owners’ are so integral to the venture. ‘This cut the cost of credit review’ which had been a major obstacle in business lending, ‘and presented an opportunity for banks.’”

The state of California finally has a budget after weeks of infighting to deal with an unprecedented $26 billion deficit. From the Sacramento Bee (John Hill): “With little of the fanfare of his first three budgets, Gov. Gray Davis signed a grim $99 billion state spending plan Thursday balanced with cuts, loans and bookkeeping maneuvers that he acknowledged fail to nurse California back to fiscal health…Sen. Chuck Poochigian, R-Fresno, predicted that the Legislature would be back in session by the end of the year to cope with a growing fiscal crisis. He warned that Democrats would try to boost taxes, using maneuvers they unveiled during the last days of budget impasse that avoid the need for GOP votes. ‘One thing is nearly certain,’ he said in a prepared statement. ‘Already hard-pressed California taxpayers can expect the worst -- higher taxes and reneging on commitments -- as soon as the November elections are behind us.’”

The economic news continues to disappoint. Yesterday’s report of a worse-than- expected $130 billion second-quarter current account deficit was dreadful, but not surprising considering the dimensions of the ongoing consumption-based lending boom. The deficit was up 16% from the first-quarter’s record and up 31% y-o-y. It is just difficult to believe that the current account deficit is up almost five-fold from 1997’s second-quarter $26.65 deficit, yet few are willing to recognize that this is indicative of incessant Credit excess and consequent severe structural problems. This week’s report of 426,000 initial jobless claims was the highest since the week of April 19th. This was the fourth gain in five weeks. Last week’s bankruptcy filings were up 12% from year-ago levels. Expectations have third-quarter filings up 8% y-o-y. The University of Michigan’s early report on September consumer confidence declined to a weaker than expected 86.2 (vs. August’s 87.6), the lowest level since last November. Current conditions declined 3 points to 95.9 (down from May’s 103.5), the lowest level since January. Expectations declined 0.6 points to 80 (down from May’s 92.7), the lowest level since last November. We did, however, today have a positive report on August retail sales, with sales up 0.8% versus expectations of up 0.5%. Yet we continue to note the relative weakness of (non-auto) consumer spending in the face of massive mortgage refi/home equity borrowings. It is worth noting that retail sales surged 6.2% last November in the midst of that refi boom. Sales were up 1.4% for the month during the less substantial October 1998 refi boom. While the historic bond market melt-up has to this point fostered sufficient borrowings to maintain boom-time (and eventually unsustainable) consumer spending, the mortgage finance Bubble cannot last forever.

While not receiving the attention it deserves, the news from the consumer finance sector remains troubling. We expect the unfolding tumult in consumer finance will be a major impediment to the vulnerable U.S. economy. Industry heavyweight Household International remains under close scrutiny by a litany of parties after years of questionable lending practices. Monday Fitch lowered its ratings on Capital One Financial Corp and its subsidiaries. The “action reflects concerns with respect to fallout from the recently signed informal memorandum of understanding (MOU) between Capital One’s bank and thrift subsidiaries…” Last week company management stated that a “hostile” regulatory environment would lead the company to cut back on its subprime lending, although we suspect that the market’s ebbing demand for the company’s securities is likely a more significant factor. Also Monday, Fitch revised its ratings outlook on MBNA to negative from stable. The outlook revision “centers on the low and recent decline in the level of tangible capital present at the company, particularly in light of increased regulatory scrutiny of specialized credit card lenders… Concerns center on the level of risk-adjusted capitalization and reliance on securitization for funding, losses, and delinquencies averaging slightly higher than historical norms, and competitive pressures within the industry, which are likely to hurt margins.”

September 12, 2002: “Fitch Ratings downgrades 85 classes ($5.95 billion) and affirms 215 classes ($11.75 billion) of 52 Conseco Finance/Green Tree Finance manufactured housing (MH) transactions… Ratings in the 'CC' category indicate that default is a real possibility and this creates a significant amount of uncertainty surrounding the viability of the company. Capacity for meeting financial commitments is solely reliant upon sustained, favorable business or economic conditions… The continued deterioration in the company's financial condition has greatly heightened Fitch's concerns about the performance of the company's manufactured housing asset-backed securities (ABS). The sheer size of Conseco's MH portfolio (at $23 billion), and the difficulties with regard to servicing this unique asset make the securitizations particularly vulnerable. Given the firm's financial difficulties, [Conseco Finance] may be unable to continue to originate new loans. In addition, certain current servicing practices may not be continued or may be altered, and the amount and position of the servicing fee in the waterfall may change… Recovery rates for manufactured housing issuers that no longer originate loans have experienced loss severities in excess of 80%. If [Conseco Finance] were no longer able to fund loan originations, loss severities on repossessions would be higher than current loss severities due to a lack of dealer relationships…”

Excerpts from “Conseco May Prove Mighty Risk For Asset-Backed Bond Market”, Dow Jones Newswires (David Feldheim): “‘The Conseco situation has the potential to set a new benchmark in the handling of servicing risk,’ said Karen Weaver, head of ABS research at Deutsche Bank. Conseco management has emphasized that the restructuring it’s trying to accomplish is only at the parent level, and that its insurance and consumer finance businesses are profitable. However, if the parent files for bankruptcy, it may prove difficult to shield assets of Conseco Life and Conseco Finance from creditors... And that ‘promises to have sweeping implications on the way securitization markets think about servicing risk…’ The question yet to be answered… is, ‘Who, if anyone, can service the portfolio of…home equity (HEQ) and manufactured housing (MH) assets if indeed the company is forced to reorganize?’ The servicer is responsible for collecting loan payments and fees and keeping them current. In the event of default, the servicer can restructure the loan or repossess the housing unit for resale or liquidation… With an estimated $24 billion in outstanding contracts, the [MH] portfolio is an extremely large one. But beyond size...the portfolio is burdened by the weak credit performance of recent deals, low servicing fees and the long weighted average life of the collateral. In the event of a bankruptcy filing, the analysts see little likelihood Conseco will retain the MH business and continue as the servicer. Creditors will be looking to sell assets to raise cash, and this is a business that will be viewed as a problem and one that the company will just as well do without. Liquidating residential real estate may be a servicing issue, said Weaver, but ‘finding buyers for used single-wides and doublewides is another game entirely.’ (Solomon Smith Barney analyst) Gjaja sees a new servicer as being less interested in trying to mitigate losses and more apt to engage in wholesale disposition of repossessed units, resulting in higher loss severities for the lender and ultimately for the investor, because there will less cash flow to pay off the outstanding ABS notes. A new servicer will also be expected to increase the current below-industry norm servicing fee on the MH portfolio, which would also cut into bondholder returns, according to Gjaja. Clearly, the ABS market is concerned, as evidenced by heavy trading in the outstanding Conseco MH securities. Dealers' sources said that since the start of the grace period 30 days ago, prices on triple-A-rated Conseco Manufactured Housing notes have ‘fallen very substantially.’ For some issues the yields have increased more than 100 basis points… Lower rated tranches have shown even weaker performance. Spread margins have widened and some issues are trading at distressed levels… Weaver said there’s a risk that the ABS market’s ‘flight to quality’ status could be compromised by Conseco’s situation. The justification for ABS, said Weaver, ‘rests on the ability to separate the seller/servicer risk from the creditworthiness of the underlying assets. But if no other eligible party can service the assets, ultimately, investors have only established themselves as senior secured creditors and not much more.’”

Last evening Moody’s placed the ratings of aggressive subprime auto lender AmeriCredit on review for possible downgrade. “AmeriCredit's effective leverage is high and is likely to remain high absent a reduction in the firm’s growth rate and/or AmeriCredit raising common equity in the capital markets… Second, AmeriCredit is experiencing deterioration in its portfolio performance. Moody’s will consider the implications of this trend with regard to the company's near-term profitability and financial flexibility.” AmeriCredit’s asset-backed securities (comprised of very low quality auto loans) have retained marketability due to Credit insurance provided by Financial Security Assurance (FSA), a subsidiary of European banking group Dexia. Today Dexia’s shares dropped 5% on mounting concerns as to its exposure to myriad losses. Today from Bloomberg: “Brussels-based Dexia yesterday said it set aside 94 million euros to cover risky loans in the second quarter, almost a third more than a year earlier. The bank cited the deterioration of corporate credit quality, particularly in the U.S., and slumping stock markets for the increase.” Today from Dow Jones: “Shares in Dexia SA slid Friday after the Franco-Belgian banking group failed to dispel worries over a controversial share leasing scheme in the Netherlands… Friday’s share price tumble is a blow to Dexia’s management, which is struggling to restore the bank’s reputation as one of the safest investments in the European banking sector… Concerns over Legio Lease - a Dutch share leasing scheme that has turned sour as equity markets have plunged in recent months - dominated a meeting between Dexia management and financial analysts Friday.”

The news out of the European financial sector is dismal, and in the face of escalating losses and plunging stock prices major European insurance companies will attempt to raise $5 billion of additional capital. Today’s Financial Times: “Aegon, the world’s fifth largest insurer, is in talks with the trust fund that is its biggest shareholder over a financial restructuring that would give it access to capital…Shares of Aegon slid 5% yesterday…as investors reacted to fresh evidence of the sector’s need for capital. Legal & General, UK life assurer, on Tuesday unveiled a deeply discounted 786m (pound) rights issue and big cash calls are expected from Zurich Financial Services, the Swiss insurer, and Royal & Sun Alliance, UK-based insurer… Aegon issued a profits warning in July blaming stock market turmoil, the falling dollar and the impact of guaranteed payouts to US policyholders.” Also from today’s FT: "Axa, the French-based insurer, made an early announcement of its interim results yesterday and was a pains to reassure investors that its solvency and gearing would not require any immediate capital injections.”

From Monday’s Financial Times: “Global reinsurers face mounting threats to their finances and credit ratings, despite a surge in premiums since the September 11 attacks on the US.” Monday’s FT also included a full-page “Special Report – The Asbestos Crisis: The toxic time-bomb exploding throughout the corporate world.” “Waves of litigation have crashed over companies and insurers on both sides of the Atlantic since the early 1980s. But a rising tide of claimants in the US is now causing more businesses to drown than ever before. Last year, nine US companies declared bankruptcy as a direct result of asbestos liabilities and at least 90,000 new cases were filed against those that remained. A record 11 companies have gone under already this year, 200,000 claims are pending and experts predict the peak is yet to come.” Disturbingly, the article also detailed the inflating actuarial estimates of “US compensation costs” that have surged from $40 billion back in 1997 to estimates this year running as high as $275 billion. Last year a Texas jury awarded one single asbestos victim $56 million.

From Breakingviews.com (Mike Monnelly): “Credit insurance: Anyone for credit? Reinsurers would rather pass. They are retreating from writing derivatives that insure banks against credit risk. France’s Scor has stopped altogether after losses on exposure to creditors of Enron and Swissair. Dirk Lohmann, chief executive of Switzerland’s Converium, says reinsurers did not understand the risks they assumed from banks in the 1990s. Reinsurers are partly scaling back because premiums are hardening in other business lines, allowing them to deploy capital more profitably elsewhere. But they are also retreating because poor credit quality is resulting in losses on the derivatives they wrote. They are thus having to reserve against their exposure even as the industry is running short of capital. Moreover, losses on the derivatives have been greater than expected. Reinsurers account for a big chunk of capacity in the credit-insurance market. So their reluctance to underwrite credit risk ought to affect the pricing and availability of loans. After all, if banks can’t lay off their exposure, or if it costs them more to do so, ‘then either they will lend less, or they will pass on extra hedging costs to customers in the form of higher interest rates. Taken to its extreme, this process leads to a credit crunch. In the short term there may be an effect. But in the long run it is less clear. Removing capacity from the credit-insurance market ought to lift premiums to the point where participants replace the lost capacity. But some reinsurers may not return because they feel they have been ripped off. In particular, the default-correlation analyses used to structure collateralised debt obligations have proven inadequate. Banks have also been slow to create secondary markets in these instruments to help reinsurers cut their losses. If the aggrieved reinsurers are right, the price of credit insurance will rise.” (my underlines)

Excerpts from a last week’s Wall Street Journal Heard on the Street column (Ken Brown): “INSURANCE MAY BE BORING, but at its heart, it is a pretty straightforward business. Control your risk and take a long-term view so you can handle the inevitable bumps in the road. Cigna Corp. appears to have been absent from insurance school the day they taught those basic lessons. The big Philadelphia insurer spent much of yesterday trying to explain a $720 million charge it had to take because it had taken on too much risk in a once-booming business line… What happened? In short, back at the height of the bull market, Cigna pledged to cover losses for many of the then wildly popular variable annuities being sold by life insurers. Turns out -- with the bear market having pummeled those annuities -- Cigna was the dominant player in selling such reinsurance. And it exposed itself to the problems of a steep market decline when it could have hedged its risk. ‘Reinsurance is typically used to spread risk. In this case it concentrated risk,’ says Vanessa Wilson, an analyst at Deutsche Bank Securities. Reinsurance and variable annuities can each be mind-numbingly complex. Combine the two and it is a recipe for brain lock. But what happened is in many ways the age-old story of underestimating risk, which brought down investors ranging from dot-com day traders to the supposed investment geniuses at Long-Term Capital Management, the giant hedge fund that nearly failed in 1998. During the 1990s, insurance companies embraced variable annuities -- the part-investment, part-insurance products sometimes referred to as mutual funds wrapped in an insurance policy. The insurance policy provides a death benefit, which guarantees beneficiaries will receive at least the original investment -- and sometimes far more -- if the policyholder dies with losses in the mutual fund-like investment accounts. Indeed, by the mid-1990s, many insurance companies were offering souped-up death benefits, the most aggressive of them ‘resetting’ or ‘ratcheting’ the promised payment to the account's peak value during the previous year. For example, if an annuity rose to $120,000 from $100,000, the death benefit would be boosted to $120,000. To spread their risks, insurance companies bought insurance from reinsurers such as Cigna, who guaranteed the death benefit… So, the annuity whose value soared to $120,000 is now valued at just $80,000, yet the death benefit stands at $120,000. Cigna says if every one of its 1.2 million annuity holders died tomorrow, it would be on the hook for $60 billion of death benefits, but the investments in those annuity accounts are valued at just $38 billion.”

It was not my intention to bore readers with the above excerpts. There are some very major developments now impacting the U.S. and global financial system. On the one hand, extraordinary U.S. financial sector expansion creates excess liquidity throughout the financial system. On the other hand, the unfolding dislocation in the global “risk” market nurtures heightened risk aversion with faltering demand for risky assets. Key global financial players - including the major U.S. money center banks, Wall Street firms, and European insurance/financial conglomerates – have been impaired by boom-time lending errors and heavy speculative losses. There is, importantly, also the issue of frothing attorneys and the astronomical cost of settling lawsuits for asbestos, Enron, WorldCom, and the like. We believe the major risk players will for some time have no alternative than seek to pare risk, not add to it. This will be a major, ongoing development with profound ramifications for the US Credit Bubble.

At the same time, it is our view that shifting marketplace perceptions as to the risk profile of U.S. asset-backed securities is now underway. This has similar momentous ramifications. With a lengthening list of troubled asset-backed players such as Conseco, Capital One, Household International, and AmeriCredit, we believe the bloom is quickly coming off of the ABS rose. And just as current holders of Conseco’s asset-backs recognize that the collateral underpinning their securities is at increasing risk due to the company’s lack of lending capability, the greater U.S. asset-backed market is faced with the distinct possibility that faltering Credit availability will significantly increase marketplace risk (the precariousness of self-reinforcing Credit cycles!). With the prior telecommunications Credit Bubble, it was a few fringe failures and the marketplace’s move away from marginal telecom players that marked the beginning of the end for one of history’s great speculative Bubbles. Similar dynamics are now in play with the U.S. consumer Credit Bubble, as subprime lenders falter and the marketplace moves away from the riskiest consumer asset-backed securities. The resulting constriction of Credit availability (in similar dynamics that afflicted the telecom/technology Bubble), has now begun impinging the economy and will soon be working its way up the consumer-lending food chain.

But, as we have witnessed several times previously, the US financial sector has an extraordinary capacity for creating its own liquidity (especially under heightened systemic risk). We must also reckon with the fact that we are in the midst of an historic collapse in interest rates (Treasuries, agencies, mortgage-backs) and resulting mortgage financing boom. What’s more, there is today considerable uncertainly as to how these crucial developments (dislocations) play out. We do see the current environment as only exacerbating dollar vulnerability. But as long as the dollar holds its own, “reliquefication” operations and continued mortgage finance excess do hold the possibility of prolonging this most dangerous game. There is little mystery as to why gold and commodities are performing well.