09/19/2002 Soul Searching *

It was a dismal week for global financial markets. Here at home, the Dow dropped 4% and the S&P500 sank 5%. The Transports declined 3%, while the Utilities and Morgan Stanley consumer index dropped 4%. The Morgan Stanley Cyclical index dipped 5%. The broader market came under heavy selling pressure, with the small cap Russell 2000 sinking 6% and the S&P400 Mid-Cap index dropping 5%. Technology stocks were hammered, with the NASDAQ100 declining almost 6%. The Morgan Stanley High Tech index sank 10%, the Semiconductors 11%, The Street.com Internet index 9%, and the NASDAQ Telecommunications index 5%. The Biotechs declined 5%. The financial stocks were also sold aggressively, with both the Securities Broker/Dealer and Bank indices hit for 7%. Although bullion rose $5.10, the HUI Gold index dipped about 3%.

Again, the Treasury market melt-up continues. For the week, the two-year Treasury yield declined 8 basis points to 1.92%, the five-year dropped 14 basis points to 2.83%, and the 10-year Treasury yield declined 12 basis points to 3.79%. The long-bond saw its yield dip 2 basis points to 4.74%. While benchmark mortgage-backs saw similar declines to comparable Treasuries, the agency market was notable for its underperformance. Benchmark agency futures saw yields decline 6 basis points, while the spread on Fannie’s 5 3/8% 2011 note widened 6 to 58. The benchmark 10-year dollar swap spread widened 4 to 59. Spreads widened throughout the corporate market, with notable poor performance from the likes of Ford and Household International. The implied rate on December Eurodollar futures declined 9 basis points to 1.68%. The dollar index was volatile, but today’s strong performance cut its loss this week to about one-half percent. European equities performed poorly, with insurance and financial stocks coming under heavy selling pressure. Year-to-date losses for the German DAX index rose to 41%. Latin American equities and currencies performed poorly, with the Mexican peso closing today at a 3-year low.

Things are going from bad to worse in Japan, with authorities announcing that the government would purchase equity positions from the troubled banking system. Further details as to crisis management measures will follow.

“The central bank must consider measures that will help banks reduce risks from their shareholdings.” Masaru Hayami, Bank of Japan governor

“The bank has never done anything like this in its 120-year history. Today the bank has decided of its own free will to cross the Rubicon.” Nobuyuki Nakahara, recent member of the Bank of Japan’s policy board

September 19 Financial Times: “IMF Warns of Risks From Current Account Deficit – Current account deficits such as that in the US appear unsustainable over the medium term and could well be resolved with a difficult adjustment, the International Monetary Fund has warned… The IMF warned that the build-up of deficits reflected the ‘financial excesses’ of the late 1990s, with expectations of the benefits delivered by the information technology revolution leading to a shift into US and other deficit countries’ assets. It sketched out a pessimistic scenario where financial markets’ expectations of higher productivity growth in the US were not fulfilled. Under such a scenario, the downwards adjustment in current account deficits would take over three percentage points off US economic growth in 2003.”

“Hedge funds have tripled their share of the credit derivatives market in the last two years, according to a draft of the British Bankers' Association's 2002 survey of the credit derivatives market…” Derivativesweek.com

Sept. 19 Bloomberg – “Munich Re lost its top financial strength rating at Moody’s Investors Service after the world’s biggest reinsurer pumped $2 billion into its unprofitable American Re U.S. subsidiary, the rating company said. The Munich-based reinsurer’s financial strength rating was lowered one notch to Aa1 from Aaa, Moody’s said in a statement. American Re had its senior debt rating cut to Aa3 from Aa1. Munich Re in July put money into American Re for a second time in eight months. Since the reinsurer acquired American Re almost two years ago, it has injected $3.5 billion into the
company.”

Sept. 19 BusinessWire: “Fitch Ratings has completed a comprehensive review of all of its ratings for the North American life insurance industry, and has downgraded ratings for 35 life insurance groups. The downgrades impacted the ratings of 42% of Fitch's life insurance ratings universe, and affected companies with a combined $1.1 trillion in assets… It is the result of Fitch’s belief that recent adverse performance within the investment markets, together with unfavorable competitive and product trends inherent in Fitch’s long standing Negative Rating Outlook for the life insurance industry, required an accelerated recognition of such trends into ratings levels generally.”

Sept. 19: “Standard & Poor’s Ratings Services has lowered its ratings on municipal transactions backed by letters of credit from JP Morgan Chase Bank because the long-term rating on JP Morgan Chase Bank was lowered on Sept. 17, 2002.”

Broad money (M3) supply increased $1.9 billion last week. Demand deposits dropped $29.9 billion, while savings deposits jumped $35.7 billion. Retail money fund assets dropped $4.6 billion, and institutional money fund assets declined $8.2 billion. Large time deposits increased $2.6 billion, repos added $3.2 billion, and Eurodollar deposits increased $3.6 billion. After its recent run-up, total commercial paper outstanding dropped $15.9 billion, with non-financial CP declining $3.5 billion and financial CP dropping $12.4 billion. After a couple of weeks of strong gains, bank assets dropped $71.8 billion last week. Securities holdings declined $39.8 billion. Loan and leases increased $8 billion, with commercial and industrial loans declining $5.5 billion and real estate loans jumping $16.2 billion.

Treasury today reported that the federal government ran a $54.7 billion deficit for August. After 11 months of the fiscal year, the federal deficit stands at $200.18 billion, a dismal reversal from last year’s comparable period surplus of $91.8 billion. Year-to-date revenues are down 9.4%, while spending is up 6.9%. Weekly unemployment claims remained above 400,000, with two-week claims the highest since April. On the economic front, J.D. Powers is now estimating September car and light truck sales at a 15.9 million rate, down from August’s 18.7 billion to the weakest level since May. Housing starts dropped in August for the third straight month, reported at a weaker than expected annualized rate of 1.609 million units (up 3% y-o-y). Single family starts dropped 4.4% from July to the lowest level since November and were down 1.7% y-o-y. Single-family starts are now about 18% below February’s record level. Starts in the Midwest dropped almost 18%, and were down 15% year-over-year. It is also worth noting that the booming multi-family sector saw building permits abruptly drop 15% during August, a development to watch carefully going forward. We see unfolding Credit market problems having a significant negative impact on future economic performance – there is at this point no doubt about it.

For now, Credit system developments far outweigh economic data in importance. The second-quarter Federal Reserve Z1 (“Flow of funds”) provides another compilation of extraordinary Credit data. For the quarter, the rate of growth for the economy’s total non-financial (federal and non-federal) Credit growth jumped to a very strong 7.8%. This was an increase from the first quarter’s 4.8% and was up from the year ago 5.5%. With the anomaly of a post-Bubble corporate bond market in tatters while general system liquidity runs rampant, federal government debt growth surged to a rate of 13.3%, household (mortgage and consumer) debt grew at 9.0%, and state and local government borrowings expanded at a 12.4% rate. The data could not more clearly illuminate the dysfunctional nature of Credit allocation or the resulting distorted U.S. economy. Moreover, the significant divergence between the quarter’s rising rate of debt expansion and the declining rate of economic growth is an ominous portent of the unfolding financial and economic crisis.

While most are determined to deny its existence (one newswire today ran the curious headline, “Record Low Mortgage Rates Questions Housing Bubble Banter”), the Bubble in mortgage finance is very much alive – and increasingly destabilizing. Total mortgage Credit growth expanded at a record annualized rate of $817 billion during the second quarter, or 10.5%. Since the beginning of 1998 (18 quarters), total mortgage Credit has surged almost $2.8 trillion, or 53%. To put the second-quarter’s $817 billion annualized growth into perspective, total mortgage Credit grew at an average rate of $207.5 billion during the six (pre-Bubble) years 1992 through 1997. Average total mortgage Credit growth then jumped to $589 billion during the four years 1998 to 2001, with last year’s $706 billion jumping strongly from 2000’s $566 billion. This past quarter’s continuation of exponential mortgage Credit expansion had growth more than double 1997’s $337 billion, and up from the first quarter’s annualized $704 billion. Or, looking at the data from another angle, the past quarter’s annualized total mortgage Credit growth was 76% of the economy’s annualized non-federal and non-financial Credit growth ($817b/$1080.2b). For comparison, this ratio averaged 43% during the six years 1992 to 1997 and 52% from 1998 to 2001. The dramatic jump in this ratio provides very strong support for our Bubble view.

While the mortgage finance Bubble runs unabated, the collapsing corporate debt market is leaving tracks in the data. Non-financial corporate debt expanded at a paltry rate of 1.60% during the second quarter. After averaging almost $148 billion from 1992 to 1997, non-financial corporate borrowings Bubbled to an average $359 billion from 1998 to 2001. Non-financial corporate borrowings averaged almost $400 billion for the three key Bubble year’s 1998 to 2000, expanding 11.6% during 1998, 10.6% during 1999, and 9.9% during 2000. Non-financial corporate borrowings then dropped to $236 billion during 2001 (5.1%), and have since collapsed to about $79 billion annualized during the second quarter. After averaging about 32% of the economy’s non-federal, non-financial Credit growth between 1992 and 2001, this ratio sank to 7% during the second quarter. The corporate debt Bubble was apparent in the data back in 1998-2000, although the dimensions of the excess were clearly less conspicuous than the current mortgage finance Bubble.

Once again, “structured finance” played an instrumental role in the quarter’s Credit expansion. Mortgage-backed securities expanded at an 11.7% rate to $3.05 trillion (up 67% in 18 quarters). Asset-backed securities grew at an annualized rate of 12.5% (up 112% in 18 quarters) to $2.26 trillion. The GSE’s had a relatively tepid quarter, with assets increasing at a 6.4% rate to $2.39 trillion. Mortgage-back, asset-back and GSE asset expansion combined to account for 71% of the economy’s non-federal, non-financial Credit expansion during the quarter. Keep this ratio and the amount of securities outstanding in mind when pondering the ramifications of the unfolding tumult in asset-backed securities and “structured finance.”

Not surprisingly, the quarterly data confirm that the banking system responded to faltering securities markets with aggressive Credit creation. Strange happenings in the sector were also confirmed. After expanding at an annualized rate of $133.7 billion during the first quarter (2%), “net acquisition of financial assets” surged to an exceptionally strong $637.8 billion, or 9.4% (second only to the $729.6 billion during Q2 2000’s tumultuous Credit market environment!). Security holdings increased at an annualized rate of $301.5 billion (31% annualized), with agency purchases of $215.8 billion (ann.). “Total loans” expanded at a rate of $255.1 billion (6.5%), with a $129.3 billion (ann.) contraction of “bank loans” more than offset by a $281.6 billion (ann.) expansion of “mortgages,” $40.8 billion (ann.) increase in “Consumer Credit,” and $61.9 billion rise in “Security Credit.” “Miscellaneous assets” expanded at a rate of $128 billion (could lending possibly be more directed to non-productive ends?). And actually more interesting than the surge in asset growth was the composition of the new liabilities created to finance them. Curiously, “Net interbank liabilities” “to foreign banks” actually contracted at an annualized rate of $200.8 billion (and “Private domestic” checkable deposits declined at a rate of $49.4 billion). Is this indicative of foreign financial institutions moving to reduce dollar exposure? At the same time, “Checkable deposits” to the “Federal government” increased an unprecedented $215.3 billion (ann.). Elsewhere, “Small time and savings deposits” surged $302.7 billion (ann.) and “miscellaneous liabilities” jumped $295.1 billion (ann.). I certainly will not claim to understand these unusual developments, but I see little indicative of a sound banking sector.

Security broker/dealers expanded “net acquisition of financial assets” at an annualized rate of $113.9 billion, or 7.9%. The composition of assets was much more volatile. “U.S. government securities” expanded at an annualized rate of $333.4 billion (purchases to hedge mortgage-related derivatives?), while “Miscellaneous assets” declined at a rate of $242.9 billion. One the liability side, “Security repurchase agreements” increased at a rate of $200.5 billion, while “Security Credit” declined at a rate of $83.4 billion. If one is searching for the leading culprit of the historic collapse in Treasury yields, look no further than ballooning Credit created in the repo market. And while we can get some sense of the distortions emanating from the repo-created liquidity excesses, we are left to ponder the consequences of their eventual reversal.

What an absolutely Dreadful Week for Structured Finance. Where do I begin…

Subprime auto lender AmeriCredit announced accounting changes, asset-write downs, and its hope of raising a significant chunk of needed equity. As is always the case with subprime lending, it’s expand aggressively or be caught and killed by ever-stalking Credit losses. With the situation clearly dire, additional finance will not be so easily found. The company also announced concessions from FSA, the insurer of $11.7 billion of its securitizations (backed by subprime loans). With losses escalating and the capacity of continued aggressive lending now in jeopardy, the viability of AmeriCredit is anything but certain. FSA today has the difficult (but increasingly common) decision to "fish or cut bait” – support the foundering company and postpone the day of reckoning, or begin dealing with its rapidly mounting problem. In a development that should keep other risk players awake at night, FSA has abruptly been transformed from “prudent” asset-backed guarantor to THE critical financial partner in a failing subprime lending business. This is big. Similar to many others operating financial speculations based on sophisticated “risk” models, we expect FSA is in store for surprisingly enormous Credit losses that their risk models would have calculated as an impossibility. Dexia, FSA’s European parent, saw its stock sink 15% this week. We have the sense that this week marked a major inflection point with many players now in the process of reevaluating risk models, financial guarantees and, perhaps, “structured finance” in general. For sure, recent events have been another major blow to the vulnerable asset-backed securities market and one more chip knocked off the bull market phenomena of Credit insurance.

Elsewhere in the nervous world of Credit insurance, mortgage insurer MGIC announced that earnings would be below expectations (with rising delinquencies and mounting Credit losses). We have in the past averred that the GSE-led mortgage finance Bubble – with rising home price inflation and (self-reinforcing) ultra-easy equity extraction – at some point would place the mortgage insurers “on the front line” of inevitable bloody trench warfare against advancing Credit losses. Well, the initial skirmishes have begun, and we have little confidence that company managements appreciate or are prepared (certainly inadequate loan loss reserves are not encouraging!) for the difficult fight ahead. The market, however, is now appreciating that the Credit cycle has turned and the mortgage insurers are in harm’s way.

Back in October of last year, we pulled a few excerpts from Fannie Mae’s Franklin Raines’s rosy mortgage growth forecasts: “Bottom line, we project that consumer demand for residential investment could double in this decade, from $11 trillion today, to $21-$25 trillion by the year 2010. This would cause demand for mortgage capital also to more than double, from the current $5.4 trillion to $11-$14 trillion by 2010. The 1990s were a terrific decade for housing. This decade could be even better.” One of the problems with such an optimistic view is that it ignores the ramifications for the quality of financial sector assets and Credit system stability. Arguably, a Credit mechanism dominated by marketable securities-based mortgage finance will eventually demonstrate atypical characteristics. On the one hand, the mortgage industry provides long-term fixed rate loans that allow borrowers the option of refinancing when rates decline (a very nice deal for the borrower!). Lenders, whether it is Fannie Mae or the holder of mortgage-backed securities, accept the risk that rates may move higher (extending the life of the loan at below market rates) or lower (with the possibility of an abruptly shortening loan life, leaving the holder with significant reinvestment risk). One of the great myths of contemporary finance and The Great Credit Bubble has been that such risks are easily hedged – that rates can move up and down and all around, and it really doesn’t matter to the lender or the financial system.

Well, the market is now recognizing that hedging is very difficult and that it does matter, and Fannie Mae (and the system?) is all of the sudden in the crosshairs. We are actually not all that worked-up that that Fannie’s debt currently has a longer life than its assets. It’s not good for earnings or the stock multiple, but it’s not life or death. But other developing issues will be life threatening. We remain very concerned that Fannie (and the GSEs generally) is much too big to effectively manage its myriad risks – interest rate, Credit, counterparty, liquidity. With over $800 billion of assets and guarantees on almost $1 trillion of mortgage-backs - all supported by shareholder’s equity of about $20 billion - this institution has zero room for error. The marketplace has become, understandably, worried about errors. Right now, the mortgage finance Bubble runs out of control, with mortgage-related hedging operations playing a key role in a self-reinforcing interest rate collapse. (A similar dislocation with interest rates rising would be catastrophic.) The key issues today are that the GSEs are much too big, their hedging operations are destabilizing, there is too much marketable mortgage-related debt in the system, and there is absolutely no way to control this monster. It must expand or die. The Fed and Wall Street have coddled and nurtured this monster, and now it is has no alternative than to live with the unruly beast. In the final analysis, it becomes a quality of financial sector asset issue. Our system continues to create egregious quantities of mortgage Credit, the quality of which will be increasingly suspect as soon as mortgage lending excess eventually tempers. It really could not be a more conspicuous Bubble. That so many cracks are appearing throughout the US and global financial system in the midst of historic mortgage Credit excess is truly frightening. Mr. Raines' dream of a utopian $25 trillion Mortgage Investment World this decade is a very unstable place.

The derivatives market is clearly becoming a very dangerous world. The Office of Comptroller of the Currency reported that total U.S. bank derivative positions increased $3.8 trillion during the second quarter (33% annualized!) to $50.1 trillion. Interest rate derivatives increased $3.4 trillion to $42.7 trillion, with “swaps” adding $2.9 trillion to $29 trillion. JPMorgan Chase only added to its dominance of the marketplace, with total notional positions increasing more than $2.7 trillion to $26.2 trillion. As financial professionals and portfolio managers, we look with concern when an institution continues to expand positions aggressively in the face of losses and a hostile market environment. When such an institution dominates the marketplace and is a key player in the U.S. and global financial system, continued expansion makes us very nervous.

This week JPMorgan Chase finally began to admit that things have gone sour and, importantly, that they have soured across the spectrum of its businesses – as we describe it, the “risk” market. “Houston, we have a problem.” Perhaps we will someday better understand if it has been a case of somewhat forgivable denial or, more likely, desperate obfuscation. For now, this is clearly a huge blow to structured finance and the U.S. Credit system. JPMorgan is everywhere, from interest rate and currency derivatives, to syndicated bank loans and collateralized debt obligations, to Credit insurance and liquidity agreements, to ABS, corporate, consumer and muni finance. They are the poster child for the “efficient” U.S. financial system so often trumpeted by Alan Greenspan – the heart and soul of “structured finance.” They are surely the undisputed King of off-balance sheet finance, as much as chairman William Harrison would now like us to believe the bank has been a victim of corporate chicanery. It looks to us like he has been operating the House of Chicanery. JP Morgan must be rolling in his grave. This bank is not the victim, but a major culprit of the myriad ills that today have so weakened our financial system and economy. To what extent this bank is a spreading terminal cancer only time will tell, but the diagnosis is not favorable. The trust is gone and financial markets are built on trust.

I have read many interesting analyses of Chairman Greenspan’s Jackson Hole speech. Not surprisingly, those that make their nice livings in the Credit market are more than happy to focus on the stock market Bubble, while giving their hero Dr. Greenspan the benefit of the doubt. But let’s not allow intellectual bantering to cloud the paramount issues involved: A financial system, monetary regime, and regulatory structure nurtured wild Credit and financial excess much to the detriment of the public interest. Not only did Greenspan fail in his fundamental responsibility to protect the soundness of the financial system, he became an outspoken proponent for the explosion of destabilizing derivatives and financial engineering that have so impaired our financial system and economy. The problem with discretionary monetary policy devoid of a sound monetary and Credit focus is that, as we have witnessed, a major policy error only ensures greater errors to follow. In a world where marketable securities dominate the global financial landscape and economy, an error by the Federal Reserve is akin to a big trading mistake in the markets. An initial trading loss is then compounded to the point of exponential explosion in a desperate attempt to make enough money to make everything right. But losses beget losses, and the bottom line is that Alan Greenspan is today the Nick Leeson of Central Banking. And as was the case with Nick’s bad trade that somehow got completely out of control, the true cost is unknown until the trade is finally, and painfully, unwound.

And while Dr. Greenspan has the “luxury” of throwing good “money” after bad, many others’ livelihoods dictates that losses must at some point be recognized and mitigated. Whether it is the shareholders of European insurance companies, holders of Conseco asset-back securities, Financial Security Assurance and their AmeriCredit exposure, Ford or Household International creditors, JPMorgan counterparties, holders of muni or asset-backs that hold top ratings only because of the vulnerable Credit standing of the financial guarantors (credit insurers and JPMorgan), or our foreign creditors, we sense that there is a lot of “Soul Searching” going on in these uncertain late summer days of 2002. The question is, “Are we throwing good money after bad?” We don’t expect such “Soul Searching” to be good news for the Consecos of the world desperately hoping to raise more money, which is terrible news for the types of collateral that they have been financing and the associated asset-backed securities. We don’t expect FSA or the other Credit insurers are comfortable watching the deterioration of the collateral backing the securities they have guaranteed. Yet, the day they back away from writing such insurance, Credit availability will falter and already deteriorating collateral values will take an abrupt turn for the worse. But are shareholders willing to accept escalating risk, and will sinking stock prices worry the holders of hundreds of billions of securities insured by the likes of MBIA and Ambac? Will the Creditworthiness of the faltering Wall Street firms become an issue?

And it is certainly not unreasonable to now assume that some holders of Ford, GMAC, Household, Capital One, or other asset-backs will decide they would rather sit out the unfolding downside of the U.S. consumer Credit cycle. There then becomes a distinct risk of a self-reinforcing Credit crunch, with this problem jumping from the corporate sector to afflict the gargantuan consumer sector. And if the marketplace, including our foreign Creditors, begins to question the creditworthiness of the rising mountain of GSE debt and mortgage-backs (the residual of an increasingly destabilizing mortgage finance Bubble), there is an immediate systemic problem. With folks now taking a closer look at interest rate exposure, expanding household Credit problems, the vulnerable mortgage insurance sector, and the soundness of the derivatives market, the entire mortgage finance Bubble is now placed in the big, bright spotlight. It looked much more appealing in dim candlelight. One thing looks clear, the marketplace is quickly moving up the learning curve as to the vulnerability of the U.S. and global Credit systems. Credit Bubbles are quite problematic in reverse, and things really started sputtering this week.

Our best guess is that global risk players will be increasingly anxious to cut losses – stop the bleeding. If we are correct in our analysis that U.S. dollar securities have been at the epicenter of global risk taking, leveraging, and speculating, the deteriorating environment poses great danger to vulnerable U.S. financial markets and the economy. We are especially fearful for what appears an accelerating dislocation throughout U.S. structured finance.