09/20/2001 A Terrible Tragedy *

We are now in the grips of a full-fledged global financial crisis. In what Bloomberg is calling "the average’s biggest weekly decline since the five days ended July 21, 1933" the Dow was hit for 14%. The S&P500 sank 12%, with the Morgan Stanley Cyclical index dropping 17% and the Morgan Stanley Consumer index declining 10% this week. With the airlines in collapse, the Transports sunk 23%. The Utilities escaped with only a 4% decline. The selling was intense and broad-based, with the small cap Russell 2000 losing 14% and the S&P400 Mid-Cap index falling 13%. Technology stocks were hammered, with the NASDAQ100 declining 17%, the Morgan Stanley High Tech index 18%, and the Semiconductors 25%. The Street.com Internet index dropped 18% and the NASDAQ Telecommunications index declined 12%. The Biotech index sank 17%. Financial stocks were under liquidation as well, with the AMEX Broker/Dealer index sinking 16% and the S&P Bank index dropping 12%. With bullion up almost $13, the HUI Gold index surged 13% this week. Mutual Fund Trim Tabs reported that $10 billion flowed out of equity mutual funds this past week.

The Goldman Sachs Commodity index of 26 commodities sank almost 10% this week, its largest weekly decline since 1991. Despite sinking equity and commodity prices, the credit market struggled. Although two and five year Treasury yields added just one basis point (to 2.86% and 3.81% respectively), the key 10-year Treasury saw its yield jump 14 basis points to 4.69%. The spread between 2 and 10-year yields widened 13 basis points this week and has surged 48 basis points since the WTC attack. The long-bond saw its yield surge 23 basis points this week to 5.58% and remains 17 basis points higher than pre-WTC. Mortgage-back and agency securities performed relatively well, with mortgage yields generally unchanged and agency yields rising 4 basis points. The benchmark 10-year dollar swap spread narrowed 13 basis points this week to 71, an extraordinary market development. Emerging bond markets, however, came under selling pressure, with Brazilian bond yields rising to the highest level since October 1999 and the real plummeting. Argentine, Mexican, Russian and Turkish bond markets also came under pressure. Global currency markets remain extremely unsettled, with the Swiss franc surging to a 21-month high against the dollar and a record level against the euro.

The American Bankers Association today reported that credit card delinquencies jumped to 3.93% during the second quarter from the first quarter’s 2.99%. According to the Associated Press, "the delinquency rate on credit cards in the second quarter was the highest since the association began tracking it in 1980." If rising delinquencies were not already problem enough, from Fitch: "The tragic events of Sept. 11 are likely to have an immediate impact on certain ABS products and recessionary pressures accelerated by these events could have a prolonged impact on the performance of virtually all ABS products." A Fitch report addressed heightened risk in "aircraft transactions," rental fleets, credit cards, auto and time-share loans. From Bloomberg: "European investors said they’re becoming wary of bonds backed by a single property or site, after terrorist attacks leveled the World Trade Center in New York in about two hours last week." The article also quoted an industry executive: "People will consider the risk of World Trade Center attacks occurring in a way they haven’t considered before."

August data is in, and we see that Fannie Mae and Freddie Mac combined to purchase $96.3 billion of mortgages during the month. The two leading mortgage lenders have made total purchases of $492 billion during the past five months. Their combined "book of business" (retained portfolios and outstanding mortgage-back securities) has increased $301 billion so far this year, a growth rate of 20%. During the month, Fannie Mae’s "total book of business" expanded at a 23% annual rate to $1.485 trillion (y-t-d growth of $171 billion, or a rate of 20%). Fannie’s retained portfolio grew at a 17% rate during August to $684 billion, while its mortgage-backs sold into the marketplace grew at a 29% rate. Freddie’s total book of business expanded at a 19% rate to $1.091 trillion, with its retained portfolio expanding at a 29% growth rate. Year-to-date, Freddie’s retained portfolio has increased almost $80 billion to $465 billion, or at a 31% growth rate.

The Federal Reserve released second-quarter credit data this week, and it makes for fascinating (if not comforting) reading. Total net credit market borrowing increased at an annual pace of $1.8 trillion to $28.3 trillion. This is just below the $1.9 trillion rate during the first quarter, and compares to last year’s $1.75 trillion net increase in credit market borrowings. Although it is significantly below 1999’s record $2.2 trillion, it is worth noting that net credit market borrowings were about $1.4 trillion during 1996 and $1.53 trillion in 1997. The "non-federal sector" borrowed at the second-heaviest annual pace of $1.251 trillion during the quarter, led by record household sector borrowings ($661 billion annualized – or 9.3% growth rate). "Non-financial corporate business" increased net bond issues at a record $424 billion pace (compared to 1999’s record $230 billion issued). The "rest of world" purchased approximately 45% of total corporate bonds issued during the second-quarter, up from 42% last year, 35% during 1999, 22% during 1998, and 20% during 1997. Total non-federal borrowings expanded at a rate of 8.3%, up from the first-quarter’s 6.7%, and the strongest growth since last year’s second quarter (9.8%). Total corporate borrowings grew at a 7.3% rate, up from the first-quarter’s 4.8%. State and local governments increased borrowings at an 8.4% pace, up from the first-quarter’s 7.8%, in the most aggressive borrowing since the first-quarter of 1998.

Total (home, multifamily, and commercial) net mortgage borrowings expanded at an eye-opening record annual pace of $839.4 billion (12% growth rate). We are easily on pace to shatter 1999’s record $601 billion increase in mortgage credit, and it is worth noting that total mortgage borrowings increased $285 billion during 1996 and $333 billion during 1997. Total commercial mortgage credit expanded at a $155 billion pace during the second-quarter, compared to 1999’s record increase of $121 billion. Total commercial mortgage credit increased $28 billion during 1996 and $64 billion during 1997. Home mortgage credit increased at a record annualized rate of $614 billion. For comparison, this is up almost 60% from home mortgage borrowings during 1998’s fourth-quarter booming refinance market. Second-quarter borrowings are also 27% greater than net home mortgage borrowings during last years’ second-quarter, the previous record.

The other side of unprecedented mortgage credit expansion is the record issuance of agency securities. Outstanding agency issues increased at an unprecedented annualized rate of $672 billion. "Government-sponsored enterprise" debt increased at a $265 billion rate during the second-quarter, while "federally-related mortgage pool" (mortgage-backed) securities expanded at a record pace of $407 billion. This rate is double last year’s total issuance of $199 billion, and almost 50% above 1999’s record issuance of $274 billion. The "rest of world" purchased about 20% ($143 billion annualized) of these securities.

Interestingly, "brokers and dealers" purchased a record $84 billion (annualized) of agency securities during the quarter. Total "net acquisition of financial assets" by the "security brokers and dealers" jumped to an annualized pace of $523 billion, a sharp increase from the first-quarter’s $79 billion. For comparison, the brokers and dealers increased financial asset holdings by a record $216 billion last year, up from $68 billion during 1996, $143 billion during 1997, $142 billion during 1998, and $79 billion during 1999. It is impossible to effectively analyze this enormous increase in securities firms’ assets with the category "miscellaneous assets" increasing at an annualized pace of $452 billion and "miscellaneous liabilities – other" growing at a rate of $392 billion. There is no doubt, however, that the investment community entered this financial crisis heavily leveraged and significantly exposed to "spread product" and market risk generally.

Total financial sector credit market borrowings expanded at an annualized rate of $763 billion (8.8%), down from the first-quarter’s $883 billion (10.5%). Importantly, 88% ($671 billion) of financial sector credit market borrowings were "federal government-related" (GSE and "mortgage-pools"), with "private financial sector" borrowings dropping to the lowest level ($92 billion annualized or 2% growth) in years. However, commercial banks did increase holdings of financial assets at a rate of almost 6% ($381 billion annualized), financed by record borrowings ($161 billion annualized) from "foreign banks." It is worth noting that mutual funds increased holdings of financial assets at an annualized rate of $284 billion, the strongest pace since last year’s first-quarter. This is indicative of the significant liquidity effects from the ongoing mortgage-refinancing boom, while begging the question of how the equity markets would have performed without such support. If either of these dominating but fragile sources of liquidity falter – mortgage credit creation or foreign-based flows – the consequences will be considerable.

Even prior to the devastating WTC attack, credit data illuminates a terribly distorted economy and vulnerable financial system. First of all, it is quite troubling that despite the rapid slowdown in economic growth, borrowing throughout much of the economy remained at extreme levels – indicative of a precarious "Bubble Economy". Certainly, the historic mortgage finance Bubble could not be more conspicuous. Total annualized mortgage credit growth during the quarter ($839.4 billion) was fully 81% of total annualized non-financial borrowings ($1.035 trillion). This ratio increased from 39% in 1996, to 41% in 1997, 50% during 1998, 55% during 1999, and 66% during 2000. We would also like to highlight what we will call the "structured finance ratio", or the ratio of the sum of borrowings from the government-sponsored enterprises, "federally related mortgage pools," and "ABS (asset-backed security) issuers" as a percentage of total non-financial borrowing. After remaining stable at nearly 50% between 1995 and 1997, this ratio jumped to 77% during the tumultuous year of 1998. It then declined to 74% during 1999 and 72% last year, only to surge to 81% during the second quarter.

And while the GSE/residential mortgage Bubble may likely survive in the short-term, the WTC attack is almost certain to prove a catalyst for major dislocation within a "structured finance" super sector that was already acutely vulnerable. We will agree with a comment from Joseph Philips, who wrote in a recent Morgan Stanley ABS Strategy report, "The horrific events of September 11th will probably go down in economic history as the straw that broke the camel’s back."

In the past I have occasionally invoked a flood insurance analogy for purposes of illustrating key aspects/misconceptions of contemporary "structured" finance (Credit Bubble Bulletin, March 31, 2000 – "A Derivative Story") with its heavy reliance on derivatives, credit insurance and liquidity agreements. The central point of the analogy is that a booming derivative marketplace, and structured finance generally, reduces the cost and greatly increases the availability of flood insurance, thus encouraging an unprecedented (and self-reinforcing) building boom along the river. Presented as a product of "risk management"/reduction, insurance protection in fact significantly increases risk for the entire system in the event of a serious flood. The situation becomes all the more precarious over time, as speculators and "dynamic hedging" strategies become key players/facets in the great proliferation of flood insurance. It has been my central thesis that contemporary "structured finance" has fostered extreme credit availability and extreme lending and speculative excess, with profound ramifications for financial fragility and economic stability.

From "A Derivative Story": "Not only do the insurers write unprecedented and staggering volumes of new flood policies, they also reduce the amount of reserves they hold for potential losses… All the major insurance companies now employ the presumably most brilliant weatherpersons. Virtually all, curiously, believing that there has been a permanent change in weather patterns. The faith in the "new era" takes firm hold, with nothing but blue skies ahead. After all, why worry when the most aggressive insurance companies now employ the best and brightest young mathematicians. These "rocket scientists" have developed sophisticated models and strategies that call for active buying in the re-insurance marketplace in the unlikely event of a significant change in atmospheric pressure, one that should signal the possibility of changing weather patterns."

Hoping to provide insight in regard to recent tragic developments and the unfolding financial crisis, I would like to briefly expand this flood insurance analogy: There has been a terrible human tragedy, while also inflicting catastrophic losses on those in the insurance marketplace. While the players had employed the most talented weatherpersons and sophisticated equipment and models to forecast precipitation, they (and their sophisticated models) were completely unprepared for the collapse of a dam up the river totally unrelated to rainfall. And while few communities outside of the severely impacted town by the dam suffered flood damage (as the reservoir level was low), the dynamics of the entire flood insurance industry were nonetheless irreparably altered – with profound ramifications for the financial system and general economy.

Many speculators were instantly wiped out, while the less capitalized insurers were left at or near insolvency. The reinsurance market (a key aspect of speculative and dynamic hedging strategies) quickly seized up, as the preponderance of players looked desperately to off-load risk. There were, however, few if any institutions with either the desire or wherewithal to accept additional exposure. Unfortunately, after a protracted and unbalanced expansion along the river, the financial system was already highly exposed to economic and financial risk, not to mention the possibility of a devastating flood. Indeed, the dam collapse could not have come at a more inopportune moment for the insurers or community.

After the catastrophe, the nature and degree of risk was dramatically and forever recast – the speculative Bubble having burst along with the economic Bubble. First of all, the capital of the insurance industry was instantly significantly depleted, forcing a comprehensive re-evaluation of the acceptable amount of risk retention, and the type and cost of coverage provided. Second, the speculative interest in writing flood insurance – having become such a key aspect of insurance availability and a critical factor in fueling the economic boom – immediately disappeared. After all, not only had marketplace liquidity evaporated, the risk of future catastrophic flood insurance claims increased substantially with the collapse of the dam up the river. "Counter-party exposure" became the new industry watchword, while insurers also had to face the prospect of huge and unforeseen losses from lawsuits related to the dam’s collapse and subsequent flooding. Few had any interest in pursuing future business in such an uncertain environment fraught with incalculable risk. Furthermore, building and related commerce came to an immediate halt in the river communities as the cost of insurance skyrocketed, if available at all. Lenders and insures then began to access the ramifications for a large number of builder failures, while for now choosing not to even contemplate the financial and economic consequences for what appeared an unavoidable downturn in home prices.

And, importantly, lenders to existing properties and businesses also backed away, increasingly losing confidence in the viability of the insurance supporting the collateral on their loans, as well as being fearful of the economic consequences of the faltering insurance and property market. It didn’t take long for the community elders to recognize the critical role that flood insurance had come to bear upon the area’s prosperity. How quickly "virtuous" transforms into "vicious" cycle. Credit, only recently seemingly of unlimited availability, quickly became increasingly scarce.

Getting back to a much more complex and troubling real world, I would like to highlight three recent quotes:

"The nation’s productive base has not been seriously damaged. Our economy is so huge that the scenes of destruction, awesome as they are, are only a pinprick…The wild card here is confidence." Paul Krugman, New York Times, September 14, 2001

"Markets will do a good job in reallocating resources. The economy as a whole need not, and I believe will not, suffer great pain. We will get back on course before long." St. Louis Fed President William Poole, September 20, 2001

"The shock of September 11, by markedly raising the degree of uncertainty about the future, has the potential to result, for a time, in pronounced disengagement from future commitments. Indeed, much economic activity ground to a halt last week. But the foundations of our free society remain sound, and I am confident that we will recover and prosper as we have in the past." Alan Greenspan, September 20, 2001.

As to Dr. Krugman’s and others’ focus on the "wild card" of consumer confidence, I will comment only that leading factors sustaining consumer spending excesses have been unsustainable borrowings, systemic mortgage credit excess, and resulting real estate inflation. The bursting of this precarious Bubble will be most likely, and most unfortunately, soon at hand. Drs. Poole and Greenspan (and many) trumpet the underlying strength of U.S. fundamentals and positive future prospects for the U.S. economy. But the harsh reality is that the foundation of the nation’s financial system is increasingly and dangerously impaired. Already fragile after years of Credit and speculative Bubble excess, and specifically with the collapse of the technology Bubble, the direct and indirect consequences from the WTC attack are truly catastrophic. This, regrettably, is neither hyperbole nor histrionics. Perhaps the "productive base has not been seriously damaged," but the acutely vulnerable U.S. credit system has suffered irreparable damage. Under "normal" circumstances, a sound system would not create a situation so dire, with recovery expected after a reasonable adjustment period. But this environment is anything but typical, with the extreme financial and economic fragility that comes with the bursting of the historic U.S. Credit Bubble. An impaired credit system and tragically maladjusted economy will simply not for some time allow us "to prosper as we have in the past."

We have written ad nausea about the acute risk hiding within the derivatives and credit insurance arena. There are now surely massive losses in equity derivatives, with significant broad-based market weakness compounding what were major ongoing problems emanating from the technology sector collapse. It is also likely that self-reinforcing derivative-related dynamic hedging strategies are playing a significant role in sinking global equity markets. Furthermore, the WTC attack, particularly with the potential collapse of the airline industry, significantly exacerbates the developing problematic dislocation in the credit derivative area. And truly an accident waiting to happen, within the scope of the unfolding environment we see little possibility of avoiding a major debacle in the vulnerable credit insurance industry generally. According to Wall Street reports, Ambac and MBIA have $27.4 billion combined insurance exposure related to the WTC attack. Apparently, the "good news" is that individual WTC exposure is only 2.5% of total insurance written by Ambac and 3.6% of that written by MBIA. Included in WTC exposure, MBI has insured $1.2 billion of Port of Authority of New York and New Jersey bonds. The majority of the insurers’ WTC-related exposure is associated with insuring debt issued by the nation’s airport systems (in what has been a nationwide building boom), including MBIA’s insurance of about $1 billion of Metropolitan Washington Airport Authority bonds.

Both companies have also provided insurance for aircraft securitization structures, a hot area over the past couple years. With equity investors running for cover, it is not beyond the realm of possibilities that the marketplace increasingly questions the value of such insurance. If such protection becomes suspect, marketplace liquidity could falter while the ability of companies to issue bonds and Wall Street to structure securitizations would be severely hampered. The economic ramifications for such a development in an environment dominated by "structured finance" and general risk aversion should be recognized as momentous.

We have often commented that insuring against market losses with derivatives written by thinly capitalized Wall Street firms, hedge funds, or wildly exposed credit insurers was too uncomfortably reminiscent of those who back in 1997/98 purchased protection against a ruble collapse from Russian financial institutions. You just better hope you don’t need the market insurance. Well, WTC related claims will be enormous and unfolding financial losses unprecedented. An untested contemporary credit system with myriad aspects of questionable financial engineering will now be severely challenged. This is a particularly problematic development in an environment of already significantly heightened global risk aversion and historic financial and economic imbalances. The consequences for a credit system dominated by "structured finance," and a Bubble U.S. economy desperate for continued heavy doses of credit creation and sustained only through continuous massive foreign inflows are almost too troubling to contemplate. The risk of the system "seizing up" is now anything but remote. We recognize that the Fed and global central bankers are understandably willing to take continued dramatic action, but they do today at times look rather unendowed standing next to the historic global debt mountain.

We have for sometime pondered how a monetary system that had come to be dominated by leveraged speculators and a daisy chain of thinly capitalized financial institutions, $10’s of trillions of financial contracts, and various agreements would function in the event of a general movement to pare risk. We are now witnessing as much and it’s not pretty. If the dollar buckles under the increasing stress, we are in some very serious trouble. In the meantime, international markets are making it clear that the entire global economy and financial system are now in extraordinary peril. We would like to think this is just a garden-variety severe equity bear market, but our analysis leads us to believe the greatest vulnerability lies in rotten credit systems.

I would imagine many of you have been dealing with similar bouts of intense and varying emotions. The overwhelming sadness for the unthinkable human loss is compounded by the sense that our great country has in a way lost its innocence and is now forced to face adversity on several levels. We are a strong country and will grow through adversity, but it is nonetheless painfully sad to so clearly see the end of an era with the future course uncomfortably hazy, unfamiliar, and down right frightening. I also get angry. I just don’t understand how we as a nation could have left ourselves so exposed to such security and financial vulnerability.