09/26/2002 The Trials and Tribulations of Speculative Finance *

Financial instability abounds. For the week, the wildly volatile stock market saw the Dow drop 3% and the S&P500 decline 2%. The Transports and Utilities, however, were about unchanged. The Morgan Stanley Consumer index dipped about 1%, while the Morgan Stanley Cyclical index dropped 3%. The broader market performed better, with the small cap Russell 2000 and S&P400 Mid-Cap indices declining about 1%. Technology stocks were down, but not dramatically. For the week, the NASDAQ100 dipped 1%, the Morgan Stanley High Tech index 3%, the Semiconductors 1%, The Street.com Internet index 1%, and the NASDAQ Telecommunications index 2%. The Biotechs declined about 1%. The financial stocks were volatile, with the Securities Broker/Dealer index declining 1% and the Banking index adding 1%. With bullion down $2.10, the HUI Gold index dropped 5%.

The Credit market dislocation only gathered steam. For the week, two-year Treasury yields dropped 12 basis points to 1.78%, the five-year sank 14 basis points to 2.68%, and the 10-year yield declined 13 basis points to 3.68%. Mortgages dramatically underperformed, as benchmark yields rose 9 basis points. Agencies also lagged, with the implied yield on agency futures declining only 3 basis points. The spread on Fannie Mae’s 5 3/8% 2011 note widened 10 basis points to 69, the widest spread since March. The benchmark 10-year dollar swap spread widened 4 to 63. The dollar was relatively quiet and ended the week nearly unchanged.

Broad money supply (M3) increased $23.1 billion last week. Demand deposits rose $3.8 billion and savings deposits increased $7.9 billion. Both small time deposits and retail money fund assets declined $2.5 billion. Institutional money fund assets surged $21.6 billion and large time deposits added $3.2 billion. Repurchase agreements declined $2.0 billion and Eurodollar deposits dropped $5.7 billion. As of the end of last week, year-to-date asset-backed security (ABS) issuance had reached $252 billion, up 25% year-over-year. Auto-backed ABS issuance of $63 billion was up 24% y-o-y, while Credit card ABS issuance of $45 billion was down 8%. Home equity loan-backed issuance of $105 billion is running 86% above the year ago level.

Last week’s bankruptcy filings increased once again, to the highest level since the first week of June. The 32,217 filings were up 9% y-o-y, with the four-week moving average rising to 14% above the year ago level. Existing home sales were reported at a disappointing 5.28 million annualized rate. This was down from July’s 5.37 million rate and August 2001’s 5.49 million. With the average sales price of $204,100 up 5.5% y-o-y, the “average transaction volume” (annualized volume multiplied by average prices) was up only 1.4% year-over-year. For comparison, August 2001 “average transaction value” was up 11.2% year-over-year.

My reading yesterday of a mid-year statement of holdings for a $49 billion money market fund reinforced the amazing inroads “structured finance” has made into our system of “money.” Commercial paper holdings included Amstel Funding Corp. $249 million, Atlantis One Funding Corp. $386.2 million, Barton Capital Corp. $90 million, Bavaria Universal Funding Corp. $197 million, Beta Finance $327 million, CBA Finance $413 million, CC Inc. $725 million, Clipper Receivable Corp. $209 million, Concord Minutemen Capital Co. $220 million, Corporate Receivables Corp. $410 million, CXC Inc. $206 million, Dorada Finance Inc. $441 million, Edison Asset Securitization Corp. $165 million, Falcon Asset Securitization Corp. $147 million, Forrestal Funding Master Trust $388 million, Fortis Funding $225 million, Galaxy Funding Inc. $486 million, Giro Funding $597 million, Greenwich Funding Corp. $340 million, Greyhawk Funding Corp $292 million, Halogen Capital Company $182 million, Hatteras Funding Corp. $241 million, Intrepid Funding Master Trust $62 million, K2 Funding $477 million, Kitty Hawk Funding Corp. $71 million, Lexington Parker Capital $385 million, Links Finance $240 million, Mont Blanc Capital Corp. $241 million, Newcastle Certificates Program $291 million, Sigma Finance $1.063 billion, Stellar Funding Group $96 million, Variable Funding Capital Corp. $824 million, and Windmill Funding Corp. $91 million.

September 25: “The International Swaps and Derivatives Association (ISDA) announced today the results of the 2002 Mid-year Market Survey of privately negotiated derivatives notional amounts outstanding at swap dealers worldwide. Interest rate and currency derivative outstandings are $82.7 trillion, credit derivatives are $1.6 trillion, and equity derivatives, surveyed for the first time, are $2.3 trillion. ‘All swaps in the Survey grew significantly in the first half of 2002, but the growth in credit derivatives exceeded all expectations,’ said Keith Bailey, Chairman of the Board of ISDA. ‘The strong increase in credit swaps is good news both for market participants and for financial markets as a whole,’ said Bailey. ‘Individual market participants are taking advantage of the availability of credit protection, and financial markets are benefiting by spreading credit risks over a wider and deeper market.’ Interest rate and currency derivatives, which consist of interest rate swaps and options and currency swaps, increased over 19% since ISDA’s Year-end Survey in December. Among firms responding to both the Year-End and Mid-Year Surveys for interest rate and currency derivatives, outstandings grew 16%; and among the top ten reporting dealers, outstandings grew nearly 18%. Credit derivatives, which consist of credit default swaps, grew 44% since the end of 2001; among firms responding to both the 2001 Year-End and the 2002 Mid-Year Surveys, outstandings grew 35%. Equity derivatives, which consist of equity forwards, swaps, and options, are the newest addition to the Market Survey.”

Paul Beckett and Henny Sender penned an excellent and timely article in today’s Wall Street Journal, “Rocky Markets Foil Bets Based On “Risk Models.” The piece highlighted the reality that many companies and market players are today stunned by mounting losses that their sophisticated models calculated as very low probability events. “Structured finance” has run amuck. And why the high correlation between the numbers of “risk” models in operation and the surprisingly large number of low probability events? Former Fed Chairman Paul Volker, as usual, gets right to the heart of the matter: “A lot of the value-at-risk stuff was invented by mathematicians who don’t know anything about the markets.”

It is central to our skeptical view of contemporary finance that “risk” and option-pricing models make the fallacious assumption of continuous and liquid markets. When I was in Sydney, my good friend Dr. Steve Keen (Debunking Economics) and I would occasionally enter into a bit of friendly debate. It was his view that with better mathematics, these models would operate more effectively. It is my argument that for “structured finance” to be a viable business (and that’s what this is really all about!), the models and those operating the models must make some rather optimistic and unrealistic assumptions about market behavior and marketplace liquidity (continuous and liquid markets, to start with).

Thinking back to the stock market Bubble, after years of rising stock prices the perception took hold that as long as one was diversified there was very little long-term risk in owning equities. Many turned to arguing (for fun and profit) that the risk was in NOT owning stocks. And as ridiculous as this argument was at the time, it struck a chord with a wide audience that wanted to believe. Of course, a proliferation of instruments and vehicles (along with intense marketing) were created to profit from this misperception. Money flooded into equity mutual funds, and an index fund became the largest stock fund in the country. Market dynamics evolved into a significant variable to economic activity. Importantly, the circumstance that had so many “diversifying” by acquiring market-based vehicles profoundly altered the nature of market risk. Is it coincidence that methods and structures aggressively incorporated by market participants to mitigate risk – that had been “irrefutably” proven by years of successful returns – ushered in devastating market losses that were considered remotely low probability events?

“Money” that flooded into the marketplace to play the S&P500 and NASDAQ100 severely inflated and distorted the stock market (while altering risk behavior in the financial system and distorting the economy). And the greater the asset inflation, the greater the demand for the assets (and the more likely one of myriad leveraging strategies would be incorporated – margin debt, derivatives, rising corporate and household borrowings). It all became one big (and increasingly leveraged) speculation on a commodity, “the stock market,” with perceived diversification risks greatly diminished and ballooning asset-Bubble risk virtually unrecognized. Now, post-stock Bubble, money flees the mutual fund complex. The depth and length of the bear market will be exacerbated as individuals become increasingly financially weakened and disillusioned by “the market,” while at the same time individual company stocks will lack the normal underpinning provided by investors’ conviction as to fair company economic value. “Contemporary” finance profoundly altered investor risk perceptions and market dynamics, which led to severe distortions in the marketplace and economy. “Investors” lost their market bet and will now think long and hard before placing more speculations. Wild speculations are destabilizing and inevitably detrimental to market-based systems and economies (regardless of post-Bubble central bank wishes and actions).

Hopefully this “micro” rehash of stock market Bubble dynamics is helpful in making sense of the unfolding “macro” financial and economic crisis. It continues to be our view that the collapsing stock market Bubble is not the central issue, but should be recognized as crucial evidence of much greater systemic ills inflicted by “contemporary finance.” Similar speculative and inflationary dynamics that fostered stock market booms and busts have dominated the expansive global “risk” markets (predominantly Credit market related), and that much of contemporary “structured finance” is more aptly named “Speculative Finance.” The residual is an unfathomable and increasingly onerous mountain of global financial claims (mostly debt).

Yet, the optimistic Chairman Greenspan has yet to be dissuaded. From his Wednesday speech in London: “A major contributor to the dispersion of risk in recent decades has been the wide-ranging developments of markets in securitized bank loans, credit card receivables, and commercial and residential mortgages. These markets have tailored the risks associated with holding such assets to fit the preferences of a broader spectrum of investors. Especially important in the United States has been the flexibility and size of the secondary mortgage market. Since early 2000, this market has facilitated the large debt financed extraction of home equity that, in turn, has been so critical in supporting consumer outlays in the United States throughout the recent period of cyclical stress. This market’s flexibility has been particularly enhanced by extensive use of interest rate swaps and options to hedge maturity mismatches and prepayment risk.” (We certainly take no issue with his assessment of the critical financial and economic role played by mortgage finance!)

The issues involved with “derivatives,” “hedging,” and “risk models” are many and complex. Their impact on risk perceptions and risk-taking, financial fragility, the nature of spending, and the character of economic “output” have been instrumental, if not easily analyzed or articulated. In the end, however, much of the (mysterious) power of contemporary “Speculative Finance” boils down to, first, diversification and, second, dynamic trading activities that are to mitigate risk exposure in response to changing market prices (buying or selling marketable securities that will provide the necessary cash-flow to pay on derivative protection sold). Today, we see problems developing in both. Just as small investors piled into index funds, global players flocked to the new and exciting “risk” market. Stock investors took ill-advised comfort from their diversification, while “risk” players became enamored with their models and sophisticated trading strategies. The nature of global risk and risk-taking was profoundly altered. Not only were the benefits of diversification unknowingly subverted, powerful Credit excess-induced boom/bust dynamics were set in motion.

The increasingly impaired “risk” players – domestic and international – have since been stung and many are now in full retreat. At the same time, enormous U.S. mortgage Credit growth only adds to the amount of risk that must be mitigated by dynamic market trading strategies, in a market suffering from a shrinking pool of players willing or able to accept market risk. Or, the requisite supply of risk continues to expand rapidly, while the demand for holding risk is contracting, perhaps at an increasingly rapid pace. Declining stock prices, faltering corporate Credits, suspect consumer Credits, a wobbly dollar, imploding Latin America and the consequent rapidly shortening life for massive quantities of mortgage debt is forcing risk players and dynamic hedgers to move to off-load risk in the marketplace. This is a serious problem. Those left in the risk market, either by choice or necessity, have become repositories for atypical risks that may threaten their viability. This is the (simplistic) anatomy of a very problematic market dislocation and financial crisis.

Dr. Greenspan repeatedly mistakes the role derivatives have played in sustaining dangerous Credit and speculative excess for a nebulous (and seductive) capability of the derivative markets to stabilize economic systems. Others are now convincing themselves that we have traded nettlesome financial instability for welcomed economic stability, but this rose-colored notion’s days are numbered. In the same vein, we think Alan Greenspan is wishful thinking when he references “a broad spectrum of investors,” and he will be sorely disappointed come the inevitably harsh reversal of speculative dynamics throughout the Credit market. It certainly appears this process has begun, and increasing revulsion to risk taking by players within the Credit system will impact Credit availability and economic performance.

While we have seen the comparisons between Fannie Mae’s derivative trading activities and LTCM, these are two very different situations with absolutely dissimilar ramifications. LTCM was a highly leveraged speculator - with large and illiquid assets - that lost its access to finance (was being called on their short-term liabilities) due to escalating market losses. It was an acute liquidity issue that was resolved by the Fed and Wall Street. The emboldened Great Credit Bubble only gained from the experience, while the Bubbling US economy didn’t miss a beat.

LTCM was a systemic issue only as long as it was not resolved by Fed rate cuts, massive GSE liquidity creation, and Fed intervention to place the hedge fund’s holdings in strong hands. Fannie is a critical player in an enormous mortgage finance Bubble that is today at acute risk. Adding insult to injury, Fannie’s “risk” problem is but part of the unfolding systemic “risk” dislocation. This Bubble is being threatened by financial dislocation (the systemic difficulties from massive mortgage refinancings) and growing Credit problems at the fringes of consumer finance. The already arduous task of hedging in this extraordinary environment is compounded by the cancerous impairment of key players throughout “Speculative Finance.” Importantly, lower interest rates only exacerbate the financial dislocation (causing more self-reinforcing market trading dynamics); additional marketplace liquidity only exacerbates financial dislocation (as this liquidity chases the Treasury market melt-up). Moreover, the mortgage finance super-industry must maintain unprecedented mortgage Credit growth to sustain levitated real estate values, not to mention boom-time over-consumption. To top it all off – and this will surely prove to be the most critical issue – this speculative blow-off of mortgage finance excess is inundating an impaired financial system with extraordinarily weak Credits, while it pushes an extremely maladjusted economy to previously unthinkable vulnerability. And on the surface it looks ok to most and pretty good to many. This is potent brew for a financial accident.

Also Wednesday from Chairman Greenspan:

“Fostered by a lowering of trade barriers, exchange of goods and services across borders has increased far faster than world gross domestic product. But what is even more remarkable is how large the scale of cross-border finance has become, relative to the value of the trade that it finances. To be sure, much global finance reflects growing investment portfolios, some doubtless with a speculative component. But, at bottom, such finance is a central element of the systems that support the efficient international movement of goods and services. We strongly suspect, though we do not know for sure, that the accelerating expansion of global finance may be indispensable to the continued rapid growth in world trade in goods and services. It appears increasingly evident that many forms and layers of financial intermediation will be required if we are to capture the full benefit of our advances in technology and trade. Indeed, the potential for a far larger world financial system than currently exists is suggested by the seemingly outsized implicit compensation for risk associated with many investments worldwide. But, as in all aspects of life, expansion of one’s activities beyond previously explored territory involves taking risks. And risk by its nature has carried, and always will carry with it, the possibility of adverse outcomes. Accordingly, for globalization to continue to foster expanding living standards, risk must be managed ever more effectively as the century unfolds.”

Greenspan again touches on issues near and dear to our analytical hearts, although the manner in which he takes liberties to massage them to his liking and ideology leaves us heartsick. It is today critically important to appreciate that the “accelerating expansion of global finance” is the residual of unrelenting lending and speculative excesses. It is the problem, not the solution.

The greatest culprit to this expansion is the unrelenting U.S. current account deficit, which is the direct result of continued dangerous domestic (largely mortgage) Credit excess. It is this borrowing to finance imported goods – the creation of dollar-based IOUs/financial claims from the U.S. financial sector – that is the other side of much of the expansion of “global finance.” This ballooning pool of destabilizing global speculative “finance” becomes only more unstable under the weight of previous bursting Bubbles, dislocation, and risk aversion. That Greenspan would this week comment that outsized risk premiums “suggest” the “potential for a far larger world financial system” suggests that he has conveniently sunk to a new low in economic analysis (and that he is deluded). This key issue goes all the way back to the John Law’s great fallacy: that economic wealth can be created simply by providing additional money (“finance”). And in reasoning that either lacks credibility or understanding, Greenspan would like us to believe we can have our cake and eat it too – that more beneficial “finance” can be created that leads to more “wealth” and higher living standards, as long as it is “managed ever more effectively.” This recalls his dangerously uninformed analysis that that SE Asian crisis was caused by “unhedged” holdings.

Very regrettably, we are reading the reiteration of the Greenspan Doctrine: Respond to bouts of rising systemic stress (“outsized implicit compensation for risk”) by fostering greater “finance” (Credit excess). I doubt history provides a more ironclad case against discretionary monetary management. For too long, the day of reckoning for past Credit and speculative excess has been postponed by nurturing only greater financial and economic imbalances. How the Fed has grossly mismanaged this unfolding fiasco goes directly back to historical revisionism of the overriding causes of the Great Depression. We have never doubted that the answer to financial and economic ills would not be found with more Credit. We are now witnessing why.

It certainly seems like the financial system is today perched precariously on the fence. It also appears many more are “connecting the dots” and appreciate the acute stress now afflicting the Credit system, as well as the enormous ramifications if it seriously stumbles. Worries about Fannie Mae, Freddie Mac, the Wall Street firms, and the Credit insures evoke nervousness for any company relying on the securitization market to garner additional finance. The performance of the financial stocks now closely correlates to the retailers and the cyclicals, as well as to the S&P500, as they should. Sinking stock prices are correlated to rising Treasury prices, exacerbating the financial dislocation. It has seemingly become one big bet on financial fragility – does or does not the system recoil from the edge as it has in the past?

We have reached a point where there is clearly a systemic problem, and the marketplace is desperate for a clue as to how this problem can be resolved. The Great Credit Bubble is at the brink. We are left to wonder this weekend if Fed Chairman Greenspan, fresh from all the pomp and circumstance, has any idea of what has developed. I just don’t see how it would have been possible for even the most talented and creative author to have crafted a fictional novel that could compare to what we all have witnessed.