11/23/2001 Edward Stone Shaw *

Today’s buying propelled the market to another positive week. For the week, the Dow and S&P500 gained about 1%. Economically sensitive issues shined, with the Transports gaining almost 2% and the Morgan Stanley Cyclical index adding 1%. The utilities were basically unchanged, while the Morgan Stanley Consumer index gained less than 1%. Strength was relatively broad-based, with the small cap Russell 2000 and the S&P400 Mid-Cap indices gaining better than 1%. Despite today’s rally, technology stocks were generally unimpressive. For the week, the NASDAQ100 and Morgan Stanley High Tech indices suffered small declines, while the Semiconductors dropped almost 4%. The Street.com Internet index gained almost 2%, and the NASDAQ Telecommunications index had a fractional advance. Biotech stocks generally gained about 3%. Financial stocks were quite strong, with the S&P Bank and AMEX Securities Broker/Dealer indices adding 3%. With bullion dropping about a buck, the HUI gold index declined about 2% for the week. The dollar index ended the week with a gain of less than 1%, with the yen taking the brunt of market selling. Crude oil prices sunk to 2-year lows this week.

Despite several rally attempts, it was another losing week for the U.S. credit market. For the week, 2-year yields added 13 basis points to 3.16% (up 86 basis points since Nov. 7th). Five-year yields jumped 18 basis points to 4.38%, an increase of 90 basis points since November 7th. Ten-year yields increased 16 basis points to 5.01%, an increase of 83 basis points since November 7th. Long-bond yields increased 11 basis points this week to 5.38%, up 59 basis points since the seventh. Agency securities again performed poorly, with the implied yield on agency bond futures jumping 18 basis points this week (88 basis points since November 7th). European bond yields generally rose modestly this week, with 10-year German yields rising 5 basis points to 4.61%. Benchmark Australian 10-year government bond yields jumped 35 basis points this week, increasing the 11-session rate spike to 92 basis points. After surging 500 basis points Monday, benchmark Argentine bonds recovered somewhat to end the week with yields at 40.05%, up about 330 basis points for the week.

Fannie Mae this week priced $5 billion of benchmark 10-year bonds – 5 3/8% due November 15, 2011. They closed Tuesday with a yield of 5.53%, at a spread to 10-year Treasuries of 64.5 basis points. We will now monitor this issue weekly for indication of increased stress in the agency market. These notes ended the week with a yield of 5.69%, with a spread to Treasuries of 69 basis points. We continue to read of heightened marketplace liquidity concerns, especially in mortgage-backs, and we will certainly watch next week’s action carefully to see if things improve when most return to their trading desks.

The Mortgage Bankers Association weekly application index dropped 7.6% this week, although dollar volume remains more than triple last year’s level. Refi dollar volume is running up seven-fold from last year, with purchase application dollar volume about flat. Despite the significant decline in long-term mortgage rates, the dollar volume of adjustable-rate mortgages is double year ago levels, with an average mortgage size of $340,100. Government-related adjustable-rate mortgage volume was up 360% versus last year. Freddie Mac announced this week that 30-year fixed mortgage rates jumped 24 basis points (the largest weekly rise this year) to 6.75%, the highest rate since the week of September 21st. Benchmark 30-year Fannie Mae mortgage-back yields increased 6 basis points this week to 6.46%, the highest since September 5th. These yields have now surged 76 basis points from the lows established on November 8th. Today’s article by the Wall Street Journal’s Christine Richard says it all: "If you think day-trading of Internet stocks is stressful, try locking into a 30-year fixed-rate mortgage. A volatile Treasury market has made latching on to a lower monthly payment akin to boarding a small boat in 12-foot seas. Just when you’re about to jump aboard the lowest mortgage rates in 40 years, the 10-year Treasury takes one of its biggest dives on record."

The "quotes of the week:"

"We don’t think much of activism in monetary policy. There is no reason to assume that the priority of price stability has to take a backseat in difficult times… In an exceptional situation, the ECB acted in an extraordinary manner. But it was important to us to make clear that this didn’t mark the beginning of a new phase in monetary policy." Otmar Issing, chief economist of the European Central Bank, November 19th, 2001

"I think the point where you can’t cut it (the Fed funds rate) any more is zero. And certainly my own opinion on this is if we have circumstances that suggested that we needed to go down more, then we’d go down more. And if we got to zero then there are also other things that can be done. But I don’t believe that we have come close to running out of the possibilities for monetary policies that have an important effect on the economy." William Poole, President of the Federal Reserve Bank of St. Louis, November 20th, 2001

From my hometown paper, the Eugene Register-Guard: "Facing skyrocketing costs and flat income, the city of Eugene expects to dip into reserves to hold steady for the next two years. Cost hikes for the fiscal year that began in July include a 15 percent increase in health care rates, a 22 percent boost in liability insurance and a $260,000 zap for higher electricity costs. Meanwhile, the city expects revenue to grow by less than 1 percent in 2003 and by less than 5 percent in 2004."

From a Nov. 20th article by Dow Jones’ Joe Niedzielski: "Looking to finance securities purchases over a few years’ time? It’s not the most liquid area of the repurchase market, but Bear Stearns wants to make it a little easier. The investment bank’s answer is Liquid Funding Ltd., a new triple-A-rated vehicle unveiled Monday that’s authorized to issue up to $20 billion in financing through medium term notes, commercial paper and repurchase agreements. The special-purpose vehicle - set up off Bear Stearns’ balance sheet - intends to lend a hand to institutional customers. It will initially focus on the trillion dollar repurchase and total return swap markets. Trigger-happy traders and savvy institutional investors rarely put down cold cash for bonds. They look to the repo market for collateralized loans that make it economically feasible to lock in financing from three months to a year and even longer to buy securities… Liquid Funding is initially restricted to investing in dollar-denominated commercial mortgage-backed securities, but intends to move into financing corporate securities through reverse repos and total return swaps."

From the Bond Market Association’s quarterly debt issuance report: "New issue volume in the first three quarters of 2001 totaled $3.2 trillion, an increase of 59.9 percent over the $2.0 trillion issued in the same period a year earlier." Booming issuance was led by the agency, mortgage-back, and municipal sectors. Highlights from the release: "Federal agencies more than doubled their long-term debt issuance to $660.8 billion during the first nine months of 2001." Short-term agency debt outstanding increased to $749.9 billion at the end of September compared to $730.5 at the end of June. According to this report, short-term agency borrowings have increased 29% during the past three quarters, led by a 44% increase in combined Fannie and Freddie short-term debt outstanding.

The report also stated that averaged daily trading in agency securities by primary dealers (during the first nine months of the year) surged 24% y-o-y to $89.3 billion. Year over year issuance of mortgage-related securities more than doubled during the first nine months, jumping from $481.4 billion to $1.1 trillion. Issuance of agency collateralized mortgage obligations (CMOs) surged 169% to $193 billion. Average daily primary dealer mortgage-backed trading volume (for the nine months) jumped 56% to $103.4 billion. The average daily volume of total outstanding repurchase agreements and reverse repurchase agreements totaled $3.03 trillion during the first nine months of 2001, an increase of 22% over last year.

"Municipal issuance increased 33.9 percent from year-earlier levels to $236.8 billion in the first three quarters of 2001… New issue volume in the corporate bond market totaled $673.4 billion through September, an increase of 26.1 percent over the same period last year… Asset-backed issuance remained strong, totaling $319.1 billion during the first nine months of this year, up from the $280.0 billion issued in the same period last year." Credit card asset-backed issuance posted the largest increase, surging 61% to $65.3 billion. Home equity-backed issuance jumped 39% to $86.1 billion, while automobile receivable-backed issuance increased 12.4% to $53.8 billion.

In accordance with our determination to "disaggregate," we’ll take a look below the surface of Wednesday’s headline "U.S. September Trade Gap Narrows to $18.7 billion." In fact, the "goods" deficit increased $1.8 billion during the month to $35.9 billion, the largest gap since April. Benefiting from foreign insurance disbursements, the "services" surplus jumped to $17.2 billion from August’s $10.3 billion. Year over year, goods imports declined 14% to $91.5 billion, while goods exports declined 17% to $55.6 billion. Interestingly, of the $14.7 billion y-o-y decline in goods imports almost $13 billion is explained by sinking imports of industrial supplies (down 18% y-o-y) and capital goods (down 27% y-o-y). Consumer goods imports have declined about $900 million, or 3.7%, from year ago levels, but remain 27% above the level from September 1998. It is worth noting that total imports surged 38% in only two years (September 1998 to September 2000), and this year dropped back to within 20% of Sept. 1998 levels. Capital goods imports jumped 38% over this two-year period, only to have returned back to 1998 levels in September. Imports of industrial supplies surged 60% over two years, and remain 18% above Sept. 98 levels. Our trade deficit with China increased to $8.5 billion on total imports of about $10 billion. Of the total $17 billion deficit with the Pacific Rim, fully $14 billion was explained by our trade gaps with China and Japan.

It is impossible to differentiate the degree to which recent declines in the dollar value of imports has been related to reduced physical volumes, changing relative currency valuations (strong dollar, weak euro, Asian and other currencies) and sinking goods prices (particularly in the technology and tech capital equipment area). We see that the Port of Los Angeles reported an all-time record for inbound shipping containers during September (up 21% y-o-y to 267,580). During October, the Port of Los Angeles and Port of Long Beach combined to receive 503,907 inbound containers, up 4% from one year ago and 25% from two years ago. Containers loaded for export from these two leading ports totaled 173,083 during October, a decline of 5% from one year ago, but up 8% from October 1999. Empty containers leaving the two ports increased to 262,899 during October, up 7% from last year and 19% over two years. There is little to find encouraging from this data.

October new housing starts were reported at a seasonally adjusted rate of 1.552 million units, up about 2% year-over-year. Annual housing starts averaged 1.307 million units during the first eight years of the 1990s (1991 was the low at 1.014 million units). We are on track for 1.6 million housing starts for 2001 - just shy of 1999’s 1.64 million (the strongest year since 1986). October issuance of new building permits was down 6% from one year ago, to the lowest level since December 1997. Year over year, we see housing units under construction were up 4.4% nationally, with the Northeast up 8.6% and the West up 10.6%. This week the Department of Commerce also reported second-quarter household spending on "home maintenance and repair" and improvements at $165.8 billion. Total annualized expenditures were up 12% year over year, with spending on improvements jumping 14% to $119 billion.

We see that Freddie Mac increased its retained mortgage portfolio at a 17% annualized rate to $478 billion during October. However, its total book of business (retained portfolio and outstanding mortgage-backs) expanded at only a 7% rate to $1.113 trillion. Freddie made record commitments to purchase mortgages during the month ($26.4 billion vs. September’s $17.6 billion). We see Freddie’s data as further confirmation that many originators were warehousing unusually large amounts of mortgages prior to the recent abrupt rise in interest rates. It will be interesting to see if institutions will now sell these mortgages and book a loss, or if they will decide to hold them as "long-term investments" (and hope). Perhaps coincidently, Countrywide Credit Wednesday filed to sell as much as $8 billion of asset-back securities, providing financing for mortgage-back security holdings.

For an "abbreviated" Thanksgiving weekend edition of the Credit Bubble Bulletin, we will highlight the work of the late American economist Edward Shaw. Shaw was born during 1908 in Albuquerque, New Mexico, although he was raised in small towns in Washington State. He basically spent his entire career at Stanford University, first receiving his bachelor’s, master’s and Ph.D. degrees, then as scholar and devoted teacher. The most important (according to Perry Mehrling) influence on his early economic thinking was his training in accounting under John B. Canning (Economics in Accountancy, 1929 – "an attempt to construct a bridge" between accounting and economics). He is most noted for his pioneering work with John Gurley in their 1960 classic "Money in a Theory of Finance." Earlier he published a 1950 textbook, "Money, Income, and Monetary Policy." In 1973 he published "Financial Deepening in Economic Development." Throughout his career he published scores of articles with a focus on money, financial intermediaries and developing economy financial and economic issues.

From my recommended source, Perry Mehrling’s The Money Interest and the Public Interest: "In his attempt to make sense of the drama outside his window (the Great Depression), Shaw followed a single thread, money. What fascinated him about money and the monetary system was the ‘mixture of good and evil’ in it. To him, a bank was never just a bank; it was a pawn in the battle between good and evil. ‘The banks are torn between the compulsion to take chances…and the compulsion to avoid taking chances…’ and left to their own devices they tend to do the wrong thing at the wrong time. Monetary instability was the work of the evil angel whispering in the ear of plodding bankers, simple souls protected only by the good angel of the monetary authority." (Mehrling p. 160/161, quoting Shaw 1950) ("During the years of depression and war, the young Shaw pinned his hopes on the Federal Reserve, but in his mature writing he realized that even the Fed enjoyed no effective control." (Mehrling p. 164))

"Stanford also provided a secure base from which Shaw could watch and reflect on developments within the economics profession. He found himself out of step with the increasingly dominant Keynesian mainstream because he rejected both the technocratic ambitions of macroeconomic management and the formalist theorizing and model building that lent intellectual respectability to those ambitions." (Mehrling p. 161)

"Shaw abhorred inflation, most of all because he saw it eroding financial stockpiles and so threatening the only security individuals could hope to enjoy. He looked on with dismay in the decade of the 1960s as not only the developed United States but also the less-developed nations of the world embraced inflation as an intentional strategy of economic development, often with the urging of quite respectable economists.
For developing countries with only rudimentary financial structures, Shaw argued, inflation not only erodes financial stockpiles, but it also obstructs and represses the development of a more adequate financial system, and so also represses economic development more generally. For poor countries it was not enough to safeguard the value of money. What was needed was a more or less conscious construction of financial infrastructure that could provide the basis not only for economic development but also for individual security in the face of that development." (Mehrling p. 165)

Shaw titled his 1936 dissertation "The Federal Reserve Requirement for Commercial Banks as an Instrument for Credit Control." From Mehrling: "…Shaw focused his attention on the determinants of the money supply by using the balance sheet of the commercial banking system to trace the origin of monetary fluctuation…Like Hawtrey, the young Shaw emphasized the inherent instability of credit, the role of credit in amplifying economic upswings and downswings, and the importance for the public interest of deliberate management by a powerful central bank." Quoting Shaw: "Cut down to its essential elements, the commercial banking system is evidently an extremely dangerous machine. Without external curbs and support it is certain to manipulate the money supply in such a way as to produce the most disastrous fluctuations in price levels and realignments in the structure of production. Regulation is necessary." (Mehrling p. 168, quoting Shaw 1936)

"What is most interesting about Shaw’s dissertation, however, is not its narrow research question, but rather its innovative use of bank balance sheets as the central organizing principle for monetary analysis… ‘Money is created or destroyed accordingly as loan committees of the commercial banks are moved by the prospect of profits and losses to alter portfolios of earning assets…’ Monetary instability traces ultimately to the profit-maximizing decision of individual bankers, and it follows that monetary control measures must concentrate first on reducing the freedom of banks and second on manipulating the essential parameters of the bank portfolio decision. For achieving these purposes, Shaw concluded, the reserve requirement has some potential but still leaves considerable room for variability in the flow of credit. Shaw’s subsequent career was devoted to working out the consequences of his early insight that banking is the key to understanding money and that banks are not pawns – not of the Federal Reserve, nor of their depositors or borrowers – but rather economic actors in their own right…His characteristic balance sheet approach meant that all his answers involved both assets and liabilities, both credit and money, both loaning and borrowing." (Mehrling p. 168)

Banks appear as a special type of dealer in the securities market, financing their expansion primarily by issuing monetary liabilities. Quoting Shaw (1950): "The monetary system…buys assets, principally interest-bearing securities and bullion, and pays for them by creating new money balances in the form of fixed-price claims against itself. It incurs debt to buy assets, and the debt is money." Mehrling on Shaw: "The result is that the supply of money is a by-product of the security dealings of the commercial banking sector, and this fact goes a long way toward explaining monetary instability… Instability is contagious and cumulative, so that instability originating in one sector of the economy tends to spread itself over the whole economy and to last for some time. An increase in income brought about by the banking system’s inclination to expand its security holdings (or any other cause) begets further increase in income." (Mehrling p. 176)

"Shaw was concerned to understand the process of monetary disequilibrium because real-world monetary experience seemed to him obvious and perpetual disequilibrium. For that purpose, the balance sheet approach seemed preferable, if not ideal, because balance sheet relationships hold even in disequilibrium. For Shaw, the road to wisdom passed through the world of historical data, and there was no shortcut passing through the world of theory. What the data of the U.S. experience told him was that cyclical stabilization through monetary manipulation was unlikely to be successful because there was simply no stable relationship between anything the monetary authority controlled…" (Mehrling p. 178)

From "Money in the Theory of Finance" (p. 183): "The worst of all policy alternatives is erratic intervention by the monetary authority. Such mischief on the money market precludes rational responses to relative prices and touches off such unpredictable variation in the absolute price level that optimal real growth, its fruits equitably distributed, is out of the question."

"If Shaw nevertheless advocated a constant money growth rule, it was not because he thought such a rule would stabilize the aggregate economy, but because he thought it would at least prevent the monetary authority itself from serving as an additional source of instability." (Mehrling p. 178) "For Shaw, instability was a problem not only in itself but more important for its political consequences in the call for greater social control over the market system." (Mehrling p. 181)

From Mehrling: Most prominent was "Shaw’s concern for protecting what he called the ‘moneyness of money.’ According to Shaw, the distinctive and defining characteristic of money is that its price is fixed in terms of the unit of account. From the point of view of the theory of value, the fixed price of money is anomalous. The price of everything else fluctuates along with fluctuations in supply and demand, but not money, and it is precisely that property that makes it money…According to Shaw, the fixed price of money is the essential property that makes it useful, but it is also the property that makes it dangerous…Thus, by its nature money is both good and evil, and this fact places limits on the degree and kind of improvement intelligent management might reasonably hope to achieve. (Mehrling p.179/180) "For Shaw, it was the duty of commercial banks issuing monetary liabilities to ensure their interconvertibility with currency, which they can do most effectively by looking after their own solvency and liquidity. Their failure to do so not only inconveniences individual depositors but also places in jeopardy the very moneyness of money, and so threatens the very basis of its acceptability." (Mehrling p. 181)

"In his attempt to engage the academic audience, Shaw located one source of the problem in the overly aggregative view of the economy adopted by many academic economists, a view which missed the essential role played by money (and finance more generally) in supporting a decentralized system of productive specialization. ‘Spending units are federated in a capitalist economy, rather than consolidated, and finance in various forms serves in many ways as a substitute for economic centralization’ (Gurley and Shaw 1960). Largely because of this, it seemed clear to Shaw that ‘the logical way for an economist to study finance is to study it as a market problem…Each set of demand, supply, market-equilibrium equations defines a market that is susceptible to analysis in its own right – to partial analysis’… Shaw emphasized that ‘disaggregation is the essence of monetary theory’ (Gurley and Shaw 1960)." (Mehrling p. 196/197)

"It comes to the conclusion that money should be studied in the context of a sectored society, that disaggregation is the essence of monetary theory. Money is supplied and demanded on in a sectored society. It is one financial phenomenon among the many that co-ordinate the activities of spending units. It is a device for communication between autonomous spending units, and a means for the self-preservation of individual spending units in a risky world. The results of consolidating spending units into a monolithic solidarity must be to eliminate money as well as other financial phenomena from aggregative economic analysis." (Money in a Theory of Finance p. 140)

"…Shaw criticized the Fed’s monetary management for failing to take into account financial development…" concluding that "regulation designed to safeguard the moneyness of money and manipulation of reserves for the purpose of short-run economic stabilization had operated perversely" allowing other less regulated financial intermediaries to "provide close substitutes for the monetary liabilities of commercial banks. The effect was not only to distort the allocation of loanable funds but also" to create the potential for an "open-ended money supply, now with private quasi-money posing the problem rather than public quasi-money. In both respects, monetary mismanagement operated to make things worse rather than better." (Mehrling p. 193)

From Mehrling’s conclusion to The Money Interest and the Public Interest: "…Edward Shaw appears as a kind of throwback to prewar traditions. More like (Allyn) Young than (Alvin) Hansen, Shaw sought to understand the course of history in order to help society adjust to its changing challenges. He was committed, as were the early Progressives, to participating in the great experiment of combining democracy with a decentralized market economy. Unlike them, however, the great obstacle he saw to further evolution of the experiment was not big business or big finance, but big government and its ambition to make history deliberately rather than allowing it to emerge organically. By virtue of its monetary mismanagement and malregulation, big government had become the problem but as a Progressive Shaw could hardly attack it. Rather, he focused his attack on convincing big government to behave differently…" (Mehrling p. 225)

"Both bemused and outraged by the world around him, both open-minded and uncompromising, conservative and progressive, self-reliant and public-interested, Shaw embodied the contradictions of Progressivism as it played itself out in the Golden Age. He died June 15, 1994, and was memorialized by his colleagues as ‘a modest but determined man, [who] made a difference for the good to the lives of people in many countries’." (Mehrling p. 166) And so we salute the work of Edward Stone Shaw, analysis that is probably more relevant today than it was during much of his distinguished career.