12/01/2000 The return on U.S. Assets *

To describe this week in one word, it was OMINOUS, as heightened financial turbulence was apparent at home and abroad. For the week, the Dow dropped about 1%, while the S&P500 gave up about 2%. The Transports declined 3%. The defensive stocks again outperformed, with the Morgan Stanley Consumer index and the Utilities adding 1%, while the Morgan Stanley Cyclical index increased 3%. The small cap Russell 2000 lost 3%, and the S&P400 Mid-cap index dropped 2%. The technology debacle continues, with the NASDAQ100 sinking 10% and the Morgan Stanley High Tech index 9%. The Semiconductors were plastered for 20%, while The Street.com Internet index sunk 12% and the NASDAQ Telecommunications index 8%. The Biotech stocks declined 3%. The financial stock outperformed, with the S&P Bank index jumping 5%, and the Bloomberg Wall Street index adding 2%. With gold jumping more than $2, gold stocks came to life with the Philadelphia Stock Exchange Gold and Silver index rallying 9%.

In an orderly and almost methodical fashion, the alarming march progresses directly into financial crisis both domestically and internationally. And quite distressingly similar to the 1997 domino collapse in SE Asia and Russia/LTCM debacle in 1998, there appears little understanding or appreciation for what is unfolding either in the marketplace or within the regulatory community. Denial reins. Yesterday evening on CNBC former Federal Reserve Vice Chairman Alan Blinder, stating what we assume is the consensus view within the Fed and economic community, claimed “we are very far away from a financial crisis in the United States.” We hope he is correct, but we do see it differently. Actually, our analysis tells us that we are at the cusp of severe financial crisis with little hope for it to be averted – the “wheels are in motion.” Quite simply, the financial and economic excesses have been too great and the damage monumental, and there is today simply no way around the consequences. One of the more cogent comments we have heard recently came from CNBC’s Ron Insana who stated that the present environment is similar to the 1998 crisis, with the U.S. this time at the “epicenter.”

It is our definite view that the U.S. financial system is in fact at the epicenter of the developing crisis, and one simply cannot overstate the momentous ramifications for the piercing of the U.S. (global) Internet/telecommunications/technology bubble. It is also our view that this “piercing” is the catalyst for a historic reversal of fortunes for the greater U.S. credit and economic bubble. However, as is always the case, when financial distress erupts, countries at the periphery are the first to suffer from a disappearance of liquidity. Turkey is a case in point. With foreign investors/speculators headed for the exits and domestic investors trying to protect themselves from a potential currency collapse, over-the-weekend interest rates in Turkey spiked to as high as 1,700%, the highest since the severe banking crisis in 1994. Over-the-weekend rates for banks borrowing from the central bank spiked to 253%. Liquidity has all but vanished throughout the financial system, with Turkish stocks dropping 23% this week. Stocks have plunged 46% during the past month, while bank stocks have collapsed. Bloomberg quoted an international strategist: “(devaluing the lira is a) possibility I am worried about. Then the real problems begin.”

There are rumors of speculators suffering significant losses in Turkey, apparently having lost big betting on high-yielding Turkish bonds. Contagion has begun in earnest, with investor/speculators moving to raise cash in other emerging markets. Yesterday, Russian stocks sunk 10% before being halted. The Prague Stock exchange dropped 4.2%, while markets in Poland and Hungary also came under pressure. Elsewhere, Latin American equities came under pressure this week as well. With Argentina teetering on the edge, the Brazilian real dropped 1.2% yesterday, its largest decline in seven months. The real has now dropped almost 10% in the last 16 weeks.

Curiously, with emerging markets faltering, this week the dollar proved anything but its usual safe haven currency. In fact, this week the dollar reversed course very abruptly. The euro began the week at 83.80 and closed today at 87.90. The Swiss franc also rallied almost 5%. It appears an important inflection point has been passed for the dollar.

Despite the collapsing technology bubble and mushrooming credit problems, there remains a complacent notion in the marketplace that, with any serious financial market turbulence, the Federal Reserve will quickly (1998-style) lower rates, add liquidity, and get stock prices higher. Without a doubt, the view that Greenspan will be (his usual) quick and aggressive self with rate cuts is contributing to the relatively strong performance of financial stocks in the face of mounting financial dislocation. At the same time, it is simply stunning to see the enormity of the rush into the so-called “safe haven” of Treasuries, agency securities and mortgage-backs. This is certainly evidence of continued highly speculative (and destabilizing) monetary flows within the U.S. financial sector. But, then again, why should we expect anything less with an estimated $500 billion in the hedge fund community and Wall Street and bank securities holdings in the trillions. The enormity of the leveraged speculating community could not be more disconcerting. And we certainly ponder who is left to purchase agency securities, with the leveraged speculators seemingly fighting with the risk averse for securities from the Government-Sponsored Enterprises. We also wonder who will “take the other side of the trade” when the speculators move to cash out of this trade.

The bottom line remains that the financial sector has become little more than one big speculative bet – history’s great interest rate arbitrage play – with potentially massive overseas speculative borrowings financing the aggressive U.S. financial sector. And, ironically, as signs of stress build in the technology sector and corporate sector generally, such circumstances only incite greater speculative flows. It is certainly our view that the huge rally in agency and mortgage-backs has been a major if unrecognized factor in keeping the U.S. financial sector relatively liquid in the face of a collapse in what was a highly leveraged NASDAQ marketplace. The good news is that the collapse in margin debt and derivative leverage within the technology sector was offset by new leverage created in the agency/mortgage arena; the bad news is that the credit market bubble has become only more extreme and dangerous. The implied yield on the 10-year agency futures contract has dropped 27 basis points in three weeks to 6.45%. The benchmark Fannie Mae mortgage-back has seen its yield drop to 7.13%.

In the Treasuries market, it has become near panic buying. Five-year Treasury yields have dropped to 5.45%, after trading around 5.80% just three weeks ago. Ten-year yields have declined 30 basis points to 5.50% during the past 15 sessions. Two-year yields have dropped almost 30 basis points also to 5.66%. Only time will tell as to losses associated with Long-Term Capital Management-type spread trades, especially for those that shorted Treasuries or agencies to take leveraged positions in higher-yielding corporate debt securities. This trade has been a disaster. Trading action has certainly been indicative of speculators trapped in losing (and illiquid) trades. We continue to see the credit market generally as an accident waiting to happen, particularly in the event of a sinking dollar.

And while the market may be correct in anticipating Greenspan rate cuts, it should be understood that the dollar is now the “wildcard.” For some time, bullish “analysis” has held that returns on U.S. assets were so superior to those available overseas, that foreign investors would happily finance our trade deficit “forever.” What silly boom-time wishful thinking that has been! Clearly, this is quite a presumption, especially with a trade position that has gone from terrible to shocking. September’s trade deficit came in at a frightening $34.3 billion. We are literally flooding the world with dollars, which may keep our trading partners’ economies booming for now, but is unsustainable and financially and economically destabilizing. As we have written previously, it is our belief that great speculative flows (likely some type of “carry trades” from Europe) have been the key mechanism for “recycling” these enormous deficits back to the U.S. If so, this is now acutely susceptible to the changing environment.

With this week’s sharp reversal in dollar fortunes, perhaps the marketplace will now reexamine the status of the U.S. currency. And despite the expectations for lower interest rates, if newfound dollar weakness proves the beginning of a major decline (we certainly remember how quickly the dollar’s fortunes reversed between August and October of 1998 with the unwind of speculative positions/the “yen carry trade”), we don’t see current Treasury and agency yields as all too enticing for foreign investors/speculators. With an annual current account deficit to surpass $400 billion, we think the big surprise going forward is that monetary policy will be held captive to the currency markets – as has been the case for every other financial system that sinks into liquidity crisis. One of the costs of so abusing credit, while accumulating trillions of dollars of foreign debts, will be a loss of interest rate flexibility by the Fed. They (or the marketplace) just don’t realize it yet.

No matter how we look at the situation, we see an incredibly vulnerable greenback. Certainly, perceptions must be changing with respect to the whole notion of a technology- and productivity-led New Paradigm. At the minimum, with the collapse in technology stocks and losses in U.S. equities generally, talk of “above average returns” from the so-called “New Economy” seems like quite a stretch. We also note that all is not going well at DaimlerChrysler, with German management now stating that things at Chrysler were worse than they realized. We also suspect that the foreign buyers of U.S. telecommunications and media properties may also be experiencing “second thoughts.” as the business and financing environment turns sour. Furthermore, and quite importantly, it appears clearly that U.S. corporate profitability is faltering (perhaps rapidly, and while demand remains robust) generally. With higher interest rates, energy and material costs, and significant wage pressures meeting with acute competitive pressures and an overvalued dollar, it is going to be tough sledding on the profit front. And throughout the technology sector, business conditions having taken an abrupt turn for the worst, where we anticipate one of the most savage collapses in margins and business profits imaginable. “Above average returns?” It’s not going to happen.

This boom cycle has produced some bullish propaganda historians will find difficult to comprehend. And while the general perception has it that this protracted boom has created unprecedented wealth throughout the country, it is today pertinent to consider the old Austrian Economists’ belief that financial and economic bubbles create little true economic wealth, and more likely destroy wealth. This great concept takes on ever greater importance when foreign borrowings are used to finance the fateful boom. Such a circumstance is precisely what got Mexico in trouble, SE Asia, Russia, Argentina, Turkey and, soon, the U.S.

But back to the question: How can wealth actually be destroyed during a bubble? Well, through massive overspending in projects of little economic value – either through over investment or malinvestment. Collapsing technology stocks should make this concept today much more credible. These stocks are discounting the inevitable industry-wide shakeout. Historic overspending in technology manufacturing capacity – from PCs, to routers, to semiconductor chips – has created a situation of debilitating overcapacity. And while the boom was fun and games while it lasted, now that enormous capacity has come online and growth has inevitably slowed, there is the sudden and harsh reality that there is too much competition and profits for no one. As should be clear in analyzing our nation’s economic experience, if a financial system provides unlimited availability of credit and capital, there will be massive overspending and a spectacular boom cycle, and a bust to follow. It’s not really too complex, that is if one just ignores “New Age Economics.” And with thousands of Internet, telecommunications, and technology companies created over the past few years with little opportunity of ever making profits, it should be recognized that this is one of history’s great episodes of squandered resources.

While it is not easy to conceptualizing the essence of over and malinvestment in the expansive and complex technology industry, the U.S. movie cinema industry provides a much more straightforward example. For too many years, unlimited credit was available to many operators who, not surprisingly, were more than happy to take the money and build with reckless abandon in communities throughout the country. Think of this example: if a small community has, let’s say, two cinemas, then both will likely operate profitably and service the debt burdens from business cash flows. If, however, a speculative financing environment allows four new (megaplex) cinemas to be built, it is quite likely that not one of the six cinema operators will operate profitably. So, not only will the debt taken on to build the four new megaplexes be unserviceable, the ill-advised lending will also make the once sound debt of the original two operators unmanageable as well. The costs of credit excess are clear in this realistic example: wasted resources and problematic credit losses for the lending community.

In an unfortunate situation that is all too commonplace in our economy, the inevitable costs are now to be paid for what has been nothing short of an absolute lending fiasco in the movie cinema sector. Thus far, seven cinema companies have filed for bankruptcy – Carmike Cinemas, General Cinemas, United Artists, Edwards Cinemas, Silver Cinemas, Resort Cinemas and Mann Theaters. Regal Cinemas, the country’s largest operator, stated last week that it was considering filing for bankruptcy protection. Last month, the 3,000-screen Loews Cineplex announced, “if the company is unable to arrive at a longer-term plan to address its liquidity issue, it faces the prospect of a restructuring under bankruptcy proceedings.” Loews is currently negotiating with bankers over a $1 billion loan due next week, attempting to forestall bankruptcy filings.

In many ways, we think the cinema debacle provides an excellent illustration of the ominous general ills of the U.S. bubble economy. Widespread bankruptcies have occurred in the face of very strong domestic demand. In fact, box office receipts were up 10% over what had been record attendance at last year’s Thanksgiving weekend. And it also appears that this year’s box office will easily surpass last year. Clearly, the present cinema debacle is the consequence of reckless lending and over expansion, with the even greater problems associated with an economic downturn lurking down the road. We believe the dramatic widening in credit spreads for many of the largest U.S. corporations is also an ominous harbinger of a developing structural profit squeeze – faltering returns on U.S. assets - as well as unfolding general financial and economic tumult.

Interestingly, this week Merrill Lynch issued research comments where it lowered earnings forecasts for the major leveraged loan syndicating banks and high yield underwriters. “Though credit deterioration may be at an early stage, we see some hints of adverse selection: deals underwritten/syndicated by Morgan Stanley Dean Witter, Citigroup, and Chase Manhattan in the past 3 years have experienced debt rating downgrades at a rate disproportionate to these firms’ overall market shares.” The report also detailed how concentrated the aggressive lending has been, with six companies dominating. “In leveraged loan syndications, two banks, Chase and Bank of America have been dominant and have accounted for 34% of all leveraged loan financings over the past three years.” Further, technology, media, and telecom have accounted for “38% of all high yield bond issuance since 1998.”

For good reason, the buyers of these syndicated loans are reassessing their involvement. Yesterday’s American Banker ran an article, Wachovia Eyes a Cut in Syndicated Lending” - The stunning speed with which several large corporate loans have gone sour this year and a general slowdown in the syndicated loan market in recent months have some participants reevaluating their stake in syndicated lending.” There is now no doubt that a major credit crunch is unfolding in the syndicated lending area. At the same time, the junk bond debacle escalates with money continuing to flee the area, and a liquidity crunch pushing junk spreads to record levels. The Bloomberg junk bond spread widened 27 basis points this week to 684, after beginning the year at about 360.

Roger Lowenstein’s book, When Genius Failed – The Rise and Fall of Long-Term Capital Management, is an excellent read. It is truly frightening, however, to see how little appreciation for market forces there was from a group that maintained extremely leverage - $100 billion of positions and another $1 trillion notional of derivatives! Even when the fund was in virtual collapse, John Meriwether apparently believed he was “liquid.” Well, his definition of liquidity was having adequate cash to meet “marks-to-mark,” while our definition is having a market that enables one to unwind trades. As for true liquidity, LTCM had absolutely none; their positions were simply much to large to liquidate without sustaining huge losses. The fact that Wall Street eagerly financed such a crazy scheme should be enough to instill the fear of God into all of us (and certainly the Federal Reserve!).

Like LTCM, the entire U.S. financial sector takes liquidity for granted. The credit card companies – extending unused credit limits to their customers of $2.7 trillion – assume that there will always be a market to sell their receivables. The GSEs, having come to absolutely dominate household mortgage finance, operate with the premise that credit will always be available in unlimited quantities. Banks, extending lines of credit and liquidity agreements for $100s of billions of asset-backed commercial paper and other structured finance vehicles, assume they can always borrow to meet their obligations. Wall Street, that finances their massive balance sheets with repurchase agreements and other short-term vehicles, assumes they will always have access to borrowings to maintain their bloated balance sheets. The problem is, as LTCM came to realize, the assumption of liquidity can be a very dangerous thing. When you need it the most, liquidity disappears.

The world has changed. The manic period where simply absurd valuations were accepted in the technology marketplace is coming to an end. The great speculative bubble has burst and, as stated earlier, the ramifications are profound. At the same time, it should be a cause for concern that trillion of dollars of financial assets maintain their value (or even increase in value), despite the fact that inadequate true economic wealth backs these securities. Markets, however, have a tendency to rectify such imbalances, and often do it in spectacular fashion. Currently, money market fund assets have ballooned to $1.819 trillion, having increased $18 billion just last week. There are $1.7 trillion of asset-backed securities currently outstanding. Agency securities outstanding total $4.06 trillion. As of June 30th, there was almost $8 trillion of credit market debt owed by the financial sector. This amount has more than doubled since 1995, the epicenter of finance for the great U.S. financial and economic bubble. Of this $8 trillion, almost $1.7 trillion is borrowed by the Government-Sponsored Enterprises, and $2.4 trillion is mortgage-back securities. The financial sector has borrowed $1.1 trillion of short-term “open market paper,” and $2.2 trillion through bond issuance. The financial sector has also borrowed $437 billion of “other loans and advances.”

The Security Brokers and Dealers sector has accumulated total liabilities of an astounding $1.05 trillion, having almost doubled since the beginning of 1996. Of these liabilities, only $36 billion are corporate bonds. Meanwhile, $273 billion are “Security RPs” (repurchase agreements) and $504 billion “security credit.” The liability item that has us most fascinated is the $392 billion “Due to affiliates.” This liability has increased $259 billion, or almost 200%, since the beginning of 1996. During the past three years, “Due to affiliates” has jumped $176 billion, or 81%. If this “due to affiliates” is borrowed from overseas, this could become a key issue for the U.S. dollar and financial system.

Right here we see the fundamental problem that will hamper the U.S. financial system and economy for years to come: the U.S. financial sector has borrowed incredibly to take on enormous (speculative) positions in financial assets, and much of this has been borrowed from foreign sources. Foreign sources (we believe much of it leveraged speculations) have financed a bubble of reckless spending and squandered resources. The return on U.S. assets after such a fiasco will be particularly poor and problematic. Yet, as long as the financial sector continues to expand, this game can play on. However, confidence in the dollar, the U.S. financial system, the American economy must hold firm, although confidence – like liquidity – can be a frustratingly fleeting thing. Let there be no doubt, if there is any flight out of U.S. financial sector debt instruments – the U.S. credit system will freeze abruptly in illiquidity.

This is a very complex financial crisis currently unfolding. It is critical to appreciate that the problems impacting the U.S. financial system today are of a much different nature and more severe than 1998. The overriding problems today are the consequences of years of credit and speculative excess – massive financial claims, enormous foreign debt, an acutely unstable financial sector, and an economy deeply mired in distortions and maladjustments. We just can’t shake the notion that some very negative surprises are lurking “around the next bend.” Surely, sinking stock prices and faltering credit system liquidity have the tendency to unearth ugly skeletons. There are likely major losses to be recognized in the derivative area, and we are waiting for one of the major derivative players to experience an accident. We have yet to hear any bad news from some of the large technology companies that were aggressively writing put options on their own shares. There are also potential accidents for the firms that were aggressively selling hedging products to company insiders, with many insiders also partaking in derivative speculation.

On Wednesday, Reuters reported that the over-the counter derivatives market grew by almost 10% during this year’s first half to $103.9 trillion. Interest-rate swaps jumped 11% to almost $59 trillion. This data was compiled by Swaps Monitor Publications. Only time will tell as to the role this explosion in derivative positions has played in fostering the ballooning of U.S. financial sector assets and the explosion in foreign holdings of U.S. securities. We suspect derivatives have played a profound role in the U.S. bubble. Everything we see is ominous and we certainly don’t like the looks of any of this. This is going to be an extraordinarily difficult period.