12/15/2000 All Eyes on the Greenback *

With triple-witch options expiration and an earnings warning from Microsoft, it was another tumultuous week for the stock market. For the week, the Dow declined 3% and the S&P500 2%. On the back of earnings disappointments, the Transports and Morgan Stanley Cyclical indices were hit for 6%. The defensive issues again outperformed, with the Morgan Stanley Consumer index and Utilities declining about 1%. The small cap Russell 2000 dropped 4%, and the previously outperforming S&P400 Mid-Cap index declined 6%. With Microsoft and Intel under heavy pressure, the NASDAQ100 declined 12%, and the Morgan Stanley High Tech index dropped 10%. The Semiconductors and The Street.com Internet index sank 9%, and the NASDAQ Telecommunications index declined 7%. The Biotech index dropped 7%. The financial stocks were mixed, with the S&P Bank index declining only 2%, while the Bloomberg Wall Street index dropped 5%. Gold stocks declined 3%.

A dramatic collapse in interest rates continues, with yields generally dropping to the lowest levels since early 1999. For the week, two-year Treasury yields declined 8 basis points to 5.37%, while 5 and 10-year yields dropped 12 basis points to 5.13% and 5.18%. The long bond saw its yield drop 8 basis points to 5.42%. The amazing collapse in agency and mortgage yields only seems to gather momentum, with the implied yield on the agency futures contract sinking 16 basis points to 6.03%. This yield has dropped 41 basis points so far this month, in what is likely exacerbated by a short-squeeze and derivative-related dislocation. The yield on the benchmark Fannie Mae mortgage-back declined 10 basis points to 6.98%, as a major refinancing boom takes hold. Perhaps anticipating moves by Greenspan, corporate debt performed better this week, with junk spreads narrowing 10 to 15 basis points.

Yesterday, Bloomberg reported that “billionaire Paul Allen entered into contracts last month that would protect the value of about $3.5 billion of his Microsoft common stock if the company’s shares continue falling.” I am underscoring this transaction, as the proliferation of such strategies has significant ramifications for the stock market and financial system generally. Allen entered into “zero-cost collars,” that in this case basically involved writing/selling “out of the money” call options to finance the purchase of “out of the money” put option. In this case, Allen has sold his rights to the upside on about 66 million shares of Microsoft stock (ranging between $108 and $167) to obtain downside protection below $55 and $63. Similar strategies have been commonplace throughout the marketplace, especially in the technology sector where insiders hold mountains of shares.

Granted, such strategies work absolutely wonderfully during bull markets. In fact, we would argue they played a critical role in exacerbating boom-time liquidity excesses, providing convenient “no-cost insurance” that kept many insiders from locking in gains the “old fashioned” way, by selling shares. Moreover, the popularity of writing “out of the money” calls was likely a factor in the market dislocation (technology “meltup”) earlier in the year, where those suddenly caught short a surging market were in near panic to purchase the underlying securities. Many companies only augmented market dislocations by actively writing puts in their own shares, in some cases pocketing $100’s of millions along the way.

Come the inevitable bear market, however, and the dynamics turn much less market friendly. Some Wall Street derivative desk(s) sold/wrote Mr. Allen (and likely many other Microsoft insiders) puts on 66 million shares of Microsoft that, after yesterday afternoon’s earnings warning, are now considerably “in the money.” The option writers are now forced to hedge exposure by shorting large quantities of Microsoft stock, and were surely a meaningful portion of today 163 million shares traded. This type of dynamic hedging, obviously, is not conducive to stock market liquidity, as buyers must be found to take the other side of the hedgers’ sales. Fortunately, the seemingly unending river of money continues to flow into mutual funds, with Market TrimTabs reporting record two-day inflows of $20 billion for the first two days of the week. (This influx of cash is most certainly a function of a major pickup in mortgage refinancings – more on this later). One should, however, consider how all of this dynamic hedging will function come the inevitable reversal of mutual fund flows. The models used for this dynamic hedging make the bold assumption of liquidity. For now, it appears that derivative related selling is very much a sponge absorbing every drop the public throws at the market.

And with key stocks such as Intel, Microsoft, Dell, and Yahoo being at the epicenter of derivative programs (for hedging and speculating, but also including individual company treasury departments!), we are actually somewhat surprised that no one has “fessed up” to an “accident” by now. Undoubtedly, there have been major losses in the equity derivatives area that will only become more problematic when liquidity disappears. For sure, equity derivatives have been an increasingly destabilizing mechanism for the marketplace.

There is, however, another twist to this unprecedented proliferation of derivative trading, one with potentially significant implications for the Great Credit Bubble. When a derivatives desk (or anyone else for that matter) shorts a security, the proceeds from these sales are then available for Wall Street to lend or use for the purchase of other securities. In the case of short sales by an individual or hedge fund, a Wall Street firm generally places these funds into a “restricted” account. Usually, these accounts are allowed only to purchase top-rated short-term securities. And with the explosion in hedge fund activities and derivative trading, one should appreciate that literally hundreds of billions of dollars of short-sale proceeds give contemporary Wall Street one more mechanism providing tremendous “liquidity” to use at its discretion. Perhaps these proceeds have played a key role in funding the boom in asset-backed commercial paper and credit card receivables, as well as other sophisticated securities created through Wall Street alchemy. And perhaps this mechanism has played a part in the tremendous liquidity-driven rally in the agency and mortgage-back marketplace, possibly providing short-term financing for ballooning GSE balance sheets. Only time will tell, but we certainly believe that these types of flows have played an unrecognized role in elevating Wall Street financial excess and perpetuating the credit bubble in the face of the unfolding collapse in a heavily leveraged NASDAQ marketplace.

According to Bloomberg, there are almost 2 billion shares shorted in NASDAQ, including 57 million shares of Oracle short, 56 million shares of Cisco, 45 million WorldCom, 44 million Microsoft and 40 million for both JDS Uniphase and Amazon. There are almost 1.2 billion shares shorted on the NYSE. These massive positions are not the makings of the very small community of “short-sellers,” but are instead indicative of the enormity of derivative strategies.

Yesterday, the Department of Commerce released third-quarter current account data. It is one more report worthy for inclusion in the “Time Capsule.” The current account deficit (net trade in goods and services, while also factoring in net investment income) expanded to $113.8 billion. For comparison, the current account deficit was $33.4 billion during 1997’s 3rd quarter (prior to the 1998 “reliquification” and the resulting runaway money and credit excess). The current account deficit is on course to total $440 billion, or quickly approaching four and one-half percent of GDP. Alarmingly, this percentage has surged from 2.5% just two years ago. There is no mystery here; we are simply over borrowing and consuming – living way beyond our means. The “mirror image” of this rapidly rising deficit is the savings rate that has fallen from 4% in 1998 to slightly negative currently. This blatant overspending helped push third-quarter imports to a stunning $462 billion, up 18% from last year. And, despite the expectation that imports would slow along with the economy, goods imports increased at an 18% rate during the quarter, slightly ahead of the second-quarter’s 17%.

To keep this game going, ever-greater trade deficits must be “recycled” as capital inflows back to the U.S. financial sector, thus feeding the lenders and perpetuating credit and spending excess. From yesterday’s report from Bureau of Economic Analysis report:

“Net foreign purchases of U.S. securities other than U.S. Treasury securities were $118.9 billion in the third quarter, up from $87.1 billion in the second. Net foreign purchases of U.S. stocks were $46.8 billion, up sharply from $26.3 billion; the increase was attributable to shifts to net purchases by investors in Caribbean financial centers and in Japan and to an increase in net purchases by investors in Western Europe. Net foreign purchases of U.S. corporate and other bonds were a record $72.1 billion, up from $60.8 billion; the increase was partly attributable to record net foreign purchases of U.S. federally sponsored agency bonds.

Net financial inflows for foreign direct investment in the United States were $64.9 billion in the third quarter, down from $100.3 billion in the second. Although net equity inflows fell sharply, they remained strong as a result of numerous large acquisitions. Net intercompany debt inflows and reinvested earnings both decreased.”

One cannot overstate the dominant role that the GSEs have come to play in financing (perpetuating) the consumer spending boom and the U.S. bubble generally. Nor is it an exaggeration to state that these institutions have become a major force in “recycling” ballooning trade deficits back into the U.S. financial sector, as we continue to enjoy the great (but unsustainable) advantage of trading “paper” (electronic entries!) for foreign goods. And, as the great technology bubble bursts, the GSEs are (again) increasingly the mechanism that - through inciting a mortgage-refinancing boom and huge equity cash outs - creates the money growth that flows into the stock market. These inflows are crucial in providing desperately needed liquidity to Wall Street derivative desks, increasingly faced with a collapse of margin and derivative-related leverage. There should be no confusion as to why Wall Street demonstrates deep and unconditional love for GSEs.

Hard at work, Fannie Mae expanded its mortgage portfolio at a 25% rate during November, only slightly below October’s 26.5%. “Average Investment Balances” increased $14.5 billion during November to $648 billion. Over the past two months, Fannie Mae has expanded assets by about the same amount as it did during the entire first half of the year. Or, pulling a quote from a bullish Wall Street research report, “the total volume of loans sold to FNM in November was very strong, at $26.0 billion. We believe 4Q purchase volume is likely to run as high as $73 billion.” From Bloomberg: “There ‘are more mortgages for us to buy,’ said Mary Lou Christy, a vice president for investor relations (at Fannie Mae)…the company also benefited from buying loans from commercial bank portfolios, Christy said. Banks are reducing their loans portfolios amid growing credit problems as the economy slows.” Once again, we see evidence of this extraordinary situation where unfolding financial and economic stress only exacerbates GSE lending excess. But, then again, that’s why we call it a bubble and “reliquefication.”

This week Freddie Mac stated that it expects to expand its net retained mortgage portfolio by “$50 to $60 billion,” or 13% to 16% during 2001. Freddie Mac ended the third quarter with a net portfolio of $359 billion. Not surprisingly, some Wall Street firms were quick to assert that this was too conservative, and that they expected 20% portfolio growth from Freddie. With another major refinancing boom in play, this 20% number is not unreasonable (for now).

Meanwhile, Freddie Mac recently released its third-quarter report on mortgage refinancings, aptly titled “Taking Out Equity Remains The Primary Reason To Refinance.” “In the third quarter of 2000, 83% of Freddie Mac-owned loans that were refinanced resulted in new mortgages at least five percent higher than the original mortgages…this contrasts with 70 percent in the third quarter of 1999.” Moreover, only 46% of mortgages refinanced during the third quarter of 1998 resulted in mortgages at least five percent higher than the original mortgage. Freddie Mac also tallies the “median appreciation of refinanced property” that is excellent in illuminating the dimensions of the current national real estate bubble. Looking back to the third quarter of 1998, the median appreciation was 9%. The extraordinary housing inflation - consequence of the 1998 “reliquefication” - is quite evident, as the median appreciation during the third quarter of 1999 jumped to 20%. The “median appreciation” then jumped to 23% during Q4 1999, stabilized at 23% for Q1 2000, increased to 26% for Q2 2000, and then surged to 32% during Q3 2000. Furthermore, this current real estate bubble could not be more conspicuous as recognized by the GSEs themselves: “Freddie Mac's Conventional Home Price Index shows the growth in the value of housing, on a national average, to be about 29.7 percent over the past 5 years.” This number, while significant, is much below what we believe to have been the actual housing inflation in many key markets. After all, what would one expect to be the consequences of total mortgage debt expanding by about 50% to $6.8 trillion over the past five years?

There is lots of finger pointing going on in regard to the severe electricity shortage developing in California. We have for sometime held the view that this was but one of many manifestations of the historic bubble that has engulfed much of the Golden State. In this regard, I would like to point out some interesting data from this week’s Barron’s. Gene Epstein’s Economic Beat column highlighted a discussion with California ‘s chief economist Ted Gibson. From Epstein’s article: “Not only are withholding-tax receipts up a whopping 19% over the first 11 months of this year, virtually every other indicator he follows in the nation’s most populous state has also been growing in double digits.” The article also detailed that “retail-sales tax receipts are up by more than 10%.” Moreover, Gibson sees a “serious pattern of lowballing” in federal statistics. While “the state’s wage income had jumped 19%,” during the first quarter, the “Bureau of Economic Analysis was crediting California with a mere 9.5%. Gibson has also talked to colleagues in Arizona and in Washington State who have seen similar gaps.” “But even with a swooning stock market, the gusher has continued, albeit at a somewhat modulated pace. In the second quarter, salary income was up 13.8% and in the third quarter, it vaulted 14.2%.”

We certainly expect that Greenspan will soon be cutting interest rates, possibly aggressively. This, despite 4% unemployment, rising wages, surging energy prices, massive trade deficits, heightened general inflationary pressures and, importantly, an historic real estate bubble in California and, in many cases, throughout the entire nation. The impetus for Greenspan, as it was in 1998, is a dysfunctional and fragile financial sector weakened by years of lending and speculative excess and distorted by the unprecedented degree of leverage and derivatives. We certainly see a 1998-style financial dislocation in the making, with a spectacular collapse in Treasury, agency and mortgage yields indicative of a derivative-related market dislocation. And, as was the case in 1998, the most serious market turbulence – what Greenspan has referred to as the “seizing up” of the credit system – occurred in early October when the dollar went into virtual collapse against the yen and fell sharply against major currencies.

Remembering back, in the four sessions between October 5th, and October 9th, 1998, the dollar versus the yen sunk from 134 to as low as 115. During this tumultuous period, the yield on the benchmark Fannie Mae mortgage-back jumped 62 basis points to 6.55%. Treasury and agency yields surged as well. Importantly, it was the combination of the sinking dollar and the abrupt reversal in an already dislocated credit market that nearly ended with financial collapse. With enormous derivative positions for both hedging and speculating, dynamic hedging trading strategies played a major role, exacerbating market dislocation as interest rates collapsed to unsustainably low levels, only to abruptly and spectacularly reverse like the snap of a rubber band.

And while things never develop exactly the same, we certainly see some very disconcerting similarities. We do believe that the recent collapse in agency and mortgage rates has been exacerbated by aggressive GSE expansion, as well as a derivative and speculative trading-related dislocation. A confluence of factors has pushed mortgage rates, in particular, much lower than reasonably justified by underlying supply/demand and inflation fundamentals. And, as stated often, it is our view that the dollar is now acutely vulnerable, the unavoidable consequence of a faltering credit system and inevitable economic downturn. Putting it all together, a 1998-style collapse in financial system liquidity should be considered a real possibility. The problem we have in trying to analyze the situation, is that the fundamental backdrop for the U.S. financial system and economy is profoundly weaker than it was just two years ago.

Undeniably, the domestic credit situation is much more problematic than in 1998. A press release from Moody’s on Wednesday was certainly disconcerting: “Moody’s estimates that between 385 and 450 companies out of the over 9,000 the index tracks will default in the next twelve months, more than triple the 114 that have defaulted since December 1999. Moody’s points to greater leverage, often brought about by debt-funded merger and acquisition activity, higher costs for credit, energy, and labor as well as litigation-driven event risk as the reasons for this high level of default risk.”

Continuing, “…Moody’s forecasting model for the trailing 12-month default rate has been pointing to higher expected default rates for issuers of rated speculative-grade corporate bonds. Moody’s is forecasting that 9.1% of those issuers will default on speculative-grade rated bonds over the 12-month period ending November 2001. Already, the record for November shows that defaults are increasing in North America, with 19 issuers defaulting on roughly $9.5 billion of debt. This is markedly up from October’s figures of eight issuers defaulting on $2.2 billion of debt.”

Monday, Moody’s titled its press release “High-yield Refinancings at Risk in Difficult Market.” “As default rates continue to climb and overall levels of corporate credit worth declines, companies with outstanding debt rated below-investment-grade could find themselves unable to tap the market to refinance their outstanding debt when that debt comes due…In total, $28 billion of below-investment-grade debt will mature in 2001. Nearly two-thirds of this is bank loans…Investors’ waning appetite for riskier credits in this environment is indicated in the fact that only $55 billion of high-yield bonds have been issued this year, compared to $100 billion in 1999 and $170 billion in 1998. Furthermore, high-yield mutual funds began experiencing net outflows of investment at the end of 1999 and have been bleeding funds ever since.”

And coming this week from the FDIC, the Quarterly Banking Profile with the headline “Net charge-offs of banks' credit-card loans totaled $2.4 billion in the quarter, for a net charge-off rate of 4.27 percent, compared to a 4.44 percent rate a year earlier. While charge-offs of credit-card loans remain higher than those of commercial and industrial loans, the latter category continues to exhibit more rapid growth. Almost one third of all loan charge-offs in the third quarter ($1.8 billion, 31.8 percent) occurred in loans to commercial and industrial borrowers. Commercial and industrial loan charge-offs were $548 million (43.7 percent) higher than a year ago, whereas credit-card charge-offs were up by a more modest $266 million (12.5 percent).

Even as banks charge off loans at higher rates, their remaining inventories of noncurrent loans continue to rise. Total noncurrent loans increased by $2.2 billion (6.0 percent) in the third quarter, and are up by $5.9 billion (17.8 percent) over the past 12 months. Noncurrent commercial and industrial loans rose by $1.3 billion (8.8 percent) in the quarter, and are up by $4.3 billion (37.7 percent) from the level at the end of the third quarter of 1999.”

And while the credit situation is deteriorating rapidly, what bothers us the most is that the U.S. financial system has been in an unrelenting and most extreme (unsound) expansion since those dark days of crisis in the fall of 1998. For one, broad money supply, at almost $7 trillion, has surged $1.3 trillion, or 23%, since June 30th, 1998. Total mortgage debt has also increased about $1.3 trillion, or 23%, to $6.8 trillion. Total outstanding corporate bonds increased 23% to $4.9 trillion. Total liabilities of the U.S. commercial banks have increased 16% to $6.3 trillion, although, (as discussed in great detail previously) the preponderance of credit creation has been outside of traditional banking sector liability expansion. Money market fund assets have increased 36% to $1.7 trillion. Total GSE liabilities have expanded recklessly, surging 52% to almost $1.9 trillion. Outstanding asset-backed securities have increased 34% to $1.75 trillion. Finance company liabilities have increased 37% to $1.1 trillion, while total Securities Brokers and Dealers community liabilities have increased $263 billion, or 28%. Mutual fund holdings have increased 54% to $4.8 trillion, since 1998’s third quarter.

And with credit excess fueling historic trade deficits, the accumulation of foreign liabilities has been nothing short of astounding (frightening). At the end of the third quarter, the “Rest of the World” held $7 trillion of U.S. financial assets, having increased by 35% ($1.8 trillion) in just two years. Foreign holdings of agency securities have surged 70% to more than $500 billion. Holdings of U.S. corporate bonds have jumped 57% to $950 billion, while equities holdings have increased 80% to $1.7 trillion. Holdings of “Miscellaneous” financial assets have risen 45% to $1.7 trillion. Granted, such an explosion of foreign liabilities works like magic (as it did in Mexico, SE Asia, Russia, Argentina, Turkey, etc.) as long as one’s currency holds its value. But make no mistake, foreign debt accumulations in the current global environment dominated by leveraging and “hot money” flows is just piling up the tinder for the inevitable firestorm. We just can’t help but to think that sparks are now coming from the derivatives marketplace – equity, interest rate, currency and energy. And with the total notional value of the global over-the-counter derivatives market now surpassing $100 trillion (compared to $70 trillion in mid-1998), the system is in truly uncharted waters. It’s all about maintaining confidence, an increasingly difficult proposition. We see big trouble brewing, and a major financial accident is only a matter of time…