12/20/2002 Pondering the Next Shoe to Drop *

It was a rather inconclusive week in the markets, as we approach the holidays and year-end. For the week, the Dow and S&P500 added about 1%. The Utilities gained 3%, and the Morgan Stanley Cyclical index increased 2%. The Transports and Morgan Stanley Consumer indices were slightly positive. The broader market was quiet, with the small cap Russell 2000 about unchanged and the S&P400 Mid-Cap index up about 1%. The Technology sector was mixed, as the NASDAQ100 and NASDAQ Telecommunications indices added 1%. The Street.com Internet index declined 1%, the Morgan Stanley High Tech index dropped 2%, and the Semiconductors were hit for 4%. The Biotechs were up 2%. The financial stocks generally outperformed, as the Securities Broker/Dealer index increased 2% and the Banks gained 3%. Although bullion surged $7.20, the HUI Gold index was about unchanged.

The Credit market definitely caught a bid. For the week, two-year Treasury yields dropped 11 basis points to 1.73%, and five-year yields sank 14 basis points to 2.90%. The 10-year Treasury note saw its yield dip 11 basis points to 3.96%, while long-bond yields declined six basis points to 4.90%. Benchmark Mortgage-back yields dropped 12 basis points and the implied yield on agency futures dipped 14 basis points. The spread on Fannie Mae’s 5 3/8 2011 note narrowed two to 42, while the benchmark 10-year dollar swap spread declined one to 45. The yield on March 3-month Eurodollars declined four basis points to 1.37%. The CRB index gained another 1% (up 24% y-t-d!), while the dollar index declined less than 1%. The obstinate nature of post-Bubble impairment was captured in a Bloomberg headline this week from Tokyo: “All Nippon Shares Fall to the Lowest Level Since at Least 1984.”

Broad money supply (M3) was about unchanged last week, as Demand Deposits dropped $20.6 billion and Savings Deposits gained $10.3 billion. Institutional Money Fund deposits added $17.1 billion, while Large Denominated Deposits dropped $11.3 billion. Repurchase Agreements added $6.9 billion. Total Commercial Paper borrowings dropped $14.9 billion last week to $1.34 Trillion. Nonfinancial CP dipped $2.8 billion to $160 billion and financial sector CP declined $12.1 billion to $1.18 Trillion. Asset-backed CP increased $8.5 billion to $722.1 billion. Total Bank Assets surged $124 billion last week to surpass $7 Trillion. Total Bank Assets have jumped $631 billion over the past 34 weeks, 15% annualized. Last week, Bank Credit increased $70 billion, with Securities holdings up $39.9 billion (Treasury&Agency up $19.1 billion and Other up $20.8 billion). Loans and Leases rose $30.3 billion, although Commercial and Industrial loans declined $1.9 billion. Real Estate loans increased $17.2 billion and Security loans added $13 billion.

The Third-Quarter OCC (Office of the Comptroller of the Currency) Derivatives Report had total U.S. commercial bank derivative positions increasing $3.1 Trillion, or 25% annualized, to $53.2 Trillion. By Type, Interest Rate contracts expanded at a 28% rate to $45.7 Trillion, while Credit Derivatives surged 66% annualized to $573 billion. Foreign Exchange and “Other” expanded at a 2% rate to $5.8 Trillion and $1.1 Trillion. By Product, “Futures and Forwards” expanded at a 20% pace to $10.8 Trillion and Swaps at a 7% rate to $29.6 Trillion. Curiously, Options expanded at a 79% rate to $12.3 Trillion (Fannie and others purchasing interest-rate protection in the OTC options market?). Little wonder the interest rate markets have been extraordinarily volatile. Not surprisingly, JPMorgan is the largest OTC Options player, with positions doubling over the past year to $4.8 Trillion. Overall, JPMorgan’s total derivative position was up 13% y-o-y to $27 Trillion.

The December Federal Reserve Bulletin contains an interesting study, “Mortgage Refinancing in 2001 and Early 2002.” An estimated $131.6 billion of equity was extracted in the refinancing process during the 18-month period 2001 through the first-half of 2002. I will touch upon a few highlights: Forty-five percent of homeowners who refinanced in 2001 and the first half of 2002 extracted equity, compared to about 35% during 1999. The average (mean) extraction jumped from 1999’s $18,240 to $26,723. By dollar amount, 26% of extracted equity was used to Repay Debt, 35% for Home Improvements, 16% for Consumer Expenditures, 11% for Stock Market or Other Financial Investment, 10% Real Estate or Business Investment, and 2% to pay Taxes.

Along with Fannie, Freddie Mac had a big November. Freddie’s Total Mortgage Portfolio expanded at an 11.9% rate to $1.28 Trillion, the strongest pace since April. And again consistent with Fannie, Freddie’s mortgage growth was largely confined to its own balance sheet. Freddie’s retained portfolio expanded at a 29% rate, the strongest since February. Combined Fannie and Freddie retained portfolios grew at a 21% rate during November to $1.31 Trillion.

This week from Fannie Mae vice president and chief economist David Berson: “A record year for mortgage originations in 2002 is a certainty - we expect a total of $2.5 trillion in originations this year. It will be difficult to hit a new record next year, however, as the modest uptick in mortgage rates that we project will slow refinancing activity. Still, with home sales down by only 1-2 percent and home prices rising by 4-5 percent, purchase originations should set a new record in 2003. Even refinance activity will stay historically strong, especially in the first half of the year, as significant accumulated equity will keep cash-out refinacings robust - and the modest rise in interest rates should slow this part of the market only a bit. Those households that refinance in order to lower their monthly mortgage payments, however, will drop out of the market in larger numbers. Mortgage debt outstanding (MDO) growth has been extremely rapid this year, helped by record home sales, strong home price gains, and cash-out refinancings. We expect that single-family MDO will grow by about 11.5 percent in 2002, the fastest pace since 1988. Moreover, this would be the second consecutive double-digit gain (the first time since 1989). MDO growth is likely to slow next year, however, as home sales slip, home price gains decelerate, and cash out refinancings ebb. Even so, MDO growth should remain at a strong 8.5 percent pace in 2003, keeping it comfortably within our long-term projection of 8-10 percent for this decade.” (Perpetual Mortgage Finance Bubble or The Next Shoe to Drop?)

Today from the California Association of Realtors: “The median price of a home in California continued to post dramatic gains last month, and has increased by double digits every month for the past 12 months… The median price of an existing, single-family detached home… during November 2002 was $328,310, a 21.5 percent increase over the $270,210 median for November 2001… The November 2002 median price increased 1.6 percent compared to October 2002.” (Definitely a Next Shoe to Drop in the unfolding post-Bubble California quagmire.)

December 18 – Bloomberg: “Wisconsin may sell bonds to raise some of the $2 billion owed to public employee pension funds as the state cuts spending because of a $2.6 billion deficit. Plans for the 19th-largest state and its local governments to sell taxable pension bonds were proposed after Governor-elect Jim Doyle suggested in late November the state take a ‘pension holiday’ to balance its budget, said Dave Mills, deputy director of the Wisconsin Department of Employee Trust Funds.”

December 18 – Bloomberg: “The state Financial Control Board, which monitors the finances of New York City, said in a report that ‘much remains to be done’ to fill a budget gap it predicts will be $3.5 billion in the next fiscal year. The board’s estimate of the gap is about $500 million higher than the $3 billion projected by Mayor Michael Bloomberg for the fiscal year starting July 1, 200 3.”

California Governor Gray Davis Wednesday projected a $34.8 billion state fiscal deficit for the next 18 months, an alarming 45% of the general fund. Dow Jones (Stan Rosenberg) quoted the vice chairman of Fitch Ratings: “I’m just stunned at how it could go from $21 billion to $35 billion in a month.” The LA Times quoted the Republican leader of the State Assembly: “These numbers go beyond the most dire predictions and projections we were looking at.” The Democrat Senate President Pro Tem was quoted by the Sacramento Bee (John Hill): “It’s a problem of almost insurmountable proportions.” Earlier proposed cuts – including $3.1 billion to schools, $2 billion to health and social services, $1.7 billion for transportation and $1.9 billion for government administration – will be increased. Taxes and fees will be hiked. Yet the state crisis will surely only worsen. The obstinate nature of post-Bubble impairment.

I have below quoted extensively from Governor Davis’s news conference. When reading through his comments, please keep in mind our principle that Credit excess and asset-inflation severely (and seductively) affect/distort both the structure of demand and the nature of income growth. Moreover, policymaker fixation on an index of consumer prices not only completely misses the inflationary boom, relative price stability in goods and services encourages a dangerous sanguine view of manifestations such as rising asset prices and surging revenues. Only the eventual bursting of Bubbles uncovers underlying economic and financial maladjustments. Throughout the country and especially in California, an enormous inflationary bulge (particularly from the technology Bubble) stoked government receipts and, consequently, expenditures and future spending plans. But now a collapsing bubble transforms ballooning revenues into ballooning budget deficits.

Golden State receipts have sunk all the way back to pre-Bubble levels, while inflationary pressures persist on the expenditure side. Furthermore, despite the Fed and U.S. financial sector’s Herculean effort to re-inflate, divergent inflationary manifestations emerge predominantly in the real estate and healthcare sectors (with disparate affects on the nature of spending and income growth). These inflationary pressures add little to state revenues, while exacerbating wage and other employment cost pressures (and housing prices!). And, importantly, once severe inflationary distortions are imparted onto the system, monetary accommodation/inflation is impotent to provide quick fixes. Instead of impacting consumer prices, contemporary inflationary consequences are primarily of the structural impairment variety, including a dysfunctional financial sector and maladjusted/imbalanced economy.

California is an historic “textbook” example of a Bubble economy and we expect little good news going forward. The Fed’s push to sustain Credit inflation only creates additional distortions, and we are left to Ponder the ramifications for the eventual collapse of the Great California Real Estate Bubble.

Wednesday night from Governor Davis: “Fifty-one percent ($17.7 billion) of this [deficit] problem is a reduction in revenues based on predictions in our current budget. Thirty-six percent ($12.6 billion) of the problem are the one-time reductions that we used last year to solve that problem. Twelve-point-five percent ($4.5 billion) are increased expenditures…

As you well know, we have a very progressive system in this state – 80% of our revenues come from 10% of the tax earners. So, we depend heavily on the well-being of highly compensated Californians. …From 1995 to 2000 these taxpayers experienced an increase in what they were providing state government on the order of about 18% in ’95, ’96, ’97, and ’98, and then it shot up in ’99 to about 25%, and a little higher in 2000. In 2001, they actually dropped down to zero – so there was a dramatic falloff in 2001. And 2002 they are down about 3%...

But when you have a very progressive tax system – which basically exempts everyone from taxes making up to $45,000 a year – and depend heavily on the performance of the top ten percent of your wage earners, then you run the risk that, if they do badly, services have to be reduced and there’s not the revenue for other things we’d like to do in government. So, if there is one single problem that has caused this problem, this is it.

Another way of looking at it: If you just took people whose incomes exceed a million dollars, and look at the impact they’ve had on state revenues – again going back to ’95 - it was a 46% increase that year in what they contributed to state revenues. ’96 it was a 20% increase, 33% increase in 1997, 21% increase in 1998, 62% increase in 1999, 45% increase in 2000, and a drop off of 47% in 2001… That’s about a 50% drop in the revenues coming into state coffers from the millionaires in one year.

There’s another way of looking at it, because capital gains is a big part of the problem. Obviously, people that do well invest their money. Many of their investments are in the stock market. I’ve told you many times that the NASDAQ was at 5,000 in April 2000; it’s now at about 1,400 – it’s a 75 or 80% reduction… Here again, from ‘90 through '95, you have a fairly steady indication of how much money is coming into the coffers of around $20 billion. Then you have a pretty good run up from '95 up through '98 – we’re up to about $50 billion. But you never realize this until after the fact, but you have a spike in 2000 up around $110 billion. 2001 you’re back down to $40 billionish and 2002 will be less…so that’s another way of looking at the same picture.

…Even the sales tax – which is very dependable and does not depend on the higher wage earners - has diminished in recent years. Again, from ’98, ’99, you can see a slight trend upward to 2000, and a slight trend down in 2001. And in the end of 2001 a pretty significant [decline and] you’re back to where you were in 1998 or less. And then an actual reduction in 2001 and 2002 from sales tax revenues from retailers and all sorts of taxable transactions... This is usually a very dependable source of revenue. You rarely see the kinds of fluctuations you do with the income tax. But we are seeing a marked reduction…

That shows you in a snapshot that while lack of revenue is not the only reason we are confronted with a major shortfall, it is the primary reason; that, plus the expectation that things would get better quicker last year. We had a lot of one-time solutions, and we did it in part because everyone from Alan Greenspan on down was saying, “The economy will recover – it will recover in the spring of 2002. In the worst-case in the summer of 2002, but it will recover.” And so we didn’t want to savage health and welfare programs and knock people off of programs for which they are eligible when we think the economy is going to bounce back that quickly. Now, the finance department has its conference with a number of financial experts and the consensus now is that it will be very unlikely there will be a recovery in 2003 at all and we’ll have to wait until 2004… But now we are faced with a very different situation and you’ll see when I make my budget plan on January 10th, with a very different response.”

While not as dire as California, after the first two months of fiscal 2003 the federal deficit has already reached $119 billion. Year-over-year, Total (two-month) Receipts are down 12.1% to $244.6 billion, with Individual Tax Receipts declining 12.1%. Total (two-month) Spending increased 5.1% to $357.7 billion. By major department, National Defense expenditures were up 10.4%, Education & Social Welfare 13%, Health 11.1%, Medicare 13%, and Income Security 12.9%. Interest expense was down 9.7%, while Social Security was up 5.5%. After two months, the ratio of federal revenues to spending is down to 68%, an alarming decline from last year’s 82%. If this ratio does not improve dramatically, California may not be the only government with an “insurmountable” deficit problem.

December 16 – Bloomberg: “MBIA Inc., the biggest financial guaranty insurer, may have larger-than-expected losses to write down the value of collateralized debt obligations it guarantees, a Morgan Stanley analyst said. ‘Our biggest concern relates to the mark-to-market losses on collateralized debt obligations’ and the potential deterioration in the credit quality of securities MBIA insures… as of August (MBIA) guaranteed about $66 billion of collateralized debt obligations -- debt backed by a portfolio of secured or unsecured bonds or loans…”

This afternoon from Moody’s: “CDO (Collateralized Debt Obligation) exposure to the recently bankrupt Conseco Inc. exceeds US $1.2 billion, Moody’s Investors Service announced today. The agency has been and will continue to assess the extent of CDO portfolio deterioration resulting from the recent Conseco default.”

Two of the seventh largest U.S. bankruptices occurred within nine days. The reality that eyebrows were barely raised attests that it has been a truly numbing year of Credit woe. Interestingly, eight of the twelve biggest bankruptcies were filed over the past thirteen months (WorldCom, Enron, Conseco, Global Crossing, UAL, Adelphia, Kmart, and NTL). Conseco’s list of Unsecured Creditors is headed by a $1.49 billion bank loan owed to Bank of America. Further down the list are the $141.6 million and $129.8 million borrowed from Chase Manhattan and Bank of America for “Director and Officer Loans.” Former GE executive Gary Wendt was paid $53 million for his short and failed tenure.

In our analytical framework the near back-to-back bankruptcies of UAL and Conseco highlight the vigor of still unfolding Credit deterioration and systemic vulnerability. These failures definitely add to the deepening woes within the complex CDO, Credit default swap, and asset-backed securities marketplaces. It would not be surprising down the road if we learn Conseco is holding a slug of weak assets. And with a $30 billion managed portfolio of subprime manufactured housing, home equity, and Credit card loans, the company has been no small player in the (“structured finance”) risk market. There are, as well, surely additional Shoes to Drop with respect to the enormous amount of airline travel industry-related debt - from the carriers, to the vehicles and instruments created to finance the aircraft leasing boom, to the airports and municipalities that borrowed aggressively during the Bubble.

It is also worth noting the continued deterioration in subprime lending, another key systemic weak link with major ramifications for “structured finance” and the economy. With more than $11 billion of Managed Receivables, things are going from bad to worse at Metris. Receivable growth has come to a grinding halt, with the predictable consequence (as witnessed with Nextcard and others) of escalating losses. The Metris Master Trust (the conduit vehicle for the company’s asset-backed securities) saw November charge-offs jump 205 basis points to 18.61%, while delinquencies rose 53 basis points to 18.24%. Fitch lowered ratings on Metris debt yesterday and Moody’s followed today, with the viability of the company very much in question. Elsewhere, November charge-offs rose between 104 and 219 basis points for three Providian Credit card trusts. Other trust data confirm that most lenders faced rising charge-offs and delinquencies during November, providing strong confirmation of expanding subprime Credit card deterioration. Charge-offs increased 53 basis points at Capital One, despite the addition of new receivables into the trust. One can already see signs that that the abrupt slowdown in growth that is currently unearthing major Credit woes throughout subprime is making its way to Capital One.

Developments over the past two weeks have hardened our conviction that expanding Credit deterioration (specifically within structured finance) will increasingly imperil the Credit insurers. This becomes only a more critical issue in the face of rapidly escalating municipal deficits. Municipalities are now embarking on the slippery slope of issuing increasing quantities of debt of deteriorating quality. Worse yet, we expect this issuance flood to hit a marketplace increasingly skeptical of Credit insurance and structured finance. It is helpful to view the confluence of bad news from UAL, Conseco, the subprime lenders, and California in this context. California will be a major issue for muni finance and, later, mortgage finance and systemic stability.

For now, we doubt the Governor of California is alone in belatedly recognizing that the optimistic forecasts of stock market and economic recovery were supported by little more than wishful thinking. Last night from Dr. Greenspan: “And, of course, the dramatic gains in information technology have markedly improved the ability of businesses to address festering economic imbalances before they inflict significant damage.” Tell that to Gray Davis and the California legislature! Shallow rose-colored rhetoric and outright denial, as Californians will soon attest, only postpone the day of reckoning while increasing pain and hardship.

And as Greenspan again crafts “analysis” to defend what we believe will be his indefensible legacy, we at least welcome Clarification of the Failed Greenspan Doctrine. From Greenspan's latest:

“Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess. But the adverse consequences of excessive money growth for financial stability and economic performance provoked a backlash. Central banks were finally pressed to rein in overissuance of money even at the cost of considerable temporary economic disruption… The record of the past twenty years appears to underscore the observation that, although pressures for excess issuance of fiat money are chronic, a prudent monetary policy maintained over a protracted period can contain the forces of inflation… It now appears that we have learned that deflation, as well as inflation, are in the long run monetary phenomena, to extend Milton Friedman’s famous dictum.”

"Prudent monetary policy"? Well, we would argue that “the record over the past twenty years” should underscore the danger of uncontrolled Credit systems fueling asset inflation, endemic speculation, Bubbles, and unending boom and bust cycles. Financial deregulation ushered in mushrooming securities markets and the proliferation of non-bank Credit creators. Monetary Processes were forever altered, as were attendant inflationary manifestations. Accordingly, Milton Friedman’s misguided focus on Fed-controlled narrow money as a determinant of inflation or deflation should have been thoroughly discredited and long ago discarded.

The analytical focus must instead be directed to the various financial and economic affects and distortions emanating from a diverse array of Credit inflation and speculative impulses. Importantly, one of the manifestations of Credit inflation is heightened domestic and foreign capital investment, thus transforming an index of consumer goods and services prices into a particularly deceiving indicator of systemic monetary stability. And, importantly, over the past two decades we have seen an unprecedented explosion of non-bank Credit creation. Here it has been a rather clear case of easy financial profits directing intensified Credit and speculative excess right to asset markets (Credit market instruments, stocks, real estate, etc.). All one need do is look at the twenty-year explosion of Wall Street and Government-Sponsored Enterprise balance sheets – along with the unprecedented expansion of mortgage-backed securities - as an indication of the propensity for asset-based lending (in the contemporary age of unfettered Credit creation!).

We would argue that attention to the issue of government fiat money is much better directed to the critical issue of the gross inflation of financial sector liabilities (the preponderance of contemporary “money” and Credit). The Fed’s focus on the stock market Bubble as THE Bubble is similarly misplaced. In reality – and should, in hindsight, be obvious - the equity Bubble was an offshoot (inflationary manifestation) of endemic Credit inflation. Yet Greenspan continues to espouse the policy of disregarding Credit and speculative excess. Asset Bubbles are to be ignored until they pop, with a focus on quick and aggressive accommodation to “mitigate the fallout [of an asset bubble] when it occurs and, hopefully, ease the transition to the next expansion.” Such experimental central banking is anathema to sound money and stable finance, and will prove an unmitigated disaster. Such policies, as we have already witnessed, only ensure that Credit and speculative excess settle in the enticing mortgage finance arena where uncontrolled Credit creation has the capacity to go to the grossest extremes and inflict its greatest structural damage.

Greenspan states, “Among our realistically limited alternatives, dealing aggressively with the aftermath of a bubble appears the most likely to avert long-term damage to the economy.” Ironically, the momentous problem we face today is that the Fed’s aggressive post-tech/equity Bubble accommodation is sowing the seeds for financial and economic collapse. The Mortgage Finance Bubble is expanding exponentially; financial sector leverage is expanding exponentially; derivatives, Credit insurance, default swaps, and other financial guarantees are expanding exponentially; and our debt to foreign-sourced Creditors is growing exponentially. All the while, the quality of this exponential expansion of (non-productive) dollar financial claims is becoming only increasingly suspect. Additionally, we have reached the point where many sectors of the imbalanced and maladjusted economy sputter despite extreme financial excess. Even Credit-induced 4% GDP growth doesn’t do the trick. What rate of GDP expansion would today be necessary to balance the California budget? What rate of money and Credit creation would be required to end state and federal deficits? To thwart bankruptcies?

As we have repeatedly attempted to explain, the issue today is not inflation or deflation. The problem is an out of control financial system locked precariously in a Credit and speculative Bubble. And the Fed, Wall Street, and Washington are, incredibly, absolutely determined to perpetuate reckless Credit inflation and the systemic Bubble. The issue is a runaway inflationary expansion of dollar claims. There is, then, little wonder that long-term dollar prospects are nowadays being questioned, while the merits of gold (and other commodities) are seen in a new, glittering light. A bull case for gold can be made today simply by recognizing that the U.S. financial sector and Fed must inflate dollar claims to avoid collapse. Credit Bubbles must inflate or die.

Greenspan last night did make the comment, “Cash borrowed in the process of mortgage refinancing…is bound to contract at some point.” Well, we will add that the degree of extreme Credit excess we are experiencing currently in mortgage finance is indeed bound to contract one day. Wild inflationary (speculative) Bubbles invariable do collapse. And as Greenspan stated correctly, “History indicates that bubbles tend to deflate not gradually and linearly but suddenly, unpredictably, and often violently.” One of these days there will be a dramatic shift in the financial and economic landscape. In this regard, think in terms of what Governor Davis faces now that inflated state receipts have collapsed along with the tech Bubble. That the economy and financial system are today struggling in the face of unprecedented mortgage Bubble excess and extreme Credit market speculation does not bode well for the day when the Next Shoe Drops.