11/24/2000 This Time it IS Different.Edmund McCarthy *

This old curmudgeon never expected to write the phrase above. More and more, however, it is apparent that the credit expansion which has financed the unparalleled boom rapidly approaching a decade in duration in the United States is different this time.

WHAT IS DIFFERENT TO SOMEONE WITH MANY YEARS OF CREDIT EXPERIENCE IS THE COMPLETE LACK OF OR DISAPPEARANCE OF THE PRINCIPLES OF CREDIT WHICH WE AND EVERY OTHER CREDIT GRANTOR IN YEARS GONE BY WERE TAUGHT BEFORE EVER PENNING APPROVAL!

THE PRINCIPLES WERE KNOWN AS THE "C’s" OF CREDIT! WE LOOK IN VAIN IN CURRENT CREDIT GRANTING METHODOLOGY FOR SUCH PRINCIPLES AS "CHARACTER", "CAPITAL" ETC.

Players have learned that it made sense to "engineer" credit so that it required no lender capital, reserves or regulatory scrutiny. In addition, this credit is "engineered" without any of the principles above being observed and utilized.

Instead of these time-honored principles, Wall Street has enshrined a new one "Cession". This term emanates from the insurance industry; the notion being to cede risk to another entity or, in common parlance, a "Reinsurer". Nothing new; just an adaptation.

THE ONLY PROBLEM IS THAT THIS ADAPTATION HAS RESULTED IN MULTI-TRILLIONS OF DOLLARS OF ORGINATED DEBT IN THE LAST DECADE HAVING BEEN "CEDED". THE DEBT SO TURNED INTO "JETSAM" IS OWNED BY HOLDERS IN DUE COURSE WHO HAVE NO POSSIBILITY OF EXERCISING ANY OF THE PRINCIPLES, IT WOULD TAKE A FAR GREATER OPTIMIST THAN THE WRITER TO THINK THAT THE ORIGINATORS EXERCISED SUCH PRINCIPLES!

The debt so ceded ranges across the entire spectrum of capital/liquidity applicants. It also ranges from the simple to mind twistingly complex in the extent of the engineering. Much of the more complex could not have been accomplished without the other miracle of engineering of the last decade - "derivatives".

It would be possible to bore the reader with all kinds of statistics on kinds of debt, totals of such kinds etc. There are better sources than this writer. What we will try to do hereafter is to look at the Wonderful World of Cession in amplitude or risk and disregard of the aforementioned "Principles".

1.Securities of Government Sponsored Enterprises

The most plain vanilla , the two major Government Sponsored enterprises, are now multi-trillion in debt and guarantees. We start with Fannie and Freddie on the assumption, valid or not, that they have the lowest probability of holders confronting default and loss. (The Pax Congressional recently announced may even diminish for a while the possibility of market loss.) The measurement of the two entities as having a low level of default risk is on the assumption, valid or otherwise, that they are the epitome of "TOO Big to Fail". This couples with the universal belief that (in spite of protestations to the contrary) that they are Government Guaranteed and will occasion whatever bailout is necessary, "Ginnie" IS guaranteed.

On the other hand, the GSEs are splendid examples of the abandonment of virtually all principles of credit extension. Increasingly, they buy from "Anyone". (It used to be a lot more difficult to become a seller to them.) And "anyone" clearly has little interest in orginal borrower. After all, "we do these things mathematically, you know." You don’t? You think that an originator might know more than the credit score about a borrower? How quaintly Dickensian! What is the CHARACTER of the borrower? Define character! If it’s not the credit score, what is it? It’s fascinating to visit one of the relics which actually portfolios mortgages rather than selling them, and see their equally quaint adherence to such a principle. Surely their low delinquency and default ratios are due to either luck or geography!

Trying to find CAPITAL in any part of this chain of multi-hundred billion originations annually is becoming increasingly difficult. Down payments (Capital of the borrower), have gone from low to none. There is virtually no recourse to intermediary capital. The GSEs themselves, even if they adhere to the Pax Congressional, will have capital levels far below those of the failed S&L’s of the 80’s. CAPACITY was shorthand for a convincing evaluation of the borrower's ability to service the debt in an ongoing fashion. In antediluvian credit circles, it was even annually reevaluated! What we now have is a static credit score and after we get all these hummers into a pile with a GSE imprimatur. It’s up to the OFHEO to worry.

2. Other Mortgage Credit Securities.

We have used a fairly catchall description for this sector. This, in spite of it’s being comprised of nearly endless variations and permutations coupled with similar complexity on the part of the derivatives used to engineer a large percentage of the aggregate amount outstanding since the underlying credit risk has the basic similarity in being title to a residence. We actually think that the owner of a primary residence with a real credit score at the outset may be a reasonable risk! Later stages of mutation in this sector into no or low down payment, marginal credit risks, developer engendered concentration into large projects and other unsavory variables provides for a fringe element with much greater risk. Generally, however, this oldest and longest established form of credit done with full or partial abandonment of the Principles is subject to less risk of default and loss with growing exceptions. An imponderable risk is in the derivatives which cling like lampreys to much of the engineered credit. Issue by issue; these "enhancements" are held beneficial. Our problem lies in their general opacity.

AS HAS BEEN STATED TO TEDIUM PREVIOUSLY, DERIVATIVES, IN GENERAL ARE NOW NOT SUBJECT TO ANALYSIS AS A CLASS. THE SOLE REPORTING ENTITY AFTER THE DERIVATIVE ISSUER’S UION ABANDONED RESPONSIBILITY FOR SUCH REPORTING BY THE ISDA IS THE BANK FOR INTERNATIONAL SETTLEMENTS. THEIR ANNUAL REPORT WAS CANCELLED AND HAS BECOME A 3- YEAR LOOK. THE ANALYSIS OF DERIVATIVES BY INDIVIDUAL ISSUER IS POSSIBLE BUT OF LIMITED VALUE AND CLOUDED BY NETTING. OUR CONCERN IS THAT EACH DERIVATIVE MUST HAVE A COUNTERPARTY! THEY APPEAR, IN THE ONLY RECENT STUDY AVAILABLE: A MOODY’S EFFORT ON ASSET BACKED COMMERCIAL PAPER, TO INCREASINGLY BEING CONCENTRATED AS TO WRITER IN A SMALL GROUP OF EXTREMELY LARGE FINANCIAL INSTITUTIONS. THE RISK OF CONCENTRATION WAS AN OLD CREDIT "PRINCIPLE".

The mortgage credit arena suffers from the same avoidance of principles as that related in the GSE ranting above. Additionally, there is the derivative and counterparty risk. Lastly, both areas of housing credit are increasingly suspect on the basis of statistical magnitude of growth. The increase in aggregate credit in the sector is astonishingly larger than the growth in units in the housing sector. There are two reasons for the anomaly. One: Housing prices are climbing at levels far above the "inflation" reported in the CPI. This is confirmed by the OFHEO report, which had prices rising nationally at 6.8% in the year to year June 2000. In some areas, the OFHEO admitted 8-10%. Anecdotal evidence yields a multitude of areas with 20-50% annual increases. No matter what the Loan to Value, and in many cases that has increased towards or to 100%, the credit being written is increasingly suspect as to further price appreciation and at risk for significant price depreciation in any type of turndown. In the 1980’s, in the old S&L crisis, the default levels went up very rapidly as borrowers realized they were under water. We suspect that the decade of increase in prices will aggravate this phenomenon this time around. IT IS NOT DIFFERENT IN THIS RESPECT.

Two: A saving grace for this multi-trillion area of risk has always been the "seasoned credits" on the books which have a low LTV based on long periods of payments. The curmudgeons recollection is that, in the sector, LTV was in the 45-50% area. I have not seen a recent statistic on this total housing portfolio LTV but suspect that the value portion has decreased significantly. Refinancing is the other reason for the ridiculously high levels of issue creation in this most securitized of markets. In a recent study published in Grant’s Interest Rate Observer, done by the inestimable Charles Peabody of Mitchell Securities; the proportion of mortgage refinancings that have at least a 5% higher loan amount had risen from as low as 40% in 1998 to over 80% in recent months. What this implies is that the borrowers are taking out the value as quickly as it is built! We wonder if the computer models predicting default risk on which this whole financial sector is built and rated are looking at this?

Three: Holders in due course. In a totally securitized world, it is impossible to understand where this paper resides. FDIC statistics indicate that an awful lot is in the Investment portfolios in the banks in the system. With Insurance still regulated by the fifty states no such information is available on that industry but it can be inferred... The mutual fund industry has also created a fair number of vehicles. This aggregate of the three, however, seems insufficient to have absorbed the startling growth in the outstandings in this sector. It is our contention, largely backed by anecdotal evidence, that a significant pile of this paper has been purchased by overseas holders; particularly the GSE part of the issuance. Statistics on the massive inflow of foreign capital in the last three years are readily available. It has been a great ride for the European buyers: Wide spreads to U.S. Treasuries and, if bought at the euro’s start, 30% exchange appreciation! In a downturn, there is appreciable risk of wholesale liquidation by these holders! These holders ARE EXCHANGE RISK SENSITIVE! It is an economic downturn, they are not going to wait for the dollar to slip. The added risk is that these instruments are largely in "held for sale" portfolios in the U.S. commercial banking system. This means mark to market. Is it not possible to hypothesize that the holders are going to seek to avoid the type of hit that might occur with foreign liquidation as the starting precipitator?

So, in the end, the safest of the engineered instruments and portfolios in this era of abandonment of credit principles seem to have quite a bit of risk. Let’s proceed DOWN the risk ladder.

1. Consumer credit in its many forms.

With the exception of some "high net worth" lending and some dinosaur personal lines of credit in the local and regional banks, virtually all consumer credit is now originated, scored and securitized. We have already demonstrated in the housing arena, how such credit lacks adherence to traditional principles and will not reiterate. What is now generally acknowledged statistically is that the consumer debt burden in relation to income is at the highest level recorded. It continues to grow apace. Why? We suspect that the same game is being played as in prior credit expansions. If growth is sufficiently large; the emerging delinquencies in percentage terms always look "manageable".

CREDIT FOR THE PURCHASE OF AUTOMOBILES/TRANSPORT is one of the oldest forms of consumer credit. The principles made it one of the safer forms. It has migrated considerably. Concentration in recent years has contributed to a growing opacity. Many in the commercial banking arena have left. A number of independent providers have disappeared or been swallowed up. Except for that portion being granted by Credit Unions (Fierce competitors and the subject of whole report on the incrementing risk to these idols of the public), the bulk is securitized. Increasingly the terms of credit are going further and further out. Leasing is also a little analyzed phenomena with increasing risk as residuals have been used as a competitive weapon. Leasing is a significant part of the auto credit market, and largely a 90s product with little data on default in difficult times. It could be a wildcard in an economic downturn, weighing heavily on the ability to resell repo’s if sufficient numbers simply turn in their keys. Let’s face it; litigating massive defaults of this nature it is not cost effective! After all of the foregoing is said, however, the auto credits are probably the safest of these forms of consumer credit. They will, however, have to take cognizance of the NR 2000-76, The Regulatory agencies' proposed revision of capital rules for the treatment of residual interests. The greatest risk in auto credit is to the captives.

CREDIT CARD DEBT has also experienced tremendous concentration in recent years. The principles of credit have completely disappeared. Origination is pure marketing with growth (other than switching between the players) virtually confined to expansion down tier. This trend has occasioned many a cavil over the last few years that a blow-up was imminent. To this writer, there have been two factors mitigating against such an eventuality. The first has been the ability of the consumer to refinance the home at higher levels and find the cash to take care of the increasing problem with cards. The second is that, in fact, cardholders as a group are becoming subprime and that the marketing to that segment is, in many cases, an expansion of card credit available to cardholders in aggregate! Looking at the growth rates in cardholders and card debt outstanding for the Providians, Capital One’s and other such entities; the inescapable conclusion is that they are adding cards to the customers of the more conservative grantors. Let’s face it, the holder of a card with Wells IS NOT periodically resurveyed as a credit as long as delinquency does not intervene. If in trouble, take out a new card from one of the myriad offerings from the lower tier providers. This theorem accounts for both the unexplainable growth in outstandings and the lack of delinquencies!

In the world of securitization, these issues are ALWAYS ENGINEERED to be high investment grade if not AAA. The Agencies' aforementioned tightening on residuals could wreak havoc on the securitizer’s world. If, adopted, some of these players' ratings might be threatened. Card debt, because of its ratings. has also become a portfolio holding in the Investments held for sale. The commercial banking sector is deeply involved and the mark to market would be very painful in the event of a downgrade. Derivatives and the relative short duration of these issues have provided suitability for money market funds to enter the arena. While we will warn against the potential for "breaking the buck" from the explosive growth in holdings of asset backed commercial paper in these funds later, there is another threat from a flight from credit card paper for the reasons enumerated here which cannot be ignored.

HOME EQUITY DEBT is, by any analysis, the most perilous of this genre! The past decade has seen this hybrid of the old second mortgage grow exponentially. An aside, the only state to hold in check, Texas, was the poster child for the proof of the fact that lending on residences can be less than safe in 1980s. The writer will never forget transferring a needed staff member from Houston to Dallas after the employer had adopted a maximum equity loss policy of 5%. The employer recompensed the employee $78,000 on an $80,000 condo that went at auction for $6300. DOES ANYBODY REMEMBER THAT THE ONLY WAY TO GET THE HOUSE IF YOU ARE A HOME EQUITY LENDER IS TO PAY OUT THE FIRST MORTGAGE? In an age of discontinuity (and the aftermath of credit bubbles always is), by the time home equity lender has title, the market will guarantee that, after legal fees, commissions and assorted costs, the resulting proceeds of sale will be nil! We have been watching the activities of the former DITECH, now firmly embedded in General Motors. When you are used to selling cars and repossessing, it is easy to think that home equity is the same game. The auto giant that is accumulating sub prime home equity must be in total ignorance of the first mortgages they are going to have to confront! If one could desegregate the mighty GECC, there might be a similar story. Where are the principles? This whole market is a complete aberration in that respect. Who are the holders? We suspect that the relatively long duration means that a considerable amount of this stuff is in Insurance company portfolios. The Agencies' proposed revisions could result in downgrades. You can’t keep that kind of lower rated stuff in Insurance portfolios usually. Risk to be remembered. (On the other hand, have you seen the horrifying proposal to permit insurers to begin to stuff pension portfolios with low grade stuff! End of cycle, anyone? ) This form of credit still demands due diligence at the outset embodying some of the principles. Unfortunately, computer-driven due diligence plays a large part. The biggest problem will undoubtedly turn out to be the Loan to Value situation. The credits being granted as this form of credit still grows at an extremely rapid pace are at end of cycle appraisals. The collection process makes all the difficulties aforementioned for mortgage credit much greater. Additionally, since virtually all of it is securitized, there is, in the absence of default, no periodic or annual resurvey in accord with the principles. These holders have no idea whether home equity borrowers use proceeds not only to consolidate debt but as a re-entry vehicle into the selfsame debt. What looks like a reasonable debt to income or cash flow at the writing is likely a ridiculously untenable one in many cases thereafter.

2. Corporate Debt in it’s many forms.

Corporate debt, in this morning’s WSJ is at 83% of net worth, still below it’s early 1990’s high but worrisome. More worrisome is the mix and the uses of corporate debt in recent years. Also to be remembered is that a lot of "worth" is suspect in the player’s who have used pooling in the ongoing mania. To set the stage, we will refer to a recent interview with the manager of one of the largest bond mutual fund aggregations around in which be basically advised staying away from "spread product" a euphemism for corporates. Spreads themselves are an endorsement to this viewpoint as they continuously widen.

TERM DEBT for corporates (including financial corporates) used to be the true citadel of the Principles. Relationship lending predominated and the lender was close enough to exercize the principles in an ongoing basis. This still applies in some community and a few regional commercial bank lenders. THE AREA OF HUGE GROWTH IN THIS ARENA, HOWEVER, IS IN "SYNDICATED LENDING". This game is the antithesis of lending by the principles. The writer had extensive experience with this form of lending in the late 80s/early 90s with one of the largest players. The writer’s constituency was financial institutions and they were the target of the syndicators. The mandate to these worthies was "book ‘em and sell ‘em! The due diligence, such as it was, limited to running impressive sets of numerical projections and flogging the output. I labeled their favorite off takers "tourists banks" since their acquaintance with what they were buying was about the same as the average tourist has with the Statue of Liberty. Since the writer had to take the risk that the buying banks would fund for the life of the deal; there were fights aplenty as the writer turned down the "future funding risk"! Fortunately in that era, the Japanese banks were open all night and much of the junk being peddled was absorbed there before things got too hot. In those days, the game was funding "buyouts" i.e. compete with Milken. The results were disastrous. These days, it’s to finance fiber optic for every kid in outer Nebraska and buy back the stock of the borrower. It will end as badly or worse! That the OCC has a team travelling the nation to look at the dreck that has been purchased says enough as they, like the agencies which rate bonds, are a lagging indicator. A difference from the prior era’s is the inclusion of Wall Street firms in the game. Last time they had to compete with "junk bonds"; this time they are in the thick of the syndicated lending fray. Since every analyst rates banks on fees not interest differential, they have to maintain position in syndicated. Is this not a perfect scenario for complete abandonment of the principles? The other wild card this time around is the number of foreign (primarily European not Japanese) banks in this game both on the loans themselves as well as on the frequently accompanying derivatives. So far, the expansion of the balance sheets in dollars of their U.S. entities has been extremely beneficial when translated into euro’s at home. If the dollar ever does plateau, could there be a drought as these worthies exit; presumably at a time of increased stress and increased demand for liquidity. Lastly, as long as whatever remains of this stuff (what they couldn’t even find a stupid buyer for) is on the books as a loan; all they have to do is frustrate the regulator. If it is ever forced into mark to market mode as it should be, trouble ahead. The other imponderable is where all the money to complete that telecom build out is coming from.

COMMERCIAL PAPER AND ASSET BACKED COMMERCIAL PAPER is an area of increasing concern. The growth in this arena is accelerating. Such acceleration in the face of high short-term rates and an allegedly slowing economy is a sign of strain not growth. Naked commercial paper (the kind that isn’t asset backed) is a fascinating reversion to the days when banks issued their own notes. Some of the larger bank holding companies are in this game. A suspension of disbelief on the part of the buyer is a necessary ingredient. What is truly fascinating in the last decade is how the issuance is financed. Remember. The writer’s aphorism for the new era of "unprincipled" credit is to do the stuff without capital, reserves or regulatory supervision. Commercial paper takes it a step further. That step is the explosion of money market funds (buyers) who make it possible for institutions to create these funds. The game can be played entirely outside the traditional money system. Wall St. (including the large banks) can do this on a self-perpetuating basis. For standard commercial paper there is the requirement to get a compliant rating agency to come up with a Prime 1 or equivalent. To any rational person, the fees charged for lines to get such ratings border on the ridiculous; from 6 or 7 BASIS points for the AA to 10-15 for the BBB. The grasping for fees for the analysts has brought this to a perilous level. Do the arithmetic. How much do you have to have to recover one loss. Can’t be done.

More fascinating is the absolute reversing of the principles in the relatively new asset backed marked. In this arena, parlous credits are packaged, enhanced, shrouded with derivatives, rated Prime and then sold to the money market funds. This is where we think the buck will be broken. By the time this dance has been completed, the holders in due course; i.e. the lenders, have no idea who the borrower is much less what the character of the borrower might be. The borrower's capacity to repay is also unknown but suspect given all the enhancements required. Capital is limited to the enhancements and they are computer generated. Essentially the lender is lending on a rating. In the last few months the writer has asked numerous holders of "money market" accounts if they have any idea of what proportion of their funds are backed by this paper. I have yet to meet one who had the first clue and the usual reply was that the writer had a screw loose to worry about it. Greenspan won’t let them take a loss! This area is also the one I would posit as having the greatest divergence from the fundamental principles of credit. The underlying borrowers represent a mongrel mix of subprime cards, autos and home equity, a variety of leasing deals of dubious capital and capacity. Also missing is any question of character. Some stuff that otherwise might be syndicated is also to be found. It seems as if this is the new device or vehicle for credit, which is difficult to otherwise find a home. Here in money market land, virtually anything can be financially engineered into a rated piece of paper. The fund manager, in search of the last basis point to outperform competitors is the last bastion. Guess how vigilant the due diligence is? I haven’t had the opportunity to deposition one of these managers but have no doubt some plaintiff’s attorney eventually will. My guess is that they have no more idea of what is in their portfolio than the poor ultimate lender, the public owner of the money market account. This toxic waste may total $600 billion and growing apace. From what I have read, it is flying below virtually all radars. Think of it, a perpetual money machine throwing off vast fee income, usable for virtually any form of credit and susceptible to finance at prime short-term rates. Nothing else comes close except General Electric Capital AAA and Prime1+.

THE INESCAPABLE CONCLUSION TO ALL OF THE ABOVE IS THAT CREDIT IS DIFFERENT THIS TIME. THERE ARE LITERALLY TRILLIONS IN CREDIT WHICH HAVE BEEN ORIGINATED AND SOLD ON PARAMETERS DERIVED FROM COMPUTER DRIVEN FORMULAS TO END LENDERS WHO ARE UNABLE TO UNDERSTAND, ANALYZE AND TRACK WHAT THEY HAVE BOUGHT. NO REGULATORY ENTITY CAN AGGREGATE AND EXAMINE THE SITUATION MUCH LESS THE PUBLIC.

There is tremendous incentive for all players to keep the game going. One of the other PRINCIPLES we were taught was that if credit grew fast enough; the delinquencies would not catch up. BUT THERE IS ALWAYS A LIMIT. Are we at or near it? Impossible to predict.

The signs of approach to a limit are multiplying in yield spreads, default rates, particularly in the corporate sector and illiquidity for some forms of issuance. The whole subject of credit outside the United States could take up a book. Nevertheless, it is apparent that there are growing strains in 1998-rescued Asia and Latin America. At the first quarter rate of $150 billion for the quarter in net change in foreign-owned assets in the United States, we are absorbing the lion’s share of global credit creation. The telecom build out to come is in the hundreds of billions. The writer will go out on a limb and say that we are certainly more than 75% through this credit bubble creation. I do NOT underestimate the ability of the financial engineers to find the next instrument for the next few hundred billion but would definitely say we are much nearer the end than the popular conception. With the belief in the Greenspan Universal Put, the end will be prolonged, THE FINALFALLOUT WILL NOT BE PRETTY, WILL SPARE NO CREDIT SECTOR AND WILL PROBABLY BE UNPRECEDENTED IN FEROCITY. CREDIT BUBBLES NEVER END GENTLY!

Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company

11/17/2000 U.S. High-Yield Lending... *

The political turmoil continued unabated this week as we are still waiting to find out who will be the next President of the United States. For the week, the Dow and the S&P500 were both unchanged. The Transports rallied 4%, and the Morgan Stanley Cyclical index remained unchanged. The defensive Utilities continued to rally and added 2%. The small cap Russell 2000 and S&P400 Mid-cap indices were unchanged. Biotechs were busted for another 12% on top of last week’s 8%. Technology did a bit better this week as the NASDAQ100 rose 2 percent and the Semiconductors 8%. The Street.com Internet index bucked the trend and was hit for 9%. The financial stocks were mostly lower, with the Bloomberg Wall Street index dropping 2%, and the S&P Bank index declining 8 percent. For the gold shares, it was another normal week with the XAU falling 3%.

I have often pondered the concept of Gresham’s Law, or that “bad money drives out good.” The long bull run in the dollar certainly makes a very good case for this “law,” particularly versus the old money mainstay – gold. We will, however, save that discussion for another day. As explained by The New Palgrave Dictionary of Economics, Gresham’s Law “denotes that well-ascertained principle of currency which is forcibly though not quite adequately expressed in the dictum – ‘bad money drives out good.’ It has also not infrequently been explained by the statement that where two media of exchange come into circulation together the more valuable will tend to disappear.”

In the contemporary environment where “money” is little more than electronic IOUs (liabilities) from financial institutions and intermediaries, I believe a more applicable “law” would hold that “bad lending drives out good.” Certainly, we have seen exactly such a situation develop over this protracted cycle as Wall Street has grabbed the reins of the money and credit creation process. While traditional finance sought to profit from lending prudently, today’s game is all about voluminous fee-based security issuance, sophisticated vehicles and structures and, of course, lots of derivative products. Quality was been completely sacrificed for quantity. In the process, the investment banker and “rocket scientist” derivative specialist has come to dominate the monetary system, supplanting the local loan officer. And while lending for investment into cash-flow- generating enterprises was the business of the local banker, the volume seeking Wall Street banker specifically pursues enterprises with negative cash flows that will require continuous financings. After all, the “best” clients are those that “keep coming back to the trough.” Besides, as Wall Street thinking goes, if the marketplace does become nervous about the soundness of securities (as it is today) doesn’t that just provide more opportunities for “our derivative department down the hall” to peddle credit insurance? Why has it not been absolutely obvious that this was no way to run a financial system?

With Wall Street at the helm, there are many examples supporting a contemporary Gresham’s Law of “bad lending drives out good.” In the New Age of growth-based lending, the “opportunities” have been in “structured finance” where huge fees and “gain on sale profits” are achieved through mountains of subprime consumer loans, telecom receivables, equipment leases, and such. In the “old days,” the marketplace would endeavor to finance sound capital investment. In the New Age, it is much more expedient to finance corporate stock buybacks and mergers and acquisitions. While it may be quite difficult to identify enough sound capital investments to meet lending and fee quotas, it’s no problem whatsoever when the goal is financing asset inflation. Asset inflation provides the Wall Street banker with seemingly endless lending “opportunities.” After all, why deal with financing new plant and equipment, when all the lending volume one could ever dream about can easily be achieved funding a real estate boom? Furthermore, why finance any other type of capital project (oil and gas refineries and electrical generation facilities, for example) when one massive telecommunications build- out provides a once-in-a-career source of infinite client fees?

Well, all this nonsense was allowed to go on for too long and to unimaginable extremes. Now, most unfortunately, the inevitable bust is knocking at the door. At the core of the problem is the fact that for too many years the marginal loan has been of very poor quality. Granted, through the “alchemy of modern finance,” these loans were packaged in a manner that enticed buyers, and all the lending did create one huge financial and economic boom. But the cost of this historic credit excess – mountains of poor loans – is, as we have explained many times, a maladjusted economy and a fragile financial system. For the hundreds (thousands?) of cash-burning companies created during this protracted cycle, there is now the harsh reality that the junk bond market is closed and most banks are running for cover. The “money spigot” is rapidly closing and many, many companies will not survive the unfolding credit crunch. For the aggressive lenders, it will be years of credit losses, impairment, and a fight for survival. It appears the situation is just beginning to “set in.”

This week, the Chicago Tribune quoted Bank One’s Jamie Dimon as saying “credit is deteriorating quarter by quarter and we expect it to continue.” There was also important confirmation this week that credit problems have taken a decided “turn for the worst” from lending heavyweights Bank of America and First Union. Interestingly, the media and Wall Street were apparently “shocked” by the news, which means they obviously have not been paying attention. We actually get the sense that bankers have been stunned by the rapidity of the credit downturn – the old “deer in the headlights” – with little understanding of how to deal with unfolding developments. But recognize their great dilemma: After having basically created their own huge client base of cash-burning clients during this long boom, do they now make the difficult (but inevitable) decision to “cut them off” – a terminal decision for dependent borrowers – or do the lenders continue to “throw good money after bad.” Yes, the latter decision does postpone the day of reckoning, but what a day it will be…

When the article ran on January 4th of this year, I immediately printed it and filed it. I must have been thinking, as I often do, that “this is one for the time capsule!” I am referring to a Bloomberg article “U.S. High-Yield Lending Hits Record in 1999, Telecoms Line Up.” I pulled it from the file this week as it underscores better than anything else the dimensions of the predicament now confronting the U.S. financial system.

The article began: “U.S companies lined up for a record amount of high-yield debt in 1999, buoyed by many communications companies taking advantage of lenders’ eagerness to lend money for expansion and acquisitions. Nextel Communications Inc., Global Crossing Ltd. and Level 3 Communications Inc. were among companies taking out high-yield loans last year, helping push (high yield) lending to $391 billion from $329 billion in 1998, according to Securities Data Corp. Companies borrowed $1.05 trillion in 1999 up from $1.04 trillion in 1998 and just shy of 1997’s record $1.1 trillion.”

There was also this key sentence: “A reluctance by high yield bond investors to buy bonds of some telecommunications companies…led them to the loan market, bankers said.” It is just unbelievable that the aggressive banking community was so eager to step up to the plate and extend enormous amounts of funding, especially in the face of a credit market that was clearly signaling trouble on the horizon.

The Bloomberg article also quoted a head of a Wall Street syndicated loan department: “The growth in leveraged lending has been fueled by telecom companies and their rapacious need for capital. Telecom companies need money for network expansion. If the bond market isn't there, they'll go to the bank market for cash. Demand continued in the fourth quarter, 752 high-yield and investment grade loans worth $25.4 billion were made as concerns also faded that the date change to 2000 might roil markets, prompting lenders to open their wallets. The co-head of another Wall Street loan department stated: “As the quarter moved on, people got less and less concerned that there would be problems. People were able to get good deals off the ground.”

“Chase and Bank of America were the top two lenders to telecommunications companies, accounting for more than half the amount borrowed. Goldman Sachs & Co. and Toronto Dominion Bank were third and fourth with 8.6 percent and 7.1 percent market share respectively. Almost 400 companies with low credit ratings organized high-yielding loans in the fourth quarter. High yield, or leveraged, loans jumped to $112 billion from $86.3 billion.”

“High-yield loans are popular among companies that can't sell bonds or stock to raise money. The loans, which are less risky than junk bonds, are also growing in popularity among funds and insurance companies looking for high-yielding investments. The number of investment vehicles buying loans rose from 64 in 1997 to 149 in 1999, according to (Portfolio Management Data’s (PMD)) research. They include collateralized loan and debt obligations, or CLOs and CDOs -- securities backed by corporate debt -- which have grown from 19 in 1997 to 42 last year, according to PMD.”

I also saved the January 10th American Banker that included an article titled, “Syndicated Lending closes Out ‘90s on a Tear.” “What a year 1999 was for the U.S. syndicated loan market. Lending topped $1 trillion for the third consecutive year. Leveraged lending, the most profitable kind of syndication soared 19% from 1998, to $391 billion, and the industry recorded its biggest deal ever: a $30 billion loan for AT&T Corp.”

Pulled from this article, “It was also the year Wall Street woke up to syndicated lending’s potential. In May, PaineWebber published “The Biggest Secret of Wall Street,” a 44-page report that labeled syndicated lending ‘the largest, highest fee generating, and most profitable corporate financing business” on the Street.”

The American Banker also quoted a Wall Street analyst: “Syndicated lending is changing the way the banking industry provides loans – period. It’s the most flexible form of financing there is and the quickest way to raise money.”

Numbers that will come back to haunt the U.S. financial system, total issuance of syndicated bank loans surpassed $1 trillion during 1999, making two consecutive years of trillion dollar loan syndications. Chase Manhattan $349,154,000,000, Bank of America $217,237,000,000, Salomon Smith Barney $93,304,000,000, JPMorgan $57,459,000,000, and Bank One $48,118,000,000. Comparing to 1998, Chase increased syndicated loan issuance by 28% and Bank America by 23%. In the midst of an historic speculative run throughout the technology sector, Bank of America issued $123 billion of syndicated loans and Chase Manhattan issued $113 billion. And while Chase was ranked #1 in total loans, Bank America had the most loan packages at 794. Year 2000 got off to a big start, with almost $120 billion of syndicated loans made during January.

Closely associated with the unprecedented boom in risky lending has been the proliferation of credit derivatives and credit insurance. It’s been quite a game – create the risk, and then develop and market products that supposedly protect against it. As such, we took note of a recent Bloomberg article by David Wigan and Tom Kohn “Credit Derivatives Boom as Bonds Dip.” The article stated that “sales of credit derivatives may increase by 50 percent this year as investors try to protect themselves…” A head of a Wall Street derivative shop was quoted as saying, “for holders of (corporate) loans and bonds, they could be a real life saver in this environment.” This same individual estimated that the market for credit derivatives has actually surpassed $1 trillion.

Wow! Why does this so remind us of the proliferation of derivative products and sophisticated strategies in SE Asia and Russia (at the peak of their booms!)? Derivatives were major factors in the absolute fiascos created with the inevitable collapse of all the leverage and acutely fragile structures? As we have stated in the past, derivatives in no way reduce risk for the system as a whole (they actually increase systemic risk!), but only shift it to other parties. And, importantly, in the midst of boom-time speculative markets, risk is often shifted to parties (speculators) with little wherewithal to deal with losses in the event of a major market disturbance. That was certainly the case in SE Asia and Russia, where great risk was shifted to highly leveraged financial speculators who were quickly destroyed when liquidity faltered and markets buckled. There is just no doubt that the enormous amounts of derivatives and associated dynamic hedging strategies played an instrumental role in collapsing markets. Yet, amazingly, no lessons were learned from the spectacular counter party defaults in Asia and, particularly, in Russia.

So, today we are looking at a market for credit derivatives estimated to now surpass $1 trillion, as well as the thinly capitalized GSEs that have guaranteed “timely payment of principle and interest” on more than $1.8 trillion of mortgages-backs. Add to this, a truly staggering amount of credit insurance written by a host of aggressive financial institutions. The two largest credit insurers are MBIA and Ambac Financial. MBIA now has net (gross insurance less amount reinsured) insurance written – “Net Debt Service Outstanding” – of a staggering $670 billion. These policies are supported by a “capital base” of $4.4 billion, thus creating a “capital ratio” of 152:1. At Ambac, net insurance – “New Financial Guarantees in Force” – of $402 billion is supported by “capital” of $2.7 billion, or 149:1. So, for these two credit insurance behemoths, over $1 trillion of credit insurance has been written, supported by a capital base of $7 billion. I will leave you to ponder how valuable all of the credit derivatives, guarantees, and credit insurance will be in the event of the type of major financial and economic dislocation that I believe is the inevitable consequence of truly unprecedented excesses.

And while we are on the subject of derivatives, Joe Niedzielski, of Dow Jones newswire, penned an excellent article today “Xerox In Talks With Counter party on Derivatives.” Niedzielski’s piece highlighted how the company is faced with “constrained access to the capital markets and is essentially shut off” from the commercial paper market. At the same time, “…Xerox may also be on the hook for $240 million of derivatives if its credit rating falls to junk status. On that score, the company’s fate is in the hands of Moody’s investors Service and Standard & Poor’s.” In Xerox’s filing with the SEC, it disclosed that it might be required to repurchase these derivatives from counter parties if it loses its investment grade ratings. A Xerox spokesman stated that the company is currently negotiating with its counter parties. The article also stated that Xerox has “drawn down $5.3 billion of its $7 billion bank credit line.” The company anticipates that it will need “another $1.1 billion during the rest of the year to refinance its commercial paper, medium-term notes and maturing bank debt.” This is a particularly poor position to be in, especially considering the unfolding market environment. Xerox should be a loud wake-up call to the complacent.

Over the coming weeks and months, it will be interesting (and critically important) to see if market confidence wanes regarding the mountains of credit derivatives and credit insurance. If and when sentiment turns, we would not want to be left holding asset-backed securities, asset-backed commercial paper, or any of the sophisticated “paper” created during this bubble. With the very poor initial quality of so much boom-time lending, and with the dramatic deterioration in the general credit environment, there are enormous quantities of securities in the marketplace backed by weak (and weakening) underlying loans/collateral. It may be triple-A, but “buyer beware.”

A few weeks ago I wrote a commentary (see archives - Sept. 29, 2000 Tale of Two Bubbles) underscoring the extraordinary circumstance where the bursting of the technology bubble was occurring concomitant with a continued expansion of an historic real estate bubble. This unfortunate dynamic clearly continues. This week, Fannie Mae reported that it increased its mortgage portfolio by $12.6 billion during October, an annualized rate of almost 27%, and the largest growth since August of 1999 (which, by the way was a month where liquidity faltered within the credit market!). Interestingly, the average balance of “other investments” increased $4 billion to $59 billion. Average “other investment” balances have increased $9 billion (18%) in the last two months. Once again, it is the ironic and dangerous circumstance that heightened stress in the U.S. financial system leads only to greater excess from the mortgage finance superstructure. The real estate bubble grows by the month, greatly increasing the risk to the U.S. financial system and economy.

Tuesday, The Los Angeles Times ran a story written by Daryl Strickland titled “Home Prices Continue to Rise in Region.”

“Los Angeles and Orange County home prices grew at a torrid pace in October over the same month last year, suggesting that the tumult in the stock market and emerging signs of a national economic slowdown have yet to faze the region's housing market. Last month's surging prices--marked by double-digit percentage gains in nearly every housing category--also set the stage for robust home sales in the last two months of the year, a time when the market typically tapers off.
The median price for homes in Orange County soared 16% from October 1999 to a record $284,000. The median in Los Angeles County grew 10% to $203,000, according to a report released Monday by DataQuick Information Systems, a La Jolla research firm.”

The article stated that the continued real estate boom was related to record employment of California workers, with 16 million employed through October, as well as wealth effects from selling stock and stock options. Another factor was a shortage of homes on the market, with only 3.3 months currently available. The article also quoted DataQuick’s John Karevoll: “I think we're due for continued price increases and high sales levels. I don't see anything changing.”

The California Association of Realtors reported that “the median price of an existing, single-family detached home in California during the third-quarter of 2000 was $247,450, the highest on record…the median price in Santa Clara hit $532,710, a 28.4% increase from the same period a year ago. For the entire state, the median price increased $27,690, or almost 13%, from a year ago. Condo prices jumped $23,230, or 14%. Prices rose sharply in virtually all regions and price levels. There was also yesterday’s Business Wire story, “California Luxury Home Values See Largest Gains of the Year.” “According to the Index, the average value of a Bay Area luxury home during the third quarter of 2000 jumped 14.5% over the previous quarter and passed the $2 million market for the first time in history…third quarter index figures also reflect a 33.3% increase since the beginning of the year…”

Again, it is just stunning how the unfolding collapse of the technology bubble has to this point simply created greater amounts of cheap credit to exacerbate an historic real estate bubble. This creates a major problem for the Fed. And with continued excess mortgage finance feeding directly into destabilizing housing inflation, it is another clear of example of how our system has seen “bad lending drive out good.” As I have written before, the current U.S. financial system could not be more dysfunctional with its unrelenting fueling of asset inflation and speculative bubbles. I will conclude with an interesting exchange between Bloomberg and Chase Manhattan’s Vice Chairman Jimmy Lee:

“What we’ve got now is a ‘stealth’ credit crunch because it’s snuck up on people. Someone said it’s worse than the 1998 credit crunch and maybe we don’t know it yet because it hasn’t affected the consumer. But it shows up in credit spreads. The credit spreads in many asset classes are wider than they have been since 1991 and that has seized up many of the asset classes.”

Is Chase pulling back in lending to riskier ventures?

“We don’t change our overall philosophy. What we do is mark-to-market our day-to-day behavior and try and stay in the market albeit on different terms. These are the periods when we can add a lot of value for the customer. When capital is plentiful, there’s not as much differentiation as there is in the period right now. It’s the nature of our business. We have always believed that you have to be in the market at all times for your client, only on different terms and conditions.”

Is Chase turning down more loans?

“I wouldn’t say we’re turning down any more or less. There are much tougher terms in the market. There are wider spreads, higher collateral and greater fees. We turn down a lot anyway.”

“I’m working on a very large financing at the moment, acquisition financing. We’re trying to reshift our ideas and our philosophy, asking ‘where can we make money in this type of market? I spend a lot of time in the private equity and LBO markets…”

As stated earlier, lenders will be forced to make the decision of whether or not to “throw good money after bad.” Things are turning sour.

11/10/2000 Monetary Processes and Current Vulnerabilities *

A political crisis was the last thing the stock market needed. For the week, the Dow declined 2% and the S&P500 4%. The Transports declined 2% and the Morgan Stanley Cyclical index 3%. Bucking the trend, the defensive Morgan Stanley Consumer index and the Utilities added 2%. The small cap Russell 2000 and S&P400 Mid-cap indices sank 5%. Biotechs were clipped for 8%. Throughout the technology sector, it was a rout. For the week, the NASDAQ100 dropped 13%, the Morgan Stanley High Tech index 14%, and the Semiconductors 15%. The Street.com Internet index was hit for 18%, and the NASDAQ Telecommunications index 12%. The financial stocks were mixed, with the Bloomberg Wall Street index dropping 4%, while the S&P Bank index declined only 1%.

Treasury prices rose unimpressively in the face of a faltering stock market. For the week, Treasury yields declined between 3 and 4 basis points between 2 and 10-year maturities, while the long bond yield actually increased a basis point. Mortgage-back yields generally declined 2 basis points. Notably, agency securities underperformed, with yields actually rising one basis point this week. The benchmark 10-year dollar swap began to move, widening 7 basis points for the week. Ominously, the 10-year swap spread widened 5 basis points today. The dollar had a slight gain for the week and gold suffered a small decline.

“Plenty of money never fails to make trade flourish; because, where money is plentiful, the people in general are thereby enabled, and will not fail to be as much greater consumers of everything, as such plenty of money can make them.” Jacob Vanderlint, Money Answers All Things, 1734.

“The use of banks has been the best method yet practiced for the increase of money.” John Law (1671-1729)

“The paper credit which, with such encomiums to themselves they boast to have set up, what effects has it produced, but only to lull the nation asleep, while the ready money that should even carry on our common business, has been exported? …Can this imaginary wealth stand the shock of a sudden calamity?” Charles Davenant (1656-1714)

“When a State has arrived at the highest point of wealth…it will inevitably fall into poverty by the ordinary course of things. The too great abundance of money, which so long as it last forms the power of States, throws them back imperceptibly but naturally into poverty.” From Richard Cantillon’s Essai (written between 1730 and 1734)

It is our basic premise that the U.S. monetary system (as well as global) is both fundamentally and severely flawed, and that an extremely unstable system again finds itself acutely vulnerable. Particularly here in the U.S., the preponderance of monetary expansion has come to revolve around asset price inflation. This is unsustainable, dysfunctional, and should today be recognized as a big problem. It is furthermore our strong contention that the very foundation of current economic prosperity is overwhelmingly monetary in nature. The boom has not been the consequence of new technologies, New Economies, New Eras or New Paradigms, and, as well, it is certainly not due to some miraculous increase in productivity. Instead, this has been primarily a historic financial bubble fueled by extreme money and credit inflation – or stated another way: absolutely reckless lending and speculative excess.

The boom has created little in the way of true economic wealth, but instead only the seduction of a massive inflation in perceived financial wealth; just mountains of financial claims. In fact, the source of this fateful boom is conspicuous in the data. Since 1995, broad money supply has increased a staggering $2.6 trillion, or 60%. Total credit market instruments have surged an astounding $9.3 trillion, or 54%, to $26.5 trillion. And, most unfortunately, since 1998, extraordinary excess has regressed into an absolute monetary fiasco, with broad money supply having jumped $1.5 trillion (27%) and credit market instrument $5.3 trillion (25%). Today, it is our strongly held view that we are falling head first into what should be appreciated as a very complex monetary crisis, the inevitable consequence of nurturing years of runaway credit bubble excess. It is, moreover, quite disconcerting to recognize how ill prepared we are as a country – citizens, businessmen, politicians, investors, central bankers and, particularly, the financial sector.

We have before compared the present cycle to John Law’s great Mississippi Bubble in France around 1720. Law, of course, introduced paper money and a “managed currency” system that fostered manic financial speculation and a spectacular bubble. This unsound boom abruptly gave way to an inevitable devastating financial and economic bust, discrediting John Law, his monetary theories and banks generally. This week, I am again highlighting monetary theory, hoping to shed further light on the gravity both for what has transpired and for what lies ahead. For valuable insights into Law’s system and monetary theory in general, one of our favorite sources is Dr. Douglas Vickers’ Studies in the Theory of Money 1690-1776, first published in 1959. We will use a few quotes and analysis that are particularly pertinent today: note that a key aspect of Law’s failed system was a monetary authority with responsibility for regulating money supply.

“The central theoretical argument behind (John) Laws’ banking proposals was concerned with the regulation of the supply of bank money to the demand for it in such a way that the desired and physically potential volume of trade may be realized (“by this money the people may be employed”) and the value of the currency maintained.” Douglas Vickers, The Theory of Money

“This paper money will not fall in value as silver money has fallen or may fall…But the commission giving out what sums are demanded, and taking back what sums are offered to be returned; this paper money will keep its value, and there will always be as much money as there is occasion or imployment for, and no more.” John Law

“This principle of the issue of notes and their return to the issuing authority dependent on the needs of trade was to recur in the later history of banking theory. The fallacy now, as later, lay in the failure to recognize that the reflux of notes gave the issuing authority power to contract its outstanding issue, but did not in any way compel it to do so. The assumption upon which the contrary proposition is based is that businessmen’s demands for currency for trade purposes could be regarded as independent of the actions of the monetary authorities. It was on precisely the fact that interdependent relationships within the monetary system did exist, however, that the purely theoretical adequacy of Law’s proposal foundered. Douglas Vickers, The Theory of Money

This is a key paragraph from Dr. Vickers. Importantly, John Law’s Mississippi Bubble was destined to fail as it lacked appreciation for “interdependent relationships within the monetary system” - or monetary processes. Law admitted as much after the spectacular collapse in 1720: “There are good reasons to think that the nature of money is not yet rightly understood.” For too long the Fed has acted to peg short-term interest-rates and ensure “adequate liquidity in the marketplace” - basically nurturing leveraged speculation - without regard for the monetary processes set in motion that have come to structurally impair the U.S. financial system and economy through a massive inflation in money and credit.

From the current feeble understanding (and lack of interest) in the nature of monetary processes, it is clear that there has been a most unfortunate disregard for history; that many harsh lessons have been forgotten over the past 280 years. We don’t know if the current monetary boom is, like Law’s scheme, a big monetary experiment gone terribly awry, or if it has simply been a case of a reckless and wildcat financial sector combined with ineptness and negligence from the Greenspan Federal Reserve. Either way, there are clear and quite disconcerting parallels between these two booms. I will try to highlight some of the key monetary aspects that I believe clearly illuminate the serious flaws and vulnerabilities in the current monetary system.

“In the first place, the essence of Law’s scheme was his proposal for the monetization of certain existing assets…in the second place, Law’s proposal to base the issue of notes on the security of the value of land begs the essential question of the stability of value of the land itself. Quite apart from changes in real asset values dependent upon growth or variation in their intrinsic income-producing potential, the money value of the assets could change as did the availability of the notes of issue themselves. The theoretical possibility existed of an unlimited expansion of the note issue, pari passu with an induced and cumulative upward movement in the money values of the assets eligible as security.” Douglas Vickers, The Theory of Money

John Law, like today’s Federal Reserve, did not appreciate the momentous role played by the ease of availability of money and credit, and the inflationary effect on prices from the over issuance of money and credit instruments. This is particularly the case for asset prices when they are the actual “backing” for monetary expansion. It should be obvious that monetary processes in such a situation work to foster a self-feeding boom (and endemic speculation) where money and credit excess begets asset inflation that begets greater collateral values for only more monetary excess. Also, for Law as well as currently, there was a lack of understanding as to the momentous role played by the widespread acceptability of financial instruments as a store of value, as well as the profound importance of general confidence in precipitating boom and bust dynamics.

“John Law’s theory of the value of money was a variant of the familiar supply-and-demand theory. It was by maintaining a stable relationship between the demand for money and its supply that the stability of value of the proposed bank money was to be preserved. More particularly, the value of money meant its value in exchange, and it is this conception which was most important for exchange, and it is this conception which was most important for Law’s general theory of monetary circulation. But money was understood as having both an exchange value and what might be termed an asset or wealth value. As to the latter, the stability of value depended, in the first place, on the stability of value of the asset backing…But there did not exist, unfortunately, a direct and logical harmony or stabilizing relationship between these wealth and exchange values respectively. This was because the distribution of the demand for the asset security on wealth account would not necessarily be the same as the distribution of the demand for money on transactions or income account. It was more likely, indeed, that disturbances in the transactions supply and demand would arise and would set up a disequilibrating action and reaction on the asset values. Quite apart from fluctuation in the volume or frequency of trading exchanges, discontinuities in payments habits could be expected to arise. (Admittedly, not the easiest paragraph to get through.) Douglas Vickers, The Theory of Money

But the need for the projected stability of both the wealth value and the exchange value of money turned finally on the same requirement: namely, it was desired that money should serve as a measure in exchange and as a store of value in the sense that “it could be kept without loss” and the possession of it should confer on the owner the right and the ability to “purchase other goods as he had occasion for, in whole or in part, at home or abroad.” Money should be the link between places and occasions geographically and temporally separate.” Douglas Vickers, The Theory of Money

“The increasing supply of new money there was based not on real asset values as had been proposed in theory, but on public confidence in scrip and share values on the one hand and on legal sanctions as to the acceptability on the other.” Douglas Vickers, The Theory of Money

“It was noted in our earlier discussion of John Law’s similar proposals that he had failed to see that the valuation of the security against which bank notes were to be issued would not remain independent of the issue of the notes themselves.” Douglas Vickers, The Theory of Money

Some leading apologists for the Fed (and the great monetary inflation generally) have argued that the omnipotent Fed has successfully followed a so-called “Price Rule,” where the central bank navigates an increase in money supply in a manner as to maintain stable consumer prices (sounds like John Law’s scheme to us!). At the same time, money and credit excess are completely ignored. There is also not even contemplation for the profound ramifications of the creation of massive financial obligations (including $1.7 trillion in money market assets), much of which are assumed to provide a store of value for their holders. It is even strongly argued that the Fed should ignore the stock market and asset inflation generally. Well, it should be obvious by now that disregarding asset inflation - as well as the resulting distortions to the financial system and economy, and the role played by complex monetary processes - has been a momentous analytical and policy blunder.

“There existed, and had to be taken into account, something of a money illusion. After examining the excesses of John Law’s schemes of money creation, and after pointing out that ‘by a glut of paper, the prices of things must rise,’ (George) Berkeley continues: Whence also the fortunes of men must encrease in denomination, though not in value; whence pride, idleness and beggary.’ The money-wealth illusion was a disincentive to productive effort, and it led ultimately to the general lowering of the prosperity of the economy. This situation, moreover, induced directly a wasteful import demand for luxury commodities and led to the kind of strain on the country’s balance of payments…” Douglas Vickers, The Theory of Money

“It was not the circulation of a large supply of money as such which was troublesome, but the overissue as compared with the real requirements of trade and industry.” George Berkeley from Vickers’ The Theory of Money

“Circulating paper” was recognized as the “true evil” in the “ruinous schemes of France and England” (France’s Mississippi Bubble and England’s South Sea Bubble) specifically because the overwhelming purpose of extreme money and credit creation was for speculating in stock and real estate prices, with little regard for actual industry. The current U.S. bubble could not more closely parallel those infamous bubbles in regard to credit excess thriving predominantly outside of industry. When this bubble bursts, many will certainly ponder the incredible resources wasted in constructing office buildings, mansions, sports complexes, entertainment venues and the like.

Interestingly, very pertinent analysis was provided by one of the “first economists” who, by the way, was a contemporary of John Law and made a fortune from Law’s bubble (by recognizing the inflationary forces and the fundamental flaws in his system, he sold before the collapse!). Richard Cantillon’s brilliance was captured in his Essai, written between 1730 and 1734. His work provided a great leap forward in monetary process analysis:

“Market prices, money prices, and levels of activity and employment were not to be regarded as homogenous variables. The Essai is interested in the structure of market prices, the structure of market supply conditions, and the structure of activity in the economy. The corollary of this is that the movement of the economic process itself depended on the structure of its own determining forces. As Cantillon argued at length, the description of the process will necessarily differ, following, for example, an increase in the supply of money, depending on the direction from which the stimulus to change has come, and depending also on the differing dispositions, notably consumption habits, of the persons through whose hand the higher flow of money and incomes passes. Douglas Vickers, The Theory of Money

“If mines of gold or silver be found in a State and considerable quantities of minerals drawn from them, the proprietor of these mines, the undertakers, and all those who work there, will not fail to increase their expenses in proportion to the wealth and profit they make; they will also lend at interest the sums of money which they have over and above what they need to spend. All this money, whether lent or spent, will enter into circulation and will not fail to raise the price of products and merchandise in all the channels of circulation which it enters. Increased money will bring increased expenditures and this will cause an increase of market prices.” From Richard Cantillon’s Essai

“Several propositions emerge from this statement. In the first place, the increased consumption which occurs is understood to be made “in proportion to” the increase in incomes enjoyed by the ‘entrepreneurs’ and workers involved, that is, ‘in proportion to the wealth and profit they make.’ Secondly, it is clearly supposed that whatever proportion of this increased money income is not spent directly by the income receivers will be lent on the money and capital markets so that, in the outcome, all the additional money supply will be maintained in circulation. There is a division of incomes into consumption on the one hand and investment on the other. On the one hand, there is a progression from an increased money supply to increases in turn in incomes, consumption, and commodity prices and, on the other hand, a similar progression of induced effects except that savings and investment replace consumption.” Douglas Vickers, The Theory of Money

“Cantillon here envisages, moreover, not merely a change in the size of the stock of money, but an altered rate of flow of money in circulation…Cantillon points out that the varying proportions in which prices will rise in the various ‘channels of circulation’ and the altered structure of prices which will result from the process, will depend on the point at which the injection of new money enters the economic system and on the different consumption habits and dispositions to spend of the successive income recipients. The differential impact on the economic system of the increased stream of money payments will depend at each stage of the process on ‘the idea of those who acquire the money.’” Douglas Vickers, The Theory of Money

We believe the analyses in the previous two paragraphs are particularly powerful and certainly quite relevant for the current bubble. Critically, Wall Street has been the epicenter for unprecedented money and credit excess throughout this boom cycle, especially during its latter (“terminal stage of credit excess”) stages. Accordingly, the “channels of monetary circulation” have been (virtually by definition) extraordinarily short-term and speculative in nature, as well as being directed specifically to asset markets. (Predominantly stocks, credit market instruments and real estate). This is a key factor – the creation of inherently unstable monetary flows - that goes completely unappreciated by the economic community. It is, however, anything but a small matter that the flow of extreme monetary excess is orchestrated by securities firms, the GSEs, and the aggressive “growth stock” lenders (that through securitizations push their mountains of risky loans onto the marketplace). It should be clear that such a system creates highly speculative monetary flows and suspect financial claims, as well as significant economic consequences. Indeed, the present “channels of monetary circulation” are could not be more divergent from what would develop with traditional lending, where prudent “local” bankers endeavor to make only sound loans, fully expecting to live with their lending decisions until maturity.

Indeed, a basic premise of our analysis is that speculative Wall Street money and credit excess - dysfunctional “channels of monetary circulation” - have been behind the historic Internet/telecommunications/technology bubble that is today in grave danger. Such flows have created highly destabilizing booms and busts in the markeplace, as well fostering extreme overspending (malinvestment/misallocation of resources) that has manifested into the present environment of over competition and rapidly deteriorating profits throughout the entire industry. Wall Street excess – with an unyielding mission to both peddle securities and derivatives products and actively trade - set in motion monetary processes that has led to devastating structural distortions throughout the entire savings and investment process, with terrible damage done to both the financial system and economy.

“The important thing for the dynamic monetary analysis is that each such divergence becomes what we have called a proximate cause of change. The ultimate causes of change subsists in the ‘humours and fancies of men’ and in the changes in the level and structure of consumption expenditures following changes, for example, in the level and rate of flow of money and thus in the level of incomes.” Douglas Vickers, The Theory of Money

“The continuance of the monetary inflation process, as distinct from its inception, is therefore price-induced via the increased profit margins in the several lines of production. Moreover, there enters at this point a further concept as to entrepreneurial action. In establishing or extending new lines of manufacturing or other activity, entrepreneurial decisions are dependent not only on a realized level of profitability, but also no such anticipations of future demand…” Douglas Vickers, The Theory of Money

“As a result of the expansion the economy has not only been lifted on to a higher level of activity, but the structure of activity itself has been changed.” Douglas Vickers, The Theory of Money

It has been estimated that the hedge fund community has ballooned to almost one-half trillion dollars in assets (and much larger positions!). Add to this the trillions of dollars of assets (their own holdings as well as managed client assets) that have accumulated at the securities firms, money center banks, and financial conglomerates (and let’s not forget the ultra-powerful GSEs!), and the frightening enormity of the leveraged speculating community become apparent. The unfathomable leverage created though speculating in rising financial asset prices and interest-rate arbitrage is simply unparalleled in financial history. As such, the role played by the leveraged speculators throughout the monetary process cannot be overstated. Unfortunately, never before have such powerful mechanisms existed to “leverage” the “humours and fancies of men,” and it is simply unbelievable that the speculating community was allowed to completely alter the dynamics of monetary systems and economies, none more than here at home.

Above, we touched upon the financial and economic distortions that develop naturally from the massive speculative flows. It should also be recognized that the leveraged speculating community has come to be the virtual provider of liquidity for the financial markets at this late stage in the cycle – the creator of the monetary fuel to keep inflated asset prices (stocks, credit market securities, real estate, etc.) levitated. Thus, there is today a critical dilemma posed by the leveraged speculating community’s rise to dominance: financial system liquidity is acutely vulnerable to any reduction in the growth of leveraged players’ holdings. In short, the great U.S. Bubble is now hopelessly dependent on continued extreme and speculative credit excess for survival.

This creates today an extremely tenuous (dangerous) financial environment. Importantly, with the technology bubble in collapse, the heavily exposed leveraged speculating community is finding itself increasingly impaired. Impairment is a keen problem for highly leveraged players with “little room for error.” Up to this point, losses have been somewhat mitigated by major rallies in the credit market (particularly mortgage-backs and agency securities) and the dollar. So the good news is tech and junk bond losses have thus far not been “terminal” for the aggressive speculators; the potentially very bad news, however, is that the leveraged players remain today highly exposed to selling in fixed-income or to any sudden downturn in the U.S. currency. And with the upside in the credit market and the dollar seemingly limited at this point, we suspect that the leveraged speculators (outside, of course, of the GSEs!) would like to move to rein in risk. The problem is that the leveraged speculating community has basically become The Market for mortgage paper, agency securities, and dollar denominated assets generally. While we see deteriorating financial conditions forcing the leveraged players to move to liquidate positions and offload risk, we just don’t know “to whom.” As goes the leveraged players, so goes financial system liquidity

A further pertinent quote from Richard Cantillon:

“If more money continues to be drawn from the mines all prices will owing to this abundance rise to such a point that not only will the landowners raise their rents considerably when the leases expire and resume their old style of living, increasing proportionably the wages of their servants, but the mechanics and workmen will raise the prices of their articles so high that there will be a considerable profit in buying them from the foreigner who makes them much more cheaply. This will naturally induce several people to import many manufactured articles made in foreign countries, where they will be found very cheap; this will gradually ruin the mechanics and manufacturers of the state who will not be able to maintain themselves there by working at such low prices owing to the dearness of living.”

“When the excessive abundance of money…has diminished the inhabitants of the state, accustomed those who remain to a too large expenditure, raised the produce of the land and the labour of workmen to excesses prices, ruined the manufactures of the state by the use of foreign productions on the part of landlords and mine workers, the money produced by the mines will necessarily go abroad to pay for the imports: this will gradually impoverish the State…The great circulation of money, which was general at the beginning, ceases; poverty and misery follow and the labour of the mines appears to be only to the advantage of those employed upon them and the foreigners who profit thereby.”

As discussed in previous commentaries, it is our view that the leveraged speculating community has today enormous exposure to the dollar. This now keeps us continually fearful of a major financial accident. And with massive current account deficits combining with years of severe structural damage to the U.S. financial system and underlying economy, there is no way around the fact that dollar confidence hangs in the balance. The current political environment certainly does not help. It is not a case of if there will be a dollar crisis, but when.

And while we’re discussing potential crises, we pulled some “fun facts” from a Fannie Mae release from earlier this week:

“Speaking to reporters in conjunction with Fannie Mae’s 16th annual meeting with its Asian debt and equity investors, Raines said that since 1998 the company has issued a total of $179.7 billion in non-callable Benchmark Notes and Benchmark Bonds. Raines said that international investors have been central to the success of these issues. Since the inception of the Benchmark program, international investors have purchased 33 percent of all Benchmark Notes and Benchmark Bonds issued, with approximately 14 percent going to Asian investors.”

“Howard noted that international investors, including Asian institutions, already have taken advantage of Fannie Mae Benchmark Securities in a variety of market transactions. ‘The exceptional liquidity and price transparency of Benchmark Bills, Benchmark Notes, and Benchmark Bonds encourage their use by investors as trading, hedging, duration management and financing vehicles,’ said Howard. ‘Futures and options on Fannie Mae Benchmark Securities are traded on the Chicago Board of Trade, and we have seen the development of a strong term repo financing market for the securities.”

The enormous holdings of U.S. financial assets by foreign investors/speculators is quite disconcerting, posing great systemic risk in the event of any change in perceptions as the soundness of the dollar and the U.S. economy and financial system generally. Granted, the GSE’s and financial sector’s aggressive overseas borrowings have worked marvelously in “recycling” massive trade deficits while dollar confidence has remained strong. These borrowings, however, have considerable potential to be highly destabilizing come a change in sentiment. Furthermore, only time will tell as to the extent of agency securities held by the leveraged speculating community. We presume they are massive, and perhaps the speculators will continue to gravitate to these securities, thus perpetuating the U.S. real estate bubble. But that will truly only provide fuel for the absolute worst-case scenario for the U.S. financial system and economy. I take no pleasure in “yelling fire in a crowded theater,” but I am fully committed to “calling them as I see them.” The way things are developing, it certainly does not take a wild imagination to envision a 1998-style financial crisis where, simultaneously, stocks sink, credit markets turn illiquid, and the dollar buckles. Such a scenario would be devastating to the leveraged speculating community, as well as the acutely vulnerable U.S. financial system. We’ve truly entered a “high risk zone.”

11/03/2000 Financial Dysfunctions *

Liquidity returned to the stock market this week, with a major rally throughout the technology sector. For the week, the NASDAQ100 gained 5%, the Morgan Stanley High Tech index 6% (y-t-d gain 4%), and the Semiconductors 8%. The Street.com Internet index surged 15%, while the NASDAQ Telecommunications index added 3%. The biotech bubble expanded, with this week’s 9% jump increasing year-to-date gains to 98% (52-week 193%). The blue chips were strong as well, with the Dow adding 2% to its recent gains, while the S&P500 increased 3%. The economically sensitive issues shined, with the Transports surging 9% and the Morgan Stanley Cyclical index jumping 7%. The Utilities and the Morgan Stanley Consumer index increased 2%. Market strength was quite broad, as the small cap Russell 2000 jumped 6% and the S&P400 Mid-cap increased 5%(y-t-d 19%). The financial stocks were very strong as well, with the S&P Bank index gaining 7% and the Security Broker/Dealers 6%.

Recovering stock prices were not good news for the Treasury market, in what continues to be a quite unsettled credit market. Treasuries came under heavy selling pressure today. For the week, although 2-year yields remained unchanged, 5-year Treasury yields jumped 7 basis points and the key 10-year yield surged 11 basis points. Long-bond yields increased 12 basis points. Mortgage-backs and agencies again outperformed, with yields rising between 3 and 7 basis points. The benchmark 10-year dollar swap spread narrowed 6 basis points to 108. Junk bond spreads generally narrowed a few basis points, while high-quality corporate spreads narrowed as much as 8 basis points. Global currency markets are extraordinarily volatile also, with the dollar this week coming under the most selling pressure in some time. Today the European central bank again intervened to support the euro. The dollar index dropped almost 2% this week. Emerging markets, particularly in Latin America, appear to experiencing a problematic loss of liquidity.

“Every era of speculation brings forth a crop of theories designed to justify the speculation, and speculative slogans are easily seized upon. The term “new era” was the slogan for the 1927-1929 period. We were in a new era in which old economic laws were suspended…We were troubled also in 1928-29 by the weird doctrine…that it was the business of central banks to maintain a fixed commodity price level, and that central banks must not concern themselves with the stock market and must not tighten credit to restrain stock market excesses because that would reduce commodity prices.” Benjamin M. Anderson, Economics and the Public Welfare 1949

“We were told, moreover, by Professor Irving Fisher that we were on a “higher plateau” of stock exchange prices.” Benjamin M. Anderson, Economics and the Public Welfare 1949

As I have written previously, it is my view that we are at the precipice of a financial and economic crisis unlike anything seen in this country since the collapse of the 1920’s bubble. Of course, to possess such a view today is tantamount to lunacy in the eyes of the unwavering bullish consensus. That’s fine. After all, leading economists, Wall Street prognosticators, media pundits, government officials and Federal Reserve members could not have been more wrong in their analysis of the late 1920s boom. So, how could they have only envisaged “permanent prosperity” when the economic train was steamrolling directly into the Great Depression?

Granted, after the publishing of Milton Friedman’s and Anna Schwartz’s The Monetary History of the United States, it became accepted doctrine that the Depression was to be blamed squarely on the Federal Reserve’s failure to expand money supply after the downturn commenced. This is both erroneous and most unfortunate analysis, but we’ll save that discussion for another day. Suffice it to say, the causes of the Great Depression predominantly emanated from the extreme nature of excesses during the preceding boom, and the resulting financial fragility and economic distortions and imbalances both in the U.S. and globally. Importantly, it is my view that spectacular booms are actually almost always a manifestation of extraordinary underlying inflationary forces. Specifically, destabilizing circumstances within the credit system lie behind sharply rising asset prices – and that asset inflation plays an increasing (and self-reinforcing) role over time, as a typical business cycle expansion develops into a precarious Bubble Economy. And with contemporary monetary systems “backed” by assets such as real estate, stocks, and marketable credit securities, money and credit excess feed systematically into higher asset prices. Asset inflation then begets only more inflation as additional collateral value provides for even greater borrowing and spending – creating a self-feeding “Bubble Economy.” In Bubble Economies, the great inflation is specifically not in consumer goods prices, but instead in stocks, bonds, homes, office buildings, sports franchises, media properties, vintage automobiles, yachts, collectables, and a myriad of other assets.

A crucial dilemma, particularly during periods of prominent financial asset inflations, is that rising financial wealth (inflation) is so alluring, and no one has a vested interest in identifying the inflationary source, let alone bringing it to an end. Of course, it is exactly the opposite, with huge vested interests determined to perpetuate asset bubbles. Certainly, Wall Street and Washington have an overly passionate love affair with asset inflation. I feel almost silly writing such a notion – that someone would endeavor to stop asset prices from rising. But thwarting asset inflation is a fundamental prerequisite to financial and economic stability, and precisely why we seek an “independent” central bank. Of course, with a culture of “optimism,” new technologies or notions of New Eras provide a seductive explanation for inflating asset prices; apparently, and quite problematically, even for current central bankers.

So, to answer the question: How could so many intelligent and knowledgeable individuals have completely misunderstood the 1920’s boom? Well, they were convinced that surging stock and real estate market prices were, in the great wisdom of the marketplace, “discounting the future” – that rising prices were an undeniable confirmation of sound underpinnings and a paradigm shift of improved fundamentals. Yet, bullish analysis could not have diverged more diametrically from what would prove a very harsh future reality. Missed was A Rather Simple Maxim: Bubbling asset prices are specifically the consequence of extraordinarily unsound factors - the inflationary manifestation of an increasingly dysfunctional credit system and a central bank having lost control of the monetary system.

We are great fans of Benjamin M. Anderson’s Economics and the Public Welfare, first published in 1949, and will share a few paragraphs of his book to illuminate the similarities between now and the 1920’s. Dr. Anderson was a brilliant student of money, banking and credit, and became a leading economist and writer, including a stint at Chase National from 1920-1939. From the foreword by Arthur Kemp: “ In this history, Anderson touches upon practically every aspect of commercial banking and, in almost every instance, he takes a position that might be called, for lack of a better name, “sound banking principles,” which means he regarded the banking business as a regulated but private enterprise, not as an instrument for economic, social, and political experimentation by government.” His views and analysis of the excesses from the 1920’s could simply not be more pertinent today.

“Where the Federal Reserve banks bought tens of millions for a few days, in connection with the first three liberty loans, they bought hundreds of millions and held them for many months in 1922, 1924, and 1927. And where the Bank of England had primarily used its open market operations for the purpose of tightening its money market in prewar days, the Federal Reserve System used them deliberately for the purpose of relaxing the money market and stimulating bank expansion in 1924 and 1927. At a time when unusual circumstances called for extra caution, they abandoned old standards and became daring innovators in the effort to play God.”

Consistent with our premise that most spectacular asset inflations are credit-induced and indicative of an inherently unsound environment, the current Fed has repeated the same critical policy errors made in the 1920’s – they “abandoned old standards and became daring innovators.” Instead of implementing “extra caution” over the years, within the context of a global financial system with an incredible proclivity of fostering spectacular credit and speculation-induced booms and devastating busts (U.S. late 80’s, Japan 80’s, Mexico, SE Asia, Russia and Latin America and, of course, the U.S. (again) in the 90’s), the Fed could not have been more accommodating of money, credit, and speculative excess. Additionally, with unparalleled financial innovation and expansion (particularly derivatives, “structured finance,” and leveraged speculation generally), these unusual circumstances shouted for “extra caution.” We got the exact opposite. Then, with the inevitable collapsing of bubbles globally, caution was absolutely “thrown to the wind” as the Fed accommodated the greatest credit and speculative excess in history over the past two years. Most likely as justification for inept policy, New Era thinking was adopted at the top of the Fed.

“Stock prices were already high in the summer of 1927. There was an unhealthy tone. There was a growing belief that stocks, though high, were going much higher. There was an increasing readiness to use cheap money in stock speculation. The situation was still manageable. The intoxication was manifest, not so much in violent behavior as in slightly heightened color and increasing loquacity. The delirium was yet to come. It was waiting for another great dose of the intoxicant.” 185

Our current experience is a circumstance disconcertingly similar to the events leading to the Great Depression. The apex of the 1920’s U.S. financial and economic boom transpired within an acutely vulnerable global financial backdrop. Indeed, it was financial and economic frailty encompassing the world that played a key role in fateful central bank acquiescence, particularly in 1927. Again, if the global environment were not so precarious and commodity deflation prevalent, it is highly unlikely that the Federal Reserve would have nurtured the late 1920’s rampant money and credit growth, the fuel for historic stock market speculation and a Bubble Economy. I argue that were it not for the acute financial and economic fragility globally, going back to the early 1990’s but particularly during 1998, the Fed would have not accommodated historic money and credit excess – the fuel for history’s greatest financial and economic bubble. It is also my view that if it were not for weak global demand and the resulting downward pressure for prices in the energy sector, basic commodities, technology components, and manufactured goods (global disinflation/deflation) during recent years, domestic consumer price pressures would have likely kept the Fed much more vigilant (and isolated from silly notions of New Eras.)

“Investor’s Money vs. Bank Expansion. It was not easy to convince investment bankers and bond dealers in the period 1925-29 that it was commercial bank expansion which was generating the demand for the securities which they were selling. They insisted, and correctly, that real investors’ money was coming in, and that a great many securities were being bought outright. They were impressed by the statistics showing the growth of stock and bond collateral loans in the banks, the growth of bank ownership of bonds, and the growth of bank deposits, but they still insisted that they were selling to investors. But here is a typical case where one could trace every step of the process. An old lady in Missouri held a mortgage which she had inherited from her father. A Missouri Joint Stock Loan Bank floated a bond issue in New York, receiving cash for it, part of which came out of a syndicate loan which the underwriters placed with New York banks, and for which they got a deposit credit. The deposit was transferred to a great Missouri city, and from there to the smaller place where the old lady lived, and the mortgage which she held was refunded at a lower rate of interest by the Joint Stock Land Bank, and she was paid off. She first placed the money on deposit with the local bank, and then wrote a kinsman in a New York bank, sending a check which she asked to have placed in good bonds for her. Here was true investor’s cash coming out of savings. The old lady’s father had saved that money sixty years before. It was a displaced old investment. Newly created money sweeping out of New York had displaced her investment, and her investment funds came back to New York for reinvestment.”

This is a powerful paragraph, although it may take more than one reading to appreciate (another “dense quote from a long-dead economist”). It came to mind when we read that $15.5 billion “poured” into mutual funds this week. Actually, I often ponder the mechanisms the allow broad money supply to expand by over $400 billion this year, while the household savings rate has turned negative and our economy runs massive trade deficits. What is the source of all this “money” when households aren’t saving and dollars leave the country in droves? Well, the source is blatant and unrelenting money and credit excess. And with large amounts of liquidity again flowing into mutual funds, all we can say is that we have “been to this movie before.” The title is “Reliquefication,” and it is no coincidence that fund flows are concomitant with the strongest level of mortgage refinancings in about 16 months. If this sounds familiar, that’s because it’s a remake of the popular “hit” from the autumn of 1998. The financial sector (particularly the GSEs), responding to faltering financial conditions, creates enormous new liabilities as they aggressively increase holdings of financial assets, spreading liquidity both near and far. While it may appear to mutual fund managers that real investor money is flowing into mutual funds and buying stocks, the root source of this liquidity is unadulterated inflationary money creation.

The GSEs (like Pavlov’s dogs) aggressively expand holdings at any sign of financial distress, a situation that has basically remained in force throughout much of the past two years. This is a key example of how, particularly in the present environment, underlying (and intensifying) systemic problems actually foster only heightened excess that manifests into increased system-wide money and credit creation. As the GSEs aggressively purchase mortgage securities and other debt instruments, mortgage rates (and market rates generally), as we have seen, decline sharply. This “intervention,” importantly, sets off a series of processes. First of all, open market purchases of mortgages, mortgage-backs and other debt securities provide the previous holders (banks, Wall Street firms, hedge funds, etc.) liquidity to pay down debt and/or to purchase other securities (credit card and other asset-backed securities?). Forceful mortgage purchases by the GSEs also encourage the leveraged speculators to take positions, while it also leads to active speculative and hedging-related trading in the interest-rate derivative market. These are powerful liquidity creating mechanisms within the financial system.

And, importantly, sharply lower mortgage rates also incite a refinancing boom, a particularly potent force of “reliquefication” currently, after homeowners have experienced significant capital gains from extraordinary housing inflation. In 1988, it was estimated that the average individual refinancing her mortgage extracted $15,000 of equity to “buy a hot stock – take a vacation.” This provided incredible, if unappreciated, fuel for what became an historic speculative bubble that pushed the economy over the edge into full-fledged historic “bubble” status. Ironically, the present “reliquefication” is directly in response to the collapse of the Internet/telecom/tech bubble fueled by the 1998 “reliquefication.” What a dysfunctional system…

“Speculation in real estate and securities was growing rapidly, and a very considerable part of the supposed income of the people which was sustaining our retail and other markets was coming, not from wages and salaries, rents and royalties, interest and dividends, but from capital gains on stocks, bonds, and real estate, which men were treating as ordinary income and spending in increasing degree in luxurious consumption. The time for us to pull up was already overdue…we could prolong it for a time by further bank expansion and by further cheap money policies, but only at the cost of creating a desperately difficult situation at a later time.”

“It must be said, by the way, that the widow’s mortgage itself was being undermined by the extravagances of the period from 1924 to 1929. Excessive money developed speculation in every field, and very specially in the field of real estate…Real estate mortgage bonds were issued at a tremendous pace. Real estate values soared and real estate mortgages of all kinds were so rapidly multiplied that in 1932-33 the widow might well have wondered whether she would not have done better to sell her mortgage in 1929, buying stocks with the money…methods which they had found conservative and safe for forty years or more had not protected them or their clients when the whole fabric of real estate values had been undermined, and when they had given guaranties for a multiple of their capital.”

We don’t believe one can overstate the role played by the real estate finance “superstructure” as the critical source of fuel for the current bubble economy. Importantly, there is also a crucial unrecognized element in the interplay between global and domestic financial fragility and the great U.S. credit bubble. With fragile financial systems throughout the world (in many cases already ravaged by credit-induced boom/bust dynamics), there remains unusually strong demand for “safe” securities. This is certainly the case for risk-averse investors, but even more importantly for the gargantuan leveraged speculating community looking for relatively stable and highly liquid securities for their sophisticated interest arbitrage operations. Agency securities and mortgage-backs are wonderful fodder for speculation.

Certainly, no other financial system has the ability to produce virtually unlimited quantities of highly rated (triple-A) securities. And what other country can compete with our team of rating agencies, credit insurers, investment bankers and “financial engineers.” Our system is further greatly advantaged by rating agencies’ and the marketplace’s presumption of an implied government guarantee for the debt of the GSE, as well as the fact that the U.S. economy remains entrenched in its inflationary Bubble Economy status. It is certainly our view that the U.S. boom is much more the result of “manufacturing” $trillions of securities than it is producing computers and software – not even close. Lots of economies produce technology… And, as we are seeing once again, when financial markets (particularly the current corporate bond market) falter, the GSEs, and financial sector generally, move immediately to create only greater liquidity for real estate speculation and additional housing inflation. Then, through various avenues, this inflationary money and credit creation finds its way into both the stock market and real economy, as well as globally through only larger trade deficits. This is the most conspicuous and direct mechanism where weak system underpinnings foster heightened asset inflation and unsound economic expansion. The consensus would like us to believe that housing prices are rising because of new technologies and increased “productivity.” Nope, it’s pure inflation. Yes, it could be prolonged for a time by further financial sector “expansion and by further cheap money policies, but only at the cost of creating a desperately difficult situation at a later time.”

“There must be a proper balance in the international balance sheet. If foreign debts are excessive in relation to the volume of foreign trade, grave disorders can come. Moreover, the money and capital markets must be in a state of balance. When there is an excess of bank credit used as a substitute for savings, when bank credit goes in undue amounts into capital uses and speculative uses, impairing the liquidity of bank assets, or when the total volume of money and credit is expanded far beyond the growth of production and trade, disequilibria arise, and above all, the quality of credit is impaired. Confidence may be suddenly shaken and a countermovement may set in.”

Here is another extremely important and pertinent paragraph. How can one look at the present situation and not fret about unprecedented “disequilibria”? Still, there remains a deeply ingrained perception in this country that we can run $400 billion-plus current account deficits in perpetuity – that foreigners will always want to invest in the U.S.’s wondrous New Economy (trade real goods for our “paper”). This has been one momentous assumption. Well, with the tech sector faltering, we would have thought by now that there would be inklings of a change in perceptions - that some would begin to question the veracity of the notion of a New U.S. Economy. And with a less euphoric view both at home and abroad of new technologies and so-called New Economies, what are the ramifications for the U.S. dollar? We find it difficult to believe that they are constructive.

Actually, we have never bought into the idea that global investors, enamored with the New Economy, were “investing” hundreds of billions continuously into our markets. Inflows that, by the way, conveniently offset our ballooning trade deficits. Instead, we have long suspected that what has actually been developing is the greatest leveraged speculation (interest and currency arbitrage) in history – borrowing at low overseas interest rates to speculate in U.S. credit marketable securities and instruments. If we are correct, there is “clear and present danger” of a severe financial accident for the U.S. dollar and the U.S. financial system generally. The way we see it, in accounting parlance – “debits equal credits.” Or, domestic credit excess creates overheated demand for imported goods, which leads to a flood of dollars globally. These dollars, however, must go somewhere, so they are placed (recycled) right back with the aggressive U.S. financial sector that created them to begin with. It is not a coincidence that the dramatic increase in financial sector debt is matched by the increase in foreign holdings of U.S. financial assets. Again, “debits equal credits” - that foreign inflows have been the result of problematic trade deficits, not trade deficits the result of investment inflows, as some prominent supply-side economists like to claim.

Moreover, we strongly believe that money and capital markets have been in a most severe “state of imbalance,” with massive credit excess being used flagrantly as a substitute for savings. Moreover, credit has gone in undue amounts into ill-advised capital uses and speculative uses, impairing the assets and liquidity of the financial sector. The quality of credit has been irreparably impaired to such a truly enormous degree that this circumstance will inevitably manifest into a full-fledged liquidity crisis for the U.S. financial sector and dollar denominated assets generally. The combination of a bloated and increasingly impaired financial sector, with faltering system liquidity and at the same time with massive liabilities held by foreign investors and leveraged speculators, should be seen for exactly what it is: a recipe for financial disaster.

Since June, the dollar has rallied strongly. This has been a most opportune occurrence for a U.S. financial system coming under heightened stress with a very unstable stock market and a very problematic faltering of liquidity throughout the junk bond and corporate financing marketplace. Dollar strength also provided quite a nice cushion for foreign investors suffering losses on technology stocks. It is certainly our view that the dollar has been in the midst of an historical speculative bubble, fueled by massive leveraged “hot money” flows. Moreover, flows from the leveraged speculators have been augmented by dynamic hedging programs emanating from unfathomable derivative positions, in what developed into a self-reinforcing currency market dislocation. Such dynamics are inherently unstable and unsustainable, while creating extreme vulnerability to sharp reversals. Not only is the marketplace today acutely susceptible to abrupt swings in market perceptions as to the soundness of the U.S. financial system and economy, it is furthermore at risk of extreme dislocation in the event of any panic unwinding of highly leveraged positions and forced selling from dynamic hedging strategies. Remember SE Asia? “Confidence may be suddenly shaken and a countermovement may set in.”

While “reliquefication” succeeded in working its magic with stock prices this week, the dollar and Treasury markets quietly suffered their worst bout of selling in some time. This is not mere coincidence. After all, it is not inconspicuous that the reckless U.S. financial sector has set course for another round of inflationary money and credit excess. Clearly, throwing more liquidity on the real estate bubble and at the consumer sector will not come to any positive end; especially with labor markets taut and wage pressures accelerating, not to mention a dangerous housing bubble, high energy prices, and what are clearly heightened general inflationary risks. In fact, we cannot imagine a more dysfunctional circumstance: a faltering corporate bond market and unfolding credit crunch on the one hand, and continued egregious excess in mortgage and consumer finance on the other. Although the “die is cast” on the fate of the Great U.S. Credit Bubble, the financial sector is (not surprisingly) determined to prolong the bubble economy, with devastating consequences for the soundness of the real economy and the stability of the financial sector. Such a dysfunctional financial system and economy are certainly not good for the U.S. dollar. It is hard to believe that these increasingly evident circumstances can go unnoticed in the marketplace. It is, at the same time, not difficult to imagine foreign central banks increasingly losing patience with the destabilizing international dollar flows and the overbearing and dysfunctional U.S. financial sector.

We’ll conclude with a final sentence from Dr. Benjamin M. Anderson, one that is painfully frustrating and much too applicable more than 50 years later.

“Between the middle of 1922 and April 1928, without need, without justification, lightheartedly, irresponsibly, we expanded bank credit by more than twice as much (as during WWI), and in the years which followed we paid a terrible price.”