Monday, September 1, 2014
Perhaps it is subtle, but wild volatility appears to be giving way to even greater instability. For example, from yesterday’s lows to today’s midday highs, the Semiconductor index surged 19%, only to reverse sharply into this afternoon close. Amazingly, the Dow ended the week largely unchanged, while the S&P500 declined about 1%. The Morgan Stanley Cyclical index actually added 4% and the Morgan Stanley Consumer index increased 1%. The Utilities and Biotechs both increased 2%. The broader market moved around a lot but ended little changed, as the small cap Russell 2000 and the S&P400 mid-cap indices ended largely flat for the week. Generally, the selling remains isolated largely in the technology sector. For the week, the NASDAQ100 declined 8%, the Morgan Stanley Technology index 7%, and the Semiconductors 4%. The Street.com Internet index dropped 8% and the NASDAQ Telecommunications index sank 6%. The financial stocks were mixed, with the S&P Bank index gaining 1% and the Securities Broker/Dealer index declining 1%. The HUI gold index ended the week sporting a 5% gain.
The U.S. credit market was particularly unsettled this week, as a significant rally for most of the week surrendered to selling today. For the week, the yield on 2-year Treasuries declined 7 basis points, the 5-year yield dropped 12 basis points, and the key 10-year Treasury note sank 15 basis points. Long-bond yields dropped 11 basis points. Mortgage and agency securities have been especially volatile, although they ended the week with yields 14 and 16 basis points lower for the week, respectively. The implied yield on the June agency futures contract dropped 12 basis points Tuesday, only to shoot 10 basis points higher today. We expect current market unstable conditions to continue, mindful of what we believe are enormous speculative trades that dominate the marketplace. The dollar came under selling pressure this week, with the dollar index declining about 1% despite a faltering yen. With the ramifications of Japanese stocks at 15-year lows an inarguable negative for the Japanese banking system, there is clear risk of unpleasant market surprises going forward. The Japanese own a tremendous amount of American securities.
Broad money supply increased another $19 billion last week, making it $358 billion (almost 17% annualized) during the past 16 weeks. We see an historic mortgage-refinancing boom as continuing to play a major role in this period of extraordinary monetary excess. Bloomberg reported yesterday that prepayments on Freddie Mac mortgage-back securities jumped to record levels during February. “Prepayments on the roughly $560 billion in outstanding 30-year Freddie Mac mortgage bonds more than doubled and in some cases tripled on the largest issues, the biggest monthly rise ever, analysts said.” The incredible real estate lending boom continues, with dire consequences for the soundness of the U.S. economy and financial system.
This week, The Office of Federal Housing Enterprise Oversight (OFHEO) released its Fourth Quarter 2000 House Price Index. The data confirms continued strong housing inflation throughout the country. Nationwide, prices increased 1.8% during the fourth quarter and have increased 8.1% during the past year. The data is broken down by eight regions: New England, Pacific, Middle Atlantic, Mountain, West North Central, South Atlantic, West South Central, East North Central, and East South Central. Interestingly, and indicative of systemic real estate lending excess, West South Central (Arkansas, Louisiana, Oklahoma, Texas) demonstrated the weakest pricing gains during the quarter, with prices still rising at better than 5% annualized. For the quarter, prices rose at a rate of 10% in New England, 9.2% in Pacific, 7.2% in Middle Atlantic, 6.8% Mountain and East South Central, 5.6% in both West North Central and East North Central. These gains, however, do not do justice to the degree of housing inflation experienced during this boom. According to OFHEO, 5-year price gains have been 42.3% in New England, 36.7% in Pacific, 24.9% in Middle Atlantic, 30.7% Mountain, 25.2% East South Central, 25.9% West North Central, and 31% East North Central. Is this not sufficient data to demonstrate an historic nationwide real estate bubble? The Fed, however, is trapped in policy that perpetuates historic lending excess.
Not surprising considering incredible money and credit creation – especially in the consumer mortgage sector - February auto sales surprised analysts, coming in much stronger than expected. Total vehicle sales were at a solid 17.5 million rate during the month, an increase from January’s 17.2 million. The story continues to be the strong market share gains by the foreign nameplates. Compared to near record sales last February, GM units sold dropped 9.5%, Ford 10.8% and DaimlerChrysler 10.5%. Elsewhere, it was a much different story. Toyota sold vehicles at a rate slightly above last February. Lexus had its best-ever February, with sales almost 7% above last year. BMW enjoyed sales 14% above last year, an acceleration from strong sales in January. Honda posted its best-ever February with sales more than 9% above last year. Acura had a record February, with sales up almost 41%. Year-to-data, Acura sales are running 39% above year-2000. Audi also had a record February, as sales increased 5%. Kia sales were 10% above last February, and are up 22% year-to-date. Hyundai announced a record February, with sales up 34% from last year. Volkswagen had its second best February in 20 years. Mazda sales were up 18%, and are running up 25% year-to-date. Porsche had a record February, selling 13% more vehicles than it did one year ago. Year-over-year sales gains were experienced at Audi and Infinity. While year-to-date domestic vehicle sales have dropped more than 8%, imported vehicle sales are down less than 1%. Year-to-date, “Big Three sales have dropped 10%, while Japanese sales are slightly positive and Korean sales have surged 31%.
I highlight “more than you want to know” auto sales detail as I think it underscores the complexity of the current environment. There is a very fine line between doing well and struggling – a fine line between profits and losses, success and failure. It is certainly an acutely competitive environment, but there remains strong demand in some sectors of the economy. The bottom line is that U.S. auto manufactures are not competing well against foreign nameplates. And with auto and housing demand relatively robust, as well as running massive trade deficits, all the talk of recession is not only superficial, it misses the key point that this is anything but a garden-variety downturn. As the technology sector falls deep into an historic industry bust, consumer- spending demand remains generally solid, for now, with some signs even pointing to a recovery in the manufacturing sector. Clearly, heightened pricing pressures show little sign of abating. This week’s report on personal income (up 0.6%) and spending (0.7%) were both very strong, and indicative of a very atypical environment.
Despite inflationary pressures and strong income and spending growth, the Fed has chosen to respond forcefully to the faltering technology and manufacturing sector. The collapse of one bubble fuels the greater bubble. Lower rates create more demand for homes and more money for consumers to spend from housing equity extraction, but it’s not going to help the failing Internet companies. It will also not create more demand for routers, fiber optics, etc. That boom is bust. It is also, importantly, not creating much demand so far for technology stocks. This week, interestingly, had the feel of a major inflection point where the hitherto technology bust began to develop into a major financial event. If this proves not to have been such an inflection point, this only means it is postponed temporarily. The stocks of the Wall Street firms have been under heavy pressure and financial stocks generally are looking increasingly vulnerable. The marketplace is now signaling acute financial fragility.
If anything, we see this highly maladjusted and imbalanced economy as much the wild animal that will respond unpredictably to aggressive Fed accommodation. The key point to recognize today is that the Fed is dealing with a very unstable economy and financial system and has few tools and little flexibility. This is a particularly perilous circumstance for the equity market.
From the Q&A, Testimony of Chairman Alan Greenspan - Federal Reserve Board’s semiannual monetary policy report to the Congress Before the Committee on Financial Services, U.S. House of Representatives February 28, 2001
Alabama Representative Bob Riley: Thank you, Mr. Chairman. Welcome, Mr. Chairman. Mr. Chairman, when I left the office this morning, I picked this off of my desk from Congress Daily. “Trade deficit hits new high. The nation's trade deficit with the rest of the world climbed to an all-time high of $369 billion, 39.5 percent higher than the previous record of $265 (billion). China now has taken over Japan as our country with the largest imbalance of $83 billion. Japan, which was up 22 percent last year, Japan rose another 10 percent. But when we're having these type numbers, when we're having a 40 percent increase in the trade deficit -- I know you answered earlier that it is of a concern, but when does it become alarming?
Fed Chairman Alan Greenspan: It doesn't becoming alarming in any sense. In other words, the way I put it previously, clearly it's a function of the extent to which there are perceived long-term rates of return on investment in the United States. And to a very large extent it's the technology acceleration, which I've discussed earlier, which is at the root in certain respects of this deficit, trade deficit, which we now have. Because --
Alabama Representative Bob Riley: Excuse me, but are you talking about the technology advances in other countries or in ours?
Fed Chairman Alan Greenspan: In ours. In the sense that, as I indicated before, if your exchange rate is rising, it's basically suggesting that there is greater demand for investment in your country than in other countries. And the result of that is that the only way to engender a very significant current account deficit, which is the other side of a capital account surplus of investment coming into the United States, is to have a trade deficit. In other words, I don't want to get into the technicalities of it, but to a large extent our trade deficit is being financed basically by the desire on the part of foreigners to invest in the United States. And the reason is quite apparently the extent of the technological advances which we have created and the very high rates of return on investment which we have relative to other countries. Now, that can't go on indefinitely. And at some point it's going to change. I --
Alabama Representative Bob Riley: But let me ask you this, sir: Could you compare where we are today with this record imbalance to where we were 10 years ago?
Fed Chairman Alan Greenspan: We are -- we are clearly far -- 10 years ago, as you may recall, we actually had a current accounts surplus -- it will be 10 years ago -- part of which was payments that we received as a result of our assistance in the Gulf War. But, in any event, it was -- were quite low, even adjusting for that. And there has been a major increase in the current account trade -- in the current account deficit and in the trade deficit, and in the extent of investment in the United States. Those trends, as best I can judge, cannot continue indefinitely.
Alabama Representative Bob Riley: Let me ask you one final question, if I can. What impact, if any, would a tax cut at this time -- what effect would it have on future trade deficits?
Fed Chairman Alan Greenspan: Well, the usual way that question is asked is: To what extent would a reduction in the unified budget surplus -- or more exactly government savings -- have on the savings we borrow from abroad? The presumption is that if we have less savings in government we have to borrow more from abroad. That's a static view of the way the world works, and I think a more dynamic view really gets to the question of whether or not say a tax cut enhances productivity in the economy, increases the rate of return and essentially induces an offset to the loss of savings from government. I don't want to get into the complexity of this or we will be here all morning --
New York Representative Carolyn B. Maloney: Thank you, Mr. Chairman. Mr. Greenspan, while I know you do not speak specifically about whether or not you plan to adjust interest rates, I am concerned about the impact that a reported rise in the money zero maturity money stock may have on some members of the FOMC.
As you know, other monetary aggregates have also recently risen at historically high rates, and I would hope that this information would not keep the FOMC from lowering rates. However, I was concerned by comments I read in the February 19th issue of Barrons, where it was reported that the annual rate of MZM increased by 16.9 percent annually from November to January. The same short articles quotes an economist at the St. Louis Fed saying that he would be concerned about this increase if it continues into the summer. I truly hope this data does not discourage you from easing monetary policy. Mr. Chairman, can you tell me whether you or members of the FOMC are concerned about the MZM and other monetary aggregates, and whether this would discourage you from easing monetary policy?
Fed Chairman Alan Greenspan: Well, congresswoman, the cause of that rise, which is as you point out a significant acceleration, results from two factors. One, a reduction in interest rates has increased the so-called opportunity costs to hold deposits and a lot of increase in M2 and M3, and indeed MZM, have resulted from that.
There has also been an apparent shift out of stocks and other financial assets into deposits as stock prices have fallen off. And so a substantial part of that rise is very -- is easily understood. The general view that we have all had over the years, as I've mentioned before to this committee in the past, is while money supply has been a major issue with respect to the American economy, and money obviously is a crucial issue of inflation -- indeed, it is almost by definition in the sense of the relationship between units of money and units of goods. But we have had extraordinary difficulty in trying to find the right proxy to measure money per se, and none of these various measures -- M2, M3, MZM -- as best we can judge, seems to have the characteristics necessary for moneyness that is at the base of concerns that a number of people have with the issue of money expansion and inflation. As a consequence, we no longer report to this committee on money supply targets. And the reason we do not is we have not found, at least for the time being, money supply useful. Having said that, we do obviously follow it like we follow all financial variables, because they are -- money supply changes do signal what's happening in the economy, and whether those signals are telling us one thing or another are quite relevant to our overall evaluation of what economic activity is likely to do.
New York Representative Carolyn B. Maloney: Well, thank you for your answer. And, again, I hope that increases in the aggregates would not discourage the FOMC from easing its monetary policy.
Texas Representative Ron Paul: Thank you. Welcome, Mr. Chairman (Greenspan). In the last few weeks you have received a fair amount of criticism and suggestions about what to do with interest rates and the economy. And I think that's going to continue, because I suspect that we are moving into what you call -- you do not call a recession, but a retrenchment. I guess that may be a new word. But anyway, there will be a lot of suggestions, and I do not want to presume that I want to make a suggestion what interest rates should be, but I would like to address more the system that you have been asked to manage, because in many ways I think it's an unmanageable system, and yet it's key to what's happening in our economy.
We have a system that you operate where you are asked to lower interest rates. And I would like to remind my colleagues and everybody else that when you're asked to lower interest rates, you're asked, really, to expand the money supply, because you have to go out and buy something. You buy debt. So every time somebody says “Lower the interest rates” they'll say, “Inflate the money.” And I think that's important. You had a little conversation before about the money supply, conceded it was important, but you don't even know what the good proxy is, so it's very difficult to talk about the money supply. I'm disappointed that we don't concentrate on that, talk about it more, even to the point now that we are -- you no longer make projections.
I think this is a mission almost of defeat. There's no requirement for you to say, “Well, we're going to expand the money supply at a precise rate.” So we're past that point of a tradition that has existed for a long time. But I think it's an unmanageable system, and it leads to bad ideas and bad consequences, because we concentrate on prices, which is a consequence of the inflation of the money supply. And therefore, if a PPI (producer price index) is satisfactory, we neglect the fact that the money supply is surging and that it's doing a lot of mischief. And therefore we talk about, “Well, maybe if we just slow up the economy, if we slow up the economy, it's going to take care of the inflation.” I think we're really missing the point.
But you did mention a couple of words in your testimony today that I thought were important, acknowledging that there are problems in the economy that we have to address. You talked about excesses and imbalances and the need for retrenchment. And I believe what is important is that we connect the excesses and the imbalances to the policy that you operate, because I think it is key. And instead of saying and being reassured that the PPI is okay, if we looked at the excesses, maybe there would have been an indication that there was a problem in the overspeculation in the stock market.
But here we have a monetary system that creates a speculation where NASDAQ goes to 5000 and then we have a lot of analysts telling us it's a good buy, and yet you're now citing the analysts that say, “Well, we can be reassured because these analysts are saying, you know, there's going to be a lot of growth.” So I'm not sure which analysts you're quoting, but I'm not sure that would be all that reassuring.
But I think we should really talk about the money supply and what we're doing. In 1996, you expressed a concern about irrational exuberance in the stock market, and I think that was very justified. But since that time, the money supply, measured by M-3, went up two and a quarter trillion dollars. And the stock market, of course, has soared. And I see those imbalances as a consequence of excessive credit.
And the system has defects in it. You're expected to know what the proper interest rate is. I don't think you can know it or the Federal Reserve. I think only the market can dictate the proper interest rate. I don't think you know what the proper money supply is. You admit you don't have a good proxy. And yet that is the job, and yet all we ever hear are the people coming and saying, “Now, Mr. Greenspan, if you want to avert a downturn, if you want to save us, just print more money.” And that's essentially what the system is doing.
When it appears that most of Washington is frenetically caught up in a mindless battle to divvy up illusionary future budget surpluses, “hats off” to The Beacon of Light, Congressman Ron Paul for his unrelenting but lonely struggle to focus attention on truly critical issues for our country and the world. He is absolutely correct that the current financial system has “defects” and very serious ones at that. Further, we could not agree more that Wall Street, Washington, and our central bank have neglected “the fact that the money supply is surging and that it's doing a lot of mischief.” How can Congressman Paul’s vision be so clear with virtually all other policymakers so blind? This truly is a very strange environment. Not only do we think Dr. Paul is “spot on” with his brilliant analysis, his understanding of the momentous role played by money and credit put Chairman Greenspan to shame - “You (Greenspan) had a little conversation before about the money supply, conceded it was important, but you don't even know what the good proxy is, so it's very difficult to talk about the money supply… I think this is a mission almost of defeat.”
I would like to highlight an interesting paragraph from a speech given by Chairman Greenspan last fall:
“Even monetary policy rules that use recent economic outcomes or money supply growth rates presuppose that the underlying historical structure from which the rules are derived will remain unchanged in the future. But such a forecast is as uncertain as any. This uncertainty is particularly acute for rules based on money growth. To be sure, inflation is at root a monetary phenomenon. Indeed, it is, by definition, a fall in the value of money relative to the value of goods and services. But as technology continues to revolutionize our financial system, the identification of particular claims as money, near money, or a store of future value has become exceedingly difficult. Although it is surely correct to conclude that an excess of money relative to output is the fundamental source of inflation, what specifically constitutes money is a notion that has, so far, eluded our analysis.” From Challenges for monetary policymakers, a speech given October 19, 2000 by Federal Reserve Chairman Alan Greenspan:
I used the previous Greenspan quote as the introduction to my application for a PhD thesis - “Endogenous Money, Wall Street Finance and the Great Millennium Credit Bubble.” Below is my first paragraph:
“I propose to undertake a comprehensive and heterodox study of money, credit and the historic financial and economic bubble that presently hangs in the balance in the U.S. In the spirit of Hyman Minsky, the analytical focus will be on the evolution of institutional and debt structures, as well as expanding on a theory of financial instability. In the spirit of Ludwig von Mises, the goal will be to present a contemporary ‘Theory of Money and Credit.’ My efforts will include an extensive review of previous literature regarding money and credit theory.”
It just doesn’t make any sense to me that the issues of money and credit are such great mystery, as they are today. I also believe the two reasons (opportunity cost and the equity downturn) given by Chairman Greenspan in response to Congresswoman Maloney’s inquiry on the recent explosion in money supply are inaccurate and indicative of an alarming lack of understanding of contemporary finance. Somewhere along the line, sound analysis has fallen by the wayside. Somehow, too many great thinkers with their brilliant analysis and writings have been lost or discarded along the way. Today, in the midst of an historic inflection point in financial history, it’s time to return to sound fundamental analysis of money and credit as a foundation for economic thinking generally. It’s not radical; it’s common sense. And I, like Congressman Paul, find the current system “unmanageable…and it leads to bad ideas and bad consequences, because we concentrate on prices, which is a consequence of the inflation” and it is “absolutely unacceptable that a central bank cannot constitute a definition of money.” These currently popular notions of “price rules” and other pop-monetary “analysis” - that hold that money and credit excess can run unfettered as long as consumer prices are stable - are as flawed as they are dangerous. I endeavor to contribute toward rectifying some truly flawed analysis in this area.
So, I will be boarding a flight for Sydney Australia tomorrow (Saturday). I am relocating to commence my formal study of economics, pursuing my PhD. This is a goal I have had for many years, and there has certainly been the recognition that “I’m not getting any younger.” I think the timing is pretty good. The environment could not be more fascinating, or the work more stimulating. I am quite excited to get started. I will be a PhD student during the day and investment professional during the evenings (nights!). I am most pleased that I have the opportunity to continue to work for David Tice, as well as publish my Credit Bubble Bulletins on Fridays. David could not be more supportive or accommodative.
I will be studying under the supervision of Dr. Steve Keen from the University of Western Sydney. Dr. Keen and I first made contact due to our mutual admiration for the work of the great Hyman Minsky. Dr. Keen is an authority on Minsky and debt structures, and I am very excited and fortunate to have the opportunity to pursue “Minskian” analysis with someone of Dr. Keen’s knowledge, expertise, and enthusiasm. Dr. Keen is not only very talented he is a determined iconoclast that is not afraid to state that there are some serious flaws in current economic thinking. He is an excellent writer and his soon to be released book “Debunking Economics” is a must read for all of us interested in sound and objective analysis. And, importantly, he is also a fine individual and a good friend (mate), very much the type of person I strive to work with.
And while I will continue to write my Credit Bubble Bulletins from Sydney, I will nonetheless take this opportunity to thank some individuals that have been particularly helpful and supportive of my work. This is long overdue. First of all, I will be forever indebted to the unqualified support and encouragement I have received from David Tice. He is truly one of the finest individuals in the industry, and my decision to come down to Dallas and work for David was a fortunate and critical decision for my analysis. While in Sydney, I will certainly miss working in his office, as he has attracted a wonderful group on talented and dedicated individuals. I have been particularly impressed by David’s efforts and intense commitment to informing and educating. David, like Congressman Paul, is truly a “Beacon of Light.” I have been touched by his overwhelming support, and remain committed to working diligently on behalf of David, his firm and its investors. I find it very difficult not to have intense loyalty to someone of David’s character, commitment and sense of duty.
A special thanks also goes out to my good friend Bill Fleckenstein. Managing money during this extraordinary mania has been especially difficult for those most educated in history and company fundamentals. You really get a chance to see someone’s character when they are forced to deal with adversity. Bill not only is a “character,” he has a great deal of character, and I have come through this experience with great respect and admiration for Bill. He has mentioned my work many times and, more importantly, has been a great friend and supporter. Many thanks Bill! He is undertaking his new venture with Jim Grant (www.grantsinvestor.com) that is certain to be a great success. Jim has also highlighted my work in the past. Thanks Jim.
Also, a special thanks to Kate Welling. Wow, what a truly wonderful person and great talent. There have even been a couple of times when I have pondered how nice it would be to have a part-time job, so I could just pick up the telephone and chat with Kate. What a treat. Kate, thank you very much for all you efforts! Thanks also to Don Hays, Jay Taylor, Michael Belkin, Bill Bonner, and John Rubino for mentioning my work. There is a long list of wonderful people that have supported my analysis. Quickly coming to mind are Jim Cook, Jim Deeds, Doug Gillespie, Tom Peterson, Jim Smith, Don McAlvany (www.mcalvany.com), Jim Puplava (www.financialsense.com), Mr. Moto (www.piraz.com), and Bill Murphy at (www.lemetropolecafe.com). These are “top-tier” individuals and I am honored that they would read my writings. Thanks also to the folks at Gold-Eagle. I also appreciate the efforts of several “mainstream” journalists, although I will not incriminate them (just kidding, sort of…) by mentioning them by name. Internally, a special thanks to Rob Peebles who creates the charts and adds considerable value in various capacities. I don’t want this to get out of hand (especially since I’m not receiving an award here!), so I will stop here with a very incomplete thank you list. Most of all, and however corny this sounds, I am sincerely and deeply appreciative for those that take the time to read my “Bulletins” (and the encouraging emails!). I have a long-term goal of becoming a very good analyst and writer. For those of you who are willing to deal with my “stuff” in the meantime, thank you very much. The best aspect of writing these pieces are the friends I am making along the way…
I am confident that I have only scratched the surface in the analysis of money and credit. I am determined to learn as much as possible in my studies, and I will strive to pass along as much knowledge and insight as I can, as we proceed into what will continue to be a most extraordinary environment. Interestingly, there is now more talk here at home about “bubbles,” and recognition that one had developed in NASDAQ. During a “bubble” discussion on CNBC last night, a money manager made the statement that “bubbles are as American as apple pie.” He also said that while the speculators at the end of the boom are losers, the country as a whole benefits and is much better off because of bubbles. There is a lot of work to do… If you asked those who lived through the Great Depression or those living in Japan today, they would clearly not share this sanguine view. As I head off for Sydney, I can’t help but to sense that “things” are now developing quickly. There is something major behind these highly unsettled markets at home and abroad. While current bubble talk centers on technology stocks, this has been only the most conspicuous part of an enormous bubble that has grown to encompass the entire U.S. credit system. The fact that the financial systems in Japan, Asia, Latin America and emerging markets, generally, are already acutely vulnerable from the bursting of past bubbles creates what is undeniably a precarious situation. There’s a lot of “rot” in financial institutions and systems throughout the world. It is now certainly appropriate to consider the ramifications for global financial crisis.
The week certainly ended on an ominous note, with a new U.S. President authorizing bombings near Baghdad, ugly inflation data, and a faltering stock market. For the week, the Dow was unchanged, while the S&P500 declined about 1%. The Morgan Stanley Cyclical index added 1%, while the Transports and Utilities declined 1%, and the Morgan Stanley Consumer index dropped 2%. The broad market continues to hold up quite well, with the small cap Russell 2000 and the S&P 400 Mid-Cap indices both unchanged. Technology stocks remain hyper-volatile. For the week, the NASDAQ100 declined 2% and the Morgan Stanley High Tech index lost 1%. The Semiconductors outperformed, adding 6% and increasing year-to-date gains to 15%. The Street.com Internet index declined 1%, while earnings disasters pressured the NASDAQ Telecommunications index to a 7% decline. The Biotechs declined 3%. Financial stocks showed some vulnerability, with the S&P Bank and Bloomberg Wall Street indices declining 1%. Gold stocks added 2%, despite a better than $2 decline in the price of bullion.
On the back of generally stronger than expected economic news this week, 2-year Treasury yields increased 7 basis points, while the 5-year saw yields rise 9 basis points. The 10-year T-note and long-bond saw yields increase about 8 basis points. The yield on the benchmark Fannie Mae mortgage-back security jumped 12 basis points, while agency yields generally added 8 basis points. Spreads generally widened, with the key 10-year dollar swap adding 2 to 95. The currency markets were volatile, although the dollar ended the week with a small gain.
From the question and answer session – Alan Greenspan’s February 13th testimony, Federal Reserve Board’s semiannual monetary policy report to the Congress:
Delaware Senator Thomas Carper: My only other question is this; in my little state of Delaware, we cut taxes seven years in a row during my time as governor, sometimes rates at the top, sometimes rates at the bottom, sometimes in between; we cut taxes for businesses and individuals. We had a four-part litmus test for the tax cuts that we adopted. And one of the things that we're wrestling with within our own caucus, and I presume our Republican friends are as well, is a set of core principles on which tax cuts should be based; if you will, a litmus test.
The four that we used in my state were the following: one, the cuts should be fair; two, they should promote or enhance economic growth; three, to the extent that they can, we should simplify the tax code, not make it more complex; and the fourth is that the cuts should be consistent with a balanced budget and sustainable throughout the full business cycle. But those four things: fairness, promoting economic growth, simplicity, and sustainability throughout the full business cycle and consistent with a balanced budget are really the litmus test that we used.
Can you just give us a little guidance -- and I know my time has expired -- but just a little guidance on the kind of principles, whether we're Democrats or Republicans, that our tax-cut policy should be based on.
Chairman Greenspan: Well, I think in a very interesting way, it depends on where one starts. I mean, going back from, say, a purview of 1995, for example, with what appeared at that point to be about a 1-1/2 percent trend growth rate in productivity, it appeared as though the level of taxation was essentially consistent with a balanced budget over the longer run at full employment. And what has happened is that productivity growth has accelerated quite significantly, and so the existing set of tax rates has engendered a very much more rapid rise in revenues. As I said at the Senate Budget Committee, that productivity over the past five to seven years has risen at about a 3 percent rate, which is twice what it had been previously, and revenues have gone up 2-1/2 times; the difference being that the rise in the productivity has elevated earnings expectations and created a permanent higher level of asset values, which spilled over into tax liabilities when realized gains were involved or even when they weren't.
And so that what you have got at this point is, as a consequence of the acceleration in productivity, a much higher rate of receipts than one had anticipated. And so I think the Congress is confronted with the choice of whether in fact you give back what, in retrospect, turned out to be an unintended excessive level of receipts, or whether those are employed for other purposes. And these are the key judgments which I think in this particular debate are critical, and these are political judgments; these are judgments which only the Congress can make.
Senator Carper: Thank you so much
Alabama Senator Richard Shelby: Mr. Chairman, a lot of people seem to be a little hesitant regarding the economy as a whole, and I know it depends on how they're looking at it, but consumer confidence is very important. Is it time to hunker down, I believe that was the phrase that was used earlier, or is it a time to be a little cautious, or is it time to be bullish or what? Because what you say today and how you say it, as you well know, is going to be interpreted many, many ways, and people are looking for everything in the world out of your utterances.
Chairman Greenspan: Well, Senator –
Senator Shelby: What would you say to the American consumer looking at the economy today seeing layoffs here, layoffs here, and not in every sector, but in some?
Chairman Greenspan: Yeah. Senator, I think that it's always important to first start with what's the longer-term outlook.
Senator Shelby: Absolutely.
Chairman Greenspan: And the longer-term outlook, as I've reiterated many times, in my judgment is undiminished in the sense that by any measure that I can see, we are only partway through one of these most remarkable periods of technological advance which is crucial to productivity growth and, indeed, to all of the deliberations we are having with respect to the budget. It really gets back to that question.
What tends to happen, however, is that while the technologies change and it creates an accelerating environment for economic activity, as I point out in my prepared remarks, we human beings react in a somewhat negative way to change when it occurs in a pronounced way. And so it is perfectly credible to find, for example, as I think we see today, that there are a number of business people who fully perceive the longer-term profitability of these new high-tech investments as pretty much fairly accurate and achievable, but they are concerned about the uncertainty, and they develop concerns about the immediate future. And even though they perceive the future in a very positive way, they tend to pull back. It's a wholly human, normal reaction. And what that does is it brings the economy down.
But if, indeed, those underlying trends are still there, as I firmly believe, it is just a matter of time before that sort of malaise dissipates and the system comes back. If you look at American economic history, it always has those characteristics. And if we focus on the longer term, as a number of business people have, and have continued to invest right through this period, it's my impression that it is they who will end up at the end of the day with the best positions in their markets to exploit them over the longer run.
Senator Shelby: Mr. Chairman, could you, in a sense, perhaps look at the economy like a long-distance race and the runners, or some of the runners are going -- if the economy is the runner, is going to get its second wind because they're trained for the long haul, we're in it for the long haul, and those who are in it for the long haul, which is all of us, we're going to be rewarded if we stay the course?
Chairman Greenspan: Oh, I agree with that, Senator. I have no doubt that at a minimum, that the turgid economic growth which we experienced from the early 1970s through the, say, early 1990s, is not something that we're about to replicate, in any sense that I can envisage, over the next 10 years.”
Does Greenspan truly believe such nonsense? While he has professed (increasingly over recent years) some convoluted analysis, associating surging tax receipts with productivity improvements takes the cake. And he may hope that better than 20 years of “turgid” economic conditions has over the past six or so years given way to a New Paradigm, but this is no doubt some combination of wishful thinking, flawed analysis and obfuscation. The last six years will prove the aberration. Sure, the mid-nineties provided a momentous inflection point in financial and economic history, it just had very little to do with a so-called productivity miracle. Instead, it had almost everything to do with the manifestation of an historic Credit Bubble. This fact is conspicuous in any chart of U.S. money or credit growth. Specifically, one can pinpoint the “Reliquefication” concomitant with the Mexican bailout and Orange County bankruptcy in 1995. It was in 1995 that the buds of credit and speculative excess were nurtured instead of quashed. That round of rampant monetary expansion precipitated a spectacular boom both here and abroad (emerging markets) and subsequent ugly bust. The resulting 1998 “Reliquefication” ushered in an absolute money and credit “free for all.”
Since 1998, truly unprecedented money and credit expansion have been only briefly interrupted by respites of moderation. Yet, for a system hopelessly addicted to extreme monetary excess, moderation simply doesn’t work. This fact is a best-kept secret and something Wall Street and the Fed would prefer not to contemplate. Why do the GSE’s and Wall Street create credit so aggressively (the force behind exploding money supply)? Because it is precisely the requirement for sustaining the Great Credit Bubble.
We monitor credit market spreads closely, as an indication of liquidity pressures and systemic stress. Similar to previous episodes, spreads have narrowed sharply over the past four months. This is not surprising, and is purely a factor of the degree of monetary expansion. Look at it this way: while the GSE’s are aggressively purchasing credit market instruments and the enormous and always-enterprising leveraged speculating community goes along for the ride, this flood of liquidity fuels higher prices/lower interest rates, particularly for more risky (high-yielding) instruments and any class of securities aggressively sought by the speculators. The catch is that a U.S. system so incredibly leveraged, with negative household savings, and reliant on huge foreign flows to finance massive trade deficits, the entire financial and economic apparatus has become so “revved up” that massive liquidity injections must be maintained to keep asset prices levitated and financial markets liquid. But like the movie Speed, there are unfortunate circumstances for letting pressure off the accelerator. Any moderation in monetary expansion, like that experienced in mid-1999 and again in early 2000, leads quickly to sinking prices for the riskier securities, liquidation by the leveraged speculators, and faltering systemic liquidity that manifests into wider credit spreads and other financial disruptions. Leverage works like magic when prices are rising but can abruptly turn problematic with any move toward liquidation. Endemic over leveraging is an accident waiting to happen. We will return to this later.
As discussed repeatedly, since the mid-1990s the government-sponsored enterprises have been leading pushers of credit excess. Today, they are dealing more forcefully than ever. Fannie Mae’s January numbers are in and, not surprisingly, we see that Fannie expanded its mortgage portfolio at a 31% annual rate, to $621 billion. Averaging about $1 billion per business day, Fannie purchased a total $20.6 billion of mortgages in January at a net yield of 7.02%. To put this in perspective, Fannie Mae’s mortgage portfolio expanded in January by about the same amount ($14 billion) as the Federal Reserve’s holdings of securities increased during the entire past year. This is exactly why I focus on the GSEs and financial sector and pay less attention to Federal Reserve Open Market operations.
Fannie’s commitments to buy future mortgages (“mandatory commitments”) jumped to $27 billion in January (from December’s $20 billion), second only to the $30.5 billion at the height of the refinancing boom (“Reliquefication”) in October 1998. During the month, Fannie Mae purchased $1 billion of multifamily loans, almost 80% more than its previous record from the prior month. Fannie’s multifamily loan portfolio has expanded by 27% over the past twelve months. After expanding its total mortgage portfolio by 13% during the 12-months ended September 30, 2000, Fannie expanded its portfolio at a rate of 30% in October, 28% in November, and 25% in December, extraordinary growth only to be surpassed in January. It has been four months of intense “Reliquefication.”
Over the past four months, money market fund assets have surged $244 billion, or at an annualized rate of 40%. During just the past six weeks, assets in money funds have jumped an astonishing $144 billion. For comparison, money market fund assets increased $39 billion during the first half of 2000. These assets increased $43 billion last week alone. Broad money supply increased $35 billion last week and $118 billion during the past six weeks. Over the past four months, broad money supply (which includes money fund assets) has increased $301 billion, or at a rate of 13% (broad money supply increased about $260 billion for all of 1995). It should not be ignored that there are great costs associated with such rampant monetary inflation, and perhaps we saw a hint of what is in the offing with this morning’s much stronger than expected report on Producer Prices. January producer prices rose at the strongest pace since September 1990, confirming what I believe are the most potent general inflationary pressures since the late 1980’s. The bond market vigilantes may have succumbed to playing The Game, and the propaganda machine hyping the death of inflation may be running louder than ever, but it’s just not going to change fundamentals.
It is rather incredible that not a word of protest has accompanied the past four-month’s 13% rate of monetary inflation. This is actually a similar rate of growth to that at the height of 1998’s Reliquefication, although the inflationary consequences have all appearances of manifesting in a much different manner. In past commentaries I have made the point that “Liquidity Loves Inflation.” Sure, combining central bank accommodation with unfettered financial sector leveraging creates an extraordinarily virile liquidity generating mechanism for contemporary financial systems. But once created, this liquidity is virtually impossible to control and even has a propensity of gravitating directly to asset classes enjoying inflation (choosing a Fannie Mae security instead of a Lucent bond, for example). And while there were acute global deflationary pressures in 1998, there are today strong general domestic inflationary pressures that are certain to be augmented by current monetary excess. On the other hand, during 1998 there was the budding of an historic inflationary boom throughout the expansive Internet/telecom/technology sector that proved an incredibly powerful liquidity magnet. The present deflationary technology bust sees the magnet turned upside down. This is a key and intractable aspect of present financial fragility.
This is where economics gets wonderfully fascinating (unless one chooses to fixate on notions of a New Economy and a productivity miracle). Over years, as credit inflation gave way to runaway money and credit excess, our dysfunctional financial system has increasingly financed enormous numbers of enterprises with inadequate cash flows and little hope for true economic profits. “Ponzi Finance,” in the words of the great Hyman Minsky. This has been, of course, an historic speculative bubble captivating investors, bankers, speculators, central bankers and American business generally. Interestingly, of the few economists and analysts that correctly recognize that the U.S. has been in the midst of a major bubble, most actually believe that it has been in NASDAQ/technology stocks. Greenspan may even believe this, and has thus embarked on yet another round of extreme accommodation to lessen the economic impact collapsing tech stocks. The major issue today is not NASDAQ, an inventory overhang, or the unfolding severe capital equipment slowdown.
The fact of the matter is that the technology bubble is but one very critical component of the Great U.S. Credit Bubble. The key yet unappreciated point to recognize today is that years of reckless credit excess have created unprecedented leverage throughout the U.S. credit system and extremely weak debt structures. And while Wall Street and Greenspan obviously hope that another bout of monetary excess will do the trick and alleviate the spectacular technology collapse, the preponderance of new liquidity will avoid technology like the plague. Moreover, it is unavoidable that the most recent Reliquefication is and will continue to lead to inflation elsewhere, while it also creates greater consumer debt burdens, perilous financial sector leverage, and even more fragile debt structures.
It is certainly significant both financially and economically that the latest shot of extreme monetary expansion is avoiding the tech collapse to play the real estate bubble. Could this prove the catalyst for the marketplace finally recognizing the dysfunctional nature of the U.S. credit system? While Lucent and a myriad of technology companies fight for survival, credit availability could not be easier in mortgage finance. Could there be a more conspicuous example of a highly maladjusted financial system and economy?
This morning the Commerce Department announced that January housing starts jumped a much stronger than expected 5%, with single family starts running at the strongest rate in one year. Building permits jumped 13%, with multifamily permits surging 24%. The bursting of this unrelenting real estate bubble will wait for another day. Also, fourth quarter mortgage refinance data has been released by Freddie Mac. During the quarter, “78% of Freddie Mac-owned loans that were refinanced resulted in new mortgages at least five percent higher than the original mortgages…” Only 9% of refinanced loans were for amounts less than the original mortgage. Interestingly, on average, loans were refinanced at comparable interest rates, confirming that the overriding motive of borrowers was to extract equity (housing inflation). The “median appreciation of refinanced property” was 28% during the fourth quarter, down slightly from the third quarter’s 29%. However, the “median age of refinanced loan” dropped sharply from 6.6 years to 4.9 years. During the refinancing boom back in the fourth quarter of 1998, the median appreciation was 9%.
There should be no doubt that the current refinancing boom is greatly exacerbating the bubble in money market fund assets, a very dangerous financial distortion that runs unchecked. What are the ramifications today for a loss of investor confidence in the $2 trillion dollar money market fund industry? Astounding… Interestingly, yesterday’s American Banker carried a lead story titled “FDIC Said to Whisper Fund Premium Warning – The Federal Deposit Insurance Corp. has been quietly warning trade groups that it could start charging banks premiums again by yearend – in part because of fast-growing accounts at large firms such as Merrill Lynch & Co., industry sources said Wednesday.”
Also from the article: “Industry representatives said the FDIC has cited fast-growing and de novo institutions that have added billions of dollars to insured deposits without paying new premiums as one of the key reasons for the coverage ratios dilution…the poster children for the issue have become Merrill Lynch, which has moved nearly $50 billion from uninsured accounts into insured deposits at its banks in New Jersey and Utah during the past nine months, and Salomon Smith Barney, a Citigroup Inc. unit that started moving money from uninsured accounts into insured deposits last month.”
Apparently, Salomon Smith Barney is now aggressively moving client assets into FDIC insured deposits, with a structure that includes six separate banking entities providing up to $600,000 of FDIC insurance protection. Coincidently, from the pile of financial reports I read from the last year’s third quarter, the one sentence that sticks most clearly in my mind came from Citigroup – Salomon Smith Barney: “Total client assets in the Private Client business grew 24% from a year ago to $1.047 trillion while annualized gross production per Financial Consultant reached $526,000 in the first nine months of 2000…” It will be quite interesting to see how aggressively Wall Street moves to obtain FDIC insurance for all this “money” it has helped create. I know if I were either Sandy Weill or Bob Rubin (Citigroup chairmen) I would do my best to get my clients into FDIC insured accounts, and this current Reliquefication provides a convenient window of opportunity.
I can’t shake the notion that we are likely in the midst of what in hindsight will be seen as The Great Distribution. While the public remains quite bullish and (helped greatly by the mortgage refinancing boom) money continues to flow into mutual funds, the stock market just doesn’t react like it has in the past. Clearly, some are aggressively selling and we’ll assume it’s the insiders and sophisticated liquidating to the public. One of the unfortunate and problematic aspects of major asset bubbles is a redistribution of wealth.
I am also now anticipating some moderation from the unsustainable monetary expansion associated with the four-month old Reliquefication. As stated above, for a system hopelessly addicted to extreme monetary excess, moderation won’t work. With signs of general economic resiliency, endemic and increasingly problematic maladjustments, an historic real estate bubble, and heightened general price pressures, something has to give. And at what cost will Greenspan attempt to maintain confidence and sustain unsustainable consumer demand? Besides, it should be increasingly apparent that fighting this war with a flood of liquidity is not only not working, it’s greatly raising the stakes for potential financial catastrophe. Before today’s unusual recovery and rally in the credit market (perhaps related to U.S. bombing in Iraq) interest rates had been rather quickly moving higher. Spreads have also begun to widen. It does not take much imagination to see how this very fragile structure could rapidly turn sour. The bottom line is that already unprecedented leveraged speculation certainly became only more extreme with the speculating community aggressively playing for a faltering economy and aggressive Fed accommodation. Endemic over leveraging in the U.S. credit market is a ticking time bomb, and there does today appear acute risk to any significant move higher in rates or widening of spreads.
I have written before that we have been witnessing the absolute worst-case scenario develop methodically right in front of our eyes. Well, today I again believe we are entering a period of potentially extreme risk with the stock market, credit market and dollar all in the line of fire. It’s been Four Months of Respite. However, not only is the effectiveness of Reliquefication dissipating rapidly, the costs are growing exponentially. When the next crisis breaks, it will be significant.
I will conclude with what I believe are two pertinent quotes:
“The favor of the masses and of the writers and politicians eager for applause goes to inflation. With regard to these endeavors we must emphasize three points. First: Inflationary or expansionist policy must result in over consumption on the one hand and in malinvestment on the other. It thus squanders capital and impairs the future state of want-satisfaction. Second: The inflationary process does not remove the necessity of adjusting production and reallocating resources. It merely postpones it and thereby makes it more troublesome. Third: Inflation cannot be employed as a permanent policy because it must, when continued, finally result in a breakdown of the monetary system.
A retailer or innkeeper can easily fall prey to the illusion that all that is needed to make him and his colleagues more prosperous is more spending on the part of the public. In his eyes the main thing is to impel people to spend more. But it is amazing that this belief could be presented to the world as a new social philosophy. Lord Keynes and his disciples make the lack of the propensity to consume responsible for what they deem unsatisfactory in economic conditions. What is needed, in their eyes, to make men more prosperous is not an increase in production, but an increase in spending. In order to make it possible for people to spend more, an “expansionist” policy is recommended. This doctrine is as old as it is bad.” Ludwig von Mises, Human Action, 1949
“The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system.” Ludwig von Mises, Human Action, 1949
“…Minsky characterized the financial balance along a scale of running from ‘fragile’ to robust.’ ‘Fragile finance’ refers to states in which cash commitments are relatively heavy compared to cash flows, so that there is some danger of widespread failure to meet commitments, failure that might cause general breakdown in coherence. ‘Robust finance’ refers to states in which commitments are relatively light compared to cash flows, so that the danger of incoherence is relatively remote. The emphasis on the threat of incoherence is one way of reading the scale. Viewed more positively, what is so appealing about a state of ‘robust finance’ is that it leaves open many different possible future paths for subsequent social freedom. What is so tragic about a state of ‘fragile finance’ is that previous commitments leave open only very few possibilities for the future, and maybe no possibilities at all that are consistent with existing commitments. Fragile finance is a state of social constraint. The degree of fragility or robustness in the economy as a whole ultimately depends on the fragility or robustness of financing arrangements at the level of the constituent economic units.” Perry Mehrling, The Vision of Hyman P. Minsky, 1998
“What nobody saw, though some people may have felt it, was that those fundamental data from which diagnoses and prognoses were made, were themselves in a state of flux and that they would be swamped by the torrents of a process of readjustment corresponding in magnitude to the extent of the industrial revolution of the preceding 30 years. People, for the most part, stood their ground firmly. But that ground itself was about to give way.” Joseph A. Schumpeter, Business Cycles, 1939
P.S. From yesterday’s American Banker: “Sears Is Back as A Player In Cards - In the eight months since it starting issuing MasterCards to seven million of its inactive Sears cardholders, Sears Roebuck and Co. has broken into the rank of the top 25 bank card issuers, amassing $1.4 billion in receivables on the general purpose cards.”
The now typical extraordinary volatility continued this week, with significant divergences between groups. The Dow added 2% and the S&P500 increased 1%. The economically sensitive issues outperformed, with the Transports jumping 5% and the Morgan Stanley Cyclical index adding 3%. The Morgan Stanley Consumer index added 2%, and the Utilities increased 1%. The small cap Russell 2000 gained less than 1%, while the S&P400 Mid-Cap index was largely unchanged. The Technology rally came to an abrupt halt as the week came to an end. For the week, the NASDAQ100 dropped 6%, the Morgan Stanley High Tech index 4%, and the Semiconductors 1%. The Street.com Internet index lost 8%, decreasing its year-to-date gain to 19%. The NASDAQ Telecommunications index dropped 3%, as its year-2001 gain declined to 14%. Biotechs continue to trade poorly, dropping about 8% this week. The financial stocks were relatively quiet, with the S&P Bank and AMEX Broker/Dealer indices unchanged for the week. Gold stocks mustered a slight advance.
On the back of extraordinary Fed accommodation, credit market yields continue their sharp decline. For the week, 2-year Treasury yields dropped 13 basis points to 4.64%, while 5-year yields declined 7 basis points to 4.83%. The key 10-year Treasury Note saw its yield drop 11 basis points to 5.16%, while the long-bond enjoyed a sold performance with its yield dropping 13 basis points to 5.51%. Mortgage-backs and agencies continue to perform well, with the yield on the benchmark Fannie Mae mortgage-back security sinking 13 basis points and agency yields generally dropping 14 basis points. The benchmark 10-year dollar swap spread narrowed 1 basis point to 85. Dollar weakness returned this week, with the dollar index dropping 1%. Whiffs of inflation were in the air, with crude oil adding $1.50 to end the week above $31, a two-month high. Gold jumped $4
“The rapid rise in the stock of money during World War I, when the Federal Reserve System served as an engine for the inflationary financing of government expenditures, continued for some eighteen months after the end of the war, at first as a result of the almost inadvertent financing of private monetary expansion by the System. The monetary expansion was abruptly reversed in early 1920 by Federal Reserve action – the first major deliberate and independent act of monetary policy taken by the System and one for which it was severely criticized.
The rest of the twenties were in many ways the high tide of the Federal Reserve System. The stock of money grew at a highly regular rate, and economic activity showed a high degree of stability. Both were widely attributed to the beneficent actions of the System. Within the System, there was much sophisticate and penetrating research on the operation of the financial markets and the role of the System. The result was a deepened understanding of its own operations and tools. Outside the System, bankers and businessmen at home regarded its powers with awe, and foreign countries sought its assistance in mending their own monetary arrangements. Cooperation with the great central banks of Britain, France, and Germany was close; and the belief arose that, through such cooperation, the central bankers could assure not only domestic but also international economic stability.
That era came to an abrupt end in 1929 with the downturn which ushered in the Great Contraction. In its initial stages, the contraction was not unlike earlier ones in its monetary aspects, albeit the money stock did decline slightly. Severe contractions aside, the money stock rises on the average during contraction and expansion alike, though at a lower rate during contraction. The monetary character of the contraction changed drastically in late 1930, when several large bank failures led to the first of what were to prove a series of liquidity crises involving runs on banks and bank failures on a scale unprecedented in our history. Britain’s departure from gold in 1931 and the Federal Reserve’s reaction to that event sharply intensified the banking collapse, if indeed they did not nip a potential revival in the bud. By early 1933, when the monetary collapse terminated in a banking holiday, the stock of money had fallen by one-third – the largest and longest decline in the entire period covered by our series (1867 – 1960). The banking holiday was a panic of the genus that the founders of the Federal Reserve System had expected it to render impossible. It was, however, of a different species, being far more severe than any earlier panic. In addition, whereas in earlier panics, restriction of payments came before many banks had failed and served to reduce the number of subsequent failures, the 1933 banking holiday occurred only after an unprecendentedly large fraction of the banking system had already failed, and many banks open before the holiday never reopened after it. One-third of the banks had gone out of existence through failure or merger by 1933.
The drastic decline in the stock of money and the occurrence of a banking panic of unprecedented severity did not reflect the absence of power on the part of the Reserve System to prevent them. Throughout the contraction, the System had ample powers to cut short the tragic process of monetary deflation and banking collapse. Had it used those powers effectively in late 1930 or even in early or mid-1931, the successive liquidity crises that in retrospect are the distinctive feature of the contraction could almost certainly have been prevented and the stock of money kept from declining or, indeed, increased to any desired extent. Such action would have eased the severity of the contraction and very likely would have brought it to an end at a much earlier date. Such measure were not taken, partly, we conjecture, because of the fortuitous shift of power within the System from New York to other Federal Reserve Banks, and the weakness of the Federal Reserve Board in Washington, partly because of the assignment – by the community at large as well as the Reserve System – of higher priority to external than to internal stability.” Milton Friedman & Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960
“The failure of the Federal Reserve System to prevent the (monetary) collapse reflected not the impotence of monetary policy but rather the particular policies followed by the monetary authorities and, in smaller degree, the particular monetary arrangements in existence.
The contraction is in fact a tragic testimonial to the importance of monetary forces. True, as events unfolded, the decline in the stock of money and the near-collapse of the banking system can be regarded as a consequence of nonmonetary forces in the United States, and monetary and nonmonetary forces in the world. Everything depends on how much is taken as given. For it is true also, as we shall see, that different and feasible actions by the monetary authorities could have prevented the decline in the stock of money – indeed, could have produced almost any desired increase in the money stock. The same actions would also have eased the banking difficulties appreciable.” Milton Friedman & Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960
The overriding goal for the Credit Bubble Bulletin is to educate and inform as I attempt to document as best I can this historic period in financial and economic history. I am also committing myself to years of endeavor striving to ensure that the true story of this fateful boom and unavoidable bust is documented completely and accurately, and that facts are not obfuscated as times passes by. Let there be absolutely no doubt, great efforts will be expended to paint all of this in a much more palatable light. One need not look far to see how fragile truth can be, with Saddam Hussein presented as responsible for the early 1990’s US recession, crony capitalism the culprit for the SE Asian collapse, and a freak occurrence of “The Perfect Storm” doing in the hard-luck Long-Term Capital Management. Some may likely go so far as to explain the boom as some variance of “the nineteen-nineties were in many ways the high tide of the Federal Reserve System.” I hope to fight this revisionist history every step of the way.
As such, I am compelled to comment on CNBC’s Wednesday afternoon panel discussion of the Federal Reserve rate cut. Two of the great propagandists of this historic bubble, Louis Rukeyser and Larry Kudlow, made up half of the panel. Both sit firmly at the top of my list of individuals that I fully expect to demonstrate a propensity and raw talent for obfuscating the facts going forward. Not surprisingly, they are vocal leaders of the popular bandwagon chastising the Federal Reserve, blaming last year’s rate increases for the sinking NASDAQ marketplace and the current economic downturn. Such analysis is a blatant distortion and a disservice to the public. The Federal Reserve’s error was not that it increased rates last year, but that it failed to aggressively tighten policy much earlier. Speculative bubbles always go bust, it’s only a matter of from what extremes and the resulting degree of financial and economic damage. Greenspan himself recognized dangerous speculative bubble dynamics at least as early as 1994 but, regrettably, never squashed these destructive impulses before they gained momentum and a very powerful constituency.
I will give the Fed the benefit of the doubt that it was appropriate to cut interest rates to 4.75% during the LTCM crisis in the Fall of 1998. However, a major policy blunder developed when these cuts were not fully reversed for almost one full year, despite a booming economy, heightened inflationary pressures, ballooning trade deficits, increasingly conspicuous financial and economic distortions, and a grossly speculative stock market. The Fed should have moved forcefully to tighten policy (and warned against speculation) to temper what were clearly unmistakable signs of an unhealthy financial and economic bubble. Moreover, the unprecedented accommodation going into Y2K was a bizarre and most unfortunate occurrence, sowing the seeds for a final historic speculative fiasco. The fact that the Fed attempted to rein in some of this extreme accommodation last year is certainly not the culprit of the inevitable collapse of this speculative bubble. To claim otherwise is obfuscation. Mr. Rukeyser and Mr. Kudlow spend a lot of time pontificating publicly about the stock market, but I don’t remember many responsible comments warning viewers in the midst of the frenzy of the danger of wild speculative excess.
One of the most perplexing aspects of this boom cycle has been the complete disregard for its dangerous financial and economic consequences, both from the economics community and Washington policy makers. Clearly, there are some enormous flaws and shortcomings in contemporary economic curriculums in this country. There is surely a complete lack of understanding of money and credit. And, specifically, the fact that policy makers and academics are basically oblivious to the risks inherent in this fateful bubble has at its roots the analysis that ignored the causes of the 1920’s bubble economy, while pinning the Great Depression on post-crash ineptness by the Federal Reserve.
In this regard, Milton Friedman’s analysis of the causes of the Great Depression has played a momentous role. I take strong exception to his work in this area. At the minimum, it grossly oversimplifies the issues that confronted the post-crash Fed. The bottom line is that the depression was not, as the consensus believes, caused by the Federal Reserves’ failure to create bank reserves/liquidity (through the purchase of government securities) after the stock market crash. Instead, depressions are the unavoidable consequence of reckless boom-time money and credit excess, rampant speculation and the resulting severe structural and economic distortions. At some point, bank reserves and “liquidity” become virtually irrelevant to the greater issue of intractable economic imbalances and maladjustments, and the instability of debt structures. This was the case after the “Roaring 20s,” and it is once again the case today. Sure, there were some post-crash policy errors, but a severe downturn and major financial dislocation were not to be avoided. Yet, under the chapter heading “Why Was Monetary Policy So Inept?” Mr. Friedman refers to the period 1929-1933. This is a convenient revision of history. The great policy blunders were made years before. I just don’t buy the notion that all the sudden policy makers became inept in the U.S. in the 1930s or that they coincidently did the same decades later in Japan during the 1990s.
We have written extensively regarding the ominous parallels between the historic credit bubble in the 1920’s and the much grander bubble that developed during the 1990’s. It is today worth noting that we see the similar paths of these two respective bubbles having now parted. Greenspan is clearly determined not to repeat the “inept” policies of post-crash 1929 (and post bubble Japan for that matter). Indeed, he believes strongly that it is much better to strike hard and early to combat developing financial crisis. Greenspan “baby steps” are now reserved only for increasing rates. And, actually, Greenspan has in the past made it perfectly clear that he would aggressively add “liquidity” to dampen the economic impact of a pierced bubble. As stated repeatedly, he (erroneously) believes that it is impossible to recognize a bubble until after the fact, but he definitely has had plenty of time to adopt a strategy for dealing with the inevitable bursting. This exercise has now begun in full force. Greenspan’s “Great Experiment” has gone to the next stage, not even waiting for a failure of a major financial institution or even significant economic weakness. He now leads us into dangerous and uncharted waters, apparently determined to avoid recession at almost all costs.
And while General Greenspan has for years planned, strategized and formulated a careful plan of attack, we have a strong hunch he is not all too clear in recognizing the enemy. It is tempting to see this confrontation in a similar light to Greenspan’s previous battles, but this is anything but the case. For his first big embroilment after the 1987 stock market crash, the enemies were discernable and all grouped together on one front - low stock prices, financial system illiquidity, and broken confidence. In the early 1990’s, it was an impaired banking system in desperate need of a recapitalization, as well as an economy requiring heightened credit growth to stimulate demand and inflate asset (real estate and stock) prices. It was certainly not the “Desert Storm-type” victory like ’87, but with the spirited assistance from Wall Street and the hedge fund community the enemy was put down. In 1994, the enemy was Deleveraging, and to prevail in that battle required only a mechanism to allow the offloading of huge speculative trades in the credit market. This time the Fed allied with the rising government-sponsored enterprises for what in hindsight can be appreciated as a rather easy triumph that greatly enhanced the fortunes of the victors.
1988 had at the time all appearances of an intense multi-front conflict, but in the end the main domestic enemy proved to be (1994-style) financial system illiquidity. This warfare the General has mastered, and despite some close calls the enemy succumbed with the heroic efforts of the government-sponsored enterprises playing a decisive role. Importantly, but not appreciated, the General had a great advantage with his old nemesis Inflation getting hammered on another front (Inflation was being ravaged by powerful deflationary forces in Asia, Russia, and elsewhere). After 1998, the General successfully fended off some covert intrusions in the gold market, derivatives markets, and was on a full stage alert for the Y2K false alarm.
As we begin 2001, the General has orchestrated an aggressive Colin Powell-style attack – the plan is to go early and hit hard with overwhelming force. The powerful and ungovernable GSE’s (always hankering to fight!) have for some time been out firing at anything that moves. And while the General is rather shadowy when it comes to identifying the enemy, interestingly, as the war begins this issue is of little concern. In fact, there is even this delusion that savage inflationary warfare can be waged with complete disregard for the possibility that the supposedly spent forces of Inflation regroup and play a decisive role. Besides, EVERYONE has been conditioned that when the General goes to war, good things always happen (I am reminded of my historical readings with respect to the jubilance that ushered in the first World War in Europe). But unbeknown to the cheering population, the General must carefully conceal his heightened self-doubt about this particular engagement, as he nervously falls back on his weathered old battle plan of fighting Illiquidity and Insufficient Demand. It has yet to be recognized that the General has succumbed to the age-old dilemma of “fighting the last war.” Most importantly, the Old General doesn’t even recognize that a powerful, sweeping and illusive new adversary has joined the fray. We Recognize His Enemy Clearly; We Know His Enemy. It goes by the name Financial Fragility.
Financial Fragility poses an intractable problem for the Greenspan Fed. Ironically, things have finally come full circle, with Financial Fragility having materialized specifically through years of rampant money and credit excess ineptly accommodated by the central bank. Financial Fragility is structural and its endemic. And, importantly, the forces of Financial Fragility will only be strengthened and become even more stubbornly entrenched by the present policy course of perpetuating monetary excess. More credit is not an antidote but instead a potent stimulant for Financial Fragility. Financial Fragility is comprehensive and very complex, but emanates from the massive amounts of over borrowing by the household, corporate and financial sectors. Clearly, the massive accumulation of foreign liabilities is a source of great fragility, and Greenspan policy ensures its perpetuation. Financial Fragility is also the term I will use to describe the deep structural distortions to the U.S. economy, and corporate America in particular. The recent episode of collapsing junk bonds and the faltering corporate debt market were an unmistakable manifestation of the acute vulnerability that has developed to even the shallowest of economic downturns. This is an ominous parallel to the 1930’s.
The California energy crisis is a great illustration of the interplay of powerful inflationary forces with Financial Fragility. Predictably, such circumstances have materialized from excessive demand, gross malinvestment and a breakdown in the market pricing mechanism. It is, at the same time, also an excellent example of the atypical and acutely volatile nature of the current environment. Truly, expect the unexpected. The unfolding energy crisis will certainly not be beaten by the Fed’s blunt instrument of accommodating greater money and credit excess.
The current troubles in the manufacturing sector should also be seen under the umbrella of Financial Fragility. Years of overheated and unsustainable demand concomitant with distortions in the economy’s investment process and over borrowing have left their indelible mark. Fed policy strives to sustain unsustainable demand. And with an overvalued dollar, rising costs, and stiff foreign competition, there is a real story here as U.S. industry rapidly loses its global competitiveness. Again, current policy is powerless.
The US automobile industry is a case in point. Looking at January industry data (that, by the way, was considerably stronger than expected), we see that weak sales by the Big Three were offset by continued strong demand for foreign nameplates. It was a record January for American Honda, up 11% from January 2000. PRNewswire quoted a Honda executive: “January turned out to be a pretty good month after all, despite the prediction of all the doomsayers. The industry as a whole may be off a little from last year, but let’s not forget that January 2000 was great month.” BMW reported its “best January on record,” with sales about 10% above last year. Lexus posted a record January, with sales 13% above last year. Acura had it best ever January, with sales 38% above last year. Mercedes reported its second-best January (behind last year), after its all-time record month during December. Mitsubishi also had its second-best January, with sales 15% above year-2000, as did Audi. Mazda announced that January sales were up 33% year-over-year, while Suzuki sales were 31% above January 2000. Kia sales increased 53% from last year and January sales at Hyundai were 50% above last year. There is certainly much more ailing US manufacturers than flagging demand.
And we certainly don’t see the technology industry quagmire ameliorated by more “easy money.” Instead, the great and now punctured technology bubble will be a case study for decades to come as to the negative financial and economic consequences of reckless money, credit, and speculative excess. Amazingly, however, there is still barely recognition that things ran so terribly amok. There appears no appreciation as to the extent of damage inflicted by an unprecedented flood of speculative capital into this sector. If the lending and speculative juices do get flowing again and $100’s of billion of additional dollars fall into the black hole of the “telecommunications arms race,” the consequence will be only an extension of this historic period of gross resource misallocation and precarious Financial Fragility. Perpetuating this boom creates considerable potential for the destructive process of “throwing good money after bad.” This is but one of the most obvious costs of what will be Greenspan’s failed experiment to repeal the business cycle.
And right here I would like to make what I believe is an important point. A key aspect of Financial Fragility is the accumulation of debt obligations (by households, businesses, financial institutions, and the American economy as a whole) that are in no way supported by sufficient underlying economic wealth-creating capacity. While the $100’s of billions of dollars that flooded into the Internet and Telecom bubble have been spent and great resources squandered with little economic value to show for it, the financial claims for the economy as a whole remain as if this money and credit melee went off swimmingly in a sound investment boom. Broad money supply ended last week at almost $7.2 trillion, about $1.75 trillion (32%) more than where it began 1998. What wealth producing assets are backing this monetary explosion? It appears a fatal characteristic of bubble economies that financial obligations grow exponentially at the same time that the true economic wealth creation collapses.
There is this most regrettable notion in this country that how money is spent is not relevant. Amazingly, even the Greenspan Fed shows scant concern for the quality of investment or our economy’s habitual over consumption. Apparently, the belief is that the quality of spending is basically inconsequential because it’s pretty darn simple to make more money at a whim. It seemingly was not appreciated in Mr. Friedman’s analysis nor by current central bankers that this is very much just “running a tab.” While the resources are wasted, particularly at the latter stages of booms, the financial obligations remain. Simply creating more financial obligations only delays and makes worse the unavoidable financial and economic adjustment. At some point there will be a call on these obligations. Financial Fragility lies in wait. A failure of current policy is that it nurtures those with a proclivity of “running a tab.”
Most important to this process, our foreign obligations now grow by almost $40 billion monthly, a truly staggering sum. Borrowing huge sums for consumption – by individuals and households at the micro level, or the U.S. economy at the macro level – should be patently recognizable as part and parcel to Financial Fragility. This is unsustainable and very much a critical structural issue that must be resolved, although the current central bank policy only exacerbates this disaster and ensures a dollar crisis at some point.
While the severity of structural economic distortions are becoming more conspicuous by the week, the heart and soul of Financial Fragility lies imperceptibly within the U.S. financial sector. Here, unprecedented leveraging and unfathomable derivative positions has created the proverbial house of cards. We have in the past often stated that when the financial sector loses its ability to leverage, the game is over. The financial sector ended the third quarter with $8.15 trillion of borrowings, an increase of $2.7 trillion, or 50%, in less than three years. However, this is the key area where Greenspan has great influence and the ability to prolong the game, albeit with incredible costs. And while the historic GSE bubble grows to unimaginable proportions, only time will tell as to what extent the US household sector takes the bait and piles on another layer of mortgage debt. We are in the midst of a major refinancing boom with attractive interest rates and years of extraordinary housing inflation providing the fodder for potentially unprecedented borrowings. Back in 1998 the average household was said to have extracted $15,000 of equity during refinancing. Taking a very conservative view with 5 million households pulling $20,000 of equity, $100 billion of additional purchasing power is created. This number could easily go much higher. Not only is such credit creation potentially destabilizing and inflationary, it will no doubt prove a very difficult burden come the inevitable piercing of the real estate bubble. Federal Reserve rate cuts are a fire hose showering gasoline onto the real estate finance bonfire, greatly exacerbating Financial Fragility.
The bottom line is that for years the financial system and economy have fallen terribly off course. Endemic over borrowing, massive over consumption, reckless speculation and incredible malinvestment have brought us to today’s critical juncture. The situation beckons for what would be a difficult but necessary business cycle downturn, the only means of beginning the process of getting back on a track of sound money and healthy economic expansion. Perpetuating the current destructive process is an unmitigated disaster. Fighting Financial Fragility with only more monetary excess is a war that cannot be won. In fact, the present course guarantees that things go terribly wrong.
In a world where analysis seems all too often to be “turned on its head,” I’ll admit that the most perplexing commentary I have seen recently comes from Pimco’s Bill Gross:
“And the most recent economic news suggests that the slowdown is picking up speed. So much so that if we aren’t already in a recession, we are very close. Confidence in the economy is crumbling. Business confidence has plunged, capital investment is slowing and production is contracting. Consumer confidence is clearly in a downtrend. This indicator is key as consumers account for as much as two-thirds of economic growth. Confidence needs to turn back up for the economy to recover. We think the Fed will ease as much as necessary to restore confidence. That means the Fed Funds rate, which stands at 5.5% today, could be pushed down to 4% or lower.”
I know that if I were the largest investor in the world in the US bond market, I would look with great consternation at the inflationary course set by Greenspan. But, then again, the bond market vigilantes are a relic from days long past.
I will end with several additional quotes that I see as particularly timely in this most fascinating environment.
“If we are dealing with a closed system, so that there is only the condition of internal equilibrium to fulfill, an appropriate banking policy is always capable of preventing any serious disturbance to the status quo from developing at all…But when the condition of external equilibrium must also be fulfilled, then there will be no banking policy capable of avoiding disturbance to the internal system.” John Maynard Keynes 812
“…We have seen that having a widely accepted medium of exchange is of critical importance for any functioning complex society. No money can serve that function unless its nominal quantity is limited.” Milton Friedman, Money Mischief 1992 MM42
“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” John Maynard Keynes, 1920 (MM 189)
“(Federal Reserve Bank of Dallas President Robert) McTeer concluded his speech by driving home the message that consumers do their part to keep the economic expansion going. He implored the audience: ‘Go out and buy something.’ Dow Jones News 2/2/01
“If we all join hands together and buy a new SUV, everything will be OK.” Robert McTeer, Associated Press, 2/2/01
It was another week of destabilized financial markets. What else is new? For the week, the Dow gained 1% and the S&P500 added 2%. The Morgan Stanley Cyclical index was unchanged, the Morgan Stanley Consumer index dropped 1%, and the Transports declined 2%. The Utilities added 2%. Interestingly, the small cap Russell 2000 was unchanged and the S&P400 Mid-Cap index declined 1%. It was, of course, a big week for the technology sector with the NASDAQ100 adding 6%, the Morgan Stanley Technology index 9%, and the Semiconductors 7%. Year-to-date, these indices have gained 13%, 21%, and 25%. The Street.com Internet index gained 6% and the NASDAQ Telecommunications index added 5%, increasing year-to-date gains to 27% and 21%. The Biotechs have not been as fortunate, posting a loss of 1% this week. The financial stocks were unimpressive, with the S&P Bank index declining 1% and the Securities Broker/Dealers adding 1%. Gold stocks were generally unchanged.
It was another very volatile week in the credit market, with yields dropping considerably once again. Two and five year yields dropped 16 basis points, while the bellwether 10-year Treasury yield declined 8 basis points. The long-bond saw its yield drop 7 basis points to 5.55%. Mortgage yields declined in line with Treasuries, with the yield on the benchmark Fannie Mae mortgage-backs dropping 9 basis points to 6.78%. Agency yields generally declined 7 basis points, while the benchmark 10-year dollar swap spread was unchanged at 90. The dollar index enjoyed a rally of about one and one-half percent. Energy markets were wild again this week, with natural gas prices declining about $1 (to $7), while crude surged more than $2 to end the week back above $32. Broad money supply expanded another $15 billion last week, making its growth $176 billion in 7 weeks.
“A pathetic side of the manipulation of credit in modern times is that the owners of capital, especially the little capitalists, are swept into a pool of adventure, in which the actual lending of the capital is on a great scale and performed by central agencies alleged to be so expert in debt-trading that it is better to entrust all to them. In this way loans are made and debtors accommodated, representing risks that the owner of the money, were he lending directly, would never dream of taking. It is supposed that the great professional lenders are vastly experienced, and possess almost magical discretion. The truth is that these pompous egotists throw money around, in prosperous times, with as much abandon as though it were confetti.” Freeman Tilden, A World In Debt, 1935
“The modern world, however, boasts of the extent of its manipulation of “credit facilities,” and announces that one unit of actual coin or convertible currency can be made to support thirty or even forty units of credit. So that, soon after the depression began in 1929, the President of the United States, Mr. Hoover, was found begging his people not to hoard money, for by doing so they were destroying, for every dollar so hoarded, many dollars of invaluable credit. Of course they were. What did the great manipulators of credit suppose would happen when they had piled obligation upon obligation in an inverted pyramid that rested upon the final right of some original creditor to claim the wealth he had lent to his debtor? Did they think the time would never come when, from panic brought on by a sense of the topheaviness of the structure, the actual owners of the goods would suddenly say ‘Pay me’? Freeman Tilden, A World In Debt, 1935
“It is the fear of capital for its safety that precipitates a panic, and it is the attendant rush to cancel debt that brings about the ensuing depression. It follows that any scheme looking toward the avoidance of panics and depressions must deal with this cause; and any plan that does not do so is not only idle, but may be a dangerous adventure. Hence, the way to deal with a collapse of exchange is not to pretend that “prosperity” is merely in a temporary eclipse, to return again if everybody will act optimistically; but frankly to acknowledge that conditions were unsound, and permit the natural impulses of trade to rectify them. This prescribes a bitter medicine, which people do not like and politicians cannot collect upon; but quack remedies merely put off the final day of reckoning.
The natural remedies, if the credit-sickness be far advanced, will always include a redistribution of wealth: the further it is postpones, the more violent it will be. Every collapse of credit expansion is a bankruptcy, and the magnitude of the bankruptcy will be proportionate to the magnitude of the debt debauch. In bankruptcies, creditors must suffer.” Freeman Tilden, A World In Debt, 1935
“While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy. The bursting of the Japanese bubble a decade ago did not lead immediately to sharp contractions in output or a significant rise in unemployment. Arguably, it was the subsequent failure to address the damage to the financial system in a timely manner that caused Japan’s current economic problems. Likewise, while the stock market crash of 1929 was destabilizing, most analyst attribute the Great Depression to ensuing failures of policy. And certainly the crash of October 1987 left little lasting imprint on the American economy.” Alan Greenspan, June 17, 1999
There is not one paragraph from the volumes of Greenspan material that I have read that I ponder more than the above. Somehow, monetary policy has regressed to the point of complete disregard for financial and economic excess. Why worry about a boom, when there is always monetary policy to insure against a bust. Why worry about poor and excessive lending when monetary policy is always available to make the reckless lenders whole? Why worry about the type of investment funded by the lenders, when new lending capacity can be created as easy as “the Federal Reserve reduces interest rates by 50 basis points”? For Greenspan, as well as Wall Street, “the answer” can always be found with accommodative monetary policy. Lower rates, create a positive yield curve, and “free money” is created out of thin air. Keep the leveraged financial players in the game, credit remains available, and a perpetual boom is assured.
The foundation of this faith was laid with the monetary accommodation after the 1987 stock market crash. The cure for the early 1990s S&L debacle and severe bank problems (significantly exacerbated by late 80’s “easy money”) was a bout of extreme monetary accommodation, as well as the resulting boom in non-bank credit creation. The heavy cost of this policy was unprecedented leveraged speculation in the U.S. credit market (and emerging markets). 1994 ushered in the inevitable crisis of “deleveraging” in the credit market, the Orange County bankruptcy, and the Mexican collapse (direct consequences of previous “ultra easy money”) and the “answer” was found in truly negligent accommodation of egregious credit and speculative excess. That time around, the cost manifested into endemic leveraging, especially in emerging markets, as the global financial system was left as “free game” for the leveraged speculating community. This, of course, led us to the spectacular booms turned domino collapse throughout SE Asia, Russia, emerging markets generally, and LTCM. With the global economy and financial system at the greatest risk since in a generation, the “natural” response was to through caution to the wind. The consequence was the historic Internet/telecom/technology speculative bubble that burst last year. But, once again, “the consequences need not be catastrophic,” with lower interest rates and the accommodation of whatever credit growth Wall Street sees fit in creating to help to let the air out easily.
Well, it sure seems like we’ve witnessed a lifetime of financial crises over the past 13 or so years. And, ominously, each crisis only comes more quickly and in greater dimensions than the one before. Why is there no recognition that the Greenspan Fed is perpetrating an absolutely failed policy, and that this is culminating in what is clearly a potential disaster? Mr. Greenspan may believe that he is masterfully letting the air out of the tech bubble, but he apparently remains oblivious to a very precarious “big picture”: his policies continue to nurture a massive credit bubble that is being pumped up by the day to truly unprecedented dimensions. The questions to be considered now are how long this period of “reliquefication” continues, the character and degree of the manifestations from this credit inflation, and the scope of the inevitable bust.
The Internet/telecom bubble lasted about 18 months. One characteristic of contemporary finance is the alarming degree of excess and resulting financial and economic damage that can be propagated in a relatively short period of time. This fact apparently does not enter into Greenspan’s thinking as he is locked in a negligent strategy of “accommodating” the latest crisis, over and over and over. Today, he recklessly accommodates what we view as the terminal stage of consumer credit excess. And just as the bulls spouted nonsense during the ridiculous Internet/NASDAQ boom, they are right back at their favorite game. Listening to the bulls, one is left to believe that it is “business as usual” as an enlightened Federal Reserve again ensures Endless Summer - the next leg in a perpetual bull market in what is without a doubt Permanent Prosperity. Isn’t life a dream… But in reality there is no such thing as a “free lunch” from the Fed, only a more conspicuous and precarious bubble. While this highly effective mechanism does create astonishing “liquidity” to perpetuate this fateful credit bubble, this is only “debt piled on debt.” This tenuous structure is made only more fragile by the very poor quality of current lending.
For this “round,” of reliquefication, it should be recognized that it is the consumer that is now being buried as he/she adds to the mountain of mortgage and installment debt. The costs will be devastating for so many in what is an absolute tragedy. In the words of the brilliant Freeman Tilden, we are witnessing a very “pathetic side of the manipulation of credit…” Why has the Japanese experience of burying the consumer sector in mortgage debt been completely ignored by our policy makers? Despite extremely low interest rates, the cautious Japanese consumer saves and shuns debt more than a decade after the bursting of the Japanese bubble. This is overwhelmingly the key to understanding the protracted stagnation in Japan.
Fourth quarter numbers are in, and there is certainly no stagnation at Freddie Mac, as the government-sponsored enterprise (GSE) expanded its mortgage portfolio at a 29% annualized rate ($25.8 billion). As expected, it was Freddie’s most aggressive expansion since the historic fourth quarter (reliquefication) of 1998. Fannie and Freddie combined to expand assets during the fourth quarter by $63 billion, a 24% growth rate. These two behemoths increased assets by $113 billion during the second half (22% rate) compared to $60 billion during the first half (12%). Interestingly, money market fund assets expanded at about 8% during the first half and then accelerated to 21% during the second half. Could the close correlation between money fund assets and GSE balance sheets be mere coincidence? Nope.
There were interesting comments from a key Federal Reserve policy maker highlighted in an article yesterday by Deborah Lagomarsino of BridgeNews: “Turning to the issue of financial market soundness, (St. Louis Federal Reserve Bank President William) Poole repeated that the United States needs to ‘make clear the extent’ of federal guarantees for government sponsored enterprises (GSEs). Poole did not name them specifically, but these include such housing-related entities as Fannie Mae and Freddie Mac. While the debts of GSEs carry no explicit guarantee, the market prices these obligations ‘as if there is a federal guarantee,’ Poole said. ‘Should there be an unpredicted shock of some sort to one of these firms, the likely outcome is substantial market disruption as a consequence of the uncertainty over the government's role,’ he said. ‘Congress ought to examine carefully whether the GSEs are managing their affairs in a way that is consistent with the inherent risks they face,’ he said.” Is the Fed getting nervous? It ought to be.
Reckless lending, however, is anything but limited to the GSEs. MBNA, the largest publicly traded credit card lender, increased loans during the quarter by $4.1 billion, a 20% annualized rate. For the entire year, the company increased “managed loans” by a record $16.5 billion (23%) to $88.8 billion. Total assets (a large portion of loans are securitized and sold) increased 25% to almost $39 billion. MBNA added 2.2 million new accounts during the fourth quarter. From the earnings release: “Charlie Cawley, president of MBNA, said, ‘We have completed the best quarter in our history. MBNA has produced earnings increases, averaging 25%, in each of the 40 quarters since we became a public company…” It is sure a lot easier to produce earnings by lending money than it is by producing products…
Subprime credit card issued Providian increased loans by $3 billion during the fourth quarter, an annualized growth rate of 50%. “For the full year 2000, total managed credit card loans increased 42% over year-end 1999.” There were 1.3 million new accounts during the fourth quarter and for the year new accounts increased by 31% to 16.3 million. Importantly, however, there is now clear trouble on the horizon with charge-offs jumping to a rate of 8.48% compared to 7.61% during the third quarter and 6.78% during the year ago fourth quarter. All the same, the company continues to give guidance for 35% loan growth for 2001. Providian ended the year with total assets of $18.1 billion (up 26% for 2000) supported by shareholder’s equity of $2 billion. The bulls continue to trumpet the rates customers are willing to pay on Providian cards. We continue to suspect that Providian books a lot of revenues that it will never collect.
To fund a ballooning balance sheet of risky subprime credit card loans, Providian has raised $13 billion of deposits. From the company’s website: “Providian offers safe, FDIC-insured deposit accounts that consistently pay among the top rates available nationally. Open your account online and get started saving today…Providian CDs are a worry-free way to earn excellent returns and diversify your portfolio.” And for you big spenders, “Providian has two banks; your total deposits are insured up to $100,000 per accountholder, per bank.” FDIC insurance hard at work…
And then there’s Capital One. The company reported that it added 4.3 million net new accounts during the quarter – yes, the quarter. Adding on average more than 47,000 new accounts daily, CapOne ended the year with 33.8 million accounts. “Managed consumer loan balances” increased $5.4 billion during the quarter to $29.5 billion, about double estimates. This 22% increase for the quarter translates to an 88% annualized rate, yes, 88%. From a Wall Street research report: “COF noted that portfolio growth in the quarter was enjoyed in all three segments (superprime, prime and subprime), with a bias towards superprime on the strength of the company’s recently launched 0% purchase teaser program. Management also stated the prime segment increased “significantly” for the first time in the last few years. Also of note, management indicated that the recently formed alliance with K-Mart has already generated in excess of 1 million new accounts since mid-September.” I don’t make this stuff up…
Elsewhere, Household International added $4.2 billion of “managed receivables,” a growth rate of about 20%. For the year, receivables grew 22%. “Growth within the quarter was strong across all consumer product lines, most notably in real estate secured and MasterCard/Visa receivables.” New home equity loans totaled $1.3 billion.
And then there is AmeriCredit, “a sub-prime auto finance company headquartered in Fort Worth, Texas, which makes loans to consumers with blemished credit histories – a market with approximately $100 billion in annual originations. The company has developed proprietary scoring and collection tools that have enabled it to be the only sub-prime finance company to not miss an earnings estimate or have credit problems since entering the indirect auto finance business in 1992.” For the quarter, automobile loan purchases were almost $1.4 billion, an increase of 41% from the comparable period one year ago. Year over year, Americredit’s managed loan portfolio surged 55% to $8.2 billion.
Subprime lender Metris, with 4.5 million accounts, saw its total assets increase 82% over the past year to $3.7 billion. Metris added 300,000 new accounts during the quarter and expanded managed receivables at a 36% rate (branded as “tepid” by one Wall Street analyst!). Managed receivables have increased 27% over the past year.
Wild excess is, not surprisingly, also seen in student loans. Here USA Education/Sallie Mae (another GSE) acquired $2.4 billion of loans during the fourth quarter, a 40% increase from last year. For the entire year, Sallie Mae acquired $20.5 billion of loans, a 50% increase from 1999.
As we have stated before, consumer credit and “subprime” are where it’s at today on Wall Street, as firms tout these “growth stocks” and profit mightily by peddling their securitizations. As usual, a “hot” sector gets the full attention of the Street’s amazingly effective propaganda machine. The “apologists” for the consumer debt bubble are not unlike those that not all too many months ago manufactured “analysis” and New Age theories supporting the Internet bubble. The bursting of a bubble, “no problem,” we’ll create a new one.
“Now let’s look more closely at the U.S. savings rate. Our gross savings rate is 18%, so we’ve been able to tolerate a lower personal savings rate because the government savings rate has been so much higher. Some of the horror stories told about overextended consumers aren’t quite true. John (Neff) indicated we’re not at the upper limit of consumer debt to income, but consumers are in even better condition when you include installment debt, about 30% of which isn’t really debt at all. It’s cash management – using our credit cards instead of cash, getting our frequent-flyer miles and all the rest of it…Thirty percent of installment debt is paid off each month.” Abby Joseph Cohen, Barron’s (Roundtable discussion) 1/15/01
Ms. Cohen either doesn’t know what she is talking about or she is blatantly obfuscating the facts. First of all, the U.S. economy is on course to run an unprecedented current account deficit that will soon approach $450 billion (4.5% of GDP). Obviously, as an economy we are living grossly beyond our means, extreme money and credit growth run unabated, and any chatter that “our gross savings rate of 18%” is simply ridiculous. But then again, we had “analysis” justifying a $500 price target for Amazon.com. Second, to look at installment debt without recognizing the explosion of mortgage debt during this boom cycle is silly (how much home equity debt has been used to pay down credit card balances?). Still, during the past 12 months (data through November), total non-mortgage consumer debt has increased 10%, while the category “revolving debt” has jumped 12%. The issue is not how many purchases are made with plastic (credit or debit cards), but how much additional debt is accumulated each month. It matters greatly that the consumer is spending beyond her income, in what should be seen as clearly fostering unsustainable borrowing and spending. To not appreciate this predicament is an inexcusable analytical blunder.
Where the bulls really have it wrong is their focus on the ratio of debt service to income. Not only is this very poor analysis, it is quite dangerous. Actually, it is interesting (hopefully enlightening) to see how the numbers really work. Using one of the many “how much home can you afford” mortgage calculators now available online, one can certainly see the seductive power of leverage, as well as getting right to the heart of the bull’s (erroneous) argument. Let’s assume that a borrower has $5,000 a month gross income, $10,000 cash on hand, $500 per month other debt service (student loans, car payments, credit cards, etc.), and interest rates are at 8%. An “aggressive” estimate by the “calculator” using a 3% downpayment (quite popular today!) will allow for a $1,300 monthly mortgage payment (almost 30% of gross income). In this case, the “calculator” says that the borrowers can borrow $133,000 to purchase a home priced at $137,000 (with mortgage insurance, of course!). Now, let’s change the assumptions a bit. Let’s say this borrower lands a 10% increase in gross income (certainly reasonable in this environment of strong wage growth) and that interest rates drop to 7% (with the Fed lowering rates and a “whiff” of financial crisis in the air). The “calculator” now says that the borrower can obtain a loan of almost $172,000 on a home valued at $177,000. A veritable gift from god…time to step up to a better neighborhood! Importantly, in this example, the borrower can now take on 30% additional debt ($44,000) with exactly the same “debt to income” level. Everyone’s happy. Credit and asset bubbles are both insidious and very seductive.
In the hopelessly bloodshot eyes of the bulls, this extra 30% ($44,000) of debt just doesn’t matter – the consumer (or the economy for that matter) is not any more “overextended.” This is, of course, complete nonsense (working to keep the “G” rating on this commentary). Clearly, the consumer has increased his risk greatly, although it may not appear this way in the current age of rising home prices, 4% unemployment and the illusion of wage gains as far as the eye can see. The critical ramifications, however, are much more apparent when looking at this situation from a “macro” perspective. As has been precisely the case, if much of the household sector goes through this “calculation” in an environment of unlimited availability of mortgage lending, then there will be a gross increase in total mortgage debt. And, just as sound analysis would have projected, this gross expansion of mortgage credit has stoked a major surge in housing inflation (too much money chasing too few homes). This credit-induced asset bubble has been the major factor fueling the over borrowing and over consumption that continues to foster massive trade deficits and the accumulation of unthinkable foreign liabilities.
And as we go full circle on this line of thinking, it is precisely the unprecedented accumulation of foreign liabilities that will prove the Achilles heel for the sanguine views espoused by Greenspan and the bulls. It is only a matter of time until a faltering currency shatters the halcyon notion that monetary policy always provides the mechanism by which credit inflation resolves any crisis, financial or economic. Today, the bulls believe that debt burdens can continue to be lessoned by asset and wage inflation. And while there are many flaws in this line of wishful thinking, there is today a basic lack of appreciation that we do in fact live in a global economy. Wage inflation at home comes at the cost of an even greater loss of global competitiveness, as is undoubtedly one of the factors behind our faltering manufacturing sector (“no problem, lower interest rates!!!”). Granted, this hasn’t been much of an issue for sometime, with domestic demand booming and the dollar benefiting from what historians will likely identify as an extraordinary aberration in the face of an extreme deterioration in underlying fundamentals. However, it is becoming clear that perceptions are changing with respect to the greenback.
For years we have traded goods for “paper.” And with the price of our “paper” inflating, huge investment and speculative foreign flows have financed our profligacy. The dollar didn’t miss a beat. Having the world (and the speculators!) enamored with our “paper” has been one heck of a wonderful advantage – it makes domestic wage inflation and the loss of competitiveness for our goods-producing industries hardly an afterthought. The key to “success” rested with “a strong dollar is in the best interest of the United States,” a policy focused specifically and stridently on maintaining the price of our “paper.” And with a credit excess-induced asset bubble fueling surging demand for the New Age service sector economy, why even be concerned with producing goods anyway (besides, they pollute!)? The consequence of this brand of economic “success” is today an acutely fragile prosperity and an enormous gap between the current “value” of all this paper and the underlying capacity to create true economic wealth.
If demand for our “paper” wanes (as we believe has commenced), we are going to have to pull out and dust off the old “rulebook,” and the New Paradigmers will have to dispose of their playbook. Crazy as it may seem, we have a sneaking suspicion that the long-forgotten issue of “competitiveness” quickly moves right back to center stage. Such an event will mark the unfortunate confrontation between strong domestic wage growth and a fierce global business environment. This is also when this Wall Street game of justifying egregious consumer debt through the extrapolation of wage inflation breaks down. Furthermore, this when what is clearly an overvalued dollar becomes acutely highly suspect. And as much as it is taboo to even think of such a thing, one of these days our creditors may even say, “Pay me!”
So, if one stands back, takes a long look, and contemplates reality for a bit, it becomes perfectly reasonable to expect that there is one heck of an adjustment waiting around the bend. Going forward, the bottom line is that the U.S. economy is going to have to compete in the global market for goods and services – the days of “goods for paper” are running on borrowed time. Sure, the Fed and Wall Street are clearly determined to perpetuate this great credit inflation as the mechanism to sustain unsustainable demand, turn around the faltering manufacturing sector, and maintain this momentous consumer debt and financial bubble. The answer, in all cases, will not be found in more credit. I just can’t shake the notion that the sophisticated global players don’t see the writing on the wall. After all, any scheme that has gotten to the point of necessitating the burying of the consumer sector must be “at the end of its rope.” At least this wouldn’t be the first option.
So, it may be next week, next month or perhaps even a few months down the road. But everyone (including Mr. Greenspan) better well be prepared for The Wrath of Mr. Market. He hasn’t been around these parts in a spell and all the townsfolk, especially the drunken gamblers and gunslingers down at the Saloon, have long forgotten what a tough Son of a Bitch he can be. He doesn’t like troublemakers and has his own way of dishing out his own ferocious brand of punishment. Mr. Market does it on his terms, is unpredictable by nature. But boy can he be quick as lightening, with his punches landing with shocking force. We’ve been on the lookout for him but don’t see him quite yet. He uses the element of surprise as one of his best weapons. He’s on his way; make no mistake. We can already hear his intimidating voice now: “The raping and pillaging, the fun and games are over for all you wild cowboys, drunks and card sharks. All this BS has gone on for way too long and has gotten way out of hand, so I have no choice but to bring it all officially to an immediate end. From here on out, there’s going to be some law and order in this here town. I’m changin’ the rules and I’m going to enforce them with an iron fist. You might darn well get used to it. From now on, we’re going to do things with some discipline and respect. There’s a new sheriff in town…”