02/07/2003 Scenario #3 *

It was another poor showing for U.S. and global equities. For the week, the Dow dipped 2% and the S&P500 declined 3%. The Transports declined more than 1%, and the Utilities were hit for 3%. The Morgan Stanley Cyclical index sank 4% and the Morgan Stanley Consumer index dropped 3%. There was no relief in the broader market, with the small cap Russell 2000 and S&P400 Mid-Cap indices shedding 3%. The technology sector suffered, with the NASDAQ100 declining 3%, the Semiconductors 4%, and the Morgan Stanley Technology index 5%. The Street.com Internet index declined 4%, and the NASDAQ Telecommunications index dipped 3%. The Biotechs dropped 3%. The financial stocks were under pressure, with the Securities Broker/Dealers down 5% and the Banks 4%. Although a volatile bullion price ended the week up $1.40, the HUI Gold index declined 3%.

Under the circumstances, the Treasury market was again not all too impressive. For the week, the two-year Treasury yield declined eight basis points to 1.62%. The five-year Treasury yield declined four basis points to 2.87%, and the 10-year yield dipped only three basis points to 3.93%. Benchmark mortgage-backs and agencies performed relatively well, with yields generally declining about six basis points. The spread on Fannie’s 5 3/8% 2011 note was about unchanged at a narrow 36.5, while the benchmark 10-year dollar swap spread was unchanged at 44.5. Corporate spreads generally widened marginally.

The dollar could not muster back-to-back weekly gains, drifting slightly lower for the week. The CRB index added less than 1%, while trading to the highest level since May 1997. Heating oil futures jumped 21% this week to a 23-year high. Crude prices matched 2-year highs at $35.20 a barrel. Natural gas also traded to a two-year high. The Mexican peso traded to a record low of 11 to the U.S. dollar. The announcement by the Mexican central bank that it was moving to tighten liquidity to support its faltering currency had no impact.

There was $47 billion of U.S. corporate and agency issuance this week. Goldman Sachs sold $2 billion (up from $1.0 billion) of 30-year bonds. Also issuing 30-year bonds, Enterprise Products (oil and gas) raised $500 million. KB Homes raised $300 million (up from $250 million). HCA sold $500 million of bonds, Rite Aid $300 million and Parker-Hannifin $225 million. Interestingly, International Lease Finance, the leasing subsidiary of AIG, was forced to cut the size of its debt offering in half to $500 million. AMG reported about $500 million flowed into junk funds this past week, a reversal from the previous week’s outflow.

Broad money supply (M3) expanded $37.7 billion last week to a record $8.54 Trillion, with two-week gains of $69.5 billion. Currency added $1.5 billion, while Demand and Checkable Deposits increased $13 billion. Savings Deposits added $2.2 billion and Retail Money Fund deposits increased $5.2 billion. Institutional Money Fund deposits jumped $20.4 billion and Large Denominated Deposits added $1.3 billion. Repurchase Agreements declined $1.7 billion and Eurodollars dipped $3.2 billion. Broad money supply is up $489 billion, or 7.7% annualized, over the past 41 weeks. Elsewhere, the commercial paper (CP) market turned quiet. For the week, outstandings slipped $500 million, with Financial Sector CP down $3.8 billion and Non-financial CP up $3.3 billion. Bank Assets were down $16.6 billion, giving back some of the previous week’s $53.7 billion expansion. Bank Credit was down $6.1 billion, with Securities holdings declining $13.1 billion. Loans and Leases gained $6.9 billion. Real Estate loans were up $4.5 billion to $2.04 Trillion, and Security loans jumped $6.7 billion to $183 billion. Meanwhile, Commercial and Industrial loans declined $2.5 billion to $960 billion. An annual conference was responsible for this week’s minimal ABS issuance.

The Mortgage Finance Bubble blow-off hit week 33, with the Mortgage Bankers Association refi index remaining (despite being down 4% this week) about double the year ago level. The Purchase application index was up 1.5%, about 9% above one year ago. Construction spending was up for the fourth straight month, increasing in December at the strongest pace in ten months. Spending on new single family units was up 12.2% y-o-y, with multi-family spending up 2.6% y-o-y. Spending on Home Improvements was up 7.2% y-o-y. However, non-residential spending was down 14% y-o-y, with Industrial down 35%, Office 23.6%, and Hotels, Motels declining 30.3%. Public sector construction spending was up 4.7% y-o-y, with Educational up 11.4%, Hospital 15.6%, and Military 28.8%.

Manufacturing lost another 16,000 jobs during January, increasing eight-month losses to 330,000. Service Producing employment jumped 143,000, with Retail Trade accounting for 101,000. This reverses December’s 99,000 decline, and by subcategory we see that Eating & Drinking establishments added 73,000 jobs after dropping 66,000 in December. Another 6,000 Mortgage Bankers were added, with 39,000 new jobs in five months. Health Services added 18,000 jobs (178,000 in 8 months!) and Government added 4,000. It is worth highlighting that the Labor Department reported total U.S. jobs at 130.8 million. Goods Producing Jobs totaled 23.6 million, with 16.4 million employed in manufacturing. Service Producing jobs accounted for 107.2 million, including Retail Trade at 23.3 million, Business Services 9.3 million, Finance and Insurance 7.8 million, Health Services 10.8 million, and Government 21.4 million. And looking at January’s Hours Worked data, we see that Total Private industry Weekly Hours Worked were up 0.1% y-o-y. January Goods Producing Hours were down 2.1% y-o-y (Manufacturing down 2.4%), while Service Producing Hours were up 0.7% (Finance and Insurance up 2.1%, and Services up 1.6%).

And while the media focused on the disappointing report on Non-farm Productivity (down 0.2% vs. expectations of up 0.7%), our eyes caught further indication of germinating inflationary pressures. Compensation per hour increased at a 4.6% annualized rate, this after the third quarter’s 5.4%. Today had the ECRI future inflation gauge jumping 2.5 points in January to 119.7, the highest level since August 2000. This is up from January 2002’s reading of 97. The ISM Manufacturing index saw the Prices Paid component rise slightly to a strong 57.5, while the ISM Non-manufacturing Prices Paid added 1.7 points to 57.

February 3 – Bloomberg: “U.S. companies generated their biggest revenue gains in almost two years in the fourth quarter, led by companies such as Exxon Mobil Corp., Amgen Inc. and Southern Co. Revenue rose 6.9 percent in the period for the 331 companies in the Standard & Poor’s 500 Index that had reported results as of Thursday, according to Bloomberg data. Oil companies benefited from a surge in prices because of concern that a war in Iraq will disrupt supplies, while colder weather boosted demand for heating fuels. Health-care companies are selling more drugs and medical devices as the U.S. population ages.” (Further evidence of heightened sectoral inflationary pressures)

February 3 – Dow Jones: “Home equity securitizations will hit $130 billion in
2003, down slightly from the $132 billion record volume recorded the year before, according to a report published by Moody’s… The issuance will be driven by subprime borrowers who haven’t yet refinanced their loans, said Moody’s, adding that much of the new supply will come to market in the first half of the year… subprime lenders, in a continuing effort to entice borrowers with new products, are expected to expand their offerings to appeal to a broader audience this year. “ (Poor quality of newly created claims/Credit.)

February 3: “Commercial mortgage originations during the final quarter of 2002 surged to a pace 18 percent above the same period a year earlier and were up 5.2 percent for the year as a whole, according to the quarterly survey of mortgage bankers conducted by the Mortgage Bankers Association of America (MBA)… The 44 MBA members reporting in the survey originated $29.4 billion in mortgages on income-producing properties - up from the revised total of $24.8 billion reported for the same quarter last year. The year-end surge was paced by strong gains in funding by life insurance companies (up 32 percent from a year earlier) and commercial mortgage-backed securities (CMBS) conduits (up 30 percent).”

February 3 – Bloomberg: “Credit-card issuers wrote off an annualized 7.5 percent of uncollectible loans in December, the second-highest loss rate in more than 10 years, according to Standard & Poor’s. The average write-off rate, on the rise since September, climbed from 7.1 percent in November and was lower only than the 7.6 percent reported in March 2002, said S&P, which has tracked losses on card loans that back securities since 1992.”

February 7 – Bloomberg: “Sales of bonds backed by derivatives more than doubled last year to $281 billion as banks offered new types of the transactions, Creditflux said. J.P. Morgan was the biggest arranger of the instruments known as synthetic collateralized debt obligations, with 12.2 percent as measured by face value. Deutsche Bank AG handled 11.5 percent and Lehman Brothers Holdings Inc. had 10.8 percent, the monthly credit-derivatives magazine said. There were 173 synthetic CDOs last year, compared with 89 in 2001. In 2002, 64 percent were backed by derivatives on investment-grade bonds… The fastest-growing section of the market for synthetic CDOs involved derivatives that use asset-backed and residential-mortgage bonds as collateral…”

February 5 – Fitch: “The ABS market is fighting battles on four major fronts: collateral quality, issuer condition, regulatory environment, and the economic landscape, according… to the latest edition of ‘The Fitch Ratings ABS Exchange.’ Along with these concerns are the potential impact of the war with Iraq, the threat of a double-dip recession and the destructive forces of fraud. ‘While the ABS market has proved its resiliency repeatedly over the past 15 years, it is difficult to imagine a more concerning confluence of events than those facing the market today,’ said Kevin Duignan, Managing Director, Fitch Ratings… While collateral quality has deteriorated in virtually all sectors, there are a few places where Fitch is particularly concerned: increasing default rates for nonprime and subprime borrowers, declining used car prices, and deterioration in aircraft values.”

February 4 – Dow Jones (Christine Richard): “Moody’s Investors Service cautioned Tuesday that it may downgrade a number of asset-backed and residential mortgage-backed transactions because some trustees are falling short on the scrutiny and service they provide to structured transactions. The rating agency said conversations with major trustees over the last couple of months have turned up a difference of opinion over the trustee’s role as a watchdog. Also, some trustees have failed to find appropriate back-up servicers for transactions or have passed the cost of back-up servicing on to investors…‘Moody’s analysis of ABS and RMBS transactions incorporates an understanding of the responsibilities of the trustees. It now appears that, in some cases, the trustees’ own views of their responsibilities differ from Moody’s understanding…” Many asset-backed and mortgage-backed transactions carry triple-A ratings. The review of the trustee role, as initially reported by Dow Jones Newswires back in December, was begun by Moody's analysts following the demise of National Century Financial Enterprises… In the NCFE case, funds meant to protect bondholders were diverted without drawing interference from the transaction’s trustees, J.P. Morgan and Bank One, according to Moody’s. That failure to intervene caused Moody’s to undertake a review of how trustees view their role, and the results haven’t been encouraging. Moody’s found some trustees see their role as purely administrative, which may leave the originator of a transaction policing its own compliance… Moody’s examination of some 2,500 transactions in the huge asset-backed and mortgage backed markets follows word from the Securities and Exchange Commission last week that it has concerns about the asset-backed market.” (Awfully late in the game for “differences of opinion.”)

The stocks of many key “structured finance” Operators have been under recent pressure. The European financial conglomerates are reeling, with the insurance sector especially strained. Here at home, risk behemoth American International Group (AIG) shocked the Street by announcing a $2.8 billion increase in insurance reserves. The Wall Street Journal (Christopher Oster) quoted a property-casualty analyst: “This is an indictment of the entire industry’s balance sheet.” The same day Chubb took a charge to add to reserves for its directors-and-officers liability business.

Credit Insurer powerhouse MBIA disappointed the Street with expectations of slowing growth. Year-over-year, Net Debt Service increased $59 billion to almost $782 billion. 2002 Global Public Finance Adjusted Direct Premium (ADP) increased 1% to $657.7 million, while Global Structured Finance ADP surged 40% to $546.6 million. Total Assets expanded 16% to $18.9 billion. And leading the list of “50 Largest Structured Finance Credits” is none other than Metris Master Trust at $2.3 billion, followed by Providian Gateway Master Trust at $2.3 billion, European Super Senior Synthetic CDO at $1.8 billion, and Global Structured Finance Vehicle at $2 billion. MBIA wrote $28.7 billion of “net par” CDO (Collateralized Debt Obligations) exposure during the year, ending 2002 with net CDO exposure of $66 billion. An MBIA exec stated to a conference call audience that he did not expect any losses from Metris, with the recent spike up in charge-offs a “seasonal” development. What?

And this today from the Wall Street Journal article (Henny Sender), “Spitzer’s Hedge-Fund Inquiry Eyes Credit Derivatives”: “Last year, MBIA saw demand for protection (credit default insurance on its debt) go from about $5 million or $10 million a week to ‘hundreds of millions of dollars a week by October for us,’ said MBIA President Gary Dunton. ‘Our view is that the market is too illiquid to be meaningful,’ he says. For Several weeks, Mr. Dunton adds, the firm indirectly sold protection on itself in an effort to keep the price from rising in a market sensitive to the sudden surge in demand. But when he became aware that the activity was primarily because of one hedge fund, MBIA withdrew from the market, Mr. Dunton says.” (An enormously exposed insurance company writing insurance on itself during a period of acute systemic stress? Very bad idea.)

February 6 – Washington Post (Daniela Deane): “The White House has announced that it will nominate Mark C. Brickell, an expert on financial derivatives (‘a former managing director in the derivatives group at J.P. Morgan & Co.’), to head the federal agency that oversees Fannie Mae and Freddie Mac, the giants of the secondary mortgage market. Sources familiar with the situation said Armando Falcon Jr., head of the Office of Federal Housing Enterprise Oversight, was asked by administration officials for his resignation Tuesday morning. That was just hours before Falcon released the findings of a "systemic risk" study, which laid out a scenario in which Fannie Mae and Freddie Mac could experience severe financial difficulties that then would cause wide-ranging disruptions in the housing and financial markets.”

February 5 – Dow Jones (Dawn Kopecki): “Fannie Mae and Freddie Mac officials… dismissed the agency’s report. ‘This simply, in our mind, is not a serious piece of policy research’ said Freddie Mac spokeswoman Sharon McHale. ‘It’s based on this completely speculative doomsday scenario where we essentially wake up and are insolvent.’ Fannie Mae spokesman Chuck Greener agreed: ‘The Falcon paper is a review of research on systemic risk and discussion of hypothetical scenarios. The director himself acknowledged these scenarios are hypothetical and quite remote.’”

I disagree vehemently; OFHEO’s report should be taken very seriously and accomplishes much more than simply addressing “quite remote” hypothetical scenarios. Indeed, Mr. Falcon should be strongly commended for courageously formulating the first examination of the GSEs and their critical role in fomenting heightened systemic risk. The 118 page report is comprehensive, thoughtful, independent, formative, and extraordinarily timely. It is by far the most relevant and important “policy research” I have read. I have compiled excerpts attempting to highlight key aspects of OFHEO’s analysis, but strongly recommend a thorough reading http://www.ofheo.gov/docs/reports/sysrisk.pdf . (This is a 118 page pdf file)

“Introduction: Over the past quarter-century, financial markets in many countries have experienced serious disturbances associated with financial institutions and failures. The period has been one of profound and rapid changes in the financial sector. Those events have heightened awareness of systemic risk – the possibility that a systemic event, a financial crisis that leads to a substantial reduction in aggregate economic activity – will occur… Recent analyses of systemic risk have concluded that some non-bank financial institutions are now so large and integral to the financial sector as a whole that their failure could lead to a systemic event. Fannie Mae and Freddie Mac – the two government-sponsored enterprises (GSEs) chartered by the federal government to support the secondary market for residential mortgages – are among the largest non-bank financial institutions in the world. Thoughtful observers have expressed concern that, if either of those Enterprises experienced severe financial difficulties, turmoil in the market for GSE debt could become severe and spread to other financial markets, substantially increasing systemic risk…

The large and rapidly growing literature on financial crises, systemic risk, and the role of governments in mitigating that risk includes no detailed analyses of how Fannie Mae and Freddie Mac can affect systemic risk. This report addresses that gap by analyzing how the Enterprises operate in the housing finance system and the financial sector, how their activities affect economic activity, and how they can affect systemic risk in different circumstances.

At the end of 1990, Fannie Mae and Freddie Mac had securitized $604 billion in outstanding mortgage loans and held an additional $136 billion of mortgages in their asset portfolios. The Enterprises combined total book of business – mortgages securitized and held on the balance sheet – represented 25% of outstanding residential mortgage debt. At the end of 2001, the combined mortgage asset portfolios of Fannie Mae and Freddie Mac had risen to over $1.2 trillion, an increase of more than seven-fold, whereas their combined outstanding MBS held by other investors had more than doubled to over $1.5 trillion… The Enterprises’ on-balance sheet assets grew rapidly from 1992 to 2001, rising at an annual rate of 18 percent at Fannie Mae and 32 percent at Freddie Mac…

Between 1996 and 2001, foreign holdings of what the Federal Reserve refers to as “U.S. agency securities” (a category that includes the debt and MBS of Fannie Mae and Freddie Mac, Federal Home Loan Bank System debt, MBS guaranteed by Ginnie Mae, and securities of smaller GSEs and federal agencies), have grown about as fast as the Enterprises’ debt, and almost twice as fast as their combined debt and mortgage-backed securities. It was not unusual in 2000 for foreign investors to buy 50% or more of a new issue of two- or three-year Enterprise notes or more than 20 percent of a new issue of long-term notes… Importantly, the Enterprises’ debt securities make up an increasing share of the portfolios of foreign central banks… At year-end 2000 and 2001, foreign and international monetary authorities held $102.3 billion and $133.1 billion in federal agency securities, respectively…

Fannie Mae and Freddie Mac are each among the largest end-users of financial derivatives. To date virtually all of the derivatives contracts of Fannie Mae, and most of those of Freddie Mac, have been over-the-counter (OTC) contracts, primarily interest rate swaps and swaptions – options to enter into interest rate swaps… The Enterprises enter into foreign currency swaps to fully hedge the exchange-rate risk associated with issuing foreign currency-denominated debt… In volatile markets such as those associated with the Asian currency crisis of 1997 and the Russian default of 1998 – the latter associated with the collapse of Long Term Capital Management – the market values of some derivatives contracts may fluctuate significantly and even be difficult to determine, especially where markets cease to function normally and model-based valuations, which assume liquidity, become invalid… The market for OTC derivatives is highly concentrated among a small number of dealers, primarily brokerage firms and commercial banks that are counterparties for at least one side of virtually all contracts. The largest dealers include JPMorgan Chase, Citigroup (including the large derivative operation in its broker/dealer subsidiary, Salomon Smith Barney), Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley Dean Witter… (Total notional value of Fannie and Freddie derivatives at year-end 2001 was $1.19 Trillion)

Fannie Mae and Freddie Mac also have significant direct interdependencies in the form of credit exposures to private mortgage insurers. Those firms pose credit risk because there is the possibility that they will be unable to meet their contractual obligations to cover credit losses or insured mortgages owned or securitized by the Enterprises. Seven firms provide nearly all primary (loan-level) insurance on single-family mortgages, and there is significant concentration among the coverage provided by that relatively small group… The top four mortgage insurers that provided the most primary insurance for each Enterprise at year-end 2001 accounted for over 70% of each Enterprise’s primary coverage…

Finally, government sponsorship contributes significantly to the size and continuing growth of Fannie Mae and Freddie Mac and their major and expanding roles in securities and derivative markets. The perception of an implicit federal guarantee encourages market participants to view the Enterprises’ obligations as almost riskless and makes Fannie Mae and Freddie Mac favored counterparties in the market for OTC derivatives. The Enterprises are so large that the direct interdependencies between them and other participants in securities and derivatives markets may exceed those of any other privately owned financial institutions. The magnitude of those interdependencies implies that, if either Enterprise became insolvent or illiquid, investors in its debt and, potentially, its derivatives counterparties could incur losses. Fannie Mae and Freddie Mac are themselves vulnerable to conditions in the market for OTC interest rate derivatives…

Measuring Systemic Risk: Financial regulators and policy makers do not systematically quantify the systemic risk posed by the financial sector or the potential effect of individual financial institutions or markets on that risk. Measuring risk means estimating the probability of the occurrence of specific losses as a result of a specific type of event. Since systemic risk, as used in this report, is the possibility that a financial crisis will lead to substantial losses in aggregate economic output, economists would use macro-econometric models to measure that risk. Unfortunately, current economic models are not suited to measuring the potential effects of large financial institutions such as Fannie Mae and Freddie Mac on systemic risk. The typical economic model represents the financial sector in a highly aggregated fashion, a manner that is ill designed to quantify explicitly the relationships between financial variables such as the supply of credit and interest rates on different types of financial assets and real variables such as output and employment. That aggregation reflects the present state of macroeconomic theory, which generally ‘presumes that the financial system functions smoothly – and smoothly enough to justify abstracting from financial considerations”…

Financial history is replete with stories of highly regarded firms that faltered, became illiquid, and failed. In fact, two GSEs – Fannie Mae and the Farm Credit System – had serious solvency problems in the 1980s… The future differs from the past in unexpected ways, and sometimes those differences can be great. The consequence is that unexpected events can cause institutions to suffer losses from exposures that neither they nor their regulators viewed as significant or of which few observes were even aware.

An admittedly imperfect, but increasingly popular, way to circumvent those limitations is to employ scenario analysis – the construction and elaboration of hypothetical, conditional scenarios without the use of econometric models. This is what military planners do with war games. Scenario analysis does not yield numerical estimates of the risk of specific adverse outcomes but generates insights into the potential functioning of the system in question under specific conditions of extreme stress… Scenario analysis is a valuable way to analyze the potential effects on systemic risk of specific institutions or markets…

The three scenarios were selected as generic examples from a broad range of possibilities because they illustrate how the financial health of Fannie Mae and Freddie Mac, and the public and private responses to severe financial difficulties at an Enterprise, could affect the likelihood of macroeconomic losses…

Scenario #1: In a Period of Reduced Liquidity, the Enterprises Help to Mitigate risk…

Scenario #2: One Enterprise Develops Serious Solvency Problems But Remains Liquid, There are few Adverse Economic Effects, and No Systemic Event Occurs…

(For brevity’s sake – as well as for the likely irrelevance to unfolding circumstances, details relating to the first two scenarios will be omitted.)

Scenario #3: One Enterprise Suffers Large Losses and Becomes Illiquid and a Systemic Event Results. In Scenario #3 Enterprise A unexpectedly incurs large losses. Some other financial institutions are also in a weakened position. Investors generally do not believe Enterprise A is viable and are uncertain about whether it will default, about the size of any credit losses they may incur, and about the future liquidity of its debt. That uncertainty leads to widespread selling of Enterprise A’s debt as well as a large decline in the market prices of its MBS.

Scenario #3 may unfold in different ways that have significantly different consequences for economic activity. How the scenario develops depends largely on 1) how the private and public sectors respond to the sell-off in markets for Enterprise A’s obligations and 2) the financial health of Enterprise B.

In some circumstances, investors – including Enterprise B – may respond to falling prices of Enterprise A’s MBS and debt by purchasing those obligations, in which case their prices remain depressed but do not collapse and the risk to the banking system is limited. Although Enterprise A is no longer able to compete for new business, if Enterprise B is financially healthy and can convince investors of that fact, the housing finance system may adjust quickly and absorb Enterprise A’s business volume with slightly higher mortgage rates, without any major adverse effects on housing activity. In that case, no systemic event occurs in Scenario #3, as in Scenario #2. On the other hand, if Enterprise B cannot expand its activities quickly, a significant short-term decline in mortgage lending, home sales and housing starts occurs, contributing to problems elsewhere in the economy and increasing the likelihood of macroeconomic losses.

In other circumstances, the sell-off of Enterprise A’s debt becomes a panic, so that trading in those obligations virtually ceases, at least for a time. The Market for Enterprise A’s MBS is somewhat less affected because those securities are backed by mortgage collateral. Illiquidity in the market for Enterprise A’s debt and the plunge in the market value of its MBS exacerbate liquidity problems at many banks and thrifts. Those problems increase the risk of contagious illiquidity spreading through the banking system, the markets for the obligations of other GSEs, and the financial sector as a whole, adversely affecting the U.S. and the global economy. In that worst case, the federal government faces difficult choices. Actions to bolster the liquidity of the market for Enterprise A’s debt, while reducing systemic risk and protecting the economy in the short run, may cause other problems or prove to be inadequate. If the government does not prevent a financial crisis, the potential decline in aggregate economic activity may be very large.

Subsequent Developments in the Financial Sector: Many market participants have strong doubts about the viability of Enterprise A. Investors in Enterprise A’s debt and MBS are aware that federal law neither creates an explicit legal obligation for the government to provide financial assistance to the Enterprise nor provides budgetary resources or establishes a process for doing so… In this scenario those uncertainties lead to widespread selling of Enterprise A’s debt. As the prices of those securities fall and their yields rise, more and more investors try to liquidate their position before the market becomes illiquid and they can no longer do so. At the same time, the quality spreads of MBS guaranteed by Enterprise A increase much more than in Scenario #2, and bid-ask spreads in the market for those obligations widen sharply, indicating a significant reduction in liquidity…

The illiquidity of Enterprise A’s debt, and the possibility of investors in that debt and that Enterprise’s MBS incurring credit losses in the event of default, lead to spikes in the yields of the uninsured deposits of and interbank loans to many depositor institutions whose holdings of GSE obligations are large relative to their capital. Even institutions that do not hold large amounts of the obligations of Enterprise A are affected… Thus, there is heightened uncertainty about the liquidity of all depositories whose holdings of GSE debt and MBS are large relative to their capital, and over sixty percent of all commercial banks, and a significant number of larger banks, experience a sudden, large increase in their marginal funding costs. The spike in funding costs worsens the solvency problems of the subset of those institutions that had recently incurred sizable losses…

Market participants and financial regulators are concerned that a vicious circle may develop in which a large number of those institutions report declines in their net income, have to pay even higher yields on new borrowings, experience losses that create solvency problems, and become illiquid. If a very large bank or a sufficient number of smaller banks become illiquid, there could be a general decline in liquidity in the interbank loan market, which could lead to a breakdown of payment and settlement systems and a disruption in the functioning of the financial sector. Other creditors of Enterprise A may experience difficulties as well. No federal statute or regulation establishes the priority of claimants among an Enterprise’s creditors or provides a process for allocating losses among creditors in the event of default…

Among those financial institutions exposed to Enterprise A are derivatives counterparties whose contracts with the Enterprise have a positive market value. The magnitude of each counterparty’s loss could depend on the size of its credit exposure to Enterprise A and the severity of a default by Enterprise A. Under some circumstances, such losses could significantly impair the capital of some counterparties…

All of the largest derivative counterparties of Fannie Mae and Freddie Mac are major securities dealers and commercial banks or subsidiaries thereof. If any of those firms incurred credit losses that were large relative to their equity as a result of a default by Enterprise A, they could experience solvency problems. Even if Enterprise A did not default, perceptions that the risk of a default was higher and uncertainty about how a default could affect the solvency and liquidity of the major derivatives dealers could lead to a temporary spike in the borrowing costs of all of them…

The adverse effects of Scenario #3 on broader financial markets unfold quickly. Observing the illiquidity of Enterprise A’s debt, the possibility of credit losses on those obligations, and the effects of financial institutions that hold such debt, many investors become less willing to hold debt and other fixed-income obligations perceived to pose a significant degree of credit risk and liquidity risk. The demand for U.S. Treasury securities increases significantly, and the demand for higher-risk obligations declines, raising quality spreads for all non-Treasury issuers. Quality spreads for Enterprise B and other GSEs rise because increased uncertainty about the perceived federal guarantee of their obligations. Enterprise B also suffers from contagion to the extent it cannot convince investors that it does not suffer from difficulties similar to Enterprise A’s. Those developments substantially reduce the desirability of all GSE debt, not just that of Enterprise A, as suitable instruments for use in hedging or as collateral for repurchase agreements, further reducing liquidity in financial markets. Foreign investors, especially monetary authorities, seek to sell their GSE obligations, and dollar-denominated assets generally, which causes a decline in the dollar’s exchange-rate value and higher interest rates in the U.S…

If the yields on Treasury securities and other interest rates change markedly during Scenario #3, the interest rate risk exposures of the Enterprises may increase materially. In that event, some derivatives dealers may not write new contracts with Enterprise A, or do so only if that Enterprise agrees to post high-quality, liquid collateral to cover any increases in the market value of the dealer’s position… Market turmoil and increased interest rate volatility may raise the cost of new hedges substantially.

As in Scenario #2, how Enterprise B and other sources of mortgage financing respond to Enterprise A’s unexpected cessation of new commitments to purchase and securitize mortgages (and, potentially, decision not to honor outstanding purchase commitments) affects the volume of lending in the primary mortgage market in Scenario #3... First, the disruption in the relationships between Enterprise A and lenders is more serious. Second, the solvency and liquidity problems of some banks and thrifts could limit the volume of newly originated mortgages they could fund with newly issued liabilities… The risk of an increase in mortgage rates and decline in mortgage lending is clearly much greater than in Scenario #2…

Financial market participants are likely to look to Congress and the Department of the Treasury for explicit statements of intent to protect investors in Enterprise A’s debt and MBS from credit losses. Such affirmations might be made quickly. However, Congress could be in recess; could be concerned about the magnitude of the cost of such assistance, particularly if Scenario #3 occurred at a time of large budget deficits that could be viewed as contributing to the underlying financial market problems; or could be concerned about the consequences for market discipline of other firms that market participants might consider to be “too-big-to-fail…” In the meanwhile, the Treasury could lend either Enterprise A as much as $2.25 billion if asked to do so by the Enterprise. Given the size of the Enterprises, those amounts might not have much effect on their liquidity.

In the short run, a heavy burden of decision might fall on the Federal Reserve System, which has broad authority to purchase the securities of or, in certain circumstances, to make a loan to a GSE. In taking any of those actions, the Federal Reserve could be concerned about the precedent that it would create, the risk that Enterprise A’s condition might deteriorate further, and potential complications for the conduct of monetary policy in an already very difficult financial environment.

Effects on Economic Activity: The range of potential effects of Scenario #3 is quite broad. The best case is a modest but short-lived decline in housing activity and no substantial decline in consumption, output, and employment… In the worst case, the market for Enterprise A’s debt becomes illiquid and there are adverse consequences throughout the financial sector and economy.

Conclusions: Scenario #3 would not have been possible a decade ago, when the failure of Fannie Mae or Freddie Mac would have posed a much smaller systemic threat to the U.S. economy. If Fannie Mae had failed at year-end 1981, when the Enterprise was insolvent on a mark-to-market basis and had less than $60 billion in outstanding debt and $3 billion in guaranteed MBS, that failure would have imposed losses on investors, mortgage lenders, and related firms but probably would not have seriously threatened a collapse of the housing finance system or a disruption of financial markets generally. At the time the Federal Housing Enterprise Safety and Soundness Enhancement Act of 1992 was enacted, the outstanding debt of Fannie Mae was about one-fifth, and that of Freddie Mac was about one-twentieth, of the levels at year-end 2001. In addition, the Enterprises’ debt and MBS were much less important in financial markets, and Fannie Mae and Freddie Mac were just beginning to use financial derivatives. Although OFHEO regulation of the Enterprises has reduced the likelihood of an Enterprise failure, the potential for such a failure, if it occurred, to contribute to disruptions in the housing market and financial system is much greater now than it was then.

We’ll take exception to the Freddie exec’s reference to Mr. Falcon creating the “doomsday scenario.” It would not take a wild imagination to create Scenario #4, with “Big Three” GSE debt and securitization markets dislocating, the dollar in free-fall, the ABS market closed for business, derivatives markets “seized up,” the leverage speculating community in chaos, and financial markets faltering in systemic liquidity crisis. But putting disastrous scenarios aside, it is rather clear to us that the entire U.S. financial sector has evolved into one massive, unmanageable leveraged speculation; the dollar one historic confidence game. And the GSEs have developed into the epicenter of systemic liquidity with a Mortgage Finance Bubble running the financial and economic show. There will be no turning back. Today, the Federal Reserve should be explicitly delegated as the sole GSE regulator – responsibility and accountability. No reason and too much at stake to obfuscate.

And from Wednesday’s Wall Street Journal article (Patrick Barta and Dawn Kopecki), New Regulator Is Veteran Finance Man: “‘He (Mark Brickell) is no friend of regulation, except for the discipline that market regulation brings upon parts of the marketplace,’ said Bob Pickel, the current executive director of the International Swaps and Derivatives Association. Mr. Brickell believes ‘the market will bring the greatest discipline to bear on the marketplace. I think he would approach problems with Fannie and Freddie from the same perspective.’

Well, “market regulation” some time ago failed spectacularly. It is today disappointing to read that the new OFHEO director, a position demanding of one of the most diligent and dedicated regulators in the world today, is “no friend of regulation.” Difficult to believe he will be a friend of the public interest.

But “Hats Off” to Armando Falcon, as well as his colleagues Patrick J. Lawler, Brian M. Doherty, Forrest W. Pafenberg, Thomas J. Lutton, David Pearl, Mary Ellen Taylor, and Mark A. Kinsey for their historic policy paper. Unfortunately, OFHEO has been deliberately placed in a powerless, thankless, and winless situation. They are a paper “regulator,” when extraordinary circumstances beckon loudly for Iron. The mighty powerful Fannie and Freddie insist on straw. And, make no mistake about it, there will come a day when the straw man will be morphed into Contrived Scapegoat. The finger-pointers have their target in waiting.

Considering the environment nowadays in Washington, we are especially appreciative of Mr. Falcon’s diligence and determination. We see so little of it from our monetary authorities that the whole thing seems rather alien to us. Scenario #3: pondering such realistic potentialities is today invaluable and an important public service, albeit worse than woefully politically incorrect. Telling it like it is has become straight out taboo and rendered self-destructive in our nation’s capital. It may have cost Mr. Falcon his job, but we hope very much that demonstrating integrity, a sense of purpose, and commitment to the public interest do not impede his career. We wish you, Mr. Falcon, all the best in your future endeavors.

01/31/2003 Pondering Post-Bubble America *

It was an even more volatile stock market than what has become the norm. Yet for the week, the Dow and S&P500 dipped less than 1%. The Transports posted a fractional advance, while the Utilities declined about 1%. The Morgan Stanley Consumer index dipped 1% and the Morgan Stanley Cyclical index shed 2%. The broader market somewhat outperformed, with the small cap Russell 2000 declining less than 1% and the S&P400 Mid-cap index about unchanged. Earnings disappointments dampened technology enthusiasm, with the NASDAQ100 declining 1% for the week. The Morgan Stanley High Tech index dropped 2%, the Semiconductors 4%, and The Street.com Internet index lost 2%. The resilient NASDAQ Telecommunications index added almost 1% and ended January with a 6% gain. The biotechs declined 1% this week. The financial stocks were unsettled, as the Banks declined 1% and the Securities Broker/Dealer index ended unchanged. Although bullion gave up only 40 cents, the HUI Gold index dropped 5%. Notably, the Treasury market gained little on days when equities suffered. For the week, the two-year Treasury yield inched up one basis point to 1.66%, while the five-year yield jumped six basis points to 2.94%. The 10-year Treasury yield increased three basis points to 3.96%, while the long-bond yield dipped two basis points to 4.84%. Benchmark mortgage-backs and agencies saw yields up five to six basis points. The spread on Fannie’s 5 3/8 2011 note was unchanged at 37, and the 10-year dollar swap spread inched up one-half point to a narrow 44.5. The dollar finally enjoyed a winning week, with a late-week rally leaving the greenback slightly positive. The CRB index shot 2% higher this week, ending January up 6%. Propane posted the strongest weekly price gains in three years (21%), while cattle futures rallied to two-year highs, and platinum and cocoa to 17-year highs. “Cost pressures” have led General Mills, Kellogg, and Quaker Oats to raise cereal prices. There was almost $41 billion of U.S. Corporate and Agency debt issuance this week (according to Bloomberg). January issuance totaled $196.5 billion, up 14% from January 2002. Sales this week included GE Capital’s $1.5 billion (up from $1.25 b), Citigroup’s $2 billion (up from $1.5b), GMAC’s $900 million, National Rural Utilities Cooperative Finance Corp.’s $1.5 billion, and Avnet’s $450 million. The convertible bond market continues to demonstrate signs of life. Micron sold $632 million of 7-year convertible bonds (2.5% convertible at $11.79 per share). ONEOK sold $400 million of converts and International Game Technology $500 million. January saw seven convert deals for $6.4 billion, compared to $54.5 billion for all of 2002. But stock market weakness appears to be responsible for a reversal to (AMG reported) $649 million of outflows from junk funds last week. But flows remained positive for the month. At $22.2 billion, municipal bond sales set a new monthly record during January. The ABS market saw $6.4 billion issued, with January’s $29.7 billion in line with January 2002. Booming home-equity ABS accounted for fully one-third of January issuance. January 29 - Bloomberg: “Pulte Homes Inc. Chief Financial Officer Roger Cregg comments on the third-largest U.S. homebuilder’s offering of $300 million of 6 ¼ percent 10-year notes… ‘Certainly we were watching all the macro-economic and geopolitical issues out there. We were watching the rates and felt now was the best time to do it. ‘We could have waited longer, we didn’t need cash at the immediate moment. But we felt the timing was good, rates were really good as well… The issue was about three times over-subscribed,’ Cregg said.” Homebuilder Lennar raised $350 million this week. January 30, 2003: “Fitch Ratings lowers AmeriCredit Corp.’s senior unsecured rating to B+ from BB… (the) rating action reflects deterioration in asset quality beyond expectations coupled with concerns regarding liquidity and ongoing access to the asset-backed securities markets. AmeriCredit is experiencing higher net charge-offs due to lower than expected recovery rates on repossessed vehicles. Fitch believes that used car prices will remain pressured due to continued high incentive financing, which indirectly depresses used car values.” (Moody’s followed today) January 30, 2003 -Dow Jones (Judith Burns): “Regulators are worried that asset-backed securities issuers are making incomplete quarterly reports, a senior Securities and Exchange Commission official said Thursday. Asset-backed securities issuers provide the SEC with a modified version of the quarterly reports filed by public companies, including an accountant’s report in lieu of an audit. SEC corporation finance division director Alan Beller said the SEC is ‘developing a serious concern’ because some asset-backed securities reports don’t contain accountants’ reports or reports from servicers. ‘The required elements are not being included,’ Beller told Dow Jones… Proposed rules for asset-backed securities are on tap, Beller indicated. Given the size of the asset-backed securities market, he said it’s ‘imperative that we get some rules’ in this area.” (Our comment: better very late than never.) January 30 - Bloomberg: “Governor Bob Taft proposed overhauling Ohio’s tax system to raise $2.3 billion of new revenue in the next two-year budget to close a deficit in the seventh-largest U.S. state… ‘Our rainy day fund is empty and we are cutting spending sharply,’ Taft said… The governor also said the state is closing a prison, cutting Medicaid spending and asking employees to go without pay raises for two years… Ohio’s estimated $4 billion budget deficit is the sixth largest among U.S. states, according to the American Legislative Exchange Council. All states face an estimated $105.7 billion of deficits.” January 30 - Bloomberg: “California may issue warrants to preserve cash and pay off short-term notes sold last year as the state faces a record budget deficit, Governor Gray Davis said. Davis said California will probably need to sell warrants to investors in June to cover its bills and pay off $12.5 billion in one-year notes that come due June 20 and June 27. California law requires the state to pay off notes in the same fiscal year they are sold. Warrants can be repaid in a future fiscal year.” Broad money supply (M3) expanded $31.7 billion last week to $8.495 Trillion (up $3 Trillion, or 55%, in five years!). Currency added $1.9 billion to $631 billion, with Demand and Checkable Deposits up $16.9 billion to $575 billion. Savings Deposits increased $9.9 billion ($59 billion in six weeks) to $2.81 Trillion, while Small Denominated Deposits declined $1.2 billion to $873 billion. Retail Money Fund deposits were unchanged at $927 billion. Institutional Money Fund deposits declined $15.8 billion to $1.18 Trillion, with a noteworthy 5-week decline of $61.6 billion. Large Denominated Deposits increased $14.5 billion last week to $813 billion, and Repurchase Agreements added $6.2 billion to $461 billion. Eurodollars were unchanged at $216 billion. Elsewhere, Total Commercial Paper (CP) borrowings declined $1.0 billion last week. Interestingly, non-financial CP declined $6.7 billion to $152.4 billion, while financial CP added $5.7 billion to $1.195 Trillion. Financial sector CP borrowings are up $28.9 billion in five weeks to the highest level since the first week of December. Total Bank Assets jumped $50 billion last week. Securities were up $5.3 billion and Loans and Leases added $6.9 billion. Commercial and Industrial loans were up $800 million, while Consumer loans increased $4.4 billion and Real Estate loans added $2.5 billion. Details from the fourth quarter GDP report are indicative of a vulnerable and grossly distorted economy. First, the 0.7% annualized growth was the weakest since the third quarter of 2001. Personal Consumption of Non-durables was up 3.9%, while consumption of Durables was down 7.3%. Gross Private Investment declined 0.7%, versus the third quarter’s 3.6% increase and the first down quarter in a year. And while Residential investment was up 6.8%, investment in Nonresidential Structures sank 9.3%. Exports dropped 1.7%, while Imports increased 3.7% (a record 5.3% trade gap for the quarter!). Federal Government consumption surged 10.1%, with National Defense up 11.2% and Non-defense up 8.3%. It is also worth noting that Services Personal Consumption expanded by only 1.3%, the weakest performance since 2001’s third quarter. Data from the Fourth Quarter Disposition of Personal Income are also worth contemplating. Year-over-year, Personal Income was up 4.4%, with Wage and Salaries up 3.4%, Social Insurance up 4.9%, and Transfer Payments up 9.2%. With Personal Taxes dropping 15.5% y-o-y, Disposable Income was actually up 7.9% y-o-y. Interestingly, Wages and Salaries increased at a 4.2% rate during the quarter (q-o-q), up from the third quarter’s 3.7%, the second quarter’s 3.2% and the first quarter’s 2.1%. Two thoughts come to mind. First, there is clearly an inflationary bias in the Personal Income data. Second, it should be quite alarming that the economy has stagnated in the face of surging government spending, rising disposable income growth, and an historic refi boom. University of Michigan January confidence was a weaker-than-expected 82.4, approaching October’s low of 80.6. The survey’s Economic Outlook index sank a significant eight points during the month to 72.8, the lowest point since November 1993. There were 25,677 bankruptcies last week, up 2% y-o-y. The Conference Board’s December Help Wanted index declined one point to 39, touching the lowest level since 1963. But, at the same time, we do not want to dismiss the stronger data from the Chicago Purchasing Managers survey. January Orders added two points to 58, while Production jumped 10.5 points to 63.1. Also this morning, the New York Purchasing Management index was reported up 9.5 points to 51.9. With the corporate bond market open for business and a weaker dollar, we would not be surprised by an up tick in manufacturing. But we have reached the point where this would be a relatively insignificant development for the service/consumption-based U.S. economy. The Mortgage Bankers Association Refi Application index jumped almost 8% last week to a level more than double one year ago. The purchase index increased almost 3% and remains about 10% above the year ago level. This historic refi boom has now reached 32 weeks and has the definite appearance of a major market speculative blow-off. Similar to NASDAQ in early 2000, it is impossible to know when the fervor will subside (and major tops invariably last much longer than one would imagine possible!). But it is also clear that these are the types of market environments that sow the seeds of their own destruction. December Existing Home Sales jumped 5.2% for the month to a 5.86 million annualized pace, the third-highest level on record. Sales were up 12.7% y-o-y, with average (mean) prices up 6.5% to $204,600. Calculated Transaction Value (CTV: annualized volume multiplied by average prices) – an indication of relative mortgage Credit growth - surged 20% y-o-y to $1.2 Trillion. CTV is up 36% in two years and has surged $484 billion, or 68%, over five years. Mirroring Fannie, Freddie Mac posted a huge fourth quarter. Total Assets expanded by $39.8 billion, or 23.4% annualized to $722 billion. This was the largest quarterly increase since the fourth quarter of 2001. Total Assets jumped $77.7 billion, or 24% annualized, during the second-half and were up 17% for the year. Looking at fourth quarter Average Balances, the Retained Mortgage Portfolio was up 13% y-o-y to $547 billion, while Investments were up 36% to $124 billion. Freddie bought back 6.2 million shares of stock during the fourth quarter and a total of 9.1 million shares for the year. Freddie’s Total Book of Business (Retained Mortgage Portfolio and guaranteed mortgage-backs in the marketplace) jumped $50 billion, or 16% annualized, during the quarter to $1.31 Trillion (up 15.2% y-o-y). Freddie’s Total Assets are up 57% over two years and a stunning 270% over five years. Its Book of Business has more than doubled in five years. Fannie and Freddie combined for fourth quarter Total Asset growth of $89.4 billion, or 24% annualized, to $1.61 Trillion. This surpassed the previous record of $88 billion set during the infamous fourth quarter of 1998. In a truly historic Credit expansion, Fannie and Freddie Total Assets are up 174% in five years. It is worth noting that combined Total Assets surpassed $200 billion for the first time during 1992 and $400 billion in 1995. Their combined Book of Business surged $128.4 billion during the fourth quarter, or 17% annualized, to $3.1 Trillion, and was up 16% ($429 billion) y-o-y. In numbers that are difficult to fathom, their combined Book of Business was up $855 billion, or 42%, in just twenty-four months (up $1.6 Trillion in five years!). And including Federal Home Loan Bank estimated Total Assets of $780 billion, “Big Three GSE” total exposure of $3.9 Trillion has more than doubled since the beginning of 1998. Stunning… Or coming at this phenomenon from another angle, total Big Three GSE exposure has jumped from 22% of GDP to 37% in just 60 months…and is climbing rapidly. January 30 - Bloomberg: “U.S. housing prices aren’t facing a bubble and the economic recovery is ‘fragile,’ said Richard Clarida, the Treasury’s chief economist. ‘There’s really no evidence of a housing bubble,’ Clarida said in an interview on Bloomberg television. ‘Investment isn’t contributing to growth the way it did in previous recoveries.’” January 27 - Bloomberg: “Equity Office Properties Trust, the largest U.S. office building owner, has a 40 percent vacancy rate for its buildings on the San Francisco Peninsula, the San Francisco Business Times reported. Equity Office is the biggest landlord on the peninsula, which stretches from South San Francisco to Palo Alto, with 71 buildings encompassing six million square feet, the paper said. The company’s vacancy rate is 24 percent on a direct basis and nearly 40 percent when sublease space is included, the paper said.” January 30 - Bloomberg: “Apartment rental demand fell in the fourth quarter to its lowest level in a year, as low mortgage rates lured renters into buying homes, according to the National Multi Housing Council. The Washington-based trade group's Market Tightness Index fell to 29 from 35 the previous quarter. The survey showed that 47 percent of respondents said market conditions worsened in the closing months of the year, 49 percent said conditions remained the same, and 4 percent said demand rose.” January 30 – Rocky Mountain News (John Rebchook): “The Denver-area apartment market, buffeted by a slow economy, overbuilding and low mortgage rates, posted an 11.7 percent vacancy rate at the end of last year, its worst performance since 1989. A year earlier, the vacancy rate stood at 8.7 percent, according to the survey authored by Gordon Von Stroh, a business professor… After the third quarter of 2002, the vacancy rate was 9.4 percent, making the December increase the biggest quarter-to-quarter jump since 1986. The vacancy rate has almost tripled over a two-year period… ‘A number of different things are going on. The stagnant national and local economy is having impact on things. No. 2 are the low interest rates, which makes it easy for renters to buy homes. And we also have a significant number of new inventory coming on line, in a market that doesn’t need the delivery of any new units.’” (Take note of what will be a national problem.) January 30 - Bloomberg: “The vacancy rate at U.S. industrial properties reached 10.4 percent in the fourth quarter, the highest in almost seven years, as business spending slowed, broker Cushman & Wakefield reported. At year-end, 786 million square feet of warehouses, manufacturing and so-called high-tech industrial space stood vacant, Cushman said. The vacancy rate rose from 8.6 percent the year before and 9.2 percent in the third quarter.” The REIT (real estate investment trust) Bubble runs unabated, although few have yet to report fourth quarter earnings. Novastar saw fourth quarter Net Income more than double from last year. Total Assets surged 85% during the quarter to $1.45 billion, up from the year ago $512 million. The company ended the third quarter with Shareholders Equity of $165 million. “During 2003 we expect to originate between $4 billion and $6 billion of non-conforming loans…” Thornburg Mortgage reported strong earnings as well, with Total Assets up 81% y-o-y to $10.5 billion. A Thornburg exec was providing advice to a CNN evening audience this week. He suggested that, for many, interest-only mortgages were a good idea when higher yielding investments - such his company’s 11% dividend - were available. FBR Asset Investment Corp. expects the REIT’s MBS investments to post returns on equity in excess of 20%. And, according to Dow Jones, management continues to have “complete confidence” in Americredit’s business model and management. The company owns 5 million shares of AmeriCredit stock (as of the third quarter). FBR ended the year with $5.2 billion of mortgage-backed securities (with repurchase agreement funding of $4.54 billion), up from the year ago $1.2 billion. The company ended the year with Equity Capital of $728 million Mortgage Insurer PMI Group reported Net Income up slightly year-over-year. Primary Insurance in Force was up 7% y-o-y to $125.8 billion. The most interesting aspect of this release was the delinquency data. The Percentage of Domestic Primary Mortgage Insurance in Default jumped 40 basis points during the quarter to 3.84%. This is acceleration in Credit deterioration that has been proceeding steadily. Going back to the third quarter of 2001, Delinquencies have increased from 2.40% to 2.67%, to 2.81%, to 3.07%, to 3.44%, to the fourth quarter’s 3.84%. “Bulk Transactions” have seen delinquencies surge to 10.4% from the year ago 5.55%. Primary Claims Paid was up 33% y-o-y to $29.5 million. Further confirmation that all is not well in mortgage land… “Last week the Federal Reserve released its triennial Survey of Consumer Finances (SCF), the most detailed report card on the state of the household sector’s balance sheet and income statement currently available. There’s no reason to equivocate on the general conclusion: the enduring hysteria that the household sector is over-levered and that this will inevitably be the catalyst for a collapse in spending is an enduring myth. Every cohort of the income distribution, every cohort of the age distribution, and every cohort of the net worth distribution have seen their debt burden (level of loan payments to income) fall in response to rallying interest rate markets and rising incomes. Whether rich or poor, old or young, your debt service burden is highly likely to be lower today than it was in the late 1990s, and there’s a good chance it’s the lowest it has been since the late 1980s, at least. What’s more, leverage ratios (level of debt to assets) are falling just like the debt service burden. In aggregate, the household sector’s debt as a proportion of assets is the lowest it has been since at least the late 1980s.” January 30, 2003, Extracted from a Wall Street economic research report There is something about major market tops that induce Bubble proponents to say and write silly things. The household sector is conspicuously over-leveraged and there is no disguising the fact that household borrowings are up about 50% in five years - and that’s starting from an already lofty base. This bullish “consumer is in great shape” nonsense is akin to how Bubble proponents saw exorbitant technology P/E ratios as reasonable because they were in line with company and industry growth rates. The hitch was that heady growth rates were Bubble induced and absolutely unsustainable. Flawed analysis had things looking “great” right into the collapse. Not wanting to address obvious consumer borrowing excesses, the proponents today have only “debt service” ratios to play around with. But the momentous hitch this time around is that egregious consumer/mortgage sector Credit excesses are what is specifically fueling income growth and sustaining the Bubble economy. The issue is not debt service ratios, but the sustainability of the Bubble. On paper (and in dim light) the consumer may appear capable of servicing his historic debt load, but the day he tempers his borrowing and spending… The Pension Benefit Guarantee Corp, the federal agency providing insurance for 44 million private-sector pensions, (according to the Washington Post) “yesterday reported an $11.37 billion loss for the last year, the largest in the insurer’s 28-year history.” This “shifted the agency from a $7.73 billion surplus to a $3.64 billion deficit.” The unfolding pension shortfall debacle encompassing companies, state and local municipalities, and the federal government is one of the more intractable consequences of the protracted Bubble. It is also an issue that will incite calls for “reflation,” a seductive elixir that will only further poison the patient. If only stock prices could return to previous levels; then there would be plenty of “money” for future retirees. Yet more money and Credit will not provide the comfortable retirement lifestyle promised to our aging workforce. Actually, the developing pension quagmire provides a solid argument against the inflationary status quo. The problem is only worsened by more consumption, higher housing prices, and a weaker dollar. The only possible solution is sound domestic investment and a stable currency providing the means of producing and trading for the goods and services to sustain our high standard of living. From Robert Prechter’s January The Elliott Wave Theorist: “…the recent rash of commentary on the assurance of continued inflation seems to require a renewed response. Here are my answers to the arguments extant today.” - - (I have extracted only one of the arguments Mr. Prechter addressed) -- “Deflation Will Cause a Run on the Dollar, Which Will Make Prices Rise.” “This is an argument that deflation will cause inflation, which is untenable. In terms of domestic purchasing power, the dollar’s value should rise in deflation. You will then be able to buy more of most goods and services. It is unknown how the dollar will fare against other currencies, and there is no way to answer that question other than following Elliott wave patterns as they develop. From the standpoint of predicting deflation, the dollar’s convertibility ratios are irrelevant. There may well be a “run on the dollar” against foreign currencies, but it would not be because of deflation. I think the impulse to predict a run on the dollar comes from people who own a lot of gold, silver or Swiss francs. They feel the ‘70s returning, and so they envision the dollar falling against all of these alternatives.” We’re big fans of Mr. Prechter and consider him one of the few around today deserving of the status market and social “guru.” We certainly share his focus on the perils of Credit excess and inflated asset markets. But while we may see eye-to-eye on the problem, it is not so clear to us that the consequence of a Credit Bubble is a predestined “deflation.” Indeed, we can look to the disparate environments in post-Bubble Japan and post-Bubble Argentina as evidence that collapsing Bubbles may end in a long, draw-out mild deflation or, in the case of Argentina, rapid financial implosion and devastating inflation. From the standpoint of attempting to analyze which of these polar extremes may best apply to Post-Bubble America, we are increasingly convinced that the dollar’s performance will play an instrumental role. Rather than focusing on inflation/deflation, the primary analytical focal point of Credit Bubble analysis today lies elsewhere. Japan made truly incredible economic progress for several decades, before succumbing to extreme financial excess in the late eighties. Sadly, they “drank the poison” and basically destroyed their financial system in a few short years. Yet, post-Bubble Japan remained endowed with great wealth-creating manufacturing capacity. The Japanese multinationals have not only survived; they have prospered. With enormous trade surpluses, the economy has been able to muddle through a wrenching decade-long financial quagmire. Importantly, the related trade surplus and household saving attributes (Japan as Creditor nation) played an instrumental role in supporting the Japanese currency. The yen today trades at about 120 to the dollar. This is just off its 10-year average and above where it began the nineties. Importantly, (and especially for retirees) the frugal Japanese saver has maintained her purchasing power. There has been no run on Japanese financial assets. Importantly, the Japanese Credit Bubble was a severe domestic debt problem, but international investors and speculators played a relatively insignificant role. The fate of the financial system and economy did not rest tenuously on yen confidence. The post-Bubble banking system has been an unmitigated disaster, but the Japanese economy’s debt structures – supported by decades of sound investment and enormous household savings – proved resilient. Stagnant private sector Credit growth was partially offset by large government borrowings, playing a critical role in tempering financial fragility and stabilizing the system. Excesses, both real and financial, had not reached the point where contracting private-sector debt growth would lead to unmanageable collapse. Fortunately, I would argue, the Japanese government used is fiscal and monetary powers to ease an arduous post-Bubble transition, rather than to sustain the Bubble. And while certainly encumbered, Japanese society has remained cohesive through a protracted and difficult adjustment period. The general population has not rioted or spent much time in protest, but rather fell back on financial discipline and its hard-work ethic. There has been too much (typical post-Bubble) talk of policy incompetence and not enough recognition of a most impressive performance by the Japanese people. At the other extreme, an arguably much less formidable and pervasive Bubble in Argentina has left the financial system and economy in absolute tatters. Many savers have been completely wiped out, and the social fabric has been severely frayed. Argentine citizens have lost confidence in the government and the country’s institutions. Sadly, bank runs have become commonplace. The Argentine peso has lost 70% of its value, with inflation running rampant. Foreign bankers, investors and speculators have abandoned the country, with international institutions (and “globalization”) under justifiable attack from Argentine citizens, politicians, and monetary authorities. The economy has sunk into deep depression, with little benefit from a collapsing currency. Indeed, the sinking Argentine peso has been a major hindrance, in stark contrast to the experiences of post-Bubble South Korea, Thailand, Russia and Brazil. The boom-time Argentine economy came to depend on foreign-sourced finance, much of it of speculative character. Once addicted, all involved were steadfast in refusing to recognize the sickness. Foreign borrowings financed too much consumption and too little of the type of sound investment capable of creating the necessary economic wealth to repay Creditors. Once this course was chosen, it was only a question of the dimensions of the inevitable financial and economic dislocation. Reliance on foreign borrowings in combination with economic maladjustments over time combined to create acutely fragile debt structures. Indeed, it was precisely the nature of the speculative capital flows fostering non-productive Credit excess that proved fatal to the Argentine financial system. Frail debt structures and economic maladjustment left the currency, Credit system, and economy hopelessly vulnerable to both the inevitable reversal of speculative flows and attendant capital flight. Confidence in the peso’s peg to the dollar became of momentous consequence. Almost overnight, Argentine financial assets were no longer an acceptable medium for international exchange. Importantly, none of these types of issues have played a role in post-Bubble Japan. So we have very difficult and complex questions to contemplate in our pursuit of What Will Be Post-Bubble America. Most regrettably, the Greenspan Fed, Wall Street, the GSEs and Washington politicians are resolute in their determination to stonewall the adjustment process. Importantly, this dangerous course of prolonging the Bubble is categorically based on continued Credit excess – inflating dollar financial claims. This should not today be in dispute, and incessant Credit inflation is why we remain fixated on dollar vulnerability and devaluation. There may certainly come a day when faltering confidence and a run on dollar financial assets wreaks (Argentine-style) havoc on the U.S. Credit system – especially its acutely fragile “Structured Finance” parallel “banking” system – but the system today retains its capacity for unchecked and rampant inflation of dollar claims (Credit inflation). But as we’ve highlighted repeatedly, these new claims could not be of poorer quality. Nor could current Credit inflation impart greater distorting affects on the real economy. Recall that during the third-quarter Household Mortgage Debt expanded at a rate of 11.8%, while Corporate Debt was virtually unchanged. And that a meaningful portion of these new claims are acquired by leveraged speculators only adds an additional layer of debt structure vulnerability. There is absolutely no way for the U.S. financial sector or economy to inflate out of this desperate quagmire. I continue to be amazed that individuals that should know better call only louder for greater U.S. inflation. It should be obvious that the dilemma we are facing has nothing to do with insufficient money or inadequate Fed-created liquidity. The Credit system continues firing on overdrive, while there remains in inflationary bias in wages and income. The dollar is the weakest in years, while gold and commodities are performing the best in some time. In an attempt to simplify a very complex environment to accessible terms, I see two critical issues today. First, the U.S. “service sector”/consumption-based Bubble economy has about reached the end of its rope. The consumer is piling on debt at a precarious and unsustainable pace (“blow-off”). Furthermore, the degree of Credit excess necessary to sustain spending/“output” at boom-time levels (in the context of a severely maladjusted economic system) is increasingly destabilizing. Credit excess-induced created purchasing power stimulates over-consumption, massive trade deficits, and uneconomic “investment,” with only a trickle financing sound investment. If one were to calculate a Stable Finance Ratio of “sound investment to total Credit growth” it would undoubtedly be crashing to an all-time historic low. Conversely, a Financial Fragility Ratio of “foreign liabilities to economic wealth creating assets” would now be rising exponentially. Continued rampant Credit inflation has in reality become dangerously counter-productive, and we look to the dollar level and gold price as confirmation of this view. Second, the “structured finance” monetary regime that retains its dominance at the epicenter of our nation’s financial system (The Master of the Great Credit Bubble) is absolutely and unalterably dysfunctional. Indelible Monetary Processes specifically direct finance to where it is not needed – to sectors where there remains an inflationary bias. The entire U.S. financial system, then, has become trapped in a consumer and Mortgage Finance Bubble that has the corporate debt and stock market Bubbles appearing quite manageable in comparison. As monetary analysts, we’ve never respected nor trusted “Structured Finance.” This is because it’s all about lending volume and financial speculation – the nemeses of sound money and economic and financial stability. The Aggressive Loan Originator (and his cohorts Clever Securitizer, Oblivious Credit Insurer, Gumptious Rating Agency, and Enterprising Leveraged Speculator) has supplanted the anachronistic Prudent Loan Officer and his preciously mundane Bank Loan. Along with volume, the Structured Finance mob covets yield. As such, Structured Finance has a rather intense fancy for subprime. Poor credits provide an almost limitless captive audience – at least during the self-reinforcing, Credit excess-induced boom. Consumption-based lending, as we have witnessed, knows no bounds (when one governs over the world’s reserve currency!). Structured Finance also has a devoted love affair with asset-based lending and speculating. As we have witnessed, inflating asset (equities, homes, mortgage-backs, agency bonds, baseball teams, etc.) prices provide unbounded lending opportunities during the boom; again, music to the ears of Structured (“Speculative”) Finance. But why does Structured Finance treat sound investment with such utter disdain? Because of volume constraints and, to a lesser extent, yield inadequacies; in contrast to consumption and asset-based lending, there are definite bounds on the amount of sound investment. The more that is financed, the more vulnerable profits and the less sound the underlying Credits. Indeed, business profits provide rather tenuous collateral after Bubbles have passed their peak. It would truly be wonderful if we could today rev up the manufacturing sector and right the system. Beguiling perhaps, but this is not today a viable alternative. The financing of sound investment would prove woefully inadequate in terms of the quantity of Credit required to sustain the U.S. Bubble. Moreover - and a major issue today for the dollar and financial fragility - Structured Finance simply does not have the luxury of turning its back on the Consumption and Asset Bubbles it has so fervently nurtured. For the U.S. Bubble Economy it remains inflate or die. Reckless Japanese Credit inflation was terminated before it was too late. Argentina’s was not. The inescapable consequences of the U.S. Credit Bubble Dilemma include only more Credit and speculative excess, heightened financial fragility, deeper economic maladjustment and impairment, and a further debasement of our currency. Considering what we have and continue to observe, I do not feel it is at all outrageous to assert that our system has set a perilous course toward the collapse of the world’s reserve currency. This is the harsh reality that we should recognize as a nation as we contemplate Post-Bubble America. And no amount of inflation will change the facts of economic life. There are no available shortcuts but many risky gimmicks to prolong the Bubble, hence only making the inevitable day of reckoning all the more painful and Balkanizing. There is nowadays only louder call for stimulating and “reflating,” but there is absolutely no discussion of the consequences. There is so much a stake. It is our view that the longer we travel down this dangerous course the more rapidly the Post-Bubble America pendulum swings away from a Japanese scenario in the direction of Argentina.

01/24/2003 An Integrity Problem *

It was a dismal week for the stock market. For the week, the Dow dropped 4% and the S&P500 declined 5%. The Transports were smacked for 7%, while the Utilities dipped 3%. The Morgan Stanley Consumer and Morgan Stanley Cyclical indices dropped about 5%. Selling in the broader market was generally less intense, as the small cap Russell 2000 and S&P400 Mid-Cap indices declined about 3%. The NASDAQ100 and the Morgan Stanley High Tech indices declined about 2%. The Semiconductors dropped 5%, The Street.com Internet index 3%, and the NASDAQ Telecom index 4%. The financial stocks came under heavy selling pressure, with the Securities Broker/Dealer index hammered for 8% and the Banks 4%. With bullion up almost $12 to a six-year high, the HUI Gold index jumped 6%.

The Credit market benefited. For the week, two-year Treasury yields declined three basis points to 1.65%. The 5-year Treasury yield declined 10 basis points to 2.87%, while 10-year yields dipped eight basis points to 3.93%. The long-bond saw its yield decline six basis points to 4.86%. Benchmark mortgage-backs and agency securities performed well, with yields generally declining 10 or 11 basis points. The spread on Fannie’s 5 3/8 2011 note narrowed one to 37, while the benchmark 10-year dollar swap spread was unchanged at 44. Corporate bond spreads widened marginally. The dollar index declined another 1%, ending the week below 100 for the first time since January 2000. The CRB index added better than 1%, with commodity prices strong almost across the board. Even copper prices are up about 10% this month.

January 24 – Dow Jones: “National Century Financial Enterprises Inc. will cease operations in the next few months after the restructuring experts brought in to revive the scandal-ridden health-care financier decided that its problems were even more widespread than originally thought… David Coles, a corporate-restructuring specialist with Alvarez & Marsal Inc… who took over as National Century’s chief executive in November, painted a picture of widespread deception at the company… ‘I’ve been involved in badly run businesses, some of which we’ve been able to recuperate, others which we’ve had to liquidate, but I’ve not had experience with a falsification of information component that compares to this,’ said Mr. Coles. The closing of closely held National Century not only runs counter to earlier expectations that the company could be revived, but it could cost bondholders more than $2 billion, depending on what can be recovered through litigation. As a result of National Century’s problems, more than 15 health-care providers that relied on the company for operating funds have filed for protection under Chapter 11 of the U.S. Bankruptcy Code.”

January 21 – Bloomberg: “Arizona’s new treasurer may seek tighter limits on how much money a government pool can put in some investments to lower risk after the state lost money last year on bonds sold by a bankrupt health-care finance company… Arizona’s local treasurers last month urged a review because they stand to lose money on $131 million in debt the pool bought from Dublin, Ohio-based National Century Financial Enterprises Inc., which provided cash to health-care providers by buying medical bills and then packaged them into asset-backed bonds.”

January 21 – Bloomberg: “Manhattan apartment prices fell 4.8 percent in the fourth quarter and sales declined 9.5 percent as a slowing economy pushed New Yorkers to search for smaller and cheaper apartments. The average price dropped to $808,657 from $849,013 the previous quarter, according to appraiser Miller Samuel Inc. and Insignia Douglas Elliman, a Manhattan residential brokerage. The number of sales fell to 2,028 from 2,241, the lowest since the third quarter of 2001.”

Providing further confirmation of the dramatic deterioration in federal government finances, the typically strong surplus month of December saw receipts only $4.37 billion more than expenditures. The December 2001 surplus was $26.6 billion. After only three months of the fiscal year, the fiscal deficit has already reached $108.72 billion. The comparable deficit from last year was $35.4 billion. Fiscal y-t-d revenues are down 8.3%, with Individual Income Tax Receipts declining 12.7%. Conversely, spending has jumped 6.9%. By leading categories, Social Security is up 5.2% to $115.5 billion, National Defense 16.5% to $98.3 billion, Income Security 14.2% to $78.5 billion, Medicare 14.3% to $65 billion, Health 10.2% to $53.8 billion, and Education, Social Welfare 13.2% to $18 billion. Interest expense has declined 6.5% to $42.9 billion.

January 21 – Bloomberg: “Nevada Governor Kenny Guinn proposed raising almost $1 billion from higher taxes on businesses, cigarettes, and property to help close a deficit and fund schools and other programs in the fastest-growing U.S. state. Nevada’s strategy of generating three-fourths of its revenue from taxes on sales and gambling in cities such as Las Vegas has made the state vulnerable to economic swings and isn’t meeting the demands of a growing population, Guinn said last night in his annual state of the state address.”

January 22 – Bloomberg: “Moody’s ratings have been downgraded to A3 from A1 for municipal bond issues backed by a letter of credit issued by Bayerische Hypo-Und Vereinsbank AG.”

From Bank of America Structured Products: “The year 2002 will be recorded as having the most downgrades in CDO (Collateralized Debt Obligations) history… Moody’s downgraded actions affected 865 tranches, or $32.5 billion of par, in 350 deals over 2002. This represented 318% yoy growth over its 205 tranche downgrades in 2001.”

January 22 – Dow Jones (John Conner): “The amount of loans outstanding under the Federal Home Loan Banks’ ‘Mortgage Partnership Finance’ program grew 68% during 2002, ending the year at $41.7 billion, up from $24.8 billion a year earlier, the Chicago FHLB said Wednesday.”

January 24 – Moody’s: “U.S. asset-backed securities (ABS) public issuance should reach $375 billion in 2003, a 6% increase over the robust total of $354 billion posted in 2002, says Moody’s Investors Service in a year-in-review and ABS outlook report… U.S. (2002) public ABS issuance…(was) up 26% over the previous record of $280 billion established in 2001, and up 63% over 2000 issuance.”

Broad money supply declined by $4.1 billion last week. Combined Demand and Checkable Deposits declined $8 billion, while Savings Deposits jumped $34.9 billion. Small Denominated Deposits declined $2.9 billion and Retail Money Fund deposits dropped $11.7 billion. Institutional Money Fund deposits dropped $23.7 billion, while Large Denominated Deposits increased $7 billion. Repurchase Agreements declined $3.8 billion, while Eurodollars added $4 billion. Elsewhere, Total Bank Credit increased $1.7 billion, with Securities holdings declining $3.3 billion. Bank Loans and Leases increased $5 billion, with Revolving Home loans and Security loans each up $3.3 billion. Commercial and Industrial loans were unchanged. Total Commercial Paper (CP) borrowings increased $5.6 billion ($24 billion in three weeks). Total financial sector issuance rose $5.8 billion ($20.3 billion in three weeks), while non-financial issuance was about unchanged. The ABS market boom continues, with about $8 billion issued this week. It was also another strong week in the corporate bond market with almost $38 billion of domestic corporate and agency issuance. Year-to-date issuance is already up to $155 billion (after only ten business days!).

A recent Moody’s downgrade did not keep Georgia-Pacific from twice raising the size of its junk bond offering from $500 million $1.5 billion. Tenet Healthcare doubled the size of its offering to $1 billion. From Bloomberg: “‘The demand in the market was overwhelming, we had nearly $2 billion in demand,’ CFO Stephen Farber said… The bank loan ‘was still in process. We decided to take the whole $1 billion from the bond market.” Dallas-based homebuilder Centex sold $300 million five year notes at a spread of 187.5 basis points. Bloomberg quoted a Centex executive: “These are the best spreads and coupons that we’ve experienced since we’ve been issuing notes. That’s for the last three years.” KB Homes sold $250 million of 7-year debt, with the CFO stating “the market was extremely attractive for the building sector for high yield companies.” GE sold $5 billion five-year notes at a spread of 112 basis points. A GE exec was quoted by Bloomberg: “We had close to $9 billion of orders from over 300 investors. We were pretty pleased…” JPMorgan Chase issued $1.75 billion of debt yesterday. One billion of 10-year notes were sold at 151 basis points over Treasuries compared to the 175 basis points paid back in November. Citigroup increased the size of its bond offering by one-third to $2 billion. There sure is a lot of liquidity. What used to work it’s magic may today be Too Much.

From today’s Financial Times (Kevin Morrison): “Managers of hedge funds have been switching from falling equity markets and taking a fresh look at commodities, pushing gold, platinum and nickel prices to highs not seen for years. Hugh Hendry, fund manager at London-based Odey Asset Management, says central banks have contributed to the increasing interest in commodities. ‘They are able to print money to keep the economy going and that money always finds its way to the fastest rising asset class. In the 1990s that was Nasdaq and now it looks like commodities.’ Metals are not the only class of commodities to benefit. Products such as cocoa, wool, soybeans, palm oil, wheat and corn have risen by between 13 per cent and almost 60 per cent since the start of last year.” The article concluded with a telling quote: “I like the prospects for wheat and corn – not that I’m an expert on the latest harvests – but then the people that bought Microsoft during the boom didn’t have to know about servers and LANs (Local Area Networks).” (“Liquidity Loves Inflation” and “The Trials and Tribulations of Speculative Finance.” – The Revival of Inflation Psychology?)

Although speculative bets in the commodity markets are now apparently becoming the trade de jour, let’s not forget that speculative infatuation with U.S. financial assets has absolutely dominated the financial landscape for several years now. Many trades will need to be unwound and leverage within dollar-denominated securities markets reduced. Considering the enormity and length of this protracted speculation, the unfolding transition period will surely be fraught with uncertainly and turmoil. Were Wall Street and the hedge funds borrowing overseas to finance their ballooning securities holdings? It is worth noting that since the beginning of 1998 (19 quarters), Securities Broker/Dealers have ballooned balance sheets 81% to $1.4 Trillion. Have the Wall Street firms partially financed their enormous holdings of U.S. securities by borrowing in Euros, Swiss francs or other low-yielding foreign currencies (“King Dollar Global Carry Trade”)? Such a strategy worked wonderfully while the euro was losing ground against King Dollar. Not today.

And are the major Wall Street firms and money center banks exposed to dollar weakness through their derivative books? After all, for some time they have enjoyed writing dollar protection (either directly or in the swaps market) with little concern for hedging King Dollar exposure. Today they worry. And how extensively had the Global Leveraged Speculating Community obtained cheap finance borrowing in previously weak euros (or shorting a sinking gold?) to finance inflating U.S. financial assets? And, did it become popular to borrow in Euros to speculate in higher-yielding Mexican or Brazilian securities? Such a strategy would have been hugely profitable for some time, but has abruptly turned quite sour. Priced in Euros, the Mexican peso is already down 7.5% this month, with the Brazilian real, Columbian peso, and Chilean peso down about 5%. The demise of King Dollar alters so many things…including relative prices, relationships, and perceptions.

There were 28,388 bankruptcy filings last week, up 1% y-o-y. The Mortgage Bankers Association’s weekly index had Refi Applications declining 6%, although remaining at an elevated level (double the year ago). Purchase Applications were down about 1% to a level about 4% below one year ago. December housing data was exceptionally strong. Housing Starts were reported at an annualized rate of 1.835 million, up 16% y-o-y. Multi-family Starts were up almost 24% from December 2001. New Building Permits jumped to a 1.88 million pace, up 13% y-o-y to the highest level since December 1986. It is also worth noting that December permits were 29% above (pre-Bubble) December 1997 and 118% above the recessionary level of December 1990. Total 2002 Starts were 7% above 2001.

There have been a couple recent articles from the Dallas Morning News worth underscoring, keeping in mind our view of greater Dallas as a “marginal” housing market to monitor closely. From “Apartment Vacancies Hit High” (Steve Brown): “Apartment vacancy rates in the Dallas-Fort Worth area have risen to a 10-year high, as building far outpaces demand… In 2002, builders completed more than 11,000 additional apartments in North Texas. But tenant demand filled a paltry 1,030. And during the fourth quarter, occupancy fell by 1,150 units.” Yet, there are 10,000 additional apartments in the development pipeline. The dearth of renters is explained by a “sluggish economy,” but also because “thousands of renters have fueled a boom in local new-home building…”

In Dallas, and likely in many markets across the country, the consequences of a multi-year housing construction boom are increasingly apparent. For one, apartment vacancies are rising, especially at the overbuilt upper-end. And, at least in Dallas, the previous boom-time seller’s market is rapidly fading into memory. I drive through an older modest neighborhood each day on my way to the office. I have watched as a few For Sale and For Rent signs last summer have turned into an alarmingly large number as we begin a New Year. It is my impression that, despite low rates and ultra-easy Credit availability, the local existing home market has hit the wall. Interestingly, however, only a dozen or so miles north into suburbia and the market for new homes remains quite strong. This is an unusual two-tiered marketplace worth contemplating.

In the past, a weakening housing market and rising inventory would rattle the nerves of local bankers; financing for new construction would quickly run dry. But this New Age housing cycle has evolved into something quite different. For one, it is dominated by large national builders with close ties to Wall Street and the mortgage-backed securities marketplace. Importantly, these builders today have unlimited access to cheap finance to pursue their aggressive growth strategies. And not dissimilar to the telecom sector during 1999, The Street, bankers, and Washington are today content to cheer along the construction boom and disregard the consequences. As we have witnessed, the weaker the economy (and more intense the financial stress) the greater the impetus for stoking the Great Mortgage Finance Bubble. Limitless Credit availability also affords the aggressive builders the decisive advantage of providing zero (“Nehemiah and the Copycats”) or minimal down-payment mortgages, along with other inducements. Along with ultra-easy financing, new home are also effortless to insure, an attribute that has taken on new significance with homeowners insurance increasingly difficult to obtain in Texas and elsewhere.

So, similar to how “zero-down, no payments until 2004” market distortions sustain strong new car sales in the face of a ballooning inventory of used cars (who wouldn’t want to buy new instead of used?), we see distortions emanating from mortgage finance excess increasingly coming at the expense of the “used” home market. From a second Dallas Morning News article – Home Foreclosures are Casualties of Economy (again by Steve Brown): “A bleak economy hit home in North Texas last year, putting thousands in danger of losing their homes. The number of homeowners threatened with foreclosure in Dallas County jumped 32 percent. And in Collin County – which has been ravaged by layoffs in the high-tech and telecom sectors – home foreclosure postings soared by 73% in 2002… January foreclosure postings for Dallas County were up 43% from January 2002. And in Collin County, foreclosure postings for the month were up a staggering 94%.” And, yet, the building boom hardly misses a beat.

One could build a case that, basically up to this point, the Mortgage Finance Bubble has worked to the interest of buyers, typical sellers and builders, alike. Perhaps this year gains for the builders come out of the hides of many distressed sellers (and their lenders and mortgage insurers!). Again, reflecting back to the telecom boom: Many prosper for some time even after the boom has passed it peak, although the “marginal” player can be devastated as new finance is no longer forthcoming from increasingly cautious lenders.

It may also be helpful to recall the late-eighties office building boom (and later bust). Even though vacancies began rising markedly and serious problems were appearing on the horizon – with it in virtually everyone’s best-interest to put a moratorium on new construction - finance just rolled into the sector and additional high-rises were added to the developing glut. Many “investors” found the sector’s above-market yields too enticing; and, besides, the returns had been quite strong for a few years! As we are witnessing today in historical proportions throughout Mortgage Finance, once the financial apparatus (and speculative infatuation) has reached a critical mass it is nearly impossible to temper. The flow of finance invariable turns to flood, and a painful bust becomes unavoidable. Indeed, it is the awe-inspiring nature of speculative markets to inundate a sector with destabilizing finance at the very late stages of the boom (The “blow-off” or “Terminal Stage of Excess”). The home-building boom is poised to run through 2003, but the cost will be high.

We are in the midst of another fascinating earnings reporting season – at least in the financial arena. Clearly, the entire financial sector continues to push consumer and Mortgage Finance to its absolute limit – pedal to the metal. Avoid commercial lending at all cost, while playing mortgage finance like there’s no tomorrow. But rampant lending excess appears to have decidedly hit the point of diminishing returns. At least one should find fourth quarter economic performance all the more alarming after confirmation that it was another truly extraordinary quarter of lending. In addition, the ominous signs of acute Credit problems afflicting the consumer sector become increasingly obvious. The ramifications for the Credit insures are becoming only more troubling. Today’s downgrades of key Structured Finance players AIG and MBIA, as well as a group of other insurance companies, should be heeded as an early warning.

January 21 – American Banker (Matthias Rieker): “UnionBanCal Corp. said its campaign to cut credit costs helped its fourth-quarter profits rise 10%. The $36 billion-asset company…has been reducing its exposure to syndicated lending and making fewer loans to companies that are not already customers… To offset the shrinking of its commercial portfolio and falling loan spreads, the parent of Union Bank of California actively marketed residential mortgages, taking advantage of the home finance boom… For the three months, commercial and industrial loans fell 10.23%… commercial mortgages rose 17.41%…and residential mortgages rose 31.85%…”

Golden West Financial expanded assets at an 18% annualized rate during the quarter (17% for 2002). At Washington Mutual, assets expanded at a 9% pace (11% for 2002). Wells Fargo saw Total Assets expand at an 18% rate during the fourth quarter to $349 billion (up 14% for the year). “The home finance businesses saw exceptional growth in 2002, with total originations of $333 billion surpassing our 2001 industry record of $202 billion… Our owned servicing portfolio grew 26 percent during 2002 to $535 billion and our home equity portfolio grew 41 percent during the year to $36 billion.” Fourth quarter mortgage banking fees were up 31% and Credit card fees rose 18%. Average commercial loans declined year-over-year.

Countrywide Financial reported fourth quarter earnings per share up 53%. The quarterly Gain on Sale of Loans and Securities surged 128% y-o-y to $1.3 billion. Loan fundings of $102 billion were up 142%” from 2001’s fourth quarter. “The servicing portfolio topped $452 billion, an increase of $121 billion over last year.” Total Assets surged 56% y-o-y to $58 billion. During a huge fourth quarter, total assets increased almost $13 billion, or more than 110% annualized. Mortgage Loans and Mortgage-backed Securities Held for Sale doubled in three months to $15 billion. The company’s balance sheet also has a new line item - “Loans Held for Investment” – that ended the year at $6.1 billion. It is worth noting that Countrywide ended 1997 with Total Assets of $7.7 billion. Also from the earnings release: “Third-party estimates indicate total mortgage originations in the range of $1.8 - $2 trillion in 2003…”

Highlights from Bank of America’s fourth quarter: “Average consumer loans increased 19% to $196 billion. Mortgage banking income rose 23 percent… Card income was up 17 percent…” “Consumer loans grew 16 percent (during 2002), primarily in residential mortgages and credit cards. Commercial loan levels declined 12 percent…” Global Corporate and Investment Banking earnings declined 17%.

Citigroup “reported record net income of $15.28 billion for” 2002, an 8% increase over 2001. By business unit, Global Corporate and Investment Banking lost “$344 million for the fourth quarter, including a $1.3 billion after-tax charge related to the establishment of reserves for the previously announced proposed settlement with regulators…” “Full year core income of $3.02 billion [was] down 33%.” Fourth quarter (Global Corp. and Invest. Banking) revenue dropped 9%. Private Client Services fourth quarter income was down 19%, while Global Investment Management saw income increase 5% during the quarter. Proprietary Investment Activities and Corporate/Other “recorded a loss of $75 million…”

The action continues to be with the consumer. The Global Consumer (Cards, Consumer Finance, and Retail Banking) group saw “core income of $2.37 billion for the fourth quarter, up 26%... Cards, which now serves 102 million accounts in 47 countries, increased income by 30%... In North America, income grew 22%... Consumer Finance saw North America income rise 19%, with average loan growth of 11%. Retail Banking income rose 25%, with North American income up 35%. “The growth in Consumer Assets income also reflected the continued record levels of mortgage refinancings and substantial volume growth in student loans.”

JPMorgan Chase fourth-quarter Total Assets were up 9% y-o-y to $759 billion. Loans were down 1% y-o-y to $211 billion (fourth quarter Average Loans were down 3% y-o-y). Trading Assets, on the other hand, jumped 31% y-o-y to $248 billion. By Trading Asset category, Debt and Equity Instruments jumped 40% y-o-y to $165.2 billion, while Derivative Receivables were up 17% to $84.5 billion. On the liability side, we see that Deposits rose 4% y-o-y to $304.8 billion, while Commercial Paper declined 10% to $16.6 billion. Federal Funds Purchased and Securities Sold Under Repurchase Agreements surged 32% to $169.5 billion. “Trading Liabilities” were up 22% y-o-y to $133 billion.

Chase Financial Services (consumer banking) saw fourth-quarter revenues jump 16% y-o-y, with Average Managed Assets up 13% y-o-y to $188 billion. Viewing Operating Revenue by business unit, Chase Cardmember Services revenue was up 25%, Chase Home Finance 45%, Auto Finance up 16%, Chase Middle Market up 3%, and Chase Regional Banking down 7%. Or, by end of period assets, Cardmember Services up 23%, Chase Home Finance up 21%, Chase Auto Finance up 28%, Chase Regional Banking up 6%, and Middle Market unchanged.

Credit card lender MBNA Financial - The King of Steady Growth – disappointed The Street by missing earnings estimates. The company took a special provision to increase its reserve for future loan losses. Managed delinquencies increased nine basis points sequentially to 4.88%, but were down 21 basis points year-over-year. Credit Losses were up 20 basis points for the quarter and 18 basis points y-o-y. Total Managed Loans expanded at a 17% annualized rate during the fourth quarter to $107.4 billion and were up 16% for the year. Total Assets increased 16% for the year to $52.9 billion.

Credit insurer Radian group reported an unimpressive quarter, although Net Income was up 12% y-o-y. Total Debt Service Outstanding expanded 7% y-o-y to $104.8 billion. The Provision (expense) for Losses was up 27% from 2001’s fourth quarter, although this was off-set by a doubling of Equity in Net Income of Affiliates (primarily from subprime securitizer C-BASS) to $23.4 million. It is fascinating to watch the risk profile of this company rise each quarter. While the number of Prime loans insured was down 7% y-o-y (primarily due to cancelled policies), Non-prime loans insured jumped 31%. Ominously, Non-Prime Loans in Default surged 86% y-o-y. Non-prime loans delinquent jumped to 7.83% from last year’s (4th quarter) 5.54%. The lowest quality loans (“A-Minus”) saw delinquencies jump from 6.35% to 11.27%. Direct Claims paid were up 50% y-o-y to $47.5 million (up from the third quarter’s $41.2 million). Direct Claims paid have now doubled in just five quarters. Radian also ballooned its balance sheet, with Total Assets up 22% y-o-y to $5.4 billion.

Credit insurer Ambac saw earnings hurt by previously disclosed losses on National Century asset-backs. But when it comes to writing new Credit insurance, it was a huge quarter. Quoting Phillip Lassiter, Chairman and CEO: “We wrapped up the year with an extraordinary quarter of business production. All sectors evidenced vibrant business activity at attractive pricing levels. We enter the new year with significant momentum and an apparent abundance of attractive opportunities.” “Adjusted gross premiums written in the fourth quarter of 2002 were…up 54% from the fourth quarter of 2001…” Public Finance premiums were up 85% and Structured Finance premiums were up 65%. Total assets expanded 24% for the year to $15.4 billion. Net Financial Guarantees in Force (NFGIF) expanded by almost $33 billion for the quarter to $557 billion, a 25% annualized growth rate. NFGIF was up $81 billion, or 17%, for all of 2002. Ambac ended the year with Qualified Statutory Capital (Capital and Surplus, along with Contingency Reserves) of $3.7 billion for a Capital Ratio (Qual. Capital to NFGIF) of 149 to 1. Returning to our favorite flood insurance analogy, there is torrential rain falling, the river is rising rapidly, and there is near panic to acquire (and reinsure) flood protection. Apparently without a care in the world, Ambac is all too happy to sell inexpensive flood insurance to any and all takers. We are all left to fear the inevitable “100-year” flood…

January 21 – American Banker (Rob Blackwell): “Several prominent ex-regulators are set to unveil a network this week designed to maximize federal coverage of deposits at small and midsize banks and make it easier for them to compete for the accounts of businesses, municipalities, and wealthy individuals. Its creators, led by former Comptroller of the Currency Eugene Ludwig and former Federal Reserve Board Vice Chairman Alan Blinder, said their marketing pitches have been well received… In theory, at least, the Promontory Interfinancial Network offers banks an opportunity to sell certificates of deposit as large as customers want, and have them fully insured by the federal government… Here is how it works: Member banks can put their customers’ funds in CDs for up to $100,000 at another Federal Deposit Insurance Corp. insured institution. In return, the banks would expect to receive an equal amount of funds from other members. For example, a bank in California could take a CD from a customer for $300,000 and send $100,000 each to banks in New York and North Carolina. In return, the California bank would receive $200,000 from other banks on the network that were engaged in similar transactions… FDIC Chairman Don Powell said that his agency will watch the network as it develops, but he does not have any immediate concerns about it. ‘New deposits coming into the banking industry is not anything we are concerned about. It means the industry is healthy – the industry has to be funded. The deposits help economic conditions at banks who can take that money and loan it out.” “Promontory is hoping the network will take off in the coming weeks as banks learn more about it, and it has assembled an industry Who’s Who to serve as its board of directors” including a former chief of staff for both the OCC and FDIC, former Senator Warren Rudman, former FDIC chairman William Seidman, and former Fed Governor Edward Kelley Jr.

Who, might we ask, is protecting the interests of the taxpayer? It is truly amazing to watch as federal government (explicit and implied) guarantees and backing are called upon to support the vulnerable mortgage market, pension and healthcare liabilities, and bank deposits (to mention only a few of the largest obligations). Over the past five years (Wall Street-created) money market fund deposits have doubled to about $2.4 Trillion. It will now be interesting to follow developments and witness the degree to which these funds are “transformed” into insured “bank” deposits. Non-bank Credit excess works magically during the boom, but has a critical deficiency come the bust. It appears some of our leading financial authorities are hard at work developing schemes to subvert the spirit of FDIC insurance. Hide your wallet.

As the week came to its conclusion, the markets found much to worry about. Importantly, the world’s reserve currency now sinks on a daily basis. And while we believe we are witnessing a momentous inflection point in financial and economic history, it is difficult to know what this dollar decline means with respect to near-term financial fragility and systemic risk. It was clear that years of recklessly inflating specious dollar financial claims (non-productive Credit creation) were destined to end in a devaluation of dollar purchasing power. This has commenced. But does it, today, also unleash acute financial fragility? Well, something clearly has players running from the Wall Street firms, the money center banks, the Credit insurers, the GSEs, and the consumer lenders. Indeed, not since those dark days back in October have we seen such pressure on the stocks of the key Structured Finance operators. This is likely partially related to recognition of the faltering consumer debt Bubble, which would seemingly provide the final impetus for a move away from U.S. financial sector claims and other dollar-denominated assets.

As we’ve written numerous times before, “As Goes the Dollar, So Goes Structured Finance.” Or was it, “As goes Structured Finance, So Goes the Dollar.” It is almost as if the symbiotic relationship conjoining Structured Finance and the dollar has (finally) come face-to-face with An Integrity Problem. And at times – probably most times, questions of marketplace Integrity are but only an annoyance that must be ameliorated with liquidity operations and demonstrations of Federal Reserve resolve. Yet there comes that fateful day when the old tricks become The Issue – the basis for a very problematic systemic Integrity Problem. Confidence Games are Dangerous Endeavors.