Saturday, August 30, 2014

03/24/2000 Hear No Evil, See No Evil, Speak No Evil *

It was, unfortunately, another historic week for this amazing stock market mania. In the face of increasing tumult in the credit market, the S&P Bank index jumped 6% and the Bloomberg Wall Street index surged 10%. For the week, the Dow surged 5%, while the S&P500 gained 4%. The Transports and Morgan Stanley Cyclical indices rose 3%, while the Morgan Stanley Consumer index added 1%. The small cap Russell 2000 was actually unchanged and the Utilities dropped 1%. The tech stocks were again on fire, with the NASDAQ100 jumping 6%, the Morgan Stanley High Tech index 5%, and the Semiconductors 3%. Year-to-date gains for these three indices increased to 27%, 25% and 83%. The Internet index was largely unchanged and the NASDAQ Telecommunications index added 1%. The Wilshire 5000 index, supposedly a measure of total stock market capitalization for US headquartered companies, ended today at $14.8 trillion, having increased by almost $1.2 trillion in seven trading sessions, while increasing its 2000 gain to 17%. Over these past seven extraordinary sessions, GE added $109 billion of market value, while Cisco added $104 billion. In what is only fitting for this mania, today Charles Schwab trades with a larger market capitalization than General Motors. The market now values Schwab at $53 billion, 94 times earnings and 25 times book value. As bullish euphoria reins, as the AMEX Security Broker/Dealer index has surged 23% in the past seven sessions and has gained 47% from the lows on February 22nd.

Despite Larry Kudlow’s ludicrous statement on CNBC that “money supply measures are falling like large boulders off cliffs,” broad money supply (M3) surged almost $32 billion last week, making it $76 billion over the past two weeks. The largest category of growth has been institutional money market funds that have jumped $26 billion. We also see that domestic financial sector commercial paper borrowings surged an alarming $27 billion last week. Bank credit expanded by $10 billion, led by a $5 billion increase in holdings of “other securities.” And while two weeks do not make a trend, it certainly appears that the financial sector has once again responded to developing systemic stress by aggressively creating additional money and credit. This is not necessarily surprising, although we do not believe that such familiar measures will in the end be successful this time around. In fact, we see a larger debacle as this mechanism only throws additional liquidity onto an already over liquefied household sector. We hear that $22 billion flowed into equity mutual funds this week, with the majority finding its way to the aggressive technology and growth funds. So, perversely, as this crisis unfolds, the financial sector injects additional jet fuel into the stock market bubble. And with the astonishing perceived wealth created, the financial sector is only stoking additional demand for the already desperately overheated economy. Not surprisingly, the January trade deficit came in at a record $28 billion.

The unfolding credit market dislocation took a decided turn for the worst this week. The key 10-year dollar swap spread spiked to 127 yesterday morning before settling today at 115, up 6 for the week. And despite narrowing 4 basis points today, the current coupon Fannie Mae mortgage-backed security spread widened 8 basis points this week. Agency security spreads also continue to widen. The spread between Treasuries and the benchmark 10-year Fannie Mae note widened 11 basis points to 101, this compared to 54 on January 26th. 10-year Freddie Mac yields ended the week 104 basis points above Treasuries, an increase of almost 13 basis points this week. Spreads widened about 7 basis points for 10-year notes from the Federal Home Loan Bank System. Ominously, today the sellers turned on the Treasury market with 2, 5 and 10-year yields rising between 11 and 12 basis points. For the week, 2-year Treasury yields jumped 14 basis points to 6.62%. Eurodollars were hammered today as well, with the implied yield on the December Eurodollar futures contract surging 15 basis points. At the end of the week, we also took note of a strong move in the Swiss franc against the dollar, something to watch going forward.

When the Thai baht faltered in July of 1997, few had any clue that this event marked the onset of financial and economic collapse for Thailand. But, then again, few understood the forces that had developed to foster the fateful bubble. Over the following months, speculators, investors and policymakers around the world would be shocked not only by the implosion in Thailand, but also that it would prove to be the catalyst for what developed into the worst global financial and economic crisis in decades. Indeed, the baht was the first of the “dominos” to fall. Yet, the fact that “dominos” were precariously lined up around the world and poised to tumble was curiously invisible to virtually everyone. Actually, at the time I don’t remember anyone recognizing the dislocation in Thailand as a major event for SE Asia, let alone the international financial system. Instead, a strong consensus held that the region’s economies were healthy, with continued robust growth and prosperity assured. These were, of course, referred to as the Tiger miracle economies. This terminology appeared justified, at least on the surface, and was certainly “the story” aggressively sold by Wall Street. Looking back, it was quite a delusion.

To have recognized the fragility of Thailand, it was necessary only to have done some digging below the surface. While economic growth was strong and the perception was of continued exceptional prospects, reality was that the foundation of the financial system had turned to rot after years of credit and speculative excess. Severe economic and financial distortions and imbalances had developed during the boom, only to remain latent for as long as the credit-induced bubble expanded. The Thai banking system had for too long lent recklessly. For too long, Thailand and SE Asia were “the places to be” for international mutual fund investors as capital flowed into these economies in much greater quantities than could be effectively allocated to sound and profitable enterprises. And, importantly, fostered by a pegged currency, for too long the leveraged speculating community had been placing big bets based on currency and interest rate differentials, creating massive “hot money” flows and leverage for SE Asian financial systems. Too much credit of increasingly poor quality after years of boom, excessive foreign inflows, and the resulting momentous misallocation of resources were indeed the ingredients for collapse.

Massive financial claims were created that could in no way be supported by actual economic assets, and a highly leveraged financial sector developed with increasingly shaky assets and a precarious asset/liability mismatch. It was a textbook financial and economic bubble, one that should have been recognized at the time. The weak link in the chain for Thailand and SE Asia was the leveraged “hot money” flows. With the breaking of the Thai baht peg to the dollar, the bubble was pierced and there was a mad scramble out of Thai financial assets. Soon, the credit system buckled under the weight of massive capital flight. And with frenetic credit expansion always a necessity to perpetuate aged credit bubbles, a breakdown in the credit creation process in Thailand doomed the fragile and vulnerable financial system and cut off the life source for the economy.

But why did the collapse in the Thai baht have such a devastating effect throughout the world? To understand the link between Thailand and the global financial system, one need only look to financial structures and relationships within the international financial system. Importantly, massive leverage had developed throughout SE Asia and the emerging markets, and really for the entire global system. Derivative trades encompassed markets in SE Asia, as well as throughout global emerging markets, and the leveraged speculators placed aggressive bets throughout. As for the SE Asia boom and inevitable bust, the currency pegs were key. With many of this region’s currencies tied to the dollar, this presented extraordinary opportunities for arbitrage between various interest rates and currencies. It was truly paradise for the “rocket scientists” structuring derivative products, just as it was for the smooth salesmen peddling them. Sophisticated computer models easily constructed trades with very high probabilities for outsized returns. Over time, enormous derivative bets were being placed, creating a flood credit creation and “hot money” flows into Thailand, South Korea, Indonesia, Malaysia, Singapore, Hong Kong and elsewhere. Not only did this create acute systemic vulnerability to debilitating capital flight, this financial excess also impaired the soundness of the underlying financial systems, not to mention economic vulnerability after years of escalating distortions and imbalances.

Again, recognize the importance of the currency pegs. It was the pegs that allowed the sophisticated computer models to create many of the highly leveraged speculations and, of course, massive credit excess. Yet, with the models having been developed based on historical relationships and the relative stability of pegged currencies, the models basically assumed the continuation of the currency pegs. Trusting the assumptions and the models, the leveraged speculating community placed enormous bets throughout the region. This wonderful game changed, however, when the battered and broke Thai central bank finally succumbed to devaluation. Initially, the perception was that Thailand was an exceptional case and no cause for serious concern. At the same time, however, the savviest players began to reduce exposure elsewhere in the region. Initial capital flight put pressure on other pegged currencies, and soon it was a mad scramble to reverse similar bets placed elsewhere in the region. Confidence quickly waned that these countries could maintain their currency pegs. Furthermore, many of the derivative strategies dictated dynamic hedging-related selling, inciting a self-feeding meltdown. Quickly, confidence in the reliability of the models that had been the impetus for so much leveraged “hot money” evaporated. The speculating crowd had all come to place big bets together, but when losses began to mount and the models faltered, it was a panic to get out. There were no buyers, only aggressive sellers, and the “dominos” began to fall. Catastrophe was unavoidable as an unwind of derivative trades and other speculations fostered a massive deleveraging and a run for liquidity

But why are the Thai baht and the SE Asian collapse relevant in the US today? First, I believe that the widening of credit spreads over the past two months is a seminal event, which may prove comparable to the breakdown of the Thai baht in July of 1997. And as was the case with the initial baht devaluation, I see no recognition of the critical importance of this development. I also believe that the key factor to recognize is that the speculators’ models are failing, models that have been at the root of unprecedented and endemic leveraging and speculation. In Thailand and SE Asia, currency pegs were not only the key factors for the models, but they were also major factors that impaired market-pricing mechanisms. These pegs induced leveraged speculation, while they also fostered massive financial and economic distortions as natural supply and demand relationships were subverted.

Here at home, market mechanisms have also been dangerously subverted. In fact, two momentous “pegs” have worked to induce unprecedented leverage and speculation, not to mention endemic distortions and imbalances to the financial system and economy. First, we have a central bank that pegs short-term interest rates, while virtually promising to forewarn the speculators of any imminent rate increases. A second “peg” is created through the implied government guarantees and “too big to fail” doctrine that has garnered the Government-sponsored enterprises unlimited access to the capital markets. These two “pegs” have for sometime fostered an extraordinary opportunity for interest rate speculation, and, of course, such situations do not go unnoticed by a leveraged speculating community that has grown to unimaginable size and power. So the ingredients for unprecedented credit excess can be found in the Federal Reserve “pegging” short-term borrowing rates for the speculators; the unregulated, unfettered and overzealous financial sector accommodating an unlimited supply of borrowable short-term funds; and the GSE’s creating a virtually endless supply of securities with the implicit backing of the US taxpayer. And as these are the savory ingredients for egregious credit and speculative excess, Wall Street is the chef and sophisticated computer models are the pot.

Today, however, our contention is that the models are faltering, a truly momentous development for the US credit bubble and financial and economic bubble, generally. And while Wall Street is quite vocal in blaming the “ineptness,” first of Treasury Secretary Summer’s debt buy-back program, and now Undersecretary Gensler’s appropriate reiteration that the American taxpayer does not stand behind Fannie Mae and Freddie Mac securities, this is completely avoiding the critical issue: Unprecedented private sector credit creation fueled by a reckless Wall Street and the GSEs has fostered an unhealthy boom that is causing government surpluses and a contraction of public sector debt. This is a major problem, as the old models assume moderately expanding private and public sector debt. Moreover, these models were developed from a history of relatively stable and predictable relationships among interest rate spreads between public and private sector debt. Increasingly, it is unmistakable that a huge and growing disparity between the marginal quantities of private and public sector debt issuance has distorted previous pricing relationships, rendering the old models defective. It is also clear that the acutely unstable nature of this historic stock market and economic bubble has also distorted the nature and predictability of many relationships, again impairing the effectiveness of many models.

The first shoe to drop appears to be in mortgages, a particularly volatile security. With new mortgage debt running at double the rate of just a few years ago, in the midst of an extraordinarily unsettled financial and economic environment, there is every reason to believe that models for hedging mortgages are faltering. Importantly, the leveraged players have for some time dominated this sector. With GSE guarantees, Wall Street has created an endless supply of AAA-rated and other mortgage-backed securities that are tailor-made for the leveraged speculating community. However, with spreads having widened sharply over the past weeks, significant losses will now likely precipitate an ongoing liquidation. Importantly, this deleveraging has and will continue to heighten illiquidity and exacerbate systemic stress, impacting other asset classes as well. We see mortgage securities as the first “domino” to fall.

If it were not for Fannie Mae and Freddie Mac’s aggressive mortgage purchases and ballooning of their balance sheets, particularly since the severe crisis back in 1998, the leveraged players would have choked on an oversupply of mortgage paper long before now. Yet, the support for the mortgage market has at the same time created an enormous issuance of agency securities to fund these bloated GSE balance sheets. Agency securities, with set maturities and implied government guarantees, have been truly wonderful fodder for the leveraged speculators, as well as popular securities for the holders of the flood of dollars we export to fund our massive trade deficits. Untold leverage has developed both domestically and internationally in agency securities. We suspect that this market is a vulnerable “domino” as well. Importantly, as bets turn sour in one market, such as mortgages, this forces an unwind of bets and a deleveraging that impacts credit market liquidity generally. Clearly, the huge wildcard is the interest rate derivative marketplace. With the US commercial banking sector holding almost $30 trillion of interest rate contracts, including almost $20 trillion of swaps, it is impossible to predict how this will play out. Just as the devaluation in Thailand set in motion destabilizing processes, we believe a similar process is unfolding in the US credit market. It sure looks to us like “the game has changed.”

All the same, the stock market operators that have come to dominate the marketplace are playing hard and, apparently, without concern. At some point, however, they will not be able to ignore the reality of an unfolding financial system dislocation. Importantly, the credit market crisis now broadens by the week. Yet, as we have seen several times before, these types of crises typically take much longer to develop than one would expect. However, at some point a “critical mass” seems to take hold and at that point things then progress very rapidly. For now, Wall Street is enjoying the game “Hear No Evil, See No Evil, Speak No Evil.” So we will stick with not predicting this wild stock market, although the chaotic and reckless nature of trading is patently indicative of an accident waiting to happen. One thing is sure, there are a number of “dominos” lined up when this crisis gathers steam. Egregious leverage and speculation permeate the US credit market, particularly in mortgage and agency securities, as well as through interest rate derivatives. Reckless leverage and speculation also underpin the US Stock market, and are likely factors as well in global equities and emerging debt and equity markets. There is a US corporate debt bubble, a consumer debt bubble, a precariously over leveraged US financial sector, an acutely vulnerable dollar, and a maligned US economy with unprecedented distortions and imbalances. This may appear hyperbole, but we believe that these are but the unfortunate and ugly facts.