Saturday, August 30, 2014

07/20/2000 Greenspan and a Dysfunctional Financial Sector *

It was certainly a wild and disjointed earnings, Greenspan, and option expiration week. For the week, the Dow dropped less than 1% and the S&P500 declined almost 2%. The economically sensitive issues under performed, with the Transports sliding almost 4%, and the Morgan Stanley Cyclical index dropping 3%. The Morgan Stanley Consumer index was largely unchanged, as the Utilities added almost 2%. The small caps came under selling pressure, with the Russell 2000 declining better than 3%. The NASDAQ100 dropped 3% and the Morgan Stanley High Tech index declined 4%. The highflying Semiconductors came down to earth a bit, sinking 12% this week. The Internet index dropped 4% and the NASDAQ Telecommunications index declined 3%. The Biotech index bucked the trend, adding more than 2% this week. The financial stocks were volatile, although the banks posted a slight advance and the Bloomberg Wall Street index ended with a marginal decline. The gold stocks were hammered, dropping 7% this week.

Credit markets absolutely loved Greenspan’s dovish testimony. Yesterday, 2-year Treasury yields jumped 14 basis points, 5-year 16 basis points, and the 10-year 15 basis points. Mortgage yields dropped 16 basis points yesterday and agency yields sank 17 basis points. So much for the “bond market vigilantes.” Actually, we suspect short covering and derivative trading were likely major factors fueling the rally. For the week, Treasury yields declined a more modest 8 to 11 basis points. Spread actually widened 2 to 3 basis points for the week. Commodity prices were quite volatile, coming under increasing selling pressure as the week progressed. The dollar’s rally, not surprisingly, ended abruptly with Greenspan’s comments, leaving the dollar largely unchanged for the week.

The essence of yesterday’s testimony was captured clearly with today’s headline from the Chicago Tribune: “Greenspan’s Green Light Starts Market Racing.” Indeed, the Fed chairman thoroughly captivated the bullish “soft landing” crowd with statements such as, “for the moment, the drop-off in overall economic growth to date appears about matched by reduced growth in hours (worked), suggesting continued strength in growth in output per hour. (The current trend) could conceivably slow or even bring to a halt the deterioration in the balance of overall demand and potential supply in our economy.” Greenspan also stated, “even with the rise in interest rates, an eventual leveling out or some tapering off of purchases of durable goods and construction of single-family housing would be expected.” Overall, Greenspan presented a sanguine view – business as usual for “New Era” prosperity - with natural forces and previous Fed rate hikes well on the way to working their magic. It is his view that the leveling off of stock market wealth effects and rising debt service burdens have already tempered household demand “several notches,” thus allowing uninterrupted prosperity.

However, the comment that most caught our attention was, “demand may be moving closer into line with the rate of advance in the economy’s potential. Should this favorable outcome prevail, the immediate threat to our prosperity from growing imbalances in our economy would abate.”

Now wait just one minute Mr. Greenspan! There is no evidence of abatement in “growing imbalances,” most notably ballooning trade deficits, problematic real estate inflation, and mounting consumer and business debt levels. In fact, the evidence is quite compelling that such imbalances are increasingly manifesting into more general inflationary pressures and economic maladjustments. Additionally, the historic stock market bubble remains intact, replete with speculation, underlying leverage and a continued gross misallocation of resources. At the same time, the credit market is a bastion of speculative excess, saturated by endemic over leveraging. The derivative markets (interest rate, stock market, credit, energy, and gold – to name the major potential “hot spots”) are an accident waiting to happen, and the highly leveraged financial sector grows only more acutely vulnerable to overvalued asset prices, interest rates, and credit problems generally. While some air has come out of the Internet bubble, the massive technology/communications bubble remains largely intact and acutely vulnerable. Most importantly, and apparently ignored by Greenspan, is that financial and economic imbalances are firmly set on a course to grow to even more dangerous extremes, the inevitable consequence of unfettered credit excess. This historic bubble is certainly much more than an easily rectifiable imbalance between demand and the supply of output – much more.

As we have stated previously, credit excess engenders self-reinforcing processes – excess begets only greater excess, creating more dangerous distortions and imbalances to both the financial system and economy. Traditionally, these processes were squelched by attentive central bankers. With this in mind, we see no indication that this cycle is correcting, especially with data now available from second quarter earnings releases. It is clear that the over aggressive financial sector is ignoring the Fed as it perpetuates the U.S. bubble – that a terribly dysfunctional system is left unchecked.

Not surprisingly, Greenspan’s testimony again failed to utter the word credit, let alone address continued egregious credit excess. We note that several previous topics are no longer mentioned, as well. Apparently, the asset bubble debate has been resolved, at least in his mind. He has also conveniently dropped the subject line of wealth effects emanating from rising home prices, despite his previous accurate analysis that wealth effects from housing gains are likely more significant than those provided by the stock market. Instead, his focus has turned to an inevitable slowdown in the housing market after years of exceptional growth. This is unfortunate. Our view holds that continued mortgage credit excess will manifest into only more severe price distortions. First, with inflation psychology having returned with a vengeance and housing inventories very low throughout the country, credit excess will feed directly into rising prices (as is already the case). And second, with home equity having increased significantly and with wage growth accelerating, credit excess will continue to stoke additional demand as homebuyers “move up” to larger, more expensive homes. And as far as Greenspan’s contention that “higher” interest rates are dampening housing demand, we see this as little more than wishful thinking. Keep in mind that millions of consumers are anything but dissuaded by paying upwards of 20% on credit card balances. So why should we expect that today’s mortgage rates, especially considering the deductibility of mortgage interest (as well as rising home prices!) will deter potential home buyers? Thus far, marginally higher rates have only driven large numbers of borrowers, particularly in the upper-end, to more risky adjustable-rate mortgages. Mr. Greenspan, until this historic credit cycle is broken, risk will only grow to more extremes for both individual borrowers and the entire system. Get with the program.

Evidence of enormous, and increasingly problematic, real estate price distortions and imbalances grow by the week. This week, Bloomberg reported on a recent study of the Manhattan apartment market commission by brokerage Douglas Elliman. “The average cost of buying a Manhattan apartment jumped 42% in the second quarter, surpassing the $800,000 mark…the Manhattan market seems to be dismissing the effects of mortgage rate increases…both the percentage and dollar increases are the highest in the 10-year history of the study…for co-op apartments, the average price rose 31% to $668,105, double the price in 1995…the average price of a condominium rose 53% to $1.04 million.”

Housing inflation is not just along the coasts. From today’s Atlanta Journal Constitution, “Instead of a big dip in second-quarter home-sale closings, metro Atlanta counties posted growth nearly equal to a year ago. ‘The market rebounded dramatically, and we had growth in closings equal to the second quarter of 1999 – and that was a very strong quarter.’” From the Houston Chronicle, “Houston’s used home prices soared to record levels in June as the median home price hit $122,000, a 9% increase from a year ago and compared to $116,000 during May. According to a Houston economist, “At this point I don’t see any end to it. The Houston economy is significantly stronger than it was 12 months ago.” Also, “prices are rising for old homes that are sold to be torn down by the home builders and replaced with new construction…lots that were selling for $125,000 about a year ago are now selling for $150,000 to $175,000.” From Denver’s Rocky Mountain News, “The average resale price of a single-family home in the Denver metro climbed to $241,518 in June, marking the fifth time in as many months the price has hit a record.” Local real estate experts were quoted, “Nothing has changed in terms of homes continuing to go up on a 1% to 2% clip per month,” and “It’s the best June we’ve had here in the last seven years.” Similar stories appear in newspapers across the country.

According to the California Association of Realtors, “housing affordability in California fell to 29% in May, down 8 percentage points from May 1999. The affordability index “measures the percentage of households that can afford to purchase a median-priced home in California…At 10%, San Francisco was the least affordable county in the state, followed by Contra Costa and San Mateo with 12%. In Southern California, San Diego County was the least affordable at 22%, followed by Orange County at 25%. In Los Angeles County, affordability was 36% and in Ventura County, it was 31%.” For the entire country, affordability was 52%, four points lower than last year. Increasingly, in California and other major markets, real estate bubble dynamics similar to Japan during the 1980s are creating huge disparities in wealth and personal hardship, with concomitant social policy issues.

This week, the Orange Country register reported that “home prices continued their skyward march in June, reaching another all-time high: $273,000. A local real estate executive was quoted as saying, “there’s one thing you can pin it on, and that’s job growth. Just about every industry is clicking.” The article stated that the county will likely create 45,000 new jobs this year, while builders are expected to construct only about 15,000 residences.” June “was the seventh-busiest month (of home sales) on record.” There was a decline in existing home sales, although “the problem isn’t a lack of buyers, particularly in the $200,000 to $300,000 range. The problem is a lack of inventory.” Quoting a real estate agent: “When you have absolutely nothing to show someone, what can you do?” And this week the Los Angeles Times reported that LA County home prices moved to new records in June. John Karevoll from DataQuick was quoted: “Everyone’s been expecting the market to taper off, but the numbers clearly indicate that the market is still strong.”

Last week from the Contra Costa Times, “The rent increases sweeping the East Bay (San Francisco Bay Area) signal an acute housing problem that figures only to get worse despite state efforts to produce more affordable housing…” On news that a Walnut Creek apartment complex was planning to increase rents 110% for August, a local Assemblywoman was quoted as saying, “We’re going through some extraordinary times. A couple of years ago, this was happening in the Silicon Valley – and now it’s happening all over and certainly here.” Last week from the San Jose Mercury News, “Silicon Valley Apartments in Demand, Rents Soaring.” “One-bedrooms in higher-end complexes are starting at $2,200 on the Peninsula and $1,800 in San Jose, a 40% increase in some cases over what a vacant unit cost at the beginning of the year. The latest hikes follow five years of steady increases…” The article highlighted the experience of a manager of a 248-unit complex in Mountain View that had 75 individuals on a waiting list for one-bedroom apartments starting at $2,200. The same apartment rented for $1,550 at the beginning of the year. “A survey of eight San Jose complexes…found that rents on vacant units had risen about 40% the first six months of the year.” From Today’s Chicago Tribune story - “Silicon Valley Revolution Crowding Out Home Buyers” - “Area workers, many earning six-figure incomes, frequently buy mobile homes because it is all they can afford. One school administrator who makes more than $90,000 purchased a mobile home recently for that reason.”

Recognizing that it is credit creation that provides the additional buying power that leads to higher prices, we have been anxiously awaiting second-quarter earnings releases to see specifically the sources of lending growth. We see than Fannie Mae and Freddie Mac expanded total assets at a rate of 12%, only slightly below the first quarter, and that bank loan growth also generally held firm at a solid 8%. It was, however, “peddle to the metal” for some of the major savings and loans. Golden West Financial, a leading California lender of adjustable rate mortgages, originated a record $5.9 billion of mortgages during the quarter. This was a 57% increase from first quarter originations and double the year-ago period. A Wall Street firm titled its research report on the company “Ever Heard a Rolls Royce Engine Purr?” Estimates have Golden West’s mortgage portfolio growing 32% this year. Quoting Chairman of the Board and CEO Herbert Sandler: “Adjustable rate mortgages were the loan of choice for a very large number of borrowers during the first half of 2000.”

Washington Mutual announced record originations during the 2nd quarter, increasing 39% from the first quarter. “…total loan volume of $17.95 billion, which included on a year-over-year-basis, a 38% increase in residential adjustable-rate mortgage loan originations and an 82% increase in second mortgage and other consumer loans generated by the company’s banking subsidiaries.” Fully 88% of single-family residential loans were adjustable rate. “Originations and purchases of second mortgage and other consumer, specialty mortgage finance, commercial business, commercial real estate and residential construction loans totaled $6.34 billion for the most recent quarter, up 91% over $3.31 billion in the second quarter. Orange County lender Downey Financial saw loans grow at an annualized rate of 45% during the second quarter, while total loans jumped 48% during the past year to $9.5 billion. At Silicon Valley Bancshares, total assets ended the second quarter at $5.4 billion, a 32% increase year-on-year

Behemoth Citigroup saw a 23% increase in revenues in its Banking/Lending business, with a 27% increase in mortgage banking. North American credit card operations added 1 million new accounts and 13% receivable growth. Citi’s Salomon Smith Barney unit saw its Private Client customer assets increase 21% to an astounding $1.032 trillion, with a “T”.

From the country’s largest bank, Bank of America chairman and CEO Hugh McColl commented, “a number of our businesses had a strong quarter – especially in consumer banking.” Average managed consumer loans and leases increased 19% to $419 billion, compared to a year ago. “Mutual fund assets rose by $12 billion, or 14%, during the first six months…Balances in Money Manager, the company’s combination checking and brokerage product, increased 80% from a year ago to $16.5 billion.”

With all the talk, including Mr. Greenspan’s, of a meaningful slowdown in consumer demand during the second quarter, one would expect this to be reflected in slower loan growth by the major consumer finance companies. Curiously, there was actually acceleration in lending. At Household International, average managed receivable expansion accelerated to an annualized rate of 26% during the second quarter, compared to 14% during the first quarter. “The company’s managed receivable portfolio grew 22% from a year ago, reaching almost $80 billion.” Real estate receivables increased $3.1 billion during the second quarter, growing at an annualized rate of 40%. Managed receivables at Associates First Capital expanded at a 17% rate during the second quarter, compared to 12% during the first quarter. For the past year, managed receivables have increased 16% to almost $85 billion. At Providian, total managed assets have increased 49% to almost $27 billion during the past four quarters. Looking at Providian’s balance sheet, total assets ended the second quarter at $17.2 billion, a 73% increase from a year ago, and almost triple the $5.8 billion of total assets at June 1998. At credit card lender MBNA, managed loans increased at an 18% rate during the second quarter to $76.3 billion. At Capital One, “managed consumer loan balances increased $1.6 billion to $21.9 billion,” a 35% annualized growth rate. Looking at Capital One’s balance sheet, total assets have increased 43% during the past year.

In search of further fuel sources for the housing boom, particularly the “jumbo” mortgages necessary to fuel the historic California bubble, one must look increasing to the non-banks and the plethora of online mortgage companies. If one goes to the Los Angeles Times mortgage section and clicks “jumbo loan,” “adjustable rate,” “no points” “A Credit”, borrowers will quickly gain access to 11 willing lenders: “The Loanleaders of America, Inc.,” “Citicredit,” “Bestrate4u,” “Amerimax Financial,” “Valueloan,” “,” “,” “American Equity Mortgage,” “Prism Mortgage Company,” and “United American Mortgage Corp.” Clearly, mortgage credit could not be more easily available. And with “New Era Finance” leading to the demise of the diligent loan officer – who in the past might have said, “these home prices are crazy and I’m not lending! – today it only takes a sufficient credit score input online and generated by the computer. Moreover, with “banking” no longer localized, borrowers in California have unlimited access to funding sources from across the entire country. Massive securitization markets provide the bevy of online traders the ability to team up with Wall Street for unlimited access to funding. Indeed, with access to national capital markets and unencumbered by reserve and capital requirements, the credit spigot is left wide open to fuel obviously ridiculous home prices. The credit system remains completely out of control.

While Greenspan trumpets wonderful technological advances, it is certainly our view that innovations throughout the financial sector have made it much more difficult for the Fed to manage the economy through minor adjustments in short-term rates. For one, lenders have been quite creative in developing products that provide low monthly payments. And the higher home prices move, the more appealing these products.

Golden West’s website provides a large selection of mortgage products including the

“4.50% Option Loan (7.890APR) – This incredibly low-payment adjustable rate mortgage is for three types of people... 1) Investors, 2) new home buyers, and/or 3) those needing debt consolidation. This is the one of the LOWEST monthly payment loans in America, and the payment increases are limited to 7.5% a year for 10 years. Use the money saved to invest in mutual funds, pay down credit card debt, or put in your new back yard.”

Adjustable-rate mortgages are clearly the product de jour, as captured here: “Some people are still convinced the only way to fly is with a fixed rate. The security is nice, but it could be costing you money.” Wall Street firms have also created mortgage products that minimize down payments and monthly payments - providing maximum funds to play the market. From one firm, a “program enables you to obtain up to 100% financing on your home using eligible securities in your investment portfolio as collateral. Now you can purchase a home without a cash down payment and without disrupting your investments. That means you can enjoy home ownership while continuing to hold or trade securities — so your assets keep right on working for you.” Or, a “strategic mortgage for the wise investor - adjustable-rate first mortgage loans enable you to make interest-only payments for the first 10 years — leaving the principal portion of the loan payment for you to use as you choose…” “Keep your assets invested. Any interest, capital appreciation or dividends continue to accrue to your benefit.” At the “Schwab Mortgage Center” “search over 70 lenders’ products…qualify for as little as 3% down…use the equity in your home to pay off your credit cards, finance a car, or pay for college…” Again, credit could not be easier, and more dangerous.

We must admit that we consider Alan Greenspan quite the enigma. Does he, as an astute student of history, appreciate the severity of the U.S. bubble? And recognizing the inevitable catastrophe that would result from any aggressive move on rates, has he chosen to let the bubble run its course? Or is he simply oblivious of this enormous house of cards, even though he addressed the bubble as far back as 1994? Either way, Wall Street now clearly takes great comfort believing that he will not end this fateful boom. Yesterday, in fact, was a great example of how markets now focus keenly on Greenspan’s take on fundamentals, as opposed to actual economic developments. Accordingly, with Greenspan at bay, credit markets have experienced a significant rally that will only throw more fuel on the overheated and distorted US economy. What a bubble… It is certainly our view that the over zealous U.S. financial sector is in desperate need of some stern disciplining. However, Greenspan wants to be the market’s buddy, when the dysfunctional U.S. financial sector needs a strict parent.