Tuesday, September 2, 2014

10/10/2002 Juan & Maria Guzman **

Just when you thought it couldn’t get any more chaotic… With a two-day rally of 564 points, the Dow ended the week up 4%. The S&P500 also gained 4%. The financially troubled Transports and Utilities added 1% and dropped 6%, respectively. The Morgan Stanley Consumer index gained 3%, while the Morgan Stanley Cyclical index added 2%. The small cap Russell 2000 added 2%, and the S&P400 Mid-Cap index gained 3%. The technology stocks enjoyed a spectacular rally that saw the Semiconductor index surge better than 20% off its Tuesday low. For the week, the NASDAQ100 and Morgan Stanley High Tech index jumped 9%, while the Semiconductors gained 8%. The Street.com Internet index surged 14%, as the NASDAQ Telecommunications index gained 4%. The Biotechs rose 7%. The financial stocks enjoyed an enormous two-day rally, with the Securities Broker/Dealer index at one point up almost 14% from yesterday’s lows. For the week, the Securities Broker/Dealer index increased 5% and the Bank index gained 6%. With bullion sinking $6.20, the HUI Gold index dropped about 6%.

The Credit market was also quite unstable. For the week, 2-year Treasury yields added four basis points to 1.82% and the 5-year increased nine basis points to 2.77%. The 10-year Treasury yield jumped 14 basis points to 3.80%, while the long-bond saw its yield increase 10 basis points to 4.81%. Benchmark mortgage-back yields rose four basis points, as the implied yield on agency futures jumped 10 basis points. The spread on Fannie Mae’s 5 3/8 2011 note narrowed 1 to 67, while the 10-year dollar swap narrowed 1.5 to 64.5. The Credit system came under intense stress on Wednesday, with spreads on Ford and Household International bonds (among others) widened spectacularly. One index of financial sector bonds had spreads widen 50 basis points Wednesday. With the stock market rallying strongly, the spreads did narrow somewhat into the end of the week. The dollar also stabilized as the week came to a conclusion. Ominously, the dollar began to come under significant selling pressure earlier in the week as stocks sank and spreads widened.

Broad money supply declined $4.2 billion for the week. Demand and checkable deposits increased $19.7 billion, while savings and small time deposits declined $2.9 billion. Institutional Money Fund assets dropped $12.8 billion and large time deposits declined $4.1 billion. Repurchase Agreements jumped $8.6 billion, while Eurodollar deposits declined $12.6 billion. Eurodollar deposits have dropped $20.7 billion over the past three weeks. After three weeks of decline, commercial paper (CP) outstanding increased $7.7 billion. Financial sector CP jumped $11.5 billion, while non-financial CP declined $3.7 billion. Non-financial CP has declined $14 billion over the past four weeks to $159.9 billion, with a drop of 29% so far this year. Financial sector CP has declined about 2% y-t-d to $1.189 trillion.

Bankruptcy filings of 33,488 were near a 52-week high and up 9% y-o-y. The ABC News/Money Magazine survey of consumer comfort dropped 5 points to negative 20, the lowest reading since 1996. The “State of Economy” component dropped six points to negative 46, down from the year ago negative 10 and the lowest reading since early 1994. "Personal Finances" were down 20 points y-o-y to 10, while the "Buying Climate" is down 10 to negative 14. Today, the University of Michigan’s preliminary report on October consumer confidence had confidence sinking to a much weaker than expected 80.4 (from 86.1). This is down from May’s reading of 96.9 (and below last September’s 81.1) to the lowest level since September 1993. Current Expectations dropped to the lowest level since October 1992. At down 1.2%, today’s retail sales report was “as expected.” This decline was the largest since last November, when sales subsided after the big pent-up demand from September’s dislocation. Interestingly, last month’s 1.2% decline is not that much less than September 2001’s 1.7% decline. Looking at the major retailers’ dismal September same store sales when compared to extremely easy year ago comparisons, one can’t be faulted for being concerned.

The Mortgage Bankers Association’s application index jumped to yet another new record and is more than 60% above last year’s post 9/11 refi boom. Last week’s index level of 6,927 compares to the April low of 1,214. Notably, the Purchase Application index is lagging, declining 2% from the previous week to the lowest level since August. The Purchase index is up 30% from the year ago depressed level.

From Countrywide Credit: “Countrywide is in the midst of a historic event in our mortgage banking business as loan application, pipeline and funding volumes reached all-time highs. September average daily loan applications hit a record $2.1 billion, a 22 percent increase from the prior mark of $1.7 billion set in August. The mortgage loan pipeline reached a remarkable $51.3 billion, 22 percent higher than last month and 141 percent higher than last year. September fundings eclipsed all previous Company records reaching $25.3 billion, surpassing last months funding record of $21.2 billion.” Wow…that one lender is capable of originating mortgages at this pace is incredible. September saw daily application volume up 132% y-o-y. Purchase fundings were up 70% y-o-y to $7.76 billion, while non-purchase fundings surged 190% to $17.56 billion. “Total e-Commerce Fundings” were up 112% (to $10.6 billion), “Home Equity Fundings” jumped 91% (to $1.01 billion), and “Sub-prime Fundings” increased 76% (to $962 million) y-o-y. We are in the midst of history’s greatest lending Bubble.

Today, Household International announced that it had settled with a group of states attorneys general for $484 million to settle various lending probes. The State of Washington has been involved in an ongoing investigation of numerous complaints against Household’s lending practices. A report was issued back in May: Washington Department of Financial Institutions Expanded Report of Examination for Household Corporation III. The 66 page document detailed complaints and the department’s analysis of truly repulsive lending practices.

I’ll extract one of many sickening lending abuses from the document, “Complaint #2550 Juan & Maria Guzman – Renton, WA branch. The borrowers claim that they responded to HFC (Household Finance) mailers for a $10,000 loan. The HFC representative apparently convinced the borrowers that it would be to their benefit to refinance out of a 7.0% first mortgage into a 12.531% mortgage. The borrowers claim that they were told that their monthly payments would drop and that they would pay off the new loan in 15 years. The borrowers made their complaint through an interpreter and claim that they do not speak English. They state that they were promised an interpreter at closing by HFC to help them understand the paperwork, however; no interpreter showed up at the time of signing. The borrowers also claim that they received no disclosures in this transaction other than the note and the HUD 1A. HFC stated that the borrowers’ total monthly payments decreased by $136.00 through this debt consolidation loan, and that all the terms and conditions of the loan were fully disclosed and explained to the borrowers at the time of closing. (WA State Dept.)Analysis: The borrowers were solicited by HFC and responded to HFC for a loan… The borrowers provided the Department with a note for their original first mortgage with FT Mortgage Companies. This loan carried a fixed rate of 7.0% and monthly payment of $1,042.52 with no prepayment penalty. The new loan closed with the borrower was made at a rate of 12.531% and a monthly payment of $2,224.22 with a significant prepayment penalty. Further, the new loan carries a term of 30 years rather than the 15 years the borrowers claimed they were promised… At closing, the borrowers paid $15,074.66 in discount points. This amount (equal to 7.25% of the loan amount) was financed by HRC, thereby increasing the loan amount significantly.”

Tuesday’s American Banker (Matt Ackermann) ran a story, “B of A Investment Unit Issues a Hedge Fund.” “To meet customer demand for alternative investments” the bank is creating a new fund product with a minimum initial investment of only $100,000. Bank of America’s managing director for alternative investments was quoted: “High-net-worth investors want these products. They go to advisers and have read about the products, and they want it. They want all the alternative investments they can get because they can endure the market.” Continuing from the American Banker article: “But analysts are wary about new alternative investments’ performance. Since hedge funds surged to $792 billion of assets at Jan. 1, returns have been flat. After average monthly returns of 16% last year, the average hedge fund rose 0.85% in August but is up only 0.82% for the year...’hedge funds are a strong product, but the bubble may be over.’”

October 7, Bloomberg – “Money managers such as Pacific Investment Management Co. are forming hedge funds to take advantage of trading opportunities in the municipal bond market, the Bond Buyer reported. Hedge funds, investment partnerships for institutions and wealthy individuals, expect to profit from buying municipal bonds while simultaneously selling borrowed securities such as Treasury bonds, the paper said. Municipal bonds are attractive to hedge-fund investors seeking refuge from losses in other markets and more opportunities for arbitrage, or profit from price discrepancies, the Bond Buyer said. Even off-shore hedge funds, which don't benefit from the tax-exempt status of most munis, are attracted to the market, the paper said.”

Earlier this week, Pimco’s Bill Gross was interviewed by CNBC’s talented Ron Insana. Mr. Gross’s comments were insightful, as he focused on the issue of financial fragility. And since large inflows have propelled Mr. Gross’s flagship mutual fund to the largest in the country, Mr. Insana deftly inquired about the possibility that the bond market could be yet another Bubble. Gross’s response was very interesting (and I hope I paraphrase accurately!). While admitting that large amounts of funds have shifted to the bond market, he believes that it will not end up a Bubble because expectations for a weak economy and deflationary pressures will be proven correct. But are Bubbles only created by false expectations? And, is money flooding into bond and hedge funds because of expectations for the economy and CPI or, instead, due to expectations for strong relative investment returns? Then, what are the consequences if these RETURN expectations are not met and the tide turns on this enormous flow of speculative finance?

Monday’s Wall Street Journal (Gregory Zuckerman) ran the story “Hedge Funds May Give Colleges Painful Lesson.” The article began, “Are some of the nation’s most prestigious universities about to get a painful education in hedge-fund risk?” Apparently, college endowment fund exposure to hedge funds has almost doubled to 13% during the past two years. From one university chief investment officer: “We expect hedge funds to protect our principal, bring down overall risk and provide us equity-like returns over the long run.” There is today absolutely no doubt that enormous speculative flows have been flooding into the hedge fund community and bond funds. There is also a very low probability that this deluge of speculation will be satisfied by future returns.

I have previously criticized the monetary analysis of the eminent Milton Friedman. He has in the past basically stated his view that there is no such thing as destabilizing speculation. And, of course, he faulted the Fed’s lack of money creation as a critical causal factor for the Great Depression. He has much more recently commended the Greenspan Fed for aggressively accommodating a monetary expansion that, in his view, will sustain the growing and fundamentally sound U.S. economy. With this as background, I would like to make an attempt at “refining” Credit Bubble analysis, hoping to make a little sense out of what is nowadays an exceedingly complex and unique environment.

A couple weeks back I titled a Bulletin, “The Trials and Tribulations of Speculative Finance.” It is becoming clearer in my mind by the week that “contemporary finance” has truly evolved into a system with an unprecedented speculative (trend following and reinforcing) component. Most importantly, the confluence of the dominance of performance-chasing investment vehicles and the trading dynamics of “structured finance” have created an untenable Credit system. Moreover, this harsh reality really goes right to the heart of today’s unprecedented market volatility and financial fragility. Market pundits often comment that they are waiting for the failure of a major financial institution that, as has been the case in the past, would mark the end of the bear market and usher in a new expansion. But the massive derivatives market and trillions of dollars of securities supported by guarantees, liquidity arrangements, Credit insurance, derivative protection, and the “structured finance” complex, bring the issue of systemic risk to the forefront like never before. Similar to Thailand being the first SE Asian domino, sound analysis would today expect the first failure of a major financial institution not to be the last.

In an attempt to simply things, let’s break this problem into two parts: 1) Hedge funds and performance chasing “investors” – speculative flows. 2) Derivatives, Credit insurance and dynamic hedging strategies. Together, we have created a “Wall Street Paradigm” the scope of which the great Hyman Minsky surely never contemplated.

Performance chasing “investors” roam effortlessly during bull markets, with returns limited only by the amount of risk one chooses to tolerate. Their brethren over in “structured finance” similarly operate seemingly without a care of in the world, as financial asset prices inflate and losses are small and isolated. Let’s use an example of a hedge fund that takes a leveraged position in technology stocks to profit from the boom (20% of profits provides quite an incentive to participate in speculative markets!). To mitigate risk, the hedge fund goes to her favorite derivative trader and purchases “put” protection. No problem. Since business is booming and their stocks rise by the week, technology companies (such as Microsoft, Dell, EDS, CSCO, etc.) are more than happy to write puts on their own stock (legalized “insider trading”?). So the derivative trader basically acts as intermediary between the hedge fund and the tech companies, while taking a little sliver of profits for himself. This works wonders. The hedge fund can aggressively play the speculative market and inexpensively hedge its exposure.

Strong performance quickly attracts speculative flows. The technology industry benefits from seemingly endless finance, with a hot IPO and junk debt market funding scores of new enterprises. Strong industry growth stokes profits, stock market gains, additional finance, and loads of junk bonds. Recognizing the risk, some investors choose to purchase bond protection in the fledgling Credit derivative market. Again, this is no problem. Other speculators (including hedge funds) are more than happy to take the bet – the other side of the trade - and speculate against bond defaults (taking such premiums does wonders for performance!). Many insurance companies (with inflating investment portfolios) are similarly in the risk-taking mood, enjoying the hefty premiums of writing Credit and financial insurance. The derivative trader, once more, plays the intermediary as he matches the buyer and seller of Credit insurance (no selling of securities required!). This cheap and readily available protection encourages speculation, which feeds both Credit growth and the boom. Lending stokes money supply, which gravitates to successful financial speculations.

So, as long as the bull stock market continues and bond prices remain stable, derivative markets subtly but strongly reinforce the boom. Derivatives (a market for financial insurance) support Credit creation and market liquidity; market liquidity supports financial asset inflation; and financial asset inflation acts as a powerful magnet for speculative financial flows. This is the story of the Roaring Nineties. Some still believe we discovered new laws of finance and economics.

We have often argued that derivatives, “structured finance,” and Credit insurance are “bull market phenomena.” We believe that current acute financial stress is evidence of this reality, and I believe that a lot of current confusion can be at least partially resolved with an understanding of this view.

As long as financial asset prices are inflating (a bull market), acquiring stock and bonds remains the preponderance of speculative activity. Most derivative activity is similarly stimulating, either providing leverage or as “insurance” that supports speculative excess. Derivatives certainly have supported the creation and accumulation of financial assets. But how does this work with the inevitable bear market? Continuing from our above example, let’s say the tech boom is faltering and the hedge fund again purchases put protection. After selling this “insurance,” the derivative trader approaches the tech companies. But faced with faltering stock prices, company treasurers inform the derivative trader that they will no longer be selling put options (and actually would like to terminate previous protection written – or “reinsure”). Now, the derivative trader must resort to working with his firm’s trading desk, as they dynamically hedge the put protection sold. As long as prices are stable, this causes little burden for the traders or the marketplace. However, when stock prices begin to sink, the trading desk must short stocks to have in place a securities position that generates the necessary cash flows to make payment on the insurance written. Somewhere, there must be actual positions that generate cash flows when security prices decline.

Over in the bond market, cracks begin to form as the marginal technology company runs into trouble, loses access to new finance, and fails. With players increasingly appreciating the value of default protection, business booms throughout the Credit insurance arena. Fortunately, the booming leveraged speculating community provides fertile ground to locate sellers of Credit insurance. The hedge funds and insurance companies that wish to acquire Credit protection are matched against those willing to speculate that they can profit from selling it. Many “exciting” new vehicles (synthetic collateral debt obligations) and instruments are developed to “intermediate” Credit default protection. This insurance market supports risk-taking and Credit creation. For some time, contemporary finance maintains the semblance of stability, as the leveraged speculators and “structured finance” work in “harmony” to sustain Credit excess.

But just as the transition to dynamic hedging in the stock market had profound ramifications for equity market liquidity, subtle changes begin to take shape in the bond market. First of all, a few speculators get stung writing Credit default swaps (Enron, WorldCom, etc.) and back away from the market. The players speculating in this arena – holding risky bonds and/or writing Credit insurance – lose money and suffer outflows or get fired. The corporate market falters, with waning Credit availability impacting an expanding number of companies. This not only exacerbates the bear in the stock market, but leads to a self-feeding string of corporate defaults. The significant increase in default risk forces those that have written Credit insurance to hedge their exposure and move to reduce risk elsewhere (reduce equity exposure, cut back on lending or acquiring new investments). Like the dynamic hedging required by the equity put writer, the seller of Credit default protection must short bonds to establish positions that will generate the necessary cash flow to pay on the derivatives in the event of default.

It may be subtle and it may lack transparency in the marketplace, but as the bull market gives way to the bear, the immense derivatives market is transformed from a mechanism reinforcing Credit creation, marketplace liquidity, and asset inflation, to one that may actually foster illiquidity, sector Credit collapse, and exacerbate deflation in certain financial asset classes. Everyone then runs around and wonders what the heck happened. How can something that functioned so magically suddenly appear so fragile and unstable?

But look at it this way. During the bull market boom, investors, the leveraged speculators, and derivative players were all basically working in concert. Everyone could do what they do best – investors buy stocks, hedge funds take leveraged positions in stocks and bonds, and the derivative players provide “insurance” by intermediating between various speculators (with rising prices creating an extremely profitable environment where the sellers of insurance were never forced to sell the underlying securities to hedge their speculations!). The rare bond or equity short-seller was welcomed with open arms to the marketplace, as almost anything they sold would inevitably be bought back at higher prices (with short squeezes providing about the best speculative opportunities around!).

But what a difference a year or two makes. Importantly, today investors, the leveraged speculators, and derivative players are not only not working in concert, their individual self-interests put them directly at add odds with one another. For one thing, with asset inflation a thing of the past, one market participant’s profits must now generally come out of the hide of another. That’s got to be a lot less fun, and it changes market dynamics profoundly. Nowhere is this more apparent than in the leveraged speculating community. When everyone was buying stocks and bonds and their derivative friends were “risk intermediaries” as opposed to dynamic hedgers, everything worked swimmingly – everyone’s a buyer and rarely a seller. Bull market forever! Well, that wonderful dream has been shattered. Today, it’s a dog-eat dog, mixed-up world.

The old days might have seen the hedge funds pile into Ford bonds and buy some cheap protection that they never expected to need, with the writers of Credit default protection sitting back and pocketing the premiums. The fat and happy insurance companies were certainly more than happy to pocket premiums (besides, writing financial insurance was a lot easier than property and casualty!). Ford was ecstatic with endless cheap finance, shareholders were enamored with the company’s bright prospects, insurance companies were overjoyed with the inflating price of their Ford bonds, and the holders of Ford Credit asset-backed securities were comforted by the sound Credit standing of their issuer (and the booming economy). Today, Ford bonds have been in a freefall, with bond managers protesting hedge fund bond sales. Those that wrote Credit protection expecting that default was a very low probability, now must aggressively short Ford bonds to hedge against their rapidly rising exposure.

The complacent insurance industry is quickly hit with a double-whammy, with their Ford bonds sinking and their exposure to default growing exponentially. This is a problem for highly leveraged institutions, especially after suffering significant losses in their stock portfolios and on previous bond collapses. Knowing that increasingly impaired players are on the hook for exposure to corporate bond and derivative losses, the enterprising speculators will become aggressive sellers of Ford and other corporate bonds. As stated above, dog-eat-dog… Market participants, watching bond prices sink and having witnessed how quickly things can go sour for the likes of NextCard and Conseco, decide maybe it makes sense to cut back on asset-backed paper from Ford, Capital One, Household, etc. All the sudden, investors are more interested in the type of paper that is held in their money market funds. And the more risk averse, the less liquidity in the corporate bond market and the more difficult it is for companies to raise needed finance. Companies are forced to cut back on spending and many fail. Faltering liquidity in the corporate bond market also makes life much more problematic for the dynamic hedger on the wrong side of writing Credit protection. He must now establish the necessary short positions to hedge against escalating default risk, but marketplace liquidity has evaporated. These players may be forced to short the company’s stock, or purchase other protection (“reinsure”) as faltering corporate bond and stock market liquidity raises the risk of systemic dislocation. They will sell securities providing liquidity and reasonable correlation with Ford’s bonds. Somehow, it seems like virtually everyone has become a seller and there are few buyers. The financial insurance business stinks and those that can want out.

But as dramatic as the ebb in equity and corporate bond market flows, we are witnessing an even more spectacular flow into the “safe-haven” of Treasuries, agencies, munis and mortgage-backs. And this is where we will come back to Dr. Friedman’s flawed views on the role of money creation and speculation. The problem today is anything but an inadequate money supply. We could drop money from helicopters but the dilemma is that it would run right to Mr. Gross’s bond fund or the hot hedge funds that placed winning bond bets. These speculative flows would then only exacerbate Treasury and agency bond inflation, leading more performance-chasing out of corporates and equities. Besides the havoc caused in the mortgage arena, the flows out of equities and corporate bonds would lead to only lower prices, additional corporate failures, and additional forced selling by the derivative and insurance players. Such a circumstance would only further impair the leveraged financial players and heightened the risk of systemic dislocation. At a certain point, the Credit system dislocation becomes a major concern for the economy, with selling begetting selling. Contemporary finance became one massive speculative play on financial asset inflation, and this system simply will not function orderly with asset prices in general decline.

If the American Banker number is correct, we have almost $800 billion now invested with the hedge fund community. Throw in their leverage positions, along with those operating like hedge funds, the Wall Street proprietary trading desks and other speculators, and performance chasing retail mutual fund “investors,” and you have truly unfathomable speculative flows that have come to dominate the marketplace. It is indeed quite possible to have destabilizing speculation, and we currently have the most extreme systemic case of it. What I am arguing today - and I believe the recent market environment provides strong support for this view - is that the financial system is now in an untenable position. On the one hand, we have the hedge funds and other speculators seeking to profit from the selling of stocks and corporate bonds, as opposed to purchasing them. On the other hand, we have some of the leading financial institutions with leveraged exposure to both the financial assets they hold and the derivative protection they have written. This exposure (and the systemic ramifications) leads to more aggressive selling from the risk averse as well as the gains-seeking speculators. This, then, forces additional hedging-related selling from the derivative traders in a self-reinforcing financial collapse.

And perhaps we have grown complacent. These dynamics, while exacerbating the NASDAQ collapse, for sometime have had minimal impact on the real economy (let alone leading to financial dislocation). But keep in mind that our highly leveraged financial system and economy benefited tremendously from bond yields that collapsed simultaneously with NASDAQ. The behemoth speculative sector has gained handsomely from the Treasury and agency “melt-up.” However, this great benefit has now run its course and, importantly, has turned destabilizing.

Quite recently, the unfolding financial and economic crisis made it to the heart of the Credit mechanism. The faltering bond prices for the likes of Ford, GM, Household International, and Capital One are evidence of a dramatic escalation of Credit system stress. That key derivative players such as JP Morgan Chase and the European financial institutions are facing extreme difficulties is a decisive blow to “structured finance.” The risk averse will now gravitate away from the securities these institutions either directly or indirectly support. The above mentioned institutions have been instrumental players in providing Credit availability throughout the U.S. system. These institutions are at the very epicenter of “structured finance,” and any loss in confidence in a major player is a major blow to the entire system.

Amazingly, Alan Greenspan was out again this week extolling the virtues of contemporary finance and risk management.

“Improved risk management and technology have also facilitated, of course, the growth of markets for securitized assets and the emergence of entirely new financial instruments--such as credit default swaps and collateralized debt obligations. These instruments have been used to disperse risk to those willing, and presumably able, to bear it. Indeed, credit decisions as a result are often made contingent on the ability to lay off significant parts of the risk. Such dispersal of risk has contributed greatly to the ability of banks--indeed of the financial system--to weather recent stresses. More generally, the development of these instruments and techniques have led to greater credit availability, to a more efficient allocation of risk and resources, and to stronger financial markets.”

There are many flaws in this line of reasoning. A key issue to ponder today is that if this system of structured finance leads to “greater credit availability” during the boom, what are the consequences to the financial system and the economy if this untested new age system - that has come to absolutely dominate Credit creation - falters. If it becomes more profitable for the speculators to sell securities, while the dynamic hedgers are forced to short securities to hedge their exposure, who will be the buyers? What if a preponderance of performance-chasing speculators and dynamic hedgers turn sellers instead of buyers? Doesn’t this feed a vicious spiral of faltering liquidity and debt collapse? Will the economy not be strangled from a systemic Credit crunch? Doesn’t it become one chaotic and unstable bet on system stability – a battle royal between those speculators betting the system holds and financial asset prices recover, matched against those speculating that individual companies and the general economy will face mounting troubles? At the minimum, isn’t this a complete breakdown of the capital allocation process? Well, after a week of dizzying volatility, I am left to write that it seems rather obvious that this system is broken and will not be easily fixed. It is just amazingly ironic that huge losses and extreme financial market instability have only fed additional money into destabilizing hedge funds and speculative vehicles. Heightened systemic risk has also only exacerbated the derivative Bubble. Fortunately, the system got through this week without an accident. Most unfortunately, a major accident appears inevitable.

From Tuesday’s Financial Times: “Phil Gramm, the conservative Texas senator who helped rewrite the rules of US financial services, is to join UBS Warburg as a vice chairman… Mr. Gramm will be joining a company that earlier this year acquired the energy trading operations of Enron, the failed Texas company the counted his wife, Wendy, as a director. Mrs. Gramm joined Enron’s board in 1993 after serving as chairman of the federal Commodity Futures Trading Commission. Both Mr. and Mrs. Gramm played key roles in keeping the energy derivatives traded by Enron free from federal regulation. Mr. Gramm said his opposition to regulating energy derivates trading followed the lead of banking supervisors, including Alan Greenspan… As chairman of the powerful Senate banking committee, Mr. Gramm helped sweep away the separation between investment and commercial banking that dated back to the Great Depression…”

“They are hiring me not for who I know, but what I do. I want people [to] say this is one of the best investment bankers since JP Morgan.” Phil Gramm

(Now I’ve heard everything…)

Senator Gramm will likely make millions in his new profession and perhaps will even become God’s gift to investment banking. But he leaves the Senate a failed public servant. He was one of a few key authorities in a position to protect the public interest, but he instead too often made the easy decision to support powerful special interests. He epitomizes what is terribly wrong with our system. I would have a difficult time looking in the mirror as I tightened my tie in the mornings.

February 12, 1999

The Honorable Phil Gramm
Chairman – Senate Budget Committee

370 Russell Senate Office Building
Washington, DC 20510-4301

Dear Senator Gramm,

I have been an admirer of yours for many years. I am a strong believer in your free-market economic philosophy and share your strong commitment to the well being of our country. I am an investment professional with my own firm of fifteen professionals that for the past twelve years has provided research on individual companies to more than 200 institutional investors. I also manage an open-end mutual fund, the Prudent Bear Fund, which was the top performing mutual fund in the country in the 3rd quarter. Because of my vocal position as a skeptic and my reputation for analytical independence, I am often asked to espouse my views on CNBC and CNN. I have been profiled several times in leading business periodicals. I have spent considerable time in a diligent pursuit to understand this most extraordinary environment and have shared by views with senior Federal Reserve Board officials and even the noted economist and former Fed member Lawrence Lindsey. Discussions with Dr. Lindsey, in particular, left me quite confident in the validity of my analysis.

I am writing this letter to you today as it has become alarmingly clear that the long-term health of our nation’s economy is being dangerously jeopardized by a financial system running completely out of control. It has also become painfully apparent that Chairman Greenspan and the Federal Reserve Board of Governors have failed and continue to fail in their momentous duty as the protector of the soundness and stability of our financial system and economy. Dr. Greenspan, tragically, has succumbed to the seductiveness of "new era" banter and has, as well, accepted Wall Street dogma as to the almost miraculous ability of derivatives to control risk. Moreover, he has now attained status as the leading proponent of the so-called "technology revolution" that is supposedly spurring unprecedented gains in productivity and extraordinary benefits from "efficient resource allocation." This is, as I am sure you are aware, all too reminiscent of the 1920’s boom-era propaganda that preceded the devastating crash and Great Depression. I am very disturbed that we now are replaying history.

The key points I will try to make in this letter are:

· The US financial system is massively overleveraged and this credit has created a dangerous financial and economic bubble. 

· Fed Chairman Greenspan and the Board of Governors have failed in their duty to protect the soundness of US financial markets and the American economy. 

· The Fed’s extraordinary move to lower rates this past autumn was a desperate policy decision that only stoked heightened credit and speculative excesses and certainly exacerbated the bubble. 

· Dr. Greenspan has recently had opportunities to “throw a little cold water” at an obvious Internet mania and stock market bubble but instead has become a proponent.

· Government Sponsored Enterprises Fannie Mae and Freddie Mac have acted recklessly in a gross expansion of assets and have been a leading factor in the explosion of money, credit and the stock market and economic bubble.

Despite the endless accolades bestowed on both Dr. Greenspan and the U.S. economy, a more exhaustive and objective analysis would recognize the disturbing similarities of today’s environment to the catastrophic bubbles existent in Japan in the late ‘80’s, SE Asia in the mid-90’s and the U.S. during the "Roaring 20’s". Today we see incontrovertible evidence of a massive explosion in credit that is fueling a stock market and financial bubble and concomitant maladjusted economy. Indeed, broad money (M3) grew by more than $600 billion in 1998, fully 35% greater than in 1997. In short, this unprecedented credit bubble is creating an illusion of limitless capital and endless prosperity that has fomented excessive borrowing and spending by US consumers as well as a massive debt accumulation by businesses, much spent on uneconomic projects, that will prove quite problematic with the coming downturn.

We have a steadfast belief as to the dire consequences of the continued massive debt build-up throughout the financial system and economy. Looking back at 1998, the amount of debt and equity issuance from Wall Street was absolutely staggering, as $1.8 trillion of new securities were sold. This was easily an all-time record and fully 37% greater than the previous record in 1997. Moreover, the explosion of junk bond offerings continued with a record $146 billion of new junk issues in 1998, fully 30% greater than 1997’s record. This record junk issuance could have been even higher; in fact, issuance was on pace to surpass $200 billion if not for the Long Term Capital Management and Russian meltdowns which led temporarily to a virtual market shut down for new issuance. To put the enormity of the $146 billion of new junk bonds into perspective, total junk issuance was $33 billion during 1986, the heyday of the Michael Milken junk bond era. After years of explosive growth, today the total junk bond market is quickly approaching one-half trillion dollars and this mountain of high-risk debt clearly leaves our financial system and economy quite vulnerable.

But the flood of new debt continues this year despite the ominous and unmistakable storm clouds of global financial and economic crisis. In today’s overheated financial markets, euphoric investors are once again happily financing risky ventures. For example, Amazon.com, the loss-generating online bookseller, initially planned to sell $500 million of convertible bonds, but recently raised the size to $1.25 billion, and even then only partially satisfied a plethora of over-eager buyers. Certainly, the recent mania in the internet stock sector is one of most extreme speculative episodes ever and, as with all great speculations, will end painfully for the marketplace and disastrously for many unsuspecting investors who own these stocks directly or indirectly in their pension or mutual funds.

While we have watched with considerable consternation as Dr. Greenspan has seemingly developed into a proponent of the stock market bubble, we were shocked by his recent testimony regarding Internet stocks before the Senate Budget Committee. With CNBC carrying his comments live to millions of Internet traders, Wall Street players, and small investors, Dr. Greenspan responded to Senator Wyden’s questioning of the soundness of underlying fundamentals supporting the Internet stock phenomenon. Despite what was an ideal opportunity to "poor some cold water" on overheated speculation, Dr. Greenspan, instead, provided what was widely interpreted by the media as a strong endorsement. The Washington Post went with the headline "Greenspan Applauds Internet Stock Frenzy." We thought his comments so extraordinary, we have included much of Dr. Greenspan’s Internet discussion.

"There is something else going on here though, which is a fascinating thing to watch. And it is for want of a better term, the "lottery" principle. What lottery managers have known for centuries is that you could get somebody to pay for a one-in-a-million shot, more than the value of that chance. In other words, people pay more for a claim on a very big payoff, and that’s where the profits from lotteries have always come from."

"But to answer the question –'Is there some hype in this?' of course, there is some hype. There is hype in lots of things. But there is at root here something far more fundamental. And indeed it does reflect something good about the way our securities markets work; namely, that they do endeavor to ferret out the better opportunities and put capital into various different types of endeavors, prior to earnings actually materializing. That’s good for our system. And that’s in fact, with all of its hype and craziness – is something that, at the end of the day, probably is more plus than minus."

So, choosing against a bit of "cold water", Dr. Greenspan endorsed this astonishing speculative mania. It is truly incomprehensible that our country’s top central banker, the designated protector of our financial system, can somehow profess that a market mechanism functioning like, as he describes, a "lottery", is somehow efficiently pricing and allocating capital in a sound manner, assuring the long-term health of our financial system and economy. It is now to the point that Dr. Greenspan not only accommodates the unprecedented money and credit growth that is powering a catastrophic bubble, he actively justifies unprecedented stock market speculative excess.

And throughout the marketplace, especially in the Internet and telecommunications sectors, loss-making companies are raising billions of equity and debt capital. It certainly appears that Wall Street investment bankers are keenly focused on companies that, aggressively expanding uneconomic businesses, have huge financing requirements and are willing to pay hefty banking fees. The critical point is that severe damage is being done to our financial system and economy during this extraordinary period of rampant credit excess and speculation while this all somehow passes for sound monetary policy. One simply can not imagine a period of "easier" money.

Dr. Greenspan may like to trumpet his view that this is a case of an efficient allocation of capital and former Fed member Wayne Angell may claim (in a recent Wall Street Journal editorial) that this is "sound money", but this is a dangerous fantasy. As history has so clearly documented, such financial excesses always lead to over-spending and exorbitant investment that is only in hindsight recognized as wasteful and ill advised. Seeing what is now so painfully apparent for Japan and SE Asia, easy credit creates the illusion of an economic miracle and permanent prosperity. Both, however, quickly vanish when boom inevitably turns to bust and the economy is left in disrepair with uneconomic enterprises and both business and household sectors drowning in debt.

Last week, as expected, the Federal Reserve decided to leave interest rates unchanged. This decision extends the Fed’s aggressively accommodative posture that has been pursued since its dramatic action this past autumn, cutting interest rates three times in a period of about six weeks. Clearly, the Fed’s decision at the time had little to do with the economy but, instead, was a desperate response to the fear of a potential financial market crisis related to the collapse of Long Term Capital Management and the tenuous state of other reckless speculators. Massive leverage had come to permeate our financial system, apparently somehow unbeknownst to the Federal Reserve, as Wall Street and the hedge fund community had borrowed heavily from Japan and from US money markets to finance hundreds of billions in higher yielding securities. This fiasco almost brought our financial system to the brink and is likely the greatest financial speculation ever, with as yet untold consequences.

But with this "house of cards" in jeopardy, Dr. Greenspan quickly stepped in to ensure that even more credit would be created to keep the game going. And, indeed, the market responded quickly, having grown accustomed to such Fed patronage many times before. Looking back, Dr. Greenspan came to the rescue back in 1987 after the stock market crash; again in the early 90’s with the banking and S&L crisis; and in 1995 with the Mexican crisis and Orange County derivative fiasco and bankruptcy. Little wonder Dr. Greenspan is Wall Street’s favorite central banker ever. Yet, there is also little question historians will look back with great consternation at the gross "moral hazard" that he created in the marketplace; each of his bailouts leading to more egregious boom-time excesses and more problematic inevitable busts.

Back in the 1960’s, Dr. Greenspan spoke and wrote extensively about the Great Depression and the factors that led to this most catastrophic financial and economic collapse. He adamantly pinned responsibility on a misguided Federal Reserve that had accommodated excessive credit growth that fueled a dangerous stock market speculative bubble and maladjusted economy. At the time, Dr. Greenspan used an interesting and quite fitting analogy, stating that the Federal Reserve in the 1920s repeatedly "put a coin in the fuse box." When the Fed was confronted with intermittent financial crises, especially in the late 1920s as much of the world lurched towards financial and economic collapse, the Fed would move to short-circuit the markets, injecting liquidity and accommodating unsound credit and speculative excesses, working diligently to forestall financial crisis and recession. Yes, the Fed did succeed for some time, at least until the "coined" fuse box eventually succumbed and the "house" – the entire financial system – virtually incinerated. Back in the 1960s, the astute economist Greenspan understood clearly the catastrophe of central banks interfering with markets, and how it only stoked the unsound boom and led to a much greater collapse.

I fear that this is exactly what is developing today and I am very troubled with what appears a critical lack of understanding by policymakers as to the developing circumstances. I do not want to see you, your committee or Congress blindsided by the coming crisis. And certainly, sound understanding is necessary in order to question current policies.

Today, Dr. Greenspan faces a momentous dilemma. With each of his bailouts leading to even more precarious imbalances, he appears to be getting very near the end of his rope. His latest move to support the markets last quarter forced him to throw gas on an already overheated economy and financial system, an economy already in the midst of the longest peacetime expansion on record, and a stock market that had doubled in just over the past two years. With Dr. Greenspan’s blessing, M3 money supply grew $200 billion for the quarter, 40% more than the growth during the 4th quarter of 1997. Fannie Mae and Freddie Mac lowered mortgage rates, inciting a massive refinancing boom that provided the fodder for Fannie and Freddie to balloon their balance sheets by $88 billion during the quarter. Emphatically, we state our belief that this extraordinary endeavor created unprecedented liquidity throughout the financial system but also helped assure future insolvency for hundreds of thousands of American families. The stock market exploded and the economy turned from strong to dangerously overheated.

In just three months this stock market rise created more than $2 trillion of perceived wealth; Wall Street celebrated loudly while consumers and businesses alike rejoiced in the all-powerful Federal Reserve and proceeded to borrow-and-spend like never before. The household savings rate went negative for the first time since the Great Depression as inflated stock prices led American families to take on even more debt for consumption. As a consequence, our nation’s current account deficit has ballooned to an unprecedented $20 billion a month, clearly jeopardizing the long-term stability of our currency, financial markets and economy. In addition, we now have more than five million individuals with on-line stock trading accounts as the transformation of Wall Street into the greatest casino ever is now complete. In short, the party was permitted to get way out of hand with the Fed spiking the punch bowl with some pretty strong stuff. This "liquid courage" engendered a new, perilous strain of "irrational exuberance."

Importantly, it is our strong view that an unappreciated key to the tremendous expansion in money, credit and the stock prices is the unprecedented growth in the balance sheets of Fannie Mae, Freddie Mac, and to a lesser extent, the Federal Home Loan Bank System. Fannie and Freddie have now doubled the size of their balance sheets since the end of 1994, growing from $380 billion to more than $800 billion today (with $28 billion of shareholders equity). Astonishingly, Fannie and Freddie ballooned their balance sheets by $220 billion in 1998 alone, at a reckless annual rate of almost 40%. Moreover, during 1998’s 4th quarter, Fannie and Freddie expanded their balance sheets by $88 billion, as a massive mortgage refinancing boom basically allowed them to accumulate mortgages previously held by other institutions throughout the financial system. These institutions then had cash to buy stocks, junk bonds and other securities, creating liquidity throughout the financial markets that manifested into the historic move in stock prices in the face of an increasingly perilous global financial and economic environment. And keep in mind, Fannie and Freddie are only allowed to grow so recklessly, and hence over-liquefy a financial bubble, because of the market’s acceptance of an implied government guarantee. We certainly believe it is of utmost importance for Congress to clarify this "implied" guarantee.

So it is my great hope that you, as the new Chairman of the Senate Banking Committee, will take an active role in pressing Congress to not only better understand the current environment but also to come to grips with the dire circumstances facing our country. I am particularly excited about your new Chairmanship and am confident you are the ideal individual to undertake this great responsibility.

I will conclude with a few suggestions: First, efforts should be made immediately to reign in Fannie Mae, Freddie Mac and the Federal Home Loan Bank System; institutions clearly creating a huge potential taxpayer liability as well as being major contributors to an impending systemic financial crisis. It is also my hope that you will challenge Dr. Greenspan to be a diligent and forthright central banker as opposed to a "new era" proponent and Internet stock advocate. History so patently demonstrates how the most devastating boom/bust cycles occur during periods of low consumer price inflation, as complacent central bankers are lulled into accommodating asset inflation and an economic bubble. This is exactly the case today and this critical point is not at all understood. Furthermore, Congress must recognize that policy that only defers the day of reckoning will only exacerbate the coming crisis. And while today’s financial and economic bubble is certainly swamping government coffers with tax receipts, extrapolating this into the future, as seems to be much the rage in Washington today, is both unsound and disingenuous. The financial well being of millions of American businesses and families is at stake, and the price of allowing the perpetuation of this bubble is simply much too high and clearly unacceptable. We have come to a critical juncture in history, and I call on you, Senator Gramm, to rise to the challenge and help lead our country through what is certain to be a very difficult time. I would be honored to provide any assistance to you and/or your committee. I would be pleased to come to Washington on short notice with my associate, Mr. Doug Noland, to further explain our viewpoint.

Best regards,

David W. Tice, CFA

April 13, 1999

Dear Mr. Tice:

Thank you for your letter regarding the long-term health of our nation's economy. I appreciate having the benefit of your views on this important matter and can assure you of my ongoing efforts to promote a strong and stable economy.

I appreciate having the opportunity to represent you in the United States Senate. Thank you for taking the time to contact me.

Yours respectfully,


United States Senator