Saturday, August 30, 2014

10/05/2000 Accolades to the Unknown Inquisitor *

It was a most unsettled week in the stock market as the ramifications from the unfolding technology debacle began to take hold. For the week, the Dow actually declined less than 1%, while the S&P500 dropped almost 2%. The economically sensitive issues outperformed, with the Transports gaining 1%, and the Morgan Stanley Cyclical index ending unchanged. Investors also gravitated to defensive issues, with the Morgan Stanley Consumer index gaining better than 1%. The highflying Utilities lost some altitude, dropping almost 5% this week. The small cap Russell 2000 and the S&P400 Mid-cap indices both sank 5%. The NASDAQ100 dropped 7%, the Morgan Stanley High Tech index 5%, and the Semiconductors 6%. As the seriousness of the unfolding credit crunch became clearer, The Internet index was hit for 16% and the NASDAQ Telecommunications index dropped 8%. In a further ominous development for the financial markets generally, financial stocks came under intense pressure today with the S&P Bank index declining 3% and the AMEX Securities Broker/Dealer index 5%. For the week, the Bank index declined 3% and the Brokers 6%. Gold shares were hit for almost 8% this week.

The credit market also traded with considerable volatility. For the week, 2-year Treasury yields were largely unchanged, while 5 and 10-year Note yields increased 2 basis points. Long-bond yields actually declined 4 basis points. Notably, mortgage-back and agency securities underperformed, with yields rising 6 basis points. Spreads widened sharply over the past three sessions, with the benchmark 10-year dollar swap yield widening 9 basis points to 116. Junk spreads remained generally unchanged at extreme levels. Going forward, these various spreads should be monitored closely for indications of increasing systemic stress. Globally, considerable tumult continues throughout currency markets as a virtual dollar melt-up feeds a general marketplace dislocation. We expect only increasing turbulence in global credit and currency markets.

“In the prosperity phase, investment from innovating activity increases consumers spending almost as quickly as producers spending. ‘…old firms will react to this situation and…many of them will ‘speculate’ on this situation. A new factory in a village, for example, means better business for the local grocers, who will accordingly place bigger orders with wholesalers, who in turn will do the same with manufacturers, and these will expand production or try to do so, and so on. But in doing this many people will act on the assumption that the rates of change they observe will continue indefinitely, and enter into transactions which will result in losses as soon as facts fail to verify that assumption…New borrowing will then no longer be confined to entrepreneurs, and ‘deposits’ will be created to finance general expansion, each loan tending to induce another loan, each rise in prices another rise’…this is a well-known cumulative process Schumpeter called “the secondary wave.” In it is included the clusters of errors, waves of optimism, and overindebtedness…” From Joseph A. Schumpeter’s Business Cycles, 1939

We often highlight silly comments from the “Lonesome Dove” - Robert McTeer, President of the Federal Reserve Bank of Dallas. While we don’t think much of his “economics,” he does enthusiastically and clearly articulate the flawed view of the bullish consensus. Besides, he’s certainly “quotable,” and has most definitely made his mark on financial history. Regrettably, his legacy will be how not to be a central banker. All the same, he maintains his status as Wall Street’s most beloved member of the Fed: “My Man McTeer, who’s just a wonderful Fed policy-maker (Larry Kudlow, CNBC 10/6/00)!”

Not only do we disagree completely with his focus on the New Paradigm, we are rather astounded that the Dallas Federal Reserve’s website so propagandizes the New Economy. This is incredibly inappropriate. Interestingly, Dr. McTeer now likes to point out that other economists have finally accepted his New Economy view. Well, the rug is about to be pulled right out from under them. There are two vital elements that are never factored into the New Paradigmers’ analysis: profits and credit. Structural developments with both of these critical issues are now emerging and together will bring the historic U.S. bubble to an end.

First, I would like to underscore an excerpt from his speech “Manufacturing in the New Economy,” given Wednesday by Dr. McTeer:

“The New Economy is good news. But it is primarily good news for the consumer. That’s what economies are for. All is not so wonderful for producers. Consumers get to participate in the New Economy. Producers have to participate or lose out. Increased competition means producers must innovate and improve constantly. Monopoly profits are harder to come by. Economic profits are temporary at best, as new producers somewhere on the planet move in like hyenas on someone else’s kill. As New Economy elements grow and infuse Old Economy firms with new efficiencies and vigor, the churn in the economy already fierce will only grow fiercer. The choice is between the quick and the dead. Innovate or die. Embrace change; learn to love chaos. Bringing order out of chaos is an American trait. All of these things are. We’re the leaders of the New Economy because we nurture our nerds better. Because we aren’t afraid to fail.”

This is a most fascinating paragraph. The fact that it comes from one of our country’s top central bankers should be shocking, and certainly provides more fodder for future financial historians as few paragraphs so illuminate the major flaws in New Paradigm thinking.

First of all, you may have noticed that New Paradigmers usually don’t discuss profits, choosing instead to focus on productivity and the notion of “creative destruction.” Yet, profits are THE critical underpinning of capitalist economies. Profits are the oil that keeps the machine running. Profits are the mechanism that effectively directs scarce capital and resources - the foundation for the market pricing mechanism. Profits, as a proxy for cash flows, provide the basis for rewarding innovation and sound investment. Profits are the rewards reaped by astute risk-taking shareholders. And, importantly, profits are what ensure that an enterprise will be able to service its debts. Without profits, there is no sustainable economic prosperity. An economy with its financial and business sectors intent on rewarding consumers at the expense of economic profits is destined for a problematic misallocation of resources, economic distortions, instability, and inevitable stagnation. Indeed, a system without a profit motive is one of inevitable financial and economic fragility.

The fact that McTeer would admit that “economic profits are temporary at best” is quite remarkable. That this in no way reduces his sanguine view of future economic prospects is as unbelievable as it is disconcerting. It certainly indicates an incredible lack of understanding of the dynamics of capitalism and economics generally. As such, we doubt the concept of financial fragility even enters into the minds of the New Paradigmers. Certainly, we have heard nothing from the likes of McTeer or Kudlow that lead us to believe they have a clue as to the root causes of the unsound boom, and certainly not the dark consequences now unfolding. We are in full agreement that economic profits are today in most serious jeopardy. But this is not part of some “New Economy” but is instead terrible news for our economy and financial system - the ugly but inevitable consequence of years of runaway credit excess and reckless overspending. But, then again, this is precisely why the Federal Reserve was created and given the momentous responsibility of vigilantly guarding our credit and financial system. To be a central banker is to err on the side of conservatism because the cost of erroneously interpreting a “New Era” is devastating. The Great Depression was not that long ago…

For too long, enormous amounts of capital, credit, and resources have been thrown at enterprises with little opportunity of ever achieving economic profits. This has particularly been the case since the “Quiet Bailout” of 1998, with the collapse of Russia’s financial system, LTCM, and the “seizing up” of the U.S. credit system. Previous financial and economic excesses were “papered over” with even greater excess – the greatest period of credit and speculative excess in history. Specifically, the resulting “reliquefication” created and funneled $100s of billions to fuel the wildcat build out of the Internet, telecommunications, and a massive technology bubble generally. It was a gross monetary and economic fiasco the likes not seen since the late 1920s. It is today important to recognize that the unavoidable cost of this breakdown in financial and economic sanity is now to be paid.

There were all kinds of rumors flying around the market today. One prominent rumor had a major securities firm with losses in the junk bond market, perhaps as much as $1 billion. We have no idea if these rumors have any substance, but such a situation is quite reasonable considering the recent performance of junk debt, particularly within the telecommunications area. There are definitely enormous festering losses out there somewhere. Clearly, both the Wall Street firms and the major banks have ballooned their balance sheets this year in their efforts to perpetuate the bubble. Much of this lending, certainly, has been to finance profitless and negative cash flow companies, many having lost their access to the capital market. Furthermore, we continue to expect major credit issues to develop in the syndicated bank loan area that has provided $100s of billions of “leveraged lending.”

Apparently, margin calls were prevalent, particularly at the end of the week. There was also heightened concern in the marketplace as to the quality of brokerage firm collateral. What a difference a few days makes. With today’s weakness throughout the financial sector, perhaps there is finally some recognition that many speculators have borrowed against credit cards and financed margin accounts with home-equity loans. Certainly, the quality of real estate collateral has been compromised by the widespread marketing of low down payment loans and other mechanisms. Wall Street firms have zealously encouraged aggressive mortgage borrowing, minimal monthly payments and the maximum exposure to the stock market. Great “indirect” leverage has accumulated, as well as the nearly $250 billion of margin debt (40% above year ago levels). During the week, there were newsworthy margin calls. Apparently the Chairman of WorldCom was forced to sell $79 million of stock to meet margin requirements. Importantly, margin calls lead to a collapse of credit and faltering liquidity for the stock market and financial system generally. We also suspect that derivative-related liquidations are also in play, another key factor that engenders a contraction of credit and illiquidity. We are certainly keen to the dangerous derivative dynamics where selling begets a contraction of credit and only more liquidations to the point of a liquidity crisis.

There are also some specific credit-related issues worth mentioning. Monday, Xerox once again shocked Wall Street, this time with news of its first loss in 16 years. Not only was the stock crushed, but Xerox’s debt was clobbered as well, basically given junk status with spreads widening 160 basis points to 408 basis points. Xerox debt due in 2004 ended the week yielding almost 11.5%, 558 basis points over the 5-year Treasury. And while the media relegated Xerox’s news to the status of just one of many earnings disappointments, keep in mind that the company has over $24 billion of liabilities (with equity of under $6 billion). The company’s predicament is certainly an interesting situation as it has been providing financing to about three-quarters of its customers. Vendor financing has been all the rage for some time now, and a great driver of spectacular industry revenue growth throughout the technology sector during this most extreme example of “ultra-easy money.”

In Xerox’s case, it was generally office copiers. For other companies it has been providing financing for startups and others to purchase mainframes, personal computers, servers, printers, routers, and mountains of telecommunication equipment. With hundreds of cash-strapped Internet and telecommunications companies in literal death spirals, there will be lots of returned equipment and unpaid receivables. There will also be cancelled orders and a major decline in demand. This morning on CNBC, Larry Kudlow stated that technology investors were erroneously “discounting the next two recessions.” No, that’s not it Mr. Kudlow. Investors, quite rationally, are discounting the beginning of the end to all the nonsense financing arrangements and a collapse of margins. It’s not that difficult to grasp. The environment has changed. The bubble has burst.

Interestingly, we see that financial sector commercial paper expanded by $19 billion last week. The “Asset-Backed Commercial Paper”/”funding corp” category jumped an extraordinary $15 billion. Only time will tell as to the degree of telecom/technology receivables that have been financed by such sophisticated Wall Street structures. We certainly suspect that such vehicles have and continue to be convenient repositories for risk as investors become increasingly risk-averse. Time for “Financial Alchemy.” As we wrote above, it is certainly our view that credit losses are huge and mounting. A story yesterday from Dow Jones caught our attention – “Default Swap Market Heats Up On JC Penney’s, Auto Parts.” “Nervousness over recent corporate downgrades and performance woes spilled over into the credit default swap market Thursday.” According to the article, “five-year default swaps…were bid at around 450 with no offer on the other side, indicating that the market participants were unwilling to ‘go long’ on J.C. Penney’s credit.” Over the years, an enormous market has developed for transferring credit risk. There has been an unprecedented proliferation of credit insurance, “funding corps” structured to accept credit risk from other sophisticated vehicles, and credit derivatives both listed and over-the-counter. Like vendor financing, the motivation is to foster the selling of product – in this case, additional lending through the creation of risky securities, structures and vehicles. Also similar to vendor financing, the market for transferring credit risk will be severely tested over the coming months. This may already have begun.

It is, unfortunately, my view that we are now moving in an uncomfortably methodical pace right into a financial and economic crisis unlike anything experienced in this country since the Great Depression. I say this because it is unmistakable that unfolding problems are not cyclical in nature, but structural, and not this time easily mitigated. As I have tried to explain in past commentaries, for way too many years money and credit excess have created unprecedented distortions to both our financial system and economy. This time more reckless “easy money” will not do the trick. In fact, this crisis is quite noteworthy as it commences with a booming economy (see Mid-Week Analysis, low interest rates, and rampant money and credit growth. Importantly, we have reached the point where the system is simply fully taxed and generating rapidly escalating credit loses, as well as faltering profits despite generally strong demand and a clear inflationary bias. Indeed, the system is beginning to suffer mightily from the effects of the previous “bailouts.” Moreover, since the 1998 crisis, even greater leverage has been added to a further impair the financial, corporate, and household sectors. And, of course, massive current accounts have created astonishing debts now owed to foreign investors/speculators.

It is critical to recognize that the unfolding financial and economic crisis made a decisive move forward this week. Today, in particular, came the market’s first recognition of the acute vulnerability for the entire financial sector to unfolding events. I am surprised that it has taken this long. But, as is often the case, these types of situations take much longer to develop than one would expect. But when they do “take hold,” they then tend to unfold with ferocious rapidity. In many respects, this is now developing similar to 1998. In the Spring of that year problems began to fester in the market for Russian debt instruments. And while this development garnered little attention (apparent only by watching widening spreads), it was, importantly, a festering problem for the highly exposed and increasingly impaired leveraged speculating community. Finally, a full-fledged crisis erupted as Russia defaulted and the dominos began to fall. Stung in Russia, the hedge funds and securities firms were forced rein in risk, dumping securities in various markets around the world. The dilemma, of course, is that highly speculative and leveraged financial systems are acutely vulnerable to any move toward liquidation. When the major leveraged players become sellers, there are no buyers.

Today, instead of Russian debt, it is telecom and other high-yielding securities. Here we find what may prove a critical difference from 1998: There are severe domestic credit issues. In fact, we cannot imagine a more fragile financial structure and imbalanced economy than those existing today. Vulnerability abounds, be it the banks, the Wall Street firms, or the hedge funds that supposedly now have assets of $475 billion, and God only knows the size of their positions. Perhaps the weakness in the financial stocks today was indicating that the leveraged speculators have been hurt and that a liquidation of positions is in the works. If this is the case, all eyes on the asset-backed and agency markets. And with extraordinary tumult in global equity, junk bond and currency markets, there have certainly been casualties within the ranks of the speculators. Wild swings in U.S. swaps markets are also signs of trouble brewing for the leveraged players as well. As was the case in 1998, dislocation can quickly develop throughout global derivatives markets. We would not be surprised if something like this is in process.

It is also worth noting that today’s stronger that expected employment report should put to rest the notion of a “soft landing.” The booming service sector created 289,000 jobs last month, while strong gains were also made in the goods producing and construction sectors. This report comes on the back of one of the strongest months of auto sales on record, a very robust housing market, ballooning imports, and signs of strengthening retail sales. A strong argument can be made that key sectors of the economy have actually accelerated during the past two months. Over the years, investors - and particularly the leveraged speculating community - have come to place increasing confidence in their “trump card”: That if financial markets falter, the Greenspan Fed will be quick to lower rates and “reliquefy.” Today, however, there is a “catch.” It is certainly my view that the persistent state of excessive demand and heightened inflationary pressures will leave the Fed much less flexibility to respond quickly and forcefully to market tumult. The Fed will likely be cautious and much slower to respond than the bulls have come to expect. This is not an insignificant issue. Perhaps this was one more factor weighing on financial stocks as this week came to an end.

I will conclude by extending Accolades to the Unknown Inquisitor. This question came at the end of recent McTeer speech in Houston, on “The Role of Technology in the U.S. Economy.”

“The question I have for you as a member of the Federal Reserve and all the Federal Reserve Governors is simply this: In the New Economy, I will use Microsoft as an example, companies are more dependent on intellectual capital as opposed to financial capital, unlike an Old Economy company like Exxon, where they obviously need a lot of intellectual capital too, but financial capital is the constraint. The question is, though, as the economy evolves into the New Economy and financial capital seems to be less important – companies are using just in time inventory, managing working capital needs better, so on and so forth. Why is it that we seem to have excessive credit growth? Why is it in a 6 or 7 percent nominal GNP economy M3 consistently grows 10 to 12% a year. Why is it the two largest government sponsored enterprises, for instance Fannie Mae and Freddie Mac are exploding their balance sheets. Why is it that the Federal Reserve, at the hint of any crisis, ‘97, ‘98, Russian defaults, Long Term Capital Management, Y2K, the Federal Reserve explodes its own balance sheet to facilitate another of explosion of credit in the economy. It seems like to me there is a disconnect because the economy seems to require a lot of financial capital to continue to grow. It seems the New Economy paradigm would argue that financial capital would be used ever more efficiently and require less credit on the part of the Nation’s central bank.”

I will spare you Dr. McTeer’s response. Suffice it to say he was not even close to providing adequate answers to these most important questions.

09/28/2000 A Tale of Two Bubbles *

Not unexpectedly, the stock market turned even more chaotic this week, with the technology sector being the wildest of rides. For the week, the Dow dropped just under 2% and the S&P500 under 1%. On the back of UAL’s earnings disappointment, the Transports dropped 3%. The Morgan Stanley Consumer and Morgan Stanley Cyclical indices bucked the trend, gaining almost 1%. The Utilities jumped better than 6%, increasing its gain for the quarter to 32%. The small cap Russell 2000 added less than 1%, while the S&P400 Mid-cap index increased 2%. The financial stocks ended a strong quarter with more gains as the S&P Bank index and Bloomberg Wall Street index both added almost 3%. The Biotechs ended the week largely unchanged, with a gain for the quarter of 20%. It was a much different story in the tech sector, of course, with many leading stocks taking a pounding. For the week, the NASDAQ100 dropped over 3%, with the Morgan Stanley High Tech index sinking almost 5%. The Semiconductors and The Internet index were hit for 8%, while the NASDAQ Telecommunications index was unchanged. The NASDAQ100 dropped 5% for the quarter.

It was a solid finish to a strong quarter for much of the credit market. Two-year Treasury yields dropped 5 basis points, while the 5-year saw its yield sink 8 basis points to 5.84%. Gains were less impressive further out the curve, as 10-year T-note yields declined 4 basis points and the long-bond 2 basis points. Mortgage and agency securities continue to outperform, with the yield on the benchmark Fannie Mae mortgage-back security dropping 7 basis points to 7.56%, the lowest yield since December. Agency securities generally dropped about 8 basis points. The benchmark 10-year dollar swap spread narrowed another 4 basis point to 110. This spread narrowed 17 basis points over the past three weeks. Importantly, however, all is not well in the junk bond sector as the spread between junk bonds and Treasuries widened sharply, increasing 13 basis points to 578. Junk spreads are now at the widest level since the financial crisis in 1998, having increased a staggering 60 basis points during the quarter. Currency markets continue to be quite unsettled, although the dollar ended the week largely unchanged. The gold market also demonstrated notable volatility, jumping more than $6 earlier in the week before ending with a gain of almost $2.

Shareholders from Apple, Intel, Microsoft, Dell, Cisco, Lucent, Motorola and a slew of other leading technology companies must today be a bit puzzled by the so-called New Economy. From PCs, to the Internet, wireless, and telecommunications equipment sectors, investors are now faced with what in many cases is the harsh reality of rapidly deteriorating business conditions, faltering profits and utmost uncertainty as to future prospects. On the fixed-income side, it is now a much less sanguine case of studying balance sheets and deteriorating cash flow positions. The game has changed. Yet, although not all too surprising, there is no letup in the “productivity miracle” hype from the Federal Reserve and the New Paradigmers. And, of course, the Wall Street spin machine is out in force, arguing that sinking tech stock prices are only temporary, related to “company specific” issues or an economic “pause that refreshes.” It is, however, patently obvious that there are severe unfolding industry problems. These developments, we might add, come quite ominously in the midst of a general economy remaining exceptionally strong and the financial sector enterprising, albeit hopelessly unsound.

The technology and telecommunications sectors are in the early stages of what will prove a devastating industry shakeout, the inevitable outcome after years of truly massive and unprecedented credit and speculative excess. Companies will struggle, many unsuccessfully, in an environment fraught with extreme imbalances and distortions, the consequences of massive credit-induced (mal/over) investment. The technology sector is traditionally rife with hyper-uncertainty and wild boom and bust cycles. Throw in an unprecedented systemic credit bubble, with a $trillion dollar flood of money and credit rushing to play, and an uncontrollable quagmire develops. We suspect that many companies have little clue as to future demand. First, it is today unknown as far the extent to which order books were distorted by the double ordering that emanated from previous shortages. There is furthermore the uncertainty that comes with customers losing financing. Indeed, the entire technology super-industry bubble has been at the epicenter of the Great American Credit Bubble, and global credit excess generally. As such, the critical issue today is certainly not productivity, but acute systemic financial fragility.

Interestingly, however, as the enormous technology bubble comes under intense stress, the overriding financial bubble turns even more outrageous. This is no coincidence. With a credit system dominated by the leveraged speculators and investment bankers, heightened credit issues in the telecom/corporate junk bond sector only incite more aggressive speculative flows into the consumer debt area, be it mortgage-backs or asset-backed securities. There are powerful forces at work. Actually, there have been occasions over the past few months when we have contemplated that the Federal Reserve acquiesces to continued extreme monetary excess as a mechanism to accommodate the air coming out of the technology bubble. Knowing the history of the Greenspan Fed, this is certainly plausible. The cost of such perpetual failed policy is a disastrous acceleration of installment and mortgage debt by the already highly overborrowed and vulnerable consumer sector.

Indeed, there is every indication that the financial sector is determined to perpetuate dangerous excess – “if not on the corporate side, let’s push consumer debt! Just keep the money creation going and hopefully enough will find its way into the stock market allowing the more savvy to get out without a debacle.” Last week, broad money supply expanded by $33 billion. While some may wish to believe that there has been a slowdown in money growth, the reality is that after a protracted period of historic monetary excess, money supply expansion has actually accelerated. During the past 10 weeks, broad money supply has surged $166 billion, an annualized rate of almost 13%. Over the past 20 weeks, M3 has expanded at a rate of nearly 10%. And while several economists a couple months back were trying to point towards a temporary slowdown in M2 as evidence of a slowing economy, such analysis has been muffled by 10-week M2 growth of $110 billion, or 12% annualized.

Again last week, “institutional money funds” led the monetary charge, increasing $13 billion. Combined with the $5 billion increase in “retail money funds,” total money market funds accounted for more than half of broad money supply growth. Over the past six weeks, “institutional money funds” have increased $33 billion (41% annualized). During the past twenty weeks, “institutional money funds” have jumped an astounding $93 billion, or an annualized rate of 38%. As we said, the financial sector is quite determined.

Not coincidently, last week was the biggest week ever for the asset-backed security marketplace, with almost $12 billion issued. Year-to-date, $162 billion of non-mortgage-back securities have been created, about flat with last year’s record pace. Of this total, 27% were collateralized by auto loans, 27% home-equity loans, 22% credit card receivables, 8% student loans, 5% equipment, 5%, manufactured housing, and 6% “other.” Last week’s record issuance included a $2.8 billion credit card deal from Citibank. CIT Group sold $1.06 billion of bonds “backed by leases on computers, telecommunications and other equipment…”(from Bloomberg). Associates sold $1 billion of securities collateralized by auto receivables. This week a long line of issuers tapped the market, including Chase with a deal of almost $1 billion, Toyota’s finance arm with $1 billion, and Providian with $1 billion, to mention only the largest deals. MBNA priced a credit deal of one billion Swiss francs ($569 billion).

Yesterday, GMAC announced a record month of securitizations, and is apparently quite tickled by its achieving the status as a “leading” lender to risky credits. Last year GMAC purchased DiTech Funding, and from the unrelenting commercials it is quite apparent that GM is working diligently to be the leader in “125% second mortgages.” We will include the entirety of yesterday’s news release. Maybe we are not hip to contemporary finance, but this is nuts. And the fact that all of this seems reasonable to everyone else is only more disconcerting. For sure, “this is not your father’s General Motors.” But, then again, it is certainly as a sign of these most extraordinary times.

“MINNEAPOLIS--September 28--Residential Funding Corporation (GMAC-RFC) today announced the issuance of a record-breaking $2.5 billion in asset-backed securities (ABS), marking the largest issuance month in the company's history. September issuance included a $583 million, high-loan-to-value (HLTV) home equity loan securitization, $1.4 billion subprime securitization, $138 million home equity line of credit (HELOC) deal, and $380 million issued from the new RAMP (Residential Asset Mortgage Products) shelf.

For the first nine months of 2000, GMAC-RFC has securitized more than $8 billion in ABS, including over $2 billion in HLTV product, making GMAC-RFC the leading HLTV issuer to date. This recent transaction, the company's fourth of the year, demonstrates GMAC-RFC's ongoing commitment to the HLTV securitization business. Year-to-date subprime issuance exceeds $4.9 billion.

"This record issuance confirms our commitment and support of the HLTV, HEL and subprime markets," said Eric Scholtz, managing director, capital markets at GMAC-RFC. Scholtz said the company fully expects to continue its support of the HLTV, HEL and subprime markets into the future. "We are dedicated to delivering a diversified product line through separate and distinct shelves on a consistent basis to our investor customers," said Scholtz. "We have every intention of building on our current success to deliver even more investment alternatives in the future."

In 1999, GMAC-RFC issued more than $1.75 billion in HLTV product, making it the largest HLTV issuer nationwide, according to industry sources. In addition, as of first half 2000, GMAC-RFC ranks as the number three issuer of ABS overall, as the number one issuer of HEL and subprime B&C product, and number two issuer of private-label MBS.

GMAC-RFC, a wholly owned subsidiary of General Motors Acceptance Corporation, is America's largest non-agency issuer of mortgage-backed securities and a leading residential warehouse lender. The company leverages its strengths in securitization, lending and investment to offer a broad portfolio of innovative capital solutions. The company is headquartered in Minneapolis and operates in the United States, Europe and Latin America.”

Considering the extraordinary environment, perhaps GMAC should be can be forgiven for boasting of its aggressive expansion into high-risk lending. After all, it has become the hottest ticket in town. Wall Street could simply not be more enamored with the consumer lending business and, importantly, the more risky the better. Telecom schmelecom, SUBPRIME is where it’s at!. Just take a look at the stocks. Year-to-date, Capital One has gained 45%, Providian 39%, Metris 66%, Household 52%, and Americredit 56%. With Wall Street cheerleading all the way, the rate at which some of these aggressive finance companies are lending is astounding. Capital One is expected to grow managed receivables by 28%, Providian 34%, and American Express 34%. Revenue is expected to grow 35% at Metris. Household International is also a favorite with its core managed loans expected to expand by 22% this quarter, led by an anticipated 40% growth rate for home equity lending and 55% for auto loans. One Wall Street industry research report stated that “customer and receivables growth remains robust, ranging from 20-40% annualized for the companies we cover.”

Something else caught our eye while reading through another piece of Street research on the credit card industry: “We expect strong 9% to 10% year over year industry wide receivables growth. We estimate that rising oil prices are contributing approximately 2% to 3% to card-industry receivable growth, which should maintain the current 9% to 10% industry growth through the first quarter of 2001.” Well, well, monetization of higher oil prices…that is precisely how inflation begets only higher inflation.

With continued incredible money and credit excess, we remain quite skeptical of the view of a meaningful economic slowdown. Today, the Chicago Purchasing Managers’ index posted a sharp increase, jumping to 51.4 during September from 46.5. Both New Orders and Production jumped more than 8 points, New Orders to 66.7 and Production to 62.4. These are both very strong levels. Also today, it was reported that spending rose at a strong 0.6% during August with the largest increase in durables purchases since February. With spending rising faster than income, the savings rate set a new record at negative 0.4%. There was also a revision to 2nd quarter GDP to 5.6% from 5.3%, as well as another significant decline in initial unemployment claims.

This week the National Association of Realtors announced a much stronger than expected 9.3% increase in August’s existing home sales. Sales jumped 16% in the West, 5% above a very strong August of 1999. The average price in the West jumped $13,700 to $247,400. Transaction dollars (volume multiplied by average price) in the West were $34.6 billion, 36% of national, and a 10% increase from last year. For comparison, transaction dollars in the West were actually 44% above August of 1997. Nationally, transaction dollars of $96 billion are 38% above August of 1997. Looking at inventories, available units dropped to a 3.7 months supply from July’s 4.3 months. The actual number of units was 19% below last year. That may explain why Homebuilding stocks were ranked second of 87 S&P industry groups during the quarter, posting a 41% advance.

From the California Association of Realtors: “The median price of a single-family home in California hit a new record in August, rising 14% to $255,580. August also was the 42nd consecutive month that the median price of a home posted an increase compared to the previous year…resale activity posted an increase of 17.7% in August 2000 compared to July 2000.” The unsold inventory index ended the month at 3.4 months. It is truly amazing how the California real estate bubble has expanded to include the entire state, from luxury neighborhoods in Hillsborough to working class communities in Riverside County and the high desert. Year over year, prices have surged 39% in Marin County, 47% in Santa Clara, 30% in Sonoma Country, 19% in Orange Country, and 35% in San Diego. Increasingly, however, the key development appears to be the dramatic broadening of this historic real estate bubble. In the Greater San Francisco Bay area, we see year-over-year prices increased 26% in Hayward, 23% in Oakland, and 34% in Richmond, not areas traditionally recognized as the most desirable. Down south with the least expensive desert real estate, we see that Palmdale experienced a 36% increase to $117,000.

From this morning’s Wall Street Journal, F.W. Dodge reported that that the value of new residential building contracts in the West region increased 12% during August. The most interesting news this week, however, comes from an article written by James B. Kelleher from the Orange County Register – “Golden View of State Economy - Forecast: A UCLA report sees a ‘truly stellar’ situation, predicting growth in spending, personal income and payrolls.” Quoting highly respected economic forecasts from UCLA, “the Golden State’s economic glow doesn’t appear to be in any danger of fading…personal income in the state will rise an eye-popping 10.3 percent this year, up from 7.5 percent in 1999…consumer spending will rise 10.9% in 2000, up from 9.9% percent in 1999.”

One could not imagine a clearer manifestation of a bubble economy than the present situation in California. In fact, it will provide an historical case study in how extreme credit excess feeds first into asset inflation. If allowed to run unabated, over time credit excess is further transmitted into extreme income and spending growth, and resulting distortions and imbalances to the financial sector and economy. It should be recognized as a textbook inflationary bubble, one that the Federal Reserve presently allows to grow to even greater and more precarious extremes. The California boom is now a severe structural dilemma that will prove quite problematic for both the financial system and economy when The Great U.S. Credit Bubble bursts.

In regard to bursting bubbles, we read with great interest a recent research report on the telecom equipment industry from Sanford Bernstein analyst Paul Sagawa. Quoting from the report: “Free cash flows have turned sharply negative – only four of 41 US (communications) carriers showed positive cash flow during (the first half) – making it painful to fund further capex acceleration without external financing…Increased scrutiny of equipment suppliers’ balance sheets has made it more difficult to secure vendor financing. In this environment, we believe we are likely to see few new-build network projects funded, more carrier bankruptcies and a trend toward capex unfriendly industry consolidation.”

All we can say is that the “communications arms race” has provided the (in the spirit of Hyman Minsky) ultimate in “Ponzi Finance” (see May 26th CB Bulletin). This scheme, however, is now faltering. Reiterating our point from last week, this is an absolute credit nightmare in the making.

With rapidly deteriorating fundamentals, it is not surprising that financing sources are rapidly running dry. That is the nature of credit bubbles. As junk debt badly lags other sectors, junk bond funds are suffering outflows. According to AMG Data Services, almost $450 million exited junk funds this week, bringing to $7 billion the outflows so far this year. With investor demand waning, issuance of junk debt during the past nine months dropped by almost 50% to $38 billion (investment grade debt issuance jumped 8% to $335 billion). So, the predicament should be obvious: A massive telecommunications sector whose lifeblood is junk debt and leveraged lending, finds itself running increasingly cash-flow negative, at the same time increasingly nervous investors flee the sector and heavily exposed bankers begin to panic. Normally, such a situation would appear quite dire. Today, that may not necessarily yet be the case, with the (temporary) solution – Wall Street structured finance.

In previous commentaries we have discussed how “funding corps” and other structured finance vehicles have and continue to play critical roles in perpetuating this dangerous credit cycle. Well, a news item caught our attention yesterday. “Moody’s Rates Lucent’s Insured Asset Funding (Asset-Backed Commercial Paper) Program Prime-1.” This is a $1.1 billion “bankruptcy-remote limited liability company (or “funding corp”)” that will be collateralized by a “a revolving pool of loans and trade receivables that finance the sale of telecommunications, data networking and other equipment, products, services and systems provided by Lucent Technologies and its affiliates.” To get the necessary top commercial paper rating, there will be the typical full credit enhancement, in this case “insurance” from National Union Fire Insurance, a subsidiary of American International Group. There will also be liquidity support from a syndicate of banks, with Citibank acting as agent. The magic of these popular “funding corp” structures is the ability to obtain top commercial paper ratings and borrow aggressively from the money market to finance higher-yielding and much riskier instruments, and do it all with virtually no transparency.

Only time will tell as to the quality of assets used as collateral for the almost $600 billion in asset-backed commercial paper. These entities have clearly been a key source of financing during this boom, having grown from about $100 billion since 1996. We certainly suspect that these entities have been repositories for telecommunications debt and industry receivables, and likely other risky credits that we would not consider appropriately funded from the money market. It is also worth noting that regular non-financial commercial paper has increased by $93 billion, or 36%, to $350 billion during the past twelve months. This dramatic increase in corporate sector short-term indebtedness is also indicative of heightened financial fragility, and could be related to investors’ lost appetite for risky credits. If there were ever a time for regulators, ratings agencies and investors to be on careful watch, it is right now.

We don’t really see much of a mystery as to why money market funds, particularly on the institutional side, have been ballooning: these are the vehicles being called upon to provide financing as investors increasingly avoid risky credits directly. As we have discussed in previous commentaries, contemporary Wall Street provides an amazing example of a seemingly perpetual “financial alchemy” - the unrelenting churning machine that turns risky loans into pristine “money” – increasingly money market fund assets (see June 23rd CB Bulletin). And the more arduous the financing environment, the greater the necessity for The Machine to perform its “alchemy” with increasing vigor. Yes, Wall Street has mastered a system where it can produce its own liquidity – create the “money” that then provides the demand for the securities it issues to feed this fateful boom. It is a system, however, of smoke and mirrors – “money out of nothing” - credit on credit, and increasingly poor credit at that.

During the just concluded third-quarter, the NYSE Financial index gained 20%, the S&P Bank index 21%, the NASDAQ Financial index 22%, and the AMEX Securities Broker/Dealer index a stunning 33% (47% ytd). For the financial sector, apparently, it was the best of times. For many leading producers of real products, however, it marked the onset of what will prove the worst of times. We don’t expect this extreme divergence to continue.

09/21/2000 The Facade of a Sound and Stable Prosperity *

The Last of the Great American Credit Bubble

What a week. And for anyone that is tempted to downplay the extraordinary nature of the current environment, keep in mind that the President of the United States this afternoon has decided to tap our country’s emergency crude oil reserves, the first such move during peacetime. Intel, arguably one of the most important companies in the world, yesterday shocks the investment community with disappointing earnings news. And then this morning, for the first time since 1995, European, Japanese and American authorities executed a coordinated global currency intervention.

It was a wild day, with the Dow experiencing a 237-point intra-day swing, while the NASDAQ100 saw a 6% recovery from morning lows. For this acutely unsettled week, the Dow and the S&P500 declined about 1%. Defensive issues outperformed, with the Morgan Stanley Consumer index adding 2%. The economically sensitive issues under performed, with the Transports and Morgan Stanley Cyclical indices dropping about 3%. The Utilities sank 5%. The small cap Russell 2000 and the S&P400 Mid-cap indices declined about 2%. The NASDAQ100 actually finished the week with a gain of 1%, as its year-to-date performance scratched back to unchanged. The Morgan Stanley High Tech index dropped 2% and the Semiconductors almost 5%. The Internet and NASDAQ Telecommunications indices fell about 3%. Despite today’s strong recoveries, the financial stocks had losing weeks. The S&P Bank and AMEX Broker/Dealer indices dropped almost 2%. Gold shared sank about 3%.

The credit market was quite volatile as well, although Treasury yields ended the week with only slight variations. Agency debt securities performed relatively well, with yields dropping slightly. Mortgage-backs strongly outperformed, with yields generally contracting 5 basis points. The benchmark 10-year dollar swap continued to narrow, sliding 4 more basis points to 114. With concerted central bank intervention, the dollar sank 2% today against the euro and Swiss franc. The dollar index dropped 2% for the week as well. After beginning the week quite strongly, crude oil prices dropped precipitously at week’s end to close $2 lower for the week.

We have entered a critical period in financial history. It is now definitely time to “get one’s house in order.” The approaching storm clouds may not look all that ominous at first glance, and are in fact peculiarly invisible to the vast majority. Nevertheless, if Doplar radar existed to identify financial storm systems, it would now be tracking a series of funnel clouds heading right for Wall Street.

But there will be no talk of crisis, no discussion of acute financial fragility. From Washington will come more New Era propaganda and, undoubtedly, the infamous adage “underlying fundamentals of our economy are sound” at any serious bending in market confidence. And throughout Wall Street, the phrase “company specific” will play like the proverbial broken record. But such propaganda is blatantly detached from a reality fraught with great uncertainty and extreme financial risk. The feeling that we have passed a momentous inflection point is almost palpable. Yet, as so many things fall increasingly into a state of flux, the facade of a sound and stable prosperity is coveted and protected with more intensity than ever. All the same, be fully prepared going forward for extraordinary financial turbulence and considerable confusion. The bottom line remains that there exists a historic gap between the unfathomable financial wealth created during this great credit bubble and actual underlying economic wealth creating capacity. True wealth cannot be created by printing up securities or by electronic entries. Nor is true wealth determined by a stock’s point of last sale. This gap will be closed; immense perceived wealth will disappear.

To better appreciate today’s extraordinary and precarious “macro” environment – The Last of the Great American Credit Bubble – let’s think through a more “micro” example. There are disconcerting and recurring cycles in the lending business, and this phenomenon definitely has its most striking manifestations in subprime credit. After all, there are few businesses that have greater initial growth potential than extending loans to poor credits. Because of their poor histories and financial standing, these individuals lack access to traditional prudent lenders. Or said another way, subprime lenders benefit from a very captive customer base willing to pay what most would see as outrageous interest rates to obtain financing. Offer them money; they’ll take it. And with borrowers accepting arduous terms, an aggressive lending business has all the appearances of exceptional profitability. This certainly explains why aggressive lenders invariable catch the eye of Wall Street and especially the “earnings” momentum crowd. Certainly, accounting profits and future earnings look quite enticing at the moment as subprime lenders borrow in the money markets and lend like crazy at yields up to 20%. And to calculate profits, well, the computer simply generates earnings based on the significant spread between the cost of borrowing and the price of lending, while taking into consideration the possibility of a small fraction of doubtful accounts.

Estimates for problem loans and future credit losses are almost always underestimated. After a year or so, a meaningful portion of accounts will be impaired with little possibility of ever being repaid. But then again, that’s why they are bad credits. And if one went through the exercise of determining the true returns generated by those initial loans, it would be quickly apparent that not only were accounting profits grossly overstated but, in all likelihood, lending to poor credits was (as its has been traditionally) a losing proposition. One might expect that this would pose an immediate problem. Surprisingly, however, the fact that the initial loans went sour causes little if any concern or disruption. How can this be the case?

Well, as long as the company continues to expand lending aggressively it is quite easy to bury bad credits. For example, let’s say that a subprime credit card company initially lends $50 million. By the end of the year, 10% of the poor quality loans turn seriously delinquent with little chance of collection. Based on actual loan performance, credit losses would most certainly have wiped out “profits” completely, with future defaults and collection costs destined to create large losses (i.e. no economic profits whatsoever.) The handy computer, however, does not pursue such an analysis but is instead simply programmed to calculate accounting “profits.” Yes, “profits.” You see, after a year of aggressive receivable growth, the lender has increased total loans outstanding to $150 million. With $5 million (10% of initial $50 million) of the old and none of the new loans delinquent, the company boasts of only 3% problem credits. The company can even pitch to a gullible marketplace that its credit policies are sound and business prospects wonderful – that it has developed a new model for profiting from risky lending after so many others before have failed. Sure enough, with financing spreads significantly greater than the losses of 3%, our credit card lender reports impressive growth of accounting “profits.” The next year, similar trends could see $15 million of delinquencies and losses. Now a problem? Nope. Not, with total loans outstanding of, say, $350 million and corresponding rapidly growing “profits.”

And as long as credit card loans are extended at ever-larger quantities (with resulting quality deterioration!), accounting profits will for sometime sprint ahead of credit losses. But don’t be confused; it is a race. During “the race” stage of extreme credit excess, everything appears splendid, indeed. For the community as a whole, with credit card borrowings creating surging purchasing power throughout, the economy booms. And with a prevailing and solidifying euphoria, very few will appreciate that the roots of the perceived prosperity are overwhelmingly financial – based on credit excess. Certainly, very few will recognize the ramifications of the Great Race between financial excess, festering credit problems and the impairment of the credit system. Nonetheless, mounting credit losses and an increasing impairment of the credit system are THE overriding issue. Eventually, inevitably, undeniably – lending excess will be overwhelmed by credit losses. New lending can only sprint so fast for so long. That’s why it’s called a credit bubble.

Trees don’t grow to the sky. With our subprime company example, the credit cycle eventually progresses to a critical juncture. At some point, the lender recognizes that a serious credit problem is developing – credit losses are rapidly catching up to receivables growth; perhaps there is recognition that the business model has been flawed; and, certainly, that accounting “profits” are in grave danger. One could certainly assume and even profess that this will prove the beginning of the end to the credit cycle. Well, it should but usually doesn’t. In fact, serious analysts would look at the developing situation and warn of impending collapse. And while their analysis is quite sound, their predictions of catastrophe will prove early. Failure is just not considered a viable option for the credit card company, so the natural response to heightened financial stress is to go to only Greater extremes in credit excess. After all, what’s to lose? There’s always a shot at growing out of credit problems, right? In past commentaries we have made repeated reference to the final period of wild and reckless credit excess: “the terminal phase of credit excess.” Indeed, our economy has been in such a perilous and most regrettable circumstance since the “quiet bailout” from the unfolding financial crisis in 1998.

In our example above, the “terminal phase” could witness our credit card company resorting to expanding new receivables by a staggering $500 million as it fights to remain one stride ahead of mushrooming credit losses. To achieve this degree of credit growth, management would lower standards to new extremes – significantly increase credit limits to even the weakest credits, perhaps lend to high school and college students, the unemployed and seek out new “opportunities” such as lending to day-traders and gamblers. This period of “ultra-easy money” would provide potent fuel to the economic boom, while creating an only more enticing environment and “great business opportunity” lending against surging home equity. Credit excess would feed asset inflation that engenders only additional excess. With money “everywhere” and surging consumer demand, entrepreneurs, businessmen and bankers extrapolate based on the recent historical trends (fueled by credit expansion) and a major (over/mal) “investment” boom transpires. Proponents of a New Era are emboldened.

It is just so important today to appreciate the amazing irony that accelerating financial stress unfortunately fosters (with the Fed on the “sidelines”) only greater and more dangerous excess, with a precarious slide down the slippery slope of reckless credit induced financial and economic distortions. Moreover, it is critical to understand that there is never ANY doubt to the inevitable outcome. Importantly, the terminal phase of credit excess sows the seeds of its own destruction. It is only the timing that is in uncertain, yet the longer the “terminal phase” is allowed to run, the greater and more structural the damage to the financial system and real economy. With the exceedingly poor quality of $500 million of new loans in our example, credit losses one year out could reasonably jump to $75 or $100 million – growing exponentially - for the credit card company. When the lender goes bust and is forced to write down receivables to reflect their true worth, the losses will be in the $100’s of millions. For the credit card company, equity will be wiped out and lending will end. As goes credit excess, so goes the boom.

The terminal phase of credit excess is a financial ticking time bomb. The terminal phase is, likewise, a period of seemingly terrific prosperity. As such, it is an environment rife with inconsistencies, anomalies and profound misunderstandings. Despite the fact that such periods are overwhelmingly driven by financial forces and credit inflation, there is absolutely no way that the causes will be commonly accepted. True cause and effect are lost with boom-time psychology and intense disinformation. After all, booms beget bullish analysis. Perceptions of endless prosperity beget stubborn denial. And protracted booms promote the most aggressive and most bullish to the top echelons of power. There are powerful forces at work.

Today’s rally will do wonders to get through the news cycle. No need now to dwell on Intel or currency disarray. We also now have 30 million barrels of oil to pump from the strategic reserve, so apparently the energy problem has been rectified as well. Hardly even a need for the spinmeisters, with the market already having spoken. So, what’s not to like?

We do not think it is an exaggeration to say that festering credit problems are in the process of rotting the very core of our financial system. It is also our view that credit problems are now accelerating rapidly – possibly approaching the limit of the system’s capacity to manage this problem. The fa├žade may look dazzling, but don’t look beyond. Even with extraordinary efforts by our reckless financial sector, egregious credit excess will no longer suffice for masking the unfolding credit debacle. Past financial sins have simply been much too outrageous, and the ever greater financial excess required to keep the game going is getting too conspicuously inflationary, causing severe distortions and, thus, are increasingly self-defeating. In essence, the Great Race is winding down - The Last of the Great Credit Bubble. We are about to witness egregious financial excess being overwhelmed by unprecedented credit losses, placing the viability of our financial system in jeopardy. I say this quite earnestly and with great consternation. This has been an absolute fiasco, and a needless one at that.

Over two years ago our financial sector hit its critical juncture. The entire system responded quickly and with truly astonishing force. A perilous “terminal phase” has been in process ever since. Like our negligent credit card company, caution was thrown to the wind and the inevitable devastating consequences not even a passing concern. And with Wall Street and even top Fed officials hyping the wonderment of new technologies and the New Paradigm, The Street was accorded absolute free rein to orchestrate the greatest episode of reckless financing, speculation, and spending the world has even known. Throughout the Internet and telecommunications sectors, literally $100’s of billions was given or lent to companies with no viable business models. There was little if any concern for future cash flows. The predictable consequence is enormous amounts of wasted capital, vast plundered resources, and massive economic loss. It’s been one hell of an ugly party. There are huge costs waiting to be paid.

Yesterday, the FDIC reported that bank profits had declined to $14.7 billion during the second quarter, a 25% decline from the first quarter’s $19.5 billion and the weakest profits since 1997’s second quarter. And for the first time since 1993, the banking industry’s return on assets sank below 1%. Net interest margin contracted to the lowest level since 1990. What’s more, this downturn is clearly not related to tempered loan growth, but eroding margins and credit issues. The Washington Post quoted FDIC Chairman Donna Tanoue: “For the past several months the FDIC has been saying that yellow caution lights are flashing. This report shows they are flashing brighter.” Ms. Tanoue was also quoted as saying “the earnings problems experienced by a few large banks reflect a rising trend in the riskiness of assets that the banking industry holds.” Also this week, federal bank regulators increased to $100 billion, or 5.1%, the percentage of problem syndicated bank loans. This is a dramatic increase from last year’s $69 billion, or 3.8%. Bloomberg quoted David Gibbons, deputy comptroller for credit risk as stating, “these are big increases. They are, I believe, big dollars….risk is increasing in the existing portfolios. The numbers confirm that the risk has been there and is rising since 1997.” The annual “shared national credit review” showed continued rising risk while lending standards eased.

As we have said before, “the chickens are coming home to roost.” For two years our financial sector has been running completely out of control. During the past 10 quarters, total credit market debt increased $5.2 trillion, or 25%. And, importantly, it was these extraordinary financial conditions that were the primary cause behind the unprecedented technology investment boom, not the new technologies and certainly not some New Era. Indeed, this fateful boom is everything to do with a financial system run amuck. Like our credit card example with its captive customer base of risky credits, the massive Internet and Telecommunications build-out provided a once in a lifetime (career) opportunity, replete with borrowers willing to pay virtually any rate to raise capital for pie-in-the-sky ventures. It was only a case of credit availability. If credit was forthcoming, they were ready to borrow as much as someone was willing to lend. It was truly an insatiable demand for borrowings of very questionable quality. Such an unfettered boom should never have been allowed to develop, but Wall Street was willing and able to provide virtually unlimited access to money. Yes, it was the “money spigot being turned wide open.” It was also a case of drunken borrowers and intoxicated lenders joining in a match made in credit hell.

Credit bubbles by their very nature require ever increasing amounts of credit. As we have explained in previous commentaries, extreme money and credit creation are now necessary to keep inflated prices levitated in the equity, credit, and real estate markets. And, as we have explained today, the financial sector must also pursue much greater credit excess in a race that it will lose to extreme credit problems. It is certainly anything but mere coincidence that global energy, currency, and equity markets have been in a state of disarray. These are the most obvious effects of what is increasingly destabilizing credit excess. Trouble brewing…story to continue…

09/14/2000 Raise the Economy's Speed Limit *

Storm clouds are turning ominously dark as global markets become more unsettled by the week. With fears mounting of a global energy crisis, crude prices surged to 10-year highs and natural gas to record highs. Currency markets were increasingly dislocated from underlying fundamentals, with the Euro and Australian dollar sinking to record lows, the British pound to a 14-year low, and “emerging” currencies from Asia to Latin America coming under selling pressure. And as the week came to an end, unusual trading hit the credit market, while heavy selling took a toll on the U.S. stock market. For the week, the Dow dropped almost 3% and the S&P500 declined 2%. The Morgan Stanley Consumer index declined 1%, the Transports 2%, and the Morgan Stanley Cyclical index 3%. The Utilities were the exception, adding 2%. Yet, many stocks ignored the turbulence, as the small cap Russell 2000 and the S&P400 Mid-cap indices declined less than 1%. The technology sector came under heavy selling pressure, with the NASDAQ100 and Morgan Stanley Technology indices dropping 3.5%. The semiconductors were hit for 6%, while the NASDAQ Telecommunications index dropped 4%. The Internet and Biotech stocks held up well, with The Internet index and the AMEX Biotech index both declining less than 1%. Even the highflying financial stocks came under selling pressure late in the week, with the S&P Bank and AMEX Security Broker/Dealer indices declining 2%. The gold stocks had a disappointing week, dropping 6%.

It was a very unusual week in the credit market, especially the past two days. The long-bond saw its yield surge 16 basis points in two sessions and 19 basis points for the week. Two and five-year Treasury yields actually declined 2 to 3 basis points for the week, as the inversion between 5 and 30-year Treasury yields narrowed 22 basis points this week. In another noteworthy development, some key spreads narrowed dramatically. The 10-year dollar swap spread dropped 9 to 119. Mortgage spreads declined 13 basis points and agency spreads narrowed 9 basis points. Since we don’t believe that the financial markets abruptly perceived less risk for the U.S. credit system, it is likely that these extraordinary moves were more a sign of an escalating market disturbance – players caught on the wrong side of losing trades. And considering that such dramatic price moves came concomitant with increasingly dislocated trading in the energy and currency markets, this supports our view of heightened financial market instability generally.

Broad money supply rose $12 billion last week, with both demand deposits and institutional money funds expanding $8 billion. Interestingly, bank credit jumped $29 billion, with holdings of non-Treasury securities increasing $15 billion. During the past four months, banks’ holdings of non-Treasury securities have jumped $43 billion, an annualized rate of 27%. Also last week, bank “loans and leases” increased $16 billion, with “other” assets surging $28 billion. Interesting…

Today’s headline, “US Nonfinancial Debt Grew at 5.6% Rate In 2nd Quarter,” sure doesn’t do another quarter of egregious credit excess justice. The latest data, in fact, once again makes for interesting reading. Total credit (non-financial and financial) growth expanded at an annual rate of $1.84 trillion, compared to $1.57 trillion during the first quarter. Corporate debt increased to an annual rate of $615.5 billion, or a 13.9% rate, the strongest pace since the first quarter of 1999. Consumer debt increased at a rate of 9%, down slightly from the first quarter’s 10%. Total mortgage debt expanded at an annual rate of $687 billion, or 11% annualized, a new quarterly record. Total mortgage debt has increased an astonishing $1.5 trillion during the past 10 quarters, or 28%. The domestic financial sector increased borrowings at an annualized rate of $843 billion, or a rate of 10.9%, compared to a rate of $618 billion, or 8.1%, during the first quarter. The GSEs increased assets by $55 billion during the quarter, or at a rate of 13%, a significant increase from the first-quarter’s 7%. Total GSE financial assets have increased $707 billion, or 64%, during the past 10 quarters. Finance companies continue to lend aggressively as assets increased at a 14% rate ($36 billion). “Funding Corps” expanded holdings of financial assets by $44 billion, a rate of 18%.

Remembering back to the first quarter, the securities firms had a record expansion as they increased holdings of financial assets by almost $150 billion. The credit baton, however, was handed off to the banking sector during the second quarter. For the quarter, banks’ holdings of financial assets increased by a record $180 billion, a 12% annualized rate (compared to $55 billion during the first quarter and $66 billion during 1999’s second quarter). Foreign banks increased holdings by $37 billion, or at a rate of 21%. To finance this significant increase in assets, U.S. banks increased “due from foreign affiliates” by $55 billion. “Fed funds and security repurchase agreements” jumped $50 billion. This is not the way we would suggest financing ballooning bank credit. Total deposits increased $39 billion.

There is every indication that the great U.S. credit machine continues to fire on all cylinders so far this quarter. Broad money supply (M3) has expanded by $146 billion during the past 10 weeks, an annualized rate of 11%. Over the same period, bank credit has increased at a rate of 12%, with “loan and leases” growing at 13% annualized. August numbers are now in for Fannie Mae. For the month, Fannie expanded its mortgage portfolio at an annualized rate of 15%. After increasing its portfolio by $14.6 billion, or a rate of 8%, during the first four months of the year, Fannie has since expanded its mortgage holdings by $28 billion, or a rate of 16%, during the past four months. Fannie issued $20 billion of mortgage-backs during August, its strongest production in 12-months. One must also assume that the Wall Street’s favorite consumer lenders continue to lend aggressively.

So, with credit excess running wild, we have a difficult time taking all the talk of a slowing economy very seriously. Either the economy is not slowing significantly, or inflation is increasing. There remains considerable evidence that key sectors of the economy continue to run red-hot. Yesterday, the Mortgage Bankers Association reported a 7% increase in its weekly mortgage application index, the strongest reading since July of last year. Mortgage purchase applications have increased strongly during the past three weeks, and are running about 16% above year ago levels. Applications to refinance surged 12% for the week, and are now at the strongest volume since early November. Applications to refinance have increased 40% since the trough in late June.

With mortgage lending running at a record pace, today’s headline from the Minneapolis Star-Tribune should not be too surprising. “Strong demand for homes has brought Twin Cities-area realtors their first billion-dollar month. The value of sales closed in August reached $1.03 billion – 18% more than the $876 million of August 1999. There were more positive signs in August: Closed sales were up 5% and pending sales up 2.4% from August 1999…” The median prices of closed sales increased 11.4% versus a year ago. Volumes increasing about 5% and prices rising 11.4% don’t appear cause for much concern. Yet, this equates to the 18% total transaction dollar volume increase. Further, it is total transaction volume that is most closely associated with new mortgage credit; credit that continues to fuel a consumer-spending binge in the “Twin Cities” and in communities throughout the country.

And while analysts were quick to play up the “weak” August retail sales report, it is worth noting that sales did post a 7% year-over-year increase. Moreover, sales were 19% above those from August of 1998. With sales to auto dealers increasing 3.3%, August durable goods sales ran just 4.5% above last year. This calculation, however, is deceptive, as it was a particularly difficult comparison. Last August’s auto sales were the strongest in 13 years. Even compared to a very strong August of 1999 (retail sales 10% above August 1998!), sales of nondurable goods looked quite robust last month, running almost 9% above year-ago levels. By category, department store sales increased 8%, food stores 6.5%, and clothing stores 2.8%. Perhaps too much attention has been paid to unimpressive clothing sales, without appreciating that consumers may be bypassing clothing for electronics and other purchases. This week Best Buy reported revenues 18% ahead of last year.

The point is not to debate whether U.S. economic growth is slowing. It very well could be. However, the critical analysis is to recognize that demand remains exceptionally strong and, in fact, excessive for a sound financial and economic system. It is like a car traveling down the road reaching its maximum speed of 100 miles per hour. The good news is the automobile is no longer accelerating. More importantly, however, is appreciating that the car is still traveling dangerously and must be slowed before there is a perilous accident. Moreover, and continuing with the speeding car analogy, there has developed a perception that because the car has been traveling accident-free at 100 mph for sometime, that somewhere near 100 mph must be a reasonable and “sound” speed for travel. It’s not.

Indeed, just this week Robert McTeer, president of the Federal Reserve Bank of Dallas, stated on CNBC that the “economy’s speed limit” had in fact been raised. Clearly, the Fed and the bullish analytical community are quite comfortable with the speeding car, confident in the condition of the road, and are particularly enamored by the perceived skill of the driver. This complacency is not only dangerous, but based on flawed analysis. The way we see it, two critical risks have been ignored: the car’s engine (the financial system) and the other drivers (the global economy). Granted, up to this point, the “engine” has sputtered a few times but has always recovered to provide the necessary horsepower, while the cars of the other drivers have been generally so slow that they were hardly a safety issue. Presently, however, there are strong indications that the environment has changed and risks have increased dramatically.

Wednesday, the Commerce Department reported that the U.S. posted a record current account deficit of $106 billion for the second quarter. This deficit has now increased 34% from last year, 73% from the 2nd quarter of 1998, and 254% since the 2nd quarter of 1997. Shipments abroad continue to accelerate, with exports increasing $9 billion (14% growth rate) during the quarter and $31 billion (13%) year-on-year. At the same time, our economy continues to absorb truly incredible quantities of foreign goods. Imports increased almost $20 billion during the quarter (18% growth rate), and $77 billion (21%) during the past year. Pulled from the text of the report: “U.S. liabilities to foreigners reported by U.S. banks, excluding U.S. securities, increased $48.7 billion in the second quarter, following a decrease of $8.8 billion in the first. Most of the second-quarter increase was attributable to a sharp rise in banks’ own liabilities, mostly to (their) own foreign offices, as U.S. banks borrowed heavily from abroad to meet the higher demand for short-term funds in U.S. banking and securities markets.”

Increasingly, the U.S. financial sector is forced to go to extreme measures to finance what are the truly massive imports required to satisfy clearly excessive domestic demand. As written above, the U.S. banking system borrowed aggressively overseas during the second quarter (strongest since the 3rd quarter of 1998), in a continuation of extreme financial sector leveraging over the past ten quarters. Add to this the strains of financing an historic real estate boom and unprecedented corporate borrowings, with a household savings rate that has turned negative. It should be patently clear the U.S. credit system “engine” has been pushed way beyond a reasonable, acceptable limit. Indeed, it is to the point now that the U.S. credit system is adding leverage upon leverage, with extreme and growing dependence on overseas financing. This situation could not be more unstable and the U.S. credit system more vulnerable. So far, global currency tumult has been to the advantage of the U.S. dollar. We not only don’t see this dislocation and dollar strength as sustainable, we expect that unfolding turbulence in global energy, currency, and credit markets, will again test our acutely fragile financial structure.

This week provided further evidence of an unfolding global energy crisis; a situation made only more problematic for countries with sinking currencies. And while the convenient finger pointing is directed at OPEC, we hear few stating that exceptionally strong world demand is overwhelming the ability of producing and refining energy products. We also don’t hear much analysis that makes the proper connection between years of egregious U.S. money and credit excess and the developing global energy crisis. The relationship should be clear. Total US imports for the second quarter were $446 billion, $77 billion (21%) ahead of a year ago. Not only has the production of U.S.-bound goods consumed considerable energy, booming exports to the U.S. has led the global economy to what is expected to be it strongest year of growth in a decade.

Earlier this week, Bloomberg news ran a story “Economic, Business Chiefs Say Asia Growth Brighter, See Risks.” The article began, “The world economy is set to post ‘blistering growth’ this year as Asia’s recovery from economic recession bolsters trade, speakers said at the World Economic Forum…From Singapore to Seoul, most Asian economies are notching growth on a par with the turbo-charged rates prior to July 1997…” Estimates have the Asia Pacific region growing at about 8% this year, with South Korea expected to post near double digit GDP, Hong Kong near 9%, Taiwan near 7%, and China 8%. Today, Singapore reported that July retail sales ran 28% above last year.

This week it was reported that Chinese industrial production grew at 12.8% during August, the same rate as July and a significant acceleration from the 10.7% growth during the first quarter. Industrial production has now expanded at an 11.6% rate for the first eight months of the year, a rapid increase from the 7.3% growth during last year’s fourth quarter. From a research report from ABN-AMRO: “The acceleration in industrial production growth over the past several months was not just due to exports, it was more because of the pick-up in domestic demand, notably fixed asset investment. We expect the trend to continue.” Retail sales continue to accelerate, growing 9.3% during August. ABN-AMRO expects that China’s 3rd-quarter GDP could reach 9%. And while domestic demand is increasing, growth continues to be driven by surging exports. During August, exports ran 27.4% above year ago levels. Imports increased a stunning 54.6% year-on-year, the largest increase this year. Year-to-date, exports have jumped 37% to $159 billion, while imports have increased 39% to $142 billion. China’s narrow money supply has surged 21.9% during the past twelve months, with broad money supply expanding by 13.3%.

Extraordinary growth is not limited to Asia. Even Russia reported that August industrial output expanded 10% from last year. South of the border Mexico is experiencing a major boom, with GDP growth of about 8%. Yesterday, it was reported that the growth of Mexican consumer spending during the second quarter accelerated to almost 10%, the most rapid pace since 1998’s first quarter. Private investment grew at 11% during the quarter. Earlier in the week, it was reported that August sales of new automobiles climbed to a six-year high, with sales jumping 10% from July. Auto exports increased 12% from July and were 41% above year ago levels. Bus sales rose 17% and truck sales 18% from July, with year-to-date sales running ahead 55% and 35%. Year-2000 auto sales are running 33% above last year. Mexican workers, not surprisingly, are demanding and receiving significant pay increases. Last month, Volkswagen gave its Mexican employees an 18% pay increase.

And this week from Market News International (MNI): “Globally, (demand for plastics is) expanding everywhere – every market around the world is now growing and that hasn’t happened since around ’95 and ’96. We’re seeing more than just a recovery of Asia, Latin America and Eastern Europe – it’s into expansion. Whatever peaks we reached in most countries prior to the Asia crisis, we’ve now exceeded.” Kevin Swift, chief economist for the American Chemistry Council on global demand for plastics.

In a separate article, yesterday Market New International focused on the US package delivery business. “UPS sees no evidence of economic slowing, although the biggest growth for the company appears to be in the international market – with the domestic market remaining ‘steady.’” MNI quoted Bob Clarin, CFO from UPS: “From what we’ve seen in terms of our own growth rates and volumes, we’ve not seen a slowdown – just steady, healthy, long-term growth. General volumes in the U.S. have been steady. Any up tick is coming from companies doing more business on a global basis. I can tell you from what I’ve seen on our planning for the peak season, we have not seen a slowdown in terms of what our retailers are planning to move through the system.”

Hopefully this sheds some light on the global energy situation and why it will not be easily resolved. We are in the midst of an historic domestic boom and an exceptionally strong global economy. The numbers should speak for themselves. After years of U.S. and global money and credit excess, the consequences are coming home to roost. And while the consensus fixates on the deceleration of U.S. domestic growth, little attention is paid to the real problem: the continuation of runaway money and credit excess, with its resulting financial and economic fragility. Importantly, what is unfolding is both a global energy crisis and a financial crisis. Neither will be easily dealt with. We continue to see the energy crisis exacerbating the unfolding currency crisis. Currency instability, at the same time, holds great potential to destabilize a highly overleveraged credit system and set off a fire in the swaps and interest rate derivative tinderbox. We should think in terms of one massive, integrated, and vulnerable derivatives marketplace. As the week came to an end, the environment sure brings back memories of 1998. The cadre of global money center banks, securities firms and the rest of the leveraged speculating community are all out operating aggressively in the various markets throughout the world, seemingly oblivious to risk. When trouble strikes, however, it quickly develops into a systemic problem and the global financial system finds itself, unfortunately, highly integrated. The disturbance inevitably finds the players most exposed to risk, in whatever market they may be speculating. Those highly leveraged are particularly at risk. And as was certainly the case in 1998, few appreciate the dimensions of what is unfolding. We just can’t shake the notion that the huge overseas borrowings by the highly-leveraged U.S. banking system and financial sector, likely associated with huge currency and interest rate derivative positions, isn’t an accident in the making.

Raise the economy’s speed limit? You’ve gotta be joking…

If you missed Chad Hudson's excellent piece on the semiconductor industry in the Wednesday, September 13th Mid-Week Analysis, check the commentary archives.

09/07/2000 Credit Bubble Dynamics *

Tumultuous conditions have returned to global financial markets, with increasingly problematic dislocations in currency and energy markets. And, importantly, global stock markets are taking notice. Here at home, it was another week of wild divergences. While the Utilities surged 9% and the S&P Bank index jumped 6%, the Semiconductors sank 9% and the NASDAQ100 dropped 7%. The Dow and S&P500 declined 2%. The Transports and Morgan Stanley Consumer index increased 1%, while the Morgan Stanley Cyclical index declined 1%. Many stocks held up well, with the small cap Russell 2000 index dropping 1%, and the S&P400 mid-index declining less than 1%. Tech stocks, however, came under heavy selling pressure as the Morgan Stanley High Tech and The Internet indices declined 5%, and the NASDAQ Telecommunications index sank 8%. The AMEX Biotech index declined 4%, while the AMEX Securities Broker/Dealer index added 1%. Gold stocks advanced 3%.

It was also an interesting week in the credit market. Treasury yields rose, with the yield for the key 10-year note increasing 5 basis points, with two-year yields adding 2 basis points, five-year 3 basis points, and the long-bond four basis points. Importantly, mortgage-backs and agencies under performed as yields jumped about 8 basis points. The benchmark 10-year dollar swap spread increased almost 5 to 129, at basically the highest close since June 1st. We believe this swap spread is an excellent indicator of underlying systemic stress, and it is certainly now issuing what we would regard as a strong warning.

This afternoon, the Fed reported that bank credit expanded by $8 billion last week, as year–to-date bank credit growth continues at brisk rate of 11%. For the week, M1 money supply rose $10 billion, with demand deposits adding $8 billion. M2 increased $8.6 billion and broad money (M3) added $2.9 billion, with institutional money funds increasing almost $8 billion. Total outstanding commercial paper (CP) increased $22 billion last week. Year-to-date, total CP has increased $181 billion, an annualized rate of about 19%. Financial sector CP increased $16 billion last week, with year-to-date growth at $106 billion (14% annualized). According to Bloomberg, $44 billion of U.S. syndicated loans were announced last week, the largest amount in four months. This afternoon’s report had consumer credit expanding by $9.4 billion (7.7% annualized rate), with June’s consumer borrowing revised higher by $2.7 billion to $14.7 billion (12.2% rate). Year-to-date, consumer debt has expanded $80.6 billion (verses $55.1 billion during the comparable period last year), a rate of 10%. Revolving debt (primarily credit cards) has expanded at a rate of 12% year-to-date.

“…The bigger, overriding long-term economic and investment point is this: High-tech, Internet-linked productivity is much more important than this temporary oil bubble, and in fact, if anyone gets too obsessive about the potential for higher inflation try to keep in mind that productivity is expanding our economy’s potential to grow. More growth means lower inflation because it absorbs the money supply, and a stronger dollar. To me this is nothing but a short-term little bubble thing and should not be a big deal.” Larry Kudlow, CNBC September 8, 2000

Current economic conjecture sure brings back memories of 1990. Back then a bullish consensus had developed that believed the U.S. economy was no longer vulnerable to nationwide recessions – that recessions had become a relic of a bygone era. Instead, the economy had been transformed into a much more stable system where excesses would be wrung out through “rolling recessions” impacting individual regions and industries. Talk about putting a positive spin on the booms turned busts in the rust belt, farm belt, oil patch and the Northeast real estate. Ironically, this view gained its strongest following just as the national economy was heading right into recession. As is very much the case today, the consensus in 1990 began with a bullish outcome and then backed into the “analysis,” no matter how detached it was from underlying fundamental developments. Somehow virtually completely ignored was the crucial fact that the U.S. credit mechanism was faltering with a spectacular collapse in the junk bond market, rapidly deteriorating credit conditions, an abrupt tightening of lending conditions instigated by our nation’s banks, and an unfolding collapse of much of the savings and loan industry. The notion of “rolling recessions” was completely irrelevant to what was unfolding. The developing credit crunch was the focal point of sound analysis in 1990, and the recognition of its significant ramifications for real estate prices, bank balance sheets, financial system health generally and economic prospects.

Today, the bullish consensus has predetermined a “soft landing” and continued non-inflation, although there is no sound analysis to support these views. Interestingly, we are increasingly reading about business cycles and even recessions - how the increasingly sated consumer is now “retrenching” and how this will create excess inventories, declining production and forced layoffs. Such layoffs will then disrupt consumer confidence, leading to only less demand, less production and more job losses. And while we have no problem with classic business cycle dynamics, we just don’t see them applying presently. Importantly, the U.S. economy two years ago diverged spectacularly from a traditional business cycle. A negligent Federal Reserve lost control to runaway money, credit and speculative excess, and powerful processes took hold that indelibly altered the financial and economic landscape. A full-fledged credit bubble developed in the U.S. unlike anything experienced since the late 1920s. Accordingly, to accurately analyze the present environment and develop reasonable expectations for the future, we strongly suggest that analysts forget about the highly improbable “soft landing” scenario, drop the fixation on productivity, the Internet and new technologies, and instead seek a better appreciation and understanding of credit bubble dynamics. Credit bubbles specifically do not play by the rules of markets forces. To be sure, credit bubbles are all about the circumvention, obstruction, impairment, and eventual breakdown of the market pricing mechanism.

A key to appreciating credit bubble dynamics is to recognize that they are acutely self-reinforcing. Here, the focus is on processes and forces not easily characterized and certainly non-quantifiable. Credit bubbles absolutely feed on money and credit excess, which only induces an intense hunger for greater excess. What’s more, this appetite is insatiable. After all, credit bubbles are about financial wealth creation and accumulation. Lending, the creation of additional liabilities, is the mechanism, while the consequences of excess are immediate spending increases and asset inflation. Wealth is, of course, about power and one should appreciate that credit bubbles have everything to do with obtaining and retaining power. Those who control a mechanism for money and credit creation have enormous power. Those who manage vast sums of financial assets on behalf of their clients are immensely powerful. And those who attain discretion to allocate an economy’s resources possess great power. Credit bubbles by their very nature direct enormous power to the financial sector, for the financial sector, by the financial sector. And, as has developed during this historic period, as the financial sector attains sufficient financial power to dictate an economy’s reward system it achieves supreme power. With this achievement, the powerful financial sector garners and relishes in its ability to create its own financial wealth, with devastating consequences to the underlying economy and financial system.

Financial wealth begets greater wealth, and power begets abusive power. Those having attained great power have no intention whatsoever of relinquishing control, of course not. And to the powerful machine the mindset becomes that to give up any control is to commence a process of losing control and relinquishing wealth and influence. Such a development is seen as completely unacceptable, and there is no compromise. The machine knows only expansion, sees only continued expansion, and accepts only the perpetuation of the boom. There is no other way. With this in mind, hopefully a nebulous cloud is becoming clearer as to the intractable momentum and self-feeding characteristics behind this historic boom. Here as well, one discovers the source for the incredible resiliency the financial system and real economy have developed to thwart any force that might temper credit or speculative excess.

This is not written as an emotional tirade but as a solemn attempt to illuminate the essence of a credit bubble – the nature of this unparalleled environment. The extraordinary nature of the bubble phenomenon is not done justice by the money and credit data I present weekly. Ideology and institutional structures play a major part. The powerful GSEs will never accept that their aggressive lending has fueled a national real estate bubble, with resulting endemic financial and economic distortions. Investments bankers will not one day ascertain that they have issued enough securities, and that there is great systemic risk created by too much “paper” of increasingly poor quality. Derivative players will not wake up one morning and realize that too many contracts have been written, and that market processes and the stability of the entire system are put at great risk by the proliferation of these instruments. The leveraged speculating community will never admit that there is endemic over leveraging and speculating, and that this is leading to an historic misallocation of resources, an increasingly distorted and imbalanced economy, and extreme financial fragility. Wall Street will never accept that the stock market has become little more than history’s greatest casino and is, as well, hopelessly dysfunctional. No way, these players are all on top of the world. They are where the action is; they are the game, the masters of the universe. They have the control of immense financial wealth, and the mechanism to produce more: the power of the “money spigot.”

This is all fine and dandy during the boom – when the game is favorable to most. However, never lose sight that the backlash against the powerful financiers and institutions during the Great Depression and the laws restricting the size and operations of financial institutions were a natural and inevitable reaction to the abuses that ended with a catastrophic financial and economic collapse. Nor should we forget about depression era tariffs and trade wars.

On a less philosophical and more “practical” basis, let’s look at several areas where Bubble Dynamics are playing major roles. Certainly, the historic mortgage finance boom continues to drive a national real estate bubble. With self-reinforcing dynamics, a housing bubble continues to fuel the dangerous consumer borrowing and consumption binge. And if the present course is maintained, it is our view that heightened home price inflation will only extend the consumer-spending boom. Recently released data from Freddie Mac support our analysis. During the second quarter, 83% of households refinancing mortgages took out loans at least 5% larger than the previous loan amounts – or, stated differently, they pulled out at least 5% of equity. For comparison, during last year’s second quarter only 58% pulled out at least 5% of equity. Additionally, during the second-quarter the average home appreciation for a refinanced mortgage was 27%, this compared to 23% during the first quarter and 13% for loans refinanced during last year’s second quarter. This strongly supports anecdotal evidence of what appears to be an acceleration in housing inflation this year. Interestingly, during this year’s first and second quarters the average borrower actually refinanced at a higher interest-rate, with the motivation specifically to drawn down equity.

Moreover, this week Freddie Mac released its quarterly report on housing inflation. During the second quarter, national prices rose on average 6.8%, compared to 6.7% during the first quarter and 5.3% during the second quarter of 1999. By region, prices in the New England Division (CT, MA, ME, NH, RI, VT) rose 11.1% annualized, and an eye-opening 33.1% during the past five years. West North Central Division (IA, KS, MN, MO, ND, NE, SD) saw prices rise 8.7% annualized, and 33.1% for five years. West South Central Division (AR, LA, OK, TX): 8.1% annualized, and 25.2% during the last five years. Pacific Division (AK, CA, HI, OR, WA) 8.1% annualized, 30.0% for five years. Mountain Division (AZ, CO, ID, MT, NM, NV, UT, WY): 8.1% annualized, and 29.3% during the past five years. East South Central Division (AL, KY, MS, TN): 6.5% annualized, and 26.9% for five years. Middle Atlantic Division (NJ, NY, PA): 6.1 percent annualized, 24.2% for five years. South Atlantic Division (DC, DE, FL, GA, MD, NC, SC, VA, WV): 5.8% annualized, 26.7% for five years. East North Central Division (IL, IN, MI, OH, WI) 5.2 percent annualized, and 31.6% during the past five years.

And while it is generally appreciated that states such as California, Washington, New York and Massachusetts have experienced extreme housing inflation, the critical and less recognized aspect of this boom is its endemic nature. According to recently released data from the Office of Federal Housing Oversight, median home prices throughout the U.S. have increased 28% during the past five years (143% since 1980!). Prices have surged 44% in Colorado, 41% in Minnesota, 43% in Michigan, 40% in New Hampshire, 34% in Georgia, 30% in Arizona and Oregon, 29% in South Carolina, 28% in Nebraska, Kansas, North Carolina and Utah, 27% in Tennessee, Wisconsin and Louisiana, and 26% in Ohio, Missouri, Iowa and Kentucky. Hawaii was the only state with 5-year appreciation below 15%. How can anyone argue that such a spectacular nationwide housing boom is not causing dangerous imbalances and distortions?

The proliferation of interest rate derivatives has been closely associated with the explosion in mortgage credit and resulting housing inflation. This week the Comptroller of the Currency released its quarterly report on bank derivative positions. The total notional amount of positions held by the commercial banks increased $1.7 trillion to $39.3 trillion. Interest rate derivatives increased $1.3 trillion, or at an annualized rate of 17%. Interest rate derivatives positions have increased $11 trillion, or 57% during the past eight quarters, and $21.5 trillion, or almost 220%, since the end of 1994. Interest rate swaps were the favored instrument again during the second quarter, with outstanding positions increasing $1.3 trillion, or at a rate of 26%, to almost $21 trillion. The top seven banks now have $37.4 trillion of derivatives, of which $20.2 trillion are swaps. Once again, Chase Manhattan sits at the top of derivative community as it increased total notional derivative position at a 20% annualized rate during the second quarter. Chase (with shareholders’ equity of $25.4 billion) now has $14.3 trillion of derivative positions, with $8.7 trillion of swaps. JP Morgan has total positions of $9.5 trillion, with Bank of America at $7 trillion, and Citibank at $4.7 trillion. As for total swaps positions, Chase is again at the top with $8.7 trillion, followed by Morgan at $5.1 trillion, Bank of America at $4.1 trillion, and Citibank at $1.5 trillion

Interestingly, we see that JP Morgan increased its credit derivative position by $70 billion during the quarter to $245 billion (160% annualized growth rate). This is consistent with a surge in credit insurance. The proliferation of credit derivatives and credit insurance corresponds directly with Wall Street’s increasing use of “funding corps” and other sophisticated financing instruments and vehicles. Such strategies are, by the way, increasingly necessary as the marketplace begins to recognize festering systemic credit problems. Credit derivatives and insurance, however, will not prove the answer after years of reckless lending and the consequential financial and economic imbalances and distortions. Indeed, derivatives are not the solution but the problem.

Meanwhile, financial and economic distortions are becoming more conspicuous and alarming by the day. This week, near chaos erupted in global energy markets as recognition grows that the world is in the midst of not only higher oil prices, but also a full-fledged energy crisis. The economic disruption and political risk associated with this week’s protests in France are but a first warning shot. This week also witnessed a significant escalation in global financial tumult, with dislocated trading in the euro and other key currencies now impacting both the European corporate bond and equity markets globally. Some European companies were said to have delayed bond issues as corporate spreads widened and liquidity waned. This is particularly troublesome for telecommunications companies in Europe and across the globe. Europe’s telecom companies have plans to issue between $30 and $40 billion of debt before year-end, with tens of billions more from American and global issuers. We don’t see the market cooperating.

To any serious analyst, it should be becoming clear that we are once again entering a period of heightened financial and economic risk - systemic risk exacerbated by the unfathomable leverage in the U.S. and global financial systems, as well as highly speculative stock markets and imbalanced economies. Mr. Kudlow and the bulls can spout propaganda all they want, but it is not going to change underlying fundamentals. It is almost like we have been watching a train wreck develop in slow motion for over two years now. Several times accidents were narrowly averted by huge injections of new money and credit. Finally, however, the costs of gross monetary abuse are coming home to roost. In the past we wrote a commentary titled “Trapped.” The gist of the analysis was that the degree of money and credit excess necessary to keep the bubble inflated would certainly lead to serious problems in the real economy. Well, “the genie is out of the bottle.”

Ironically, in the midst of unfolding global financial tumult, the financial stocks continue a very strong rally. During the past six weeks, the bank stocks have rallied about 20% and the brokerage stocks 25%. At the same time, we remember all too clearly a similar financial sector rally right into the 1998 Russian collapse and LTCM debacle. It is as if approaching storm clouds only work to energize and embolden the financial sector to more aggressively protect its turf. As written above, great efforts are made to perpetuate the bubble – to maintain power. All the same, it is now our view that going forward the great U.S. credit bubble will find itself in the most perilous position since 1998. The weak link is today, as it was in 1998, is the highly integrated global derivative markets. In 1998 it was the dislocation in Russia that proved the catalyst for widespread financial dislocation, astounding inter-market contagion, and near financial meltdown. This time around, it appears that the catalyst may originate in the currency or energy markets. If we had to venture a guess as to how this may develop, we suspect that the current dislocation in currency derivatives leads to dislocation in the closely tethered interest-rate swaps market. Tumult in the swaps market would then quickly impact the highly leveraged credit markets in Europe and the U.S. A bout of deleveraging would quickly lead to a problematic dislocation, perhaps in junk (telecommunications) bonds, mortgages, and/or agency securities. If, as we suspect, credit market liquidity evaporates for the Telecommunications and technology sector, this would prove quite problematic for technology stocks and the stock market generally. At the same time, the highly overleveraged mortgage finance sector (mortgage-backs and agencies) is an accident waiting to happen.

As the week came to a close, there were clear indications that stress was building, and that the probability of a problematic scenario is increasing. Which leaves us with one other key aspect of credit bubble dynamics: while extraordinary efforts are made to perpetuate the boom, when things falter they falter big and ugly. Stress is allowed to build - it holds, it holds, it holds and it holds, that is until the dam breaks. That is the nature of highly leveraged markets, derivatives and credit bubbles. They all exacerbate the upside, but result in abrupt and spectacular dislocation and illiquidity on the downside. This is precisely why we spend so much time discussing financial fragility.