It was a highly speculative week for the U.S. stock market. The AMEX Biotech index jumped 5%, increasing its year-to-date gain to 100%. The AMEX Securities Broker/Dealer index surged 12%, as its year-2000 gain jumped to 53%. The S&P Midcap 400 index added 3%, increasing year-to-date gains to 23%. The NASDAQ100 advanced 4%, as its year-2000 gain returned to double-digits, while the Morgan Stanley High Tech index added 2%, with its year-to-date gain increasing to 21%. The Morgan Stanley High Tech index now sports a 52-week gain of 79%, dwarfed, however, by the 172% gain for the AMEX Biotech index. This week both The Street.com Internet index and the NASDAQ Telecommunications index advanced 5%, while the small cap Russell 2000 added 3%. Value stocks and the bluechips performed much less spectacularly. The Dow added less than 1% and the S&P500 added just over 1%. The Utilities jumped 4%, increasing year-to-date gains to 22%. The Morgan Stanley Cyclical index was unchanged, while the Morgan Stanley Consumer index declined 1%, and the Transports dropped 4%. Although the banks did underperform the highflying brokerage stocks, the S&P Bank index nonetheless added 2% this week. The gold stocks mustered a 2% gain for the week.
Volatility has returned to the credit market. After rising earlier in the week, 2-year Treasury yields then sank 16 basis points as yields dropped 11 basis points for the week. Five-year yields declined 10 basis points, while 10-year yields dropped 4 basis points. Mortgage and agency yields jumped almost 10 basis points then reversed sharply yesterday and today to end the week down between 4 and 6 basis points. Spreads also reversed after widening during the first-half of the week. The benchmark 10-year dollar swap spread narrowed three basis points today and ended one basis point lower for the week at 124. The dollar finished the week largely unchanged, although currency markets were also unsettled. The dollar dropped more than 1% today against the euro and Swiss franc, and lost ground again this week to the Japanese yen. Energy prices continue to rise, with crude oil increasing another 4% this week to $33.38 a barrel.
“Sooner or later, the crisis must break out as the result of a change in the conduct of the banks. The later the crack-up comes, the longer the period in which the calculation of the entrepreneurs is misguided by the issue of additional fiduciary media (i.e., banknotes and checking accounts not fully backed by money). The greater this additional quantity of fiduciary money, the more factors of production have been firmly committed in the form of investments which appeared profitable only because of the artificially reduced interest rate and which prove to be unprofitable now that the interest rate has again been raised. Great losses are sustained as a result of misdirected capital investments.” Ludwig von Mises, Von Mises on the Manipulation of Money and Credit.
“There is no regularity as to the recurrence of paper money inflations. They generally originate in a certain political attitude, not from events within the economy itself. One can only say, with certainly, that after a country has pursued an inflationist policy to its end or, at least, to substantial lengths, it cannot soon use this means again successfully to serve its financial interests. The people, as a result of their experience, will have become distrustful and would resist any attempt at a renewal of inflation.” Ludwig von Mises, Von Mises on the Manipulation of Money and Credit.
“According to the Circulation Credit Theory, it is clear that the direct stimulus which provokes the fluctuations is to be sought in the conduct of the banks. Insofar as they start to reduce the “money rate of interest” below the “natural rate of interest,” they expand circulation credit, and thus divert the course of events away from the path of normal development. They bring about changes in relationships which must necessarily lead to boom and crisis. Thus, the problem consists of asking what leads the banks again and again to renew attempts to expand the volume of circulation credit.
Many authors believe that the instigation of the banks’ behavior comes from outside, that certain events induce them to pump more fiduciary media into circulation and that they would behave differently if these circumstances failed to appear. I was also inclined to this view in the first edition of my book on monetary theory. I could not understand why the banks didn’t learn from experience. I thought they would certainly persist in a policy of caution and restraint, if they were not led by outside circumstances to abandon it. Only later did I become convinced that it was useless to look to an outside stimulus for the change in the conduct of the banks. Only later did I also become convinced that fluctuations in general business condition were completely dependent on the relationship of the quantity of fiduciary media in circulation to demand.
Each new issue of fiduciary media has the consequences described above. First of all, it depresses the loan rate and then it reduces the monetary unit’s purchasing power. Every subsequent issue brings the same result. The establishment of new banks of issue and their step-by-step expansion of circulation credit provides the means for a business boom and, as a result, leads to the crisis with its accompanying decline. We can readily understand that the banks issuing fiduciary media, in order to improve their chances for profit, may be ready to expand the volume of credit granted and the number of notes issued. What calls for special explanation is why attempts are made again and again to improve general economic conditions by the expansion of circulation credit in spite of the spectacular failure of such efforts in the past.
The answer must run as follows: According to the prevailing ideology of businessmen and economist-politician, the reduction of the interest rate is considered an essential goal of economic policy. Moreover, the expansion of circulation credit is assumed to be the appropriate means to achieve this goal.” Ludwig von Mises, Von Mises on the Manipulation of Money and Credit.
“Every single fluctuation in general business conditions – the upswing to the peak of the wave and the decline into the trough which follows – is prompted by the attempt of the banks of issue to reduce the loan rate and thus expand the volume of circulation credit through an increase in the supply of fiduciary media. The fact that these efforts are resumed again and again in spite of their widely deplored consequences, causing one business cycle after another, can be attributed to the predominance of an ideology – an ideology which regards rising commodity (today stock and real estate?) prices and especially a low rate of interest as goals of economic policy. The theory is that even this second goal may be attained by the expansion of fiduciary media. Both crisis and depression are lamented. Yet, because the causal connection between the behavior of the banks of issues and the evils complained about is not correctly interpreted, a policy with respect to interest is advocated which, in the last analysis, must necessarily always lead to crisis and depression.
Every deviation from the prices, wage rates and interest rates which would prevail on the unhampered market must lead to disturbances of the economic “equilibrium.” This disturbance, brought about by attempts to depress the interest rate artificially, is precisely the cause of the crisis.
The ultimate cause, therefore, of the phenomenon of wave after wave of economic ups and downs is ideological in character. The cycles will not disappear so long as people believe that the rate of interest may be reduced, not through the accumulation of capital, but by banking policy.” Ludwig von Mises, Von Mises on the Manipulation of Money and Credit.
“…The practice of intervening for the benefit of banks, rendered insolvent by the crisis, and of the customers of these banks, has resulted in suspending the market forces which could serve to prevent a return of the expansion, in the form of a new boom, and the crisis which inevitably follows. If the banks emerge from the crisis unscathed, or only slightly weakened, what remains to restrain them from embarking once more on an attempt to reduce artificially the interest rate on loans and expand circulation credit? If the crisis were ruthlessly permitted to run its course, bringing about the destruction of enterprises which were unable to meet their obligations, then all entrepreneurs – not only banks but also other businesses – would exhibit more caution in granting and using credit in the future. Instead, public opinion approves of giving assistance in the crisis. Then, no sooner is the worst over, than the banks are spurred on to a new expansion of circulation credit.” Ludwig von Mises, Von Mises on the Manipulation of Money and Credit.
We are obviously fascinated with Mises’ money and credit analysis (and strongly recommend “Von Mises on the Manipulation of Money and Credit”) and how brilliantly he concentrated on distortions emanating from the expansion/manipulation of “fiduciary media,” or instruments (money substitutes) that have the economic functionality of traditional “money.” Unfortunately, contemporary economic analysis is devoid of these great insights. Mises’ analysis broadened the universe of financial instruments whose expansion he recognized as fueling inflationary manifestations. We are quite confident that were Mises alive today, he would as well focus on broad money supply and credit expansion as the inflationary fuel for this unsound boom. And although during Mises’ life the banks were the main mechanism of money and credit creation, today one must clearly look at the financial sector and its vast array of liabilities and structures for the inflationary source of the great U.S. financial and economic bubble.
Looking again with consternation at the most recent data, we see a continuation of an astonishing period of monetary excess. Bank credit increased by almost $10 billion last week, continuing the rapid expansion that has seen a nearly 11% growth rate so far this year. Broad money supply (M3) expanded by another $21.4 billion last week. Demand and checkable deposits (components of M1) increased by about $14 billion. During the past 25 weeks, broad money has expanded by $317 billion, or at a 10% annualized rate. Fully one-half of this expansion is explained by just two components, “institutional money funds” and “large time deposits.” Over this 25-week period, “institutional money funds” have expanded by $83 billion, or at an annualized rate of 28%, while “large time deposits” have grown $75 billion, or at a rate of 22%. Year-to-date, these two “institutional” components have increased a total of $178 billion, or at an 18% annualized rate. For comparison, during the same period last year, “institutional money funds” and “large time deposits” combined to expand by $36 billion, or 5%. During the past twelve months, broad money supply has increased by a staggering $625 billion, or nearly 10%. During this period, “institutional money funds” increased $146 billion, or 26%, and “large time deposits” surged $162 billion, also 26%.
Not coincidently, we see that five leading Wall Street firms – Citigroup, Goldman Sachs, Merrill Lynch, Morgan Stanley Dean Witter, and Lehman Brothers – continue to aggressively expand their balance sheets. These companies combined to increase total assets (and liabilities!) by about $220 billion during the first-half, an annualized growth rate of 24%. Also during the first-half, non-federal debt (non-federal government and non-financial sector) expanded by $610 billion, or at a rate of 9%, the largest expansion since the first quarter of 1999. Non-federal debt has also expanded by 9% ($1.198 trillion) during the past year and 20% ($2.379 trillion) during the past twenty-four months. And while we do not yet have financial sector debt numbers for the second quarter, as we have highlighted in past commentaries, financial sector debt exploded by $2.16 billion, or 40%, for the 1998 and 1999 period.
We are now in the sixth year of extraordinary credit-induced excess (although a strong case could be made to include the financial excess years of 1992/1993). And while bank credit expanded by $1.45 trillion, or 44%, during the second-half of the 1990s, even greater fuel for the financial and economic bubble originated through credit creation from both non-bank financial institutions and the capital markets. During this five-year period (1995-1999), the Government-Sponsored Enterprises increased total assets (largely loans and “investments”) by $938 billion, or 120%. Mortgage-backed securities or, in Federal Reserve parlance, “federal mortgage pools” expanded $820 billion, or 56%. Outstanding “asset-backed securities” surged $1.05 trillion, or 186%, while “funding corporations” expanded $568 billion, or 156%. Aggressive expansion of security broker/dealer assets was also instrumental in fueling the bubble, as total assets increased $545 billion, or 120%. Finance company assets increased $357 billion, or 59%. And as money market funds took on a prominent role, particularly in funding financial sector balance sheet expansion, holdings surged $982 billion, or 163%.
During this five-year bubble period, total financial sector debt increased almost $3.8 trillion, or 99%. Total outstanding credit market debt increased $8.4 trillion, or 49%, to an astonishing $25.6 trillion. This unprecedented monetary expansion fueled enormous asset inflation, with stock market values surging $9.27 trillion, or 204%, to $13.8 trillion. Combining credit market debt instruments with total stock market value, total marketable securities surged $17.7 trillion (81%) to $39.4 trillion.
With this amazing data in mind, we would like to highlight an article written this week by noted economist Dr. Irwin Kellner from CBSMarketwatch titled, “Consumers’ Rational Exuberance.” While we are regular readers and appreciate Dr. Kellner’s articles, we will critique this particular analysis as it clearly illuminates a key area of erroneous thinking held by the bullish consensus. Quoting from his writing, “The drop in July’s personal savings rate to an all-time monthly low of negative 0.2% is not as ominous as it might appear. Nor is the fact that people have saved very little of their take-home pay all this year.” The gist of Dr. Kellner’s argument is that a household sector holding incredible “wealth” is demonstrating only “rational exuberance” as it binges on borrowing and consumption. With household wealth having “more than doubled in the past nine years…clearly, people can spend more than they earn in a given month -- or even over longer periods of time -- as long as they have assets that they can convert into cash.” “Holdings of stocks certainly fall into this category. The major market averages have more than doubled over the past five years alone…This alone has added a big chunk to people’s buying power – to say nothing of their confidence. Rising home prices have helped, too.”
And while Dr. Kellner’s analysis is seemingly straightforward and reasonable, it actually goes right to the heart of a momentous flaw in current economic thinking. Ludwig von Mises would be aghast. In the past we have emphasized how monetary inflation generally manifests into three forms: consumer goods and services inflation, rising asset prices and trade deficits. Unfortunately, current thinking looks askance at only rising consumer prices, while trumpeting the virtues of the rising asset prices and imports. We, however, subscribe to the brilliant analysis of Dr. Kurt Richebacher, who states that consumer price inflation is the least dangerous form of credit inflation as it is easily rectified by strong monetary tightening from the central bank. Moreover, it is most critical to recognize that asset inflation is powerfully seductive (Larry Kudlow, Dr. Kellner and many of the bulls mistakenly view asset inflation as “wealth creation”!) and of much greater danger to the soundness of an economy and stability of its financial system. With asset inflation having a broad and determined constituency including the general public, bankers, Wall Street, corporate America and politicians, the resulting damage is allowed to unfold over long periods, while hardly even garnering the attention of central bankers. As such, this week’s report that spending expanded at double the rate of income growth, while the savings rate went negative, is clear evidence of asset inflation fostering a severely dysfunctional economic and financial environment. Yet, current bullish “New Paradigm” thinking has turned sound analysis on its head. Instead of understanding that a negative savings rate is indicative of a severely distorted bubble economy, the bullish consensus sees the continued borrowing and spending binge as evidence of a sound and stable prosperity. It is this momentous gap between the perceived supreme health of the current environment and the actual reality of massive financial and economic imbalances that is disturbingly reminiscent of the bubbles of 1929 in the U.S., 1989 in Japan, and 1996 in SE Asia.
The key point that is lost by the bullish consensus (as well as the Federal Reserve) is that unsustainable processes drive current overheated demand. Indeed, money and credit excess have irreparably distorted market pricing mechanisms, fostering rising stock and home prices and a massive misallocation of resources. At the same time, this massive inflation has created unprecedented financial wealth that only works to perpetuate the financial and economic bubble. This massive inflation has created the perception of unprecedented wealth creation for the household sector that now, according to Federal Reserve data, has net worth (household sector and non-profit organizations) at an unfathomable $42 trillion. (Is there any mystery why the household sector binges on borrowing and consumption?). To appreciate the forces behind current spending, it is critical to recognize that household net worth increased a staggering $4.75 trillion last year, fully 50% of GDP. For comparison, household net worth advanced a total of $4.3 trillion during the entire first-half of the 1990’s, averaging 15% of GDP annually. Household net worth increased $725 billion during 1994, $2.8 trillion in 1995, $2.5 trillion in 1996, $3.8 trillion in 1997, and $3.3 trillion in 1998.
As great economic thinkers have appreciated for centuries, there is significant danger in allowing excessive credit growth, as credit excess begets only more credit and a runaway boom destined for bust. And as Mises recognized, the extent of the unavoidable bust is directly proportional to the excesses committed during the preceding boom. Importantly, the longer monetary excess is allowed to continue, the further economies and financial systems diverge from conditions of sustainable growth and stability. Articulated brilliantly by Mises, “every deviation from the prices, wage rates and interest rates which would prevail on the unhampered market must lead to disturbances of the economic “equilibrium”.
As we have witnessed during this boom cycle, credit excess creates disturbances, including the increase in perceived household wealth. This perception of profound wealth further stimulates excessive borrowing and spending, which leads the economy only deeper into a boom/bust cycle. And, as is presently observable, the more protracted the period of unfettered credit-induced boom, the greater the monetary inflation feeds directly into rising wages and income, again working to exacerbate the precarious expansion and more permanently distort the underlying economic system. Additionally, Mises’ analysis focused on “entrepreneur errors” that were a function of decision making in a distorted marketplace, as well from the extrapolation of unsustainable boom-time trends. And the longer the calculation of the entrepreneurs is misguided by credit-induced distortions, the greater the over investment and malinvestment by the business sector, and the further the economy travels down an unsustainable track. Certainly, signs are proliferating within the economy of the significant costs to be paid for previous errors. With current difficulties being experienced within the Internet, retail and movie cinema sectors as good examples, we can add these sectors to a lengthening list of trouble spots. These, however, are merely harbingers of much greater dislocations to come. Quite simply, the business sector, particularly within technology and telecommunications, is geared up for demand that is absolutely unsustainable.
And while credit-induced imbalances and distortions wreak subtle havoc on the real economy, equally dangerous disturbances are inflicted on the financial system. It may appear harmless for an individual consumer to borrow against a surging home price or increasing stock values. It is, however, an altogether different matter when the entire household sector increases its debt load substantially to fund consumption, not only above income but also much beyond what an economy can produce. For one, this process presently adds additional debt on an already over leveraged system, again in a self-reinforcing bubble. What’s more, over time this monetary expansion has been increasingly backed by rising asset values. The greater the expansion, the more fuel for additional asset inflation; and this creation of additional “collateral” only fosters more borrowing and higher debt loads. And as this self-reinforcing process stokes destabilizing asset inflation (i.e. California and New York real estate prices!) and resulting over consumption, the outcome is much larger quantities of increasingly poor quality debt for the financial system. When debt is created to finance sound investment with stable future cash flows, that’s one thing. When enormous credit excess is created to finance consumption and rising asset prices, that’s something completely different! (see May 26th commentary “Ponzi Finance”). Today, it is critical to recognize that the U.S. economy and financial system have diverged spectacularly from equilibrium, are in the midst of a credit bubble financing consumption and an asset bubble, and that this process is self-reinforcing and destabilizing.
We also have the sense that the bulls do not appreciate that “one person’s asset is another’s liability.” And while the household sector is perceived to be enjoying a bonanza from historic financial asset inflation, the majority of this “wealth creation” is simply the other side of the explosion of liabilities from both the business and financial sectors. And with both sectors locked in a process of extreme over borrowing where the proceeds are funding questionable expenditures, it should be clear that these respective credit bubbles are creating a mountain of liabilities of increasingly dubious character. The extreme leverage that has developed within the financial sector is certainly a house of cards, and Wall Street is recklessly financing incredible numbers of businesses with negative cash flows and little hope of ever generating economic profits. We simply cannot imagine an environment with greater “entrepreneur errors” or the funding of more uneconomic enterprises. Our analysis also leads us to believe that there is a clear relationship between the household sector’s lack of savings and the financial sector’s increasing leverage. Indeed, financial sector leverage has increasingly been the financing vehicle for the household sector’s consumption binge, and it is our view that this is what is behind the strange anomalies in the monetary aggregates. There is also the major issue of foreign creditors financing our consumption binge ($400+ billion expected year-2000 current account deficit), and the unavoidable future costs associated with such profligacy. On all fronts, these factors foster acute financial fragility and extraordinary economic vulnerability.
Borrowing from Mises, according to the prevailing ideology of businessmen, economists, politicians, and, of course, Wall Street, the reduction of interest rates and the maintenance of asset inflation is considered an essential goal of economic policy. How else can one explain the Fed’s accommodation of $1.1 trillion of broad money supply expansion over the past 24 months without even the slightest show of concern for unprecedented money and credit excess? This ideology, having strengthened over the course of many crisis resolutions, holds that the Fed will always possess the power to manipulate money and credit. One would think that the Japanese experience over the past decade would have illuminated one of the serious flaws in this line of reasoning: A monetary system that has fallen victim to financing a runaway asset bubble becomes acutely vulnerable to any decline in asset prices. After all, it becomes very difficult to borrow against an asset deflating in value. Furthermore, indebted consumers turn very cautious when they see the value of their assets sink while debt levels remain constant. In such an environment, it is only natural that individuals and businesses reduce spending and strive to reduce debt. On the other hand, it takes enormous credit growth to maintain inflated asset prices at the tenuous late stage of a bubble. And right there is the big dilemma.
Presently, there are three distinct and historic asset bubbles, all falling within the “umbrella” of the great U.S. credit bubble. First, there is the obvious stock market bubble. As consequential although not generally appreciated, there is also a real estate bubble that has grown over the years to become one of history’s great asset inflations. And third, also remarkable if not at all recognized, is the momentous leverage and speculative bubble in the U.S. (global) debt market. Importantly, continued extraordinary monetary expansion will be required to sustain inflated prices in all three of these sweeping asset bubbles. Why, one may ask, is broad money supply growing at a ridiculous rate of 10%? Well, we would argue that this is apparently the degree of monetary expansion necessary to keep these fragile bubbles from deflating, as the financial sector is determined to perpetuate the boom. However, as we have written, it is now to the critical point where such egregious monetary excess “presents a clear and present danger” to financial stability, both at home and abroad. In this regard, we have witnessed a major inflation in the key global market for crude oil that is only now being recognized as more than a temporary price “blip.” We also note that global currency markets have demonstrated exceptional volatility and unsettled trading, with Asian currencies and markets demonstrating particular weakness. There is also the problem with the weak euro. These should all be interpreted as ominous indications of mounting global financial instability.
Increasingly, the risks of the present course of U.S. and global monetary excess must resonate with central bankers in Europe, Japan, and elsewhere. Going forward, we certainly expect increasing bouts of dislocation in currency markets that will reverberate throughout global debt and equity markets. If nothing else, we are entering what we view as an extraordinary period of uncertainty, as questions and indecision develop regarding the sustainability of the U.S. bubble. We certainly believe that the “stakes have changed” globally. No longer will all economies perceive they are benefiting equally from the U.S. led game of global money and credit profligacy. And now that it is becoming increasingly clear that the U.S. has been and appears poised to remain the big winner, we ponder the possibility of global central bankers breaking rank. After all, one of these days central bankers may determine that the endless flow of dollars flooding the world is inflationary, destabilizing and detrimental – that the U.S. bubble must be reined in. That day would prove an historic inflection point for the U.S. dollar, as well as for the American credit and equity markets. Whether that day is near at hand remains unclear. There is now, however, no longer any doubt that we are moving squarely in that direction.
Saturday, August 30, 2014
08/24/2000 The Law of Diminishing 'Reliquefications' *
The speculative juices were certainly flowing in the equity market this week, as the AMEX Biotech index surged 13% and The Street.com Internet index jumped 6%. The year-to-date gain for the AMEX Biotech index has now reached 92%. For the week, the NASDAQ100 added greater than 3%. The Morgan Stanley High Tech index also added 3%, increasing its year-2000 gain to 19%. This week, the small cap Russell 2000 advanced 2%. The Semiconductors added 1%, increasing year-to-date gains to 62%, while the NASDAQ Telecommunications increased slightly for the week. For the bluechips, the Dow and S&P500 gained 1%. The Morgan Stanley Cyclical index declined about 1%, while the Transports, Utilities, and Morgan Stanley Consumer indices all declined nearly 2%. The financial stocks were generally mixed, with the S&P Bank index adding about 1%, while the Bloomberg Wall Street index declined almost 1%.
With this week’s continued rally, long-bond yields are now near 15-month lows. For the week, 2-year yields dropped 4 basis points, 5-year yields 8 basis points, and 10-year Treasury yields sank 5 basis points to 5.72%. Spreads generally narrowed this week, with the benchmark 10-year dollar swap declining 4 basis points to 125. The benchmark Fannie Mae mortgage-back saw its yield decline 4 basis points to 7.68%. The implied yield on the 10-year agency futures contract dropped 7 basis points to 6.81%. It appears that corporate debt is dramatically under performing, with the spread on AA investment grade corporates widening about 3 basis points to a near record 172. Spreads on junk debt also widened several basis points this week to levels approaching 1998 extremes. With oil prices rising, a faltering euro, and yesterday’s report of the strongest German producer price gains in 9 years, pressure is mounting on the ECB to raise rates. European note yields are now near 5-year highs.
Despite all the talk of economic slowdown, there is certainly little sign of moderation in recent money and credit data. Either the economy is not slowing as presumed, or pricing pressures are considerably stronger than perceived. While we continue to suspect that demand remains quite resilient throughout the economy, we also recognize that rising inflation fuels money and credit growth. During the past 14 weeks, broad money supply (M3) has expanded $173 billion, or at an annualized rate of almost 10%. This continues a period of rampant money excess that has seen broad money supply expand $600 billion (almost 10%) during the past year. Looking at recent bank data, we actually see acceleration in bank credit growth, with total bank credit expanding by $127 billion, or at an annualized rate of almost 13% over the past 10 weeks. Total bank loans and leases have expanded at a rate of almost 16% during this period. Year-to-date, total bank credit has expanded at a rate of 9.4%, with loans and leases expanding at a rate of 11%. Interestingly, so far this year commercial and industrial loans have expanded by $75 billion (11.1% rate), while real estate loans have surged $134 billion (13.7% rate). During the past year, total bank credit has expanded by 11% ($500 billion), with total loans and leases increasing 13% ($435 billion). Looking at the two largest categories, commercial and industrial loans increased 11% ($111 billion), and real estate loans expanded 16% ($226 billion). Looking back over what has been an historic 24 months of money and credit excess, we see that total bank credit has expanded 19% ($807 billion), with commercial and industrial loans growing 20% ($182 billion) and real estate loans increasing 26.5% ($336 billion.)
After several months of stagnation, we see that money market fund assets are again expanding rapidly. During the past seven weeks, money market fund assets have increased $73 billion, or at an annualized rate of 33%. Over this period, institutional money funds have increased $40 billion, or at a rate of about 45%. During the past two years, money market fund assets have surged almost $500 billion, or near 40%.
We also see that Fannie Mae has returned to aggressive credit creation. During July, Fannie Mae made gross purchases of $15 billion of mortgages, the most since last September. For the month, Fannie Mae expanded its mortgage portfolio at an annualized rate of 18.6%, its strongest growth since November. After expanding its mortgage portfolio at an 8% rate during the first four months of the year, this rate has since doubled to 16% during the past three months.
With the Federal Home Loan Bank System (FHLB) recently reporting financial results, we now also know that this powerful GSE once again played a major role in “reliquefying,” or perpetuating the great U.S. Credit Bubble. During the second-quarter, the FHLB expanded “advances” (loans) to member institutions by an eye-opening $32.3 billion, or at an annualized rate of 32%. During the past four quarters, FHLB advances have expanded $108 billion, or 33%, to $437 billion. Over this same period, total assets have increased $135 billion to $621 billion, while FHLB short-term debt has increased 67% to $155 billion.
For the “Big Three GSEs” – The FHLB along with Fannie Mae and Freddie Mac - total assets increased $58 billion during the second quarter. For the past four quarters, “Big Three” assets increased $289 billion, or 21%. During the past eight quarters, total “Big Three” assets surged an incredible $612 billion, or 59%. Wow… With such egregious credit excess, there is no mystery surrounding the U.S. bubble. “Big Three” assets now total $1.642 trillion, after ending 1992 at $396 billion. For comparison, during the past two years, total assets of the Federal Reserve have expanded by about $70 billion, or 14%.
With the continuation of truly astonishing money and credit growth, there should be little surprise that the economic boom endures, nor should there be any wonder as to the source for increasingly problematic distortions affecting the U.S. economy. All the same, our central bankers continue to ignore money and credit excess. Most regrettably, they have chosen instead to trumpet productivity improvements and the “New Economy” as responsible for this the longest ever expansion. We would consider this silly analysis, if it were not so perilous. All the same, we have no doubt whatsoever that it is the unprecedented credit explosion that is behind the U.S. boom, not productivity enhancements or improved technologies.
As we have discussed previously, our highly leveraged and vulnerable credit system again came to the brink of a liquidity crisis during this year’s first quarter. As soon as the extreme pre-Y2K money and credit expansion moderated in January, spreads widened abruptly, credit market liquidity began evaporating, and the stock market began faltering. As such, it is critical to recognize and appreciate that for a system involved in credit bubble dynamics, enormous money and credit expansion fodder - additional leveraging – is required to keep a highly leveraged system viable. In the case of the U.S. credit bubble, the focal point of this leveraging is within the financial sector. And, importantly, it is probably most accurate to view the U.S. credit system as being in a state of extraordinary stress since the crisis in the summer and fall of 1998 – a protracted crisis interrupted only by periods of extreme leveraging/money and credit creation (“reliquefication”).
Remembering back to 1998, the key 10-year dollar swap spread widened from 55 to almost 100 as the crisis took hold between August and mid-October. Then, however, unprecedented money and credit growth “reliquefied” the credit system over the next 7 months, with the 10-year dollar swap spread narrowing all the way back to 65. Yet, this massive “reliquefication” ran its course and spreads again widened sharply over the summer of 1999, actually rising all the way to 110 in August and early September. Credit market liquidity was again faltering, stress was building in the fragile interest-rate derivative area, and then the gold derivatives market dislocated spectacularly. But with fears associated with the quickly approaching Y2K, the Greenspan Fed was more than willing to accommodate another round of extreme money and credit growth – “reliquefication” -going into year-end. Over the following five months, truly unprecedented money and credit growth fueled an 80% surge in NASDAQ, with historic speculation especially in the Internet sector. The Street.com Internet index surged almost 300% in seven months. As liquidity returned to the credit market, the 10-year dollar swap narrowed from 110 in September to 70 by late January.
When the historic Y2K “reliquefication” subsequently ran its course, systemic stress returned to the fragile U.S. financial system with a vengeance. The heedless Internet bubble was pierced, and the historic NASDAQ speculative bubble was at the brink of a dangerous implosion. The 10-year dollar swap spread widened from 70 in January to an unprecedented 140 during April, while access to the capital market closed for many companies. However, with a return to crisis, it quickly became time for another bout of financial sector “reliquefication.” Here, we definitely believe it became Greenspan’s intention to ward off a major stock market decline, choosing instead to “let the air out” of the U.S. bubble slowly and gradually. The mechanism to “manage” such a major undertaking was to ensure financial market liquidity while accommodating only more money and credit excess. In essence, it became one momentous policy error to add to a lengthening list of major blunders. The consequence has been that since the end of February, broad money supply has expanded by nearly $300 billion, a rate of nearly 10%. This surge in new money creation provided the necessary mutual fund inflows to fuel a significant recovery in NASDAQ, a now nearly 20% year-to-date gain in the Morgan Stanley High Tech index, and a wild speculative run for the AMEX Biotech index that has now posted a 92% year-2000 advance. So much for “letting the air out.” And much to the delight of Wall Street, the IPO market was revived, with speculative demand leading to a flurry of new deals. Liquidity also returned to the debt market, much to the relief of a very long list of cash-strapped companies.
However, there is no cure for the credit bubble disease, and certainly the Fed accommodating additional money and credit excess is anything but a panacea. In fact, we very much believe that there are dynamics in play that can be aptly described as “The Law of Diminishing Reliquefications.” Indeed, we have argued for months that this round of “reliquefication” would be less effective for the markets and, importantly, much more problematic than previous episodes (and inevitable future “reliquefications” even more so!) for the real economy. For one, with the U.S. economy desperately overheated and imbalanced, another big shot of credit-induced liquidity was precisely what was not needed. Our view has been that with the economy running white-hot and capacity constrained, creating additional spending power would lead to bottlenecks, rising wages, rising home prices, general inflationary pressures, and surging imports. Clearly, some unmistakable bottlenecks have developed, with the California energy market, gasoline production, and summer airline travel quickly coming to mind. In past commentaries, we have also highlighted both rising wage pressures and a national real estate bubble that is absolutely out of control in California. These are the enormous costs directly associated with “reliquefications” and continued monetary excess.
And while distortions and inflationary manifestations are generally difficult to quantify, imports are much less so. Monthly imports have now surged more than $11 billion (10%!) during just the past six months. Year-over-year, imports have increased an alarming 19%. Further, the unprecedented money and credit bonanza transpiring during the past two years has stoked a staggering 31% increase in imports – credit inflation manifestations in true form! Right here - with an unprecedented surge in imports - we see the factor most directly raising our country’s standard of living and fueling a protracted period of prosperity. Yet, the Federal Reserve ignores reality, choosing to trumpet what is sold as a miraculous productivity story and a “New Economy.” With June imports totaling $120 billion - almost one-third larger than June of 1998 - it is simply ridiculous to espouse surging productivity as the source of current prosperity. It is also clear that we are increasingly “exporting” our credit inflation. The surge in global oil prices is but only the most obvious of what is surely heightened distortions and imbalances for the global economy. Clearly, US money and credit excesses have come to play a profound role for the global economy, a development that only creates greater fragility for the already vulnerable global financial system and economy.
On another front, it is also interesting (an we would certainly argue quite noteworthy) to see how this most recent “reliquefication” has engendered only a minor pullback in credit spreads. The 10-year dollar swap spread trades today at 126 (versus an average of 84 for all of 1999), while junk bond and corporate spreads remain near record highs. The benchmark Fannie Mae mortgage-back spread to the 10-year Treasury trades today not far off all-time highs at 195, this compared to 122 during January. Agency spreads also trade today at about 114, up considerably from 55 in January. The financial sector may create enormous additional quantities of money and credit, but this liquidity demonstrates increasing preference towards Treasuries and relative safety, at the expense of corporate debt securities and companies that need funding. It is our view that the relative poor performance of U.S. junk and corporate debt issues provides clear and ominous portents for the coming cycle downturn.
And while this most recent bout of “reliquefication” has had a much-diminished impact on the financial system (financial asset prices), it has and continues to be our view that it carries significantly more punch for general inflation and other distortions. One way to look at this situation is to say that while past monetary excess largely fueled NASDAQ and stock prices generally, recent money and credit creation demonstrates considerable “leakage” into wage pressures, imports, and surging crude, gasoline, natural gas and heating oil prices specifically. In this regard, it is our view that we have crossed an important inflection point. The days where monetary excess would conveniently flow into stock market and home price inflation without overt negative consequences are a thing of the past. Going forward, the distorting consequences of money and credit excess will be much more easily discerned, and we don’t see how such newfound “transparency” will be bullish.
In conclusion, it is our belief that the Greenspan Fed has set course for an attempt to “let the air out” of the U.S. stock market bubble slowly and gently (and the nonsense that profound productivity improvements is responsible for minimizing economic imbalances is simply justification for not acting appropriately against bubble excess). And while such a strategy may seem reasonable on the surface, it terribly flawed. With the U.S. in the midst of an historic credit bubble, anything that prolongs this dangerous period of excess will only create a greater disaster for the future. In fact, after so many years of credit and speculative excess, we are now at the point where truly immense money and credit creation is required to keep highly overvalued U.S. equities levitated. At the same time, the degree of monetary excess necessary to perpetuate the U.S. financial and economic bubbles is gargantuan. After all, this credit bubble should have been pierced in 1998, if not sooner. Unprecedented excesses since 1998 have only extended the period of dangerous end-of-cycle extremes we refer to as “the terminal phase of credit excess.” It should be obvious that it is an absolute disaster for the Federal Reserve to accommodate the continuation of this exceedingly long and reckless party. Hopefully (but we are not holding our breath) the surge in oil prices and the appearance of many other distortions and imbalances is aiding the Fed’s appreciation for its failed approach. If not, perhaps global central bankers, increasingly nervous of rising oil prices and heightened risk of inflation, as well as other distortions and imbalances, will finally draw the line and demand that the Federal Reserve rein in this bubble. It is certainly our view that the major rally in energy prices over the past few weeks should have significantly raised the awareness of the danger of the present course in U.S. monetary policy. It is also our perception that the most recent “reliquefication,” as diminished as it was, is about to have run its course. Things could get interesting…
With this week’s continued rally, long-bond yields are now near 15-month lows. For the week, 2-year yields dropped 4 basis points, 5-year yields 8 basis points, and 10-year Treasury yields sank 5 basis points to 5.72%. Spreads generally narrowed this week, with the benchmark 10-year dollar swap declining 4 basis points to 125. The benchmark Fannie Mae mortgage-back saw its yield decline 4 basis points to 7.68%. The implied yield on the 10-year agency futures contract dropped 7 basis points to 6.81%. It appears that corporate debt is dramatically under performing, with the spread on AA investment grade corporates widening about 3 basis points to a near record 172. Spreads on junk debt also widened several basis points this week to levels approaching 1998 extremes. With oil prices rising, a faltering euro, and yesterday’s report of the strongest German producer price gains in 9 years, pressure is mounting on the ECB to raise rates. European note yields are now near 5-year highs.
Despite all the talk of economic slowdown, there is certainly little sign of moderation in recent money and credit data. Either the economy is not slowing as presumed, or pricing pressures are considerably stronger than perceived. While we continue to suspect that demand remains quite resilient throughout the economy, we also recognize that rising inflation fuels money and credit growth. During the past 14 weeks, broad money supply (M3) has expanded $173 billion, or at an annualized rate of almost 10%. This continues a period of rampant money excess that has seen broad money supply expand $600 billion (almost 10%) during the past year. Looking at recent bank data, we actually see acceleration in bank credit growth, with total bank credit expanding by $127 billion, or at an annualized rate of almost 13% over the past 10 weeks. Total bank loans and leases have expanded at a rate of almost 16% during this period. Year-to-date, total bank credit has expanded at a rate of 9.4%, with loans and leases expanding at a rate of 11%. Interestingly, so far this year commercial and industrial loans have expanded by $75 billion (11.1% rate), while real estate loans have surged $134 billion (13.7% rate). During the past year, total bank credit has expanded by 11% ($500 billion), with total loans and leases increasing 13% ($435 billion). Looking at the two largest categories, commercial and industrial loans increased 11% ($111 billion), and real estate loans expanded 16% ($226 billion). Looking back over what has been an historic 24 months of money and credit excess, we see that total bank credit has expanded 19% ($807 billion), with commercial and industrial loans growing 20% ($182 billion) and real estate loans increasing 26.5% ($336 billion.)
After several months of stagnation, we see that money market fund assets are again expanding rapidly. During the past seven weeks, money market fund assets have increased $73 billion, or at an annualized rate of 33%. Over this period, institutional money funds have increased $40 billion, or at a rate of about 45%. During the past two years, money market fund assets have surged almost $500 billion, or near 40%.
We also see that Fannie Mae has returned to aggressive credit creation. During July, Fannie Mae made gross purchases of $15 billion of mortgages, the most since last September. For the month, Fannie Mae expanded its mortgage portfolio at an annualized rate of 18.6%, its strongest growth since November. After expanding its mortgage portfolio at an 8% rate during the first four months of the year, this rate has since doubled to 16% during the past three months.
With the Federal Home Loan Bank System (FHLB) recently reporting financial results, we now also know that this powerful GSE once again played a major role in “reliquefying,” or perpetuating the great U.S. Credit Bubble. During the second-quarter, the FHLB expanded “advances” (loans) to member institutions by an eye-opening $32.3 billion, or at an annualized rate of 32%. During the past four quarters, FHLB advances have expanded $108 billion, or 33%, to $437 billion. Over this same period, total assets have increased $135 billion to $621 billion, while FHLB short-term debt has increased 67% to $155 billion.
For the “Big Three GSEs” – The FHLB along with Fannie Mae and Freddie Mac - total assets increased $58 billion during the second quarter. For the past four quarters, “Big Three” assets increased $289 billion, or 21%. During the past eight quarters, total “Big Three” assets surged an incredible $612 billion, or 59%. Wow… With such egregious credit excess, there is no mystery surrounding the U.S. bubble. “Big Three” assets now total $1.642 trillion, after ending 1992 at $396 billion. For comparison, during the past two years, total assets of the Federal Reserve have expanded by about $70 billion, or 14%.
With the continuation of truly astonishing money and credit growth, there should be little surprise that the economic boom endures, nor should there be any wonder as to the source for increasingly problematic distortions affecting the U.S. economy. All the same, our central bankers continue to ignore money and credit excess. Most regrettably, they have chosen instead to trumpet productivity improvements and the “New Economy” as responsible for this the longest ever expansion. We would consider this silly analysis, if it were not so perilous. All the same, we have no doubt whatsoever that it is the unprecedented credit explosion that is behind the U.S. boom, not productivity enhancements or improved technologies.
As we have discussed previously, our highly leveraged and vulnerable credit system again came to the brink of a liquidity crisis during this year’s first quarter. As soon as the extreme pre-Y2K money and credit expansion moderated in January, spreads widened abruptly, credit market liquidity began evaporating, and the stock market began faltering. As such, it is critical to recognize and appreciate that for a system involved in credit bubble dynamics, enormous money and credit expansion fodder - additional leveraging – is required to keep a highly leveraged system viable. In the case of the U.S. credit bubble, the focal point of this leveraging is within the financial sector. And, importantly, it is probably most accurate to view the U.S. credit system as being in a state of extraordinary stress since the crisis in the summer and fall of 1998 – a protracted crisis interrupted only by periods of extreme leveraging/money and credit creation (“reliquefication”).
Remembering back to 1998, the key 10-year dollar swap spread widened from 55 to almost 100 as the crisis took hold between August and mid-October. Then, however, unprecedented money and credit growth “reliquefied” the credit system over the next 7 months, with the 10-year dollar swap spread narrowing all the way back to 65. Yet, this massive “reliquefication” ran its course and spreads again widened sharply over the summer of 1999, actually rising all the way to 110 in August and early September. Credit market liquidity was again faltering, stress was building in the fragile interest-rate derivative area, and then the gold derivatives market dislocated spectacularly. But with fears associated with the quickly approaching Y2K, the Greenspan Fed was more than willing to accommodate another round of extreme money and credit growth – “reliquefication” -going into year-end. Over the following five months, truly unprecedented money and credit growth fueled an 80% surge in NASDAQ, with historic speculation especially in the Internet sector. The Street.com Internet index surged almost 300% in seven months. As liquidity returned to the credit market, the 10-year dollar swap narrowed from 110 in September to 70 by late January.
When the historic Y2K “reliquefication” subsequently ran its course, systemic stress returned to the fragile U.S. financial system with a vengeance. The heedless Internet bubble was pierced, and the historic NASDAQ speculative bubble was at the brink of a dangerous implosion. The 10-year dollar swap spread widened from 70 in January to an unprecedented 140 during April, while access to the capital market closed for many companies. However, with a return to crisis, it quickly became time for another bout of financial sector “reliquefication.” Here, we definitely believe it became Greenspan’s intention to ward off a major stock market decline, choosing instead to “let the air out” of the U.S. bubble slowly and gradually. The mechanism to “manage” such a major undertaking was to ensure financial market liquidity while accommodating only more money and credit excess. In essence, it became one momentous policy error to add to a lengthening list of major blunders. The consequence has been that since the end of February, broad money supply has expanded by nearly $300 billion, a rate of nearly 10%. This surge in new money creation provided the necessary mutual fund inflows to fuel a significant recovery in NASDAQ, a now nearly 20% year-to-date gain in the Morgan Stanley High Tech index, and a wild speculative run for the AMEX Biotech index that has now posted a 92% year-2000 advance. So much for “letting the air out.” And much to the delight of Wall Street, the IPO market was revived, with speculative demand leading to a flurry of new deals. Liquidity also returned to the debt market, much to the relief of a very long list of cash-strapped companies.
However, there is no cure for the credit bubble disease, and certainly the Fed accommodating additional money and credit excess is anything but a panacea. In fact, we very much believe that there are dynamics in play that can be aptly described as “The Law of Diminishing Reliquefications.” Indeed, we have argued for months that this round of “reliquefication” would be less effective for the markets and, importantly, much more problematic than previous episodes (and inevitable future “reliquefications” even more so!) for the real economy. For one, with the U.S. economy desperately overheated and imbalanced, another big shot of credit-induced liquidity was precisely what was not needed. Our view has been that with the economy running white-hot and capacity constrained, creating additional spending power would lead to bottlenecks, rising wages, rising home prices, general inflationary pressures, and surging imports. Clearly, some unmistakable bottlenecks have developed, with the California energy market, gasoline production, and summer airline travel quickly coming to mind. In past commentaries, we have also highlighted both rising wage pressures and a national real estate bubble that is absolutely out of control in California. These are the enormous costs directly associated with “reliquefications” and continued monetary excess.
And while distortions and inflationary manifestations are generally difficult to quantify, imports are much less so. Monthly imports have now surged more than $11 billion (10%!) during just the past six months. Year-over-year, imports have increased an alarming 19%. Further, the unprecedented money and credit bonanza transpiring during the past two years has stoked a staggering 31% increase in imports – credit inflation manifestations in true form! Right here - with an unprecedented surge in imports - we see the factor most directly raising our country’s standard of living and fueling a protracted period of prosperity. Yet, the Federal Reserve ignores reality, choosing to trumpet what is sold as a miraculous productivity story and a “New Economy.” With June imports totaling $120 billion - almost one-third larger than June of 1998 - it is simply ridiculous to espouse surging productivity as the source of current prosperity. It is also clear that we are increasingly “exporting” our credit inflation. The surge in global oil prices is but only the most obvious of what is surely heightened distortions and imbalances for the global economy. Clearly, US money and credit excesses have come to play a profound role for the global economy, a development that only creates greater fragility for the already vulnerable global financial system and economy.
On another front, it is also interesting (an we would certainly argue quite noteworthy) to see how this most recent “reliquefication” has engendered only a minor pullback in credit spreads. The 10-year dollar swap spread trades today at 126 (versus an average of 84 for all of 1999), while junk bond and corporate spreads remain near record highs. The benchmark Fannie Mae mortgage-back spread to the 10-year Treasury trades today not far off all-time highs at 195, this compared to 122 during January. Agency spreads also trade today at about 114, up considerably from 55 in January. The financial sector may create enormous additional quantities of money and credit, but this liquidity demonstrates increasing preference towards Treasuries and relative safety, at the expense of corporate debt securities and companies that need funding. It is our view that the relative poor performance of U.S. junk and corporate debt issues provides clear and ominous portents for the coming cycle downturn.
And while this most recent bout of “reliquefication” has had a much-diminished impact on the financial system (financial asset prices), it has and continues to be our view that it carries significantly more punch for general inflation and other distortions. One way to look at this situation is to say that while past monetary excess largely fueled NASDAQ and stock prices generally, recent money and credit creation demonstrates considerable “leakage” into wage pressures, imports, and surging crude, gasoline, natural gas and heating oil prices specifically. In this regard, it is our view that we have crossed an important inflection point. The days where monetary excess would conveniently flow into stock market and home price inflation without overt negative consequences are a thing of the past. Going forward, the distorting consequences of money and credit excess will be much more easily discerned, and we don’t see how such newfound “transparency” will be bullish.
In conclusion, it is our belief that the Greenspan Fed has set course for an attempt to “let the air out” of the U.S. stock market bubble slowly and gently (and the nonsense that profound productivity improvements is responsible for minimizing economic imbalances is simply justification for not acting appropriately against bubble excess). And while such a strategy may seem reasonable on the surface, it terribly flawed. With the U.S. in the midst of an historic credit bubble, anything that prolongs this dangerous period of excess will only create a greater disaster for the future. In fact, after so many years of credit and speculative excess, we are now at the point where truly immense money and credit creation is required to keep highly overvalued U.S. equities levitated. At the same time, the degree of monetary excess necessary to perpetuate the U.S. financial and economic bubbles is gargantuan. After all, this credit bubble should have been pierced in 1998, if not sooner. Unprecedented excesses since 1998 have only extended the period of dangerous end-of-cycle extremes we refer to as “the terminal phase of credit excess.” It should be obvious that it is an absolute disaster for the Federal Reserve to accommodate the continuation of this exceedingly long and reckless party. Hopefully (but we are not holding our breath) the surge in oil prices and the appearance of many other distortions and imbalances is aiding the Fed’s appreciation for its failed approach. If not, perhaps global central bankers, increasingly nervous of rising oil prices and heightened risk of inflation, as well as other distortions and imbalances, will finally draw the line and demand that the Federal Reserve rein in this bubble. It is certainly our view that the major rally in energy prices over the past few weeks should have significantly raised the awareness of the danger of the present course in U.S. monetary policy. It is also our perception that the most recent “reliquefication,” as diminished as it was, is about to have run its course. Things could get interesting…
08/10/2000 'Elasticity' and A Cycle of Perpetual Boom and Busts *
While the bulls maintained general control this week, their grip looked quite tenuous. For the week, the Dow gained 260 points, or almost two and one-half percent, while the S&P500 added about 1%. The economically sensitive issues outperformed, with the Morgan Stanley Cyclical index jumping better than 4%. The Utilities added 2%, and the Transports increased 1%. The Morgan Stanley Consumer index and the small cap Russell 2000 gained about 1%. The technology stocks were quite volatile, with the NASDAQ100 and Morgan Stanley High Tech indices adding 1%. The Semiconductors rallied 4%, while the NASDAQ Telecommunications index dropped 3%, and the Street.com Internet index gave up about 1%. The Biotechs continue to hold their own, as the AMEX Biotech index added 1%. The wild rally throughout the financial sector continued, with the AMEX Securities Broker/Dealer index adding 2% and the S&P Bank index increasing 1%. The Broker/Dealer index has now surged 54% from the May 26th trading lows.
Interestingly, there was a whiff of inflation in the air, as the gold stocks gained almost 5% for the week, with the metal adding almost $2. It was another big week for the energy sector. On the back of strong gains in crude oil, natural gas, and heating oil, the Goldman Sachs Commodity index increased 2%. As the week came to a conclusion, there were also indications that the recent credit market rally could be faltering. Clearly, there are fundamental issues in the economic and inflation backdrop that argue that current low interest rates are not justified. Ominously, today 2-year Treasury yields jumped 6 basis points. For the week, 2-year yields rose 7 basis points, while 5-year to 30-Treasury yields had more moderate increases. Interestingly, mortgage-backs and agency securities continue to perform well, with mortgage yields dropping another 4 basis points this week to the lowest level since December.
“Sooner or later, the crisis must inevitably break out as the result of a change in the conduct of the banks. The later the crack-up comes, the longer the period in which the calculation of the entrepreneurs is misguided by the issue of additional fiduciary media. The greater this additional quantity of fiduciary money, the more factors of production have been firmly committed in the form of investments which appeared profitable only because of the artificially reduced interest rate and which prove to be unprofitable now that the interest rate has again been raised. Great losses are sustained as a result of misdirected capital investments. Many new structures remain unfinished. Others, already completed, close down operations. Still others are carried on because, after writing off losses, which represent a waste of capital, operations of the existing structures pays at least something.” Ludwig von Mises, von Mises on the Manipulation of Money and Credit.
We see two critical aspects to the current cycle that go completely unrecognized. First, our system is held captive to perpetual credit-induced booms and inevitable busts of growing proportions. Second, we are in the grips of credit bubble dynamics, with traditional business cycle factors and Federal Reserve monetary restraint largely irrelevant. Few appreciate the relevance of these factors. Clearly, the bullish consensus misperceives and incorrectly analyzes the current environment, as they have little understanding of the origins, nor the underlying factors, of the current boom. They do not appreciate that the seeds for the present bubble were in fact sown with last decade’s financial boom turned bust.
There were considerable analyses during the early 1990s regarding the enormous losses due to reckless lending and fraud throughout the S&L industry, and including many banks. One economist made a seemingly compelling case that S&L losses were simply destroyed money, similar to as if $160 billion of currency had simply been “flushed down the toilet.” And, supposedly, since the “capital” no longer existed, it was not only reasonable but it made perfect sense for the Fed to simply replace this “destroyed money.” At the time, I was dumbfounded that such analysis was given favorable attention, when it should have been recognized as nonsense and harshly dismissed. Little did I know at the time that it would prove a harbinger of much greater economic fallacies. There is clearly a strong perception that the Fed will be there when it is called upon to again “create money” come the next downturn.
Last time around, the government was finally forced into action during the early 1990’s after lending losses were allowed to mount for years. With an ever-growing mountain of bad loans creating widespread insolvencies, the government was on the hook to make insured deposits whole, while also acting to ensure the stability of a faltering U.S. financial system. Basically, the creation of additional government liabilities (deficits) was necessary to replace depositors’ monies that were either lost on bad loans or just pilfered away. Generally, the process was rather simple as “deposits” from failed lenders were simply transferred to other institutions (often ailing), and the “purchasing” bank was issued “freshly printed” government securities. Although this process (“monetization”) added considerably to the federal deficit, it had little detrimental effect on the financial markets. In fact, the heavy issuance of government debt in a disinflationary environment with the Fed reducing interest rates, created additional financial wealth like magic. The situation took a decided turn for the worst, however, when California began sinking into a deep funk in late 1991. If the real estate market were allowed to crash in the golden state, the losses to the California banks and to the U.S. financial system would have been catastrophic. No longer would a bailout of individual institutions do the trick; a system-wide monetization was required. More on this later
The critical issue with respect to the massive losses suffered by the S&L was not that “money” was destroyed, but, instead, that capital was squandered. As a matter of fact, money was anything but destroyed. During the 1980’s lending boom, money was actually “multiplied” aggressively, particularly by the savings and loans, as savers placed money into high-yielding S&L deposits. Back then these funds were made immediately available to eager S&L borrowers for spending on a myriad of projects, quickly disseminating “money” throughout the economy. Depositor funds enriched many a developer, S&L executive, seller of property, real estate agent, investment banker, supplier, and, all too often, swindlers. But clearly, the “money” the S&Ls borrowed from depositors and other creditors remained in the system. It just changed hands as it was “multiplied.” Interestingly, and an pertinent reminder today, the fact that depositor money was pilfered and directed to uneconomic projects would be of little issue to depositors, the financial system, or the economy during the boom.
And while the day of reckoning was postponed for years, capital was often plundered or basically destroyed the day it was lent. All the same, depositors slept well at night, with little regard for the type of venture their money was financing. And while regulators and many in Washington recognized a festering problem early, it, of course, proved expedient to do nothing for almost a decade as losses mushroomed. In fact, accounting profits posted by the S&L industry masked truly massive economic losses that grew exponentially throughout the 1980s. As they inevitably do, such accounting profits reverted abruptly to big losses with enormous write-downs and insolvencies. Finally, the debacle became simply too big to ignore. Sure, deposits held their value despite the impairment of the loans backing the deposits, while insurance eliminated the risk of bank runs. But beneath the surface of the financial system, there was no way around the fact that actual capital had been squandered, leaving financial sector assets woefully insufficient to make good on depositor. The market had failed, and the “making good” was left to the government and Federal Reserve.
If one were to pinpoint a specific point of origin for today’s credit bubble, it would be this exercise of “making good” - the S&L/bank bailout and Greenspan’s orchestration of a massive monetization. The singular key was certainly the Fed’s unprecedented manipulation in short-term interest rates. With the financial system in tatters after reckless lending and other excess from the late 1980’s, as well as ballooning government deficits, the only viable option became a covert bailout - providing an environment where financial institutions could “earn” (more accurately – let’s call it “managed speculation”) exceptional profits to replenish lost capital. The solution was a steep yield curve where banks could borrow at the Fed’s artificially low interest rates and hold higher-yielding government and other debt securities, and pocket the enormous spreads. With 10-year Treasuries yields above 8% for the first half of 1991, it was as close as it gets to free money. Between December 1990 and October 1991, short-term rates were reduced from 7% to 5%. As the enormity of the crisis came to be recognized – particularly with California real estate turning to quicksand – an understandably panicked Greenspan moved aggressively over the next nine months by reducing rates to 3%.
This incredible Federal Reserve largesse did not go unnoticed by the leveraged speculating community. Indeed, this monetization provided enormous profits to the speculators and was greatly responsible for the proliferation of hedge funds (a most critical credit bubble phenomenon!) during the early 1990s. With hedge fund assets expanding rapidly and the parallel security issuance bonanza (for the speculators to leverage, there must be securities!), the seeds were sown for Wall Street’s dominance of the U.S. financial sector and economy. At the same time, the economy was faced with the stubborn “head winds” of an impaired banking system. Significant credit growth was needed to fuel the economic growth necessary to heal the banking sector. As such, Greenspan was more than happy to accommodate aggressive lending by the Wall Street inspired non-bank financial companies. Minimal short-term interest rates and an extraordinarily steep yield curves were also a godsend for the now aggressive GSEs. With Wall Street’s enthusiastic blessing, these institutions began what would be a protracted period of extreme credit creation.
It was during this period that the Federal Reserve basically relinquished the monetary reins to Wall Street investment bankers and derivative desks, the leveraged speculating community generally, the GSEs, captive finance companies, sub-prime lenders, credit cards providers, and other finance companies. Of most profound importance, credit bubble dynamics took over. No longer would traditional business cycle dynamics dictate economic performance, or would natural forces work to temper excess. But, instead, the economy would be at the whim of ballooning leverage within a financial sector that strived only to grow more dominant while perpetuating the boom. And, the greater the leverage was allowed to grow, the more powerful the financial sector, and the more problematic it became to rein in excess. No longer would market interest-rates be determined by the interplay between the supply of savings and borrowing demands. Instead, interest rates would be determined by Federal Reserve manipulations and the degree of credit creation by the overzealous financial sector. Moreover, no longer would the Federal Reserve have the option of raising rates aggressively to temper demand, punish excessive speculation, or nip economic distortions and imbalances in the bud. After all, the risk of a serious accident within the financial system was too great. The Fed was then, and remains today, held hostage to the leveraged financial sector.
With this in mind, I would like to expand on a quote from Gottfried Haberler’s excellent book, Prosperity and Depression:
“The supply of investible funds is sometimes very elastic, so that a higher demand can be satisfied at slightly higher interest rates. At other times it is inelastic, so that a rise in demand is calculated to lead to a rise in interest rates rather than to evoke a greater supply.”
Although brief, this brilliant insight comes about as close as anything we have read in helping to explain the destabilizing forces behind what has come to be dangerously misinterpreted as a “New Economy.” Here, again, it is critical to focus on the powerful role assumed by the leveraged players. With the creation of additional financial sector liabilities (leveraging) determining the demand for securities (the degree of financial system liquidity), the “supply of investible funds” became extraordinarily “elastic.” Actually, we would argue that the degree of “elasticity” during this cycle has been unprecedented, and that this peculiarity is most responsible for the extreme degree and protracted nature of the current U.S. boom. As long as the financial environment was maintained conducive for leveraged positions, virtually unlimited demand for borrowings could be accommodated with little, if any, impact on interest rates. This has created unlimited mortgage credit to fuel a historic real estate bubble; unlimited funds for consumer credit card purchases, auto loans, home equity, and other borrowings; unlimited funds for margin debt and derivative leverage in the stock market; unlimited funds for corporate stock repurchases and M&A activity; unlimited funds for endless movie cinemas, casinos, hotels, office buildings, and sports venues; and unlimited funds for unprecedented expenditures throughout the technology area, particularly for funding the massive Internet/telecommunications “arms race.” In short, out of control credit excess to fuel an unsound boom perceived as a wondrous “New Paradigm.”
The role played by the unfathomable growth in both interest derivatives and credit insurance can also not be overstated. On the one hand, interest rate, and credit derivatives have provided the banks, GSEs, other leveraged players, and the marketplace generally, with what is essentially the guise of “insurance” necessary to justify clearly reckless lending, speculation, and leveraging. On the other hand, derivatives gave the speculators powerful instruments for leveraging. Meanwhile, the proliferation of mortgage-backs, asset-backs, junk bonds, structured notes, and other sophisticated securities was invaluable fodder for the leveraged players. On the financing side, money market funds, “repos,” asset-backed commercial paper, funding corps, and other sophisticated vehicles subverted the traditional inhibitors of credit, bank capital and reserve requirements. With the Fed’s apparent blessing, Wall Street created the mechanisms of financial alchemy - transforming risky loans into money and highly rated securities – forever…
So it has been a confluence of factors creating this historic credit bubble: a growing supply of high-yielding securities; derivative “insurance”; virtually unfettered credit creation capabilities (infinite multiplier effect!); and the Fed pegging short-term interest-rates. Just as important, Greenspan’s repeated assurances to Wall Street that there would be no surprises – that it was safe to speculate and leverage, and that he stood ready to inject liquidity at an instant and reduce rates with the approach of any storm clouds. A dangerous environment was created that was exceedingly accommodative to the leveraged financial sector. And as long as the environment remained relatively stable, the hyper-aggressive financial sector was very willing and able to create an endless supply of “investible funds” to meet virtually unlimited borrowing demands - with little impact on interest rates, nor other natural “checks and balances.” This, critically, is the anatomy of the greatest credit bubble in history.
While appearing almost an economic miracle – the stuff of “New Eras” - these dynamics actually create a highly unstable system. Any development that impairs the credit market environment holds the potential to “pierce the bubble” of enormous financial sector leverage and initiate collapse. This was certainly the case when the Fed moved to reduce the extreme accommodation in 1994, and it has remained the case through repeated periods of financial stress whereby the Fed was forced to cater (reliquefy) again and again to the leveraged speculating community. 1998 was certainly the greatest example of this, but we would argue that more subtle financial crises during last autumn and early this spring are consistent with an environment requiring permanent accommodation.
It is certainly our view that credit bubble dynamics today command both the financial markets and the economy. The credit market rallies not because of reduced demands for borrowings from the real economy, but because of the expectation that the Fed will maintain an environment conducive to additional leveraging. A financial sector built on speculation is hypersensitive to greater levels of speculating! Further, trillions of interest rate derivatives add to interest rate and credit market distortions as well as volatility, especially as perceptions change as to prospective Federal Reserve policy. Again, this has little to do with borrowing demands or the economy, and has nothing to do with savings. Instead a hopelessly dysfunctional system provides only more credit and lower interest rates, throwing additional gas on a fire of overconsumption, real estate inflation, and stock market speculation. In 1997 and 1998, the Fed was forced to accommodate great domestic credit and speculative excess as bubbles collapsed abroad. This year, it is the collapse of the Internet bubble and danger of a general technology collapse that ensures the Fed will be kept at bay. Yet, with each collapsing bubble the Fed only accommodates greater credit excess that fuels the next more dangerous boom and bust cycle. Certainly, the stock market has an intense propensity toward speculative excess; if not in tech stocks, then it will be financials or another sector. But, there will be blatant speculation – you can count on it.
Today, we also continue to see all the ingredients for a final wild crescendo in what is already a historic, as well as reckless, consumer and mortgage credit boom. We actually can’t believe the Fed does not even utter a tepid protest. Wall Street is geared up for this boom, the economic backdrop is quite supportive, and the Fed is apparently willing to accommodate. In so many respects, we are witnessing the destruction of capital similar but on an immensely grander scale than the S&L fiasco. Today, instead of S&Ls directing deposits to uneconomic ventures, the entire capital markets infrastructure is perpetuating truly massive credit excess and misallocation of resources. And while the government was eventually successful in “monetizing” away S&L and bank losses, the inevitable capital market crisis will be a much much different animal – one the Fed will be unprepared to handle. In particular, hundreds of billions (trillions?) of dollars of capital having been squandered, but this fact has not yet been recognized by the holders of technology securities and tech-related debt. How this plays out will be most interesting to follow. Ironically, the great 1990’s monetization and the recurring Fed-orchestrated liquefications over the past decade have created the dangerous misperception that lending booms and misallocation of resources are virtually inconsequential and easily rectified by the Federal Reserve. This is certain to prove a devastating misconception. The bulls and the media can talk all they want about a soft land, but such is certainly not the nature of credit bubbles.
We will conclude with a quote from a recent article titled “GE’s Hidden Flaw” by John Plender of the Financial Times. We think it is important on two counts. One, it is certainly our view that GE, more than any company, epitomizes the U.S. credit bubble. Second, such an article would not have been written in the past. Indeed, it appears many are beginning to dig a bit deeper - taking a more critical examination of the so-called “New Economy.” What they are finding, more than anything else, is massive leverage. It is certainly our view that GE’s balance sheet is a microcosm of a highly overleveraged and vulnerable U.S. financial sector.
“Central bankers traditionally argue that finance is importantly different from other business because of its systemic implications. At GE, this boils down to the statistic that $129 billion of GE Capital’s $200bn borrowings are short term, consisting partly of commercial paper unsupported by bank lines. This could make the group vulnerable to funding shocks. Since it is the biggest non-bank financial group in the US, that could in turn pose a systemic threat. At the end of last year, its balance sheet contained $330bn of tangible assets. Of this total, $168bn consisted of loans and receivables, including investment financing in such industries as aircraft, rail and automobiles. A further $80bn consisted of investment in corporate, government and mortgage-backed debt, and equity holdings. It would take only a 3 per cent fall in the value of tangible assets, or a 5.9% fall in the value of receivables, to wipe out its tangible capital base of $9.9bn.” Financial Times July 31, 2000
08/03/2000 The Emperor Has No Clothes!!! *
It was, unfortunately, just another “typical” week for an acutely dysfunctional stock market. During the past two sessions, a veritable buyers panic saw the S&P bank index and the AMEX Security Broker/Dealer index surge 8% and 5%. For the week, these indices increased 10% and 9%. Since lows established on May 26th, the AMEX Security Broker/Dealer index has risen 50%. From March trading lows, the S&P Bank index has gained 30%. The AMEX Biotech index surged 10% this week, increasing year-to-date gains to 70%. Elsewhere this week, the Dow added better than 2%, and the S&P500 increased 3%. The Transports advanced 4%, and the Utilities soared 6%. Both the Morgan Stanley Cyclical and Morgan Stanley Consumer indices gained 2%, while the small cap Russell 2000 increased 3%. The technology sector was generally strong, with a 4% advance for the NASDASQ100 and 3% increase for the Morgan Stanley High Tech index. The Street.com Internet index gained 5%, and the NASDAQ Telecommunications index added 3%. The previous high-flying Semiconductors were the major exception, dropping 4%, and reducing year-to-date gains to 31%. The gold stocks dropped 2% this week. The credit market continues to demonstrate extraordinary liquidity. Treasury yields between 2 and 10-year maturities declined 13 basis points. Ten-year Treasury yields ended the week at 5.9%, the lowest since mid-April. With spreads narrowing, mortgage and agency securities outperformed. Yields on both the Agency futures contract and Fannie Mae benchmark mortgage-backs dropped 15 basis points. Mortgage-back yields ended the session at 7.75, 61 basis points below the highs established back in mid-May. On the inflation front, crude jumped 6% as oil prices quickly ran right back to $30 a barrel. Natural gas prices surged 12%. While broad money supply and bank credit growth were more tempered (M3 expanded $3 billion and bank credit $7 billion), we see that commercial paper outstanding increased $24 billion during the past week. During the last four weeks, total commercial paper has expanded $57 billion, or at an annualized rate of 39%. Year-to-date, total commercial paper has increased $161 billion (more than total M2 growth of about $130 billion!), or at a rate of 20%. We will begin with recent quotes from top Federal Reserve officials. “I think the economy can grow at 4% a year or maybe even a little faster. Why do I think that? Because it is has been doing it for 4 ½ years - that is why I think that. If you go to a rodeo and you are riding a bull, I think you only have to stay on for 8 seconds, then the buzzer sounds and somebody helps you get them out and it is all right. Unfortunately, we are in an experiment here - we have been on for 4 ½ years and people still have not been acknowledging what is right before their eyes. The buzzer is not going to go off until something bad happens. That is the problem. The bell will sound when the experiment fails, as long as the experiment is working it won’t sound. So there is no way that I can ultimately win this debate that we are engaged in. Just with my own eyes I can say that (it) is capable of growing at 4% without inflation picking up. That is still a minority view - not as much as a minority view as it was a year or two ago. Most of the people in the technology areas agree with me; I think most of the businessmen agree with me, and there are 2 or 3 maverick economists out there that agree with me--- Larry Kudlow, Brian Westbury, Ed Yardeni---people like that. But the people who don’t agree with me at all are the older establishment economists from elite universities that don’t have good football teams. They still evoke the view that it may be working in practice, but will it work in theory.” Robert McTeer, President of the Federal Reserve Bank of Dallas, July 25, 2000 “What we know about household debt is, one, that, even though the ratio of debt to income has been rising, that the debt-service burdens, meaning the actual monthly payments as a percent of disposable income, have been rising less, although they nonetheless, have been rising in the last couple of years or so, as I recall. There is very little evidence to suggest that rising debt burdens on the part of households per se, are a trigger for an economic recession. Most people have a generally good idea of how much debt they can carry, and they don’t go beyond it. The problem is not that rising debt will create a problem for the economy but that, should the economy turn down, then the high debt burdens could create some significant problems for a number of America’s households. That’s been the typical pattern over the years. Consumer debt has been a remarkably beneficent force in moving people into the middle class in this country over the last two or three generations. And it continues to be a very potent and very desirable financial institution. But you (Representative Melvin Watt) are quite correct in raising the issue that there are potential concerns. The concerns, however, are when a recession occurs, not that consumer debt can create a recession; at least the evidence certainly does not suggest that that’s a problem.” Alan Greenspan, Hearing of the House Banking and Financial Services Committee, July 25, 2000 “So there is good reason to believe that the relationship between money and GDP, or price level, should be more variable and therefore money growth is a less important guide to current economic policy than it used to be. That said, anyone who totally ignores money growth does so at his peril because the fundamental responsibility of the central bank is to control the amount of money that is created. And we have ample reason in history to know that if we let money creation get out of hand – on the upside or the downside – that there is going to be big costs to pay – big cost that the economy will have to bear. And I think what we have seen in recent years is that money growth numbers have never gotten grossly out of line. If you look at the numbers over the last five to eight years there’s been periods when it looks to be on the low side, periods that looked to be a little bit on the high side. But it’s not been grossly off on either direction. I use, look at those numbers but I use it in conjunction with other information we’re receiving at the same time.” William Poole, President of the Federal Reserve Bank of St. Louis, August 2, 2000 “I am quite ready to insist that our situation is far far more stable. We are much less subject to this being a critical period than in many times in the past – many times in the past. We are not dealing with the upset that we were about the time of the Asian crisis. Things were moving pretty fast back then, and we were watching the data really carefully. There were a lot of peculiar things going on. And we don’t have that in the economy today. We’ve been through a pretty big increase in energy prices. But that all seems to be sort of shaking out and settling down now. So I would say to you that the current environment is actually more benign, more stable than the run of the mill environment. Certainly, a lot more stable than it was in the 1970’s.” William Poole, President of the Federal Reserve Bank of St. Louis, August 2, 2000 While the bulls and the media continue to trumpet the brilliance and unparalleled competence of the Alan Greenspan Fed, we strongly question the validity of this perception. Unfortunately, it is becoming clear that many top Federal Reserve officials have little if any understanding of the underlying factors, nor appreciation of the great risks posed by the continuation of this momentous bubble. In fact, and I do not say this without considerable contemplation, many of our top Federal Reserve officials are flirting with ineptness and bordering on negligence. How can the President of the St. Louis Fed, a devoted monetarist, ignore the fact that broad money supply has increased by almost $1.1 trillion, or 19% over just the past 24 months? “Looked to be a little bit on the high side” Mr. Poole? Come on… How can William Poole talk about stability when the US and global financial system nearly buckled less than two years ago? Is an unprecedented $400 billion current account deficit indicative of a stable future for the U.S. financial and economic system? Does the unprecedented leverage and derivative holdings within our financial sector create a stable situation for the financial system and economy? Is continued unprecedented corporate and consumer borrowing symptomatic of inherent health and stability? How can anyone look at the U.S. economy, with the historic bubbles throughout the enormous technology sector and California real estate market - mentioning only the most blatantly obvious - and see anything but precarious instability? Are historic speculative bubbles and the most volatile stock market in modern U.S. history consistent with a stable environment? There is absolutely no question that our acutely unstable system is being allowed to only deteriorate into a more vulnerable position each week that incredible excess continues. Any discussion from Federal Reserve Bank Presidents professing current stability is absolutely ridiculous. We suggest that Mr. Poole and other Federal Reserve officials read the history of the South Sea Bubble, the Mississippi Bubble, and the “roaring” 1920’s bubble. To Mr. McTeer, we would like to remind him that his region has a dramatic and expensive history of booms turned ugly bust, with enormous cost to the U.S. taxpayer. In fact, looking at FDIC data, we see that 849 banks failed in Texas between 1980 and 1998. Further, several of the most costly bank failures in U.S. history have occurred within the greater Dallas/Ft. Worth area, and basically every major Texas bank failed or was severely impaired after the most recent boom/bust cycle. So, we would argue his role and responsibility is that of a serious and cautious central banker, warning stridently against overlending, overbuilding and other excess within his jurisdiction. It is most inappropriate for McTeer to ignore obvious excess in the guise of a “New Paradigm.” Importantly, the soundness of the U.S. financial system and economy, as well as our nation’s future prosperity are definitely not to be put at jeopardy by any “experiments” by a group of aggressive central bankers. This is not a game, and there is absolutely no analogy to be made to an 8 second rodeo event. When the “bell” inevitably sounds, it will be much too late. Looking at the big picture, how can one see anything but instability – a period of perpetual and ever larger booms and busts - after the US experienced the 1987 stock market crash, the collapse of the Japanese financial and economic bubble beginning in 1990, the S&L debacle and our country’s worst banking crisis since the depression during the early 1990s, a near financial debacle with the Fed’s tightening cycle in 1994, the Orange County Bankruptcy and Mexican collapse in 1995, the SE Asian melt-down that began during 1997, the Russian/LTCM/credit system meltdown in 1998, and general derivative/credit market tumult last fall and again during this year’s first quarter? The way we see it, with the leveraged speculating community completely dominating the credit market, it is now clear that the Federal Reserve caters to and basically allows Wall Street to dictate the terms of monetary policy. At any sign of trouble, the Greenspan Fed quickly pampers the markets, in history’s greatest episode of moral hazard. In response, the financial sector aggressively takes on additional leverage to purchase securities, creating the money and credit that liquefies the financial markets and leads to lower interest rates. This result, then, is interpreted as evidence of the “proper” monetary policy, and the Fed relaxes until the next storm cloud arrives. With “New Era” Greenspan making it clear that he accommodate the markets and will specifically not pierce the bubble – that the Fed is basically frozen and short-term rates pegged at current levels while injecting “liquidity” when necessary - one must now accept the harsh reality that Wall Street and the leveraged speculating community are now firmly “running the show.” (This is supported by the fact the AMEX security broker/dealer index sports a 34% y-t-d gain). And, while Mr. Poole may state that it is the “fundamental responsibility of the central bank is to control the amount of money that is created,” the Fed has and continues to shirk this critical responsibility, much to the delight of King Wall Street. As such, it is now the investment banks, the powerful money center institutions, and the equally powerful GSEs that largely determine the amount of lending and security issuance, hence money and credit creation. It is Wall Street that partners with the GSEs to create virtually endless amounts of mortgage finance that fuels higher home prices and increased consumer home equity (additional collateral to borrow against!). It’s Wall Street that partners with the aggressive consumer lenders, particularly the non-bank finance companies, whereby creating vast quantities of securities that provides unlimited funding for further consumer lending and consumption. It is Wall Street that creates sophisticated structures and vehicles that “transform” the most risky of loans into asset-backs, mortgage-backs and other marketable securities. Wall Street is the derivatives market that holds immense influence over present financial markets. It is, as well, Wall Street that partners with the likes of GE Capital Services and other business sector finance companies that create the fuel for a runaway “investment” boom. It is Wall Street that is behind the enormous expansion of commercial paper, repos, and other money market instruments. It is Wall Street and the leveraged speculators that determine the degree of leverage in the financial sector, hence the demand for securities and credit market liquidity generally. It is Wall Street that determines which companies and industries have access to funding – the allocation of our nation’s resources. And it is Wall Street, having forged managerial control over vast pools of assets, that lavishes the great reward of higher stock prices to those company managements (possessing huge stock option packages, of course) that “toe the line” in perpetuating the boom. Importantly, it is Wall Street and not the Fed that today holds the helm of the “money spigot,” hence determining the rate of economic growth. Of course, Wall Street pursues only one goal: the perpetuation of the financial and economic boom. Increasingly, and most unfortunately, this is reminiscent of the infamous S&L debacle from the late 1980’s and early 1990’s. While the S&L problems were apparent in the early 1980’s, no one had the courage to step in to stop the reckless lending boom before it got completely out of hand - no one was willing to put a “stop-loss” on the mushrooming fiasco, clean house of the reckless, incompetent, irresponsible, and fraudulent before it became a systemic risk and enormous taxpayer bailout. Not the politicians, certainly not Wall Street, not the Fed or the bank regulators. Instead, a dysfunctional system was allowed to grow tremendously and disastrously. Then, there were hundreds of individual S&Ls and banks whose ill-advised lending were fueling unhealthy regional booms. Although there were many indications of unsound lending and improprieties, and increasingly poor asset quality at many institutions, the day of reckoning was delayed while a dysfunctional boom expanded exponentially. Today, there is unequivocal evidence that the current system is dysfunctional – that truly enormous amounts of unsound loans are being extended and very poor quality securities issued. Evidence abounds of an ominous deterioration in the quality of assets throughout the financial sector. This boom, unlike the S&L debacle, is endemic to the entire financial sector and U.S. economy. And, like before, no one is willing to stop the party, as a momentous and dysfunctional boom grows exponentially. While ignored by the bullish contingent, we will highlight recent data on corporate debt quality that is quite disconcerting. From a recent report from Moody’s Investors Service - US Corporate Credit Quality Continues to Slide - “The decline in the credit quality of US corporations, particularly of speculative grade industrial companies, continued its two and one-half year decline and is not likely to improve in the immediate future.” “Moody’s downgrades of credit rating for US corporate borrowers outpaced upgrades by a margin of 2 to 1 in the first half of 2000. The rating agency cited equity buybacks and debt-financed M&A for difficulty in the investment-grade sector while difficulty accessing capital and softer earnings weakened credit worth at the lower end of the rating ladder.” Quoting John Puchalla, senior economist at Moody’s: “Greater use of debt in capital structures is negatively affecting US corporate credit worth compared to the very strong levels of the mid-1990s, and this has helped widen credit risk premiums on corporate bonds…Not since the 1991 recession year have upgrades been so few relative to downgrades among high-yield US corporate issuers.” “By sector, Moody’s reports that downgrades outpaced upgrades by 2 to 1 among industrials, with 159 downgrades worth $269 billion, and 71 upgrades valued at $115 billion. ‘In addition to equity buybacks and debt-based M&A, the industrial downgrades reflect increasing tolerance of corporate managers for greater risk as they try to satisfy shareholder demands. The result is the highest use of debt in capital structures in seven years.’ The debt-to-net worth ratio of non-financial companies stands at 81%…compared to a low of 70% in 1997.” Monday, the Wall Street Journal covered the Moody’s report and quoted their outstanding chief economist John Lonski: “There has been an erosion of corporate credit worth that investors ought to pay attention to.” Taking the other side of the argument, the Journal quoted Robert DiClemente, chief U.S. economist at Citigroup’s Salomon Smith Barney: “You’re always worried about debt, but so much of this debt expansion is being poured into investments in capital expansion that is driving productivity gains, so it may be more likely to produce profits, rather than financial stress.” Not surprisingly, the first big wave of defaults is coming from the junk sector. According to the Los Angeles Times, Moody’s “projects that (junk bond) defaults in the 12 months ending 2001 will total more than 8% of bonds outstanding, up from 5.4% so far this year.” So far this year, 65 issues have defaulted, compared to a record 108 defaults last year. The previous record was 88 defaults in 1990. “Many recent defaults stem from a period of easy money in late 1997 and early 1998, when corporate earnings were strong, foreign money was pouring into U.S. debt markets, and investors generally let down their guard,” according to analyst John Lonski at Moody’s. In the first quarter of 1998 alone, $30 billion in low-rated bonds were issued. Many junk deals that shouldn’t have been done at all are now coming undone, Lonski said. ‘It’s payback time,’ he said.” We agree completely with Mr. Lonski – not only will it be payback time going forward, but it should also be recognized that the most problematic loans are made during “a period of easy money.” We watched the post 1987 crash “easy money” period fuel real estate bubbles that culminated with the S&L and banking crisis of the early 1980s. This led to a historic “easy money” period in the early 1990s that fostered unprecedented financial system leverage and the severe credit market disruption in 1994. This crisis culminated with the Orange County bankruptcy and Mexican collapse, with the subsequent Mexican bailout. The next post-crisis period of easy money – “reliquefication” - fueled the terminal stage of credit and speculative excess throughout SE Asia, Russia, and emerging markets generally. The Fed was forced to respond to this series of inevitable busts by lowering interest rates and accommodating the greatest period of “easy money” in history – a virtual unending “reliquefication.” Unprecedented money and credit growth for the past two years has fueled an economic boom and a massive technology/Internet/Telecommunications bubble. Moreover, money and credit excess powered a great asset bubble, particularly in financial assets and home prices. In this regard, it is now our view that the great technology speculative bubble is in the process of coming undone. It is also our “hunch” that this problematic situation is, as the same time, quietly responsible for another period of heightened credit system liquidity – “reliquefication” or “easy money.” Sure, a return of ultra-easy credit conditions may work to help mitigate the destabilizing forces and allow a more gradual unwind of problematic speculative positions and imbalances throughout the technology sector. However, this is an unmitigated disaster as continued egregious money and credit excess only fuels unsound booms elsewhere. For one, we suggest looking specifically to the consumer and mortgage-lending sector. In fact, it almost appears that “the die is cast” on a final wild speculative boom in consumer and mortgage finance. Clearly apparent in second quarter data, finance company managements are more than willing to lend with reckless abandon to meet Wall Street’s aggressive earnings expectations. With liquidity and speculative fervor returning to the credit market, there appears, for now anyway, considerable demand for high-yielding asset-backed securities. And, as evidenced by the phenomenal performance of these stocks, Wall Street, as always, is right there to cheer and handsomely reward the leading instigators of credit and speculative excess. With the Fed asleep at the wheel, our analysis finds us in the midst of an historic consumer debt bubble, with credit excess-induced housing inflation providing rising collateral values that fuels additional borrowings from credit cards, auto loans and leases, and margin debt. This enormous credit growth is increasingly making its way into income growth, which adds further fuel to rising home prices and spending generally in a self-reinforcing process. And, actually, as long as enormous credit growth fuels higher home prices and income, this Ponzi scheme plays well. Rising home prices rise keep mortgage defaults low, over-exposed credit card borrowers happy to borrow against home equity to stay current on credit card balances, and the consumer borrowing and spending binge runs on – the monetization of real estate inflation into trade deficits, rising wages, and higher prices generally. Mr. Greenspan may see consumer credit as “very desirable,” but to make such comments in the present environment is astounding and, quite simply, irresponsible. Interestingly, the debate continues as to whether this, the greatest of bubbles, will end in ugly deflation or a great inflation. Well, in the longer run, we believe this historic credit and asset bubble will likely end in a devastating deflation, at least in financial assets and home prices. However, our analysis continues to lead us to expect in the short-run a continuation of overheated economic conditions and even greater inflationary manifestations. We have for some time expected that the Federal Reserve would come (belatedly) to recognize that the US was in the midst of a dangerous credit bubble with endemic asset inflation, dangerous imbalances and distortions, and heightened inflation risks generally. We expected that the Fed would respond by aggressively raising short-term interest rates. This would then, in our thinking, precipitate dislocation and forced deleveraging in the acutely over leveraged credit system and stock market. We must admit that we our confidence in the Federal Reserve was in error. Never in our wildest dreams did we anticipate that “New Era” thinking would gain such a strong foothold with adherents at the very top of the Federal Reserve System. Moreover, it is beyond us that such thinking has taken precedence over historic money and credit excess, endemic real estate inflation, outrageous financial speculation, and unheard of trade deficits. The facts speak for themselves. The Greenspan Fed is a disgrace, and we are compelled to shout “THE EMPEROR HAS NO CLOTHES!!!” |
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