The Credit Bubble Bulletin
A Guiding Belief Resting on a Firm Foundation?
or Current Mythology Perched Precariously on the Edge of a Razor!!!
by Edmund M. McCarthy
Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company
As we start a New Year (and the true beginning of the new millennium!) The question above seems extremely important but not yet susceptible to a clear answer. The question relates to the near universal belief that the tried, trusted and true hypothesis that interest rate cuts, timely and sufficient will: turn a flagging economy upward, renew consumer optimism and spending, stimulate flagging capital investment, make financial institutions hugely profitable and restart and bring to former intensity the now twenty year old bull market in equities. This paragraph clearly fails the Occam's razor test and bears some resemblance to the "Twelve days of Christmas" but does encompass what we discern to be the prevailing opinion. "The Maestro" as the current book about him described the Fed Chairman, will ride to the rescue with at least 50 basis points this quarter and all this unpleasantness will disappear. There seems to be a paucity of adherents to the analysis before conclusion theorem raising the either/or question above. Even Rukeyser's elves in both indices have moved from 8-2 to 9-1 bullish. An aside but it was fascinating that a reason given by an elf for moving to bullish was "the universal pessimism". Certainly the debt markets and the fund managers are demonstrating incredible (possibly incredulous) faith in this theorem. Prior to year end the short end of the treasury curve moved precipitously higher in price and lower in yield, threatening to pierce the 5% level with the gap to Fed Funds widening to a seldom seen spread. Agencies narrowed what had once been formidable gaps and the scent of rate cuts sent bank and thrift equities (particularly those which had not yet warned of credit problems) to highs for the year or even longer periods. The firm foundation on which this guiding belief that interest rate cuts will work these wonders is based on the reality that, certainly since 1987, when the then newly appointed Fed Chairman first worked his magic; that has been exactly the result! Therefore, ipso facto, it will happen again! And it well may. At least for a while. Particularly if Easy Al and/or W (who recently has been clearly off message by disparaging the economy) not only cut rates but get out there and make it clear that they are in charge and things are just fine for the economy and markets. Never should the power of the ingrained "buy the dip" mentality be belied. CNBC will trumpet that "a bottom has been put in!" and, who knows, even Rukeyser's last "neutral" elves may turn bullish, providing a 10-0 consensus based on, to be sure, the overwhelming negative opinion out there. There is always a Brobdingnagian flow of funds into 401k's and the like in January and it may well follow tradition into equities in 2001. We refuse to underestimate the power of the public's guiding belief. In the Christmas weekend edition of Barron's, even Alan Ableson is forecasting a rally and touting a stock! (Maybe Rukeyser will recruit him as an elf)!
We still think, however, that the question of the firmness of the foundation is one worth asking this new year and millennium. We even ascribe a small but rapidly growing likelihood to the edge of a razor part of the question. We do so on the basis of our growing unease on the state of credit quality globally.
YES, WE REALLY DO MEAN THE STATE OF CREDIT QUALITY IS LOUSY AND BECOMING WORSE THE LENGTH AND BREADTH OF THE GLOBE EXPONENTIALLY!
Recent headlines on the perils of the California utilities, the using up of the Xerox credit lines and the problems showing up in Lucent's portfolio of borrowers are certainly to be heeded. The problem loans out there to come, however, are beyond comprehension and will render these early harbingers tiny in comparison. The globe is on course to reap the harvest of a decade long policy of refusal to mark to market expeditiously. The number, complexity and universality of the devices used to avoid this painful but necessary step in problem credit resolution are exceeded only by the imagination of those "financiers" who developed and are continuing to develop them. The end game, however, is increasingly coming into view. The global requirements for capital are excessively strained.
THERE SIMPLY IS NOT ENOUGH CAPITAL BEING GENERATED ANNUALLY ON THE GLOBE TO SUSTAIN: 1.) THE ENORMOUS POOL OF DUBIOUS ASSETS FROM THE PAST WHICH MUST BE CARRIED 2.) THE GROWTH OF THE EXTERNAL OBLIGATIONS OF THE UNITED STATES! 3.) THE MULTI-HUNDRED BILLION WIPEOUTS OCCURRING IN THE EQUITIES MARKET; PARTICULARLY IN THE INTERNET/DOT.COM ENVIRONMENT. THE LAW OF LARGE NUMBERS IS COMING INTO PLAY.
The stretch to the breaking point is occurring simultaneously with the decline in the quality of the areas of investment for this increasingly scarce commodity: capital! Whether we are viewing the outlook for earnings, i.e. the direct return on capital or the cashflow coverage for debt; the situation is clearly changing from Rosy Scenario to Debbie Doubtful.
TO THE THREE ELEMENTS ABOVE WILL BE ADDED, WE PREDICT, THE FOURTH HORSEMAN OF GLOBAL DEBT DEFAULT AND BANKRUPTCIES AND WRITEOFFS IN 2001 AND BEYOND!
Although the press and visual media would have the audience believe that 2000 has been bad in this respect and that the excess is out of the system, we see the increase in credit difficulty in 2000 as only the very tip of an extremely large iceberg which the global economy is on course to impact. Relentlessly, we will reiterate the word GLOBAL in this effort. For a decade, the IMF, the U.S. Treasury, the World Bank, a host of mini-IMF's such as the Asian and Latin American Development banks and the coterie or, I prefer, CABAL of major international financial institutions such as GE, Fannie, Freddie, Citi, JPM, Credit Suisse, Goldman, UBS, Deutsche, Barclays, CIBC etc. have temporarily hidden the financial failures which should have been resolved through the mark to market or liquidation. What this has created (other than the "Greenspan put" and universal MORAL HAZARD) is a humongous international morass of alleged assets having a market and/or intrinsic value of ZERO or minuscule fraction of the amount carried on the books. They are carried on the books at par through a plentitude of ingenious mechanisms. If the premise above on the overstraining of the global capital creation mechanism is correct, it explains the increasing array of surfacing credit disasters.
We put GE into the "cabal" above since a perfect example of this financial legerdemain showed only this week in the case of Montgomery Ward. The over 120 year old retailer, raped and pillaged to these many years by an assortment of "strategic advisors" and other financial reprobates, finally was killed off by the last perpetrator, GE. The AAA rated parent of GE Capital provides the ridiculously low cost capital for the financial sub to leverage buyout the poor firm, then thrust it into and out of bankruptcy and now exterminate it. The fees and other emoluments for GE and other members of the cabal have been enormous. At extinction, GE says that the incident will cause no harm to their future earnings projections or multiple. There is no doubt that the numbers shown for poor old Monkey Ward were poor but reality and honest mark to market would have provided an honorable funeral long ago rather than casting the corpse summarily on Potter's Field after draining the last sanguine drop and selling any saleable internal organs. Anything else like this in the GE Capital portfolio? Try and find out! The opacity of the entity makes the Taliban look forthcoming about Bin Laden.
Moving from Asia to Central and Latin America, the situation bears no more cheer. That is not to say that the cheerleaders from "bubblevision" to the U.S. Treasury are not trumpeting another triumph in "regional stabilization" through the latest $40 billion bailout in Argentina. Like cocaine users, nations can become addicts. This bailout will not be the last.
We also in 2000 had the ingenious increase in moral hazard implemented by some members of the cabal with the assistance of many fiscal authorities in Ecuador creating an "immaculate default" on their supposedly immutable Brady's. Neither this flagrant breach and harbinger of others using a similar plan nor the "dollarization" have rescued this basket case from the brink. Should El Nino resurface and the anchovies disappear along with $30 oil, just ring for the IMF fireman again.
If it were not so tragic, the less than divine comedy known as Peru would seem a perfect subject for a Dave Barry column. We will use this horrible example to introduce our rant against the so-called "War on drugs". This misbegotten reversion to the failed doctrines of the Volkstead era of Prohibition has less than the chance of success (nil) which that effort had. I say less because the amount of damage caused by this wrongheaded attempt by a capitalistic nation to exterminate the entrepreneurs enjoying 100% profit margins on a commodity trade is going to cause far more damage to the cause of capitalism than the ludicrous '20's attack on alcohol did. In the case of Peru, we are ascertaining that our glorious warriors were actually financing the opposition through failing to recognize that the Montesino's of the world are a lot smarter than they are. In the meantime, they have gutted the improving economy of this poor nation, placed it's democracy in danger again, financed arms exports to further the Colombian mess and set up an ideal next candidate to collapse it's banking system, maybe do an immaculate default and be another bellringer for more IMF.
We are using IMF as shorthand for the entire grouping of moral hazard intensifiers we listed at the outset! In any given instance, the leader/leaders can be one or more of the coterie of players.
Colombia, less than a decade ago, was one of the strongest economies in the region. The diplomatic and economic policies foisted upon them to bring them to the current state are self evident proof of the failure of the "War on drugs" initiative. To think that an intensification will improve things is so absurd as to defy analysis. Some authors are beginning to write about the possibility that the guerrilla element in Colombia, the leftist government of Venezuela, the resurgent Sandinistas and what's left of Fidel may begin to make common cause with like minded players in other countries in the region. This risk is real! In the meantime, the banking disasters in Colombia and the cost of the various military may provide another candidate for "immaculate default" in one form or another. We see an economic sinkhole here with the "War" justifying the pouring of the funds. We will leave the political analysis to those better qualified. There is some hope that Bush/Powell will use what honeymoon they are granted to the hell out. If they miss that opportunity, ego and "national prestige" will drag us further and further into this lacking in logic play, benefiting only the budgets of the committed interests to this war.
The risk in Venezuela is not so much economic as imponderable. It is one of the largest suppliers of oil product to the U.S. and is increasingly hostile. With our ally intensifying the "War" on Palestinians, the price of oil could become a major systemic aggravation of the to the "hard landing" or worse, much worse, that we see for the 2001 GLOBAL economy.
Brazil successfully pulled off a major devaluation a la Asia and has an export driven recovery going. With a quarter trillion in trade with the U.S., they have looked fairly good. Given anything like a hard landing or the like for the U.S. in '01, this will falter.
We have been bullish on Mexico for the last few years. Fox is an obvious add-on plus. The problem, not to be forgotten, is that they still have tens of billions of dollars of bad loans never dealt with in the banking system. Fox may use this scandal politically which would not help if, as our expectation goes, the export boom falters as the global capital creating machine runs low enough to cut back the ability of U.S. consumers to overspend their incomes. Mexico has been the happy beneficiary of this tendency. Don't count on every U.S. manufacturer moving all of their production to Mexico to save costs in the downturn. Recessions or (Depression; there we have said the word) are not good for this type of cost reduction. Politicians lose their free trade mentality very quickly in that type of environment.
The one plus here is that things are so bad there that the capital has been coming here at a prodigious rate, contributing mightily to satiation of our $1.5 billion a day need/appetite. The two risks are that most of what is available may already be here and that in a trade war, which we view as likely in a recession, capital controls are never far away. Who will the Latin Malaysia be? It has often been said that a two front war is folly; the IMF may have one in Asia and Latin America in '01.
The greatest contributor to the satisfaction of the U.S. necessity of bringing in some $1.5 billion a day in external funds in 2000 was Europe. We have no way of analyzing how much of the 4th quarter malaise in U.S. capital markets was the result of a reversal in the previously no-lose bet on a declining euro and better short term rates in the U.S. Looming large on the immediate horizon, though, is Easy Al's promise of interest rate cuts. There is certainly a level at which irrationally rapid rate cuts will completely reverse the equation. The euro is already up a dime. If there comes a favorable interest rate spread against the dollar, we will hazard the guess that it is not going to provide the rejuvenation of U.S. markets which 12 out of 12 (count 'em) of the esteemed investment strategists quoted in Barron's 1/1 outlook for 2001 provided. Yes, all of these multi-million dollar men and women show the Dow and S&P up for 2001. They don't have the marvelous % gains of prior years, but hey, why knock them, they get paid to be exclusively optimistic. With the bulk of them calling for 10 year yields in the high 4, low 5% range, there could be a lot of folks who find yields at home, whether home be Dusseldorf, Auckland or Ottawa, quite attractive for 2001. Any such predilection will NOT be salutary for the continued optimism of the aforementioned 12. Ah well, those who are not already, may find employment as Rukeyser elves!
For the best outlook on Europe for 2001, we refer readers to Marshall Auerback's International Perspective pieces on the Prudentbear website. Cribbing mercilessly from him, we agree that the over exuberance in telecom, tech, etc there in 2000 is going to cause a credit problem for their banking sector. Nevertheless, the social contract still in force there is an anchor to windward. They started their expansion a little later than we did. They have revved money creation a little less and, finally, they actually got their currency to either under or fairly valued! We will hazard the guess that their economic landing will be somewhat more propitious than the U.S. Among other things, they have nearly $1 trillion in U.S. investments which, if need be and if U.S. markets have the bids and the liquidity, can be repatriated to ease the difficulties. So, the best that can be hoped for is a gradual slowdown in the flow of Europe's capital to the U.S. and the worst is that the buggers in Frankfurt and Amsterdam are really smarter than we are! Expect some of their gelt to go home. Maybe be smart their way and emulate their trade.
Emblazoned across front and editorial pages incessantly is the Question! What will W do with the surplus now that he is the guy who gets to decide what to do with it. I saw an article this weekend on the fact that this number is still growing! The genius penning the missive came to the conclusion that the Budget Bureau is going to show a number so large that W can have his tax cut and exterminate the debt simultaneously. Will somebody, for the sake of reason, do a little calculation on what % of the 1999 surplus capital gains taxes provided and extrapolate the 2000 results! Then maybe we might have a real idea of what THE NUMBER really is. (We think it will be an awful lot less than even this calculation given our outlook for 2001 but that is another topic). Once upon a time, I was present at a learned discussion on future growth and the probable results. Each speaker improved upon the last. A realist shattered the atmosphere with the following: "In an Age of Discontinuity, the long term extrapolation may arrive at a destination that is no longer there!" This is how we view THE NUMBER and THE DEBATE. All of the input we have seen assumes: 1) continued economic growth not decline. 2) Readily available foreign capital to cover that "other deficit". 3) Funds devoted to debt reduction, not fiscal stimulus and, 4) There is a tooth fairy! BUT, with all of the expectations built up in the mind of the public and that mindset now showing in polls an overwhelming preference for use of THE NUMBER for debt reduction, the shock at arriving at a destination no longer there is NOT going to do the consumer confidence number a lot of good.
THE TRULY HORRIFYING THING ABOUT THIS BUBBLE IS IT'S INVISIBILITY! I AM INDEBTED TO DOUG NOLAND, PUBLISHER OF THE "CREDIT BUBBLE BULLETIN" FOR THE FOLLOWING: TOTAL CREDIT MARKET DEBT IN THE UNITED STATES INCREASED FROM $14 TRILLION IN 1991 TO OVER $27 TRILLION IN MID 2000!
The fact that it took from 1776 to 1991 to compile $14 billion is probably irrelevant. The fact that a combination of GDP for those 8 ½ years from end 1991 to mid 2000 and the relevant inflation for that period can't possibly account for this growth in debt is not! The period in question also saw the currency strengthen to its strongest point. Unlike other countries in this predicament, inflation and/or currency devaluation are not excuses. This is THE NUMBER we should be focused on, not the illusory surplus. Yet I will wager that there are few who are aware of the magnitude of this number or the nature of it's components as we end 2000.
Perusing the financial pages at year end, the preponderance of ink is devoted to the coming rate cuts and re-institution of parallel economic and equity market growth. The next most popular content is weeping and wailing for the dot.com mania's end and apologias for the editorial content on it's rise and fall. About $650 billion of money "went to money heaven" as one CNBC talking head put it in the dot.com implosion. A couple of trillion followed it recently as the supposedly invulnerable infrastructure companies in the TMT world followed the dot.coms down.
THESE ARE PITTANCES COMPARED TO THE POTENTIAL LOSSES TO COME AS THE CREDIT BUBBLE INEVITABLY FACES THE CONSEQUENCE OF EXCESS!
For at least several years, the credit bubble has been maintained, as with all prior bubbles, by throwing good money after bad and then bad money after bad.
MATHEMATICS MAKES IT ABUNDANTLY CLEAR THAT THE DETERIORATION IN PRIOR CREDIT EXTENSION WILL NOT BECOME APPARENT AS LONG AS THE RATE OR PERCENTAGE OF NEW CREDIT EXTENDED IS SUFFICIENTLY LARGE TO MORE THAN OFFSET THE FINITE AMOUNT OF OLD CREDIT GOING BAD!
Individual grantors of credit, (they used to be mostly banks) and even banking systems have known this truth from earliest times. Ponzi also was an expert at it. BUT, there used to be some constraints. There had to be a little capital under the credit; there had to be some visible reserves for the part obviously gone bad and there were usually some outsiders somewhere who looked at the whole thing and eventually one of these factors called a halt! In the 1990's, the humongous $14 trillion in growth in credit extended has largely evaded these constraints!
In the New Age of Technology, it is not surprising that the term used for this NEW AGE credit is FINANCIAL ENGINEERING. What it really amounts to is wrapping credit in credit enhancements and tying the package with derivatives for sale to buyers who look primarily at the package and not at it's contents. Computer-driven analysis based on past events derives metrics (I love that New Age word) which the rating agencies can use to pronounce pontifically (that means infallibly) on creditworthiness. Once this holy water has been sprinkled upon the package, the only effort is for the buyers to use ingenuity to outdo other buyers in finding stray basis points to enhance performance of their pension, mutual, hedge or other funds.
What I have searched in vain to find is any effort to develop data on the extent of the INCEST in this process. There is a finite universe of major players in this new game. As we have used IMF as shorthand for the "Global plunge protection team"; we will use "Securitization" as shorthand for this process and "THE SECURITIZERS" as shorthand for participation in Financial Engineering. The odd study or publication from time to time gives some insight. Moody's did on "ASSET BACKED COMMERCIAL PAPER" some time ago which was illustrative. The Securitizers usually require credit enhancers, guarantors, interest rate and sometimes currency derivative players, credit derivative players and sometimes, repackagers.
ALL OF THEM PLAY ALL OF THE ROLES SOME OF THE TIME AND SOME OF THE ROLES ALL OF THE TIME…TO USE A HACKNEYED PHRASE - THEY ARE TAKING IN EACH OTHER'S LAUNDRY! BUT! THERE IS NO WAY OF AGGREGATING WHICH PLAYER IS INVOLVED WITH WHICH OTHER PLAYER OR THE EXTENT OF THE INVOLVEMENT - IN THE OLD DAYS IT WOULD HAVE BEEN EXTREMELY, EVEN VITALLY, IMPORTANT TO KNOW THIS TO OBVIATE ONE OF THE MOST CRITICAL RISKS IN CREDIT CONCENTRATION!
This is what we meant above in stating that this time around, the credit bubble is invisible.
The debtors are sold anonymously in packages and the ancillary parts of the package are footnotes somewhere at best, also anonymous. The Securitizers have thereby avoided the old constrictions of capital, reserves and scrutiny. Excess leads to excess. Did anybody notice that some of our mutual funds had some assets the Securitizers made impeccable through the above process from the obscure Turkish Demir Bank which failed before IMF put in it's most recent rescue?
TO PARAPHRASE THE OLD CAUTION ON CHILDREN: DOES ANYBODY KNOW WHAT ASSETS ARE REALLY IN THEIR MONEY MARKET OR BOND MUTUAL FUNDS TONIGHT; WORSE YET DOES ANYBODY KNOW WHAT ASSETS ARE IN THEIR PENSION FUNDS TONIGHT? OR; WITH THE RECENT GRANTING OF PERMISSION FOR FANNIE AND FREDDIE TO HOLD ASSET BACKED'S AS "ADDITIONAL LIQUIDITY" DO THE TAXPAYERS KNOW WHAT ASSETS ARE IN THEIR GSE'S TONIGHT WHICH THEY (NOT THE IMF) WILL HAVE TO BAILOUT IN THE EVENT OF TROUBLE?
It would be bad enough if it were only the oblivious citizens of this country who should be asking this question. The greater problem, as we have demonstrated is that we have to, as a nation, persuade the rest of the world to send us $1.5 billion a day. They have, collectively, a net position of $1.8 trillion of our assets or gross, something like $5 trillion which might appear in part or more on the market if this fragile structure starts to unwind.
We profoundly hope that we are mistaken, but we see the early signs of just such an unwinding. The recent pages of our publications are awash in stories of credit difficulty. The aforementioned, Monkey Ward, Bradlees, Unicapital, increases in card delinquencies, increases in bankruptcies etc. This with prior quarter GDP at 2.2% the unemployment rate at 4% and such indicators as housing still strong.
IF OUR PREMISE ABOVE IS CORRECT THAT THE LAW OF LARGE NUMBERS HAS CAUGHT UP; THAT THE GLOBAL GENERATION OF CAPITAL IS INSUFFICIENT FOR FURTHER "RELIQUIFICATION" AS DOUG NOLAND PUTS IT, THEN THE ANSWER TO THE QUESTION ON THE FIRST PAGE IS THAT WE ARE INDEED POISED ON A RAZORS EDGE.
It may not yet be the time to call for a fall off the edge. The ingenuity, self interest, power and vested financial interests of those entities which have brought us this far will, inevitably, use every device to carry further; if only to liquidate first. Nevertheless, it would be well to be aware of the proximity to the edge and perhaps precede them.
Grant's has an interesting piece on the "Unthinkable hedge" for those who may share qualms about the dollar. A piece of Wilmington Savings called everbank.com offers FDIC insured possibilities in this respect.
In any event, we will close with another hackneyed but veritable saying. 2001 will be an "interesting" year, in the Oriental meaning of the word interesting! We hope this missive is a mite thought provoking and some help in avoiding the worst part of interesting!
May you find safe harbor in the New Year; not the Perfect Storm.