Pondering an Enlightening Day in Pleasantville

By: Doug Noland | Fri, Mar 23, 2001
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Argentina Dollar Bond Yields
US Dollar vs. Brazilian Real
Emerging  Market Bond Spreads
FNMA Mortgage-Backed Yield Spread

I guess we are all getting a little numb to this continued historical volatility and the wild divergences between individual stocks and groups…I guess. For the week, the Dow dropped 3%, while the S&P500 declined about 1%. The Transports added 1%, as the Morgan Stanley Consumer index dropped 2% and the Morgan Stanley Cyclical index sank 3%. The weakness in the blue chips was more than offset by a major rally in the technology sector. Yesterday's nearly 12% rally in the major Semiconductor index helped this group post an 18% advance for the week. Year-to-date, the semiconductors have gained 11%. The NASDAQ100 added 3% this week, while the Morgan Stanley High Tech index jumped 8%. The Street.com Internet index added 6%, while the NASDAQ Telecommunications index posted a small decline. The broader market was quite volatile, but in the end the small cap Russell 2000 posted a slight gain while the S&P400 Mid-Cap index posted a slight decline. Despite today's strong performance, the financial stocks ended the week with losses. For the week, the S&P Bank index shed 3% while the AMEX Securities Broker/Dealer index declined about 1%. Gold stocks were largely unchanged.

The dollar continues to benefit from acute global financial instability, with the dollar index adding about 1% today. Despite today's sharp stock market rally, it was a very difficult week in South America as financial crisis engulfs the region. Equity markets were hit for about 7% yesterday in both the key regional markets of Brazil and Argentina. With markets concerned with the $27 billion of Argentine debt coming due through the remainder of the year and increasingly fearful of potential collapse, there is a general flight out of Latin American securities. The benchmark dollar denominated Argentine bond was hit hard again this week and has now suffered a 17% decline since March 7th. There is, not surprisingly, a strong contagion effect in neighboring Brazil, with that country's currency and bonds under significant pressure. The Brazilian central bank responded by raising interest-rates 50 basis points yesterday, but the currency (down 10% y-t-d) closed at a record low today. From an afternoon Bloomberg story: " 'Sorry, but we're in crisis,' said Domingo Cavallo, Argentina's economy minister, after meeting with Brazilian officials in the capital Brasilia looking for support for an economic recovery program from its largest neighbor and a major trading partner."

More confirmation of the downturn in the consumer lending cycle came this afternoon from Moody's. "For the second consecutive month, more Americans fell behind in making their credit card payments on time in January 2001, judging from the credit performance in securitized pools of U.S. bank credit card loans…Moody's reports that the delinquency rate in January 2001 was 5.11%, an increase from 4.95% in January 2000." We expect credit card woes will get much worse come a weakening economy and, importantly, the end of the current mortgage lending and refinancing boom.

February numbers are in for Freddie Mac. It was quite a month. Freddie expanded its portfolio by a record $15.4 billion, a stunning 47% annualized growth rate. For comparison, last February Freddie Mac increased its assets by about $2.7 billion. Freddie purchased a record $24 billion of new mortgages during the month, versus total purchases of $7.6 billion last February. Fully 44% of last month's portfolio growth was in "non-Freddie Mac mortgage-backed securities" that expanded by $7.6 billion, or at a 98% annualized rate. Freddie Mac's Chief Investment Officer Greg Parseghian stated, "there have been many attractive investment opportunities during the last two months. Mortgage spreads widened, and the volume of securities sold by banks remained strong." Well, perhaps that explains it. More likely, Freddie is accommodating Wall Street firms, banks, and hedge funds that now could be working to reduce exposure, a not too bullish development for the U.S. financial system. What would spreads have done if Fannie and Freddie weren't buying mortgages at a record rate?

I received a friendly email from a very sharp and learned student of the "Austrian" school of economics. I extracted a paragraph I found interesting:

"I would caution you just a bit on your admiration of Minsky here (the same with Soros). The guy is a total Keynesian. This means he has a warped view of what capitalism is. While I agree with your assessment of his analysis for parts of this particular situation, I do not subscribe to a Minsky view of the world in General. Minsky cannot conceive of a capitalist economy operating any other way."

My interest in Minsky lies specifically in his formulation of a "Financial Instability Hypothesis." While a proponent of free market capitalism, he articulated a theory of financial instability that is critically pertinent to the unfolding U.S. and global financial crisis. It is irrelevant to me whether or not he can be labeled a "Keynesian." What does matter to me greatly is that he focused on the evolution of financial institutions and debt structures and the inherent nature of Capitalistic financial systems to create fragility. It is my goal to bring in analysis from the various "schools" of economics - attempting to "extract" what I see as the most brilliant and pertinent thinking from wherever it can be found, particularly as it applies to financial instability and money and credit excess. No single individual or any one "school" has all the answers. In this vein, it is also obvious that financial markets have come to possess a dominating impact on real economies in the U.S. and globally. With this in mind, I will strive to incorporate the analysis of those that I believe possess extraordinary insights into financial market processes.

Interestingly, I received several emails questioning my reference to George Soros' work. I happen to think Mr. Soros' writings provide brilliant and pertinent insights into various aspects of market and economic dynamics. Obviously, the billions of profits achieved over a long and illustrious career are testament to his extraordinary understanding of market behavior. I also thought he was right on with his warning of the danger of fervent "market fundamentalism" in his Crisis of Global Capitalism. Looking back to 1998, perhaps Greenspan should have recognized markets were going terribly amiss with the Internet/technology bubble - that a bubble was in fact quite recognizable at the time - not only in "hindsight" as he has repeatedly claimed. After all, it is the roll of the central bank to protect the soundness and stability of the financial system.

Unfortunately, going forward I have little doubt that as this historic crisis unfolds one of the consequences will be a weakening of commitment to free markets both in the U.S. and abroad. As a believer in the virtues of free market capitalism and (in the words of Soros) "open society," I am both appalled and saddened that the U.S. and global financial system were allowed to run terribly amok, as Wall Street, the U.S. economic community, and members at the very top of the Federal Reserve System were spouting senseless New Paradigm propaganda. The focal point of my analysis is trying to make some sense out of the processes behind this fiasco, and hopefully providing some insights on how this all will play out, as well as a historical record. My condemnation is not of market forces, but of unavoidable tragic consequences of the reckless credit and speculative excess associated with "wildcat" finance. Let there be no doubt, if unlimited credit availability is provided to a large number of basically unregulated financial speculators, all acting in their own self-interest, all with the expectation that the Fed, the government-sponsored enterprises, and the U.S. Treasury are prepared to underwrite their activities in the event of financial stress, one should certainly not expect the system that evolves from these processes to be to the benefit of the society at large - anything but. I just don't believe it's the speculators financial system to play with using the guise of "free markets" as justification for their reckless activities is unacceptable. Contemporary markets operating in an environment of unfettered credit expansion are disequilibrating and, hence, dangerous. Financial stability is at the foundation of effective capitalism and must be coveted and protected at significant cost, if necessary.

The global system is now clearly in the midst of a severe unfolding crisis. With this in mind, I have chosen not to "yell fire!" this week. As I have done a few times in the past, I will experiment with a bit of fiction as I attempt to shed light on a subject I expect to gain considerable interest going forward: bubble economies.

It had been almost 10-years, so Berry was overdue for a visit. "Let me tell you," he said, "on a drive into wonderful Pleasantville one simply cannot be more impressed by the general prosperity of the place." By all appearances, the decade has been very good to the community. Incredible wealth was obvious, although it did strike him as a tad bit conspicuous. About 40 miles outside of town the billboards began, "Live the Life of Luxury at Golden Park Estates - 10 miles ahead"; "Be the First to Build Your Dream Home at the New Woodside Vista - Lots Start at $1.2 million"; "Lakeside Living For Less Than You'd Think - Belmont Shores Estates 6 Miles Ahead"; "You Work Hard and Deserve to Live in Westchester Bluff." Still out in the middle of "nowhere," - and he still cannot believe the size of the complex - was the Chinook Winds Indian Casino. And the parking lot - it looked like a tailgate party before a college football game, with all the RVs and such. It was packed. The flashing neon sign read "Vince Gill Appearing Saturday March 24th - Come See Our New Expansion Spring 2001 - More Tables, More Winning Slots!" It was about 20 miles out where the hills and farmland quickly transformed into a series of housing developments, first exclusive and then less so closer to the city.

Wow, it seems they only build new homes in one size in Pleasantville: giant. Berry could see why the signs read "Estates." He remembers thinking to himself, "Sure are a lot of wealthy people living quite a ways out of town. They must have to drive for miles to do any shopping." Before he could even complete that thought, the issue was resolved. The highway came up to an exchange where a new shopping center was being constructed that included a Home Depot, Wal-Mart, Sam's Warehouse, a multi-plex cinema complex, ToysAreUs, Best-Buy, CompUSA, Staples, an Applebees, CheeseCake Factory, Starbucks, and Outback Steak House, to name just a few. And then, it couldn't have been less than a half-mile, on the other side of the highway workers were just finishing the final construction on a retail center that included Lowes, Target, Costco, Circuit City, Office Depot, California Pizza Kitchen, Lone Star Steak House, Olive Garden and, of course, Starbucks. The new mall included both Tiffany and Neiman Marcus. This center also included two multiplex cinemas. Curious, Berry pulled in to take a look around but drove on after not being able to find a parking space.

Although the heavy traffic was a bit of an annoyance, the roads were occupied by a large number of Mercedes, BMWs, Lexus, and Saabs, not to mention what at times appeared a parade of Ford Expeditions and Chevy Suburbans. The parking lot at the mall looked like an enormous sales lot of SUVs. A mile down the road, there were the real thing - gigantic lots of foreign and SUV dealerships that sparkled with newness. They sure like their automobiles in Pleasantville and, like the houses, they like them big. It seemed like every third vehicle had come right off the dealer's lot. Although it was likely just a bad day, it did seem like too many drivers were in a rush and very quick on the horn.

Berry decided to stop in for lunch at a little place he remembered near Lake Washington, just on the outskirts of Pleasantville. With all the restaurants, shops and, my lord, all the condos, the area was hardly recognizable. They had even built high-rise office buildings. He struck up conversation with the gent at the next table who was on his way to the Golf Club at Newcastle, a $40 million dollar development financed from stock option proceeds. It is said have stunning views of Pleasantville. Berry was envious when the man at the table explained how a group of retired software engineers get together every Tuesday and Thursday for 18 holes. The man laughed when he told Berry that, at 36, he was the "old man" in the group. Berry chuckled politely.

Berry met up with an old friend Darrel. They had been CPAs together. If fact, he still lives in the same flat that Berry originally leased for $1,300 a month in 1990. With rent control, he now pays about $1,900, although similar units are now going for upwards of $4,000. Darrel's kicking himself for not buying years ago. Although prices seemed very steep at the time, they were but a fraction of what they are today. The neighborhood has been a Mecca for the "Dot.comers". Darrell says nothing in the neighborhood sells for less than $1 million, and prices have in many cases jumped 40% during the last 18 months. Today, basically the entire neighborhood caters to young technology professionals. Not only has Darrell had a "ringside seat" for the area's incredible boom, he now runs the Pleasantville tax department. Walking along a booming Chestnut Street, Berry could hardly recognize the place.

His favorite local coffee shop apparently lasted only about a month after Starbucks opened down the block. The Marina Superette had been replaced by an upscale Wild Oats Market with quite a selection of wines, cheeses, and a veritable jungle of herbs for cooking. Apparently, the entire neighborhood has become gourmet cooks, Berry thought to himself. Darrell related the tale of Marina Hardware, with the owners posting the sign "Thanks for a wonderful 57 Years." It was replaced with one of dozens of new upscale eateries. Berry asked, "Where does one go to buy paint, electrical tape, a length of pipe, a quart of motor oil, or some nails to hang a painting." Darrell laughed, "nobody does that kind of stuff anymore. You need something done; you call someone to do it. You can even order it online. People are busy and don't mind paying for convenience. They add more value using their time elsewhere. Besides, when you were a kid and your father changed the motor oil in the car he wasn't contributing to GDP or, even better, sales tax receipts. Bring on the service sector economy!"

Seeing that the Marina Laundry, where Berry used to wash his clothes every Saturday morning, was replaced by an "International Wraps" eatery, he asked if everyone sends their clothing out. "Yep," responded Darrell. "They'll even come and get them and have them back by dinner." While not sentimental about the passing of the Laundromat, Berry admitted disappointment that that the local bookstore had been replaced by an upscale fashion retailer. "The owners of Marina Books struggled, but they were getting by even after their rent was doubled. But then one of those national chains opened down the block and they were toast. The chain lasted about 2 years before closing, so now we are without a bookstore," stated Darrell, "but there's always Amazon.com." "At least they closed down that dumpy donut shop and replaced it with Noah's Bagels!" "I would trade bagels for books," Berry stated with slight exasperation. "You ought to see the tax receipts from that bagel shop," exclaimed his CPA friend.

"If I went back and looked at the numbers, I would bet you that revenues have tripled on Chestnut Street since you left," Darrell added. Berry thought he got a bit carried away with reference to being in the "heart of the New Economy." Although Darrell's always been the "optimistic" sort, he used to be more of a skeptic. He's always said that if he had his "druthers" he would be an economist. What followed was quite a fascinating discussion of the "Productivity of the Sushi Chef." "Berry, that low-cost Chinese eatery you used to frequent was replaced by the Kamikaze Sushi Factory. The production of that shop space has jumped 10-fold, with only a few extra employees. The productivity of those workers has probably gone up 5-fold. People come in willing and able shell out $40 on platters of sushi, and these chefs just crank the stuff out. It is truly amazing how much value they add." "Forty dollars!" Barry exclaimed, "I used to try to keep dinner limited to $7 dollars at that very same location."

Barry continued: "While everyone says inflation is dead and buried, don't you think there is inflation at work here and not some miracle economy?" Darrell responded: "No, the sushi is about the same price it's has always been. Folks just prefer and can afford the more expensive selections and order a lot more items than they used to. They also carry a great selection of premium sake that is all the rage. This is about wealth creation Berry, not inflation," his friend confidently explained. Berry wasn't convinced, but kept his thoughts to himself.

Darrell added, "Speaking of wealth, let's stop by and say hello down at Joe's office at the end of the block. I see Joe's numbers and they're unbelievable." Later, Berry met up with Joe, who, after losing his sales job with the commercial real estate bust in 1992, has rebounded quite nicely by developing a very profitable insurance business. Walking into his office, Darrell was quick to say that "outside of the women next door charging $3,000 a pop for Lasik eye surgery, Joe is the most 'productive' worker in Pleasantville." Darrell then whispered, "He grosses $3 million, with a staff of two!" After lengthy pleasantries, Berry asked Joe to explain the secret of his success. "Well, Berry, I am first to admit that I was at the right place at the right time. You see, with all the wealth created from new technologies, I am fortunate enough to have the opportunity to skim just a tiny little sliver off my clients increased fortunes - and they have no qualms about it. On the automobile side, the average policy I wrote when I first got in the business was for $1000 a year to insure a Ford; now I write $3,500 policies to insure a Lexus LS430 or a Mercedes M-Class. And with my clients' investments in their homes appreciating so much in value, they don't think twice about acquiring additional coverage. I'm also insuring greater numbers of more expensive sailboats and you would not believe the number of $5,000 bicycle and $20,000 home entertainment center policies I write. And I bet I write more policies on horses and horse trailers than they do out in the country. Horses are where it's at in the marina, even though the closest stables are 20 miles away. People get caught up in the darnedest things when they have money burning a hole in their pockets. Nothing compares, however, to the life insurance business now with so many of my clients having multimillion dollar estates."

Already hearing Darrell's response, Berry changed his approach. "Do you see much inflation in your business, Joe?" "Well, I had a very difficult time hiring my new secretary. I lost my previous one to a tech company that tripled her pay. I advertised but found not one taker. Finally, I paid the stiff commission to a headhunting firm that was able to find me a secretary with the title and salary of "executive assistant." I don't know if that really counts as inflation. As for my business, we've seen premiums increase somewhat, and I know the retired people are livid with surging health care premiums, but the vast majority of my additional business has been generated because people are so much wealthier. And while I'm doing pretty well, you should see my wife. She brokers real estate sales and her business has doubled over the past few years. You ought to see what they are getting for office space these days. It's because of her we could afford our 'toys' and to build our new home. You ought to see how much kitchen cabinets are going for these days…and how about what these plumbers and electricians are charging."

Over lunch, the local economy was the focus of considerable discussion. Darrell was quick with the figures. Local payroll tax receipts up 15% annually over the past five years, retail sales tax receipts not far behind. Building permits up 15% each year, new business licenses up 20%. "We do have the New Paradigm here in Pleasantville. There's really no denying the facts. It's based on new technologies and increased "productivity." If we calculated a Pleasantville Gross Domestic Product, it would have certainly expanded by 10% each of the past several years." "So tell me again what you produce," asked Berry. "Well, we are an efficient service sector-based economy."

Increasingly skeptical, Berry knew where to go for answers. Berry rang to confirm a dinner meeting his old friend Sue, executive vice president at The Bank of Pleasantville. But first, Berry had some time on his own to sit at the sidewalk café and ponder the local boom. One can walk or drive through a community, he thought, and see crowded streets, bustling sidewalks, busy shops, loaded delivery trucks and plenty of new construction. One can query local government officials, who will undoubtedly see a sound and vibrant economy and secure future as long as tax receipts are strong. Such is the case in Pleasantville, what's not to like? To the naked eye, it would appear as nothing short of undeniable prosperity. To most economists, the analytical focus would be on rising local incomes, surging government budget surpluses, increased business revenues and heightened labor productivity. In accounting parlance, the analytical focus would be on the community's "income statement." To witness the increased wealth, the traditionalist would say: "just look at the values of homes and businesses and the money people have to spend. These are market prices reflective of the wealth creation capabilities of the community." The traditional analytical focus would be on the current market value of "total assets."

Yet, if one is interested in identifying the true health, it's what one cannot see from the vantage point of the street-side cafe that holds the key to unlocking the secrets of the economy's underlying soundness and future prospects. Answers lie, however, hidden in the community's "total liabilities" and the debt structures of its institutions. Issue number one: Is growth sustainable or is it a credit-induced bubble? This is where economic analysis can turn fascinating, if not easily discernable. Are the luxury automobiles purchased or leased? How much is owed? How much equity do the drivers have in their automobiles? Are purchases being made with credit cards or with cash? How much installment debt have shoppers accumulated? Have rising asset values - stocks, stock options, homes, businesses, etc. - worked to increase spending? How exposed are shoppers to declining asset values? How would spending levels and the nature of purchases be impacted by a decline in asset values? How stable are the shoppers' incomes? How much do they have in secure savings? How secure are their jobs? How strong financially are their employers and how much debt have they taken on during the boom? How much short-term debt do the employers owe? What are the cash flows of the employing companies and how reliant are they on raising additional funds in the marketplace? How vulnerable are local businesses to changing national or local business conditions? Are local businesses overly exposed to discretionary-type spending? What is the financial position of local government? How much debt has been accumulated by local governments and municipal bond issuers during the boom? What types of projects back municipal borrowings? How vulnerable is the local tax base to slower growth and faltering asset prices? How vulnerable are the lenders - credit card, auto, mortgage, etc. - to heightened stress in the financial system? What would be the impact to lenders of a general market liquidity crisis? Berry had never really thought in these terms so clearly before.

When he arrived at the restaurant, Sue had already been seated and, much to Barry's pleasant surprise, another old friend, Michael, was also at the table. "I did not realize that you two were acquainted." Michael, a managing director at Pleasantville Capital and Brokerage (PCB), quickly explained how his firm had become Sue's bank's best customer and that the two of them now spend considerable time together "redlining documents, doing deals, closing loan agreements." About the time only ice cubes were remaining from the first round of drinks, Barry "cut to the chase" and asked for the "inside scoop" on how "everyone" was making this "unimaginable" amount of much money and "where was all this money coming from? Has someone been dropping this stuff from helicopters?"

"Well Barry, the entire neighborhood virtually became wealthy overnight when tech stocks surged and all the people with equity and options came and incited a housing bidding war. This proved one hell of a boon to our business. We became major lenders to these buyers, with most liquidating just enough stock for a minimal down payment and keeping the rest for their "nest eggs." We even recommend that they cash out as little of their holdings as possible - it's a once in a lifetime opportunity to become very wealthy. Looking back, perhaps that wasn't the best advice but the stocks will come back. But actually, this whole thing could not have worked out better for our bank, as we picked up new customers while our now much wealthier older clients used housing capital gains as down payments for building out in Golden Park or Woodside Vista. It's beautiful out there and you should see the homes they have been constructing.

We picked up unbelievable amounts of volume of very solid credits. Those who didn't flee to the 'burbs' borrowed against increasing home equity for remodels or to purchase a new car or boat. Business has been truly unbelievable. Plus, these tech people are God's gift to bankers. Most are millionaires with all their stock and options but have little in the way of cash flow or savings. We also quickly put together a team and aggressively developed a dealer financing business for the surging demand for everything - motorcycles, jet skies, luxury autos, and yachts. Still, our most profitable business is providing credit cards and lines of credit to our group of 'techies.' And then we picked up some great clients in the new developments out of town. Let me tell you, it is a bottomless pit out their for our contractor clients. They can't build luxury homes fast enough, and we finance them all. It's great business and with these lower rates, we'll lend more aggressively there. Then there is Pleasantville Real Estate Investment Trust. They are building a number of malls and super retail complexes out in the ''burbs'' and they are doing extremely well. It's almost funny to watch the money go around the circle. We lend to the 'techie', who transfers the money to the "natives" who take the money out to the "burds" to spend for builders and at retailers, and they're all our customers."

"Do you lend much to industry?" Berry asked. "Very little. Most have left Pleasantville and the ones remaining struggle. We keep our distance and prefer our other clients. Actually, I'm to the point now where I would lend to a REIT or to Michael's firm any day of the week over a manufacturer. They have the profits." Following up, "And you are not worried about a repeat of the '91/'92 downturn?" "No, it is a completely different market now. We certainly learned from our mistakes. We now maintain a very diversified loan portfolio and, actually, this is where Michael has become a tremendous asset. You see, we securitize and sell the vast majority of our real estate loans. I just call Michael and he structures the deal and provides us continuous liquidity to finance our customers' borrowing requirements. We certainly don't see a downturn in the cards, despite all the talk of recession, but we have nonetheless off-loaded a lot risk anyway. I sleep well at night. I'm with Alan Greenspan on this; if this is a bubble, there's no way to know until after the fact, so I just refuse worry about it. I focus on satisfying my customers and enhancing my bonus."

Darrell was beginning to understand. "So then Michael, it is your firm that is really financing the Pleasantville boom!" "I wouldn't look at it that way," Michael replied. "We are basically just an intermediary - matching those looking to sell securities, like Sue's institution, with our clients that are undertaking an accumulation of security positions and spread product." "Like what kind of clients Michael?" inquired Darrell. "Well, we have a lot of tech insiders who have sold tens of millions - in some cases $100's of millions of stock - the public's money was flowing right into the mutual funds that sent the money right over to the accounts of my clients. These guys don't want anything to do with the stock market but live for yield and will buy about whatever I recommend. But one of the best trades I've got going right now is having my clients refinance their mortgages and use the proceeds - after they go on vacation or fund their 401K, of course - to buy municipal bonds. You can't beat the after-tax yields - it's a slam-dunk. For a while it was a pretty easy "do" to get my high-net worth individual clients to refinance their mortgages and use some extracted equity to purchase Cisco at what I thought were bargain basement prices. That trade has kicked my ass, so I'm sticking with munies for now. With the economy booming, Pleasantville is expanding the airport, building a new fine arts center, constructing a new bypass, and we now have both the new football and baseball stadiums under construction. I hope they don't experience any problems with the big sponsorship deals and skybox sales. The tech companies have been key players in all of this.

But, really, that's small potatoes in relation to my book of business with the hedge funds. It's exploded over the past few years, and the money has really been rolling in after they made profits throughout last year's tech sell-off. I don't think many of these guys even bother with equities any more; too much money to be made in spread product, and the guys "arbing" convertibles are kicking some butt. You should see these guys Darrell - they're absolutely brilliant. All PhDs in mathamatics, physics and/or economics and they literally 'print' money. They're truly money machines. The amount of money they are making - well, it makes most of these 'techies' look like paupers; I kid you not. I don't know what our investment bankers would do without these guys. Even in tough markets like we're seeing, our bankers have buyers for all the convertibles they can issue. These funds have their very sophisticated - and highly proprietary - models that allow them to build these huge 'hedged' portfolios; they arbitrage various markets with little risk and the money just rolls in. They take 20% of fund profits for the trouble and we take a nice little commission when they buy or sell, while making most of our money extending margin. We've even set up our own hedge funds internally and we're doing exceptionally well. At least we were, I'm not sure what's been going on the past few weeks. And Sorry Sue. You see Darrell, with Pleasantville Bank having also recently set up internal hedge funds, I guess there is a bit of friendly rivalry at work from now on."

"Never forget who is lending a few of your best hedge fund clients the money that allows them to play," exclaimed Sue. "Furthermore, I see your firm has already taken down much of that line of credit we negotiated last quarter."

Darrell then asked Sue if she ever gets nervous about these hedge fund and brokerage loans and credit lines. "No, we are not concerned about these loans at all. They are actually some of the best credits we have on our books. Granted, it's low margin business but it is fully collateralized. The margins work out ok as we can do this type of lending with minimal cost and make it up on volume. And, if worse comes to worst, we can take possession of the securities that are generally loans we originated in the first place. Really, we almost look at these lending arrangements as part of the service to maintain this mutually beneficial relationship with PCP. Everyone wins here. And the marvelous aspect of client banking is we don't have to worry about a portfolio of problem real estate loans like we've faced in past cycles. What a relief this is - we can just keep lending and securitizing. The whole nature of what we do as bankers has changed. And the fees we charge for backup lines of credit are almost criminal. It goes right to the bottom line and, fortunately, a slice makes its way to my incentive compensation."

So the hedge funds have no problem buying securities backed by the REITs? Isn't that risky paper?" asked Darrell. "Oh, funny you should mention that. You remember Russell, he used to sell energy limited partnerships? Well, he walked into a veritable goldmine with PBAC (Pleasantville Bond Assurance Corp) selling bond insurance. With these insurance products we can garner a Triple-A rating on demand. This allows us to borrow in the commercial paper (CP) market to fund our security holdings and provide liquidity for our clients. Especially when the markets stink, we can always fund in CP. Russ was telling me that his firm doubled the amount of business insuring "structured finance" in just the past three quarters. It's been hot. The markets have really changed to the point that there is always a vehicle available for funding. Sometimes we've got to be creative, but we've got a team that excels in constructing innovative funding solutions. It's not like before where liquidity was always on the back of our minds. If you can believe this Darrell, our greatest concern is often finding securities in large enough quantities to accommodate our clients. I call Sue and say, "Doggone it Sue, you're a damn banker - get out there and lend, lend, lend…I got phones ringing off the friggin hook trying to find paper. You should have seen it in January. When the Street could see Greenie was about to panic and cut aggressively, I think I could have personally sold $1 trillion of securities - demand was endless. And I've got guys, some of my best clients even, still pissed that I cost them a ton of money 'cause we didn't have the inventory. I even called our proprietary trading desk begging for paper and they said 'get lost, we ain't giving it up. Got kids to feed. We got the Greenman eating out of our hands…' It was something else…chaos. Come to find out, I guess the derivative desk was being a pig with all the securities they were holding. You just never know what those guys are up to."

"So," says an increasingly enlightened Darrel, "the speculators are financing this boom. This is amazing but you two discuss all of this like its normal, business as usual. What happens if they decide they don't want anymore paper - or what the devil will you guys be dealing with when they decide to sell."

"They'll never sell. Darrell, don't take this the wrong way, but you don't really understand the process at work here. They borrow cheap, lend dear. In fact, this is really about the efficiency of the entire capital allocation process. And there are always buyers for these securities; it is just a matter of at what price. If one fund gets caught overexposed and is forced to liquidate some holdings, there is always another opportunistic 'arb' waiting to make a quick buck on the back of the other poor saps misfortune. It's dog eat dog, the wonder of free market capitalism in its purest form. And all the worry of a repeat of LTCM is way overblown - no one uses that type of leverage anymore. They were hit by the 'perfect storm' and there's a lot less leverage today than 1998. Really, these guys use leverage brilliantly. Besides, with this rout in NASDAQ and currencies blowing up right and left - did you see Brazil and Argentina yesterday? - Greenie's on the fast road to 1%. It's like all of us on Wall Street can put a gun to our heads and say, 'let us down Greenie, and we'll shoot! He's got no choice. Plus, he's got to help bailout the Japanese who have had their heads buried in the sand for years. Thank God Greenie's not inept like those Japanese central bankers. The way I see it, this tech collapse is great for my business. And my guys are salivating at borrowing for free in yen and watching that currency tank. My guys see at the minimum a couple of years of financial harvest before the next tightening - probably much longer. They've done very well the past few years, now its time to get serious. The Fed's going to be handing out money for the taking and my guys are ready to make a killing."

Darrell turned to Sue: "You buy Michael's story? There will always be buyers for your loans?" "Well," she responded, "we had one hell of a scare back in October '98. All the sudden, not only were there no buyers for our loans, we had everyone at once ready to draw down their credit lines. I almost fell off my chair when within the same hour I got calls from the controller at BeanTown Mutual Funds and the president of Provident Subprime Credit Cards saying they would soon need to tap backup credit facilities. Money started coming out of BeanTown in droves and the market for credit card securitizations looked like it could collapse. They found a bit of religion at Provident and went out and raised billions of FDIC insured time deposits. But fortunately, when the dollar started to crack the Federal Reserve responded quickly to avert the crisis before it got out of hand. Greenspan said the markets "seized up." Well, I can tell you I almost had a seizure. I had a couple or clients blow up that were warehousing mortgage paper, but fortunately Fannie Mae came right in and took care of that problem for us. Saved us a ton of grief, a lot of money and my bonus. And while I am more concerned than Michael, I don't see anyone with the LTCM-type of leverage. And we've seen how quickly the Fed can add liquidity, so we are not really worried. We've been through the drill a few times."

Berry jumps in, "So tell me this Sue: what can go wrong with this supposedly wonderful and bulletproof arrangement." She responds, "I've actually given this considerable thought. We were watching things carefully last year when tech began to tank. We've seen some issues

crop up, but the real estate market has really proved resilient. As long as prices stay strong, we'll continue to lend. I think the bears have it wrong. The tech boom was definitely the catalyst, but this prosperity does not depend on stock options. It's gone way past that. My clients have enormous financial assets. Sure, they have debt and have taken a hit on their stock portfolios, but their incomes have increased substantially. I don't think the ratios are out of whack and many of my clients are extracting equity as they refinance at lower mortgage rates. As long as the stock market doesn't crash, the money markets are safe and we don't have any problems in the asset-backed securities marketplace, I don't see much trouble. We'll get through this as we always do - the entire U.S. financial system is amazingly resilient. And ironically, when these global problems surface this just increases the appeal of safe Pleasantville debt instruments. Look at the strength of the dollar - that's telling you something.

Yet, I would hate to ponder what the world would be like if confidence wanes for the money funds or asset-backs, or the greenback for that matter. And I am concerned that some of these New York headquartered banks - if they still call themselves banks today - could get themselves in trouble overseas. Surely they don't have too much exposure in Turkey, Indonesia, Brazil or Argentina… I hope. And Lord only knows what messes some of these Wall Street investment houses have gotten into. I know they wrote a lot of derivative insurance to some of my technology clients and will be cutting huge checks next year if these stocks don't recover. And I must admit to being a bit on edge after Freddie Mac called yesterday asking if we needed to unload any mortgage paper - residential, commercial or otherwise. That call only comes when someone or maybe a bunch of hedgies are in trouble."

"That's interesting," interjects Michael. "My guys have definitely been on edge the last week or so. I guess there are rumors of funds in trouble in Brady bonds. Maybe that explains why my phone hasn't been ringing. And for the first time in awhile, I am seeing bid lists of asset-backs and commercial mortgage-backs to sell. And I can't get anyone to even take a look at some equipment and aircraft leasing paper our proprietary trading desk is looking to dump. And I hear some guys are leaving from the derivative group."

Conversation drifted away from lending, hedge funds and derivatives to old friends, local sports teams, and favorite recent films. When the evening was complete and Berry wandered to his hotel, he just couldn't get over the astounding reformation of Pleasantville. The entire structure of the economy has changed - it's gone "service sector" and "upscale," he thought, based on some nebulous notion of wealth creation from new technologies and increased productivity - the New Economy. Very little was actually produced, instead the focus of the economy was spending, finance and constructing homes and consumption-based structures. As far a Berry could tell, the Pleasantville economy was a fragile edifice built on rising asset values and aggressive lending, and he just couldn't imagine how this would work well in reverse. One thing was clear in his mind, if the New Economy concept proved merely boom-time fancy, there was one heck of an adjustment process in store for its citizens and the community at large. He could see how lower local real estate prices would immediately but a damper on the construction boom in the "burbs" as well as spending on Chestnut Street.

And the more he thought about it, the more convinced he became that the real estate bubble was the key factor fueling what he could see was clearly a bubble economy throughout the greater Pleasantville community. It may have been incited by surging tech stocks and the general technology boom, but it was mortgage credit that was really underpinning continued heightened spending. If these borrowers ever get underwater on their mortgages, they will almost certainly pull back on spending, turn risk averse and generally retrench. What troubled Barry the most was the fact that the financial speculators had developed into such key players providing credit to the community. If the speculators falter, there will be a severe liquidity crisis. How could this not breed a boom and bust cycle of over speculation and lending excess, only to succumb at some point to unavoidable liquidation and financial impairment. It certainly reminded him of his readings of the stock margin lending bubble that precipitated the 1929 stock market crash. He certainly could appreciate the momentous ramifications of having the community's credit mechanism dominated by security issuance and the capital markets. Things were clearly much more unstable today in comparison to that of really not all that many years ago when the Bank of Pleasantville was lending prudently for loans it would hold on its own books until they were repaid. Sure, he pondered, with all these new vehicles, instruments, and entities, credit is much more readily available today than ever before. But right then he was hit with an epiphany: "isn't that precisely the problem - the excessive availability of credit fueling an unsustainable bubble economy. As goes financial excess, so goes the economy." Feeling a bit uneasy as he prepared to get some rest, Barry nonetheless certainly felt satisfied that it was an Enlightening Day In Pleasantville.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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Source: The Contrarian Take http://blogs.forbes.com/michaelpollaro/
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