Credit Bubble Dynamics
Tumultuous conditions have returned to global financial markets, with increasingly problematic dislocations in currency and energy markets. And, importantly, global stock markets are taking notice. Here at home, it was another week of wild divergences. While the Utilities surged 9% and the S&P Bank index jumped 6%, the Semiconductors sank 9% and the NASDAQ100 dropped 7%. The Dow and S&P500 declined 2%. The Transports and Morgan Stanley Consumer index increased 1%, while the Morgan Stanley Cyclical index declined 1%. Many stocks held up well, with the small cap Russell 2000 index dropping 1%, and the S&P400 mid-index declining less than 1%. Tech stocks, however, came under heavy selling pressure as the Morgan Stanley High Tech and The Street.com Internet indices declined 5%, and the NASDAQ Telecommunications index sank 8%. The AMEX Biotech index declined 4%, while the AMEX Securities Broker/Dealer index added 1%. Gold stocks advanced 3%.
It was also an interesting week in the credit market. Treasury yields rose, with the yield for the key 10-year note increasing 5 basis points, with two-year yields adding 2 basis points, five-year 3 basis points, and the long-bond four basis points. Importantly, mortgage-backs and agencies under performed as yields jumped about 8 basis points. The benchmark 10-year dollar swap spread increased almost 5 to 129, at basically the highest close since June 1st. We believe this swap spread is an excellent indicator of underlying systemic stress, and it is certainly now issuing what we would regard as a strong warning.
This afternoon, the Fed reported that bank credit expanded by $8 billion last week, as year-to-date bank credit growth continues at brisk rate of 11%. For the week, M1 money supply rose $10 billion, with demand deposits adding $8 billion. M2 increased $8.6 billion and broad money (M3) added $2.9 billion, with institutional money funds increasing almost $8 billion. Total outstanding commercial paper (CP) increased $22 billion last week. Year-to-date, total CP has increased $181 billion, an annualized rate of about 19%. Financial sector CP increased $16 billion last week, with year-to-date growth at $106 billion (14% annualized). According to Bloomberg, $44 billion of U.S. syndicated loans were announced last week, the largest amount in four months. This afternoon's report had consumer credit expanding by $9.4 billion (7.7% annualized rate), with June's consumer borrowing revised higher by $2.7 billion to $14.7 billion (12.2% rate). Year-to-date, consumer debt has expanded $80.6 billion (verses $55.1 billion during the comparable period last year), a rate of 10%. Revolving debt (primarily credit cards) has expanded at a rate of 12% year-to-date.
"…The bigger, overriding long-term economic and investment point is this: High-tech, Internet-linked productivity is much more important than this temporary oil bubble, and in fact, if anyone gets too obsessive about the potential for higher inflation try to keep in mind that productivity is expanding our economy's potential to grow. More growth means lower inflation because it absorbs the money supply, and a stronger dollar. To me this is nothing but a short-term little bubble thing and should not be a big deal." Larry Kudlow, CNBC September 8, 2000
Current economic conjecture sure brings back memories of 1990. Back then a bullish consensus had developed that believed the U.S. economy was no longer vulnerable to nationwide recessions - that recessions had become a relic of a bygone era. Instead, the economy had been transformed into a much more stable system where excesses would be wrung out through "rolling recessions" impacting individual regions and industries. Talk about putting a positive spin on the booms turned busts in the rust belt, farm belt, oil patch and the Northeast real estate. Ironically, this view gained its strongest following just as the national economy was heading right into recession. As is very much the case today, the consensus in 1990 began with a bullish outcome and then backed into the "analysis," no matter how detached it was from underlying fundamental developments. Somehow virtually completely ignored was the crucial fact that the U.S. credit mechanism was faltering with a spectacular collapse in the junk bond market, rapidly deteriorating credit conditions, an abrupt tightening of lending conditions instigated by our nation's banks, and an unfolding collapse of much of the savings and loan industry. The notion of "rolling recessions" was completely irrelevant to what was unfolding. The developing credit crunch was the focal point of sound analysis in 1990, and the recognition of its significant ramifications for real estate prices, bank balance sheets, financial system health generally and economic prospects.
Today, the bullish consensus has predetermined a "soft landing" and continued non-inflation, although there is no sound analysis to support these views. Interestingly, we are increasingly reading about business cycles and even recessions - how the increasingly sated consumer is now "retrenching" and how this will create excess inventories, declining production and forced layoffs. Such layoffs will then disrupt consumer confidence, leading to only less demand, less production and more job losses. And while we have no problem with classic business cycle dynamics, we just don't see them applying presently. Importantly, the U.S. economy two years ago diverged spectacularly from a traditional business cycle. A negligent Federal Reserve lost control to runaway money, credit and speculative excess, and powerful processes took hold that indelibly altered the financial and economic landscape. A full-fledged credit bubble developed in the U.S. unlike anything experienced since the late 1920s. Accordingly, to accurately analyze the present environment and develop reasonable expectations for the future, we strongly suggest that analysts forget about the highly improbable "soft landing" scenario, drop the fixation on productivity, the Internet and new technologies, and instead seek a better appreciation and understanding of credit bubble dynamics. Credit bubbles specifically do not play by the rules of markets forces. To be sure, credit bubbles are all about the circumvention, obstruction, impairment, and eventual breakdown of the market pricing mechanism.
A key to appreciating credit bubble dynamics is to recognize that they are acutely self-reinforcing. Here, the focus is on processes and forces not easily characterized and certainly non-quantifiable. Credit bubbles absolutely feed on money and credit excess, which only induces an intense hunger for greater excess. What's more, this appetite is insatiable. After all, credit bubbles are about financial wealth creation and accumulation. Lending, the creation of additional liabilities, is the mechanism, while the consequences of excess are immediate spending increases and asset inflation. Wealth is, of course, about power and one should appreciate that credit bubbles have everything to do with obtaining and retaining power. Those who control a mechanism for money and credit creation have enormous power. Those who manage vast sums of financial assets on behalf of their clients are immensely powerful. And those who attain discretion to allocate an economy's resources possess great power. Credit bubbles by their very nature direct enormous power to the financial sector, for the financial sector, by the financial sector. And, as has developed during this historic period, as the financial sector attains sufficient financial power to dictate an economy's reward system it achieves supreme power. With this achievement, the powerful financial sector garners and relishes in its ability to create its own financial wealth, with devastating consequences to the underlying economy and financial system.
Financial wealth begets greater wealth, and power begets abusive power. Those having attained great power have no intention whatsoever of relinquishing control, of course not. And to the powerful machine the mindset becomes that to give up any control is to commence a process of losing control and relinquishing wealth and influence. Such a development is seen as completely unacceptable, and there is no compromise. The machine knows only expansion, sees only continued expansion, and accepts only the perpetuation of the boom. There is no other way. With this in mind, hopefully a nebulous cloud is becoming clearer as to the intractable momentum and self-feeding characteristics behind this historic boom. Here as well, one discovers the source for the incredible resiliency the financial system and real economy have developed to thwart any force that might temper credit or speculative excess.
This is not written as an emotional tirade but as a solemn attempt to illuminate the essence of a credit bubble - the nature of this unparalleled environment. The extraordinary nature of the bubble phenomenon is not done justice by the money and credit data I present weekly. Ideology and institutional structures play a major part. The powerful GSEs will never accept that their aggressive lending has fueled a national real estate bubble, with resulting endemic financial and economic distortions. Investments bankers will not one day ascertain that they have issued enough securities, and that there is great systemic risk created by too much "paper" of increasingly poor quality. Derivative players will not wake up one morning and realize that too many contracts have been written, and that market processes and the stability of the entire system are put at great risk by the proliferation of these instruments. The leveraged speculating community will never admit that there is endemic over leveraging and speculating, and that this is leading to an historic misallocation of resources, an increasingly distorted and imbalanced economy, and extreme financial fragility. Wall Street will never accept that the stock market has become little more than history's greatest casino and is, as well, hopelessly dysfunctional. No way, these players are all on top of the world. They are where the action is; they are the game, the masters of the universe. They have the control of immense financial wealth, and the mechanism to produce more: the power of the "money spigot."
This is all fine and dandy during the boom - when the game is favorable to most. However, never lose sight that the backlash against the powerful financiers and institutions during the Great Depression and the laws restricting the size and operations of financial institutions were a natural and inevitable reaction to the abuses that ended with a catastrophic financial and economic collapse. Nor should we forget about depression era tariffs and trade wars.
On a less philosophical and more "practical" basis, let's look at several areas where Bubble Dynamics are playing major roles. Certainly, the historic mortgage finance boom continues to drive a national real estate bubble. With self-reinforcing dynamics, a housing bubble continues to fuel the dangerous consumer borrowing and consumption binge. And if the present course is maintained, it is our view that heightened home price inflation will only extend the consumer-spending boom. Recently released data from Freddie Mac support our analysis. During the second quarter, 83% of households refinancing mortgages took out loans at least 5% larger than the previous loan amounts - or, stated differently, they pulled out at least 5% of equity. For comparison, during last year's second quarter only 58% pulled out at least 5% of equity. Additionally, during the second-quarter the average home appreciation for a refinanced mortgage was 27%, this compared to 23% during the first quarter and 13% for loans refinanced during last year's second quarter. This strongly supports anecdotal evidence of what appears to be an acceleration in housing inflation this year. Interestingly, during this year's first and second quarters the average borrower actually refinanced at a higher interest-rate, with the motivation specifically to drawn down equity.
Moreover, this week Freddie Mac released its quarterly report on housing inflation. During the second quarter, national prices rose on average 6.8%, compared to 6.7% during the first quarter and 5.3% during the second quarter of 1999. By region, prices in the New England Division (CT, MA, ME, NH, RI, VT) rose 11.1% annualized, and an eye-opening 33.1% during the past five years. West North Central Division (IA, KS, MN, MO, ND, NE, SD) saw prices rise 8.7% annualized, and 33.1% for five years. West South Central Division (AR, LA, OK, TX): 8.1% annualized, and 25.2% during the last five years. Pacific Division (AK, CA, HI, OR, WA) 8.1% annualized, 30.0% for five years. Mountain Division (AZ, CO, ID, MT, NM, NV, UT, WY): 8.1% annualized, and 29.3% during the past five years. East South Central Division (AL, KY, MS, TN): 6.5% annualized, and 26.9% for five years. Middle Atlantic Division (NJ, NY, PA): 6.1 percent annualized, 24.2% for five years. South Atlantic Division (DC, DE, FL, GA, MD, NC, SC, VA, WV): 5.8% annualized, 26.7% for five years. East North Central Division (IL, IN, MI, OH, WI) 5.2 percent annualized, and 31.6% during the past five years.
And while it is generally appreciated that states such as California, Washington, New York and Massachusetts have experienced extreme housing inflation, the critical and less recognized aspect of this boom is its endemic nature. According to recently released data from the Office of Federal Housing Oversight, median home prices throughout the U.S. have increased 28% during the past five years (143% since 1980!). Prices have surged 44% in Colorado, 41% in Minnesota, 43% in Michigan, 40% in New Hampshire, 34% in Georgia, 30% in Arizona and Oregon, 29% in South Carolina, 28% in Nebraska, Kansas, North Carolina and Utah, 27% in Tennessee, Wisconsin and Louisiana, and 26% in Ohio, Missouri, Iowa and Kentucky. Hawaii was the only state with 5-year appreciation below 15%. How can anyone argue that such a spectacular nationwide housing boom is not causing dangerous imbalances and distortions?
The proliferation of interest rate derivatives has been closely associated with the explosion in mortgage credit and resulting housing inflation. This week the Comptroller of the Currency released its quarterly report on bank derivative positions. The total notional amount of positions held by the commercial banks increased $1.7 trillion to $39.3 trillion. Interest rate derivatives increased $1.3 trillion, or at an annualized rate of 17%. Interest rate derivatives positions have increased $11 trillion, or 57% during the past eight quarters, and $21.5 trillion, or almost 220%, since the end of 1994. Interest rate swaps were the favored instrument again during the second quarter, with outstanding positions increasing $1.3 trillion, or at a rate of 26%, to almost $21 trillion. The top seven banks now have $37.4 trillion of derivatives, of which $20.2 trillion are swaps. Once again, Chase Manhattan sits at the top of derivative community as it increased total notional derivative position at a 20% annualized rate during the second quarter. Chase (with shareholders' equity of $25.4 billion) now has $14.3 trillion of derivative positions, with $8.7 trillion of swaps. JP Morgan has total positions of $9.5 trillion, with Bank of America at $7 trillion, and Citibank at $4.7 trillion. As for total swaps positions, Chase is again at the top with $8.7 trillion, followed by Morgan at $5.1 trillion, Bank of America at $4.1 trillion, and Citibank at $1.5 trillion
Interestingly, we see that JP Morgan increased its credit derivative position by $70 billion during the quarter to $245 billion (160% annualized growth rate). This is consistent with a surge in credit insurance. The proliferation of credit derivatives and credit insurance corresponds directly with Wall Street's increasing use of "funding corps" and other sophisticated financing instruments and vehicles. Such strategies are, by the way, increasingly necessary as the marketplace begins to recognize festering systemic credit problems. Credit derivatives and insurance, however, will not prove the answer after years of reckless lending and the consequential financial and economic imbalances and distortions. Indeed, derivatives are not the solution but the problem.
Meanwhile, financial and economic distortions are becoming more conspicuous and alarming by the day. This week, near chaos erupted in global energy markets as recognition grows that the world is in the midst of not only higher oil prices, but also a full-fledged energy crisis. The economic disruption and political risk associated with this week's protests in France are but a first warning shot. This week also witnessed a significant escalation in global financial tumult, with dislocated trading in the euro and other key currencies now impacting both the European corporate bond and equity markets globally. Some European companies were said to have delayed bond issues as corporate spreads widened and liquidity waned. This is particularly troublesome for telecommunications companies in Europe and across the globe. Europe's telecom companies have plans to issue between $30 and $40 billion of debt before year-end, with tens of billions more from American and global issuers. We don't see the market cooperating.
To any serious analyst, it should be becoming clear that we are once again entering a period of heightened financial and economic risk - systemic risk exacerbated by the unfathomable leverage in the U.S. and global financial systems, as well as highly speculative stock markets and imbalanced economies. Mr. Kudlow and the bulls can spout propaganda all they want, but it is not going to change underlying fundamentals. It is almost like we have been watching a train wreck develop in slow motion for over two years now. Several times accidents were narrowly averted by huge injections of new money and credit. Finally, however, the costs of gross monetary abuse are coming home to roost. In the past we wrote a commentary titled "Trapped." The gist of the analysis was that the degree of money and credit excess necessary to keep the bubble inflated would certainly lead to serious problems in the real economy. Well, "the genie is out of the bottle."
Ironically, in the midst of unfolding global financial tumult, the financial stocks continue a very strong rally. During the past six weeks, the bank stocks have rallied about 20% and the brokerage stocks 25%. At the same time, we remember all too clearly a similar financial sector rally right into the 1998 Russian collapse and LTCM debacle. It is as if approaching storm clouds only work to energize and embolden the financial sector to more aggressively protect its turf. As written above, great efforts are made to perpetuate the bubble - to maintain power. All the same, it is now our view that going forward the great U.S. credit bubble will find itself in the most perilous position since 1998. The weak link is today, as it was in 1998, is the highly integrated global derivative markets. In 1998 it was the dislocation in Russia that proved the catalyst for widespread financial dislocation, astounding inter-market contagion, and near financial meltdown. This time around, it appears that the catalyst may originate in the currency or energy markets. If we had to venture a guess as to how this may develop, we suspect that the current dislocation in currency derivatives leads to dislocation in the closely tethered interest-rate swaps market. Tumult in the swaps market would then quickly impact the highly leveraged credit markets in Europe and the U.S. A bout of deleveraging would quickly lead to a problematic dislocation, perhaps in junk (telecommunications) bonds, mortgages, and/or agency securities. If, as we suspect, credit market liquidity evaporates for the Telecommunications and technology sector, this would prove quite problematic for technology stocks and the stock market generally. At the same time, the highly overleveraged mortgage finance sector (mortgage-backs and agencies) is an accident waiting to happen.
As the week came to a close, there were clear indications that stress was building, and that the probability of a problematic scenario is increasing. Which leaves us with one other key aspect of credit bubble dynamics: while extraordinary efforts are made to perpetuate the boom, when things falter they falter big and ugly. Stress is allowed to build - it holds, it holds, it holds and it holds, that is until the dam breaks. That is the nature of highly leveraged markets, derivatives and credit bubbles. They all exacerbate the upside, but result in abrupt and spectacular dislocation and illiquidity on the downside. This is precisely why we spend so much time discussing financial fragility.