The Facade of a Sound and Stable Prosperity
or, The Last of the Great American Credit Bubble
What a week. And for anyone that is tempted to downplay the extraordinary nature of the current environment, keep in mind that the President of the United States this afternoon has decided to tap our country's emergency crude oil reserves, the first such move during peacetime. Intel, arguably one of the most important companies in the world, yesterday shocks the investment community with disappointing earnings news. And this morning, for the first time since 1995, European, Japanese and American authorities executed a coordinated global currency intervention.
It was a wild day, with the Dow experiencing a 237-point intra-day swing, while the NASDAQ100 saw a 6% recovery from morning lows. For this acutely unsettled week, the Dow and the S&P500 declined about 1%. Defensive issues outperformed, with the Morgan Stanley Consumer index adding 2%. The economically sensitive issues under performed, with the Transports and Morgan Stanley Cyclical indices dropping about 3%. The Utilities sank 5%. The small cap Russell 2000 and the S&P400 Mid-cap indices declined about 2%. The NASDAQ100 actually finished the week with a gain of 1%, as its year-to-date performance scratched back to unchanged. The Morgan Stanley High Tech index dropped 2% and the Semiconductors almost 5%. The Street.com Internet and NASDAQ Telecommunications indices fell about 3%. Despite today's strong recoveries, the financial stocks had losing weeks. The S&P Bank and AMEX Broker/Dealer indices dropped about 2%. Gold shared sank about 3%.
The credit market was quite volatile as well, although Treasury yields ended the week with only slight variation. Agency debt securities performed relatively well, with yields dropping slightly. Mortgage-backs strongly outperformed, with yields generally contracting 5 basis points. The benchmark 10-year dollar swap continued to narrow, sliding 4 more basis points to 114. With concerted central bank intervention, the dollar sank 2% today against the euro and Swiss franc. The dollar index dropped 2% for the week as well. After beginning the week quite strongly, crude oil prices dropped precipitously at week's end to close $2 lower for the week.
We have entered a critical period in financial history. It is now definitely time to "get one's house in order." The approaching storm clouds may not look all that ominous at first glance, and are in fact peculiarly invisible to the vast majority. Nevertheless, if Doplar radar existed to identify financial storm systems, it would now be tracking a series of funnel clouds heading right for Wall Street.
But there will be no talk of crisis, no discussion of acute financial fragility. From Washington will come more New Era propaganda and, undoubtedly, the infamous adage "underlying fundamentals of our economy are sound" at any serious bending in market confidence. And throughout Wall Street, the phrase "company specific" will play like the proverbial broken record. But such propaganda is blatantly detached from a reality fraught with great uncertainty and extreme financial risk. The feeling that we have passed a momentous inflection point is almost palpable. Yet, as so many things fall increasingly into a state of flux, the facade of a sound and stable prosperity is coveted and protected with more intensity than ever. All the same, be fully prepared going forward for extraordinary financial turbulence and considerable confusion. The bottom line remains that there exists a historic gap between the unfathomable financial wealth created during this great credit bubble and actual underlying economic wealth creating capacity. True wealth cannot be created by printing up securities or by electronic entries. Nor is true wealth determined by a stock's point of last sale. This gap will be closed; immense perceived wealth will disappear.
To better appreciate today's extraordinary and precarious "macro" environment - The Last of the Great American Credit Bubble - let's think through a more "micro" example. There are disconcerting and recurring cycles in the lending business, and this phenomenon definitely has its most striking manifestations in subprime credit. After all, there are few businesses that have greater initial growth potential than extending loans to poor credits. Because of their poor histories and financial standing, these individuals lack access to traditional prudent lenders. Or said another way, subprime lenders benefit from a very captive customer base willing to pay what most would see as outrageous interest rates to obtain financing. Offer them money; they'll take it. And with borrowers accepting arduous terms, an aggressive lending business has all the appearances of exceptional profitability. This certainly explains why aggressive lenders invariable catch the eye of Wall Street and especially the "earnings" momentum crowd. Certainly, accounting profits and future earnings look quite enticing at the moment as subprime lenders borrow in the money markets and lend like crazy at yields up to 20%. And to calculate profits, well, the computer simply generates earnings based on the significant spread between the cost of borrowing and the price of lending, while taking into consideration the possibility of a small fraction of doubtful accounts.
Estimates for problem loans and future credit losses are almost always underestimated. After a year or so, a meaningful portion of accounts will be impaired with little possibility of ever being repaid. But then again, that's why they are bad credits. And if one went through the exercise of determining the true returns generated by those initial loans, it would be quickly apparent that not only were accounting profits grossly overstated but, in all likelihood, lending to poor credits was (as its has been traditionally) a losing proposition. One might expect that this would pose an immediate problem. Surprisingly, however, the fact that the initial loans went sour causes little if any concern or disruption. How can this be the case?
Well, as long as the company continues to expand lending aggressively it is quite easy to bury bad credits. For example, let's say that a subprime credit card company initially lends $50 million. By the end of the year, 10% of the poor quality loans turn seriously delinquent with little chance of collection. Based on actual loan performance, credit losses would most certainly have wiped out "profits" completely, with future defaults and collection costs destined to create large losses (i.e. no economic profits whatsoever.) The handy computer, however, does not pursue such an analysis but is instead simply programmed to calculate accounting "profits." Yes, "profits." You see, after a year of aggressive receivable growth, the lender has increased total loans outstanding to $150 million. With $5 million (10% of initial $50 million) of the old and none of the new loans delinquent, the company boasts of only 3% problem credits. The company can even pitch to a gullible marketplace that its credit policies are sound and business prospects wonderful - that it has developed a new model for profiting from risky lending after so many others before have failed. Sure enough, with financing spreads significantly greater than the losses of 3%, our credit card lender reports impressive growth of accounting "profits." The next year, similar trends could see $15 million of delinquencies and losses. Now a problem? Nope. Not, with total loans outstanding of, say, $350 million and corresponding rapidly growing "profits."
And as long as credit card loans are extended at ever-larger quantities (with resulting quality deterioration!), accounting profits will for sometime sprint ahead of credit losses. But don't be confused; it is a race. During "the race" stage of extreme credit excess, everything appears splendid, indeed. For the community as a whole, with credit card borrowings creating surging purchasing power throughout, the economy booms. And with a prevailing and solidifying euphoria, very few will appreciate that the roots of the perceived prosperity are overwhelmingly financial - based on credit excess. Certainly, very few will recognize the ramifications of the Great Race between financial excess, festering credit problems and the impairment of the credit system. Nonetheless, mounting credit losses and an increasing impairment of the credit system are THE overriding issue. Eventually, inevitably, undeniably - lending excess will be overwhelmed by credit losses. New lending can only sprint so fast for so long. That's why it's called a credit bubble.
Trees don't grow to the sky. With our subprime company example, the credit cycle eventually progresses to a critical juncture. At some point, the lender recognizes that a serious credit problem is developing - credit losses are rapidly catching up to receivables growth; perhaps there is recognition that the business model has been flawed; and, certainly, that accounting "profits" are in grave danger. One could certainly assume and even profess that this will prove the beginning of the end to the credit cycle. Well, it should but usually doesn't. In fact, serious analysts would look at the developing situation and warn of impending collapse. And while their analysis is quite sound, their predictions of catastrophe will prove early. Failure is just not considered a viable option for the credit card company, so the natural response to heightened financial stress is to go to only Greater extremes in credit excess. After all, what's to lose? There's always a shot at growing out of credit problems, right? In past commentaries we have made repeated reference to the final period of wild and reckless credit excess: "the terminal phase of credit excess." Indeed, our economy has been in such a perilous and most regrettable circumstance since the "quiet bailout" from the unfolding financial crisis in 1998.
In our example above, the "terminal phase" could witness our credit card company resorting to expanding new receivables by a staggering $500 million as it fights to remain one stride ahead of mushrooming credit losses. To achieve this degree of credit growth, management would lower standards to new extremes - significantly increase credit limits to even the weakest credits, perhaps lend to high school and college students, the unemployed and seek out new "opportunities" such as lending to day-traders and gamblers. This period of "ultra-easy money" would potent fuel to the economic boom, while creating an only more enticing environment and "great business opportunity" lending against surging home equity. Credit excess would feed asset inflation that feeds only more excess. With money "everywhere" and surging consumer demand, entrepreneurs, businessmen and bankers extrapolate based on the recent historical trends (fueled by credit expansion) and a major (over/mal) "investment" boom transpires. Proponents of a New Era are emboldened.
It is just so important today to appreciate the amazing irony that accelerating financial stress unfortunately fosters (with the Fed on the "sidelines") only greater and more dangerous excess, with a precarious slide down the slippery slope of reckless credit induced financial and economic distortions. Moreover, it is critical to understand that there is never ANY doubt to the inevitable outcome. Importantly, the terminal phase of credit excess sows the seeds of its own destruction. It is only the timing that is in doubt, and the longer the "terminal phase" is allowed to run, the greater and more structural the damage to the financial system and real economy. With the exceedingly poor quality of $500 billion of new loans in our example, credit losses one year out could reasonably jump to $75 or $100 million for the credit card company. When the lender goes bust and is forced to write down receivables to reflect their true worth, the losses will be in the $100's of millions. For the credit card company, equity will be wiped out and lending will end. As goes credit excess, so goes the boom.
The terminal phase of credit excess is a financial ticking time bomb. The terminal phase is, likewise, a period of seemingly terrific prosperity. As such, it is an environment rife with inconsistencies, anomalies and profound misunderstandings. Despite the fact that such periods are overwhelmingly driven by financial forces and credit inflation, there is absolutely no way that the causes will be commonly accepted. True cause and effect are lost with boom-time psychology and intense disinformation. After all, booms beget bullish analysis. Perceptions of endless prosperity beget stubborn denial. And protracted booms promote the most aggressive and most bullish to the top echelons of power. There are powerful forces at work.
Today's rally will do wonders to get through the news cycle. No need now to dwell on Intel or currency disarray. We also now have 30 million barrels of oil to pump from the strategic reserve, so apparently the energy problem has been rectified as well. Hardly even a need for the spinmeisters, with the market already having spoken. So, what's not to like?
We do not think it is an exaggeration to say that festering credit problems are in the process of rotting the very core of our financial system. It is also our view that credit problems are now accelerating rapidly - possibly approaching the limit of the system's capacity to manage this problem. The facade may look dazzling, but don't look beyond. Even with extraordinary efforts by our reckless financial sector, egregious credit excess will no longer suffice for masking the unfolding credit debacle. Past financial sins have been much too great, and ever greater financial excess required to keep the game going is getting too conspicuously inflationary, distorting and, thus, self-defeating. In essence, the Great Race is winding down - the last of the Great Credit Bubble. We are about to witness egregious financial excess being overwhelmed by unprecedented credit losses, placing the viability of our financial system in jeopardy. I say this quite earnestly and with great consternation. This has been an absolute fiasco, and a needless one at that.
Over two years ago our financial sector hit its critical juncture. The entire system responded quickly and with truly astonishing force. A perilous "terminal phase" has transpired ever since. Like our negligent credit card company, caution was thrown to the wind and the inevitable consequences not even a passing concern. And with Wall Street and even Fed officials hyping the wonderment of new technologies and the New Paradigm, The Street was given absolute free rein to orchestrate the greatest episode of reckless financing, speculation, and spending the world has even known. Throughout the Internet and telecommunications sectors, literally $100's of billions was given or lent to companies with no viable business models. There was little if any concern for future cash flows. The predictable consequence is enormous amounts of wasted capital, vast plundered resources, and massive economic loss. It's been one hell of an ugly party. There are huge costs that will be paid.
Yesterday, the FDIC reported that bank profits had declined to $14.7 billion during the second quarter, a 25% decline from the first quarter's $19.5 billion and the weakest profits since 1997's second quarter. And for the first time since 1993, the banking industry's return on assets sank below 1%. Net interest margin contracted to the lowest level since 1990. The Washington Post quoted FDIC Chairman Donna Tanoue: "For the past several months the FDIC has been saying that yellow caution lights are flashing. This report shows they are flashing brighter." Ms. Tanoue was also quoted as saying "the earnings problems experience by a few large banks reflect a rising trend in the riskiness of assets that the banking industry holds." Also this week, federal bank regulators increased to $100 billion, or 5.1%, the percentage of problem syndicated bank loans. This is a dramatic increase from last year's $69 billion, or 3.8%. Bloomberg quoted David Gibbons, deputy comptroller for credit risk as stating, "these are big increases. They are, I believe, big dollars….risk is increasing in the existing portfolios. The numbers confirm that the risk has been there and is rising since 1997." The annual "shared national credit review" showed continued rising risk while lending standards eased.
As we have said before, "the chickens are coming home to roost." For two years our financial sector has been running completely out of control. During the past 10 quarters, total credit market debt increased $5.2 trillion, or 25%. And, importantly, it was these extraordinary financial conditions that were the primary cause behind the unprecedented technology investment boom, not the new technologies and certainly not some New Era. Indeed, this fateful boom is everything about a financial system run amuck. Like our credit card example with its captive customer base of risky credits, the massive Internet and Telecommunications build-out provided a once in a lifetime opportunity, replete with borrowers willing to pay any rate to raise capital for pie-in-the-sky ventures. If credit was made available, they were ready to borrow as much of it as someone was willing to lend. It was truly an insatiable demand for borrowings. It should never have been allowed to develop, but Wall Street was willing and able to provide virtually unlimited access to money. The "money spigot was turned wide open." It was a case of drunken borrowers and intoxicated lenders joining in a match made in credit hell.
Credit bubbles by their very nature require ever increasing amounts of credit. As we have explained in previous commentaries, extreme money, and credit creation are now necessary to keep inflated prices levitated in the equity, credit, and real estate markets. And, as we have explained today, the financial sector must also pursue greater credit excess in a race it will lose to extreme credit problems. It is certainly anything but a coincidence that global energy, currency, and equity markets have been in a state of disarray. These are the most obvious effects of what is increasingly acutely destabilizing credit excess. Trouble brewing…story to continue…