A Tale of Two Bubbles

By: Doug Noland | Fri, Sep 29, 2000
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Total Corporate Borrowing by Quarter
Corporate Debt Outstanding
Institutional Money Funds
Junk Bond Spreads vs. 10 Year Treasury

Not unexpectedly, the stock market turned even more chaotic this week, with the technology sector being the wildest of rides. For the week, the Dow dropped just under 2% and the S&P500 under 1%. On the back of UAL's earnings disappointment, the Transports dropped 3%. The Morgan Stanley Consumer and Morgan Stanley Cyclical indices bucked the trend, gaining almost 1%. The Utilities jumped better than 6%, increasing its gain for the quarter to 32%. The small cap Russell 2000 added less than 1%, while the S&P400 Mid-cap index increased 2%. The financial stocks ended a strong quarter with more gains as the S&P Bank index and Bloomberg Wall Street index both added almost 3%. The Biotechs ended the week largely unchanged, with a gain for the quarter of 20%. It was a much different story in the tech sector, of course, with many leading stocks taking a pounding. For the week, the NASDAQ100 dropped over 3%, with the Morgan Stanley High Tech index sinking almost 5%. The Semiconductors and The Street.com Internet index were hit for 8%, while the NASDAQ Telecommunications index was unchanged. The NASDAQ100 dropped 5% for the quarter.

It was a solid finish to a strong quarter for much of the credit market. Two-year Treasury yields dropped 5 basis points, while the 5-year saw its yield sink 8 basis points to 5.84%. Gains were less impressive further out the curve, as 10-year T-note yields declined 4 basis points and the long-bond 2 basis points. Mortgage and agency securities continue to outperform, with the yield on the benchmark Fannie Mae mortgage-back security dropping 7 basis points to 7.56%, the lowest yield since December. Agency securities generally dropped about 8 basis points. The benchmark 10-year dollar swap spread narrowed another 4 basis point to 110. This spread narrowed 17 basis points over the past three weeks. Importantly, however, all is not well in the junk bond sector as the spread between junk bonds and Treasuries widened sharply, increasing 13 basis points to 578. Junk spreads are now at the widest level since the financial crisis in 1998, having increased a staggering 60 basis points during the quarter. Currency markets continue to be quite unsettled, although the dollar ended the week largely unchanged. The gold market also demonstrated notable volatility, jumping more than $6 earlier in the week before ending with a gain of almost $2.

Shareholders from Apple, Intel, Microsoft, Dell, Cisco, Lucent, Motorola and a slew of other leading technology companies must today be a bit puzzled by the so-called New Era. From PCs, to the Internet, wireless, and telecommunications equipment sectors, investors are now faced with what in many cases is the harsh reality of rapidly deteriorating business conditions, faltering profits and utmost uncertainty as to future prospects. On the fixed-income side, it is now a much less sanguine case of studying balance sheets and deteriorating cash flow positions. The game has changed. Yet, although not all too surprising, there is no letup in the "productivity miracle" hype from the Federal Reserve and the New Paradigmers. And, of course, the Wall Street spin machine is out in force, arguing that sinking stock prices are only temporary, related to "company specific" issues or an economic "pause that refreshes." It is, however, patently obvious that there are severe unfolding industry problems. These developments, we might add, come quite ominously in the midst of a general economy remaining exceptionally strong and the financial sector enterprising, albeit hopelessly unsound.

The technology and telecommunications sectors are in the early stages of what will prove a devastating industry shakeout, the inevitable consequence of years of truly massive and unprecedented credit and speculative excess. Companies will struggle, many unsuccessfully, in an environment fraught with extreme imbalances and distortions, the consequences of massive credit-induced (mal/over) investment. The technology sector is traditionally rife with hyper-uncertainty and wild boom and bust cycles. Throw in an unprecedented systemic credit bubble, with a $trillion dollar flood of money and credit rushing to play, and an uncontrollable quagmire develops. We suspect that many companies have little clue as to future demand. First, it is today unknown as far the extent to which order books were distorted by the double ordering that emanated from previous shortages. There is furthermore the uncertainty that comes with customers losing financing. What a quagmire. Indeed, the entire technology super-industry bubble has been at the epicenter of the Great American Credit Bubble, and global credit excess generally. As such, the critical issue today is certainly not productivity, but acute systemic financial fragility.

Interestingly, however, as the enormous technology bubble comes under intense stress, the overriding financial bubble turns even more outrageous. This is no coincidence. With a credit system dominated by the leveraged speculators and investment bankers, heightened credit issues in the telecom/corporate junk bond sector only incite more aggressive speculative flows into the consumer debt area, be it mortgage-backs or asset-backed securities. There are powerful forces at work. Actually, there have been occasions over the past few months when we have contemplated that the Federal Reserve acquiesces to continued extreme monetary excess as a mechanism to accommodate the air coming out of the technology bubble. Knowing the history of the Greenspan Fed, this is certainly plausible. The cost of such perpetual failed policy is a disastrous acceleration of installment and mortgage debt by the already highly overborrowed and vulnerable consumer sector.

Indeed, there is every indication that the financial sector is determined to perpetuate dangerous excess - "if not on the corporate side, let's push consumer debt! Just keep the money creation going and hopefully enough will find its way into the stock market allowing the more savvy to get out without a debacle." Last week, broad money supply expanded by $33 billion. While some may wish to believe that there has been a slowdown in money growth, the reality is that after a protracted period of historic monetary excess, money supply expansion has actually accelerated. During the past 10 weeks, broad money supply has surged $166 billion, an annualized rate of almost 13%. Over the past 20 weeks, M3 has expanded at a rate of nearly 10%. And while several economists a couple months back were trying to point towards a temporary slowdown in M2 as evidence of a slowing economy, such analysis has been muffled by 10-week M2 growth of $110 billion, or 12% annualized.

Again last week, "institutional money funds" led the monetary charge, increasing $13 billion. Combined with the $5 billion increase in "retail money funds," total money market funds accounted for more than half of broad money supply growth. Over the past six weeks, "institutional money funds" have increased $33 billion (41% annualized). During the past twenty weeks, "institutional money funds" have jumped an astounding $93 billion, or an annualized rate of 38%. As we said, the financial sector is quite determined.

Not coincidently, last week was the biggest week ever for the asset-backed security marketplace, with almost $12 billion issued. Year-to-date, $162 billion of non-mortgage-back securities have been created, about flat with last year's record pace. Of this total, 27% were collateralized by auto loans, 27% home-equity loans, 22% credit card receivables, 8% student loans, 5% equipment, 5%, manufactured housing, and 6% "other." Last week's record issuance included a $2.8 billion credit card deal from Citibank. CIT Group sold $1.06 billion of bonds "backed by leases on computers, telecommunications and other equipment…"(from Bloomberg). Associates sold $1 billion of securities collateralized by auto receivables. This week a long line of issuers tapped the market, including Chase with a deal of almost $1 billion, Toyota's finance arm with $1 billion, and Providian with $1 billion, to mention only the largest deals. MBNA priced a credit deal of one billion Swiss francs ($569 billion).

Yesterday, GMAC announced a record month of securitizations, and is apparently quite tickled by its achieving the status as a "leading" lender to risky credits. Last year GMAC purchased DiTech Funding, and from the unrelenting commercials it is quite apparent that GM is working diligently to be the leader in "125% second mortgages." We will include the entirety of yesterday's news release. Maybe we are not hip to contemporary finance, but this is nuts. And the fact that all of this seems reasonable to everyone else is only more disconcerting. For sure, "this is not your father's General Motors." But, then again, it is certainly as a sign of these most extraordinary times.

"MINNEAPOLIS--September 28--Residential Funding Corporation (GMAC-RFC) today announced the issuance of a record-breaking $2.5 billion in asset-backed securities (ABS), marking the largest issuance month in the company's history. September issuance included a $583 million, high-loan-to-value (HLTV) home equity loan securitization, $1.4 billion subprime securitization, $138 million home equity line of credit (HELOC) deal, and $380 million issued from the new RAMP (Residential Asset Mortgage Products) shelf.

For the first nine months of 2000, GMAC-RFC has securitized more than $8 billion in ABS, including over $2 billion in HLTV product, making GMAC-RFC the leading HLTV issuer to date. This recent transaction, the company's fourth of the year, demonstrates GMAC-RFC's ongoing commitment to the HLTV securitization business. Year-to-date subprime issuance exceeds $4.9 billion.

"This record issuance confirms our commitment and support of the HLTV, HEL and subprime markets," said Eric Scholtz, managing director, capital markets at GMAC-RFC. Scholtz said the company fully expects to continue its support of the HLTV, HEL and subprime markets into the future. "We are dedicated to delivering a diversified product line through separate and distinct shelves on a consistent basis to our investor customers," said Scholtz. "We have every intention of building on our current success to deliver even more investment alternatives in the future."

In 1999, GMAC-RFC issued more than $1.75 billion in HLTV product, making it the largest HLTV issuer nationwide, according to industry sources. In addition, as of first half 2000, GMAC-RFC ranks as the number three issuer of ABS overall, as the number one issuer of HEL and subprime B&C product, and number two issuer of private-label MBS.

GMAC-RFC, a wholly owned subsidiary of General Motors Acceptance Corporation, is America's largest non-agency issuer of mortgage-backed securities and a leading residential warehouse lender. The company leverages its strengths in securitization, lending and investment to offer a broad portfolio of innovative capital solutions. The company is headquartered in Minneapolis and operates in the United States, Europe and Latin America. www.gmacrfc.com."

Considering the extraordinary environment, perhaps GMAC should be can be forgiven for boasting of its aggressive expansion into high-risk lending. After all, it has become the hottest ticket in town. Wall Street could simply not be more enamored with the consumer lending business and, importantly, the more risky the better. Telecom schmelecom, SUBPRIME is where it's at!. Just take a look at the stocks. Year-to-date, Capital One has gained 45%, Providian 39%, Metris 66%, Household 52%, and Americredit 56%. With Wall Street cheerleading all the way, the rate at which some of these aggressive finance companies are lending is astounding. Capital One is expected to grow managed receivables by 28%, Providian 34%, and American Express 34%. Revenue is expected to grow 35% at Metris. Household International is also a favorite with its core managed loans expected to expand by 22% this quarter, led by an anticipated 40% growth rate for home equity lending and 55% for auto loans. One Wall Street industry research report stated that "customer and receivables growth remains robust, ranging from 20-40% annualized for the companies we cover."

Something else caught our eye while reading through another piece of Street research on the credit card industry: "We expect strong 9% to 10% year over year industry wide receivables growth. We estimate that rising oil prices are contributing approximately 2% to 3% to card-industry receivable growth, which should maintain the current 9% to 10% industry growth through the first quarter of 2001." Well, well, monetization of higher oil prices…that is precisely how inflation begets only higher inflation.

With continued incredible money and credit excess, we remain quite skeptical of the view of a meaningful economic slowdown. Today, the Chicago Purchasing Managers' index posted a sharp increase, jumping to 51.4 during September from 46.5. Both New Orders and Production jumped more than 8 points, New Orders to 66.7 and Production to 62.4. These are both very strong levels. Also today, it was reported that spending rose at a strong 0.6% during August with the largest increase in durables purchases since February. With spending rising faster than income, the savings rate set a new record at negative .4%. There was also a revision to 2nd quarter GDP to 5.6% from 5.3%, as well as another significant decline in initial unemployment claims.

This week the National Association of Realtors announced a much stronger than expected 9.3% increase in August's existing home sales. Sales jumped 16% in the West, 5% above a very strong August of 1999. The average price in the West jumped $13,700 to $247,400. Transaction dollars (volume multiplied by average price) in the West were $34.6 billion, 36% of national, and a 10% increase from last year. For comparison, transaction dollars in the West were actually 44% above August of 1997. Nationally, transaction dollars of $96 billion are 38% above August of 1997. Looking at inventories, available units dropped to a 3.7 months supply from July's 4.3 months. The actual number of units was 19% below last year. That may explain why Homebuilding stocks were ranked second of 87 S&P industry groups during the quarter, posting a 41% advance.

From the California Association of Realtors: "The median price of a single-family home in California hit a new record in August, rising 14% to $255,580. August also was the 42nd consecutive month that the median price of a home posted an increase compared to the previous year…resale activity posted an increase of 17.7% in August 2000 compared to July 2000." The unsold inventory index ended the month at 3.4 months. It is truly amazing how the California real estate bubble has expanded to include the entire state, from luxury neighborhoods in Hillsborough to working class communities in Riverside County and the high desert. Year over year, prices have surged 39% in Marin County, 47% in Santa Clara, 30% in Sonoma Country, 19% in Orange Country, and 35% in San Diego. Increasingly, however, the key development appears to be the dramatic broadening of this historic real estate bubble. In the Greater San Francisco Bay area, we see year-over-year prices increased 26% in Hayward, 23% in Oakland, and 34% in Richmond, not areas traditionally recognized as the most desirable. Down south with the least expensive desert real estate, we see that Palmdale experienced a 36% increase to $117,000.

From this morning's Wall Street Journal, F.W. Dodge reported that that the value of new residential building contracts in the West region increased 12% during August. The most interesting news this week, however, comes from an article written by James B. Kelleher from the Orange County Register - "Golden View of State Economy - Forecast: A UCLA report sees a ‘truly stellar' situation, predicting growth in spending, personal income and payrolls." Quoting highly respected economic forecasts from UCLA, "the Golden State's economic glow doesn't appear to be in any danger of fading…personal income in the state will rise an eye-popping 10.3 percent this year, up from 7.5 percent in 1999…consumer spending will rise 10.9% in 2000, up from 9.9% percent in 1999."

One could not imagine a clearer manifestation of a bubble economy than the present situation in California. In fact, it will provide an historical case study in how extreme credit excess feeds first into asset inflation. If allowed to run unabated, over time credit excess is further transmitted into extreme income and spending growth, and resulting distortions and imbalances to the financial sector and economy. It should be recognized as a textbook inflationary bubble, one that the Federal Reserve presently allows to grow to even greater and more precarious extremes. The California boom is now a severe structural dilemma that will prove quite problematic for both the financial system and economy when The Great U.S. Credit Bubble bursts.

In regard to bursting bubbles, we read with great interest a recent research report on the telecom equipment industry from Sanford Bernstein analyst Paul Sagawa. Quoting from the report: "Free cash flows have turned sharply negative - only four of 41 US (communications) carriers showed positive cash flow during (the first half) - making it painful to fund further capex acceleration without external financing…Increased scrutiny of equipment suppliers' balance sheets has made it more difficult to secure vendor financing. In this environment, we believe we are likely to see few new-build network projects funded, more carrier bankruptcies and a trend toward capex unfriendly industry consolidation."

All we can say is that the "communications arms race" has provided the (in the spirit of Hyman Minsky) ultimate in "Ponzi Finance" (see May 26th CB Bulletin). This scheme, however, is now faltering. Reiterating our point from last week, this is an absolute credit nightmare in the making.

With rapidly deteriorating fundamentals, it is not surprising that financing sources are rapidly running dry. That is the nature of credit bubbles. As junk debt badly lags other sectors, junk bond funds are suffering outflows. According to AMG Data Services, almost $450 million exited junk funds this week, bringing to $7 billion the outflows so far this year. With investor demand waning, issuance of junk debt during the past nine months dropped by almost 50% to $38 billion (investment grade debt issuance jumped 8% to $335 billion). So, the predicament should be obvious: A massive telecommunications sector whose lifeblood is junk debt and leveraged lending, finds itself running increasingly cash-flow negative, at the same time increasingly nervous investors flee the sector and heavily exposed bankers begin to panic. Normally, such a situation would appear quite dire. Today, that may not necessarily yet be the case, with the (temporary) solution - Wall Street structured finance.

In previous commentaries we have discussed how "funding corps" and other structured finance vehicles have and continue to play critical roles in perpetuating this dangerous credit cycle. Well, a news item caught our attention yesterday. "Moody's Rates Lucent's Insured Asset Funding (Asset-Backed Commercial Paper) Program Prime-1." This is a $1.1 billion "bankruptcy-remote limited liability company (or "funding corp")" that will be collateralized by a "a revolving pool of loans and trade receivables that finance the sale of telecommunications, data networking and other equipment, products, services and systems provided by Lucent Technologies and its affiliates." To get the necessary top commercial paper rating, there will be the typical full credit enhancement, in this case "insurance" from National Union Fire Insurance, a subsidiary of American International Group. There will also be liquidity support from a syndicate of banks, with Citibank acting as agent. The magic of these popular "funding corp" structures is the ability to obtain top commercial paper ratings and borrow aggressively from the money market to finance higher-yielding and much riskier instruments, and do it all with virtually no transparency.

Only time will tell as to the quality of assets used as collateral for the almost $600 billion in asset-backed commercial paper. These entities have clearly been a key source of financing during this boom, having grown from about $100 billion since 1996. We certainly suspect that these entities have been repositories for telecommunications debt and industry receivables, and likely other risky credits that we would not consider appropriately funded from the money market. It is also worth noting that regular non-financial commercial paper has increased by $93 billion, or 36%, to $350 billion during the past twelve months. This dramatic increase in corporate sector short-term indebtedness is also indicative of heightened financial fragility, and could be related to investors' lost appetite for risky credits. If there were ever a time for regulators, ratings agencies and investors to be on careful watch, it is right now.

We don't really see much of a mystery as to why money market funds, particularly on the institutional side, have been ballooning: these are the vehicles being called upon to provide financing as investors increasingly avoid risky credits directly. As we have discussed in previous commentaries, contemporary Wall Street provides an amazing example of a seemingly perpetual "financial alchemy" - the unrelenting churning machine that turns risky loans into pristine "money" - increasingly money market fund assets (see June 23rd CB Bulletin). And the more arduous the financing environment, the greater the necessity for The Machine to perform its "alchemy" with increasing vigor. Yes, Wall Street has created a system where it can create its own liquidity - create the "money" that then provides the demand for the securities it issues to feed this fateful boom. It is a system, however, of smoke and mirrors - "money out of nothing" - credit on credit, and increasingly poor credit at that.

During the just concluded third-quarter, the NYSE Financial index gained 20%, the S&P Bank index 21%, the NASDAQ Financial index 22%, and the AMEX Securities Broker/Dealer index a stunning 33% (47% ytd). For the financial sector, apparently, it was the best of times. For many of leading producers of real products, however, it marked the onset of what will prove the worst of times. We don't expect this extreme divergence to continue.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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