Accolades to the Unknown Inquisitor
It was a most unsettled week in the stock market as the ramifications from the unfolding technology debacle began to take hold. For the week, the Dow actually declined less than 1%, while the S&P500 dropped almost 2%. The economically sensitive issues outperformed, with the Transports gaining 1%, and the Morgan Stanley Cyclical index ending unchanged. Investors also gravitated to defensive issues, with the Morgan Stanley Consumer index gaining better than 1%. The highflying Utilities lost some altitude, dropping almost 5% this week. The small cap Russell 2000 and the S&P400 Mid-cap indices both sank 5%. The NASDAQ100 dropped 7%, the Morgan Stanley High Tech index 5%, and the Semiconductors 6%. As the seriousness of the unfolding credit crunch became clearer, The Street.com Internet index was hit for 16% and the NASDAQ Telecommunications index dropped 8%. In a further ominous development for the financial markets generally, financial stocks came under intense pressure today with the S&P Bank index declining 3% and the AMEX Securities Broker/Dealer index 5%. For the week, the Bank index declined 3% and the Brokers 6%. Gold shares were hit for almost 8% this week.
The credit market also traded with considerable volatility. For the week, 2-year Treasury yields were largely unchanged, while 5 and 10-year Note yields increased 2 basis points. Long-bond yields actually declined 4 basis points. Notably, mortgage-back and agency securities underperformed, with yields rising 6 basis points. Spreads widened sharply over the past three sessions, with the benchmark 10-year dollar swap yield widening 9 basis points to 116. Junk spreads remained generally unchanged at extreme levels. Going forward, these various spreads should be monitored closely for indications of increasing systemic stress. Globally, considerable tumult continues throughout currency markets as a virtual dollar melt-up feeds a general marketplace dislocation. We expect only increasing turbulence in global credit and currency markets.
"In the prosperity phase, investment from innovating activity increases consumers spending almost as quickly as producers spending. '…old firms will react to this situation and…many of them will 'speculate' on this situation. A new factory in a village, for example, means better business for the local grocers, who will accordingly place bigger orders with wholesalers, who in turn will do the same with manufacturers, and these will expand production or try to do so, and so on. But in doing this many people will act on the assumption that the rates of change they observe will continue indefinitely, and enter into transactions which will result in losses as soon as facts fail to verify that assumption…New borrowing will then no longer be confined to entrepreneurs, and 'deposits' will be created to finance general expansion, each loan tending to induce another loan, each rise in prices another rise'…this is a well-known cumulative process Schumpeter called "the secondary wave." In it is included the clusters of errors, waves of optimism, and overindebtedness…" From Joseph A. Schumpeter's Business Cycles, 1939
We often highlight silly comments from the "Lonesome Dove" - Robert McTeer, President of the Dallas Federal Reserve Bank. While we don't think much of his "economics," he does enthusiastically and clearly articulate the flawed view of the bullish consensus. Besides, he's certainly "quotable," and has most definitely made his mark on financial history. Regrettably, his legacy will be how not to be a central banker. All the same, he maintains his status as Wall Street's most beloved member of the Fed: "My Man McTeer, who's just a wonderful Fed policy-maker (Larry Kudlow, CNBC 10/6/00)!"
Not only do we disagree completely with his focus on the New Paradigm, we are rather astounded that the Dallas Federal Reserve's website so propagandizes the New Economy. This is incredibly inappropriate. Interestingly, Dr. McTeer now likes to point out that other economists have finally accepted his New Economy view. Well, the rug is about to be pulled right out from under them. There are two vital elements that are never factored into the New Paradigmers' analysis: profits and credit. Developments with both of these critical issues are now emerging and together are bringing an end to the historic U.S. bubble.
First, I would like to highlight an excerpt from his speech "Manufacturing in the New Economy," given Wednesday by Dr. McTeer:
"The New Economy is good news. But it is primarily good news for the consumer. That's what economies are for. All is not so wonderful for producers. Consumers get to participate in the New Economy. Producers have to participate or lose out. Increased competition means producers must innovate and improve constantly. Monopoly profits are harder to come by. Economic profits are temporary at best, as new producers somewhere on the planet move in like hyenas on someone else's kill. As New Economy elements grow and infuse Old Economy firms with new efficiencies and vigor, the churn in the economy already fierce will only grow fiercer. The choice is between the quick and the dead. Innovate or die. Embrace change; learn to love chaos. Bringing order out of chaos is an American trait. All of these things are. We're the leaders of the New Economy because we nurture our nerds better. Because we aren't afraid to fail."
This is a most fascinating paragraph. The fact that it comes from one of our country's top central bankers should be shocking, and certainly provides more fodder for future financial historians as few paragraphs so illuminate the major flaws in New Paradigm thinking.
First of all, you may have noticed that New Paradigmers usually don't discuss profits, choosing instead to focus on productivity and the notion of "creative destruction." Yet, profits are THE critical underpinning of capitalist economies. Profits are the oil that keeps the machine running. Profits are the mechanism that effectively directs scarce capital and resources - the foundation for the market pricing mechanism. Profits, as a proxy for cash flows, provide the basis for rewarding innovation and sound investment. Profits are the rewards reaped by astute risk-taking shareholders. And, importantly, profits are what ensure that an enterprise will be able to service its debts. Without profits, there is no sustainable economic prosperity. An economy with its financial and business sectors intent on rewarding consumers at the expense of economic profits is destined for a problematic misallocation of resources, instability, and inevitable stagnation. Indeed, a system without a profit motive is one of inevitable financial and economic fragility.
The fact that McTeer would admit that "economic profits are temporary at best" is quite remarkable. That this in no way reduces his sanguine view of future economic prospects is as unbelievable as it is disconcerting. It certainly indicates an incredible lack of understanding of the dynamics of capitalism and economics generally. As such, we doubt the concept of financial fragility even enters into the minds of the New Paradigmers. Certainly, we have heard nothing from the likes of McTeer or Kudlow that lead us to believe they have a clue as to the root causes of the unsound boom, and certainly not the dark consequences now unfolding. We are in full agreement that economic profits are today in most serious jeopardy. But this is not part of some "New Economy" but is instead terrible news for our economy and financial system - the ugly but inevitable consequence of years of runaway credit excess and reckless overspending. But, then again, this is precisely why the Federal Reserve was created and given the momentous responsibility of carefully guarding our credit and financial system. To be a central banker is to err on the side of conservatism because the cost of erroneously interpreting a "New Era" is devastating. The Great Depression was not that long ago…
For too long, enormous amounts of capital, credit, and resources have been thrown at enterprises with little opportunity of ever achieving economic profits. This has particularly been the case since the "Quiet Bailout" of 1998, with the collapse of Russia's financial system, LTCM, and the "seizing up" of the U.S. credit system. Previous financial and economic excesses were "papered over" with even greater excess - the greatest period of credit and speculative excess in history. Specifically, the resulting "reliquefication" created and funneled $100s of billions to fuel the wildcat build out of the Internet, telecommunications, and a massive technology bubble generally. It was a gross monetary and economic fiasco the likes not seen since the late 1920s. It is today important to recognize that the unavoidable cost of this breakdown in financial and economic sanity is now to be paid.
There were all kinds of rumors flying around the market today. One prominent rumor had a major securities firm with losses in the junk bond market, perhaps as much as $1 billion. We have no idea if these rumors have any substance, but such a situation is quite reasonable considering the recent performance of junk debt, particularly within the telecommunications area. There are definitely enormous festering losses out there somewhere. Clearly, both the Wall Street firms and the major banks have ballooned their balance sheets this year in their efforts to perpetuate the bubble. Much of this lending, certainly, has been to finance profitless and negative cash flow companies, many having lost their access to the capital market. Furthermore, we continue to expect major credit issues to develop in the syndicated bank loan area that has provided $100s of billions of "leveraged lending."
Apparently, margin calls were prevalent throughout and there was also concern as to the quality of brokerage firm collateral. With today's weakness throughout the financial sector, perhaps there is finally some recognition that many speculators have borrowed against credit cards and financed margin accounts with home-equity loans. Certainly, the quality of real estate collateral has been compromised by the widespread marketing of low down payment loans and other mechanisms. Wall Street firms have zealously encouraged aggressive mortgage borrowing, minimal monthly payments and the maximum exposure to the stock market. There are also newsworthy examples of margin calls. Apparently the Chairman of WorldCom was forced to sell $79 million of stock to meet margin requirements. Importantly, margin calls lead to a collapse of credit and faltering liquidity for the stock market and financial system generally. We also suspect that derivative-related liquidations are also in play, another key factor that engenders a contraction of credit and illiquidity. We are certainly keen to the dangerous derivative dynamics where selling begets a contraction of credit and only more liquidations to the point of a liquidity crisis.
There are also some specific credit-related issues worth mentioning. Monday, Xerox once again shocked Wall Street, this time with news of its first loss in 16 years. Not only was the stock crushed, but Xerox's debt was clobbered as well, basically given junk status with spreads widening 160 basis points to 408 basis points. Xerox debt due in 2004 ended the week yielding almost 11.5%, 558 basis points over the 5-year Treasury. And while the media relegated Xerox's news to the status of just one of many earnings disappointments, keep in mind that the company has over $24 billion of liabilities (with equity of under $6 billion). The company's predicament is certainly an interesting situation as it has been providing financing to about three-quarters of its customers. Vendor financing has certainly been all the rage for some time now, and a great driver of spectacular industry revenue growth throughout the technology sector during this most extreme example of "ultra-easy money."
In Xerox's case, it was generally office copiers. For other companies it has been providing financing for startups and others to purchase mainframes, personal computers, servers, printers, routers, and mountains of telecommunication equipment. With literally hundreds of cash-strapped Internet and telecommunications companies in literal death spirals, there will be lots of returned equipment and unpaid receivables. There will also be cancelled orders and a major decline in demand. This morning on CNBC, Larry Kudlow stated that technology investors were erroneously "discounting the next two recessions." No, that's not it Mr. Kudlow. Investors, quite rationally, are discounting the beginning of the end to all the nonsense financing arrangements and a collapse of margins. It's not that difficult to grasp. The environment has changed.The bubble has burst.
Interestingly, we see that financial sector commercial paper expanded by $19 billion last week. The "Asset-Backed Commercial Paper"/"funding corp" category jumped an extraordinary $15 billion. Only time will tell as to the degree of telecom/technology receivables that have been financed by such sophisticated Wall Street structures. We certainly suspect that such vehicles have and continue to be convenient repositories for risk as investors become increasingly risk-averse. Time for "Financial Alchemy." As we wrote above, it is certainly our view that credit losses are huge and mounting. A story yesterday from Dow Jones caught our attention - "Default Swap Market Heats Up On JC Penney's, Auto Parts." "Nervousness over recent corporate downgrades and performance woes spilled over into the credit default swap market Thursday." According to the article, "five-year default swaps…were bid at around 450 with no offer on the other side, indicating that the market participants were unwilling to 'go long' on J.C. Penney's credit." Over the years, an enormous market has developed for transferring credit risk. There has been an unprecedented proliferation of credit insurance, "funding corps" structured to accept credit risk from other sophisticated vehicles, and credit derivatives both listed and over-the-counter. Like vendor financing, the motivation is to foster the selling of product - in this case additional lending through the creation of risky securities, structures and vehicles. Also like vendor financing, the market for transferring credit risk will be severely tested over the coming months.
It is, unfortunately, my view that we are now moving in an uncomfortably methodical pace right into a financial and economic crisis unlike anything experienced in this country since the Great Depression. I say this because it is clear that problems are not cyclical in nature, but structural, and not this time easily mitigated. As I have tried to explain in past commentaries, for way too many years money and credit excess have created unprecedented distortions to both our financial system and economy. This time more reckless "easy money" will not do the trick. In fact, this crisis is quite noteworthy as it commences with a booming economy, low interest rates, and rampant money and credit growth. Importantly, we have reached the point where the system is simply fully taxed and generating rapidly escalating credit loses, as well as faltering profits despite generally strong demand and a clear inflationary bias. Indeed, the system is suffering from the effects of the last "bailout." Moreover, since the 1998 crisis even, more leverage has been added to a further impair the financial, corporate, and household sectors. Additionally, massive current accounts have created astonishing debts now owed to foreign investors/speculators.
It is critical to recognize that the unfolding financial and economic crisis made a decisive move forward this week. Today, in particular, came the market's first recognition of the acute vulnerability for the entire financial sector to unfolding events. I am surprised that it has taken this long. But, as is often the case, these types of situations take much longer to develop than one would expect. But when they do "take hold," they then tend to unfold with ferocious rapidity. Right now, this is developing similar to 1998. In the Spring of that year problems began to fester in the market for Russian debt instruments. And while this development garnered little attention (apparent only by watching widening spreads), it was a festering problem for the highly exposed leveraged speculating community. Finally, a full-fledged crisis occurred as Russia defaulted and the dominos began to fall. Stung in Russia, the hedge funds and securities firms were forced rein in risk, dumping securities in various markets around the world. The dilemma, of course, is that highly speculative and leveraged financial systems are acutely vulnerable to any move toward liquidation. When the major leveraged players become sellers, there are no buyers.
Today, instead of Russian debt, it is telecom and other high-yielding securities. Here we find what may prove a critical difference from 1998: There are severe domestic credit issues. In fact, we cannot imagine a more fragile financial structure and imbalanced economy than those existing today. Vulnerability abounds, be it the banks, the Wall Street firms, or the hedge funds that supposedly now have assets of $475 billion and God only knows the size of their positions. Perhaps the weakness in the financial stocks today was indicating that the leveraged speculators have been hurt and that a liquidation of positions is in the works. If this is the case, all eyes on the asset-backed and agency markets. And with extraordinary tumult in global equity, junk bond and currency markets, there have certainly been casualties within the ranks of the speculators. Wild swings in U.S. swaps market are also indicative of trouble for the leveraged players as well. As was the case in 1998, dislocation can quickly develop throughout global derivatives markets. We would not be surprised if something like this is in process.
I will conclude by extending Accolades to the Unknown Inquisitor. This question came at the end of recent McTeer speech in Houston on The Role of Technology in the U.S. Economy.
"The question I have for you as a member of the Federal Reserve and all the Federal Reserve Governors is simply this: In the New Economy, I will use Microsoft as an example, companies are more dependent on intellectual capital as opposed to financial capital, unlike an Old Economy company like Exxon, where they obviously need a lot of intellectual capital too, but financial capital is the constraint. The question is, though, as the economy evolves into the New Economy and financial capital seems to be less important - companies are using just in time inventory, managing working capital needs better, so on and so forth. Why is it that we seem to have excessive credit growth? Why is it in a 6 or 7 percent nominal GNP economy M3 consistently grows 10 to 12% a year. Why is it the two largest government sponsored enterprises, for instance Fannie Mae and Freddie Mac are exploding their balance sheets. Why is it that the Federal Reserve, at the hint of any crisis, 97, 98, Russian defaults, Long Term Capital Management, Y2K, the Federal Reserve explodes its own balance sheet to facilitate another of explosion of credit in the economy. It seems like to me there is a disconnect because the economy seems to require a lot financial capital to continue to grow. It seems the New Economy paradigm would argue that financial capital would be used ever more efficiently and require less credit on the part of the Nation's central bank."
I will spare you Mr. McTeer's response. Suffice it to say he was not even close to providing adequate answers to these most important questions.