Asset-backed Securities

By: Doug Noland | Fri, Jul 15, 2005
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HIGHLY UNEDITED!

The Dow gained 2% this week, with the S&P500 up 1.3%. Economically sensitive sectors shined. The Transports and Morgan Stanley Cyclical indices added 1.6%. The Utilities posted a fractional gain, while the Morgan Stanley Consumer index rose 2%. The broader market was somewhat restrained this week. The small cap Russell 2000 was slightly positive, and the S&P400 Mid-cap index added 0.5%. The tech sector was strong. For the week, the NASDAQ100 and Morgan Stanley High Tech indices jumped 3%. The Semiconductors surged 5%, with The Street.com Internet Index up 2.5%. The NASDAQ Telecommunications index rose 1.3%. The Biotechs added 2.6%, increasing y-t-d gains to 13%. The Broker/Dealers were up 1.4%, with 2005 gains rising to 10%. The Banks caught fire, rising 2% this week. With bullion down $1.55, the HUI Gold index declined 3%.

For the week, two-year Treasury yields jumped 10 basis points to 3.86%, the highest level since the late-March spike. Five-year government yields rose 9 basis points, ending the week at 3.97%. Ten-year Treasury yields gained 8 basis points for the week to 4.17%, and long-bond yields added 6 basis points to 4.40%. The spread between 2 and 10-year government yields dropped to 31. Benchmark Fannie Mae MBS yields rose 6 basis points, outperforming Treasuries. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note narrowed one basis point to 31, and the spread on Freddie's 5% 2014 note narrowed 1.5 basis points to 30. The 10-year dollar swap spread declined 0.25 to 42.75. Corporate bonds generally performed well, with investment grade spreads narrowing to 4-month lows. Auto bond and CDS spreads narrowed. Junk bond spreads also narrowed moderately this week. The implied yield on 3-month December Eurodollars rose 5.5 basis points to 4.145%, the highest level sincne April 9.

At $23.2 billion, it was the second-strongest week of corporate issuance this year (from Bloomberg). Investment grade issuers included Genentech $2.0 billion, Petroleum Export $1.5 billion, SLM $1.25 billion, Wrigley $1.0 billion, HSBC $750 million, Archstone-Smith $500 million, Mylan Labs $500 billion, Dominion Resources $1.0 billion, Monsanto $400 million, Regency Centers $350 million, John Deere $350 million, Beazer Homes $350 million, CCM Merger $300 million, Northern States Power $250 million, Valspar $150 million and Entergy Gulf States $100 million.

Junk bond fund reported inflows of $(80.7) million (from AMG). Junk issuers included Quiksilver $400 million, Clayton William Energy $225 million, million.

Convert issues included Oil States International $175 million and Advanced Medical Optics $150 million.

A surge in foreign dollar debt issuance included Royal Bank of Scotland $3.0 billion, L-Bank $1.5 billion, Sumitomo Mitsui Bank $1.35 billion, Export Import Bank China $1.0 billion, Colombia $1.0 billion, Swedish Export Credit $1.0 billion, CSN $750 million, Peru $750 million, Gazprom $650 million, PCCW $500 million, Nippon Life $450 million, KT Corp $400 million, and Stats Chippac $150 million.

Japanese 10-year JGB yields jumped 6.5 basis points this week to 1.27%. Emerging debt markets were somewhat mixed but generally impressive. Brazilian benchmark dollar bond yields dipped 3 basis points to 7.76%. Mexican govt. yields ended the week unchanged at 5.41%. Russian 10-year dollar Eurobond yields rose 3 basis points to 6.04%.

Freddie Mac posted 30-year fixed mortgage rates rose 4 basis points to 5.66%, an eight-week high yet down 34 basis points from one year ago. Fifteen-year fixed mortgage rates gained 5 basis points to 5.25%. One-year adjustable rates jumped 6 basis points to 4.39%, up 37 basis points from a year earlier to the highest level since August 2002. The Mortgage Bankers Association Purchase Applications Index declined 7.2% last week. Purchase applications were up 4% compared to one year ago, with dollar volume up almost 16%. Refi applications dropped 8.4%. The average new Purchase mortgage dipped to $236,900. The average ARM declined to $346,300. The percentage of ARMs dropped to 27.9% of total applications.

Broad money supply (M3) declined $13 billion to $9.744 Trillion (week of July 4). Year-to-date, M3 has expanded at a 5.4% growth rate, with M3-less Money Funds expanding at a 6.8% pace. For the week, Currency dipped $0.1 billion. Demand & Checkable Deposits fell $6.2 billion. Savings Deposits gained $4.5 billion. Small Denominated Deposits added $3.0 billion. Retail Money Fund deposits dipped $0.2 billion, while Institutional Money Fund deposits added $3.1 billion. Large Denominated Deposits dropped $14.2 billion. For the week, Repurchase Agreements increased $2.5 billion, while Eurodollar deposits declined $5.6 billion.

Bank Credit rose $37.5 billion last week. Year-to-date, Bank Credit has expanded $476 billion, or 13.6% annualized. Securities Credit advanced $9.7 billion during the week, with a year-to-date gain of $155.8 billion (15.7% ann.). Loans & Leases have expanded at a 13.2% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 18.8%. For the week, C&I loans gained $7.0 billion, and Real Estate loans jumped $19.1 billion. Real Estate loans have expanded at a 15.4% rate during the first 27 weeks of 2005 to $2.744 Trillion. Real Estate loans were up $344 billion, or 14.3%, over the past 52 weeks. For the week, Consumer loans rose $1.1 billion, while Securities loans declined $8.4 billion. Other loans gained $8.8 billion.

Total Commercial Paper jumped $24.4 billion last week to $1.537 Trillion, reversing much of last week's decline. Total CP has expanded $122.8 billion y-t-d, a rate of 16.1% (up 15.0% over the past 52 weeks). Financial CP increased $18.6 billion last week to $1.397 Trillion, with a y-t-d gain of $112.8 billion (16.3% ann.). Non-financial CP rose $5.7 billion to $139.5 billion (up 14.3% ann. y-t-d and 10.0% over 52 wks).

ABS issuance increased to $13 billion (from JPMorgan). Year-to-date issuance of $387 billion is 24% ahead of comparable 2004. At $244 billion, y-t-d home equity ABS issuance is 28% above the year ago level.

Fed Foreign Holdings of Treasury, Agency Debt jumped $4.7 billion to $1.443 Trillion for the week ended July 13. "Custody" holdings are up $106.8 billion, or 14.9% annualized, year-to-date (up $209bn, or 16.9%, over 52 weeks). Federal Reserve Credit declined $3.8 billion to $792.0 billion. Fed Credit has increased 0.3% annualized y-t-d (up $36.5bn, or 4.8%, over 52 weeks).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $593 billion, or 18.1%, over the past 12 months to $3.897 Trillion.

July 14 - XFN: "China's foreign exchange reserves stood at $711 bln at the end of June, up 51.1% from a year ago, the People's Bank of China said. ...The central bank said the country added a total of $101 bln in foreign exchange reserves during the first half of this year."

Currency Watch:

The dollar index dipped about 0.6%. On the upside, the South African rand gained 3.5%, the Brazilian real 1.5%, the South Korean won 1.5%, the Chilean peso 1.4%, and the Swedish krona 1.3%. On the downside, the Polish zloty declined 0.9%, the Norwegian krone 0.4%, and the Canadian dollar 0.1%.

Commodities Watch:

July 15 - Bloomberg (Saijel Kishan and Petter Narvestad): "Supertanker bookings for oil exports from the Middle East reached their highest monthly level this year in July, doubling shipping costs, as OPEC increased output."

August crude oil declined $1.54 to $58.09. For the week, the CRB index dipped 0.1%, reducing y-t-d gains slightly to 9.0%. The Goldman Sachs Commodities index slipped 0.5%, with 2005 gains declining to 2%. Corn this week traded to a one-year high.

China Watch:

July 15 - Dow Jones: "General Electric Co.'s chief executive said he sees 'unbelievable' growth potential in the Asian markets for the company's business units. In a CNBC interview Friday, Chief Executive Jeff Immelt said the Chinese will invest $1.1 trillion in infrastructure between now and 2014, and added that India was not far behind its northern neighbor... Immelt said the global energy shortage affecting China and India will drive new business unit growth for the company."

July 11 - Bloomberg (Nerys Avery and Yanping Li): "China had its third-biggest monthly trade surplus in June as exports of home appliances and clothing surged, stoking trade disputes with the U.S. and Europe. The surplus widened to $9.7 billion from $8.99 billion in May... Exports jumped 30.6 percent from a year earlier to a record $66 billion, while imports rose 15.1 percent to $56.3 billion..."

July 11 - XFN: "China recorded 21.7% year-on-year growth in tax revenue for the first half, down from 26.2% a year earlier, the official Xinhua news agency reported..."

July 14 - Bloomberg (Nerys Avery): "China's money supply grew in June at the fastest pace in a year as banks increased lending and surging exports helped drive the nation's foreign-exchange reserves to a record $711 billion. M2, which includes cash and all deposits, rose 15.7 percent from a year earlier to 27.6 trillion yuan ($3.33 trillion) after 14.6 percent growth in May..."

July 12 - XFN: "China's foreign exchange market reported trading turnover of a total $146.15 bln for the first half of the year, or an average $1.2 bln per day, up 85.8% year-on-year..."

July 11 - Bloomberg (Yanping Li): "China's urban housing prices rose 8 percent in the second quarter from a year earlier, the official Xinhua News Agency reported, citing statistics from a survey carried out in 35 major cities."

July 12 - XFN: "China's sedan sales in June jumped 57.16% year-on-year to 258,600 units while output was up 24.97% at 264,400 units... China's overall auto sales in June rose 35.98% year-on-year to 517,000 units..."

Asia Boom Watch:

July 15 - Bloomberg (Douglas Wong): "Richard Hoon, who runs an executive headhunting company in Singapore, says he's turning down private banks in Asia that are desperate for wealth managers. The possible recruits are tired of hearing from him. 'Any private banker worth their salt is getting a call every other week offering them a job,' says Hoon... Five countries from the Asia-Pacific region - excluding China -- were among the 10 fastest-growing markets for millionaires, said the report by Paris-based Capgemini... Citigroup Inc. and Zurich-based UBS AG, the largest private bankers in Asia, are bolstering employee counts as they battle increasing competition for $7.2 trillion of individual riches in the region."

July 12 - Bloomberg (Cherian Thomas): "India's industrial production rose in May at the fastest pace since August 1996 as increasing incomes and the cheapest credit in 32 years lifted sales... Production at factories, utilities and mines rose 10.8 percent from a year earlier, after a revised increase of 8.4 percent in April..."

July 11 - Bloomberg (Amit Prakash ): "Singapore's economy expanded in the second quarter at almost twice the pace expected by forecasters... Gross domestic product grew at an annual 12.3 percent pace, the fastest in almost two years, after a 5.5 percent contraction in the first quarter..."

July 12 - Bloomberg (Beth Jinks): "New car sales in Thailand, Southeast Asia's biggest auto market, rose 26 percent in June from a year earlier, bolstered by sales of pickup trucks, according to Toyota Motor Corp..."

July 12 - Bloomberg (Naila Firdausi): "Automobile sales in Indonesia rose 15 percent in June from a year earlier, PT Toyota Astra Motor said..."

July 13 - Bloomberg (Wahyudi Soeriaatmadja): "Indonesia's economic growth may exceed 6 percent this year because of higher spending by the government on social work projects and rising investment, said Minister for National Economic Planning Sri Mulyani Indrawati."

July 15 - Bloomberg (Francisco Alcuaz Jr.): "Philippine commercial bank loans rose 6.9 percent in May...the fastest pace in 4 1/2 years, on lending to financial institutions, property developers and manufacturers. The increase was the biggest since a 7.8 percent gain in January 2001."

Unbalanced Global Economy Watch:

July 12 - Bloomberg (Mayumi Otsuma): "Japan's producer prices rose for a 16th straight month in June, threatening to squeeze profits at companies struggling to pass costs on to customers. An index of prices of energy and raw materials in the world's second-largest economy rose 1.4 percent from a year earlier..."

July 11 - Bloomberg (Greg Quinn): "Canadian housing starts rose a more-than-expected 7.2 percent in June, led by a surge in construction of multiple-family homes, the federal government's housing agency said."

July 11 - Bloomberg (Laura Humble): "The cost of raw materials used by British factories rose at the fastest annual pace in 20 years in June as oil prices surged to a record, a sign that inflation may accelerate in coming months. Prices rose an annual 12.1 percent, the fastest since March 1985..."

July 12 - Bloomberg (Fergal O'Brien): "Ireland's economy will expand 5.5 percent this year... The pace of expansion compares to growth of 4.9 percent in 2004..."

July 12 - Bloomberg (Jacob Greber): "Swiss construction of new homes jumped in the first quarter as the Swiss central bank left its benchmark interest rate unchanged at 0.75 percent to spur economic growth. The number of new homes completed rose 23 percent to 8,065 from a year earlier... Fourth-quarter construction rose 15 percent."

July 14 - Bloomberg (John Fraher): "European Central Bank Chief Economist Otmar Issing said he's concerned about the pace of asset price appreciation in parts of the dozen-nation euro region. 'goods prices are under control. But whether asset prices are under control is doubtful,' said Issing in a speech in Frankfurt late yesterday. The ECB's monthly report, which is edited by Issing, said today that money supply and credit growth 'could become a source of strong asset price increases.' Central bankers in Europe and the U.S. are debating how best to tackle asset price 'bubbles' after failing to restrain a stock market boom in the late 1990s and as property prices in parts of the euro region surge. Issing said the issue is 'one of the biggest intellectual challenges for policy makers.'"

July 14 - Bloomberg (Todd Prince): "Russia's economy expanded by 5.4 percent in the first half... Industrial production advanced 3.6 percent... Capital investment rose 8.9 percent while real wages increased 8.1 percent."

Latin America Watch:

July 15 - Bloomberg (Heather Walsh): "Chile, the world's biggest producer of copper, said exports of the metal surged in June as prices extended gains to a 16-year high. Exports rose by 55 percent to $1.53 billion...from June 2004..."

July 15 - Bloomberg (Alex Emery): "Peru's gross domestic product in May grew at the fastest pace since December as fishmeal output, manufacturing and construction expanded, signaling a diversification in the mining driven economy. Gross domestic product expanded 7.1 percent in the month from a year earlier..."

Speculative Bubble Watch:

July 14 - Dow Jones (Marietta Cauchi): "Hedge fund investors across the board are not concerned about the overall health of the asset class and plan to increase their allocations again this year. These are the findings released Wednesday by Deutsche Bank...which polled 650 investment firms... Altogether, these represent some $645 billion dollars of the estimated $1 trillion industry. While 67% of investors felt that large asset flows depress returns, a similar percentage believed that the asset class will still return between 6% and 8% in 2005."

California Bubble Watch:

July 12 - The Wall Street Journal: (Pui-wing Tam and Mylene Mangalindan): "Manuel Henriquez wanted a house in Atherton, Calif., last fall, but he knew time was running out: The Google money was coming. Atherton, which is located between San Francisco and San Jose, is one of Silicon Valley's most elite addresses. People like financier Charles Schwab and eBay Chief Executive Meg Whitman own houses here. Google Inc.'s stock offering had made millionaires of many employees..., and Mr. Henriquez knew securities regulations would soon let some Googlers cash in stock. Some of them, he figured, would be home-shopping in Atherton, which is just a few minutes' drive from the company's headquarters... So late last year, Mr. Henriquez, a private-equity executive, bid more than $7.95 million on a 10,000-square-foot Atherton house then under construction. Too late: David Cowan, a venture capitalist, had the same idea and won the house for $8.2 million. 'I wanted to buy before the Google lockups expired in February,' says Mr. Cowan. Mr. Henriquez later visited the developer of that house to put dibs on a yet-to-be-built Atherton house. Too late again: The builder...says he had already agreed to sell to a Google employee. Early this year, Mr. Henriquez offered $12 million for an Atherton mansion with a marble-walled media room; the agent told him a Googler got it. 'I started aggressively looking because I didn't want to get caught in the Google wave, but I got caught anyway...' 'There's a lot of Google money out there,' says Mary Gullixson, a Silicon Valley real-estate broker who says she has sold nearly $130 million in residences this year, the bulk of them in Atherton. 'It's turning out to be the best year ever.'"

Bubble Economy Watch:

June Retail Sales were up 10.4% y-o-y, the strongest year-on-year rise since March 2000. And it wasn't just employee discounted automobiles. Retail Sales Ex-Autos was up 8.8% from June 2004. Electronic sales were up 9.1% y-o-y, Food & Beverages 6.1%, Gasoline Stations 16.4%, General Merchandise 9.8%, and Eating/Drinking establishments 7.8%.

July University of Michigan consumer confidence rose to the highest level since last December. The New York ("Empire") Manufacturing Index popped 13 points to the highest level since December. Industrial Production rose a stronger-than-expected 0.9% during June, the strongest gain since February 2004. Capacity Utilization jumped 0.6 points to 80%, the highest level since December 2000.

I would suggest caution when it comes to extrapolating the improved federal deficit situation. In a replay of 1999/2000, Bubble Economy receipts are soaring. Fiscal year-to-date Total Receipts are running 14.6% ahead of last year to $1.604 Trillion. Corporate Tax receipts are running 41% ahead of last year at $197.8 billion. After nine months of the fiscal year, Individual Tax receipts are 16.3% above last year's pace at $693.7 billion. Employment taxes are 8% ahead of last year's pace at $564.1 billion. Not surprisingly, spending levels are also inflating. Year-to-date Total Spending is running 7.3% ahead of last year to $1.854 Trillion. By major department, Social Security spending is up 5.5% to $391.6 billion; National Defense is up 7.1% to $360.1 billion; Income Security up 3.1% to $272.6 billion; Medicare up 9.6% to $217.8 billion; Health up 4.1% to $189.9 billion; and Interest up a notable 13.1% to $140.8 billion.

The May Trade Deficit was reported at a somewhat less-than-expected $55.35 billion, up 14% from one year ago. May Goods Imports were up 12% from May 2004 to $135.3 billion. Good Exports were up 9% to $74.5 billion. The year-to-date Trade Deficit with China is up 33.3% to $72.5 billion; with Japan up 15.8% to $34.7 billion; With Canada up 3.8% to $27.2 billion; with Germany 10.8% to $20.1 billion; and with Mexico u 11.4% to $19.7 billion.

June Import Prices were up 7.0% from one year ago. Import Prices have been up more than 5% y-o-y for 14 consecutive months. For comparison, beginning in March 2001 Import Prices posted year-over-year declines for 19 straight months.

July 14 - Reuters (Jui Chakravorty): "Marriott International Inc., the largest U.S. hotel operator, said quarterly profit...rose as an upswing in travel drove room rates and occupancy higher... Revenue per available room, a key measure of health in the lodging industry, rose 10 percent at Marriott-operated North American hotels open at least a year. That growth was driven by an 8.5 increase in average daily room rates."

Mortgage Finance Bubble Watch:

July 15 - New York Times (Edmund L. Andrews): "For two months now, federal banking regulators have signaled their discomfort about the explosive rise in risky mortgage loans. First they issued new 'guidance' to banks about home-equity loans, warning against letting homeowners borrow too much against their houses. Then they expressed worry about the surge in no-money-down mortgages, interest-only loans and 'liar's loans' that require no proof of a borrower's income. The impact so far? Almost nil. 'It's as easy to get these loans now as it was two months ago,' said Michael Menatian, president of Sanborn Mortgage, a mortgage broker in West Hartford, Conn. 'If anything, people are offering them even more than before.' The reason is that federal banking regulators, from the Federal Reserve to the Office of the Comptroller of the Currency, have been reluctant to back up their words with specific actions. For even as they urge caution, officials here are loath to stand in the way of new methods of extending credit. 'We don't want to stifle financial innovation,' said Steve Fritts, associate director for risk management policy at the Federal Deposit Insurance Corporation. 'We have the most vibrant housing and housing-finance market in the world, and there is a lot of innovation. Normally, we think that if consumers have a lot of choice, that's a good thing.'"

July 13 - "The National Association of Realtors has again raised its forecast for the housing sector, with both existing- and new-home sales to set an even bigger all-time record in 2005. Existing-home sales are expected to rise 2.8 percent to 6.97 million this year; last month, the association was expecting 6.89 million sales - the record was 6.78 million in 2004. New-home sales should increase 3.2 percent to 1.24 million in 2005, also a record. Total housing starts - single-family and multifamily - are forecast to grow by 5.0 percent to 2.05 million units, the second highest on record; the peak was 2.36 million in 1972. This year is seen to be a record for single-family construction, with 1.68 million homes started... The most notable problem in the housing market is the shortage of homes available for sale, as well as some shortages of building materials... These shortages are proving to be a challenge for home buyers, builders and remodelers, and are continuing to put pressure on home prices... the national median existing-home price for all housing types [is expected] to rise 9.4 percent this year to $202,600, with the typical new-home price increasing 5.8 percent to $233,900."

Countrywide posted a rather remarkable - yet mortgage "blow-off" consistent - month of June. Total Fundings surged to $47.26 billion (up 48% y-o-y), the strongest level since the peak of the refi boom in June 2003. Purchase Fundings jumped to a record $24.0 billion (up from May's $19.8bn), up 37% from June 2003. Second quarter Purchase Fundings were up 32% from comparable 2004 to $61.0 billion. June ARM fundings were up 50% from June 2004 to a record $26.0 billion (55% of total fundings). Home Equity Fundings were up 39% from one year ago to a record $4.2 billion. "Non-purchase" (refi) Fundings jumped from May's $18.9 billion to $23.2 billion, up 60% from one year ago to the strongest level since August 2003. Subprime Fundings were up 12% from a year earlier to $4.2 billion. At $77.0 billion, Countrywide's Pipeline was the largest in two years. Bank Assets expanded $4.0 billion during the month to $65.5 billion, up 140% from June 2004.

July 10 - Wall Street Journal (Sebastian Moffett): "As U.S. home prices shoot to unprecedented highs in many regions, the notorious property bubble in Japan presents a scary scenario. Japanese land prices shot up in the late 1980s. Around 1991, when they peaked, the land under Tokyo's Imperial Palace was worth more than all the land in Florida. Now, over a decade later, average Japanese land prices are still falling and banks are only just pulling out of a land-related bad-loans crisis. And Japan's economy only in the past two years has appeared to emerge from a series of recessions and on-off recoveries. If, as some analysts claim, the U.S. has a property bubble, does Japan's 'lost decade' of economic misery provide a glimpse of what's in store?"

July 13 - Wall Street Journal (Ryan Chittum): "Global investment in commercial real estate last year jumped 12% from a year earlier to about $457 billion and more money flowed into properties from across international borders... Investors poured $99 billion into real estate in countries other than their own in 2004, a 21% increase from the previous year, according to the study by Jones Lang LaSalle Inc.... The globalization of real-estate investing is increasing at a time when real-estate markets are awash in cheap capital... Much of the money is coming from the U.S. 'It's a two-way street, and that's what's different from the past,' says Dale Anne Reiss, who heads Ernst & Young's real-estate practice. 'In the past, the Japanese invested in the U.S., but the U.S. didn't invest in Japan.'"

Asset-backed Securities:

The term "Asset-backed Securities" (ABS) represents different things to different people. Traditionally, ABS referred to securitizations backed by pools of non-mortgage collateral (held in trusts), particularly consumer loans and trade receivables. It is now commonplace to include (as Lehman does in their tallies noted above) home equity loan securitizations while excluding whole loan mortgages and conduits ("MBS"). The Federal Reserve categorizes ABS as basically all securitizations with collateral not backed by mortgages guaranteed by the government-sponsored enterprises (which they categorize as "MBS"). The Fed's methodology suits me fine.

The ABS market (from "flow of funds" data) expanded $481.5 billion annualized during the first quarter to $2.685 Trillion. To put this growth into some perspective, the ABS market expanded on average $122 billion annually during the nineties. ABS grew $173 billion during 2000, $243 billion during 2001, $195 billion during 2002, $226 billion during 2003, and jumped to a record $309 billion last year. After beginning the nineties at $210 billion, the Asset-backed marketplace has expanded almost 13-fold.

There are good reasons the ABS market deserves special analytical attention (it receives virtually none). For one, with the recent slowdown in GSE asset growth and agency securitizations (MBS), the ABS marketplace now plays a crucial role in filling a major risk intermediation void. It is a Fact of Bubble Life that during the late stages of Bubble excess - with escalating Credit creation requirements - any "void" is potentially terminal. Instead, ballooning ABS has thus far sustained the Mortgage Finance Bubble, the key mechanism continuing to provide the liquidity for seemingly all things: from purchasing homes, to consuming imported goods, to paying for crude oil, to providing the cashflow for company stock repurchases.

Of 2004's record $1.215 Trillion Total Mortgage Debt Growth, almost 38% made its way into new ABS. This compares to a yearly average of 14% during the previous 5 years. Or, from another angle, $460 billion of new mortgage debt was intermediated through the ABS marketplace during 2004, up from 2003's $187 billion, 2002's $91 billion, 2001's $114 billion, and year-2000's $67 billion.

ABS combined with escalating Bank mortgage holdings to account for 66% of Total Mortgage debt growth last year, up from an average 40% during the preceding 5 years. And during this year's first quarter, ABS (46%) and Banks (44%) accounted for fully 90% of net additional mortgage debt. Or, ABS and Banks combined to intermediate an annualized $1.01 Trillion of new mortgage debt during the first quarter, up from 2004's $800 billion, 2003's $385 billion, 2002's $359 billion, 2001's $244 billion, and year-2000's $231 billion.

I would argue that the ABS market has become the key securities risk intermediation marketplace. This coveted role was previously enjoyed by the powerful GSE and money market fund tandem that took command of system liquidity (excess) during the (post-LTCM) late-nineties. After expanding $327.6 billion during the first half of the nineties, GSE Assets surged an historic $941.4 billion during the decade's second half ($305bn during 1998 and $317bn during 1999).

Especially throughout the period 1998 through 2001, a significant portion of GSE liabilities were intermediated through the money market fund complex (MMF) - either directly, in the case of short-term GSE debt, or indirectly through repurchase agreements ("repo") financing agency bonds ("repo" financing arrangements as MMF asset holdings). Money Market Fund Assets expanded $979 billion during the five years 1995 through 1999 (assets increased $175bn 1990-94). Asset growth at both the MMF ($429bn) and the GSEs ($344.4) peaked in 2001.

The Federal Reserve's post-tech Bubble rate collapse and, later, GSE troubles profoundly altered market dynamics. MMF assets have contracted since 2002 and GSE growth slowed last year to $93 billion (low since 1996). Meanwhile, agency MBS issuance, having averaged $142 billion during the nineties, slowed abruptly last year to $53 billion. The Fed had incited a major disintermediation from money market accounts (and other low-yielding instruments), with Wall Street "financial engineers" primed to structure higher-yielding products to satisfy the wall of liquidity aggressively seeking better returns. All they lacked were Trillions of loans...

The "Moneyness of Credit" is a fundamental theoretical issue for "structured finance" and contemporary economics. Through the alchemy of diversification, government explicit and (GSE) implicit guarantees, Credit insurance, letters of Credit, liquidity arrangements, interest-rate and Credit derivatives, various securitization structures for absorbing initial losses, and the like, pools of risky loans are transformed into appealing highly-rated securities. In the case of GSE debt and securitizations, there is basically no limit to the quantity of highly liquid short-term "AAA" securities that can be issued (directly and indirectly). The financial and economic ramifications for this Powerful Monetary Process, as we continue to witness, are momentous.

I continue to read economists that fixate on its narrow "transaction" role, when the essence of "money" is so much broader (and complex!) and revolves around the key attributes of the perception of safety, liquidity and a store of nominal value. It is the perceived "preciousness" of "monetary" instruments (certainly today including deposits, money market fund accounts, commercial paper, Treasury and GSE bills, and short-term ABS) that creates the innate risk of over-issuance and attendant inflationary manifestations. In the case of contemporary "structured" instruments, it is their "moneyness" qualities that stoke historic Credit and Asset Inflation. Contemporary finance luxuriates in its capacity to create its own liquidity to fund the unrestrained expansion of financial sector liabilities. Asset inflation and resulting (financial and economic) distortions and imbalances are the seductive scourge of contemporary "monetary" (in the broadest sense) inflation. CPI is a mere distraction...

The GSE debt Bubble has some defining characteristics. Despite the explosion of agency debt and MBS guarantees (not to mention accounting irregularities), the marketplace perceives little risk in agency obligations. Understandably, market participants fully expect the U.S. government to stand firmly behind the GSEs. This moral hazard was certainly emboldened by Fed governor Bernanke's 2002 market promises that the Fed would take all steps necessary measures - including "helicopter money" and other "unconventional measures"! - to ensure that deflationary forces would never be allowed to take hold. This was the "all's clear" signal that the Fed was fully behind the GSE and Wall Street finance liquidity juggernaut (liquidity juggernaut safeguarded...then buy junk, stocks, emerging markets, commodities...!)

But the GSEs became too powerful and too corrupt, bringing this historic Credit and liquidity-creating mechanism to at least a temporary impasse. This would have been a major systemic blow had GSE problems materialized in, say, the late-nineties. But by 2003 Mortgage Finance Bubble dynamics were well-entrenched. Several years of unrelenting mortgage lending excess and collapsing interest-rates had imparted a strong inflationary bias throughout real estate finance. Home prices had risen significantly in most regions which, along with the easy of refinancing and equity extraction, had fostered an environment of reduced foreclosures and minimal charge-offs. Lenders were printing money.

From years of experience Wall Street mastered the art of catering its instruments and "structures" to changing environments - and was well-prepared to take full advantage. The Mortgage Finance Bubble was in full bloom, while the ballooning leveraged speculating community was in desperate search for sufficient quantities of instruments to leverage (no easy task!). Huge amounts of asset-backed securities without GSE backing would have been a hard sell during the nineties. Such was definitely no longer the case in the frenetic "post-Bernanke" environment.

While this view is open to debate, I do believe that the Greenspan Fed was (is) very concerned about GSE exposure to rising rates and interest-rate derivatives (especially considering their major accounting irregularities). It was Greenspan's intention to countenance the flight of households into variable-rate mortgages, in the process shifting problematic interest-rate risk away from the GSEs, banks, and the ambiguous derivatives marketplace. Holding short-term interest rates significantly below long-term yields - with "real" after-tax borrowing costs a fraction of housing inflation - incited a stampede into ARMs and myriad variable rate mortgages. And perhaps Mr. Greenspan was intent upon having the system primed to assure a seamless transition away from the troubled GSEs, institutions and market processes that had grown to so dominate the Credit system. Whether the Fed planned it this way is unknown, but what transpired evolved into a major financial system development.

Collapsing rates and the proliferation of new mortgage products pushed key housing markets already demonstrating powerful inflationary biases (including California, Las Vegas, Washington DC, Manhattan, South Florida and generally anything near water or in the more appealing neighborhoods throughout the entire country) into full-fledged speculative manias. And the low monthly mortgage-payment-inspired price spikes incited only greater "innovation" in the option-ARMs and other "exotic" mortgage products necessary to sustain the Bubble. With volume surging and minimal boom-time losses, huge lending "profits" encouraged a veritable Mortgage Arms Race. An unlimited supply of loanable funds and ultra-loose lending standards fueled record subprime mortgage and home equity lending growth. And the more outrageous the lending excesses and resulting higher home prices, the stronger the economy - and the greater lending and speculating "profits"!

The Fed's astonishingly accommodative monetary policy incited a stampede into risky variable rate mortgages. Meanwhile, the yield hungry clamored for securities to acquire and leverage at decent spreads to Treasuries. Adjustable-rate loans - especially non-prime, home equity and subprime - provided just the ticket for the aggressive leveraged players seeking strong returns but mindful of the Fed's inevitable move to higher short-term rates. Leveraging variable-rate products with a nice spread above the (variable-rate) cost of funds ("repo") became the hot game - seemingly perfect for borrower, lender and speculator, alike. There was, as well, huge demand for top-rated short-term instruments providing some return to satisfy institutional demand as they "dis-intermediated" out of money market funds. Indeed, there was a confluence of factors that hoisted ABS to the Credit Bubble vanguard position.

I have argued that the securitization marketplace is vulnerable to the new environment without the GSEs as insatiable mortgage/MBS "Buyers of First and Last Resort." I have similarly rambled on that the marketplace is susceptible to speculator deleveraging and faltering liquidity. Well, I can argue 'till I'm blue in the face but I also appreciate that there is a decent shot at $1.4 Trillion of Total Mortgage Debt Growth this year. This would be a 15% increase from last year's record growth. The Credit Bubble is very much in its self-preservation "blow-off" stage and the markets remain highly over-liquefied. To have lived through 1999 and early-2000 is to forever appreciate the immense power of major market tops.

Yet is was clear to the discerning analyst back in 1999 that the junk bond, leveraged lending, and "structured products" financed technology Bubble was increasingly vulnerable. Massive amounts of speculative liquidity were financing negative cash flow companies (especially telecom) in a textbook case of Minsky's "Ponzi finance." Inevitably, the ever expanding wall of liquidity seeking outsized speculative "profits" was going to be disappointed. And especially with the expansive technology industry locked in manic borrowing and spending excess, any stagnation in the flow of speculative finance would quickly expose underlying acute financial fragility. The inevitable reversal of speculative flows - coming abruptly as they tend to do - was devastating.

I see today troubling parallels between telecom debt in 1999 and ABS today. An over-financed and speculation-crazed world has spurred a self-reinforcing flight into higher-yielding instruments. The greater the speculative flows, the more that financial "profits" (lending, speculating and otherwise) are distorted/inflated by Bubble effects. And I do remember reading articles after the bursting of the telecom debt Bubble that described how losses in various collateralized debt obligations (CDOs) and other structured products were significantly higher than even the worst-case scenarios had forecast. I expect similar dynamics to unfold with the eventual bursting of the Mortgage Finance Bubble.

I passionately argue that the ABS marketplace is today significantly under-pricing mortgage finance. General excess marketplace liquidity, intense competition for yields, unprecedented leveraged speculation, and boomtime delusions of scant future Credit losses have spurred a collapse in ABS and MBS spreads. And as long as the wall of speculative liquidity continues to flow into ABS the entire mechanism does appear to function wonderfully (nurturing only further excess). Unlimited finance will provide cheap funds for home purchases, speculation and equity extraction. Consumption and economy growth will continue to surprise on the upside here at home, while attendant massive Current Account Deficits stoke the Asian, energy, commodities, and emerging market booms.

As we witnessed with the telecom debt Bubble, the problem with unlimited amounts of under-priced finance is that it stubbornly fuels spectacular boom and bust dynamics. The Mortgage Bubble is today demonstrating all the characteristics of precarious "blow-off" dynamics. Too similar to NASDAQ Bubble dynamics, excesses went to unimaginable extremes - only now to "double." Today's buyer (marginal price-setter) of properties in the highly inflated markets is forced to resort to risky interest-only or negative amortization mortgages. The new mortgage is backed by a vulnerable borrower acquiring a grossly over-valued property. Moreover, the attendant price spike creates the capacity for neighbors to then borrow against inflated equity or use inflated equity as a downpayment for a more expensive home, in the process significantly undermining the soundness of many more mortgages. And with the extraordinary level of mortgage churning - transactions, refis, and home equity loans - the potential to impair huge quantities of mortgage loans (the asset backing ABS) during "blow-off" excesses is unparalleled. The potential to create enormous liquidity and Monetary Disorder to destabilize the global system is similarly unprecedented.

There will come a day when it does matter that the GSEs are not waiting as gluttonous buyers of ABS and MBS. And, in a wild thought, perhaps there will be another bond bear market during our lifetimes. Regarding the degree of leveraged speculation in ABS, I can only speculate that it is enormous. Outstanding primary dealer "repo" positions recently surpassed $3.5 Trillion, and they're not financing only Treasuries and agency debt. Significantly higher market yields would place the massive Mortgage and ABS Bubbles in harms way. And I assume this has much to do with the propensity for Street analysts and economists to see economic weakness around every corner.

The Fed and market participants are hoping that the Fed's rate increases are well on the way toward tempering mortgage excesses. They hope in vain. The bond market rally since late-March safeguarded a manic summer housing season (finale?). To be sure, current "blow-off" dynamics ensure that problematic real estate price spikes will be followed by unnerving declines (the nature of parabolic market disruptions). The ballooning ABS marketplace - the last bastion for today's riskiest mortgage Credits - is poised to experience the painful downside of "Ponzi Finance" schemes. And it is the very nature of Credit Bubbles that they function poorly in reverse.

And, recalling Tech 1999, the "when" may be tough to pin down, although the outcome becomes increasingly lucent. At what point various ABS sectors begin to discount trouble is an issue worth pondering (has it already commenced?). Moreover, take a moment and contemplate the potential for the marketplace to at some point question today's perception of asset-backed "moneyness" - perceptions and market confidence that I believe are much more fragile for ABS (financing "blow-off" excess) than for the GOVERNMENT-SPONSORED enterprises. And, later, when ABS liquidity begins to wane and the Banks are forced to intermediate the vast majority of problematic late and down-cycle mortgage lending (trying to keep the Mortgage Bubble from imploding), we will revisit the issue of contemporary "structured" finance as a wonderful mechanism for aggregating and dispersing risk to those most capable of managing it.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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