To the Brink

By: Doug Noland | Fri, Dec 22, 2000
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Total Bank Credit
Total Money Market Fund Assets
US 3Month Treasury Bill Future
Freddie Mac 15-Year Mortgage Yields

It was, once again, a most chaotic week in the financial markets. For the week, the Dow gained 2%, while the S&P500 declined 1%. Economically sensitive issues shined, with the Transports jumping 6% and the Morgan Stanley Cyclical index surging 8%. The Morgan Stanley Consumer index added 3% and the Utilities advanced 5%. The small cap Russell 2000 and the S&P400 Mid-Cap indices gained 1%. Tech stocks generally declined for the week, but these losses were substantially reduced by today's major rally. For the week, the NASDAQ100 dropped 4% and the Morgan Stanley High Tech index 8%. The Street.com Internet index was hit for 16% and the NASDAQ Telecommunications index was clipped for 11%. Today's 10% advance put the Semiconductors in the plus column for the week. Today's 6% gain, brought the Biotechs back to unchanged for the week and maintained their 64% year-to-date advance. Financial stocks had a big week, with the S&P Bank index jumping 8%, increasing its year-to-date gain to 16%. The AMEX Securities Broker/Dealer index added 4% this week, increasing year-2000 gains to 21%. Gold stocks gained 6% this week. An historic credit market rally runs unabated.

For the week, 2-year Treasury yields collapsed 30 basis points to 5.07%, and have now declined 53 basis points in three weeks. Five-year Treasury yields declined 24 basis points to 4.89%, making it 57 basis points in three weeks. Ten-year Treasury yields declined 17 basis points to 5.01%, 54 basis points in three weeks. The long bond under performed as its yield declined just three basis points to 5.39%. Fannie Mae benchmark mortgage-back yields declined 17 basis points this week and Agency yields dropped 13 basis points, as mortgage rates dropped to the lowest levels in 18 months. Agency yields have declined 54 basis points in three weeks. For the week, junk spreads widened slightly while investment grade corporates continue to under perform. The dollar continues to trade poorly, with the dollar index declining almost 2% this week. The euro gained almost 3% this week to end above 92, as European currencies and stock markets generally outperform.

It was certainly an active week on the credit front, with disconcerting news from some prominent credit "problem children." Clearly, strong evidence abounds as to how rapidly the general environment is deteriorating. Things certainly appear to be heading south very rapidly at Lucent (total liabilities of $20 billion at 9/30/00), with the company yesterday announcing that it is expecting a 20% year-over-year decline in revenues and will be reporting a larger than expected loss this quarter. Lucent will also take a $1 billion charge and make dramatic moves to reduce expenses. In what is clearly an ugly picture, Lucent also announced that it would be restating previous quarterly earnings and revenues (reduced revenue by $700 million!) because of returned equipment and "misleading documentation." Also yesterday, Xerox ($24 billion of liabilities at 9/30/00) announced that they would report a wider-than-expected loss for the quarter. The company has stated that it has exhausted its $7 billion credit line and must now resort to asset sales to manage a severe cash crunch. Today, Bloomberg reported that the combined Chase and JPMorgan would have the largest exposure to Xerox, as both banks are on the hook for $375 million as part of the $7 billion emergency credit line.

Also this week, AT&T announced that it would not meet revenue and earnings forecasts, while also cutting its dividend 83%. With management now expecting slower business growth and consumer revenues to decline "at a mid teens rate," analysts are slashing earnings estimates for next year by upwards of 30%. With total liabilities of $128 billion (9/30/00), up from $80 billion one year earlier, the unfolding saga at AT&T is one to monitor closely. AT&T ended 1998 with $34 billion of liabilities (total assets of $60 billion), before ballooning assets to more than $250 billion in an aggressive acquisitions binge and infrastructure build out. And while the "macro" debt numbers are often not the easiest to appreciate, AT&T (and its bloated balance sheet!) provides a notable example of the tremendous debt taken on by a company in pursuit of success in the "New Economy." Today, the Wall Street Journal reported that AT&T is considering using its cable systems as payment for $3.2 billion owed to Cox and Comcast. "Under an agreement struck earlier in this year, Cox and Comcast can exercise "put" options anytime after Jan. 1 for their respective stakes in the Internet access company. Once the puts are exercised, AT&T is then obliged to pay each company about $1.6 billion in cash or AT&T stock - COX and Comcast get to choose the form of payment…" Contemporary finance run amuck.

It is not just the technology sector that is experiencing rapid deterioration, as quite ominous news comes out of the automobile sector this week. This is a sector to watch very closely, with the industry having taken on tremendous debt loads to fund their captive finance companies. It is also worth noting an alarming deterioration in profits, despite historically very strong auto sales. GM announced that it would cut 15,000 North American jobs and eliminate the 100-year old Oldsmobile line to reduce costs. GM ended the third-quarter with total liabilities of $265 billion (compared to $214 billion two years ago) and shareholder's equity of $32 billion. Yesterday, Ford announced that earnings would be about 15% below estimates and that it would be cutting North American production 17% during the first quarter. Ford ended September with $263 billion of liabilities with $19 billion of shareholders' equity (compared to $204 billion of liabilities two years ago.) And then today, Bloomberg ran a story - "DaimlerChrysler May Run Short of Cash, Analysts Say." Apparently, there is concern that company cash levels have dropped to $3.39 billion from about $8 billion in just nine months. The situation at Chrysler is an unmitigated disaster, as this unit lost $512 million during the third quarter and is now expected to lose $1.3 billion during the fourth quarter. According to Bloomberg, DaimlerChrysler "has to refinance 25 billion euros of debt in the next two years…"

"These companies, as big and strong as they used to be, are on the brink now." Richard Cortright, analyst at Standard and Poor's

There should be no denying that we are in the midst of an historic and systemic collapse in credit quality. And while Mr. Cortright's quote could easily pertain to technology bellwethers such as Xerox, AT&T, or Lucent, or even the automobile companies, it is actually directed to the major California utilities, PG&E and Edison International. These two utility behemoths are now fighting tooth and nail to avoid filing for bankruptcy protection, as they are forced to pay surging prices for energy while unable to pass along these costs to their 19 million customers.

Mr. Cortright also stated that "absent meaningful and sustainable actions by the decision makers in the next 24 to 48 hours," Standard and Poor's will severely cut the utilities' credit rating to below investment grade. This is no "small potatoes," as these two companies ended the third-quarter with total assets of almost $72 billion. Combined, long-term debt totaled almost $18 billion, with total liabilities of about $57 billion (supported by equity of about $15 billion). Liabilities had already jumped almost $9 billion during the past year, and now must be ballooning as they are forced to borrow to fund massive losses. PG&E president Gordon Smith was quoted as saying "we have been borrowing an average of $1 million per hour to pay for the power we deliver to Californians. No company can continue to operate indefinitely under such conditions."

From Dow Jones: "With rate hike negotiations at a standstill and forward supply talks in Washington yielding nothing, PG&E Corp.'s regulated utility subsidiary Pacific Gas and Electric reiterated Wednesday that it has "virtually exhausted its resources." And from Bloomberg: "PG&E Corp. and Edison International, saddled with $8.1 billion in debt from surging power costs, said they may run out of cash unless California regulators allow them to raise electricity rates…That may be too late. The surge in California's power costs, driven largely by a shortage of generation, may push both companies to file for Chapter 11 bankruptcy protection, analysts and investors say." Also from Bloomberg:

"If the Federal Energy Regulatory Commission doesn't act, 'Edison will be required to seek the protection of the bankruptcy courts,' the company said in a FERC filing. Without higher rates, it's 'very uncertain that Edison will be able to meet its obligations for January, …" This afternoon, Dow Jones ran the headline" "Moody's Won't Downgrade California Utilities to Junk Before January 4th."

Curiously, this dramatic collapse in credit standing has been seemingly of little concern in the marketplace (although have recently heard of evaporating liquidity for PG&E bonds!). All the same, some investors rest well at night with the knowledge that their bonds have been insured by one of the major credit insurers. From yesterday's company release, we see that "as of October 31, 2000, MBIA had net par exposure of approximately $438 million to Southern California Edison and $590 million to Pacific Gas & Electric." Further, "in response to market inquiries, MBIA Inc. announces that it expects that Southern California Edison and Pacific Gas & Electric will continue to make debt service payments on their MBIA-insured bond." Richard L. Weill, Vice Chairman of MBIA stated: "While we have some concerns over the way the California electricity market has been deregulated, we believe that Southern California Edison and Pacific Gas & Electric will continue to meet their debt service obligations on MBIA-insured bonds given our strong secured position and the fact that California regulators and legislators are working to remedy the situation. We continue to be in contact with officials at Southern California Edison and Pacific Gas & Electric and are monitoring the developments closely." We'll see.

Writing credit insurance is a very tricky proposition, although it does have all the seductive appearances of "free money" during the halcyon days of economic and financial boom. Yet, seemingly few appreciate the true nature of this "business." While actuaries can make quite accurate calculations as to the average age of death for a pool of life insurance policyholders, or how many automobile accidents to expect in a year, or even the likely number of homes destroyed by fire, credit losses are an entirely different animal. Importantly, losses are not random events that can be modeled and calculated using normal distributions - they are not like car accidents. Instead, credit problems are quite cyclical and are problematically self-reinforcing - they come in bunches, with great potential for devastating "domino effect." And while we haven't seen this in some time, credit losses mushroom during financial and economic downturns. Furthermore, credit losses are exacerbated by waning confidence and any interruption in credit availability. It should also be appreciated that credit losses during the inevitable downturn will be proportional to the credit excess during the boom and this will be quite a predicament for an untested industry. Ironically, it is specifically the trillions of dollars of insurance and "guarantees" that were major factors during this cycle, creating the unprecedented credit excess that now ensures massive credit losses. Leave no doubt, unavoidable losses over this unfolding economic downturn will greatly test the credit insurance industry, as well as the bull-market notion of credit insurance.

Now, back to the California energy debacle. Apparently, MBIA's "risk models" did not factor in the likelihood of a surge in energy prices, and how this development would create momentous losses for these utilities. And you can be absolutely sure that MBIA's models did not have the capacity to consider the possibility that California energy costs could rocket higher concomitant with an historic collapse in technology stocks. After all, the models (programmers!) would have seen these as two unrelated and very low probability events. They are, however, anything but unrelated.

Credit insurance has been a key aspect of "Wall Street financial alchemy" that has fostered unprecedented credit excess with inflationary manifestations evident in the spectacular boom that now turns bust throughout the technology sector, as well as the economic bubble and other distortions in California that are major factors in surging energy prices. These severe financial and economic distortions are now coming back to haunt the financial system, and there is little that the Federal Reserve accommodation can do to rectify such severe structure maladjustments.

Yet, as we have discussed in the past, when the U.S. system comes under increasing stress, this just only incites the financial sector to greater aggressiveness. But, then again, that's why it's called a bubble. That's also why we have written in the past about "The Concentration of Financial Power" that will ensure that the financial sector goes to virtually any extreme to perpetuate this boom - the alternative is simply unacceptable. The fundamental concept to appreciate today is that the financial sector must create sufficient (extreme) additional money and credit - expand its liabilities - to keep asset prices levitated - particularly stocks, real estate and fixed income securities - and the system liquid. And in the face of a collapse in technology stocks, which certainly involves a great contraction in underlying leverage (margin debt, derivatives, etc.), this has only forced more aggressive money and credit creation to "fill the gap" and forestall a general collapse in financial system liquidity.

Speaking of liquidity, November numbers are out from Freddie Mac and (what do you know?) they matched Fannie Mae by expanding their mortgage portfolio at a 25% annualized rate. Also, this week, Freddie Mac announced, "it expects to issue $90 billion of U.S. dollar-denominated Reference Note and Bond debt according to its financing calendar for 2001." Clearly, Fannie and Freddie have big plans for 2001.

A key aspect of the recent voluntary agreement by the GSEs to "reduce" systemic risk was the notion that they would hold more "liquidity." This week, the Office of Federal Housing Enterprise Oversight (OFHEO) issued proposed guidelines for governing, among other issues, "non-mortgage liquidity investments" that are an important aspect of this additional "liquidity." From OFHEO: "The Enterprises must maintain sufficient liquidity to meet both known and unexpected payment demands on borrowings and mortgage securities, for operations and to purchase mortgage assets…For purposes of this Guidance, the types of assets listed below are generally considered to be appropriate non-mortgage liquidity investments. Debt issued by the U.S. Treasury, Debt issued by U.S. Government Agencies, general obligation debt issued by states and municipal authorities, corporate debt instruments, money market instruments, non-mortgage asset-backed securities, and reverse repurchase agreements."

This is not good. Actually, the regulators are completely "missing the boat" on this issue. Allowing Fannie and Freddie to purchase more asset-backed securities (credit card and equipment leases?) and provide financing for others to hold (agency?) securities - "reverse repos" - only is one more mechanism for these institutions to foster continued credit excess (they already hold about $130 billion of "other investments"), while increasing already enormous financial power and risk to the system. Besides, increasing security holdings is nothing more than an illusion of liquidity for the GSE's. After all, when systemic liquidity is faltering, who has the wherewithal to purchase asset-backs from those who have become the "The Lenders of First and Last Resort" - the liquidity backdrop for the leveraged speculating community? Let there be no doubt, when Fannie and Freddie face a liquidity squeeze, this game is over. To address this critical liquidity issue, however, the regulators must address the critical "right hand side" of the balance sheet (liabilities), where illiquidity always lurks. To reduce systemic risk, why not require the GSE's to fund their massive mortgage portfolios with long-term debt, instead of short-term commercial paper? Fannie and Freddie ended September with almost $400 billion of debt due within one year. Now that has all the makings of an inevitable liquidity problem and creates the potential for financial collapse.

Looking at the "big picture," the fact that two financial institutions with combined total assets of about $1.1 trillion (shareholders equity of $33 billion) are expanding at a 25% rate. This should be appreciated as a truly extraordinary development for a financial system, one leaving increasingly conspicuous tracks. We see that broad money supply has now expanded by almost $50 billion during the past three weeks. As was certainly the case in the 1998 "reliquefication," it appears that the GSE's are again borrowing aggressively in the money markets to fund their purchases of mortgages and, importantly, other debt instruments (funding a major mortgage refinancing boom). Not coincidently, money market fund assets have exploded since mid-year, expanding by $205 billion (25% annualized rate). Money market fund assets have increased by $68 billion in just four weeks. And, despite rapidly escalating credit problems, the banking sector is at it again, aggressively expanding their balance sheets. Over the past four weeks, bank credit has jumped $59 billion, or at an annualized rate of 15% (y-t-d $416, 9%). As mentioned earlier, purchases of "other securities" (agencies?) account for fully $37 billion (63%) of this expansion (90% annualized growth rate over 4 weeks). Year-to-date, "other securities" holdings have surged $88 billion, or 19%. Interestingly, commercial and industrial loans have actually declined over the past four weeks. Yet, total loans and leases have increased by $24 billion (8% annualized growth), with real estate loans accounting for $7 billion, consumer loans $2 billion, security credit $6 billion and "other" $11 billion. It is not a comforting sign of financial soundness and stability to see significant new credit growth directed specifically at security and asset markets; quite the contrary.

So, we'll assume that "the word is out;" that the Fed is on the verge of forcefully cutting interest rates, and that Greenspan is determined to move aggressively if necessary to combat deteriorating financial conditions. How else can one explain the dramatic 41 basis point three-day plunge in the implied yield for the March Treasury Bill futures contract? And, perhaps, like in the early 1990's, it has been made clear with a "wink and a nod" to the major banks and brokerages that increased holdings of fixed income securities is a "pretty good idea." This could help to explain the $37 billion increase in "other securities" by the banking sector over the past four weeks. And, if this is the case (or even if it's not), the always-enterprising hedge fund community is all over this trade. There is nothing like having the government on your side when it comes to speculating. As we have written in the past, one of the great-unappreciated characteristics of the present environment is the "elasticity" of demand for fixed-income securities. With a gargantuan acutely aggressive leveraged speculating community, it takes only the faintest hint of Greenspan accommodation to immediately foster (as we have seen of late!) a virtual buyers' stampede in the credit market. The speculators do it on leverage, and these purchases create instant financial system liquidity. Sure, this makes Greenspan's efforts to "reliquefy" almost a "walk in the park," but there will be momentous cost to be paid sometime down the road when all these leveraged trades are unwound.

We will also assume that the Fed has instructed the major banks to keep the lending desk wide open, and instructed the bank regulators to "look the other way" from any close examination at faltering credits - at least until the financial backdrop improves. This could explain the buyers' panic in bank stocks. In short, it looks like the system has come (once again) To The Brink and the powers that be are (once again) working diligently to stem the crisis and rectify the problem. After all, it's worked like magic in the past. Well, they may be able to mitigate the crisis, but there will be no rectifying the problem. That is a losing proposition.

There are some key differences that differentiate today's crisis to those previously "successfully rectified:" For one, we have a corporate debt sector that is in very serious trouble. This creates major problems, including a major dilemma for the current "reliquefication": to keep the credit engine running with enough horsepower to sustain the U.S. bubble economy, the financial and consumer sectors are left to carry an enormously heavy load. This, clearly, is not the optimum type of credit for an economy and increasingly unstable financial system. It is only the makings for greater distortions and continued massive trade deficits. Indeed, greater consumer credit excess and further financial sector leveraging ensure a more precarious disaster down the road. So it becomes clearer by the week, the proverbial "fly in the ointment" for this ("reliquefication") scheme is that it places the soundness of the dollar in only increasing jeopardy. In fact, at this point, the overriding issue comes right down to the solvency of the entire U.S. financial sector, and the Federal Reserve and the leveraged speculating community are playing with fire. Or, stating it differently, they are "betting the ranch" by perpetuating absolutely reckless financial sector leveraging and an historic accumulation of foreign liabilities, especially in the face of mounting credit and economic problems. To be candid, I see this as nothing less than the absolute worst-case scenario developing - the unrelenting self-destruction of our financial system.

But on a more cheerful note, I would like to wish everyone a wonderful holiday. Let's all try to forget about this "stuff" for a few days…


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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