Fifty Basis Points to Sustain the Unsustainable
or, The Inevitability of Derivative Problems
Wow. For the week, the Dow declined 1% and the S&P500 dropped 2%. The Morgan Stanley Cyclical index added 2%, while the Transports jumped 6%. Some of last year's highfliers came into heavy selling pressure, with the Morgan Stanley Consumer index dropping 4% and the Utilities and Biotechs being clobbered 14%. The small cap Russell 2000 and the S&P400 Mid-Cap indices declined 4%. In truly unprecedented volatility, the NASDAQ100 declined 3%, while the Morgan Stanley High Tech index gained 1%. The Semiconductors increased 7% and the NASDAQ Telecommunication index gained 1%. The Street.com Internet index was hyper volatile, with a 20% gain on Wednesday given back by week's end. The financial stocks, at least until today, continue to trade well. For the week, the S&P Bank index gained 1% and the AMEX Broker/Dealer index jumped 7%.
Historic market conditions continue in the credit market, as well. For the week, two-year Treasury yields collapsed a stunning 54 basis points to (I double checked!) 4.56%. Five-year yields dropped 31 basis points and the 10-year 19 basis points. The long bond saw its yield drop 6 basis points. Agency securities saw their yields drop 28 basis points. It was a stunning week for mortgage-backs, with yields on the benchmark Fannie Mae security dropping 40 basis points. In just three sessions, the spread between benchmark mortgage-backs and the 10-year T-note narrowed 20 basis points. The dollar swap spread continues its collapse, narrowing 18 basis points this week to 84. Let there be no doubt, this is all about derivative markets run-amok.
"The session (House Banking Committee on the LTCM Bailout, October 1, 1998) began with Representative James A. Leach, the Iowa Republican and committee chairman, criticizing hedge funds such as LTCM. 'They are seen by some to be run-amok, casino like enterprises, driven by greed,' Leach said. Some congressmen then voiced suspicions that the Fed had bailed out their Wall Street friends - 'high-flying dude billionaires,' Paul Kanjorski, a Democrat from Pennsylvania, called them.
'I am just wondering, is there any way you can inject sex into this so we can get a little more national attention?…We are talking about the potential meltdown of the world's economic system instead of a fling at the White House, and yet nobody in the world seems to understand what may have transpired or may have been at risk in the last two weeks.' Kanjorski then asked a number of questions about why the government shouldn't regulate hedge funds more closely.
'I am scarcely defending hedge funds. But many of the things which they do in order to obtain profit are largely arbitrage-type activities' - buying in one market in order to sell in another - 'which tend to refine the pricing system in the United States and elsewhere, and it is that really exceptionally and increasingly sophisticated pricing system which is one of the reasons why the use of capital in this country is so efficient. It is why productivity is the highest in the world, why our standards of living, without question, are the highest in the world.' He was giving them a dose of his militant free-market capitalism. Keeping the government's hands off the market allowed people to develop ingenious ways to make money. As long as it was legal, he supported it because of the pure market efficiency.
'I am not saying that the cause of all this great prosperity is the consequence of hedge funds,' he went on. 'Obviously, not. What I am saying is that there is an economic value here which we should not merely dismiss.'" Excerpt from Bob Woodward's Maestro - Greenspan's Fed and the American Boom.
On numerous occasions, Greenspan has associated contemporary finance with the "efficient" allocation of capital. Whether it is the massive hedge fund industry, Wall Street firms, derivatives or other sophisticated vehicles, he holds the view that these are "wealth-creating" mechanisms and critical players in the New Economy. This will go down as the greatest blunder in the history of central banking. What Greenspan has interpreted as wealth have been only the seductive manifestations of this historic credit bubble. Over time, Wall Street "structured finance" developed into THE KEY mechanism to perpetuate credit excess - sustaining the historic credit bubble. There is no coincidence that since the bursting of the Asian bubble in the second half of 1997 there has been an explosion in derivatives of all types, as well as a surge in issuance of asset-backed commercial paper, unprecedented expansion in money market fund assets, and ballooning GSE and Wall Street balance sheets. Indeed, as investors became increasingly risk averse, it was left to Wall Street "alchemy" to convert risky loans into acceptable securities for the investing public - converting risky paper into money. We have seen this repeatedly, especially over the past few months.
For lack of any understanding as to how such a thing could have occurred, I am left to accept that the whole process just somehow got out of hand. Unprecedented "money" and credit creation fueled an historic speculative bubble that played right into the hopes, dreams, and imaginations of individuals from Main Street to the Fed. Wall Street, of course, could not have been more excited by the prospect of taking control of the reins of the monetary system. Wall Street, however, does everything in excess. The problem with bubbles is that they are self-reinforcing and can go to great extremes if not terminated by the central bank. Amazingly, not only did the Fed not quash this bubble, it became a proponent. The ever-enterprising Wall Street saw its opportunity. The bubble grew to truly massive proportions. But now history's greatest financial bubble encompasses the entire U.S. credit system and hopelessly speculative stock market. It has truly become leverage on leverage, speculation on speculation, piling risk on risk - the proverbial "house of cards." And after years of endemic financial excess, the highly maladjusted U.S. economy has developed into history's greatest bubble economy, a fact that should not be dismissed. This is not like 1987, not like 1990, and not 1998; this is a once in a lifetime bubble economy and will not respond to the Fed as expected.
There will be no quick fix, no "soft-landing" and certainly no painless recovery. For one, the recovery process will begin only from much lower levels of consumption. The usual Fed "medicine" of stimulating spending by lowering rates is specifically counterproductive for this bubble. The problem today is definitely not a lack of consumption - the exact opposite. We are dealing with extreme structural distortions, both financial and economic. The public is completely oblivious, and policymakers stunningly unprepared. This is, most regrettably, the worst-case scenario developing right in front of our eyes.
Importantly, lower interest rates from the Federal Reserve will only exacerbate distortions. In the past, leading bulls have referred to the "Supertanker U.S. Economy." Well, there is some truth to this analogy, but it is the Exxon Valdez heading for the rocks. Granted, in the past the Fed was able to "reliquefy" and give new life to the bubble, but it won't work this time around. The system is literally "at the end of its rope," precariously left today with the financial sector locked in a self-destructing process of leveraging, the only means of sustaining this momentous bubble. I just can't come to see how this ends in any other way than disaster. I don't want to yell "fire" in a crowded theater and I am mindful of the seriousness of the current environment. But I will be honest about this: I don't like the looks of this one bit and am particularly worried about how this is developing.
Certainly, the unfolding financial crisis passed an important inflection point this week, with the Federal Reserve obviously seeing something that it didn't like. While some speculate that Greenspan was alarmed by the sharp decline in the National Association of Purchasing Manager's index, we don't believe it was economic data that led to the extraordinary 50 basis points inter-meeting move. Let's keep in mind that the unemployment rate is 4%, over 100,000 jobs were added during December and strong wage gains continue. Yes, the manufacturing sector is in tatters, but that is one of many structural problems after years of economic maladjustments. Perhaps, there was finally recognition within Fed corridors as to the seriousness of the unfolding collapse in the California utilities and electricity market. Our hunch, however, is that Greenspan was likely made aware of very serious financial problems, of which the faltering utilities are but a symptom. Could we be at the precipice of the inevitable crisis within the derivatives marketplace and the leveraged speculating community?
There were well-publicized rumors this morning of derivative problems at Bank of America. These were, of course, denied. Since LTCM, there is no talk of derivative problems. Here no evil, speak no evil… We assume that the major players have all agreed to keep all such discussions "behind closed doors." After all, if one of the major derivative players gets in trouble, all players are in trouble. If confidence wanes in one institution, all are in jeopardy. It's a small community and problems will be handled within this group and between the Fed, like LTCM, but importantly, outside of the public's eye. It is truly a "confidence game," one that is possible since there is virtually no transparency in public financial statements or documents, and no way for the marketplace to have any clue as to the extent of derivative problems. But I just cannot believe that there are not major derivative market dislocations. Importantly, extreme price movements have become commonplace across the board - equities, interest rates, currencies and throughout the energy markets. And with the stunning collapse in credit quality, there is also the issue of significant risk of loss in the credit derivatives area, one more untested marketplace that has ballooned over the past couple years.
It sounds extreme, but we have always assumed that the massive U.S./global derivatives market would at some point collapse (perhaps Russian-style with systemic counterparty defaults). This, in what we view as sound and rational analysis, is based on the fact that there are serious fundamental flaws in the entire process of relying on sophisticated derivative models, especially to the tune of $100 trillion. For one, they are based upon historical data that is patently not applicable to today's extraordinary environment. These models also assume the benefit of "diversification" and negative correlation when writing "insurance" in various markets, like writing auto collision and fire insurance. This was made perfectly clear with LTCM. However, this experience absolutely had to be ignored or the entire premise of contemporary "risk management" and "structured finance" would come under serious questioning (much too late for that!).
So reliance persisted, and tens of trillions of dollars of additional contracts were written based on models that assumed risk could be mitigated by writing insurance against, say, higher energy prices and lower mortgage rates. After all, based on historical data, what would be the probability that natural gas would shoot up to almost $10 while 30-year mortgage rates drop to 6.75%? Or, what would be the probability of a dramatic increase in the VIX (equity volatility) index simultaneous to a collapse in the 10-year dollar swap spread (traditionally indicating systemic stress)? Or, what would be the probability of spreads (to Treasuries) on corporate debt widening dramatically, concomitant with an equally dramatic narrowing of spreads on agency securities? What would the models calculate as the probability that the faltering euro could within weeks gain 20% against the Japanese yen? How about the probability of a rapid 50% drop in NASDAQ with much greater declines for many individual stocks? In the credit derivatives area, what probability would the models have placed that the major California utilities could accumulate more than $10 billion of losses over several months and be on the brink of bankruptcy? Or, better yet, what would the models calculate as the probability that all the before mentioned scenarios would occur simultaneously? The probabilities would have been near zero, but it happened! The models don't work.
When an individual firm wrote insurance against higher energy prices, lower stock prices, interest rate moves and a falling dollar, the models made the erroneous assumption that these individual risks are not highly correlated. And enormous amounts of credit were created in this the process where "insurance" is widely available to protect against such risks. Massive leveraged positions have been accumulated under the assumption that such risks could be mitigated through the derivatives market. Apparently, there is no need to ever sell positions if risk can be transferred to the derivatives marketplace. Unprecedented financial sector expansion has occurred under these assumptions, as well as almost unfathomable accumulation of foreign liabilities. As we have said before, the proliferation of derivatives has created truly frightening risk, not reduced it.
At the same time, there remains this amazing deeply ingrained perception within the marketplace that a lower Fed funds rate is a free gift that Greenspan can hand out at his discretion; that financial crisis is like Christmas. After the historic Internet/Telecom/technology fiasco that were the direct consequences of Greenspan's 1998 gift of aggressive accommodation, you would think that there would be some discussion of the heavy costs associated with inciting more speculation and credit excess. They are anything but a free lunch. As we go into what will almost certainly be an aggressive period of monetary accommodation, it should be appreciated that the costs associated with these "reliquefications" have increased exponentially. Alarmingly, there is no appreciation of the great risks of aggressive monetary accommodation.
Reading through Bob Woodward's "Maestro," I was struck hard by the shallowness of Greenspan's and the Federal Reserve's analysis. Actually, the most notable aspect of this book was that nowhere in 229 pages were there any passages that gave me comfort that the Greenspan Fed had a fundamental grasp of what has been developing over the years, or is in the least bit prepared for the impending financial and economic storm. On the LTCM bailout: "McDonough explained to Greenspan that he and the New York Fed had just played the role of catalyst and honest broker. No public money had been offered or spent. He didn't have to pressure anyone to participate, but he believed that only the Fed could have called all of the players together into one room. Greenspan wasn't happy. McDonough had lent the good name of the Fed to the resolution. The meeting could have been held in any other boardroom in New York. The Fed didn't have to play matchmaker. Greenspan thought that McDonough had exercised bad judgment, rushed in a little too fast. The probability that LTCM's collapse would unravel the entire world financial system was significantly less than 50 percent, but that was still enough to be worrisome." Wow…I very much hope that this was not an accurate interpretation…
The book, however, certainly reinforced what is well known: Greenspan looks through reams of economic data and enjoys doing mathematical equations. There was nothing, however, that hinted of an appreciation for financial fragility or particular vulnerabilities of the U.S. financial system or economy. There was no mention of trade deficits or the accumulation of foreign liabilities. Nothing to suggest Greenspan was anything but sanguine as to the proliferation of derivatives. No mention whatsoever regarding the aggressiveness of the Wall Street firms or GSE's.
Ironically, while he has been a leading adherent to the New Economy, he is very much a master of the economics of the old industrial economy. I was certainly struck by his apparent fixation on productivity and corporate profits. There is one episode where he and his associates apparently believe that they have discovered the "Holy Grail," when a sector breakdown of productivity data isolated negative productivity in the service sector. Since clearly such data must be erroneous, this revelation apparently provided proof of Greenspan's hunch that productivity growth had been significantly understated for the economy as a whole. I could only grimace at the thought that this "analysis" was seen as solid evidence supporting the New Economy. There was also the recognition that since corporate managements were claiming they lacked pricing power, and that profits were nonetheless growing substantially, this strongly supported Greenspan's belief of a paradigm shift in worker productivity. As I said, pretty shallow stuff…
Anyway, I could not help but to see strong parallels between Greenspan's analysis of the economy and the bull's analysis of the stock market. Both erroneously focus on "income statements" and ignore balance sheets. In Greenspan's case, he focuses on GDP, corporate profits, and productivity, while ignoring debt growth, financial sector expansion, and the quality of financial system assets. But, then again, this comes from a Federal Reserve Chairman who states that money supply cannot be defined. In the case of the bull's analysis of stocks, there is a comparable fixation on earnings per share growth, while ignoring the quality of earnings, the soundness of assets and mounting debt growth. Any good analyst will go right to the balance sheet and statement of cash flows to look for trouble spots. It can be excess receivable growth, notable increases in "other assets" or special items. Are these assets property valued? Are assets being overstated and/or have proper reserves been taken? Important clues are also certainly found on the liability side, with unusual increases in account payables or increased debt levels. Are all liabilities properly recognized? Analyzing how the cash flow statement reconciles profits with actual cash flows is also critical. Often, despite fundamental negative developments, companies can for some time "massage" income and expense items and report earnings to "match or beat estimates."
I remember back in the fall of 1998 when two finance companies filed for bankruptcy without ever missing a Wall Street earnings estimate. An excellent recent example can be found with the troubled California utilities. Yesterday's Wall Street Journal ran an excellent piece on PG&E by Rebecca Smith and John R. Emshwiller. The article began, "In August, Bruce R. Worthington did something no PG&E Corp. executive had done in the utility's nearly 150-year history: He hired lawyers to prepare it for possible bankruptcy protection." Well, isn't that interesting. PG&E reported Operating Earnings for the third-quarter of $629 million and Net Income of $225 million. Earnings per share were 68 cents, 26% year-over-year increase. Immediately after the earnings release, the bulls were in force. Merrill Lynch titled their research report "Smooth Sailing…," First Boston "Strong Growth Continues…" and UBS Warburg "Bullseye!…" All of this despite the fact that PG&E's "uncollected deficit" had surpassed $2.2 billion by August 31st. Looking at the balance sheet, we see that liabilities jumped almost $2.7 billion during the third-quarter. All the same, a consortium led by Bank of America provided a $1 billion line of credit. At the end of October, Lehman Brothers was the lead manager as PG&E raised funds (apparently $1.3 billion) through a private sale of notes (brought back memories of Goldman Sachs underwriting Russian debt just months before the collapse in 1998!).
Yesterday, Standard & Poor's lowered ratings on PG&E and Edison International to one notch above investment grade. Commercial paper ratings were cut to "A3" from "A1," basically making their short-term borrowings unacceptable to money market funds and other investors. Fitch lowered ratings to "deeply speculative grade," sighting that "approval of a 7-15% retail rate increase is wholly insufficient to reverse the cash drain that could lead to default….with access to cash and bank credit for the utilities drying up, possibly only a few weeks remain before funds are exhausted. Default is a real possibility for these utilities and their parent companies." It is pretty clear these huge utilities are now in a fight for their lives. These downgrades now endanger commercial paper back-up credit lines and other credit facilities. Along with BofA's unsecured billion-dollar credit line to PG&E, in April Chase arranged an unsecured $800 million for Edison that expires in May. Estimates now have PG&E's near-term cash needs as high as $5.6 billion (including $2 billion of commercial paper).
The issue going forward will be the tentacles of this unfolding energy market credit debacle. The entire energy sector has been aggressive users of "structured finance" with a proliferation of derivatives and sophisticated financing arrangements including "funding corporations." Enron, the largest "player," has seen its total liabilities surge 82% over the past four quarters to $39 billion. Looking at assets, we see that "Trade Receivables" more than doubled to $6.5 billion, "Assets from Price Risk Management Activities" jumped from $2.2 billion to $7.3 billion, and "Total Investments and Other Assets" increased 50% to almost $23 billion. At the same time, "Net Property, Plant and Equipment" increased $772 million (7%) to $11.5 billion, about 20% of total assets. Now, that is one New Age energy company… From its most recent 10Q: "Enron builds its wholesale businesses through the creation of networks involving asset ownership, contractual access to third-party assets and market-making activities. Each market in which Enron Wholesale operates utilizes these components in a slightly different manner and is at a different stage of development…Enron manages its portfolio of contracts and assets in order to maximize its portfolio of contracts and assets in order to maximize value, minimize the associated risks and provide overall liquidity. In doing so, Enron Wholesale uses portfolio and risk management transactions to manage exposures to market price movements (commodities, interest rates, foreign currencies and equities). Additionally, Enron Wholesale manages its liquidity and exposure to third-party credit risk through monetization of its contract portfolio or third-party insurance contracts. Enron Wholesale also sells interests in certain investments and other assets to improve liquidity and overall return…" Not your Grandfather's energy company…There is no doubt that the California utility fiasco and an historic spike in energy prices (particularly natural gas) has wreaked havoc within the energy derivatives marketplace.
The bottom line is that derivatives and Wall Street "structured finance" are deeply imbedded throughout the financial system and economy. The unfolding crisis is systemic and the problems structural. Throwing more credit and "liquidity" at this extraordinary situation is a grave mistake with extreme risk. This is very much a U.S. financial system and economy "balance sheet problem." Not only has the financial sector become grossly overleveraged, the quality of financial sector assets is very poor. The accumulation of unprecedented foreign liabilities continues by the day. The "off-balance sheet" derivative "overhang" makes the situation only much more precarious. The possibility of an inevitable collapse in confidence in the U.S. dollar and financial system can certainly not be ignored at this point.