The Credit Bubble Bulletin
We May Be Wrong, But Won't Say So Yet
by Edmund M. McCarthy
Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company
What better omen to admit possible fallibility than the above palindromic date? Our previous maunderings about a possible replication of the Japanese experience could easily be dead on arrival; given Mr. O'Neill's public television pronouncement that "There probably never was a recession since two quarters of negative GNP did not occur." There are daily explosions of good news on the economy, and equity and debt markets remain extremely sanguine on forthcoming prospects. Even the niggling problems in Argentina, Japan, Enron, pro-forma earnings and off balance sheet vehicles elicit only temporary concern. To summarize: 1. The recession is ending or never was. 2. Interest rates are accommodating. 3. Money supply expands exponentially. 4. The dollar index hits new highs. 5. Inventories are accumulating. 6. Rising unemployment has reversed. 7. Capital expenditures are firming. 8.Dram prices are up. Conclusion: GDP of 3.5% for the year. S&P profits up 30% and Nasdaq heading for the good old days. This consensus is so nearly universal (sentiment indicators and the volatility index at or near respective highs and lows) that only a curmudgeon could fail embrace the new NEW economy to come.
IS THERE ANYTH1NG WRONG WITH THIS PICTURE? YES, SAYS CURMUDGEON
We are willing to agree that there has at least, been a temporary cessation in the economic downtrend (we choose NOT to use the "r" word or otherwise explicitly define it). A trillion dollars growth in the money supply and 4.75% in interest rate cuts have finally pushed some money into inventory rebuilding (certainly in housing and autos where tidal money waves and infinitesimal rates have elevated demand even during the decline or whatever it was!) And in such other price cutting arenas as are so numerous.
THIS SERENDIPITOUS RE-IGNITION OF DEMAND, HOWEVER, HAS BEEN ACCOMPANIED BY FURTHER EXACERBATION OF THE CONSUMER DEBT POSITION TO ALL TIME HIGIIS IN PERCENT OF INCOME AND OF NET WORTH!
FURTHERMORE, AS HIGHLIGHTED BY MOODY'S IN A RECENT REPORT CORPORATE CASH FLOW AND PROFITS ARE AT AN ALL TIME LOW AS A PERCENT OF CORPORATE DEBT OUTSTANDING!
No Curmudgeon in good standing is going to buy a new sustainable economic expansion with such a debt anchor weighing on it.
While browsing the estimable Moody's, we also ran across their report on 2001 asset backed commercial paper. It is more than mildly interesting to note that at well over $700 billion. It now exceeds the more conventional unsecured commercial paper of yore. Moody's notes that growth is certainly due, in no small part, to the ratings declines of former pristine issuers BUT also, ingenuously, says that these vehicles provide flexibility and ANONYMITY to the issuers. Does anybody proof read this stuff before they publish? Moody's also presages some $300 billion in additional term asset backed in 2001 with a third of it in the home equity market (assuming any equity is left). Lastly they see a great Year for the CDO and CLO game as such small (3% remember Enron) capital is required to get it off balance sheet. but sees clouds on the horizon if the new Basle risk based accords start to look at this stuff in a couple of years. I know that all of this stuff makes for an avalanche of fees for ratings. but is anybody noticing the big picture? The same rating agencies are now reporting that 2001 was a record year for corporate bankruptcies (individual also) and ratings downgrades.
Also interesting was a bureaucratic language report from the Office of Federal Housing Enterprise Oversight on their "rule" on capital for Fannie and Freddie, which pay them to regulate them. Some 40 odd pages relate in tedious detail the development of the labored compromised phrasing of the rule and the objections of the enterprises and the final verbiage.
NOWHERE IN THE WHOLE IMBROGLIO DOES IT SAY THAT THE TWO (FANNIE AND FREDDIE) HAVE COMBINED BALANCE SHEET AND GUARANTEED MORTAGES TOTALLING $2.7 ITRILLION ON CAPITAL OF $38 BILLION!
In other words 1 1/2% in losses wipes out the capital. Not to worry; we all know houses only appreciate and their holders would never default in such numbers. Makes the Japanese banking system look prudent.
And should such losses begin to manifest; what's to worry? Everybody, including the foreigners who hold multi-hundreds of billions of this paper, "knows" that the obligations of these two whoopsies, are guaranteed by the U.S. Government. Let's hope they at least buy next year's issuance before they find out to the contrary. That issuance should be another record according to the omniscient Chairman of Fannie. This worthy sees double-digit growth for at least the next decade (to be known 'as the "Decade of the American Dream"). Last time we looked, the demographics of such would only work if we not only take in the population of Cuba, Haiti and Mexico, but may as well throw in that of the New Axis of Korea, Iran and Iraq. (Might be cheaper than a war and think of the benefit to the economy.)
Used to be that the humongous growth in these two entities was somewhat offset in terms of Government obligation or quasi obligation by the pay down of real Government debt, but that reversed out quicker than could be believed. And for a couple of years at a minimum, those foreigners are not only going to have to finance the equity market and the housing market but actual increases in Treasuries. Good thing they like the dollar a lot better than oxen, to paraphrase the worthy Chairman of the Fed.
The usage of the two housing entities in re-liquefying is a little understood phenomenon of the need for this sort of thing in 1998 and 2000/01 continuing. With money supply catapulting again some $30 billion in a week, it is relevant and worth repeating. These triple A credits can essentially self-fund portfolio purchases. They are able to respond outside the Fed balance sheet by market purchases of outstanding securities. These need not even be mortgage backeds any longer. Through derivatives they can fund either directly from institutional money market funds or (a rapidly rising trade given the shape of the yield curve) through direct or repo operations with hedge funds and other leveraged players. Fannie's portfolio purchases in '01 hit $270 billion, up a third from '98 when they hit $185 billion which was more than twice any number previously seen. This scale of profligacy firehoses liquidity into the market. It also sustains housing price increases which sanity says are a bubble of unprecedented proportions.
It's really nice that the American dream is being so completely fulfilled but we have some reservations. As even the dumbest homebuyer knows, the home is the ultimate "put" option. It used to receive a lot of negative press before the two housing entities perfected hedging and portfolio purchase liquidity to obviate risk as "dual convexity". I.e. the mortgage lender always ultimately loses. The "good" rates are refi'd ay and duration balloons on the bad ones. Later we will cavil against the notion that they have so successfully derivatized away such convexity, but what we would like to bring up now is how, residential housing differs from other forms of investment having anything like this kind of size. It's the only asset class in the multi-trillions that we can think of which generates NO CASH! It is entirely dependent on the owner providing debt service from income other than the asset. We know, there is a small portion of the stock in rental and exclude that from our defamation. We are being overly simplistic in the following. The housing stock, securitized, has very considerably been financed through return of our trade deficit over the last decade. The lenders think it is sovereign risk at a better yield. What they really have is a low equity, non-cashflowing asset class dependent on employment.
The housing pyramid has been elevated to the current level during an uninterrupted decade of domestic prosperity, and the incredibly complicated financial fabric of housing has been completed without any verifiable test of this structure! We are assured that all of the players have "stress tested" the ingredients to the point of assured safety but stress testing is self designed and the regulatory authorities are really in no position to dispute the computer models the heavy lifters use. (They do on the fringe and satisfy supervisors by negotiating tiny increments of little value). Only by adding another decade of such hyper-growth can this pyramid continue. Any prolonged (more than 1 quarter?) flattening, much less multi-quarter turndown, will expose the weaknesses which are inherent. In current non-recession, we see the agency using such devices as paying the originator $500 to "restructure" a loan thereby avoiding having to adversely impact the underlying security.
If we are wrong and the U.S. economy is now on the thresh-hold of another sustained expansion, the housing model has a reprieve. Certainly the prospective trade deficit will send out enough dollars when round tripped to add any more hundreds of billions to this game next year.
Nevertheless, there is a finite end to how much consumer income must be directed to cashflow this debt, how much equity can be subtracted through refi's to sustain the thing, and how much dual convexity can be siphoned away by accretion to the derivatives players dynamically hedged risk profiles. While we are certain of the truth of this; the timing continues obscure.
In any normal universe the afore-mentioned trade deficit would long since have had an effect on the currency of the generator of such profligacy . Jim Grant of Grant's Interest Rate Observer calls it "Marshall Plan in reverse". At 4.7% of GDP it even exceeds the 4.3% devoted to residential real estate; a bubble, we believe of munificent proportions. We have long expected the dollar to weaken and long have been wrong. Recently, the super rally in U.S. equities, a flagging European economy with some inflation and deficit problems and the collapse of Argentina have sent the dollar back to all time highs . We now feel, however, that the ultimate high for the dollar may be yet to come. We predicate this change of thinking on the extremely parlous condition of the world's second largest economy, Japan. It is not outside the imaginable to see a likelihood of total collapse occurring there in the near future. While the Japanese citizen may be slow, he/she nevertheless has enormous savings; as much $ 100M equivalent per household. If they become increasingly doubtful of their banks in advance of the decrease in guarantee on deposits at the end of March, those banks are going to have to unload Japanese Government bonds in very large amounts. If the JGB goes into freefall along with the yen, even more will be sold and dollars bought. Result, new highs for the dollar. Ultimately, of course, it has to go the other way.
The Japanese Government will have to unload its very substantial U.S. Gov't and Agency.
Holdings and the dollar gets slammed. In the meantime, however, the housing bubble here could be even further exacerbated. The big wild card in a Japanese debacle are the hundreds of billions of Govt. and Agency holdings of the Chinese. Will they hold and continue to buy when the Japanese liquidate? The near in scenario favor the dollar but the end game is unpalatable to disastrous without fail as U.S. sovereign/agency debt is liquidated and competitive devaluation spreads widely. The U.S. is the least. prepared for a battle to export.
In retrospect, the dotcom and telcom bubbles are being recognized for what they really were: an atrocious form of MALINVESTMENT!
Economists much smarter than we have reported over the centuries on the likelihood of manias/bubbles to waste enormous amounts of capital in malinvestment. We argue that the current housing bubble is yet another form of malinvestment. Throw in the last couple of years in auto's, particularly SUV's and we have some pretty large misuse of that scarcest of resources. We aver that all this is the result of round-tripping of trade deficit wealth, coupled with, in recent years, the capital gains-enhanced Federal Revenues resulting in a fiscal windfall. This enabled the Fed to pursue what would otherwise have been catastrophic easy money and Agency induced liquidity. Time will tell if the scenarios above are the end game for the dollar bubble or whether it somehow continues through other "Deus ex Machina" we cannot foresee, but the other important element, budget surpluses is a fond memory. The administration is already talking some $80 billion in deficits for the coming budget. History says such talk should produce two or three times that number. Even with slowed trade, the twin deficits (Yes, it's time for that term again) should be up in the $600-700 billion range.
Again, some analysts, a lot smarter than we may be, are predicting that the Enron/KMart/Global Crossing/PNC/Tyco combined horror shows on corporate governance and accounting probity are going to result in vast disillusionment on the part of the investing public. (The institutional guys have known it all along but have to beat their indexes and ignore the underlying reality). On Feb 4 Tyco announced that it will pay off (was forced to or anticipates ratings downgrade which would force it?) all of it's commercial paper. Watch the ratings agencies for a slew of offshore's holding Tyco assets for new asset backed commercial paper. This is another symptom. If they won't lend to you clean, hock the assets, get a couple of derivatives to get Moody's to issue a Prime 1 c/p rating and dump the stuff in the ubiquitous institutional money funds!
Only time will tell the extent of the damage but we are inclined to agree that it may insert a dollop of caution. The main difficulty likely to arise, we would argue, is that the number of perpetrators not yet found is incredibly large. The more intelligent will move heaven and earth to finagle their unbalanced balance sheets and pro forma nonsense income pronouncements into something more likely to withstand scrutiny. The result is going to be, with all the spin these worthies can muster, an awful lot of debt added to the already record amounts on these already strained sheets and a serious reduction in income reported. With p/e's already multiples of any previous boom, there might be a little risk that can't be reliquified away. Boards of Directors are going to be taking a lot closer took at the 10Ks, not just the press releases. One by one, the changes are likely to intensify the growing doubt as they cumulate in the "investing public's" mind over the real worth of their holdings. Of such doubt bull markets are seldom constructed. We also presage more scrutiny by analysts, bankers and regulators. The 47,000 special purpose vehicles in the Caymans alone with their $800 billion in holdings make it clear that there is a lot not yet exposed. Clarity will be long in coming but has started the journey!
ANY READER OF THESE SPORADIC MIISSIVES IS PROBABLY READY TO DISMISS THE INVEIGHINGS AGAINST IDERIVATIVES WHICH (WITH THE EXCEPTION OF THE LTCM DEBACLE) HAVE BEEN "CRYING WOLF" TO DATE! AS WITH ANY OTHER PREMATURE CONCERN, THERE IS ALWAYS THE CHANCE IT'S TIME MAY COME. WE THINK THAT TIME IS APPROACHING. THE BULK OF THE MORE THAN $100 TRILLION IN THESE INSTRUMENTS IS CONCENTRATED IN LITTLE MORE THAN A COUPLE OF HANDFULLS OF GIANT FINANCIAL ENTERPRISES. A SURPRISINGLY LARGE PERCENTAGE IN ONE!
J.P.MORGAN/CHASE IS AFFECTIONATLEY KNOWN TO SOME AS THE "DERIVATIVE KING" HAVING BEEN THE RESULT OF A MERGER OF A COUPLE OF THE BIGGEST PLAYERS. THEY ARE AN ACCIDENT IN WAITING. THE RATING AGENCIES ARE BETWEEN THE PROVERBIAL ROCK AND HARD PLACE! THIS IS NOT NOW A COMPANY DESERVING AA RATING. NEITHER CAPITAL NOR EARNINGS PLACE IT IN THAT CATEGORY. PROSPECTIVELY IT CAN ONLY GET WORSE. ON THE OTHER HAND, ANY DOWNGRADE WILL BE AS BAD AS LTCM FOR THE MARKETS. THE LITTLE KNOWN SECRET IN THIS GAME IS NETTING. IT IS POSSIBLE TO HAVE A HUMONGOUS GROSS EXPOSURE TO MORGAN IF YOU HAVE OFFSET WITH HUMONGOUS "DYNAMIC HEDGING". ALL OF THIS STUFF IS ONLY IN FOOTNOTES BUT GROSS EXPOSURES FOR A NUMBER OF THE OTHER GIANTS ARE IN VERY BIG NUMBERS! A DOWNGRADE IS GOING TO FORCE THEM OUT OF NETTING INTO EXPOSURE!
After Enron, they can't take the chance of having it come out with the wrong spin!
Among others, Citi, Morgan Stanley, Goldman, AIG, Merrill and GECC are likely very large netting counterparties. A downgrade, which looks increasingly likely, will force interesting disclosures there. Other counterparties will be the beleaguered Japanese banks and the large British, Dutch, German and, to a lesser extent, other continental banks. If the safety and secrecy of netting begins to unravel, this could be quite a story. They may, with the aid of the Fed, be able to again sweep this under the rug but we doubt it. On the interest rate front, the Agencies have enormous exposure if their "mitigants" to rate fluctuations don't have the enormous liquidity the Derivative King and the others have provided. The Agency portfolios are full of low yield stuff now. Any duration spike would be unwelcome without a big short in derivatives going the other way. We can't (because of lack of disclosure) even begin to quantify the possible risk but can easily surmise that it is very large. We really hope we are either wrong or they find another form of bailout to obviate this progression but think it is a giant risk very much worth considering.
A fast growing (even Enron was a player) area of derivatives is credit quality instruments- We have previously inveighed against them since there is not an actuarially sound way of writing such protection. This toxic waste is now in the hundreds of billions and (given the paucity of recoveries in recent bankruptcies), the notional amount nearly equates to the real risk. The ingenuity of the players here was already stretching as AIG, in the PNC case, was out there helping with actual non-performing loans. We wonder if this was the first experiment or are there others extant. We also wonder how deterioration in the Bank of America "tax" vehicle, should such continue to occur, will be handled. We would be very wary of any new off balance sheet vehicles in this environment!
On February 4 there was a Wall Street Journal article on the need to regulate derivatives. There is also another on the popular "Mips" product. Pardon the cynicism, but if Wall Street and the lobbyists couldn't be budged on mips issues, we see little hope to take on the derivatives players successfully. It used to be that I would base this opinion largely on the incredible profitability in fees for the creators and writers of these opaque instruments. This is now nearly certainly compounded by the need to hide the true situation in a lot of the over the counter stuff created in different atmospheres. There are probably fairly enormous losses rattling around in the system. They will grow if the recovery or faux recovery doesn't bail them out. The mere thought of regulating this funny farm, however, further illustrates the change in the climate of trust which we hypothesized earlier.
It will be interesting to see how this initiative plays out. We have long contended that the greatest systemic risk in the system is in this little understood and largely invisible world with the VERY LARGE NUMBERS WHETHER WE ARE TALKING NOTIONAL OR ACTUAL RISK!
In 1998, the Fed, particularly the New York Fed contained the LTCM debacle with a bailout out and floods of liquidity, largely engendered by portfolio purchases by the GSE's and the Fed, as well as some rate cuts. The package ignited the 1999 dotcom mania and exploded the telecom nonsense to its peak. The economy then had demand and credit totals that were only unreasonable, not yet ridiculous. A replay now is missing the interest rate cut component and would come in an environment of increasing credit concern.
Net Net, we are willing to give a hesitant, faltering recovery a few months breathing room but see all of the above risks detailed as elements which will curtail any such expansion. It's a matter of time not question.