Two Economic Postulates

By: Doug Noland | Fri, Aug 9, 2002
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Wow...yet another wild one. From Monday's lows, the Dow surged 715 points, or almost 9%. For the week, the Dow and S&P500 gained 5%. The Transports increased 7% and the Utilities 6%. The Morgan Stanley Cyclical index gained 5%, while the Morgan Stanley Consumer index added 3%. The broader market generally underperformed, with the small cap Russell 2000 gaining 3% and the S&P400 Mid-Cap index rising 4%. The technology stocks rallied, with the NASDAQ100, Morgan Stanley High Tech, and Semiconductor indices gaining 5%. The Street.com Internet index gained 2%, and the NASDAQ Telecommunications index inched up 1%. The major Biotech index surged 9%. The financial stocks rallied strongly as well, with the Securities Broker/Dealer index jumping 9% and the Bank index up 8%. With bullion up $7.0, the HUI Gold index gained 6%.

It was very volatile week in the Treasury market, with spreads continuing to widen problematically. For the week, the two-year Treasury yield rose six basis points to 2.07%. The five-year saw its yield decline one basis point to 3.19%, while the 10-year yield declined seven basis points to 4.22%. The long-bond saw its yield fall nine basis points to 5.11%. Mortgage-backs and agencies underperformed, with benchmark Fannie Mae mortgage-back yields adding one basis point. The implied yield on agency futures declined three basis points. The December Eurodollar yield declined two basis points to 1.67%. The spread on Fannie Mae's 5 3/8% 2011 note narrowed one to 56, while the 10-year dollar swap spread narrowed 7 to 56. The dollar index gained about 1% this week.

There was little relief in the beleaguered corporate market, with spreads widening significantly in many instances. Ford's 7.25% 2011 bonds saw spreads widen 35 basis points today to a record 420 over Treasuries. This spread widened an alarming 95 basis points this week, and is now up about 240 basis points since late May. GM's 7.25% 2011 bond spreads widened 25 basis points today to 304 over Treasuries. Spreads were up almost 40 basis points for the week and 200 since late May. These companies' dependence on a booming securitization marketplace cannot be exaggerated. "Vulnerable" does not do justice to their current predicament, with their securitizations surely becoming much less attractive by the week. We would not be surprised if selling related to the hedging of Credit default protection previously sold is exacerbating bond weakness.

Standard & Poor's August 8, 2002—"Standard & Poor's Ratings Services said today that it revised its outlook on Aon Corp. to negative from stable following the company's disappointing second-quarter 2002 earnings announcement. 'This rating action reflects the margin deterioration in Aon's insurance brokerage and consulting practices, which reported lower-than-expected earnings, partly because of higher-than-expected expense levels and continued execution problems associated with the implementation of its business-transformation plan.'"

Broad money supply surged $44.3 billion last week, with three-week expansion at $91.8 billion. Broad money supply has now surged $243 billion over the past 15 weeks, an annualized growth rate of 10.5%. Last week's surge saw demand deposits increase $5.7 billion, other checkable deposits $6.4 billion, saving deposits $6.8 billion, large time deposits $3.5 billion and repurchase agreements $4.2 billion. Money fund deposits surged $21.3 billion, with institutional funds up $11.5 billion and retail funds up $9.8 billion. Commercial paper increased $5.7 billion last week, with domestic financial commercial paper issuance up $8.6 billion last week and $33.7 billion over five weeks. Bank Credit increased $17.2 billion for the most recent reporting week (July 31st), with securities holdings up $8 billion and bank loans and leases up $10 billion.

From Countrywide Credit's July operational data: "Driven by continued low interest rates and market share growth, Countrywide's core mortgage banking business delivered outstanding performance results in July. Average daily loan applications hit a record $1.4 billion, an increase of 28 percent from the prior month. The mortgage loan pipeline jumped 33 percent over the prior month to $31 billion. Application and pipeline trends indicate robust loan fundings for the near term. Mortgage loan fundings in July were $17.1 billion, fast approaching the company record set in December 2001 of $17.6 billion. July's purchase fundings reached an all-time high of $8.5 billion, eclipsing the prior month's record by 10 percent." Making year-over-year comparisons, average daily volume was up 98%, while the mortgage pipeline was up 73% ($31.1 billion). Purchase volume was up 81% ($8.5 billion) y-o-y, while refi volume jumped 50% to $8.7 billion. E-commerce volume increased 49% to $7.7 billion, while home-equity volume surged 78% to surpass $1 billion during July. Subprime originations jumped 42% to $729 million.

With fixed mortgage rates sinking to the lowest level in 32 years, it is not surprising that the Mortgage Bankers Association's weekly application index increased to its highest level on record (10 years of surveys). The refi index jumped 6.2% to the highest level since November (up 103% y-o-y), while the purchase index gained 3.7% (up 17.5% y-o-y). The index of adjustable-rate mortgages is up 210% y-o-y.

Despite the flood of additional mortgage finance, July was a very disappointing month for retailers. Best Buy shocked the Street with news of a major spending slowdown in July. Elsewhere, the Bank of Tokyo-Mitsubishi retail survey had July same-store sales up a disappointing 2.6%, down from June's 5.1% increase. Wal-Mart saw same store sales slow to a below-plan 4.5%, compared to last July 2001's comps that were up 6.0%. This is a notable decline from June's 7.9% same store sales gain (up from June 2001's 6.9%) and May's 6.2% (up from May 2001's 3.8%). Ex-Wal-Mart, same store sales were up only 1.5%. Target same-stores sales increased 1% (vs. year ago 4.6%), down significantly from June's 4.9% (vs. June 2001's 0.%). The Gap saw its same store sales decline 8%, J.C. Penney dropped 2.2%, Federated 5.2%, Sears 4.9%, and Dillards 3.0%.

The Rockefeller Institute (Nicholas W. Jenny) this week reported that second-quarter state tax receipts fell an alarming 10.9% from last year's second quarter. With the well of huge stock market capital gains having run dry, personal income taxes sank 23%. Corporate taxes were down 12.5%. By state, California had the worst performance as its quarterly revenue dropped a shocking 24.7% from a year ago. Oregon saw its tax revenue decline 24.1%, New York 19.4% and Connecticut 19%. This is quite a change from the peak of the boom in 2000, when y-o-y increases in quarterly personal income tax receipts averaged 12.3%. The National Conference of State Legislatures is estimating that states will run deficits this year approaching $58 billion. The California legislature is locked in a stalemate with the states estimated $23.6 billion budget shortfall. Governor Davis's administration yesterday (Sacramento Bee: "State Budget Stalemate: Day 38") warned that individual agencies may be required to institute permanent 20% spending cuts. A spokesperson from the governor's office stated, "We've got to get this budget passed and move forward to the bigger challenge that lies ahead of us." Estimates have an additional deficit of $51.6 billion accruing over the next five years. The state is considering significant tax increases for cigarettes, automobile registrations, satellite television, and real estate to go along with a reduced state services.

Bond insurer behemoth (and largest Credit insurer in the world) MBIA reported light earnings this week. "For the second quarter, adjusted direct premiums in the global public finance business decreased 50 percent to $98.1 million from $196.6 million, due to minimal production outside the U.S. Global structured finance adjusted direct premiums in this year's second quarter were $206.4 million, an increase of 87 percent from $110.2 million in last year's second quarter, due to very strong production from domestic structured finance operations... Global structured finance adjusted direct premiums in the first half of 2002 rose 32 percent to $263.9 million from $199.6 million in last year's first half." The company purchased another 750,000 shares during the quarter, bringing first-half purchases to 1.75 million. "Net debt service outstanding" (net Credit insurance in force) is up almost $20 billion during the first-half to $742 billion. The company's "capital base" has increased about $225 million to $5.2 billion.

From yesterday's American Banker (Robert Julavits): "[Office] vacancy rates and available sublease space are approaching record highs from Atlanta to San Francisco, according to several reports, and nationwide, supply still vastly exceeds demand - stressing that office and other commercial real estate sectors... 'In 1999 and 2000 you couldn't build enough office space...but a lot of the space was never occupied,' and most of that new space has been put back on the market in the past year. PNC said in a report released Wednesday that it found close to 142 million square feet of sublease office space, making up 24% of all vacant office property." Dallas/Fort Worth second-quarter office vacancy rates were estimated at 25.5%, with 19% in Atlanta, 18.4% in Denver, 18.4% in San Francisco, 18.9% in San Jose, and 19.6% in Salt Lake City.

Aug. 9, 2002 - "Fitch Ratings places Conseco Finance & Green Tree Finance Manufactured Housing Bonds on Rating Watch Negative and downgrades certain limited guarantee bonds. This action follows Fitch's downgrade of Conseco Finance Corp.'s (Conseco) senior debt rating to CC from CCC... These actions reflect Fitch's heightened concerns regarding maintenance of the servicing quality in the manufactured housing portfolio."

Today insurance company Conseco announced that it was delaying interest payments on some of its bonds, while admitting, "Radical change in the company's capital structure is required." A bankruptcy filing could now be in the offing. The company ended the first quarter with total assets of $61.5 billion and shareholder's equity of $6.5 billion. Along with its insurance business, Conseco is also a significant lender. After its purchase of Greentree Acceptance, the company became a leading Credit provider of risky finance for the manufactured housing industry. It is also a major player in home equity loans and other consumer finance. Importantly, the company has issued $35 billion of asset-backed securities. A bankruptcy filing would be one more blow to this increasingly stressed sector, especially at the fringes of manufactured and home equity securitizations. Many very bright analysts believed that new management and low interest rates would provide the medicine to heal this impaired financial institution. That these efforts are now an admitted failure speaks volumes to how profoundly the financial landscape has deteriorated.

It was quite a week. While it somehow seems like a while ago, the system was coming under extreme stress this past Monday. The stock market was sinking, Treasuries were in melt-up, Credit spreads were blowing out, and it appeared that major liquidity problems were developing in the asset-backed securities market. Importantly, the price of default protection for the automobile manufactures surged Monday, as Credit spreads for Ford and GMAC widened dramatically. One pricing service had protection against a default at Ford surging 70 basis points Monday to 390 basis points, up from 160 basis points at the end of May. GMAC default protection surged 55 basis points on Monday to 270 (up from 100 in May). Financial industry debt spreads were widening meaningfully as well. With this backdrop, virtually all companies with significant capital markets exposure (borrowers, lenders, securitizers, Credit insurers, investment bankers, etc.) saw their stocks come under heavy selling pressure Monday. The rally that commenced Tuesday in European trading could not have come at a more critical time. The hastily orchestrated IMF bailout for Brazil further comforted the marketplace that the authorities were finally appreciating the seriousness of the unfolding financial dislocation.

The way we see it, there is basically a confluence of four major factors that are pushing the global financial system to the brink: the sinking U.S. (and, to a lesser extent, global) stock market, the faltering dollar, an imploding Brazil, and dislocation within the U.S. Credit market. All four were exacerbating the dislocation in global "risk" markets that has been developing for months, and all four were quickly leading to severe impairment for the major U.S. and global money center "banks" and derivative players. Certainly, recent events recall the 1995 Mexican bailout and the October 1998 bailout of Long Term Capital Management. The issue then becomes whether the authorities have again managed to plug all the holes in the dike and rescue the great Credit Bubble. If so, recent declines will likely mark major market trading lows. "Reliquefication" does appear possible, as the mortgage finance Bubble generally made it through this bout of financial tumult nearly unscathed. GSE balance sheet explosion will surely pump liquidity into the system, and it would appear that the banking system is keen to lend and repurchase shares. The way the financials stocks rallied the past few sessions, certainly many market participants believe "The Fix" is in, and that the stocks of the capital market participants can be bought with hope and the comfort of knowing it's work in the past.

But there's a problem: "The Fix" just may not work this go round. While global stock markets may have finished the week seemingly showing some encouraging signs of life, problems elsewhere don't appear as amenable. The dollar wobbles, Brazil teeters, and the U.S. Credit system appears immune to any sign of improvement. It looks broke and not easily fixed. We'll stick with our analysis that the heart of the problem is an unfolding structural breakdown in the "risk" markets, with players scurrying to off-load Credit and market risk with few takers to be found. And with risk players impaired and their sophisticated models in tatters (what probability would Credit default models have calculated for WorldCom bonds turn worthless?), it will remain a case of seeking opportunities to reduce exposure to risky Credits, whether it is Brazil, vulnerable U.S. corporations, or subprime American consumers. In the "old days" - back with the halcyon, bull market days in derivatives, CDOs, "structured finance," Credit default swaps, and other sophisticated risk instruments - a Mexican or LTCM bailout (in concert with lower interest rates) would be like opening the floodgates to marginal borrowers. While we expect the mortgage arena to continue to be inundated with Credit excess, this fascinating story's plot now revolves around the drought and not the flood.

On a whim, I'll throw out Two Economic Postulates for the next 12 months: First, the U.S. economy cannot live on mortgage Credit alone. Second, economic Growth emanates in the Credit trenches with the availability of finance for the marginal borrower (telecom 1998 to 2000, lower-tiered consumer/mortgage borrower 2000 through first-half 2002). While we don't believe the economic community appreciates either, they are definitely missing the point that the marginal borrower is such a significant player. They, furthermore, seem absolutely oblivious to the reality that the Credit well is quickly running dry. The marginal corporate borrower today is out of luck, and the marginal consumer borrower may not be far behind.

We have often highlighted the role of asset-backed securities in financing economic growth, especially over the past year with the faltering U.S. corporate bond market. Recall that there were $1.1 trillion of asset-backed securities outstanding at the end of 1997. This amount then doubled to almost $2.2 trillion by the end of this year's first quarter. ABS were issued at a record annualized rate of $371 billion during the first quarter, and we expect similar numbers from the second quarter. Last week, the unfolding crisis hit the ABS market, with unconvincing signs of stabilization this week despite the stock market rally. Clearly, the list of impaired issuers is growing by the week: Conseco, Providian, Metris, and Capital One, to name a few. Household Finance and AmeriCredit and others looked poised to follow. To appreciate the acute vulnerability of the U.S. consumer sector, one should recognize the enormous role this list of aggressive lenders has played in fostering the Great Credit Bubble.

Capital One began 1998 with total managed loans of $14.2 billion, and total assets of $14.9 billion. By the end of this year's second quarter, total managed loans had ballooned to $53.2 billion, with total assets of $33.8 billion. Cap One now has 48.6 million accounts. Amazing! Household International began 1998 with managed assets of $51.9 billion and total assets of $46.8 billion. At June 30, 2002, managed assets had increased to $105.5 billion, with total assets of $90.4 billion. AmeriCredit saw managed receivables increase from about $3 billion to $14.8 billion. Managed receivables actually jumped 45% over the past year. Providian, beginning 1998 with total assets of $4.5 billion, ended 2001 at almost $20 billion. We do not believe economic analysts appreciate the major role this group of aggressive lenders has played in funding the consumption boom (misidentified as a "resilient" economy). We definitely see little indication that the economic community recognizes that the game has changed. These lenders have now found themselves in the middle of the unfolding dislocation, and there will be reduced Credit availability for the U.S. consumer (especially subprime!). Could Best Buy's sudden problems be related to less readily available consumer Credit?

Considering the size of the market and its importance for the U.S. economy, we have been rather alarmed by some of the things we have been reading regarding the asset-backed securities market. Capital One is one of the major issuers of asset-backs, and we were rather surprised by a recent research report that candidly addressed the issue of pricing for what we would have expected to be one of the more actively traded securities in this arena. From the report: "We thought that the most compelling part of the capital structure was the A rated Cap One ABS, which we had understood traded at LIBOR +60-70 bp after Cap One's memorandum of understanding (MOU) with regulators was announced. However, that was a notional estimate of where our trading desk thought they would trade and our trading has not seen actual transactions in A rated Cap One paper; in fact, their estimate of where it would trade now - and, in retrospect, where it probably would have traded just after the MOU was announced - is on the order of LIBOR +100 bp. What this shows is just how illiquid the Cap One name is in the ABS sector and how difficult it is to do price discovery... The problem is that it is unclear where these really do trade and where to mark them. We still don't like Metris ABS, unless it is wrapped by a monoline insurer."

Well, well, well. All we can say is that it is disturbing to see such a key securities marketplace - having expanded enormously to the point of playing such a major role in the U.S. economy - appear to be so vulnerable to pricing and liquidity problems (not to mention economic issues!). There are times when we fear that things may in fact be worse than we thought. While we would expect that concerns of a deepening economic downturn would increasingly dog the ABS sector, we also sense that the old "trust" issue is playing an increasing role in the unfolding dislocation. If confidence wanes for company management, as in the case of Capital One, why hold their securitizations? And what happens when you go to sell and you find out there is no market? Yet, if demand falters for securitizations, won't the resulting decline in Credit availability simply exacerbate economic weakness and make these securities only less appealing? This is no "nightmare scenario," only common sense. But, then again, that is precisely the nature of Credit booms and busts.

In conclusion, I will again address the consensus view that the securities marketplace has absorbed significant risk that would have previously resided in the banking system. Well, that is surely the case. But is this missing the key point? The ABS market has been instrumental in financing the marginal spender that has fueled the U.S. Bubble economy. Perhaps the big surprise will be the economic impact of the faltering securities marketplace, with the banks having no alternative than to be left holding the bag.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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