The Credit Bubble Bulletin
by Edmund M. McCarthy
Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his June 19 newsletter.
This effort is so entitled to recognize Doug Noland, who gave me this phrase that, I believe, best describes the current global environment. I have always been loath to accept any utterance that "It is different this time" but in enlarging on the manifestations that follow, I can only conclude that, if it is not different, it certainly includes an awesome number of new/changed conditions not previously seen by the author or readily found in economic history. I therefore concur with my friend Doug in deciding that, for once, the legions using past trends, ratios, and happenstance to analyze and predict are subject to a high probability of failure. Once, when stationed in Canada many years ago, I had an associate who deplored the usual reasoning for investors that they should invest for the long term with the phrase: "In the Age of Aquarius, the long term investor may arrive at a destination that is no longer there!" The Current consensus projections made by the pundits leaves me with some sympathy for such a thought.
MANIFESTATIONS FOR WANT OF A BETTER WORD
- A near unanimous race by the Central Banks of the world to an interest rate of 0%.
- With the exception of China, Russia and a few mini's like Ecuador, current and simultaneous economic downturn or stagnation on a global basis which the above is supposed to overcome.
- Dual (Fed and GSE's) Credit Creation mechanisms in the U.S. operating enormous liquidity and liability creation surges concomitant with 1. above.
- "Institutionalization" (my word) of Investment Management of financial resources which is virtually exclusively performance compensated.
- Unregulated "Hedge Fund" assets and numbers of enormous magnitude ($700 Billion +/- according to what can be gleaned.) Tack on the GSE balance sheets that are subject to being considered hedge funds because they resemble them in most respects, and there is more than $3 trillion of this type of arcane unregulated machinery out there. Yes, admittedly, in the 1920's, there were the pools but they pale in comparison.
- Opacity on the part of Institutionalized Investment Management (technical phrase I just coined) as to strategies, holdings and causes of performance. Hedge funds tell you they wont tell you. Mutual funds tell you they will only tell you quarterly after the fact, etc.
- Quoting Steve Roach at Morgan Stanley, "A Global Imbalance." Author's opinion: an imbalance greater than any previous "manifestation" of imbalance! (A.) Global net debt of the U.S. in excess of $3 trillion. The U.S. currency is the global reserve currency. (B.) Approaching $1 trillion of U.S. government debt (including the "too big to fail" Agencies) held abroad. As much as 40% of new issuance bought abroad. (C.) Current Account deficit approaching 5-6% of GDP in the Global Reserve Currency nation! (Empires are supposed to produce surpluses.).
- Booming Debt and Equity markets at valuation and discount levels previously considered to be absurd for such tremendous levitation.
- Creation of $8 trillion+ and growing of "Structured Finance". While lauded as risk dispersion by Sir Printsalot (Mr. Magoo/Greenspan) the bulk of this NEW form of credit has been generated during a prolonged boom and is virtually un-tested except by "models" a la LTCM!
- $140 TRILLION! Of notional amount of derivatives sloshing around the global financial markets. The conventional wisdom is that these "artificial moneys" also disperse risk. WE HOPE SO! But are not convinced.
- A Mortgage Refinance Boom coupled with a Housing Price Appreciation Boom of magnificent proportions. Any cause/effect connection to the aforementioned submarine-ing of interest rates and ballooning of liquidity which might otherwise be characterized as a "BUBBLE" is dismissed by savants as unlikely in housing.
- With some trepidation as such caviling is now frequently criticized as unpatriotic, we observe a growing tendency of unilateral (with a few "willing") foreign military and diplomatic adventurism entailing not only significant upfront expense but also a largely unrecognized long tail after action expense.
This list could continue further but will be curtailed at this point as it seems sufficient to illustrate the point that these are truly Amazing Times. The multi-trillion dollar question is whether or not these unparalleled measures and strategies, supported by the above-described unique if not new machinery for credit creation can renew and prolong the multi-decade expansion without serious downturn the U.S. economy has been privileged to experience.
THE ANSWER IS YES, BUT! IN NO WAY DO WE WANT TO UNDERESTIMATE THE ORCHESTRATORS OF THIS EXERCISE. IT HAS BEEN ASTONISHING AND AMAZING THAT THE DRAMA HAS PLAYED OUT AS LONG AS IT HAS BUT NOT OUTSIDE THE REALM OF POSSIBILITY FOR IT TO GO FURTHER HOW MUCH FURTHER? THE ANSWER IS, WE BELIEVE, TO BE FOUND IN THE WILLINGNESS OF TWO CURRENT VICTIMS OF THE SILENT DEVALUATION OF THE DOLLAR TO CONTINUE AS WILLING RECIPIENTS OF THE PAIN. (1.) THE FOREIGN BUYERS OF U.S DOLLAR DENOMINATED SECURITIES, PARTICULARLY DEBT SECURITIES AND (2.) THE AMERICAN PUBLIC.
Given the unanimity of ignorance of the American public on the issue, we have presumed they would be the last to revolt. It would have seemed that the combination of lower yield and currency loss would have curtailed the foreign appetite by now. Many disparate factors, however, have lengthened the masochistic willingness of the foreign side of the equation. The Chinese (enormous buyers and holders) have long anticipated the recent demand by Treasury Secretary Snow that they take a look at their ridiculously (some estimate by as much as 50%) undervalued currency and can point to their faithful accumulation of offsetting $ instruments. For a less sanguine view, see the recent commentary on the prudentbear.com website by Marshall Auerbach. He and I share the view that Chinese eleemosynary is an oxymoron. The inscrutable Japanese are still an enigma. Admittedly, they actually have a carry trade against their own yields and constantly falling rates and rising prices have further lessened the currency pain. Following, still, their failed policies, they are constrained to buy more and more to prevent THEIR currency from appreciating to the detriment of the politically powerful export cabal. While there is quite a bit of evidence that the Rest of the World has largely moved to the sell side, it is at a glacially slow pace. Some of this is, perhaps, again due to the rising prices/falling yields in debt securities and mini-mania in equity propelled by the continuing Niagara of Liquidity.
In a column on June 24, Steve Roach of Morgan Stanley comes up with another version of "Is it different this time". He chronicles the failures of Central Bank and fiscal policies over time. He further elucidates on the obverse of our No. 1 above (The global race to 0% in interest rates), i.e. the managed explosion in money supply accompanying this policy and the proliferation of substantial deficits on the fiscal side and asks, "Can it be different this time?" He makes his point that efforts of this nature have failed in the past. We grant that point but revert to numbers 2-12 above. No Nation has ever, to our knowledge, created such a proliferation of CREDIT CREATING CAPABILITY. This combination of massive entities, coupled with an Administration and Federal Reserve determined to use any and all measures to restart an economy of serial failed bubbles with whatever bubble can be found reinforces our conclusion of Yes, but!
DOES INFINITE LIQUIDITY EQUAL ZERO WRITE-OFFS? THIS SLIGHTLY FACETIOUS QUESTION COMES AS WE PONDER 2002 CREDIT EXPANSION IN THE BANKING SECTOR OF $800 BILLION+ AND STRUCTURED FINANCE CREATION OF $800 BILLION+ ALSO FOR A TOTAL FOR THESE TWO OF $1.6TRILLION+ OR 16% OF GDP IN A YEAR WHERE GDP WAS EXPANDING AT A SMALL FRACTION OF THIS NUMBER.
Certified curmudgeons find continuing credit expansion at multiples of GDP without concomitant credit disaster to be counter-intuitive. However, in this "New Age of Finance" there may be a new expansion of INVISIBLE CREDIT DISASTER. We will go out on a limb (not such a long one where accounting scandals have been exploding with monotonous repetition and the incentives to create them in the form of options continue to expand) and say that we are highly dubious of the continuing sanguine results in terms of credit quality of the financial sector. ZERO WRITE-OFF may be approached if the "Re" prefix is used with sufficient vigor. What are we grumping about? The development of the expanding cluster of terms/euphemisms(?) such as Re-Aging, Re-Performing, and the older Re-Structure, Re-Schedule, Re-Finance etc. Although not an "Re" word, inclusion of the term Forbearance is something we believe justifiable. We listened to one of the purveyors of this kind of finance explain that in this New Age of Finance, it was/is to "everyone's" benefit to adopt a "KINDER, GENTLER APPROACH" to troubled credit. Foreclosure/sale/liquidation were tactics of the barbarous past.
With 33% more of the nation's credit in structured finance than in the banking system, our major concern is that there really is NO/VERY LITTLE regulation of this $8 trillion and growing pile. Within the banking system there is the wonderful world of "HELD FOR SALE".
FULL DISCLOSURE! A CERTIFIED CURMUDGEON OF GREATEST CYNICISM IS HEREINAFTER MAKING COMPLETELY UNJUSTIFIED AND PURELY SPECULATIVE REMARKS BASED SOLEY ON 40+ YEARS EXPERIENCE......READERS UNDER THE AGE OF 50 MAY WISH TO DELETE OR BURN BEFORE READING!
Long held to be a primary reason for the longevity of the Japanese collapse was the unwillingness of the system to put defunct, superfluous or clearly anachronistic companies out of their misery. Some of what is currently going on in corporate credit in the United States may have more of a resemblance when examined through the eyes of a curmudgeon than is comfortable. Without maligning any specific financial institution, we decry the growing world of Chapter 22. The number of bankruptcies ending in liquidation is accounted for without using too many digits (fingers of the hand). The number in which the sinner emerges shriven, reconstituted and re-financed must exceed the number actually viable in such a state given the enormous over-capacity almost always prevalent in the industry in which the respective company is situated
Why are these supposedly rational financial enterprises re-floating (our new Re word!) these entities, many of which seem destined rapidly or eventually, for another Chapter 11, thus reaching the Chapter 22 level! (If they go down again after the 2nd 11 does the subsequent 7 bring the total to 29?) Two reasons. The write-off in liquidation usually approaches total and there are no fees for the erstwhile lenders. Go for a re-launch and such fees are lusty, the collateral improves to what should have been gotten in the first place making the subsequent re-entry into bankruptcy far less injurious to the players. In the meantime, lots of DIP money to be made!
Without maligning any specific entity, we point to the whole miasma of energy and the swamps called telecom and retail and, lastly, the ridiculous world of airlines and airline finance as horrible examples. We know, after the coming second half recovery, all of this form of forbearance will be justified by the fantastic prospects of the resuscitated. That's what the Japanese have been saying for the last decade.
The WSJ article today on GM incorporated some comments on the giant bond sale to make a bet that stocks can outrun interest paid to fix their pension plan. There is a lot of research available to prove that the over-capacity (still growing) in the global auto industry could best be solved by having a couple of giant players disappear. Instead, there seems to be a march to zombification (WSJ technical term). Occasionally an article appears on the federal guaranty Agency for pensions which would be in Chapter whatever if not federal. The zombies in auto's steel, airlines etc. dwarf the future resources of the entity. Ah well, Congress may legislate all the problems away with a pension specific solution "re-aging" all the beneficiaries. Anyhow, all of the company stock being dumped into the plans may go up a la 1997-2000 and bail everything out.
In the consumer arena, we are less able to point to specifics but the growing anecdotal input we have is far from re-assuring.
Example: Not once, but more than several times we have run across instances of home-owners falling in arrears, which would have resulted in summary foreclosure. In this "kinder, gentler" world, they are contacted by the lender for a "re-finance". The appraisal shows sufficient equity to bring payments current, escrow several months into the future and handle taxes and insurance as well as all the substantial requisite fees for the lender. Future ability to service is not of interest to the lender as there is now way this sucker is staying on the balance sheet. For those of you who have not been there, I commend the Appraisersforum.com. Some of the chat on pressure from lenders to over-appraise is startling. The mortgage inception process also has devolved into a situation without a responsible adult in the origination process. The anecdotal we are receiving may explain why recent statistics released show delinquencies down while ultimate foreclosures are up to a record. "Refi until it gets impossible and then shut down." Tangentially, bankruptcies continue to hit new records. As long as the bubble in residential is provided some of that 16% growth aforementioned the dance can go on. By the way, each appraisal obviously affects all the "comparables". Is there any wonder we have double-digit growth in prices. Is it any wonder that the buyer (previously the ultimate check on prices) cares less or is motivated to "BUY BEFORE THE PRICE GOES UP AGAIN, NOW!?
I also again commend to you the entity mentioned previously in earlier writings. I point to that strange "piscatorial" venture "C-Bass" jointly owned by a couple of outstanding Mortgage Insurance entities, MGIC and Radian. They do "re-performing mortgages". Constituting a large and growing part of earnings for their parents, this curiosity is obviously relying on the self-reinforcing housing bubble for valuations permitting the prestidigitation necessary to turn non-performing dross into "re-performing gold".
Then we get to the wonderful world of "re-aging". If only it were physically so easy! Credit card outstandings have some fairly simple rules for write-off. Not if things get re-aged. Sometimes another "Re" not previously mentioned, re-affirmation, is included, maybe sometimes not. Sometimes maybe the original issuer re-ages, sometimes they buy somebody else's write-offs and get reaffirmation, sometimes there may be methodology yet not described. Suffice it to say that, since virtually no card outstandings are on anybody's books but are virtually all in some form of structured credit, it may be a little difficult to really know what is going on. Theoretically, the Master Trust tells one on a periodic basis. Nevertheless, as long as the ratios are as required, the Master Trust numbers pass muster. Who is actually looking at individual loans. NO ONE!
It may not be the Age of Aquarius but it definitely is the age of accounting fraud. Are we actually to believe that the $8+ trillion in structured finance is immune? Has human nature been repealed?
Speaking of individual loans, we find the area of auto finance incomprehensible. Again, digging down to the individual loan is virtually impossible. Almost all vehicle finance is now structured. Vehicles continue to sell at near record rates with record incentives. Particularly for the domestic producers, it is profitless prosperity on the vehicle sale itself. The profits substantially are in the finance entity. These worthies actually carry a notch higher credit rating than the parent! The rest is in various Master Trusts as in cards. I was reading a provocative article on "Where are the repo's?" recently and that added to the incomprehensibility. What is happening to the flood of used cars? The likelihood that they are being resold without significant losses is slight but any such losses are not making any headlines. Suffice it to say that our credulity is strained. As with the housing bubble, this sales phenomenon depends on the continuation of even higher and higher discounts, lower rates for financier and buyer and somehow dealing with all the used cars. Again, not a problem as long as tame rating agencies and loads and loads of continuing lower cost credit is available. We suspect, being the cynics we are, that a lot of used car finance may be using "re-value" in what the car is financed for, and absorbing any losses in the financing process. DON'T STOP THE CARNIVAL! to use the title of a book describing another economic incongruity.
Many years ago in a universe in which we still live but with totally different credit creation and evaluation standards, the writer was so stupid as to approach a senior lender with the proposition that we take as primary collateral a second mortgage which appeared on the appraisal to provide value. After a short stint in the emergency room, we have never forgotten the response. Obviously negative, the primary tautology was the necessity to buy out the first to realize. We wonder how many of the ubiquitous players in this world of "HOME EQUITY" have actually undergone the process.
WE ALSO WONDER HOW HIGHER INTEREST RATE HOME EQUITY LOANS CAN EXPAND IN THE NEW WONDERFUL WORLD OF INSTANT RE-FINANCE BUT THEY ARE DOING SO!
One possible answer is the ubiquitous offers to do your home equity flooding mailboxes in an industry desperate for further growth where finance availability saturates every facet of the market. These are only possible if the aforementioned appraisal for whatever is required is available. We obviously are jaundiced on the whole subject of appraisals! Since appraisals beget "comparables" which beget appraisals which beget comparables which beget loans for the fastest (resembling the oldest) profession in the world, mortgage broking, you may understand our yellow color on the subject.
Again, the wonderful world of structured finance readily takes these loans and transforms them into magnificent rated securities. As long as the ratios meet their computer derived tests, the ratings are fine. How can we be suspicious that anything could ever be done to keep these all important ratios where they should be of a dubious nature?
In Summary, AMAZING TIMES encompasses CREDIT CREATION CAPABILITY never seen before, ENORMOUS SELF INTEREST on the part of the credit creators, Official, semi-official (the GSE's) and private, to keep INFLATING the credit and even more ENORMOUS SELF INTEREST to maintain ratios on all the Structured Finance so created. In this Age of Accounting Prestidigitation are we actually to put totally unbounded faith in the results. Not this curmudgeon!
FOR ANYONE WHO UNDERSTANDS THAT THE RESULTS OF ANY SUCH PRESTIDIGITATION (FOR THOSE WHO DON'T KNOW THIS TERM IT DESCRIBED THE MAGICIAN'S "NOW YOU SEE IT; NOW YOU DON'T") CAN BE MANAGED AS LONG AS THE DENOMINATOR IN THE RATIO EXPANDS FAST ENOUGH THE REASON FOR ALL THE PLAYERS WANTING TO CONTINUE OR EXPAND THE CREDIT CREATION IS OBVIOUS.
NOBODY IS REALLY GOING TO CLOSELY EXAMINE INDIVIDUAL ELEMENTS IN THE NUMERATOR AS LONG AS THE RATIOS HOLD UP AND THEY WILL AS LONG AS THE DENOMINATOR EXPANDS FAST ENOUGH.
WATCH OUT BELOW WHEN YOU SEE THE FIRST SIGNS OF SLOWING!