Lost Control

By: Doug Noland | Fri, Aug 1, 2003
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I'll try to add some things and get this Bulletin "cleaned up" in the morning. Thanks!

Stocks ended the week somewhat lower. Managers were apparently focusing on increasingly favorable economic reports, while working diligently to ignore major upheaval in interest rate markets. For the week, the Dow Jones Industrials lost 1.4%, hurt by poor showings from financials Citigroup and JP Morgan. The S&P500 shed 1.9% this past week. The Transports lost 0.8% and the Utilities fell 1.8%. The Morgan Stanley Cyclicals were relatively unchanged, while the Morgan Stanley Consumer index dipped 1.8%. The broader market continued to outperform, with the small-cap Russell 2000 about unchanged. The S&P400 Midcap index was down only 0.4%. The tech-heavy Nasdaq100 and Morgan Stanley High Tech indices were down about 1%. The Semiconductors added almost 1%, while The Street.com Internet index dipped only 0.3%. The Nasdaq Telecom index dropped 1.4% and the Biotechs gave back 0.8%. Especially late in the week, financial stocks came under heavy selling pressure. The Broker/Dealers and banks were slammed for 4%. With the volatile bullion sinking $16.80, the HUI suffered a decline of 2.6% this week.

The dollar index gained almost 2%, while the CRB commodity index rose 1.5%. Copper traded to a 28-month high this week (up almost 10% during July), as industrial metals continue to trade impressively.

If not outright chaos, it was close. It was clearly an unmitigated Credit market rout, capping off the worst month in the Treasury market since 1980 (according to Bloomberg). For the week, two-year Treasury yields jumped 27 basis points to 1.77%, with 5-year yields up 23 basis points to 3.21%. The 10-year Treasury yield surged 21 basis points to 4.38%, while the long-bond saw its yield jump 20 basis points to 5.32%. The Treasury market, however, was a picnic when compared to agencies and mortgage-backs. The implied yield on agency futures surged 46 basis points, while the yield on Fannie Mae benchmark mortgage-backs spiked 53 basis points. Articles describing trading conditions used words such as "obliterated" and "unprecedented." The 10-year dollar swap spread (to Treasuries) surged 7.5 basis points today to 66, with a stunning 24.5 basis point widening for the week. Intraday, this spread today traded to 71, the highest level since March 2002. For comparison, the dollar swap spread widened a total of 35 basis points (60 to 95) during the two month Russian and LTCM crisis (August 10 to October 10, 1998). Demonstrating the clear panic players were having off-loading interest rate risk, December 2004 3-month Eurodollar rates spiked 70 basis points higher this week to 2.93% (up 103 basis points in three weeks). Not surprisingly, the CME yesterday posted its highest volume (interest rate futures) on record.

Curiously, market tumult seemed to have minimal impact on corporate issuance (for now). Tennessee Valley Authority issued $1 billion, SLM Corp $600 million, Kimberly-Clark $500 million, Devon Energy $500 million, CSX $300 million, International Lease Finance $250 million, and Humana $300 million. The junk market booms rolls on: Dynegy sold $1.45 billion, Graphic Packaging $850 million, Eagle-Picher $250 million, Morris Publishing $250 million, Corrections Corp $200 million, National Beef Packaging $160 million, Energy Partners $150 million, Seabulk International $150 million, Select Medical $175 million, and Vale Overseas $180 million. Converts were, again, "flying off the shelf": STM Micro issued $1.217 billion, Veritas Software $500 million, Flextronics $500 million, Vishay $450 million, Fair Issac $350 million, Invitrogen $325 million, American Tower $175 million, Bausch & Lomb $140 million, Nextel Partners $125 million, WCI Communities $125 million, Expressjet $125 million, Wabash National $125 million, Mentor Graphics $100 million, and Priceline.com $100 million.

The national ISM Manufacturing index added 2 points to 51.8, surpassing 50 for the first time since February. New Orders added 4.4 points to 56.6, up 10 points from the March low to the strongest reading since January. Prices Paid declined 3 points to 53. The July Chicago Manufacturing index was reported at a stronger-than-expected 55.9, up 3.4 points from June to the highest level since January. New Orders jumped 6.9 points to 61.7, the strongest reading since last November. Order Backlog was up 3.6 to 49.4, the highest since December. Curiously, Prices Paid declined 1.2 points to 47.9. The New York Purchasing Manager's index jumped 2.9 points to 46.2, the highest reading since January. The Milwaukee Purchasing index jumped 10 to 58, the strongest performance since last November.

Second quarter GDP was reported at a stronger-than-expected rate of 2.4%, with y-o-y growth of 2.3%. The "Quality of Output" was nothing to write home about, with Federal Government "consumption" expanding at a 25.1% annualized rate (National Defense up 44.1%). Final Sales to Domestic Purchasers expanded at a notable 4.6%, the strongest showing in more than three years. Final sales were up from the first quarter's 1.4% and the year earlier 1.3%. Second-quarter Personal Income expanded at a 3.3% annualize rate (up 2.9% y-o-y), accelerating from the previous quarters' 2.4% and 2.1%. And while Wages and Salaries rose at a 1.9% rate during the quarter, Transfer Payments increased at a 7.2% rate and were up 6.4% y-o-y. Personal Outlays increased at a 4.4% clip during the quarter and were up 4.5% y-o-y. Year-over-year compensation numbers are rather interesting. Civilian Workers total compensation is up 3.7% y-o-y. Wages and Salaries are up 2.7%, with Benefits up 6.3%. For comparison, Benefits increased at a 5% rate during last year's second quarter and 4.5% during Q2 2001.

The Refi index sank 33% last week to the lowest level since December. Refi applications have now dipped 13% below the year ago level. And while all the focus is on the Refi index, we'll be watching the Mortgage Bankers Association Application index quite closely going forward. The Purchase index dipped only 3.5% last week, while remaining up 19% y-o-y. In dollar terms, Purchase applications were up 26.2% y-o-y.

Freddie Mac announced second quarter mortgage refi data. The number of new loans with a "5% higher loan amount" declined 9 basis points to 32%. The "median appreciation of property" dropped to 3% from the first quarter's 7%. For comparison, last year's second quarter saw 63% of new loans for 5% or higher, with average appreciation of 20%.

The F.W. Dodge Construction Activity index surged 12 point in June to 159, a new record high.

Four of the major mortgage real estate investment trusts (REITs) that we follow have reported second quarter balance sheets posted combined 83% annualized growth during the second quarter to $44.5 billion. Year-over-year assets were up 63%.

After recent notable gains, broad money supply (M3) declined $28 billion last week. Demand and Checkable Deposits added $9.8 billion, while Savings Deposits declined $4.9 billion. Small Denominated Deposits dipped $2.5 billion and Retail Money Fund deposits declined $6.2 billion. Institutional Money Fund deposits dropped $9.7 billion and Large Denominated Deposits declined $2.3 billion. Repurchase Agreements declined $6.5 billion and Eurodollars decreased $6.0 billion. Fed foreign "custody" holdings of U.S. Debt, Agencies declined $5.2 billion. Outstanding Commercial Paper declined $11.3 billion ($18.9 billion in three weeks), with financial sector CP down $11.8 billion.

Total Bank Assets expanded $39.2 billion last week. After sinking $81.2 billion over two weeks, Securities holdings increased $28.8 billion (mortgage-backs up $22.9 billion). Loans and Leases declined $3.9 billion. Commercial and Industrial loans were unchanged, while Real Estate loans dipped $5.7 billion. Consumer loans added $3.0 billion, as Security loans dipped $1.6 billion.

Returning to my "weathered" flood insurance analogy, I have excerpted from the March 14th Bulletin, "Climbing the Wall of Water":

"...the community made it through the panic after a bold government official guaranteed that the authorities would "take extraordinary measures" to stop the flood waters before damage initiated a vicious spiral of financial and economic collapse. The authorities began working frantically up the river, using whatever materials and means available to construct dykes, dams and levees. These efforts saw the river level recede and, quite favorably, the rain let up for a few months... The players sleep well at night with the knowledge that the authorities are on the case -- up the river working diligently to hold the water at bay. Down river in the community, the water level rises only minimally. And, much to the delight of everyone, the insurance market remains open for business and prices remain uncharacteristically stable. The trepidation and angst that had become the rainy day norm has been replaced by calm and optimism. (Those incessant naysayers are shocked by the complacency) What's more, in the midst of the rainy season the community is emboldened to increase construction. With the river level rising only moderately and the insurance market functioning splendidly, the litany of homeowners, builders, bankers and insurers come to a consensus that it has become practical to build well inside the 100-year flood plane. The insurers are emboldened by now tested assurances from the authorities - they promised and delivered... And while the energized community gets back to business as usual, up the river the make-shift dams and levies grow only taller and less stable."

A great deal has transpired since those dark days last October when Team Greenspan/Bernanke too successfully reversed an unfolding Credit crisis. In the above analogy, the river level only "grows taller and less stable" over time. In real life, it's the mortgage-related securities mountain rising relentlessly to the heavens. I will throw out a rough estimate of $750 billion of Total Mortgage Credit growth during the past nine months (at artificially low interest rates), more than double the growth from the entire year 1997. We have witnessed the great Mortgage Finance Bubble go to historic "blow-off" extremes. We are now beginning to pay what will be a very heavy price for reckless excess.

Understandably, Fannie Mae Chairman Franklin Raines has been quick to blame Freddie's accounting snafu for recent market turmoil. However, the root of the problem lay elsewhere: unparalleled Credit expansion and the resulting securities Bubble, replete with unprecedented leveraging, speculating and hedging activities. To try to put the dimensions of the bursting Bubble into perspective, recall that Fannie and Freddie's combined Book of Business has more than doubled since the beginning of 1998 to almost $3.3 Trillion. Moreover, Fannie expanded its Book of Business at an unprecedented annualized rate of $460 billion, or 26.8% annualized, during this year's first half. Of this, outstanding mortgage-backs surged at a $416 billion annualized pace, or an astonishing rate of 44.5%. Bloomberg's tally of mortgage-backed security issuance has $1.5 Trillion of (gross) new securities created from last October through this June. There's never been anything like this, with the household sector winning a huge interest rate bet (with Fed-induced artificially low mortgage rates). Now, the financial sector sinks only deeper under water. From Fannie, we see a 5.22% average "net yield" for mortgages purchased so far this year. Benchmark 30-year mortgage rates jumped to 6.14% this week.

Extending the flood insurance analogy, the confidence instilled by the authorities' "desperate measures" assurances led to an unprecedented building boom right along the river's edge. Caution was thrown to the wind. The amount of systemic risk quietly ballooned exponentially. Moreover, the emboldened insurance marketplace became absolutely transfixed by manic irrational exuberance. Writing flood insurance was recognized as virtually "free money" and lots of it was there for the easy taking. Speculation ran rampant. Players operated with the assumption that, in the very low probability that flood waters began to rise to dangerous levels, they would simply and inexpensively hedge flood risk in the (liquid) reinsurance market (with rates collapsing post-"assurances").

Curiously, there was little concern when the river again began to rise. There was actually a virtual stampede by the speculator insurance players to write more insurance when prices began to increase. More "free money," courtesy of our able authorities. Apparently, with many false flood alarms over the years - and especially knowing that the authorities were on the case - the marketplace had been afflicted with a grave case of greed and complacency.

Looking back, it seems only reasonable that someone would have asked a few basic questions: First, how much insurance has been written? Second, what is the financial wherewithal of the insurance industry? Third, how will the insurance market operate in the event of heightened risk of a catastrophic flood? Instead, with crises always having been averted in the past, it was assumed that the insurance market was sound and stable. Somehow, the authorities were only concerned with holding the water at bay so the building boom could be sustained along the river.

After a few weeks of casually watching the water level rise moderately along the riverbank, some concern began to set in. Yet the marketplace remained relatively calm, appreciating that the authorities were apparently still operating on the dykes, dams and levees up the river. Besides, the water was still significantly below dangerous flood stage. A few of the more sophisticated players, however, became a little unnerved when talk spread that the authorities had decided to let some water run from the levees, seemingly to relieve building pressure. Were the authorities having second thoughts on their strategy? Or perhaps there were problems up the river that were being kept under wraps. Do the authorities have a viable "end game"?

Then a very unusual thing then developed: the price of reinsurance began to rise dramatically and inexplicably. The herd of insurance writers/speculators all had monitors where they followed the river level to the quarter inch, by the second - green flashes when the river rises, red when it declines. And while they were for awhile comforted that the river remained well below flood stage, they were mystified by the steadily rising cost of reinsurance. What had changed? Looking back, it is difficult to pinpoint the day that Greed turned to Fear; it just happened. All of the sudden, a few speculators recognized that the cost of reinsurance was becoming so prohibitive that they risked insolvency with any further delay in hedging their exposure. Having already written significant insurance during the recent boom, the limited number of seasoned sellers of reinsurance immediately backed away from the marketplace. Prices spiked. And while many worked to calm the market with the "analysis" that flood fears were overblown, almost overnight panic overwhelmed the reinsurance market. Everyone suddenly realized they were on the "same side of the boat," and market dislocation was unavoidable if any serious flood risk unfolded. Over the life of the boom there had developed massive flood risk, and there were grossly insufficient resources to render this market viable.

I'll leave our analogy this week with confidence throughout the flood insurance marketplace firmly shaken. And while the savviest insurance operators now appreciate that the insurance business has in reality been destroyed by the explosion of risk and the proliferation of speculation, this is certainly not the consensus view. Most expect reinsurance rates to quickly reverse as they always do - where's the devastating flood? The river level remains, after all, significantly below flood stage. The only losses "suffered" to date are "on paper." The issue then becomes, will the speculator herd race to the exits or, as they've done successfully so many times before, be enticed to only raise the size of their bets? Interestingly, word of the major tumult wreaking havoc on the insurance market goes largely unnoticed by the ebullient homeowners and builders (they're still celebrating the post-"assurances" boom-let). Citizens have grown accustomed to rising waters, and are well-conditioned to stay focused on the job at hand: growth along the river. Ironically, considering the rising waters, the fiasco unfolding up with the authorities up river, and the near cataclysm in the insurance market, confidence runs high in the community.

Returning to reality, major tumult overwhelmed the Credit market this week. Despite Treasury bond option volatility reaching the highest level since LTCM and panic selling gripping the marketplace, yesterday's developments didn't even muster one of the 15 "Top Stories" on Bloomberg News in the evening. The stock market responded only by giving up the majority of its earlier 160 point gains. Bullish pundits were quick to explain that bond market weakness was confirmation of the recovering economy. I see no recognition that we have abruptly returned to near systemic crisis.

Not since 1994 have we seen such a dramatic jump in interest rates, although nothing compares to the hastiness of the recent rate spike. Wow! It has clearly caught many a leveraged speculator, many an aggressive bank, many a Wall Street proprietary trading desk, many a REIT, and likely the major derivative players. The markets to off-load interest rate risk have dislocated. The mortgage-backed market is in disarray and it would appear the same can be said for the interest rate derivative markets generally. 1994 saw a few sophisticated (mortgage securities) "market neutral" hedge funds blow up, the big "macro" funds suffer significant losses, and myriad derivative losses. Later in the year, Orange County filed bankruptcy after suffering huge losses on structured notes, most issued by the government-sponsored enterprises (at least they proved good interest rate hedges for the GSEs). It concerns me greatly that this is nothing like 1994's "flood with some homes along the river." There's been an historic 10-year building boom that's completely changed both the environment and the marketplace. Previous "100 year floodplains" are meaningless at best. .

All the same, it is today surely not all too difficult for the bulls to think back to 1994 and sleep comfortably at night. It was a ravaging bear bond bear market, but the system made it through with only (in hindsight) a good scare. For the equity market, it proved an early hiccup preceding one of history's great bulls - a truly great buying opportunity. Yet there was a key unappreciated development that I believe played a crucial role in saving the day back during 1994, back when the impaired leveraged players were unwinding positions and the risk of a systemic liquidity crisis ran high. The financial sector, especially the "fledgling" government-sponsored enterprises, enjoyed the capacity to expand Credit aggressively. And they did expand, aggressively.

Indeed, despite a major Credit market cataclysm, the Financial Sector managed record Credit market borrowings of $468.4 billion during 1994, up 14% for the year. This compares to Financial Sector borrowings of $292.4 billion during 1993 and $244 billion during 1992. Importantly, Federally Related Mortgage Borrowings (the GSEs and mortgage-backed securities) increased Credit by $287.5 billion, up from 1993's $165.3 billion. The GSE's expanded Credit market borrowings by an unprecedented $150.7 billion, or almost 24% during 1994. This was double 1993's growth and was almost the amount of expansion over the previous three years. The GSE-led financial sector was successful in generating sufficient Credit creation to "paper over" the liquidity problem. In the process the GSEs ushered in the Great Credit Bubble.

But 1994 today appears a modest little hill when compared to 2003's Mountain. Total Credit Market Debt has ballooned from 1994's $17.2 Trillion to today's $32.5 Trillion. Total financial sector borrowings have ballooned from $3.8 Trillion to $10.5 Trillion. Total Mortgage Credit has ballooned from 1994's $4.4 Trillion to today's almost $9 Trillion. At the same time, the leveraged speculating community has absolutely mushroomed. Is it feasible that the financial sector, after almost doubling in size over five years, has today the capacity to expand sufficiently to sustain the financial and economic Bubbles, while playing buyer of last resort to the de-leveraging speculator community? It is not readily apparent to me that this can occur.

All facets of the Credit system have been firing on all cylinders, with resulting massive Credit growth barely sustaining the Bubbles. The banking system, the GSEs, the Wall Street firms, the REITS and the hedge funds have all ballooned over the past few years. Who, then, today has the capacity to take risk from the scores of speculators looking and needing to offload? Well, the explosion of the interest rate derivative market has never made much sense. Somehow the GSE and mortgage securities are apparently able to balloon forever, with players enjoying the capability to easily and inexpensively hedge interest rate risk. But to whom? Who is going to take the other side of the interest rate trade - a "trade" that is ballooning in size and must continue to balloon to ward off a serious risk of Credit collapse? That is the question. One thing appears clear today, the Fed has lost control of the interest rate market, with ominous portents for the highly leveraged and speculation-rife U.S. Credit system.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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