The Post-Boom Boom

By: Doug Noland | Fri, Aug 8, 2003
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Every week in these most-unsettled financial markets is an adventure. This week saw the Dow and S&P500 about unchanged for the week. The Transports declined 1%, while the Utilities were unchanged. The Morgan Stanley Cyclical index was also unchanged, as the Morgan Stanley Consumer index added 1%. The broader market was weaker, with the small cap Russell 2000 hit for 3%. The S&P400 Mid-caps declined about 2%. The outperforming technology sector was hit with some decisive underperformance. For the week, the NASDAQ100 and Morgan Stanley High Tech indices were hit for 4%. The Semiconductors and The Street.com Internet indices declined 6%. The Biotechs also faced heavy selling, declining 6% for the week. The financials recovered some of last week's losses, with the Broker/Dealers adding 2% and the Banks 1%. With bullion up $10, the HUI gold index jumped 8%.

Miraculously, last week's Credit market dislocation was this week's un-dislocation. The yields on benchmark Fannie Mae mortgage-backed securities sank an eye-opening (mirror image of last week) 40 basis points, while the implied yield on agency futures declined 41 basis points. The spread on Fannie's 4 3/8% 2013 note narrowed 25 to 40, with Freddie's 4 ½% 2013 note narrowing 24 to 42. After last week's 23.5 point widening, the 10-year dollar swap spread narrowed 24 to 42. I know of no comparable two-week period. For the week, 2-year Treasury yields declined 7 basis points to 1.70%. The 5-year yield dipped 14 basis points to 3.07%, while the 10-year saw its yield sink 19 basis points to 4.19%. The long-bond yield declined 8 basis points to 5.23%. The implied yield on December 2004 3-month Eurodollars declined 37 basis points to 2.56%. We have been expecting volatility, but the past two weeks have been truly amazing.

The dollar index declined slightly, while the CRB index advanced marginally. Crude oil traded to almost $33 this week, the highest price since mid-March. With blistering temperatures throughout

Corporate issuance slowed noticeably this week. Miller Brewing issued $2 billion, Thomson Corp $450 million, Medco Health $500 million, Office Depot $400 million, and Northern States Power $375 million. According to AMG, junk bond funds this week suffered a record $2.5 billion outflow, although year-to-date inflows of $19 billion still surpass any previous yearly inflow. Steady junk issuance included Hilcorp Energy's $275 million, Calpine $365 million, Amsted $250 million, Ardent Health $225 million, Bio-Rad Labs $225 million, Sonic Automotive $200 million, Norcross Safety $152.5 million, Gencorp $150 million, Concentra $150 million, Group1 Auto $150 million, Tempur-Pedic $150 million, Haights Cross $140 million, and Armor Holdings $150 million. This week's converts: Lockheed Martin $850 million, DST Systems $450 million, Advanstar Communications $360 million, Yellow Corp $200 million, Andrew Corp $200 million, Ptek Holdings $75 million, and Artesyn Tech $75 million.

August 6 - Bloomberg: "Convertible bond issuance in the U.S. may reach $120 billion this year as low interest rates and a rebound in share prices encourage companies to issue the debt, said Jeff Zajkowski, head of U.S. equity linked capital markets at J.P. Morgan Chase & Co.'s securities unit. U.S. companies have issued $62.76 billion worth of convertible bonds this year, according to Bloomberg data, and issuance is on track to surpass 2001, when $99.81 billion of securities were issued."

August 5 - Dow Jones (Stan Rosenberg): "Unless the Federal Reserve engineers an extraordinary and unexpected interest rate rise, and unless the balance sheets of state and local governments suddenly stop bleeding red ink, municipal bond volume appears to be on track for another record year of issuance. With state budgets expected to continue confronting deficits, and with the flow of funds from the states to local governments severely pinched, counties, cities, towns and villages across the country will continue to have little choice but to borrow to meet essential project needs, even if they do cut back on other spending... after the first six months of 2003, long-term municipal issuance already had soared 20.2% from the year-earlier period to $198.7 billion and is 'on target for yet another record-breaking year.' The record of $357.1 billion was set just last year as state and local governments wrestled mightily with falling revenues and increased credit quality concerns and stepped up their market borrowings as their reserves were run down and in some instances depleted. Those long-term borrowings shattered the previous record of $292.2 billion set in 1993."

August 6 - Bloomberg: "Asian finance ministers plan to study creating a common currency system for the region that will be modeled on the European Monetary System, the predecessor of the 12-nation euro, Reuters reported, citing a report. The finance ministers intend to establish a group including central bank officials and researchers to examine the proposal, Reuters said. The group would be made up of the 10 members of the Association of Southeast Asian Nations, known as Asean, plus China, Japan, and South Korea, Reuters said."

August 8 - Bloomberg: "The Japanese government plans to guarantee bonds issued in local currencies by Japanese companies with operations in Asia, Nikkei English News said... The Ministry of Economy, Trade and Industry's action will make it easier for Japanese companies to issue bonds in Asian markets outside of Japan, and to raise funds without guarantees from parent companies or banks, Nikkei said. It will also help support the creation of an Asian bond market"

August 6 - Bloomberg: "Texas will have record power demand for a second consecutive day as temperatures exceed 100 degrees Fahrenheit (38 Celsius) in much of the state, the Texas grid operator forecast. Power use will climb to 62,500 megawatts late this afternoon, the Electric Reliability Council of Texas, or Ercot, predicted. That amount is about a fifth more electricity than the record for power consumption in Italy." (I thought it was an interesting fact)

August 8 - Bloomberg: "The Federal Home Loan Bank of New York had its ratings outlook cut to negative from stable by Standard & Poor's, which cited greater risk in the investments of the government-sponsored enterprise. 'The FHLB-NY has added Investments to the portfolio that, although they had minimal credit risk at the time of investment, have proven to contain larger portions of credit risk than the bank and Standard & Poor's had expected,' Jonathan Ukeiley, an analyst at S&P, said... Standard & Poor's focused on recent downgrades of securities backed by manufactured-housing loans owned by the bank... Standard & Poor's is evaluating the credit of all 12 banks in the Home Loan system after an increase in interest rates since mid-June..."

August 4 - American Banker (Robert Julavits): "E-Trade Inc. is hoping its foray into recreational vehicle and marine lending not only diversifies revenues but provides new customers for its growing list of financial products... E-Trade said that in the second quarter it originated $2.9 billion of mortgage loans, up 16% from the first quarter, and 146% from a year earlier."

The ISM Non-manufacturing index surged to a record high, gaining 4.5 points to 65.1. New Orders jumped 9.4 points (19.2 points in 4 months) to 66.9. Backlog gained 3 points to 54.5, up 8.5 points to 54.5.

Broad money supply (M3) jumped $21.7 billion last week to $8.9115 Trillion. Money supply has now doubled since May 1995. For the week, Demand and Checkable Deposits added $2.4 billion. Savings Deposits increased $7.2 billion (up $523bn y-o-y or 20%). Small Denominated Deposits declined $3.0 billion and Retail Money Fund deposits gained $0.4 billion. Institutional Money Fund deposits declined $2.4 billion, while Large Denominated Deposits added $1.1 billion. Repurchase Agreements increased $7.9 billion and Eurodollars added $7.3 billion. Foreign (Fed "custody") holdings of U.S. debt increased $4.82 billion.

Total Bank Assets increased $29.5 billion last week, with 52-week gains of $744.7 billion (11.2%). Securities holdings increased $11.8 billion and were up 12.3% from one year earlier. Loans and Leases added $2.5 billion. Commercial and Industrial loans were down $2.0 billion, increasing the 52-week decline to $56.7 billion (5.8% y-o-y). Real Estate loans surged $19.9 billion, with a 52-week increase of $322.8 billion (up 17.1%).

The Risk Intermediation Bubble continues to balloon. Credit insurer MBIA reported second-quarter profits up 53%. With California and other state and local governments borrowing at record levels, there is virtually insatiable demand for insurance against the rapidly deteriorating quality of municipal debt (writing flood insurance during torrential rains). The company's U.S. Public Finance Adjusted Direct Premiums written surged 136% y-o-y to $217.2 million. Examining MBIA's insurance exposure, it is worth noting that California General Obligation (at $2.81 billion) ranked number two in its list of Largest Public Finance Units. The top eight exposures also include California Housing Finance Agency at $2.2 billion and Los Angeles Unified School District General Obligation at $1.92 billion. California jumped to 17% of net 2003 added exposure by geographical region. Other major exposures include Metris Master Trust, Cendant and AmeriCredit.

The Mortgage Bankers Association Refi Application index declined 2.4% this week to the lowest level since December (down 20% y-o-y). The Purchase Application index, however, jumped 6.6% to the second-highest level ever (second only to a convoluted Memorial Day holiday-impacted reading). The Purchase index was up 22.8% y-o-y, with dollar volume up a notable 35.2%. For some markets, it would appear virtual buyers' panic conditions now pervade.

August 7 - Seattle Times (Kristina Shevory): "Rising mortgage rates sent Western Washington home buyers scrambling last month to beat the increases, boosting sales in July and signaling a sizzling August. Compared with July 2002, closed sales last month jumped 36 percent in King County and 18.2 percent in Snohomish County... In the 14 counties tracked, closed sales rose more than 25 percent, and pending sales soared 39 percent. Pending sales - in which offers have been made and accepted but sales haven't closed - were higher in July than in any other month since the listing service began tracking home sales in 1984. If July's sales all close in August, this month could be even stronger... In Western Washington, pending sales - a barometer of next month's closed sales - climbed 45.3 percent in King County, 44.9 percent in Snohomish County, 20.9 percent in Pierce and 34.5 percent in Kitsap, compared with July 2002..."

Fannie and Freddie's accounting is receiving much-deserved attention these days. The New York Times' Alex Berenson penned an interesting article yesterday, "Fannie Mae's Loss Risk Is Larger, Computer Models Show." "At the end of last year, the models showed that Fannie Mae's portfolio would have lost $7.5 billion in value if interest rates rose immediately by 1.5 percentage points, internal company documents provided (by a former Fannie employee) to The New York Times indicated." Understandably, the focus today is on GSE interest-rate exposure. But when it comes to accounting treatment and the risk of future losses, a significant (and less nebulous) issue goes unnoticed: The GSEs have provided grossly inadequate reserves for future Credit losses.

Fannie Mae ended June 30, 2000 with a Total Book of Business (mortgages held in its retained portfolio and mortgage-backed securities it has guaranteed) of $1.247 Trillion. The company had an Allowance for Losses of $808.9 million, or 0.06% (six basis points) of its Total Book of Business. During 2000's second quarter, "Single-Family Property Acquired" (SFPA) totaled 3,649 units. Over the next three years, Fannie's Total Book of Business surged $803 billion, or 64%, to $2.05 Trillion. SFPA during this year's second quarter had shot up 80% from Q2 2000 to 6,569 units. So what about Fannie's Allowance for Losses? Well, it actually declined by $900,000 to $808 million after three years of historic expansion. Over this period, the company has gone from $1 of loss reserve for every $1,541 of business exposure to $1 for every $2,537 of exposure.

Management, of course, argues that such low reserves are justified by the minimal Credit-related losses suffered over the past few years (because of "new technologies" and such). While providing a nice boost to reported earnings, such logic is seriously flawed. Losses have remained at insignificant levels specifically because of the unprecedented lending boom illustrated by Fannie's three-year $800 billion surge in its Book of Business. How significant were Credit losses on telecom debt during the boom years 1997 to 1999? There should be no doubt that housing-related Credit losses will accelerate as soon as lending excess subsides, with the degree of post-Bubble pain determined by the dimensions of Boom-time excesses. And paralleling the distortions wrought from the unprecedented excesses that unfolded throughout the telecom/tech Bubble, traditional models will also grossly underestimate future losses on residential real estate. Indeed, the current system that encourages housing inflation and aggressive equity extraction is truly in a league of its own; the U.S. mortgage finance lending super-structure is unmatched in history and we expect the same from future Credit losses.

The environment persists at a manic stage where eager homebuyers and aggressive lenders share unflinching conviction that home values only go higher. And the more expensive the home purchased, the greater expected future profits. In 1999/early 2000, after years of steady equity price inflation, we witnessed "stocks for the long-term" over-confidence erupt into a "got to own them at any price" final panic buying melee (speculative blow-off). Importantly, as such excesses go to extremes, risk for all involved (speculator, investor, borrower, lender and the system) rises exponentially. Not only did equity prices inflate to dangerous over-valuation, egregious industry spending excesses throughout the technology sector assured a devastating profits collapse. The final manic "melt-up" proves the killer, exacerbating asset price distortions, over-lending, and severe maladjustments to underlying business fundamentals. Major dislocation then becomes unavoidable. Central banks must recognize and nip fledgling Bubbles in the bud, while having absolute determination to not allow the precarious "blow-off" stage to materialize. To incite such dynamics is gross negligence.

To better comprehend the current extraordinary environment, it is invaluable to appreciate that it was specifically the Fed's post-Russia/LTCM reliquefication that stoked the final devastating telecom/tech/equity "blow-off"; no (Fed and GSE) reliquefication, no wildly destabilizing melt-up - plain and simple. And once the financial and real economy sectors succumbed to blow-off dynamics, there was no avoiding eventual industry dislocation; plain and simple. It was only a case of from what level of extremes the bust was to commence. It is so frustrating that this crucial lesson apparently cannot be learned.

The historic 1998/99 central banking folly, however, was outdone this past fall and winter. The most recent reliquefication has rendered similar but more catastrophic (blow-off) excesses throughout mortgage finance. Resulting damage to the already vulnerable financial sector and maladjusted economy are huge and growing, and there is no way to turn it off. After a protracted building boom, housing construction has accelerated (as we continue to gut our manufacturing base). The GSEs are leading the charge, as associated risks rise exponentially. There is today increasing attention paid to the GSEs exposure to rising interest rates. While I don't want to in anyway dismiss the possibility that a rate surge could severely impair these institutions, I'd wager that, in the end, it will be Credit losses that kill the GSEs.

The current (Fed reliquefication-incited) buyers' panic and building Boom assure dynamics that risk eventual collapse for many Bubble markets. Inflation psychology has taken firm hold, and if eager buyers don't like today's higher 30-year fixed mortgage rates they will surely opt for low variable rates. Credit availability, most importantly, remains ultra-easy. Going forward, the Fed's artificially low short-term rates will prove too attractive for many eager mortgage borrowers. Clearly, the out of control California housing Bubble by itself now poses major systemic risk. Moreover, the worst-case scenario of rising market rates and sinking home prices is, courtesy of Fed "reflation," now an increasingly likely intermediate-term scenario. Again, it was the parabolic rise in NASDAQ that sealed its fate. We are witnessing a repeat throughout mortgage finance.

It will take some time, but the thinly-capitalized and fatly risk-exposed GSEs have (with the Fed's assistance) placed themselves in serious harm's way. I see no way for these institutions to now sidestep eventual collapse, unless speculative market dynamics are somehow repealed. This is the harsh reality created by gross Fed (and GSE) incompetence.

It has now reached the point where we can recognize the Fed's latest reliquefication as having orchestrated one more fateful Boom - The Post-Boom Boom. Conventional thinking would scoff at such a view, with the common fixation on moderate aggregate GDP expansion, record government deficits, and stubborn unemployment. But our analysis is focused elsewhere, recognizing and analyzing (Credit and speculation-induced) Boom-time distortions and maladjustments, of which there are plenty. Indeed, to ignore current Boom/Bubble dynamics (and consequent excesses and distortions) is to miss a critical analytical perspective; the framework illuminating and clarifying an environment many find so confounding.

To support my case that we are in the midst of a Post-Boom Boom (an inarguably quite unbalanced one!), I note the following: Record July sales for Lexus (up 16% y-o-y), the third-best month on record for Acura, BMW sales up 16% y-o-y, Mercedes up 26%, Infinity up 38% and Porsche up 9%. Surging luxury auto sales provide evidence that a large number of individuals are enjoying Boom-time conditions. Furthermore, July total vehicle sales were at a rate of 17.3 million units, a level not surpassed during the nineties boom until the final month of 1998. We are in the midst of extraordinary home sales. Existing Home Sales are set for new records over the next month or two, with average prices already having surged to a new record ($224,900). New Home Sales and prices have surged to new records. Many key housing markets are demonstrating extreme price inflation, especially in Southern California and along the East Coast. Retail Sales have recently accelerated and are at a record level. The ISM non-manufacturing index has jumped to a new record, indicative of booming sectors within the expansive services economy. Key services prices, such as for health care, insurance, and tuition, are demonstrating strong inflation. The financial services industry is Booming, with record earnings and employment. The economy is generating record (debt-induced) Trade Deficits, with the Current Account Deficit surpassing 5% of GDP. Crude oil is above $32 and natural gas is higher than $5.

And, importantly, Credit data un-mistakenly support the view of Boom-time conditions. The household sector is borrowing record amounts (double-digit pace), this after expanding debt by 50% over the past five years. When it comes to consumer borrowing, Post-Boom Boom excesses, amazingly, are eclipsing those of the previous historic Boom. Second quarter mortgage debt growth will set a new record at more than three times pre-Bubble annual borrowings. State and Local governments are also borrowing at double-digit rates and likely established a new record during the second quarter. The federal government will also set a new borrowing record this year. Corporate debt issuance, although remaining considerably below late-nineties Bubble levels, is picking up meaningfully. We are on pace for record junk and convertible debt issuance. In total, we are in the midst of record system Credit growth.

Last week I averred that the Fed had Lost Control of the interest rate markets. Well, many would argue that this week's dramatic recovery is quickly returning the Credit system back to business as usual. I am skeptical that Humpty Dumpty is so readily pieced back together. I will nonetheless somewhat adjust the focal point of my analysis: I believe the critical issue is that the marketplace has lost the capacity to effectively regulate Credit expansion, an issue that takes on heightened relevance with the commencement of The Post-Boom Boom.

In decades past ("The Way We Were"), the market pricing mechanism would temper (self-regulate) borrowing excesses through higher market borrowing rates (increased price of Credit) - the interplay of supply and demand for loanable funds dictated the price of borrowing. But for contemporary U.S. financial markets, the wondrous "invisible hand" has been relegated to an outmoded notion that's interesting to read about. The U.S. Credit system, having become incredibly leveraged and commanded by speculation, is simply no longer capable of sustaining the higher market rates necessary to temper borrowing excesses. I certainly don't expect that current rates will inhibit eager borrowers. This week's lower rates and sharply narrower spreads are certainly excellent news for holders of debt instruments (especially the leveraged speculators and derivative players), but it will work to sustain over-borrowing.

For the real economy, major structural distortions from years of excess have nurtured a system sustained only by huge unrelenting Credit and speculative excess. And with the bond Bubble having now burst, this fact of life will weigh heavily on the U.S. Credit market. The marketplace, after all, faces massive new supply as far as the eye can see. Especially in regard to the mortgage finance Bubble, there can be no let-up in Credit expansion. And as I have written too many times, the unprecedented amount of Credit growth required to achieve only minimal growth for the maladjusted (asset inflation/services-centric) U.S. economy lay at the heart of a serious intractable problem. The degree of Credit excess necessary to finance impressive GDP growth would be more than the bloated financial sector could effectively manage for any meaningful length of time.

All the same, there is a hardening consensus view that historic productivity increases and the death of inflation have created a favorable environment where strong GDP growth is the order of the day (Mr. McTeer is back!). Some even suggest that 5% growth is required to reduce unemployment. This "raising the economy's speed limit" view is today especially seductive and dangerous, with a captive audience including Washington politicians, hopeful investors, an enterprising Wall Street and, apparently, a desperate Fed.

The Post-Boom Booming U.S. Credit system is today firing on all cylinders, and it would appear that there is nothing short of outright dislocation/Credit crisis that will slow it down. The bottom line is that an Unsustainable Bubble is being Sustained, but at a staggering cost. And while the Refi boom has petered out, I expect record mortgage debt growth to continue for now. Homes remain the speculative asset of choice for Americans, with both record purchase volume and home equity lending likely sustainable at current rates. Yet the resulting liquidity is spread especially unevenly throughout the U.S. economy and asset markets, as well as globally. Over-liquefied bond markets around the world have succumbed to Bubble dynamics. Here at home, the moribund U.S. manufacturing sector and dismal job performance are the consequences of the severely distorted financial system and real economy. The only available "growth" scenario is to expand a hopelessly unsound economy more rapidly. This is an exceedingly dangerous environment.

There is a strongly held view in the marketplace that the Fed should maintain short-term rates at 1% for the foreseeable future. Apparently, it makes sense to some to ignore rampant financial excess, acute financial fragility, and unprecedented economic imbalances as long as the core rate of consumer prices remains around 2%. Historians will not be kind... Along with continued record household borrowings, I'd also bet on only larger Trade and Current Account Deficits. But how long will our foreign creditors continue to finance our profligate Bubbles? When will Asian central banks cry "uncle!"?

For now, the Credit market can rejoice its miraculous recovery. Yet keep in mind that this week the New York Times ran an unflattering piece on Fannie Mae, the Wall Street Journal highlighted the practice by some of the major U.S. banks of using special purpose vehicles to skirt state taxes, and S&P today cut its outlook on the Federal Home Loan Bank of New York. There are many shoes to drop, financial accounting and otherwise. We don't expect the issue of the integrity of the U.S. financial system to dissipate any time soon. Irrespective of the market's daily and weekly ebb and flow, I can look to a confluence of developments that do not bode favorably for the U.S. Credit system. To finance today's Post-Boom Boom will entail massive Credit creation and inordinate U.S. financial sector expansion. Under watchful eyes, the GSEs will need to aggressively balloon their balance sheets and mortgage guarantees. The banking system balloon will need to expand as well. Worse yet, the vast majority of this Credit growth will continue to finance housing inflation and consumption. And we have no alternative than to rely on our foreign creditors (largely central banks) to continue to balloon their holdings of these increasingly dubious U.S. financial claims.

There sure is a lot of Credit inflation in the pipeline. And with the arrival of Post-Boom Boom returns Acute Financial Fragility. They just refuse to learn their lesson.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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