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May 19, 2007

It's a Mad, Mad, Mad, Mad World
by Kevin Duffy

This article was adapted from a speech given to the Committee for Monetary Research & Education (CMRE) on May 10, 2007 in New York City.

The classic 1963 slapstick comedy, "It's a Mad, Mad, Mad, Mad World," begins when the occupants of four vehicles learn about hidden treasure in the fictional town of Santa Rosita, California. According to a dying man's last words, $350,000 (about $2.3 million in today's dollars) is buried under a mysterious "big W," less than a day's drive away. When the strangers can't agree on how to share the loot, a wild race for riches ensues.

In the 44 years since, the mad dash for wealth without work has been repeated throughout countless bubbles and manias. Witness the Japanese mania and U.S. takeover bubble of '89, the biotech bubble of '91, the 2000 tech bubble, and more recently the 2005 housing bubble - all ending in tears. Fittingly, in the movie's finale the protagonists fall off a fire escape and all end up in the hospital.

Was the film's director, Stanley Kramer, prescient - metaphorically speaking - or have we evolved to the current state of perfection in which the investing masses are entitled to get rich simply by tuning in to Jim Cramer's Mad Money?

Fractional reserve madness

The lure of easy money begins with the government printing press. First, the central banker buys an asset - typically a government debt instrument - writes a check on itself and deposits it into the banking system. Since the bank never "redeems" the check, this is equivalent to creating money out of thin air. The banker, happy to receive fresh "reserves," loans out all but a sliver. This new money ends up back with the banks, is counted again as reserves, mostly lent out, and so on and so on. Through this process of fractional reserve banking, credit is expanded at a multiple of the initial central bank deposit. Through such a system, the creation of money and credit (the promise to pay money) looks like an upside-down pyramid - essentially a pyramid scheme on top of a counterfeiting operation.

As James Grant has counseled, the inflation process gives a finite pool of capital the illusion of an endless sea of liquidity, in effect "turning all the traffic lights green."

Such a scheme is a concoction of government privilege (or mercantilism), not laissez faire. The so-called "capitalists" are no longer efficient allocators of capital to its most productive uses, but beneficiaries of and cheerleaders for a monetary fraud in which capital is debased, taken for granted, abused. As long as they remain chummy with their friendly liquidity provider of last resort, they can act recklessly without fear of igniting an economic forest fire - or if they do, without fear of having to bear the costs. And as long as the value of their collateral is constantly inflated, they never feel the need to worry about default.

Liberated from the gold standard straightjacket, the system has few restraints. For starters, the counterfeiter has an incentive not to draw attention to his racket. But the effectiveness of his ongoing propaganda campaign has weakened this deterrent. The real inflationary action, however, is in credit expansion. For example, in the last 6 years, the Federal Reserve has grown its balance sheet less than $300 billion while the nation's money supply has expanded by $4.3 trillion, or 14 times as much. In other words, the central banker can bait the hook, but lenders and borrowers still have to take the bait.

This new money is never evenly distributed, but instead gets funneled into whatever narrow area happens to capture the public's fascination. As prices and valuations soar, greater doses of credit are required to keep the game going. Either more marginal borrowers are drawn in at ever more precarious levels or greater leverage must be applied to existing borrowers. This is what ultimately doomed the housing bubble. In the end, nearly anyone who could fog a mirror was getting an invitation to join the party.

The trouble with pyramid schemes is that they're not designed to go in reverse. Eventually, the number of willing dupes is exhausted. The same people who panicked late to get into the game are just as likely to panic when the music stops. The longer the music plays, the more leveraged and unstable the inverted credit pyramid becomes. As the late economist Hyman Minsky observed, "stability is unstable."

The trouble with stability

The current Federal Reserve experiment with stability began on January 3, 2001. With the Nasdaq Composite down 55% from its March, 2000 peak and a bursting technology bubble threatening to plunge the economy into recession, the Fed began lowering rates. The impact was immediate. The Nasdaq rallied 14% that day and stood 24% higher four weeks later. The guru du jour, Abby Joseph Cohen, echoed the prevailing faith in the Greenspan put: "I am assuming this will be a very short-lived slowdown because policy makers have significant tools at their disposal. The Federal Reserve in adjusting rates last week stood up and said, 'We are watching and will do more if necessary.' That serves as a confidence builder."

Lost on the bulls, such misplaced faith in central bankers is commonplace at major tops. In April, 1929 Financial World reassured its readers, "It may be well again to stress the all-important point that the Federal Reserve has it in its power to change interest rates downward any time it sees fit to do so and thus to stimulate business."

The first quarter of 2001 saw a spike in corporate bond offerings, including aggressively priced zero coupon bonds by Enron and Tyco International. MCI WorldCom issued $10.8 billion in investment grade bonds - the second largest bond offering on record at the time. Within 18 months the company was bankrupt.

Time - June 13, 2005
"Why we're going gaga over real estate"

For two years the Fed pounded the funds rate relentlessly from 6.40% to 1.24%. Regardless, the tech balloon continued to deflate, with the Nasdaq collapsing another 61% from its January, 2001 high to its October, 2002 low. The Fed was, however, successful in avoiding the bogeyman of deflation as cheap credit lit a fire under the housing market. From 2000 to 2005, homebuilding stocks leapt nine-fold. Lending standards eroded and, as home prices moved out of reach of the average American, "affordability products" such as interest-only and negative amortization loans became the rage. As it turns out, Time magazine pegged the top of the housing bubble with its June 13, 2005 cover, "Home $weet Home: Why we're going gaga over real estate." Time captured the zaniness of the times: "If home is where the heart is, it is now where ever more of your cash is. And when love and money collide, things can get a little crazy."

As the new millennium unfolded, the engine of wealth creation shifted from technology to finance. In 2000, technology claimed 99 members of the Forbes 400 who accounted for 40% of the total wealth. By 2006, real estate, investments and finance boasted 140 members and a record 27% share of the billionaire market, while technology slipped to 17%. (This share will certainly go higher when Forbes tallies the numbers this October.)

Another sign of the times (and hubris) is the naming rights on stadiums. From 2000 to 2007, the number of financial sector stadiums doubled from 12 to 24, while tech names slipped from 12 to 9. The Class of 2000 was notable for a number of corporate implosions such as PSINet Stadium, CMGI Field, MCI Center, and Enron Field. In fact, 19% of the sponsors eventually went bankrupt, including several airlines. The Class of 2007 includes Chase Field, Wachovia Center, and Quicken Loans Arena; 14 or 19% of today's naming rights sponsors are banks.

It appears the Fed experiment in monetary stimulus from 2001 to 2003 didn't just ignite a housing bubble, but fomented a full-blown credit bubble.

Credit assembly line shifts into high gear

More than in any previous cycle, a sophisticated assembly line has developed to facilitate the creation of credit and expansion of leverage. The days of the neighborhood banker on a first name basis with his customer are long gone. Loans are now originated, packaged into securities by Wall Street, endorsed by insurance companies and ratings agencies, and sold to investors. The assumption is that each of the gatekeepers is unbiased and financially sound. Yet commercial banks such as Citigroup have assets-to-equity of 12 times, investment banks are typically levered 25-to-1, and bond insurers like Ambac and MBIA guarantee 80 to 90 times their capital. If a chain is only as strong as its weakest link, there is plenty that could go wrong with the great intermediation of credit creation.

Investment banks have reveled in an elevated role during this credit cycle. In the past six years, the Fed grew its balance sheet 50%, money supply expanded 60%, and the Top Five investments banks increased total assets by 160%. In the latest quarter, the total assets of Goldman Sachs exceeded total bank credit at the Fed for the first time. Structured finance has become a lucrative business as nearly $500 billion in collateralized debt obligations (CDOs) were issued in 2006 alone, a 60% increase. To at least one cynic, Barron's editor Thomas G. Donlan, "The work of Wall Street often is to introduce people who should not borrow to people who should not lend."

The credit rating agencies not only sign off on the soundness of the gatekeepers (all investment grade, of course), but on the securitizations themselves. (They also designed the structures with the help of Wall Street.) Without their blessing, institutions such as insurance companies and pension funds would be restricted from investing. Yet the rating companies get paid by the credit issuers - a clear conflict. In fact, structured finance now accounts for over half of Moody's ratings revenue.

The credit assembly line would not be complete without the end demand of the loan holder. In particular, many public pension funds which got addicted to the strong returns of the late 1990s bull market have been climbing the risk ladder in order to keep employer contribution rates low. Driven by the mantra that diversification into "alternative investments" can deliver the holy grail of higher returns with reduced risk, pensions have moved aggressively since 2000 to place funds with highly compensated managers who have the ability to add leverage and trade more actively.

Condo flipper passes torch to professional speculator

From our perch, it appears the slowly deflating housing bubble has simply morphed into a massive professional speculator bubble, driven by commercial real estate, hedge funds, and private equity.

The number of real estate sector funds has doubled since 2000 and now exceeds the number of technology funds. Commercial mortgage-backed securities (CMBS) issuance is expected to exceed $350 billion this year, credit spreads are widening, and leverage is increasing. According to Moody's estimates, the average loan-to-value on CMBS was 111.6% in the first quarter, up from 90% in 2003.

Signs of excess are everywhere with regard to hedge funds and private equity. More bells are ringing than at an Austrian downhill. Exhibit A: the highly successful IPO of Fortress Group and the proposed IPO of Blackstone Group. Steve Schwarzman, CEO of Blackstone, recently graced the cover of Fortune as "the new king of Wall Street." U.S. private equity firms raised $160 billion in 2006 and are on pace to double that take this year. During the tech bubble, venture capital inflows went parabolic as well, peaking at $91 billion in the year 2000. The same investment banks who acquired tech underwriters in 2000 and subprime loan originators in 2006 are now busy snapping up hedge funds. According to Bridgewater Associates, hedge fund borrowings were $1.46 trillion last year, up from just $177 billion in 2002.

In addition, investment banks are no longer content to play with other peoples' money ("OPM"). They are putting record amounts of their own capital at risk. For example over two-thirds of Goldman Sachs' net revenue now comes from trading and principal investments versus one-third five years ago.

Living on planet leverage

On April 30th, The Wall Street Journal featured a cover article about the copious amounts of leverage employed by the professional speculator community. They quoted a senior credit analyst at Standard & Poor's: "There's leverage everywhere - whether at corporations or broker dealers or hedge funds or private equity funds. It sort of feels like something's got to give." The conclusion of the two WSJ journalists: "We're living on planet leverage."

The American consumer has been living on planet leverage for quite some time, having taken on another $5.5 trillion in debt just the past six years - an 85% increase. Despite generation-low interest rates and a housing boom for the ages, homeowners' equity is at all-time lows and the consumer's balance sheet has never been more stretched.

Cracks are already appearing in the credit façade. Year-to-date, the Bearing Credit Bubble Index (a proprietary composite of 22 credit-related stocks) has underperformed the S&P 500 by over 10%. Sub-indices closest to the mortgage finance bubble are particularly weak, with homebuilders -16.3% and subprime lenders -54,8%.

The trouble with liquidity

Liquidity remains the rallying cry of the bulls, just as it has at the top of every bubble. But they confuse cash on the sidelines with ready access to credit. As BlackRock CEO Laurence Fink recently warned, "Probably the greatest issue that's confronting the world's investors is we are trading liquidity for illiquidity." With mutual fund balances and mutual fund cash levels at record lows, the fuel to power stock prices higher is depleted. The strain of liquidity that has financial markets on steroids is cheap credit, a fair weather friend who will turn tail at the first sign of trouble.

BusinessWeek - February 19, 2007
"Why money may stay cheap longer
than you think"

Perhaps the ultimate contrary indicator of this credit cycle will be BusinessWeek's February 19, 2007 cover story, "It's a Low, Low, Low, Low-Rate World." BW's authors gushed, "Borrowers, of course, are deliriously happy. Even the shakiest companies are seeing their debt costs plunge... Most remarkably, the craziness isn't likely to stop anytime soon." Sound familiar? Simply substitute "home buyers" for "companies" and this quote could have easily appeared two years ago at the top of the housing bubble.

As the actors in this madcap movie continue to chase that illusive pot of gold buried under the "big W," we can't help but be reminded of the advice of InvesTech Research editor James Stack: "Never confuse an economic miracle with a liquidity bubble."

As the great Austrian economist Ludwig von Mises warned, "There is no means of avoiding the final collapse of a boom brought about by credit expansion."

Kevin Duffy
Bearing Asset Management, LLC

Mr. Duffy is a principal of Bearing Asset Management.

Copyright © 2005-2007 Bearing Asset Management LLC

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