Page 1 of 3 CREDIT BUBBLE BULLETIN Fed's 'Flow of Funds'
Commentary and weekly watch by Doug Noland
The global government finance bubble has seen at least its second crack develop.
The Federal Reserve's first-quarter 2013 Z.1 "Flow of Funds" was notable for the surprising ongoing lackluster credit expansion throughout much of the private-sector. Even with continuing double-digit percentage growth in federal borrowings, total non-financial debt expanded at a 4.6% rate during the first quarter (down from Q4 2012's 6.5%). Household debt contracted at a
0.6% rate, a reversal from Q4's 2.2% expansion.
Surprisingly, household mortgage debt declined at a 2.3% pace versus Q4's 1.0% rate of contraction. Non-mortgage household borrowings remained relatively strong, with Q1's 5.7% pace down only slightly from Q4's 6.5%. Corporate borrowings slowed from Q4's blistering 12.1% pace to 7.6%.
The federal government's domination of US credit runs unabated. Federal debt expanded at a 10.3% rate during the quarter, down only slightly from Q4's 11.2%. Keep in mind that federal debt expanded 24.2% in 2008, 22.7% in 2009, 20.2% in 2010, 11.4% in 2011 and 10.9% in 2012. In nominal dollars, outstanding Treasury debt increased $337 billion during the quarter, with a one-year gain of $1.078 trillion. Treasury debt increased a staggering $6.655 trillion, or 127%, during the past 19 quarters.
In seasonally adjusted and annualized (SAAR) nominal dollars, total non-financial debt expanded $1.850 trillion, down from Q4's SAAR $2.585 trillion but still relatively strong. For comparison, total non-financial debt increased $1.872 trillion in 2012, $1.325 trillion in 2011, $1.472 trillion in 2010, $1.058 trillion in 2009, $1.921 trillion in 2008 and $2.554 trillion in 2007.
At SAAR $1.198 trillion, federal borrowings during the quarter accounted for 65% of total non-financial debt growth. For comparison, federal borrowings as a percentage of total non-financial debt growth were 61% in 2012, 79% in 2011, 107% in 2010, 136% in 2009 and 64% in 2008. During the boom years 2006 and 2007, federal borrowings amounted to less than 10% of total non-financial debt growth.
There are a few striking facets of the most recent Z.1 report from the Fed. Importantly, private-sector credit continues to struggle in the face of ongoing ultra-loose financial conditions and inflating asset markets. Surprisingly, even with mortgage rates at all-time lows (along with the reemergence of house price inflation), total mortgage credit contracted 1.9% annualized during Q1 to $13.091 trillion. This follows Q4's 0.4% gain, the first positive mortgage credit growth since Q1 2008. Both household and commercial mortgage credit contracted during the first quarter.
We'll now watch with keen interest how the significant jump in borrowing costs impacts mortgage credit and bubbling real estate markets more generally. Even a major refinancing boom and recovery in home prices was not enough to spur even positive growth in household mortgage borrowings. For households, low returns on savings have incentivized paying down mortgage debt.
While this dynamic has helped improve the household balance sheet, it has provided ongoing headwinds against a self-sustaining private-sector credit resurgence. Said another way, despite years of zero rates, an historic increase in government debt and massive Fed monetization there is little to indicate a sustainable private-sector credit expansion.
Total bank assets expanded $186 billion during Q1 (to $15.244 trillion), with reserves at the Fed surging $299 billion during the quarter to a record $1.790 trillion. Bank loan growth slowed to a 1.3% pace, the slowest since the recession, as year-over-year loan growth slipped to 8.4%. Mortgage loans declined $38 billion during the quarter after gaining $57 billion during Q4. Miscellaneous assets dropped $63 billion (to $1.208 trillion). Government securities holdings jumped $38 billion, the strongest increase in a year.
Away from the banking system, securities broker/dealer assets contracted slightly to $2.049 trillion (down 0.7% y-o-y). Funding corp assets were little changed at $2.166 trillion (up 5.4% y-o-y). Securities credit declined $28 billion to $1.485 billion (up 7.9% y-o-y). Finance company assets declined slightly during the quarter (down 4.7% y-o-y) to $1.519 trillion. Real estate investment trust (REIT) assets were little changed for the quarter at $797 billion (up 14% y-o-y). Credit union assets expanded at a 9% rated during the quarter to $980 billion (but up 3.8% only y-o-y).
With legislation in the works that would seek to "privatize" mortgage guarantors Fannie Mae and Freddie Mac, it's worth taking a look at this quarter's government-sponsored enterprise (GSE) data. Total agency securities (debt and mortgage-backed securities - MBS) jumped $47 billion during the quarter to $7.591 trillion, with a one-year gain of $58 billion, or 0.8%. Despite the ongoing contraction in overall mortgage borrowings, total GSE securities are little changed from 2010 levels. Total GSE assets (holdings) actually increased $4.4 billion during Q1 to $6.300 trillion.
From a year ago, total assets were down 2.1%, or $133 billion. GSE (insured) MBS actually increased $26 billion, or 7.2% annualized, during the quarter to $1.463 trillion. GSE MBS jumped $133 billion, or 10%, over the past year. In three years, GSE MBS jumped $456 billion, or 45%. It will be a very tall order to ever privatize a largely nationalized household mortgage industry.
I also have no doubt that it is going to be very difficult to wean US and global markets off of Federal Reserve QE liquidity. Federal Reserve assets surged $289 billion, or 39% annualized, during the quarter to a record $3.244 trillion. The Fed's balance sheet surpassed $1 trillion for the first time back in 2008. Fed assets are now on track to reach $4.0 trillion near year-end.
There were a couple key aspects of past "Flow of Funds" analysis that came to mind as I made my way through recent data. I recall becoming increasingly concerned with mortgage credit dominance over system credit expansion back in 2005/06. And the longer that trend continued the greater my fear for the deep structural impacts that this unusual flow of finance was having on our financial system and the underlying real economy.
The dominance of Washington-based finance has similarly long overstayed its welcome. When the Fed was aggressively expanding its balance sheet in 2008/09, its purchases were essentially accommodating financial sector de-leveraging (the Fed providing a liquidity backstop for troubled banks, leveraged hedge funds, securities firms, REITs and such). Federal Reserve buying (monetization) over the past six months has been of an altogether different kind. Instead of accommodating de-risking/de-leveraging, the Fed purchases have instead incited risk-taking and leveraged speculation.
Even former Fed chair Alan Greenspan went public (CNBC) Friday with his call to begin tapering: "The sooner we come to grips with this excessive level of assets on the balance sheet of the Federal Reserve, which everyone agrees is excessive, the better ... The issue is not only a question of when we taper down, but when do we turn? And I think that the markets may not give us all of the leeway we would like to do that."
Well, the Fed is supposedly one of these days going to "come to grips with this excessive level of assets on the balance sheet". But there's a heck of a dilemma developing. The Fed has been using its balance sheet to stoke the asset markets, in the process incentivizing risk-taking and leveraging. If the Fed does at some point decide to restrict asset purchases, where will the markets look to for their coveted "liquidity backstop"?
I recall the 1993 bond market bubble as if it were yesterday. I was confident in the analysis that extraordinary speculative leverage had accumulated through hedge fund trading and the derivatives markets. The Greenspan Fed's low short-term rates and orchestrated steep yield curve created powerful market incentives and distortions. I was convinced that an inevitable bond market reversal would unleash considerable turmoil and market dislocation. And I was right, to a point. When the Fed moved to reverse its loose monetary policy in early 1994, many were stunned by the dramatic jump in market yields all along the curve. After trading at 4% in early January, 2-year yields spiked to 7.7% by year-end.
There was considerable pain and even a few fund failures. The surge in yields even precipitated financial and economic collapse in Mexico. At the same time, I was surprised that a major speculative de-leveraging wasn't having a more profound impact on overall financial conditions. I suspected at the time that Fannie Mae and Freddie Mac purchases were providing the leveraged players an important liquidity backstop. The 1994 experience had a profound impact on my macro credit and bubble analysis framework.
"Flow of Funds" data tell the story pretty well. GSE assets surged an unprecedented $148 billion in 1994, or 23%, to $782 billion. With little fanfare, Fannie and Freddie had morphed from insuring mortgage securities to highly leveraged holders of mortgages and debt that were more than happy to buy huge quantities of securities (at top dollar) in the midst of acute market turbulence. And the GSEs were anything but finished in 1994.
GSE assets increased $115 billion in 1995, $92 billion in 1996 and another $112 billion in 1997. When markets were rocked by the collapse of LTCM and attendant speculative deleveraging, the GSE's expanded holdings an unprecedented $305 billion in 1998 - followed by another $317 billion in bubble year 1999. The GSEs added another $822 billion during the tumultuous 2000-2002 period. By the end of 2003, GSE assets had inflated to $2.4 trillion, in the process playing an instrumental role in transforming the marketplace for mortgage finance, market-based credit and speculative finance more generally.
In the late-'90s, I was explaining to anyone who would listen (basically no one) that the GSEs had evolved into quasi central banks. With the revelation of accounting fraud and malfeasance at Fannie and Freddie, the leveraged speculating community had lost their liquidity backstop. By then, however, the mortgage finance bubble had gained such powerful momentum that a euphoric marketplace saw no reason to fret.
But as mortgage credit came to so dominate the financial and economic systems, with each quarterly analysis of the Z.1 in the 2006/07 period I would contemplate how the system might function during the next period of market de-risking/de-leveraging. There was no doubt in my mind that the backstop function would rest exclusively with the Federal Reserve. Further, I believed a bursting of the mortgage finance bubble would likely require trillions of market liquidity support. The rest is history. I look at 2013 as nearing the 20-year anniversary of the liquidity backstop.
Well, this is year five of the "global government finance bubble". This bubble encompasses the world's securities markets. Central banks having played such a profound role in fueling this bubble, it's not easy for me to conceptualize how their balance sheets will now be looked upon to backstop global markets in the next major de-risking/de-leveraging episode. A serious global de-leveraging would require multi-trillions of liquidity support, which I fear at this point might unleash currency and market chaos. Global central bankers have been doing everything possible to avoid a de-risking scenario.
The liquidity backstop issue becomes especially pertinent to the MBS marketplace. Pressure is (again) mounting for Fannie and Freddie to further shrink their holdings. It would appear they're out of the market backstop business for good. Moreover, pressure mounts for the Fed to wind down its foray into mortgage support ("credit allocation").
Meanwhile, as the Fed apparently prepares to back away from its historic experiment in suppressing market yields, the situation becomes only more intriguing. MBS are a particularly problematic security in a rising yield and extraordinarily uncertain market environment. Perhaps this helps explain why MBS yields are up 74 basis points (bps) since May 1 and mortgage borrowing costs last week jumped to a 14-month high.
US home buyers are not alone in confronting rising borrowing costs, while MBS investors have plenty of global company when it comes to contemplating prospective market liquidity backstops. Bloomberg's William Pesek titled his most recent article "Specter of Another Bond Crash Is Spooking Asia". "Developing" markets were last week showing heightened instability - bonds, currencies and equities. The thesis of problematic underlying financial and economic fragility is coming to fruition.
Indonesian equities were hit for 5.2%, the Philippines 4.6% and Thailand 2.9%. South Korea's Kospi sank 3.8%, and China's Shanghai composite dropped 3.9% this week. India was down 1.7% and Taiwan fell 1.9%. Brazil's Bovespa dropped another 3.5% (20-month low) and Mexico's Bolsa fell 3.3%. And while Eastern European equities held up better than "developing" Asia and Latin America, stocks in Turkey were slammed for almost 9% after an eruption of public protests and a rather undemocratic crackdown.
Market instability was certainly not limited to "developing" markets. Currency market instability now worsens by the week. The yen abruptly surged 3% against the dollar last week. The yen has a huge hedge fund short position and has surely been a source of cheap "carry trade" finance (sell yen and use proceeds to buy higher-yielding securities elsewhere). Moreover, the notion of Japanese institutions and retail investors flooding the world with liquidity as they escape the collapsing yen has played a not insignificant role in recent Financial Euphoria.
Nowhere did the perception of boundless Japanese buying power boost market sentiment more than in peripheral Europe. Notably, when the yen launched its Thursday melt-up, Spanish, Italian and Portuguese bonds were taken out to the woodshed (yields up 25, 23 and 27 bps, respectively). For the week, Portuguese 10-year yields jumped 54 bps to a six-week high (6.14%) - having now reversed the entire "Kuroda BOJ rally". Italian and Spanish yields ended the week somewhat higher, while their equities markets came under pressure. Notably, Italian stocks were hit for 3.0%. It is worth noting that European financial credit default swap (CDS) prices jumped higher again last week - and it appears this important risk market has turned increasingly unstable.