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5 CREDIT BUBBLE
BULLETIN Road to ruin By
Doug Noland
COMMENTARY
The
gentlemen at Pimco are, once again, the leading
cheerleaders for another round of easier "money."
Calling for the Fed to cut rates to 3.5%, Bill
Gross commented Wednesday on Bloomberg television:
"The nominal [third quarter] GDP number was 4.7%.
Any time you get a nominal GDP growth less than 5%
the economy is basically struggling. The U.S.
needs at least 5%
nominal growth in order to
pay its bills on a longer term basis."
I
will, once again, take the other side of their
analysis. First of all, 4.7% traditional nominal
GDP growth would have easily in the past "paid its
bills." It doesn't get it done today even with
4.7% unemployment specifically because of a long
period of gross monetary excess. For some time
now, the U.S. economy has been hopelessly
finance-driven, and the greater and more
protracted the Credit excesses the greater the
"transformation" of the economic structure. And it
is the underlying real economy that today cannot
"pay its bills" and is therefore hooked on ever
increasing Credit inflation. This should by now be
recognized as the Road to Ruin. Contemporary
finance and its operators should be held
accountable.
The majority of contemporary
"services" economic "output" is intangible in
nature. The system creates various types of new
financial claims (Credit), and this new purchasing
power spins today's economic wheels. It seemingly
works wonders during the boom, but the end result
is an endless mountain of financial claims backed
by insufficient real economic wealth-creating
capacity. Nominal GDP would "pay it bills" today
only in the context of monetizing additional debt
or inflating the quantity of Credit to inflate
"purchasing power" to inflate incomes and earnings
all in order to service previous borrowing
excesses.
Admittedly, the Fed has
opportunely administered several bouts of
"reflation." We have, however, reached the point
where another round will be self-defeating. To
throw out some numbers, from the Fed's Z.1 "flow
of funds" report we know that Total Credit Market
Borrowings (non-financial and financial) expanded
at a $3.75 TN annualized rate during the first
half. To put the immense scope of recent Credit
inflation into perspective, Credit Market
Borrowings expanded on average $1.233 TN annually
during the nineties (see chart above). Total
borrowings accelerated to $1.694 TN in 2000,
$2.013 TN in 2001, $2.365 TN in 2002, $2.767 TN in
2003, $3.085 TN in 2003, $3.380 TN in 2003, and
$3.825 TN last year. It is this degree of Credit
creation - and the associated Risk Intermediation
- that is today untenable and unsustainable at any
interest rate.
Before I dive into the U.S.
Credit system fiasco, I was struck by a story by
Jamil Anderlini from today's Financial Times:
"The murder of a man who jumped a petrol
queue in China's central Henan province on
Wednesday is the stuff of nightmares for the
authoritarian Chinese government. Faced with
worsening fuel shortages across the country
Beijing raised petrol, diesel and jet fuel prices
at the pump by almost 10% yesterday, in an effort
to boost domestic supplies and exorcise the
spectre of social unrest. The policy reversal came
as shortages spread to the capital, which is
usually immune from the country's periodic supply
crunches. But the government is unwilling to allow
prices to rise too much because of a morbid fear
of spiralling inflation, which has a history of
toppling governments in China and is currently
running at a 10-year high, above 6%... Soaring
global crude oil prices pose a serious dilemma for
Beijing, which last raised its tightly controlled
fuel prices in May 2006. China is the
second-largest crude oil consumer after the US and
although it was a net exporter as recently as 1993
it now relies on imports for nearly 5% of its
crude supply. The current shortages, particularly
of diesel, result from a combination of high
global oil prices and strict government controls,
causing huge losses for Chinese refiners that must
pay more for oil but cannot raise prices at the
pump."
I pose the following question for
contemplation: How much would the Chinese
government, with their $1.4 TN stockpile of
chiefly dollar reserves, be willing these days to
pay for the necessary energy resources to sustain
their economic boom and stem social unrest?
The legacy of years of runaway U.S. Credit
excess includes many trillions of dollar liquidity
balances circulating around the globe. Chinese
reserves, for example, have inflated almost
seven-fold in just five years. On the back of
unprecedented global Credit and liquidity excess,
energy, food, precious metals and other
commodities now attract intense demand and
virtually unlimited purchasing power. Our economy
our financially stretched consumers and
vulnerable businesses - will now have no option
other than to bid against highly liquefied
competitors for a lengthening list of resources.
Failure to recognize that this situation is a
major inflationary problem is disregarding
reality. The same can be said for suggesting that
we can continue on this current course - with
massive Current Account Deficits and rampant
speculative financial outflows to the world
fueling myriad dangerous Bubbles and maladjustment
on an unprecedented global scale.
Today's
backdrop is unique. There are literally trillions
of dollars of liquidity slushing around the world
keen to hold "things" of value. Liquidity sources
include the massive central bank reserve holdings
as well as funds at the disposal of the sovereign
wealth funds. Importantly, the more apparent
becomes U.S. financial fragility, the keener they
are to stockpile real "things". There is as well a
global leveraged speculating community, in control
of trillions of liquid purchasing power. The
speculators are also keen to acquire (non-dollar)
"things" as opposed to our securities. Indeed, it
should be noted that this is the Federal Reserve's
first attempt at reflation where U.S. securities
are not the speculators' or foreign central banks'
asset class of choice.
Not only is the
pool of potential global buying power unparalleled
in scope. It is fervidly attracted to tangible
assets - as opposed to U.S. securities - and is
highly speculative in character. At the same time,
an unwieldy global boom is stoking unprecedented
demand in China, India, Asia generally, and the
other "emerging" markets including Russia and
Brazil. Throw in various weather related issues
and energy production constraints and the prospect
for some very serious bottlenecks and shortages
has developed.
Granted, these dynamics
have been evolving for some time now. What has
changed is the speed and breadth of financial
crisis enveloping the U.S. financial system. When
I read of mounting energy and food shortages and
witness the unfolding run on the U.S. financial
sector, as an analyst I must contemplate the
likelihood we have entered a uniquely unstable
monetary environment at home and abroad. In short,
the backdrop exists where incredible dollar
liquidity flows could be released (from myriad
sources) upon key things (notably energy, food,
metals and commodities) already in severe supply
and demand imbalance. Again, how much are the
Chinese willing to pay for energy? The Russians
for food? The Indians for commodities in general?
How much will investors be willing to pay for
precious metals as a store of value? How
aggressively will the speculators "front run" all
of them? Can the Fed afford to continue fueling
this bonfire?
I have so far this evening
purposely avoided the unfolding U.S. financial
crisis, a historic fiasco that took a decided
turn-for-the-worst this week. I'll admit that I am
rather amazed that key financial stocks
including the financial guarantors, "money center
banks", and Wall Street firms were hammered yet
the market maintained its composure. NASDAQ was
actually up on the week, as major technology
indexes added to their robust y-t-d gains. I'll
assume there is a confluence of great complacency
and gamesmanship, with operators determined to
play aggressively through year-end (bonuses and
payouts).
I wouldn't bet on the stock
market holding 2007 gains for another eight weeks.
The Credit meltdown is now moving too fast and
furious. Importantly, confidence is faltering for
the entire Credit insurance industry, including
the mortgage insurers and the financial
guarantors. This is a devastating blow for the
securitization marketplace, already reeling from
pricing, liquidity and trust issues. The Credit
system has lurched to the edge of meltdown, while
the economy hasn't even as yet succumbed to
recession. It's absolutely scary. Last week I
wrote that subprime and the SIVs were "peanuts" in
comparison to the CDO market. Well, the CDO
marketplace is chump change compared to Credit
Default Swaps and other over-the-counter (OTC)
Credit derivatives that, by the way, have never
been tested in a Credit or economic downturn.
The scale of the Credit "insurance"
problem is astounding. According to the Bank of
International Settlements, the OTC market for
Credit default swaps (CDS) jumped from $4.7 TN at
the end of 2004 to $22.6 TN to end 2006. From the
International Swaps and Derivatives Association we
know that the total notional volume of credit
derivatives jumped about 30% during the first half
to $45.5 TN. And from the Comptroller of the
Currency, total U.S. commercial bank Credit
derivative positions ballooned from $492bn to
begin 2003 to $11.8 TN as of this past June. It
today goes without saying that this explosion of
Credit insurance occurred concurrently with the
expansion of the riskiest mortgage (and other)
lending imaginable. It's got "counter-party
fiasco" written all over it.
The stocks of
Ambac and MBIA collapsed this week. I can only
surmise that part of the selling pressure emanated
from players caught on the wrong side of rapidly
widening Credit default swap prices. Since these
companies have limited amounts of bonds trading in
the markets in debt markets generally suffering
acute illiquidity those needing to hedge rising
default risk in this industry had little
alternative than to aggressively short the stocks.
And the faster the stocks declined, the wider the
CDS spreads and the more "dynamic" hedge-related
selling required. This dynamic could play out
throughout the financial sector and beyond. The
"dynamic hedging" (shorting securities to offset
increasing risk on derivatives written) of Credit
risk today poses a very serious systemic issue.
The general inability to hedge escalating
default and market risk has become and will remain
a major systemic problem. Liquidity has
disappeared, and there now exists an untenable
overhang of risky securities and derivatives to be
liquidated and/or hedged. Most playing in the
Credit derivatives market lack the wherewithal to
deliver on their obligations in the (now likely)
event of a systemic Credit bust. The vast majority
were "writing flood insurance during a drought,
happy to book annual premiums while expecting to
purchase reinsurance/hedge if and when heavy rains
ever developed." Well, it all happened at a pace
so much faster than anyone ever contemplated. So
abruptly, the flood is now poised to wreak bloody
havoc the scope of which was unimaginable and
there's no functioning reinsurance market.
Unlike this summer, last week saw the
Credit crisis engulf the epicenter of the U.S.
Credit system. Not surprisingly, the Fed rate cut
only seemed to exacerbate market tension, with
oil, gold and commodities spiking and the dollar
faltering. Those arguing that the Fed needs to cut
rates aggressively to avoid recession are
disregarding the much higher stakes involved.
There is today no alternative to a wrenching
recession. The economy is terribly maladjusted,
while the financial sector is at this point
incapable of
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