Page 2 of
5 CREDIT BUBBLE
BULLETIN Nationalization and
dislocation Commentary and
weekly watch by Doug Noland
the
orchestration a politically expedient economic
boom. After beginning the nineties with assets of
$454 billion, the GSEs ended the decade with
balance sheets that had swelled more than
three-fold to $1.723 trillion.
In the
latter years of the '90s, global financial crisis
coupled with political foible - not to mention
Wall Street’s rapidly growing power and influence
- granted the GSEs carte blanche. And then there
was the market hysteria surrounding Y-2K (or
millennium computer bug), followed by the bursting
of the technology bubble, the terrible terrorist
attacks, and then the 2002 corporate bond
dislocation. By the time
accounting irregularities surfaced in 2004, GSE
assets had almost reached $3 trillion.
I
also have a hunch with regard to Alan Greenspan's
now infamous prodding, when he was Fed chairman,
of households into adjustable-rate mortgages. I
think he recognized clearly the degree to which
the impaired GSEs (and their scantily capitalized
counterparties) had become acutely vulnerable to a
rise in market yields. As the Maestro, his
interest-rate policies (market manipulations)
orchestrated a massive shift of interest-rate risk
from the financial sector to the household sector.
In the process, however, recklessly low interest
rates spurred unprecedented mortgage lending and
speculative excesses that today imperil borrower,
lender, leveraged speculator and system stability
alike.
Affront to credit
pricing Somewhere along line, I think the
Fed came to appreciate the extent to which they
had delegated monetary (mis-) management to the
agencies (and their Wall Street enthusiasts).
Meantime, some politicians belatedly came to
recognize what an affront the GSEs had become to
the pricing and allocation of system credit, as
well as to the functioning of free markets more
generally. Especially after the 2004 revelation of
massive fraud and gross system inadequacies, a
consensus developed in Washington that the GSEs
needed both restraint and a powerful regulator
(although the legislative details were much too
slow to materialize). Apparently, all these
justifiable concerns were chucked out the window
this week in the name of "system stability".
After first reaching $2 trillion in 1999,
Fannie and Freddie’s combined books of business
surpassed $5.0 trillion in January. This "book"
increased $638 billion, or 16%, last year, in what
will surely be the greatest transfer yet of risky
mortgage credit to the GSEs (only to be greatly
outdone in 2008). Interestingly, OFHEO, Washington
politicians, and Wall Street analysts are keen to
play a dangerous game pretending that there is
limited risk in guaranteeing MBS (as opposed to
the obvious risk associated with mortgages
retained on their balance sheet). The absurdity of
Mr Lockhart stating that the GSEs will be in a
position to take on an additional $2 trillion of
mortgage risk this year is simply
incomprehensible. Keep in mind that the GSEs are
on the hook for the "timely payment of principle
and interest" on more than $5 trillion of American
mortgages - and counting … Such obligations will,
in the post-bubble era, prove untenable.
I
remember when my old analytical nemesis Paul
McCulley would refer to himself as a "populist" (I
still prefer my "inflationist" characterization).
Well, where are our "populist" statesmen today?
The average American is getting slammed by rapid
inflation in the prices for fuel, food,
healthcare, education and other basis necessities.
He was duped into various dangerous mortgage
products to purchase homes with, in many cases,
grossly inflated market values. Millions are in
the process of losing virtually everything.
The average American was also duped into
various risky investment products, while the
bursting of bubble markets will leave him
dreadfully unprepared for retirement. Now, he is
seeing the returns from his savings crushed by the
melee to bailout Wall Street "money changers" and
speculators. Over the coming months, millions will
lose their jobs with the inevitable adjustment and
realignment to cope with post-bubble realities.
And now, apparently, the American taxpayer is to
sit back and watch his contingent liabilities
balloon (even further) with the nationalization of
the US mortgage market.
I understand
perfectly the motivation Wall Street, the
administration and the Fed have in blindly
throwing the kitchen sink at this unfolding
crisis. These are indeed scary times bereft of
solutions. I am certainly familiar with the view
that bailing out Wall Street and the speculators
is medicine necessary to stabilize the system. But
not only is this approach both inequitable and
unethical on moral grounds, it is my view that
such endeavors will prove only further
destabilizing for the system overall.
Many
this past weekend were undoubtedly relieved by the
market's strong rally. The Fed and administration
finally are said to have discovered the right
antidote - crisis resolved - buy financial stocks!
I will caution, however, that US and global
markets this week had "dislocation" written all
over them.
First of all, there is the
issue to resolve of a problematic dislocation in
the massive "repo" market (involving agreements in
which the seller of securities agrees to buy them
back at a specified time and price). We all should
hope and pray that this is not the next
contemporary financing market buckling under the
forces of contagion. And to see commodities break
down while financial stocks go into spectacular
melt-up mode forebodes only greater losses for
leveraged speculators in the troubled "market
neutral" and "quant" arenas.
The short
financials and long commodities "pairs trade" was
quickly added to the list of favorite trades gone
sour. And those (and there were many) using March
options (especially financial sector derivatives)
to hedge market risk saw this strategy go up in
flames as well. Speculators that were long
international markets against shorts in the US
were similarly crushed. And speculators hedging
with short positions in agency, agency MBS, and
many other fixed-income derivative indices quickly
found themselves on the wrong side of hasty
developments.
Surely, policymakers were
keen to mete out some punishment on the
increasingly destabilizing "systemic risk trade"
(shorting stocks, bonds, credit derivative
indices, buying bearish derivative products,
etc.), but the upshot was only further
destabilization.
News that the GSEs were
back in the game in a big way added to an already
highly unsettled situation for myriad
sophisticated trading strategies. But before
getting too excited about the spectacular
short-squeeze, keep in mind that shorting has
become an instrumental facet of leveraged
speculator trading strategies - and, really,
contemporary finance more broadly speaking. And
the disintegration of an ever increasing number of
hedge fund and Wall Street strategies, as I’ve
written previously, remains at the heart of
deepening monetary disorder.
Not
surprisingly, the Fed could not risk a Bear
Stearns failure - not with all of its derivative,
repo and counterparty exposures. It really was not
a difficult fix. Yet the rapidly lengthening line
of vulnerable non-bank lenders (Thornburg, CIT
Group, and Rescap come immediately to mind) and
hedge funds will pose a greater challenge. There
are some very substantial balance sheets at risk
and significantly more "de-leveraging" in the
offing - and the big banks will have no appetite.
The S&P500 is down a modest 7% from
the much-changed financial and economic world of
one year ago. While having little impact on the
unfolding credit crisis (or home prices),
policymakers have thus far largely succeeded in
sustaining inflated US stock prices. But, in
reality, the profound deterioration in the US and
global credit backdrop has greatly altered
prospects for the vast majority of companies,
industries, and the US and global economies more
generally.
Unsustainable
credit Despite any number of policy actions
and all the good intentions imaginable, there is
absolutely no way that the US financial system
will now be capable of sustaining either the
(pre-bust) quantity of credit or the uniform flow
of finance that levitated bubble economy asset
prices, household incomes, corporate cash-flows,
"investment" spending or consumption.
Huge
sections of the credit infrastructures (notably
throughout Wall Street-backed finance) are
inoperable and discredited. Prominent monetary
processes have been broken and the resulting flow
of finance radically revamped.
Prospective
credit and financial flows will prove insufficient
for scores of companies, as well as for state and
local governments and various entities all along
the economic food chain. Enormous numbers of
business downsizings and failures - many by
companies that thrived during the bubble era -
will lead to huge losses of jobs and incomes (many
at the "upper end" where the greatest excesses
transpired).
I simply see no way around it
- nationalization of US mortgages notwithstanding.
It is fundamental to my analytical framework that
efforts to subvert the unavoidable adjustment
process only extend the misallocation of finance
and real resources, while adding greatly to the
future burden of the financial institutions today
aggressively intermediating very risky
pre-adjustment credit (certainly including the
banking system and GSEs). And I certainly don’t
believe this week’s rally in the dollar should be
viewed as a vote of confidence for the direction
of US policymaking. Nationalization will prove a
further blow to already fragile confidence.
WEEKLY WATCH The NYSE Financial
Index declined 2.1% Monday, jumped 6.8% Tuesday,
fell 2.3% Wednesday and then surged 5.0% Thursday.
The Bank Index jumped 10.2% in this extraordinary
four-day trading week (down 3.1% y-t-d). Morgan
Stanley gained 20.4%, Lehman Brothers 19.3%, and
Goldman Sachs 12.7%. The Homebuilder index jumped
13.3% (up 13.4% y-t-d), and the Morgan Stanley
Retail index rose 7.7% (down 1.9%). For the week,
the Dow gained 3.3% (down 6.8%) and the S&P500
3.1% (down 9.5%). The Transports surged 4.3% (up
3%), and the Morgan Stanley Cyclical index gained
0.6% (down 8.5%). The Utilities added 0.3% (down
11.1%), and the Morgan Stanley Consumer index
increased 1.3% (down 6.5%). The small cap Russell
2000 gained 2.7% (down 11%), and the S&P400
Mid-Caps rose 1.1% (down 10.3%). The NASDAQ100
gained 2.2% (down 16%), and the Morgan Stanley
High Tech index advanced 1.6% (down 16%). The
Semiconductors added 0.4% (down 16.7%). The
Street.com Internet Index gained 2.9% (down
11.5%), and the NASDAQ Telecommunications index
increased 0.8% (down 12.5%). The Biotechs gained
1.1% (down 11.6%).
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
