Page 1 of 5 CREDIT BUBBLE BULLETIN End of an era
Commentary and weekly watch by Doug Noland
The Fed-orchestrated 1998 rescue of Long-Term Capital Management (and the
"leveraged speculating community") proved instrumental in instigating the
"golden age" of Wall Street finance. This on Thursday from the Wall Street
Journal (see Speculator Watch below): "Ten years after overseeing a hedge-fund
collapse that buckled the world’s financial markets, John Meriwether again is
scrambling to stem losses and keep investors from jumping ship. Mr Meriwether
is best known as a founder of Long-Term Capital Management …" Meriwether’s
largest hedge fund - profitable in each year since its 1999 launch - is down
28% year to date. The fund now surely faces investor redemptions, a problematic
high-water mark (hedge funds must make up for past
losses before they can again collect big performance fees) and a resulting
exodus of top talent.
Again this week, we see one of Wall Street’s most elder leveraged speculators
fall into serious trouble. A strategy that had worked so nicely for almost a
decade turned unworkable. While sharply reducing the risk profile and degree of
leverage from the LTCM days, Meriwether’s bond fund was nonetheless leveraged
14.9 to 1 (according to Jenny Strasburg’s WSJ article). As was the case with
the Peloton fund and others, the most aggressive use of leverage had navigated
to the perceived safest ("money-like") instruments - "His funds’ losing
positions have included mortgage securities backed by Fannie Mae and Freddie
Mac, trades tied to municipal bonds and triple-A-rated commercial
mortgage-backed securities".
Understandably, most fully expect Wall Street to rebound and the leveraged
speculating community to emerge from current turmoil as it did following LTCM -
albeit at a more measured pace. Some assume it’s merely a case of our
policymakers "playing whack a mole" until they find the requisite instrument(s)
to successfully beat down the sources of financial instability. Of course, I
view things very differently, instead seeing Meriwether’s predicament as
emblematic of an End of an Era - with huge ramifications for both the financial
and economic spheres.
I would expect it will be quite some time before the marketplace (investors as
well as lenders) grants Mr Meriwether or similar leveraged strategies another
shot at financial genius. Indeed, there is mounting evidence supporting the
bursting hedge fund bubble thesis - from the angle of the quality of underlying
assets; from the capacity to leverage; from the ability to retain investors;
and from a regulatory perspective. And keep in mind that the historic
ballooning in the leveraged speculating community has been an absolutely
instrumental - and extraordinarily opaque - facet of the bubble in Wall Street
finance and the overall credit bubble.
I would argue forcefully that the leveraged speculating community for some
years now has assumed the key role of unappreciated marginal source of demand
for risk assets - risky debt instruments financing asset inflation, in
particular. Over time, Wall Street "alchemy" mastered the process of
transforming virtually unlimited risky loans into perceived safe and liquid
securities. A sizable - and growing - chunk of these securities were then
purchased on leverage by the rapidly expanding speculator community, in the
process fueling an increasingly maladjusted US bubble economy. We’re now
witnessing it all beginning to wind down. End of an era.
It is today analytically imperative to differentiate the authorities’ focus on
stabilizing marketplace liquidity from the unfolding bursting of the Wall
Street bubble. Our policymakers may be exerting meaningful impact on the
former, yet the latter remains largely out of their control - and certainly
thus far impervious to their actions.
Especially when it comes to the key marketplace for agency securities,
policymaker efforts are directed at sustaining perceived "moneyness" - through
both governmental support (tacit guarantees and Fed liquidity operations) and a
renewed bid for mortgages by the GSEs (Fannie, Freddie, and the FHLB - the
Federal Home Loan Banks). And while such efforts have important ramifications
with regard to accommodating the ongoing de-leveraging process (and averting
credit system implosion), they are at the same time completely inadequate when
it comes to generating sufficient new credit to sustain US financial and
economic bubbles. "Moneyness" will definitely not be retained in non-agency
securitizations, especially as the economy falters.
Widening deterioration
Debt problems are accelerating and expanding from mortgages to home equity,
autos, credit card, student loans, small business finance, munis and corporate
credits. At the same time, Wall Street has been significantly tightening
lending requirements for leveraging of all types of debt instruments. While the
focus has been on mortgage credit, recent deterioration in other types of loans
- and, importantly, the leveraged holders of large amounts of this debt - have
major consequences for credit availability throughout the economic sphere.
Housing markets and foreclosures are obviously major issues. Not commonly
recognized is the now virtually across-the-board tightening in credit
throughout the securitization markets (consumer, student, muni, corporate,
etc), exerting more expansive headwinds upon the US economy than even the
tightening in mortgages (that predominantly impacted transactions and home
prices).
February California median home prices declined US$20,550 to $409,240. Median
prices are now down $67,140 in two months and a stunning $179,730 since August.
Prices are down 32% from June’s high, and are now even 13% below the level from
three years ago. Granted, these median prices are impacted by the dearth of
sales at the upper-end. Yet it’s clear that the California market is in the
midst of an historic crash. The credit standing of Golden State households,
businesses, and various governmental agencies now deteriorates virtually by the
day. I would argue the explosion over the past three years in "private-label"
mortgages, Wall Street balance sheets, hedge fund assets, and California home
prices were all part of the same bubble. This bubble inflated largely outside
the banking system and outside GSE finance - and will now prove stubbornly
unaffected by policy maneuvers.
Some argue rather forcefully that we’re now immersed in "debt deflation". I
understand the basic premise, but to examine double-digit growth in bank
credit, GSE "books of business" and money fund assets provides a different
perspective. To be sure, our credit system continues to provide sufficient
credit to finance massive current account deficits. And it is this ongoing
outflow of dollar liquidity that stokes both indomitable dollar devaluation and
global credit excess. Many contend that inflationary pressures are poised to
wane as the US economy weakens. I’ll suggest that inflation dynamics will prove
much more complex and uncooperative. There is further confirmation of this view
- that the bursting of the Wall Street finance bubble will have a significantly
greater impact on asset prices than on general consumer pricing pressures.
The analysis gets much more challenging in the commodities markets. The simple
view holds that commodities are just another bubble waiting their turn to
burst. This thinking gained greater acceptance last week, with the sharp
reversal of prices and unwind of speculative positions. And it goes without
saying that major speculative excess has developed throughout the commodities
complex ("par for the course"). I am as well sympathetic to the view that
liquidations by the leveraged speculating community could lead to some major
price instability. Yet it’s my sense that there really is much more to the
commodities story - and inflation, more generally - that is not widely
appreciated.
Deflationary spiral The bursting of the Wall Street finance and US credit bubbles marks an
end of an era. But the start of a deflationary spiral? Importantly, these
bursting bubbles are in the process of consummating the demise of the dollar as
the world’s functioning "reserve currency" and monetary standard. Examining
global markets, I note the ongoing strength of currencies in China, Russia,
Brazil and India for example. Considering mounting financial and economic
imbalances in all these economies - not to mention histories of less than
exemplary monetary management - I can state categorically that these are
fundamentally very weak currencies. Today, however, it’s all relative to the
sickly dollar. In the face of rampant domestic credit growth, these currencies
nonetheless attract endless global finance and appreciate.
When it comes to ending of eras, I am increasingly fearful that we are falling
deeper into a precarious period devoid of a functioning global currency regime
necessary to discipline credit excess and restrain mounting inflationary
pressures. And as long as dollar liquidity inundates the world economy,
domestic credit systems across the globe enjoy the extraordinary capacity to
inflate domestic credit and use this new purchasing power for the benefit of
their citizens and economies. And, in particular because of their enormous
populations, as long as the Chinese and Indian credit systems enjoy the freedom
to inflate at will there will remain significant upside pricing pressure for
energy, food, and various goods and commodities in limited supply - hedge fund
speculative excess and/or bust notwithstanding.
I throw this analysis out as food for thought. I am increasingly of the mind
that commodities should be differentiated from US financial assets when it
comes to the consequences from the bursting of the Wall Street finance and
leveraged speculating community bubbles. Prices will likely remain
hyper-volatile but (un-bubble-like) well-supported by underlying fundamental
factors. Similarly, I believe general inflationary pressures may likely prove
more significantly influenced by runaway global credit excesses than by the
Wall Street and US asset price busts.
If this proves to be the case, perhaps the greater risk is a bursting of the
Treasury market bubble. It may take some time, but an enormous supply of
government debt is in the offing and - let’s face it - these instruments will
become only less appealing over time. It also begs the question as to the
advisability of aggressive Fed rate cuts. They are having
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
