Page 1 of 3 CREDIT BUBBLE BULLETIN The cost of credit seizure
Commentary and weekly watch by Doug Noland
I've been eagerly awaiting the first-quarter 2008 Federal Reserve "flow of
funds" credit report. In particular, I have been keen to explore two key first
quarter dynamics. First, Q1 was historic for the breakdown in Wall Street
finance and the freezing up of most securitization markets. Second, the US
bubble economy was notably resilient in the face of extreme credit market
tumult. The question then became: What types and sources of credit took up the
slack?
To begin with, non-financial debt growth (NFDG) expanded during the quarter at
a respectable 6.5% annualized rate, a rate sufficient to at least keep the
general economy from sinking into negative "output" growth. And while 6.5% was
a meaningful decline from Q4’s 7.5%, I'll note that it compares with an annual
average of
5.4% NFDG growth throughout the decade of the nineties.
Examining Q1 non-financial credit growth in somewhat more detail, total
household debt growth slowed sharply to 3.5% from Q4's 6.1%, as household
mortgage borrowings growth was cut almost in half from Q4’s 5.8% to 3.0%. Yet
this was largely offset by a notable 9.2% annualized expansion in total
business debt growth (down from Q4’s 10.8%), along with a 9.5% rate of federal
debt expansion (up from Q4’s 5.1%). At the same time, state and local debt
expanded 6.4% annualized during Q1 (down from Q4's 7.7%) - this despite turmoil
throughout the muni debt markets.
Not surprisingly, financial sector debt growth (FDG) slowed sharply. After
expanding 15.8% annualized during 2007’s Q3 and 8.8% in Q4, FDG slowed to a
5.1% pace during the first quarter. This is largely explained by contractions
in both asset-backed securities (ABS) and open market paper (chiefly commercial
paper).
These days, in particular, useful perspective is garnered from examining credit
data at seasonally adjusted and annualized rates (SAAR). Total net borrowing
(non-financial and financial) expanded at a SAAR US$3.115 trillion during Q1.
This was down meaningfully from Q4's $3.693 trillion and 2007's annual $4.055
trillion increase. For perspective, however, one can compare Q1's rate of
credit expansion to 2006’s $3.875 trillion, 2005’s $3.414 trillion, 2004's
$3.057 trillion, 2003’s $2.771 trillion, and 2002’s $2.362 trillion.
Importantly for the real economy, non-financial credit market borrowings slowed
only moderately to $2.036 trillion during Q1 (down from Q4’s $2.316 trillion
and 2007's annual $2.367 trillion), although this should be noted as
significant growth in the face of the period’s severe credit market stains. It
is worth noting that annual non-financial credit growth surpassed $1.0 trillion
for the first time in 1998 and $2.0 trillion for the first time in 2005.
Non-financial debt growth averaged $701 billion annually during the nineties,
and despite the mortgage bust and credit turmoil the system is still currently
running at about three-times this pace.
Divergence
A key theme of Q1 analysis is the divergence between the marked slowdown in
asset-based lending and the continued readily available finance for much of the
real economy. Total mortgage debt (TMD) expanded SAAR $581 billion, down from
Q4's SAAR $988 billion and 2007’s growth of $1.092 trillion. In percentage
terms, TMD expanded at a 3.6% pace, with household mortgage debt increasing at
a 2.4% rate and commercial at 6.8%. Over the past year, TMD expanded 6.9%, with
household mortgage debt expanding 5.4% and commercial 12.2%.
The breakdown in the market for Wall Street "private-label" mortgages is
evident in Q1’s contraction in ABS. Through the first eight years of this
decade, the ABS market had almost doubled in size. The greatest excesses were
in 2005 and 2006, years of 25.7% and 23.6% growth, respectively. Growth slowed
markedly to 4.4% last year, with Q4 posting an actual decline. The ABS market
contracted at a 7.4% rate during Q1, or SAAR negative $305 billion to $4.148
trillion - reflecting the profound tightening of credit for non-conventional
mortgages. The ABS market has posted no growth over the past year (at $4.148
trillion).
The expansion of guarantees and balance sheets of GSE (government sponsored
enterprises such as mortgage agencies Fanny Mae and Freddie Mac) certainly took
up considerable credit slack. Growth in the (conventional) agency MBS market
slowed as well, from Q4’s overheated 20.8% rate to Q1’s still strong 11.7%.
This placed one-year growth at a notable $639 billion, or 16.2%, to $4.595
trillion. GSE (holdings) growth slowed from Q4’s 11.7% to 5.8%. GSE holdings
have expanded $332 billion, or 11.5%, over the past year to $3.220 trillion.
Interestingly, broker/dealer assets posted double-digit growth during the
quarter (by choice?). After contracting at a 13.7% annualized rate during Q4,
the broker/dealers expanded at an 11.8% rate during Q1 to $3.183 trillion.
One-year growth has been reduced to 5.4%, although two-year broker/dealer
growth remains a notable (and problematic) 39%. Examining broker/dealer asset
growth for the quarter, credit market instruments expanded at a 33% annualized
rate to $869 billion, and securities credit grew at a 45% rate to $363 billion.
On the liabilities side, "securities repo" expanded at a 20% rate to $1.205
trillion.
Money fund assets expanded at a 46% annual rate during the quarter to $3.408
trillion. In SAAR terms, assets expanded at an unprecedented $1.549 trillion,
up from Q4’s SAAR $820 billion. By asset category, agency and GSE securities
expanded SAAR $463 billion, Treasury securities SAAR $374 billion, open market
paper SAAR $270 billion, and corporate bonds SAAR $114 billion. Over the past
year, money fund assets ballooned $1.018 trillion, or 42.6% (two-year growth
69%). This risk intermediation has played an instrumental if unheralded role in
sustaining general credit expansion.
It was, as well, an interesting quarter for the banking sector. Bank assets
expanded at a 10.0% rate during the quarter, down somewhat from Q4’s 11.3%. In
SAAR terms, bank assets increased $710 billion during the quarter, to $11.474
trillion. Bank assets posted a one-year gain of 12.6% ($1.285 trillion) and
two-year rise of 20.7% ($1.970 trillion). During Q1, total loans expanded SAAR
$336 billion and miscellaneous assets SAAR $324 billion. Mortgages expanded
SAAR $299 billion, down from Q4’s SAAR $518 billion. Securities credit dropped
SAAR $203 billion, after increasing SAAR $103 billion during Q4. Holdings of
both Treasuries and agencies declined modestly during the quarter, offset by
increases in municipal and corporate bonds.
Clearly, the breakdown of key securitization markets was mitigated during the
quarter by double-digit growth in bank assets, agency MBS, broker/dealer assets
and money fund assets. One can also safely assume that such strong growth in
key financial sectors goes far in explaining the resiliency of the US bubble
economy in the face of imploding Wall Street finance. Yet there are obvious
questions revolving around the sustainability and consequences of such
expansion.
Drag on consumption
As usual, the household (and non-profit) balance sheet provides important clues
regarding the underlying performance of the US bubble economy. During Q1,
household assets declined $1.590 trillion (8.8% annualized) to $70.466
trillion, led by a $1.334 trillion (11.8% annualized) fall in financial assets
values and a $305 billion (5.5% annualized) drop in real estate. And with
liabilities increasing $106 billion (3% annualized), household net worth
contracted a meaningful $1.696 trillion (11.8% annualized). Over the past year,
household assets have increased only $309 billion (0.4%). And with liabilities
growing $871 billion (6.8%), household net worth dropped $563 billion from a
year earlier. This is in sharp contrast to the almost $12.0 trillion surge in
household net worth during the preceding three years.
This negative wealth effect has and will continue to place a drag on
consumption. It should be noted, however, that so far resilient 4.5%
year-on-year income growth has worked somewhat to bolster spending in the face
of declining wealth.
First quarter data provide important corroboration for my contention that the
US bubble economy is sustained only by huge ongoing credit growth - unusually
risky ("pre-economic adjustment") credit that must increasingly be
intermediated by the banking system, the GSEs and the money fund complex.
With Wall Street finance having lost its perceived "moneyness", the ongoing US
credit expansion will only be sustained by rampant growth of instruments that
retain the perception of safety and liquidity - namely, Treasuries, agency debt
and MBS, bank liabilities and money fund "deposits". And, at least for the
first quarter, double-digit growth virtually across all these key sectors
generated the necessary SAAR $2.036 trillion of non-financial credit and SAAR
$3.115 trillion of total system credit to prop up an acutely vulnerable
economic bubble. But at what cost? And for how long does today's functional
"money" - being inflated at double-digit rates through the intermediation of
risky credits - retain its "moneyness"?
The Rest of World (ROW) page of the Fed’s Z.1 report always provides a good
place to start when it comes to trying to gauge the scope of the global
"recycling" effort required to redirect excess dollar liquidity back to the US
financial sector. On average, ROW acquired $166 billion of our credit market
Instruments annually during the nineties to "recycle" our current account
deficits and speculative dollar outflows.
These purchases jumped to $467 billion in 2002, $583 billion in 2003, $854
billion in 2004, $749 billion in 2005, $855 billion in 2006, and $827 billion
in 2007. And despite the weak dollar, a rapidly slowing economy, and severe US
credit tumult the intractable dollar "recycling" requirement had ROW acquiring
US credit instruments at a stunning SAAR $996 billion during the quarter. This
is an enormous US and global problem.
Total ROW holdings of US financial assets have expanded $1.383 trillion over
the past year to $15.507 trillion. It is no coincidence that this growth
closely matches the increase in international reserve assets over the past year
($1.426 trillion). And the various forms of acute global monetary disorder that
have taken root are certainly a consequence of this increasingly unwieldy pool
of excess global finance. Crude oil and energy prices have surged better than
40% so far this year (natural gas up 70%), with the Goldman Sachs Commodities
Index sporting a year-to-date gain of 38%.
Moreover, the end-of-week's moon shot in crude and commodities provides further
warning as to the newfound degree of global price instability that has emerged
from a dysfunctional US credit mechanism and global financial "system".
It was a week where Mr Trichet warned that inflationary pressures may force the
ECB to raise rates again. Central banks around the world are feeling increasing
pressure to tighten. Here at home, chairman Bernanke voiced the Fed’s concern
with the inflation backdrop, while making notable comments to support of the
dollar. The markets took Mr Trichet’s comments seriously and, not surprisingly,
essentially disregarded Mr Bernanke. The Fed has left itself no leeway - and
little credibility.
Bernanke also suggested that sustainable US economic growth would be the most
important factor supporting the dollar. I’ll continue to argue passionately
that the current trajectory of US credit expansion and today’s unsound economic
structure are highly inflationary and a dollar disaster. Importantly, today’s
dollar outflows hit a world already inundated with excess dollar balances - not
to mention domestic credit excesses that become extreme almost across the
globe.
It is also my view that current monetary processes and the trajectory of US and
global imbalances ensure ongoing ballooning of the massive global pool of
speculative finance. Indeed, this "pool" is at the epicenter of today’s most
intense inflationary and speculative biases, biases that are being thrust to
blow-off extremes by the latest round of aggressive (and misguided) Fed
reflation (think NASDAQ 1999 and US mortgages 2006).
There were developments last week that seemed to indicate an important
inflection point may have been reached. Energy price instability took a decided
turn for the worst; global inflationary concerns ratcheted higher; dollar
vulnerability reemerged; financial stocks were crushed; and, importantly, the
US credit system demonstrated its greatest instability in a couple of months.
And while the US bubble economy has proved relatively resilient thus far,
sinking stock prices and a further tightening of financial conditions would at
this point prove too much to bear. I’ll also venture a presumption that all the
excitement, along with the unwind of hedges, instigated by the Fed’s March
bailouts could now prove a source of added instability. Clearly, rampant
speculation has taken hold and should be expected to remain well-embedded until
the bust.
To be sure, there are huge costs associated with endeavors to sustain a bubble
economy. Some are now readily apparent.
WEEKLY WATCH
Volatility, heightened "Monetary Disorder", and, seemingly, acute systemic risk
have returned. For the week, the Dow dropped 3.4% (down 8.0% y-t-d), and the
S&P500 was hit for 2.8% (down 7.3%). The Economically-sensitive issues were
under pressure. The Transports declined 3.4% (up 14.9%) and the Morgan Stanley
Cyclicals dropped 4.1% (down 6.0%). The Utilities fell 2.0% (down 5.8%), and
the Morgan Stanley Consumer index declined 2.4% (down 6.8%). The broader market
held together better. The small cap Russell 2000 declined 1.1% (down 3.4%), and
the S&P400 Mid-Caps dipped 0.9% (up 1.8%). Technology stocks held their
own. The NASDAQ100 declined 2.1% (down 4.5%), and the Morgan Stanley High Tech
index fell 2.4% (down 3.1%). The Semiconductors declined 2.3% (down 0.6%), the
Street.com Internet Index 2.1% (down 2.5%), and the NASDAQ Telecommunications
index 1.6% (up 1.8%). The Biotechs gained 1.1% (down 2.4%). Financial stocks
were under heavy selling pressure. The Broker/Dealers dropped 3.6% (down 21.9%)
and the Banks 8.2% (down 21.4%). With bullion jumping $15.70, the HUI Gold
index increased a modest 2.3% (up 5.4%).
One-month Treasury bill rates dropped 21 bps this week to 1.75%, and 3-month
yields declined 8 bps to 1.83%. Two-year government yields fell 37 bps to
2.38%. Five-year T-note yields sank 25 bps to 3.18%, and 10-year yields fell 10
bps to 3.92%. Long-bond yields declined 9 bps to 4.63%. The 2yr/10yr spread
widened 12 to 154 bps. The implied yield on 3-month December ’08 Eurodollars
declined 8.5 bps to 3.025%. Benchmark Fannie MBS yields held about unchanged at
5.70%. This pushed the spread between benchmark MBS and 10-year Treasuries a
notable 14 wider to 179 bps (high since mid-April). Agency debt spreads widened
to levels not seen since mid-March. The spread on Fannie’s 5% 2017 note widened
15 bps to 72 bps, and the spread on Freddie’s 5% 2017 note widened 16 bps to 72
bps. The 10-year dollar swap spread increased 10 to 75 (high since March 11).
Corporate bond spreads were wider as well. An index of
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