Page 1 of 3 CREDIT BUBBLE BULLETIN In short, crisis reaches bedrock level
Commentary and market watch by Doug Noland
The benchmark yields on Fannie Mae mortgage-backed securities last week jumped
31 basis points (bps) to an 11-month high 6.15%. Spreads versus treasuries
widened 18 bps to the widest level (206bps) since the height of the crisis in
March. Also last week, the SEC took an extraordinary step to tighten the rules
for shorting the large financial stocks. These developments are not unrelated.
In JPMorgan Chase's and Citigroup's earnings conference calls, both major
lenders last week noted deterioration in prime mortgages. This provides
additional confirmation that the mortgage crisis is now reaching the bedrock of
our nation's mortgage credit system. And particularly with the mortgage
insurers, the government-sponsored enterprises such as Fannie Mae and Freddie
Mac, and the leveraged-speculation community having come under varying degrees
of stress, a tightening in "conventional" mortgages will now significantly
exacerbate the mortgage/housing/financial/economic crisis.
In years past, I have occasionally used my fictional "town by the river"
analogy to demonstrate how the introduction of inexpensive flood insurance and
a resulting speculative boom in writing this protection fostered a building
boom along the river. The financial (insurance, lending and speculation) and
economic (building, asset inflation, and spending) aspects of the boom were
interrelated and reinforcing. In my fictional account, the booms were further
spurred by a drought that both inflated the profitability of writing risk
insurance (attracting throngs of speculative players) and buoyed complacency
for those living, building, and spending freely near the water's edge.
These dynamics set the stage for the inevitable dislocation in the flood
insurance market. With the arrival of the first torrential rains, there was a
panic as the thinly capitalized "insurers" rushed in a futile attempt to
re-insure their risk of potentially catastrophic losses in the event of a flood
along what had become a highly over-developed river bank. Few in the insurance
market had built reserves, as most speculators simply planned on hedging flood
risk in what was, at least the time of the boom/drought, a highly liquid
insurance marketplace. Worse yet, over time the pricing of flood protection had
become grossly inadequate with respect to the mounting ("bubble") risks that
had developed over the life of the financial and economic booms. Any
reinsurance available during the crisis was priced prohibitively.
Back in 1990, when I first began working on the short-side, there was an
estimated US$50 billion to $60 billion in the hedge fund community. The few of
us actually shorting stocks were primarily focused on diligent fundamental
company "micro" research and analysis. It was not until some years later that
"market neutral" and "quant" strategies took the financial world by storm. And
back in the early nineties the OTC (over-the-counter) derivatives industry was
just starting to take hold. Today's Wild West credit default swap (CDS)
marketplace didn't even exist.
Nowadays, the "leveraged speculating community" is measured in the
multi-trillions; the derivatives market in the hundreds of trillions. The scope
of players and sophisticated strategies utilizing short-selling is unlike
anything previously experienced in the markets. And similar to how drought
magnified the boom along the river, it was the boom in leveraged speculation
and derivatives that played the instrumental role in fueling self-reinforcing
credit expansion and the resulting credit, asset price and economic bubbles.
But those bubbles are bursting - the torrential rains are falling and there is
today extraordinary and overwhelming impetus to "reinsure" - to offload - the
various risks that ballooned over the life of the protracted boom.
Many of those who write the multitude of types of market insurance incorporate
"dynamic hedging" strategies. This means that few hold little in the way of
actual "reserves" to pay in the event of major losses. Instead, they rely on
"shorting" various securities that, in a declining market, will provide the
necessary cash-flow to satisfy any insurance obligations.
This all worked wonderfully in theory, and the basic premise of modern-day
risk-hedging capabilities was supported by the nature of highly liquid
boom-time financial markets. But "torrential rains" have a way of rapidly and
dramatically altering marketplace liquidity. The reality is that entire markets
cannot insure themselves again declines. Any attempt by a large swath of the
marketplace to hedge exposure will be problematic. Selling will either
immediately overwhelm the market or the "put options" accumulated as protection
will create acute market vulnerability to self-reinforcing selling pressure and
market dislocation.
Today, there is little liquidity in the securitization or corporate bond
markets. So the multi-trillions of strategies relying on shorting securities
for hedging and speculating purposes have gravitated to the relative liquidity
of US equities. And, when it comes to hedging against or seeking profits from
heightened systemic risk, one can these days see rather clearly how incredible
selling pressure can come down hard on the 19 largest US financial
institutions.
And when one considers the scope of derivative strategies that incorporate
"delta hedging" trading dynamics - where the amount of selling/shorting
increases as the market declines (systemic risk increases) - one recognizes the
possibility of a marketplace dislocation along the lines - but significantly
more systemic - than the "portfolio insurance" fiasco that fueled the 1987
stock market crash.
Importantly, this issue of acute systemic risk has taken a turn for the worst
with the recent deterioration in the conventional mortgage market. The highly
exposed GSEs, mortgage insurers, and leveraged speculators are positioned
poorly to withstand a bust in prime mortgages. The fate of the US bubble
economy today rests on the ongoing supply of low-cost "prime" mortgages. Any
meaningful tightening in conventional mortgage credit - including the lack of
availability of mortgage insurance, required larger down payments, and/or
tougher credit standards - would have a major impact on credit availability for
core housing markets throughout the country (many that have thus far held
together fairly well).
Such a tightening would put significant additional downward pressure on prices,
exacerbating already escalating problems for the GSEs, credit insurers, and
speculators.
WEEKLY WATCH
For the week, the Dow surged 3.6% (down 13.3% y-t-d) and the S&P500 gained
1.7% (down 14.1%). The Transports rallied 4.8% (up 9.5%), while the Utilities
sank 4.3% (down 9.2%). The Morgan Stanley Cyclicals jumped 4.1% (down 15.5%),
and the Morgan Stanley Consumer index increased 1.9% (down 6.7%). The small cap
Russell 2000 rose 2.7% (down 9.5%), and the S&P400 Mid-Caps gained 1.6%
(down 6.7%). The NASDAQ100 added 0.7% (down 12.6%), and the Morgan Stanley High
Tech index rallied 2.6% (down 11%). The Semiconductors jumped 5.8% (down 11%),
and the Street.com Internet Index added 0.1% (down 11.4%), while the NASDAQ
Telecommunications index dipped 0.3% (down 12.4%). The Biotechs gained 4.2% (up
1.1%). Financial stocks went into melt-up mode. The Broker/Dealers surged 14.4%
(down 25.8%), and the Banks jumped 14.8% (up 29.1%). With Bullion declining
$9.0, the HUI Gold index fell 3.8% (up 6.8%).
One-month Treasury bill rates dropped 13 bps this week to 1.27%, and 3-month
yields fell14 bps to 1.465%. Meanwhile, two-year government yields rose 6 bps
to 2.65%. Five-year T-note yields jumped 14 bps to 3.42%, and 10-year yields
increased 13.5 bps to 4.095%. Long-bond yields increased 12 bps to 4.66%. The
2yr/10yr spread increased 8 to 144 bps. The implied yield on 3-month December
'09 Eurodollars surged 29.5 bps to 4.19%. Benchmark Fannie MBS yields surged a
remarkable 31 bps to 6.15%. The spread between benchmark MBS and 10-year
Treasuries widened 18 to 206. The spread on Fannie's 5% 2017 note widened 4 bps
to 73 bps, and the spread on Freddie's 5% 2017 note widened 4 bps to 73 bps.
The 10-year dollar swap spread increased 8 to 76. Corporate bond spreads were
mixed. An index of investment grade bond spreads narrowed 3 to 145 bps, and an
index of junk bond spreads narrowed 8 to 549 bps.
Investment grade issuance this week included Walgreen $1.3bn, Pacificorp $800
million, and Entergy $300 million.
Junk bond funds reported $70.6bn of outflows this week. Junk issuers included
Intelsat $1.25bn, CRH America $650 million, Ticketmaster $300 milion, PPL
Energy Supply $300 million, and HSN $240 million.
Convert issuers this week included Sino-Forest $300 million and Trina Solar
$120 million.
International dollar bond issuance included Ukrsibbank $250 million.
German 10-year bund yields surged 14 bps to 4.57%. The German DAX equities
index rallied 3.7% (down 20.9% y-t-d). Japanese 10-year "JGB" yields slipped 4
bps to 1.565%. The Nikkei 225 declined 1.8% (down 16.4% y-t-d and 28.9% y-o-y).
Emerging markets were mixed. Brazil's benchmark dollar bond yields rose 7 bps
to 5.95%. Brazil's Bovespa equities index slipped 0.3% (down 6.1% y-t-d). The
Mexican Bolsa gained 2.0% (down 4.6% y-t-d). Mexico's 10-year $ yields added
one basis point to 5.52%. Russia's RTS equities index fell 1.5% (down 6.8%
y-t-d). India's Sensex equities index gained 1.2%, with y-t-d losses of 32.8%.
China's Shanghai Exchange index dropped 2.7%, boosting 2008 losses to 47.2%.
Freddie Mac 30-year fixed mortgage rates dropped 9 bps to 6.26% (down 47bps
y-o-y). Fifteen-year fixed rates fell 13 bps to 5.78% (down 60bps y-o-y), and
one-year adjustable rates declined 7 bps to 5.10% (down 62bps y-o-y).
Bank Credit increased $16.9bn to $9.394 TN (week of 7/9). Bank Credit has
expanded $154bn y-t-d, or 3.3% annualized. Bank Credit posted a 52-week rise of
$801bn, or 9.3%. For the week, Securities Credit rose $14.7bn. Loans &
Leases increased $2.2bn to $6.888 TN (52-wk gain of $621bn, or 9.9%). C&I
loans added $2.0bn, with one-year growth of 20.3%. Real Estate loans dropped
$11.5bn (up 2% y-t-d). Consumer loans fell $2.5bn, while Securities loans
gained $9.8bn. Other loans were little changed.
M2 (narrow) "money" supply jumped $24.5bn to $7.699 TN (week of 7/7). Narrow
"money" has expanded $236bn y-t-d, or 6.1% annualized, with a y-o-y rise of
$442bn, or 6.1%. For the week, Currency increased $2.5bn, while Demand &
Checkable Deposits dropped $8.2bn. Savings Deposits jumped $22.6bn, and Small
Denominated Deposits added $3.2bn. Retail Money Funds increased $4.5bn.
Total Money Market Fund assets (from Invest Co Inst) declined $7.4bn to $3.498
TN, with a y-t-d increase of $385bn, or 23% annualized. Money Fund assets have
posted a one-year increase of $925bn (36%).
Asset-Backed Securities (ABS) issuance this week was stable at a slow $2.3bn.
Year-to-date total US ABS issuance of $112bn (tallied by JPMorgan's Christopher
Flanagan) is running at 27% of comparable 2007. Home Equity ABS issuance of
$303 million compares with 2007's $206bn. Year-to-date CDO issuance of $14.7bn
compares to the year ago $241bn.
Total Commercial Paper outstanding dropped $9.1bn this week to $1.750 TN, with
a y-t-d decline of $36bn. Asset-backed CP fell $5.5bn last week to $745bn,
increasing 2008's fall to $27.5bn. Over the past year, total CP has contracted
$445bn, or 20.3%, with ABCP down $433bn, or 36.7%.
Fed Foreign Holdings of Treasury, Agency Debt last week (ended 7/16) decreased
$2.1bn to $2.348 TN. "Custody holdings" were up $292bn y-t-d, or 25.4%
annualized, and $352bn year-over-year (17.6%). Federal Reserve Credit increased
$0.5bn to $888.4bn. Fed Credit has increased $14.9bn y-t-d (3.1% annualized)
and $34.6bn y-o-y (4.0%).
International reserve assets (excluding gold) - as accumulated by Bloomberg's
Alex Tanzi - were up $1.376TN y-o-y, or 24.6%, to a record $6.977 TN.
Global Credit Market Dislocation Watch
July 18 - Bloomberg (Jody Shenn): "Yields on agency mortgage securities
relative to US Treasuries rose to a four-month high on concern that financial
companies including Fannie Mae and Freddie Mac may need to sell the debt or buy
less of it. The difference between yields on Fannie Mae's current- coupon,
30-year fixed-rate mortgage bonds and 10-year government notes widened 5 bps to
206 bps ... Freddie Mac is considering selling assets carried below their value
to maintain acceptable capital ratios, it said today in a filing with the US
Securities and Exchange Commission."
July 13 - Wall Street Journal (Michael Corkery and James R. Hagerty): "At the
heart of the near-panic rocking Fannie Mae and Freddie Mac is a vicious cycle
gripping the US housing market. It starts with the oversupply of homes, which
is causing prices to plummet. Falling prices are leading to more foreclosures,
as homeowners have difficulty refinancing their mortgages or selling their
houses. Banks are reluctant to lend freely at a time when home values keep
sinking and defaults keep rising. That is crimping housing demand further and
leading to more price drops and defaults. This phenomenon ... began with
subprime borrowers but has gone well beyond the small segment of borrowers with
poor credit. It is now spreading to the much-larger market of prime borrowers,
which forms the bread and butter of Fannie's and Freddie's mortgage assets."
July 18 - Financial Times (Chris Flood): "Gold's appeal as a safe haven for
investors has again been rising amid widespread fears that the stability of the
global financial system is exhibiting renewed strains ... On Friday there was a
record one-day increase in holdings in gold exchange traded funds as Fannie Mae
and Freddie Mac, linchpins of the US mortgage market, threatened to collapse
and IndyMac Bank imploded - the third-largest financial institution to fail in
the US."
July 16 - Bloomberg (Josh P. Hamilton): "MGIC Investment Corp., PMI Group Inc.
and competing US mortgage insurers reeling from record claims may have to
absorb even higher loss rates from bad home loans, Fitch Ratings said. About
70% of the industry's policies cover loans issued from 2005 through 2007 when
mortgage and insurance underwriting standards were lax, leading to
progressively higher default rates, Fitch said. Mortgage insurers pay lenders
when borrowers default and foreclosure fails to recoup costs. 'The mortgage
insurance industry's troubles are not over and may, in fact, get worse,' Fitch
said ... The industry
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