Page 1 of 5 CREDIT BUBBLE BULLETIN The Uppers
Commentary and market watch by Doug Noland
The US bubble economy has burst. I sympathize with those who would argue this
is old news, but the probabilities are now high that gross domestic product
turns decisively negative during the second half if it hasn't already. Instead
of the year-long credit crisis showing signs of improvement or even
stabilization, a further tightening of credit availability is taking hold
broadly throughout the economy.
The so-called "subprime" crisis has, of late, invaded "prime" and
"conventional" mortgages. This is a major additional blow for home prices and
the economic support provided from built-up
home equity. The securitization markets remain in shambles. Even corporate debt
issuance dropped to a five-year low in July. Meanwhile, the increasingly
impaired banking system has sharply curtailed lending virtually across the
board - to households, to students, and to businesses both small and large.
Bank credit is basically unchanged over the past nine weeks, and without
sufficient credit creation, the finance-driven US "services" economy is an
unmitigated bust. It is my view that this bust has over the past few weeks
gained critical - and self-reinforcing - mass.
The subprime mortgage fiasco provides a convenient poster child for this boom's
egregious excesses. I would argue, however, that its role in fueling the boom
was much less than presumed. It actually wasn't a critical source of finance
for the overall bubble economy. Or, stated differently, the relatively brief
period of subprime excess was not a major factor in the protracted period of
financial excess that spurred imbalances and deep structural economic
impairment. Likewise, last year's subprime bust wasn't a decisive development
for the bubble economy generally. Its overall impact on system employment and
incomes was not great - its effect on tax receipts only marginal.
I tend to view subprime as chiefly a "lower end" issue with respect to the real
economy, and it is my view that the greatest - as well as least appreciated -
bubble economy excesses were at The "Upper-middle" to "Upper-end." It is in The
Upper-ends where years of credit excess had the most pronounced effects on
incomes, household net-worth, spending and government revenues.
It was the at The Uppers where loose finance encouraged many to stretch to buy
the expensive home, to lease the luxury vehicle, and to finance the upscale
lifestyle - credit creation that then further stoked the overall economy and
asset markets. And it was the Uppers that enjoyed spectacular gains in income
and financial wealth. It was the momentous changes in Uppers' spending patterns
that spurred enormous real economy investments in a multitude of new businesses
and services - a great deal of this spending of the discretionary and luxury
variety. It was the Uppers' windfalls that encouraged state, local and federal
governments to rapidly boost spending. These were the inflationary distortions
that had a profound impact on the underlying economic structure - over years
spurring the transformation to a "services"-based bubble economy.
It is my view that the Uppers are now in the process of being hit with rapidly
tightening financial conditions. This year will see a historic decline in
financial sector compensation, led by collapsing Wall Street bonuses and
unprecedented layoffs throughout the financial services industry. This week
also saw the announcement of major "white collar" job losses at General Motors,
an employment trend that I expect to spread throughout the real economy. Many
companies and industries must today respond to collapsing profitability (as
financial conditions tighten and spending patterns and levels adjust), and
there will be no alternative than to shrink "Upper-end" employment and
compensation.
This week also saw evidence of a significant tightening of credit availability
for the Uppers. BMW, GM, Ford and Chrysler all announced that major changes in
vehicle leasing terms are in the offing - especially for SUVs. BMW apparently
has recognized that it is problematic that 60% of its US unit sales have been
leases. Surging gas prices and other economic worries have hit used-vehicle
residual values hard, turning the leasing business into a losing proposition.
Leasing terms are now being tightened significantly - a dynamic that will
further depress used-vehicle prices. It is worth noting that July new vehicle
sales were reported at the lowest level since 1992. They will most certainly go
lower.
This week also saw higher rates and additional withdrawal from the jumbo
mortgage marketplace (that is, those mortgages that exceed conventional
conforming loan limits and home-loan guarantors Fannie Mae and Freddie Mac do
not cover the whole loan amount). At 7.56%, 30-year fixed jumbo borrowing rates
this week were almost 100 basis points higher than a year ago. And one can
assume that lending standards continue to tighten, with downpayment
requirements putting many buyers out of the market for "Upper-end" homes in
neighborhoods throughout the country. Keep in mind that, to this point, home
prices have actually held up reasonably well in many locations, a dynamic that
will likely not withstand a further tightening of credit in prime jumbo and
conventional mortgages. A more broad-based downturn in housing prices will spur
a more broad-based decline in spending - especially for discretionary purchases
by The Uppers.
This week was also notable for bankruptcy announcements from a few national
restaurant and retail chains. Increasingly, the post-boom adjustment in
spending patterns is challenging the profitability of scores of businesses.
This dynamic is poised to feed on itself, as more business closures and layoffs
severely impinge incomes. What I expect to be rapidly deteriorating business
credit conditions will surely worsen the financial crisis.
For years now, the leveraged speculating community has profited handsomely from
taking leveraged positions in higher-yielding business loans. Borrowing from
Wall Street was easy, and it was just as easy during the boom to extend credit
to profitable (or at least cash flow positive) businesses. This dynamic is
changing profoundly. With business and economic prospects now deteriorating
rapidly, I would expect significant tumult to unfold in the corporate credit
market. A reversal of speculative flows away from leveraged business lending
would be a major blow to both corporate credit availability and the vulnerable
leveraged speculating community, a dynamic with negative ramifications for the
Uppers.
When it comes to states with huge exposure to Uppers, California and New York
sit at the top of the list. Not surprisingly, both states are today in the
grips of intense fiscal pressure. With my expectation that economic prospects
are now worsening by the week, it is not at all clear how California, New York
and other states will deal with ballooning deficits. Drastic spending cuts and
tax increases are inevitable to get budgets back somewhat in line with
post-boom receipts, and this will prove one more problematic dynamic for the
bursting US bubble economy.
WEEK AHEAD
For the week, the Dow dipped 0.4% (down 14.6% y-t-d), while the S&P500
added 0.2% (down 14.2%). The Morgan Stanley Cyclicals jumped 1.6% (down 14.5%),
and the Morgan Stanley Consumer index added 0.7% (down 9.2%). The Transports
slipped 0.2% (up 8.3%), and the Utilities declined 2.1% (down 13.3%). The
broader market rally continued. The small cap Russell 2000 gained 0.8% (down
6.5%), and the S&P400 Mid-Cap index rose 0.7% (down 6.7%). The NASDAQ100
declined 1.1% (down 12.4%), while the Morgan Stanley High Tech index gained
0.7% (down 11%). The Semiconductors recovered 0.2% (down 17.1%). The Street.com
Internet Index dipped 0.4% (down 11.1%), and the NASDAQ Telecommunications
index slipped 0.2% (down 6.6%). The Biotechs rose 1.9%, boosting 2008 gains to
8.0%.The financial stocks rallied sharply. The Broker/Dealers gained 4.9% (down
26.8%), and the Banks rallied 6.4% (down 24.1%). With Bullion sinking $20, the
HUI Gold index dropped 4.6% (down 4.7% y-t-d).
One-month Treasury bill rates sank 19 bps this week to 1.51%, and 3-month
yields fell 9 bps to 1.66%. Two-year government yields dropped 22 bps to 2.49%.
Five-year T-note yields declined 21 bps to 3.21%, and 10-year yields fell 17
bps to 3.93%.Long-bond yields dropped 13 bps to 4.56%. The 2yr/10yr spread
widened 5 to 144 bps. The implied yield on 3-month December '09 Eurodollars
sank 31 bps to 3.795%. Benchmark Fannie MBS yields declined 14 bps to 5.94%.
Yet the spread between benchmark MBS and 10-year Treasuries widened 3 to a
notable 200 bps. The spread on Fannie's 5% 2017 note widened 10 bps to 71 bps,
and the spread on Freddie's 5% 2017 note widened 10 bps to 72 bps. The 10-year
dollar swap spread increased 2.75 to 72.25. Corporate bond spreads were mixed
to wider. An index of investment grade bond spreads narrowed 2 to 140 bps,
while an index of junk bond spreads widened 4 to 563 bps.
Investment grade issuance this week included Berkshire Hathaway $1.0bn,
Autozone $750 million, General Mills $700 million, and Coca-Cola Enterprises
$300 million.
Junk issuers included Commercial Metals $500 million, Roper Industries $500
million, and Ferrellgas $200 million.
Convert issuers this week included XM Satellite $550 million, Affiliated
Managers $400 million, and PSS World Medical $200 million.
International dollar bond issuance included Rogers Communications $1.75bn and
Lebanon $500 million.
German 10-year bund yields sank 25 bps to 4.35%. The German DAX equities index
dipped 0.6% (down 20.7% y-t-d). Japanese 10-year "JGB" yields declined 6 bps to
1.51%.The Nikkei 225 fell 1.8% (down 14.5% y-t-d and 22.4% y-o-y). Emerging
markets were mixed. Brazil's benchmark dollar bond yields declined 3 bps to
5.88%.Brazil's Bovespa equities index rallied 0.8% (down 9.8% y-t-d). The
Mexican Bolsa declined 0.5% (down 8.7% y-t-d). Mexico's 10-year $ yields fell
10 bps to 5.47%.Russia's RTS equities index declined 0.5% (down 15.2% y-t-d).
India's Sensex equities index rose 2.7%, narrowing y-t-d losses to 27.8%.
China's Shanghai Exchange index fell 2.2%, boosting 2008 losses to 46.7%.
Freddie Mac 30-year fixed mortgage rates dropped 9 bps to 6.52% (down 16bps
y-o-y). Fifteen-year fixed rates fell 11 bps to 6.07% (down 25bps y-o-y), and
one-year ARMs declined 22 bps to 5.27% (down 32bps y-o-y). Bankrate's survey of
jumbo mortgage borrowing costs had 30-yr fixed jumbo rates at 7.56%, a 3-week
increase of 36 bps and up 98 bps from a year earlier.
Bank Credit dropped $13.8bn to $9.403 TN (week of 7/23). Bank Credit has
expanded $190bn y-t-d, or only 3.6% annualized. Bank Credit posted a 52-week
rise of $762bn, or 8.8%. For the week, Securities Credit sank $26.9bn. Loans
& Leases increased $13.1bn to $6.923 TN (52-wk gain of $594bn, or 9.4%).
C&I loans declined $2.4bn, with y-t-d growth slowing to 8.0%. Real Estate
loans jumped $11.8bn (up 1.5% y-t-d). Consumer loans declined $1.4bn, while
Securities loans jumped $20.1bn. Other loans fell $14.9bn.
M2 (narrow) "money" supply surged $48.7bn to a record $7.747 TN (week of 7/21).
Narrow "money" has expanded $284bn y-t-d, or 6.8% annualized, with a y-o-y rise
of $468bn, or 6.4%. For the week, Currency increased $2.4bn, and Demand &
Checkable Deposits jumped $16.1bn. Savings Deposits rose $11.8bn, and Small
Denominated Deposits added $3.2bn. Retail Money Funds jumped $15.2bn.
Total Money Market Fund assets (from Invest Co Inst) declined $5.2bn to $3.502
TN, with a y-t-d increase of $389bn, or 21.7% annualized. Money Fund assets
have posted a one-year increase of $895bn (34.3%).
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