Page 1 of 5 CREDIT BUBBLE BULLETIN The 'arb' game is over
Commentary and weekly watch by Doug Noland
I'll admit to having warmed up a little to Federal Reserve chairman Ben
Bernanke. He speaks clearly and candidly, in stark contrast to the years of his
predecessor Alan Greenspan's spin and deception. I certainly have sympathy for
the predicament Bernanke finds himself in today, and I'll give the chairman
credit this week for comments suggesting that he is rethinking his flawed views
with regard to bubbles.
Yet this doesn't change the reality that his infamous 2002 "helicopter Ben"
speeches played an integral role in fostering terminal credit and asset bubble
"blow-off" excesses. I was a critic of his selection as Greenspan's successor,
fearing that his appointment would bolster what had by that point evolved into
runaway global credit and speculative bubbles. And while I appreciated the
frankness of chairman Bernanke's comments last week, for the record I'm
compelled to take exception to his assertion that subsequent developments have
proved the Fed adroit for commencing aggressive rate cuts a year ago last
summer.
When the Fed unexpectedly reduced the discount rate on August 17, 2007,
inflationary pressures were mounting and, despite subprime tumult, financial
excesses were actually accelerating. Financial sector debt expanded at 16.8%
rate and non-financial debt at a 9.1% rate during 2007's third quarter.
Importantly, the dollar index was trading at about 81.50. Crude oil closed at
$71 on August 16, 2007. The CRB index at the time was at about 300. Emerging
debt and equity markets were bubbling. The bubble in the leveraged speculating
community was out of control. Citigroup, Wall Street and the global banking
community were struggling to dance in what had become a drunken global mergers
and acquisition blowout.
With a US mortgage crisis brewing, the markets were keenly awaiting aggressive
Federal Reserve largesse. They got it, and after six months of Fed rate cuts
the dollar index had sunk another 15% to new bear market lows. During that
period, crude oil surged almost 60% (to $110 and on its way to $145). Wheat and
other commodities experienced spectacular speculative runs, provoking angst and
bouts of food hoarding around the world. The CRB commodities index jumped about
40%. Emerging market bubbles went to extremes. Brazil's Bovespa equities index
quickly gained about a third, while their $ bond yields dropped from an already
stunning 6.5% to below 5.8%. US bank credit surged at double-digit rates; GSE
books of business expanded by record amounts; money fund assets ballooned at an
almost 50% rate; and funds flooded into the booming hedge fund community.
A world awash in excess dollars saw generalized global monetary excess wildly
inflate world markets and economies (at least partially to chase the highly
profitable weak dollar trade). At home, US corporate borrowings expanded at a
better than 13% rate during the second half of 2007 (and 13% overall for the
year).
The European Central Bank has been widely assailed for its hesitance to lower
rates, while aggressive Fed moves have been applauded. Yet I believe it is
important to recognize that the Bernanke Fed only compounded earlier mistakes
by signaling their intentions so imprudently to a highly speculative
marketplace. There is absolutely no doubt that today's global financial crisis
was made much worse because of additional late-cycle excesses - and resulting
acute monetary disorder - fostered by the Fed's accommodative stance beginning
in the summer of 2007.
The scope of the bubbles and today's spectacular collapses in global equities,
energy, commodities, currencies, emerging debt and equity, corporate bonds, and
the hedge fund community generally was exacerbated by the Fed's premature move
to "mop up" after the bursting of the US bubble. Moreover, I see very little
offsetting benefit to the system from lower Fed funds.
Clearly, the US and global credit systems are today suffering mightily from
years of reckless lending, capped off by 2007's blowoff excesses (especially
corporate and M&A-related debt). Fortunately, there were indications last
week that recent unprecedented global policymaker response is having some
positive impact. Dollar London Interbank Offered Rates declined and there were
other signs of an easing of conditions in the money and inter-banking lending
markets. Commercial paper rates dropped to three-week lows. At the same time,
however, it is becoming increasingly clear that there has been a fundamental
transformation in the pricing of long-term finance for households, corporations
and municipalities.
Over the past year, Fed funds were reduced 375 basis points to 1.50%. At the
same time, 30-year jumbo mortgage borrowing rates are up 88 basis points to
7.62%. And despite "nationalization," yields on benchmark Fannie Mae
mortgage-backed securities are still 33 basis points higher than they were a
year ago. Spreads on benchmark credit card and auto loan asset-backed
securities (ABS) were said to have widened between 100 and 125 basis points
last week to record levels. Junk bond premiums (Standard &Poor's) have
surged from 380 to 830 basis points. During the past 12 months, investment
grade spreads have almost quadrupled to 200 basis points. And while there was
minimal investment grade issuance last week, it is worth noting that those
deals that did make it to the market were sold (mostly utilities) at spreads
above 400 basis points. Meanwhile, an index of municipal bond yields has risen
from 4.15% to 6.01%.
There is now recognition that "de-leveraging" is behind the jump in
private-sector borrowing costs. And yes, the system has suffered through bouts
of forced liquidations before (1994, 1998, and 2002 come to mind), although
nothing in the past is relevant to the massive overhang of credit instruments
now weighing on the marketplace.
There remains, however, hope that some degree of normalcy will return to the
fixed income marketplace when policy measures have had time to take effect and
liquidations have inevitably run their course. I will throw out a thesis that
there will be no return to what we grew to accept as normal. Despite
policymakers' best intentions (and resulting ballooning deficits and Fed
credit), market yields appear poised to surprise on the upside.
Wall Street finance is an unmitigated bust; Wall Street alchemy - transforming
endless risky loans into perceived "money-like" debt instruments - is a spent
force. The greatest credit and speculative bubble in history is collapsing.
Trust in innovative private-sector credit instruments has been broken.
Confidence in contemporary private-sector "money" has been severely shaken. Not
in our lifetimes do I expect to again see booming securitization and
derivatives markets. The days of unfettered leveraged speculation are over.
And, importantly, the amount of Wall Street risk intermediation - through
sophisticated securities, complex derivative structures, various types of
credit insurance, financial guarantees and liquidity arrangements, and
unlimited speculator leveraging - will be significantly reduced for years and
decades to come.
And it is my view that the demise of Wall Street risk intermediation means
higher yields for household, corporate and municipal long-term borrowings. For
years, there was virtually insatiable demand from Wall Street for high-yielding
risky credits - loans that could be transformed/intermediated into perceived
safe and liquid debt instruments. Almost any risk could be sliced and diced,
structured, and transferred to the "marketplace", with enticing securitizations
emerging from the financial alchemy.
In many cases, these securities were then accumulated by the leveraged
speculating community, in the process creating additional financial sector
leveraging and the perception of endless system liquidity. It seemingly didn't
matter at all that we spent instead of saved.
Along the way, there were times when this bubble found itself under some degree
of stress. But with lower financing costs from the Federal Reserve and moves by
speculators to arbitrage widening spreads, this financing mechanism would
quickly right itself. Indeed, soon the credit bubble would more than regain any
lost momentum. Importantly, the expanding scope of the speculator community and
the endless amount of cheap credit from the Wall Street firms (along with the
global mega-"banks") nurtured the perception that this historic episode of
Ponzi finance could last forever.
Today, Wall Street risk intermediation is a bloody wreck; the securities and
derivatives markets are in complete disarray; the deeply impaired Wall Street
firms have no choice but to rein in lending for securities speculation; and the
hedge fund industry is in the midst of a massive de-leveraging and industry
collapse. The market for creating, pricing and distributing finance is in
complete upheaval.
Not only is the capacity gone for Wall Street to transform risky long-term
loans into palatable debt securities. Market dynamics have profoundly altered
the appeal of speculative risk arbitrage. For one, there is now a
multi-trillion dollar inventory of risky debt securities overhanging the market
(from speculator de-leveraging). Second, the capacity for speculators to
procure cheap financing for securities leveraging has been greatly diminished.
Third, since there will be scant Wall Street demand for new risky credits
(previously transformed into easily marketable securities), ongoing financing
requirements for the real economy will burden an already stressed marketplace
with an unrelenting supply of risky credits. And, fourth, risky credits are
especially unappealing as the economy sinks into a deep downturn.
In summary, the "arbitration" game is over. Both supply and demand dynamics
have been radically altered, while the cost and availability of new borrowings
is now so uncertain. And, truth be told, speculative risk arbitrage had evolved
into a primary monetary policy stimulus mechanism under the Greenspan Fed. In
the event of any kind of systemic shock - or at any point market liquidity
began to wane - a Greenspan signal of lower financing costs was all that was
required to incite risk-taking and leveraging.
Today, in contrast, with Wall Street finance in crisis, no amount of rate
cutting or other policymaking can resuscitate leveraged speculation. Going
forward, the price of long-term private-sector borrowings will be determined by
unadulterated supply and demand dynamics.
For years, the Wall Street bubble distorted the price of finance. In
particular, high-yielding risky loans - the favored domain of Wall Street
alchemy - were dramatically mispriced. This under-pricing of risk led to a
massive (and self-reinforcing) over-extension of risky loans - for real estate,
for speculating in securities markets, for funding enterprising businesses and
municipalities, and for consuming. Over the long life of the credit bubble,
this historic expansion of risky credits altered the very fabric of our
economic structure.
In particular, Wall Street finance fostered asset inflation, over-consumption,
and a finance-driven "services" bubble economy. The consequences were
momentous, and the unavoidable economic restructuring has now commenced
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