Page 1 of 3 CREDIT BUBBLE BULLETIN Washington's guilty sermonizers
Commentary and weekly watch
by Doug Noland
We start with two Bloomberg reports from Thursday, the first from Dawn Kopecki:
"The 'phenomenon of securitization' must be curtailed by lawmakers to prohibit
banks and mortgage lenders from shifting all the risk on loans they originate
and sell to investors, US House Financial Services Committee chairman Barney
Frank said. 'I will be pushing for legislation that will make it illegal for
anybody to securitize 100% of anything,' Frank ... told reporters ...
Securitization is a 'large part' of the problem in the housing market, he
said."
The same day, Scott Lanman and Craig Torres reported: "Federal Reserve vice
chairman Donald Kohn came under fire from Democratic and Republican senators
for rescuing American
International Group Inc without providing cost estimates or enough openness,
risking public confidence in government. Federal aid to AIG 'appears to be a
bottomless pit,' said Mark Warner ... Regulators 'are asking for an open-ended
check and' are 'not going to get' it, said Senator Robert Menendez ... 'The
people want to know what you have done with this money,' said Senator Richard
Shelby ... The US$163 billion AIG rescue ... may worsen prospects for
congressional approval of more spending on bank rescues beyond the $700 billion
Troubled Asset Relief Program, lawmakers said…"
Our Washington policymakers have too belatedly recognized the perils associated
with unregulated Credit and speculative finance. They now come down hard on our
Federal Reserve and Treasury Department officials, quickly losing sight of the
mountains of blame to be spread around. Let us not forget that Congress
repealed the Depression era Glass-Steagall Act back in 1999. And it is fair to
remind leaders from both parties and both Houses that they are directly
culpable for the spectacular rise and unfolding fall of the
government-sponsored enterprises (GSEs) such as mortgage guarantors Fannie Mae
and Freddie Mac. I get no sense that a coherent understanding of the credit
bubble is manifesting in Washington.
I could on a weekly basis come up with dire predictions, but there's more than
enough of this type of reading available these days. I'll stay focused on
(contemporaneously) analyzing this historic credit bubble from every angle,
with the objective of contributing to lessons learned. And I believe quite
strongly that gleaning the key lessons from major bubbles is incredibly more
challenging than one would ever imagine - that confusion, flawed analysis,
ideologies and the overwhelming forces of historical Revisionism create
imposing obstacles to understanding. One can point to the 80 years or so of
writings examining the Roaring Twenties and the Great Depression (what Federal
Reserve chairman Ben Bernanke refers to as the "Holy Grail of Economics") to
support this view.
There is no doubt the securitization and CDS (credit default swap) markets were
key facets of the credit boom and are today at the heart of the devastating
bust. Financial "innovation" always plays a critical role in major bubbles -
and this process of experimentation and innovation is consistently evolutionary
in nature. While it is in many ways reasonable to cast blame upon these markets
and their operators, lessons learned requires an understanding as to how these
markets came to play such decisive roles.
What critical features of the financial landscape contributed to the
marketplace's enthusiasm for these types of instruments? More specifically, how
was it that total mortgage credit growth surpassed $1.5 trillion annualized
during the first-half of 2006? How did asset-backed securities (ABS) issuance
balloon to $900 billion annualized in late-2006? How was it that Wall Street
asset growth surpassed $1.0 trillion annualized during the first-half of 2007?
How could collateralized debt obligation (CDO) issuance have possibly reached
$1.0 trillion in 2007 - and that the CDS market mushroomed to more than $60
trillion at the very top of the credit cycle?
The ratings agencies provide such easy and browbeaten scapegoats. They adorned
"AAA" ratings on trillions of MBS, ABS, and CDOs during the heyday of the boom
- back when home prices were forever rising, incomes were surging, credit
losses were disappearing, and new era babble was as unnerving as it was
alluring. The rating agencies, Wall Street, Congress and virtually everyone
else believed the boom was sustainable.
But the radically altered post-bubble backdrop now finds the rating agencies
appearing as nincompoops complicit with shady Wall Street operators. Such a
post-boom spotlight is predictable. From an analytical perspective, however,
focus on the idiocies and malfeasance of the boom is certain to neglect key
bubble nuances.
From a "moneyness of credit" perspective, the Wall Street credit mechanism
evolved to the point of creating virtually endless debt instruments perceived
by the marketplace as safe and liquid stores of nominal value (contemporary
"money"). One cannot overstate the principal role top-rated money-like debt
instruments played in fueling the bubble, although let's not get carried away
and convince ourselves that the rating agencies had much at all to do with
market psychology and speculative dynamics. For more culpable villains I
suggest Washington look in the mirror. The "moneyness" enjoyed by Wall Street
finance was either explicitly or implicitly underwritten within the beltway.
It was said back in the 1960s that Bernanke's predecessor at the Federal
Reserve, Alan Greenspan, blamed the Great Depression on the Federal Reserve
repeatedly placing "Coins in the Fuse Box" - repeated market interventions with
the intention of perpetuating the 1920s boom. Going back at least to the 1987
stock market crash, our policymakers cultivated the markets' view that
Washington was right there to nurture and forever protect the "free" market.
And the greater the prosperity and the higher asset prices went - the more
certain the market became that policymakers would never let it all come
crashing down.
The Greenspan Federal Reserve (1987-2006), in particular, nurtured the market
perception that Washington was there to backstop marketplace liquidity.
Greenspan pegged the cost of finance and essentially promised liquid and
continuous markets. he became a leading proponent for securitizations,
derivatives and "contemporary finance" more generally. "Liquid and continuous"
markets were the lifeblood of these momentous credit system innovations - and
Washington seemingly delivered the goods.
Importantly, the GSEs - with their implied government guarantees - became
commanding market operators and quasi-central banks, aggressively intervening
to stem varying degrees of financial stress in 1994, 1998, 1999, 2000, 2001,
2002, and 2003. Congress was enamored with the virtues of deregulation, while
turning a blind eye to the most glaring market distortions and excesses. Both
sides of the aisle were elated with the newfound capacity for the Federal
Reserve and GSEs' to jam coins in our system's "fusebox."
Congress steadfastly refused to address the issue of the GSEs' implicit
government backing, thus endorsing the most dangerous distortion to a "free"
market pricing mechanism in the history of finance. All along, market
confidence that Washington was backstopping system liquidity became more
ingrained and problematic. Trillions of "money-like" agency debt and MBS
securities were accumulated, with operators (and GSE "enablers") cocksure that
this market was much too big to stumble. The GSEs eventually did falter and
were hamstrung by their accounting issues. By that time, however, the
inflationary bias within mortgage finance and housing had become so powerful
that the boom in Wall Street "private-label" mortgages/MBS easily supplanted
GSE-related credit creation.
This credit boom - along with the GSE's (and Fed's) capacity for intervening to
stem market liquidity crises - played a fundamental role as the market's
evolving perception of "moneyness" branched out to Wall Street's private-label
mortgages and ABS more generally. Or, said another way: "No GSEs, then no
uninterrupted credit expansion; no rampant housing inflation and current
account deficits; no massive global pool of speculative finance; no endless
demand for perceived safe and liquidity mortgage securities of all stripes; and
no evolving mortgage/housing/ABS/CDS bubble." There is plenty of blame to share
with New York, London and elsewhere, but a strong case can be made that this
was, at its core, a Washington-induced credit bubble.
The securitization and CDS markets are the financial crisis' current focal
point. The markets' misperception of liquid and continuous markets - that was
instrumental in fueling the explosion of debt issuance and credit insurance -
has come home to roost in a very bad way.
The securitization market's basic premise was that the creditworthiness of
trillions of credit instruments would be supported by the capacity of borrowers
to forever refinance and/or increase debt loads (Minskian "Ponzi Finance"). The
basic premise of the CDS market was twofold: One, that contemporary
securitization markets (backstopped by Washington) would provide borrowers
endless quantities of inexpensive finance. And, second, that liquid securities
markets would provide an effective means of ("dynamically") hedging credit
exposures sold into the ("wild west") CDS marketplace.
Today, those on the wrong side of the CDS market (having written credit
insurance) are getting financially killed and this dynamic is seemingly taking
the entire system down with it. Corporate bond (bear) market liquidity is
scarce, while the viability of scores of participants on all sides of the
market is very much up in the air. This means that the hundreds of billions of
default protection sold against troubled debt issuers (that is, GMAC, Ford
Motor Credit, GE Capital, AIG, and so on) today confront a serious dilemma when
it comes to hedging rapidly escalating losses (and unwieldy "books" of
derivatives and counter-party exposures).
Originally, the writers of this credit protection would have assumed only a
remote possibility that any one of a number of major institutions would
default. They also would have expected that, in the event of rising default
risk, short positions would be established in the bond market to hedge credit
risk. They wrongly assumed benefits from diversifying credit risks, the
availability of market liquidity, and various forms of "too big to fail."
Today, those on the wrong side of these trades and dislocated markets confront
an environment that their models would have suggested was impossible: a domino
collapse of major debt issuers in the face of near illiquidity throughout the
corporate bond marketplace. During the boom, market participants would have
assumed the opposite of an impotent Washington rummaging market wreckage for
villains.
I'll surmise that the CDS market is now in complete dislocation. I'll also
assume the sellers of CDS (and various credit insurance) have resorted to
shorting equities (individual stocks, exchange traded funds and futures) in a
desperate attempt to hedge escalating losses. This has likely placed additional
pressure on sickly equities markets - and it goes without saying that it is
especially damaging to market confidence when the stocks of our nation's (and
the world's) major borrowers and financial institutions are all locked together
in a death spiral.
This dynamic has surely led to another round of forced de-leveraging. And,
importantly, this type of market dynamic incites an acute case of "animal
spirits". While perhaps not as gigantic as before, the global pool of
speculative finance (that accumulated over the boom) remains a force to be
reckoned with. The dynamic of panic liquidations, de-leveraging and market
operators seeking to profit from systemic dislocation creates a problematic
deluge of selling.
WEEKLY WATCH
For the week, the Dow sank 6.1% (down 24.5% y-t-d) that the S&P500 was
hammered for 7.0% (down 24.3%). The Transports sank 12.2% (down 37.9%), and the
Morgan Stanley Cyclicals tanked 13.7% (down 39.8%). The Utilities declined 8.3%
(down 20.8%), and the Morgan Stanley Consumer index fell 5.0% (down 21.5%). The
S&P 400 Mid-Caps sank 9.1% (down 24.2%), and the small cap Russell 2000
dropped 9.8% (down 29.7%). The Nasdaq100 lost 4.7% (down 12.1%), and the Morgan
Stanley High Tech index fell 3.7% (down 9.8%). The Semiconductors declined 2.0%
(down 8.1%), and the InteractiveWeek Internet index fell 3.9% (down 4.9%). The
Biotechs dropped 5.5% (down 12.9%). The Broker/Dealers sank 11.6% (down 26.5%),
and the Banks were drilled for 22.9% (down 58%). With Bullion down about $4,
the HUI Gold index declined 1.7% (down 5.8%).
One-month Treasury bill rates ended the week at 9 bps, and three-month bills
were at 18 bps. Two-year government yields
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