Page 1 of 3 CREDIT BUBBLE BULLETIN
Q4 flow of funds
Commentary and weekly watch by Doug Noland
The Federal Reserve's Z1 Flow of Funds reports remain fascinating in today's
post-bubble landscape. The basic thrust of my credit bubble analysis these days
is that the highly maladjusted US (finance and "services" driven) bubble
economy requires in the neighborhood of US$2.0 trillion of annual credit growth
to hold implosion at bay. Recent dramatic financial and economic tumult -
especially during the fourth quarter - supports this view.
But it is, at the same time, important to differentiate today's economic
backdrop from the dynamics that fomented financial and economic collapse
throughout the emerging markets during the 1990s and earlier this decade (that
is, in Mexico, Southeast
Asia, Russia, Brazil, Argentina, and elsewhere). The US economy is in severe
crisis, but it is not today collapsing. We are not in another Great Depression.
We are not yet witnessing the worst-case scenario.
The "Flow of Funds" illuminates why the collapse of the greatest credit bubble
in history has not yet translated into one of the greater economic collapses.
Despite financial panic and the freezing up of credit markets, total
non-financial credit expanded at a 6.3% annualized rate during the fourth
quarter. While down from the third-quarter's 8.1% pace, I would argue that 6%
plus credit expansion was about the minimum required to forestall systemic
implosion. Importantly, this feat was achieved by the federal government
expanding borrowings at a 37% annualized rate.
Some would argue that this massive federal credit expansion has had minimal
impact. They would point to moribund markets for housing and autos, the steep
rise in unemployment, and the sharp economic slowdown. Sure enough, household
mortgage debt contracted at a 1.6% rate during the quarter, with household
(non-mortgage) credit sinking at a 3.2% pace. Corporate debt growth, having
expanded at a double-digit rate during the first half of 2007, slowed markedly
to 1.2%. Yet, despite collapsing markets for private-sector credit, total
(economy-wide) compensation for the 4th quarter was actually up 1.9% y-o-y to a
record (annualized) $8.096 trillion. For the year, national income was up 1.5%
to a record $12.453 trillion, with total compensation up 3.1% to $8.058
trillion.
How was it possible for such a deeply impaired credit system to sustain such an
inflated level of national Income in the face of a housing and asset market
collapse?
Remarkably, domestic financial sector debt growth accelerated from Q3's 6.8%
pace to a 7.2% rate of expansion. On a seasonally-adjusted and annualized rate
(SAAR) basis, total financial sector borrowings jumped to $1.222 trillion
during the quarter. This was in the face of the asset-backed securities (ABS)
market contracting SAAR $616 billion. This critical contraction in private
sector credit was, however, largely offset by combined growth in
government-sponsored entities' (GSE) debt and mortgage-backed securities (MBS)
growth of SAAR $569 billion. Bank commercial loans expanded SAAR $858 billion,
while open market paper increased SAAR $341 billion.
For all of 2008, Treasury securities outstanding increased an unprecedented
$1.239 trillion, or 24.3%. Meanwhile, agency securities (GSE debt and MBS)
jumped $716 billion, or 9.6%. Combined federal and quasi-federal securities
outstanding ballooned an incredible $1.955 trillion in just one year. For
comparison, Treasury and the agencies combined to increase debt securities
$1.146 trillion during 2007, $514 billion in 2006 and $390 billion in 2005.
This ramp up of government credit growth is outdoing even the historic surge in
mortgage credit during the mortgage finance bubble years.
Federal debt growth offset a contraction in several key sectors of
private-sector credit intermediation/creation. Total mortgage debt (TMD)
expanded only $78 billion during 2008. TMD growth reached about $1.4 trillion
annually during '05 and '06 and averaged $1.177 trillion annually during the
six bubble years 2002 through 2007. For comparison, TMD expanded on averaged
$270 billion annually during the 1990s. With the mortgage finance bubble now
burst, the ABS (including Wall Street's "private-label" mortgage-backed
securities) market is in disarray.
Through the first eight years of the decade, the ABS market ballooned 240% to
$4.50 trillion. Annual growth peaked in 2006 at $912 billion. In an historic
reversal of fortunes, the ABS market contracted SAAR $616 billion during the
fourth quarter and declined $442 billion for all of 2008.
Nowhere was the implosion of Wall Street finance more apparent than it was with
the securities broker/dealers. Broker/dealer assets contracted nominal
(non-annualized!) $785 billion during the final three months of the year,
although much of this was likely reclassification of Lehman Brothers and
Merrill Lynch assets. It is worth noting that miscellaneous broker/dealer
assets contracted SAAR $1.726 trillion, while Treasury holdings expanded SAAR
$774 billion. For the year, broker/dealer assets were down $875 billion, or
28%, to $2.217 trillion.
With the "moneyness" of Wall Street finance having disappeared, the
(offsetting) issuance of government "money" has amounted to nothing less than a
historic explosion of debt issuance. For the year, agency debt expanded 9.0% to
$3.459 trillion. GSE MBS grew 11.2% to $4.965 trillion. Over the past two
years, agency debt expanded $585 billion, or 20%, and GSE MBS ballooned an
unprecedented $1.128 trillion, or 29%. Combined with Treasury's two-year debt
issuance of $1.477 trillion, one tabulates incredible two-year federal
government ("money" ) issuance of $3.20 trillion (28%).
This already incredible debt growth is now poised to really accelerate. At the
Federal Reserve, total assets expanded an unmatched $729 billion during the
quarter to $2.270 trillion, with one-year growth of 139%. Washington should
feel quite fortunate that the markets continue to accommodate such alarming
debt expansion at such meager little interest rates. There is no mystery why
the Chinese and our other creditors are increasingly disturbed by our
government's borrowing habits.
The unfolding government finance bubble has been somewhat able to mitigate the
implosion of Wall Street finance. But the greater dilemma is two-fold: On the
one hand, the distorted economy requires massive ongoing credit creation. Here,
government finance can and has taken up the slack. However, the nature of
spending created by the inflation of government obligations will remain quite
dissimilar to that spurred by the runaway inflation of Wall Street finance.
The flow of finance has been permanently altered. There will be no rejuvenating
the previous asset inflation and consumption booms. Indeed, the household (and
non-profits) balance sheet rather starkly illustrates the nature of the
problem.
During the fourth quarter, total household assets dropped a record $5.419
trillion, or 31% annualized, to $65.719 trillion. Wow! Financial asset values
sank a record $4.537 trillion (to $40.814 trillion), and real estate dropped a
record $871 billion (to $20.512 trillion). Little wonder auto purchases and
retail spending went into a tailspin, as household net worth shrank a record
$5.110 trillion during the quarter (to $51.477 trillion).
For the year, household assets collapsed $11.30 trillion (14.7%), while
liabilities were little changed at $14.242 trillion. For the year, $11.213
trillion of household net worth ("perceived financial wealth") disappeared.
This compares to the average annual increase in household net worth of $5.444
trillion during the period 2003 through 2006. The household balance sheet
continues to offer invaluable insight on the workings of a bubble Economy.
Rest of World (ROW) data document a quarter of mayhem in global finance. ROW
holdings of US financial assets increased SAAR $738 billion (to $16.897
trillion), down from Q3's $1.010 trillion and Q4 2007's $804 billion.
But there were some abrupt shifts in the composition of holdings. Net interbank
assets jumped SAAR $1.344 trillion, while securities repos dropped SAAR $1.273
trillion. Treasury holdings surged SAAR $1.094 trillion (to $3.187 trillion),
while agency and GSE MBS holdings dropped SAAR $1.006 trillion (to $1.331
trillion). Miscellaneous assets expanded SAAR $407 billion during the quarter
to $5.409 trillion.
For the year, ROW holdings of US assets increased $857 billion, down from
2007's $2.081 trillion increase - to the slowest rate of growth in more than a
decade.
Chaos on Wall Street has thrown an additional layer of complexity upon an
already challenging banking sector "flow of funds" analysis. I'm forced to keep
it simple. Banking system assets were up $1.033 trillion (nominal) during the
quarter to $13.417 trillion, with 2008 growth of $2.225 trillion (20%). Bank
credit expanded 15.2% for the year to $9.680 trillion, while miscellaneous
assets jumped 65% to $2.858 trillion. On the liability side, total deposits
were up 8.9% for the year to $7.180 trillion. Miscellaneous liabilities jumped
62% to $2.933 trillion.
The move by the US Treasury and the Federal Reserve to bolster the money fund
complex was critical to averting financial collapse. Retaining their
"moneyness", money fund assets expanded at a 45% rate during the fourth quarter
to a record $3.757 trillion. For the year, money fund assets jumped $724
billion, or 24%.
Elsewhere, the enigmatic Funding Corps had a huge quarter and year. Funding
Corp assets increased $1.057 trillion during the quarter to $3.571 trillion,
with total 2008 growth of $1.735 trillion. Credit union assets expanded 7.3%
last year to $814 billion, while finance companies were about unchanged at
$1.912 trillion. Real-estate investment trusts (REITs) contracted about 10% in
2008 to $523 billion. Savings institution assets fell 16% to $1.526 trillion.
Life insurance assets declined 6% last year to $4.411 trillion.
I suppose I'll for now reside in the camp that believes the system is perhaps
not as acutely unstable today as many fear. The unfolding government finance
bubble is - until it isn't - a major stabilizing force. Government finance by
its nature will not exert sufficient stimulus to rejuvenate deflating asset
markets, but it is nonetheless playing a major role in underpinning wages and
incomes.
Moreover, the massive inflation of government finance is thus far bolstering
the markets' perception of "moneyness" for tens of trillions of Treasuries,
agency debt, MBS, municipal, corporate and household debt securities, along
with another ten trillion or so of bank deposits and money fund liabilities.
This "bolstering" of "moneyness" is also likely central to the resilience of
the dollar.
But such extraordinary stabilization does not come without a heavy price. I am
firmly in the camp that believes that Washington is now trapped in a massive
inflation of government obligations - the latest round of historic credit
inflation captured clearly throughout the Q4 2008 "Flow of Funds" data. The
worst-case scenario unfolds when our creditors and the marketplace turn against
these government obligations.
WEEKLY WATCH
For the week, the Dow jumped 9.0% (down 17.7% y-t-d) and the S&P500 rallied
10.7% (down 16.2%). The Morgan Stanley Cyclicals surged 16.4% (down 30%), and
the Transports jumped 10.0% (down 31.6%). The S&P Homebuilding index rose
28.2% (down 6.0%), and the Morgan Stanley Retail index gained 15.4% (down
5.0%). The Morgan Stanley Consumer index advanced 8.4% (down 14.9%), and the
Utilities increased 1.3% (down 19.8%). The broader market rallied sharply. The
S&P400 Mid-Caps jumped 11.9% (down 15.2%), and the small cap Russell 2000
surged 12% (down 21.3%). The Nasdaq100 gained 9.8% (down 3.6%), and the Morgan
Stanley High Tech index jumped 11.3% (up 0.4%). The Semiconductors surged 12.9%
(up 3.7%), and the InteractiveWeek Internet index gained 8.5% (up 3.2%). The
Biotechs gained 6.9% (down 6.8%). Financials rallied spectacularly. The
Broker/Dealers surged 25.5% (down 7.8%), and the Banks rallied 37.4% (down
42.3%). Although Bullion declined $10, the HUI Gold index mustered a 0.9% gain
(down 4.9%).
One-month Treasury bill rates ended the week at 9 bps, and three-month bills
were at 21 bps. Two-year government yields were up one basis point to 0.93%.
Five year T-note yields were little changed at 1.82%. Ten-year yields increased
one basis point to 2.88%. Long-bond yields jumped 14 bps to 3.75%. The implied
yield on 3-month December '09 Eurodollars were little changed at 1.59%.
Benchmark Fannie MBS yields dropped 10 bps to 4.17%. The spread between
benchmark MBS and 10-year T-notes narrowed 9 to 127 bps. Agency 10-yr debt
spreads widened 4 to 78 bps. The 2-year dollar swap spread declined 8 to 69.25
bps; the 10-year dollar swap spread declined 1.5 to 23.5bps, and the 30-year
swap spread declined 1.25 to negative 33.5 bps. Corporate bond spreads
narrowed. An index of investment grade bond spreads narrowed 10 to 270 bps, and
an index of junk spreads narrowed 54 to 1,246 bps. GE Capital Credit default
swap prices narrowed about 250 bps to around 700 bps.
It was a big week for corporate debt sales. Investment grade issuance included
Bank of America $8.5 billion, GE Capital $6.5bn, Goldman Sachs $5.0bn, Morgan
Stanley $5.0bn, Boeing $1.85bn, Halliburton $2.0bn, Medtronic $1.25bn, CVS
Caremark $1.0bn, US Bank $750 million, Eaton $600 million, Union Bank $1.0bn,
Florida Power & Light $500 million, South Carolina E&G $535 million,
Disney $500 million, Sysco $500 million, Keycorp $430 million, Private Export
Funding $400 million, AND PG&E $350 million.
Junk issuers included Valero Energy $1.0bn, Dole Foods $350 mllion, Union
Electric $350 million, and Mystic RE $225 million.
International debt issues this week included Bank of England $2.0bn, ING Bank
$2.0bn, Inter-American Development Bank $1.0bn, African Development Bank $500
million, Digicel $335 million, and Oriental Bank & Trust $105 million.
U.K. 10-year gilt yields dropped 9 bps to 2.95%, while German bund yields
jumped 13 bps to 3.06%. The German DAX equities index surged 7.8% (down 17.8%).
Japanese 10-year "JGB" yields
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