Page 1 of 3 CREDIT BUBBLE BULLETIN 2010 vs 2007
Commentary and weekly watch by Doug Noland
Greek and periphery European debt markets have stabilized. The euro is above
1.33 to the US dollar, having now recovered back to April levels. Global risk
markets have rallied, and commodities markets are again heading north.
Throughout the markets, risk premiums have contracted meaningfully. Debt
issuance at home and abroad has rebounded. I have posited that the Greek debt
crisis provided another critical juncture for global markets. Others contend
that Greece is a small country with limited global impact. Moreover, possible
effects from Greek problems have diminished as the crisis has subsided. I'm
unswayed.
The current environment increasingly reminds me of the long, scorching summer
of 2007. The subprime crisis turned serious in
early June. And not to pick on Ben Stein, but this week I went back and reread
his August 12, 2007, New York Times article, "Chicken Little's Brethren, on the
Trading Floor". Stein's perspective at the time was in tune with the majority
of analysts and pundits: subprime was just not that big of a deal; markets had
way overreacted.
From his article: "The total mortgage market in the United States is roughly
$10.4 trillion. Of that, a little over 13%, or about $1.35 trillion, is
subprime ... Of this, nearly 14% is delinquent ... Of this amount, about 5% is
actually in foreclosure ... Of this amount ... at least about half will be
recovered in foreclosure. So now we are down to losses of about $33 billion to
$34 billion ... But by the metrics of a large economy, it is nothing. The total
wealth of the United States is about $70 trillion. The value of the stocks
listed in the United States is very roughly $15 trillion to $20 trillion. The
bond market is even larger."
Efforts to quantify potential damage from subprime or, more recently, Greece
completely miss a fundamental facet of analyzing bubble dynamics: both were
examples of the marginal borrower abruptly being denied access to
liquidity/Credit in a highly speculative, hence susceptible ("Ponzi finance"),
financial environment - thus marking critical junctures for their respective
bubbles. The mortgage/Wall Street finance bubble, in the case of subprime, and
the global government finance bubble, with respect to Greece, marked critical
inflection points for both market perceptions and stability.
Amid this past month's global market rally, perceptions have shifted to the
view that the European debt crisis is behind us. Recalling the summer of '07,
the subprime crisis "officially" erupted in early June with the halting of
redemptions by two structured mortgage product mutual funds managed by Bear
Stearns (these funds collapsed later in the month). From a July high of 1,555,
subprime worries hit the S&P500 for about 10%, with the market trading
below 1,400 intraday on August 16th. Living up to market expectations, the Fed
was quick to the rescue.
In an atypical inter-meeting move, the Federal Open Market Committee (FOMC) cut
the discount rate 50 basis points (bps) on August 17, 2007. With an escalating
subprime crisis, speculative markets moved confidently in anticipation of
another aggressive round of monetary easing. The S&P500 rallied over 12% in
less than two months. After having traded at almost 5.30% in mid-June, 10-year
Treasury yields sank below 4.33% by early-September. Despite escalating
mortgage tumult, the yields on "safe haven" benchmark Fannie Mae
mortgage-backed securities (MBS) fell from 6.40% in June to 5.40% by
late-November. The drop in market yields incited a rush to refinance mortgages
in late-2007 and into 2008. Dynamics that would culminate in a historic credit
market seizure and liquidity crisis were being masked by melt-up/dislocation in
the Treasury and agency markets.
With fed funds at near zero, the Federal Open Market Committee has had little
room to cut rates in response to the Greek/European debt crisis and a faltering
US recovery. The markets, however, clamored and the Fed delivered assurances
that additional quantitative ease would be forthcoming as necessary. Akin to
the summer of 2007, markets have rallied in anticipation of a further loosening
of monetary conditions. Ten-year Treasury yields closed on Friday at 2.82%,
down 113 bps from the early-April (pre-Greece) high. Benchmark MBS yields are
down 111 bps to 3.56%.
The 2007 subprime eruption and the Fed's response had a profound impact on
perceptions throughout various markets. The dollar index - which had traded
above 82 on August 16th 2007 - was down to 75 by late-November. The prospect
for additional dollar devaluation gave further impetus to buoyant commodities
markets. The Goldman Sachs Commodities Index jumped from 485 in August to end
2007 above 600 - on its way to almost 900 by mid-2008. Crude prices almost
doubled in 10 months. Many of the "emerging" markets ran to frothy new highs -
right before the big fall.
The implosion of the mortgage/Wall Street finance bubble unfolded over about 18
months. There were powerful countervailing forces. On the one hand, a marked
change in market perceptions was leading to a reduction in the availability of
mortgage credit. As new buyers/speculators lost their ability to obtain
mortgages, it quickly became apparent that many key housing market bubbles
would soon burst. The US housing mania and economic boom were doomed. This led
to a broadening panic out of private-label MBS and a liquidity crisis for the
overheated asset-backed security/collateralized debt obligation marketplace.
The dominoes had started to tumble.
Meanwhile, the behemoth Treasury, agency and government-sponsored enteprise
(GSE) MBS markets (with GSE securities enjoying a combination of explicit and
implicit government guarantees) enjoyed big rallies. Liquidity problems in
subprime-related sectors were for a while more than offset by liquidity
overabundance in the more dominant fixed-income markets. Ironically, the
initial bursting of the mortgage finance bubble - with all eyes fixated on the
Ben Bernanke Federal Reserve - fostered destabilizing liquidity excess.
The declining dollar; leveraged "dollar carry trades"; an unwind of bearish
bond positions and interest-rate hedges; a mortgage refinance boom and
resulting hedging against MBS pre-payment risk; Fed-induced speculation on
lower market yields; a bout of safe-haven buying; and large foreign central
bank Treasury purchases all combined to create an over-liquefied and highly
speculative market backdrop. The resulting liquidity-induced rally throughout
global risk and commodities markets only exacerbated systemic vulnerabilities
to the unfolding credit and economic crises.
I highlight the 2007/08 experience as a reminder of how bursting bubbles and
financial crises can evolve over many months - with surprising ebbs and flows
and occasional confounding twists and turns. I don't see anything in the
current backdrop that tempts me to back away from my view that the Greek crisis
marked a critical change in market perceptions. Those that dismissed how the
subprime eruption had fundamentally altered the financial landscape would later
regret their complacency.
Today, I believe global faith in government policymaking has been badly shaken.
There is now an appreciation that policymakers are running out of options.
Confidence that fiscal and monetary stimulus ensures a sustainable global
recovery has waned. There is recognition that massive stimulus can't assure
market stability; in fact, profligate fiscal and monetary measures will likely
prove destabilizing. There is appreciation that global central bankers can't
guarantee normally-functioning markets. There is, these days, no denying that
structural debt issues will be a serious ongoing problem. And, importantly, the
world is increasingly keen to the severity of US financial and economic
problems. Indeed, the post-Greece backdrop beckons for reduced risk and less
leverage. Yet the markets can - at least for a period of time - luxuriate in
destabilizing policymaking-induced liquidity excess and dysfunctional markets.
The dollar is in trouble. Our currency has now dropped for nine straight weeks,
sinking to a near 15-year low against the yen. Crude oil traded above $82 this
week. Wheat prices are up about 50% over the past month. The last thing our
struggling economy needs right now (in common with 2007/08) is surging energy
and food prices.
And there is clearly interplay at work between tumult in the currencies and
dislocation in our fixed income markets. Fed talk of another round of
quantitative easing; rumors of the administration forcing Fannie Mae/Freddie
Mac to refinance and/or reduce principal on troubled mortgages; the potential
for a wave of mortgage refinancings; and the likelihood that many have been
caught on the wrong side of a major move in market yields have Treasury, agency
and MBS yields in near freefall.
As Bloomberg's Caroline Salas and Jody Shenn reported on August 2: "For all the
good the Federal Reserve's $1.25 trillion of mortgage-bond purchases have done,
they've also left part of the market broken. By acquiring about a quarter of
home-loan bonds with government-backed guarantees to bolster housing prices and
the US economy, the Fed helped make some securities so hard to find that Wall
Street has been unable to complete an unprecedented amount of trades. Failures
to deliver or receive mortgage debt totaled $1.34 trillion in the week ended
July 21, compared with a weekly average of $150 billion in the five years
through 2009 ... The difficulty of executing transactions may eventually drive
investors away from the $5.2 trillion mortgage-bond market, which has
historically been the most liquid behind US Treasuries, potentially causing
yields to rise, according to Thomas Wipf ... The unsettled trades also stand to
exacerbate the damage caused by the collapse of a bank or fund. 'You're adding
systemic risk into the market,' said Wipf, chairman of the Treasury Market
Practices Group and the ... head of institutional-securities group financing at
Morgan Stanley. 'Investors are taking on counterparty risk in trades they
didn't intend to take on.' An incomplete agreement can lead to a 'daisy chain'
of unsettled trades because a broker-dealer acting as a buyer in one
transaction may fail to deliver those bonds as a seller in another, according
to Alexander Yavorsky, a senior analyst at Moody's ... Investment banks are
required to hold capital against both sides of the trades, which also makes the
agency mortgage-backed market less attractive to make markets in ... "
It is worth noting that Treasurys held in reserve by foreign central banks at
the New York Federal Reserve Bank have surged $74 billion in just seven weeks.
Dollar weakness appears, once again, to be forcing foreign central banks back
into the role as "backstop bid" for the dollar in global currency markets.
These dollar balances are then "recycled" back into our Treasury market, a
dynamic that does not go unrecognized by the speculator community. This presses
market yields only lower, increasing the risk of prepayment on mortgage
securities and forcing additional interest rate hedging (further exacerbating
the decline in market yields). And once a market dislocates, many will pile on
in search of easy speculative profits.
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