Page 1 of
2 CREDIT BUBBLE
BULLETIN Fannie and Freddie live
on Commentary and weekly watch
by Doug Noland
The Dow Jones Industrial
Average closed last week at its highest level
since December 2007. The S&P 500 trades only
10% below its 2007 high. The S&P 400 Mid-Cap
index is just 4% below its all-time high (April
2011). The Morgan Stanley Retail Index is up 14%
so far in 2012 and rests only 3.7% below its
record high
(March 2012). The small cap
Russell 2000 is 5.2% below its all-time high
(April 2011). While still some distance from 2000
Bubble peaks, the Nasdaq 100 sports a 2012
year-to-date gain of 22% and the Morgan Stanley
High Tech is up better than 17%.
Near
record debt issuance has corporate credit poised
for its strongest growth since 2007 (Q1 7.2%
growth rate). At almost $30 billion, junk bond
issuance so far this month is already an August
record and compares to the five-year average for
the month of $8.4 billion.
My thesis has
been one of a historic global credit bubble and
financial mania. For the past 18 months, Europe
has been the focal point of my and others' macro
analysis. I've viewed the Greek debt crisis
eruption as the first crack in the "global
government finance bubble". Not unexpectedly,
aggressive policy responses have done little to
resolve the steady downward debt spiral in Europe.
As the crisis that began at Europe's
periphery methodically engulfed the core,
confidence in the sustainability of euro monetary
integration began to falter. Structural flaws and
deep political fissures have been exposed.
Confidence in the European banking system has
waned.
The resulting severe tightening of
financial conditions and weakening economies are
having an increasing global impact, especially on
the overheated "developing" economies. Europe has
been at the precipice of unleashing a historic
global financial and economic crisis.
At
the same time, the US these days remains firmly
immersed in its credit bubble, fueled
predominately by Washington-based debt, federal
guarantees and monetary distortions. Somewhat
ironically, the European crisis has worked to
exacerbate US bubble excess, as Treasury bond and
market yields have sunk to record lows. While risk
aversion and the tightening in global financial
conditions have repeatedly threatened US shores,
the bottom line is that credit conditions here
have remained extraordinarily loose. With Europe
in somewhat of a late-summer crisis respite, I'll
take the opportunity to focus on US bubble
dynamics.
When Europe is unraveling,
global de-risking/de-leveraging market dynamics
are in command, and US confidence is waning - the
feeble US recovery becomes immediately susceptible
to recessionary forces. Not irrationally, market
attention quickly returns to the Fed's itchy QE
trigger finger. Yet, a few weeks of potent "risk
on" have an impact: things start to look different
and not particularly deflationary. Crude oil is
back above $96, the housing recovery appears on
track, spending looks resilient and the US stock
market is posting boom-time gains. Suddenly, the
case for additional quantitative easing seems
really weak. The bond market gets fidgety.
The Standard & Poor's 500 Homebuilding
index sports a year-to-date gain of 71% and a
52-week rise of 123%. July building permits were
reported at a four-year high, although they remain
at less than half of boom-time levels. Yet housing
fundamentals have clearly improved. An increasing
number of locations are again enjoying strong
price appreciation, with froth returning to
scattered markets. Given sufficient time,
incredibly low mortgage rates will work their
magic.
The consensus view holds that the
worst of the housing crisis is fading into
history. This on Friday, from the Treasury
Department's Michael Stegman:
With today's announcement, we are
taking the next step toward responsibly winding
down Fannie Mae and Freddie Mac, while
continuing to support the necessary process of
repair and recovery in the housing market.
The plan is to push forward with the
shrinking of Fannie and Freddie's balance sheets.
This implies real reform, with reduced reliance on
these troubled institutions and less exposure
burdening the US taxpayer (federal bailout $190
billion and counting).
Truth be told,
mortage guarantors Fannie and Freddie - two
government-sponsored enterprises (GSEs) - and the
American taxpayer and economy will remain highly
exposed to mortgage credit risks for many years to
come. While GSE mortgage holdings (and balance
sheets) have been somewhat reduced, exposure to
mortgages they've insured remains at near-record
levels.
Fannie's "Total Book of Business"
(mortgages held in the portfolio and
mortgage-backed securities insured) ended June at
$3.183 trillion, little changed for 2012 and down
only about 2% from the March 2010 high. Across
town at Freddie Mac, total mortgage exposure
remains above $2.0 trillion, down only 10% from
record highs. It is also worth noting that Federal
Housing Administration (FHA) guarantees have
increased dramatically since the 2008 crisis to
exceed $1.0 trillion. I've argued that there will
be "no exit" from Federal Reserve "easy money",
and there will similarly be "no exit" from federal
control over mortgage credit.
The virtual
nationalization of US mortgage credit in concert
with incredible monetary stimulus has ensured the
ongoing availability of inexpensive mortgage
credit. Fannie, Freddie and the FHA - key players
in the mortgage finance bubble - are today
important participants in the government finance
bubble. There will be huge future costs, but for
now housing and the economy enjoy the stimulus.
And while mortgage credit in aggregate remains
stagnant, there are indications of typical
problematic excesses spurred by mispriced finance.
I have posited that today's bubble is the
latest in a series of Federal Reserve-accommodated
bouts of credit and speculative excess. And as
each successive bubble grows larger and more
systemic, the effects actually become less
conspicuous.
The technology bubble was
rather obvious, although the greatest associated
excesses were more generally contained (ie
Internet/technology stocks, telecom debt,
California incomes and real estate). The mortgage
finance bubble was much less conspicuous until the
arrival of the more egregious late-cycle price and
construction excesses. Few appreciated how
trillions of new mortgage debt were inflating
incomes, spending, and corporate profits, while
covertly distorting the economic structure. Today,
it seems that virtually no one recognizes how
government finance bubble excesses inflate
incomes, spending, profits, state and local
government receipts, and equities and bond prices.
In the five years 2003 through 2007, total
mortgage debt increased about $6.2 trillion, or
almost 75%. This historic credit expansion saw
national income inflate $3.0 trillion, or 32%, to
$12.4 trillion, with total compensation increasing
29% to $7.9 trillion. Corporate profits (before
tax) surged 128% to $1.74 trillion.
The
2009 recession saw a one-year 3.7% decline in
national income, a 3.2% fall in total
compensation, and a 22% drop in profits. But
unprecedented Washington stimulus was immediately
forthcoming.
In the 15 quarters June 30,
2008 to March 31, 2012, Treasury debt increased
almost $5.6 trillion, or 106%, to $10.828
trillion. This massive inflation of government
credit, in concert with Federal Reserve rate cuts
and monetization, reflated system price levels
that in 2009 had commenced a problematic downward
spiral.
Indeed, national income jumped
4.5% in 2011 to a record $13.421 trillion, after
increasing 5.7% in 2010. After gaining 4.0% in
2010 and 3.3% in 2011, total compensation has also
grown to record levels. Corporate profits have
inflated to record levels after increasing 25% in
2010 and another 4% in 2011. As bullish analysts
extrapolate corporate profit growth, US stock
prices appear "cheap" after doubling from 2009
lows.
The key has been that overall system
credit resumed its historic expansion. While down
from 2007's 8.4% growth rate, US non-financial
credit still increased 5.9% in 2008, 3.1% in 2009,
4.1% in 2010 and 3.6% in 2011.
It didn't
really matter that the vast majority of 2009-2011
growth originated from Treasury debt. Massive
Washington stimulus was able to sustain inflated
price levels throughout much of the economy -
perhaps not home prices, but definitely system
incomes, spending, gross domestic product, and
profits, while state and local receipts bounced
back to, and in many case surpassed, pre-crisis
levels.
There was a school of thought
coming out of the bursting of the technology
bubble that a jump in mortgage credit growth was
necessary to help ward off dangerous deflationary
forces. And, predictably, once the mortgage
finance bubble gained momentum no one was willing
to take away the punchbowl.
Today, our
policymakers are using government finance to
inflate system credit and price levels, and are
again willing to tolerate excesses that will only
become more unwieldy over the life of this latest
bubble. Somehow, the Fed's biggest concern is the
timing of its next spike to the punchbowl.
From Bloomberg: (Sarika Gangar, August
16): "Sales of junk bonds in the US have already
set a record for August ... Charter Communications
Inc., the cable-TV provider that emerged from
bankruptcy in 2009, and Energy Future Holdings
Corp, the Texas power producer struggling with
$36.6 billion of long-term debt, are among
companies that have sold $29.6 billion of
speculative-grade securities this month. That
compares with an average $8.4 billion in August
sales for the past five years ... Companies are
tapping into an unprecedented $44.9 billion of
cash that has poured into funds that buy junk
bonds in 2012 as the fourth year of near-zero
short-term interest rates prompts investors to put
their money into higher-yielding assets. Issuance
accelerated even as the pace of earnings at
speculative-grade companies slowed in the second
quarter ... 'It has become such a feeding frenzy,'
Bonnie Baha, who helps oversee $40 billion as head
of global developed credit at DoubleLine Capital
... said ... 'It's almost like credit fundamentals
don't even matter in markets like this. You've got
too many dollars chasing too few bonds."
On Friday from the Financial Times, "The
Danger of Getting Hooked on Junk Bonds" and "Debt
Dealers Await Move From Greed to Fear."
This week from Bloomberg: "Morgan Stanley
Leading Long-Bond Sales to Record."
From the Wall Street Journal: "As
Corporate-Bond Yields Sink, Risks for Investors
Rise."
And from the New York Times: "Muni Bonds Not
as Safe as Thought," and "Risk Builds as Junk
Bonds Boom."
Current excesses certainly go
well beyond junk. With record issuance and market
prices that make little sense, bubble excess is
increasingly conspicuous throughout the entire
fixed-income complex. To be sure, the Fed-induced
yield chase has created historic price distortions
from Treasury bonds to corporates to municipal
debt.
From Bloomberg: (Brian Chappatta and
Tim Jones, August 16): "Illinois has set aside
only 45% of what it needs to meet public-worker
pension obligations, the worst of any US state.
Standard & Poor's may cut its bond rating if
lawmakers don't come up with a fix tomorrow.
Investors are unfazed. The fifth-most populous
state's unfunded pension liability is growing by
an estimated $12.6 million a day ... Yet the
penalty on general-obligation bonds from issuers
in Illinois, relative to top-grade debt, fell to
1.51 percentage points last month, the lowest
since February 2011 ... "
Over the years,
I've noted how the credit bubble saw annual
non-financial debt growth increase from about
$650bn in the mid-nineties to surpass $2.0
trillion by 2004. This enormous credit expansion
inflated price levels throughout the entire
economy, with non-financial credit growth peaking
at 2007's $2.5 trillion. Non-financial credit
growth dropped to $1.1 trillion in 2009, before
bouncing back somewhat in 2010 and 2011.
Importantly, however, growth appears to have more
recently jumped back to the $1.8 trillion range.
Such credit growth implies that an inflationary
bias is quietly regaining a foothold in the US
economy.
"Risk on" has seen 10-year
Treasury yields jump 40 basis points (bps) off
July 24 lows to 1.81%. The way things are
unfolding, the placid Treasury market might turn
into rather treacherous waters. I expect European
Central Bank president Mario Draghi's Plan to be
yet another European disappointment. "Risk off"
waits patiently. But it's also apparent that
over-liquefied US securities markets have turned
highly speculative.
An enduring "risk on"
backdrop could easily see things get out of hand.
Amazingly, as the signs of excess become
increasingly apparent, the Fed apparently remains
ready with additional monetary stimulus. It's
going to be an interesting fall.
WEEKLY
WATCH The S&P500 increased 0.9% (up
12.8% year-to-date), and the Dow gained 0.5% (up
8.7%). The broader market outperformed. The
S&P 400 Mid-Caps rose 1.7% (up 11.2%), and the
small cap Russell 2000 jumped 2.3% (up 10.7%). The
Morgan Stanley Cyclicals jumped 2.2% (up 10.4%),
and the Transports rose 2.6% (up 3.4%). The Morgan
Stanley Consumer index added 0.7% (up 8.0%), while
the Utilities fell 1.6% (up 1.6%). The Banks
increased 1.4% (up 20.0%), and the Broker/Dealers
gained 0.9% (down 2.9%). The Nasdaq100 was up 2.1%
(up 22.1%), and the Morgan Stanley High Tech index
gained 1.4% (up 17.3%). The Semiconductors slipped
0.2% (up 11.2%). The InteractiveWeek Internet
index jumped 2.1% (up 13.1%). The Biotechs
increased 0.4% (up 32.8%). While bullion slipped
$4, the HUI gold index gained 1.1% (down 12.8%).
One-month Treasury bill rates ended the
week at 9 bps and three-month bills closed at 8
bps. Two-year government yields were up 2.5 bps to
0.29%. Five-year T-note yields ended the week 9
bps higher at 0.80%. Ten-year yields jumped 16 bps
to 1.81%. Long bond yields surged 18 bps to 2.93%.
Benchmark Fannie MBS yields rose 20 bps to 2.58%.
The spread between benchmark MBS and 10-year
Treasury yields widened 4 bps to 77 bps. The
implied yield on December 2013 eurodollar futures
increased 4.5 bps to 0.54%. The two-year dollar
swap spread was unchanged at 21 bps, and the
10-year dollar swap spread was unchanged at 11
bps. Corporate bond spreads narrowed. An index of
investment grade bond risk declined 3 to 100 bps.
An index of junk bond risk fell 8 to 541 bps.
Debt issuance remained quite strong.
Investment grade issuers included JPMorgan Chase
$2.5bn, Philip Morris $2.25bn, American Express
$2.0bn, Liberty Mutual $1.5bn, Continental
Resources $1.2bn, Duke Energy $1.2bn, Thermo
Fisher $800 million, Pacific Gas & Electric
$750 million, International Lease Finance $750
million, Blackstone $650 million, Burlington
Northern $650 million, Moody's $500 million,
Broadcom $500 million, Mississippi Power $450
million, Ameren Illinois $400 million, Ryder
Systems $350 million, and Appalachian Power $275
million.
Junk bond funds saw inflows slow
to $378 million (from Lipper). The bevy of junk
Issuers included Davita $1.25bn, General Motors
$1.0bn, Tronox $900 million, Caesars $750 million,
ServiceMaster $750 million, Concho Resources $700
million, Belden $700 million, Univision
Communications $625 million, Penske Auto Group
$550 million, Graton Economic Development
Authority $450 million, Scientific Games
International $300 million, Media Broadband $300
million, American Gilsonite $260 million, Legend
$250 million, Live Nation Entertainment $225
million, Unisys $210 million, and Taylor Morrison
$125 million.
I saw no convertible debt
issued.
International dollar bond issuers
included Rio Tinto $3.0bn, Shell $2.5bn, Cenovus
Energy $1.25bn, Kommunalbaken $900 million, and
ICICI Bank $750 million.
Spain's 10-year
yields ended the week down 46 bps to 6.39% (up
135bps year-to-date). Italian 10-yr yields
declined 12 bps to 5.76% (down 127bps). German
bund yields rose 11 bps to 1.49% (down 33bps), and
French yields increased 6 bps to 2.12% (down
102bps). The French to German 10-year bond spread
narrowed 5 bps to 63 bps. Ten-year Portuguese
yields fell 18 bps to 9.38% (down 339bps). The new
Greek 10-year note yield rose 16 bps to 23.55%.
U.K. 10-year gilt yields jumped 13 bps to 1.67%
(down 31bps). Irish yields were up 2 bps to 5.84%
(down 242bps).
The German DAX equities
index gained 1.4% (up 19.4% year-to-date). Spain's
IBEX 35 equities index surged another 7.3% (down
11.7%), and Italy's FTSE MIB gained 3.8% (up
0.2%). Japanese 10-year "JGB" yields increased 3
bps to 0.83% (down 16bps). Japan's Nikkei gained
3.1% (up 8.4%). Emerging markets were mixed but
for the most part notably unimpressive. Brazil's
Bovespa equities index slipped 0.3% (up 4.1%), and
Mexico's Bolsa declined 0.7% (up 9.4%). South
Korea's Kospi index was unchanged (up 6.6%).
India's Sensex equities index added 0.8% (up
14.5%). China's Shanghai Exchange dropped 2.5%
(down 3.8%).
Freddie Mac 30-year fixed
mortgage rates rose 3 bps to 3.62% (down 53bps
y-o-y). Fifteen-year fixed rates increased 4 bps
to 2.88% (down 48bps). One-year ARMs were up 4 bps
to 2.69% (down 17bps). Bankrate's survey of jumbo
mortgage borrowing costs had 30-yr fixed rates
unchanged at 4.22% (down 69bps).
Federal
Reserve Credit increased $4.8bn to $2.840
trillion. Fed Credit was down $8.6bn from a year
ago, or 0.3%. Elsewhere, Fed Foreign Holdings of
Treasury, Agency Debt this past week (ended 8/15)
increased $9.8bn to a record $3.546 trillion.
"Custody holdings" were up $126bn year-to-date and
$67bn year-over-year, or 1.9%.
Global
central bank "international reserve assets"
(excluding gold) - as tallied by Bloomberg - were
up $396bn y-o-y, or 3.9% to a record $10.532
trillion. Over two years, reserves were $1.984
trillion higher, for 23% growth.
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