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3 CREDIT BUBBLE
BULLETIN The myth of
deleveraging Commentary and weekly watch
by Doug Noland
A Bloomberg headline from
earlier in the week caught my attention: "US
Downgrade Seen as Upgrade as $4 Trillion Debt
Dissolved." As someone that analyzes the data
closely - and disputes the entire notion of
deleveraging - I had to read on:
US debt has
shrunk to a six-year low relative to the size of
the economy as homeowners, cities and companies
cut borrowing, undermining rating companies'
downgrading of the nation's credit rating. Total
indebtedness including that of federal and state
governments and consumers has fallen to
3.29 times gross domestic
product, the least since 2006, from a peak of
3.59 four years ago ... Private-sector borrowing
is down by $4 trillion to $40.2 trillion.
Reduced borrowing means there is less
competition for the US Treasury Department as it
sells debt to fund spending programs to help the
nation recover from the worst financial crisis
since the Great Depression. Credit-rating firms
are discounting the improvement even as debt,
equity and currency markets suggest the US is
more creditworthy than before Standard &
Poor's stripped the nation of its AAA grade in
2011. Deleveraging in the private sector may
allow households to boost spending, which
accounts for about 70% of the economy, and
increase their capacity to pay
taxes.
The data and macro credit
analysis always pose challenges, so I figured it
was worth a deeper dive. This requires going
directly to the Federal Reserve's own Z.1 data.
Total system credit market
debt outstanding ended Q2 2012 at a record
US$55.031 trillion. As a percentage of gross
domestic product (GDP), this was 352.6%, down from
371.6% at the end of 2008. I'll attempt to explain
why this actually does not reflect system debt
deleveraging.
Total system-wide credit
market debt combines total non-financial market
debt along with financial sector credit market
debt (FSCMD). Total non-financial market debt
ended Q2 at a record $38.924 trillion - and 249%
of GDP. This compares to Q4 2008 total
non-financial debt of $34.479 trillion - and 240%
of GDP.
The post-2008 decline in
total debt and the improvement in the ratio of
total debt/GDP are predominantly explained by the
contraction in financial sector credit market
borrowings. Total FSCMD peaked at $17.123 trillion
during Q4 2008, or 119% of GDP. Total FSCMD ended
Q2 2012 at $13.838 trillion, down $3.285 trillion
to 89% of GDP.
There are crucial credit
dynamics at work here worth exploring.
Combining non-financial and
financial sector debt incorporates an element of
double counting. Say a new homeowner takes out a
$100,000 mortgage to buy a new home. This would
add $100,000 to household mortgage debt (a
component, along with corporate and governmental
borrowings, of non-financial debt). If this
mortgage was then securitized and sold into the
marketplace, this would as well add $100,000 to
financial sector (mortgage-backed security or
asset-backed security - MBS and ABS) market
liabilities/debt.
Perhaps there's still some
value in using total system credit, despite the
double counting. Yet it has become a flawed
aggregate for the purpose of supporting the
"deleveraging" thesis.
Interestingly, during the
mortgage finance bubble, most analysts were
content to proclaim "double counting!" - and then
conveniently disregard myriad ramifications of an
unprecedented financial sector expansion.
In
fact, the combination of non-financial and
financial proved among the best indicators of
mounting systemic fragilities. Why? Because it
captured the "double the risk" dynamic associated
with aggressively (I'm being kind here)
intermediating bubble-period credit risk. Indeed,
the total debt aggregate went parabolic right
along with systemic risks during the "terminal"
phase of mortgage finance bubble excess.
Importantly, the doubling of
FSCMD between 2001 and 2007 reflected the
intensive risk intermediation required to
transform increasing quantities of risky mortgage
debt into instruments perceived as safe and liquid
("money"-like) stores of value in the marketplace.
Even poor quality mortgage loans were pooled and
structured into mostly top-rated marketable
securities.
Indeed, "Wall Street alchemy"
and the "moneyness of credit" were instrumental in
creating the capacity for the credit system to
easily double mortgage debt during the bubble.
From the financial sector perspective, this
dynamic was fundamental to the near doubling of
FSCMD during this period, largely through the
expansion of MBS, ABS, and government-sponsored
enterprise obligations, and sophisticated Wall
Street off-balance sheet "special purpose
vehicles" and such.
Financial sector credit
market debt ended year 2000 at $8.168 trillion.
GSE issues (agency debt and MBS) and asset-backed
securities ended 2000 at $4.320 trillion and
$1.504 trillion, respectively. The market debt of
depository institutions, finance companies and
real-estate investment trusts (REITs)combined for
$1.506 trillion, while brokers and dealers,
holding companies, and Wall Street funding corps
ended at a combined $831 billion.
Let's fast-forward to
December 31, 2008, after mortgage credit had more
than doubled. FSCMD ended the year at $17.123
trillion, up 110% in eight years of historic Wall
Street alchemy. The process of transforming
increasingly risky debt into beloved instruments
(specially made for leveraged speculation) saw GSE
debt/MBS jump 89% to $8.142 trillion.
ABS,
largely "private-label" Wall Street
mortgage-backed securities, ballooned 174% to
$4.123 trillion. Depository institutions, finance
companies and REITs saw their combined market debt
increase 70% to $2.227 trillion. Meanwhile, at the
heart of the "alchemy", brokers and dealers,
holding companies, and Wall Street funding corps
combined for market debt of $2.204 trillion, an
increase of 165% in eight years.
Now,
let's update the data for the post-mortgage
finance bubble backdrop. As noted above, total
FSCMD ended Q2 2012 at $13.838 trillion, a decline
of $3.285 trillion since the conclusion of 2008.
GSE debt/MBS declined $626 billion, or 8%, to
$7.517 trillion, a rather modest contraction
considering their dismal financial circumstances.
Notably, ABS dropped $2.267 trillion, or 55%, to
$1.856 trillion.
The three-trillion-plus
contraction in FSCMD did reduce total system
market debt - in the process seemingly improving
debt-to-GDP ratios. It is not, however, indicative
of true system deleveraging and surely doesn't
reflect an improvement in our nation's overall
credit standing.
Far from it. From a
macro-credit analysis perspective, the decline in
FSCMD is instead reflective of fundamental changes
in both the type of debt now fueling the boom and
the corresponding nature of system risk
intermediation.
First of all, mortgage debt
is about to wrap up its fourth straight year of
post-bubble contraction. Problem loan charge-offs
have played a significant role, as have
individuals using lower debt service costs (and
near-zero returns on savings!) to speed the
repayment of outstanding mortgages.
And,
importantly, the decline in home values and the
steep drop in transaction volumes have reduced
demand for new mortgage debt - hence the need to
intermediate mortgage credit.
That
said, the biggest factor behind the drop in FSCMD
has been the activist Federal Reserve.
The
Fed's balance sheet is separate from the financial
sector. Federal Reserve assets ended 2007 at $951
billion. Fed holdings ended Q2 2012 at $2.882
trillion, up $1.931 trillion, or 203%, in 18
quarters. The Fed essentially transferred $2
trillion of financial sector liabilities to a
secure new home on its balance sheet. Some may
refer to this as "deleveraging", but I won't.
Importantly, the Fed's moves
to collapse interest rates and monetize debt (in
conjunction with mortgage assistance programs)
incited a major wave of mortgage refinancing. And
through the refi process, large quantities of
private-label mortgages (previously included in
FSCMD as ABS) were essentially transformed into
sparkling new GSE-backed mortgage securities - and
many then conveniently found their way onto the
Federal Reserve's rapidly inflating balance sheet.
This provided critical
liquidity that allowed highly leveraged Wall
Street proprietary trading desks, hedge funds and
banks to de-risk/de-leverage. This bailout
accommodated deleveraging for the financial
speculators, yet for the real economy the boom in
non-financial debt ran unabated.
As
noted above, total non-financial market debt ended
this year's second quarter at $38.924 trillion and
249% of GDP - both all-time records.
Garnering all the focus from
the deleveraging crowd, total household debt has
indeed declined since 2008 - having dropped $787
billion, or 5.8%, to $12.896 trillion. At the same
time, Federal debt has increased $4.689 trillion
to $11.050 trillion.
Non-financial corporate debt
increased $434 billion since '08 to end Q2 2012 at
a record $11.990 trillion. State and local debt
has expanded $101 billion since '08, ending Q2 at
about $3.0 trillion. The data is the data - and
deleveraging is a Myth.
A 100%
increase in Federal debt and 200% growth in the
Federal Reserve's balance sheet are surely not
indicative of system de-leveraging. Such
extraordinary credit developments do, however,
have profound effects throughout the markets and
real economy.
The ongoing credit expansion
has inflated incomes, spending, corporate earnings
and securities prices, in the process sustaining
for now the US economy's bubble structure. And I
would argue strongly that the data support the
thesis that our system remains dominated by bubble
dynamics.
Also keep in mind that, in
contrast to risky mortgage debt, federal debt
requires little intermediation. The marketplace
absolutely loves it just the way it is,
conspicuous warts and all. For now, at least, it
is "money" and shares money's dangerous attribute
of enjoying virtually insatiable demand.
The
only alchemy necessary is to keep those electronic
"printing presses" running 24/7. It is, after all,
the massive inflation of federal debt that is
inflating incomes, cash-flows and profits,
equities and fixed-income securities prices, and
government tax receipts and expenditures - in the
process validating the "moneyness" of the
ever-expanding level of system debt (Ponzi
Finance).
The history of money is a sad
state of affairs. Failing to learn from a litany
of previous monetary fiascos, "money" is these
days being abusively over-issued. And when the
marketplace inevitably decides that over-issuance
(in conjunction with only deeper structural
maladjustment) has sufficiently impaired the
"moneyness" of federal and related debt, there
will be no one to step in to backstop Washington's
creditworthiness.
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