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The next bubble to be burst.
> The Credit Bubble Bulletin - by Doug Noland
> Four Months of Respite
> February 16, 2001
> The week certainly ended on an ominous note, with a new U.S. President
> authorizing bombings near Baghdad, ugly inflation data, and a faltering
> stock market. For the week, the Dow was unchanged, while the S&P500
declined
> about 1%. The Morgan Stanley Cyclical index added 1%, while the Transports
> and Utilities declined 1%, and the Morgan Stanley Consumer index dropped
2%.
> The broad market continues to hold up quite well, with the small cap
Russell
> 2000 and the S&P 400 Mid-Cap indices both unchanged. Technology stocks
> remain hyper-volatile. For the week, the NASDAQ100 declined 2% and the
> Morgan Stanley High Tech index lost 1%. The Semiconductors outperformed,
> adding 6% and increasing year-to-date gains to 15%. The Street.com
Internet
> index declined 1%, while earnings disasters pressured the NASDAQ
> Telecommunications index to a 7% decline. The Biotechs declined 3%.
> Financial stocks showed some vulnerability, with the S&P Bank and
Bloomberg
> Wall Street indices declining 1%. Gold stocks added 2%, despite a better
> than $2 decline in the price of bullion.
> On the back of generally stronger than expected economic news this week,
> 2-year Treasury yields increased 7 basis points, while the 5-year saw
yields
> rise 9 basis points. The 10-year T-note and long-bond saw yields increase
> about 8 basis points. The yield on the benchmark Fannie Mae mortgage-back
> security jumped 12 basis points, while agency yields generally added 8
basis
> points. Spreads generally widened, with the key 10-year dollar swap adding
2
> to 95. The currency markets were volatile, although the dollar ended the
> week with a small gain.
> >From the question and answer session - Alan Greenspan's February 13th
> testimony, Federal Reserve Board's semiannual monetary policy report to
the
> Congress:
> Delaware Senator Thomas Carper: My only other question is this; in my
little
> state of Delaware, we cut taxes seven years in a row during my time as
> governor, sometimes rates at the top, sometimes rates at the bottom,
> sometimes in between; we cut taxes for businesses and individuals. We had
a
> four-part litmus test for the tax cuts that we adopted. And one of the
> things that we're wrestling with within our own caucus, and I presume our
> Republican friends are as well, is a set of core principles on which tax
> cuts should be based; if you will, a litmus test.
> The four that we used in my state were the following: one, the cuts should
> be fair; two, they should promote or enhance economic growth; three, to
the
> extent that they can, we should simplify the tax code, not make it more
> complex; and the fourth is that the cuts should be consistent with a
> balanced budget and sustainable throughout the full business cycle. But
> those four things: fairness, promoting economic growth, simplicity, and
> sustainability throughout the full business cycle and consistent with a
> balanced budget are really the litmus test that we used.
> Can you just give us a little guidance -- and I know my time has
expired --
> but just a little guidance on the kind of principles, whether we're
> Democrats or Republicans, that our tax-cut policy should be based on.
> Chairman Greenspan: Well, I think in a very interesting way, it depends on
> where one starts. I mean, going back from, say, a purview of 1995, for
> example, with what appeared at that point to be about a 1-1/2 percent
trend
> growth rate in productivity, it appeared as though the level of taxation
was
> essentially consistent with a balanced budget over the longer run at full
> employment. And what has happened is that productivity growth has
> accelerated quite significantly, and so the existing set of tax rates has
> engendered a very much more rapid rise in revenues. As I said at the
Senate
> Budget Committee, that productivity over the past five to seven years has
> risen at about a 3 percent rate, which is twice what it had been
previously,
> and revenues have gone up 2-1/2 times; the difference being that the rise
in
> the productivity has elevated earnings expectations and created a
permanent
> higher level of asset values, which spilled over into tax liabilities when
> realized gains were involved or even when they weren't.
> And so that what you have got at this point is, as a consequence of the
> acceleration in productivity, a much higher rate of receipts than one had
> anticipated. And so I think the Congress is confronted with the choice of
> whether in fact you give back what, in retrospect, turned out to be an
> unintended excessive level of receipts, or whether those are employed for
> other purposes. And these are the key judgments which I think in this
> particular debate are critical, and these are political judgments; these
are
> judgments which only the Congress can make.
> Senator Carper: Thank you so much
> Alabama Senator Richard Shelby: Mr. Chairman, a lot of people seem to be a
> little hesitant regarding the economy as a whole, and I know it depends on
> how they're looking at it, but consumer confidence is very important. Is
it
> time to hunker down, I believe that was the phrase that was used earlier,
or
> is it a time to be a little cautious, or is it time to be bullish or what?
> Because what you say today and how you say it, as you well know, is going
to
> be interpreted many, many ways, and people are looking for everything in
the
> world out of your utterances.
> Chairman Greenspan: Well, Senator -
> Senator Shelby: What would you say to the American consumer looking at the
> economy today seeing layoffs here, layoffs here, and not in every sector,
> but in some?
> Chairman Greenspan: Yeah. Senator, I think that it's always important to
> first start with what's the longer-term outlook.
> Senator Shelby: Absolutely.
> Chairman Greenspan: And the longer-term outlook, as I've reiterated many
> times, in my judgment is undiminished in the sense that by any measure
that
> I can see, we are only partway through one of these most remarkable
periods
> of technological advance which is crucial to productivity growth and,
> indeed, to all of the deliberations we are having with respect to the
> budget. It really gets back to that question.
> What tends to happen, however, is that while the technologies change and
it
> creates an accelerating environment for economic activity, as I point out
in
> my prepared remarks, we human beings react in a somewhat negative way to
> change when it occurs in a pronounced way. And so it is perfectly credible
> to find, for example, as I think we see today, that there are a number of
> business people who fully perceive the longer-term profitability of these
> new high-tech investments as pretty much fairly accurate and achievable,
but
> they are concerned about the uncertainty, and they develop concerns about
> the immediate future. And even though they perceive the future in a very
> positive way, they tend to pull back. It's a wholly human, normal
reaction.
> And what that does is it brings the economy down.
> But if, indeed, those underlying trends are still there, as I firmly
> believe, it is just a matter of time before that sort of malaise
dissipates
> and the system comes back. If you look at American economic history, it
> always has those characteristics. And if we focus on the longer term, as a
> number of business people have, and have continued to invest right through
> this period, it's my impression that it is they who will end up at the end
> of the day with the best positions in their markets to exploit them over
the
> longer run.
> Senator Shelby: Mr. Chairman, could you, in a sense, perhaps look at the
> economy like a long-distance race and the runners, or some of the runners
> are going -- if the economy is the runner, is going to get its second wind
> because they're trained for the long haul, we're in it for the long haul,
> and those who are in it for the long haul, which is all of us, we're going
> to be rewarded if we stay the course?
> Chairman Greenspan: Oh, I agree with that, Senator. I have no doubt that
at
> a minimum, that the turgid economic growth which we experienced from the
> early 1970s through the, say, early 1990s, is not something that we're
about
> to replicate, in any sense that I can envisage, over the next 10 years."
> Does Greenspan truly believe such nonsense? While he has professed
> (increasingly over recent years) some convoluted analysis, associating
> surging tax receipts with productivity improvements takes the cake. And he
> may hope that better than 20 years of "turgid" economic conditions has
over
> the past six or so years given way to a New Paradigm, but this is no doubt
> some combination of wishful thinking, flawed analysis and obfuscation. The
> last six years will prove the aberration. Sure, the mid-nineties provided
a
> momentous inflection point in financial and economic history, it just had
> very little to do with a so-called productivity miracle. Instead, it had
> almost everything to do with the manifestation of an historic Credit
Bubble.
> This fact is conspicuous in any chart of U.S. money or credit growth.
> Specifically, one can pinpoint the "Reliquefication" concomitant with the
> Mexican bailout and Orange County bankruptcy in 1995. It was in 1995 that
> the buds of credit and speculative excess were nurtured instead of
quashed.
> That round of rampant monetary expansion precipitated a spectacular boom
> both here and abroad (emerging markets) and subsequent ugly bust. The
> resulting 1998 "Reliquefication" ushered in an absolute money and credit
> "free for all."
> Since 1998, truly unprecedented money and credit expansion have been only
> briefly interrupted by respites of moderation. Yet, for a system
hopelessly
> addicted to extreme monetary excess, moderation simply doesn't work. This
> fact is a best-kept secret and something Wall Street and the Fed would
> prefer not to contemplate. Why do the GSE's and Wall Street create credit
so
> aggressively (the force behind exploding money supply)? Because it is
> precisely the requirement for sustaining the Great Credit Bubble.
> We monitor credit market spreads closely, as an indication of liquidity
> pressures and systemic stress. Similar to previous episodes, spreads have
> narrowed sharply over the past four months. This is not surprising, and is
> purely a factor of the degree of monetary expansion. Look at it this way:
> while the GSE's are aggressively purchasing credit market instruments and
> the enormous and always-enterprising leveraged speculating community goes
> along for the ride, this flood of liquidity fuels higher prices/lower
> interest rates, particularly for more risky (high-yielding) instruments
and
> any class of securities aggressively sought by the speculators. The catch
is
> that a U.S. system so incredibly leveraged, with negative household
savings,
> and reliant on huge foreign flows to finance massive trade deficits, the
> entire financial and economic apparatus has become so "revved up" that
> massive liquidity injections must be maintained to keep asset prices
> levitated and financial markets liquid. But like the movie Speed, there
are
> unfortunate circumstances for letting pressure off the accelerator. Any
> moderation in monetary expansion, like that experienced in mid-1999 and
> again in early 2000, leads quickly to sinking prices for the riskier
> securities, liquidation by the leveraged speculators, and faltering
systemic
> liquidity that manifests into wider credit spreads and other financial
> disruptions. Leverage works like magic when prices are rising but can
> abruptly turn problematic with any move toward liquidation. Endemic over
> leveraging is an accident waiting to happen. We will return to this later.
> As discussed repeatedly, since the mid-1990s the government-sponsored
> enterprises have been leading pushers of credit excess. Today, they are
> dealing more forcefully than ever. Fannie Mae's January numbers are in
and,
> not surprisingly, we see that Fannie expanded its mortgage portfolio at a
> 31% annual rate, to $621 billion. Averaging about $1 billion per business
> day, Fannie purchased a total $20.6 billion of mortgages in January at a
net
> yield of 7.02%. To put this in perspective, Fannie Mae's mortgage
portfolio
> expanded in January by about the same amount ($14 billion) as the Federal
> Reserve's holdings of securities increased during the entire past year.
This
> is exactly why I focus on the GSEs and financial sector and pay less
> attention to Federal Reserve Open Market operations.
> Fannie's commitments to buy future mortgages ("mandatory commitments")
> jumped to $27 billion in January (from December's $20 billion), second
only
> to the $30.5 billion at the height of the refinancing boom
> ("Reliquefication") in October 1998. During the month, Fannie Mae
purchased
> $1 billion of multifamily loans, almost 80% more than its previous record
> from the prior month. Fannie's multifamily loan portfolio has expanded by
> 27% over the past twelve months. After expanding its total mortgage
> portfolio by 13% during the 12-months ended September 30, 2000, Fannie
> expanded its portfolio at a rate of 30% in October, 28% in November, and
25%
> in December, extraordinary growth only to be surpassed in January. It has
> been four months of intense "Reliquefication."
> Over the past four months, money market fund assets have surged $244
> billion, or at an annualized rate of 40%. During just the past six weeks,
> assets in money funds have jumped an astonishing $144 billion. For
> comparison, money market fund assets increased $39 billion during the
first
> half of 2000. These assets increased $43 billion last week alone. Broad
> money supply increased $35 billion last week and $118 billion during the
> past six weeks. Over the past four months, broad money supply (which
> includes money fund assets) has increased $301 billion, or at a rate of
13%
> (broad money supply increased about $260 billion for all of 1995). It
should
> not be ignored that there are great costs associated with such rampant
> monetary inflation, and perhaps we saw a hint of what is in the offing
with
> this morning's much stronger than expected report on Producer Prices.
> January producer prices rose at the strongest pace since September 1990,
> confirming what I believe are the most potent general inflationary
pressures
> since the late 1980's. The bond market vigilantes may have succumbed to
> playing The Game, and the propaganda machine hyping the death of inflation
> may be running louder than ever, but it's just not going to change
> fundamentals.
> It is rather incredible that not a word of protest has accompanied the
past
> four-month's 13% rate of monetary inflation. This is actually a similar
rate
> of growth to that at the height of 1998's Reliquefication, although the
> inflationary consequences have all appearances of manifesting in a much
> different manner. In past commentaries I have made the point that
"Liquidity
> Loves Inflation." Sure, combining central bank accommodation with
unfettered
> financial sector leveraging creates an extraordinarily virile liquidity
> generating mechanism for contemporary financial systems. But once created,
> this liquidity is virtually impossible to control and even has a
propensity
> of gravitating directly to asset classes enjoying inflation (choosing a
> Fannie Mae security instead of a Lucent bond, for example). And while
there
> were acute global deflationary pressures in 1998, there are today strong
> general domestic inflationary pressures that are certain to be augmented
by
> current monetary excess. On the other hand, during 1998 there was the
> budding of an historic inflationary boom throughout the expansive
> Internet/telecom/technology sector that proved an incredibly powerful
> liquidity magnet. The present deflationary technology bust sees the magnet
> turned upside down. This is a key and intractable aspect of present
> financial fragility.
> This is where economics gets wonderfully fascinating (unless one chooses
to
> fixate on notions of a New Economy and a productivity miracle). Over
years,
> as credit inflation gave way to runaway money and credit excess, our
> dysfunctional financial system has increasingly financed enormous numbers
of
> enterprises with inadequate cash flows and little hope for true economic
> profits. "Ponzi Finance," in the words of the great Hyman Minsky. This has
> been, of course, an historic speculative bubble captivating investors,
> bankers, speculators, central bankers and American business generally.
> Interestingly, of the few economists and analysts that correctly recognize
> that the U.S. has been in the midst of a major bubble, most actually
believe
> that it has been in NASDAQ/technology stocks. Greenspan may even believe
> this, and has thus embarked on yet another round of extreme accommodation
to
> lessen the economic impact collapsing tech stocks. The major issue today
is
> not NASDAQ, an inventory overhang, or the unfolding severe capital
equipment
> slowdown.
> The fact of the matter is that the technology bubble is but one very
> critical component of the Great U.S. Credit Bubble. The key yet
> unappreciated point to recognize today is that years of reckless credit
> excess have created unprecedented leverage throughout the U.S. credit
system
> and extremely weak debt structures. And while Wall Street and Greenspan
> obviously hope that another bout of monetary excess will do the trick and
> alleviate the spectacular technology collapse, the preponderance of new
> liquidity will avoid technology like the plague. Moreover, it is
unavoidable
> that the most recent Reliquefication is and will continue to lead to
> inflation elsewhere, while it also creates greater consumer debt burdens,
> perilous financial sector leverage, and even more fragile debt structures.
> It is certainly significant both financially and economically that the
> latest shot of extreme monetary expansion is avoiding the tech collapse to
> play the real estate bubble. Could this prove the catalyst for the
> marketplace finally recognizing the dysfunctional nature of the U.S.
credit
> system? While Lucent and a myriad of technology companies fight for
> survival, credit availability could not be easier in mortgage finance.
Could
> there be a more conspicuous example of a highly maladjusted financial
system
> and economy?
> This morning the Commerce Department announced that January housing starts
> jumped a much stronger than expected 5%, with single family starts running
> at the strongest rate in one year. Building permits jumped 13%, with
> multifamily permits surging 24%. The bursting of this unrelenting real
> estate bubble will wait for another day. Also, fourth quarter mortgage
> refinance data has been released by Freddie Mac. During the quarter, "78%
of
> Freddie Mac-owned loans that were refinanced resulted in new mortgages at
> least five percent higher than the original mortgages..." Only 9% of
> refinanced loans were for amounts less than the original mortgage.
> Interestingly, on average, loans were refinanced at comparable interest
> rates, confirming that the overriding motive of borrowers was to extract
> equity (housing inflation). The "median appreciation of refinanced
property"
> was 28% during the fourth quarter, down slightly from the third quarter's
> 29%. However, the "median age of refinanced loan" dropped sharply from 6.6
> years to 4.9 years. During the refinancing boom back in the fourth quarter
> of 1998, the median appreciation was 9%.
> There should be no doubt that the current refinancing boom is greatly
> exacerbating the bubble in money market fund assets, a very dangerous
> financial distortion that runs unchecked. What are the ramifications today
> for a loss of investor confidence in the $2 trillion dollar money market
> fund industry? Astounding... Interestingly, yesterday's American Banker
> carried a lead story titled "FDIC Said to Whisper Fund Premium Warning -
The
> Federal Deposit Insurance Corp. has been quietly warning trade groups that
> it could start charging banks premiums again by yearend - in part because
of
> fast-growing accounts at large firms such as Merrill Lynch & Co., industry
> sources said Wednesday."
> Also from the article: "Industry representatives said the FDIC has cited
> fast-growing and de novo institutions that have added billions of dollars
to
> insured deposits without paying new premiums as one of the key reasons for
> the coverage ratios dilution...the poster children for the issue have
become
> Merrill Lynch, which has moved nearly $50 billion from uninsured accounts
> into insured deposits at its banks in New Jersey and Utah during the past
> nine months, and Salomon Smith Barney, a Citigroup Inc. unit that started
> moving money from uninsured accounts into insured deposits last month."
> Apparently, Salomon Smith Barney is now aggressively moving client assets
> into FDIC insured deposits, with a structure that includes six separate
> banking entities providing up to $600,000 of FDIC insurance protection.
> Coincidently, from the pile of financial reports I read from the last
year's
> third quarter, the one sentence that sticks most clearly in my mind came
> from Citigroup - Salomon Smith Barney: "Total client assets in the Private
> Client business grew 24% from a year ago to $1.047 trillion while
annualized
> gross production per Financial Consultant reached $526,000 in the first
nine
> months of 2000..." It will be quite interesting to see how aggressively
Wall
> Street moves to obtain FDIC insurance for all this "money" it has helped
> create. I know if I were either Sandy Weill or Bob Rubin (Citigroup
> chairmen) I would do my best to get my clients into FDIC insured accounts,
> and this current Reliquefication provides a convenient window of
> opportunity.
> I can't shake the notion that we are likely in the midst of what in
> hindsight will be seen as The Great Distribution. While the public remains
> quite bullish and (helped greatly by the mortgage refinancing boom) money
> continues to flow into mutual funds, the stock market just doesn't react
> like it has in the past. Clearly, some are aggressively selling and we'll
> assume it's the insiders and sophisticated liquidating to the public. One
of
> the unfortunate and problematic aspects of major asset bubbles is a
> redistribution of wealth.
> I am also now anticipating some moderation from the unsustainable monetary
> expansion associated with the four-month old Reliquefication. As stated
> above, for a system hopelessly addicted to extreme monetary excess,
> moderation won't work. With signs of general economic resiliency, endemic
> and increasingly problematic maladjustments, an historic real estate
bubble,
> and heightened general price pressures, something has to give. And at what
> cost will Greenspan attempt to maintain confidence and sustain
unsustainable
> consumer demand? Besides, it should be increasingly apparent that fighting
> this war with a flood of liquidity is not only not working, it's greatly
> raising the stakes for potential financial catastrophe. Before today's
> unusual recovery and rally in the credit market (perhaps related to U.S.
> bombing in Iraq) interest rates had been rather quickly moving higher.
> Spreads have also begun to widen. It does not take much imagination to see
> how this very fragile structure could rapidly turn sour. The bottom line
is
> that already unprecedented leveraged speculation certainly became only
more
> extreme with the speculating community aggressively playing for a
faltering
> economy and aggressive Fed accommodation. Endemic over leveraging in the
> U.S. credit market is a ticking time bomb, and there does today appear
acute
> risk to any significant move higher in rates or widening of spreads.
> I have written before that we have been witnessing the absolute worst-case
> scenario develop methodically right in front of our eyes. Well, today I
> again believe we are entering a period of potentially extreme risk with
the
> stock market, credit market and dollar all in the line of fire. It's been
> Four Months of Respite. However, not only is the effectiveness of
> Reliquefication dissipating rapidly, the costs are growing exponentially.
> When the next crisis breaks, it will be significant.
> I will conclude with what I believe are two pertinent quotes:
> "The favor of the masses and of the writers and politicians eager for
> applause goes to inflation. With regard to these endeavors we must
emphasize
> three points. First: Inflationary or expansionist policy must result in
over
> consumption on the one hand and in malinvestment on the other. It thus
> squanders capital and impairs the future state of want-satisfaction.
Second:
> The inflationary process does not remove the necessity of adjusting
> production and reallocating resources. It merely postpones it and thereby
> makes it more troublesome. Third: Inflation cannot be employed as a
> permanent policy because it must, when continued, finally result in a
> breakdown of the monetary system.
> A retailer or innkeeper can easily fall prey to the illusion that all that
> is needed to make him and his colleagues more prosperous is more spending
on
> the part of the public. In his eyes the main thing is to impel people to
> spend more. But it is amazing that this belief could be presented to the
> world as a new social philosophy. Lord Keynes and his disciples make the
> lack of the propensity to consume responsible for what they deem
> unsatisfactory in economic conditions. What is needed, in their eyes, to
> make men more prosperous is not an increase in production, but an increase
> in spending. In order to make it possible for people to spend more, an
> "expansionist" policy is recommended. This doctrine is as old as it is
bad."
> Ludwig von Mises, Human Action, 1949
> "The boom can last only as long as the credit expansion progresses at an
> ever-accelerated pace. The boom comes to an end as soon as additional
> quantities of fiduciary media are no longer thrown upon the loan market.
But
> it could not last forever even if inflation and credit expansion were to
go
> on endlessly. It would then encounter the barriers which prevent the
> boundless expansion of circulation credit. It would lead to the crack-up
> boom and the breakdown of the whole monetary system." Ludwig von Mises,
> Human Action, 1949
> "...Minsky characterized the financial balance along a scale of running
from
> 'fragile' to robust.' 'Fragile finance' refers to states in which cash
> commitments are relatively heavy compared to cash flows, so that there is
> some danger of widespread failure to meet commitments, failure that might
> cause general breakdown in coherence. 'Robust finance' refers to states in
> which commitments are relatively light compared to cash flows, so that the
> danger of incoherence is relatively remote. The emphasis on the threat of
> incoherence is one way of reading the scale. Viewed more positively, what
is
> so appealing about a state of 'robust finance' is that it leaves open many
> different possible future paths for subsequent social freedom. What is so
> tragic about a state of 'fragile finance' is that previous commitments
leave
> open only very few possibilities for the future, and maybe no
possibilities
> at all that are consistent with existing commitments. Fragile finance is a
> state of social constraint. The degree of fragility or robustness in the
> economy as a whole ultimately depends on the fragility or robustness of
> financing arrangements at the level of the constituent economic units."
> Perry Mehrling, The Vision of Hyman P. Minsky, 1998
> "What nobody saw, though some people may have felt it, was that those
> fundamental data from which diagnoses and prognoses were made, were
> themselves in a state of flux and that they would be swamped by the
torrents
> of a process of readjustment corresponding in magnitude to the extent of
the
> industrial revolution of the preceding 30 years. People, for the most
part,
> stood their ground firmly. But that ground itself was about to give way."
> Joseph A. Schumpeter, Business Cycles, 1939
> P.S. From yesterday's American Banker: "Sears Is Back as A Player In
Cards -
> In the eight months since it starting issuing MasterCards to seven million
> of its inactive Sears cardholders, Sears Roebuck and Co. has broken into
the
> rank of the top 25 bank card issuers, amassing $1.4 billion in receivables
> on the general purpose cards."
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>
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