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     Jul 1, '13


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CREDIT BUBBLE BULLETIN
Uninsurable risks
Commentary and weekly watch by Doug Noland


An extraordinarily unsettled quarter ended on a tenuous up note.

June 24 - Financial Times (Alistair Gray and Pilita Clark): "Insurers have issued a rare warning that the speed at which the oceans are warming is threatening their ability to sell affordable policies in a growing number of places around the world. Parts of the UK and the US state of Florida were already facing 'a risk environment that is uninsurable', said the global insurance industry trade body, the Geneva Association. They were unlikely to be the last areas with such problems, said John Fitzpatrick, the association's secretary-general ... 'Governments may have fiscal



austerity issues in the short run. But in the long run they're going to have big exposures - to repair damaged infrastructure from storms.'

"... In spite of the losses from Sandy and a spate of natural catastrophes the previous year, overall global property insurance premiums have remained broadly stable outside loss-hit areas. However, insurers warn [that] premiums have been kept artificially depressed in the short term because capital has flocked to the sector in the face of historic low interest rates."

I found multiple reasons last week to think back to a March 2000 Credit Bubble Bulletin, "A Derivative Story." It was my fictional account of how cheap flood insurance spurred a spectacular boom and bust cycle on "a little town along the river".

Basically, writing flood insurance during a drought provided extraordinary "return" opportunities. A speculative bubble developed in the marketplace, whereby thinly capitalized speculators came to dominate the market for cheap insurance. The easy availability of inexpensive protection was instrumental in fueling a self-reinforcing economic bubble along the waterfront. Between the building boom and inflating real estate prices, the amount of outstanding flood insurance ballooned (exponentially).

As speculation in this marketplace turned manic, the entire insurance "industry" became precariously undercapitalized, especially in the context of rapidly inflating latent risks. Losses had been avoided for years - and many just presumed drought was the new normal. And in the unexpected event of torrential rainfall, most anticipated "hedging" potential flood loss exposures in the liquid marketplace for cheap reinsurance. Well, the insurance market collapsed in illiquidity with the inevitable arrival of a major flood. Financial and economic losses proved catastrophic in my sad little tale.

So have the Ben Bernanke Federal Reserve and fellow global central banks been adeptly supporting the global economic recovery after 2008's "100-year flood" - as conventional thinking believes? Or have they instead been inflating history's greatest credit bubble? Policy uncertainties and unstable global markets have again made this a pressing question.

The usual ("inflationist") punditry has been in attack mode against Bernanke's call to begin (most gingerly) the process of backing away from extraordinary crisis-period quantitative easing measures. They claim the recovery remains too weak and inflation too low to contemplate policy tightening. Some go so far as to claim the Fed is repeating its 1937 mistake, whereby tightening measures are said to have aborted a fledgling recovery and needlessly extended the Great Depression.

Every boom and bust cycle runs its own course, but I would strongly argue any comparison to 1937 is misguided. In no way do I believe the 2008 financial crisis was the current historic cycle's 1929. There was indeed significant financial and economic stress in 2008/09. But there was definitely no global collapse in credit or economic activity - no globalized economic depression.

Actually, on a global basis debt growth has run unabated. And after a meaningful yet non-catastrophic setback in 2009, global gross domestic product (GDP) growth quickly recovered. With record outstanding debt, record GDP and near-record securities prices, it's unreasonable to argue for unending depression-era fiscal and monetary stimulus.

More than a decade ago, Bernanke, with his "helicopter money" and "government printing press", arrived on the scene with academic theories to fight the scourge of deflation. Well, the tech bubble had burst - but I argued strongly at the time that the greater credit bubble was very much alive and well. Extraordinary Fed stimulus was poised to inflate the fledgling mortgage finance bubble. I argued in 2009 that the Bubble hadn't burst; instead, unmatched global fiscal and monetary stimulus had unleashed the "granddaddy of them all" - the global government finance bubble.

This is not "intelligentsia" - and I would add that recent market developments have again made this a most pertinent debate. Has the Fed been successfully countering a post-bubble landscape - or has it instead been further inflating a historic bubble? Do Dr Bernanke's academic theories of how the Fed must ensure there is ample "money" in the real economy to address insufficient demand really hold water? Or have zero rates and trillions of quantitative easing dollars imply flooded excess liquidity into already distorted global securities markets? Has Federal Reserve policy led to runaway bubbles in dysfunctional risk markets - fueling an epic global "building boom along the river"?

I have in past Credit Bubble Bulletins noted key differences between the traditional government currency printing press and today's newfangled electronic version. Traditional monetary inflations created government currency - purchasing power that worked to bid up prices throughout the real economy. The contemporary "printing press" creates electronic debit and credit entries that predominantly provide new purchasing power that bids up prices of financial assets. I have argued that this mechanism has been fueling dangerous securities markets and asset bubbles around the globe. I have further argued that the Fed and central banks had unwittingly nurtured acute bubble fragility to any potential reduction in central bank liquidity.

How does one reconcile massive ongoing "money printing" with deflating commodities prices and generally contained consumer price inflation? Well, perhaps the commodities market is the proverbial canary in the coal mine warning that QE has indeed fueled increasingly vulnerable credit and asset bubbles.

The backdrop is increasingly reminiscent of the late-1920s, when many (including the Fed) believed weak commodity prices were a call for further monetary accommodation. I am today playing the role of the old codgers from the Roaring Twenties who warned of the dangers (and utter futility) of trying to sustain a deeply maladjusted system and historic financial bubbles. While they were correct in their analysis, history has been unkind to these "liquidationists" and Bernanke "bubble poppers".

Bernanke (and conventional thinking) is convinced the issue during the late '20s and '30s was deflation and the Fed's negligence in failing to print sufficient money supply. I am convinced that Bernanke's analysis is flawed: the key issue was the Fed repeatedly placed "coins in the fusebox" during the '20s - in the process accommodating precarious financial and economic bubbles.

Quantifying current bubble risk is an impossible task. Global debt and securities markets easily surpass a hundred trillion dollars. Gross derivative exposures are in the many hundreds of trillions. The now enormous Chinese and emerging market financials systems, in particular, lack transparency. The amount of global speculative leverage is unknown. The degree of global financial distortion and economic maladjustment will not become apparent until the next major period of market risk aversion and resulting tightened global financial conditions. For now, recent market gyrations support my view of precarious latent market bubble risks.

I'll attempt to use some data to illustrate how Fed policymaking has greatly exacerbated already outsized market risks. As a crude proxy for "market risk", I'll combine outstanding Treasury debt, agency debt/mortgage-backed securities, corporate bonds, municipal debt and the value of US equities - securities that fluctuate in the marketplace based upon perceptions of value, liquidity and risk. It is worth noting that "market risk" had inflated to US$33 trillion during the booming '90s, after beginning the decade at $10 trillion. Importantly, the '90s saw a fundamental shift to market-based credit instruments, with the proliferation of asset-backed securities, MBS, agencies (government-sponsored enterprises) and "Wall Street Finance" more generally.

I have over the years argued that credit is inherently unstable. The move to market-based debt instruments created an acutely unstable credit system, instability that provoked a change at the Federal Reserve to a policy regime committed to backstopping the securities markets. For more than 20 years now, this new policy regime has led to an unending series of bubbles, booms and busts, even more aggressive policy responses and only bigger, more precarious bubbles. This is critical analysis that remains completely outside of mainstream economic thinking.

When Bernanke began his crusade against deflation risk back in 2002, "market risk" was at $29.7 trillion. Extraordinary monetary stimulus (and resulting mortgage finance bubble excess) was instrumental in market risk surging to $53 trillion by the end of 2007, before dropping abruptly to $44.8 trillion in 2008. During the past four years, "market risk" has inflated $16.7 trillion, or 37%, to a record $61.5 trillion.

Perhaps more illuminating, as a percentage of GDP, "market risk" began the 1990s at 182% and closed the decade at 323%. Post tech-bubble asset prices had the ratio back to 284% by the end of 2002. By 2007, however, it had inflated all the way to 378%. In 2009 it fell back to 314%. It then ended 2012 at a record 392%. From another angle, over the past 10 years GDP increased $5.2 trillion, or 50%, while "market risk" inflated $31.8 trillion, or 107%. While conventional thinking subscribes to the post-2008 de-leveraging viewpoint, I believe the data strongly support my re-leveraging and historic bubble thesis.

Global insurance companies have come to believe that global climate change has made some locations "uninsurable". Extraordinary changes in the weather landscape have made areas so prone to potential catastrophe that risks cannot be effectively priced in the insurance market and reserved for by those writing policies.

I will posit that years of central bank intrusion and market domination have made global risk markets "uninsurable". Market risk has ballooned precariously higher, with massive issuance of non-productive government debt and other late-cycle private-sector credit excesses. Meanwhile, central bank liquidity injections have inflated global asset market prices, while inciting speculation along with a manic global search for yield. Distorted "bubble" global economies are increasingly succumbing to the debt and maladjustment overhang, while financial euphoria has seen securities markets inflate into dangerous speculative bubbles.

There is a great flaw in the Bernanke doctrine of inflating the Fed's balance sheet to both accommodate massive fiscal deficits and inflate securities markets, while using zero rates to force savers into the risk markets. This has led to an unprecedented (and problematic) mispricing of debt and securities prices globally, while incentivizing leveraging and speculation. Trillions of risk-conscious "money" has flowed into global markets (through exchange-traded funds, hedge funds, mutual funds, etcetera) with little appreciation for the true risk-profile of global financial markets. One could say a bubble in perceived low-risk "investing" evolved into a key facet of the overall global risk market bubble.

There remains a perception that risks can be readily hedged and that central banks will ensure liquid markets even in the event that the marketplace moves to de-risk. But the marketplace cannot offload market risk.

Risks can be shifted around the marketplace. Yet if the market en masse seeks to reduce risk there is no one with the wherewithal to take the other side of the trade. This issue becomes especially salient when market risks are exceptionally elevated; when risks are under appreciated and misunderstood; and when most (sophisticated speculators, investors and unsophisticated "savers" alike) are heavily committed to the risk markets. That's where I believe we are today.

Importantly, at least segments of the "global leveraged speculating community" must by now be increasingly impaired. The gold, precious metals and commodities "reflation trade" has been an unmitigated disaster. While not yet a full-fledged disaster, the popular emerging market (EM) trade is unraveling. The currencies and global leveraged "carry trades" have become perilous minefields. Global fixed income markets, more generally, are increasingly unstable and illiquid.

Extremely low market yields and risk premiums/credit spreads ensured the speculators ramped up leverage in order to achieve their bogey 8-9% (pension fund acceptable) annual returns. The exchange-traded fund phenomenon ensured that a couple of trillion flowed easily into all types of mis-priced asset classes. The torrent of leveraged buying and ETF flows brought unprecedented liquidity to generally illiquid US corporate and municipal bonds. A torrent of leveraged buying and ETF flows brought unprecedented liquidity to emerging markets that over the years earned their "roach motels" moniker. A torrent of flows ensured ultra-easy financial conditions that for four years have worked to validate the (mis)perception of minimal risk throughout US and global markets.

Of course, New York Federal Reserve president William Dudley and other Fed officials have come out to comfort an unsettled marketplace. Dudley even suggested that the Fed could actually do QE bigger and longer if necessary. Such pandering is precisely why markets are these days so exposed to bubble risks. The Fed has made such an incredible mess of monetary policy.

Fed policies have fomented a historic bubble and there will no painless extrication. Various Fed officials have said the market has "misinterpreted", "misunderstood", and is "quite out of synch" with the Fed's recent policy message. I don't believe the market misunderstands the Fed as much as the Fed and market participants for years have misunderstood market risk dynamics.

Bubbles don't inflate forever. I'll assume that at least the sophisticated market operators now appreciate the rapidly escalating risk to emerging markets and economies. I'll assume there is newfound appreciation for the serious liquidity issues overhanging various markets. I'll assume the leveraged players are responding to the new backdrop with plans for reduced leverage and risk. The sophisticated market operators will now work to "distribute" risk to the less sophisticated, a process they expect will be aided by ongoing Fed verbal and QE market support.

Prominent fund managers and bullish pundits have blanketed the airways the past few days with hopeful messages that the worst of the bond selling is over and that the great equities bull market remains intact. It's just not going to be that easy.

Outflows from bond, EM and stock funds have been enormous. Despite last month's late rally, the fear is that investors will be none too pleased when they see monthly/quarterly brokerage statements. The "sophisticated" surely don't want to be in a situation where they're fighting the "unsophisticated" to the exits. They need to see that feel-good bull market feeling return to risk markets relatively quickly - or else.

Above I mentioned how Federal Reserve doctrine changed during the nineties to support the proliferation of market-based credit. During the decade, the market for derivatives and myriad types of risk insurance ballooned right along with credit and market risk. I've argued over the years that credit and financial market risk are actually uninsurable - in that they are neither random nor independent events such as car accidents and house fires. Actually, it is the nature of market risk for losses to occur in particularly non-random and non-independent waves. Somehow the lessons of 2008 were quickly unlearned.

And while I'm on the subject of risk management, it's worth noting that for years one could simply mitigate risk by holding Treasuries (and bunds, agency debt, etcetera.). In the event of market turbulence, rising Treasury prices would work to offset declining prices for stocks, junk bonds and such. Problematically, Treasury prices have of late been declining right along with risk assets, as "safe haven", risk asset and commodity prices all turn atypically correlated. There's been a proliferation of "risk parity" strategies that are struggling under current market conditions. If things don't normalize quickly, market participants will be forced to adjust their views of risk and liquidity management.

In a way, the Federal Reserve has for years circumvented "nature" by assuring market liquidity. It is this assurance that has empowered a booming derivatives "insurance" marketplace that operates on the specious assumption of "liquid and continuous markets". The vast majority of derivative market insurance written requires some degree of "dynamic" hedging - ie selling of instruments to generate sufficient cash flow to pay on market insurance contracts sold/written. This is one of those key latent market bubble risks.

Global climate change is fundamentally altering the risk and the insurance marketplace, although "premiums have been kept artificially depressed in the short term because capital has flocked to the sector in the face of historic low interest rates". Global central banks have unwittingly inflated risk and grossly distorted the risk "insurance" landscape across global risk markets.

We'll see how long "capital" continues to flock to global securities markets. Early indications of how global risk markets will function in the face of a reversal of flows are anything but encouraging.

WEEKLY WATCH
The S&P500 gained 0.9% (up 12.6% y-t-d), and the Dow added 0.7% (up 13.8%). The Morgan Stanley Consumer index increased 0.4% (up17.4 %), and the Utilities jumped 3.0% (up 7.4). The Banks rallied 2.1% (up 19.8%), and the Broker/Dealers gained 1.0% (up 33.0%). The Morgan Stanley Cyclicals were up 0.6% (up 12.7%), and the Transports gained 1.0% (up 16.3%). The S&P 400 MidCaps jumped 2.1% (up 13.8%), and the small cap Russell 2000 gained 1.4% (up 15.1%). The Nasdaq100 rose 1.1% (up 9.4%), and the Morgan Stanley High Tech index added 0.1% (up 8.7%). The Semiconductors jumped 1.7% (up 22.0%). The InteractiveWeek Internet index rose 0.8% (up 15.4%). The Biotechs surged 5.0% (up 26.5%). With bullion down $62, the wildly volatile HUI gold index declined 1.2% (down 48.7%).

One-month Treasury bill rates ended the week at one basis point and three-month bill rates closed at 3 bps. Two-year government yields slipped a basis point to 0.36%. Five-year T-note yields ended the week down 3 bps to 1.395%. Ten-year yields declined 4 bps to 2.49%. Long bond yields fell 8 bps to 3.50%. Benchmark Fannie MBS yields dropped 12 bps to 3.32%. The spread between benchmark MBS and 10-year Treasury yields narrowed 8 to 83 bps. The implied yield on December 2014 eurodollar futures fell 11 bps to 0.675%. The two-year dollar swap spread declined 4 to 16 bps, and the 10-year swap spread declined 2 to 21 bps. Corporate bond spreads reversed course. An index of investment grade bond risk fell 7 to 87 bps. An index of junk bond risk sank 28 to 435 bps. An index of emerging market debt risk declined 9 to 341 bps.

Debt issuance remained slow. Investment grade issuers included ITC Holdings $550 million.

Junk bond fund outflows surged back to $3.1bn (from Lipper). Junk issuers included Valeant $3.2bn, Audatex North America $850 million, Gibson Energy $500 million, Transdigm $500 million, Hercules Offshore $400 million, Petroquest Energy $200 million, Creditcorp $165 million and Smith & Wesson $100 million.

Convertible debt issuers included Starwood Property Trust $400 million.

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