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5 CREDIT BUBBLE
BULLETIN The meaning of stage
II Commentary and weekly watch
by Doug Noland
The US credit bubble was
punctured this past summer, as the mortgage crisis
escalated from the confines of subprime to the
expansive marketplace for Wall Street
"private-label" asset-backed (ABS) and
mortgage-backed (MBS) securities. Especially with
the bursting of the Florida and then California
housing bubbles, literally trillions of mortgages,
sophisticated debt structures, credit insurance,
various financial guarantees, leveraged
speculative positions and bloated Wall Street
balance sheets were in almost immediate peril.
Contagious deleveraging overwhelmed the system. In
a brief period of only several months the US
credit system went from unmatched expansion and
speculative excess to the
brink of implosion.
Last week, I made the
case for thinking in terms of the end of the first
stage of the financial crisis. The epicenter of
this initial upheaval was in highly leveraged
positions in mortgage credit exposure -
encompassing mortgage-related securities positions
(that is, ABS and MBS); sophisticated credit
structures (such as collateralized debt
obligations, or CDOs, structured investment
vehicles, or SIVs, real estate investment trusts,
or REITs, and so forth); various derivatives
exposures (including subprime ABX indices, credit
default swaps and synthetic CDOs); and a broad
assortment of financial guarantees and liquidity
agreements (monoline insurance, mortgage
insurance, asset-backed commercial paper, and
cash-equivalent funds). I have referred to this as
the breakdown in Wall Street-backed finance.
This collapse had reached the cusp of
bringing down the entire credit system. In stark
contrast to traditional credit crises, this one
engulfed the entire system before the general
economy so much as succumbed to a negative quarter
of contraction in gross domestic product. To stem
implosion required nothing less than a
Fed-orchestrated bailout of a major Wall Street
firm; the opening of the discount window to the
securities firms; the implementation of massive
liquidity facilities at home and abroad; the
promotion of mortgage securities as collateral for
borrowings from the Fed; assurances of enormous
market intervention (mortgage purchases and
guarantees) by the troubled GSEs; the imposition
of significantly negative real short-term rates;
and open-ended federal government stimulus and
financial guarantees.
An argument could be
made that, while dramatic, these measures were not
world changing. I would counter that such measures
gave assurances to the marketplace that the
Federal Reserve (along with global central
bankers) and our government policymakers were
willing take any and all measures necessary to
stabilize the credit system and sustain the US
bubble economy. There were no longer any bounds on
government intervention.
I have referred
to these policy measures as the supplanting - or
underpinning - of Wall Street-backed finance with
federal government-backed finance. Or, perhaps
somewhat less analytically ambiguous, to avoid
implosion Washington had no alternative but to
explicitly and implicitly nationalize both system
credit and liquidity risk.
It was
desperate policymaking in the extreme; it was bold
and it was historic. It reworked the rules of our
credit apparatus, and the markets have for more
than a month now grappled with the ramifications
of these changes. To be sure, each week of
relative credit system stability has provided
various troubled players the opportunity to raise
new capital, others to pare problem positions, and
many to adjust various risk exposures.
Importantly, the unwinding of "bearish"
speculations and hedges is now playing an
instrumental role in the resurgence in marketplace
liquidity.
According to Bloomberg data,
last week saw an all-time record US$43.3 billion
of US corporate debt issuance (compared with a
year-to-date weekly average of $18 billion).
Issuers included Citigroup, Merrill Lynch, Bank of
America, Wachovia and Goldman Sachs - and much of
their issuance was in the form of new hybrid
"equity capital". Investment-grade bond spreads
narrowed last week to the lowest level since
mid-January; junk bond spreads to early-March
levels; and leverage loan prices recovered this
week all the way back to December levels.
Many people, including seasoned
strategists, are today arguing that the worst of
the financial crisis is now behind us. I disagree,
of course. Yet from an analytical perspective it
is imperative to appreciate that (the bust of Wall
Street-backed finance notwithstanding) we still
very much operate in a unique period of
market-based credit. The ebb and flow of market
perceptions (of greed and fear) continue to have
an outsized impact on credit availability and
marketplace liquidity, hence economic performance.
Stage II gets underway Not many
weeks ago the system was seizing up in the face of
collapsing confidence and fears of systemic
failure. Today, with confidence and greed
regaining some of their "flow", credit conditions
are loosening meaningfully, which does wonders for
reigniting marketplace enthusiasm not to mention
short covering). So, stage II - the dynamics,
excesses, distortions and imbalances leading to
the inevitable second phase of crisis - is now off
and running.
Does stage II mean the credit
bubble has returned? No. Does stage II mean credit
losses will no longer trouble the system?
Definitely not. Does stage II mean the reemergence
of Wall Street-backed finance? No. Does stage II
Mean the reigniting of US asset inflation? No, at
least not generally. Does stage II Mean the
leveraged speculating community has been granted a
new lease on life? Don't bet against it. Does
stage II mean the US bubble economy could take on
some additional air? Perhaps. Does stage II mean
the exacerbation of global credit bubble excesses?
Most certainly. Do global credit bubble dynamics
impact our credit and economic systems? Of course
- more than ever.
I've written much on the
issues of monetary processes and inflation
dynamics. These themes now should play crucial
roles in how we analyze the many complexities of
today's financial and economic landscape. Prior to
the bust, the rampant expansion of Wall
Street-backed finance was directly fueling US
asset inflation and bubbles - housing in
particular. Today, post-crash, no amount of
policymaker intervention can repair broken
confidence in all facets of Wall Street finance,
including subprime and "exotic" mortgages, the
monoline financial guarantee business, CDOs,
private label MBS, auction-rate securities and so
forth. Indeed, their problems are poised to only
worsen as the economy falters.
It is one
thing to stem implosion and something altogether
different when it comes to restoring the Wall
Street credit mechanism to the point of fostering
new bubbles. Wall Street "alchemy" is a spent
force unless it melds in some type of government
obligation. The best policymakers can do today is
place a federal government guarantee on 90% of new
mortgage debt and hope this somewhat stabilizes US
housing.
Faltering housing markets and
waning consumer confidence will place increased
strains on economic performance. That's not at
issue. At the same time, the finance-driven bubble
economy is unmistakably on more stable footing now
compared with its perilous perch a month earlier.
Recognizing the ebb and flow of
contemporary market-based credit (and the reality
that today's "flow" could easily be augmented in
the short-run by the unwind of bearish positions),
I will remain mindful of the potential for a
meaningful loosening of credit conditions. To be
sure, outside of housing and finance, the US
economy is still demonstrating some powerful
inflationary biases and impulses. And inflationary
biases spur credit growth that spurs heightened
inflationary pressures. That's the way it works.
The global credit bubble must factor into
our analysis. Most conspicuously, powerful price
pressures throughout global energy, food, and
commodities markets are stoking growth in various
sectors of our economy. Our export sector
continues to boom.
Global financial
excess Less obvious, I would argue that
rampant global financial excess is a contributing
factor in our financial institutions' capacity to
raise new "capital" from the global markets - and
more generally in bolstering marketplace liquidity
in the face of the collapse of Wall Street-backed
finance. Foreign demand for our assets is a not
insignificant issue. Moreover, the global
leveraged speculating community, and international
liquidity flows more generally, are a major stage
II wildcard.
Otherwise intelligent
financial commentators argue that today's rising
energy and food prices are not a "monetary
phenomenon". Instead, these price pressures are
said to be due to strong demand from China and
India - wealthier consumers choosing to upgrade
their diets. But both the Chinese and Indian
economies (and many others) are now operating with
virtually unlimited credit - a unique combination
of rampant domestic credit growth coupled with
massive foreign financial inflows. As I've
explained ad nauseam, US current account deficits
and dollar impairment are the root cause of scores
of runaway domestic credit systemic that these
days comprise the global credit bubble. This
historic bubble is everywhere and in every way a
monetary (credit) phenomenon.
It is my
argument that stage II means another year of
massive US current account deficits. This would
mean, for one, a prolonging of the massive flow of
liquidity into international central bank reserves
(creating domestic credit in the process),
sovereign wealth funds, and (to a lesser extent)
the hedge fund community. The consequences from a
further ballooning of this unwieldy global pool of
speculative finance are not at all clear.
Secondly, another year of US deficits
would mean another year of excessive liquidity
flows into the already overheated economies
throughout Asia, the Middle East and elsewhere.
These flows are hitting economies with already
acute inflation pressures and related problems.
Importantly, these monetary processes and
inflationary dynamics are by now well entrenched
and extraordinarily powerful after years of
unrelenting excess. Resulting monetary disorder
should be expected to go to increasingly
destabilizing extremes (think NASDAQ 1999 and
subprime 2006) - and indeed we're seeing evidence
of as much in near $120 crude, the global food
price spike and related hoarding, and wildly
unstable and speculative global financial markets.
It is in this context that I believe US
policymakers are today unknowingly risking global
financial and economic catastrophe.
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