Page 1 of 4 CREDIT BUBBLE BULLETIN Misdirected credit runs unabated
Commentary and weekly watch by Doug Noland
When I titled last week's piece
Too big to suffer a loss I had no real inkling of what this past week
would have in store. Actually, I had presumed that the Treasury and Fed
wouldn't allow Lehman Brothers to fail. Lehman, after all, was one of the major
players in the precarious daisy chain of Wall Street risk intermediation. A
failure by any key player in this realm would immediately have this historic
credit crisis jumping the firebreak from the rugged terrain of mortgages and
"risk assets" into the hallowed land of perceived safe and liquid contemporary
"money."
The consequences of such a lurid escalation were so potentially catastrophic
that I believed that Paulsen and Bernanke were prepared to use the overwhelming
force of fleets of aerial
supertankers to ensure our "money" tinderbox was not set ablaze.
It now appears they didn't appreciate the ramifications for Lehman going under
- how this would quickly ignite a run on the core of our monetary system. It
wasn't long, however, before the horror of watching the entire system going up
in flames prompted a mad scramble to conjure the equivalent of monetary
firefighting shock and awe. What an incredible week.
On Thursday, the administration presented Congress a US$700 billion plan to
stem the credit and, increasingly, economic crises. Wall Street and the banking
system have been rapidly burning through their entire "capital" buffer, as the
risk intermediation community suffers enormous and unending losses. The
bursting of the credit bubble is proving catastrophic for many that
intermediated the risk between trillions of risky loan assets funded by the
issuance of trillions of perceived safe and liquid money-like liabilities.
For awhile, the global sovereign wealth funds, speculators, and some investors
were content to step up and lead a recapitalization process. As time passed,
however, this was increasingly recognized as a classic case of throwing good
"money" after bad.
As losses escalated and sources of additional "capital" dried up, focus quickly
turned to escalating losses being suffered by some gigantic and highly
leveraged players (such as Lehman, Merrill Lynch, and American International
Group). At least in the case of Lehman, a run on their money market liabilities
(especially "repos") had commenced. Bankruptcy by Lehman - with the extreme
market uncertainty associated with unprecedented losses to bondholders,
creditors and counterparties - immediately froze the credit default swap
(CDS)marketplace. Dislocation in the CDS market was a deathblow for AIG and
many hedge funds.
The Lehman contagion quickly incited panic throughout the money fund complex, a
to-this-point bulletproof sector that had, after a year of enormous growth,
become an even more vital pillar to the sacred domain of contemporary "money."
Exposure to Lehman forced the Primary Reserve Fund, a venerable money market
operation, to mark down its portfolio 3%. Primary Reserve saw 60% of its fund
(almost $40 billion) redeemed in just two days, as trading in even the lost
"liquid" short-term money market instruments seized up. A modern day electronic
"run" on contemporary "money" had commenced; the system had reached the brink
of collapse.
To stabilize the system at such a point required nothing less than
unprecedented measures. The Treasury and Federal Reserve would have to become
major buyers of last resort - both the providers of massive marketplace
liquidity and the underwriter of massive credit losses. With the monetary
system breaking down, the federal government saw no alternative than to fill
the void left by the impaired risk intermediators. Or, from a more theoretical
perspective, our government would have to guarantee the "moneyness of credit" -
assume the spiraling losses between the trillions of risky system loans and the
trillions issued of perceived safe and liquid "money."
No systemic federal guarantee, no more "moneyness" - and an immediate end to
the last bastions of credit growth that have been sustaining the US bubble
economy.
So what's the problem with the government stepping to guarantee "moneyness"?
How can it be inflationary, when credit growth has slowed so dramatically,
assets prices have come under such pressure, and confidence in the system has
been so shaken? Well, I continue to believe that some overriding issues are
today lost in the discussion; lost in all the pontificating; lost in the frenzy
of panicked policymaking.
I am not surprised that our policymakers nationalized Fannie Mae and Freddie
Mac. It was predictable that the Treasury and Federal Reserve were forced into
wholesale bailouts and unprecedented liquidity operations. That Washington had
to step up and guarantee money fund deposits is not all too surprising. Ditto
with the upwards of $1 trillion of congressional authorizations, with
policymakers bumbling through various measures in hopes of stabilizing the
system.
Over the years, we've been pretty cognizant of the extreme nature of excesses;
the extent of system vulnerability; and the expensive bill that would come due
with the arrival of the bust. But I want to be especially clear on one thing: I
am shocked and incredibly alarmed that all these measures became necessary at
such an early stage of financial and economic adjustment. After all, the Dow
remains above 11,000 and gross domestic product expanded 3.3% last quarter.
And this gets right to the heart of the matter - where the analytical rubber
meets the road. A massive inflation of government obligations; a major
government intrusion into all matters financial and economic; and an
unprecedented circumvention of free market forces has been unleashed - but to
what end?
I believe it is a grave predicament that such a rampage of radical policymaking
has been unleashed in order to maintain inflated asset markets and to sustain a
bubble economy. Normally, such desperate measures would be employed only after
a crash and in the midst of a major economic downturn - not in efforts
specifically to forestall the unwind. Not only will such measures not work, I
believe they will only exacerbate today's already extreme global monetary
disorder. They will definitely worsen the inevitable financial and economic
dislocation.
I have over the past several years repeatedly taken issue with the revisionist
view that had the Fed recapitalized the banking system after the '29 stock
market crash the Great Depression would have been avoided. Some have suggested
that $4 billion from the Fed back then would have replenished lost banking
system capital and stemmed economic collapse. But I believe passionately that
this is deeply flawed and dangerous analysis.
An injection of a relatively small $4 billion would have mattered little. What
might have worked - albeit only temporarily - would have been the creation of
many tens of billions of dollars of new credit required to arrest asset and
debt market deflation and refuel the bubble economy. Importantly, however, at
that point only continuous and massive credit injections would have kept the
system from commencing its inevitable lurch into a downward financial and
economic spiral.
Importantly, market, asset and economic bubbles are voracious credit gluttons.
I would argue that the system today continues to operate at grossly inflated -
bubble - levels. The upshot of years of credit excess are grossly distorted
asset prices, household incomes, corporate cash flows and spending, government
receipts and expenditures, system investment and economy-wide spending and,
especially, imports. So to generally stabilize today's maladjusted system will,
as we are now witnessing, require massive government intervention. Enormous
government-supported credit growth will be necessary this year, next year, and
the years after that. To be sure, a protracted and historic cycle of
misdirected credit runs unabated.
Present efforts to sustain the bubble economy create an untenable situation.
Washington is now in the process of spending trillions to bolster a failed
financial structure, while focusing support on troubled mortgages, housing, and
household spending. Regrettably, this is a classic case of throwing good money
after bad. Not yet understood by our policymakers, literally trillions of new
credit will at some point be necessary to finance an epic restructuring of the
US economic system. Our economy will have no choice but to adjust to less
household spending, major changes in the pattern of spending (this is, less
"upscale" and services), fewer imports, more exports, and less energy
consumption.
Moreover, our economy must adjust and adapt to being much less dependent on
finance and credit growth - which will require our "output" to be much more
product-based as opposed to "services"-based. We'll be forced to trade goods
for goods.
The current direction of bubble-sustaining policymaking goes the wrong
direction in almost all aspects. At some point, the markets will recognize this
bubble predicament, setting the stage for a very problematic crisis of
confidence for the dollar and our federal debt markets.
WEEKLY WATCH
Just when you thought you'd seen it all... Yet how wild could it have been with
the Dow down only 0.3% (down 14.1% y-t-d) and the S&P500 up 0.3% (down
14.5%)? Amazingly so. The Transports gained 0.5% (up 11.6% y-t-d), and the
Morgan Stanley Cyclicals added 0.2% (down 13%). The Utilities were hit for 3.3%
(down 17.6%), and the Morgan Stanley Consumer index declined 2.5% (down 7.4%).
The broader market rallied sharply. The small cap Russell 2000 jumped 4.7%
(down 1.6%), and the S&P400 Mid-Caps gained 2.1% (down 6.2%). The NASDAQ100
declined 1.2% (down 16.3%), and the Morgan Stanley High Tech index dipped 0.9%
(down 16.4%). The Semiconductors rallied 3.7% (down 18.2%); The Street.com
Internet Index added 0.6% (down 10.4%); and the NASDAQ Telecommunications index
gained 0.6% (down 9.7%). The Biotechs were little changed (up 2.8%). Financials
were unbelievably volatile and ended the week up big. The Broker/Dealers jumped
7.6% (down 31%). The Banks surged 16.3%, slashing y-t-d losses to 6.8%. With
bullion rocketing $108 higher, the HUI Gold index rallied 11.5% (down 20.9%).
September 19 - Bloomberg (Dakin Campbell): "Treasuries tumbled, sending two-
year note yields up the most in 26 years, after Treasury Secretary Henry
Paulson and Federal Reserve Chairman Ben S. Bernanke announced plans to help
stem a collapse in financial- market confidence."
One-month Treasury bill rates traded as low as one basis point yesterday before
closing the week at 0.69%, down 66 bps Three-month yields collapsed 47 bps to
0.99%. After today's sell off, two-year government yields ended the week down
only 4 bps to 2.17%. Five-year T-note yields rose 9 bps this week to 3.04%, and
10-year yields increased 9 bps to 3.81%. Long-bond yields gained 7 bps to
4.38%. The 2yr/10yr spread increased 13 to 163 bps. The implied yield on
3-month December '09 Eurodollars added 5.5 bps to 3.375%. Benchmark Fannie MBS
yields rose 11 bps to 5.40%. The spread between benchmark MBS and 10-year
T-notes widened 2 to 159 bps. Agency 10-yr debt spreads were 17 wider to 64
bps. The 10-year dollar swap spread increased 5 to 66.25. Corporate bond
spreads moved wildly. An index of investment grade bond spreads ended somewhat
wider at 163 bps, and an index of junk bond spreads widened to 636 bps.
I saw only one debt issue this week, a $500 junk borrowing by Sungard Data
Systems. German 10-year bund yields added 2 bps to 4.21%. The German DAX
equities index declined 0.7% (down 23.3% y-t-d). Japanese 10-year "JGB" yields
fell 5 bps to 1.48%.
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