Page 1 of 5 CREDIT BUBBLE BULLETIN Debt trap
Commentary and weekly watch by Doug Noland
The economy lost 651,000 jobs in three months. Auto sales have collapsed, and
retail sales have fallen off a cliff. And there is at this point little
indication that credit availability will normalize anytime soon for household,
corporate or municipal borrowers. While the extraordinary efforts by the Fed
and global central bankers have loosened the clogged-up inter-bank lending
market, risk markets remain hopelessly paralyzed. The unfolding collapse of the
leveraged speculating community continues to overhanging the marketplace.
Securitization markets are still essentially closed for business.
We can continue to analyze developments in the context of two overarching
themes: First, there is the implosion of contemporary
"Wall Street finance". Second, the bursting of the credit bubble has initiated
what will be an arduous and protracted economic adjustment. Each week provides
additional confirmation of the interplay between the breakdown of Wall Street
risk intermediation and the bursting of the US bubble economy. This process has
gained overwhelming momentum.
I know some analysts are anticipating an eventual return to "normalcy". The
thought is that it is only a matter of time before "shock and awe" policymaking
and trillions of newly created liquidity entice investors and speculators back
into risk assets. This view is too optimistic, and history offers an especially
poor guide in this respect. By and large, the unprecedented growth in Federal
Reserve and global central bank balance sheets is (scarcely) accommodating
de-leveraging. Between the hedge funds, global "proprietary trading" and other
leveraged speculators, it is not unreasonable to contemplate an overhang of
(prospective forced and deliberate sales) of upwards of US$10 trillion.
It's popular to label Federal Reserve operations as a massive effort to "print
money". Yet it is important to recognize that, at least to this point, the
expansion of the Fed assets (Fed credit) is counterbalanced by the collapsing
balance sheets of leveraged financial operators. The inflationary effects - the
increased purchasing power created by the expansion of credit - occurred back
when the original loan was made, securitized, and leveraged by, say, a hedge
fund. Today's ballooning central bank holdings (and TARP spending) may very
well stem financial system implosion. This is, however, a far cry from
engendering a meaningful increase in either the market's appetite for risk
assets or the expansion of new system credit in the real economy.
I don't want to imply that unprecedented monetary policy measures aren't having
an impact. Overnight lending rates (Libor) were quoted at 0.33% today, down
from a spike to almost 7.00% in late September. And at 2.29%, three-month Libor
has dropped from early October's 4.82%. Other measures of systemic risk and
liquidity premiums (including the 2- and 10-year dollar swap spreads) have
dropped dramatically over the past month.
The problem is that the unclogging of inter-bank and money markets has had
little effect on the pricing and availability of credit for the vast majority
of borrowers operating throughout the real economy. After ending September at
about 650, junk bond spreads have surged to 950 basis points. Investment-grade
bond spreads are also higher today than at the end of the third quarter.
Benchmark mortgage backed security spreads have changed little, while Jumbo
mortgage borrowing rates remain elevated. Risk premiums for municipal
borrowings have been reduced only somewhat from extreme levels. Unsound
borrowers everywhere have little hope of borrowing anywhere.
There are complaints out of Washington that, despite oodles of bailout funding,
the banks are refusing to lend. Well, total bank credit has expanded $575
billions over the past 10 weeks, or 32% annualized. Importantly, the
asset-backed securities (ABS), collateralized debt obligations (CDO) and
securitization markets generally remain closed for new business.
The heart of the matter is not so much that banks are refusing to extend credit
but that the entire mechanism of Wall Street risk intermediation has collapsed.
After ballooning into multi-trillion dollar avenues for credit expansion,
intermediation through the ABS and CDO markets is basically over. The
convertible bond market has also badly malfunctioned, along with the
"private-label" MBS marketplace. Wall Street's auction-rate securities have
ceased as a mechanism for credit expansion, along with myriad other avenues for
securitization. And, importantly, derivatives markets, having evolved into an
essential element of contemporary risk intermediation and credit expansion,
have suffered a devastating crisis of confidence. Scores of leveraged
strategies are no longer viable. Indeed, monetary processes essential for
funding broad cross-sections of the economy have completely broken down.
Even if banks had a desire to make the same types of risky loans Wall Street
financed throughout the boom (which they clearly don't), it is difficult to
envisage how bank credit could today adequately compensate for the interrelated
collapses in Wall Street risk intermediation and leveraged speculation. And
unlike previous crises, no amount of rate cuts, liquidity injections, or
policymaker jawboning will revive leveraged speculation. That historic bubble
and mania has burst, and it is now only a matter of waiting to dissect the
devastation wrought by the unfolding run on the industry. A typical Federal
Reserve-induced return to risk-taking in the credit markets will be stymied for
some time to come by an unrivaled inventory of debt instruments overhanging the
markets.
The critical issue then becomes how the system can generate sufficient new
credit to keep our asset markets and bubble economy from completely imploding.
Well, we can assume at this point that the Fed will continue to accommodate
de-leveraging through the ballooning of its balance sheet. At the same time,
the federal government will soon be running trillion dollar annual deficits.
GSE (Fannie Mae and Freddie Mac) balance sheets will likely commence a period
of aggressive expansion. And, importantly, the banking system will have no
alternative than to expand rapidly. At this point, timid banks equate to a
bubble economy spiraling into depression.
If the markets cooperate, perhaps over the coming months the now breakneck
economic contraction will somewhat stabilize. I fear, however, that current
dynamics are setting the stage for yet another stage of this vicious crisis.
Some analysts believe - and certainly it is the Fed's intention - in ultra-low
interest rates to assist in the recapitalization of the banking system. The
early 1990s provides a nice example: aggressive rate cuts and a steep yield
curve provided a backdrop for troubled banks to quietly convalesce by raising
cheap deposits and sitting on a safe portfolio of longer-term government debt
securities. Why can't a similar operation bail the banks out of their current
predicament?
One should note the stark contrasts between today's environment and that from
the early nineties. First of all, 10-year government yields averaged about 7.8%
in the three years 1990 through '92. Bond markets back then were commencing a
historic bull run and, strangely enough, the price of government debt ran
higher in the face of huge deficits. There are reasons these days to fear an
emergent bond bear. Second, from the Fed's "flow of funds" report, we know that
"Total Net Borrowing and Lending in Credit Markets" averaged $770 billion
annually during the '90-'92 period. "Total Net Borrowing ... " last year
approached a staggering $4.40 trillion. The important point is that today's
bubble economy dynamics were not in play in the early nineties. Sustaining the
system required a fraction of today's credit creation, thus there was little
prevailing pressure on the banks back then to lend amid their convalescing.
Indeed, banking system impairment and resulting Fed policymaking engendered the
emergence of Wall Street finance in the early 1990s - from the Wall Street
firms, the GSEs, securitizations, derivatives and leveraged speculation. All
were more than happy to take up the slack in bank credit creation - relating
both the overall and banking systems.
With the bursting of the bubble in Wall Street finance, the banking system will
today have no alternative than to lend and expand credit aggressively. The
banks provide the only hope for reflation, and there will be no room for
'90s-style risk-free spread government carry trades. Instead, it will now be
the banking system's role to take up enormous systemic credit slack and rapidly
expand its portfolio of risk assets. Especially at this precarious stage of the
credit cycle, the banking system's predicament ensures the ongoing need for
hugely expensive government funded industry recapitalizations.
In today's interest rate and market environment, massive government deficits
don't worry the bond market. I view the marketplace as quite complacent when it
comes to the scope of unfolding Treasury and agency debt issuance. Actually,
the Treasury, the GSEs and the banking system have in concert succumbed to debt
trap dynamics. With Wall Street risk intermediation now out of the equation,
the system is down to four principal sources of "money" creation - the Fed,
Treasury, GSEs and the banks. It's that old "inflate or die" dilemma that's
already smothered Wall Street finance.
The good news is these sources of credit creation do today retain the capacity
to somewhat stabilize financial and economic systems. The bad news is that
going forward all four must expand aggressively - in collaboration - to
forestall acute systemic crisis. All four must expand aggressively to bolster a
highly maladjusted economic system, in the process sustaining confidence in the
value of their liabilities. At some point, one would expect a crisis of
confidence with respect to the quality of these credit instruments. And, you
know, the way things have unfolded, Murphy's Law would only seem to dictate a
destabilizing jump in market yields.
WEEKLY WATCH
For the week, the S&P500 fell 3.9% (down 36.6% y-t-d) and the Dow declined
4.1% (down 32.6%). The Transports were hit for 5.7% (down 19.8%) and the Morgan
Stanley Cyclicals 5.4% (down 49.5%). So-called defensive stocks held up better,
with the Utilities about unchanged (down 30.8%) and the Morgan Stanley Consumer
index declining 2.2% (down 25%). The broader market gave back some of last
week's outperformance. The small cap Russell 2000 dropped 5.9% (down 34%), and
the S&P400 Mid-Caps fell 5.1% (down 37.1%). The NASDAQ100 dropped 4.7%
(down 39%), the Morgan Stanley High Tech index fell 5.7% (down 42.9%), and the
Semiconductors sank 6.8% (down 45.3%). The Street.com Internet lost 4.2% (down
35.9%), and the NASDAQ Telecommunications index declined 3.8% (down 39.9%).
With Bullion recovering $13, the HUI Gold index gained 3.7% (down 50.9%).
One-month Treasury bill rates ended the week at 0.08% and three-month yields at
0.28%. Two-year government yields dropped 23 bps to 1.33%. Five-year T-note
yields sank 25 bps this week to 2.56%, and 10-year yields dropped 18 bps to
3.78%. Long-bond yields declined 12 bps to 4.27%. The implied yield on 3-month
December '09 Eurodollars sank 40 bps to 2.44%. Benchmark Fannie MBS yields fell
a notable 48 bps to 5.55%. The spread between benchmark MBS and 10-year T-notes
narrowed 31 to a one-month low 177 bps. Agency 10-yr debt
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