Asia Times Online :: Asian news and current affairs

Oct 6, 2009

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CREDIT BUBBLE BULLETIN
No way to fix a collapse
Commentary and weekly watch by Doug Noland

I'll begin with an excerpt from the latest "Investment Outlook" by PIMCO's Bill Gross: "But California's problems, while somewhat unique and self-inflicted, are really America's problems, and not just because the California economy is 15% of national GDP [gross domestic product]. While California's $26 billion deficit is not directly comparable to the federal gap of $1 trillion-plus, they both reflect a lack of discipline and indeed vision to perceive that the strong growth in revenues was driven by the same excess leverage and same delusionary asset appreciation that was bound to approach cliff's edge."

It's contagious. Both at the state and local level and in Washington, policymakers "lack discipline and indeed vision ... " It is said that "bull markets create genius". I'll suggest that the

downside of the credit cycle fashions lousy policymaking. I feel for the "Governator" and the California legislature, and I feel for our new president and members of Congress. They confront the harsh post-bubble reality of no-win circumstances - wearing big bullseyes on their backs in an age of slings and arrows.

As much as I respect Bill Gross - and can't take strong exception with much of what he has been saying and writing of late - I just can't find it within myself to move on. Newer readers might be unfamiliar with my long-standing - and one-way - debate with the view of the financial world held by Gross and PIMCO managing director Paul McCulley. They have over the years been leading proponents for the popular consensus ideology that I have labeled "inflationism".

It is a basic tenet of credit bubble theory that if the system inflates the quantity of credit it will be spent. Credit bubbles are fundamentally about a lack of discipline - one could say a confluence of undisciplined behavior. Credit bubbles evolve specifically because of undisciplined monetary system management, undisciplined lending, undisciplined borrowing, undisciplined investment, undisciplined speculation and, at the end of the day, undisciplined spending throughout. And there are some absolutes: inflated mortgage credit, home price gains, and elevated incomes will absolutely inflate the propensity for undisciplined consumption. Inflated tax receipts will absolutely inflate government expenditures - in California, Washington DC, and all across the country. The discipline problem goes way back but commenced within the bowels of our new-age credit system.

Mr McCulley, in particular, was a vocal proponent for post-technology bubble reflation. This reflation doubled total mortgage credit in about six years and unleashed monetary disorder all over the world. In the process, this historic credit inflation inflated asset prices, incomes, corporate profits, and government receipts. The state of California was at the epicenter of this massive inflation. Going back to fiscal year 2002-2003, California general fund revenues were about US$71 billion. By the beginning of the 2007-2008 year, the state was budgeting for general revenues of $101 billion.

In percentage terms, state revenues inflated about 40% during the five-year boom. With receipts rising each year, of course legislators were going to extrapolate and increasingly inflate state spending. There's no mystery here. Keep in mind that in typical bubble economy form, much of the rising expenditure was the result of inflating costs all along the chain of state services. Those campaigning earlier this decade for aggressive monetary easing to fight deflation got, not surprisingly, more than they bargained for.

In hindsight, it is amazing to contemplate the complete and utter lack of vision that afflicted policymakers throughout the golden state and all across the country. How could they not perceive that sophisticated Wall Street financial leveraging and resulting asset bubbles were only temporarily inflating their coffers? When seemingly everyone bought into the notion of endless prosperity, why couldn't they have kept their heads? Just because everyone believed the enlightened Federal Reserve had forever mastered the business cycle, why couldn't they have been more skeptical? That the economic community, the regulator community, the Federal Reserve and the marketplace all missed this credit bubble dynamic is, apparently, no excuse. As I have often written, I sympathize with post-bubble policymakers.

It is a tenet of credit bubble theory that politicians - given the opportunity - will inflate. There is ample history illuminating the dangerous propensity to run the government printing press. Contemporary analysis gets more complex because of the nature of private-sector credit and the penchant for government (explicit and implicit) guarantees. During the boom, "money" was burning a hole in policymakers' pockets, but it was Wall Street and the government-sponsored enterprises (GSEs) commanding the electronic printing press 24/7. By far the most precarious absence of discipline and vision belonged to those operating in and accommodating this historic private-sector credit bubble.

I disagree with the policy of massive deficits. Yet the California and US budget quagmires are the direct consequences of the bursting of the Wall Street/mortgage finance bubble. As much as greed and leverage have provided easy scapegoats, responsibility lies first and foremost with the nature of contemporary unchecked finance and flawed "activist" monetary management (trumpeted, not coincidently, by our era's preeminent market operators). As much as the consensus view believes that previous financial maladies have been largely rectified, I see a continuation of the same malignant credit system dynamics. In short, massive government intrusion into the market pricing of credit continues to fuel economic maladjustment and bubble dynamics.

Why did Wall Street issue trillions of asset-backed securities (ABS), auction-rates securities, collateralized debt obligations, and private-label mortgage-backed securities (MBS)? Because they could. Why did the hedge funds and others leverage so egregiously? Because they were making a bloody fortune and the marketplace was more than ok with it. Why did the GSEs increase their MBS guarantees by $400 billion over the past year, and why did the Treasury issue $1.9 trillion of Treasuries the past 12 months - and will likely do only somewhat less over the next year? And why are cash-strapped state and local governments borrowing so aggressively these days? It's because the marketplace continues to readily accommodate credit excess. Who is demonstrating a lack of discipline and vision - the borrower or the lender? The "Governator" or the market operator? Is this the way the market pricing system is supposed to function?

Why is the marketplace inherently incapable of disciplining the egregious borrower - whether mortgage debt during that bubble or government debt today? First of all, there are no inherent system restraints on credit creation. Recalling the mortgage finance bubble, recent massive increases in the supply of government debt have been met with a collapse in borrowing costs. Second, the marketplace perceived that fiscal and monetary policymakers were backstopping mortgage credit during the boom. Today, the market is confident that policymakers are firmly behind the Treasury and agency securities markets. Borrowers are undisciplined for one reason: the distorted market mechanism not only fails to discipline them - it accomplishes the exact opposite.

I could ramble on for pages on the myriad costs associated with unchecked, undisciplined and mispriced finance. Mr Gross touched upon a key cost, noting today's uncompetitive California and US economies. This is a key aspect of bubble economy distortions. The dangerous flaw in inflationism dogma is that the Federal Reserve and policymakers can manipulate the cost and quantity of credit with positive systemic results. In reality, the consequences of increasingly bold policy activism over time include a more distorted and unbalanced economic structure, as witnessed today. It is my view that a flawed credit apparatus, ill-advised government intervention, and dysfunctional market dynamics ensure economic maladjustment gets worse before it gets better.

WEEKLY WATCH
For the week, the S&P500 (up 13.5% y-t-d) and the Dow (up 8.1%) both declined 1.8%. The Morgan Stanley Cyclicals fell 2.5% (up 47.6%), and Transports declined 3.0% (up 4.4%). The Banks dropped 2.8% (up 1.1%), while the Broker/Dealers gained 1.1% (up 50.3%). The Morgan Stanley Consumer index added 0.3% (up 15.1%), while the Utilities were hit for 2.6% (down 3.1%). The broader market gave up some ground. The S&P 400 Mid-Caps dropped 2.2% (up 23.3%), and the small cap Russell 2000 sank 3.1% (up 16.2%). The Nasdaq100 declined 1.9% (up 37.2%) and the Morgan Stanley High Tech index fell 1.6% (up 51.3%). The Semiconductors were slammed for 4.5% (up 44.5%). The InteractiveWeek Internet index dipped 1.6% (up 57.9%). The Biotechs sank 4.1% (up 37.4%). While Bullion advanced $12, the volatile HUI gold index dipped 0.7% (up 30.5%).

One-month Treasury bill rates ended the week at 3 bps, and three-month bills closed at 10 bps. Two-year government yields dropped 11 bps to 0.76%. Five-year T-note yields sank 15 bps to 2.15%. Ten-year yields were 10 bps lower to 3.22%. Long bond yields declined 9 bps to 4.00%. Benchmark Fannie MBS yields sank 15 bps to 4.12%. The spread between 10-year Treasuries and benchmark MBS narrowed 5 to 90. Agency 10-yr debt spreads narrowed 4 to 10 bps. The implied yield on December 2010 eurodollar futures dropped 13 bps to 1.635%. The 2-year dollar swap spread increased 3.5 to 35.25 bps; the 10-year dollar swap spread was unchanged at 16.25 bps; and the 30-year swap spread declined 0.25 to negative 12 bps. Corporate bond spreads were mixed. An index of investment grade bond spreads widened 12 bps to 145, and an index of junk spreads narrowed another 27 to 603 bps.

Corporate debt issuance is booming. Investment grade issuers included Citigroup $5.0bn, L-3 Communications $1.0bn, Tyco $500 million, Penn Electric $500 million, Weyerhaeuser $500 million, Guardian Life $400 million, Entergy Gulf States $300 million, and Alliant Energy $250 million.

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