From The Prudent Bear
.... for Private Use Only
If one takes a step back, it is truly astounding (and enormously disconcerting) to see what has been allowed to transpire within the U.S. financial system. Today, the three largest U.S. ?banks? - Citigroup, Bank of America and Chase Manhattan - have come to hold combined assets of almost $1.8 trillion. The three largest ?securities firms,? Morgan Stanley Dean Witter, Merrill Lynch and Goldman Sachs have combined assets of $1.05 trillion, having increased $182 billion (21%) during the past 12-months.
The ?Big Three GSEs,? Fannie Mae, Freddie Mac and the Federal Home Loan Banks have combined assets of almost $1.6 trillion, having increased $302 billion (24%) during the past 12-months and a stunning $562 billion (55%) during the past 7 quarters. Total agency securities ended 1999 at $3.9 trillion, an increase of $905 billion in just 18 months. Even the largest ?industrial? firm, General Electric, continues to aggressively expand its financial services business as its total assets have grown to $422 billion. Combined, these 10 institutions have balance sheets with total assets of $4.8 trillion, supported by shareholders? equity of $ 280 billion.
But in the present period of ?wild cat? finance, an institution?s power is certainly not limited by the size of its security holdings or balance sheet. Indeed, we don?t think one can overstate the influence derivatives and the key derivative players have come to exert over the financial markets, and the financial system generally. At the end of 1999, the seven commercial banks with the largest derivative positions combined for a whopping $33 trillion of derivative positions, or 95% of total bank exposure. The proliferation of money management services has also certainly augmented these firm?s power, dominance that is attained with balance sheets bloated with securities and loans and, of course, massive derivative books. The three largest brokers have combined assets ?under management,? largely client accounts and funds within money management operations, of a staggering $3 trillion. Elsewhere, the largest private money management firm now manages over $1 trillion in assets.
Such an enormous concentration of power is not conducive to free and efficient markets. Instead, it is clearly much to the contrary, as increasing size begets additional influence over market mechanisms. With this in mind, it is now becoming apparent that this unprecedented concentration of financial power is having an important influence on the character of the developing financial crisis. As we have stated, it is our view that - as opposed to the 1997/98 crises that originated at the periphery in the emerging markets - Wall Street is this time the ?epicenter? for what we expect to be a return to global financial crisis. With the piercing of the momentous US credit bubble, it is now our expectation that the US stock market and economic bubbles are in grave danger. It has also been our view that the piercing of the US credit bubble would commence a bear market in the dollar. In regard to the dollar, our analysis has not yet been proven accurate. We believe, however, that the most powerful forces recently propelling the dollar are anything but bullish for the intermediate and long-term.
We continue to believe that the most powerful, if not recognized, dynamic in the US financial system is the forced unwind of leveraged interest rate speculations ? the deleveraging of what developed into an historic interest-rate arbitrage (borrowing short and lending long and play the ?yield curve,? or shorting quality and going long risk and playing ?credit spreads?). With these trades now faltering badly, the forced liquidation is creating an enormous supply of credit market instruments searching for demand. The consequence is much higher interest rates. And, not surprisingly, the most significant jump in interest rates has transpired in the sectors that had come to be dominated by the leveraged players ? mortgage-backs and agency securities.
The deleveraging and resultant surge in rates has led to two negative, but not widely appreciated, major developments for the global financial system. First, higher US interest rates and increasingly dramatic interest rate differentials (especially to European and Japanese securities), is working like a magnet attracting global funds. This is particularly the case today as the powerful US financial institutions, armed with top credit ratings, can go overseas to obtain virtually unlimited funding. We believe all of the major US financial institutions ? and clearly Fannie Mae and Freddie Mac - are major borrowers internationally, a powerful force recycling the flood of dollars back to the help sustain the faltering US credit market. And ironically, as the deleveraging US credit system sucks global capital from other industrialized economies and emerging markets, a strong and destabilizing feedback mechanism develops. Indeed, faltering currencies and financial markets globally leads to heightened risk and risk aversion. The immediate result is an even more pronounced flight to ?high-grade? US securities. These dynamics are today unusually precarious, as most emerging markets, especially those in Asia and Latin America, remain very frail with economies and financial systems acutely vulnerable to any capital outflows or financial disturbance.
There is also a second major development now in play. The piercing of the US credit and technology bubbles is in the early stages of what will create a momentous global technology credit crunch. For some time, US and international speculators, investors and investment bankers have canvassed the globe for ?new economy? plays, particularly in the telecom and Internet areas. The resulting speculative and credit excess were extreme. In time, the amount of ?hot money? involved and the extent and consequences of historic malinvestment and economic distortions will become apparent. Now, however, this momentous bubble is in the process of imploding, and players are beginning to run for cover. Since much of the ?hot money? likely originated from the US, the bursting of overseas bubbles is first forcing a repatriation of ?hot money? back to the US.
And while these unusual forces have supported the dollar up to this point, our mountain of foreign obligations is allowed to grow by the month. During March our trade deficit surpassed $30 billion for the first time. The first quarter deficit was a disastrous $86.3 billion, an increase of 60% from last year. Going forward, there are two important questions to ponder with regard to the dollar. First, how much foreign capital flowed into the US from overseas, particularly to play the US high tech economic miracle? Second, how aggressively will the major US financial institutions continue to borrow from overseas? And, importantly, what will be the ramifications for these institutions, US financial markets, and the dollar when it becomes appreciated that the epicenter of the global crisis is, in fact, the US financial system?
As the week came to an end, financial markets were looking quite ominous. Stock markets were coming under heavy pressure globally, as both technology and financial stocks were being sold here at home, and the dollar was hit hard against the Japanese yen. For sure, it appears investors are beginning to ?connect the dots? and recognize the seriousness of developments. Still, few appreciate that the ramifications for the crisis now unfolding go deep and broad. How this all plays out depends considerably on how long confidence holds in the soundness of what we believe is an acutely vulnerable US financial system. Certainly, the extraordinary concentration of power within the US financial system has played a major role in exacerbating and perpetuating the US boom. This, however, has only exacerbated credit and speculative excess and fostered devastating imbalances and distortions to the US economy.
The unavoidable downside is that when confidence wanes the consequences are historic and not easily rectified. Let there be no doubt that the unprecedented concentration of financial power today greatly heightens systemic risk.
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