Credit Bubble Bulletin, part 2:
prudentbear.com
Excerpt from a Bloomberg interview as Fannie’s Franklin Raines responds to an inquiry about the possibility of a housing Bubble: “Well, we see this bubble argument every 10 years. It was made at the beginning of the ‘90s and now we’re seeing it again right now. And the fundamental flaw in it is that people are comparing housing, where people actually live with speculative investments in the stock market or commodities or other things that can be turned into bubbles. People live in their homes, and they borrow in order to own the home. If we were experiencing a bubble, we’d be seeing supply flooding into the market, and we’re not seeing that. What’s actually happened is there’s a shortage of supply in the market and that’s what’s driving up the cost of homes. But home prices, overall, given these interest rates, remain surprisingly affordable. So the average consumer is not experiencing this kind of pressure. You will see it in local markets. You will see some local markets that may take on bubble characteristics from time to time. But we haven’t seen a national decline in housing prices in 30 years. So I think that the bubble rhetoric, although it makes for a nice article, is not really grounded in the fundamentals of the housing market.”
From Alan Greenspan’s prepared testimony before the Joint Economic Committee, April 17, 2002: “The ongoing strength in the housing market has raised concerns about the possible emergence of a bubble in home prices. However, the analogy often made to the building and bursting of a stock price bubble is imperfect. First, unlike in the stock market, sales in the real estate market incur substantial transactions costs and, when most homes are sold, the seller must physically move out. Doing so often entails significant financial and emotional costs and is an obvious impediment to stimulating a bubble through speculative trading in homes. Thus, while stock market turnover is more than 100 percent annually, the turnover of home ownership is less than 10 percent annually--scarcely tinder for speculative conflagration. Second, arbitrage opportunities are much more limited in housing markets than in securities markets. A home in Portland, Oregon is not a close substitute for a home in Portland, Maine, and the ‘national’ housing market is better understood as a collection of small, local housing markets. Even if a bubble were to develop in a local market, it would not necessarily have implications for the nation as a whole.”
Then there was Federal Reserve Bank of New York President William McDonough’s response yesterday in Long Island to a question regarding the possibility of a real estate Bubble: “The prices of Manhattan real estate are once again defying the law of gravity and going up. Since I own an apartment in Manhattan, I think that’s a very good thing. I think we have to be very careful to distinguish – actually Greenspan did a very good job of this before the Joint Economic Committee yesterday – to distinguish between a stock market Bubble, which is a macro economic issue, and real estate (inaudible) people’s homes and apartments and commercial. In all cases, even commercial, they are local markets. So if you had – let’s stay away from Long Island – if you had in Manhattan a market which was overpriced and people stopped bidding for apartments and the price had to go down, that’s a problem for Manhattanites. It wouldn’t affect you in the slightest. It certainly wouldn’t affect anybody in Chicago, Denver, San Francisco. So the likelihood of having a home real estate Bubble nationally is very low – because it’s a collection of individual markets. Some of the markets are quite frothy, because people want to live there. And, as for example, in Manhattan in the golden days of yuppie traders very young people were buying houses that the rest of us wouldn’t have dreamed of until we were a lot older than they. But that’s come and gone and the prices have stayed pretty well. So I don’t think we have to be concerned about it – a residential real estate problem, even though the value of people’s homes nationally has continued to go up. That has made people feel richer. Most rich Americans own both homes and stocks. Most Americans own not very much stock – it’s in a 401K plan and they think about it as something for their retirement and they don’t really change their spending habits very much in relation to it. The important thing is the value of your home. The value of your homes has continued to go up; that has made people richer. They look at their balance sheet and they say ‘I can spend more.’ So it is adding positive effects on consumer spending without any doubt. But I don’t think it is in a position now where we expect it to become a macro economic problem.”
It is fascinating – and a not insignificant development – that we have arguably the three most powerful men in U.S. finance – Greenspan, Raines, and McDonough – attempting to throw cold water on the increasing talk of a U.S. real estate Bubble. From reading these individual comments, one would almost forget that the a real estate Bubble virtually destroyed the Japanese financial system; that U.S. financial history is replete with housing boom and bust cycles; and that the U.S. banking system was severely impaired from the consequences of the late-eighties real estate lending boom. It is even more curious that all three have chosen to use the “local markets” argument against the Bubble view, an especially unconvincing argument today.
We all are familiar with the dilemma of fudging the truth. In response yesterday to a question from Representative Dunn regarding unemployment, Alan Greenspan responded with the following: “And the one thing one can say about the American economy is that it is really far more a single economy than it has been at any time in my recollection. All aspects of this economy -- actually, I'll put it this way. There are not the significant geographic differences that we used to experience three, four and five decades ago. Very recently we are finding that when we survey all of various different industries and various regions of the country, it is remarkable throughout, say, 2001 they behaved very much in sync with one another. It would almost replicate the discussions in one area and another -- with another, and that’s still true to this day. And with the recovery coming back we’re seeing very much the same phenomenon; everyone’s moving together.”
So much for “local markets.” There is absolutely no doubt that the U.S. economy is “really far more a single economy” than ever before. The key explanation is rather obvious, and it lies with the national character of the Credit system. No longer do local bank loan officers dictate the pace of local commerce and investment. National securities markets have supplanted local bankers as the major players in Credit creation. The commercial paper market, mortgage-back securities, asset-backs and other securitizations, syndicated bank lending, and the gargantuan bond market absolutely dominate contemporary finance. And with the rise of securities markets and endemic Credit market speculation, Credit availability is overwhelmingly dictated by whatever the hot game is on Wall Street. Today, the hot game and domination reside in mortgage finance no matter how much Greenspan or anyone else wants to downplay its significance.
I would like to try to be clear on one point: The issue in not so much a traditional “housing Bubble” per se, but a precarious Bubble throughout mortgage finance. The nature of the problem is first and foremost financial excess, and secondarily a real economy development. And, in fact, this simply could not be further from a “local market” issue. We warned about the GSE and mortgage finance Bubble back at our Credit Bubble Symposium in September of 1999. Amazingly, since then Fannie Mae’s total book of mortgages has surged about $450 billion, or nearly 40%. National housing prices have followed closely behind. Mr. Raines and others have stated (unconvincingly) that Bubble analysis is inapt, as we haven’t experienced overbuilding and excessive housing inventory. But that is exactly the point. Builders’ memories from a decade ago remain clear, and their bankers appear to be keeping a relatively tight leash. The problem lies elsewhere, where the GSEs and over liquefied securities markets have unleashed wild lending and speculative excess. The consequence has been unprecedented availability of inexpensive mortgage finance, with this liquidity reverberating throughout the financial system. We would even go so far to say that the situation would have been significantly less dangerous to systemic stability had the Bubble been in homebuilding. This would have tended to keep prices from inflating to such an extent, inflation that has led to a self-reinforcing Bubble of over borrowing, asset inflation, over spending, the accumulation of unprecedented foreign debt, and severe structural maladjustments to the real economy. If only the issue was housing inventory...
Back during the height of the Internet Bubble, Greenspan made comments to the effect that the speculation in the stock market was akin to people buying lottery tickets. His (and the media’s) focus was misdirected. Not appreciated at the time was that the most damaging Bubble was not to be found with individuals speculating in the Internet stocks, but rather with wild lending and speculative excess running out of control throughout telecom junk bonds, securitizations, CDOs, syndicated bank lending, special purpose vehicles, and other areas of “structured finance”. The critical issue was the “hot game” on the institutional side (as opposed to the daytrader), and the consequences of a highly speculative Credit market providing the key liquidity to the industry Bubble. The retail stock speculator was but a consequence, and certainly not a cause, of the overriding Bubble running out of control in the Credit system. Over time, the massive over liquidity from too many institutions playing too aggressively led to self-destruction. And when the telecom debt Bubble inevitably began to burst, it quickly became clear how distorted the whole process had become. A virtual stampede quickly developed as players tried desperately to get out before the imminent collapse.
Today, similar speculative dynamics again emanate from the Credit system. But the mortgage finance Bubble is on a much grander scale, and is covertly imparting severe structural distortions on a much more systemic basis. This round of Credit Bubble inflationary manifestations is imparting more generalized asset inflation, particularly in the housing market, and consequent increasingly serious distortions to the structure of demand and investment. It is our view that the severity of the U.S. economy’s maladjustment will (like the tech Bubble) also quickly become evident when the over-liquefied situation in the securities markets subsides. This vulnerability makes the current environment all the more precarious. Moreover, we are very concerned (as we have tried to explain repeatedly) that the mortgage finance Bubble has come to play the critical role in keeping the contemporary U.S. (global?) securities markets liquid, while at the same time providing the vital mechanism for recycling surplus dollars. Liquidity can be a very fleeting thing, and today the dollar looks quite vulnerable. Again, this is anything but a “local” housing market issue; it is anything but just a housing issue. Mr. McDonough may believe that if New Yorkers “stopped bidding” for apartments and prices “had to go down” that it’s a problem only for “Manhattanites.” We are much less sanguine, as our fear lies elsewhere: the inevitable bursting of another speculative Bubble of much greater dimensions. The consequences will be very national when bidding wanes for mortgage-backs, agency bonds, and home equity securitizations. And if Dr. Greenspan is today comforted that he sees little evidence of the “turnover,” “speculative conflagration,” or “arbitrage opportunities” typically associated with a speculative Bubble, we suggest he take a look in the murky world of leveraged speculation in mortgage-backs, agency debt, and the repo market.
Back in August of 1999 at the annual Jackson Hole central banker shindig, Dr. Greenspan presented a fascinating speech titled New challenges for monetary policy. Buried in his talk was analysis that hits on a great fallacy of contemporary central banking that is especially pertinent today:
Greenspan, August 27, 1999: “History tells us that sharp reversals in confidence happen abruptly, most often with little advance notice. These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short time period. Panic market reactions are characterized by dramatic shifts in behavior to minimize short-term losses. Claims on far-distant future values are discounted to insignificance. What is so intriguing is that this type of behavior has characterized human interaction with little appreciable difference over the generations. Whether Dutch tulip bulbs or Russian equities, the market price patterns remain much the same. We can readily describe this process, but, to date, economists have been unable to anticipate sharp reversals in confidence. Collapsing confidence is generally described as a bursting bubble, an event incontrovertibly evident only in retrospect. To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific companies that make up our broad stock price indexes. If episodic recurrences of ruptured confidence are integral to the way our economy and our financial markets work now and in the future, it has significant implications for risk management and, by implication, macroeconomic modeling and monetary policy.”
Over time, it is rather obvious that the Greenspan Fed has come to believe that it has the responsibility to protect against the results of temporary bouts of “collapsing confidence.” This role takes on monumental significance in the contemporary, securities market-dominated financial system. The problem is to recognize that the system is always adapting and evolving – entrepreneurs, financial players and institutions adjust away from problems and move forward to exploit opportunities. Monetary policy can have varying and unpredictable consequences. Nowhere is this more true than with financial players seeking to profit from the Fed.
It has been an enormous mistake for the Fed to associate bursting Bubbles with collapsing confidence. The analytical focus should not rest with market confidence, but with speculative impulses and evolving debt structures. Bubbles collapse specifically because they are unsustainable; confidence necessarily follows the collapsing Bubble. We saw precisely these dynamics unfold with the telecommunications Bubble, where speculative forces created unsustainable monetary flows, gross industry distortions, and unstable debt structures. A bust was unavoidable because the flood of liquidity being thrown on this sector ensured that sustainable profits and positive business cash flows would be impossible for the majority of enterprises. Any reversal of speculative flows would quickly illuminate acutely fragile financial structures, with a mad scramble to the exits absolutely unavoidable. But this is the very nature of speculative Bubbles – they are inevitably issues of illiquidity. If everyone is in the game, there is a problem as soon as the game doesn’t look so good or another looks a little better. Everyone is not in the game forever.
A quote from Edward S. Shaw, Monetary Policy and the Structure of Debt, The American Economic Review, May 1954, pp. 476-477 “...All of us realize that monetary policy reverberates through the debt structure as a whole. Its impact on real variables is conditioned by the way in which the debt structure responds. This implies that the speed, force, and locus of impact are not the same in all economic systems or in one economic system at all times...the financial structure which emerges from a specific growth process has its own distinctive way of reacting to and transmitting the impact of monetary controls...”
Today, extreme Fed accommodation is being transmitted most directly to mortgage and consumer Credit excess. We believe the ramifications are enormous. First of all, we view mortgage finance as the last remaining sector with the dimensions necessary to sustain the systemic Credit Bubble. As goes mortgage finance, so goes the Credit Bubble, the strong dollar, and the vaunted “resiliency” of the U.S. Bubble economy. Second, this is a particularly dangerous stage of the Credit cycle, as the preponderance of lending and speculating is reverberating through non-productive debt creation. We simply cannot imagine the creation of a more fragile debt structure, and this is why we state unequivocally that this has been following the worst-case scenario. In fact, in reviewing recent bank earnings releases we see an especially troubling trend: not only are lenders moving toward a new level of consumer lending excess, but it is almost as if the entire financial sector is looking to reduce exposure to commercial lending. If this combination proves the key dynamic of this period, this would be a very different animal than we have seen before. We should be prepared to expect atypical inflationary consequences over time as long as these dysfunctional monetary processes are maintained.
I am reminded of analysis I read from the Federal Reserve from the early 1990s. The point was being made that the Fed’s aggressive accommodation was in reality advantageous in the context of long-term inflationary performance; policy was attenuating pressures for companies to close plants and reduce capacity. When the economy recovered, this capacity would be instrumental in satisfying heightened demand with minimal inflationary pressures. I thought this interesting analysis at the time, but perhaps this line of reasoning has more relevance today after a decade of plant closings and “de-industrialization.” I continue to think a reasonable case can be made that the financial sector is now proceeding on a course raising the possibility that a surprise could come with heightened general inflation – from over stimulating consumption while avoiding the finance of new capital investment. We saw this week a worse than expected $31.5 billion February trade deficit, with a strong bounce back in imports. There is, furthermore, no longer the technology sector acting as the magnet absorbing excess system liquidity, as has been the case for several years. So we are left to ponder the very interesting circumstance that has the financial sector pressed to create the enormous Credit necessary to keep the Credit Bubble and Bubble economy levitated, but no clear avenue for consequent inflationary manifestations outside of housing and trade deficits.
Watching chairman Greenspan this week, I couldn’t help but to sense that things are finally beginning to close in on him. I don’t think his unconvincing housing Bubble commentary and incessant reference to “productivity” as some kind of magic elixir is going to suffice. Perhaps the markets are coming to appreciate that endemic financial sector leveraging and speculation has the Fed trapped in dangerously accommodative policy, leaving Greenspan little alternative but to look the other way from the conspicuous housing Bubble, intractable trade deficits, severe economic maladjustments, and heightened inflationary pressures. This is not the circumstance of a strong currency, and it was not a good week for the dollar. The question then becomes, is the weakening dollar a harbinger of waning demand for U.S. Credit market instruments? If so, such a development would mark a major inflection point for the leveraged speculators and, hence, the Great Credit Bubble. Up to this point, the Fed has been able to resolve every bursting Bubble with sufficient accommodation to fuel the next larger one that keeps the game going. But it hasn’t been a case of sustaining faltering confidence as much as it was inciting continued Credit excess. Hopefully the members of the Fed haven’t convinced themselves that the markets will always be so accommodating. When the current Bubble in mortgage finance wanes, the Fed is going to be faced with a dilemma much more problematic and unlike any it has faced previously |
