Possible Economic Business Debt Meltdown
Tom, this stuff is really getting on the brink of
getting out of hand. Good luck on your shares. Peter.
A Rally Crumbles, a Debt-Doomsday Warning Appears
By Aaron L. Task / Senior Writer – Street.Com: 07/08/2002
It's impolite, bordering on rude, but bears could be forgiven for rightly wearing the "I told you so" smirk today.
Friday's much-ballyhooed advance proved very much to be a one-day wonder as the Dow Jones Industrial Average fell 1.1% to 9274.90 after having traded as low as 9240.36. The S&P 500 shed 1.2% to 976.98 vs. its early low of 972.91 and the Nasdaq Composite lost 3% to 1405.61 after trading as low as 1401.28.
Shares were depressed by the spectacle of the House's hearings on the WorldCom scandal and allegations of accounting chicanery at Merck, which says it was in compliance with GAAP.
Weak earnings by Alcoa, a profit warning by Allegheny Energy (AYE), and a resumption of weakness in the dollar didn't help either. Additionally, there was a re-examination of Friday's lackluster employment report and the realization that day's gains were built on a tenuous foundation.
Oh, and there's also the fact we're in a bear market, which are commonly demarked by sharp rallies that get some participants excited, for a fleeting moment.
Sweat Down Your Body, a Chill Up Your Spine
Despite the stock market's struggles, the hunt for a bottom continues, as reported earlier. Something many would-be bottom pickers are missing is the message from the bond market, which continues to suggest trouble afoot.
Last week I noted reports that collateralized debt-obligation managers (read "banks") could be on the hook for $500 million if WorldCom were to file for bankruptcy.
"Suffice to say it is worse than described," said a source in the CDO market, who requested anonymity, "as my career is tied to the distribution of precisely the product that is blowing up."
More troubling, Pimco managing director Paul McCulley argued on the firm's Web site today that the entire U.S. economy may be on the brink of a "meltdown" due to ongoing revelations of corporate malfeasance and resulting risk intolerance among banks.
"If we don't see a renewal in risk appetite in the corporate lending market in the next six to 12 months, then we are on a very greased banana peel toward a Japan-type syndrome," McCulley said, with typical flair, in a follow-up interview. (Concerns about Japan-style deflation were commonly heard last year but have recently faded, as the economy improved and some signs of inflation re-emerged. McCulley certainly isn't alone in warning of the risk of a deflationary spiral here, but is the most notable market participant to publicly discuss it, certainly in recent memory.)
Being the conduit for the Fed's role as lender of last resort, banks "serve a unique place in the financial firmament," he continued. "The banking system has got to step up and take responsibility, as opposed to contracting banks' lines of credit," as is occurring now.
The most recent Fed survey of senior loan officers found "further tightening of standards and terms for loans to both businesses and households."
McCulley recommended the Fed "order the banking system to quit withdrawing from 'liquidity lending,'" using the term "order" quite intentionally. The quid pro quo of the commercial banks' access to the Fed's discount window is they are "supposed to lend when the capital markets are caught in a paroxysm of rectitude," he wrote.
Of course, banks prefer to lend when times are flush and retreat in tougher environments, but "with inflation near the 'tipping point' into deflation, the pro-cyclicality of bank lending is noxious at the macroeconomic level," McCulley wrote.
Let's set aside for now the debate over whether a Japan-style deflationary scenario is more a risk than the re-emergence of inflationary or "stagflationary" pressures: McCulley clearly believes the former risk is greater and his second recommendation is that Fed Chairman Alan Greenspan should convey "the doctrine of pre-emptive tightening to be dead and buried." Point being it's easier for the Fed to deal with a re-emergence of inflation than the onset of deflationary pressures, as Japan's experience demonstrates.
In arguing "the Fed must be willing to use all its powers to save capitalism from itself," McCulley incorporated the macroeconomic theories of John Maynard Keynes, the essence of which he described as: "Attack private sector deflation with public sector reflation."
Secondly, McCulley cited the work of Hyman Minsky, an economics professor and author of (among others) Stabilizing an Unstable Economy, who in 1992 wrote about three types of corporate borrowers, which the professor labeled "hedge, speculative, and Ponzi finance."
The concern being that many speculative finance units -- which Minsky defined as those that "need to 'roll over' their liabilities -- issue new debt to meet commitments on maturing debt," i.e. most of Corporate America -- are "being exposed as Ponzi finance units in drag," McCulley wrote. "These developments are, as Minsky declared, a prescription for an 'unstable system' ... in which the purging of capitalist excesses is not a self-correcting therapeutic process, but a self-feeding contagion: debt deflation."
McCulley doesn't believe we reached that juncture yet, but fretted we're "far closer to the point than I thought we would get 18 months ago, or even three months ago."
Meanwhile, as I write this, President Bush is talking about the potential for investors to lose faith in the free enterprise system.
Hard times, indeed. |
