August 2, 2003
From Doug Noland .... Prudent Bear. For the record ...
Not since 1994 have we seen such a dramatic jump in interest rates, although nothing compares to the hastiness of the recent rate spike. Wow! It has clearly caught many a leveraged speculator, many an aggressive bank, many a Wall Street proprietary trading desk, many a REIT, and likely the major derivative players. The markets to off-load interest rate risk have dislocated. The mortgage-backed market is in disarray and it would appear the same can be said for the interest rate derivative markets generally. 1994 saw a few sophisticated (mortgage securities) “market neutral” hedge funds blow up, the big “macro” funds suffer significant losses, and myriad derivative losses. Later in the year, Orange County filed bankruptcy after suffering huge losses in structured notes, most issued by the government-sponsored enterprises (at least they proved good interest rate hedges for the GSEs). It concerns me greatly that this is nothing like 1994’s “flood with some homes along the river.” There’s been an historic 10-year building boom that has completely changed both the environment and the marketplace. Previous “100 year floodplains” are meaningless at best. .
All the same, it is today surely not all too difficult for the bulls to think back to 1994 and sleep comfortably at night. It was a ravaging bond bear market bear, but the system made it through with only (in hindsight) a good scare. For the equity market, it proved an early hiccup preceding one of history’s great bulls – a truly great buying opportunity. Yet there was a key unappreciated development that I believe played a crucial role in saving the day during 1994, back when the impaired leveraged players were unwinding positions and the risk of a systemic liquidity crisis ran high. The financial sector, especially the “fledgling” government-sponsored enterprises, enjoyed the capacity to expand Credit. And they did expand, aggressively.
Indeed, despite a major Credit market cataclysm, the Financial Sector managed record Credit market borrowings of $468.4 billion during 1994, up 14% for the year. This compares to Financial Sector borrowings of $292.4 billion during 1993 and $244 billion during 1992. Importantly, Federally Related Mortgage Borrowings (the GSEs and mortgage-backed securities) increased Credit by $287.5 billion, up from 1993’s $165.3 billion. The GSE’s expanded Credit market borrowings by an unprecedented $150.7 billion, or almost 24% during 1994. This was double 1993’s growth and was almost the amount of expansion over the previous three years. The GSE-led financial sector was successful in generating sufficient Credit creation to “paper over” the liquidity problem. In the process, the GSEs ushered in the Great Credit Bubble.
But 1994 today appears a modest little hill when compared to 2003’s Mountain. Total Credit Market Debt has ballooned from 1994’s $17.2 Trillion to today’s $32.5 Trillion. Total financial sector borrowings have ballooned from $3.8 Trillion to $10.5 Trillion. Total Mortgage Credit has ballooned from 1994’s $4.4 Trillion to today’s almost $9 Trillion. At the same time, the leveraged speculating community has absolutely mushroomed. Is it feasible that the financial sector, after almost doubling in size over five years, has today the capacity to expand sufficiently to sustain the financial and economic Bubbles, while playing buyer of last resort to the de-leveraging speculator community? It is not readily apparent to me that this can occur.
All facets of the Credit system have been firing on all cylinders, with resulting massive Credit growth barely sustaining the Bubbles. The banking system, the GSEs, the Wall Street firms, the REITS and the hedge funds have all ballooned over the past few years. Who, then, today has the capacity to take risk from the scores of speculators looking and needing to offload? Well, the explosion of the interest rate derivative market has never made much sense. Somehow the GSE and mortgage securities are apparently able to balloon forever, with players enjoying the capability to easily and inexpensively hedge interest rate risk. But to whom? Who is going to take the other side of the interest rate trade - a “trade” that is ballooning in size and must continue to balloon to ward off a serious risk of Credit collapse? That is the question. One thing appears clear today, the Fed has lost control of the interest rate market, with ominous portents for the highly leveraged and speculation-rife U.S. Credit system. |
