The Anatomy of a Maladjusted Economy
Credit Bubble Bulletin, by Doug Noland
December 6, 2002
The almost two-month stock market rally hit a speed-bump. For the week, the Dow and S&P500 dropped about 3%. The Transports actually added 1%, while the Utilities dipped 2%. The Morgan Stanley Consumer index declined 1%, while the Morgan Stanley Cyclical index was hit for 4%. The broader market generally outperformed the major indices, with the small cap Russell 2000 and S&P400 Mid-Cap indices dipping 2%. The fledgling technology recovery backtracked, with the NASDAQ100 declining 4%. The Morgan Stanley High Tech index dropped 7% and The Street.com Internet index 6%. The wild and speculative Semiconductors sank 11%. The NASDAQ Telecommunications index declined only 2%. The Biotechs were resilient, with the major index giving up only 1%. The financial stocks were under some pressure, with the Securities Broker/Dealer index dropping 5% and the Bank index 2%. With bullion surging $9.30, the HUI Gold index jumped 9%.
The Credit market remains extraordinarily unsettled. For the week, buyers returned to Treasuries, with two-year yields dropping 18 basis points to 1.87%. The five- year saw yields sink 17 basis points to 3.09%, while 10-year yields declined 12 basis points to 4.09%. The long-bond saw its yield dip six basis points to 4.98%. Benchmark mortgage-back yields generally sank 15 basis points, while the implied yield on agency futures dropped 16 basis points. The spread on Fannie’s 5 3/8% 2011 note declined three to 46, while the benchmark 10-year dollar swap spread narrowed 3.5 to 46.5. Corporate spreads began to widen somewhat toward the end of the week. The dollar came under selling pressure, with the dollar index declining about 1% this week.
December 6 – Bloomberg: “California must trim $10.2 billion in spending as the most populous U.S. state seeks to eliminate a deficit equal to one-quarter of its budget, Governor Gray Davis said. Davis announced spending cuts over two years, including $3.2 billion from schools and $1.8 billion from road-building accounts. California’s deficit is expected to exceed $21 billion by the end of the next fiscal year...”
December 5 – Bloomberg: “Connecticut Governor John Rowland in a televised speech said he plans to raise income taxes on people who make more than $1 million and that he may cut $100 million of aid for cities and towns to help close the state’s $500 million budget deficit. The speech, carried by several Hartford TV stations, comes on the eve of Rowland firing 2,800 state workers, about 6 percent of the state workforce.”
December 4 – Bloomberg: “Massachusetts’ budget deficit could exceed $2 billion next year, the worst fiscal crisis since the 1930s, said Eric Kriss, the chief budget officer of governor-elect Mitt Romney”
December 3 – Bloomberg: “Illinois’ $12.9 billion of municipal bonds may be downgraded, Moody’s Investors Service said, citing widening budget deficits and rising health care costs.”
December 3 - Dow Jones (Christine Richard and David Feldheim): “National Century Financial
Enterprises’ default Monday on asset-backed bond payments underscores growing concerns about potential weak spots in the more than $2 trillion asset-backed market (ABS). Market participants say the NCFE fiasco has raised questions about who’s ultimately responsibly for ferreting out fraud in highly complex asset-backed transactions, many of which carry the highest possible rating of triple- A.” An ABS analyst was quoted: “This is not just an example of a deal going bad. This is a call to action for the ABS market so that it doesn’t happen again.” Also from the article: “Moody’s, the only rating agency that has continued to rate NCFE transactions, is reviewing issues it hopes will allow the agency to catch any future NCFE-type situations earlier.” From a Moody’s executive: “We need to see if National Century is an isolated incident, or if there could be problems with other transactions and other asset classes. We are having discussions with trustees to see what they believe is their role in potentially finding these types of misdeeds. Do they have a fiduciary responsibility beyond their administrative role and how will it affect our ratings if they don’t?” From the article: “If trustees aren’t looking behind the numbers, said (the Moody’s exec) it’s possible that ‘we will require an additional party to find potential problems in the transaction or we may require more credit protection in the transaction.’ Moody’s also is looking at the conditions under which non- investment grade rated or unrated companies should be able to issue top-rated debt.”
While money is again flowing to the corporate bond market - with spreads having narrowed significantly over the past month or so - there remain unresolved issues in the marketplace. A bankruptcy filing by United Airlines would be a further blow, with UAL bonds, company-related municipal debt, and aircraft leases in a myriad of special purpose vehicles all posing potential problems for “structured finance.” To what extent the vulnerable Credit insurers are exposed is today unclear. As for the ABS marketplace, we continue to believe effects from the likes of NextCard, Conseco, and National Century have yet to be fully felt. We expect Credit conditions to tighten. It is worth noting that widened ABS spreads have been rather sticky in the face of narrowing corporate spreads, with riskier asset classes seeing little in the way of recent improvement.
December 4 – PRNewswire: “Residential originators funded a record-breaking $729 billion in home mortgages in the third quarter, according to National Mortgage News… It appears, based on the current run-rate, that mortgage bankers will wind up funding just shy of $2.5 Trillion in home mortgages this year.” (up from last year’s $2.1 Trillion)
December 3 – MortgageDaily.com: “Bankruptcy figures broke records – and backs – in the federal courts during the fiscal year 2002, according to the Administrative Office of the U.S. Courts’ quarterly report. The courts’ fiscal year, which ended Sept. 30, saw more bankruptcies than at any other time in history. They totaled 1,547,669, up 7.7% from the 1,437,354 of fiscal year 2001. No new bankruptcy judgeships have been added since 1992, but the caseload has soared 59% in the last decade… The judiciary has requested new bankruptcy judgeships and budget relief, but the matter will not be addressed until Congress returns in January.”
December 5 - Inman News Features (Susan Romero): “Thomas Morgan, associate general counsel for the Texas Association of Realtors, concisely sums up the state of the homeowner’s insurance marketplace as many brokers and home buyers see it today: ‘(Insurance) is too expensive and there’s not enough of it.’ Morgan is in a good position to know. Texas for some time has been the poster child state for insurance industry woes that now appear to be spreading across the country. Real estate brokers aren’t yet yelling ‘crisis.’ But practitioners increasingly are reporting that buyers are facing serious and worsening difficulties in obtaining the homeowner’s insurance they need to close their home purchase transactions, comply with mortgage lender requirement for loan funding and protect what is likely their most valuable asset. An inadequate supply of affordable insurance would put the free flow of the housing market itself in jeopardy. The obstacles buyers face in their pursuit of homeowner’s insurance no longer are shaped solely by the location of the home or the local area’s predisposition to natural disasters. Instead, insurers are citing a wide variety of reasons for cutting coverage and raising premiums, experts say.”
December 3 - American Banker (Tommy Fernandez): “In the latest move by a government-sponsored loan buyer to firm up relationships with smaller lenders, Freddie Mac has allied itself with credit unions. Freddie will offer favorable pricing as well as access to its technology and advisory staff to members of the Credit Union National Association… The idea is to make the trade group’s 10,000 members – more than 90% of the nation’s credit unions – more competitive in mortgages.”
December 5 - American Banker (Tommy Fernandez): “Bank One Corp. and
Fannie Mae on Wednesday announced a $12.5 billion loan program in which borrowers can make ‘little or no down payment’ without the usual requirement for mortgage insurance. Over five years, Bank One will make the loans to low and moderate-income homebuyers and then sell the loans to Fannie… The loans will also feature ‘flexible’ credit qualifications, the companies said.”
Monday, the ISM Manufacturing index slightly disappointed, with the composite number inching up from October but remaining below 50. Production jumped 5.3 points to 54.6 and Prices remained strong at 55.7. However, New Orders declined one point to 49.9 and Backlog dipped a point to 42.5. Wednesday’s report on Non-Manufacturing conditions was, interestingly, a much different story. The composite index jumped 4.3 points to 57.4, the strongest reading since May. Prices Paid was stuck at 54, while New Orders jumped 7.1 points to 58 (the strongest reading since October 2000!).
The eye-opening money supply growth runs unabated. Broad money supply (M3) expanded $20.2 billion last week, and is up $236.5 billion over seven weeks. For the week, Demand and Checkable Deposits increased $7.1 billion, while Savings Deposits dropped $27 billion. Small Time Deposits declined $1.7 billion, as Large Time Deposits gained $3.6 billion. Retail Money Fund deposits declined $3.6 billion. Institutional Money Fund deposits jumped another $21 billion, increasing three- week gains to $131.5 billion. Repurchase Agreements jumped $10 billion and Eurodollars added $3.7 billion. Non-financial Commercial Paper borrowings declined by $1.6 billion to $159 billion. Financial CP borrowings were unchanged at $1.204 Trillion. Total Bank Credit increased $11.7 billion, following last week’s $24.5 billion decline. Loans and Leases expanded $16.5 billion, with Commercial and Industrial loans adding $5.6 billion. Real Estate loans increased $8.2 billion. Bank Securities holdings declined $4.9 billion. Total Bank Assets jumped $53.4 billion, reversing the previous week’s decline of $51.8 billion.
In what is developing into an historic monetary expansion, broad money supply (M3) has now jumped $498 billion, or 10% annualized, over the past 32 weeks. It is again worth noting that M3 expanded by $276 billion, or $55 billion annually, during the first five (disinflationary) years of the nineties. Money supply then surged by $2 Trillion (46%), an average of about $400 billion annually, during the second-half of the Roaring Nineties. And then, in less than three years, M3 exploded another $2.15 Trillion (34%), or about $720 billion annually, to today’s $8.53 Trillion. It has taken less than nine years for the money supply to double.
Yesterday, the Federal Reserve released the latest Z1- quarterly Flow of Funds (Credit) report. The Great Credit Bubble becomes only more conspicuous in the data by the quarter. Since the beginning of 1998 (the past 19 quarters), total (non-financial and financial) Credit growth has surged $9.7 Trillion, or 62%, to $30.4 Trillion. Total (federal and non-federal) non-financial Credit growth has jumped $5.09 Trillion, or 45%, to $20.3 Trillion. By category, Total Household Borrowings jumped 64% to $8.2 Trillion, while Total Business Borrowings increased 64% to $7.1 Trillion. State and Local Government Borrowings jumped 42% to $1.5 Trillion. Since the beginning of 1998, Financial Sector Credit market borrowings have more than doubled to surpass $10 Trillion.
For the third quarter, Total Household debt expanded at an annualized pace of 9.6%, the strongest rate of growth since the 1980s. The Household sector added debt at a record annualized rate of $724 billion. For comparison, 1998 was the first year that Households increased their debt-load by more than $400 billion. During the third quarter, the Federal Government ran up debt at a 7.5% rate, while State and Local Governments borrowed at a 9.7% rate. The Corporate sector borrowed at an annualized rate of 0.2% during the quarter. Over three quarters, Household sector debt expanded at a 9.3% pace, and one has to go back 15 years to beat this rate. The Federal Government has borrowed at an 8.2% rate over nine months, the strongest pace since 1988. The Federal Government’s appetite for debt, though, is more than matched by their State and Local counterparts. State and Local government debt growth of 8.9% was at the strongest pace since 1987. Year-to-date, Corporate sector borrowings have expanded at less than 1%, the weakest performance since 1992. These lending figures illustrate The Anatomy of a Maladjusted Economy.
The bursting of the corporate debt Bubble has seen Corporate Borrowings drop to a feeble annualized $10.7 billion during the third quarter, a far cry from the $400 billion borrowed by the sector during 2000. During the 10-year period 1987 to 1996, Corporate Borrowings averaged $122 billion annually. Sector debt growth averaged about 5.3% annually over this period. Corporate borrowings then jumped to $292 billion during 1997 (up from 1996’s $183 billion), or 9.4%, with borrowings averaging $369 billion during the four Corporate Debt Bubble years 1997-2000. The Bubble “blow-off” stage saw Corporate debt expand by 11.6% during 1998, 10.3% in 1999, and 9.5% during 2000. The faltering Bubble then saw Corporate Borrowings drop to $246 billion during 2001 (5.3%), with borrowings running at a paltry annualized pace of $39 billion over this year’s first three quarters (0.8%). As we have witnessed, deflating sectoral Bubbles prove quite problematic.
And while economic “output” expanded at a 4% pace during this year’s third quarter in the face of a shuttered corporate debt market, it required heroic 12.8% Household Mortgage Credit growth to do it. It is, however, a sad case of the appeasement of one faltering Bubble having set in motion much more precarious excess in a grander Bubble. During the third quarter, Total Mortgage (household, multi-family, commercial) Credit expanded by $235 billion - a stunning annualized pace of $941 billion (12.4%) to $8.2 Trillion. This was 20% above the previous quarterly lending record set during last year’s second quarter, and we are now on track for a record $826 billion of Total Mortgage lending for 2002 (up 17% and 46% from 2001 and 2000 growth). For the 10-year period 1988-97, Total Mortgage Credit expanded by an average $222 billion annually. The system now accomplishes as much in three months. And after a decade of heady real estate lending (up 75%), Total Mortgage borrowings then jumped to $499 billion during 1998, and averaged $637 billion annually since 1998. Total Mortgage debt actually jumped $3 Trillion, or 58%, in just 19 quarters, a feat previously accomplished over a 13 year period. During the past seven quarters (Mortgage Finance Bubble “blow-off”), borrowings have surged to an annualized pace of $758 billion. Or, from another angle, over the 10-years 1988-97, quarterly Mortgage Borrowings averaged $55.5 billion. Borrowings have ballooned to an average $189 billion during the past seven quarters.
This is some kind of Bubble. And for those that missed it, CNBC should have provided a viewer warning announcement for the other night’s “housing is a sound investment” tirade courtesy of Kudlow & Cramer. With Mr. Cramer professing “housing will always be a great investment” and Mr. Kudlow spouting the virtues of the sector’s “wealth creation,” we haven’t seen such fervent propaganda since the heyday of the Internet/technology Bubble. If we’ve learned anything, it’s that when it has reached the point where we are subjected to the old “you’ve gotta own ‘em at any price,” it is time for us buyers to beware (and hide our wallets!).
I have never been especially fond of the inflation/deflation debate. Such a one-dimensional perspective may have been reasonable decades ago when economies were production-driven, finance was generally infused into the economy through bank Credit funding investment (“Monetary Processes”), and domestic economic and financial systems were relatively resistant to global forces. But a focus on an “aggregate” price level is inapt in today’s exceedingly complex global economic and financial labyrinth. To manage U.S. monetary policy on the basis of an aggregate goods and services price index is inappropriate and quite dangerous. To disregard Credit excess, endemic speculation, and asset Bubbles is a failure of monetary theory and central bank policy. And to ignore that contemporary Monetary Processes predominantly inject liquidity into the U.S. economy through the financing of asset holdings (real and financial) is to miss the very essence of contemporary economic analysis. Now that the supposed risk of “deflation” is the focus of considerable attention, it has become clearer in my mind that the nature of the discourse only detracts from the key financial and economic issues of our time.
Deflation is simply not today the great risk. It may be, sporadically, a symptom of a serious malady, but it is not the illness. The issue is not the pricing of goods and services, nor does it relate in any manner to insufficient aggregate demand. As yesterday’s data confirm, we remain categorically in a period of historic money and Credit inflation. That this exponential rise in dollar claims coincides with our economy’s declining capacity to produce tangible goods should be disconcerting to our foreign creditors, if it is not to our economic community and policymakers. The critical issue of our day remains a runaway Credit system, with the increasingly fragile financial system and maladjusted economy it has effectuated. Dispersed downward pricing pressures are, in many instances, but manifestations of the Credit Bubble disease. You can treat a distressingly feverish individual by throwing him into a bath of ice water, or you can seek professional help in an attempt to identify the underlying illness. Denial is dangerous, and the appropriate course of action may determine life or death.
I will at this point interject some data from today’s disappointing employment report. The Goods Producing sector lost another 40,000 jobs during November, increasing eight-month losses to 332,000. That so many producing jobs have been lost in the face of (ultra-easy Credit-induced) booming auto and home sales is further evidence that something is amiss. To those that continue to trumpet the “underlying soundness of the U.S. economy,” we suggest digging deeper. Indeed, 28 straight months of declining employment has reduced the number of manufacturing jobs back to the level from November 1961. Still, those with rose-colored glasses are quick to point out that, overall, employment has increased 174,000 since April. Considering the enormity of Credit excess and the reported increases in “output” during this period, the data suggest ominous portents for the American workforce. We will not celebrate the Service Producing sector’s creation of 506,000 jobs over the past eight months. With the number of Mortgage Brokers up 47,000, Health Services employment increasing 178,000, Education up 92,000, and Government jobs up 158,000, we see instead illumination of The Anatomy of a Maladjusted Economy.
Examining in concert the employment backdrop and third-quarter Credit data provide us with valuable insights to the economy’s predicament. Clearly, the issue is not insufficient money and Credit. Systemic excess liquidity has been more than enough to finance unprecedented household borrowings at declining interest rates. Indeed, rampant monetary excess directs liquidity to the services “producing” arena where there remain strong sectoral inflationary biases – healthcare, mortgage finance, education and government. At the same time, the goods producing area suffers from acute global pricing pressures. While created in over-abundance, liquidity avoids the manufacturing sector like the plague. At this point, it is almost incontrovertible that the U.S. manufacturing depression is structural and not cyclical. This is a dollar problem.
For now, at least superficially, extreme financial and economic imbalances cause little grief. Although job creation remains tepid, the booming services sector does support 4% “output” growth. But there is an increasingly important catch to the vaunted New Age Economy. The service/ consumption-based U.S. system is becoming only more monetary in nature – only progressively dependent on rampant money, Credit, and speculative excess. Granted, the financial sector has thus far more than accomplished a rather historic feat of endless money and Credit creation, but it is worth pondering the ramifications for the fact that Total Mortgage Credit growth accounted for 88% of Total Non-federal Borrowings during the third quarter (versus 1990’s average of 51%). This one ratio provides a striking elucidation of The Anatomy of a Maladjusted Economy.
For a moment, let’s allow our imaginations to run a bit wild. Let’s contemplate that we could still be enjoying the luscious fruits of the Great Stock Market Bubble; that is, if somehow everyone could have been convinced not to sell. If only the small investor, institutions, the gargantuan speculating community, foreign players, and the wealthy insiders would have just held tight. Today’s Great Mortgage Finance Bubble is more complex. For it to prosper on to eternity, we must first convince the household sector to never stop borrowing at increasing growth rates. Second, we must persuade the leverage speculating community, institutions, and our foreign-sourced financiers to only accumulate and never sell agency debt and mortgage-backed securities. But even if the concerted efforts of the Fed, the Treasury, and the GSEs remain successful in keeping everyone in the only game in town, there will nonetheless be increasingly problematic inflationary manifestations. At this point, such a scenario appears in the cards.
Today, a powerful and entrenched financial infrastructure is determined to perpetuate the Mortgage Finance Bubble. The Fed has done everything possible to accommodate, thus solidify this dysfunctional financial apparatus. While a fraction of new mortgage Credit finances new construction, the vast majority sustains housing inflation and over-consumption (with, dollar for dollar, considerably less tax revenue impact than corporate debt). For the financial system, only more acute fragility is assured by the ballooning of mortgage Credit of increasingly weak quality. The quality of financial sector assets is poised to deteriorate and become only a more critical issue.
Yet, at all cost don’t risk letting the Bubble slow; inflate, inflate, will be the mandate. Although the larger the accumulation of speculative positions in this arena, the more precarious the inevitable reversal. Unlike love, speculator infatuation is not forever. Then there is the insoluble dilemma of dimensions. When it comes to sustaining the Great Credit Bubble, size does matter. The Mortgage Finance Bubble was the one sector sufficient to mollify the effects from the bursting NASDAQ and corporate debt Bubbles, but the sheer size of this Credit monster is unmatched and irreplaceable.
From the economy's perspective, the perpetual Mortgage Finance Bubble similarly has no match for its capacity to affect economic distortions – both at home and abroad. To perpetuate mortgage finance excess is to perpetuate over-consumption and massive trade deficits. This is, today, a critical point with profound ramifications. Again, this is a major dollar problem. It has been our argument that endless U.S. current account deficits (inflating global dollar balances) were largely responsible for the ballooning global pool of destabilizing “hot money.” This pool of finance has over the years been increasingly funneled into speculative channels, fueling refashioned booms and busts around the globe. Moreover, this speculative pool has, most unfortunately, found comfortable accommodation in our Credit system.
Less appreciated is the reality that U.S. exported inflation has been a leading culprit for the over- finance of global goods producing industries. Whether it was Japan in the late eighties, SE Asia during the nineties, or nowadays in China (with its heavy investment from Hong Kong, Taiwan, and elsewhere), the inflating U.S. financial sector has been, either directly or indirectly, an original source for much of the global pool of available finance. It is over-abundant finance that is responsible for manufacturing sector over-investment that now exerts downward pressure on good prices. Yes, China may today be “exporting deflation” in the manufacturing sector, but the root cause can be traced back to the inflationary U.S. Credit Bubble.
While not appreciated by the bullish consensus, today’s extraordinary global backdrop increasingly places the U.S. financial sector directly in harm's way. It has no alternative than to perpetuate the Great Mortgage Finance Bubble, but this entails the unending creation of massive amounts of non- productive, volatility-inducing, economy- distorting debt. Regrettably, previous Credit excess has made profitable U.S. productive investment largely a thing of the past. Not only have distorted investment flows throughout Asia created enormous over-capacity, inflating U.S. wages and other costs have priced the U.S. out of the global manufacturing marketplace. And this will prove a rather tough structural sticking point for the inflationists. To sustain a level of household income growth necessary to support inflating (largely mortgage) debt levels only widens the competitive disadvantage of U.S. producers and fosters further manufacturing atrophy. While they don’t realize as much, the inflationists are fighting a losing war – fighting fevers with ice baths.
To dream that we will forever enjoy the capacity to trade newly created (electronic) dollar balances (financial sector IOUs) for foreign-produced goods becomes only more fanciful in an era of out of control current account deficits, an acceleration of manufacturing hollowing, a heightened loss of global competitiveness, and, not unimportantly, Fed governor references to “printing presses.” What about the quality of these inflating quantities of financial sector IOUs? We have watched over the past decade repeated episodes of bursting Credit and speculative Bubbles. There are, virtually by “design,” many consequent examples of faltering currencies. Not many have been orderly, and most can be appropriately described as collapses.
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