Guest Commentary, by Ed McCarthy
Global Systemic Pollution!
October 1, 2003
Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his newsletter.
There is a document produced by the Federal Reserve (unfortunately lagged a couple of months) called the Z1. Little known, it should be mandatory, required reading. Obviously, for those having interest, it can be readily accessed at the Fed website. For interpretation, there are many astute analysts; we particularly value, Doug Noland at Prudent Bear and our friend Gillespie at Gillespie Research Associates. Nevertheless, we also drag our own inept attempts at analysis direct. The most recent Z1 we find to be shocking! The number that leaps out is the $700 billion INCREASE in the net number that the “rest of the world” has from the U.S. in excess of the amount the U.S. has from the “rest of the world”. The total now exceeds $4 TRILLION! From the end of WWII to the early 1980’s, the U.S. was first a massive and then progressively smaller net creditor or OWNER of MORE than THEY (“the rest of the world”) OWNED. At yearend 2002, THEY OWNED $3.3 trillion more than the U.S. OWNED and at 6/30 our net debtor position increased to $4.0 trillion. 20%+ IN SIX MONTHS!
What does all this have to do with the title?
It is the writer’s belief that Mr. Magoo, the current Fed Chairman, still denying the dotcom/telecom bubble he foistered on the suckers, and oblivious of the recently diminishing if not punctured housing bubble his frantic response to the near recession of 2001 created, has engineered quite a bit of collateral damage in economies around the globe.
He and the parallel credit creation mechanism known as the GSE’s have proliferated so much CREDIT thereby as to cause SYSTEMIC CREDIT POLLUTION globally. Not understanding the equity refrain of 10% “over the long haul,” the writer prefers investments in debt. Readers of past missives know that, in recent years, a qualifier of foreign denominated has been added as it has increasingly become apparent that the U.S., although probably AAA rated forever, is an increasingly poor exchange risk. What we are getting at now, however, is that the SPLURGE in credit globally occasioned by what we call THE SPILLOVER EFFECT from the Fed/GSE blastoff in credit creation coupled with an emasculation of interest rates has ABSOLUTELY AND COMPLETELY POLLUTED GLOBAL CREDIT. THE PRICE OF CREDIT (THE SPREAD) SHOULD BE DETERMINED BY THE INHERENT RISK IN THAT CREDIT, BUT THE PRICE OF CREDIT IS BEING TOTALLY WARPED BY THE AVAILABILITY OF COMPLETE LIQUIDITY ON A GLOBAL BASIS OCCASIONED BY THE U.S. LIQUIDITY CREATION MACHINES AND THE FED DRIVEN COLLAPSE IN SHORT TERM RATES!
A COROLLARY OF THE ABOVE IS THAT THE INFAMOUS “CARRY TRADE” PLAY (Borrow low and short and lend higher and long) IS NOW POSSIBLE IN MOST GLOBAL MONEY MARKETS.
As we view the global credit scene, we see total chaos, domestically and internationally. An exemplar recently was the ability of Venezuela to find buyers for a debt issuance. This, to us, falls into the category of “what were they thinking?” We noticed in the “Credit Bubble Bulletin” that the demoralized country had sold $700 million of 10’s at 12.4%! Internal buyers are demanding well into the mid-20% range for short stuff in refi’s. Who’s the fool? Yeah, we know, they suffer exchange risk but the spread still tells a story of what the most knowledgeable think. This kind of lunacy occurs in the desperate race to “beat the index” that the geniuses who manage other peoples money (OPM) are engaging in. We diverge from our central theme. RISK ANALYSIS on credit has been superseded by desperation to achieve return.
Emerging market debt issuance is at a peak, junk debt issuance is at a peak, corporate issuance (these guys know a good deal when they see it) is exploding and governmental, particularly U.S. governmental and agency, issuance is parabolic. All this is being done at spreads that, to this observer, totally fail to represent any relevance to real credit risk.
THE UNDERLYING PREMISE (MAYBE THE UNDERLYING LIE) SEEMS TO BE PREDICATED ON A GLOBAL ECONOMIC EXPANSION SO STRONG AS TO PROMOTE THE CREDIT OF ALL THESE ISSUERS TO A LEVEL JUSTIFYING PURCHASE OF THESE ISSUANCES IN SPITE OF THE LIKELIHOOD RATES WILL RISE IN THE EXPANSION.
THE CORE BELIEF, WE THINK HOWEVER, IS IN THE PROMISE OF THE GREENSPAN/BERNANKE FED TO HOLD SHORT RATES SO LOW, SO FAR (THEREBY KEEPING GLOBAL SHORT RATES EQUALLY LOW) THAT THE HUMONGOUS CARRY TRADE SPECULATION POSSIBLE WITH THESE RATE CURVES GENERATES THE EXTREMELY ATTRACTIVE PROFITS CURRENTLY FOUND!
If one reads the exhortation of McCulley of PIMCO to the Fed to, in effect to go for it in fostering inflation, one has to wonder. This is a cheerleading comment from a guy in the biggest fixed income player. THIS IS A BOND VIGILANTE? No, this is one more example of the total lack of credit analysis currently abounding.
With great humility we propound a metaphor:
THE RATE OF CREATION OF EXCESS LIQUIDITY WILL EQUAL THE RATE OF DETERIORATION OF DUE DILIGENCE!
The abandonment of due diligence is aided in the extreme by the ongoing invasion of structured finance into the credit markets. Once a piece of structured finance has been “derivatized” into a rating; there is no need to examine the underlying loan/s individually at all! With such structured issuances rapidly ascending in percentage of total credit/loan issuance, true due diligence as we knew it recedes even further. The jettisoning of the assets through structured finance from the balance sheet of the originator, to this dubious observer, says that the due diligence done by the originator can be measured by what, if any, residual risk may reside with said originator. In most cases such residual is small to nil and we would characterize the due diligence therefore done as equivalent.
THAILAND!
This is one of our personal favorite countries. Having visited several times, including the internal and coastal areas as well as the capital, Bangkok as well as spent even more time due to the airport being the equivalent of Jamaica on the Long Island railroad (virtually everybody has to change trains at Jamaica, and virtually everybody traveling Asia has to change planes at Bangkok), we claim reasonable exposure.
Now, in mid 1997 1000 Thai bath peaked at a value of roughly $42.00. Listening to the IMF, they let the currency ”float”. It floated down to the point in early 1998 where the same 1000 baht was worth about $19.00. It is currently at about $24.70. Fascinating but painful ride if you were a Thai. Obviously, the collapse in the currency occasioned economic collapse and the banks in the country accumulated vast amounts of bad loans. Credit virtually vanished. THAI BANKS, ON AVERAGE, STILL HAVE NON-PERFORMERS IN THE RANGE OF 30%.
One would think that the country would be flat on it’s back. NOT SO! Example: The equity market is up 74% year to date. The country’s total debt has risen in the past couple of years from 40% of GDP to 60%. This time, they have eschewed the foreign debt route that brought the catastrophe of ’98 and borrowed domestically. How does all this work? The Thai’s are exporters and savers. In the last couple of years, the Thai Central Bank has accumulated another trillion or so of baht invested in foreign assets, the proceeds of exports. The total foreign assets have increased 50% in the last couple of years. When they buy these assets, virtually all dollars; they roundtrip them into U.S. Treasuries. An equivalent amount of local currency/liquidity is created. Even banks with NPA’s of 30% can increase loans with enough liquidity. Even though the Thai’s have lost a lot of potential export growth to China, they still have had a liquidity driven credit increase of great strength and have an expansion going. With global liquidity awash, they have recently gone to external markets increasingly to borrow and with the emasculation of rates by Greenspan, they can do so at moderate duration in middle single digits, only a couple hundred basis points over U. S. Treasuries. I like the Thai’s, Thailand, exporters and savers BUT such spreads on the continuing risks in Thailand are totally absurd. The known weaknesses of unresolved crippled banks, totally corrupt political system, lacking legal protection and reliance on exports for economic expansion, make the spread being given ludicrous. Nevertheless, with the continuing firehose of liquidity barreling across the globe, IT IS HAPPENING!
We could do the same for Korea, where the result has been a massive bubble in consumer credit and credit cards or for China itself, dealing with mounting inflation this year after fearing deflation last year (Anything like the Bernanke induced hysteria in the U.S. about deflation?). Suffice it to say that It has been reported that the combined foreign exchange reserves (virtually all in dollars) of China, Japan, Korea, Hong Kong and Singapore (not including the 1.8 trillion baht equivalent in Thailand afore-mentioned or lots of others in the region) now total over $1 trillion and are going to rise, if the latest Z1 is any indicator, by much more than another 20% this year. A fascinating advertisement in Forbes offers $3 million apartments in a development in Shanghai. The U.K. with financial institutions eerily similar to our own has a housing bubble that may exceed anything in the U.S. other than the housing price nonsense (to distinguish from the political nonsense) in California. Even rational New Zealand reports housing prices leaping into double digits after three rate cuts to try and keep up with our scimitar slashing Alan Greenspan.
Brazil, still having all the problems that almost brought it to default last autumn, is thinking about issuing $5 billion in bonds in 2004. Spreads have halved in the Fed led liquidity explosion. Moscow (remember the 1998 default in all of Russia?) is issuing mid range paper at 8%. Argentina is offering 25% to creditors after an immaculate default to the IMF (they defaulted and then signed a new standby!), expecting that the suckers will accept and they can then go back to market. In this weekend's Credit Bubble Bulletin, Doug Noland quotes Bloomberg quoting a bond manager: “It’s an environment where all kinds of companies can get ANYTHING they want done, and they’re taking advantage of it!” Substitute any borrower for companies and you have it!
We could go on endlessly with further anecdotal and statistical “bon mots” on the result of the Fed/GSE latest explosion of liquidity or “reliquification” in response to the near seize-up in capital markets last fall. There are the domestic idiocies to be found at length in spreads such as the collapse in spreads on the DLJ high-yield index from 899 basis points over treasuries to 466 latest. Before moving on to other subjects, we will sum up by referring the reader to Page 9 of the afore-referenced Z1 report. This page, entitled “Total Net Borrowing and Lending in Credit Markets,” has two numbers that stand out.
The first is the “Total Net Borrowing” number. First, we would point out as the Fed does, that these quarterly figures are seasonally adjusted annual rates. The figure for the 2nd quarter ’03 for total net borrowing is $3, 347.2 TRILLION! That is more than $1 TRILLION over any other quarter ever by any borrower!
The second is the “Rest of the World” figure for Net Lending (How the Net borrowers, all within the U.S. as was outlined in the paragraph above funded their borrowings). The figure for the 2nd quarter of 2003 was $1,055.8 TRILLION! This number is $600 billion higher than ever before required of all those savers out there who are obviously willing to fund the excess consumption of the U.S.!
Remember, a very high percentage of that “rest of the world” is foreign Central Banks buying the dollars that the humongous trade and current account deficits produce. Unless they “sterilize” and most don’t, the local currency equivalent LIQUIDITY is thus created and flows out into these country’s domestic markets. Result: Excess liquidity everywhere you look, Credit Bubbles galore and collapsing spreads as every investor and manager on the globe look for an extra basis point to meet whatever index they are measured against or are measuring themselves against. Small irony; under net borrowing, the “ rest of the world” decreased (repaid) $48billion.
In spite of the Brobdingnagian numbers run up in the 2nd Quarter in the OUT OF CONTROL Liquidity Binge the U.S. is indulging in, it is still impossible to determine where the inevitable end game is. We have been dumbfounded for years at the willingness of the “Rest of the World” to keep accepting ever-increasing amounts of fiat money from an out of control debtor. More recently we have been astonished at the willingness to do so at spreads that don’t even half remunerate the lender for the loss of value as the U.S. dollar has dropped from record highs in 2002. We can understand the authoritarian Chinese to an extent. The Central Government is still dictatorial enough to maintain a peg to the dollar. They are increasing exports exponentially and therefore pick up in gross revenue, to an extent, what they are losing in global purchasing power as the dollar and the yuan/renmimbi linked to it decline. To be remembered, however, is the fact that their global trade balance is only modestly in surplus. As they import more and more to feed the manufacturing Goliath AND to give some needed consumer goods to an increasingly affluent population, they are going to a deficit themselves. At that point, they are too smart to sell for declining dollars and buy at inflated kiwi’s etc. They DO, however, HAVE THE CHOICE of first liquidating their monstrous U.S. dollar reserves. Another choice, and this may seem far out, is to move to convertibility with the yuan/renmimbi linked to a commodity basket or gold.
If they were actually to make the yuan/renmimbi convertible to gold, they could probably suck in the reserves of much of South-East Asia (Way over $1 Trillion and growing). Change of Regime in currencies? Maybe so mythical to most as to seem ridiculous but the life of a currency has always been limited and the $ is awfully long in the tooth, and its position vis a vis the “Rest of the World” has seldom been so invidious for an imperial currency.
ENOUGH CAVILLING ON THE LIQUIDITY EXPLOSION; WHAT ABOUT THE STATE OF CREDIT AT HOME?
Again, we refer to the core page 9 in the Z1 report. On the Domestic side, i.e. as the Fed expresses it “Domestic Non-financial sectors”, simple arithmetic from the above reveals annualized borrowing in the 2nd Quarter of $2.523.8 TRILLION!
Folks, there ain’t never been such a number before! The Federal Government skyrocketed to an annualized rate of $888.2 BILLION (We only “bold” the trillions now). The household sector made it over $1 TRILLION for the first time. If the GSE’s and Federally related mortgage pools (this is the stuff Fannie/Freddie guarantee but don’t have on the books) hadn’t held relatively even with the 1st qtr at $460.4 Billion from $450.2, the aggregate number would have been even higher. Still a respectable amount of credit issued. The asset-backed folks actually only managed $280 billion, down from the $300-350Billion range they had been running.
On Page 11, we find two more categories that are hitting annualized running rates over the TRILLION number. Under Credit Market Borrowing, we find the U.S. Government Securities chugging along at $1.348 Trillion and Mortgages at $1.144 TRILLION. (Going forward, we aren’t even going to use exclamation points for trillions, they are getting too common.)
The same page reveals a couple of enigmatic numbers, Security RPs (repurchase agreements) at $564 Billion and Security Credit at $642 Billion under Net Increases in Liabilities. Bull market in equities and bonds, anyone? (Remember June was the month the 10 year bottomed at 3.07%)
We will skip over Page 22 “Rest of the World” except to comment that Foreign Direct Investment at $53 Billion annualized is way down from hundreds of billions a couple of years ago and near a low. Why comment. There are two kinds of rest of world money. Foreign Direct Investment which sits bricks and mortar and is the good kind, and “portfolio” investment, which sits in marketable securities and can easily leave town. Given the annualized trillion we are looking for, this FDI portion is pitifully little.
Page 69 is worth a passing glance as it is a national representation of Commercial Banking. Notable is the ascension of Agency holdings over $1 TRILLION for the first time. It is interesting that the Fed lists them under U.S. govt securities.
Mortgages reached almost $2.2 TRILLION. Both Agencies and mortgages have doubled since 1997, while loans to business went up only about $120 million. There is an awful lot riding on the premise that there cannot be a national downturn in housing prices.
Page 68 on the GSE’s and Federally related mortgage pools shows the exponential growth since 1997 from $2.9 trillion to the current $5.9 trillion for the two categories (We don’t bold the numbers for this activity as we all know these folks only measure themselves in the trillions). Two thoughts come to mind. One is that if you throw in only the aforementioned $2.2 trillion in mortgages in the banks, mortgage related debt comes to $8.1 trillion or 80% of gdp. Go find anything like this anywhere else. The other is that if the $5.9 is added to Treasuries outstanding and the amounts in the so-called trust funds for Social Security and medicare etc., the liabilities of the govt are in the neighborhood of 130% of gdp, Yeah, we know, on the $5.9 trillion, they have all those houses as collateral. Try and foreclose! Any way one looks at it 130% is a level that Argentina and Nigeria didn’t reach. Japan pulls it off with a 15% savings rate. That rate, should some unlikely scenario unfold where the U.S. consumer saved in like fashion has Dow 3000 and Chapter 11 for Walmart written all over it. Not going to happen. We are simply saying that sooner or later, the relentless expansion in credit ( irresistible force) is going to meet funding inability (immovable object) or deteriorating credit.
Page 79 Asset Backed Securities deserves scrutiny but we are going to simply note that at $2.6 trillion, this aberration from due diligence lending is in a class of it’s own. In previous missives our cynicism and skepticism that ratios and ratings can keep this behemoth in line and in health has been more than amply voiced. The New York Federal Home Loan Bank recently found out some of the peril in an area they should not have been involved in, mobile homes. We expect scandal here when the headlong expansion levels off, much less decreases. We hope to be proven wrong.
We noted that a paltry half a dozen countries in Asia have reserves in excess of $1 trillion. For you scholars out there, a question: What does the U.S. have? Page 82 tells us: $82 billion. Need we say more? The world’s reserve currency doesn’t have any reserves!
The Z1 is endlessly fascinating and we find many more pages worth comment but have belabored the topic long enough. Going through this morning’s incoming, we found two missives “en point” to the ramblings above.
1. A German Finance official of note warned of pools of excess liquidity globally and urged that central banks be aware and take action to prevent bubbles. Our commentator averred that they are there already.
2. Business Week online has a multi-part on the $32 billion in emerging markets debt coming this year and why IT IS DIFFERENT THIS TIME and all the buyers will live happily ever after. Yeah! |
