Credit Bubble Bulletin
Chairman Greenspan’s testimony Tuesday before the Senate Banking Committee and Wednesday before the House Financial Services Committee proved surprisingly interesting. The message was clear: the Fed is prepared to “normalize” short-term interest-rates, and that the economy hitting a bit of a “soft-spot” has not altered the Fed’s agenda. My read is that Mr. Greenspan is seeking to affect two markets. First, he has been satisfied with the orderly rise in market rates and wants to avoid another big yield decline, one that would again destabilize the mortgage and interest-rate hedging markets. Second - and this is a continuation of what I believe is a significant but unspoken policy shift - the Fed recognizes the vulnerability of the dollar. The Fed must signal to the marketplace that U.S. rates are going higher, weak data or not. Only time will tell as to the true degree of Fed resolve - as opposed to “hawkish” talk to comfortably manipulate markets. For now, bond yields backed-up somewhat, while currency traders bought dollars as if our Fed chairman was speaking to them directly.
One of the more interesting exchanges during Greenspan’s testimony was provided courtesy of an astute question from California Congressman Edward Royce: “Chairman Greenspan, in preparing for your visit here I read an economic research note from a very respected economist, in which he called the Federal Reserve, in his view, the world’s biggest hedge fund. And his rationale for making that claim is that the Fed has encouraged the financial markets to participate, in his view, in the carry trade, where one can borrow cheaply on the short end of the yield curve and invest those borrowings in a longer-dated security. So, according to this economist, the Fed encouraged the carry trade in 1993 when they took the Fed funds rate down to where it equaled the rate of inflation. And the current period is cited as another era, in his view, of the carry trade, since the Fed funds rate is negative or below the rate of inflation. The risk cited in this paper of his is that these Fed-encouraged carry trades can encourage artificial bubbles in asset prices. This claim is applied to the housing bubble today, but could, you know, the equity bubble in the 1990s could also be explained from that perspective. And I just wanted to get your thoughts on this critique of Fed policy.”
Chairman Greenspan: “Well, Congressman, so long as the normal tendency is for long-term rates to be higher than short-term rates, there’ll always be some carry trade. And indeed, one can even argue that commercial banks are largely carry trade organizations. But, as I point out in my prepared remarks, the awareness currently of the risks in taking extended positions in the carry trade markets is clearly being unwound, and our judgment is that while there is some, and there always will be some, it’s not been a problem. Certainly, if you have an extended period and you lock-in these differences, you can create great distortions. But when we move rates down, as we have on several different occasions, we are acutely aware that in that process we will increase the carry trade. The more important question is, what is the significance is if we do that? And if we perceived that that was creating bubbles or distortions, obviously we wouldn’t do that. And I must say that our history of dealing with that problem, and it is a problem, as indeed there are huge numbers of related sorts of problems – we’re aware of what happens when we move, but we try to adjust our policies in a manner as to significantly minimize any secondary consequences of such actions, and indeed, I think the recent history suggests that so far, at least, we’ve been successful in doing that.”
Where do I begin? Traditionally, banks have been thought of as primarily lenders to finance sound investment and profitable business enterprise. In the process, “safe” deposits were created that yielded less than the return on riskier bank assets (loans). As long as these assets were expanded judiciously - nurturing a stable return on business investment that exceeded the cost of borrowing - bank assets remained sound and the banking system profitable. It was only when bank assets became largely detached from economic investment/returns – as they have evolved to be with the explosion in consumption and asset-based lending – that the notion of banks as “carry trade organizations” became applicable.
All the same, Mr. Greenspan asserts that “positions in the carry trade market [are] clearly being unwound.” He is either uniformed or disingenuous. It is true that the Fed has dedicated the past year’s ultra-accommodation to the process of unwinding interest-rate speculations. Less appreciated, this process has been immeasurably facilitated by unprecedented foreign central bank Treasury purchases. Those endeavoring to off-load interest-rate risk – commonly accomplished by shorting Treasury bonds - enjoyed the luxury/anomaly of intemperate central bank buying.
The (too clever) Greenspan Fed has toddled patiently, carefully communicating its intensions to the leveraged speculating community. And this has surely spurred a significant unwind of the traditional borrow short/lend long “carry trades,” as well as having accommodated hedging programs for those exposed (including the derivative players themselves). But there has been no rectifying of systemic leveraging or distortions – anything but.
Importantly, I would argue that Mr. Greenspan’s strategy has only incited a major reconstitution of the traditional interest-rate carry trade to a more problematic predicament I will refer to as “The Great Mortgage Spread Trade.” With the Fed signaling tranquil rising yields (“Transparent Tightening Lite”), the hot speculation quickly shifted from profiting from the steep yield curve (borrow short, lend long) to playing credit spreads (some variation of shorting Treasuries and buying higher-yielding debt).
It is briefly worth contemplating the notion of a “neutral” Fed funds rate, a topical subject these days. But what does it mean? Some would suggest a neutral rate would (magically) produce a 2.5% “core CPI.” Others would argue for a rate consistent with 4% GDP, full employment, or general economic "equilibrium." However, I think this line of thinking completely misses the point. Any concept of a “neutral” interest-rate must at least recognize the predominant mechanism (Monetary Process) for Credit expansion – today this is clearly the mortgage finance arena. What rate would have been “neutral” over the past couple of years, in respect to not inciting excessive mortgage borrowings and attendant distortions? How about today?
The momentous flaw in Mr. Greenspan’s strategy is that 1% Fed funds has been a fraction of what would have been required (“neutral”) over the past 18 months to rein in a runaway mortgage finance system. On the one hand, there has been a momentous Inflationary Bias throughout the financial system, with ballooning hedge fund and proprietary trading communities; scores of aggressive GSEs, REITS, banks, S&Ls, insurance companies, finance companies; and many others clamoring to participate in the mortgage spread game (and enterprising investment bankers creating sophisticated instruments to satisfy demand). On the other hand, an overly liquefied mortgage finance super-system has been creating new mortgage Credit at an unprecedented pace of $1 Trillion annually – with the underlying quality of these loans deteriorating commensurate with manic borrowing excesses. The upshot has been insatiable demand for high-yielding instruments matched by explosive growth in the supply of subprime, less-than-prime, and jumbo/non-conforming mortgage lending. The situation beckoned for aggressive tightening but got aggressive accommodation.
Keeping in mind that it took the Japanese banking system only a few short years of reckless lending to virtually destroy itself with bad loans, the Fed’s notion that it can dilly-dally for a couple of years to ensure the placid unwind of carry trades is one more example of failed (negligent) central banking. Indeed, it is becoming increasingly clear in my mind that problem mortgage Credits will likely pose the paramount risk to the U.S. financial system and economy, as opposed to interest-rate risk.
The Great Mortgage Spread Trade – and the resulting torrent of cheap liquidity flowing to housing finance – has fostered a price Bubble in California and, generally, at the “upper end,” along with excessive construction throughout. The surge in no-downpayment, adjustable-rate (with teasers!), negative amortization and subprime lending has incited millions of buyers to bid up prices on properties to unsustainable levels. Perhaps most will be able to afford their monthly payments down the road, but the odds of millions becoming underwater on their mortgages when the Mortgage Finance Bubble bursts is alarmingly high and growing.
And while the Greenspan Fed is "succeeding" (by dilly-dallying) in shifting interest-rate risk from the financial sector to the unsuspecting household sector, the cost will be enormous future loan problems. Prices are being artificially bid up and imputed equity extracted, while the amount of mortgage fraud is surely massive. The Fed may hold sway over interest rates going forward (mitigating the systemic risk attendant with surging ARM borrowings), but the unfolding Monetary Disorder throughout mortgage finance guarantees the Fed will have little power over furture Credit losses. Recall the telecom debt debacle?
Interestingly, Fannie Mae is understandably troubled by financial sector developments. The following was drawn the company’s earnings conference call:
“In the last two quarters of 2003, one of the main factors supporting the sustained accumulation of mortgage assets by depositories showed signs of weakening, with core deposit growth slowing significantly in each quarter. That slowing turned around dramatically in the first quarter of 2004, with banks adding over $160 billion in core deposits. While growth slowed to $80 billion in the second quarter, that remains nearly three times the levels of growth recorded in both the third and fourth quarters of 2003. At the same time, we have seen no sustained pick-up in the level of C&I loan demand, with loan levels at the end of June exactly where they finished last year. As a result of these dynamics, depositories have continued to add to their mortgage holdings, albeit at a more moderate pace. Total mortgage holdings at commercial banks rose by 26 percent in the first quarter, but decelerated to 8 percent in the second quarter...
The second environmental factor that I would like to address is the increased ARM share we’ve seen during the past 18 months, and the proportion of that increase that has recently been driven by interest-only ARM hybrids. As interest rates have turned upward, and home price appreciation has remained strong, borrowers have turned to alternative mortgage products to maintain affordability. And as refinance-driven volume has disappeared, lenders have turned increasingly to these products, often extending into the Alt-A and sub-prime markets, to keep up volumes in their pipelines. In the first quarter of this year, first-lien ARMs grew by an estimated 34 percent on an annualized basis compared to only 5 percent for conventional fixed rate loans. On a loan count basis, the ARM share of conventional mortgage applications in May averaged over 36 percent -- the highest monthly rate since the survey began in 1990… A record percentage of ARM originations in the first quarter were interest-only hybrids. And an increasing proportion of these interest-only hybrids are being made to borrowers with blemished credit. In addition, so-called ‘sub-prime’ mortgage debt grew at an annualized rate of nearly 23 percent in the first quarter, nearly double the growth rate for conventional prime. And at the end of the quarter, the sub-prime share of residential mortgage debt reached an all-time high of 9.3 percent. We believe that interest-only loans, when used appropriately, are a valuable tool to help homeowners qualify for mortgages. But we view the combination of these factors with some concern, because adjustable rate, interest only loans leave consumers vulnerable to severe payment shock in a rising rate environment. Our analyses indicate that in some instances, as rates rise homeowners could see payment increases of up to 150 percent.
The third trend that I will address is the recent growth in share of private label MBS. With the spread between private label and our own MBS contracting modestly, and spreads on riskier subordinated tranches contracting considerably, private label share of new MBS issuance actually exceeded that of both Fannie Mae and Freddie Mac. When you take a closer look, you see that aggressive lending practices are driving the growth of private label issuance. An increasing proportion of the growing sub-prime and alt-A volume that I referenced earlier is being swept into private label MBS. In fact, these loans now account for over half of private label dollar volume. And in the Alt-A market, there has been a sizable increase in the investor loan share and the interest-only share of originations. The fact is that we do not believe the level of credit risk in private label securities has been adequately reflected in the current pricing.”
As industry kingpins and Mortgage Finance Bubble Instigators, Fannie and fellow GSEs have good reason to be alarmed by the nature of current Credit excesses and general disorder. They surely were much more comfortable back when they dominated the mortgage lending process – when they controlled the monetary spigot. But financial excess and resulting Bubbles, by their very nature, become increasingly unwieldy over time. The masters of inflationary processes eventually lose control - in this case to an unparalleled pool of global speculative finance. I see this loss of control today for the GSEs and their Mortgage Finance Bubble, and this will be followed more generally with respect to the Fed and its market manipulations.
Ironically, the Fed has, of late, succeeded in stemming GSE growth. But what a Pyrrhic victory. Leaving rates at such artificially low levels – accommodating the interest-rate speculators and derivative players – incited manic “blow-off” excesses throughout non-GSE mortgage finance. The problem with such a development is that an unsound boom – and this one is of historic proportions - is inevitably vulnerable to devastating bust at any point that lending excesses subside. The All Too Clever Greenspan Fed will, at such time, have met its match. The Fed has committed a grave error in mobilizing speculative finance to accomplish its monetary policy objectives. The Great Mortgage Spread Trade will eventually unwind but this time there won’t be a bigger leveraged trade to take its place.
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