Noland nails what's happening in the world in this Credit Bubble Bulletin ending
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Credit Bubble “Blow-offs,” the Abuse of Financial Power and Anniversaries
Conventional economists and analysts disregard “financial Credit.” When examining Credit growth, they maintain that including financial sector borrowings in an analysis would involve erroneous “double counting” – since the assets acquired in the process of financial sector expansion would already be included in the liabilities of households, businesses, and governments (“non-financial” borrowings). Yet to ignore the ballooning of the financial sector is to miss a fundamental aspect of historic Credit Bubbles. Indeed, not since the Roaring Twenties has there been anything comparable to the recent surge in financial sector expansion and leveraging.
According to the Fed’s second quarter “flow of funds” report, total Financial Sector market borrowings have increased $5.77 Trillion, or 106%, since the beginning of 1998 (26 quarters). I view this period as the “blow-off” of a Bubble that has evolved over the past several decades throughout the U.S. and global Credit systems. Over the past 6 ½ years, Commercial Bank assets have expanded 58% to $8.2 billion; GSE assets 157% to $2.8 Trillion, and Security Broker/dealer assets 115% to $1.7 Trillion. Combined ABS and MBS has jumped 108% to $6.0 Trillion.
To ignore the mushrooming financial sector is to fail to appreciate the profound “evolution” that has truly transformed the character of finance, marketplace dynamics, and raw power (marketplace, financial, political and otherwise) – not to mention effects and distortions to the real economy. Students of the late-twenties financial folly recognize the crucial role over-leveraging, reckless speculation, financial shenanigans, marketplace abuse/manipulation, and fraud played in fomenting acute financial and economic fragility. And having witnessed the keen aggressiveness with which our major financial institutions have pursued market power, we should not be the least bit surprised by recent revelations of profound arrogance, chicanery and corruption. Such goes part and parcel with attaining astonishing market power in the most profligate of financial environments.
Since the beginning of 1998, Fannie Mae assets have ballooned from $392 billion to $989 billion (153%), Citigroup $584 billion to $1.437 Trillion (146%), and AIG $164 billion to $736 billion (349%). I will not be easily swayed that it is merely coincidence that these, among the most aggressive and powerful institutions, have all recently faced allegations (and worse) of wrongdoing. And only a diehard optimist would not today fear that Mr. Spitzer’s efforts have uncovered only the tip of the iceberg when it comes to financial sector misdeeds and market abuse (just wait until the mortgage finance Bubble bursts!).
Yet arrogance and the abuse of market power are but only one facet of the deleterious consequences of massive inflation in financial sector Credit. Monday’s Financial Times carried an article by hedge fund manager James Altucher, “Hedge Funds Evolve into New Breed of Banks.” “Can you get a car loan from a hedge fund? A loan to buy a television? A credit card? A school loan or financing to fund a movie? Yes. Hedge funds specializing in alternative financing rather than alternative trading have sprung up in every category of asset-backed lending and have taken up the banner in areas where banks have either been too bureaucratic or too risk-averse to make the leap. The result has been funds that are uncorrelated to the traditional financial markets and have so far been delivering above average returns at lower volatility.”
While it garners little attention during the halcyon days of gross financial excess, the terminal Credit Bubble “blow-off” phase has fostered massive over-expansion throughout the entire financial system. Granted, unprecedented mortgage lending has to this point sustained bank-lending profits (while liquefying financial markets, stoking the economy, and holding Credit losses as bay). In the same vein, unparalleled leveraging has maintained speculative financial profits for banks, brokers, hedge funds, insurance companies and others comprising the “leveraged speculating community.” And while collapsing spreads and continued low market rates have thus far generally been a boon to lender and borrower alike, this will certainly not remain the case going forward for those providing finance.
It is the very nature of market “blow-offs” that late-cycle euphoria fosters a tidal wave of liquidity to the (increasingly distorted) hot sector. The crowd of “investors,” speculators and “bankers” fall over themselves to participate in what have come to be perceived as sure profits, despite the reality that years of escalating financial flows and resulting over-investment has already severely weakened prospects. The final manic speculative and liquidity onslaught guarantees future disappointment, a reversal (likely abrupt) of speculative flows, and eventually huge losses. It was only a few years ago that we witnessed precisely these dynamics in action throughout telecom and technology, although lessons were not learned. But, then again, similar previous learning experiences were ignored, including the ’93 bond market Bubble, Mexico, SE Asia, Russia, and LTCM.
It is worth noting the market’s tepid reaction to what have thus far been generally decent bank earnings reports. And while the mortgage/consumer lending boom may have not quite run its course, I am willing to aver that the best days for the banking system have passed, with future prospects increasingly maligned by historic late-stage excesses. It is consistent with the irony of market blow-offs that lending spreads/margins have collapsed (from over-liquefied conditions and gross speculative excess) at this most dangerous late-stage of Credit Bubble Excess. Going forward, the leverage speculating community and banks will partake in a precarious dogfight for dwindling financial profits.
It goes beyond financial trivia that today marks the two-year anniversary of Dr. Bernanke’s first major speech as a Federal Reserve governor, “Asset Price ‘Bubbles” and Monetary Policy.” It is befitting – and worthwhile analytically - to concurrently note the second anniversary of the “great” Greenspan/Bernanke Reflation. In hindsight, the title of Dr. Bernanke’s speech told us all we needed to know: Monetary policy inflated Asset Price Bubbles to historic extremes. And as students of inflation would have expected, the initial constructive aspects of Credit excess (liquid and booming financial markets, rising real and financial asset prices, stronger income growth and economic expansion) are now in the process of giving way to the inevitable detrimental effects of inflation.
Surging energy and commodity prices, along with rising import prices, have joined higher housing, insurance, medical and insurance costs. Sporadic inflationary effects only exacerbate economic distortions and imbalances, while general economic performance (especially job creation) disappoints. The inflating cost of doing business in the U.S. has significantly impacted our global competitiveness and further fiscal and monetary stimulation is certain to only worsen the situation. All the while, the nature of the financial and economic Bubbles require (as great inflations always do!) ever increasing amounts of Credit and liquidity.
It goes to the very nature of Credit inflation and speculative market dynamics that the 1991/92 Fed interest-rate collapse/reliquefication set the stage for the 1993 bond Bubble and 1994 collapse. Then the 1995 Mexican bailout incited the 1996 mania throughout SE Asia and, somewhat later, Russia and other emerging markets. Busts methodically followed booms. The Fed and GSE’s 1998 reliquefication (post-Russia and LTCM) provided the inflationary fuel for the 1999/early-2000 technology blow-off. The Fed’s telegraphed rate-cutting response to a bursting NASDAQ threw gas on the corporate bond Bubble “blow-off” that then nearly collapsed in 2002. The subsequent panicked Greenspan/Bernanke reliquefication similarly stoked a much more momentous “blow-off” throughout mortgage finance that has provided the liquidity for myriad Bubbles at home and abroad.
Now what? With massive U.S. Credit inflation manifesting predictably in a $600 billion annual trade deficit, there is little mystery surrounding the perpetually weak dollar. That the dollar has not been able to rally from a more than 2-year bear market despite strong financial markets, an expanding economy, and $500 billion of Asian central bank purchases over the past 12 months does not portend positive prospects for our currency or markets. Moreover, indications of Monetary Disorder are becoming more conspicuous by the week. Crude oil has spiked to $55, while wild volatility is wreaking increasing havoc in various commodity markets (copper!). Currency markets are becoming increasingly unstable, while the Treasury market is in the midst of a destabilizing “melt-up.” Emerging bond markets have inflated to extreme valuations and issuance has ballooned, emerging as the speculative asset-class of choice in over-liquefied global markets.
At two years, this Reliquefication is well into old age. Granted, this is “the granddaddy of them all,” and the capacity to inflate mortgage Credit goes significantly beyond corporate or emerging market debt. Yet the harsh reality is that we have clearly entered the problematic phase of this inflationary cycle. The financial sector must continue to inflate or commence the “dying” process. But inflating will only amplify increasingly destabilizing Monetary Disorder. And there is no turning back.
I find the current environment especially alarming. Despite a significant de-valuation of our currency, the trade deficit has only ballooned. Instead of higher interest-rates restraining Credit excess and initiating the required adjustment process, two years of declining rates incited a most extreme and destabilizing (domestically and globally) Credit inflation. This has fostered only more dangerous dollar and U.S. economic debasement, not to mention historic speculation and financial leveraging. And the weaker the dollar the greater the demand for non-dollar asset classes and reinforcing flows out of the greenback. There are, in addition, now serious issues with respect to the integrity of our financial system, with the search for wrongdoing drifting awfully close to “structured finance.”
Examining the markets, I see vulnerable U.S. and emerging bond markets, a fragile U.S. stock market, and the dollar at the cusp of what I fully expect to be more troublesome next leg down. With crude oil at $55, I expect foreign central banks to be much more cautious when it comes to massive dollar support operations. And it is worth noting that we saw again today the recent phenomenon of rising U.S. yields no longer prompting dollar buying. Are we finally poised for a bout of concurrent dollar and bond market weakness? Now that would be an unwelcome development for our foreign creditors, the leverage speculators, the derivative players, and global central bankers. The timing is right – commemorating the two-year Anniversary - and I see all the makings for the re-emergence of The Great Bear Market. |
