The Greatest Ever Speculative Bubble in Risk
by Doug Nolan, Prudent Bear
April 15, 2005
prudentbear.com
It was a week of significantly heightened global financial instability. Global equity prices broke down. Treasury bond prices broke upward. GM and Ford bonds broke down. Some key Credit default swap prices blew out. Crude and some commodities prices broke downward. Emerging market bonds were unsettled, with spreads widening. The dollar’s attempted strong upward thrust was for now largely rebuffed in volatile currency trading. In short, Risk markets are under increasing stress, the goliath leveraged speculating community is not making money – at best – and the derivative players must now be studying their risk exposure and questioning their risk assumptions and models. The Speculative Bubble in Risk has been pierced.
The Greenspan/Bernanke Reflationary Bubble Period (the fall of 2002 to present) will go down as the most unsound boom in history. That it has been so misinterpreted by many only undermines already tenuous system underpinnings. Somehow the optimists were willing to ignore the explosion of non-productive Credit, unprecedented leveraged speculation, a conspicuous Mortgage Finance Bubble, and unparalleled Current Account Deficits. They instead put their trust in inflating asset prices and abundant liquidity.
It has always been a case of when this unhealthy boom would face the reality of a faltering Financial Sphere. Credit and speculative excess fostered a widening gap between inflating market valuations and true underlying sustainable (post liquidity boom) economic value. And while I do appreciate that there have been some significant economic developments of late, I nonetheless believe financial developments remain paramount.
Back in 2002 the Fed cloaked its reflationary policies in clever Friedmanite “determined to thwart deflation” talk. Dr. Bernanke proclaimed, “We’ll never let ‘it’ (deflation) happen again.” I have always believed that top Fed officials were keenly cognizant that they were in reality fighting systemic debt market dislocation – a problem with key differences to outright deflation. If the Credit system was incapable of generating sufficient finance and liquidity to avoid a general debt collapse and downward price (including assets) spiral – in a general environment of extreme risk aversion - then the Fed’s effort to “reflate” would at least have not been reckless. But the circumstances were diametrically different, and the Fed succeeded only in inflating Bubbles.
Throughout 2002, the U.S. financial system was extending significant Credit, although it was extraordinarily unbalanced (“Financial Arbitrage Capitalism”). While corporate debt growth slowed to 1.3%, Household Mortgage Credit expanded by 12.4% during 2002. This was the strongest mortgage growth since 1987. The Federal Government increased borrowings by 5.5%, while State & Local government debt surged 14.1%. Total Non-financial Debt expanded at a 7.1% rate during 2002, the strongest expansion since 1989. Financial sector Credit market borrowings expanded at a 9.8% rate. And in regard to the general risk environment, at the time the speculating community, leveraged trading, and the derivatives markets were all mushrooming. Similar to the strong inflationary bias throughout technology/telecom that was stoked into a “blow-off” excess post-LTCM reliquefication, powerful expansionary and speculative forces in “risk” were poised for wild excesses with the assistance of the Fed’s “fight against deflation.”
There were some very serious financial issues back in 2002. The technology and telecom debt Bubble had burst, and the corporate debt market was in tatters. The empowered speculators certainly preferred aggressively leveraging in agency securities, while shorting soiled corporate America (including Ford and GM bonds). The Fed’s determination to inflate signaled that the corporate bond bears had best reverse positions and go long. The ballooning speculating community went aggressively long corporate debt, junk bonds and equities, along with upping leveraged bets in agencies and MBS. The resulting liquidity inundation stoked U.S. and global equities, emerging markets, and the rapidly expanding market in Credit default swaps (CDS). An historic Housing Mania took hold throughout the U.S. (and the U.K., Australia, and China, to name only a few), while the U.S. Credit Bubble morphed into the Global Credit Bubble. It all evolved into The Greatest Ever Speculative Bubble in Risk.
I believe it is very important analytically to appreciate that it has always been a case of from what degree of excess this Risk Bubble would eventually burst. The Key Issues Have Been Financial Sphere Issues, and at the top of the list is that the Fed used the leveraged speculating community as a fundamental reflating mechanism. Fed reflationary policies incited systemic Monetary Disorder – speculative and liquidity excesses that completely distorted the demand and pricing for Risk (securities, derivatives, lending, housing, etc.). Writing insurance (Credit Default Swaps) on GM, Ford and other risky Credits became virtually free money – month after month, quarter after quarter. And declining risk premiums – lower cost of funds – stimulated debt issuance. Credit Availability made a phenomenal comeback. The return of liquidity to the corporate bond market then fueled a “virtuous cycle” of narrower spreads, a more robust business environment, higher equity prices, improved confidence and only greater speculative appetite for risk-taking (including fueling a Bubble in Credit default swaps). Risk premiums narrowed dramatically, while those on the wrong side of trades were forced to take (leveraged) long positions in the underlying bonds and stocks – which only further stoked the self-reinforcing asset inflation and boom cycle.
Bull markets create their own liquidity – and always nurture the perception of endless liquidity. The Bubble in Risk has been no exception. And as long as the crowd hankered to play risk – including writing Credit and market insurance - there was going to be continued downward pressure on risk premiums, upward pressure on bond and stock prices, greater liquidity excesses, increasingly robust economic conditions, and only more emboldened speculators. There was going to be escalating leverage in the system (stocks, bonds and aggressive lending), along with an ambiguous leveraging of speculative risk-taking (CDS and other derivatives).
For example, let’s say the price for writing insurance against default at GM was 300 basis points a year (3%). And while GM may have “only” a few hundred billion of debt, the speculative interest in pocketing those 300 basis points of premium (“free money”) was significantly larger. Aggressive hedge funds had an appetite to write, say, $500 billion “notional,” intending to pocket $15 billion of annual premiums. “Street” derivative players gladly accommodate the trade, hedging their exposure by acquiring a partial long position in the underlying bonds, and everyone was happy. And as premiums declined and market liquidity flourished, the demand for easy profits from writing CDS became intense. The self-reinforcing demand for CDS, the underlying bonds, and resulting marketplace liquidity also supported a high GM stock price, which then supported only lower bond and CDS risk premiums. Yet perceived “virtuous cycle” was in reality a precarious Bubble of Risk.
There is just no way around some things. The speculation and liquidity induced collapse in risk premiums must eventually face the true reality of GM’s dismal financial condition and prospects (certainly made worse by the concurrent inflationary spike in healthcare, steel and energy prices!). The speculative Bubble in GM Risk – a historic mis-pricing of risk in the marketplace - was pierced when the company announced a major earnings shortfall. This immediately incited a move to unwind bets and liquidity evaporated. The huge crowd that had so handsomely profited by writing GM Credit insurance rushed to unwind and/or hedge their trades. Many speculators would attempt to short GM bonds to offset their risk to widening spreads, but the size (“notional”) of the bets placed during the Bubble ended up at multiples of the underlying tradable bonds. With derivatives and hedging, the size of the trade didn’t matter – that is, liquidity was no issue when trades were being put on.
Meanwhile, the derivative players – dynamically trading their exposure using sophisticated hedging models – dump their bond holdings and attempt to get positioned short. Other opportunistic speculators, appreciating the unfolding train wreck, begin aggressively shorting GM bonds and stock. Selling pressure leads to a spike in risk premiums and more aggressive efforts to unwind, hedge and place bearish bets against GM risk. And with Credit Availability quickly disappearing for GM, the company’s prospects take a decided turn for the worst. Liquidity quickly disappears for GM bonds, and speculators and hedgers are forced to sell GM stock as a means of shorting GM “risk.” When liquidity disappears in the stock, sellers must then turn to shorting related companies or simply the more liquid market futures contracts. GM bond market illiquidity feeds GM stock market illiquidity, quickly spilling over into the general marketplace. Simultaneously, similar dynamics are leading to contagious dislocations, first in Ford, then the auto supply companies, and increasingly throughout the leveraged industrials, and other companies impacted by the expanding financial dislocation. Players throughout the CDS market re-evaluate the risk and liquidity dynamics of their strategies and the Risk markets generally. How long until the storm hits the financials?
With some of the major CDS markets in tatters, the bloom is now off the rose. The piercing of this Bubble of Risk has important negative ramifications for both Credit Availability and Marketplace Liquidity. It is also clear that risk aversion is quickly taking hold and that the leveraged speculating community is taking some blows. CDS and auto bonds have been painful. Major losses are quickly adding up in global equities. And the poor bond market bears have been battered – once again. The volatile currencies have been tough and the stalwart dollar short a recent loser. Emerging bond markets have been treacherous. Crude spiked up and broke hard. Even the Old Faithful “reflation trade” is now a war zone. For now, I will assume that the leveraged players are hoping to off-load risk, a dynamic that will, these days, have negative ramifications for liquidity in various markets.
But I sense that we are only kidding ourselves if we believe that the analysis is getting much easier. I specifically did not use “Credit Bubble” in the title of this evening’s piece; I conjecture about the piercing of the Bubble of Risk, not the Great Credit Bubble. After all, the sharp drop in Treasury yields plays right into the hands of the thriving Mortgage Finance Bubble. Barring outright financial crisis, I will assume lower yields throw a bit more gas on the housing finance fire. And while the bond market bulls are breathing a loud sigh of relief, I can envisage how this respite could be but part of The Unfolding Worst Case Scenario – the path of a collapse in Treasury yields and a blow-out in spreads; the path of continued mortgage Credit excess, over-consumption, Current Account Deficits and dollar crisis. Things can go in many directions...
I still believe it is a case of dollar stability requiring higher U.S. yields, although this analysis is somewhat muddied by recent developments in U.S. and global markets. Surging Treasury prices are dollar unfriendly, not to mention spread trade unfriendly. Spread trade unfriendly is leveraged speculator unfriendly. I will confess that it is difficult for me to judge how short-term economy unfriendly a sinking stock market would be if the equity bear market equates to significantly lower market yields. And as important as the Credit default market has become, the dollar and “spread trades” are the Achilles heal of financial stability. In regard to both, there remains significant uncertainty. But with air now flowing out of the speculative Bubble in Risk, financial dislocation dynamics are in play. We’ll come in Monday morning with lots to watch and ponder, including contagion effects and the potential for financial crisis. |
