noland this weekend does a great job summarizing where we are
prudentbear.com
The Hand of Finance:
Beginning with my early-January “Issues 2007,” “It’s All About Finance” has been the underlying theme of almost every one of this year’s CBBs. For me, the important unanswered questions inevitably relate back to my December 2000 presentation “How Could Irving Fisher Have Been So Wrong?” Why are so many caught bullish – and completely oblivious to escalating risk - at major tops? And why is it that booms and bull markets cannot endure indefinitely? Clearly, the vast majority are today convinced they can and will. We’re witnessing why they can’t and won’t.
Well, booms inevitably falter at The Hand of Finance. In this distant past the post-Bubble post-mortem would simplify the state of things to “the money went bad.” People had lost confidence and “ran” from banks and the stock market. The Credit wheels had ground to a halt and the abundant liquidity that seemed as if it would always be readily available instead abruptly evaporated. Jump forward to today and perceptions have it that the Fed and global central bankers are waiting to ensure that confidence is maintained and liquidity remains always bountiful. We’re apparently so much more enlightened today, especially with our sophisticated risk monitoring and mitigating systems. We have derivatives.
I have my somewhat different take on why Credit-induced booms are destined for bust. Bubbles are sustained only by increasing quantities of Credit creation – a rather simplistic proposition encompassing highly complex processes. Inevitably, the dilemma evolves (sometime late in the cycle) to the point where the quantity of requisite additional Credit turns enormous – and the rapid financial expansion accelerates to breakneck speed. At the same time, the risk profile of the marginal (late-cycle) new loan deteriorates, while the major financial intermediaries (right along with the vast majority of market participants) are caught reaching too aggressively for perceived easy profits. Too much Credit is financing speculative endeavors, highly inflated assets values, and enterprises that, at best, are economic only as long as boom-time conditions exist.
Underlying Credit risk eventually succumbs to parabolic growth tendencies – as we’ve witnessed this past year. Yet one critical upshot of this dynamic is the associated (Credit-induced) surge in overall system liquidity, especially in wild securities markets inflation. Naturally, this “Monetary Disorder” unfolds some number of years into the prosperous boom – after an entrenched inflationary bias has taken firm hold in the securities markets and the economy generally. Irving Fisher was making a fortune at the top. He was intoxicated by his inflating wealth and was as emboldened as the naysayers were fully discredited. Almost by cruel design, the Credit Bubble's "terminal phase" is guaranteed to entrap those willing to subscribe to New Eras.
The unappreciated predicament of 1929 and today is Risk Intermediation. Dr. Bernanke refers to the study of The Great Depression as the “Holy Grail of economics.” He blames the “Bubble Poppers” and the Fed’s subsequent failure to create enough money. Conventional thinking has it that had the Fed only created $5 billion and filled the hole in bank capital the devastating downturn could have been avoided. But the issue at the time wasn’t, as conventional monetary economist believe today, the few billions necessary to recapitalize the banking system - but the ongoing tens of billions that would be required to sustain unsustainable Credit Bubble-induced inflated asset prices, inflated corporate profits, inflated earnings, and myriad worsening economic maladjustments.
Citigroup expanded its balance sheet by $200bn during the second quarter (to $2.22 TN). JPMorgan’s Assets expanded $50bn during Q2 and Bank of America’s $32bn. Goldman Sachs, Morgan Stanley and Lehman Brothers combined for $92bn of Q2 asset growth. Merrill’s second quarter balance sheet is not yet available, but we do know that assets expanded $140bn during Q1. The four “broker/dealers” have combined for one-year growth surpassing $700bn. The “good news” is that they have to this point succeeded in supplying the necessary Credit to sustain global financial and economic booms. The bad news is that this Credit deluge is wildly inflating global asset prices and feeding an historic worldwide speculative Bubble in debt and equity instruments, real estate, and assets generally. We are witnessing in real time the dynamics of rapidly escalating late-cycle risk and the dilemma of how to intermediate it.
With few exceptions, the major financial firms have so far reported “better-than-expected” earnings. Almost without exception the market sold stock on the news. Citigroup’s Q2 Revenues were up 20% from a year ago to $26.6bn. And while Revenues in its Global Consumer division expanded only 8% from Q2 2006, Markets & Banking was up 33%, Global Wealth Management 28%, and Alternative Investments 77%. Examining the balance sheet, Trading Assets surged $78bn (to $538bn), “fed funds/repo” $44bn (to $348bn), and Loans $50bn (to 743bn). Citigroup is the poster child for a (struggling) major financial player responding to weakening profits and business fundamentals in its traditional lending business by pushing its capital markets activities to new extremes. Why not, all the other firms’ stocks – until recently – were amply rewarded for doing the same. Now they’re all fully exposed to market risk with nowhere to go. And, for their efforts to support the boom, their stocks are now under liquidation.
July 18 – Financial Times (Ken Fisher): “Headlines herald a US prime-time, subprime mortgage implosion leading to an upcoming credit-crunch crisis - destined to sink shares, raise interest rates and impale economies. But this is demonstrable nonsense. Yes, there have been media autopsies of the few notable subprime lenders that have gone belly up. More are certainly in the wings. But what makes this a systemic problem? If subprime is to ripple systemically into a crisis, it is a take-it-to-the-bank certainty that we will see vast credit-spread widening. Yet spreads between high quality and low quality debt of the same maturity - by any measure - are at near record lows, in spite of six months of subprime hand-wringing. And the biggest single days of upside volatility have been historically very subdued - about 10 to 20 basis points. Every true credit crisis in history had huge spikes in credit spreads early on and - while not always - usually well before equities implode. By contrast, wrong-headed credit fear babble blows through history like the wind without a ripple in credit spreads.”
I’ll assume that if Ken Fisher ever read my analysis he would pronounce me the “king of Credit fear babble.” The title of Mr. Fisher’s FT article was a rather catchy “Be Bullish and Watch the Bears Impale Themselves.” Mr. Fisher did well to disregard previous Credit fears, but I suspect he will regret his current complacency. It’s been a long and profitable bull market. Too long.
July 20 - Financial Times (Michael Gordon): “Will the troubles in the US subprime market pass by as a little local difficulty - or will they start a rout across capital markets and bring to an end the great bull run in a broad range of asset classes? That’s the big question faced by those in capital markets right now. Can history teach us anything on this score? Well, it’s certainly worth looking at the collapse of Long-Term Capital Management in -September 1998. The near-demise of this -mammoth hedge fund marked a turning-point for credit markets, hitting brokers and banks hard. The debacle is less than a decade ago, but banks were smaller and less diversified firms in those days and so less able to absorb large shocks. Also, their risk management systems were not as well developed as they are now… Wind forward to today. Does the collapse of confidence in the US subprime market have any similarities to the LTCM affair? Well, many of the weaknesses of the banks and brokers that emerged in 1998 have since been addressed. They are larger, more diversified institutions. They have also invested a great deal in risk management. Overall, the banks look far more resilient.”
Like Ken Fisher, Michael Gordon seems blind to today’s acute financial fragility. It is wishful thinking that “banks” are today “more resilient” than in 1998. The financial system today has unprecedented exposure to risky mortgage Credit, highly leveraged and speculative financial markets, an M&A Bubble and global asset Bubbles. The entire global Credit system is one vulnerable Minskian “Ponzi Finance Unit.”
It may be valuable to do a little contrasting of today’s backdrop to the LTCM crisis. The near LTCM debacle had its roots in highly leveraged speculation across many markets. It was a Credit issue only in the context of the impact of potential forced position position unwinds and systemic de-leveraging. It was much more about the fear of contagious liquidations than of latent Credit issues. The underlying Credit instruments were not in and of themselves suspect. The market dislocation was (in hindsight, easily) resolved by ameliorating the fear of de-leveraging and re-invigorating financial expansion.
Importantly, during the LTCM and other recent Credit scares the marketplace’s faith in the evolving market in “structured finance” was not in question. Actually, it was a perceived strength. The GSEs were recognized as powerful pillars of strength (and willing and able to balloon assets holdings at a whim). Mortgage Credit in general was solid in 1998. The “financial guarantors”/Credit insurers (notably MBIA and Ambac) had relatively small exposure to insuring sophisticated Wall Street securitizations. The Credit derivatives market was small and a non-issue. There were, at the time, no festering domestic Credit issues. The U.S. economy was not remotely as susceptible as it is today. The dollar was in the midst of a multi-year bull run. The Current Account Deficit was running at about a $200bn pace.
The issues today are more serious and deep-rooted. Confidence in the dollar is faltering in the face of untenable $800bn annual Current Account Deficits. The Credit system is weakened by unprecedented impending subprime losses and acute vulnerability throughout “prime” mortgages. The GSEs are weak financially and extraordinarily vulnerable. The Credit insurers are highly exposed to myriad Credit and financial risks. The Wall Street firms and “money center banks” are heavily exposed to mortgage and capital market risk. The untested Credit derivative marketplace has been shaken by the rapidity and severity of the subprime implosion. The CDO market wasn’t a factor in 1998, let alone a vital facet of system Credit creation and risk intermediation.
What appeared at the time (1998) a large leveraged speculating community seems today tiny by comparision. Today's vast global pool of speculative finance was but a little puddle, and a dollar bullish one at that. Meanwhile, the expansive marketplace for trading Credit exposures has created a major venue for placing aggressive bets on systemic Credit conditions – over-stimulating liquidity creation when the bets are bullish only to imperil liquidity when the bulls turn, as they are these days, into enterprising bears. Moreover, the coveted risk modeling and management systems are oblivious to end-of-cycle Credit Bubble dynamics.
The most important difference between today and 1998 is that the Credit system back then was not a full decade into problematic Credit and Economic Bubble dynamics. The amount of Credit necessary to support the economy and markets was a fraction of what it has become. Both the quantity and quality of risk to be intermediated was relatively small in comparison and, besides, there was a bevy of risk intermediators easily up to the task.
In stark contrast, today – and going forward – there will be an unrelenting torrent of risk that must be intermediated (risky Credits transformed into palatable debt instruments), and it is not at all clear who is in a position to absorb significant risk. The leveraged speculators are more than likely keen to shed risk. The big “banks” and “brokers” are already fully-loaded. And the general marketplace, well, it’s reeling with the realization that much of structured finance today suffers from pricing and liquidity issues and, worse yet, not even debt ratings can be trusted. “Ponzi Finance” dynamics are in full play and the U.S. Bubble economy is incredibly exposed to a reversal in speculative finance and resulting liquidity crisis. These are very serious issues and indicative of the types of unavoidable risk intermediation problems that will stymie this historic Credit Bubble. |
