From Noland this week:
prudentbear.com
Clash of the Paradigms:
David Tice, banking analyst Charlie Peabody (Portales Partners), and I led a panel discussion, “End Game for Credit Bubble: Implications for Financial Markets & Wall Street Finance,” last Thursday at an Argyle Executive Forum (“Alternative Thinking About Investments” in NYC). It was moderated by the wonderfully talented Kate Welling (welling.weedenco.com). The following is certainly not an official transcript of David and my comments but, rather, Q&A expanded in hope of providing more complete responses:
Question: For starters, why don’t you provide us a framework for the analysis behind your provocative title, “The End Game for the Credit Bubble.”?
It is our view that we are in the midst of history’s greatest Credit Bubble. History and sound economic theory have taught us that unconstrained credit systems are inherently unstable – and the longer excesses and imbalances are accommodated the more serious the consequences from the impairment of underlying financial and economic structures. We’ll begin by presenting two slides that contrast between the current conventional view and our own. We see this very much as the Clash of Incompatible Paradigms – and it’s this “clash” that will remain at the epicenter of unfolding Credit system instability.
The Conventional View Paradigm:
· “Perfect/Efficient” Markets Paradigm
· Economic performance governs market behavior
· Underlying economic fundamentals are sound
· Fed commands system liquidity
1. Capacity to initiate reflations/reliquefications on demand
2. Disregard asset Bubbles until they come under stress
· Current Account Deficits are largely irrelevant.
· The system enjoys unlimited capacity to leverage and limitless liquidity.
· Contemporary models-based finance presumes continuous and liquid markets
·The present-day U.S. financial system is more stable, with banks actively disbursing risk throughout the markets.
Our Paradigm – History’s Greatest Credit Bubble
· Unconstrained Credit systems are inherently unstable.
· Markets are inherently susceptible to recurring bouts of instability and illiquidity.
· Wall Street financial innovation and expansion created what evolved into a precarious 20-year Credit cycle, replete with self-reinforcing liquidity abundance and speculative excess.
· “Wall Street Alchemy” – the transformation of risky loans into enticing securities/instruments - has played a momentous role in fostering myriad Bubbles.
· Unrelenting Credit and speculative excesses have masked a deeply maladjusted U.S. “services” Bubble Economy.
· The prolonged U.S. Credit Bubble and resulting interminable Current Account Deficits have cultivated myriad global Bubbles.
· Recessions are an integral aspect of Capitalistic development – and busts are proportional to the preceding booms.
· Today, speculative-based liquidity commands the financial markets and real economy, creating unparalleled fragility.
· Late-cycle “blow-off” excesses are the most perilous because of their deleterious affects upon the underlying structure of the financial system and economy.
Question: Can you provide a brief explanation of “Bubble Economies,” “Credit Bubbles” and some of your theory behind these concepts?
Bubble Economies are highly complex creatures. Clearly, they are dictated by financial excess - most notably a sustained inflation in the quantity of Credit. Substantial Bubble Economies develop over an extended period of time. The momentous variety are often nurtured by the interplay of extraordinary technological and financial innovation, and are almost always perceived at the time as so-called “miracle economies.” Both Credit and speculative excess play prominent roles, especially late in the cycle. Central bankers are likely to be caught confused and accommodating.
It is the nature of Credit that excess begets only greater excess. Major Bubbles are associated with exceptional yet generally unrecognized Credit system phenomenon (“Monetary Disorder”). It is imperative to appreciate that Bubble Economies are as seductive as they are dangerous. Credit excess causes different strains of inflation – rising consumer, commodity, and asset prices to note the most obvious. Asset inflation is the most dangerous, as there is no constituency to stand up and demand the Fed rein it in. Furthermore, the longer asset inflation and Bubbles run unchecked the greater their propensity to go to wild, destabilizing extremes – likely hamstringing policymakers in the process.
Bubble Economies become progressively distorted by inflations in incomes, corporate earnings, government receipts and spending, and Current Account Deficits. Inflationary spending, investment, and speculative financial flow distortions play prominent roles in progressive economic maladjustment. By the late stage of the Credit boom, inflation effects tend to be highly divergent and inequitable.
The greatest systemic danger arises when speculative-based liquidity comes to dominate financial flows and economic development, creating a highly Credit-dependent and unstable system. End of cycle market price distortions tend to create the greatest impairment to financial and economic systems. Bubbles are inevitably sustained only by ever-increasing Credit and speculative excess. Any bursting Bubble must be supplanted by a more pronounced one (or series of Bubbles). As we are witnessing these days, the great danger associated with central banks accommodating Credit and asset Bubbles is that a point of Acute Fragility will be reached – with policymaking gravitating toward prescriptions to sustain financial excess.
Question: You have discussed in the past a concept that you refer to as “The alchemy of Wall Street finance.” Can you describe it for us and relate it to our current environment?
There are two related concepts that are fundamental to our analytical framework – how we view Credit-induced booms and their inevitable busts. These are the “Alchemy of Wall Street Finance” and the “Moneyness of Credit.”
First, the “Alchemy of Wall Street Finance:” This is basically the process of transforming risky loans – loans that become increasingly risky throughout the life of the credit boom - into debt instruments that are appealing to the marketplace. This is very important, because as long as Credit instruments enjoy robust market demand they can be created in abundance – in an extreme case fueling a runaway Credit Bubble with dire consequences for the financial system and real economy.
Our second concept, “Moneyness of Credit,” also plays a central role in boom dynamics. If you think about contemporary “money”, it’s really not about the government printing press or Federal Reserve issuance. Instead, “money” is today largely the domain of private sector Credit and the Marketplace’s Perceptions of Safety and Liquidity. “Moneyness” always plays a prominent role in Credit booms, due to the unbounded capacity to inflate Credit instruments that are perceived as safe and liquid.
Think of it this way, a boom financed by junk bonds likely isn’t going to progress too far – market restraint will be imposed by limitations in demand for these risky Credits. On the other hand, a boom fueled by virtually endless quantities of highly-rated agency debt, ABS, MBS, commercial paper, repos and the like – instruments the market perceives as “money”-like no matter how many are issued – has the very real potential to get out of hand.
And this gets to the heart of the issue – the dangerous state of this Wall Street Alchemy. Over the life of the boom there has been a growing disconnect between the market’s perception of “moneyness” and the actual mounting risk associated with the underlying Credit instruments. Especially because of the heavy use of derivatives, sophisticated structures, and leveraging, along with Credit insurance and various guarantees throughout the intermediation process – the entire risk market became highly distorted and dysfunctional.
And we would argue that the market’s perception of “moneyness” has recently changed – and we believe this to be a momentous development. The market now has serious trust issues related to ratings, pricing, liquidity, leveraging, counter-party risk, Credit insurance, and sophisticated Wall Street structures in general. In short, Wall Street’s capacity to create contemporary “money” has been dramatically constrained.
Of late, the rapid growth of central bank and banking system balance sheets has taken up the slack. But this is only a temporary stop-gap. The unrecognized dilemma today is that to sustain our Bubble economy will require continuous huge quantities of Credit creation – and these loans are by nature high risk. Wall Street risk intermediation is impaired – the market today seeks risk avoidance and de-leveraging – and there is little alternative than the banking system turning to risky lender of last resort.
Question: So where are we today, and what are the ramifications for the current economy?
Putting it all together, a confluence of factors has created what we expect to be an ongoing highly unstable Credit backdrop. In the nomenclature of economist Hyman Minsky – we have today “Acute Financial Fragility” – as opposed to previous backdrops where the U.S. system, in particular, was positioned to weather periods of turmoil relatively well. Despite dogged global central bank interventions, we still fear the potential for the Credit market to seize up – with devastating economic consequences. And the combination of unusually frail financial and economic structures leaves us very fearful of a dollar crisis of confidence.
At the minimum, the bursting of the Mortgage Finance Bubble has instigated a serious tightening of mortgage Credit Availability, leading to escalating foreclosures, Credit losses, pressures on home prices, and ongoing marketplace illiquidity for MBS and mortgage-related debt instruments. A classic real estate bust will feed on itself, ensuring further havoc throughout mortgage finance and imperiling the over-borrowed consumer sector.
Question: There’s a lot of talk these days about the GSEs – their roles in market excess, previous financial crises, and the potential for GSE liquidity to come to the market’s rescue once again. What’s your view on these matters?
There is a key facet of GSE analysis that does not garner the attention it deserves – and it relates, importantly, to the stark contrast between the inherent stability of GSE obligations and the underlying instability of much of today’s debt market structures. Let me begin by sharing data I believe go far in illuminating recent acute financial fragility. Returning to the four-year period 1998 through ‘01, direct GSE borrowings expanded $1.2 TN versus a $788bn increase in outstanding asset-backed securities (ABS). Compare this to the three-years 2004 through ‘06, when GSE debt grew only $57bn while ABS ballooned almost $2.0 TN.
In developing his hypotheses of inherent financial instability, Hyman Minsky coined the terminology “Ponzi Finance.” It is crucial to appreciate that GSE-related debt (agency debt and MBS) behaves atypically during crisis: I refer to the GSEs as the “Anti-Ponzi Finance Units” – in that finance flows aggressively to this (quasi-government) asset class during periods of market tumult. The GSEs enjoyed basically unlimited capacity to expand liabilities during previous crises – 1994, 1998, 1999, 2000, 2001/02 – and their operations played a momentous role in repeatedly backstopping the Credit boom.
Today – the GSEs are constrained and their balance sheets will not play their typical prominent role in accommodating speculator deleveraging and system reliquefication. Furthermore, by far the greatest excesses over the past few years were in Wall Street “private-label” ABS/MBS – subprime and, more importantly, Alt-A, jumbo, interest-only and other mortgages that encouraged borrowers to reach for more home than they could afford.
So, from a GSE standpoint, these agencies played an instrumental role in fostering the Mortgage Finance Bubble. When, in 2004, the scandal-plagued GSEs faltered, Wall Street was keen to snatch control. Consequently, trillions of unstable non-GSE debt instruments now permeate the system. At the same time, the GSEs are today incapable of orchestrating their typical market liquidity operations. This helps explain the difference between previous relative stability during crises versus recent Acute Fragility – especially in Wall Street ABS, sophisticated leveraged strategies, and derivatives more generally.
And we don’t expect this dynamic to be easily reversed or even meaningfully mitigated. Central bank interventions will have minimal intermediate and long-term impact on the bursting Mortgage Finance Bubble. Liquidity today flows in abundance to gold, precious metals, crude oil, commodities and virtually any non-dollar asset market – where robust inflationary biases prevail – content to avoid Wall Street mortgage-related securities and exposures. The situation will only worsen as home price declines gather momentum and Credit losses escalate.
Question: So, it is your contention that the current crisis marks a major inflection point for the Credit system?
We strongly believe so. Going forward, markets will be decidedly more cautious when it comes to ratings and liquidity. “AAA” was perceived as “always liquid” – even in the midst of financial crisis. In reality, GSE-related debt and their ballooning balance sheets played a prominent role in fostering this fateful market misperception. Yet, over the past few years, the most egregious Credit excesses were in speculative leveraging of highly-rated non-GSE securitizations. This scheme is now over.
The bursting of the Mortgage Finance Bubble has ushered in a major tightening of mortgage Credit, which will lead to escalating foreclosures, Credit losses, home pricing pressures, and ongoing marketplace illiquidity for MBS and mortgage-related debt instruments. We see the so-called “subprime crisis” transforming over time to an expansive dislocation in “Alt-A”, jumbo and "exotic" mortgages.
There are now literally trillions - and growing - of suspect debt instruments and many multiples more in problematic derivative instruments. We suspect that the proliferation of sophisticated leveraged strategies created considerable demand for high-yielding mortgage products, and now these vehicles are trapped with losses and illiquidity. Worse yet, Credit insurance and guarantees in the tens of trillions have been written and, as the downside of the Credit cycle gains momentum, we expect this exposure to become a major systemic issue. In short, we see Credit “insurance” as a bull market phenomenon that will not stand the test of the impending Credit and economic downturns. In too many cases, Credit guarantees, “insurance,” and myriad other exposures have been “written” by thinly-capitalized speculators and financial operators. They will have little wherewithal in the event of a serious Credit event. This is a major evolving issue. We fear the entire Wall Street risk intermediation mechanism is at considerable risk.
Question: Can you wrap thing up with some summary comments?
To summarize, we believe the current fragile boom – one characterized by unprecedented imbalances and maladjustments – can only be sustained by ongoing massive Credit creation. In an increasingly risk-averse world, this poses a colossal risk intermediation challenge. Thus far, the confluence of a highly inflationary global backdrop, extraordinary central bank interventions, and a major expansion of U.S. banking system Credit has sufficed. We, however, view Fed and the U.S. banking system capabilities as constrained and aggressive actions feasible only over the short-term. Importantly, an impaired Wall Street risk intermediation mechanism – the main source of finance behind the past few years of “blow-off” excess - will be hard-pressed to meet challenges and new realities.
Likely, liquidity issues and faltering asset markets will instigate problematic de-leveraging upon highly over-leveraged Credit and economic systems. We expect significant unfolding tumult in the securitization, derivatives, and risk “insurance” marketplaces. We view ballooning Credit insurance and derivatives markets as a bull market phenomenon that won’t withstand the test of the downside of the Credit Cycle. We believe the stock market has of late benefited from a combination of complacency, misperceptions with respect to Fed capabilities, and its newfound status, by default, as favored risk asset class. We see US equities, in particular, highly susceptible to unfolding detrimental financial and economic forces. We expect the economy to soon succumb to recession. California and other inflated real estate Bubble markets are now poised to suffer severe price declines – residential as well as commercial. And we expect contemporary “Wall Street Finance” to face a crisis of confidence – to suffer on all fronts – liquidity, Credit losses and regulatory. Our faltering currency is, as well, a major issue. |
