Page 1 of 4 CREDIT BUBBLE BULLETIN Misdirected credit runs unabated
Commentary and weekly watch by Doug Noland When I titled last week’s
piece Too big to suffer a loss I had no real inkling of what this past
week would have in store. Actually, I had presumed that the Treasury
and Fed wouldn’t allow Lehman Brothers to fail. Lehman, after all,
was one of the major players in the precarious daisy chain of Wall
Street risk intermediation. A failure by any key player in this
realm would immediately have this historic credit crisis jumping the
firebreak from the rugged terrain of mortgages and “risk assets”
into the hallowed land of perceived safe and liquid contemporary
“money.” The consequences of such a lurid escalation were so
potentially catastrophic that I believed that Paulsen and Bernanke
were prepared to use the overwhelming force of fleets of aerial
supertankers to ensure our “money” tinderbox was not set ablaze. It
now appears they didn’t appreciate the ramifications for Lehman going
under – how this would quickly ignite a run on the core of our
monetary system. It wasn’t long, however, before the horror of
watching the entire system going up in flames prompted a mad
scramble to conjure the equivalent of monetary firefighting shock
and awe. What an incredible week. On Thursday, the administration
presented Congress a US$700 billion plan to stem the credit and,
increasingly, economic crises. Wall Street and the banking system
have been rapidly burning through their entire “capital” buffer, as
the risk intermediation community suffers enormous and unending
losses. The bursting of the credit bubble is proving catastrophic
for many that intermediated the risk between trillions of risky loan
assets funded by the issuance of trillions of perceived safe and
liquid money-like liabilities. For awhile, the global sovereign
wealth funds, speculators, and some investors were content to step
up and lead a recapitalization process. As time passed, however,
this was increasingly recognized as a classic case of throwing good
“money” after bad. As losses escalated and sources of additional
“capital” dried up, focus quickly turned to escalating losses being
suffered by some gigantic and highly leveraged players (such as
Lehman, Merrill Lynch, and American International Group). At least
in the case of Lehman, a run on their money market liabilities
(especially “repos”) had commenced. Bankruptcy by Lehman – with the
extreme market uncertainty associated with unprecedented losses to
bondholders, creditors and counterparties – immediately froze the
credit default swap (CDS)marketplace. Dislocation in the CDS market
was a deathblow for AIG and many hedge funds. The Lehman
contagion quickly incited panic throughout the money fund complex, a
to-this-point bulletproof sector that had, after a year of enormous
growth, become an even more vital pillar to the sacred domain of
contemporary “money.” Exposure to Lehman forced the Primary Reserve
Fund, a venerable money market operation, to mark down its portfolio
3%. Primary Reserve saw 60% of its fund (almost $40 billion)
redeemed in just two days, as trading in even the lost “liquid”
short-term money market instruments seized up. A modern day electronic
“run” on contemporary “money” had commenced; the system had reached
the brink of collapse. To stabilize the system at such a point
required nothing less than unprecedented measures. The Treasury and
Federal Reserve would have to become major buyers of last resort –
both the providers of massive marketplace liquidity and the
underwriter of massive credit losses. With the monetary system
breaking down, the federal government saw no alternative than to fill
the void left by the impaired risk intermediators. Or, from a more
theoretical perspective, our government would have to guarantee the
“moneyness of credit” – assume the spiraling losses between the
trillions of risky system loans and the trillions issued of
perceived safe and liquid “money.” No systemic federal guarantee,
no more “moneyness” – and an immediate end to the last bastions of
credit growth that have been sustaining the US bubble economy. So
what’s the problem with the government stepping to guarantee
“moneyness”? How can it be inflationary, when credit growth has
slowed so dramatically, assets prices have come under such pressure,
and confidence in the system has been so shaken? Well, I continue to
believe that some overriding issues are today lost in the
discussion; lost in all the pontificating; lost in the frenzy of
panicked policymaking. I am not surprised that our policymakers
nationalized Fannie Mae and Freddie Mac. It was predictable that the
Treasury and Federal Reserve were forced into wholesale bailouts and
unprecedented liquidity operations. That Washington had to step up
and guarantee money fund deposits is not all too surprising. Ditto
with the upwards of $1 trillion of congressional authorizations, with
policymakers bumbling through various measures in hopes of stabilizing
the system. Over the years, we’ve been pretty cognizant of the
extreme nature of excesses; the extent of system vulnerability; and
the expensive bill that would come due with the arrival of the bust.
But I want to be especially clear on one thing: I am shocked and
incredibly alarmed that all these measures became necessary at such
an early stage of financial and economic adjustment. After all, the
Dow remains above 11,000 and gross domestic product expanded 3.3%
last quarter. And this gets right to the heart of the matter –
where the analytical rubber meets the road. A massive inflation of
government obligations; a major government intrusion into all
matters financial and economic; and an unprecedented circumvention
of free market forces has been unleashed – but to what end? I
believe it is a grave predicament that such a rampage of radical
policymaking has been unleashed in order to maintain inflated asset
markets and to sustain a bubble economy. Normally, such desperate
measures would be employed only after a crash and in the midst of a
major economic downturn – not in efforts specifically to forestall
the unwind. Not only will such measures not work, I believe they
will only exacerbate today’s already extreme global monetary
disorder. They will definitely worsen the inevitable financial and
economic dislocation. I have over the past several years
repeatedly taken issue with the revisionist view that had the Fed
recapitalized the banking system after the ’29 stock market crash
the Great Depression would have been avoided. Some have suggested
that $4 billion from the Fed back then would have replenished lost
banking system capital and stemmed economic collapse. But I believe
passionately that this is deeply flawed and dangerous analysis.
An injection of a relatively small $4 billion would have mattered
little. What might have worked – albeit only temporarily – would
have been the creation of many tens of billions of dollars of new
credit required to arrest asset and debt market deflation and refuel
the bubble economy. Importantly, however, at that point only
continuous and massive credit injections would have kept the system
from commencing its inevitable lurch into a downward financial and
economic spiral. Importantly, market, asset and economic bubbles
are voracious credit gluttons. I would argue that the system today
continues to operate at grossly inflated – bubble – levels. The
upshot of years of credit excess are grossly distorted asset prices,
household incomes, corporate cash flows and spending, government
receipts and expenditures, system investment and economy-wide spending
and, especially, imports. So to generally stabilize today’s
maladjusted system will, as we are now witnessing, require massive
government intervention. Enormous government-supported credit growth
will be necessary this year, next year, and the years after that. To
be sure, a protracted and historic cycle of misdirected credit runs
unabated. Present efforts to sustain the bubble economy create an
untenable situation. Washington is now in the process of spending
trillions to bolster a failed financial structure, while focusing
support on troubled mortgages, housing, and household spending.
Regrettably, this is a classic case of throwing good money after
bad. Not yet understood by our policymakers, literally trillions of
new credit will at some point be necessary to finance an epic
restructuring of the US economic system. Our economy will have no
choice but to adjust to less household spending, major changes in
the pattern of spending (this is, less “upscale” and services),
fewer imports, more exports, and less energy consumption.
Moreover, our economy must adjust and adapt to being much less
dependent on finance and credit growth – which will require our
“output” to be much more product-based as opposed to
“services”-based. We’ll be forced to trade goods for goods. The
current direction of bubble-sustaining policymaking goes the wrong
direction in almost all aspects. At some point, the markets will
recognize this bubble predicament, setting the stage for a very
problematic crisis of confidence for the dollar and our federal debt
markets. WEEKLY WATCH Just when you thought you’d seen it all… Yet
how wild could it have been with the Dow down only 0.3% (down 14.1%
y-t-d) and the S&P500 up 0.3% (down 14.5%)? Amazingly so. The
Transports gained 0.5% (up 11.6% y-t-d), and the Morgan Stanley
Cyclicals added 0.2% (down 13%). The Utilities were hit for 3.3%
(down 17.6%), and the Morgan Stanley Consumer index declined 2.5%
(down 7.4%). The broader market rallied sharply. The small cap
Russell 2000 jumped 4.7% (down 1.6%), and the S&P400 Mid-Caps gained
2.1% (down 6.2%). The NASDAQ100 declined 1.2% (down 16.3%), and the
Morgan Stanley High Tech index dipped 0.9% (down 16.4%). The
Semiconductors rallied 3.7% (down 18.2%); The Street.com Internet
Index added 0.6% (down 10.4%); and the NASDAQ Telecommunications index
gained 0.6% (down 9.7%). The Biotechs were little changed (up 2.8%).
Financials were unbelievably volatile and ended the week up big. The
Broker/Dealers jumped 7.6% (down 31%). The Banks surged 16.3%,
slashing y-t-d losses to 6.8%. With bullion rocketing $108 higher,
the HUI Gold index rallied 11.5% (down 20.9%). September 19 –
Bloomberg (Dakin Campbell): “Treasuries tumbled, sending two- year
note yields up the most in 26 years, after Treasury Secretary Henry
Paulson and Federal Reserve Chairman Ben S. Bernanke announced plans
to help stem a collapse in financial- market confidence.” One-
month Treasury bill rates traded as low as one basis point yesterday
before closing the week at 0.69%, down 66 bps Three-month yields
collapsed 47 bps to 0.99%. After today’s sell off, two-year
government yields ended the week down only 4 bps to 2.17%. Five-year
T-note yields rose 9 bps this week to 3.04%, and 10-year yields
increased 9 bps to 3.81%. Long-bond yields gained 7 bps to 4.38%.
The 2yr/10yr spread increased 13 to 163 bps. The implied yield on
3-month December ’09 Eurodollars added 5.5 bps to 3.375%. Benchmark
Fannie MBS yields rose 11 bps to 5.40%. The spread between benchmark
MBS and 10-year T-notes widened 2 to 159 bps. Agency 10-yr debt
spreads were 17 wider to 64 bps. The 10-year dollar swap spread
increased 5 to 66.25. Corporate bond spreads moved wildly. An index
of investment grade bond spreads ended somewhat wider at 163 bps,
and an index of junk bond spreads widened to 636 bps. I saw only
one debt issue this week, a $500 junk borrowing by Sungard Data
Systems. German 10-year bund yields added 2 bps to 4.21%. The German
DAX equities index declined 0.7% (down 23.3% y-t-d). Japanese
10-year “JGB” yields fell 5 bps to 1.48%.
Continued 1 2 3 4
1.US at a turning point 2.Oil market collapse waiting to happen
3.Islamabad rides a terror tiger 4.The end of a gilded age 5.All
change in the US’s Afghan mission 6.Tehran feels an Arab sting 7.What
a buzz 8.BOOK REVIEW:’We blew her to pieces’ 9.Iran plays the mediator
(Sep 19-21, 2008)
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