 |
|
Storm Watch Update |
|
Easy Credit & Multiple Bubbles Considering the U.S. economy, financial markets, and the myriad bubbles present everywhere, I couldn’t help but recall the tragedy of Macbeth. Like the characters in the play that are tossed about by forces they cannot control, central bankers, GSEs and financial intermediaries have created a cauldron of credit that has turned into an uncontrollable financial force. Central bankers may not be witches, but they have become the modern day version of alchemists trying to create real money out of paper. Credit continues to expand exponentially throughout the system -- whether it is consumer debt, mortgages, corporate debt or municipal, state, and federal debt. Credit expansion in the U.S. over the last three years is running at an annual rate of $2 trillion, equivalent to 20% of U.S. GDP. 1 In addition, unlike an earlier era in American history when debt was used to build the nation's infrastructure during the 19th century, debt today is used for consumption by consumers and unproductive investments by businesses resulting in malinvestments in the economy. Consequently, the U.S. economy is now made up of multiple bubbles. Risk-Shifting As the economy heads into a deflationary spiral because of collapsing asset prices, the credit creation mechanisms are running at full throttle. The Fed accelerated the process through its 11 rate cuts over a 12-month period, bringing the discount rate down from 6% to its present level of 1.25%. In this process, the Fed expanded reserves through the banking system through its purchase of government securities. This action put cash into banks which enabled them to expand their loan portfolios aggressively by virtue of our fractional reserve banking system. At the same time through the securities market, GSEs and financial intermediaries were able to expand their lending activities through the securitization of loans. Money center banks and financial intermediaries are able to offload their debt onto the financial system through the process of securitizing their loans. Banks and other financial institutions such as credit card companies and the capital arm of major corporations have been making loans and then repackaging those loans into asset-backed bonds. These securities are then sold to insurance companies, pension funds, and institutional investors. The large banks and financial intermediaries have been able to elude the financial fallout from rising bankruptcies and growing defaults by transferring that risk to the securities markets. A good example of this is the recent rash of telecom defaults from high profile companies such as WorldCom, Winstar, McLeodUSA, and Global Crossing. Big money center banks such as Citigroup, JPMorgan Chase, and Bank of America were lead lenders in $365 billion in loans to the telecom industry. Instead of hemorrhaging from these loans, banks were able to shift these risky loans onto pension funds, insurance companies, institutional investors, and mutual funds. Unlike the past when lenders had a direct stake in the loans they made, modern financial markets have enabled banks to offload their loans through the process of syndication. As the table below indicates, the big banks only held on to a small portion of their telecom debt. The big losers in this case were institutional investors such as Calpers, which lost $330 million on WorldCom, Mellon Financial $100 million, Texas Teachers pension fund $59 million, and $88 million for the New York State pension fund . Many others are sitting on major losses from not only WorldCom, but also other debt debacles such as Global Crossing, and Enron.
BOND MARKET BUBBLE
As stock prices plunged over the last three years, institutional money has exited the stock market and has shifted over into the bond market as a place of refuge from the storm. With the Fed lowering interest rates 11 times last year, institutional investors such as insurance companies and pension funds have been starved for high yields. The demand for high quality debt has driven long-term yields down and has provided new fodder for the credit creating mechanisms of the financial markets. As the assets in bond funds have swollen over the last two years, another bubble has developed in the bond market. Money is shifting from one paper asset class (stocks) to another paper asset class such as bonds and money market funds. Inflows of new money into mutual funds continue to fall, but a drastic change in allocation is taking place as shown in the table below.
Stock fund assets have fallen from their peak of $3,962 billion in 2000 to $2,770.5 billion in July of this year. Bond funds and money market funds seem to be the destination of those seeking shelter from the carnage in the stock market. Bond fund assets have grown from $811.1 billion at the end of 2000 to $1,033.3 billion in July of this year. Money market fund assets have grown from $1,845.3 billion in 2000 to their present size of $2,253.7 billion.
Unlike the past, credit growth isn’t migrating its way into the stock market as it did in 1994, 1997, 1998, and 1999. During those periods of severe financial stress, money growth and interest rate cuts were directly linked to a rise in stock prices. In fact, with each new crisis the financial markets would salivate in anticipation of lower interest rates and injections of liquidity into the financial system. This time around, the money is moving into fixed income assets such as bonds, money market funds, and other cash or debt-type instruments. This is providing the fuel for the asset securitization of loans and mortgages, which is helping to fuel the refi boom and real estate markets. This movement into fixed income assets is reflected in the growing size of bond funds. Pimco’s bond fund has now moved into second place in asset size displacing Fidelity Magellan. Debt Market Disaster Brewing Syndicated
Bank Loans While many investors are focusing on the risks of falling stock prices, they are ignoring an equally dangerous risk in the bond market. Like the equity markets, which are in a process of correcting the excesses of the 90’s, a similar process is taking place in the debt markets. It began in the telecom sector, has now spread to the energy markets, and is slowly working its way to the financial sector. All of the loans, mortgages, credit cards, auto loans and other type of installment debt that have been syndicated will eventually be unwound. Unemployment = Debt Risk Mortgage Delinquencies On
The Rise Corporate & Household
Balance Sheet Blues Companies are now in the process of correcting those excesses through downsizing, restructuring, and paring back new capital investments. These layoffs are occurring across a wide swath of companies, which can only make matters worse in the months ahead for households and individual consumers. Future layoffs in the months ahead will create even greater stress for the consumer as more individuals lose their jobs due to corporate downsizing. Only the government is expanding employment at above-average rates as it attempts to use fiscal stimulus to counter the contraction in the private sector. As mentioned earlier, the credit bubble of the 90’s and 21st Century would not have been possible without the full cooperation of the financial markets. The ability of banks and other financial intermediaries to transfer their credit risk onto the financial markets through securitization of loans was made possible by a growing remoteness of the saving class from their investments. The American consumer contributed very little to the credit bubble other than his willingness to borrow and spend. Throughout the 90’s, most consumers spent all they earned and then borrowed the rest to meet their voracious appetite for consumable goods. Savings rates dropped to zero and then went negative by the end of the decade. In the place of domestic savings, a new investor emerged — the foreign investor, hedge funds, and financial institutions. Foreign investors financed 40% of all domestic debt, financial institutions such as insurance companies and pension funds provided funds for another 40%, with the balance coming from Wall Street brokers, hedge funds and leveraged speculators. As Peter Warburton has written in his book, Debt & Delusion, that a large contingent of funds provided to the U.S. capital markets is coming from a relatively unstable class of investors, mainly offshore investors, many of whom are leveraged to the gills and suffer from short-term attention spans. 3 Deflating The Bond Market Bubble
In the case of foreign investors, they have been key players in keeping the U.S. credit bubble alive. Between the years of 1999-2001, they invested $1.8 trillion in the U.S. securities markets. Investments in the stock market have fallen off and have been replaced by bond purchases. 4 With foreign investors holding a greater share of U.S. assets, their continued patronage is dependent on the strength of the dollar. The real risk now to U.S. financial markets has become the dollar. Since much of the money that is financing our capital markets is “hot money,” that money could suddenly leave our markets if returns fall or risk perceptions change. For many years the U.S. capital markets were the only game in town. That has now changed. Equity markets in the U.S. are down double digits for the third year in a row. Economic growth has been sluggish, profit growth nonexistent, and the U.S. is now prone to event-driven risk as a result of September 11. In the area of fixed income, short-term rates are higher overseas, especially in Europe where short-term rates are 3.25% versus 1.25% in the U.S. Dollar Crisis Looming If these foreign investors get nervous over U.S. financial stability or fear dollar depreciation, they could exit en masse, creating a severe financial crisis, which would force the Fed to raise interest rates at a time of economic stress. Even if they don’t exit U.S. markets, they could impact the financial system by simply placing their new funds elsewhere. With trade and current account deficits now running at an annual rate of $500 billion, a decrease in foreign funding would create a crisis in and of itself. Recently the IMF (International Monetary Fund) listed America’s current-account deficit as one of the greatest risks to the world financial system. The IMF should know. They are in the financial rescue business. Just as capital inflows from financing the U.S. trade deficits contributed to the dollar's strength, their withdrawal would contribute to its decline. In this case, the most vulnerable asset would be the domestic bond market which is home to most of those dollars. Foreign investors now own and control 43% of outstanding U.S. government debt, close to 25% of all corporate debt, and 15-20% of our equity markets. Cumulative U.S. trade deficits since 1985, when the U.S. became a creditor nation, now total $3.2 trillion. 5 So what foreigners think, say and do with their money will exert a greater role over our securities markets. It may be one reason the Fed has been reluctant to lower rates in light of growing evidence of economic weakness and financial stress throughout the system as reflected in growing credit spreads. (For a greater understanding of U.S. debt problems, I highly suggest you visit Grandfather Economic Report and read its content in its entirety.) A clear understanding of the U.S. debt problem and how it is financed leads to the conclusion that a dollar crisis is imminent. There is a limit to how much debt the American financial system can continue to absorb. At some point, there will not be enough money to finance it. There is also a time coming here shortly when foreign money will no longer be willing to finance America’s voracious appetite for consumption and debt to finance it. When that moment in time arrives, the next step in the process of currency depreciation will be the monetization of assets, in particular Treasury debt and other financial assets. They will implode and go under. Foreign Decision Point It may be hard for many to conceive of such a thing happening when interest rates are this low. But to understand how this might happen, you need to think in terms of what has happened to foreign investment in the United States. Foreign equity holdings have declined three years in a row. Bond investments have appreciated this year, but whatever gains have been made have been lost through dollar depreciation. In addition to losses, fixed income returns are higher elsewhere and less subject to risk. The foreign investor view of the U.S. capital markets is no different than how the U.S. investor views investments in Latin America. If you saw rising trade and budget deficits, a declining economy, falling financial assets and event-driven risks, what would you do with your money? This is the question that many foreign investors are now asking themselves. The days of the yen-carry trade, gold leasing, and rising financial markets are over. The arbitrage plays are coming to an end. In their place are rising gold prices, widening credit spreads, falling financial markets, and a nation set upon a course of war -- conditions that are all hazardous to investing in the U. S. markets. In summary, the bond market is a bubble waiting to burst. All it will take is a falling dollar to deflate it. It is one bubble few investors see. Falling yields and rising bond prices don't register. The bond market bubble has kept afloat by asset transfers out of equities into bonds in a flight to safety. On Wall Street, few are able to think outside the box. For most fund managers, it is inconceivable that such an event could happen. Rising credit spreads, rising trade and budget deficits, and the enormous risk of expanding credit are simply ignored. To most money managers, switching to bonds has been like catching another train without giving any thought to its final destination. Another painful lesson is about to be learned. THE MORTGAGE BUBBLE If the bond market has turned into a bubble, a second bubble has developed as a result of the Fed’s intervention in the credit markets. It is the mortgage bubble and it is directly related to the bond market bubble. Without the securitization of loans made possible through an expanding bond market, the mortgage bubble would not have been possible. Many financial institutions involved in the mortgage markets such as Freddie, Fannie, and Sally have become nothing more than conduits and sources of new credit within the financial system. The primary function of these Government Sponsored Enterprises (GSE) is to provide secondary market facilities for residential mortgages. These entities buy, sell and guarantee mortgages. The Fed-induced, credit bubble accelerated as a result of recession and the terrorist attacks of September 11, eleven interest rate cuts drove down short-term interest rates to levels not seen since the Eisenhower Administration. With the Fed injecting money into the financial system, banks and savings institutions were able to expand their lending through our fractional reserve system. At the same time, a deflating asset bubble in the stock market created a demand for fixed income securities as institutional money moved out of stocks and into bonds. This created a huge market for asset-backed securities such as mortgage-backed bonds. Institutional investors were yield starved, so they became a willing supplier of capital to the mortgage markets through their purchase of mortgage-backed bonds offered by Freddie, Fannie, and Sally. This combination of the Fed injecting liquidity into the banking system through its purchase of government securities and lowering interest rates, combined with the hyperactivity of GSEs and a willing bond market, helped to create multiple bubbles both in mortgages and in housing. The housing and stock market bubbles will be discussed in Part II of Bubble Troubles.
The influx of money into the bond market by institutional investors and the change in asset allocation from stocks to bonds drove down long-term interest rates. This was especially evident with 10-year notes, which drive interest rates on mortgages. As the graph of the yield curve illustrates, rates have fallen at several key points throughout the year. Each drop is closely associated with a drop in the stock market. This market loss drove institutional money into the bond market lowering yields in the process. These lower yields, in turn, affected the rates offered on residential mortgages. Each new down cycle in the market ushered in lower yields as money fled equities and found its way into bonds. Refi Equity Well The result was a wave of mortgage refinancing. According to the Bond Market Association (BMA), new U.S. bond market offerings totaled $2.5 trillion for the first half of the year, up 16.8% over last year. Most of this growth was due to mortgage- related securities. The BMA said that the rise in volume reflected strong investor demand for bonds and a low interest rate environment. “The issuance volume shows the strength of the bond markets and is reflective of the overall economy and issuers’ needs, whether its homeowners financing or refinancing new mortgages or federal and local governments meeting their budgetary needs in a more stressed fiscal environment.” 6 The report indicates that mortgage-related securities, which include agency and pass-through securities and collateralized mortgage obligations, led the surge in issuance with $1.01 trillion of mortgage-backed securities underwritten during the first half of the year, a figure that is up by 51.6% from the previous year. Rising Home Values The rise in housing values, combined with lower interest rates, have created a new borrow and spend orgy on the part of consumers. Homeowners are extracting money out of homes to pay for vacations, new cars, new swimming pools, home entertainment systems, recreational vehicles, and good times. This is the crowning moment of the instant gratification and entertainment society, which America has embraced. Low interest rates are making it easier for borrowers to extract equity through cash-out finance loans. Economists estimate that cash-out borrowers will extract about $10,000 in equity this year through refinancing. This compares to $30,000 last year. However, for some borrowers the drop in interest rates has made it possible to refinance several times this year taking out equity at each visit to the refi equity well. Lower Mortgage Standards Millions of Americans are now dependent on this refi cycle to finance their consumption desires. This has led to skirmishes with appraisers as homeowners scramble to tap new lines on equity through refis. Each refi normally requires a new appraisal. Fortunately for many, housing prices have risen. But for those individuals or households living on the edge, they need higher appraisals to get bigger loans and better terms. This reflects the changing dependency of American finance. Rising equity markets enabled Americans to reduce their savings down to zero and increase consumption. Rising equity markets have replaced savings as part of household finances. Now, with equity markets no longer rising, housing prices and cash-out financing is all that keeps the consumption binge from slipping into recession or depression. When this bubble bursts, it is all over for the economy.
One of the unrecognized dangers of the last economic boom and the recession that followed it is the changing financial behavior of most households. Unlike past recessions where consumers paid down debt and rebuilt savings, during this recession, they went on a borrowing and spending spree, continuing the bubble behavior of the 90’s. The 90’s stock market bubble allowed consumers to forgo savings in order to increase consumption. The rise in stock prices replaced the habit of savings as this graph on the U. S, Personal Saving Rate shows. With money freed up from savings, it went into consumption, which was financed not only out of income but also out of debt. The graphs of installment debt and mortgage growth below reflect this trend.
Source: Credit
Bubble Bulletin, Doug Noland With the 90’s stock market bubble coming to an end, a new source of financing consumption became available to replace rising stock prices. The refi boom became the new bubble that allowed consumers to continue their profligate spending habits. Since it began in 2000, it has now morphed itself into a mortgage bubble as shown in the graph of GSE asset growth, which took a sharp upturn beginning in 2000. In addition to the expansion of GSE balance sheets, the trend in lower interest rates goes hand in hand with the jump in mortgage applications shown in the above graphs. The first refi cycle took place in January of 2001 when the Fed began aggressively to cut interest rates. Another cycle began after the terrorist attacks last September as the Fed moved once again to lower interest rates and flood the financial system with liquidity. The latest refi boom followed the plunge in stock prices this summer. This forced a dramatic change in asset allocation in investment portfolios as money shifted out of equities and into bonds, thereby driving down interest rates in the process.
Case
Study: John
Q.
Swinger Mr. Swinger is currently undergoing his second round of financing this year. The first round was in April. His home appraised at $320,000 -- up from $270,000 last year. Of the $50,000 new equity, he used $17,000 of additional cash to pay off credit cards. He was back at the refi equity well again in August. This time his home has appraised at $350,000, up $30,000 from last Spring. John wants to tap the equity well again to pay off nearly $19,000 in new credit card debt. Mr. Swinger is living the high life as a bachelor. Weekend jaunts to Tahoe, Vegas, and a trip to Hawaii have run up the credit card bills with fun living. John leads the life of a swinger. What his salary and commission bonuses can’t cover is supplemented by credit cards. Case
Study: Mr. & Mrs. John Q. Traveler Both husband and wife have stressful jobs and need to get away. After losing money in the stock market, they have tried their hand at real estate. They own a home with a lot of equity, but bought a rental last year that is bleeding them dry with negative cash flow as a result of low rent-to-value ratios. They can’t get favorable financing for rental property because it is a rental and there is very little equity. They overpaid for the property and the rent isn’t commensurate with their expenses of taxes, insurance and mortgage payments. They have decided to pull out the equity of their home to put down on their rental to reduce the negative cash flow. They can get a much more favorable rate on their residence versus their rental. Makes sense until you consider that it has not occurred to them that real estate prices are at bubble levels. It would make more sense to get rid of the rental, since prices are softening and it is creating a household budget problem. This financial strain has created stress in their lives. They were doing well until the stock market collapsed and they lost money in stocks. They thought it better to go with a sure thing with real estate, which can only go up. Besides, they figured they could write off most of the expenses. In addition to refinancing their home and rental, they need an extra $12,000 to pay for a European vacation to relieve the emotional stress. They don’t have the cash to pay for the vacation -- that will come from the cash out of refinancing their home. They called the loan officer from Europe to make sure that they were approved as Mrs. Traveler was worried about how the credit cards will be paid if their new loan is approved for less money. My friend tells me they will probably get the money. Very few households have been turned down in this market. Case
Study: Mr. & Mrs. John Q. Outdoors This family loves the outdoors and enjoys camping, hiking and jet skis. They are not very good at budgeting, but were fortunate enough to have bought in the aftermath of the last recession in the mid-90’s. Rising residential prices and good timing on buying their last home make up for poor budget habits. Like Mr. Swinger, they are back at the refi well for the second time this year. Last time they took out $20,000 in the Spring to pay for a second jet ski for the wife and a pop-up camper trailer. Recently they traded in the minivan for a Suburban, which they were able to finance at zero-percent. This time around they need an additional $12,000 to pay for two more jet skis for the kids. In their case, their home has appreciated since the last refi in the spring, so they are able to tap the well again. They were fortunate enough to buy their last home during the trough of the last real estate cycle. So even though they are extracting equity, they have seen more than enough appreciation of their home to pay for their avocation. It is not my intention to turn this Update into a written version of the Jerry Springer show. I have left out the rude, lewd, bizarre, and the bodacious. Believe me, my friend had many other examples I could write about, but I felt it best to leave those stories out of print. I tried to stay with what sounded normal, if there is such a thing in the land of bubbles we call the USA. He recently told me a story of one refi where the client threatened the appraiser and refused to pay his fee because the appraisal came in less than what the client needed to get more equity out of the home on favorable terms. The End of The Line What needs to be understood here from a broader perspective is that the character of household finances changed in the 90’s. The bubble-like conditions of the mid-90’s stock market enabled households to abandon traditional savings patterns, which were financially healthy. Why save money when stocks were going up 20% each year? Rising stock prices allowed individuals and households to reduce their savings to zero and redirect that savings towards consumption. This made the 1990’s the ultimate decade of self-gratification. When the stock market bubble burst in 2000, it was replaced by another Fed-induced bubble in the mortgage market, which has fed into the real estate market. This ran completely contrary to previous cycles when housing would lead the downturn and when consumers traditionally would rebuild their balance sheet, setting up a new cycle for recovery. Now with the stock market no longer providing the gains that replaced savings, consumers have turned to their personal residence as a source of capital to support their consumption. Once again, unlike past economic cycles when consumers would strive to pay down debt, including mortgages, they are now siphoning off equity through cash-out financings, home equity loans and second mortgages. It goes hand-hand-in hand with American-style financial capitalism. Essentially, the country has been consuming all of its seed corn. It began during the 80’s with mergers and leveraged buyouts and continued on into the 90’s with another round of mergers, acquisitions, and stock buyback programs. At least until the 90’s household finances were more fiscally conservative. During the last recession, consumers had paid down debt and rebuilt their savings. During this recession, consumers and households piled on debt that has made them extremely vulnerable to any economic or financial setback. At the moment American consumers are making the most of rising housing prices and falling interest rates to finance their monthly bills. The current trend in refis is coming from cash-strapped homeowners who need to borrow more money than their house is worth. Pressure is mounting on appraisers to come up with higher appraisal values now that home prices are starting to soften. We are now approaching the end of the line. When prices start to fall debt-trapped households will have nowhere else to go. The equity markets are doing the heavy lifting to replace savings and home prices will eventually turn down when a dollar crisis hits the bond markets. When this happens, interest rates will head up and the refi boom will go bust. The home equity well will run dry. When rates start to rise, variable-rate mortgages payments will go up. Limited-term fixed rate mortgages will have to be refinanced at higher rates when they mature. Home equity will start to disappear. The result will be a flood of bankruptcies that overwhelm the financial system as homeowners walk away from properties, leaving financial institutions and bondholders holding the bag. This will be a time of extreme social unrest. Homeowners just don’t see the storm clouds that are on the horizon. The rising tide of asset prices that have supported consumption this last decade is coming to an end. Like cargo ships overloaded with cargo in a violent storm, debt-laden balance sheets and no savings have left households ill prepared for the storm that lies directly in front of them. Instead of taking precautionary steps as the equity bubble burst, consumers have been led astray by the next bubble. Most investors follow whatever is hot. For the last three years, real estate has been "the place to be." But just as expanding credit helped to create the stock market bubble, it has also led to a mortgage bubble, which spilled over, into the housing market creating yet another asset bubble. The real estate bubble is the subject of next week's Part II of this Storm Watch Update. ~ JP Bubble
Troubles Part II: Yes, Virginia, There IS a Housing Bubble Endnotes 1
The Richebächer Letter, September 2002, p. 2. Recommended
Reading
NOTICE: You are welcome to print this article for your personal use. However this article may NOT be reproduced for public distribution without the expressed, written permission of the author. Email Author Selective quotations are permissible as long as the author, Jim Puplava, and this web site are acknowledged through hyperlink to: www.financialsense.com
Copyright
©
James J. Puplava
Financial Sense ® is a Registered Trademark
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
In
the Shakespearian play, Macbeth, the cast of characters are tossed about by
forces they cannot control. During the opening scene, the three
witches gather, blown by storms of nature and war, as they swirl in and swirl
out. Preparing to leave, they ask each other “
to
1.75%
This enormous
change in asset preferences by individual investors has created a new home for
over $630 billion in debt. When mutual money fund and bond fund inflows are
added to pension and other institutional needs for income producing assets, it 
Surging
Mortgage-Backed Securities
Decreased
Saving & Increased Debt
Refi
Boom Ready to Bust
We
have now arrived at a bubble state in consumption and borrowing that is heavily
dependent on rising housing prices and lower interest rates. An example of the
bubble state in mortgage refinancing can be demonstrated by the following case
studies. A friend of mine is a mortgage broker here in San Diego. Over dinner
last weekend as I discussed my “Bubble Trouble" thesis with him, he
shared the following stories which corroborate this viewpoint. He once again
confirmed my view that household behavior during this recession is different
than previous cycles. In the past when rates fell, as in the last recession in
1990-91, households used the opportunity to reduce debt, lower payments and
build savings. This recent cycle has seen a remarkable change in behavior. Of
all the mortgage refi’s this year, he tells me about 1/3 of mortgage
applications have been used to lower monthly mortgage payments. The remaining
2/3rds have been a combination of cash-outs and lower payments. A few examples
will illustrate the bubble-like behavior that is now going on inside the refi
market.
