Our Economy has been in a "Credit Bubble"
Part - I
It is now critically important to reassess the long-running US financial and economic boom, recognizing that what appeared to most as a sound and prosperous economy and what many called a "new era" was actually a product of unprecedented credit excesses. In particular, financial credit allowed the massive leveraging of securities on the balance sheets of hedge funds, Wall Street securities firms and other financial institutions. It was this massive leveraging of debt securities that provided the illusion of unlimited easy access to the capital markets. Only time will tell how much of this leverage was financed by cheap bank borrowing from Japan; we suspect it could be in the hundreds of billions. Indeed, it was this profligate credit creation mechanism that was largely responsible for the explosive growth of today's $3.7 trillion mortgage and asset-backed securities market and the $430 billion junk bond market. In fact, it is difficult to imagine a more egregious credit bubble than what has transpired throughout the U.S. credit system. Wall Street issued a record $1 trillion of new securities, including $100 billion of junk bonds, during the first six months of the year, an increase of more than 50% over the prior year. This financial excess has also been responsible for the boom in subprime consumer lending which has created hundreds of billions of high-risk auto, credit card and mortgage debt that has been a great but unappreciated stimulant for the US economy. Just as the Japanese and SE Asian "Tiger" economies were perceived as economic miracles until the inevitable bursting of their respective credit bubbles, we see an alarming lack of understanding as to the true underpinnings of today's financial bubble and terribly maladjusted US economy.
Long periods of economic prosperity with accommodative financing, as history has proven time and again, lead to excesses, usually as confident consumers over-consume and as over-zealous companies borrow and invest in excess, eventually building too much capacity, and often borrowing too aggressively to finance projects later proving spendthrift and uneconomic. This was certainly the case throughout Asia as extremely "easy money" led to massive overinvestments in manufacturing and basic industries. But such excesses were certainly not limited to just Asia. As GE Chairman, Jack Welch has said, there is "excess global capacity in virtually every industry."
But the problem with booms is that they eventually turn to "busts", leaving overcapacity that becomes ever-more problematic as overindebted consumers and businesses eventually must retrench. This can easily lead to a "vicious cycle" as deflationary conditions lead to excess supply, lower prices, unmanageable debt, default and a severe economic downturn. That is exactly what we are seeing throughout the Asian region, and this is now spreading elsewhere. Importantly, the current Asian depression is more of a global problem, as this region, after years of heavy investment, acts much as the global price setter as the major manufacturer of most goods, as well as being the marginal buyer for many basic commodities. As domestic demand has collapsed following financial meltdown, and with greatly depreciated currencies, these economies now have almost unlimited capacity and considerable pricing flexibility to destroy pricing and, hence, profitability for producers of goods, worldwide. We see this in many companies and industries we follow and the long-term implications of this major development is much unappreciated by Wall Street.
Particularly, producers from troubled economies with excess capacity are now clearly focused on the US consumer. As was said in Business Week, "after the latest round of devaluations, every region except for the U.S. will be a net exporter making the global economy dangerously dependent on the U.S. as the consumer of last resort." The recently reported record $61 billion trade deficit for the third quarter, rose more than 60% from last year's level. This largess has been made possible because foreigners have been willing to let us trade paper for products. This has been a phenomenal deal for the US, as there has been an insatiable demand for American debt. However, during the third quarter, foreigners became net sellers of US treasuries and stocks, after being large purchasers earlier in the year. All fundamental factors point towards a vulnerable dollar.
Credit Bubble Has Helped Create the Overleveraged American Consumer
The unappreciated dilemma is that the typical American has already over-consumed beyond any reasonable standard. Not only has demand been boosted by strong wealth effects, the boom has been much the result of stretching credit use to an extreme. That means household debt is now at an all-time record high, having increased from 68% of personal disposable income to 95% over the last fifteen years. And with confidence that prosperity is here to stay, the US savings rate stands at a record low level. It is little wonder our domestic economy has been so strong; "It's been a great party", fueled by an enormous credit binge.
Just look around. Traditionally the bulk of mortgage loans required a 20% down-payment. Now, a whole industry has mushroomed that makes its living lending almost exclusively to home buyers offering little, if any, down-payment and poor credit is not an issue. In fact, today 40% of borrowers require some type of mortgage insurance to qualify for a loan. But poor credit and lack of a down payment are not a problem for today's creative financial infrastructure that through the alchemy of modern finance, pools these mortgages together and sells them to buyers hungry for yield. Or that is how it has worked until quite recently. Now, with de-leveraging and risk aversion, the market has disappeared for risky mortgage securities.
And financial historians will certainly look back with disbelief at financial institutions lending homeowners up to 125% of their home's value, providing extra cash to "take a vacation, buy a hot stock." Even worse, an inflationary real estate boom has provided double-digit housing appreciation for many areas over the past few years. Essentially, borrowers have been able to cash out at 125% of an already overinflated value, using these funds to boost consumption or play the market. Certainly the rapid and substantial price declines from the real estate busts in Texas, Louisiana, Oklahoma, and Colorado in the early 1980's and the coasts during the late 80's/early 90's have not completely faded from memory. It is our belief that this real estate boom has been much more national and with particular pronounced excesses in the upper-end category that has been most impacted by stock market wealth effects. What will happen when a debtor, anticipating ongoing stock option appreciation and purchasing an expensive house with little money down, not only loses the value of his options but also his job. Well, if he has little or no equity, he will most certainly walk. Multiply that situation by the millions of people who have little home equity, choosing instead to funnel savings into the stock market or consume their perceived "equity", and it is not difficult envisage a disastrous bust scenario after years of weak credit standards and general credit excesses throughout the real estate industry.
During this most extraordinary credit bubble, banks aggressively advertise loans for vacations or even for more extravagant holiday gifts. Financial companies proliferated which lent for plastic surgery, hair transplants, taxi medallions, restaurant franchises or, really, about anything. It didn't seem to matter as this new ilk of lenders were able to bundle and securitize these loans much to the delight of an insatiable market appetite for risky securities. But as the collapsing stocks of these types of financial companies clearly attests, this game is ending; a victim of the piercing of the credit bubble. And while the aggressive, one could say negligent, credit card companies continue their ever more egregious lending -having saturated college campuses, they now target high school students - we think this game will be ending soon as we expect investors will look with increasing skepticism at these types of high-risk asset-backed securities. As has been the experience with many mortgage lenders, it does not take long between investors turning against a company's securitizations, followed by the company's withdrawal from extending new loans, to possibly a bankruptcy filing.
While the securitization market has come to a near halt, bank lending remains brisk. Lending aggressively, banks have abandoned their strict attention to debt-to-asset and debt-to-income ratios. Now, nearly all lenders use credit scoring systems that simply track past loan payments, (regardless of where the repayment funds came from), as the key indicator for giving someone a loan. That is why there is so much anecdotal evidence of people filing bankruptcy, who owe 3-5 years income, excluding their mortgage. That could never have happened even five years ago. Government regulators, however, now belatedly acknowledging pending credit problems, press banks to tighten lending standards.
But for much too long, banks and other lenders have aggressively sought out poor credit risks, euphemistically known as "subprime". Indeed, the 90's has been much the decade of the subprime lending boom as a leading source for aggressive companies seeking to grow interest income. Nothing comes as easy as revenues from lending to borrowers who were previously denied access to money. Especially in the age of gain-on-sale accounting and earnings momentum investing; the strategy has been to recognize the entire "profit" of a loan currently, and worry about the inevitable credit losses much further down the road. Ten years ago, the only options for these high-risk borrowers were pawn shops and loan sharks. But during the 1990's, aggressive companies came public in droves that would anxiously lend to anyone even with the worst of credit histories, cleverly packaging bunches of these loans with some credit insurance product and securitizing them. This has been wild credit excess in its purest form but this party is coming to an end.
Furthermore, try and find a retailer that isn't offering 0% interest and no payments for twelve months for anything. Circuit City, Best Buy, Comp USA, department stores, even some traditional Visa and Mastercard issuers; they're all doing this. Even normal fixed payment consumer loans come with payment coupons that offer the borrower the chance to skip a payment every few months, "just for being such a great customer." Some credit card companies, such as Banc One's First USA unit, have gone as far as to cancel customer accounts that were always paid in full and on time.
The Credit Bubble Has Enhanced the "Boom" & Created a Mania
Importantly, credit excesses have proliferated throughout our financial system and economy from Mercury Finance to Long Term Capital Management. This "credit bubble" fueled both a booming economy and a stock market that surged from about 2,400 in October of 1990 to almost 9,400 this past July. But periods of gross excess always create their own destruction. The current environment is amazingly similar to that of the "Roaring 1920's," when the economy was vibrant, interest rates and inflation were low, and the stock market boomed. But the unappreciated danger was the massive credit excesses easily ignored during the boom, but only appearing so obvious in hindsight.
Low Reported Inflation Caused Complacency & Exacerbated the "Bubble"
How many pundits have you heard argue that "low inflation justifies current stock prices?" The problem is that this low inflation is the result of a tug-of-war between mild deflation in commodities and product prices and inflation in many other areas from this excessive credit and monetary stimulus. This excessive credit has created more overspending by the consumer and business over-investment, which will eventually exacerbate the coming deflation. This same camouflage fooled all the economists in the 1920's who thought the low inflation was a guarantee of future prosperity. Importantly, as similar to the recent period, it is exactly the low consumer price inflation that kept the Fed too accommodative to financial asset inflation and other credit excesses. This fueled the boom further and made the resulting bust an absolute certainty. Today's predicament, most critical for understanding where we go from here, is that the decline that follows a credit-induced bubble is much dependent on the extent of the bubble that precedes it, rather than the action taken later. One point about which we are very confident, the bubble that is now ending is simply unprecedented in scope.
For quite some time, economists, Wall Street analysts, investors and the Federal Reserve have been fixated on the rate of consumer inflation. Presumably, no amount of consumer borrowing was too extreme, no type or amount of business investment too much, no trade deficit could be too large, or stock market too high as long as the CPI was low. Well, this has been very much a case of fighting the last war, at best.
A Ruptured Credit Bubble Can Cause Economic Collapse
Unfortunately the inflationary excesses to worry about have been in credit creation much directed at the financial markets with obvious effect. Too much debt was created and, due to the massive leveraging of securities, the artificial demand for securities for speculative purposes resulted in the mispricing of risk globally. In SE Asia, "hot money" led to financial and economic excesses that became apparent only with the bursting of the bubble and capital flight. When the extent of the credit excesses and economic vulnerability were recognized, capital flight quickly left financial markets illiquid, leading to collapsing currencies and financial systems. Economic collapse followed quickly.
In the U.S. today, we see alarming similarities. What was erroneously perceived as the marvel of healthy economies and sound financial systems, is now recognized as a system exposed to massive financial leverage and speculation. Not surprisingly, with this recognition follows a weak dollar and financial instability. In particular, illiquidity throughout the US credit markets surfaced in August-September as vulnerable leveraged financial institutions were unable to sell securities to reduce exposure. Increasingly, it appears that several major institutions may be vulnerable to funding problems if a systemic funding crisis develops again as we expect. If significant foreign borrowings have financed leveraged speculation in our markets as we suspect, there will surely be heightened systemic risks to a weaker dollar. Unfortunately, the worst-case scenario of deleveraging, a falling dollar, foreign capital flight and an acute financial crisis is, today, not a remote possibility. Yet, even without this crisis, we see the US economy unusually vulnerable to credit market turmoil. The credit bubble has been pierced and an economic downturn is now inevitable.
(Part - II next week)
David W. Tice
24 December 1998
DAVID W. TICE manages the Prudent Bear mutual fund.
His Dallas-based research firm advises more than 150 institutional investors.
Prudent Bear Fund: http://www.prudentbear.com