Part - II

The Global Credit Bubble Has Been Pierced, and "Patched", but Not for Long

We have shown how the credit bubble fueled the economy and the last leg of this bull market. We are now highly confident that the bull market in stocks is over, because the credit bubble has been pierced. The turmoil in Russia was especially important to the global credit cycle because it was there that the credit bubble first popped. Leveraged speculators who participated in Russian markets were also involved in leveraged speculation in most other markets around the globe. Therefore, when the credit crisis struck in August, it caused massive losses to hedge funds and banks, and yield spreads skyrocketed.

With this financial crisis came the revelation of the unimaginable leverage incorporated in the strategies of Long Term Capital Management (LTCM) and other hedge funds. At that point, it became apparent to knowledgeable observers that there was no longer any doubt that the US financial system was not immune from the same credit excesses that had led to the booms and inevitable painful busts in Japan and throughout Asia. In fact, the unwinding of leveraged speculations took our financial system quickly to the brink. The collapse of LTCM and other funds created acute distress and illiquidity in the fixed income markets in August/September. Clearly, this near debacle and resulting credit crunch was proof that the US had firmly joined the global credit collapse that began in Thailand fifteen months ago. Keep in mind, it had been only five months before that the dollar traded above 145 yen with the perception of a strong US economy and healthy financial system certain to attract capital from risk averse investors throughout the world. But perception proved much different than reality. Almost overnight, US credit markets turned chaotic and illiquid, the US dollar sunk almost 20% (including a nearly 15% one-week collapse -the worst dollar sell-off since the abandonment of the gold standard back in 1971), and the stock market tumbled with stocks dependent on vibrant capital markets in virtual freefall. Clearly, all indications were that the credit bubble had been pierced with profound ramifications for US financial markets and economy.

The credit crisis intensified and leveraged positions were being unwound everywhere. The desire and ability to maintain risky positions evaporated almost overnight in a breathtaking development. Undoubtedly stunned, the FED quickly stepped in and cut interest rates three times. Over the last two months, America's policy-makers have "pulled out all the stops" to reinflate the credit bubble, but in our opinion, these efforts will eventually be unsuccessful, only extending the period of excesses and the inevitable bust. Unfortunately, you cannot cure a credit bubble with more credit. Mr. Doug Noland, who recently joined my firm, did an outstanding job of detailing this rescue effort in his article "Greenspan's Quiet Bailout – Again". Doug's article explained how the banks, Fannie Mae and Freddie Mac have participated in an unprecedented buying spree of securities for the last couple of months. . October was a historic month for the US credit system as the money supply expanded at the strongest rate since the economy emerged from a deep recession in June of 1982. In obvious contrast, the current economy has merely treaded water, as record credit growth today largely feeds financial and asset markets, essentially increasing the size of the bubble.

What Exactly Happened to Restore Liquidity

For the recent three-month period, August through October, astonishing record M3 money growth reached $200 billion (fully 60% greater than the same three month period in 1997!), almost 70% of which can be traced directly to an explosion of money market fund assets. To clarify, during this period, currency in circulation grew by $14 billion, total checkable deposits actually declined by $400 million, savings deposits increased $53 billion, large time deposits grew $6 billion and money fund assets ballooned $137 billion. Remarkably, and what should be setting off deafening alarm bells throughout the Federal Reserve System, this three-month money fund growth compares to $50 billion during the similar period in 1997, or fully 270% the level of the previous year. Clearly, if anyone is searching for an explanation for the parabolic move in the money aggregates, it lies patently with the money markets.

Importantly, Freddie Mac and Fannie Mae played a powerful role in reliquifying the credit markets and helped create this explosion in money market assets. What happened was that despite dramatically wider credit spreads and considerable tumult throughout the mortgage-backed securities marketplace, Fannie and Freddie sharply lowered consumer mortgage rates to as low as 6.49% in early October, the lowest rate in decades. This quickly incited record mortgage refinancings, providing Freddie and Fannie a huge pool of new mortgages for which to balloon their balance sheets.

During October Fannie and Freddie purchased, for their own balance sheets, a shocking $26 billion of mortgages, by far an all-time record and fully 400% the level of October 1997 purchases. Indeed, Fannie and Freddie expanded assets at an astonishing 50% annualized rate in October and, not surprisingly, money fund assets also experienced a momentous month, expanding at a 60% annualized rate.

Borrowing aggressively from the money markets to absorb the flood of mortgage refinancings, this operation was a godsend as much needed cash was directed to previous holders of mortgage-backed securities who could use this liquidity to reduce leverage or purchase other credit market instruments. Moreover, Fannie and Freddie also forcefully expanded purchases of loans and securities financing commercial real estate, multifamily, home-equity, subprime and manufactured housing, much explaining the celebrated contraction in credit spreads throughout. It must be said, Greenspan has found vigorous partners in Fannie and Freddie to reliquify the system for a while.

And the banks helped as well. For the month of October, total bank credit expanded at a stunning annual rate of 22%. Importantly, almost half of this growth was in security purchases as banks became aggressive buyers. Holdings of non-US government securities surged $37 billion, or at an annual rate surpassing 100%. Taking up the slack from faltering security markets, banks were also aggressive lenders as commercial and industrial loans grew at an annual rate of 27% and loans for securities exploded at 125%. Interestingly, as bank credit exploded by almost $100 billion during October, bank deposits increased but $23 billion leaving the funding source for the majority of security purchases and loan growth to "borrowings" from banks and others.

Why A Liquidity Crisis Will Return

Doug and I believe that the massive liquidity injection in October/November will ultimately fail because there will eventually be more sellers of risky securities than buyers. The banks and Fannie and Freddie cannot buy all the securities for sale by hedge funds and proprietary trading departments of banks needing to deleverage, as well as from leveraged companies and developing nations needing financing, and consumer lenders requiring securitizations. This massive security acquisition boom represented only a short-term "fix" to provide an appearance of stability. We believe that leveraged institutions deferred their security sales to allow this charade of stability to return to the market. We also believe that there still exists a massive overhang of securities, and hedge funds must still liquidate these positions to meet redemptions and reduce risk. The recent "fix" only exacerbates the credit and economic excesses and heightens systemic risk down the road. Therefore, we expect a similar credit crisis to return in the near future. Credit spreads have already begun creeping up in the last two weeks.

While Greenspan's rate cuts and liquidity surge have powered a stock market rally and huge speculative run in the internet and technology stocks, this action has had little if any impact on the real global economy. Recent data provide clear evidence that Japan and Asian economies are still in depression, Latin America is quickly sinking into recession and acute financial stress, European (and particularly emerging East European economies) economies are slowing rapidly, and the American manufacturing and agricultural sectors are faltering. These short-term moves have also had no impact on the global collapse in commodity prices. This is clear evidence that global deflationary forces are gathering steam. Clearly, lower oil and basic commodity prices will exacerbate the global debt collapse as many already weakened and impaired economies are acutely exposed. Additionally, the dollar remains today at 117 yen after trading at 148 in August. And this, despite a worsening situation for the Japanese economy and financial system. This is clear and ominous evidence of an impaired and acutely vulnerable US financial system. We expect that the dollar could trade much lower, especially if the current reckless credit excesses continues.

This global de-leveraging is important because nothing has a greater impact on an economic sector than a change from an accommodative credit environment to a restrictive environment. As reported before, exceptionally easy credit has artificially prolonged the American business cycle. Tightening credit will eventually spell tremendous trouble for the entire US economy, as it has been the jet fuel that has kept it humming. Excess capital has been funneled into marginal investments in plant and equipment, real estate, and common stocks.

When asset-backed securitizations dry up again, credit for the consumer will also be restricted. Subprime home equity lenders were virtually shut out of the securitization market earlier this year, causing Southern Pacific Funding to claim bankruptcy protection. Other subprime lenders, such as United Companies Financial, Conti Financial and FirstPlus Financial have seen their stocks drop 80%-90% in the last five months due to these troubles. There were extremely serious problems in the mortgage arena for a couple of months until just described buying effort from the banks and Fannie Mae and Freddie Mac in October/November restored some order to the residential mortgage market. Nonetheless, mortgage spreads remain wide, an ominous development for this huge and critically market, which may be indicative of an overhang of mortgage securities, likely by leveraged players. The commercial real estate mortgage market has shown some improvement but remains in general disarray with funding problems for many real estate transactions.

America's ruptured credit bubble has economic implications the stock market cannot ignore. Among these negatives will be corporate America's inability to work off excess capacity. Quality companies are finding out that their industries have expanded too much to meet sinking demand. Marginal companies will find credit unavailable. There has simply been too much credit created, everywhere – for consumers, businesses and financial markets. All the makings are in place for a debt collapse.

We are in just the very early stages of the financial crisis in the U.S. As in Asia, first the financial crisis occurs, then the economic crisis leading to layoffs, bankruptcies, collapsing consumer demand, plunging corporate profits, termination of capital spending, debt defaults and then the "vicious circle" of ever lower stock prices. Another threat is for America's currency to decline. We strongly believe that the dollar will be hurt badly by the unwinding of the global debt bubble.

The Effects of a Ruptured Bubble are Becoming Apparent

The deflationary affects of the downturn abroad can be seen in our manufacturing sector that is now facing severe contraction. The performance of specific companies reflects this slowdown. And some of the companies experiencing slowdowns are consumer brand companies that some thought would be immune to a slower economy. Nike recently reported its third straight quarter of lower sales and its fourth quarter of lower profits. Companies like Caterpillar, Poloroid, International Paper, Rubbermaid, 3M, Procter & Gamble, and DuPont have all missed recent earnings estimates. Because of weakness abroad and at home, giant companies including Revlon, Coca Cola, Boeing, 3M, Sears, Union Carbide, JP Morgan and Merck have reported that earnings estimates are too high going forward. Yet Wall Street analysts appear to be "asleep at the switch" as the consensus estimate for 1999 earnings is for 16% growth according to First Call. This is purely wishful thinking.

Business confidence has peaked, and significant layoffs have begun for scores of companies. The Washington Post just reported that layoffs are up 54% for the first nine months of 1998 over last year. Gillette, Raytheon, Applied Materials, LSI Logic, and Motorola are laying off a whopping 11%, 16%, 15%, 17% and 10% of their workforce, respectively. This is not a concern as of now, because these layoffs are simply creating more potential day-traders to make money buying internet stocks. But someday soon, this WILL AGAIN MATTER. When the stock market bubble ends, the Internet day-traders will need real jobs again, and they won't be there.

(Part - III next week)

David W. Tice
4 January 1999

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