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The Credit Bubble Bulletin - by Doug Noland
Liquidity
Just another historic week, with stunning swings in the prices for
individual stocks and leading indices. For the week, the Dow dropped
4% and the S&P500 declined 2%. The economically sensitive issues
were pounded, with the Transports and Morgan Stanley Cyclical index
dropping 4%. The defensive stocks outperformed, with the Morgan
Stanley Consumer index unchanged and the Utilities adding 4%. The
NASDAQ100 dropped 4% Tuesday, and three percent both Wednesday
and Thursday, before exploding for a 9% gain today. For the week, the
NASDAQ100 declined 1%, while the Morgan Stanley High Tech index
actually posted a slight advance. The NASDAQ Telecommunications
index dropped almost 3%, and The Street.com Internet index sank 8%.
The Biotech index added 1%, while the small cap Russell 2000 and the
S&P400 Mid-cap indices dropped 2%. The financial stocks were weak,
with the S&P Bank index declining 7% and the AMEX Broker/Dealer
index sinking 3%. Gold shares were largely unchanged.
Unsettled conditions dominated the credit market as well, as unfolding
financial dislocation and a crisis in the Middle East fostered a major
stampede into Treasury securities. For the week, 2-year Treasury yields
sunk 12 basis points, as the 5-year collapsed 16 basis points. Ten-year
yields dropped 10 basis points, while the long-bond underperformed with
yields declining 4 basis points. Mortgage-backs and agency securities
underperformed as yields declined about 7 basis points. The benchmark
10-year dollar swap spread jumped four basis points to 119. The
corporate debt market continues to falter, with liquidity all but
disappearing in the tattered junk bond universe. The dollar generally
added about 1% this week, while crude oil surged 10% and gold added
$2.
Broad money supply expanded by $11 billion last week as retail money
market funds increased $5 billion. M3 has increased at an 8.8% rate
during the past three months and 10% rate for the previous year.
Commercial paper outstanding increased $15 billion last week, with $12
billion of additional borrowings from the financial sector. We do note an
interesting stagnation in bank credit over the past few weeks. Total bank
credit has contracted by $13 billion during the past three weeks, with
security holdings declining $20 billion, Commercial and Industrial loans
flat, and Real Estate loans rising only marginally.
Fannie Mae reported third-quarter earnings this week. For the period,
Fannie increased assets by more than $29 billion, only slightly below its
record balance sheet expansion during 1998's historic fourth quarter
"reliquefication." For comparison, Fannie Mae increased assets by $13
billion during 1997's third quarter. For the just completed quarter, total
assets increased at a 19% annualized rate, up from 15% during the
second-quarter. Interestingly, (non-mortgage loan) "investments" have
surged $17 billion to $55 billion (43%) during the past six months. Fannie
Mae ended the quarter with total assets of $638 billion. During the past
11 quarters, Fannie Mae has expanded total assets by an astounding
$246 billion, or 63%. Fannie Mae Chairman Franklin Raines was quick
to appear on CNBC to trumpet Fannie's earnings and the health of the
U.S. housing market.
Well, all we can say is that housing inflation ("health") will continue as
long such egregious mortgage credit excess continues. But make no
mistake; it is a massive bubble and Fannie Mae is the leading instigator
of reckless credit excess.
Paralleling mortgage finance, consumer credit excess runs unabated.
After a huge month of issuance ($30 billion), the asset-backed market is
on track for total issuance of almost $230 billion for the full year. This
compares to $217 billion last year. Year to date, 27% of issuance has
been for home-equity loans, 19% for credit cards, 20% auto loans, and
34% for "other." The "other" category includes manufactured housing,
aircraft leases, student loans and equipment leases. Only time will tell as
to the quality of these loans, particularly in the "other" category.
Obviously, the asset-backed market is a key source of funding for the
continuing consumption binge. With its earnings release, we see a 26%
year on year increase in managed receivables from credit card
powerhouse MBNA. Capital One experienced 30% loan growth during
the third quarter, up from 23% during the second-quarter and 13%
growth during last year's third quarter. There is little mystery behind
today's stronger than expected report on retail sales it's all about
credit.
Importantly, the asset-backed market has held up exceedingly well
throughout this period of enormous issuance, as investors and speculators
alike have flocked to this "safe haven" as heightened stress engulfs the
corporate debt market. Now, however, faltering financial system
liquidity is making its way to this key market as well. During the past
week, top-rated credit card spreads have widened 6 to 12 basis points.
Not surprisingly, spreads for equipment lease paper have performed
poorly, widening as much as 7 basis points. The home-equity sector has
seen spreads widen as much as 9 basis points during the past week. We
will keep a keen eye focused on what we see as a vulnerable
asset-backed marketplace over the coming days and weeks.
We are extremely concerned and saddened by the possibility of war in
the Middle East, and very much hope that peace can somehow be
restored as quickly as possible. The potential for great hardship and
catastrophic loss of human life certainly makes the flashing prices on my
Bloomberg machine seem almost inconsequential.
What had been an unfolding financial dislocation took a dramatic turn for
the worst earlier this week. And despite today's wild rally, it is my view
that we are now in the midst of a full-fledged financial crisis. Further, for
the U.S. financial system and economy, the Middle East crisis could not
have come to a head at a more inopportune time. In numerous
commentaries, we have written extensively on the issue of financial
fragility and we do not think one can overstate the critical importance of
this concept. Unfortunately, over this protracted boom cycle the U.S.
financial system has developed acute vulnerability to the point that it
hangs in a truly fragile balance there is absolutely no room for error.
There is going to be an accident, it is only a matter of time and under what
circumstances. The amount of leveraged speculation is unprecedented.
There has been considerable marketplace speculation with respect to
losses suffered by U.S. financial institutions. Clearly, there are problems
associated with a near breakdown in the junk bond market - with the
plethora of downgrades, earnings disappointments, defaults and now a
self-feeding credit crunch. Morgan Stanley Dean Witter denied the most
heated rumor of a billion dollar hit. There are, however, serious losses
out there somewhere, and we suspect that the entire leveraged
speculating community is desperately hoping for a recovery. According
to MarketNews International, the spread between Treasuries and the
S&P Speculative grade credit index widened 17 basis points yesterday,
indicative of a virtual panic.
This week, Moody's announced that it expects corporate bond defaults
to rise to a staggering 8.4% during the next twelve months. During the
third-quarter, Moody's downgraded $44.3 billion of junk debt, compared
to upgrades of $19 billion. There were 82 junk downgrades versus 29
upgrades. Also during the quarter, Moody's placed 62 US corporate
issues under review for downgrade, compared to 37 for possible upgrade,
and 50 for downgrade during the second quarter. Dow Jones quoted
Moody's John Lonski, "we ought not to be quick to assume that the worst
is over for the high-yield bond market." There should also be no mystery
why junk bond yields are at the highest in 10 years and why they will not
be narrowing any time soon.
A Los Angeles Times headline caught our attention Wednesday: "Xerox
Goes to Banks, Not Commercial Paper." As investors, and apparently
the commercial paper market in particular, continue to shun Xerox debt,
the heavily leveraged company resorts to its credit line from a group of 58
lending banks. We would not expect, however, that prudent bankers are
all too excited to lend to such a rapidly deteriorating credit. But then
again, that is precisely why companies are willing to pay the fees during
the "good times" to ensure that the banks are there to provide liquidity
protection if things turn nasty. The bankers, on the other hand, take the
fees during the "good times" because they love such revenues that flow
directly to the bottom line. When things turn sour, as they are presently,
unsuspecting bankers quickly find themselves in deep trouble with
faltering credits in their own loan and securities portfolios. The last thing
they need is to take on additional risk lending to faltering credits losing
access to the commercial paper and capital markets. And as the banking
system is forced to become the liquidity backdrop to a growing list of
troubled companies (industries), it should not be difficult to envision an
increasingly risk-averse marketplace turning against the banks and the
credit system generally. As such, the Xerox situation provides a good
example of how during periods of rapidly rising systemic risk liquidity
becomes a very precious commodity. As fears mount, both companies and
bankers are apt to move simultaneously to increase their own liquidity.
We suspect this is already in play. Corporations would rationally like to
tap their credit lines in preparation for continued market turbulence, much
to the detriment of banking system liquidity. Banks likely desire to rein
in risk. Xerox's predicament and reliance on commercial paper and bank
lines highlights what will be a critical issue going forward the rush to
liquidity. Keep in mind that there is almost $1.6 trillion of commercial
paper outstanding.
It is our strong belief that the epicenter of the unfolding crisis is not
necessarily to be found in junk bonds, but much more likely involves a
general dislocation in the derivatives marketplace. As we have
highlighted previously, it has been our view that derivative-related
dislocations were contributing to turbulent trading in global currency,
energy, equity, and credit markets. As such, any disturbance that tended
to exacerbate these dislocations would be quite problematic.
Accordingly, the possibility of war in the Middle East is particularly
problematic as it creates safe-haven buying of the U.S. dollar and
Treasury securities as well as liquidation of equity positions and panic
buying in the energy markets. During 1998, it was panic buying of
Treasuries that blew out many derivative trades and led to the infamous
"seizing up" of the credit market. Despite today's episode of panic
buying, we do see this as truly a worst-case scenario in the making.
And while we haven't come across any recent estimates, last year it was
estimated that an equivalent of 4 billion shares of stock/stock options had
been granted - worth $220 billion or 9% of total stock value at the time
for the NASDAQ100 alone. Estimates also had the market value of stock
options issued by S&P500 companies at $543 billion. A year ago August,
New York Times' Gretchen Morgenson wrote an article titled "Rumbling
of an Avalanche" where she quoted Baruch Lev, professor of accounting
and finance at New York University, "This is an avalanche-in-waiting.
And this avalanche may fall at the worst time of all." We see this as a
most prescient quote.
A truly unprecedented mountain of employee stock and options was
created, and the timing of this avalanche is terrible. For quite some time,
I have been bothered by a nagging unanswered question in my mind:
With the proliferation of sophisticated Wall Street derivative programs
providing corporate insiders the ability to "cash out" of stock and option
positions, where was the source for all the liquidity? What was the
source for all the money that flowed to the insiders for the purchase of
expensive cars and homes and such? I have a hunch that the answer to
this question could lead us directly to a key focal point of the unfolding
financial crisis.
Last August we wrote a commentary titled "90% Stock Loan - The
Magic of Credit & Financial Engineering." The piece highlighted an
advertisement that had caught my attention in Investor's Business Daily:
"First Security Capital's 90% Stock Loan the proprietary financial
instrument that provides liquidity without triggering a taxable event,
protection from a market downturn, and unlimited upside potential."
I want to clearly underscore this product as this type of structure has
significant ramifications presently for our financial system. Continuing
from their website: "With capital gains in your portfolio or vested options,
you would be subject to capital gains taxes should you decide to sell
taxes that would be especially significant if you have shares with a low
relative cost basis, or have employee stock options with a low relative
exercise price. Loans, however, are not taxable events. So in many
cases you could actually net more cash by borrowing 90% of the current
value of your stocks with our 90% Stock Loan than if you were to sell.
And because you still own your stocks, you retain the ability to realize
future growth in the value of your portfolio. The loan is also
non-recourse, so you have no personal liability for your loan, and your
maximum downside is capped at 10% for your entire loan term.
Ultimately the 90% Stock Loan can help you net more cash, get
long-term downside protection, and keep your stocks. "
"Diversify into real estate or other ventures by leveraging your stock
portfolio without the risk of a margin call if your stock declines in value.
You can access standard margin loans when it comes to leveraging your
stock portfolio, but these leave you exposed to downside risk if your
holdings drop in value. Our 90% Stock Loan is non-callable and it has no
margin maintenance requirements, so it enables you to leverage 90% of
the value of your stock portfolio without the risk of a cash squeeze from a
margin call. And unlike margin loans, with the 90% Stock Loan you are
not required to make any interest payments until the end of your loan
term. Than means you get 90% of the current value of your stock
portfolio in cash and you have long-term downside protection without
negative cash flow. So you can leverage your stock portfolio and
diversify into real estate and other ventures without worrying about
making monthly payments or meeting margin calls."
"With the 90% Stock Loan you receive 90% of the current value of your
portfolio in cash, and still keep your stocks. Even if your stocks go down
significantly in value over the course of your loan term, you have no
obligation to repay either the original loan or the accrued interest at
maturity yet you continue to realize future growth in the value of your
portfolio if it keeps going up."
And while this sounds "too good to be true," this company was set up to
do basically what Wall Street derivative groups have been doing for some
time: providing liquidity to corporate insiders and other wealthy clients. It
has been, not surprisingly, a popular product. And with the Internet and
technology mania, particularly since the 1998 "reliquefication," derivative
structures that would allow scores of new Internet and technology million
and billionaires to "cash out" or lock in gains became the hottest, most
sought after product anywhere. In an interesting aside, I am told that
Internet Billionaire (and owner of the Dallas Mavricks) Mark Cuban,
responding to a question on talk radio as to what he would do if his huge
holdings of Yahoo stock tanked, stated something to the effect that "its
no problem, Goldman Sachs has taken care of that." And while Wall
Street firms had in the past dominated this market, the banks increasingly
had a hankering to get into the action. This was particularly the case for
the money center banks moving aggressively into the securities and
leveraged lending business. What better way to get a deal than to
provide "wealth-enhancing" products to insiders? Anyway, at June 30th,
Chase Manhattan had $38 billion of notional equity derivative positions,
JPMorgan $183 billion, Bank of America $122 billion and Citibank $44
billion.
But, you may ask, how can a company provide a non-recourse loan, or
protect against loss, while still providing the insider the upside to higher
stock prices? The answer lies in "financial engineering." Through
hedging "dynamic hedging" the issuers of these derivative products
are theoretically able to protect themselves against a decline in stock
prices with sophisticated computerized trading programs often by
shorting the underlying stock into declines. Of course, this is the same
type of strategy that failed miserably with the "portfolio insurance"
debacle in 1987 and with LTCM in 1998. However, these products are so
popular that the myth that they actually work as prescribed is
perpetuated. Basically, there are two key erroneous assumptions built
into these dynamic hedging strategies: liquidity and continuous markets.
Bear markets provide neither.
When stocks collapse quickly, there is a big problem as it becomes
impossible to implement the necessary hedges. Apple is certainly a good
example, as its stock gapped down almost 50% after its earnings
disappointment. In such a situation, dynamic hedging not only doesn't
work, it can lead to quick disaster. Think of an example where a company
provides 90% non-recourse loans to Apple executives while holding stock
and options as collateral. One day everything is fine. The next day, the
news breaks, the stock collapses, and there is absolutely no chance to get
"hedged." It is not difficult to see how a lender caught in this
predicament could quickly face insolvency. Indeed, with the collapse of
stocks throughout the Internet and technology sector, it is a certainty that
the operators of these strategies have suffered huge losses. While such a
strategy can work well on a limited basis, it becomes an impossibility
when a large numbers of employees and insiders from a pool controlling
over $1 trillion of stock market value want into the game. Quite simply,
there was absolutely no way adequate liquidity would be available to
hedge this amount of perceived wealth when the bubble burst.
And, back to my question, where did all the liquidity come from in the
first place to make these loans and provide the opportunity to "cash
out"? Well, perhaps it was bank loans or perhaps Wall Street has been
using sophisticated vehicles such as asset-backed commercial paper or
other securitizations. Why is this important? Because there are almost
certainly massive losses involved in the equity derivatives marketplace
that have greatly impaired the value of financial assets, either on the
books of the banks, the Wall Street firms, the securities marketplace or
"all of the above." This is most definitely a systemic issue today, and
may be the "big problem" "behind the scenes."
This situation becomes even more critical as it is my belief that
derivative players are also impaired by losses in the credit and currency
markets, and likely the energy markets. Many derivatives players
"write" volatility (sell both put and call options) in various markets and,
like 1998, destabilized market conditions have impacted markets across
the board. As I wrote last week, I think it is increasingly important to
think of this as an unfolding crisis in derivative markets generally. And
with the derivative players the leveraged speculating community -
increasingly impaired, we see faltering liquidity conditions likely
impacting markets generally. And with virtual technology/Internet
meltdown in progress, especially for firms that have aggressively played
in equity derivatives themselves such as Intel, Dell, and Microsoft, the
equity derivative players were in desperate need of a major rally. They
got it today, but the issue has in no way been resolved.
Enthusiastic kudos to Christine Richard, a very talented journalist from
Dow Jones, for her excellent article this week, "Lucent Sells Vendor
Loans To Money Market As Risks Rise." We will include excerpts:
"Through the creation of an asset-backed commercial paper
program, Lucent will transfer $1.1 billion in loans and trade
receivables financing for the sale of telecommunications, data
networking and other equipment products off its balance sheet and
into the money market.
The Lucent receivables will be credit enhanced by an insurance
policy issued by National Union Fire Insurance Co. which is a
subsidiary of American International Group. This credit
enhancement will protect holders of the commercial paper -
including the millions of small investors who keep a portion of their
savings in money market funds - against losses.
Additionally, Citibank N.A. will lead a group of banks in
providing liquidity support for the paper. Should money market
funds and other investors refuse to buy the paper, then, the banks
will step in and purchase it.
Asset-backed commercial paper conduits need continual access
to funds as they must roll-over short-term paper to fund the
purchase of longer-term obligations such as trade receivables.
Many companies sell their trade receivables into the
asset-backed commercial paper market. Typically, however, those
companies sell their receivables to a bank which combines them
with the receivables of hundreds of other companies to set up a
multi-seller conduit.
In this case, however, it is Lucent, rather than a bank, that is the
sole sponsor of Insured Asset Funding. And only loans and trade
receivables extended by Lucent and its affiliates are included as
assets of the conduit.
The lack of diversification might appear to increase the risk on
the notes. But James McDonald, a vice president in the
asset-backed commercial paper group at Moody's Investors
Service which assigned the conduit it top rating of Prime-1, doesn't
see it that way.
"The rating is primarily based upon the insurance policy because
it is a fully supported program," said McDonald. "The fact that
the assets are all Lucent originated assets is not a factor in the
rating."
According to McDonald, AIG's National Union Fire Insurance
Co. bears the risk that Lucent's customers won't pay their bills
and the insurer has agreed to step in to make up any shortfall in
the payments. Therefore, the credit risk on the notes is really the
insurance company's top-rated risk, explained McDonald.
Furthermore, should the market for some reason reject the
Lucent notes even though payments are being made, Citibank,
along with a syndicate of banks, would step in to buy the paper to
assure that the conduit remains funded. The banks are required to
fund the notes unless National Union and Lucent were bankrupt,
McDonald said.
The asset-backed commercial paper market has grown rapidly in
recent years and now makes up around one third of the $1.5
trillion commercial paper market.
The market is used mainly by banks and finance companies
looking to take debt off their balance sheets. Whether the
offloading of vendor financing risk into the super conservative
money market raises questions of systematic risk to the insurance
and banking system or even to money market investors is a
subject of some disagreement.
Bruce Bent, Chief Executive Officer of the Reserve Funds in
New York and the creator of the first money market in early 70s
says securitized debt has no place in the money market.
"Sure the risk gets spread far and wide with asset-backed
commercial paper but the risk is totally inappropriate to start with
in a money market fund," said Bent.
Bent says most people invest in the money market under the
assumption that it is a reasonable alternative to a bank deposit but
with a slightly better return, and they rarely question what is in the
fund.
For that reason, investors simply aren't compensated for the level
of risk they take, he says. "People don't have the slightest idea
what's in their money market fund," said Bent."
Another news release from Moodys caught our eye this week. "The
number of downgrades in the U.S. asset-backed securities market
significantly exceeded the number of upgrades by 122 to 23 during the
first six month of 2000." We continue to see cracks in the foundation of
Wall Street "structured finance," with the highest probability of a serious
break in US and global financial markets since 1998. An acute liquidity
crisis has developed in at least the equity derivatives and junk bond
markets, with quite negative implications for liquidity throughout the US
financial system generally. Again, the focus is on the impairment of the
leveraged speculating community and the inevitability of forced
liquidations. It's all about liquidity, or the lack thereof
David W. Tice & Associates
17 October 2000
DAVID W. TICE manages the Prudent Bear mutual fund.
His Dallas-based research firm advises more than 150
institutional investors. http://www.prudentbear.com
