27 April 2008

The Meaning of Stage II

The U.S. Credit Bubble was punctured this past summer, as the Mortgage Crisis escalated from the confines of subprime to the expansive marketplace for Wall Street “private-label” ABS and MBS. Especially with the bursting of the Florida and then California housing Bubbles, literally Trillions of mortgages, sophisticated debt structures, Credit insurance, various financial guarantees, leveraged speculative positions, and bloated Wall Street balance sheets were in almost immediate peril. Contagious deleveraging overwhelmed the system. In a brief period of only several months the U.S. Credit system went from unmatched expansion and speculative excess to the brink of implosion.

Last week, I made the case for thinking in terms of the end of the first Stage of the Financial Crisis. The epicenter of this initial upheaval was in highly leveraged positions in mortgage Credit exposure - encompassing mortgage-related securities positions (i.e. ABS and MBS); sophisticated Credit structures (i.e. CDOs, “SIVs,” REITs, etc.); various derivatives exposures (i.e. subprime ABX indices, Credit default swaps, synthetic CDOs, etc.); and a broad assortment of financial guarantees and liquidity agreements (monolines, mortgage insurance, asset-backed CP, cash-equivalent funds, etc.). I have referred to this as the breakdown in Wall Street-Backed finance.

This collapse had reached the cusp of bringing down the entire Credit system. In stark contrast to traditional Credit crises, this one engulfed the entire system before the general economy so much as succumbed to a negative quarter of GDP contraction. To stem implosion required nothing less than a Fed-orchestrated bailout of a major Wall Street firm; the opening of the discount window to the securities firms; the implementation of massive liquidity facilities at home and abroad; the promotion of mortgage securities as collateral for borrowings from the Fed; assurances of enormous market intervention (mortgage purchases and guarantees) by the troubled GSEs; the imposition of significantly negative real short-term rates; and open-ended federal government stimulus and financial guarantees.

An argument could be made that, while dramatic, these measures were not world changing. I would counter that such measures gave assurances to the marketplace that the Federal Reserve (along with global central bankers) and our government policymakers were willing take any and all measures necessary to stabilize the Credit system and sustain the U.S. Bubble economy. There were no longer any bounds on government intervention.

I have referred to these policy measures as the supplanting – or underpinning - of “Wall Street-Backed finance” with “federal government-backed finance.” Or, perhaps somewhat less analytically ambiguous, to avoid implosion Washington had no alternative but to explicitly and implicitly nationalize both system Credit and liquidity risk. It was desperate policymaking in the extreme; it was bold and it was historic. It reworked the rules of our Credit apparatus, and the markets have for more than a month now grappled with the ramifications of these changes. To be sure, each week of relative Credit system stability has provided various troubled players the opportunity to raise new capital, others to pare problem positions, and many to adjust various risk exposures. Importantly, the unwinding of “bearish” speculations and hedges is now playing an instrumental role in the resurgence in marketplace liquidity.

According to Bloomberg data, this week saw an all-time record $43.3bn of U.S. corporate debt issuance (compared to a y-t-d weekly average of $18bn). Issuers included Citigroup, Merrill Lynch, Bank of America, Wachovia and Goldman Sachs – and much of their issuance was in the form of new hybrid “equity capital.” Investment grade bond spreads narrowed this week to the lowest level since mid-January; junk bond spreads to early-March levels; and leverage loan prices recovered this week all the way back to December levels.

Many – including seasoned strategists – are today arguing that the worst of the financial crisis is now behind us. I disagree, of course. Yet from an analytical perspective it is imperative to appreciate that (the bust of Wall Street-Backed finance notwithstanding) we still very much operate in a unique period of Market-Based Credit. The ebb and flow of market perceptions (of greed and fear) continue to have an outsized impact on Credit Availability and Marketplace Liquidity – hence economic performance. Not many weeks ago the system was seizing up in the face of collapsing confidence and fears of systemic failure. Today, with confidence and greed regaining some of their “flow”, Credit conditions are loosening meaningfully – which does wonders for reigniting marketplace enthusiasm (not to mention short covering). So, Stage II – the dynamics, excesses, distortions and imbalances leading to the inevitable Second Phase of Crisis - is now off and running.

Does Stage II Mean the Credit Bubble has returned? No. Does Stage II Mean Credit losses will no longer trouble the system? Definitely not. Does Stage II Mean the reemergence of Wall Street-backed finance? No. Does Stage II Mean the reigniting of U.S. asset inflation? No, at least not generally. Does Stage II Mean the leveraged speculating community has been granted a new lease on life? Don’t bet against it. Does Stage II Mean the U.S. Bubble Economy could take on some additional air? Perhaps. Does Stage II Mean the exacerbation of Global Credit Bubble Excesses? Most certainly. Do Global Credit Bubble dynamics impact our Credit and Economic systems? Of course – more than ever.

I’ve written much on the issues of Monetary Processes and Inflation Dynamics. These themes now should play crucial roles in how we analyze the many complexities of today’s financial and economic landscape. Prior to the bust, the rampant expansion of Wall Street-Backed finance was directly fueling U.S. asset inflation and Bubbles – housing in particular. Today, post-crash, no amount of policymaker intervention can repair broken confidence in all facets of Wall Street finance, including subprime and “exotic” mortgages, the “monoline” financial guarantee business, CDOs, “private label” MBS, auction-rate securities, and so forth. Indeed, their problems are poised to only worsen as the economy falters.

It is one thing to stem implosion and something altogether different when it comes to restoring the Wall Street Credit mechanism to the point of fostering new Bubbles. Wall Street “alchemy” is a spent force unless it melds in some type of government obligation. The best policymakers can do today is place a federal government guarantee on 90% of new mortgage debt and hope this somewhat stabilizes U.S. housing.

Faltering housing markets and waning consumer confidence will place increased strains on economic performance. That’s not at issue. At the same time, the finance-driven Bubble economy is unmistakably on more stable footing now compared to its perilous perch a month earlier. Recognizing the Ebb and Flow of Contemporary Market-Based Credit (and the reality that today’s “flow” could easily be augmented in the short-run by the unwind of “bearish” positions), I will remain mindful of the potential for a meaningful loosening of Credit Conditions. To be sure, outside of housing and finance, the U.S. economy is still demonstrating some powerful inflationary biases and impulses. And inflationary biases spur Credit growth that spurs heightened inflationary pressures. That's the way it works.

The Global Credit Bubble must factor into our analysis. Most conspicuously, powerful price pressures throughout global energy, food, and commodities markets are stoking growth in various sectors of our economy. Our export sector continues to boom. Less obvious, I would argue that rampant global financial excess is a contributing factor in our financial institutions’ capacity to raise new “capital” from the global markets – and more generally in bolstering marketplace liquidity in the face of the collapse of Wall Street-backed finance. Foreign demand for our assets is a not insignificant issue. Moreover, the global leveraged speculating community - and international liquidity flows more generally - are a major Stage II wildcard.

Otherwise intelligent financial commentators argue that today’s rising energy and food prices are not a “monetary phenomenon.” Instead, these price pressures are said to be due to strong demand from China and India – wealthier consumers choosing to upgrade their diets. But both the Chinese and Indian economies (and many others) are now operating with virtually unlimited Credit – a unique combination of rampant domestic Credit growth coupled with massive foreign financial inflows. As I’ve explained ad nauseam, U.S. Current Account Deficits and dollar impairment are the root cause of scores of runaway domestic Credit systemic that these days comprise the Global Credit Bubble. This historic Bubble is everywhere and in every way a monetary (Credit) phenomenon.

It is my argument that Stage II Means another year of massive U.S. Current Account Deficits. This would Mean, for one, a prolonging of the massive flow of liquidity into international central bank reserves (creating domestic Credit in the process), sovereign wealth funds, and (to a lesser extent) the hedge fund community. The consequences from a further ballooning of this Unwieldy Global Pool of Speculative Finance are not at all clear. Secondly, another year of U.S. Deficits would Mean another year of excessive liquidity flows into the already overheated economies throughout Asia, the Middle East and elsewhere. These flows are hitting economies with already acute inflation pressures and related problems. Importantly, these Monetary Processes and Inflationary Dynamics are by now well entrenched and extraordinarily powerful after years of unrelenting excess. Resulting Monetary Disorder should be expected to go to increasingly destabilizing extremes (think NASDAQ 1999 and subprime 2006!) – and indeed we’re seeing evidence of as much in near $120 crude, the global food price spike and related hoarding, and wildly unstable and speculative global financial markets.

It is in this context that I believe U.S. policymakers are today unknowingly risking global financial and economic catastrophe. They are, of course, fixated on domestic concerns and are willing to do any and everything in a desperate attempt to sustain the U.S. Bubble Economy. They are oblivious to both the heightened risks associated with today’s Current Account Deficits and to the various linkages of their policies to Heightened International Monetary Disorder. Stage II is fraught with great but not easily recognizable risks.

It is my view that there are significant risks associated with postponing the inevitable adjustment to the U.S. Bubble Economy. As I’ve attempted to explain previously, the amount of Credit necessary to sustain our uniquely maladjusted Economic Structure is unmanageable. It is unmanageable for our troubled banking system, for our troubled GSEs, and for the expansive money-fund complex – for risk intermediation generally. Stage II Means great risk to the heart of contemporary “money.” The problem rests on the reality that “pre-adjustment” Credit (borrowings associated with many businesses and enterprises that will be uneconomic come the arrival of the post-Bubble backdrop) is inherently weak and vulnerable. And as discussed above, today’s U.S. Credit is extraordinarily destabilizing in its effects upon the Global Credit Bubble and Resulting Monetary Disorder.

I am at this point more convinced than ever that only a severe crisis will instigate the necessary adjustment to the distorted and imbalanced U.S. and global economies. One is then left with the disconcerting view that Stage II will lead our authorities to exhaust all policy measures in a futile attempt to sustain the unsustainable. The obvious question: how long does the lead up to Crisis Stage II last? I would today guess a number of months, although I wouldn’t at all be surprised if it was rather short. What will be the impetus for Crisis Stage II? A spike in interest rates, a run from U.S. Treasury and agency debt, a disorderly drop in the dollar, another bout of derivative and Credit market implosion, or acute global financial tumult should be considered leading candidates based upon Stage II ramifications. Or it could easily be something completely unexpected, perhaps even war.

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