9 October 2008

A masterful summary

To make a reliable assessment of where we are and where we are going, we need to tie together some important evidentiary points. The evidence is there for all to see. The problem is that most lack the intellectual rigor and concept of time frames to put it together. I will endeavour to lead you through that process as simply as possible. Every analysis starts with a “where are we” and how did we get here précis. Doug Nolan of Prudent Bear lays out a masterful summary. As the consumer on which much of Asia relies, US is still the epicenter of the Asian financial picture. I urge you to read Doug’s summary carefully and reflect on what it means. Reading lists of numbers can be tiresome but there is simply no way for you to be informed investors without an understanding of the magnitude of the problem that the addiction to debt has wrought.

Where we are


Looking back, Total Non-Financial Debt (NFD) expanded $578bn during 1994. By 1998, NFD growth for the year had surpassed $1.0 TN. Non-Financial Credit increased $1.153 TN in 2001, $1.415 TN in 2002, and $1.676 TN in 2003, before reaching the $2.0 TN milestone in 2004. Incredible as it was, debt expansion then surged over the next fateful three years. Growth rose to $2.319 TN in 2005, $2.428 TN in 2006 and then to last year’s record $2.561 TN.

Importantly, this historic Credit Inflation inflated asset prices, incomes, corporate cashflows/earnings, government revenues, and various types of spending throughout the U.S. and global economy. It was a self-sustaining Bubble bolstered by ongoing Credit excesses, asset inflation and resulting purchasing power gains. But NFD growth slowed sharply to an annualized $1.726 TN during this year’s first quarter and then sank to $1.127 TN annualized during the second quarter. Credit growth is now in the process of collapsing.

To be sure, there were momentous effects to both the Economic and Financial Structures during the Bubble period between 1994’s $578bn Non-Financial Debt Growth and 2007’s $2.561 TN. It is also worth noting that Financial Sector Debt expanded $462bn in 1994 compared to $1.753 TN in 2007. Mortgage debt almost doubled in the six years 2002 through 2007 to $14.0 TN, while Financial Sector borrowings rose 75% to $16.0 TN. This Credit onslaught fostered huge distortions to the level and pattern of spending throughout the entire economy. It is today impossible both to generate sufficient Credit and to maintain previous patterns of spending.

It is worth recalling today that Wall Street assets began year 2000 at about $1.0 TN and ended 2007 at $3.0 TN. The ABS market surpassed $1.0 TN in 1998 and ended 2007 at $4.5 TN. GSE assets surpassed $1.0 TN in 1997 and ended last year at almost $3.4 TN. Agency MBS surpassed $2.0 TN in 1998 and closed 2007 at almost $4.5 TN. “Fed Funds and Repos” reached $1.0 TN in 2000 and ended 2007 at $2.1 TN. This Bubble in Wall Street Finance was one of history’s most spectacular Credit expansions. It also comprised the greatest use of speculative leverage ever.

Despite last summer’s collapse in private-label MBS and related markets, the faltering Wall Street Bubble nonetheless persevered up until the Lehman collapse. While it was problematic that overall system Credit growth had slowed markedly, there remained key sectors of Credit and risk intermediation that remained very much in expansionary mode. In particular, GSE-related obligations, bank Credit, and money market fund assets had expanded rapidly in spite of the subprime collapse. Importantly, the speculator community had maintained easy access to cheap finance. As I have noted often, despite the unfolding bust in mortgage and risk assets, market faith in “money” and the core of the system had held steadfast. This all ended abruptly three weeks ago with the Lehman filing.

Today, confidence has been shattered, and Wall Street finance is a complete and unsalvageable bust. The spigot for Trillions of finance - that for years fueled the asset markets and U.S. Bubble economy – has been essentially shut off and dismantled. In particular, Wall Street finance was a mechanism for intermediating higher-yielding riskier loans. This finance provided rocket fuel for both residential and commercial real estate markets – and the attendant wealth effects. Wall Street finance also grew into the key source of finance for auto purchases, student loans, Credit cards, municipal finance and various business enterprises. Many of these loans were of a risk profile unappealing to traditional bank lending – and, hence, provided the type of higher yields quite appealing to the speculator community.

And, importantly, as the stature of Wall Street finance grew its impact upon the real economy became embedded deep into the Economic Structure. Or, stated differently, risky loans came to play a major role in determining spending and investment patterns throughout the “Bubble” economy. Wall Street finance became a major direct and indirect generator of household incomes and corporate profits. Moreover, Wall Street finance came to dominate the flow of finance both in and out of the securities markets. Wall Street could create its own liquidity and funnel it into the U.S. and global markets – and earn unimaginable returns in the process.

The leveraged speculating community played such an integral role in the overall Credit Bubble and, more specifically, to the Bubble in Wall Street Finance. They were instrumental in both spurring financial sector Credit creation/leveraging, while directing this Flood of Finance to the asset markets. And the more the leverage and the greater the Flow to inflating markets, the higher the returns generated by this expanding pool of speculative finance. And the greater the returns, the more robust the “investment” flows into the hedge fund community – spurring more leverage and more potent fuel for additional self-reinforcing asset inflation. One of the greatest manias ever – surely The World's Greatest Episode of “Ponzi Finance” – is absolutely coming apart. And the wreckage is accumulating in all markets – everywhere.

Here at home, our maladjusted economic system will only be sustained by somewhere in the neighborhood of $2.0 TN of new Credit. It’s simply not going to happen. The $700bn from Washington would seem like an enormous amount of support. In reality, it’s nowhere even close to the amount necessary for systemic stabilization. To the $2.0 TN or so of new Credit required this year (and next) add perhaps as much as several Trillion more necessary to accommodate speculative de-leveraging (liquidations forced by huge losses).

How we got here

No solution to any predicament is possible without an examination of how we got here. Failure to recognise the causes and the key players instrumental in the serial bubble blowing we have seen since 1997 means a continuation of failed policies. Central banks led by US and Japan have failed to establish a proper credit regime. Greenspan’s insistence that he couldn’t recognise a bubble at the time it was happening and Bernanke’s subsequent acquiescence in setting rates below their real risk cost directly led to first the dot.com bubble and now a larger asset bubble, this time based around property assets. By fostering unsustainable levels of economic activity, secondary bubbles formed in other asset classes notably the stocks of players in the bubble game. Japan’s decade long obsession with near zero interest rates created the bubble in the carry trade which was directly responsible for the commodity bubble and the pain borne by consumers from $100 plus Oil. UK and Europe aped this behaviour by having their central banks too maintain rates at below real risk costs. As a general observation we know that over 60 central banks assisted with the marketing of US securitized paper with Asia taking its share particularly of GSE paper.

Today we have direct evidence that US, UK, Europe and the lands Down Under, Australia and New Zealand are using their central banks and their sovereign wealth funds as repositories for not only tainted securities but new securities specifically parceled to take advantage of these facilities. We have a one line announcement that the Australian Futures Fund has made unspecified advances to all the major Australian trading banks and last week the Australian Treasury created a $4 billion facility specifically to assist non bank mortgage originators. As Australia is one of the nine central banks participating in the US TARP program we can assume that these actions mesh with the wider approach of many central banks. It’s the same old game. None have yet faced up to the alternate of drastically reduced credit. None have yet contemplated life without a 90% LTV mortgage. Last year in the face of an obvious topping of housing markets, 46% of mortgage originations Down Under were of the 100% LTV variety. I suspect that many more obtained 100% status by other means.

Indeed most central banks are engaged as partners in a fascinating dance. One of the endearing lessons from the 30’s is that whatever remedies are available must be delivered conjointly and not piece meal. One out attempts at solutions for global problems merely focuses the attack, so all of the 9 central banks involved in TARP and the other 50 who assisted in the great securitisation sales are taking urgent lessons in the Tango. They are dancing together whether they like it or not!

Yesterday the Australian Reserve Bank triggered a storm in currency markets and a one day recovery in its equity markets with a 1% or 100 point cut in official interest rates. Aussie Reserve had at least been active in moving its rates upwards in baby steps but as Paul Volker pointed out many years ago, the baby steps don’t have an affect on markets so the Aussie bubble too kept inflating together with the rest of the world.

On 29 January I wrote for you in Financial Sense about the Uridashi trade that has been financing Australia and New Zealand’s property bubbles. It was a strange word unfamiliar to all but the elite London traders who originate most of these bonds. The crux of those articles was that the borrowings were extreme and essentially backed into the AUD-USD hedge (although the capital raising is done in NZ the NZ banks are subsidiaries of Australian parents). Uridashi today has seen the light of day in UK Telegraph and NZ talk shows as commentators are belatedly coming to grips with what you knew nine months ago. As holders rush to exit the weakening commodity currency of Australia and retreat into the relative safety of the Yen, this is what the pincer movement on AUD has produced.

A 29% drop in 2.5 months. Does that look like fun?

Parenthetically we ask how willing Japanese investors are going to be in rolling over this issuance when it rolls to maturity. Conventional wisdom is that they always take the 15 year compounding view but these are not conventional times. For Aussie and Kiwi exporters particularly miners and primary producers who have long term contracts denominated in USD, this is cause for celebration but if they are not cash flow positive, restrictions on bank funding may soon impact although that is not happening yet.

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