4 October 2008

The Wall Street Bust:

I still owe readers a thorough analysis of the Q2 2008 Flow of Funds. For now, I’ll just point out some data relevant to the Current State of Acute Fragility.

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.

At this point, there is clearly insufficient Credit expansion to support inflated asset markets; incomes and household spending; corporate cash flows and investment; and government receipts and expenditures. Lending markets are frozen, securitization markets broken, corporate and muni debt markets in disarray, derivatives markets in shambles, and the leveraged speculating community is engaged in panic de-leveraging. As a consequence, the over-indebted household, corporate and state & local sectors now face a devastating liquidity crisis.

We are today witnessing the Acute Stage of Bursting Credit Bubble Dynamics. It’s an absolute debacle, and there’s little our well-intentioned policymakers can do about it other then try to slow the collapse. 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 and $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 main previous patterns of spending. Economic upheaval and adjustment are today unavoidable.

Over the years I’ve chronicled this historic Bubble in Wall Street Finance. It is worth noting 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 Wall Street Bubble 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 expanded rapidly in spite of subprime collapse. The speculators maintained easy access to cheap finance. As I have noted often, despite the unfolding bust in mortgage and risk assets, market faith in “money” had held steadfast. That ended 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. In particular, Wall Street finance was a mechanism for intermediating higher-yielding risky 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 higher yields.

And, importantly, as the stature of Wall Street finance grew its impact upon the real economy became embedded deep in 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.

It is today impossible to comprehend the full ramifications from The Bust in Wall Street Finance. Yet we can be rather certain that much less Credit and liquidity will be directed to the asset markets, and at the same time there will be significantly less Credit Availability for riskier loans – for the household, business, financial and the government sectors. Few appreciate that these dynamics are extremely problematic for the U.S. Bubble economy – an economy that had come to a large extent to be governed by asset-based and high-risk lending. These dynamics are at the heart of today’s imploding markets.

The leveraged speculating community played 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 and directing the Flow 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 the speculators. And the greater the returns, the more robust the “investment” flows into the hedge fund community – and the more leverage and the more fuel for additional self-reinforcing asset inflation. Well, this historic speculative Bubble is now blowing up. One of the greatest manias ever – surely The Greatest Episode of “Ponzi Finance” – is absolutely coming apart. 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. And while $700bn from Washington would seem like an enormous amount of support – in reality it’s nowhere close to the amount necessary for systemic stabilization. To the $2.0 TN or so of new Credit required add perhaps as much as several Trillion more necessary to accommodate speculative de-leveraging. The Bust in Wall Street Finance has ensured that insufficient liquidity will be forthcoming to maintain inflated asset prices and sustain the Bubble economy – creating catastrophe for the leveraged speculating community.

The “Freidmanites” thought they understood the policy mistakes that led to The Great Depression. They believed the “Roaring Twenties” was the “Golden Age of Capitalism.” The great bust could have been avoided with a simple ($5bn) banking system recapitalization. As we are witnessing today, the issue is not a manageable amount of new “capital” to replenish banking system losses, but instead the massive and unmanageable amount of new Credit necessary to, on the one hand, sustain a mal-adjusted Bubble Economy and, on the other, accommodate a gigantic speculative de-leveraging. I have a very difficult time seeing a way out of this terrible mess.

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