The Steve Puetz Letter

Dear Fellow Thinker:

US Gross Domestic Product surged ahead during the lst quarter of 1997. The rise was the largest in several years. Does this new gain in consumption mean that my bearish forecasts are completely out of touch with reality? To properly answer that, an examination of the forces behind the surging economy are essential.

The May 1997 issue of The Richebacher Letter (Welt Research, 1050 Southeast 5th Ave., Suite 100, Delray Beach, FL 33483) does an excellent job of analyzing these forces. Richebacher explains: "We are left to evaluate the sustainability of this consumption boom. In contrast to Wall Street's complacent view, we regard it as extremely vulnerable to possible, sudden disruption. It seems appropriate to distinguish in this assessment between the two groups of borrowers: the relatively poor and the affluent. The surging delinquency rates and record bankruptcies that bewilder analysts, but which Wall Street discards as being of marginal importance, obviously refer to the relatively poor part of the population. Actually, the crucial changes in the economy are always at the margin. What's more, recent reports from sub-prime lenders and the credit card industry suggest a looming financial disaster. The first major shock came in January as the largest sub-prime lender, Mercury Finance, announced that 'Improper accounting entries' would lead to losses and the restatement of prior years'earnings reports. Only days later, sub-prime lender Jayhawk Acceptance disclosed that heavy losses would force the company to seek bankruptcy protection. Subsequently, one small lender after the other reported heavy losses, often in connection with accounting irregularities.' Similar severe distortions were reported in the creditcard industry.... Clearly, there is serious trouble looming in consumer credit - more precisely, in installment and creditcard borrowing.... Surprisingly, consumer demand instead accelerated because another dynamic began to work in the opposite direction, sharply boosting consumer demand: drastically lower savings by the more wealthy people. Here, the connection with the big capital gains provided by the particularly steep rise of US stock prices in 1996's last months seems self-evident - in other words, a spill-over effect from the stock market bubble. How dependable is such a spending boom against capital gains? Not at all, of course. Essentially, it is extremely vulnerable to a change in market sentiment and implies that a bear market carries a very high risk for a dramatic decline in consumer spending and thus for the economy in general. There is one historical precedent: the coincident collapse of the stock market and consumer spending in 1929-30.... The important lesson of 1929-33, for the present, is that such an economic expansion is vulnerable in the extreme. Once the bull run of the stock market stops, or even turns into a bear market, which is'sure to happen one day, the US economy is prone to a drastic, protracted decline in sales, incomes, and profits. For numerous Americans, just as in the late 1920s, the stock market is where the savings for retirement or educating their children have been stashed. Today, some 84 million adults own stocks, double the rate of the late 1980s."

Richebacher's conclusion that 1st quarter economic strength was tied to the "wealth effect" created from the booming stock market has been reinforced in recent weeks. The decline in retail sales during the last-half of March and the first half of April coincided with the sharp stock market break at that time. Furthermore, economic strength is being exaggerated by inventory building.

By no means can this economic expansion be called solid or durable. It's foundation lies in fleeting paper-profits for stock market investors, and increasingly unpayable installment loans for the less wealthy.

The May 5th issue of Barron's confirmed the shakiness of the present consumption boom: "Reports of retail sales slowing toward the end of the month were bolstered by the news that bad credit-card debt continued to balloon."

GLOBAL CREDIT

The US economy does not stand alone with it's credit problems. In a May 7, 1997 article entitled Waiting to Explode -- Next Economic Crisis May Stem From Woes of the World's Banks, The Wall Street Joumal exposes the fragile composition of the global financial system: "From Beijing to Brazil to Bulgaria, many banks are shaky. In the fast-growing economies of Asia, the reforming economies of Latin America, and the transition economies of Eastern Europe, fragile banks and lax government supervision are emerging as threats to prosperity and stability. 'I am frequently asked: Where will we have the next international economic crisis, the next Mexico?' says Michel Camdessus, managing director of the International Monetary Fund, 'I don't know, but I suspect it will begin with a banking crisis.' And even if it doesn't, he adds, 'it will almost certainly be worsened by a banking crisis.' ... Since 1980, the IMF says, 133 of its 181 member countries have had significant problems. By one tally, 52 developing countries have lost most of their banking-system capital, and some more than once.... Of the 58 banks around the world rated by Moody's Investors Service as most likely to need rescuing, 40 are in emerging markets, though, Japan, with nine, has the most on th'6 list.... And most alarming of all, the biggest banking bust may lie ahead, in China. The Bank of China... 'conservatively' estimates that one-fifth of the roughly $600 billion in Chinese bank loans are bad. Some private estimates are twice that worrisome total.... The global economic environment has grown more volatile in nearly every respect - exchange rates, interest rates, private capital flows - while banks have gained economic importance in many developing countries. But they haven't expanded their capital base to reflect their increased size and the changed game. Most lack expertise in evaluating credit risk, and state-run or stateinfluenced banks often disregard it.... Just last week, Harvard University economist Jeffrey Sachs decried lndia's state-run financial system as a 'time bomb" economy, and a bad economy can sink poorly run banks. In Bulgaria, to pick one current mess, the banking system has collapsed and taken the economy with it. More than a dozen of Bulgaria's 40-odd private and state-run banks are shut. After being forced to lend too heavily to money-losing state enterprises, the banks are in the hole by nearly $1 billion, a huge sum in a country with a $13 billion GDP.... Not only state-owned banks, such as Bulgaria's, feel such pressure. Even where banks are privately owned, governments sometimes undermine them by pushing them to lend to particular borrowers or economic sectors. 'Connected lending' to businesses with ties to bank managers or owners has figured in banking problems in Indonesia, Malaysia, Thailand, and Jamaica as well as in Latin America.... But corruption and fraud don't begin to explain the rash of banking failures worldwide. In many countries, newfound prosperity and an influx of foreign money have encouraged excessive lending to particular industries, and often for real estate.... After Chinese banks, lent willynilly to developers in the early 1990s, sometimes on projects the banks themselves owned, Beijing banned all real-estate loans in 1993. But it was too late. Haikou, the main city on South China's Hainan Island, has acres of gleaming white office towers and apartments, mostly empty and nearly all bank-financed. Each building represents a loan that won't be repaid.... That such distress has become so public shocks banks once required by governments to hide any hints of trouble, the banks find themselves exposed to market scrutiny and a risk of runs by panicked depositors."

While The Wall Street Joumal does a good job of highlighting the extent of the banking problem, it erroneously concludes that lax supervision is behind the problem. Government does hold an important and necessary role in any monetary system. That role, however, must be limited to preventing fraud and ensuring monetary honesty. On both counts, all governments throughout the world have failed miserably.

A lack of monetary stability eats away at the fabric holding together the global monetary system. That system is credit-based with the US Dollar as the center-piece. The US Dollar is the primary reserve that foreign central banks hold. Not too many years ago, gold was the primary reserve for central banks. That transformation from hard commodity-money to credit-money has taken place over the relatively short time-span of 50 years. The vast majority of investors either haven't noticed or haven't cared that our money is drastically different from the Dollar of yesteryear.

A look at the Federal Reserve's historical credit aggregates shows, that for the - United States, credit has expanded virtually non-stop during the post-World War II era. Only briefly, during a recession, did credit growth slow.

As unemployment rose in recessionary times, political pressure worked in favor of easing credit and stimulating a new credit-based economic boom. The Federal Reserve usually gave in to the pressure and eased credit.

Most people will argue: That's true. And the next time we go into recession, the Fed will ease credit like it has in the past, and the economy will be saved once again.

Clearly, though, there are some huge differences between the credit conditions of the 1940s and the credit circumstances of the 1990s. First, liquidity, that is cash and cash-equivalents as a percent of other assets, is drastically lower today than the liquidity levels of 50 years ago. Second, credit quality has deteriorated dramatically over the years.

If the standards of the 1940s were still in place, virtually no new loans would take place today. Whenever qualified borrowers disappeared, which made new lending difficult for the banks, hey simply lowered their qualification standards a little. Then new loans developed, bank profits soared, and everything appeared hunky-dory. These conditions usually took place at the height of an economic recession.

Lending standards have deteriorated so much that, today, instead of a 50% down-payment for a home, 5% will do. No need to put up collateral for a personal loan these days, just get a creditcard.

But the lowering of lending standards has finally caught up with the banking system -- not only domestically, but internationally as well. Credit difficulties, defaults, and bankruptcies mount with each passing month.

Yet, people have jobs. The unemployment rate is at a 25-year low, and the economy is in the 7th year of expansion. A system has been created in which credit-standards are so low that borrowers increasingly cannot repay their loans no matter how well the economy behaves. Something is drastically wrong. This begs the question: What will happen when the economy finally turns sour?

The seeds of financial collapse have been sewn long ago. Top monetary officials recognize the precarious situation of the global banking system. However, easy credit during an economic downturn will not revive the economy like it has in the past. Dangerously low liquidity levels and excessively low lending standards all but guarantee massive numbers of bankruptcies during the next economic contraction. Unfortunately, these bankruptcies won't be isolated cases. Instead, they are likely to expose the Systemic Risk built into our financial system.

Derivatives critic, Burkhard Vamholt, defines Systemic Risk as: "The possibility that due to some unforeseen event the liquidity of a financial system suddenly dries up causing chain reactions such as counter party defaults or asset price crashes and a breakdown of the financial system as a whole."

In recent papers issued by monetary authorities such as the Bank of International Settlements (the central bankers' bank) and the Congressional General Accounting Office, Systemic Risk was rated as the highest risk facing our financial system. Systemic Risk was rated above (in order from next-highest to lowest) legal risk, credit risk, market risk, and settlement risk.

These concerns are fully warranted. Excessively low credit standards are the culprit that has already started the chain reaction of bankruptcies that will soon bring the global credit-system to a grinding halt.