The Credit Bubble Bulletin

“U.S. High-Yield Lending…”

The political turmoil continued unabated this week as we are still waiting to find out who will be the next President of the United States.  For the week, the Dow and the S&P500 were both unchanged.  The Transports rallied 4%, and the Morgan Stanley Cyclical index remained unchanged.  The defensive Utilities continued to rally and added 2%.   The small cap Russell 2000 and S&P400 Mid-cap indices were unchanged.  Biotechs were busted for another 12% on top of last week’s 8%. Technology did a bit better this week as the NASDAQ100 rose 2 percent and the Semiconductors 8%.  The Street.com Internet index bucked the trend and was hit for 9%.  The financial stocks were mostly lower, with the Bloomberg Wall Street index dropping 2%, and the S&P Bank index declining 8 percent.  For the gold shares, it was another normal week with the XAU falling 3%.

I have often pondered the concept of Gresham’s Law, or that “bad money drives out good.”  The long bull run in the dollar certainly makes a very good case for this “law,” particularly versus the old money mainstay – gold.   We will, however, save that discussion for another day.  As explained by The New Palgrave Dictionary of Economics, Gresham’s Law “denotes that well-ascertained principle of currency which is forcibly though not quite adequately expressed in the dictum – ‘bad money drives out good.’  It has also not infrequently been explained by the statement that where two media of exchange come into circulation together the more valuable will tend to disappear.” 

In the contemporary environment where “money” is little more than electronic IOUs (liabilities) from financial institutions and intermediaries, I believe a more applicable “law” would hold that “bad lending drives out good.”  Certainly, we have seen exactly such a situation develop over this protracted cycle as Wall Street has grabbed the reins of the money and credit creation process.  While traditional finance sought to profit from lending prudently, today’s game is all about voluminous fee-based security issuance, sophisticated vehicles and structures and, of course, lots of derivative products. Quality was been completely sacrificed for quantity.  In the process, the investment banker and “rocket scientist” derivative specialist has come to dominate the monetary system, supplanting the local loan officer.  And while lending for investment into cash-flow- generating enterprises was the business of the local banker, the volume seeking Wall Street banker specifically pursues enterprises with negative cash flows that will require continuous financings.  After all, the “best” clients are those that “keep coming back to the trough.”  Besides, as Wall Street thinking goes, if the marketplace does become nervous about the soundness of securities (as it is today) doesn’t that just provide more opportunities for “our derivative department down the hall” to peddle credit insurance?  Why has it not been absolutely obvious that this was no way to run a financial system?

With Wall Street at the helm, there are many examples supporting a contemporary Gresham’s Law of “bad lending drives out good.”  In the New Age of growth-based lending, the “opportunities” have been in “structured finance” where huge fees and “gain on sale profits” are achieved through mountains of subprime consumer loans, telecom receivables, equipment leases, and such.   In the “old days,” the marketplace would endeavor to finance sound capital investment.  In the New Age, it is much more expedient to finance corporate stock buybacks and mergers and acquisitions.  While it may be quite difficult to identify enough sound capital investments to meet lending and fee quotas, it’s no problem whatsoever when the goal is financing asset inflation.  Asset inflation provides the Wall Street banker with seemingly endless lending “opportunities.”  After all, why deal with financing new plant and equipment, when all the lending volume one could ever dream about can easily be achieved funding a real estate boom?  Furthermore, why finance any other type of capital project (oil and gas refineries and electrical generation facilities, for example) when one massive telecommunications build- out provides a once-in-a-career source of infinite client fees? 

Well, all this nonsense was allowed to go on for too long and to unimaginable extremes.  Now, most unfortunately, the inevitable bust is knocking at the door.   At the core of the problem is the fact that for too many years the marginal loan has been of very poor quality.  Granted, through the “alchemy of modern finance,” these loans were packaged in a manner that enticed buyers, and all the lending did create one huge financial and economic boom. But the cost of this historic credit excess – mountains of poor loans – is, as we have explained many times, a maladjusted economy and a fragile financial system.  For the hundreds (thousands?) of cash-burning companies created during this protracted cycle, there is now the harsh reality that the junk bond market is closed and most banks are running for cover. The “money spigot” is rapidly closing and many, many companies will not survive the unfolding credit crunch. For the aggressive lenders, it will be years of credit losses, impairment, and a fight for survival.  It appears the situation is just beginning to “set in.” 

 This week, the Chicago Tribune quoted Bank One’s Jamie Dimon as saying “credit is deteriorating quarter by quarter and we expect it to continue.”  There was also important confirmation this week that credit problems have taken a decided “turn for the worst” from lending heavyweights Bank of America and First Union. Interestingly, the media and Wall Street were apparently “shocked” by the news, which means they obviously have not been paying attention.  We actually get the sense that bankers have been stunned by the rapidity of the credit downturn – the old “deer in the headlights” – with little understanding of how to deal with unfolding developments.  But recognize their great dilemma: After having basically created their own huge client base of cash-burning clients during this long boom, do they now make the difficult (but inevitable) decision to “cut them off” – a terminal decision for dependent borrowers – or do the lenders continue to “throw good money after bad.”  Yes, the latter decision does postpone the day of reckoning, but what a day it will be…

 When the article ran on January 4^th of this year, I immediately printed it and filed it. I must have been thinking, as I often do, that “this is one for the time capsule!”  I am referring to a Bloomberg article “U.S. High-Yield Lending Hits Record in 1999, Telecoms Line Up.”  I pulled it from the file this week as it underscores better than anything else the dimensions of the predicament now confronting the U.S. financial system.

 The article began: “U.S companies lined up for a record amount of high-yield debt in 1999, buoyed by many communications companies taking advantage of lenders’ eagerness to lend money for expansion and acquisitions.  Nextel Communications Inc., Global Crossing Ltd. and Level 3 Communications Inc. were among companies taking out high-yield loans last year, helping push (high yield) lending to $391 billion from $329 billion in 1998, according to Securities Data Corp.  Companies borrowed $1.05 trillion in 1999 up from $1.04 trillion in 1998 and just shy of 1997’s record $1.1 trillion.”

 There was also this key sentence:  “A reluctance by high yield bond investors to buy bonds of some telecommunications companies…led them to the loan market, bankers said.”  It is just unbelievable that the aggressive banking community was so eager to step up to the plate and extend enormous amounts of funding, especially in the face of a credit market that was clearly signaling trouble on the horizon. 

 The Bloomberg article also quoted a head of a Wall Street syndicated loan department:  “The growth in leveraged lending has been fueled by telecom companies and their rapacious need for capital.  Telecom companies need money for network expansion. If the bond market isn't there, they'll go to the bank market for cash.  Demand continued in the fourth quarter, 752 high-yield and investment grade loans worth $25.4 billion were made as concerns also faded that the date change to 2000 might roil markets, prompting lenders to open their wallets. The co-head of another Wall Street loan department stated:   “As the quarter moved on, people got less and less concerned that there would be problems. People were able to get good deals off the ground.”

“Chase and Bank of America were the top two lenders to telecommunications companies, accounting for more than half the amount borrowed. Goldman Sachs & Co. and Toronto Dominion Bank were third and fourth with 8.6 percent and 7.1 percent market share respectively. Almost 400 companies with low credit ratings organized high-yielding loans in the fourth quarter. High yield, or leveraged, loans jumped to $112 billion from $86.3 billion.”

“High-yield loans are popular among companies that can't sell bonds or stock to raise money. The loans, which are less risky than junk bonds, are also growing in popularity among funds and insurance companies looking for high-yielding investments. The number of investment vehicles buying loans rose from 64 in 1997 to 149 in 1999, according to (Portfolio Management Data’s (PMD)) research. They include collateralized loan and debt obligations, or CLOs and CDOs -- securities backed by corporate debt -- which have grown from 19 in 1997 to 42 last year, according to PMD.”

I also saved the January 10^th American Banker that included an article titled, “Syndicated Lending closes Out ‘90s on a Tear.”  “What a year 1999 was for the U.S. syndicated loan market.  Lending topped $1 trillion for the third consecutive year.  Leveraged lending, the most profitable kind of syndication soared 19% from 1998, to $391 billion, and the industry recorded its biggest deal ever: a $30 billion loan for AT&T Corp.”

Pulled from this article, “It was also the year Wall Street woke up to syndicated lending’s potential.  In May, PaineWebber published “The Biggest Secret of Wall Street,” a 44-page report that labeled syndicated lending ‘the largest, highest fee generating, and most profitable corporate financing business” on the Street.” 

 The American Banker also quoted a Wall Street analyst:   “Syndicated lending is changing the way the banking industry provides loans – period.  It’s the most flexible form of financing there is and the quickest way to raise money.”

 Numbers that will come back to haunt the U.S. financial system, total issuance of syndicated bank loans surpassed $1 trillion during 1999, making two consecutive years of trillion dollar loan syndications.  Chase Manhattan $349,154,000,000, Bank of America $217,237,000,000, Salomon Smith Barney $93,304,000,000, JPMorgan $57,459,000,000, and Bank One $48,118,000,000.   Comparing to 1998, Chase increased syndicated loan issuance by 28% and Bank America by 23%.  In the midst of an historic speculative run throughout the technology sector, Bank of America issued $123 billion of syndicated loans and Chase Manhattan issued $113 billion.   And while Chase was ranked #1 in total loans, Bank America had the most loan packages at 794.  Year 2000 got off to a big start, with almost $120 billion of syndicated loans made during January. 

 Closely associated with the unprecedented boom in risky lending has been the proliferation of credit derivatives and credit insurance.  It’s been quite a game  – create the risk, and then develop and market products that supposedly protect against it.  As such, we took note of a recent Bloomberg article by David Wigan and Tom Kohn “Credit Derivatives Boom as Bonds Dip.” The article stated that “sales of credit derivatives may increase by 50 percent this year as investors try to protect themselves…”  A head of a Wall Street derivative shop was quoted as saying, “for holders of (corporate) loans and bonds, they could be a real life saver in this environment.”  This same individual estimated that the market for credit derivatives has actually surpassed $1 trillion.  

 Wow!  Why does this so remind us of the proliferation of derivative products and sophisticated strategies in SE Asia and Russia (at the peak of their booms!)? Derivatives were major factors in the absolute fiascos created with the inevitable collapse of all the leverage and acutely fragile structures?  As we have stated in the past, derivatives in no way reduce risk for the system as a whole (they actually increase systemic risk!), but only shift it to other parties.  And, importantly, in the midst of boom-time speculative markets, risk is often shifted to parties (speculators) with little wherewithal to deal with losses in the event of a major market disturbance.  That was certainly the case in SE Asia and Russia, where great risk was shifted to highly leveraged financial speculators who were quickly destroyed when liquidity faltered and markets buckled.   There is just no doubt that the enormous amounts of derivatives and associated dynamic hedging strategies played an instrumental role in collapsing markets.  Yet, amazingly, no lessons were learned from the spectacular counter party defaults in Asia and, particularly, in Russia. 

So, today we are looking at a market for credit derivatives estimated to now surpass $1 trillion, as well as the thinly capitalized GSEs that have guaranteed “timely payment of principle and interest” on more than $1.8 trillion of mortgages-backs. Add to this, a truly staggering amount of credit insurance written by a host of aggressive financial institutions.  The two largest credit insurers are MBIA and Ambac Financial.  MBIA now has net (gross insurance less amount reinsured) insurance written – “Net Debt Service Outstanding” – of a staggering $670 billion. These policies are supported by a “capital base” of $4.4 billion, thus creating a “capital ratio” of 152:1.  At Ambac, net insurance – “New Financial Guarantees in Force” – of $402 billion is supported by “capital” of $2.7 billion, or 149:1.  So, for these two credit insurance behemoths, over $1 trillion of credit insurance has been written, supported by a capital base of $7 billion.  I will leave you to ponder how valuable all of the credit derivatives, guarantees, and credit insurance will be in the event of the type of major financial and economic dislocation that I believe is the inevitable consequence of truly unprecedented excesses.

And while we are on the subject of derivatives, Joe Niedzielski, of Dow Jones newswire, penned an excellent article today “Xerox In Talks With Counter party on Derivatives.”  Niedzielski’s piece highlighted how the company is faced with “constrained access to the capital markets and is essentially shut off” from the commercial paper market.  At the same time, “…Xerox may also be on the hook for $240 million of derivatives if its credit rating falls to junk status.  On that score, the company’s fate is in the hands of Moody’s investors Service and Standard & Poor’s.”  In Xerox’s filing with the SEC, it disclosed that it might be required to repurchase these derivatives from counter parties if it loses its investment grade ratings.  A Xerox spokesman stated that the company is currently negotiating with its counter parties.  The article also stated that Xerox has “drawn down $5.3 billion of its $7 billion bank credit line.”  The company anticipates that it will need “another $1.1 billion during the rest of the year to refinance its commercial paper, medium-term notes and maturing bank debt.”  This is a particularly poor position to be in, especially considering the unfolding market environment.   Xerox should be a loud wake-up call to the complacent. 

Over the coming weeks and months, it will be interesting (and critically important) to see if market confidence wanes regarding the mountains of credit derivatives and credit insurance.   If and when sentiment turns, we would not want to be left holding asset-backed securities, asset-backed commercial paper, or any of the sophisticated “paper” created during this bubble.  With the very poor initial quality of so much boom-time lending, and with the dramatic deterioration in the general credit environment, there are enormous quantities of securities in the marketplace backed by weak (and weakening) underlying loans/collateral.  It may be triple-A, but “buyer beware.”

A few weeks ago I wrote a commentary (September 29, 2000-A Tale Of Two Bubbles)underscoring the extraordinary circumstance where the bursting of the technology bubble was occurring concomitant with a continued expansion of an historic real estate bubble.  This unfortunate dynamic clearly continues.  This week, Fannie Mae reported that it increased its mortgage portfolio by $12.6 billion during October, an annualized rate of almost 27%, and the largest growth since August of 1999 (which, by the way was a month where liquidity faltered within the credit market!). Interestingly, the average balance of “other investments” increased $4 billion to $59 billion.   Average “other investment” balances have increased $9 billion (18%) in the last two months.  Once again, it is the ironic and dangerous circumstance that heightened stress in the U.S. financial system leads only to greater excess from the mortgage finance superstructure.  The real estate bubble grows by the month, greatly increasing the risk to the U.S. financial system and economy.

Tuesday, The Los Angeles Times ran a story written by Daryl Strickland titled “Home Prices Continue to Rise in Region.”

“Los Angeles and Orange County home prices grew at a torrid pace in October over the same month last year, suggesting that the tumult in the stock market and emerging signs of a national economic slowdown have yet to faze the region's housing market. Last month's surging prices--marked by double-digit percentage gains in nearly every housing category--also set the stage for robust home sales in the last two months of the year, a time when the market typically tapers off.
The median price for homes in Orange County soared 16% from October 1999 to a record $284,000. The median in Los Angeles County grew 10% to $203,000, according to a report released Monday by DataQuick Information Systems, a La Jolla research firm.”

The article stated that the continued real estate boom was related to record employment of California workers, with 16 million employed through October, as well as wealth effects from selling stock and stock options.  Another factor was a shortage of homes on the market, with only 3.3 months currently available.  The article also quoted DataQuick’s John Karevoll: “I think we're due for continued price increases and high sales levels. I don't see anything changing.”

 The California Association of Realtors reported that “the median price of an existing, single-family detached home in California during the third-quarter of 2000 was $247,450, the highest on record…the median price in Santa Clara hit $532,710, a 28.4% increase from the same period a year ago.  For the entire state, the median price increased $27,690, or almost 13%, from a year ago.  Condo prices jumped $23,230, or 14%.  Prices rose sharply in virtually all regions and price levels.  There was also yesterday’s Business Wire story, “California Luxury Home Values See Largest Gains of the Year.”  “According to the Index, the average value of a Bay Area luxury home during the third quarter of 2000 jumped 14.5% over the previous quarter and passed the $2 million market for the first time in history…third quarter index figures also reflect a 33.3% increase since the beginning of the year…” 

 Again, it is just stunning how the unfolding collapse of the technology bubble has to this point simply created greater amounts of cheap credit to exacerbate an historic real estate bubble.   This creates a major problem for the Fed.   And with continued excess mortgage finance feeding directly into destabilizing housing inflation, it is another clear of example of how our system has seen “bad lending drive out good.” As I have written before, the current U.S. financial system could not be more dysfunctional with its unrelenting fueling of asset inflation and speculative bubbles. I will conclude with an interesting exchange between Bloomberg and Chase Manhattan’s Vice Chairman Jimmy Lee:

“What we’ve got now is a ‘stealth’ credit crunch because it’s snuck up on people.  Someone said it’s worse than the 1998 credit crunch and maybe we don’t know it yet because it hasn’t affected the consumer.  But it shows up in credit spreads.  The credit spreads in many asset classes are wider than they have been since 1991 and that has seized up many of the asset classes.”

Is Chase pulling back in lending to riskier ventures?

“We don’t change our overall philosophy.  What we do is mark-to-market our day-to-day behavior and try and stay in the market albeit on different terms. These are the periods when we can add a lot of value for the customer. When capital is plentiful, there’s not as much differentiation as there is in the period right now.  It’s the nature of our business.  We have always believed that you have to be in the market at all times for your client, only on different terms and conditions.”

Is Chase turning down more loans?

“I wouldn’t say we’re turning down any more or less.  There are much tougher terms in the market.  There are wider spreads, higher collateral and greater fees.  We turn down a lot anyway.”

“I’m working on a very large financing at the moment, acquisition financing.  We’re trying to reshift our ideas and our philosophy, asking ‘where can we make money in this type of market?  I spend a lot of time in the private equity and LBO markets…”

As stated earlier, lenders will be forced to make the decision of whether or not to “throw good money after bad.”  Things are turning sour.