"Elasticity" and a Cycle of Perpetual Booms and Busts

While the bulls maintained general control this week, their grip looked quite tenuous. For the week, the Dow gained 260 points, or almost two and one-half percent, while the S&P500 added about 1%. The economically sensitive issues outperformed, with the Morgan Stanley Cyclical index jumping better than 4%. The Utilities added 2%, and the Transports increased 1%. The Morgan Stanley Consumer index and the small cap Russell 2000 gained about 1%. The technology stocks were quite volatile, with the NASDAQ100 and Morgan Stanley High Tech indices adding 1%. The Semiconductors rallied 4%, while the NASDAQ Telecommunications index dropped 3%, and the Street.com Internet index gave up about 1%. The Biotechs continue to hold their own, as the AMEX Biotech index added 1%. The wild rally throughout the financial sector continued, with the AMEX Securities Broker/Dealer index adding 2% and the S&P Bank index increasing 1%. The Broker/Dealer index has now surged 54% from the May 26th trading lows.

Interestingly, there was a whiff of inflation in the air, as the gold stocks gained almost 5% for the week, with the metal adding almost $2. It was another big week for the energy sector. On the back of strong gains in crude oil, natural gas, and heating oil, the Goldman Sachs Commodity index increased 2%. As the week came to a conclusion, there were also indications that the recent credit market rally could be faltering. Clearly, there are fundamental issues in the economic and inflation backdrop that argue that current low interest rates are not justified. Ominously, today 2-year Treasury yields jumped 6 basis points. For the week, 2-year yields rose 7 basis points, while 5-year to 30-Treasury yields had more moderate increases. Interestingly, mortgage-backs and agency securities continue to perform well, with mortgage yields dropping another 4 basis points this week to the lowest level since December.

"Sooner or later, the crisis must inevitably break out as the result of a change in the conduct of the banks. The later the crack-up comes, the longer the period in which the calculation of the entrepreneurs is misguided by the issue of additional fiduciary media. The greater this additional quantity of fiduciary money, the more factors of production have been firmly committed in the form of investments which appeared profitable only because of the artificially reduced interest rate and which prove to be unprofitable now that the interest rate has again been raised. Great losses are sustained as a result of misdirected capital investments. Many new structures remain unfinished. Others, already completed, close down operations. Still others are carried on because, after writing off losses, which represent a waste of capital, operations of the existing structures pays at least something." Ludwig von Mises, von Mises on the Manipulation of Money and Credit.

We see two critical aspects to the current cycle that go completely unrecognized. First, our system is held captive to perpetual credit-induced booms and inevitable busts of growing proportions. Second, we are in the grips of credit bubble dynamics, with traditional business cycle factors and Federal Reserve monetary restraint largely irrelevant. Few appreciate the relevance of these factors. Clearly, the bullish consensus misperceives and incorrectly analyzes the current environment, as they have little understanding of the origins, nor the underlying factors, of the current boom. They do not appreciate that the seeds for the present bubble were in fact sown with last decade's financial boom turned bust.

There were considerable analyses during the early 1990s regarding the enormous losses due to reckless lending and fraud throughout the S&L industry, and including many banks. One economist made a seemingly compelling case that S&L losses were simply destroyed money, similar to as if $160 billion of currency had simply been "flushed down the toilet." And, supposedly, since the "capital" no longer existed, it was not only reasonable but it made perfect sense for the Fed to simply replace this "destroyed money." At the time, I was dumbfounded that such analysis was given favorable attention, when it should have been recognized as nonsense and harshly dismissed. Little did I know at the time that it would prove a harbinger of much greater economic fallacies. There is clearly a strong perception that the Fed will be there when it is called upon to again "create money" come the next downturn.

Last time around, the government was finally forced into action during the early 1990's after lending losses were allowed to mount for years. With an ever-growing mountain of bad loans creating widespread insolvencies, the government was on the hook to make insured deposits whole, while also acting to ensure the stability of a faltering U.S. financial system. Basically, the creation of additional government liabilities (deficits) was necessary to replace depositors' monies that were either lost on bad loans or just pilfered away. Generally, the process was rather simple as "deposits" from failed lenders were simply transferred to other institutions (often ailing), and the "purchasing" bank was issued "freshly printed" government securities. Although this process ("monetization") added considerably to the federal deficit, it had little detrimental effect on the financial markets. In fact, the heavy issuance of government debt in a disinflationary environment with the Fed reducing interest rates, created additional financial wealth like magic. The situation took a decided turn for the worst, however, when California began sinking into a deep funk in late 1991. If the real estate market were allowed to crash in the golden state, the losses to the California banks and to the U.S. financial system would have been catastrophic. No longer would a bailout of individual institutions do the trick; a system-wide monetization was required. More on this later

The critical issue with respect to the massive losses suffered by the S&L was not that "money" was destroyed, but, instead, that capital was squandered. As a matter of fact, money was anything but destroyed. During the 1980's lending boom, money was actually "multiplied" aggressively, particularly by the savings and loans, as savers placed money into high-yielding S&L deposits. Back then these funds were made immediately available to eager S&L borrowers for spending on a myriad of projects, quickly disseminating "money" throughout the economy. Depositor funds enriched many a developer, S&L executive, seller of property, real estate agent, investment banker, supplier, and, all too often, swindlers. But clearly, the "money" the S&Ls borrowed from depositors and other creditors remained in the system. It just changed hands as it was "multiplied." Interestingly, and an pertinent reminder today, the fact that depositor money was pilfered and directed to uneconomic projects would be of little issue to depositors, the financial system, or the economy during the boom.

And while the day of reckoning was postponed for years, capital was often plundered or basically destroyed the day it was lent. All the same, depositors slept well at night, with little regard for the type of venture their money was financing. And while regulators and many in Washington recognized a festering problem early, it, of course, proved expedient to do nothing for almost a decade as losses mushroomed. In fact, accounting profits posted by the S&L industry masked truly massive economic losses that grew exponentially throughout the 1980s. As they inevitably do, such accounting profits reverted abruptly to big losses with enormous write-downs and insolvencies. Finally, the debacle became simply too big to ignore. Sure, deposits held their value despite the impairment of the loans backing the deposits, while insurance eliminated the risk of bank runs. But beneath the surface of the financial system, there was no way around the fact that actual capital had been squandered, leaving financial sector assets woefully insufficient to make good on depositor. The market had failed, and the "making good" was left to the government and Federal Reserve.

If one were to pinpoint a specific point of origin for today's credit bubble, it would be this exercise of "making good" - the S&L/bank bailout and Greenspan's orchestration of a massive monetization. The singular key was certainly the Fed's unprecedented manipulation in short-term interest rates. With the financial system in tatters after reckless lending and other excess from the late 1980's, as well as ballooning government deficits, the only viable option became a covert bailout - providing an environment where financial institutions could "earn" (more accurately – let's call it "managed speculation") exceptional profits to replenish lost capital. The solution was a steep yield curve where banks could borrow at the Fed's artificially low interest rates and hold higher-yielding government and other debt securities, and pocket the enormous spreads. With 10-year Treasuries yields above 8% for the first half of 1991, it was as close as it gets to free money. Between December 1990 and October 1991, short-term rates were reduced from 7% to 5%. As the enormity of the crisis came to be recognized – particularly with California real estate turning to quicksand – an understandably panicked Greenspan moved aggressively over the next nine months by reducing rates to 3%.

This incredible Federal Reserve largesse did not go unnoticed by the leveraged speculating community. Indeed, this monetization provided enormous profits to the speculators and was greatly responsible for the proliferation of hedge funds (a most critical credit bubble phenomenon!) during the early 1990s. With hedge fund assets expanding rapidly and the parallel security issuance bonanza (for the speculators to leverage, there must be securities!), the seeds were sown for Wall Street's dominance of the U.S. financial sector and economy. At the same time, the economy was faced with the stubborn "head winds" of an impaired banking system. Significant credit growth was needed to fuel the economic growth necessary to heal the banking sector. As such, Greenspan was more than happy to accommodate aggressive lending by the Wall Street inspired non-bank financial companies. Minimal short-term interest rates and an extraordinarily steep yield curves were also a godsend for the now aggressive GSEs. With Wall Street's enthusiastic blessing, these institutions began what would be a protracted period of extreme credit creation.

It was during this period that the Federal Reserve basically relinquished the monetary reins to Wall Street investment bankers and derivative desks, the leveraged speculating community generally, the GSEs, captive finance companies, sub-prime lenders, credit cards providers, and other finance companies. Of most profound importance, credit bubble dynamics took over. No longer would traditional business cycle dynamics dictate economic performance, or would natural forces work to temper excess. But, instead, the economy would be at the whim of ballooning leverage within a financial sector that strived only to grow more dominant while perpetuating the boom. And, the greater the leverage was allowed to grow, the more powerful the financial sector, and the more problematic it became to rein in excess. No longer would market interest-rates be determined by the interplay between the supply of savings and borrowing demands. Instead, interest rates would be determined by Federal Reserve manipulations and the degree of credit creation by the overzealous financial sector. Moreover, no longer would the Federal Reserve have the option of raising rates aggressively to temper demand, punish excessive speculation, or nip economic distortions and imbalances in the bud. After all, the risk of a serious accident within the financial system was too great. The Fed was then, and remains today, held hostage to the leveraged financial sector.

With this in mind, I would like to expand on a quote from Gottfried Haberler's excellent book, Prosperity and Depression:

"The supply of investible funds is sometimes very elastic, so that a higher demand can be satisfied at slightly higher interest rates. At other times it is inelastic, so that a rise in demand is calculated to lead to a rise in interest rates rather than to evoke a greater supply."

Although brief, this brilliant insight comes about as close as anything we have read in helping to explain the destabilizing forces behind what has come to be dangerously misinterpreted as a "New Economy." Here, again, it is critical to focus on the powerful role assumed by the leveraged players. With the creation of additional financial sector liabilities (leveraging) determining the demand for securities (the degree of financial system liquidity), the "supply of investible funds" became extraordinarily "elastic." Actually, we would argue that the degree of "elasticity" during this cycle has been unprecedented, and that this peculiarity is most responsible for the extreme degree and protracted nature of the current U.S. boom. As long as the financial environment was maintained conducive for leveraged positions, virtually unlimited demand for borrowings could be accommodated with little, if any, impact on interest rates. This has created unlimited mortgage credit to fuel a historic real estate bubble; unlimited funds for consumer credit card purchases, auto loans, home equity, and other borrowings; unlimited funds for margin debt and derivative leverage in the stock market; unlimited funds for corporate stock repurchases and M&A activity; unlimited funds for endless movie cinemas, casinos, hotels, office buildings, and sports venues; and unlimited funds for unprecedented expenditures throughout the technology area, particularly for funding the massive Internet/telecommunications "arms race." In short, out of control credit excess to fuel an unsound boom perceived as a wondrous "New Paradigm."

The role played by the unfathomable growth in both interest derivatives and credit insurance can also not be overstated. On the one hand, interest rate, and credit derivatives have provided the banks, GSEs, other leveraged players, and the marketplace generally, with what is essentially the guise of "insurance" necessary to justify clearly reckless lending, speculation, and leveraging. On the other hand, derivatives gave the speculators powerful instruments for leveraging. Meanwhile, the proliferation of mortgage-backs, asset-backs, junk bonds, structured notes, and other sophisticated securities was invaluable fodder for the leveraged players. On the financing side, money market funds, "repos," asset-backed commercial paper, funding corps, and other sophisticated vehicles subverted the traditional inhibitors of credit, bank capital and reserve requirements. With the Fed's apparent blessing, Wall Street created the mechanisms of financial alchemy - transforming risky loans into money and highly rated securities – forever…

So it has been a confluence of factors creating this historic credit bubble: a growing supply of high-yielding securities; derivative "insurance"; virtually unfettered credit creation capabilities (infinite multiplier effect!); and the Fed pegging short-term interest-rates. Just as important, Greenspan's repeated assurances to Wall Street that there would be no surprises – that it was safe to speculate and leverage, and that he stood ready to inject liquidity at an instant and reduce rates with the approach of any storm clouds. A dangerous environment was created that was exceedingly accommodative to the leveraged financial sector. And as long as the environment remained relatively stable, the hyper-aggressive financial sector was very willing and able to create an endless supply of "investible funds" to meet virtually unlimited borrowing demands - with little impact on interest rates, nor other natural "checks and balances." This, critically, is the anatomy of the greatest credit bubble in history.

While appearing almost an economic miracle – the stuff of "New Eras" - these dynamics actually create a highly unstable system. Any development that impairs the credit market environment holds the potential to "pierce the bubble" of enormous financial sector leverage and initiate collapse. This was certainly the case when the Fed moved to reduce the extreme accommodation in 1994, and it has remained the case through repeated periods of financial stress whereby the Fed was forced to cater (reliquefy) again and again to the leveraged speculating community. 1998 was certainly the greatest example of this, but we would argue that more subtle financial crises during last autumn and early this spring are consistent with an environment requiring permanent accommodation.

It is certainly our view that credit bubble dynamics today command both the financial markets and the economy. The credit market rallies not because of reduced demands for borrowings from the real economy, but because of the expectation that the Fed will maintain an environment conducive to additional leveraging. A financial sector built on speculation is hypersensitive to greater levels of speculating! Further, trillions of interest rate derivatives add to interest rate and credit market distortions as well as volatility, especially as perceptions change as to prospective Federal Reserve policy. Again, this has little to do with borrowing demands or the economy, and has nothing to do with savings. Instead a hopelessly dysfunctional system provides only more credit and lower interest rates, throwing additional gas on a fire of overconsumption, real estate inflation, and stock market speculation. In 1997 and 1998, the Fed was forced to accommodate great domestic credit and speculative excess as bubbles collapsed abroad. This year, it is the collapse of the Internet bubble and danger of a general technology collapse that ensures the Fed will be kept at bay. Yet, with each collapsing bubble the Fed only accommodates greater credit excess that fuels the next more dangerous boom and bust cycle. Certainly, the stock market has an intense propensity toward speculative excess; if not in tech stocks, then it will be financials or another sector. But, there will be blatant speculation – you can count on it.

Today, we also continue to see all the ingredients for a final wild crescendo in what is already a historic, as well as reckless, consumer and mortgage credit boom. We actually can't believe the Fed does not even utter a tepid protest. Wall Street is geared up for this boom, the economic backdrop is quite supportive, and the Fed is apparently willing to accommodate. In so many respects, we are witnessing the destruction of capital similar but on an immensely grander scale than the S&L fiasco. Today, instead of S&Ls directing deposits to uneconomic ventures, the entire capital markets infrastructure is perpetuating truly massive credit excess and misallocation of resources. And while the government was eventually successful in "monetizing" away S&L and bank losses, the inevitable capital market crisis will be a much much different animal – one the Fed will be unprepared to handle. In particular, hundreds of billions (trillions?) of dollars of capital having been squandered, but this fact has not yet been recognized by the holders of technology securities and tech-related debt. How this plays out will be most interesting to follow. Ironically, the great 1990's monetization and the recurring Fed-orchestrated liquefications over the past decade have created the dangerous misperception that lending booms and misallocation of resources are virtually inconsequential and easily rectified by the Federal Reserve. This is certain to prove a devastating misconception. The bulls and the media can talk all they want about a soft land, but such is certainly not the nature of credit bubbles.

We will conclude with a quote from a recent article titled "GE's Hidden Flaw" by John Plender of the Financial Times. We think it is important on two counts. One, it is certainly our view that GE, more than any company, epitomizes the U.S. credit bubble. Second, such an article would not have been written in the past. Indeed, it appears many are beginning to dig a bit deeper - taking a more critical examination of the so-called "New Economy." What they are finding, more than anything else, is massive leverage. It is certainly our view that GE's balance sheet is a microcosm of a highly overleveraged and vulnerable U.S. financial sector.

"Central bankers traditionally argue that finance is importantly different from other business because of its systemic implications. At GE, this boils down to the statistic that $129 billion of GE Capital's $200bn borrowings are short term, consisting partly of commercial paper unsupported by bank lines. This could make the group vulnerable to funding shocks. Since it is the biggest non-bank financial group in the US, that could in turn pose a systemic threat. At the end of last year, its balance sheet contained $330bn of tangible assets. Of this total, $168bn consisted of loans and receivables, including investment financing in such industries as aircraft, rail and automobiles. A further $80bn consisted of investment in corporate, government and mortgage-backed debt, and equity holdings. It would take only a 3 per cent fall in the value of tangible assets, or a 5.9% fall in the value of receivables, to wipe out its tangible capital base of $9.9bn." Financial Times July 31, 2000