Love to read your thoughts on this subject.
This is 2/3s down the column.
http://www.prudentbear.com/creditbubblebulletin.asp
Credit Bubble Bulletin, by Doug Noland
More Trials and Tribulations of Wall Street Finance
October 14, 2005
I do not argue that Wall Street Finance is necessarily inherently corrupt. Instead, I propose that a highly energized, market-based Credit system offering enormous and easily attained financial rewards openly invites abuse and corruption. What’s more, the combination of Federal Reserve easy “money” policies and overly abundant marketplace liquidity virtually guarantees a gold rush mentality of wealth-seeking endeavors – legal, legitimate and otherwise (Why did Willie Sutton rob banks?).
This week’s news of fraud and deception at futures powerhouse Refco should come as no major surprise. After all, the Wall Street Finance infrastructure that had coddled and financed the likes of Enron and Worldcom is these days more powerful and commanding than ever. Sure, there were some hefty fines to pay – but their relevance was readily diminished by a few years of historic windfall profits courtesy of the Fed’s ultra-easy monetary accommodation. Those pushing the (risk or statutory) envelope were emboldened and windfall fortunes only more handily procured.
I contend that the defining feature of Wall Street Finance is the propagation of excess and self-reinforcing risk (excessive speculation, leveraging, asset inflation/Bubbles, unsound lending, and malfeasance). The past few years have witnessed a veritable (blow-off) explosion of derivative trading and securitizations, areas particularly ripe for abuse and fraud. Nonetheless, my view is in stark contrast to chairman Greenspan’s and the consensus view that contemporary finance provides an unparalleled capacity to recognize and manage risk. For now, Mr. Greenspan’s sanguine view receives ongoing support from the potent elixir of abundant marketplace liquidity and rising asset prices. There are indications, however, that the environment is in the process of changing. As Warren Buffett has commented, “You don’t know who’s swimming naked until the tide goes out.”
With hedge fund returns lagging, recent revelations of improprieties (Bayou Group and Wood River) are likely the proverbial tip of the iceberg (there are, after all, 8,000 funds!). And to what extent market fluctuations (currencies, interest-rates, energy, oil, equities…) played a role in this week’s collapse at Refco, only time will tell. For now, we should expect the wrecking ball of destabilizing volatility across the spectrum of securities markets to continue to chip away at marketplace confidence and liquidity. In textbook fashion, the strength of U.S. equity markets has narrowed over time, and we see of late that the few favored groups have a proclivity for abrupt and major downturns. Clearly, the market environment is becoming increasingly challenging for the leveraged speculating community. There will be ongoing pressure to rein in risk, counterbalanced by the necessity of posting positive returns.
While the end-of-week focus was on Refco and inflation data, Delphi’s bankruptcy was a decisive blow to the tottering auto sector. Auto and auto-related bonds were hit hard, while GM and Ford Credit default swap prices surged to levels not seen since last spring’s marketplace tumult. Yet - and a curious departure from that period’s market response - Treasury yields this week rose sharply instead of their typical precipitous decline at the first inkling of heightened systemic stress. It is very tempting to view this as a major marketplace development.
Confidence that the Fed would cut rates in the event of a bout of marketplace angst has for sometime underpinned not only the U.S. bond market but the stock and “risk” markets as well. A player speculating in the higher risk sectors (say, auto bonds, Credit default swaps, junk, emerging markets, homebuilding stocks, energy, etc.) could at least partially hedge market exposure with (leveraged?) holdings of Treasuries. And while the various risk markets have tended to become more highly correlated over time, faith has held strong that bond prices would spike concurrently with any turbulence that might encompass the “risk” markets. I would furthermore propose that the predictability of bond market rallies in response to tumult in the “risk” markets has played a major role in stabilizing leveraged speculator performance. Diversification among various asset classes (large bond exposure?) has been a fundamental feature of relatively stable positive hedge fund returns and, hence, a crucial element fostering systemic leveraging. A less accommodative and predictable Treasury market would mark an important development with respect to speculator returns and, importantly, market and liquidity dynamics.
Returning to our ongoing question: Why can’t booms last forever? Well, we can continue to focus on Financial Sphere inflation and the resulting strong inflationary bias that that has engulfed the global oil and energy sector. This development has now significantly altered the likely possibilities of Fed policy actions. The probability of a scenario of much higher rates has increased significantly, while the likelihood that the Fed would be quick to ease policy has largely diminished. And while market rates are adjusting to this new reality, I believe that market players have not yet adjusted risk portfolios to this much less hospitable backdrop. Keep in mind that up until recently the market perceived that the Fed was in the “eighth inning” and that cuts would like commence in earnest early next year.
There is a prominent dichotomy with respect to Wall Street Finance: unprecedented Credit and speculative excesses have fomented asset Bubbles, economic booms, myriad distortions and untold corruption, right along with an historic speculative Bubble in Credit insurance/protection. This is a huge systemic issue that I expect will become more of a factor in the unfolding environment. In the first place, I don’t believe Credit is an insurable risk. Credit losses are not random, independent or quantifiable events, such as auto accidents, house fires, health issues or death. Credit, by its nature, is very cyclical and non-random.
The problem lies in the reality that the Credit insurance “business” will always appear extraordinarily profitable during the boom cycle (today in mortgages), with losses coming out of the woodwork on the downside (today in airlines and auto parts). Importantly, cheap and abundant Credit insurance incites greater lending, debt issuance and speculative excesses, fomenting problematic aged financial and economic Bubbles. Protracted Bubbles, then, guarantee commensurate down-cycles that prove devastating to the inflated Credit insurance marketplace. It’s the nature of the beast.
Fed “reflationary policies” incited aggressive risk-taking behavior throughout the markets (including speculating in GM, Ford, Delphi and other auto-supplier Credit default swaps); Dallas Fed president Robert McTeer led the cheer for consumers to all “hold hands and buy SUVs;” and booming ABS and mortgage finance ensured sufficient liquidity to create a global energy shock our system is today ill-structured to handle. The inflationary backdrop (including energy, healthcare, and pension liabilities) has thus far largely destroyed the old-line U.S. airline and auto-parts industries. And while the prognosis for General Motors and other industrials is not encouraging, the changing environment has me peering further out into the future.
The rampant inflation in asset markets (homes and securities, in particular) has set the stage for Credit “insurance” disaster – including Credit default swaps, GSE guarantees, mortgage insurance, bond insurance, financial risk arbitrage and myriad federal guarantees. Perhaps even more than leveraging, this Credit Insurance Bubble is the System’s Achilles heel. Inflated home prices, reckless lending and corruption are today sowing the seeds for enormous Credit losses throughout ABS, MBS and mortgage arena. But that is jumping ahead… a bit.
In some respects, the market environment has returned to where I thought it was earlier in the year. I believed that “risk markets” had reached a critical juncture in the early spring. Market rates were moving higher, stocks were in retreat and then near debacle struck in auto Credit default swaps. I expected the leveraged players would be forced to shed risk, ushering in the end of the Credit boom cycle. Well, I was wrong. I today believe I was wrong because of the liquidity-creating power of a final unanticipated (for me, at least) bond market rally and declining mortgage rates. What transpired was a classic final melee, replete with negligent mortgage lending, wild Wall Street excesses, a Credit default swap boom, an emerging market boom, and a Global Liquidity Glut sufficient for $70 crude. Those having hedged against higher rates were forced to unwind and dreams of a 3% 10-year yield filled giddy traders’ imaginations. For good reason, events have unnerved the Fed, and I suspect it will be some time before they are again so eager to pander to an imperious Wall Street.
If I am correct, pieces are falling into place for the unavoidable adjustment to highly leveraged and speculative U.S. asset markets. I would expect stress in auto-related risk markets to be contagious. Higher market yields from this point are also problematic. The highly leveraged MBS marketplace is vulnerable to rising rates, wider Credit spreads and self-reinforcing hedging-related selling. The entire financial sector is vulnerable to the unfolding environment, and this reality should begin to manifest in widening sector Credit spreads. Further negative Refco revelations would likely push this process forward. Because of the complex nature of the expansive speculative Bubble, we are forced to analyze subtleties in various markets for indications of heightened risk aversion, de-leveraging and waning liquidity.
One would generally expect such speculative dynamics to ebb and flow depending on the prevailing sentiment of greed or fear. Yet this week Refco did remind us how prone fragile underpinnings are to sudden collapse. And, let there be no doubt, the shallow underpinnings of Wall Street Finance are - from here on out - highly susceptible to any slowdown in Credit expansion, any serious bout of risk aversion, or any meaningful move by the speculator community to de-leverage.
Platinum this week traded to a 25-year high
Nor have REFCO's situation or Bennett's (et al.?) actions to do with credit, certainly little more than incidentally. When a super-sharp chap like Lee gets led down the garden path, it's almost a given that ''due diligence'' on a subsequent IPO of that same company will be inadequate. And so it proved to be.
Bennett moved free balances around like a hen in a high wind, always meeting capital requirements (just), and effectively making one dollar do 5 or 10 dollars' work. You and I call this process 'kiting checks'; Wall Street have looked the other way at this stuff for decades...until the perps screw up and a good hard audit seals their doom.
Other than these somewhat off-topic references, the observations about a credit bubble and a sanguine Fed seem to me to be spot on.