Weekday Commentary from Jim Puplava
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Banks In All The Wrong Places
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Market WrapUp for the Week
Monday l Tuesday l Wednesday l Thursday l Friday
Monday's Stock Market WrapUp
Banks In All The Wrong Places
Over the course of these last two years others as well as myself have been sounding the alarm over the condition of the nation's credit system. It doesn’t matter which kind of debt we are talking about — mortgage debt, installment debt, credit card debt, corporate debt, municipal debt, or federal debt — we have become a nation of debtors. Taking on debt has its limitations. At some point you reach a limit where that debt is no longer sustainable. What we are now seeing is the unraveling of that debt at the corporate level from Enron, Global Crossing, Kmart and to WorldCom. The stock market decline has ushered in the first phase of a deflating credit bubble. Companies can no longer tap the credit markets to pay their bills. Bond defaults are up, delinquencies are rising, and many companies have been forced out of the commercial paper markets. So they now have to tap the long-term debt markets and pay higher rates of interest as credit spreads have widened. This means that their interest costs are going up. To help mitigate rising costs of borrowing long-term, many companies are using the swap markets, exchanging their long-term debt for short-term debt to help lower interest rate costs.
The problem is that interest rate swaps makes up the bulk of the derivative market. These swaps pose another risk if interest rates begin to rise later on this year. The rise in interest rates will be triggered by the dollar's decline. So in addition to the credit risks, we also have derivative risk. This poses an additional risk for many companies such as GE and others that have swapped out much of their debt in order to lower their costs of borrowing. It also raises counterparty risk for banks if many of these companies can’t honor their swap arrangements, having to pay the difference if rates begin to rise. So in addition to credit risks, we also have interest rate risks lurking in the form of these swap arrangements. Banks are the largest writers of these instruments.
Danger in Derivatives
The media attention has been on the companies that have defaulted on their loans or have filed for bankruptcy protection. To a lesser extent, the attention has been on the banks. A credit bubble has two sides to the equation: the borrower (Enron, Global Crossing, Kmart WorldCom) and the lender (J.P. Morgan Chase, Citigroup, Bank America). Banks have not only been the lender and underwriters on much of this debt, they have also been the writer of derivatives that go hand-in-hand with the expansion of credit. In fact, bank derivative growth has been growing at double-digit rates over the last decade. During the first quarter of this year the notional value of derivatives in bank portfolios increased by $946 billion. Interest rate contracts increased by $972 billion to $39.3 trillion. So in addition to the debt debacle, you also have the danger of another derivative debacle such as we had with LTCM back in 1998. Many of the top banks such as J.P. Morgan Chase, Citigroup, and Bank America are also the nation's largest writers of derivatives. These three banks have derivative portfolios totaling close to $40 trillion in notional value or roughly 87 percent of the derivative portfolio of the nation's top 354 banks. This is a high concentration in just a few players in what is a very risky business.
On top of making bad loans, the banks also have exposure as the largest underwriters in the derivative business. J.P. Morgan Chase is leveraged over 700-1 when you look at the bank's exposure to derivatives. The net equity of JPM has to back those derivatives. If you look at J.P. Morgan Chase’s derivative book, the bank looks and acts more like a hedge fund then it does a pillar of stability of the financial establishment. The credit problems are only one side of the problem. No one knows what the bank's derivative risks are other than that they have $23.4 trillion in derivatives against equity of around $40 billion.
This isn’t the only problem the bank has at the moment. J.P. Morgan Chase and Citigroup made $5 billion in cash loans using complex transactions that were disguised as energy trades. This made the loans hidden from Enron’s balance sheet. Investigators found out that J.P. Morgan and Citigroup were Enron’s main source of prepay funding. The Senate Governmental Affairs subcommittee is now looking into the extent to what these banks knew and the role they may have played in aiding Enron’s accounting deceptions. J.P. Morgan promoted prepay loans to customers in the 90’s because of their “balance sheet friendly” nature. In addition to the Senate, the Manhattan’ district attorney’s office is looking into the role J.P. Morgan Chase played in making offshore loans to companies in an effort to keep the debt off the balance sheet. Insurance companies, which issued surety bonds as guarantees that Enron would repay its offshore loans, are now suing the banks because they claim the banks kept knowledge of the company’s perilous financial condition from them.
And Still There's More
Just when you think you have had enough the WorldCom bankruptcy, brace yourself for another accounting scandal. In a late breaking story in the New York Post, it now appears that $1 billion in corporate assets from the books of bankrupt Polaroid have reappeared, most of it, free of charge, in the pockets of a Wall Street buyout fund. The scheme is an accounting maneuver that shifts assets from the books of Polaroid to a Wall Street partnership that is set to take Polaroid private in a buyout for less than $24 million. Like previous scandals, big name Wall Street law firms such Skadden, Arps, Meagher & Flom to Arthur Andersen are involved in this one. So while the shareholders are left with nothing as a result of bankruptcy, the Wall Street buyout firm along with the attorneys will get the bulk of the $1.1 mysteriously missing assets.
Even though the headlines are filled with the bankruptcy stories of big named corporations, we have just begun to scratch the surface of this unraveling credit bubble. There are more scandals to get through. Then we must deal with the condition of the banks that have made bad loans and are up to their eyeballs in derivatives. The media is focusing on the companies when they should also be directing their gaze to the condition of the nation's banking system. The credit and debt binge of the 90’s has only just begun to unwind. We still have the consumer credit bubble, which has yet to burst. If you think the corporate debt problems are bad, I have even worse news when it comes to consumers. Consumer and household debt is at a record. The good news is that consumers are still paying their bills. But that too may begin to end. Last week two U.S. credit card companies that ran into problems have eported higher default rates that showed the companies had much greater exposure to defaults than previously expected. Capital One and Metris Cos. Inc., both announced major losses for the quarter because losses in the sub-prime credit card market were much greater than expected. Both companies have been aggressively lending to the low-income market segment during the boom of the 90’s. Now with more and more companies laying off workers and the economy weak, many in this credit group have lost their jobs. Now those loans are starting to be a burden. In the words of one analyst, ”During the wild party of economic growth and the stock market, excesses on the credit side came to the fore and as the bubble unwinds, we’ll see who’s standing naked on the shore.”
The point to realize here is that while the Fed, Wall Street and Washington are urging the consumer to keep on spending and borrowing, another bubble in the housing market and in consumer loans has yet to begin to deflate. When that does, the bursting of the consumer credit bubble will be added to the bursting of the corporate and stock market bubbles to push us over to a deflationary depression in the general economy and in the financial markets. We will have deflation in all things associated with credit and paper and will have inflation in hard assets or things. Even on a day like today, when stock prices headed lower, the CRB Index of 17 commodities rose. That has been the story all year -- the fall of paper and the rise of “things.”
The Drooping Markets - Will Supports Hold?
The Dow has broken through another support level, falling below 8,000 and through 7,800. The next support levels are at around 7,600; 7,300; and then 6,600. For the S&P 500, support is between 780-800 and 725-675, and then around 600. The bad news is that as the markets fall through key support levels, on the way down they become resistance levels on the way up. So any rally that may now occur will have to push through many more resistance levels on the way up. This means that any rally that will now occur, and I still believe we will get one will be shorter and shallower. So the best bet is going to be on the short side for the duration of this bear market. The greatest corrective action on the downside will occur in the Dow and the S&P 500, which have held up well during the early phases of this bear market. The large point drops that we have been getting on a day-to-day basis is all part of this capitulation process.
Until the Dow began to break down, we have seen the absence of fear. Now those fear levels are starting to rise again, but we are not quite there yet. Only this morning one of my clients, a recent widow brought me two magazine covers and newsletter brochures that are still promising investors high returns in this market. “The top 10 funds to own now” was the cover story on one magazine while a famous financial TV personality's newsletter promised investors that good times are just around the corner. When these magazines tell you the safest places to put your money or how to short the market, we will be close to hitting that intermediate-term low with a short-term rally that follows.
Pointing Fingers
This weekend I headed to the bookstores looking for magazines covers to be full of bear market stories. Outside of Businessweek, they weren’t. In their place were stories blaming the Bush Administration for today’s economic and financial market problems. The press still doesn’t get it. The problem should be laid at the door of the Fed whose policies of running the printing press at full throttle created this bubble that is now bursting in different phases. The blame should be also be placed on Congress and the Clinton Administration, which blocked all of the reform proposals of the last SEC Chairman Arthur Levitt. Even today, lobbying efforts are being made on behalf of corporations to stop all attempts at expensing stock options. As a result, the expensing of stock options was dropped from the Senate reform bill. We’re still playing politics; while the financial markets burn.
Meanwhile the Dow suffered from its third straight session of consecutive triple digit losses. The Dow is now at the lowest levels since the financial crisis of October 1998 with LTCM. The S&P 500 and the Nasdaq are at levels not seen since May of 1997. In effect, the Nasdaq and the S&P 500 have now given back nearly five years of gains. This means that most investors are now in the red. Each day brings new scandals, bankruptcies and investigations, which add more fire to the markets. As pointed out in these columns, no Congress or an American President can solve most of these problems. The market is in the process of cleansing all of the abuses, overvaluations, the corruption and the greed of the 1990’s. Until the system is cleansed of all of these excesses, no meaningful recovery in the markets or the economy will take place. The more the government tries to prevent this process from taking place, the longer it will last. You only have to look at Japan to see an example of monetary and fiscal policy run amok. It has now been over 12 years since the Japanese markets peaked. As of today, the Nikkei stood at 10,189 -- 74% below its peak of over 39,000 back in 1989.
Volume levels were heavy today at 2.14 billion on the NYSE and 2.35 billion on the Nasdaq. These are the kind of numbers you want to see on big down days in points. This is what has been lacking in getting us closer to a bottom.. Market breath was brutal with losers trouncing winners by 26-6 on the NYSE and by 24-11 on the Nasdaq. Other signs of getting closer to a bottom is investor sentiment sank to an all-time low in July dropping from 72 in June to 46. Only 32 percent of investors surveyed are now optimistic over the prospects for the financial markets. Mutual fund redemptions are starting to build. They were $15.6 billion as of last week ending on Thursday and $18.4 billion the week before. That was the biggest outflow of money out of mutual funds since the tragedies of last September. We’re getting close but we are not there yet. A few bear pictures on magazines, or comparisons to the 1987 or 1929 crash are still needed to grace the cover of major magazines.
Treasury Market
Bonds ended up the beneficiary of today’s market turmoil after a brief sell of this morning. The 10-year note gained 15/32nds to yield 4.455 percent while the 30-year bond rose 18/32 to yield 5.285 percent.
Overseas Markets
Asian exporter stocks fell, led by Sony Corp. and Samsung Electronics Co., on concern a plunge in U.S. markets will dent consumer confidence and spending in Asia's biggest trading partner. Japan's Nikkei 225 stock average shed 0.1 percent to 10,189.01
European stocks tumbled, led by insurance and oil shares. The Dow Jones Stoxx 50 Index posted its biggest two-day loss since the European benchmark started in February 1998. The Stoxx 50 fell 5.1 percent to 2500.39 after dropping 5.6 percent Friday.
Treasury Markets
Government bonds gained considerable ground for a second session as safe-haven seekers bid up the fixed-income sector. The 10-year Treasury note put on 20/32 to yield 4.53% while the 30-year government bond piled on 1 6/32 to yield 5.33%.
© Copyright Jim Puplava, July 22, 2002