Doug Noland's Credit Bubble Bulletin: The road to ruin


By Doug Noland
Friday, November 2, 2007

The gentlemen at Pimco are, once again, the leading cheerleaders for another round of easier "money." Calling for the Fed to cut rates to 3.5%, Bill Gross commented Wednesday on Bloomberg television: "The nominal [third quarter] GDP number was 4.7%. Any time you get a nominal GDP growth less than 5% the economy is basically struggling. The U.S. needs at least 5% nominal growth in order to pay its bills on a longer term basis."

I will, once again, take the other side of their analysis. First of all, 4.7% traditional nominal GDP growth would have easily in the past "paid its bills." It doesn't get it done today -- even with 4.7% unemployment -- specifically because of a long period of gross monetary excess. For some time now, the U.S. economy has been hopelessly finance-driven, and the greater and more protracted the Credit excesses the greater the "transformation" of the economic structure. And it is the underlying real economy that today cannot "pay its bills" and is therefore hooked on ever increasing Credit inflation. This should by now be recognized as the Road to Ruin. Contemporary finance and its operators should be held accountable.

The majority of contemporary "services" economic "output" is intangible in nature. The system creates various types of new financial claims (credit), and this new purchasing power spins today’s economic wheels. It seemingly works wonders during the boom, but the end result is an endless mountain of financial claims backed by insufficient real economic wealth-creating capacity. Nominal GDP would "pay it bills" today only in the context of monetizing additional debt -- or inflating the quantity of credit to inflate "purchasing power" to inflate incomes and earnings -- all in order to service previous borrowing excesses.

Admittedly, the Fed has opportunely administered several bouts of "reflation." We have, however, reached the point where another round will be self-defeating. To throw out some numbers, from the Fed's Z.1 "flow of funds" report we know that total credit market borrowings (non-financial and financial) expanded at a $3.75 trillion annualized rate during the first half. To put the immense scope of recent credit inflation into perspective, credit market borrowings expanded on average $1.233 trillion annually during the nineties. Total borrowings accelerated to $1.694 trillion in 2000, $2.013 trillion in 2001, $2.365 trillion in 2002, $2.767 trillion in 2003, $3.085 trillion in 2003, $3.380 trillion in 2003, and $3.825 trillion last year. It is this degree of credit creation -- and the associated risk intermediation -- that is today untenable and unsustainable at any interest rate.

Before I dive into the U.S. credit system fiasco, I was struck by a story by Jamil Anderlini from today's Financial Times:

"The murder of a man who jumped a petrol queue in China's central Henan province on Wednesday is the stuff of nightmares for the authoritarian Chinese government. Faced with worsening fuel shortages across the country Beijing raised petrol, diesel and jet fuel prices at the pump by almost 10% yesterday, in an effort to boost domestic supplies and exorcise the spectre of social unrest. The policy reversal came as shortages spread to the capital, which is usually immune from the country's periodic supply crunches. But the government is unwilling to allow prices to rise too much because of a morbid fear of spiralling inflation, which has a history of toppling governments in China and is currently running at a 10-year high, above 6%. ... Soaring global crude oil prices ... pose a serious dilemma for Beijing, which last raised its tightly controlled fuel prices in May 2006. China is the second-largest crude oil consumer after the US and although it was a net exporter as recently as 1993 it now relies on imports for nearly 5% of its crude supply. The current shortages, particularly of diesel, result from a combination of high global oil prices and strict government controls, causing huge losses for Chinese refiners that must pay more for oil but cannot raise prices at the pump."

I pose the following question for contemplation: How much would the Chinese government, with their $1.4 trillion stockpile of chiefly dollar reserves, be willing these days to pay for the necessary energy resources to sustain their economic boom and stem social unrest?

The legacy of years of runaway U.S. credit excess includes many trillions of dollar liquidity balances circulating around the globe. Chinese reserves, for example, have inflated almost seven-fold in just five years. On the back of unprecedented global credit and liquidity excess, energy, food, precious metals, and other commodities now attract intense demand and virtually unlimited purchasing power. Our economy -- our financially stretched consumers and vulnerable businesses -- will now have no option other than to bid against highly liquefied competitors for a lengthening list of resources. Failure to recognize that this situation is a major inflationary problem is disregarding reality. The same can be said for suggesting that we can continue on this current course -- with massive current account deficits and rampant speculative financial outflows to the world fueling myriad dangerous bubbles and maladjustment on an unprecedented global scale.

Today's backdrop is unique. There are literally trillions of dollars of liquidity slushing around the world keen to hold "things" of value. Liquidity sources include the massive central bank reserve holdings as well as funds at the disposal of the sovereign wealth funds. Importantly, the more apparent becomes U.S. financial fragility, the keener they are to stockpile real "things." There is as well a global leveraged speculating community, in control of trillions of liquid purchasing power. The speculators are also keen to acquire (non-dollar) "things" as opposed to our securities. Indeed, it should be noted that this is the Federal Reserve's first attempt at reflation where U.S. securities are not the speculators' or foreign central banks’ asset class of choice.

Not only is the pool of potential global buying power unparalleled in scope. It is fervidly attracted to tangible assets -- as opposed to U.S. securities -- and is highly speculative in character. At the same time, an unwieldy global boom is stoking unprecedented demand in China, India, Asia generally, and the other "emerging" markets, including Russia and Brazil. Throw in various weather related issues and energy production constraints and the prospect for some very serious bottlenecks and shortages has developed.

Granted, these dynamics have been evolving for some time now. What has changed is the speed and breadth of financial crisis enveloping the U.S. financial system. When I read of mounting energy and food shortages and witness the unfolding run on the U.S. financial sector, as an analyst I must contemplate the likelihood we have entered a uniquely unstable monetary environment at home and abroad. In short, the backdrop exists where incredible dollar liquidity flows could be released (from myriad sources) upon key things (notably energy, food, metals, and commodities) already in severe supply and demand imbalance. Again, how much are the Chinese willing to pay for energy? The Russians for food? The Indians for commodities in general? How much will investors be willing to pay for precious metals as a store of value? How aggressively will the speculators "front-run" all of them? Can the Fed afford to continue fueling this bonfire?

I have so far this evening purposely avoided the unfolding U.S. financial crisis, a historic fiasco that took a decided turn-for-the-worst this week. I'll admit that I am rather amazed that key financial stocks -- including the financial guarantors, "money-center banks," and Wall Street firms -- were hammered yet the market maintained its composure. NASDAQ was actually up on the week, as major technology indexes added to their robust year-to-date gains. I'll assume there is a confluence of great complacency and gamesmanship, with operators determined to play aggressively through year-end (bonuses and payouts).

I wouldn't bet on the stock market holding 2007 gains for another eight weeks. The credit meltdown is now moving too fast and furious. Importantly, confidence is faltering for the entire credit insurance industry, including the mortgage insurers and the financial guarantors. This is a devastating blow for the securitization marketplace, already reeling from pricing, liquidity, and trust issues. The credit system has lurched to the edge of meltdown, while the economy hasn't even as yet succumbed to recession. It's absolutely scary. Last week I wrote that subprime and the SIVs were "peanuts" in comparison to the collateralized debt obligation market. Well, the CDO marketplace is chump change compared to credit default swaps and other over-the-counter (OTC) credit derivatives that, by the way, have never been tested in a credit or economic downturn.

The scale of the credit "insurance" problem is astounding. According to the Bank of International Settlements, the OTC market for credit default swaps (CDS) jumped from $4.7 trillion at the end of 2004 to $22.6 trillion to end 2006. From the International Swaps and Derivatives Association we know that the total notional volume of credit derivatives jumped about 30% during the first half to $45.5 trillion. And from the comptroller of the currency, total U.S. commercial bank credit derivative positions ballooned from $492 billion to begin 2003 to $11.8 trillion as of this past June. It today goes without saying that this explosion of credit insurance occurred concurrently with the expansion of the riskiest mortgage (and other) lending imaginable. It's got "counterparty fiasco" written all over it.

The stocks of Ambac and MBIA collapsed this week. I can only surmise that part of the selling pressure emanated from players caught on the wrong side of rapidly widening credit default swap prices. Since these companies have limited amounts of bonds trading in the markets -- in debt markets generally suffering acute illiquidity -- those needing to hedge rising default risk in this industry had little alternative than to aggressively short the stocks. And the faster the stocks declined, the wider the CDS spreads and the more "dynamic" hedge-related selling required. This dynamic could play out throughout the financial sector and beyond. The "dynamic hedging" (shorting securities to offset increasing risk on derivatives written) of credit risk today poses a very serious systemic issue.

The general inability to hedge escalating default and market risk has become and will remain a major systemic problem. Liquidity has disappeared, and there now exists an untenable overhang of risky securities and derivatives to be liquidated and/or hedged. Most playing in the credit derivatives market lack the wherewithal to deliver on their obligations in the (now likely) event of a systemic credit bust. The vast majority were "writing flood insurance during a drought, happy to book annual premiums while expecting to purchase reinsurance/hedge if and when heavy rains ever developed." Well, it all happened at a pace so much faster than anyone ever contemplated. So abruptly, the flood is now poised to wreak bloody havoc the scope of which was unimaginable -- and there's no functioning reinsurance market.

Unlike this summer, this week saw the credit crisis engulf the epicenter of the U.S. credit system. Not surprisingly, the Fed rate cut only seemed to exacerbate market tension, with oil, gold and commodities spiking and the dollar faltering. Those arguing that the Fed needs to cut rates aggressively to avoid recession are disregarding the much higher stakes involved. There is today no alternative to a wrenching recession. The economy is terribly maladjusted, while the financial sector is at this point incapable of intermediating the massive amount of ongoing credit necessary to keep this bubble economy inflated. Wall Street "structured finance" is today faltering badly, now leaving the highly vulnerable banking system with the task of sustaining the ill-fated boom. The least bad course for the Federal Reserve at this point would have a primary focus on supporting the dollar and global financial stability.

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