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A Liquidity-creating Juggernaut

A Liquidity-creating Juggernaut
March 05, 2005
by Doug Noland





There is, especially following comments last week from chairman Greenspan, considerable attention directed to the happenings of GSE balance sheets. Fannie's Retained Portfolio actually contracted by $13.7 billion during January, 18% annualized. Freddie's Retained Portfolio declined $6.0 billion, or 11% annualized. There has been less mention of the growth of their guarantee business. Fannie's Outstanding MBS (not retained on its balance sheet) expanded $13.3 billion during January (12% annualized), the largest increase in 11 months. Freddie's was even stronger at $15.9 billion (22% annualized), the strongest growth in a year. Combined Outstanding MBS expanded $29.1 billion in one month (16% annualized) to $2.28 Trillion, the strongest growth since January 2004. Furthermore, combined non-retained MBS was up $92.8 billion, or 10% annualized, over the past five months.

Throughout the market, agency and non-agency MBS issuance remains quite strong, while home equity and other asset-backed securitizations are running above last year's record pace. "Structured finance" is on course for a historic year, right along with bank Credit.

At this stage of the Credit Bubble, GSE mortgage-backed guarantees and the booming ABS marketplace are more critical to the sustainability of Credit expansion than the expansion of GSE balance sheets. There is more than ample financial asset expansion from the booming banking, REIT, hedge fund, and Wall Street sectors.

I would like to refresh readers' memories with respect to Mr. Greenspan's recent comments on the GSEs and market distortions.

"...What concerns me is not what Fannie and Freddie have been doing in the securitization area, which they've been exceptionally effective - as indeed their competitors as well -- have created a very important element within the total financial system. And so let me just stipulate that that's important, and that has got to be maintained and essentially to expand, if at all possible... they have, granted by the marketplace, a significant subsidy which enables them to sell debentures significantly -- at a significantly lower interest rate than their competition."

I am, of course, quite sympathetic to Mr. Greenspan's (tardy) appreciation for market distortions throughout the agency debt market. I will, however, part company with respect to his wholesome view of the securitization marketplace. Inarguably, the market's perception of implicit government backing of GSE securitizations has and continues to play a momentous role in fostering insatiable marketplace demand. This has had a profound impact on both Credit Availability and the pricing of mortgage finance. I would argue as well that the entire arena of "structured finance" rests on the capacity for transforming pools risky loans - especially real estate borrowings - into perceived safe and liquid securities. This incomparable championing of The Moneyness of Credit has nurtured history's greatest marketplace distortions, and Mr. Greenspan has no intention whatsoever of addressing this issue.

It has become a crowd-pleasing exercise to trumpet the economy's hitherto resiliency to a litany of hurdles and setbacks. Flawed analysis has borne dogged complacency. And one cannot too often repeat that recognizing the commanding role played by contemporary finance and Credit system exuberance is critical to sound economic analysis. Yes, the structure of the economy has been significantly altered by intense Monetary Processes. But this is much more a case of a strange service sector/finance/asset inflation economy, and certainly not some wonderful New Economy or New Paradigm. What is new is the economy's dependency to rampant Credit growth and abundant liquidity.

It is tempting, in the current revisit with boom-time euphoria, to extrapolate the past decade's extraordinary U.S. economic growth and asset price gains far into the future. As bullish thinking goes, with a weaker dollar buttressing U.S. competitiveness and the global economy demonstrating the strongest underpinnings in decades, economic growth (and stock prices!) can now really get humming. In this precarious period of rational over-exuberance (things do, indeed, look enticing to the "naked" analysis), it is more important than ever to have and apply a sound analytical framework.

First of all, 10-year Treasury yields have been in a steady (albeit squiggly) 20-year downward trajectory from 1985's 11.5% to the recent 4% or so. Yields are about half of where they were 10 years ago, while benchmark 30-year mortgage rates are down from 8.6%. Credit Availability - fostered by the evolution and historic expansion of both the securitization marketplace and speculative finance - has never been as robust for households, corporations, governments, the emerging markets, or speculators. This gives pause to students of financial and economic history.

It is also important to recognize that for more than a decade the global economy faced disinflationary headwinds emanating from the aftermath of the Japanese Bubble and the downfall of the Soviet Union and Eastern block economies. There were, as well, the recurring global financial dislocations (Mexico, SE Asia, Russia, Argentina, Latin America, etc.) that severely impaired domestic Credit systems and fanned general disinflationary pressures. The U.S. economy was the great beneficiary of abundant supplies of cheap manufactured goods, commodities, and, most importantly, crude oil. This unusual backdrop provided the U.S. Credit system a blank checkbook to inflate at will and at a whim, with little risk of heightened traditional price pressures.

For the U.S. financial markets, well, it became virtual nirvana; they were only game in town; they relished a global monopoly on speculative finance. The American Credit system created liquidity in gross excess, only for ballooning Current Account Deficits to be recycled right back into U.S. securities markets. With unlimited access to finance, the GSEs ignited one of history's spectacular Credit inflations. Concurrently, the mushrooming global leveraged speculating community pledged full faith and Credit in the power and guardianship of Alan Greenspan. It was a most deleterious combination of Credit excess, liquidity recycling and central bank accommodation. Why would speculators have played any other market?

When the technology/telecom Bubble burst, the Fed had the great advantage of strong inflationary biases throughout mortgage finance, structured finance, and leveraged speculation. Somewhat later (2002), when the U.S. corporate bond market was on the threshold of dislocation, the Fed dug deeper in the realm of marketplace subversion, reducing rates and offering unparalleled assurances of central bank support and limitless marketplace liquidity. It is with the Mortgage Finance Bubble, the Bubble of Leveraged Speculation, booming structured finance and extraordinary market insurance that one can isolate the source of U.S. economic "resiliency."

Underwriting market subversion is not without great cost. Unrelenting Credit inflation has spawned myriad Bubbles and distortions, while severely devaluing our currency. Still, this type of inflationary Bubble has scores of powerful friends and but a few (ineffectual) detractors. As we continue to witness, the danger is that, left to its own devices, this strain of inflation has a proclivity to strengthen and broaden (while expanding its fanatical patrons).

Only a determined Federal Reserve could have extinguished the California housing Bubble before it succumbed to dangerous blow-off extremes. Only a determined Fed could have thrown some cold water on the kindling hedge fund fire before it raged uncontrollably. Only determined central bankers could have suppressed the mushrooming pool of global leveraged finance before it commanded so many markets and economies. Instead, the Greenspan Fed was determined to sustain both artificially low U.S. rates and excess marketplace liquidity, while pandering to the leveraged players and other speculators. The costs of the Fed's mistaken determination continue to expand exponentially.

The current market environment could not be more challenging and fascinating. Yesterday afternoon's data had the NY Fed's foreign official "custody" holdings up $36 billion in two weeks. This suggests recent large central bank dollar support operations and significant underlying dollar vulnerability, consequent to another alarmingly brief dollar "rally." Foreign central banks surely recognize that an abrupt dollar drop at this point could precipitate a full-fledged currency crisis. Such a dilemma does not go unrecognized by the bevy of "macro" speculators. So when the dollar reversed lower immediately following the jobs report, there was a mad dash to buy bonds and sell more dollars. Not only do these bond purchases "front run" the central banks, it also catches the bond shorts and derivative players exposed. Bond market speculative dynamics, having sustained artificially low yields and excess liquidity for sometime, resurfaced again today.

For those extrapolating quiescent financial and economic conditions far into the future, I would like to raise a few issues. First, the massive pool of global speculative finance - of which the Fed nurtured and used as a key "reflating" mechanism - has today vastly different interests than those of our central bankers. Before, when the Fed wished to force market rates lower and stimulate, leveraged speculators were happy to oblige all the way to the bank. This symbiotic relationship created the semblance of Federal Reserve control. But the environment is now altogether different. The need today is for lower bond prices, greater risk premiums, less Credit Availability and reduced marketplace liquidity. Outside of risking financial crisis, the Fed has limited control of over the environment. Speculative finance is running the show and is increasingly willing to play chicken with the diffident Fed.

In the past, the Fed enjoyed monopoly power over the speculators, inciting them to purchase/leverage dollar securities almost on demand. Now, the massive pool of global speculative finance has its sights on myriad markets and asset classes. Over the past decade, the Fed and U.S. economy benefited handsomely from Credit inflation's propensity to finance speculative buying of bonds, equities, and real estate prices. These days, Credit excess increasingly stokes global oil, energy, and commodity prices. For some time, the U.S. enjoyed an extraordinary liquidity advantage over the rest of the global economy. Today, in The Global Credit Bubble and Wildcat Finance World, we must bid for energy, commodities and things against a bevy of liquefied competitors.

I would argue that the past decade's seemingly placid U.S. inflationary environment was an aberration borne of the disinflationary/asset inflation-centric/outperforming U.S. currency and market world. Only asset inflation remains from the previous favorable backdrop. Acute energy inflation (and looming shortages) and dollar fragility ensure that the era of seemingly riskless liquidity excesses has ended. And, importantly, the Fed some time ago relinquished its control over the liquidity spigot. This returns us to the securitization market, speculative finance and the issue of fragile "resiliency."

Whether the Fed recognized it clearly at the time or not, in those peculiar days back in autumn 2002 - with talk of printing presses, helicopter money, and non-conventional measures - they implicitly promised to bankroll "structured finance" and endemic speculation. The securitization and derivative markets have never looked back. And as much as it believes the GSEs are too big to fail, the marketplace is absolutely certain that structured finance is much, much too big. At the same time, the emboldened speculating community plays confidently knowing the timid Fed will not risk wresting back power. These forces have created momentous marketplace distortions that have manifested in fervent global asset inflation. Here at home, there is virtually unlimited capacity to transform risky loans into enticing securities and no bounds whatsoever on liquidity creation. What we are dealing with here is a Liquidity-creating Juggernaut.

I look at the market environment with great concern. The dollar liquidity-creating mechanism (most notably bank Credit, structured finance, and speculative leveraging) has dislocated. Excess dollar liquidity is dangerously inflating U.S. asset markets, while at the same time inundating global markets. Foreign central bank dollar purchases only exacerbate marketplace and liquidity distortions. Never have global boom/bust dynamics been as synchronized, from the California housing Bubble, to U.S. bonds and equities, to global markets and economies.

The U.S. bond market is right in the thick of liquidity-induced distortions. First of all, the inflationary backdrop is conducive to much higher market rates. I would argue that inflation expectations are being distorted by today's artificially low yields ("Inflation must not be a problem or else bond prices wouldn't be this high."). This creates the potential for an abrupt change in marketplace perceptions to manifest into a self-reinforcing spike in yields. Second, I believe that the "structured finance"/speculator Liquidity-creating Juggernaut will continue to be impervious to Federal Reserve baby-steps. It is my view that we are witnessing blow-off dynamics in the Mortgage Finance Bubble, the Structured Finance Bubble, and the Bubble of Leveraged Speculation. If this is the case, it will require the Fed to take short-term rates significantly higher to temper Bubbling Credit and liquidity excess. The defining contrast between 2004 and 1994 was the differing perceptions as to how far the Fed might be forced raise rates. Fears that short-term rates might be forced back to the levels of the late-eighties tightening cycle (fed funds were at 9% in late 1989) precipitated the self-reinforcing 1994 bond rout. Last year's fearlessness that fed funds would stay below 2.5 to 3.0% kept bond yields exceptionally low, while emboldening "animal spirits."

One of the problems with today's inspirited animal spirits is that it only exacerbates already malignant liquidity excesses and distortions. It is a central tenet of Credit Bubble analysis that inflating asset markets create their own liquidity, and the greater the speculative component the more excessive the liquidity creation. And as I examine the financial landscape this evening, I see every indication that the mortgage finance and global securities Bubbles are in a dangerous state of self-reinforcing liquidity excess. There is the intermediate issue of myriad liquidity-induced booms eventually succumbing to faltering liquidity and busts. That asset markets across the globe are concurrently in liquidity Bubbles suggests that massive ongoing liquidity will be required to sustain the global boom. This may be possible in the short-term, but at the same time raises a few key issues: First, how high can the Global Liquidity and Speculation Bubble inflate oil and commodity prices? Second, how long can global markets and policymakers thwart a dollar and global currency crisis? Third, how much longer will the effects of rampant liquidity and speculative dynamics overwhelm deteriorating U.S. bond market fundamentals?


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