Saturday, October 18, 2008

foreigner, don't go home

summary: after years of pumping cheap money into our economy, foreigner investors may exit our market. this could translate into a long-term drain of liquidity that will make it harder to borrow, and resemble a tax on business that increases the cost of capital.

last week, the Treasury Department reported that overseas investors sold more than $13bln of corporate bonds in the month of august. it was the second negative month in a row, and the third to show a precipitous drop off. after averaging more than $40bln a month in purchases during 2006 and 2007, foreigners are suddenly fleeing the US credit market.

this is not the sort of event americans are used to seeing. we are accustomed to being the world's preferred borrower -- the highest quality credit. for years, our debt grew faster than the rest of the economy, allowing us to spend a little more than we ought, and letting companies borrow a little more than they normally could ...

two conditions allowed us to live beyond our means like this for years. the scary thing is that both of them seem to have reversed, so conditions could get a lot worse.

the first thing that made foreigners into our willing lenders was the trade deficit:

the U.S. has helped other countries develop for years by eagerly buying every barbie doll, pair of sneakers, or barrell of oil they produce. by 2004, the U.S. trade deficit had climbed to more than 5% of GDP, compared with the 1.3%. between 2003 and 2007, sucked a net total $3.3 trillion from our economy.


as the clothes, fruits and consumer electronics flooded the U.S., foreigner economies built vast stockpiles of dollars...

these dollars wound up at banks and financial institutions around the world. these same countries had policies of promoting exports, so they naturally wanted those dollars to stay as strong as possible. they didn't want to SELL THEM to buy their own currencies. so if you have a few hundred billion dollars you need to invest safely, where do you go? THE U.S. BOND MARKET.

the bond market is a place where anyone can lend money. you can chose between municipalities, companies, governments, and, of course, people.

established bond investors are very cautious by nature, so they research investments thoroughly and don't take stupid risks. but, unlike a being a loan officer at a bank, bond investors don't have to pass tests and answer to state regulators (who make banks stay conservative). bond investors don't have to know their borrower, the borrower's income or finances. all you need to buy into this market is a couple of hundred million dollars.

until about 30 years ago, only major organizations with long-term assets and cashflows sold bonds: governments, railroads, utilities, etc. but then came securitization. it started with fannie mae and freddie mac.. the GSEs ... in 1975, they issued $9bln of debt, while traditional corporates sold $27bln... GSEs were only 33% the size of corporates ... three years later, GSEs had blown past corporates.. by 1982, they sold two twice the amount ...

the GSEs purchased mortgages and assembled them into pools, which then issued bonds. this kept money flowing to the banks, promoting the general post-WWII trend in favor of homeownership. using structured finance, they transformed millions of loans into homogenous financial products. it was all for a good cause, and most importantly, it proved to be quite safe.


then came salomon brothers, which created the first private-label mortgage pool in 1983. the technology worked and soon spread to credit cards and auto loans. importantly, it passed through the S&L crisis of the late 1980s unscathed -- validating the belief that it was possible to structure a bunch of small consumer-based assets into a predictable source of cash flows... it was a new homogenized product in the market where everyone was looking for yield... salomon had invented a new widget, and it spread.

in the late 1990s, companies like worldcom, qwest, bell atlantic, time warner, comcast, etc, were building out the information superhighways, issuing hundreds of billions of dollars in the process. general motors and utilities others joined as well...

in 1998, the trade deficit started to widen sharply .. right around the same time china joined the World Trade Organization....

as investment declined and americans responded to 9/11 and the recession with furious spending as houses and cars grew bigger and retailers across the nation "went upscale" ... factor in the rising cost of oil imports, and the U.S. was consumed $700bln+ more than it produced in 2005 and 2006... a trade deficit of 5.75% of GDP both years.

as I explained above, most of those dollars were then recycled back into U.S. bonds, including corporates and asset-backed securities.

we do not know which kinds of bonds foreigners buy. the treasury department combines corporates bonds and all asset-backed securities under the same group. (the bonds related to fannie mae and freddie mac are not counted.)


in general, foreigners will buy a broad smattering of everything that's coming to market. in the late 1990s, they surely bought all the bonds from GM and worldcom... by 2002, companies didn't need the money, and most capital expenditures were finished.

but this was the same time the trade gap exploded wider, and the foreigners had more money than ever to put to work.

issuers of asset-backed securities stepped in to fill the breach. they basked in the liquidity, spoiled like children as the market gobbled up deal after deal.

investors loved ABS because they yielded a nice 10-30bp more than corporate bonds with comparable credit ratings.

bankers loved ABS because they generated underwriting fees. I am not sure, but I would believe they charged a higher commission than would have been standard for corporate bonds. (I say this because ABS were a newer market with a shorter history of competition.)

Moody's and S&P loved ABS because they generated much bigger fees. like investment banks, the credit-rating firms take a cut of issuance volume. they won't disclose their commissions, but moody's does report its revenue from structured products and corporates. combining this dealogic's data on annual debt issuance, I have calculated my own measure of their commissions... I found that that Moody's earned about 0.04% of all structured debt issued... compared with 0.02% for corporates... this was a cash cow.

credit card companies loved ABS because they allowed them to keep churning over more money and collecting fees and interest on the way.

mortgage brokers loved ABS because that's where they got their money. they grew increasingly reckless, and came to realize they could sell any kind loan to the market. they also got a percentage of issuance, like the credit rating agencies and the investment banks.

all of these groups benefitted from ABS and had a vested interest in churning more money through the system. then came a flood of foreign capital, and the mortgage-lending orgy was in full swing.


I have reached two important conclusions about this period:

1- the problems happened because the capital markets took over for the banks. loans were issued to people, not because they needed a house or were able to pay back. loans were issued because the money had to be invested.

the capital market was doing the job of the bank, but without any of its regulation or accountability. but everyone was getting rich, so it continued .

because the originators didn't hold the loan to maturity, there was no incentive make good loans.

the loans wound up on a trust, backing thousands of different bond offerings.

for credit quality, everyone essentially deferred to the moodys and S&P, which provided the necessary spectrum of ratings.

2- trade can concentrate huge amounts of money to financial assets, like mortgages. history provides many unhappy examples .... in the 1970s, where US banks channeled arab oil money to latin american governments... in the 1980s, japanese export earnings were recycled into tokyo real estate. both ended in bubbles and years of anguish.

so, imagine what would have happened if those $700bln+ had stayed in the USA in 2005-7. that money would have filtered through the economy in the form of wages and tax receipts. most of it would have been spent on normal consumption... only a small fraction of it would have wound up on the bond market (probably via some retirement fund)...

in contrast, when that money leaves the country and returns, almost half of it goes to the bond market. (in the 1985-2007 period, an average 44% of the trade deficit was invested in the "corporate bond" category.)

this was a big part of the credit bubble. by far not the only cause, but the single strongest single event that made the bubble inflate.

the economic problems originated in the capital market. unfortunately, few people of influence, whether reporters, economists or government officials, seem to appreciate this. they are trying to fix it by tinkering with overnight lending rates and emergency liquidity tools... these are all tools designed to deal with banks. no one at the Fed is talking about the sick bond market -- even though issuance has fallen off a cliff.

even if ben bernanke and hank paulson aren't paying attention, plenty of people seem to understand this. economists, investors and traders have told me that the government should be either guaranteeing or simply buying corporate bonds. one big ABS investor told me "people have no idea how large and important the asset-backed market is."

it started coming apart in august 2007 when SIVs unwound (they borrowed using short-term commercial paper and bought longer-term ABS). this dumped large amounts of ABS onto the market, which drifted about at discounted prices. this extra supply made it difficult for credit card companies and other lenders to securitize their assets. this caused a net reduction in the financial system's liquidity, which caused more problems -- each of which makes the situation worse ... the collapse of bear, lehman, AIG, etc. all of it started when the SIVs unwound in august 2007.

we're suffering from a sudden reduction of liquidity in the capital market. this has created a series of implosions. I fear it could cause a severe decline of credit in the entire economy, which could be much more devastating.

it could be like the great depression in one, big depressing way.

the common understanding now about the great depression was that the fed made things worse by raising interest rates and reducing money in the economy. they correctly observed that the fed was too worried about inflation. (it really didn't make any sense because commodity prices were plunging in the late 1920s...)

this year commentators such as paul mcculley at pimco invoked this memory to argue in favor of low interest rates.

I believe they were right in spirit, yet reach the wrong conclusion. the answer is not for the Fed to cut rates or provide easy money to banks. the answer is to fix the problem in the capital market: NO ONE IS BUYING BONDS. that is tightening the noose around our credit system. THE ENTIRE SYSTEM IS POTENTIALLY INSOLVENT if this contagion spreads.


NO ONE UNDERSTANDS HOW MUCH MONEY THIS COULD BE. at the end of june, foreign investors owned $2.86 trillion of corporate bonds -- exactly 25% of the market.

as late as 2005, life insurers were the largest holders of credit securities. but foriegn investors blew past and now exceed them by a full TRILLION DOLLARS.

and, as I pointed out at the top of this entry, these foreigners are already selling their trillions.

two things that made them buyers before now make them sellers.

1-fewer are dollars streaming in.

2-their currencies are now falling too fast, so they might sell dollars and dollar assets. after all, corporate bonds are now their top holdings, surpassing treasuries and stocks.

the scariest thing of all may be that the government plans to stimulate the economy and borrow to do it... that means trillions of dollars of brand new, safe treasuries will come to the market, at the same time foriegners are dumping their own trillions of corporate bonds...

this will be devastating for credit, and could cause companies throughout the entire economy to freeze up.

the government's inability to see how this chain of events could play out is frightening. this is why I think bernanke's Fed is actually a lot like it was back in the 1930s. it's like terminator 3... even if you think you can stop it, the catastophe is almost destined to happen. our efforts play right into it.

finally.. I had some other observations about what caused this bull market in credit...

1-years of declining interest rates. since the Fed defeated inflation in 1982, long-term rates steadily marched lower.

2-improving corporate profitability, bolstered by higher worker productivity...
in addition to technology, globalized supply chains drove productivity gains... in other words: cheaper sourcing ... especially after china joined the World Trade Organization in december 2001.

... and once you have a surge in international trade, you get:

3-globalized capital flows: as the rest of the world sold more goods and services to the US, they accumulated dollars. those dollars were recycled back into the US, creating a boomtime in U.S. financial history I call "the foreign bid for credit."

many things happened during the great foreign bid for credit:

1-US treasury supply fell as budget deficits narrowed. (this deprived foreigners of places to park dollars.)

from 1985-96, the US government borrowed an average $201bln a year.
from 1997-2001, we paid back an average $80bln a year.

in other words....
treasury bond supply declined sharply starting in 1996. at the same time, corporate america globalized supply chains, leaving more dollars in the hands of foreigners. these foreigners generally wanted the dollar to remain as strong as possible (because that's how they get paid). loath to sell their dollars, they bought dollar-denominated bonds.

but because there were so few Treasuries, they started buying US corporate debt. over time they grew accustomed to it.... by June of 1998, a new trend had emerged.

between June 1998 and may 2007 corporate bonds were the leading destination for overseas money 56% of the time, compared with 22% during the previous 20 years (1978-98) ... (there are 4 categories under which the Treasury reports foriegn purchases of U.S. long-term securities: Treasuries, Agency/GSE, Corporate bonds and Corporate Equities. "corporate bonds" include asset-backed securities linked to everything from mortgages, credit cards and auto loans.)

this buying reached a fever pitch at the height of the US credit bubble:

just to round it out, you can see US home prices rose along with the foreign capital flows, and started falling only earlier.

looking at these charts, it's clear what drove the housing bubble: a vast surge in foreign demand for "corporate bonds" .. this was the great foreign bid for credit. it was a market trend that seems to be ending... this is why I fear a potential bear market in credit .. the possible implications of such a bear market have not yet been fully grasped... everyone now assumes credit will just "get better" ... but can that happen with foreigners turning into net sellers?

I put "corporate bonds" in quotations because it comprised both normal corporate bonds, issued by telecom companies and utilities, and asset-backed securities, which are dominated by mortgage debt.

during the great foreign bid for credit, both kinds of issuers had their day...

normal companies like GM, worldcom, qwest, ford dominated until about 2001 as they built networks and funded long-term pension liabilities...

by 2002, they fell off the map as the enron-worldcom credit crunch hit...

... at the same time, all this foreign money was flowing in and tens of billions of dollars cascaded through the system each month... before long, every half-witted mortgage broker from miami to las vegas had learned how to stick out a bucket...

thanks to them.... between 1998 and sept 2007, debt of banks, financials and structured entities rose from 40% of GDP to 110% of GDP.

given that US stocks were tacitly subsidized by foreign quasi-official purchases, what does the removal of that capital do to our economy?

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