Friday, January 9, 2009

More on the Global Nature of the Credit Bubble

You always have to know from whence you come... For months, I have stressed the global nature of the recent credit bubble, and emphasized that this history will make the future more difficult than many anticipate. My basic thesis is that a massive flow of undiscriminating foreign money into the U.S. credit market was one of the causes of the credit bubble that peaked in 2005-2007. This flow of money resulted from our own consuming habits, because Americans bought more products from abroad than at any other point in the post-WWII era.

In posts like this one I have argued that as Americans import fewer goods and send less money abroad, it will reduce our access to credit because it will mean less money flowing back into our bond market. This is why I see little reason to rejoice at falling oil prices, although I do agree over the longer term it will help the U.S. economy by keeping more money at home.

An important economist at a major brokerage/primary dealer recently scoffed at this theory of mine. (I won't name him because he didn't know he might appear on this blog.) Furthermore, the U.S. credit market has looked much better in December and so far in January, with borrowing costs inching lower and issuance rising.

Many experts have been arguing this bullish case of cheap gasoline and a stronger corporate-bond market (Larry Kudlow and his "mustard seeds" of hope for instance), but I reject that because the improvement results entirely from government action: Massive rate cuts and FDIC insurance on bank debt. This new AAA-rated governent-backed paper accounts for a substantial amount of the debt being sold (right now, I don't have hard data on this now, but the trend is clear with everyone from John Deere to JPMorgan getting in on the act.) Even Sovereign Bancorp, which was in danger of going under before being acquired by a Spanish bank, recently used the government guarrantee.

This is a bit like having a heart-attack patient on life support, with a machine pumping his heart and breathing for him. Would any competent doctor take the patient's pulse and say "it's going at 70 beats a minute -- sounds good to me" ?? (Economist Jim Bianco minces no words, calling it a "medicated market.")

The government has essentially pointed its entire nuclear arsenal at the head of the credit market and said "rally or else." Just like all the money in the world can't buy love, government force cannot restore health to a market based on free will and free choice. If a thug ties a woman to his bed tells her to love him, he might get his way with her a few nights. But one day she's going to find a way to kill him and run away. Financial markets are no different. (I worry that we're going to make deal flow dependent on government support rather than enlightened self-interest. After all, that's the foundation of capitalism -- the idea two people can wind up richer, each acting out of self-interest.)

This reminds me of what Georgetown University historian Carroll Quigley wrote about the 1920s in his brilliant book Tragedy and Hope:

As soon as the war was finished, governments began to turn their attention to the problem of restoring the prewar financial system. Since the essential element in that system was believed to be the gold standard with its stable exchanges, this movement was called "stabilization." Because of their eagerness to restore the prewar financial situation, the "experts" closed their eyes to the tremendous changes which had resulted from the war. These changes were so great in production, in commerce, and in financial habits that any effort to restore the prewar conditions or even stabilize on the gold standard was impossible and inadvisable.
Instead of seeking a financial system adapted to the new economic and commercial world which had emerged from the war, the experts tried to ignore this world, and established a financial system which looked, superficially, as much like the prewar system as possible. This system, however, was not the prewar system. Neither was it adapted to the new economic conditions. When the experts began to have vague glimmerings of this last fact, they did not begin to modify their goals, but insisted on the same goals, and voiced incantations and exhortations against the existing conditions which made the attainment of their goals impossible. p.320 (Emphasis added.)

WWI dealt a fatal body blow to the UK-based international money system because all the gold wound up stockpiled in the USA rather than London. The powers that be ignored this fact and tried to force a return to the old system, causing the flow of money to stop, which resulted in the Great Depression. This is why I cannot take heart in the jubilant words of many economists and observers who are excited about the credit market's apparent improvement over the last few months. We are now in a fictitious market the same way the global economy was in the 1920s, insisting that falsehood was truth. The Fed's success at driving Libor lower means nothing. The fact they had to use their coercive power to do it speaks volumes. Don't forget T in TLGP is for "temporary." What happens in June 30 when this program allegedly ends? Hint: It won't! It will be only slightly less temporary than farm subsidies in the 1930s.

The British financed modernity using the gold standard, and few countries benefiting more than the USA. (This was evident whenever that gold was withdrawn, such as in the "Panics" of 1837, 1857 and 1907.) When that model broke, the world changed.

Similarly, the American consumer has financed the global economy for the last 10-20 years. As he started running out of money early this decade, the rest of the world helped out by lending him some of his money back. According to my calculations, 54% of our trade deficit was plowed directly back into our market for corporate bonds and private label mortgage-backed securities (those were the stupid ones).

Just as it's erroneous to conclude all's well in the credit market because bond sales have risen on the back of government force, I maintain that the absence of foreign money flowing into our economy cannot ignored. I have heard a few economists touch slightly on this issue, but I believe it is significantly under-appreciated.

The data confirms my argument about the role of foreign capital played inflating the bubble: At the peak of the credit bubble in late 2006 through early 2007, foreign inflows to the U.S. credit market represented 3-5% of GDP.. That's an annual rate of $400-500bln, comparable to the entire economy of New Jersey or Ohio. (I am only looking at foreign flows into U.S. corporates, private label mortgage bonds and asset-backed securities. Bonds issued by the Treasury, Fannie Mae and Freddie Marc are not included.)

Since then, it has plummeted to essentially zero. Wall Street economists may scoff at my point, but I am sticking to my guns. The quick removal of this money from the bond market cannot be ignored as a major technical factor causing the credit crunch. This is why I fear the benefit of Americans saving more money might be eclipsed by the inability of companies and credit-card issuers from borrowing in the capital market.

After all, if Americans put their money into banks, they are essentially lending to the government. That's because banks have extremely small positions in Treasuries now, so they are far more likely to buy safe government bonds rather than make loans to companies. (I explain this at the bottom of this posting.) Before, Americans spent money and a lot of it came right back into our economy as credit. Now we're saving money, and it leaves the productive private-sector economy. How is this good??

I just wanted to end by bolstering my argument about the role of foreign capital with a few quotes from Dear Mr. Buffett, a new book worth reading by structured-finance guru Janet Tavakoli:

On pages 80-81, she describes a mortgage-backed bond offering in late 2006. It was more than 60% backed by loans from New Century Financial, which went backrupt the following spring. "The deal seemed targeted for foreign investors," Tavakoli notes.

On page 120, she observes that securitized bonds with AAA ratings in 2007 were cut to junk within months of being issued. "This is unprecedented," she wrote, adding that the most rotten apples came from 2005-2007.

While she doesn't emphasize the link to foreign capital flows, I will. This was the time that influx of money reached its lunatic peak, exceeding $300bln on an annualized basis for nine straight quarters. In the first half of 2007 alone, the money was coming at a $700bln clip. Based on that level alone, it would be the world's 16th largest economy!

Money of that size cannot be ignored. We can keep pretending we have an old fashioned bank-based financial system, but that would mean repeating the same mistakes as the monetary authorities pretending the gold standard was still viable after WWI. Things are different now.

This is a new era, and we need a new approach.

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