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The Great Distortion

GSE Assets
Total Money Market Fund Assets
Fannie Mae Current Coupon 30-Year
Mortgage Refinancing Applications
Asset-Backed Commercial Paper

The technology recovery took a turn for the worst this week, with the Morgan Stanley High Tech, Semiconductors, The Street.com Internet, and the NASDAQ100 all dropping about 9%. The broader market was much stronger, with the S&P400 Mid-cap index unchanged and the small cap Russell 2000 declining about 1%. The Dow declined 1%, while the S&P500 dropped about 3%. The Morgan Stanley Consumer index actually gained 1%, while the Morgan Stanley Cyclical index declined 2% and the Transports sank 3%. The Utilities jumped 6%. The Biotechs were unchanged. The S&P Bank index declined 2% and the AMEX Broker/Dealer index dropped 4%. Gold stocks had a rough week, dropping 5%.

It was a relatively quiet week in the credit market, with Treasury yields declining slightly. For the week, 2-year Treasury yields declined 2 basis points to 4.64%. Five-year yields dropped 5 basis points to 4.86% and 10-year yields declined 2 basis points to 5.14. The long-bond saw its yield drop 2 basis points to 5.50%. Mortgage-backs and agencies performed well, with yields generally declining 1 to 2 basis points. And while the dollar was in retreat today, the dollar index gained about 1% for the week.

“Every single fluctuation in general business conditions – the upswing to the peak of the wave and the decline into the trough which follows – is prompted by the attempt of the banks of issue to reduce the loan rate and thus expand the volume of circulation credit through an increase in the supply of fiduciary media (i.e. banknotes and checking accounts not fully backed by money). The fact that these efforts are resumed again and again in spite of their widely deplored consequences, causing one business cycle after another, can be attributed to the predominance of an ideology – an ideology which regards rising commodity prices and especially a low rate of interest as goals of economic policy. The theory is that even this second goal may be attained by the expansion of fiduciary media. Both crisis and depression are lamented. Yet, because the casual connection between the behavior of the banks of issue and the evils complained about is not correctly interpreted, a policy with respect to interest is advocated which, in the last analysis, must necessarily always lead to crisis and depression.” Ludwig von Mises, On The Manipulation of Money and Credit, 1978

If there were one defining feature of this protracted boom, it would be the insidious but revolutionary manipulation of money and credit. And in this regard, there are certainly no institutions more in the thick of this quagmire than the government-sponsored enterprises. Wednesday a reporter from Bloomberg News interviewed Treasury Secretary Paul O’Neill. There was an interesting exchange on Fannie Mae that I believe is worth highlighting.

Bloomberg: I wanted to ask you about an issue that is going to be before the Senate and House banking committees concerning government sponsored enterprises. I'm sure you're aware of the subsidies that Fannie Mae and Freddie Mac receive, the Treasury line of credit and so forth.

Treasury Secretary O'Neill: Do they really? I'm saying, that isn't right.

Bloomberg: It's not right?

Treasury Secretary O'Neill: They don't receive a subsidy. The market might give them a preferential rate because of the prospect of government support but they don't really receive a subsidy.

Bloomberg: Okay, we can debate that point later. There still is legislation to more closely regulate Fannie Mae, Freddie Mac and the other GSEs. What is your position on this legislation? Do you support the Baker bill?

Treasury Secretary O'Neill: I haven't looked at it in any detail. I've watched this conversation about Fannie Mae and Freddie Mac over the last couple of years. And I've also had an occasion to spend some time, in fact, earlier this week, I spent more than an hour with Frank Raines, who is an old friend of mine. One of the things about going around and going through lots of different incarnations is you get to know people who are in all of these kind of positions. I consider Frank to be a good, close personal friend. We served on a board together here in New York 10 years ago.

And he came to talk to me about his view of his institution and the questions that are being raised about how they should be structured and how they should be regulated going forward. You wouldn't be surprised to know that Frank Raines is a very credible, knowledgeable, intelligent person who is running a very large institution.

One of the things that he brought to my attention that I would have guessed wrongly about if somebody had given me an examination -- what percentage of the total mortgage market does Fannie Mae have? I don't know if you know the answer to that question. I'd be interested. Do you know what their fraction of the mortgage market is?

Bloomberg: Well, the way they measure it, it's far lower.

Treasury Secretary O'Neill: No, let me say my question again. What is their share of the U.S. mortgage market?

Bloomberg: I think they say it's around 10 percent.

Treasury Secretary O'Neill: Right. You wouldn't get that from reading most of the things that have been written. You would walk away with an impression that it must be 80 percent and what they don't have, Freddie has. Right? One of the things I'm working on very hard is to raise the level of debate in our society about things like this, so we get the real facts on the table. And I'm not saying there isn't a different way to think about this question other than the way that I posed it to you. But I really find it not helpful at all to the making of intelligent policy to use selected facts to try to achieve a purpose. Because I don't think it's in the interest of the American people.

   One of the things I'm going to work really hard at in the time that I'm in Washington, I'm going to work to get the clearest, barest-bone facts on the table for every issue of public policy, and not be an advocate for a particular sector or a particular group or a particular interest except for one which is the interest of the American people.

Bloomberg: If you think they have 10 percent of the market, does that mean you'd be comfortable with agencies becoming a new benchmark with which we price out other...

Treasury Secretary O'Neill: I don't know. That's an ongoing conversation with the Chairman. I think we need to come to some resolution point. At the moment, I'm not sure what it is. I do think, as I said, there needs to be a reference point for the markets on what's a zero risk, a coupon rate across from a maturity rate. We've got to figure out a structure that will accomplish that. It's not clear to me it's through these intermediaries. In fact, I think you could argue this is an important question and if you don't restrict yourself on an accounting notion of how to do this but think about it in economic sense, you could argue we could have, say, $2 trillion of debt outstanding to create a sufficiently liquid market across a maturity curve, and on a real economic basis, take the $2 billion and give it back to the taxpayers. And if you think about it in the sense of a big corporation, it'soften true that the net cash position of a corporation is positive. If you wash through all the outstanding debt, they could completely defease their entire debt. Why do they stay in the market?

So when they do have a need to get money, the bond market, the equity market, that they've got a presence and people know them and understand their business and their industry. In that very broadest of sense, it's not necessarily true that we have to give up the risk-free reference point because we don't have a need to have debt for spending purposes. Okay? We're kind of in the open-ended stage of doing creative thinking and trying to serve the needs.

Bloomberg: Who do you go to on Wall Street, would you go to, to look for advice? I know this morning you had a meeting with...

Treasury Secretary O'Neill: Did you see who they were? Most of these are my old friends. And most of them I talk to and have talked to for 30 years on a regular basis. I'm just amused beyond what I can tell you about the conversation that I don't know anything about Wall Street, and I don't know anything about financial markets. It's just hilarious.

Franklin Raines may have convinced Secretary O’Neill that Fannie Mae is 10% of the U.S. mortgage market and that Fannie Mae critics use “selected facts,” but it is pretty obvious that Mr. Raines is the master perpetrator of “fuzzy math.” Fannie Mae ended the year-2000 with total assets of $675 billion, as well as an additional $707 billion of Fannie Mae mortgage-backed securities (guaranteeing the “timely payment of principal and interest”) that are held in the marketplace (all supported by shareholder’s equity of less than $21 billion), for total exposure of $1.38 trillion. The most recent Federal Reserve data (9/30/2000) has total home mortgages at $5.1 trillion (total mortgages were $6.8 trillion). It is just very difficult to come up with how Fannie Mae is only 10% of the mortgage market.

And if it is the new Treasury Secretary’s goal to “get the clearest, barest-bone facts on the table,” I will volunteer some data. During the 11 quarters ended September 30, 2000 (most recent data), home mortgage borrowings surged a stunning $1.143 trillion, or 29%, to $5.114 trillion. (For comparison, during the preceding 12 quarters ended 12/31/97, home mortgage debt increased about $642 billion, or 19%). Over the 11 quarters ended 9/30/2000, the assets of the government-sponsored enterprises (largely Fannie Mae, Freddie Mac and the Federal Home Loan Bank) increased a stunning $784 billion, or 73%, to $1.883 trillion (growth during the preceding 12 quarters was $308 billion, or 39%.) Also during this period, Fannie Mae and Freddie Mac mortgage-backed securities in the marketplace (not held on GSE balance sheets) increased by nearly $210 billion to about $1.27 trillion. Combining GSE asset growth with the increase in mortgage-backed securities with explicit GSE guarantees, we see that this totals approximately 87% of total household mortgage growth since 1998. Combining GSE assets with the almost $1.3 trillion of outstanding GSE mortgage-backs brings total GSE exposure to $3.15 trillion, just shy of total home mortgage debt at the end of 1993. It is going to take some interesting creativity to downplay the fact that the GSE’s have come to absolutely dominate the U.S. mortgage market. It is also going to be difficult to ignore the financial and economic ramifications for a continuation of reckless credit excess from Fannie Mae and Freddie Mac.

We are currently in the midst of another extraordinary mortgage refinancing boom. Yesterday Freddie Mac announced that the average 30-year mortgage rate again dropped below 7%, so the deluge of refinancings will continue. Wednesday, the Mortgage Bankers Association reported that its weekly mortgage applications index jumped 19% from the previous week, with purchase applications increasing 4.5% and refinancing applications surging 31%. Applications to refinance are running almost 500% above the levels of this time last year and have almost returned to last month’s peak refinancing rate. As for January, key data was released by industry heavyweight Countrywide Credit. It makes for fascinating reading.

From Bloomberg: “The rise in the number of refinancing loans boosted the average daily volume of loan applications for the Calabasas, California-based company to $610 million in January, the highest level since September 1998, ‘the height of the last refi boom,’ said David Bigelow, a Countrywide spokesman.”

For the month, daily applications surged to “the second-highest mark in the company's history.” From the Countrywide press release: “The surge in application volume pushed our pipeline of loans in process to $12.9 billion, up 30 percent from last month and nearly 70 percent higher than a year ago. Consolidated mortgage fundings were $6.8 billion, the highest level in 19 months and more than twice the volume of January 2000. The emerging refinance boom provided much of the impetus for growth. Refinance fundings were $3.1 billion, representing 46 percent of total fundings in January. This is a 61 percent increase over last month and marks the highest level since April 1999. Purchase volume was also strong at $3.7 billion, up 47 percent from January 2000…In January, Countrywide continued to stretch its lead in on-line home lending with a company-record $2.9 billion in e-commerce fundings, or 42% of total volume.” Figuratively and otherwise, there simply could not be “easier money.”

If you think about it, it is rather incredible testament to the “efficiency” of the contemporary U.S. credit system that one institution with shareholder’s equity of about $3.2 billion can originate loans to the tune of $610 million daily. Equally amazing, compared to last January, “Total Loan Fundings” increased 105%, “Total e-Commerce Fundings” 336%, “Purchase Fundings” 47%, “Refinance Fundings” 287%, “Home Equity Fundings” 57%, and “Sub-prime Fundings” 19%. And while Countrywide sells the vast majority of its mortgage originations to Fannie Mae and Freddie Mac, it is worth noting that Countrywide has increased its total assets by 34% to $20.7 billion during the past four quarters.

With such a flood of mortgage credit, it should be no surprise that the economy is anything but “falling off a cliff.” Consumer confidence may be way down and the manufacturing sector struggling, but for most folks and the majority of the economy, it remains business as usual, for now. Yesterday, retailers followed auto dealers by generally reporting stronger than expected sales. Year over year, Wal-Mart sales increased 13.3%, Federated 14.5%, May company 10%, and Costco 10%, to highlight a few industry bellwethers with strong sales. Radio Shack enjoyed 9% same-store sales growth, with total sales increasing 13% from last year. From Merrill Lynch: “January sales were strong, with 14 of 17 (or 82%) of broadline retailers meeting or exceeding their monthly comp plan, the best performance since last February.” The Bank of Tokyo-Mitsubishi reported same stores sales averaged 4.8% above last year’s levels. Curiously, St. Louis Federal Reserve Bank President William Poole stated this afternoon that he believes the U.S. is not presently in recession nor does he expect it to fall into one any time soon.

Consumer spending is certainly not the only beneficiary of the refinancing boom. “Reliquefication” is once again working wonders for the corporate bond market. Moody’s reported “a record $68.6 billion of investment-grade corporate debt was sold in January 2001, compared with $27.1 billion in December 2000 and $29.5 billion in January 2000.” Also, last month’s “26 new high-yield bond issues were the most since the 29 of July 1999…After averaging merely $1.5 billion per month during 2000’s final quarter, offerings of speculative-grade bonds jumped up to $13.5 billion in January for the biggest monthly amount since May 1999’s $15.9 billion.” Interestingly, Moody’s also stated that “bond issuance ought to get considerable support from the refinancing of outstanding variable rate obligations. A good deal of January’s $23.7 billion shrinkage of commercial paper outstanding in the US market could be ascribed to the refinancing of variable-rate commercial paper as fixed-rate bonds.” Corporate issuance remains exceptionally strong, with Bloomberg reporting that $10.5 billion of corporate and agency debt was sold Wednesday alone.

It is clearly a current overriding goal of the Federal Reserve to stimulate consumer spending. We see this as a very poor policy goal but, for now, the consumer is cooperating. The costs of prolonging this credit bubble, however, include a perpetuation of disastrous trade deficits with the resulting accumulation of foreign liabilities, as well as the augmentation of already severe structural distortions to the U.S. financial system and economy. And while the vast majority views the federal government surplus as an unmistakable benefit and direct consequence of sound and sustainable prosperity (the New Paradigm), in reality this development is complex and anything but indicative of economic and financial well being. In fact, government surpluses are part and parcel to The Great Distortion – the waxing replacement of government debt with private sector debt. The essence of the problem is that the private sector credit bubble creates debt with profoundly heightened risk characteristics, such as California utility debt, especially at the latter stages of an inflationary boom. The above quote from von Mises is particularly pertinent today, as the focal point for this Great Distortion is one massive episode of “The Manipulation of Money and Credit.” Current policy only exacerbates this Great Distortion, and right here one can locate the fault line for inevitable acute financial fragility.

The fact of the matter is that the pay down of government debt is directly the result of the explosion of credit at the household, corporate and financial sector levels. As credit excess - particularly in mortgage finance - fuels asset inflation, increased spending, and massive capital gains, the conspicuous consequence is a surge in government (local, state and federal) tax receipts. And, importantly, over time (as is quite apparent currently) credit excess feeds more insidiously into rising incomes that also work to the benefit of the tax collector, as well as the perpetuation of the bubble. But make no mistake; this is simply replacing public sector debt with private sector debt. And, importantly, there has been an alarming (although predictable) deterioration in the quality of private debt at the same time quantities have grown exponentially. This is precisely the destructive nature of credit bubbles. And let there be no doubt, if the GSE’s would not have created upwards of $850 billion (these numbers shock me every time I type them) of new credit over the past three years, there would be no government surpluses nor the illusion that trillions of surplus dollars will be waiting to be spent for as far as the eye can see. It should come as no surprise that a new Treasury Secretary intent on large tax cuts is quick to support Franklin Raines, Fannie Mae and the GSEs. It is disappointing, however, that only hours after Secretary O’Neill’s positive comments Representative Richard Baker, chairman of the House subcommittee on Financial Services, cancelled his scheduled press conference where he was expected to discuss his aggressive legislative agenda for dealing with the GSEs.

If one steps back for a moment, it should be alarming to everyone from the Halls of Congress to the sidewalks of Main Street that $100’s of billions of government debt – backed by the “full faith and credit” of the U.S. government (with its ability to raise revenues through imposing taxes) – is being replaced by the debt of institutions such as the government-sponsored enterprises that incorporate truly reckless leverage, more than one-half trillion dollars of short-term debt, and $100’s of billions of derivatives, to purchase household mortgages backed by grossly inflated values at the peak of an historic financial and economic boom. This is much worse than ridiculous; it’s a F.I.A.S.C.O. that will prove a very prominent issue to follow going forward. Pretending that there is not a problem is certainly not the solution.

And while there is great debate in Washington and intense media attention paid nationwide to the manner in which these endless government surpluses will be deployed, how can this be seen as anything but a humorless joke? I don’t expect much from the political establishment, but you would think that someone with considerable influence would lend sound analysis to this debate. Yet, sound analysis is nonexistent. Even within an economics community that should know much better, there is an absolute disregard for the true source and unsustainable nature of the surge in government revenues: the private sector money and credit explosion. All the same, ominous signs point to an important inflection point for The Great Distortion. As goes the credit bubble, so go government budget surpluses.

One of the better illustrations of the heightened risks of private sector debt, particularly in and the context of a highly maladjusted U.S. economy and financial system, can certainly be found with the California energy debacle. As of the first day of February (according to Bloomberg), the two troubled California utilities had defaulted on more than $1.1 billion commercial paper - $380.8 million for Southern California Edison and $726 million for PG&E. These utilities have another $458 million of commercial paper maturing this month. In a separate story, Bloomberg News reported that “investors withdrew more than $1 billion from a Texas investment pool for local governments last month after they learned it held $20 million in commercial paper” from PG&E. This run accounted for just over half of fund assets, and is likely indicative of other similar episodes that were quietly major factors behind the Fed’s decision to move aggressively. Next week appears critical for the utilities as they fight in court and negotiate with the state of California in a bid to avoid bankruptcy. One thing is certain, the state of California, now flush with Great Distortion tax receipts, will be issuing billions of dollars of debt that will not look so innocuous down the road. The cancer spreads…

This week, Moody’s issued a timely special report - U.S. Money Fund Assets Reach Highs: Managers Face Challenges. The report begins, “Money market fund management companies face new challenges as they enter 2001, even in the face of asset growth that will soon see money fund assets reach the $2.0 trillion mark…” It is today difficult to comprehend that money market funds began 1995 with assets of about $630 billion. This is very much an historic financial bubble in its own right, and at the same time one cannot overstate the critical role played by the money market as the Fountainhead in feeding the Great US Credit Bubble. Unimpeded by either capital or reserve requirements, the money market is the heart and soul of a system of unfettered money and credit expansion. Indeed, money market assets are the final readily saleable product manufactured by the great Wall Street Alchemy Machine, a truly breathtaking mechanism that has for some time been working overtime to convert an explosion of risky private sector credit into assets with the appearance of a “store of value.”

We have in past commentaries highlighted the enormous growth in asset-backed commercial paper and other sophisticated structures that have become dominant features of contemporary money funds. From the Moody’s report: “The surge in money fund assets and the relatively static supply of traditional commercial paper as a percentage of total domestic commercial paper, have made ABCP (asset-backed commercial paper) a welcome addition to first tier portfolios. Issuance of ABCP has been driven by several factors, including: increased off-balance sheet securitization by financial institutions, swelling receivables across several asset classes, and growing investor demand for higher yields. While funds have increased their exposure to asset-backed transactions, this has required stepped-up resource commitments on the part of fund advisors to clearly understand deal mechanics and structural supports…”

Ironically, as the initial faltering of the U.S. bubble has corporate credit quality deteriorating rapidly, this has actually made the fruits of Wall Street Alchemy “a welcome addition to first tier portfolios.” And the fact that asset-backed commercial paper has been driven by “increased off-balance sheet securitization” and “swelling receivables across several asset classes” does not give comfort to the quality of underlying money market fund assets. We do remember clearly that when Lucent found itself in trouble it moved immediately to establish an off-balance sheet entity (“funding corporation”) for the issuance of asset-backed commercial paper. There is also the issue of serious accounting irregularities at major technology companies such as Xerox and Lucent. We certainly fear that these examples could prove the “tip of the iceberg” with the distinct possibility of widespread questionable accounting and receivable problems throughout the high-tech industry. There is also the issue of the heavy reliance on interest rate and credit derivatives, as well as liquidity guarantees and lines of credit, in these sophisticated structures. Moreover, with ABCP basically coming into existence over the past six years, there is the fact that these vehicles remain untested to any environment outside of historic economic boom. Combined this list of issues with what we expect to be massive credit problems in the unfolding technology/telecommunications bust, and one should see great potential for some nasty surprises going forward in the asset-backed commercial paper and money market sectors.

We already sense cracks in the foundation of confidence that has to this point allowed unfettered credit excess through the money market fund mechanism. Confidence is a very precious and often fleeting commodity. When confidence falters for the notion of “risk-free” money market funds, it will mark an important change for the U.S. financial and economic landscape for years to come.

The Moody’s research report also mentioned “…the migration of money market fund assets into FDIC accounts. The magnitude of this migration has already been illustrated by news reports of $50 billion in money market fund assets that were migrated from Merrill Lynch’s money funds to FDIC insured accounts at a Utah bank owned by Merrill Lynch.” Interesting…what do they know that most don’t? As the environment becomes increasingly perilous, will there be a wholesale movement by Wall Street to get FDIC insurance for the mountains of money fund deposits they have created?

Over the coming weeks and months it is certainly not a stretch to anticipate a major challenge in the works for Wall Street to maintain the perception of money market funds as “risk free.” The quality of fund assets is increasingly suspect, and likely deteriorating quickly. And the Great Distortion forges full steam ahead, converting the majority of money market assets from what in the past were Treasury-Bills and sound short-term corporate borrowings, to GSE and Wall Street liabilities, “repos,” and commercial paper from financial players the likes of “Tulip Funding Corp” or any of the hundreds of other sophisticated vehicles and entities created during this long boom. Increasingly, it has become a case of trying to anticipate the timing for the inevitable accident. Any funding mechanism that has expanded from about $600 billion to almost $2 trillion in just over six years poses a great systemic risk by definition.

In closing, it is worth mentioning the recent news of a move by banks to tighten lending standards. In 1990 this was the key piece of news that assured the onset of recession. We suspect the something very similar is in play today, but we are mindful of the fact that the government-sponsored enterprises now play a profoundly greater role in systemic credit creation than they did in the early 1990’s. We also know these institutions are determined to lend aggressively for the foreseeable future, and have a very convenient mechanism to do exactly this with the current refinancing boom. I believe a major economic downturn is imminent, but it will likely commence in force only with some tempering of the current mortgage-lending boom that could furthermore usher in a period of faltering financial system liquidity. In the meantime, The Great Distortion runs on…

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