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Coming Apart at the Seams

10_Year Dollar Swap Spread

Wow, that was another extraordinary week. For the week, despite Tuesday's 347 point gain, the Dow ended the week down 2%. The S&P500 dropped 3% and the Utilities sank 4%. The "defensive" Morgan Stanley Consumer index declined only 1%. Cyclical stocks came under selling pressure, with the Morgan Stanley Cyclical index dipping 4% and the Transports declining 2%. The broader market performed poorly, with the small cap Russell 2000 dropping 4% and the S&P400 Mid-Cap index declining 5%. The technology sector continues to be punished, with the NASDAQ100 and Morgan Stanley High Tech indices declining 5%, while the Semiconductors sank 8%. The Street.com Internet index dropped 10% and the NASDAQ Telecommunications index sank 4%. The Biotechs declined 3%. The financial stocks came under heavy selling pressure, with the Securities Broker/Dealer and Bank indices getting hit for 8%. Acute financial fragility was conspicuous. Although bullion gained $2.20, the HUI Gold index dropped 5%.

Notably, heightened financial fragility did not this week lead generally to lower interest rates. For the week, the key 10-year Treasury note saw its yield rise one basis point to 3.67%, while the long-bond yield increased three basis points to 4.71%. The 5-year Treasury yield was unchanged at 2.68%, while the 2-year yield declined two basis points to 1.78%. The implied yield on the December Eurodollars rose one to 1.60%. Mortgage-backs again lagged, with benchmark yields rising 2 basis points, while yields on agency futures declined two basis points after last week's poor performance. The spread on Fannie Mae 5 3/8% 2011 note widened one to 68, while the benchmark 10-year dollar swap spread widened 2.5 to 66. Spreads generally widened throughout the financial sector, in some cases significantly. With today's strong advance, the dollar index ended the week about unchanged.

Commercial bank assets expanded $21.6 billion last week. Security holdings increased $16.5 billion, with Treasury (including agencies) holdings up $6.5 billion and "other" assets rising $10.0 billion. Broad money supply (M3) increased $2.6 billion last week, with demand deposits rising $8.1 billion, savings deposits $1.2 billion, and large time deposits $2.8 billion. Retail money fund assets gained $4.5 billion, while institutional money fund assets dropped $13.4 billion (after gaining $21.6 billion the previous week). Repurchase agreements gained $3.3 billion while Eurodollar deposits declined $2.5 billion. Year-to-date, M3 has added about $295 billion, or 5% annualized, less than half of last year's expansion. For the year, institutional money fund assets have expanded only $26 billion, or about 3% annualized. For comparison, institutional money fund assets surged $426 billion, or 55% in last year's GSE-led monetary "free-for-all." This year, with sharply reduced GSE balance sheet growth rates (and an even more dramatic reduction of GSE short-term borrowings), money market funds are not a key intermediary for financial sector liability expansion ("money" creation). Instead, traditional bank lending has (by necessity?) returned to significance. Year-to-date, Savings deposits have increased $354 billion, or 21% annualized, to surpass $1 trillion. Total bank assets have thus far jumped $426 billion, or 8% annualized, after expanding $253 billion, or 4%, for all of 2001. And in a development worth noting, commercial paper outstanding (seasonally adjusted) declined $9.1 billion last week, with three-week declines of $53.7 billion. Over this period financial CP borrowings have dropped $40.4 billion.

September's 43,000 lost jobs is the first decline in payrolls since April and the most since February (and follows August's 107,000 jobs created). Another 35,000 factory jobs disappeared last month, while employment at financial service (mortgage brokers?) and real estate firms increased 28,000. Service-producing jobs actually declined 5,000, after increasing 132,000 last month. It is the first decline in service sector jobs since February. Last week's bankruptcy filings of 31,194 were up 16% year-over-year, consistent with the disconcerting trend that has developed over the past couple of months. The Mortgage Bankers Association weekly refi index jumped 12% from last week to an off-the-charts record 6,671. This is up from April's low of 1,213 and the pre-2002 record high of 5535 set last November. The purchase index was about unchanged at 359, up 16% from the year ago level. It is worth noting that over the past three weeks the purchase index has remained at the lower end of its 4-month range, in spite of a major decline in mortgage rates. September domestic auto sales were reported at a dismal 12.9 million units, just below last year's WTC-impacted sales level. This was the weakest September sales since 1997, and 14% below sales from September 2000.

Continuing the year's trend, third quarter fixed-income performance was a story of the "haves" and the "have nots." Treasuries returned 7.23% for the quarter (11.06% y-t-d), followed by 6.43% (11.22%) for muni bonds, 5.06% (9.36%) for agencies, and 4.69% (6.77%) for investment grade corporates. Mortgages, at 2.96% (7.75%), were notable for their weakened relative performance. The "have nots" included "convertibles" with a third-quarter loss of 6.50% (down 12.29% y-t-d), emerging markets lost 2.90% (down 4.67%), and high yield lost 2.96% (down 8.16%). Enjoying their safe haven status, municipalities have issued a record $250.2 of debt so far this year.

From Tuesday's American Banker (Alissa Schmelkin): "The three biggest syndicated loan arrangers - J.P. Morgan Chase & Co., Bank of America Corp., and Citigroup Inc. - held their ground during the third quarter, but Lehman Brothers continued to advance in the rankings. The U.S. syndicated lending market raised proceeds of $225.3 billion in the third quarter, a 21.1% decline from the same quarter a year earlier…"

October 3 - Financial Times : "Credit Suisse, the Swiss financial services group, yesterday issued its fourth profit warming in a year after pumping another SFr2bn of its own capital into Winterthur, its loss-making insurance operations. The group, which has only reported a profit in one of the previous four quarters, said its third-quarter results would be affected by a 'significant net loss' in its insurance business and a 'modest overall negative effect' from the group's other businesses."

Credit Suisse, Switzerland's second largest bank, today saw its stock sink 16% to a nine-year low (down 69% y-t-d). The stock lost about 28% of its value this past week alone. The company is suffering heavy losses in its investment portfolio (and at CS FirstBoston), and is being forced to make large capital infusions to its insurance unit. German banks remain under heavy selling pressure. DeutschBank sank 13% this week, increasing its 2002 decline to 47%. Commerzbank sank 18% this week and is now down 66% for the year. The stock of German financial conglomerate Allianz sank 13% this week, increasing 2002 losses to a staggering 70%. Moody's today downgraded the ratings of Allianz banking subsidiary Dresdner, and stating that Allianz rating "may still be cut." Dresdner's financial strength rating was cut from B minus to C, with more downgrades possible. BNP Paribas, France's largest lender, saw its share price sink 20% this week (y-t-d down 42%). ABN Amro, the largest Dutch bank, dropped about 8% this week (down 37% y-t-d). The shares of Swiss's UBS dropped 13% this week (y-t-d down 33%). Abbey National, the U.K.'s second largest mortgage lender, saw its stock price sink 10% this week on concerns that it will be forced to take a major write-down for losses in its insurance unit.

The European insurance meltdown runs unabated, with the Bloomberg European index sinking 4.5% today. With the list of companies hoping to raise equity lengthening by the week, index year-to-date losses have grown to 53%. Zurich Financial saw its share price drop another 4% this week, with 2002 losses now at 65%. Swiss Re saw its stock sink almost 10% this week, with y-t-d losses at 53%. The Dutch insurer Aegon also announced a rights offering, with y-t-d losses of 66%. France's Axa also dropped about 10% this week, with 2002 losses at 57%. UK's Royal & Sun sank 10%, with y-t-d losses at 76%. French reinsurer Scor saw its price drop 28% this week, with 2002 losses at 79%.

Sweden's Skandia (Scandinavia's largest insurer) saw its stock sink 20% this week. The company has been an aggressive seller of insurance products linked to stock market returns. The insurer, which receives about one-third of its revenues from the U.S., announced that it would inject $255 million into its faltering American Skandia unit. The company's stock has collapsed 82% this year, and Moody's is now warning that its debt may be downgraded.

Today - "Radian Group Inc. today announced that it would significantly expand the capacity of its financial guaranty direct insurance business, in response to the downgrade of Radian Reinsurance Inc. by rating agency Standard & Poor's. The company will maintain the capacity of and focus on its reinsurance business. Radian said that while it was disappointed with the downgrade, from AAA to AA, the company would combine and optimize risk capacity and capital structure across its financial guaranty businesses to significantly increase its capacity to write new, high-return business. 'Radian Reinsurance's new AA rating will free significant capital for us to redeploy to Radian Asset Assurance, beginning immediately,' said Frank P. Filipps, Radian's chairman and chief executive officer." (One of the more interesting positive spins on a ratings downgrade, and hopefully not indicative of their true view of risk-taking in this increasingly inhospitable environment for risk players.)

Today - "Standard & Poor's Ratings Services said today that it revised its counterparty credit rating on Conseco Inc. to 'D' (default) from 'SD' (selective default) following the resignation of Gary Wendt, Conseco's CEO.  Standard & Poor's also said that it lowered its senior debt and preferred stock ratings on Conseco to 'D' from double-'C'. The single-'B'-plus counterparty credit and financial strength ratings on Conseco's insurance subsidiaries remain on Credit Watch with negative implications, where they were placed on Aug. 9, 2002. 'The 'D' rating reflects Standard & Poor's view that Mr. Wendt's resignation is a prelude to an ultimate bankruptcy filing …therefore, Standard & Poor's expects that Conseco's future payments on principal and interest will be adversely affected.'"

October 3 - American Banker: "Allmerica Financial Corp is the latest company to face financial problems related to guaranteed death benefits on variable annuity products - and industry observers expect more to surface… Allmerica said it is considering raising external capital, using reinsurance, or possibly selling some lines of business. It also said it expects to reduce sales of variable annuities and life insurance… Reinsurance may be hard to come by for guaranteed death benefits - industry watchers say Cigna was one of the few companies that provided it before it pulled out - but Allmerica may be able to find a buyer for the troubled business lines."

Allmerica saw its stock price sink 30% this week, increasing its 2002 loss to 78%. The company ended the second quarter with assets of $29.2 billion and shareholder's equity of $2.7 billion. Today, variable annuity juggernaut Cigna saw its stock price sink 10%, with the stock down 33% y-t-d. Cigna ended the second quarter with assets of $89 billion and shareholders' equity of $5.2 billion.

Credit concerns hit the banking sector with a vengeance this week. The Bank of New York announced a $185 million charge for soured cable and telecom loans. More alarming to the marketplace, Comerica's $328 pre-tax charge related to additions to loan loss reserves and the write-down of its faltering investment in asset manager Munder. Importantly, this brought market attention to worsening Credit conditions throughout the Midwest, with the company specifically mentioning the auto, retail, and manufacturing sectors. Comerica has been a major "middle market" lender and syndicated loan acquirer. Today we saw earnings warnings from Northern Trust and Hibernia. Hibernia (along with others) is being stung by the massive mortgage refi boom, as it writes down the value of its mortgage servicing assets. Northern Trust will miss earnings estimates as its adds to its loan loss provision. Salt Lake City-based Zions Bancorp yesterday announced that it would take a $50 million charge largely against losses in its venture capital unit. This evening JPMorgan Chase announced that it would be cutting 4,000 investment banking jobs, or about 20%. The reality that things will not be turning around anytime soon is beginning to sink in. While market followers would contend that these are the types of announcements that would indicate market bottoms, it is our view that they are instead likely indicative of expanding Credit problems and an increasingly impaired Credit mechanism - harbingers of imminent recession.

October 3 - "The Bond Market Association warned today new legislation aimed at halting predatory lending would ultimately wind up making it harder for people with imperfect credit to get a mortgage. New York Governor George Pataki signed legislation today which would hold buyers of mortgage pools in the secondary bond markets liable for any so-called predatory loans contained in the package. As a result, The Bond Market Association warned secondary market participants will be far more cautious about purchasing loans. 'Bond market participants could easily decide it's not worth the risk,' said Michael Williams, vice president for legislative affairs at the Association. 'Our members strongly support responsible efforts to curb predatory lending but this law will hurt the subprime mortgage market by discouraging the purchase and securitization of legitimate subprime mortgages thereby reducing the availability and increasing the cost of credit for borrowers.'"

While there is little transparency, the tape is telling us all is not well throughout the asset-backed securities market and structured finance generally. Key consumer lenders/securitizers such a Capital One, Household International, MBNA, and American Express were under heavy selling pressure. Fringe "new age" subprime mortgage lender/securitizer New Century Financial was hammered. The Credit insurers were hit hard, as were the stocks of the Wall Street firms. If faltering financial markets and accelerating Credit losses were not enough, today's announcement that a California jury awarded a former smoker a $28 billion judgment against Philip Morris must not be too comforting to Wall Street firms that will be facing juries for years to come.

Yet, in the most extraordinary environment, the mortgage finance Bubble runs absolutely rampant. There is apparently several months' worth of refis backlogged to be processed. From today's American Banker: "Wells Fargo Home Mortgage Wednesday introduced a product that combines a mortgage with a home equity credit line. The Home Asset Management Account enables homeowners to use the equity in their homes without filling out a second application, waiting for a second approval, or applying a second fee. Instead, a borrower can take cash out of the home by writing a check, using an electronic access card, phoning Wells, or visiting one of its branches. Available credit would increase quarterly, as long as consumers pay down their mortgages, and annually, should their home appreciate."

Yesterday from Bloomberg TV: "At this point, how do you see this refinancing rally and this tremendous move - It seems like everywhere I turn around people are either refinancing or getting new mortgages here. When is this kind of going to kind of fizzle out here if it's going to fizzle out?"

Fannie Mae's Franklin Raines responds: "Well, this is a great day for the American consumer, and I'm glad for them. Even though it may make the life of people on Wall Street a little more complicated, it's a great thing for the American consumer and the American economy because its allowing people to reduce the cost of home ownership - it's made housing more affordable - and people have taken money out of their homes and they've used it to fix up their homes and to fix up their balance sheet, as well as spend that has helped the economy. But it can't go on forever. Rates can't keep dropping forever. But we're going to see a complete reduction of vast quantities of the six trillion dollars of mortgage debt outstanding during this period. And that will be good for consumers. This last quarter will be astounding. We will be originating mortgages in our industry at a rate in excess of three trillion dollars on an annualized basis. This is unheard of in the mortgage industry. But, again, it'll be wonderful for consumers."

"Wonderful" is a poor choice of words to describe the affect unprecedented mortgage borrowings will have on the American household sector. We can only hope that the damage caused by this year's speculative "blow-off" within the Great mortgage finance Bubble is not the unmitigated disaster for the consumer sector that the 1999 telecom debt "blow-off" has proved to be for the corporate sector. It is a central facet of Credit Bubble analysis (as we learned from the brilliant Mises) that the resulting damage to surface during the bust will be proportional to the nature and degree of excess during the boom. As we have witnessed, risk grows exponentially through the life of the boom. Not only does the quality of individual Credits deteriorate over time, but the quantity of new (weak) Credits grows at a compounding rate. Moreover, the structural impact to the real economy becomes more extreme at the late stages of the speculative Credit cycle (distortions, both financial and economic, accumulate on top of distortions). The telecom Credit Bubble provides an historic example of these dynamics, as extreme lending excess created an industry devoid of economic profits and lacking the necessary cash-flow to service mushroomed debt levels. The industry has been irreparably decimated, while lenders are facing years of impairment.

If the telecom debt Bubble was ridiculous during the 1999 "blow-off," this year's excesses throughout mortgage finance are absolutely outrageous. It is simply difficult to fathom a system creating new mortgages at a $3 trillion annualized pace. It is certainly beyond credulity to believe these Credits are being created well. And while the system is (hopefully) not in the process of lending to frauds of the scope of Worldcom, only time will tell to what extent mortgage brokers, bankers, and appraisers are today pushing the envelop (we'll bet they are pushing mighty forcefully!). Only time will also tell to what extent troubled borrowers are extracting every penny of equity in a desperate attempt to stay afloat. But there is absolutely no doubt that tens of billions of problematic Credit card debt is being transformed into mortgage balances. There is no doubt that equity extraction has financed unprecedented consumption.

There is also no doubt that enterprising mortgage brokers/lenders throughout the country are relishing in their ability to capitalize their hefty fees ("points") within their heady borrowers mortgage balances. And while borrowers in today's ultra-low rate environment are more concerned with their monthly payment and not the size of their outstanding loan, it is the size of the loan (and its deteriorating quality) that will come back and bite the lender when the tide of defaults arrives. How many solid mortgages are today being converted to vulnerable Credits through the extraction of currently inflated equity and the addition of "points"? We certainly would not be comfortable acquiring today's new mortgages (or insuring them!), especially at these yields, and we get more than an inkling that others may be looking more skeptically as well. But Bubbles do not respond well at all to faltering Credit availability, yet such a troublesome circumstance is inevitable. As Mr. Raines stated, "…it can't go on forever." And when it all ends, the system will be left with one towering mountain of weak mortgage Credits.

A friend was commenting on what a "broken record" I have become, so I will try to shorten this week's "analysis." In the current very fluid financial and economic environment, it is nonetheless again worth pondering systemic effects. The economic community is fixated on the benefits a consumer receives from refinancing at a lower interest rate and extracting equity to support spending. But what are the systemic consequences if the entire country does it, and are they permanent or transitory, stabilizing or destabilizing? Well, we have witnessed how the mortgage finance boom has both supported boom-time over-consumption and augmented financial sector liquidity. But the economic consensus is again seriously erring in its analysis. They are once more extrapolating absolutely unsustainable excesses from the "terminal stage" of the Bubble. Moreover, the consensus does not appreciate the transitory nature of the monetary affects of this Bubble or the heightened financial fragility that will be the legacy of this ill-advised mortgage finance free-for-all. The telecom sector provided a seemingly wonderful mechanism for monetary stimulation (with few visible problematic inflationary manifestations); that is until its increasingly voracious appetite for new Credits could not be satisfied and the Bubble began to implode.

The bottom line is that the economy is today faltering in the midst of record low interest rates and unprecedented Credit availability throughout the consumer sector. This could not be more ominous for a consumer/consumption-based economy, yet most are determined to ignore the dire implications. Credit conditions could not be looser throughout the expansive mortgage-finance super-industry, yet housing markets are weakening in many key markets. Spending is barely sustaining the massive retail/consumption sector that has ballooned over the protracted boom. Auto finance could not be more freely available, yet auto sales are weakening and U.S. manufactures (and their behemoth finance subsidiaries) are already in fights for their lives. And except for the fringes of subprime, Credit card finance could today not be more readily available. Yet spending is stagnating. At the same time, the financial system remains generally flush with liquidity and the dollar is holding its own, as mortgage and auto Credits are being created in record volumes. Yet the U.S. and global financial systems are truly Coming Apart At The Seems. There is a real dilemma today that large quantities of increasingly weak U.S. Credits are barely sustaining an unruly consumption beast with a voracious and insatiable appetite. But feeding this uncontrollable animal was always a serious mistake. He's grown big and mean. The situation is only today finally being recognized as unacceptably burdensome. Financial fragility has become too extreme.

With the financial system under intense stress, it is time to prepare for what will be a deep and protracted recession. And, importantly, those (wishful) thinking that it made good sense to stimulate the mortgage finance borrowing binge until the capital spending boom returned, should now accept the reality that it's not going to happen (and that such a "strategy" was a momentous mistake!). The Credit system is too impaired, chastened investors and speculators too risk-averse, and the Bubble economy too maladjusted. And, the old hero, "structured finance," is indeed today's villain. Paraphrasing the great Schumpeter, people have been determined to dig in their heels and hold their ground; but the ground is about to give way.

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