For the first quarter of 2002 the Prudent Bear Fund No-Load shares returned 9.41% while the S&P 500 gained 0.27% and the NASDAQ lost 5.30%. The fund returned -14.74% for the six months ended March 31, 2002 while the S&P 500 gained 10.99% and the NASDAQ gained 23.33%. Consistent with our investment philosophy, the fund held more short equity positions than long positions throughout the period. While this allocation adversely affected performance during the sharp bear market rally in the fourth quarter of last year, the fund benefited when the bear market resumed early in 2002. As a result, the fund continued to protect investors during the initial stage of the bursting of the U.S. stock market bubble. For example, for the two years ending March 31, 2002, the fund produced an average annual return of 24.38% compared to an annual return of -11.42% for the S&P 500 and -36.37% for the NASDAQ. The Prudent Safe Harbor Fund return was 8.10% for six months ending March 31, 2002 as the U.S. dollar finally retreated and gold prices rose. We continue to believe that global stock prices will decline dramatically, gold stocks will rise and the U.S. dollar will decline. Our two funds are positioned to benefit handsomely as these trends are realized.
Our confidence in a continued significant stock market decline is based on a three-pronged analysis: 1) Stock market history and the nature of speculative bubbles. 2) Macroeconomic forces, so ably analyzed by my top strategists Doug Noland and Marshall Auerback, and 3) Continued comprehensive analysis of individual companies in an environment where obtaining financing has become increasingly difficult. In addition, many sectors that we see as vulnerable to unfolding developments have enjoyed significant rallies as tech stocks have faltered. As a result, valuations in virtually all sectors remain extended. In our view a secular bear market is well underway, but far from over. The Japanese experience illustrates that secular bear markets can last far longer than once thought. The Nikkei currently trades in the vicinity of 11,500 after peaking near 39,000 more than a decade ago.
Just as Doug Noland predicted, the U.S. economy has proven stronger than many economists projected, thanks to credit excess-induced spending. We do not, however, see this as healthy or the beginning of sustainable recovery. Most of this letter incorporates Doug's analysis, which can be found each week in his Credit Bubble Bulletin at www.PrudentBear.com. Doug works diligently to challenge conventional thinking and go beyond traditional analysis, which we believe is especially valuable in this most extraordinary of environments. If anything, events over the past year have confirmed our view that credit bubble dynamics go far in explaining the genesis and progression of the historical financial and economic developments we are all witnessing. Unfortunately, I am convinced that when this bubble bursts it will lead to the deepest and most protracted recession of the last century.
We have positioned the Prudent Bear and Prudent Safe Harbor funds to benefit from the conclusion of the credit bubble and the continued secular bear market for stocks. The Prudent Bear fund continues to have far more short than long exposure, with long positions consisting of gold stocks and small special situations. The Prudent Safe Harbor fund remains primarily invested in foreign government notes with an allocation to gold stocks and gold bullion.
The Markets
Extraordinary volatility and unusual divergences continue in an acutely unstable stock market. That a virtual collapse in the telecommunications sector can be immediately followed by an 11% one-session gain in the NASDAQ100 is indicative of a seriously impaired marketplace. In the credit market, instability reigns as well. Corporations continue to lose access to the commercial paper market, and the corporate bond market has been closed to many borrowers. At the same time, there has been almost panic buying of Treasury and agency bonds. Today's markets are providing unlimited finance for mortgages and other consumer borrowings, while there seems to be only a trickle available for business investment, again indicating serious marketplace impairment. Only the most die-hard optimist would not recognize how dysfunctional the U.S. financial system has become. The surging gold price and faltering dollar seem to support our view.
The Economy
First-quarter GDP growth of 5.8% confirms that there has been a strong resumption of borrowing and spending. Retail spending remained relatively robust; extremely easy credit conditions (a bubble throughout mortgage finance) have created a wildly buoyant national housing market, with California and other markets now in dangerous bubbles. Auto sales remain strong, with monthly auto sales data providing great insight into the nature of distorted consumer spending patterns. Stellar performance of the luxury brands is especially eye opening. April was the strongest month ever for BMW and Mercedes sales, which are running 17% and 8% above last year's records, respectively, as virtually all luxury models performed exceptionally well. With California traditionally the largest market for luxury autos, this boom has tracks of the Golden State real estate bubble written all over it.
What we are experiencing is not so much an economic recovery as it is the last gasp of a terribly maladjusted bubble economy. Most of the growth in the economy has come from rebuilding inventories and stoking consumer spending, much of it luxury-oriented, or what can be funded from proceeds from home equity loans and refinancing. The consumer has spent money aggressively because financial markets have made borrowing so easy, especially for extricating home equity from inflating home values.
The problem is that the imbalances are growing increasingly problematic, so this is clearly not a case of healthy or sustainable economic growth. There are also troubling signs of heightened risk that inflation may rear its ugly head in goods and services prices. The April ISM (formerly National Association of Purchasing Managers) index showed an 8.4 point jump in "prices paid" to 60.3, the highest level since January 2001. The "prices paid" component rose 18.8 points in two months, and 27.1 points in four months. April's non-manufacturing pricing component jumped from 53 to 59.5. The non-manufacturing "prices" component has surged 21.5 points in four months.
While financial flows have flooded into a problematic mortgage finance bubble, the ongoing technology collapse has taken a decided turn for the worse and is having its own very serious repercussions. It should be increasingly clear that the Fed made a momentous error in responding to the bursting of the technology bubble by accommodating further speculative and credit excess. Such policies only created another larger bubble and an even more precariously imbalanced U.S. economy. It's interesting that such notable economists as Bill Dudley of Goldman Sachs and Stephen Roach from Morgan Stanley have discussed the peril of re-igniting a bubble economy. It's almost as if they've been reading from the script of the "Credit Bubble & Its Aftermath" symposium that we sponsored in September of 1999. Never did we imagine back in 1999 that the credit bubble would still remain so out of control in 2002.
Real Estate Bubble
Let's take a moment to discuss a real estate bubble that many of our policymakers claim does not exist. First of all, first quarter existing home sales were on a record pace, with strong price gains in many markets. In California, April median prices jumped to $305,940, surpassing $300,000 for the first time. Prices were 18.8% higher than last year's level. Sales rose 13.1% from year-ago levels, while the inventory of available homes dropped to a noteworthy 2.3 months (compared to 3.5 months one year ago). The median condominium price of $249,820 is 21.5% higher than last year's level, with the sales volumes rising 38.5%. We believe that the real estate bubble and accommodative mortgage finance have been crucial factors in keeping the economy growing.
"Structured finance," or lending related to the government sponsored enterprises ("GSEs" - such as Fannie Mae & Freddie Mac) and mortgage and asset-backed security issuance, has developed into the key monetary transmission mechanism of the real economy. It has, as well, evolved into the key liquidity mechanism for the securities markets. This most unusual of credit mechanisms was largely responsible for last year's uninterrupted flow of easy credit to the mortgage and consumer sectors - providing the true source of the "resiliency" of the U.S. economy in the face of severe financial tumult.
The consensus view is that with deregulation and extraordinary innovation, the U.S. financial system has developed into a modern miracle of "efficient" contemporary finance. The efficiency of directing limited savings to their best opportunities has supposedly allowed our economy to post impressive uninterrupted growth for nearly two decades. For good reason, we are quite skeptical of this view and don't believe in financial miracles. Instead, we see endemic credit excess and the evolution of what we see as a new "Monetary Regime." This Regime has sustained dangerous borrowing, spending, and speculative excess, when a traditional monetary system would have long ago been forced into necessary adjustment. This monetary regime involves the structured finance phenomena that we believe is a major accident waiting to happen.
We believe that the Fed is typically given too much credit for creating liquidity and accommodating economic growth, while the GSEs and the U.S. financial sector (through the structured finance arena) are not credited enough. The process of contemporary liquidity creation is not well understood. It is not appreciated how when a home mortgage is made to an individual and that mortgage is purchased by Fannie Mae, that Fannie creates liquidity as it issues securities and borrows from money market funds. Fannie also creates liquidity when it borrows and purchases existing mortgage securities in the marketplace. But the very financial sector that has been responsible for keeping the U.S. system awash in liquidity since 1998 has built up unprecedented financial leverage, speculative positions, and fragile debt structures. And while the resulting liquidity has played the major role in accommodating the de-leveraging and derivative-related selling associated with the collapse of the technology bubble, the residual has been an only greater degree of leverage and derivative exposure associated with the explosion of GSE debt, mortgage and asset-backed securities, CDOs (collateralized debt obligations), and convertible securities.
Last year, combined credit growth from the GSEs, mortgage-backed, and asset-backed securities surpassed $1 trillion for the first time and was four-fold higher than 1993's level. In fact, the $1.003 trillion borrowed was not only up from 2000's level of $647 billion, but it jumped to 91% of total U.S. non-financial borrowings. This is an amazing statistic.
The combined book of business for Freddie Mac and Fannie Mae surged an incredible $471 billion (20%) during the past year to $2.83 trillion. This compares to the $262 billion expansion during the preceding 12 months. During the past 36 months, their combined book of business has jumped $953 billion, or 51%. We know of no comparable episode of credit excess in history.
Year-to-date sales of asset-backed securities of $109 billion are now running up 16% from last year's record issuance. Home-equity loan securitizations are 68% above last year's record pace. The auto-backed securitization boom runs unabated, with year-to-date issuance of $31.2 billion up 33% from 2001. While the financial system looks askance at financing business investment, there remains virtually unlimited finance available to fuel consumption. Consequently, our poor trade position is poised to get worse.
While it has not been an issue thus far, there is inevitably a problem when foreign finance fuels a consumption-based economic expansion. In the case of the U.S., foreign-sourced financial flows have become an integral aspect of our contemporary monetary regime. After a long series of financial crises elsewhere, and with the Fed and GSE's overly successful efforts to sustain the evolving U.S. "structured finance" regime, U.S. securities markets became the "darling" ("safe haven") of the speculating community. Wild excesses throughout "structured finance" became the key transmission mechanism distorting both financial markets and the economy. Ironically, the fragility of the dysfunctional global financial architecture has only played into the hands of the expanding U.S. consumer-centric Credit Bubble and the evolving "structured finance" Monetary Regime.
Each brush with financial crisis the United States has faced over the past decade has only worked to sustain the evolving bubble. The consequence has been greater credit excess, and the development of an unstable monetary regime and bubble economy. As an example, the U.S. financial system suffered a brief liquidity crisis when the system was "seizing up" back in October 1998. But since that time an unrelenting flood of GSE and "structured finance"-induced liquidity has besieged the system. Credit growth exploded, the consumer spent more money, and the economy roared back. However, the response to the 1998 crisis ensured excessive credit growth to business and over liquefied markets generally. This ignited the Internet and telecom bubbles, and a NASDAQ rally where the NASDAQ100 advanced by 86%. Once again, more extreme imbalances were imparted that will now need to now be corrected. Commensurate with worsening imbalances, each correction will require even greater dislocation and pain to work off.
The nature of the problem is that destabilizing speculative financial flows are always poised to fund credit excess one way or the other, one sector or another; it is only a case of in what sectors and to what negative consequence. Throughout SE Asia, malinvestment in manufacturing sectors was the most extreme inflationary manifestation emanating from excessive foreign finance. In countries such as Argentina and the U.S., with higher labor costs and generally uncompetitive currencies, the "hot money" played differently with divergent consequences.
Argentina's Lesson
Contrary to conventional wisdom, the problem in Argentina was not a short-term break in investor confidence, but rather a collapse assured by enormous speculative financial flows and the resulting maladjustments due to a dysfunctional Monetary Regime. This regime had been adopted specifically to ensure stability, but instead it spawned acutely fragile debt structures and extreme financial and economic imbalances. Because of the gross imbalances, there was no avoiding the disastrous consequences to the real economy. Argentina's economy is well into its fourth year of recession and today is in virtual economic collapse. The banking system has effectively stopped functioning.
While the forces and causes involved are numerous and complex, the bottom line is that its once acclaimed Monetary Regime has imploded. Argentina is left today without a functioning credit system and as a result is in financial chaos.
Even though many might view a comparison between the U.S. financial system and Argentina's as irrelevant, both experienced fundamental changes to their respective domestic credit systems. These changes, interacting with wildcat global speculative finance, nurtured credit bubbles that then evolved into precarious and untenable Monetary Regimes.
The Argentines adopted a monetary regime where they linked their currency to the U.S. dollar. The government debt market provided the key mechanism for channeling liquidity into the financial markets and economy. The economy boomed as a massive credit bubble developed. While nominal GDP expanded by a very healthy 26% over five years, total public debt quietly surged a whopping 79%. What should have been an obvious credit bubble - and could have been made clear by a simple chart of government debt growth - was disguised by "impressive" GDP expansion.
On the surface, all looked fine. Although rapid spending and income growth were in reality inflationary manifestations, they were at the same time (as they are today in the U.S.) the key variables identified as evidence of economic well being. These seductive forces imbued perceptions of a healthy expansion that incited additional foreign finance (Remember: credit excess begets credit excess). Plentiful liquidity allowed the government to spend freely and to privatize ("monetize") state assets, while the perception of endless liquidity took firm hold. With ultra-easy credit availability, Argentine governments, households, and corporations borrowed freely in foreign currencies and a bubble economy expanded with all appearances of a sound and sustainable prosperity. Confidence in the new Monetary Regime ran high throughout, with unsustainable borrowing and spending rising accordingly. It was a textbook Credit Bubble fueling a bubble economy and, as is typical, there was a key new "wrinkle" that made it all somehow appear reasonable.
As time went on, Argentina was adopted as the favored emerging market, while previous IMF concerns as to the long-term viability of its pegged currency system dissipated. This allowed the country to float large issues of medium and longer maturity debt on world credit markets at comparatively modest spreads over US Treasuries. Against a global backdrop of over liquefied financial markets and intense speculative impulses, Argentina's Monetary Regime (that very effectively constrained domestic inflationary credit creation) had a major unintended consequence of inciting a flood of foreign finance.
It should be recognized that new monetary regimes generally perform very well initially. The vaunted features of the system attract foreign finance, while a revived credit mechanism fuels expansion and the positive feedback of changing market perceptions. This initial success naturally foments disregard for longer-term sustainability issues, while discrediting the cautious and more vocal "naysayers." The initial financial players are rewarded handsomely for accepting the risk of the new Regime and - especially in this extraordinary environment - performance-chasing speculative finance arrives in waves. The money simply pours in. Monetary disorder is imparted, and the character and stability of the system is forever altered.
Interestingly, like in the U.S., inflationary effects of this foreign-sourced liquidity were not of the traditional pressures on consumer prices. The effects increased asset prices and stimulated commerce. They were thus off the radar screen of policymakers and financial players, as there exists no constituency against asset price inflation. The government was happy to borrow, and global financial players were ecstatic to buy government bonds dominated in dollars with a significant spread to U.S. interest rates. So foreign finance flowed freely, system debt grew rapidly, and financial and economic imbalances escalated exponentially.
No one contemplated a reversal of the speculative foreign flows. And the greater the accumulation of foreign liabilities, the more the Monetary Regime became "too big to fail." Total commitment to sustaining an unsustainable system did work to keep the "hot money" in the game a while longer. However, disregard of the obvious is a rather strange dynamic of our time. After all, we have by now seen such processes in action again and again, and it should be very clear to policymakers that attentive speculators are keen to aggressively play above-market yields, various spreads, or any other "trade" made attractive by government policies. It is not rocket science to appreciate that such flows are specifically not sustainable and will, in fact, generally reverse abruptly and problematically at some point.
It should be appreciated that - instead of being merely a possibility - financial history tells us clearly that a reversal of foreign flows is inevitable. That which can't go on forever doesn't. Regrettably, the consequence for Argentina of allowing the accumulation of immense foreign liabilities was the cataclysmic effect of the reversal of global flows. It hit especially fragile debt structures and an economy with little wherewithal to generate sufficient cash flows. Yet, only with the reversal of these vital flows and consequent faltering liquidity did it then become a critical issue that there was little economic wealth producing capacity underpinning all the accumulated debt. These are precisely the dynamics that we find most disconcerting in the U.S. today.
As was the case throughout SE Asia and Russia beforehand, when the "hot money" headed for the door and the derivative players were forced simultaneously to aggressively sell the underlying currency (dynamic hedging) to hedge exposure on the derivative "protection" they had written, collapse was virtually assured.
There is one critical lesson to be taken from the Argentina experience: it is a grievous policy error to adopt a monetary structure that is unsustainable over the longer-term and vulnerable to implosion, no matter how immediately expedient. When it comes to monetary policymaking, conservatism must overrule seductive experimentalism.
Back in the U.S.A.
We have more conviction than ever that the U.S. is in the midst of an historic monetary experiment run amuck. With similarities to Argentina but on a much grander scale, the U.S. system has developed a monetary structure/"regime" that, while politically expedient, is nonetheless unsustainable. The authorities have repeatedly refused to address underlying problems, choosing instead the short-term monetary fixes necessary to sustain the maladjusted boom. However or wherever credit growth could be stimulated, policy has been to just keep it flowing and worry about the consequences later. In the recent highly unstable character of financial markets and the grossly imbalanced U.S. economy, we see indications that things could soon be coming to a head - we may finally be forced to face the tragic consequences of these choices.
For Argentina, the government debt market provided the key mechanism for channeling liquidity into the financial markets and economy, while for the U.S. such processes have been (especially post-tech bubble) increasingly dominated by mortgage and consumer finance. The key is to appreciate that over time these flows impose distinct monetary processes, and any contraction or reversal of this finance can have profound ramifications for the functioning of a liquidity-dependent financial system and economy.
In the U.S., financial, political and social forces impart a significant inflationary bias throughout household mortgage finance. The strong American sentiment against federal government deficits is nonexistent when it comes to mortgage debt creation. And, as we have witnessed, these inflationary pressures have only thus far been emboldened by heightened financial fragility.
Our greatest concerns with respect to U.S. Credit Bubble developments over the past few years relate to the evolution of an untenable "structured finance" Monetary Regime. For some time, the "de-industrialized" U.S. economy has won the undivided affections of global speculative finance by default and otherwise. A new Monetary Regime was covertly adopted - with the capacity for the GSEs, Wall Street, credit insurance, and derivative markets to produce endless "safe" and liquid top-rated agency debt, unlimited "Triple-A" rated mortgage and asset-backed securities, etc. - that ensured sufficient credit to stimulate spending and the appearance of a stable and resilient economy. The aggressive U.S. financial sector could both create its own liquidity and incite what at times has seemed an insatiable demand for the dollars flooding the global economy.
Somewhere along the line, this Regime became much too big to fail, and this fact only emboldened the global financial community that looks confidently to the Federal Reserve and GSEs to guarantee liquidity. The upshot has been an unprecedented explosion of non-productive debt, along with an underlying maladjusted economy with little capacity for generating sufficient cash flows when these speculative flows inevitably reverse. Like Argentina, we see in the U.S. all the necessary ingredients for an inevitable run against U.S. financial claims. Again paralleling Argentina, debt growth has greatly surpassed GDP growth, while consumption and not true economic investment has been driving economic "output." In our case, the greatest excesses have been in financial sector borrowings, primarily with the explosion of credit throughout "structured finance." Over the four years between 1997-2000, nominal GDP expanded by about 26%, while financial credit expanded 70%. Over this period, GSE debt grew by 99%, while outstanding asset-backed securities grew 114%.
Unprecedented current account deficits exceeding 4% of GDP have been the most conspicuous manifestation of U.S. consumption-based credit excess. For years, there has been blind faith that the U.S. would always maintain its status as the favored home for global finance. Even today, to question that all this foreign-sourced finance might someday tire of accumulating U.S. financial claims (and may even decide to sell a few) is tantamount to lunacy. We disagree, and this is why we formed the Prudent Safe Harbor Fund. Admittedly, up to this point the Federal Reserve has enjoyed the luxury of a strong dollar and what has seemingly been the markets' insatiable appetite for U.S. securities.
We don't expect these luxuries to continue for much longer, and we view the current conviction that the Fed will always maintain control over systemic liquidity as extremely dangerous. In Argentina, while foreign finance was forthcoming, the government bond market had all appearances of sustainable liquidity. This illusion, however, abruptly evaporated into devastating illiquidity and market dislocation.
We see a problem commencing with the faltering dollar. Foreign finance, having evolved to play such an instrumental role in funding our economy's growth, appears to be growing increasingly nervous. Recent data indicates that foreigners may now be less willing to finance our enormous current account deficits. The Treasury's monthly report of "Foreign Purchases and Sales of U.S. Long-Term Securities" shows net monthly inflows into U.S. securities averaged $53.6 billion during the fourth quarter and $42 billion for all of 2001. For the first two months of 2002, net flows have ebbed markedly to $14.6 billion. After being net monthly buyers of $12.7 billion in Treasuries during the fourth quarter, foreigners have turned sellers to the tune of $8.5 billion. During 2001, foreign-sourced purchases accounted for a monthly average of $13.8 billion of agency bonds and $19.7 billion of U.S. corporates. So far for 2002, these average monthly inflows have dropped to $5.1 billion and $11.4 billion. Foreigners purchased a net $2.4 billion of stocks each month last year, but have averaged only $638 million so far this year.
The Disappearance of the Guardian
We now expect credit losses to play an increasingly destabilizing role for the U.S. financial sector and dollar. Over many years our contemporary credit mechanism has drifted toward a financial system in which credit has no guardian. This systemic problem finally appears to be coming home to roost, and with interest rates at 1.75% the Fed has little leeway. As the legendary credit authority Henry Kaufman warned:
"The integrity of credit is being chipped away by a financial revolution that is helping to lower credit standards and muting the responsibilities of both debtors and creditors.
We began moving in this direction when deposit insurance was legislated in the 1930s. This measure, generally laudable when viewed against the financial disaster of that period, removed the disciplining link between the creditor of the financial institution (that is, the depositor) and the institution itself. Increased "securitization" of credit obligations is another development that has had unfortunate consequences, as what was a "private" loan becomes part of a "public" marketable security. This further loosens the link between creditor and borrower. Credit derivatives also accomplish the same loosening. These are complicated instruments that protect a holder from the risk of default and therefore remove that risk from the lender. In a non-marketable relationship, the creditor is tied to the borrower for the life of the loan; of necessity, under these circumstances, credit scrutiny at the inception of a loan or investment is likely to be quite intensive. The same degree of credit investigation is not likely to take place when the relationship between lender and borrower is to be temporary.
In a securitized arrangement, many market participants fail to distinguish between the essence of liquidity and marketability. Liquidity means being able to dispose of a financial asset at par, or close to it, while marketability provides the holder an opportunity to sell at some price. The illusion of marketability is that holders believe they will be able to sell their investments before a significant deterioration in credit quality is generally perceived. Thus the initial pressure to be highly circumspect in the creation of the obligation is absent. A world of relatively unrestrained credit growth is also encouraged by the use of credit lines and guarantees. These assurances lead investors to make commitments based on the strength of the guarantor and not on that of the borrower. The heroes of credit markets without a guardian are the daring - those who are ready and willing to exploit financial leverage, risk the loss of credit standing, and revel in the present casino-like atmosphere of the markets." - Henry Kaufman, Interest Rates, the Markets, and the New Financial World (1986).
The above insights from Dr. Kaufman are especially pertinent, with the "long-run consequences of market, regulatory, and legislative changes" he warned of in 1986 having finally arrived. Henry Kaufman was indeed ahead of his time.
Derivatives
In our view, the systemic debt problems we are experiencing are magnified with the addition of derivatives to the equation. Outstanding credit derivatives have increased more than five-fold in just four years. Analyzing this extraordinary macro environment in its simplest terms, credit growth engenders economic expansion. This expansion - in the contemporary financial world of unharnessed credit and extraordinary speculative impulses - sets in motion self-feeding credit and speculative excess. During the boom, derivatives play a critical role in the perception of enhanced risk management, which occasions risk-taking and heightened general credit availability. Derivatives also play a major role in fostering financial sector leveraging and speculative trading, instrumental factors fueling the unsustainable bubble demand for securities, while over time creating acute financial fragility. Derivatives greatly accentuate the boom, only later to play an instrumental role in exacerbating the bust.
As was experienced in SE Asia and Russia, it is precisely when the risk of a bursting financial bubble begins to manifest (in their cases with higher interest rates and increased "premiums" for writing credit and currency "insurance) that a booming speculative market takes hold between those looking to off-load risk accumulated during the boom and the captive audience of speculators believing they can profit handsomely by taking the other side of these trades (the hefty premiums available from insuring against risk). It is this final "bundling" of untenable risk in weak hands that sets the stage for eventual collapse.
When the "hot money" heads for the door and the derivative players are forced simultaneously to aggressively sell the underlying currency (dynamic hedging) to hedge exposure on the derivative "protection" they have written, collapse is virtually assured. Authorities, hoping to avoid such a scenario at all cost, in actuality nurture dynamics that over time ensure that speculative holdings and corresponding derivative exposure become so enormous that there is simply no avoiding serious market dislocation when the inevitable reversal comes.
The unfolding telecom debt collapse is an historic development and, alarmingly, the amount of debt involved dwarfs the Russian debacle. And while it has received virtually no attention in the general or financial media, recent weeks have witnessed what appears to be a major dislocation in the credit derivatives area. In this regard, this is uncomfortably reminiscent of the initial complacent attitude held by U.S. investors to the unfolding SE Asian and Russian crises. At the same time, it appears that currency markets do have a keen appreciation of the seriousness of the unfolding U.S. risk.
First of all, there is major problem when an enormous industry (or economy) is comprised of negative cash flow companies. Recently, as credit derivative players have been forced to scramble to sell short telecom bonds to hedge their escalating exposure to industry defaults, already scant liquidity quickly evaporates. Faltering liquidity then occasions the next marginal company losing access to finance, with default then a likely possibility. The domino collapse gains momentum, and it becomes a panic for those that have been merrily pocketing premiums for writing default insurance. With the market for default protection in increasing dislocation, the debt market that is the life-source for the hopelessly cash-flow deficient telecommunications industry quickly grinds to a halt (too many sellers and few buyers).
For leveraged players in need of finance, this is the kiss of death. Sinking equity prices are a consequence of industry illiquidity, and it should be appreciated how stock market disarray further augments general industry collapse. Derivative players that were selling default protection for pennies on the dollar (believing their derivative book was diversified, that only a fraction of industry debt would eventually default, and that recoveries from these limited number of bankruptcies would be significant) are now faced with a much different equation: a general industry collapse and the possibility of upwards of a dollar of loss on a dollar of insurance written (as opposed to pennies!). Credit loss models can be thrown out the window as potential losses quickly grow exponentially.
The key to recognizing the great risk to U.S. financial markets developing back in 1998 with the Russian collapse was to appreciate the unfolding impairment of the leveraged players - how a vulnerable leveraged speculating community irreparably linked various markets, and that these players had become instrumental to the liquidity position of U.S. securities markets. A serious impairment of the speculators in one market became a problem for all markets, and posed especially acute risk for the dollar and the grossly over leveraged U.S. credit system.
We believe this dynamic likely holds true today, although in a somewhat different form. We fear the dangerous leverage (and link) today is not as much gross LTCM-type leveraging in securities markets, but a similarly dangerous "leveraging" of risk in global derivatives markets. Especially post-WTC, there are impaired financial players throughout the global "insurance" industry, and additional losses in credit derivatives hold the clear possibility of pushing some into insolvency (if they are not already there). We see a problematic situation where credit risk has been "bundled" and placed with especially weak (and rapidly weakening) hands. The enormity of the problem immediately raises the issue of counterparty risk, and any time counterparty exposure becomes a major issue it poses a clear and present danger to systemic stability.
The ongoing collapse of the telecom/technology bubble will result in unprecedented credit losses. The Fed has responded aggressively to the bursting tech bubble by accommodating a much larger bubble. Importantly, this latest round of Fed and GSE "reliquefication" is directing credit and speculation predominately to consumer and mortgage debt. We'll go on the record as predicting that real estate credit losses - particularly in the precarious California housing bubble - will eventually significantly surpass telecom losses. Regrettably, Fed policies and the resulting market dynamics are ensuring this outcome. With market perceptions that the Fed will hold rates low, speculative finance is providing unlimited cheap credit throughout mortgage finance. As conspicuous as this bubble has become, Wall Street "research" departments are busy creating propaganda arguing against the bubble hypothesis. And with speculative interest and resulting credit excesses in high gear, Wall Street is heartened with the reality that this mortgage finance bubble has room to run. This also buttresses general market complacency.
The Key Issue - Dollar Risk
So this brings us to the key issue of dollar risk. Our hunch is that this is precisely where the wildness lurks, and recent market action supports this view. We sense that there is not much appreciation for the character of the most recent Fed/GSE "reliquefication" or its ramifications. The post-Russia/LTCM systemic bailout (and Credit Bubble), of course, ushered in an historic technology bubble. This, importantly, acted as a magnet for global speculative financial flows, perversely imparting strength to a dollar that should have been vulnerable in the face of unprecedented and reckless domestic credit excess.
Moreover, with lenders and speculators favoring the U.S. consumer over the lowly producer, the prospect of a marked deterioration in the U.S.'s overall trade position appears virtually assured. 2002 is no 1999. The halcyon days of the Fed enjoying the luxury of a strong dollar have ended.
The nearer and longer-term risks emanating from Fed policies and U.S. financial sector practices are clearly with the dollar. And while a case can be made that the telecom debt collapse is a global phenomenon and not a U.S. dollar issue, we are not so sure. The Russian collapse was transmitted to the U.S. securities markets through the hedge funds and global speculators. Today, we fear that the transmission mechanism may prove to be through the derivative players comprising the global swaps market.
It is certainly our belief that credit derivatives written by offshore financial players have played an instrumental role throughout U.S. structured finance (transforming risky loans into "safe" money and highly-rated securities). It has been demand for these top-rated securities (at least partially financed with foreign-sourced borrowings) that has supported the dollar, and any development that impairs the writers of these derivatives would pose risk to dollar stability.
It is not hyperbole to proffer that the derivatives industry is looking increasingly like a potentially cataclysmic accident. In an example of how the complexion of risk has changed of late, the Wall Street firms are now faced with the indefinite prospect of scores of attorneys licking their chops from an ever-lengthening list of misdeeds. Wall Street must now manage its various risks especially carefully. There is also what must be a festering issue of enormous losses lurking out there somewhere in equity derivatives. Adding insult to injury, the gold derivative market has also turned rather inhospitable to any derivative player short bullion or gold stocks. And then there are hints of unfolding tumult and losses in the obscure world of convertible arbitrage.
We are witnessing a dysfunctional system having set course for a serious financial accident. The U.S. bubble economy requires continuing credit excess to sustain boom-time demand and to maintain inflated asset prices. The bubble within the credit system depends on significant continued expansion from an increasingly impaired financial sector to sustain liquidity for our securities-based credit system. Our fear is that the great U.S. credit bubble is approaching an historic crossroads. Rampant GSE credit excess has run unabated for three years, imparting only increasingly destabilizing forces including a real estate Bubble. The Fed has similarly largely shot its bullets in the process of fostering only greater financial excesses. So when the final bubble now running rampant throughout consumer and mortgage finance runs its course, we fear major financial and economic dislocations are unavoidable. A vulnerable dollar appears to provide a potential catalyst for an imminent piercing of the credit bubble.
In conclusion, we expect the second half of the year to result in extreme disappointment for investors as the credit bubble we have spoken about for several years comes to an end. Warn those you care about to carefully evaluate the "bear case" which we have prepared at www.prudentbear.com.
The Prudent Bear Fund no-load shares total return for the 12 months ending March 28, 2002 was 1.70%. Its average annual return for 3 and 5 years ending March 28, 2002 was 9.51% and -6.66% respectively, and -6.91% since inception (December 29, 1995). The Prudent Safe Harbor Fund total return for the 12 months ending March 28, 2002 was 14.84% and 1.62% since inception (February 2, 2002). Performance figures include the reinvestment of all dividends and capital gains. Investment returns will fluctuate, and when redeemed, shares may be worth more or less than their original cost. Past performance does not guarantee future results.
