The Great Credit Bubble: What Could Go Wrong?
By Frank Barbera CMT. January 30, 2007
Blissfully unaware, the average American sails through another day listening to the radio reports of a growing economy and the illusion of deep-seated prosperity. For twenty years, the US economy has been in a “boom,” with technology spearheading the economic growth and the standard of living continuously on the rise. At least this is the impression that has been created.
Not discussed is the increasing polarization between economic classes, the fact that over the last four years the so-called “recovery” has been one of the most uneven and lopsided events in US History. Almost never before have the poor and middle classes lagged so far behind the wealthy, with the one exception being the robber-baron’s of the Gilded Age in the late 1800’s. Spoon fed a steady diet of mis-deception and non-contiguous economic data, the majority of the American public falls steadily behind as real wage growth has now stagnated for 10 years with inflation data dramatically unreported visa-vie real world experience. As real wages have gone nowhere, or decreased (adding in the serious cut-backs in employee benefits seen in recent years), corporate profits have soared, gaining ground on the back of outsourced manufacturing and white-collar jobs. The disconnect between “Wall Street” and “Mainstreet” has truly never been so wide.
Yet somehow, we tend to look past it; we know the government numbers on inflation are too low, that unemployment is seriously under-estimated, and that wage growth remains absent. For the very wealthy, times have never been better as unrelenting monetary inflation has been channeled into unrelenting asset inflation. For the owners and managers of corporations (CEO’s), the bonus checks have never been larger, the stock options largesse never more extreme. For Corporate America profit margins remain lodged at historic highs, the windfall of globalization. Last year, Wall Street bonus checks were bigger than the GDP of most third world countries, and larger than some developing nations. Welcome to the “Wal-Mart/Nordstrom” economy, where the wealthy shop at Coach, Neiman and Nordies, and the less prosperous at Wal-Mart and other discount retailers.
Despite all of the imbalances, there is nothing we are more blissfully unaware of than the Great Credit Bubble. Going back over the last few decades, it was the US Dollar and the Federal Reserve Bank that controlled the supply of credit. However in recent years, the emergence of the non-bank financial sectors and the ascent to power by giant Wall Street investment banks has led to a credit boom of unimaginable proportions taking place outside the confines of the traditional banking system. According to the Bank of International Settlements, Total Notional Derivatives grew nearly $72 Trillion dollars in the first six months of 2006. Only a few years ago, that number was less than a few trillion. Similar unrestrained credit booms have also transpired in the markets for Credit Default Swaps, Agency Debt, and Mortgage Back Debt. What used to take several years to accumulate in terms of debt growth, the “system” now tacks on in only a few months. The implications of even “a slowing” in this type of runaway credit growth could imply the potential for a massive financial crisis, the likes of which no country in world history has ever seen. In this vein, the backdrop of late has turned much cloudier as the slow down already underway in the US Housing market places at risk much of this highly leveraged paper.
December 13 - Bloomberg (Kathleen M. Howley): “U.S. foreclosures begun on adjustable-rate mortgages rose to a four-year high in the third quarter as borrowers struggled to pay higher interest rates. The share of the loans entering foreclosure… climbed to 0.30 percent for so-called prime borrowers… The rate for sub-prime borrowers rose to 2.19 percent. Both are the highest since the second quarter of 2002, according to a report today from the Mortgage Bankers Association
Bonds backed by risky US “subprime” mortgages were downgraded in record numbers in the fourth quarter, Fitch Ratings said… The development is the latest in a series of ominous signals for the fast-growing sector, which has seen the failure of two lenders this month. Subprime mortgages are higher-interest loans made to borrowers who are seen as risky because of past payment problems or large debt burdens. The loans are often packaged into securities and sold to investors to help lenders reduce their risks. More than $500bn of these securities were issued last year. In recent months, a growing number of these borrowers have fallen behind on payments. Fitch has downgraded 100 of these securities since October.”
In his excellent article work at the Credit Bubble Bulletin, Credit Analyst Doug Noland recently pointed out the enormous leverage that is embedded within many of these markets.
“People who watch financial markets for a living tend to become blasé about big numbers. Nevertheless, the latest activity in the collateralized debt obligation (CDO) world, could make anybody blink. According to data released by JPMorgan this week, total issuance of CDOs - repackaged portfolios of debt securities or debt derivatives - reached $503bn worldwide last year, 64 per cent up from the year before. Impressive stuff for an asset class that barely existed a decade ago. But that understates the growth. For JPMorgan’s figures do not include all the private CDO deals that bankers are apparently engaged in too. Meanwhile, if you chuck index derivative portfolio numbers into the mix, the zeros get bigger: extrapolating from trends in the first nine months of last year, total CDO issuance was probably around $2,800bn last year, a threefold increase over 2005.
Noland quotes a Financial Times article in further detail recounting,
“Last week I received an e-mail that made chilling reading. The author claimed to be a senior banker with strong feelings about a column I wrote last week, suggesting that the explosion in structured finance could be exacerbating the current exuberance of the credit markets, by creating additional leverage. The message went. ‘I have been working in the leveraged credit and distressed debt sector for 20 years . . . and I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity will last indefinitely and that volatility is a thing of the past. ‘I don't think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions . . . with very limited capacity to withstand adverse credit events and market downturns. ‘I am not sure what is worse, talking to market players who generally believe that ‘this time it’s different’, or to more seasoned players who . . . privately acknowledge that there is a bubble waiting to burst but . . . hope problems will not arise until after the next bonus round.’ He then relates the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds' money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. ‘Thus every ‘1m of CDO bonds [acquired] is effectively supported by less than ‘20,000 of end investors' capital - a 2% price decline in the CDO paper wipes out the capital supporting it.’ ”
The point here could not be more well taken — we are looking at highly leveraged markets closely intertwined, where a relatively small mis-queue would seem to have the power to set off a heart-stopping chain reaction. For most of us, these markets — what could be termed the “Nouveau Credit Markets” are almost invisible — they are not quoted widely, they are not widely reported, yet they are enormous and they are highly leveraged. Where will the next financial “Perfect Storm” come from? It would not shock me at all if the ‘Credit Markets’ are ground zero. What is more visible for most of us are the companies that deal heavily in these credit markets, and in this vein, there appears to be trouble on the horizon dead ahead. Take a look at the chart of Accredited Home Lenders (LEND) over the last few months. From a high of $57.09 last May 16th, the share price of LEND has crashed an amazing 54%, while others of its kind are also NOT doing well. Let’s look at New Century Financial (NEW). Here again, we see a share price down from $50.60 last May to a current value near $28, a decline of 44.6%. With New Century shares hitting new 52 week lows over the last few weeks, and mind you, this in a stock market that has been a one way escalator up, the thought must arise, "Is there something unpleasant going on behind the scenes, -- what’s wrong?
Above: Accredited Home Lenders falling sharply, and
Below: New Century Financial also tumbling to new lows
What does the market know about these companies that is not front page news just yet?
Above: Fremont General share price, also plunging to new 52 week lows.
It appears the answer to “what’s wrong” is a wave of defaults in the sub-prime arena, as Santa Monica based Fremont General copped to the problems just yesterday, announcing the elimination of some 8,000 brokers amid a wave of defaults. From Yahoo Financial, Fremont stated,
“Fremont Investment and Loan on Monday said it severed ties last quarter with some 8,000 brokers whose loans were responsible for some of the highest delinquency rates in the industry. Such moves to improve loan quality have helped trim the number of early defaults on Fremont mortgages to a 3 percent rate from almost 6 percent in mid-2006, Mike Koch, a Fremont vice president of marketing, told investors at the American Securitization Forum meeting in Las Vegas. The so-called early payment defaults were close to 1 percent in 2005. The brokers "released" were "highly correlated" to the sudden rise in defaults on Fremont loans, he said in response to questions from investors. "First and foremost, increased loan quality is the No. 1 initiative for the year," Koch said. Fremont was the fifth-biggest originator of subprime loans last year, with about $33 billion of loans issued. A surge in defaults across the industry from low levels in 2003-2005 came as subprime underwriters loosened standards to help maintain volume in a shrinking market. The loans, most destined for the $575 billion home-equity, asset-backed bond market, are being returned by investors at an alarming pace, hurting profits.
Other Mortgage related stocks at present, do not look that healthy either. Consider shares prices for IndyMac Banking, a major mortgage lender and Downey Financial, a major issuer of adjustable rate paper. Again, the trend in motion bespeaks of something highly unpleasant taking place, perhaps liquidity issues are work, perhaps default rates are rising. Whatever the problem, the share prices are clearly trying to send a very loud and clear message.
Above: Indymac Bank, and
Below: Downey Financial, both carrying highly levered loan portfolios. Both stock prices appear to be building large tops, with Indymac breaking down last week and Downey slowly rolling over.
Of course, not all financial institutions are in trouble. In fact, most are ostensibly doing quite well. At what point would problems in one area start reflecting an even bigger, perhaps more ‘systemic’ concern? In my view, the major broker dealers-investment banks are another key group to be focused on. Last year, Goldman Sachs earned in one year about the same amount of money it earned in 2004 AND 2005 combined. With revenues up 50%, fixed income helped EPS figures dwarf the prior earnings record seen in 2003. Bear Stearns and Lehman Brothers also saw revenues explode last year by 40% and 37% respectively. Combined, Goldman, Lehman and Bear saw Net Revenues up 36% from 2005 to a record $64.5 Billion dollars.
Yet a close look at the stock price for Goldman Sachs (GS) shows a very clear five-wave Elliott pattern that may have just completed on the heels of last week's violently steep “two-day’ reversal, wherein Goldman shares traded up +7.30 on the 24th, and down $6.60 on the 25th. Since the downside reversal the share price has been under pressure with today’s decline challenging some short term support near $209. That said, this sector still has a lot of upside momentum carrying over to potential under-pin the stock prices. In the case of bellwether Goldman Sachs, any near term decline would have to carry down to at least the $195 area and break it for a day or two, to send even an initial warning. However, a decline to $195 and then a subsequent failing rally back up toward $208 to $210 over the course of the first quarter could set up a more complete topping pattern, which could in turn, be sending a larger message of building financial problems. At this point in time, where the large brokers are concerned, it is simply too soon to tell whether a more important high is being seen.
In my view, the brokerage sector should be ‘front and center’ on the financial radar moving forward as the Brokerage Stocks of “today” have become every bit the market bellwethers that GM and IBM were in days gone by. We now live in the age of the “Financial Economy,” an environment that has supplanted the manufacturing economy, and even the Service Economy, as the prime ‘mover and shaker’ of economic vitality. In this vein, there is nothing more important than to keep an eye on the trend of these leading stock prices as a more abrupt decline would likely signal the emergence of a much more difficult period ahead. In recent weeks, it is worth noting that the number of times the words “soft landing” and “global liquidity” have been quoted in the financial media have soared at exponential rates. Perhaps it is time to start thinking about the consequences of a “non-soft landing” and “contracting” global liquidity.
Source: Alan Abelson “Up and Down Wall Street” Monday, DECEMBER 11, 2006
In our final chart today (above) we plot the share price of Goldman Sachs over-laid against the price of Gold with the relative strength ratio of ‘Goldman-to-Gold’ plotted on the lower clip. Note that during the great bear market of 2000-2003, the R/S Ratio was moving down, indicating lessening confidence in Goldman, and a better showing by the ‘safety and security’ offered by gold. Over the last few years, as the cyclical bull market has progressed, confidence has gained and the Goldman-to-Gold Ratio has been steadily on the rise. In the weeks ahead, any downside reversal in this ratio would suggest that the focus is being re-directed once again, and that “confidence” -- the very bedrock of the financial economy -- could be fraying at the seams.
On Tuesday, equity averages gained ground led higher by a large rally in energy related stocks. At the close, the DJIA gained + 32.53 to end at 12,523.31, NASDAQ up 7.55 at 2448.64, Russell 2000 up +4.85 at 797.96, S&P 500 up +8.20 at 1428.82, Oil up +2.96 at $56.97, April Gold up 1.00 at $644.20, nearby Silver 13.377 up .1250, and the 10-year Bond ended with a yield of 4.88%. Among Energy related indices, the XOI Amex Oil and Gas Index ended higher by 21.71 index points to close at 1157.91 (1.91%) with the Philly Oil Service Index (OSX) up 6.02 at 194.21, a gain of 3.20%.
© 2007 Frank Barbera