9/19

FED MEN TELL NO TALES

Yo Ho Ho And A Bottle Of Numb...As we have been anticipating, every quarter along about this time the Fed releases their Flow of Funds report.  All of the grimy details on debt outstanding, credit creation, etc. among various sectors and segments of the economy for the preceding quarter.  In this case 2Q 00.  What we find a bit amusing is that none of the Fed officials ever mention this report in their rather public comments about the economy.  We hear the word "productivity" ad infinitum.  "New economy", at least until oil has recently diminished that little bit of rhetoric, is another of the favorites on the Fed top ten list.  Maybe it's because they aren't taking the time to read the report.  (Or, rather, silence may be prompted by the fact that they have read it.)  After all, it's about 150 pages of nothing but numbers.  Who has time for that stuff these days?  Certainly not masters' of the universe.

We find it rather telling that so many current market participants have become rather numb when it comes to discussions of debt and credit.  Don't get us wrong, we're not saying that the economy and financial markets are ready to blow tomorrow because of the use of credit and debt.  As you know, leverage has its proper place in any capitalist oriented economic system.  It's rather that some of the numbers have grown so large and have seemed to have become very much accepted as normal.  Much like the trade deficit, nothing has gone wrong yet, so what's the worry?  We continue to report on the Fed Flow of Funds report each quarter to try to maintain our own perspective on the current relationships interwoven between money, credit, longer term debt, financial asset prices and real asset prices.

The NUMBers...Here comes the quantitative and pictorial onslaught.  In the second quarter of 2000, as the headlines read, domestic non financial sector debt in the US grew at a 5.5% annualized rate.  What's wrong with that?  In line with GDP growth, is it not?  As with corporate press releases, it's what's behind the headline that most often counts.   
  

The headlines on non financial sector debt growth are clearly skewed by the fact that the government is buying back debt.  Beyond the activities of the government, debt growth on the part of households and corporations is simply booming.  Booming well beyond rates of GDP growth.  Booming well beyond rates of return found in the financial markets.  As can be seen, excluding the federal government, non financial sector debt grew at a 10% annualized rate in the second quarter of this year.  It's simply a rotten shame that the government hasn't started repaying citizens' mortgages for them, buying back and retiring their credit card debt, and having the Treasury philanthropically extinguish corporate debt outstanding.  Don't give up hope, though.  In the new economy, anything's possible, isn't it?  If the economy is theoretically slowing, why is there the need to increase aggregate leverage as witnessed in the 2Q numbers?

Just when you thought they simply couldn't give any more, the US domestic financial sector increased borrowing to the annualized tune of 10.9% in 2Q.  One quick point of order.  We do not combine aggregate financial sector debt with that of non financial sector debt to come up with a whole.  Clearly there is double count here.  After all, the credit card lender that so kindly upped your credit limit recently borrowed the money to make you the loan (assuming, of course, that you took advantage of their seemingly unlimited generosity).  According to the government stats and the headlines, the economy is cooling down to a "just right" temperature.  According to the Fed report, there has been no cooling off in aggregate increases in borrowing among the participants that make up the domestic economy in the least.

Going For The Gold...The US women's swim team is going to simply have to move over.  The US consumer and business sector has been intent on shattering some records of its own in 2Q.  And just think, they didn't even have to travel to Sydney to do it.  As you know, the US consumer and corporate sector has been putting in many long years of training preparing for the borrowing records they broke in 2Q.  Households endured blinding blizzards and extremes in summer heat just to put above asking price offers on homes.  Corporations have diligently persevered into the wee hours of the morning preparing debt covenants suitable to pump up the liability portions of the right side of their balance sheets.  The human spirit is capable of miraculous achievements.  In fact, let's have a look at the highlights:

The above chart is a little retrospective of growth in household mortgage debt outstanding over the last three and one half decades. The rise to the mountaintop has not been without struggle. Surmounting the S&L plateau, household mortgage borrowing has scaled previously uncharted peaks - namely the 125% LTV loan - in this housing cycle.

2Q 00 registered the highest quarterly annualized growth in absolute dollar mortgage debt in history (an annualized $477.1 billion).  Total household borrowing in 2Q also took the record breaking honors largely due to the Olympian performance of the mortgage debt component.  

After the longest economic expansion in US history, growth in mortgage debt continues to explode.  What is perhaps more telling is the trend of owners equity as a percentage of residential real estate values.  The Fed also kindly imparts its findings for all to see:

In one of the hottest real estate price inflation periods in many a moon, owners equity is actually shrinking.  What is even more striking is that as of ten short years ago, this number stood closer to 65%.  Conclusions?  Not only are people borrowing more to buy homes, all of the price appreciation in real estate in the last few years (in the aggregate) has been borrowed away and then some.

Too Much Monkey Business?...As can be surmised from the summary table at the beginning of the discussion, corporate America is still borrowing to beat the band.  As with household mortgage borrowing in the second quarter, annualized borrowing on the part of US business in 2Q earned another gold for a record breaking quarterly performance (an annualized $747.9 billion).  Clearly, US businesses are going the distance in stretching their balance sheets.  

Although it's clearly been an uphill battle, corporate America has shown the stamina of a marathon runner in its ability to accept ever increasing quantities of leverage.  Again, if we are moving into a soft landing where economic growth cools off, but doesn't collapse, does it really make sense to take on debt at one of the fastest rates anywhere in the last decade while presumably growth in earnings and cash flow are moderating?  From the following chart, the answer is "apparently so".

As a last comment, on the financial sector side of the equation, the star players for the US team in 2Q were the GSE's (government sponsored agencies) and the banks.  After a brief respite in 1Q, the GSE's were back expanding their balance sheets quite noticeably in 2Q.  It only follows given the demand for mortgage debt on the part of households.  Commercial banks, likewise, witnessed an explosion in liabilities.  Interestingly enough, the dollar amount of increase in liabilities "due to foreign affiliates" (as documented in commercial bank net interbank transactions) has no precedent anywhere in the last five years.  Somebody has to help finance our trade deficit, don't they?  Now really, we can't be expected to do everything.  Please. 

The Chicken Or The Egg...Credit extension and debt acceptance may not make the financial and real asset price world go around, but it sure helps.  As a fun little exercise, we concocted the following charts.

What we do in each of the following is start with a base year of 1970.  From there we chain link the annual growth rate of the Dow Jones and what we believe are two relevant aggregate sector views of total debt - total non financial sector debt and total financial sector debt.  Remember, we view non financial and financial sector debt independently, not from an additive or double counting perspective.  Now clearly, debt is not supporting the stock market solely.  Debt underpins real estate values, consumption, capital equipment purchase, business expansion, etc.  Nonetheless, we believe it's a fun little exercise in perspectives. 

Possibly the more thought provoking chart of the two is the following (we inadvertently mixed up the color of the Dow line, so watch it):

The growth in US domestic financial sector debt in the last thirty years has truly been a sight to behold.  A veritable mushroom cloud that has not stopped expanding as of yet.  Greenspan could only hope that productivity would be this kind of a consistent grower over time.  This chart is testimony to the fact that lending and debt creation is big business in today's new economy.  (And here you thought it was technology.)  Is it credit creation that helps financial and real estate asset prices rise over time?  Or is it the rise in financial and real estate asset prices that provides the base for ever higher amounts of lending?  Hence the bull and bear argument over what is considered excessive leverage in the modern marketplace.  That question will only be answered over time in the movement of the values on the left side of the balance sheet.  We're pretty sure that values on the right side aren't going anywhere anytime soon (except maybe higher).

These brief highlights of the 2Q Fed Flow of Funds report pretty well demonstrate that borrowing is running as hot and heavy as at any point in the current economic expansion.  In fact, borrowing is running faster as the economic cycle ages.  To us, these facts suggest a number of possible outcomes.  The supposed economic slowing the government statistics  suggest we are experiencing is temporary.  Secondly, borrowing rates are about to fall off a cliff as the economy truly slows.  Lastly, both consumer and corporate America are very highly levered in a period where asset values (both financial and real) may be abnormally high (while the cash flows and earnings that underpin these values are about to recede in growth rate).  Door number one, door number two, or door number three?  "Monty, maybe we'll just take the cash and go home now.  We're not sure we want to find out the answer to this one."  

Backed Into A Corner...The following is brought to you by our friend and favorite chartist Tim.  Do yourself a favor and step back from the day-to-day, minute-to-minute action and have a look where we have come from.  What we find interesting is that the NDX appears to be at a very important longer term juncture, at the exact point where a good number of its former drivers have careened off the track.  Heavyweights and top cap index members such as Microsoft, Worldcom, Dell, and even Cisco seem to have lost their way.  That puts all the more strain on the Intel's, Sun's and Oracle's of the world.  Can a dwindling number of super cap issues carry the day ahead?  Will the fallen angels of the NDX find new sponsorship?  As of now, each time the music stops in this market there are a few less chairs.  We would suspect that if the NDX is to breakout to the upside, it will have very few engines straining mightily to pull the entire beast up the hill.  From a longer term perspective, resolution just isn't that far off.  We have the feeling that what happens to this chart in the weeks/months ahead will be a heavy determinant in overall equity market confidence.

Derivatives Redux...Due to a darn good amount of email we received regarding our 2Q Bank Derivatives report last week, we thought we would make a few comments.

Notional Values Vs. Cash Values:

We've discussed this a bit in the past and didn't include it this go around for fear of being redundant.  Notional values of derivatives are not cash values.  Derivatives are highly leveraged contracts where nominal amounts of actual cash supporting large notional exposures are initially exchanged as good faith in entering into the contract.  It is usually extreme cases where cash values approach nominal values.  A complete blowup like LTCM will get you close, but again the chances of approaching nominal values in terms of a total liability are small.  Believe us, if it ever happens in the aggregate, you'll be much more worried about securing your dinner than your bank account (at least what used to be your bank account).

What most concerns us in looking at notional values is that it is a reflection of activity and growth in the broad derivatives market.  In our minds, the greatest risk in derivatives is what is termed "counterparty" risk.  As we explained, most of the derivatives in the bank world are OTC (over the counter) vehicles.  They are specific contracts written for specific customers of the bank.  Most often, banks and other players in the derivatives market will try to "lay off" or negate the risk in their derivatives book(s) by entering into contracts with third parties that offset the risk they assumed in conducting business for their customers.  Essentially, it may be a simplistic description, but the derivatives world is an interdependent web of promises.  If one party fails to perform, the effect can ripple across other contract holders originally dependent on the defaulted party's promise.  In turn, on a large scale, a default can ripple across the financial system.  Although we will never know all of the details, this is probably what we were (at least partially) looking at with LTCM.  In our minds, the larger the derivatives world grows in the aggregate (notional values) the greater the counterparty risk becomes.

JPM/Chase Manhattan Merger

There is plenty of conjecture regarding the JPM/Chase deal.  These are two of the largest derivatives players in the marketplace.  The bearish community has suggested that a possible motive in the deal is to save a failed derivatives book.  Another dark side suggestion is that the deal creates an entity "too big to be allowed to fail" (ultimately systematic failure).  The more optimistic camp proclaims that the derivatives books of these large institutions will at least partially offset each other and lower overall individual company and systematic risk as a whole.  The fact is that both of these opposing claims are unknowable.  Derivatives disclosure at the current time is macro in orientation.  Individual direction (of the trade) and position of individual company operations is hidden from view.  All we can guess is that many of both JPM and Chase's customers were looking to offset similar risk when they originally came to these two institutions in the first place.  It's always our guess that market players usually think as a herd.  We have a hard time believing the risk offset is huge, if any, in combining these derivatives operations, but we have no facts on which to rely or conclude anything for now.  One thing is for sure, the world of the counterparties dealing with both Chase and JPM, based on a rationale of diversification, is about to get a whole lot smaller.