Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his newsletter.
UNICYCLE, BICYCLE, CREDIT CYCLE OR PERPETUAL CYCLE?
The ridiculous starting phrase to this article above seems, to the author, in concert with the progression of what used to be known as, quite simply, the credit cycle. Put simply, business and consumers got frisky; the Fed raised rates/reserves, they got less frisky and the cycle restarted. We will refer to the bicycle as the point a couple of years ago when the Fed, consciously or unconsciously got the GSE’s in as augmentors of their interest rate cuts, liquidity expansions etc. Listening to (some) of the Fed, and (most) of the regulatory entities, it would now seem they yearn for something like the old Cycle. No Bicycle this time as the GSE’s are still mildly unable to find reliable numbers and some politicians actually think they should concentrate on median housing for those left out of the sub-prime bubble which was what they were created for in the first place.
How does a Perpetual cycle ensue if the Fed/Regulators etc. want a return to something new, but which brings about the result of the old cycle.? We have discarded the likelihood of the old cycle coming back to life after 17 Fed rate rises not only failed to stem the bubble, but a combination of either their amplification of money supply or
MORE LIKELY! A WHOLE NEW MONEY SUPPLY GENERATION CYCLIC MACHINERY INADVERTENTLY CREATED OUT OF THE U.S. PROPENSITY TO BORROW TO CONSUME FROM VIRTUALLY EVERY OTHER NATION ON EARTH.
If this is the case, there is a completely new set of players/machines at the helm! Even in the memory of some of the youngest is the parlous state of the rest of the world back in 1998. Now, in the aggregate, they have reserves over $5 Trillion. The Fed’s balance sheet of a paltry $1.8 Trillion shrinks in the shadow. The other new players, many of whom access greater or lesser parts of that $5 Trillions, the hedge funds at $1.3 Trillion (?) not including leverage, the private equity funds at much more than a trillion, depending on leverage and how you count or double count it, the mutual funds, still formidable at multi-trillions, even more if we throw in the money market funds, the investment banks having doubled into more than $3 Trillion.
All of these in the aggregate dwarf not only our fabled Fed but also the power of the rest of the central banks out there trying to realize they are operating in a different environment. (Remember though, those OTHER central banks are the guys with the $5 Trillion in reserves!). Talk about conundrum. Somewhere in here it is worth mentioning that the multiple needed to grow a dollar of GDP has moved from roughly 1-1 in the process to heading for $6 to 1 to produce the same dollar of GDP at the moment. Why and How? Credit Creation that is completely outside the traditional central bank/fractional reserve commercial bank/borrower mechanism that prevailed for such a long time.
Before getting into the details of how this phenomenon has come to pass, we would like to illustrate how fast this incredible world of non-bank credit creation is progressing. Yesterday, a financial executive I had mentioned CPDO’s to, e-mailed me asking what were CPPI’s. I had to profess ignorance and contacted a bunch of people smarter than me. I print below the amazing answer I received.
“Constant Proportion portfolio insurance (CPPI)”
Constant proportion portfolio insurance is a capital guarantee derivative security
that embeds a dynamic trading strategy in order to provide participation in the performance of a certain underlying asset. See also dynamic asset allocation. Note that the intuition behind the CPPI was adopted from the interest rate universe.
In order to be able to guarantee the capital investment, the option writer (option seller) needs to buy a zero coupon bond and use the proceeds to get the exposure he wants. While in the case of a bond + call case, the client would only get the remaining proceeds (or initial cushion) invested in an option, bought once and for all, the CPPI provides leverage through a multiplier. For example, say an investor has a $100 portfolio, a floor of $90 (price of the bond to guarantee his $100 at maturity) and a multiple of 5. Then on day 1, the writer will allocate 5 * ($100-90) = $50 to the risky asset and the remaining $50 to the riskless asset (The bond). The exposure will be changed as the asset performs and with leverage multiplied by 5 times the performance. (or vice versa). Same with the bond. These rules are predefined and agreed once and for all and for the life of the product. (All of the foregoing bad English from the writer of the definition not sender).
Two things stand out.
1. The CPPI is pretty much the same as the afore-mentioned CPDO except leverage can go up to 15x on the CPDO
2. The guys who re-invented the term portfolio insurance must have been in diapers (maybe still should be) in 1987 when portfolio insurance became a really dirty phrase!
All of this in aid of showing how complex the world of non-regulated credit creation has become. Another interesting statistic recently learned from a Financial Times article. Wall St/Hedge Funds etc. are proliferating Collateralized Debt Obligations or CDO’s. These are also fairly well known in the regulated Commercial/Investment Bank world inhabited by denizens like Citicorp. The regulated are in the Trillions. The Non-regulated-Private-Over the Counter- or basically opaque unknown CDO’s are also in the Trillions. Credit creation is truly beyond the ken of the world’s Central Banks.
How, in the opinion of the writer has all of this come to pass?
IF GIVEN THE OPPORTUNITY TO LEVERAGE WITH NO SKIN IN THE GAME (IF THE DEAL CRATERS, THE LENDER LOSES, YOU GO ON TO THE NEXT TRIUMPH/TRUMP?) AND INTEREST RATES GO TO A LEVEL WHERE THE MOST RAVENOUS OF LEVERAGE PLAERS (REAL ESTATE DEVELOPERS AND PRIVATE EQUITY, OR WHAT USED TO BE KNOWN AS LEVERAGED BUYOUT OPERATORS AFTER THEY ESCAPED THEIR PREVIOUS INVIDIOUS LABEL OF CONGLOMERATEURS) SLAVER AND DROOL , ENORMOUS AMOUNTS OF MONEY WILL BE BORROWED. THIS TIME, LOTS OF INGENIOUS DOCTORS OF PHILOSOPHY THOUGHT UP INCREDIBLE DEVICES TO BORROW OUTSIDE AS WELL AS INSIDE TRADITIONAL LENDING PARAMETERS!
When the now renowned Greenspan took interest rates to 0%, the horde was let loose. Pity the poor commercial banks and the GSE’s. They were in bad stead from the dot-com/telecom disaster and had to go into shipyard, opening the door for the Investment banks and the non-bank creations they had birthed to take off. The Brokers (Investment Banks) doubled and, as past readers know, the world of hedge funds, private equity funds, etf”s, venture capital and other non-regulated lending went wild. Since the successful, valiant effort of the hedge funds to face down the SEC on registration succeeded, there have only been estimations and gross numbers to give some idea of how much credit has been created out here in the unregulated world. In our previous missive, we came up with roughly 1½ times the amount to be found in the banking system or +/- $15 Trillion. That is only in the U.S. As we all know, numbers in much of the rest of the world are a flag of convenience rather than a certainty but that $5 Trillion in reserves from less than a trillion at the start of this run hints that the number must be at least the aggregate of the $25 Trillion combined in the U.S. before govt and agencies, if our hypotheses are anywhere in the ballpark.
All those who are research minded can go to the Bank for International Settlements website and get the numbers for the central banks scattered around the world. (Don’t put too much credence in the numbers of such worthies as Russia or China, much less Indonesia, but the sum total is truly dwarfed in any reasonable conclusion by the total non central bank balance sheets/credit out there in the non-regulated credit world. In terms of non-regulated U.S. credit (We are averse to using the word regulated even for the “commercial banks” in much of the rest of the planet) added to what we will, in the absence of the word “regulated” call “credit set loose by U.S. current account deficit,” in pools of Greed or ”CSLUSCAD” CREDIT, we have credit creation of humongous proportions. Recurrent rate raises by adventurous central banks in other parts of the world have had about the same effect in “CONTRACTING” money supply as has been the case so far in the U.S. That answer being slim to none and Slim went over the horizon.
To digress for a moment we look at the housing market in London. They raised rates there for a while and actually slightly slowed the housing bubble. Then they thought they had done enough. The creators of non-regulated credit are as ingenious (maybe more so) as the Wall St. creation machine and house prices began another precipitous ascent. They are raising rates again and house prices are going up even faster. CSLUSCAD credit is the answer to any pesky central bank that thinks it can get in the way of a Pool of Greed in full flight. Norway is sticking its neck out as the last unemployed Norwegian found two jobs and that Central bank actually thinks it should be responsible in monetary policy. Result so far, the Norwegian price index continues up led by housing prices.
A few weeks ago, we were privileged to hear a conference call by Larry Jeddlow of the TIS Group, Inc. that included slides he sent of the presentation. His thesis: “Investment Banks/Hedge Funds vs. Central Banks.” His conclusion: during the fall months, the central banks of the world were warning the CSLUSCAD crowd that they had gone too far in their headlong rush to lend; more recently (February/March) the warnings had gotten stronger. Therefore, credit/money (See the “Moneyness of Credit” by David Tice) growth was finally going to slow. There were actually a couple of mild warnings stuck in there by various Fed Presidents and Governors. Result, we have a Dow one day slide and Bernanke replays Greenspan’s 1987 performance (subtly), at least giving the CSLUSCAD crowd the “certainty” the Fed “PUT” is still in full force and effect. KKR is going to buy FirstData with no partners proving that those pesky investigators worried about collusion in the CSLUSCAD crowd are way off the mark. One possibility put forward in the aforementioned TIS Group presentation was “Property Derivatives.” While yet in their infancy, we actually found a four bank consortium writing a multi-hundred million play. Since the commercial property market dwarfs the commercial bond area that the CSLUSCAD players had run up to a reported $10 Trillion here in the U.S., the question we have been asking ourselves on where can a tens of trillions market be found to propagate the next bubble may have found an answer. Not at Sam Zell cap rates, however, as even the ridiculous spreads currently being accepted wouldn’t cut it in this proposed game. Who knows, this writer has been wrong before. If the private equity boys all go public, this kind of cash return on stocks is more the norm than the exception.
Continues at a frantic pace. The 4th Quarter Federal Reserve Z1 report is another clear indication that debt growth in the U.S continues at a frantic pace. Total Credit Market Borrowings running at an annualized rate of $3,567,000,000,000 (That is what it looks like in numbers instead of abbreviated Trillions. The admittedly slowing housing market cut back mortgage credit by several hundred billion but the U.S. CSLUSCAD more than made up the difference. (A decision on how to pronounce this newly created acronym is to leave the first S silent thus producing CLOOSCAD for anyone who wants to adopt it.)
What, if anything, will slow, halt or reverse this juggernaut (old name for battleship)? This observer, guided by mentors such as Doug Noland has resisted premature pronouncement of the end but is willing to hypothesize as such can always be dismissed as musings rather than predictions.
We are willing to agree with some rather astute financial analysts who have recently observed that the Credit Cycle (old version) has turned. The 1stData deal says the CSLUSCAD bunch are still at it. It is fairly evident from the slaughter in the world of sub-prime that the most egregious of “throughput” credit created by the alchemists on the Street has struck both the rock and the hard place. Early on the “throughput” crowd looked as though they might provide their own version of the Greenspan “Put” for this, their offspring but the wizened regulated banks seemed to have pulled that plug. Bubblevision or CNBC was just this morning babbling on about danger in the Alt A arena. M&T bank that thought it had found a niche there is looking at a New Century like hit for the day.
Another astute analyst we follow is fairly certain of a 2008 recession. Again, we are in agreement, at least for the United States. Happening to live in a state with the 2nd most ridiculous run-up in house prices over the last few years (California taking the crown in that race), we were perusing what goes for a local paper these days this morning. Even forewarned by our bear persuasion, we were still stunned by some data therein. Miami/Dade residents at the peak in 2005 extracted over 17% of their income from either home equity facilities or refinance/cashout mortgages. It was still running at 14.5% in the fourth quarter of 2006. While the average for the country peaked at about 10% in 2005 (Over $1 Trillion AND IS STILL HANGING IN THE 8.5% RANGE, ABOUT $900 BILLION+, THE PROFLIGACY IN south Florida has been amazing. With Chavez sending us floods of Venezuelans and the euro sending plenty of buyers from those countries, the real estate boom is lasting longer than anyone expected. Sign that the cycle has turned in the region, however, houses listed for sale doubled in the last year. One condo with 10 foot barbed wire fence ¾ of the way up 40 stories. Razor wire on top and dilapidated sign saying “All permits in place, for sale as is”. 48 cranes on the horizon in the Biscayne corridor. The ultimate end of the cycle will not be pretty.
Have an immediate relative who has found a nice business in the Florida keys. It isn’t worth it to an attorney in Key West to spend a day and 350 miles filing a chapter in Miami. Better to introduce the client to an attorney from Miami who can spend a day and file in a bunch. Business is booming. The papers are full of cruise ship ads offering deals. Like airlines, cruise ship guys have to order way in advance and capacity can quickly exceed demand. Even got an upgrade on a recent flight packed last year with spring-breakers. All this anecdotal.
Facts: C&I loan growth peaked at over 15% in mid 2006; now at 12.9%. Quarterly change in C&I loans March 2006-up $46 Billion, September $24 Billion. Mortgages in 2005, over $1.4 Trillion, 2006, just over $ 1 trillion. So, both consumer and C&I seem to have peaked. CRE is a subset of C&I and usually worse than C&I overall, both in the excesses and the whiplash when the cycle turns. Think about it; if the mortgage game based on refi/cashout and home equity lending really turns, a trillion could come out of income. Extreme to this generation’s thinkers but not beyond the realm of possibility. Home equity lending in the first quarter as measured by Asset Backed Securities issuance, is down some 35% so far this year. Conundrum: Year to date CDO issuance is running 38% ahead of last year.
WHAT ARE THEY PUTTING IN THESE THINGS AND WHO IS BUYING THEM AT THIS POINT IN THE CREDIT CYCLE? THE CSLUSCAD BOYS REALLY HAVE IMAGINATION!
All right, some data points which to this observer says the “old” credit cycle has turned. The conventional, regulated lenders are getting whatever mixed message the Fed less Bernanke seem to be sending out and the OCC is pretty clear that, particularly in CRE where they have been before, they want to dampen enthusiasm.
SO!THE ONE NECESSARY INGREDIENT FOR A CONTRACTION IN CREDIT(MONEY) CREATION IS STARTING TO HAPPEN IN THE REGULATED, CONVENTIONAL CREDIT CREATION MECHANISMS. !EXPLAIN THE 38% YEAR OVER YEAR GROWTH IN CDO’S! !EXPLAIN THE FIRST DATA ACQUISITION WITH THE CHUTZPAH TO GO IT ALONE ON KKR’S PART? THE ONE NECESSARY INGREDIENT THAT WE FORGOT TO MENTION ABOVE IS FEAR AND THAT IS OBVIOUSLY STARTING TO BUILD IN THE REGULATED, CONVENTIONAL CREDIT CREATORS BUT THE CSLUSCAD BOYS ARE APPARENTLY FEARLESS!
While our observations are agreeing with the TIS Group that the central banks around the globe and that the U.S. regulators (At least some of them) are starting to think that a dose of caution may need to be administered; is there a mechanism in place to enforce it with the CSLUSCAD gang?
At least so far in 2007, they seem to be ignoring any warnings. I am grateful to Doug Noland for having captured the following from the last week illustrating this.
1. Global debt issuance rose to $1.73 Trillion in the 1st quarter
2. Global mergers and acquisitions reached $1.130 Trillion, the busiest 1st quarter on record. The boom, driven by buy-out fever etc. rose 14% from the previous year’s record.
3. U.S. merger activity surged 21% in value year over year in the 1st quarter.
4. 1st quarter merger activity in the U.S. totaled $428 billion up from 2006’s record $352 billion.
5. U.S. companies sold $38.6 billion in high yield in the quarter, up from $29 billion the previous year.
NONE OF THE ABOVE SUGGESTS ANY FEAR OF CENTRAL BANKS IN THE CSLUSCAD GANG IN THE QUARTER AND, UNTIL SOMETHING OR SOME EVENT INSTILLS SOME FEAR INTO THIS TOTALLY FREE TO ROAM PARTY OF HIGH ROLLING DEAL MAKERS DRIVEN BY FEE INCOME AND BONUSES SUFFICIENT TO LEAD TO BELIEF IN INVINCIBILITY, LIQUIDITY/MONEY/WAMPUM OR WHATEVER THE ECONOMISTS WANT TO CALL IT WILL GROW AT THE 12% RATE IN THE U.S..; THE TEENS RATE IN EUROPE AND THE RIDICULOUS 20’S, 30’S AND EVEN 40 % RATES SEEN THROUGHOUT THE GLOBE.
Will inflation grow? According to John Williams of Shadow Government statistics, it already is in double figures. With rents being the owner equivalent rental income input for the Commerce Dept. it is even growing in the official statistics. Will the Fed raise rates to stop it? Who cares, we are funded in yen anyhow, so the long end of the curve is dependent on the Japanese Central Bank, a pillar of strength. Will a recession occur? Almost certainly and it will truly be a CONUNDRUM for Helicopter Ben as any cut while “Old Europe” continues to raise rates may avalanche the dollar. Sad to say, to use the Oriental sense of the word. “We live in interesting times!”