Doug Noland seems deceptively young to an old person(me) - but I find his comment/thought exceptional given the mediocracy of most releases dealing with the world's (aka USA's) economy.
Noland runs 'The Prudent Bear' website.
His latest comment (available after each weeekend our time) includes the following:
...... Bank Credit has expanded $252.2 billion during the first 10 weeks of the year (19.4% annualized), more than it expanded during the entire year of 2001. Bank Credit jumped $23.2 billion for the week of March 9 to a record $7.0 Trillion.
- and -
Booming Broker Finance and Market Tops:
Four of the major Wall Street securities firms reported blockbuster earnings this week.
Morgan Stanley reported Net Income of $1.468 billion, up 20% from the comparable year ago period. “Net revenues of $6.8 billion were 10 percent higher than last year’s first quarter and 26 percent ahead of last year’s fourth quarter.” “The Individual Investor Group had its highest revenues since the second quarter of 2001.” “Fixed income sales and trading net revenues were a record $2.0 billion, a 21 percent increase over a strong first quarter of 2004. The increase was broad-based, with strong performances across the interest-rate & currency products, credit products and commodities group. Interest Rate & currency products benefited from strong new deal activity with clients and successful interest rate, foreign exchange and volatility positioning.” “Fixed income underwriting revenues rose 48 percent from a year ago… The increase in fixed income underwriting revenues reflected higher non-investment grade activity.” “Equity sales and trading revenues were $1.2 billion, a 10 percent increase from a year ago and the highest since the second quarter of 2001. Record revenues in the company’s Prime Brokerage business were a substantial contributor to the increase. Higher revenues were also achieved in the derivatives business…” Total Assets expanded at a 13.8% rate to $802.2 billion and were up a noteworthy $145.3 billion, or 22%, from one year ago. Total Assets are up 43% over two years. “In the first quarter of 2005, the company repurchased 24 million shares of its common stock.”
Lehman Brothers reported Net Income of $875 million, up 34% from the year earlier period (fiscal 2004 Q1). Highlights included: “Achieved record revenues in Investment Banking, Capital Markets, Europe and Asia.” “Investment Banking revenues increased 34% to a record $683 million…reflecting improved performance across all products, including record results in debt origination and continued strength in M&A activity. Record Capital Markets net revenues, which increased 21% to $2.7 billion…were driven by record results in Fixed Income Capital Markets and strong results in Equities Capital Markets. The record results in Fixed Income Capital Markets reflect a strong performance across all major businesses, and in particular mortgages and interest rate products.” Total Assets expanded at a 12.8% rate to $370 billion and were up 15% y-o-y. “Secured financing arrangements (reverse repo and securities borrowed)” was up 18% for the year to $169 billion. Total Assets are up 38% from two years ago. The company repurchased 8.6 million shares of stock during the quarter, up from the previous quarter’s 6.0 million.
Goldman Sachs reported record Net Earnings of $1.51 billion during the first quarter, up 17% from the year earlier period. CEO Henry Paulson stated, “The strength of our performance comes from the breadth of our global franchise.” “Fixed Income, Currency and Commodities (FICC) generated record quarterly net revenues of $2.49 billion, 18% higher than the previous record set in the first quarter of 2004.” “Net revenues in Trading and Principal Investments were $4.38 billion, 6% higher than the first quarter of 2004 and 52% higher than the fourth quarter of 2004.” “Net revenues in Investment Banking were $893 million, 17% higher than the first quarter of 2004…” “Compensation and benefits expenses were $4.26 billion, 7% higher than the first quarter of 2004 and 49% higher than the fourth quarter of 2004.” The company repurchased 11.5 million shares of stock during the quarter.
Bear Stearns reported first quarter Net Income of a record $379 million, up 5% from the year ago quarter. “Once again the diversity of our franchise is demonstrated in this quarter’s strong performance,” said CEO James Cayne. “Fixed Income net revenues were $824 million, up slightly from $819 million in the year-ago quarter. The Credit business produced record revenues led by the credit derivatives, high yield, distressed debt and leveraged finance areas. Record revenues from interest-rate businesses were driven by increased customer flow in interest-rate derivatives and foreign exchange. Mortgage-related revenues remained robust…”
Not only are all the securities firms doing exceptionally well, virtually all businesses of each of the brokers are doing exceptionally. This is true by product type as much as it is by region globally. I would argue that there are today no better indicators of broad-based Liquidity Excess and Credit Availability than those provided by the operating success of Wall Street. It is worth digging a little deeper.
Combined Bear Stearns, Lehman, Goldman, and Morgan Stanley first quarter revenues were up 29% from the year ago period to a remarkable $31.6 billion. By major category, Principal Transactions were up 11% to $9.3 billion. Investment Banking increased 13% to $ 2.6 billion. Commissions were down 2% to $1.5 billion. Most notably, Interest & Dividends surged an amazing 63% from one year ago to $14.9 billion. And as Interest Expense rose 74% to $12.5 billion, Net Revenues increased 10% to $19.0 billion. How large must positions be (by the brokers and their clients) to generate approximately $60 billion of annual interest and dividends?
The degree of recent Wall Street ballooning is demonstrated more clearly by comparing combined first quarter 2005 results back two years to comparable 2003. Combined Total Revenues were up 54%. By major category, Principal Transactions were up 84%, Investment Banking 51%, Commissions 31% and Asset Management 4%. With Interest & Dividends up 56%, Total Combined Net Revenues were up 44% over two years. And, more specifically, Principal Transactions combined with Interest & Dividends increased 66% in two years to $24.2 billion. How much have positions mushroomed over the past two years to generate such incredible growth?
Combining the most recent data available from Bear, Lehman, Goldman, Morgan Stanley, and Merrill, I come up with combined Total Assets of approximately $2.60 Trillion. This is up 24% from comparable year-ago Total Assets, with a two-year gain of 44%. Fellow data hounds might question why the Fed’s “flow of funds” data has total Securities Broker Assets at $1.84 Trillion, significantly below my total of assets for just the five largest firms. Well, the Fed does not report “Security RPs” (repos) assets, but instead nets repo assets against liabilities. A “Security RP (net)” of $528 billion shows up as Security Brokers and Dealers liability, thus understating actual total assets and liabilities. It is worth noting that the Fed also nets Banking sector repos, also underreporting total bank assets and liabilities. With outstanding repos now approaching $3.2 Trillion, the netting of repo assets and liabilities significantly understates the financial sector balance sheet.
Listening to this week's Wall Street earnings conference calls, I clearly sensed a newfound degree of confidence – the type that develops over time after making more money than one could ever have imagined; making it in so many ways in so many diverse markets; and after overcoming myriad setbacks and a few near panics. After all, if things go wrong in one market, there are all these other hot markets. Today’s Exuberance is rational but misguided. These diverse markets couldn’t all falter concurrently, could they?
As always, overly abundant liquidity and acute asset inflation create genius and fearlessness, and there’s more of all of the above today than ever. Everything is working for Wall Street – Absolutely Everything. Opportunities seem endless and everyone is energized. Sure, rising rates would marginally hurt the value of bond positions, but this would supposedly be offset by a jump in trading and derivative volumes as hedge funds and other clients move aggressively to hedge and reposition. Similarly, a further decline in the dollar or gain in crude would present additional opportunities. Both would incite only greater trading and hedging volume. And just look at the huge (limitless?) opportunities available in the emerging markets!
We have reached The Pinnacle of Wall Street Finance. Endless Credit and liquidity has fueled booms in virtually all asset classes everywhere – 24/7 around the globe. Indeed, Wall Street “structured finance” has mastered the powerful capacity to generate its own liquidity – to create buying power for securities and instruments it fashions and sells. And these skills, technologies and structures have been aggressively implemented across the globe. It is natural for Wall Street and market participants to extrapolate current boom-time conditions – The Heyday of Financial Engineering - far into the future. It is too easy today to forget that there are critical market dynamics at play; that market tops sow the seeds of their own demise.
We all have learned that a market top is established when “everyone” has finally bought in – literally and figuratively. When The Crowd is secure with the bullish story and enthusiastically owns the asset (classic mania), there is no one else left to buy. Prices are left to go nowhere but lower and often abruptly. Well, that’s an important aspect of market dynamics. Not as straightforward or commonly appreciated are the commanding liquidity dynamics that fuel unsustainable asset inflation and resulting distortions. This is true for individual markets tops and can be true as well for entire financial systems.
When a Credit system as a whole succumbs to speculative market dynamics, liquidity effects and distortions become dangerously systemic. Such dynamics played crucial roles during historic boom and bust periods such as the “Roaring Twenties,” and to a lesser extent late-eighties Japan.
The ballooning of the broker call loan market in the late-twenties evolved into the mechanism providing the marginal source of liquidity for the asset markets and the increasingly finance and asset-based economy. In a definitive demonstration of the power of late-cycle market dynamics, the 1928/29 “blow-off” of margin lending and resulting asset price spikes assured imminent systemic crisis. Price gains had, at that point, become unsustainable, while liquidity and perceived wealth effects were severely distorting the Bubble Economy. Highly speculative and inflated asset markets, along with an increasingly maladjusted economy, required uninterrupted and ever increasing amounts of Credit and liquidity. There was no way out.
The inevitable (if not easily predictable) market reversal set in motion a liquidation of positions and a self-feeding collapse in speculative leverage. Not only had the boom created its own source of finance, the resulting asset inflation and liquidity effects fostered profound distortions to the nature of spending and investing, hence the underlying structure of the real economy. When the marginal source of liquidity – stock market leveraging – reversed, the financial and economic spheres’ underlying vulnerability quickly manifested. Perceptions and spending patterns changed overnight.
To this day, there are many (notably, Dr. Bernanke and the “Friedmanites”) who believe the underlying economic fundamentals of the 1920s were sound. The twenties were The Golden Age – The New Paradigm - for American ingenuity, productivity, free markets and, not to be underappreciated, central banking. If only the (post-Benjamin Strong) Fed had not “popped the Bubble” and then compounded the crisis by failing to create sufficient “money” after the market break, then that great period would have been sustained. What they fail to grasp about late-twenties systemic fragility, they fail to appreciate today: Speculative Leveraging Having Evolved into the Marginal Source of Systemic Liquidity.
Today, Wall Street “structured finance” is The Speculative Bubble – the marginal source of liquidity for both the financial and economic spheres. It has evolved to commandeer our entire Credit system and others’. And never has the structure of a Credit system been more conducive to Bubble dynamics. Financial engineering provides the capability to craft any type of security or any instrument to satisfy the demand of would be speculators or investors. At the same time, virtually any type of loan can be devised for the convenience of the borrower, and then easily found a home as collateral for a structured product. Moreover, Wall Street, especially through the “repo” market, essentially provides unlimited low-cost finance for securities leveraging (financing spread trades). The resulting liquidity excess then stokes inflation across a broadening array of asset classes, only inciting greater and more diverse speculative leveraging. It is really a case of the harder Wall Street works the greater the demand for their services and products.
The problem today – too similar to 1929 – is that the larger the number and the greater degree that markets domestically and internationally succumb to Asset Inflation Dynamics, the greater the amount of Credit and liquidity required for sustaining the Bubble. How much additional Mortgage Credit will be required this year to sustain housing inflation throughout California, Florida, the East Coast and nationally? How much additional Credit market leveraging will be required to supply the cheap finance necessary to sustain The Great Mortgage Credit Bubble? How much U.S. Mortgage Credit will be necessary to sustain U.S. consumption, the key source of global demand? How much financial Credit will be necessary to sustain the enormous flow of speculative finance to emerging equity and bond markets? How much additional Credit will be required to finance the rising cost of energy and commodities? Investment in global energy research, exploration, extraction and transport?
Well, let’s just answer each of the above questions with “a lot.” The point is that to now sustain myriad asset Bubbles and broadening inflation will require enormous quantities of additional Credit and liquidity. Ask Wall Street and they would enthusiastically avouch that they are quite up to the task – more than able and willing. And, for now, that may indeed be the case. Importantly, however, we have now reached the point – with spiking crude, California home values, and the Current Account Deficit – that the system has developed a powerful inflationary bias. Sustaining the Wall Street Bubble has become immediately destabilizing and problematic.
Today a familiar pundit asserted on CNBC – supporting his view that the market has discounted too many Fed rate hikes - that the rise in fuel costs is similar to a tax increase. He contends that the Fed is nearing “neutral” territory and will soon back off. Well, I disagree. If crude and energy prices were rising in isolation, I would say he makes a valid point. Energy inflation, instead, is only one dimension of what is now endemic asset inflation, commodities being only one facet. While losing a bit at the pump, more consumers than ever perceive they are profiting from asset inflation and the resulting investment boom (especially housing and energy). Moreover, this type of inflation, by its very nature, will incite only greater speculative leveraging. The system, at this point, demonstrates a strong proclivity to monetize rising prices - inflation begeting higher inflation. This highly unstable environment will not make it easy on the Fed.
While Wall Street is a huge beneficiary of the inflationary boom, a few of the early losers (to inflation's wealth transfer) are beginning to surface. The airlines and American auto manufactures come to mind. And this week we saw some financial turbulence erupt at the periphery. Yet I don’t want to make too much of potential problems in the corporate or emerging bond market arenas at this point. I still have the sense that the key developments will manifest initially at The Core – Mortgage and “Repo” Finance. And this is precisely where Bubble and asset inflation dynamics turn most fascinating.
Wall Street is making (“printing”) incredible amount of “money” these days in both leveraged speculation and aiding and abetting the other leveraged speculators. Finance is easier than ever; excess easily everywhere. There is as yet no sign of faltering systemic liquidity - anything but.
I do think we have reached the “pinnacle.” In the past, flight from riskier assets and a bout of safe-haven buying were just what the doctor ordered for The Core. Credit and speculative excess would be restrained at the fringe, while Treasury yields were pressured lower. The backdrop would support increased (repo?) leveraging in government, agency, and MBS, while stoking liquidity at The Core. Today, however, with the all-encompassing securities boom and endemic leveraging having become so persuasive, there is unappreciated heightened vulnerability at The Core. Things have become so hot at the expanding and prospering periphery that this old faithful mechanism to help cool The Molten Core no longer functions.
Inflationary forces – most powerfully manifesting in global asset and commodities markets - are reaching the point that risks a significant rise in market yields. The wheels of global Credit are spinning much too fast. And this dynamic appears poised to risk havoc upon the highly leveraged and those exposed to interest rate derivatives. Sophisticated models, used in exuberant excess, were not developed to anticipate the historic Credit Bubble Blow-off they have worked to incite. Indeed, there are now the initial rumblings of problems in mortgage-related derivatives instruments.
I am this evening reminded of 1994 and the dynamics of deleveraging, derivative unwind and contagion. There are, as well, aspects of today’s acute systemic vulnerability that recall the “Asian contagion” and the LTCM fiasco. But there are also key aspects of the current environment unlike anything during these previous crisis periods. On the one hand, the global economy and domestic Credit systems, in most cases, are more robust. The Periphery does not appear as fragile, and the general liquidity backdrop and inflationary bias are much stronger. On the other hand, The Core – U.S. Mortgage and Repo Finance – appears more assailable than ever. And the GSEs’ market support has been basically taken out of the equation, while the Fed is hamstrung by a fragile dollar, already too low interest rates and heightened inflationary pressures. The unfolding environment will surely provide the utmost challenge for our analytical capacities.
