The King of Non-Productive Debt
By Doug Noland June 10, '11 (PrudentBear.com)
There is important confirmation of the “bear” thesis to discuss. But, as usual, let’s first set the backdrop:
The world is in the midst of history’s greatest Credit Bubble. A dysfunctional global financial system essentially operates without mechanisms to regulate the quantity and quality of debt issuance. In response to severe banking system impairment and fiscal problems in the early-nineties, the Greenspan Fed helped nurture a Credit system shift to nontraditional marketable debt. The bank loan was largely replaced by mortgage-backed securities (MBS), asset-backed securities (ABS), GSE debt instruments, derivatives and a multitude of sophisticated “Wall Street” Credit instruments. The Credit expansion grew exponentially, while becoming increasingly detached from production and economic wealth-creation (the boom, in fact, exacerbated deindustrialization).
The Fed implemented momentous changes in monetary management to bolster the new “marketable debt” Credit system structure, including “pegging” short-term interest rates; serial interventions to assure “liquid and continuous markets;” and adopting an “asymmetrical” policy framework that disregarded asset inflation/Bubbles, while guaranteeing the marketplace an aggressive policy response to any risk of market illiquidity or financial/economic instability. Massive expansion of marketable debt coupled with a highly-accommodative policy backdrop incited incredible growth in speculation and leveraging. Over time, trends in U.S. Credit, policy and speculative excess took root around the world.
Global markets suffered a devastating crisis of confidence in 2008. The failure of Lehman Brothers, in particular, set off a panic throughout global markets for private-sector debt, especially Credit intermediated through sophisticated Wall Street structures. Unprecedented government intervention reversed the downward spiral in Credit and economic output. Especially in the U.S., Trillions of private debt instruments were put under the umbrella of government backing. Meanwhile, Trillions more were acquired by the Fed, ECB and global central bankers in the greatest market intervention and debt monetization in history. Policy making – fiscal and monetary, at home and abroad – unleashed the “Global Government Finance Bubble”.
Currency market distortions have been instrumental in sowing financial fragility and economic instability. Chiefly because of the dollar’s special “reserve currency” status, U.S. Credit system excesses have been accommodated for way too long. Global central banks have been willing to accumulate Trillions of our I.O.U.s, providing a critical liquidity backstop for the marketplace. Highly liquid and orderly currency markets have been instrumental in ensuring a liquid Credit market, which has provided our fiscal and monetary policymakers extraordinary flexibility to inflate our Credit, our asset markets and our economy. Meanwhile, massive U.S. Current Account Deficits and other financial flows have inundated the world, creating liquidity excess and unfettered domestic Credit expansion throughout the world. Global imbalances, having mounted for decades, went “parabolic” over the past few years.
I would argue strongly that the euro currency regime owes much of its great success to the structurally weak U.S. dollar. For all the flaws and potential pitfalls of a common European currency, the euro has from day one looked awfully appealing standing side-by-side with the dollar. And the buoyant euro created powerful market distortions that promoted Credit excess throughout the region, especially in Europe’s periphery (Greece and the so-called “PIIGS” would never have enjoyed the capacity to push borrowing to such extremes had they been issuing debt denominated in their own currencies). The weak dollar and strong euro – along with the perception that the Eurozone and ECB would never tolerate a default by one of its sovereigns – were instrumental in promoting profligate borrowing, lending, spending and speculating.
I have recently turned more focused on differentiating between “productive” and “non-productive” debt. This is an important analytical distinction – although, by nature, a challenging gray area for Macro Credit Analysis. At the time of its creation, there might actually be little difference from a systemic perspective whether a new financial claim is created in the process of financing real investment or an asset purchase or, instead, to fund a government stimulus program. In each case, new purchasing power is released into the system. The key is that the new Credit stimulates economic “output” through increased spending, incomes and/or asset inflation. Especially during the halcyon Credit boom days, the markets will pay scant attention to the assets underpinning the new debt instruments (particularly when policymakers are actively intervening and distorting markets!).
However, don’t be fooled and don’t become too complacent. At some inevitable - if not predictable - point the markets will care tremendously whether a Credit system is sound or not. Regrettably, the current era’s (unrestrained global finance, structurally-unsound dollar, “activist” policymaking, rampant global speculation, etc.) unique capacity for sustaining non-productive debt booms poses major problems. In short, the booms last too long and activist policymaking ensures they end up afflicting the heart of Credit systems. These protracted Bubbles are resolved through problematic crises of confidence, debt revulsion and economic restructuring.
First of all, booms create a fragile mountain of debt not supported by underlying wealth-creating capacity. Second, Credit Bubbles inflate various price levels throughout the economy, creating systemic dependencies requiring ongoing debt and speculative excess. And, third, the boom in non-productive debt will tend to foster consumption and malinvestment at the expense of sound investment in productive capacity. When the boom eventually falters, market revulsion to unsound debt, the economy’s addiction to uninterrupted Credit expansion, and the lack of capacity for real wealth creation within the (“Bubble”) real economy ensure a very severe crisis and prolonged adjustment period. These dynamics become critically important as soon as a government (finally) loses its capacity to perpetuate the Bubble (i.e. Greece, Portugal, Ireland, etc.)
As a crisis unfolds, the markets eventually must come to grips with a very harsh reality: There will be denial and it will take some time to really sink in - but the markets will come to recognize that too little of the existing debt is backed by real wealth. Non-productive Credit booms are, after all, essentially “Ponzi Finance” schemes. Worse yet, only huge additional injections of debt/purchasing power will hold economic collapse at bay. Fundamentally, non-productive Credit booms foment deleterious effects upon the economic structure – that only compound over time. As we have witnessed with Greece and Ireland, “bailout” costs can quickly skyrocket to meaningful percentages of GDP - and will keep growing.
And once stunned by the downside of “Ponzi Finance,” markets will be keen to mitigate risk exposure to the next episode. This is the essence of “contagion effects.” Especially in interlocking global markets dominated by leveraged speculation and trend-following trading strategies, de-risking and de-leveraging in one market tend to quickly translate to risk aversion and faltering liquidity throughout the marketplace. Markets perceived as liquidity abundant can almost overnight be transformed to liquidity-challenged. This dynamic went to devastating extremes during the 2008 crisis – only to begin mount a resurgence with last year’s Greek debt crisis and contagion.
It has been my thesis that last year’s aggressive market interventions – QE2, the European fiscal and monetary “bailouts,” and massive global central bank monetization – incited a highly speculative Bubble environment vulnerable to negative liquidity surprises. And now we’re down to the final few weeks of QE2. The European bailout strategy is unwinding, with little possibility of near-term stabilization. Meanwhile, the US economy has downshifted in spite of massive fiscal and monetary stimulus. Risk and uncertainty abound; de-risking and de-leveraging are making a comeback.
Bloomberg went with the headline, “Fed’s Maiden Lane Sales Trigger Bank Stampede to Dump Risk.” At The Wall Street Journal, it was “As ‘Junk’ Bonds Fall, Some Blame the Fed.” Both articles noted the deterioration in pricing for a broadening list of Credit market instruments, including junk bonds, subprime mortgage securities, and various Credit derivatives. And while the Fed’s liquidation of an old AIG portfolio is surely a drag on some prices, I believe the rapidly changing liquidity backdrop is more indicative of global de-risking dynamics. This is providing important confirmation of the bear thesis.
here are fascinating dynamics at work throughout our Credit market. Arguably, the U.S. is the King of Non-Productive Debt. In the wake of a historic expansion of non-productive household debt comes a Bubble in government (Treasury and related) Credit. The assets underpinning too much of the U.S. debt mountain are of suspect quality, although this hasn’t mattered recently. And in true Bubble fashion, the marketplace has increasingly gravitated to Treasury debt as the “Greek” crisis escalates and contagion effects gather momentum. The corporate debt market has enjoyed extreme bullish sentiment – along with waves of investment and speculative inflows. While the corporate balance sheet appears sound, I would counter that corporate earnings and cash flows have been artificially inflated by unsustainable federal deficits. In particular, the bubbling junk bond market would appear vulnerable to the deteriorating liquidity backdrop.
Elsewhere, there is the murky world of subprime derivatives and such. This bastion of speculative excess certainly enjoyed the fruits of policy-induced reflation. But not only has housing performed dismally, there are now the market issues of de-risking and liquidity uncertainties. Today from the WSJ: “Since April, prices of many subprime mortgage securities have declined between 15% and 20%... The decline in subprime mortgage bonds accelerated in the last two weeks…” From Bloomberg this morning: “Declines in credit-default swaps indexes used to protect against losses on subprime housing debt and commercial mortgages accelerated this month, reaching almost 20% in the past five weeks..” Also from Bloomberg: “Default swaps on the six largest U.S. banks have gained an average of 19.4 bps to 137.2 bps since May 31…
In conclusion, support seemed abundant this week for the thesis which holds that the U.S. Credit system and economy are much more vulnerable to contagion effects than is commonly appreciated. Treasury and dollar rallies appear constructive for system liquidity. In reality, it is likely that both markets are heavily impacted by speculative trading (speculators, in various forms, have used Treasury and dollar short positions to finance higher-returning holdings). Strength in the Treasury market and the dollar are indicative of – and place additional pressure on – the unwind of leveraged trades. And it is when the speculator community finds itself back on its heels and backing away from risk that liquidity becomes a critical market issue.
http://prudentbear.com/index.php/credit ... t_id=10541
Apparently he didn't like my simpler mathematical solution since it was so easy to understand.
