I hear pundits still referring to a “deflationary Credit collapse.” Well, the U.S. Credit system implosion was largely stopped in its tracks last month. The Fed bailed out Bear Stearns; opened wide its discount window to Wall Street; and implemented unprecedented liquidity facilities for the benefit of the marketplace overall. Central banks around the globe executed unparalleled concerted market liquidity operations. Here at home, the GSEs’ regulator spoke publicly about Fannie and Freddie having the capacity to add $200 billion of mortgages to their balances sheets, with the possibility of increasing their guarantee business as much as $2 TN this year (certainly including “jumbo” mortgages). The Federal Home Loan Bank system was given the ok to continue aggressive liquidity injections and balloon its balance sheet in the process. And now (see “GSE Watch” above) we see that the Federal Housing Administration (with its new mandate and $729,550 loan limit) is likely to increase federal government mortgage insurance by as much as $200bn this year, while Washington’s Ginnie Mae is in the midst of a securitization boom.
Together, the Fed and Washington have effectively nationalized a large portion of both mortgage and market liquidity risk. It is, as well, worth noting that JPMorgan Chase expanded assets by $80.7bn during the first quarter (20.7% annualized) to $1.642 TN, with six-month growth of $163.3bn (22.1% annualized). Goldman Sachs expanded its balance sheets by $69.2bn during Q1 (24.7% annualized) to $1.189 TN, with half-year growth of $143.2bn (27.4%). Even Wells Fargo grew assets at an almost 14% pace this past quarter. And we know that Bank Credit has expanded at a 12.6% rate over the past 38 weeks. Meanwhile, GSE MBS issuance has been ramped up to a record pace. And let’s not forget the Credit intermediation function now being carried out by the money fund complex - with assets having increased an unprecedented $371bn y-t-d (41.3% annualized) and $900bn over the past 38 weeks (47.7% annualized). It is also worth noting the $184bn y-t-d increase (29% annualized) in foreign “custody” holdings held at the Fed. Sure, the Credit system remains under significant stress, with additional mortgage and corporate Credit deterioration in the offing. But, at least for now, policymakers have successfully stemmed systemic deleveraging. The Credit system is simply not in deflationary collapse mode.
I could not be more pessimistic with regard to our economy’s prognosis. And certainly much more severe Credit problems lay ahead. I could argue further that recent Credit system developments are indeed consistent with the unfolding “worst-case scenario”. Yet I tend this evening to see benefits from analyzing the current backdrop in terms of the conclusion of the first Stage of the Crisis. The key aspect of this “first Stage” was a breakdown in Wall Street’s highly leveraged risk intermediation and securities speculation markets. The speed and force of the unwind was extraordinary and in notable contrast to traditional banking crises that track real economy developments. “Resolution” came only through the Federal Reserve and federal government assuming unprecedented risk - and at a cost of an unprecedented policymaking mix of interest-rate cuts, marketplace interventions, and government guarantees. It is worth pondering some of the near-term ramifications.
First of all - and as the market recognized this week - yields had been driven to excessively low levels. Fed funds are today ridiculously priced in comparison both to the inflationary backdrop and to global rates. Mr. Feldstein is calling for a halt to rate cuts when it would be more appropriate for the Fed to move immediately to return rates to a more reasonable level. They, of course, would not contemplate as much. So I will presume that today’s non-imploding Credit system - replete with government-backed mortgage securitizations, government-guaranteed bank Credit, presumed government-backstopped money funds and a recovering debt issuance apparatus - will suffice in the near-term in generating Credit sufficient to perpetuate our enormous Current Account Deficits. This is no minor point.
I have in past Bulletins made the case that U.S. Credit and Economic Bubbles had become untenable - the scope of Credit and risk intermediation necessary to support the maladjusted economy had become too large. Extraordinary measures to effectively “nationalize” mortgage and market liquidity risk change somewhat the direction of the analysis. I would today argue that the risk of a precipitous economic downturn has been reduced in the near-term. As a consequence, U.S. Credit growth could surprise on the upside with risk to global Price Instability increasing markedly.
I would argue firmly that - in the face of a rapidly weakening economic backdrop - global inflation dynamics coupled with our highly maladjusted economy ensure intractable trade deficits. I would further argue that the current inflationary backdrop will prove an impetus to Credit creation - that then begets only more heightened inflationary pressures. There are certainly indications that the over-liquefied global “system” is not well situated today to handle more dollar liquidity (akin to throwing gas on a fire). Inflation and its consequences have quickly become major issues around the world.
With crude hitting a record $117 today, there is every reason to expect that newly created global liquidity will further inflate energy, food, and commodity prices generally. The Goldman Sachs Commodities index has gained 21% already this year. But when it comes to Monetary Instability, our financial markets might just prove the unappreciated wildcard. When the Fed and Washington radically altered the rules of U.S. finance last month, they placed in jeopardy huge positions that had been put in place to hedge against and profit from systemic crisis. With the end of “Stage one” arises a major short squeeze in the Credit, equities, and derivatives markets. And when it comes to contemplating the scope and ramifications of today’s “hedging” activities, we’re clearly in Uncharted Waters. It is not beyond reason that a disorderly unwind of “bearish” Credit market positions could incite a mini bout of liquidity, speculation, and Credit excess that exacerbates Global Monetary Instability - while Setting the Backdrop for Stage Two of the Crisis.
