<blockquote>"
Today, Wall Street risk intermediation is a bloody wreck; the securities and derivatives markets are in complete disarray; the deeply impaired Wall Street firms have no choice but to rein in lending for securities speculation; and the hedge fund industry is in the midst of a massive de-leveraging and industry collapse. The market for creating, pricing and distributing finance is in complete upheaval.
In summary, The “Arb” Game is Over. Both supply and demand dynamics have been radically altered, while the cost and availability of new borrowings is now so uncertain. And, truth be told, speculative risk arbitrage had evolved into a primary monetary policy stimulus mechanism under the Greenspan Fed. In the event of any kind of systemic shock - or at any point market liquidity began to wane - a Greenspan signal of lower financing costs was all that was required to incite risk-taking and leveraging. Today, in contrast, with Wall Street finance in crisis no amount of rate cutting or other policymaking can resuscitate leveraged speculation. Going forward, the price of long-term private-sector borrowings will be determined by unadulterated supply and demand dynamics.
For years, the Wall Street Bubble distorted the price of finance. In particular, high-yielding risky loans – the favored domain of Wall Street “Alchemy” - were dramatically mispriced. This under-pricing of risk led to a massive (and self-reinforcing) over-extension of risky loans – for real estate, for speculating in securities markets, for funding enterprising businesses and municipalities, and for consuming. Over the long life of the Credit Bubble, this historic expansion of risky Credits altered the very fabric of our Economic Structure. In particular, Wall Street finance fostered asset inflation, over-consumption, and a finance-driven “services” Bubble economy. The consequences were momentous, and the unavoidable economic restructuring has now commenced."</blockquote>
The "Arb" Game is OverBy Doug Noland
October 16, 2008
SourceI’ll admit to having warmed up a little to chairman Bernanke. He speaks clearly and candidly, in stark contrast to the years of Greenspan spin and deception. I certainly have sympathy for the predicament Bernanke finds himself in today, and I’ll give the chairman Credit this week for comments suggesting that he is rethinking his flawed views with regard to Bubbles. Yet this doesn’t change the reality that his infamous 2002 “helicopter Ben” speeches played an integral role in fostering terminal Credit and Asset Bubble “blow-off” excesses. I was a critic of his selection as Greenspan’s successor, fearing that his appointment would bolster what had by that point evolved into Runaway Global Credit and Speculative Bubbles. And while I appreciated the frankness of chairman Bernanke’s comments this week, for the record I’m compelled to take exception to his assertion that subsequent developments have proved the Fed adroit for commencing aggressive rate cuts a year ago last summer.
When the Fed unexpectedly reduced the discount rate on August 17, 2007, inflationary pressures were mounting and, despite subprime tumult, financial excesses were actually accelerating. Financial sector debt expanded at 16.8% rate and non-financial debt at a 9.1% rate during 2007’s third quarter. Importantly, the dollar index was trading at about 81.50. Crude oil closed at $71 on August 16, 2007. The CRB index at the time was at about 300. Emerging debt and equity markets were Bubbling. The Bubble in the leveraged speculating community was out of control. Citigroup, Wall Street and the global banking community were struggling to dance in what had become a drunken global M&A blowout.
With a U.S. mortgage crisis brewing, the markets were keenly awaiting aggressive Federal Reserve largesse. They got it, and after six months of Fed rate cuts the dollar index had sunk another 15% to new bear market lows. During that period, crude oil surged almost 60% (to $110 and on its way to $145). Wheat and other commodities experienced spectacular speculative runs, provoking angst and bouts of food hoarding around the world. The CRB commodities index jumped about 40%. Emerging market Bubbles went to extremes. Brazil’s Bovespa equities index quickly gained about a third, while their $ bond yields dropped from an already stunning 6.5% to below 5.8%. U.S. bank Credit surged at double-digit rates; GSE books of business expanded by record amounts; money fund assets ballooned at an almost 50% rate; and funds flooded into the booming hedge fund community. A world awash in excess dollars saw generalized global monetary excess wildly inflate world markets and economies (at least partially to chase the highly profitable weak dollar trade). At home, U.S. corporate borrowings expanded at a better than 13% rate during the second half of 2007 (and 13% overall for the year).
The ECB has been widely assailed for their hesitance to lower rates, while aggressive Fed moves have been applauded. Yet I believe it is important to recognize that the Bernanke Fed only compounded earlier mistakes by signaling their intentions so imprudently to a highly speculative marketplace. There is absolutely no doubt that today’s global financial crisis was made much worse because of additional late-cycle excesses – and resulting Acute Monetary Disorder - fostered by the Fed’s accommodative stance beginning in the summer of 2007. The scope of the Bubbles and today’s spectacular collapses in global equities, energy, commodities, currencies, emerging debt and equity, corporate bonds, and the hedge fund community generally was exacerbated by the Fed’s premature move to “mop up” after the bursting of the U.S. Bubble. Moreover, I see very little offsetting benefit to the system from lower Fed funds.
Clearly, the U.S. and global Credit systems are today suffering mightily from years of reckless lending, capped off by 2007’s blowoff excesses (especially corporate and M&A-related debt). Fortunately, there were indications this week that recent unprecedented global policymaker response is having some positive impact. Dollar libor rates declined and there were other signs of an easing of conditions in the money and inter-banking lending markets. Commercial paper rates dropped to three-week lows. At the same time, however, it is becoming increasingly clear that there has been A Fundamental Transformation in the pricing of long-term finance for households, corporations and municipalities.
Over the past year, Fed funds were reduced 375 bps to 1.50%. At the same time, 30-year jumbo mortgage borrowing rates are up 88 bps to 7.62%. And despite “nationalization,” benchmark Fannie Mae MBS yields are still 33 bps higher than they were a year ago. Spreads on benchmark Credit card and auto loan asset-backed securities (ABS) were said to have widened between 100 and 125 bps this week to record levels. Junk bond premiums (S&P) have surged from 380 to 830 bps. During the past twelve months, investment grade spreads have almost quadrupled to 200 bps. And while there was minimal investment grade issuance this week, it is worth noting that those deals that did make it to the market were sold (mostly utilities) at spreads above 400 bps. Meanwhile, an index of municipal bond yields has risen from 4.15% to 6.01%.
There is now recognition that “de-leveraging” is behind the jump in private-sector borrowing costs. And yes, the system has suffered through bouts of forced liquidations before (1994, 1998, and 2002 come to mind), although nothing in the past is relevant to the massive overhang of Credit instruments now weighing on the marketplace. There remains, however, hope that some degree of normalcy will return to the fixed income marketplace when policy measures have had time to take effect and liquidations have inevitably run their course. I will throw out a thesis that there will be no return to what we grew to accept as normal. Despite policymakers’ best intentions (and resulting ballooning deficits and Fed Credit), market yields appear poised to surprise on the upside.
Wall Street finance is an unmitigated bust; Wall Street Alchemy – transforming endless risky loans into perceived “money-like” debt instruments - is a spent force. The greatest Credit and speculative Bubble in history is collapsing. Trust in innovative private-sector Credit instruments has been broken. Confidence in contemporary private-sector “money” has been severely shaken. Not in our lifetimes do I expect to again see booming securitization and derivatives markets. The days of unfettered leveraged speculation are over. And, importantly, the amount of Wall Street risk intermediation – through sophisticated securities, complex derivative structures, various types of Credit insurance, financial guarantees and liquidity arrangements, and unlimited speculator leveraging – will be significantly reduced for years and decades to come.
And it is my view that the demise of Wall Street risk intermediation means higher yields for household, corporate and municipal long-term borrowings. For years, there was virtually insatiable demand from Wall Street for high-yielding risky Credits – loans that could be transformed/intermediated into perceived safe and liquid debt instruments. Almost any risk could be sliced and diced, structured, and transferred to the “marketplace,” with enticing securitizations emerging from the financial alchemy. In many cases, these securities were then accumulated by the leveraged speculating community, in the process creating additional financial sector leveraging and the perception of endless system liquidity. It seemingly didn’t matter at all that we spent instead of saved.
Along the way, there were times when this Bubble found itself under some degree of stress. But with lower financing costs from the Federal Reserve and moves by speculators to arbitrage widening spreads, this financing mechanism would quickly right itself. Indeed, soon the Credit Bubble would more than regain any lost momentum. Importantly, the expanding scope of the speculator community and the endless amount of cheap Credit from the Wall Street firms (along with the global mega-“banks”) nurtured the perception that this historic episode of Ponzi Finance could last forever.
Today, Wall Street risk intermediation is a bloody wreck; the securities and derivatives markets are in complete disarray; the deeply impaired Wall Street firms have no choice but to rein in lending for securities speculation; and the hedge fund industry is in the midst of a massive de-leveraging and industry collapse. The market for creating, pricing and distributing finance is in complete upheaval.
Not only is the capacity gone for Wall Street to transform risky long-term loans into palatable debt securities. Market dynamics have profoundly altered the appeal of speculative risk arbitrage. For one, there is now a multi-Trillion dollar inventory of risky debt securities overhanging the market (from speculator de-leveraging). Second, the capacity for speculators to procure cheap financing for securities leveraging has been greatly diminished. Third, since there will be scant Wall Street demand for new risky Credits (previously transformed into easily marketable securities), ongoing financing requirements for the real economy will burden an already stressed marketplace with an unrelenting supply of risky Credits. And, fourth, risky Credits are especially unappealing as the economy sinks into a deep downturn.
In summary, The “Arb” Game is Over. Both supply and demand dynamics have been radically altered, while the cost and availability of new borrowings is now so uncertain. And, truth be told, speculative risk arbitrage had evolved into a primary monetary policy stimulus mechanism under the Greenspan Fed. In the event of any kind of systemic shock - or at any point market liquidity began to wane - a Greenspan signal of lower financing costs was all that was required to incite risk-taking and leveraging. Today, in contrast, with Wall Street finance in crisis no amount of rate cutting or other policymaking can resuscitate leveraged speculation. Going forward, the price of long-term private-sector borrowings will be determined by unadulterated supply and demand dynamics.
For years, the Wall Street Bubble distorted the price of finance. In particular, high-yielding risky loans – the favored domain of Wall Street “Alchemy” - were dramatically mispriced. This under-pricing of risk led to a massive (and self-reinforcing) over-extension of risky loans – for real estate, for speculating in securities markets, for funding enterprising businesses and municipalities, and for consuming. Over the long life of the Credit Bubble, this historic expansion of risky Credits altered the very fabric of our Economic Structure. In particular, Wall Street finance fostered asset inflation, over-consumption, and a finance-driven “services” Bubble economy. The consequences were momentous, and the unavoidable economic restructuring has now commenced.