Anybody who reads this will go out and buy GOLD,SILVER,GUNS AND AMMO!!!!!

April 5, 2006



Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his newsletter.



There is a well known old saying “Nothing succeeds like success.” There is another perversion of that saying: “Nothing succeeds like excess!” In recent decades, both have become an acceptable mantra proven by “successive” ends to efforts to create success and excess! As the globe’s economies cross from Winter into Spring in this year 2006, there is virtually no area not enjoying “prosperity” and success. Economic “success”, as usually described by pundits and media (think Larry Kudlow’s television mantra) always encompasses the word “growth.” Virtually in every instance growth in any economic form relates to “profits.” Obviously, profits are success in this early 21st century. Much of the world measures these profits in United States dollars. For much of the last four years, this “growth” or expansion has been fueled by the most incredible growth in global liquidity in the known annals of human history. Not only has there been enormous liquidity, interest rates have been phenomenally low until very recently. Admittedly, the United States Federal Reserve has spent over a year raising the overnight rate in the United States from 1% (below 0% on an inflation adjusted basis) to the current 4.75%, but the longer end of the curve has virtually ignored their efforts. Liquidity during this Federal Reserve charade has mounted. In the case of the broadest measure (to be extinguished with this month’s last report for reasons unexplained by the Federal Reserve) M3 has advanced at rates approaching 10% in recent months. In passing, it might be noted that the required contribution by financial institutions of the components of M3 to the Federal Reserve are to be continued; the Fed just doesn’t want to publish this revealing measure any more.



One of the most prolific areas of growth globally has been real estate, particularly residential real estate. With interest rates at epochal lows around the globe, the old adage in real estate of low rates equals high growth has been exploited to the utmost. Much has been written about this munificent growth in houses and house prices and, other than a “canary in the coal mine story” about one small country sucked into the orgy, this will not concentrate on that aspect of liquidity and credit growth, but on other manifestations.



First, to get the afore-mentioned housing related bubble story out of the way, we would initially mention a central bank today forced to raise its interest rate equivalent to our Fed funds rate to 11.5%! That beleaguered central bank is the central bank of Iceland. This miniature country got caught up in the “house prices only go up” mantra as their relatively high rate several years ago attracted a tsunami of liquidity which poured into - you guessed it - the housing market. As more houses than Icelanders emerged, the market flooded and the tsunami went back out to sea, leaving the Iceland kronor down some 20% in a couple of weeks. How the story will play out, we have no idea, but there is at least a lesson to be learned for possible other liquidity driven booms, bubbles and housing explosions for the near future. The same hedge fund driven carry trade that caused this Icelandic meltdown (technical term) is besetting the New Zealand kiwi, recently forcing their short term rate to over 7%. As these hedge fund games unravel, some serious damage will be done to small, innocent countries. Since there has been a residential property bubble, in each instance, the commercial banking systems, in which most mortgages reside in these small countries, will confront increasingly difficult credit quality, default, foreclosure and bankruptcy situations. This may possibly lead to severe damage or crisis in the banking systems involved.



The Brave (And It Had Better Be) New World Of Credit!

Now we proceed to the main point of this exercise. It is our contention that The World of Credit Extension has changed dramatically since the last significant test of credit during the 1989-1991 slowdown (the 2001 drop was so slight as to have not been a test of underwriting and delinquency in our opinion). We will attempt to catalogue some of the more significant of these changes. There are so many that detailing the whole universe is impossible.



My friend, Doug Noland has made the point for an increasing number of years now that the definition and nature of Credit has changed completely from what most still assume it to be. What is endlessly fascinating is how little this transmogrification is understood at this late stage of the game. Doug first showed that the conventional central bank creation of credit definition was outmoded quite a few years ago, using as an example, the Government Sponsored entities Fannie and Freddie. These two Agencies were able to create virtually unlimited amounts of credit through the belief that they were governmentally supported and an accommodating financial market without any interaction with the reserve based banking traditional method of credit creation.





In 2003, they essentially restarted the economy after the blow-up of the dot-com/telecom bubble through easy credit to a housing sector emboldened by Fed rate cuts to levels which could not be resisted, both in the refinance and the construction arenas of residential housing. Too bad it turned out that these supposedly pristine, superbly managed entities were really cooking the books! Nevertheless, they have several trillions of assets now, and even more trillions of indirect exposure through guarantees of mortgage debt. The totals exceed direct U.S. Treasury debt. The Administration has tried to rein in these institutions without success. It is anybody’s guess as to whether they could be used by the Treasury and Fed should the housing bubble burst to again re-liquify the housing market. There has to be some hesitation as neither institution has been able to produce certifiable financial results as yet. There seems little likelihood that the U.S. Government can divorce itself from responsibility for all these trillions if the housing situation suffers an extreme hard landing rather than the expected glide onto the runway. I was just reading that 10 of the 12 Federal Home Loan Banks with another $600 Billion in liability claims have failed to file appropriate financial statements on time. These worthies took up credit extension, again outside the traditional reserve based methodology when Fannie and Freddie left off. Again, there is no way to separate them from direct U.S. debt if they get into difficulty.



Enough about Agency creation of credit. Suffice it to say it is massive, dubious in underwriting standards, accounting and credit quality, and constitutes a potential systemic risk. Worse yet, a very sizeable portion of the debt these entities have issued has been either used by hedge funds with leverage for a carry trade (the more conservative type of hedge fund, the swingers are trying to leave an afore-mentioned northern island before the ice completely melts) or by foreign central banks looking for a little more yield than the pitiful amount available in Treasuries.



When scandal hit the most easily accessible liquidity source for housing, the Agencies, the Financial Engineers revved up the Senior/Subordinated Structured Security for Collateralized Mortgage Obligations and sliced and diced the tranches to the point that any buyer could find exactly the “right” mix of risk and return! To a yield starved world, it was Christmas morning but with the advantage of knowing in advance the goodies to be unwrapped and proudly shown to the Bonus Committee! All kinds of fascinating advantages in “engineering” could be embedded in these structures. In the bad old days, if the mortgages in the pool were a little too toxic even for a relaxed Fannie and Freddie, PMI would have to take care of lack of a down payment etc. In the wonderful world of senior/subordinated, a little tweaking could even do away with such an inconvenience. This is confirmed by the fact that Mortgage Insurance in force has remained static at about $700 Billion for several years now. On the other hand, there is a surely worsening adverse selection going on as bulk insurance written has mounted as a percentage of the total. Additionally, with the wonders of “financial engineering on the senior/subordinated game, only the worst of pools will have required bulk private mortgage insurance. The MTG’s and MBIA’s of the world look to have slow growth, rapidly increasing credit problems and lots of future fun in raising liabilities. Ah well, they may well make it up in the Credit Default swap game at which they are increasingly active.



In the wonderful world of senior/subordinated CMO’s, given the “perfect” yield and risk the buyer was getting, the fees to the creator were not to be questioned. On the other hand, the buyers for the so-called equity tranches (this is the stuff that even the most insane of hedge funds are likely to either spurn or ask too much of a discount for) seem increasingly to be the issuers. We have a lot of “seems” and similar weasel words in our peroration on the wonderful world of Collateralized Mortgage Obligations and their senior/sub structures, etc. This is due to the fact that this whole market is customized, over-the-counter issuance, and nearly perfectly opaque in analysis. In a few instances, some analysts have been able to track pools such as those issued by the GMAC mortgage subsidiary, and these are showing early signs of significant credit deterioration, but in many super customized issuances, there is simply no follow on after issuance available.



The aggregate total of CMO’s issued without Agency involvement in the senior/sub or other financially engineered format, is rising rapidly, and the global aggregate has long since exceeded the $1 trillion mark and continues to grow rapidly. This is yet another burgeoning form of credit issuance without involvement of the traditional fractional reserve banking structure other than having the balance sheets of the commercial banks holding very large amounts of the product. Exactly what entities are the counterparties/buyers for all of this issuance is impossible to determine. Where the risk and return are high enough and can be leveraged even higher, there is little doubt that the now estimated $1.5 trillion hedge fund community is a large player. What is as perilous is the likelihood that buyers of the more highly rated tranches are relying on “financial engineering” and a flawed rating agency mechanism to stretch for supplemental yield in an environment where insurance companies and pension funds are desperate for duration yield. Embedded in this mortgage creation/securitization explosion are many opportunities for the creation of well-rated paper, either mistakenly or deliberately over-rated. The potential for hazard is enormous.



1. The appraisal mechanism on which all this hinges is virtually unregulated and the compensation is from the entity wanting to have the “right” number.



2. The percentage of ARM, “option ARM”, 0% down, low doc/no doc mortgages in these securtizations has been steadily climbing over the last few years. The issuers are relying on models which really have no precedent in the creation of the various tranches.



3. The underwriting standards on equity, income, payment history, two income necessity, etc. have been and are being stretched to the utmost to “qualify” buyers at the rim of affordability.



4. The home building industry has finally over-reached as supply is at 6.3 months in an economy with extremely low unemployment, high GDP growth and burgeoning profits.



Leaving for the moment the inordinately large credit creation in the new and existing home purchase arena through Structured Finance and Financial Engineering with or without Agency support aggregating well into the trillions, there is yet another much more than trillion dollar credit creation mechanism to be found in what can be entitled the “Extraction of Paper Wealth from Incredibly Appreciated Home Equity on the Aforementioned Rickety Appraisal Mechanism Game.” While our Fed Chairman kept rates at “accommodating” levels and house prices mounted exponentially in many markets, the “game” was in the “refi” area of structured finance. Enormous amounts of credit over the last four years have been utilized to extract cash from the “appreciated” equity; contributing hundreds of billions of dollars to purchasing power in the “recovery.” Admittedly, there is probably a bell curve aspect and much of what has been withdrawn was from individual financial situations leaving more than sufficient equity. Nevertheless, at the margin (and it is always at the margin that credit deterioration begins) there have clearly been abuses as shown in delinquency ratios in pools available for analytical scrutiny where clear deterioration is manifest. The worst performance so far is in the early stages of the 2005 pools, a year where lenders were desperately attempting to maintain volume. Underlining this trend are the returns of mortgages within 2005 pools that are escalating astronomically. These returns are under indenture provisions permitting return of delinquent or defaulting mortgages within the first 6 months after the purchase of the security. Taken together, the performance of the 2005 class augurs for significant future credit problems. In the pools available for public scrutiny this builds on worse performance also for the ’04 and ’03 issuances than historic averages would have predicted. The net of all this is that Financial Engineering has not changed human nature and where bubbles are in full expansion, standards will be abandoned and volume created without discrimination. Again, this credit extension is virtually all without prior precedent and experience and outside the traditional fractional reserve banking system. Attempts to regulate underwriting standards have been feeble and strongly resisted by the player universe.



In the world of “financial engineering” and “structured finance” there are few to no barriers. Particularly in the investment bank arena there are none of the regulatory strictures to be found in traditional banking. The bulk of the product is distributed to far flung counter-parties of largely unknown nature although foreign buyers, including central banks with their endless supply of deficit created dollars, are surely present. Of concern is the likelihood that duration seeking insurance and pension buyers are also heavily involved.



The year 2006 will see more than $2 trillion in mortgage security issuance and as a sidebar, it is fascinating to see that the banking industry still finds these securities attractive as their earlier holdings slowly sink into the red.



In the aggregate, the mortgage issuance game is the most monumental of credit creations in the “Brave New World” of credit where “value” created from a housing mania abetted by appraisal raising can generate this multi-trillion credit expansion totally outside the bounds of historic, conventional credit extension.



With rates finally slowing the housing spectacle, 2006 has continued the shift in credit creation in housing into another alternative, home equity lending. While apparently still a few billions short of the usual trillion or more mark for these new sources of credit in this expansion, that mark could well be achieved this year. Not only has there been no slowdown, it is clear that homeowners are increasingly turning to the home equity credit creation mechanism as the price rise on their homes shuts down the cash-out refi ATM.

It is interesting to note that some of the most rapid growth in these instruments is coming from the newcomers to residential credit banking, such as the Countrywide bank. It is not so surprising as volume must be maintained and the new 2006 bubble, commercial real estate, is not as readily available to these non-traditional entities.



Although not new in the sense of “imaginative financial engineering”, there is yet one other form of credit extension in the structured finance world of large dimension and different standards this time around. This is the hackneyed world of auto finance. With average terms now well over 5 years, many loans written “upside-down” as incentives have yanked future sales forward, and underwriting standards are suffering the same deterioration as other consumer credit. This more conventional but newly aggravated bloat of outstandings will not escape problems as the cycle turns.



It is hoped that the above compendium on credit in formats that are not your grandfather’s format on credit creation in, largely, the real estate arena as well as some others, illustrates the stance that credit creation in the United States has completely escaped the bounds of the Treasury/central bank regulated credit creation mechanism of old! The “leveraged speculating community” and their providers can create credit at will and absolutely must continue to do so at ever accelerating rates to maintain the bubble. With a hiss escaping from the housing mega bubble, commercial real estate, private equity and mergers and acquisitions are striving to fill this need. Will they find enough to succeed?



Momentarily we will revert to ground covered in previous missives on how part of this credit explosion has succeeded. 2006 will see a current account deficit approaching the number $1 trillion.





The cumulative deficit since the last slowdown is approaching $6 Trillion. Foreign central banks, loath to let their currencies appreciate, have recycled the bulk of this into Treasuries and Agencies, freeing up the more aggressive speculators to do the risky housing credit, the recent surge in commercial real estate, with the inveigling of pension and insurance investors into the game, the private equity and M&A players have had massive liquidity infusions and pursue such endeavors with abandon.. The United States deficit has led to foreign reserves growing to well over $4 trillion. All of this has been labeled “a global savings glut” by our inimitable Federal Reserve pundits. Absurd! It is a lack of U.S. savings! Therefore unparalleled borrowing.



There will come a time where this cycle is unsustainable. There has never been a case of a debtor, individual, company or nation, having an infinite capacity to borrow!



The timing of the denouement is obviously unknown, but the melting of Iceland and difficulty of New Zealand say the dynamic is beginning to change as does the more than 6 months supply of houses in the U.S.



We have written previously of a mongrelized form of credit extension/insurance known as the Credit Default Swap market. Since our last mention, figures for this market for full year 2005 have become available. Jim Grant’s Interest Rate Observer (we are “paid up subscriber” and therefore a member of his “small perverted cult of readers”) says with what might be sarcasm that the market “only” grew some 40%+ last year, i.e. from $12 trillion to $17.5 trillion! We are puzzled, frankly, as to whether this phenomenon constitutes credit extension. Certainly the purchasers believe that they have shed credit exposure and may well be emboldened to use the capacity freed up to expand their balance sheet further. There is also the question of settlement. The “industry,” if that is a proper term, is trying to move to cash settlement as it is embarrassing at least when a company gets into difficulty and multiples of their bond issuance are outstanding in the CDS world. If cash settlement is adopted, the issuers of CDS will have contingent and perhaps actual cash liabilities, and we would argue that credit has therefore been created through this market. Ah well, an enigmatic question to draw thoughtful discussion.



Without unduly repeating the jeremiad in our last missive on the largely uncircumscribed risks in the explosively growing universe of CDS, there is no question this new form of quasi credit is totally outside the purview of normal regulation. So much so that the President of the NY Fed has done well to extract a commitment that by summer, they will ONLY have 30% of the burgeoning contracts delineating (or not delineating as the case may be) the terms of CDS issued and extant.



Outside the U.S. over the last two years as the internally generated carry trade occasioned by the Fed’s long encampment on 1% overnight rate gradually dissipated, there was a transfer of this humongous carry trade to other, particularly the Japanese yen and the Swiss franc, hospitable carry trade currencies.



Much of the offset assets acquired were also foreign but a significant amount was invested within the U.S. as the enormous Caribbean country holding increases made evident. These hundreds of billions are yet another form of credit creation totally outside the traditional credit granting and issuance methodology. Iceland may serve as an early warning that these carry trade plays may be beginning to dry up as the Japanese withdraw excessive reserves, their economy thrives and eventually they raise rates from 0%. The Swiss are finally realizing how far they have strayed from traditional Swiss central bank practices and will accelerate rate increases, perhaps even more rapidly. Nevertheless, there was certainly an enormous amount of credit created in these trades and the unwinding of extremely low historic spreads in the assets wantonly accumulated, frequently also highly levered, may prove more painful than the models predicting such events.



We will mention one further ballistically growing form of credit extension, completely outside the divorced from the traditional banking system/fractional reserve, regulated credit extension system of our past. We have only aggregated the balance sheets of the five most well known “brokers.” These traditional intermediaries are now ballooning credit granting machines. Balance sheet growth from 15-30% per annum has been the story for the last few years. These five, Morgan Stanley, Goldman, Lehman, Bear and Merrill now have in excess of $3 trillion in Liabilities. How much more is to be found in all the other “brokers” is an unknown but probably significant additional amount of credit. With M3 no longer being reported, it will be more difficult to track the continuing growth in this pool of credit. On average, they have less than 4% equity to assets, a ratio which would bring bank regulators running if they were in the commercial banking system. They do make the argument in their filings that there is a substantial composition of risk free assets in there, but there is no way to analyze in detail the veracity of such a claim. In any event, this is another enormous and incredibly rapidly growing form of credit extension that did not exist in prior cycles to anywhere near this extent. Oh, we would mention in passing that margin credit is back up to the tops numbers of the dot-com/telecom bubbles. Embedded in these entities in their capacity as prime brokers are the major relationships with the risk taking hedge fund community as well as CMO equity tranches, private equity deals held on balance sheets and other potential dynamite in a systemic or liquidity crisis. The magnitude of the credit exceeds that in any previous period of difficulty.

All of the foregoing has been an attempt to emphasize that the credit creation mechanism and credit granting systems in the united states in particular, and also in many other parts of the world which we do not have time or space to detail, are exponentially different and geometrically larger, more complex, difficult to analyze and categorically more dangerous in any turn to the downside in the credit cycle. Current euphoric risk spreads may not continue ad infinitum!