Issue Number 02-4, January 2003
"Finance" in the Nineties
"And all the King's horses and all the King's men couldn't put Humpty together again." This line might well be the epitaph for the economy of the 1990s. We have had tax rebates, tax cuts, and the lowest interest rates in 40 years, but the economy continues to lag. An era of little or no growth looms before us.
Current developments are always a product of past developments; therefore it is incumbent upon us to examine those past developments. In the case of the nineties this means developments in the credit markets.
The first notable aspect of debt growth in the nineties is its sheer size. In the twelve year period 1990-2002, total debt grew $16.9 trillion or 125.0 percent. Outstanding debt grew more in 12 years than in the preceding 112 years! This averaged $1.4 trillion per year of consumption financed by credit.
Another notable development in the nineties is the disparity between the growth rates of nonfinancial and financial debt. Financial debt grew 283.9 percent whereas nonfinancial debt grew 86.2 percent. One factor slowing the growth of nonfinancial debt was the federal budget surplus from 1998-2001. The major factor swelling the growth of financial debt was the amazing growth of government-sponsored enterprises, federally related mortgage pools, asset backed securities, and finance companies. As a group, these four entities accounted for 85.6 percent of the increase in financial debt and 36.8 percent of the increase in total debt. Since these entities came into prominence during the nineties, they merit considerable attention.
There are complex market risks involved with the forgoing types of securities. Mortgage securities' prices fluctuate in response to changing interest rates: when interest rates rise, prices fall and vice-versa. Interest rate movements may also affect mortgage securities because they affect prepayment rates (by borrowers), which in turn affect yields. The price of ABS also fluctuate in response to changes in interest rates in the general economy, and ABS face a prepayment risk as well, but not to the level of mortgage securities. ABS have an additional risk called "early amortization" that may be triggered by a number of developments such as a rise in the default rate on the underlying security or a drop in available credit enhancements below a specified level. These events trigger an early return of principle and interest to investors.
Investors in GSE-ABS include virtually the whole spectrum of the securities markets - corporations, commercial banks, life insurance firms, pension funds, mutual funds, trust funds, charitable endowments, and individuals. And most of this vast market has developed since 1990!
One of the more intriguing aspects of the GSE-ABS phenomenon is the shift in direction from traditional bond investing. Historically, bonds were issued for corporate purposes - to expand productive capacity, facilitate acquisitions, eliminate short-term debt, etc. The thrust was to boost production. GSE-ABS issues, by contrast, underwrite consumption. They represent another technique to drive the economy higher through debt-created consumer demand, and may well be the principal vehicle responsible for the surge in consumer credit and mortgage debt through the nineties. This shift of investment focus from production to consumption is not a healthy one, but, for the moment, the housing and consumer credit sectors are flourishing because of it (a connection that popular comment fails to make).
Due to the numerous parties involved in structured mortgage and asset backed securities and the complexity of their instruments, there are many risks inherent in the market that have never been tested. There are widely differing views regarding these markets. To Alan Greenspan:
To which Doug Nolan (Prudent Bear.com) counters:
Well, for that we will have to wait and see.
As noted by Alan Greenspan "The development of these instruments and techniques have led to greater credit availability....." The question is whether the accumulation of ever more debt contributes to stability or instability. The process should be thought of as a layering of one debt on top of another. At the bottom we have a borrower (buying a home, car, computer, etc.) who owes money to a lender. The lender then sells his loans to an issuer of securities who packages the loans in a variety of ways and sells securities backed by the loans. These securities are bought by investors (mutual funds, insurance companies, endowments, etc.) These [institutional] investors, in turn, raise money by selling their products to the public. Thus, the original income stream is divided in half a dozen different ways, and the resulting risks are both spread and magnified.
Most of us have been struck by the volume of credit card solicitations we receive and the soaring generous credit terms now offered (zero financing, etc.) The "structured finance" we are discussing is the basis for them. Consider a bank making home or home equity loans. The bank has every incentive to make as many loans as possible since they generate fees in several forms. Risk is not of too much concern since the bank is going to sell the loans to an issuer of mortgage-backed securities (and there are buyers even for sub-par loans). Thus, the bank quickly regains the capital it loaned and is ready to make more loans. This same process applies to consumer credit card debt, auto loans, furniture, boats, etc. So we have to ask the question - What have we found - a magic elixir or a deadly trap?
The Income Side
Debt obviously must be serviced from income. A larger burden of debt requires a larger income. Therefore, to assess the ability
of debtors to service and repay debt we must compare the two. This
can be done on two levels - a macro and a sector, as follows:
Nonfinancial debt as a percent of national income has risen steadily. In 1980 it was 129.7 percent of income, in 1990 233.7 percent, and in 2002 240.0 percent (despite federal government surpluses 1998-2001).
Household debt as a percent of disposable personal income has risen more sharply. In 1980 it was 73.6 percent of d.p.i., in 1990 it was 83.8 percent, and in 2002 103.9 percent. Thus, debt quality has been declining for an extended period.
Of the two measures of debt shown above, the household sector may be the more significant. Personal consumption expenditures constitute two-thirds of GDP. Sustaining the "consumer" has therefore become a preoccupation of popular analysts. But, disposable personal income grew 80.0 percent 1990-2002 whereas household debt grew 123.2 percent. During the first half of 2002 it was still growing at a 5.4 percent annual rate whereas household debt was growing 9.1 percent. Something has to give.
The household sector is doubly important because, as we have seen, several additional layers of creditors now are exposed to it along with the original creditor: the asset-backed security issuer, the guarantors of those securities, the mutual funds and other purchasers of the securities, and the ultimate investor in all of those vehicles. The party can go on for an indeterminate time, but it will surely come to an end.
The GDP data for the five economies show a remarkably similar pattern. After falling in 2001, all five rebounded in the first three quarters of 2002, led by Canada and the U.S. Britain's rebound was the weakest. Industrial production, however, does not follow the same pattern. The U.S., Britain, and Japan show declines in both 2001 and 2002. Canada fell in 2001 but rose in 2002. Germany rose in 2001 but fell in 2002.
Retail sales showed strong growth in Canada and the U.S. while remaining negative in Germany and Japan and falling in Britain.
Consumer prices followed a familiar path - upward except in Japan. In the U.S. prices paused for several months at the end of 2001, then resumed their steady gait of about 3 percent rise per year. Unemployment rates rose in all five economies except Britain, with the largest increase in the U.S. Interest rates followed just the opposite path - downward except in Japan where they have reached zero. This phenomenon should be pondered by those who believe our present low rates are due to the Fed. The Fed funds rate follows the 3 month Treasury (market) rate, which on December 7 was 1.21 percent. This low rate is a reflection of the high risk aversion of much of the investing community. Risk aversion is also prominent in the stock indices. At the end of September all the indices in the table showed substantial losses. The German index fell 46 percent while the U.K. and U.S. indices fell about 25 percent. These losses carried through to the end of the year except for the U.S. which closed the year with a 16.8 percent loss. This made three consecutive years of losses in the German, Japanese, British, and American markets.
Canada, Germany, and Japan continued to earn current account surpluses, but the British and American deficits appear to be headed for another record.
There were no major shifts in currency values through the third quarter, but the Euro rose persistently from .88 in January to .98 in September.
Real gross domestic product increased 4.0 percent in the third quarter of 2002 compared with 1.3 percent in the second quarter. Most of this increase (2.95 percent) was due to personal consumption expenditures, as gross investment and net exports changed little. Government consumption and investment also changed little. Consumption was benefited by a continued surge in household borrowing - up 9.1 percent for the quarter (a.r.)
Industrial production fell 0.5 percent in the first three quarters of 2002 compared with a decline of 3.8 percent in 2001. The index rose through July but then began to fall. The capacity utilization rate was 75.2 in October. Manufacturers' new orders increased slightly during the period but remained below prior levels.
New construction expenditures continued to rise during the period, but the momentum is faltering. Expenditures rose $22.2 billion in 2001 but only $3.50 billion through September, 2002. Residential construction rose strongly, aided by low interest rates and no down payment programs. Commercial and industrial actually declined, but government continued to expand.
Gross investment edged upward after falling in 2001. Nonresidential investment declined due to the falloff in structures, but this was offset by the rise in residential structures. Inventory change turned positive after five quarters of decline.
Business and retail sales trended upward during the first three quarters and inventories ended the period higher than they began. Inventory-sales ratios are below recent levels. Per capita personal consumption expenditures continued to grow at about the same pace as in recent years, stimulated by lower tax rates and easy credit.
Payroll employment along with investment are key to the future direction of the economy. Employment had grown every year since 1991, but that record seems destined to end in 2002. Through the third quarter employment in goods production fell about one million while employment in services was little changed, and government employment increased a bit. Interestingly, employment in retail trade has trended down since the early part of 2001 despite the "strong consumer" buying.
National income growth accelerated in the first nine months of 2002 after decelerating in 2001. All major sectors increased. This pattern is also reflected in the per capita real income data which rose in each quarter of 2002. It is also reflected in the real weekly earnings data. The pause in GDP growth has not had a major impact on income growth.
Gross saving continued a fall that began in 2001. The decline is due to a steep fall in government saving as federal surpluses give way to deficits.
The rise in commodity prices is due to food and nonfood agricultural items which are up 20 plus percent over year earlier levels. Producer finished goods prices continued a fall that began in the latter part of 2001. Producer pricing weakness is illustrated by the automobile industry where the most generous financing terms in history are needed to maintain sales.
After declining for two years, corporate profits rebounded in 2002, but the increase appears to be related to changes in the capital consumption adjustment.
The 10-year Treasury yield fell to 3.8 percent in September, the lowest since the 1950s. High risk aversion makes Treasury securities especially desirable.
The M-3 money supply has grown faster than debt since 1995, culminating in 2001 when it grew more than twice as fast. Apparently this represented uncertainty as money was parked in safe and liquid instruments. But this tendency slowed in the early part of 2002.
The Federal budget has been in deficit each of the first three quarters of 2002 due to a combination of lower receipts and higher expenditures. There is no indication that this will change soon.
After a pause early in the year, bank credit began growing again in May. The primary recipients have been securities, especially Treasury/agency issues, and real estate. Commercial and industrial loans actually fell. Consumer credit growth decelerated in 2001, and this tendency persisted in 2002. From August through October consumer credit increased less than $10 billion. Nonfinancial credit market debt grew 6.5 percent in the first three quarters while financial debt grew 8.8 percent. The household rate rose to 9.1 percent but business debt rose only 2.4 percent. And, looming in the background, the third quarter of 2002 produced 391,873 bankruptcy filings, up 11.6 percent from a year earlier and a record.
The negative balance on goods and services was headed for a new high through September, 2002. Exports of goods grew $30 billion whereas imports grew $104 billion. Exports of services grew $22 billion whereas imports grew $12 billion. While the deficit on goods continues to mount, the surplus on services continues to shrink.
This situation is reflected in the U.S. international investment position. Money flows out of and into the U.S. have both slowed, but outflows have slowed the most. Foreign demand for Treasuries has strengthened, but demand for other securities (which includes agency issues) has shrunk. Is this still another indication of risk aversion?
Copyright © Andrew Caughey, 2003
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