An Orgy of Speculation

Mike Whitney

Ben Bernanke is confident that his policies have paved the way for a self sustaining recovery, but there's plenty of reason to be skeptical. For one thing, the Fed's zero rates and bond buying program (QE2) have had a negligible effect on unemployment and housing. And for another, they've led to a surge in speculation. That's hardly a reason to celebrate. In the last week, a number of reports confirm that hedge funds have been loading up on debt believing that improving economic data and the Fed's liquidity support will push stocks even higher. That seems like a risky bet given the unevenness of the rebound and the spreading mayhem in the Middle East. Even so, fund managers are levering-up like there's no tomorrow convinced that this is the beginning of another bull market. Here's the rundown from Bloomberg:

"Hedge funds increased their net leverage in January to the highest level since October 2007, as they took advantage of record-low borrowing costs to bet that the U.S. equity rally will continue.

Debt at margin accounts at the New York Stock Exchange minus cash and unused credit from margin accounts climbed to $46 billion, according to data released by NYSE yesterday. Hedge funds had $290 billion of debt from margin accounts in December, the largest sum since Lehman Brothers Holdings Inc. collapsed in September 2008.

"It makes a lot of sense given the low cost of borrowing and some equities' valuations," said Patrick Armstrong, who helps manage $356 million in multiasset strategies at Armstrong Investment Managers LLP in London. "There is a capital- structure arbitrage to be made by buying stocks with leverage." ("Hedge Funds Borrow the Most Since 2007 to Purchase U.S. Stock, Bloomberg)

Indeed, it does make sense to borrow tons of money (to bet on stocks) if the outcome is certain, but QE2 is not a "sure thing" by a long shot. While swapping Treasuries for reserves does push investors into riskier assets, like stocks; it's no guarantee that the market won't suddenly go into a nosedive and wipe out earlier gains. What this shows is that even very bright people don't understand how the Fed's program works. They think QE2 is a one-way ticket to Brigadoon, so they're gearing up and setting the stage for another meltdown. This seems to be a recurring theme with Bernanke; slash rates, inflate bubble, crash, rinse, repeat. This latest cheap money boondoggle is bound to end as badly as it did in 2008.

While it's true that QE2 has been net-positive for stocks, (so far!) the dangers of the Fed's easy money policies are considerable. They encourage financial market speculation while doing very little to boost the real economy. In fact, Fed policy hasn't increased overall investment at all. Big business is still hanging on to $2 trillion that they refuse to invest (and create jobs) because they don't see growing demand for their products. Here's an excerpt from an article by Mark Provost that explains what's going on:

"Corporate executives have found a simple formula: the less they contribute to the economy, the more they keep for themselves and shareholders.....

Non-financial companies have amassed nearly two-trillion in cash, representing 11% of total assets, a sixty year high. Companies have not deployed the cash on hiring as weak demand and excess capacity plague most industries. Companies have found better use for the cash, as Robert Doll explains, "high cash levels are already generating dividend increases, share buybacks, capital investments and M&A activity—all extremely shareholder friendly."...

Companies invested roughly $262 billion in equipment and software investment in the third quarter. That compares with nearly $80 billion in share buybacks. The paradox of substantial liquid assets accompanying a shortfall in investment validates Keynes' idea that slumps are caused by excess savings. Three decades of lopsided expansions has hampered demand by clotting the circulation of national income in corporate balance sheets. An article in the July issue of The Economist observes: "business investment is as low as it has ever been as a share of GDP." ("Corporate Profits Soaring Thanks to Record Unemployment", The Economic Populist)

None of this is news to Bernanke who knows exactly what's going on. He knows that zero rates and swapping bonds won't trigger a wave of investment, just as he knows that higher stock prices won't necessarily lead to more jobs. Just look at the facts. Businesses are not going to invest their money where demand for their products is weak. They're not fools. That's why they're using their windfall for more mergers and acquisitions (M&A), more share buybacks, more dividends and more paper-shuffling operations that do nothing for the broader economy. They're doing what they have to do to maximize profits without risking their capital.

What's needed is more fiscal stimulus to put money in the hands of people who will spend it quickly and rev-up the economy. If businesses have no incentive to spend (because of flagging demand) and consumers cannot spend (because their personal balance sheets are in the red), then government must take the initiative and increase its budget deficits to keep the economy chugging-along in positive territory. Of course, that won't happen because the leaders of both parties have abandoned Keynesian remedies and taken the vow of austerity. That means unemployment benefits, state aid, and other critical fiscal lifelines will be further slashed leading to more misery and more economic contraction. David Leonhardt makes this very point in a recent article in the New York Times. Here's what he said:

"....many members of Congress continue to insist that budget cuts are the path to prosperity. The only question in Washington seems to be how deeply to cut federal spending this year....

The fundamental problem after a financial crisis is that businesses and households stop spending money, and they remain skittish for years afterward. Consider that new-vehicle sales, which peaked at 17 million in 2005, recovered to only 12 million last year. Single-family home sales, which peaked at 7.5 million in 2005, continued falling last year, to 4.6 million. No wonder so many businesses are uncertain about the future.

Without the government spending of the last two years — including tax cuts — the economy would be in vastly worse shape. Likewise, if the federal government begins laying off tens of thousands of workers now, the economy will clearly suffer." ("Why Budget Cuts Don't Bring Prosperity", New York Times)

So, there's a real danger that the deficit hawks on both sides of the aisle will fail to see how weak the economy really is and begin trimming the deficits too early. This is what happened to FDR in 1937, and it thrust the country into another slump. Here's another clip from the NY Times that explains what tightening on the state level will mean. The article is titled "Smaller Government Can Be a Drag (on Growth)":

"Output last quarter grew more slowly than initially reported, according to the Bureau of Economic Analysis: an annual rate of 2.8 percent rather than 3.2 percent. One of the main reasons for the downward revision was that state and local governments cut their spending at a 2.4 percent annual pace.....

A decline in state and local spending — and the layoffs that are likely to be involved — can have dangerous reverberations throughout the economy. So would the cut in federal spending that many Congressional Republicans have been threatening. Besides chucking even more workers into the pool of the unemployed, such cutbacks would also take away services supporting the many Americans trying to get back on their feet. This in turn hurts their ability to spend, threatening the bottom lines of the businesses they patronize, potentially leading to even more layoffs in the private sector. And so on." ("Smaller Government Can Be a Drag (on Growth)", Catherine Rampell, New York Times)

So, the cutbacks in state assistance will have a contractionary effect that will increase excess capacity, raise unemployment, and put a damper on growth. Slashing deficits when long-term bond yields are at historic lows and there's no sign of a fiscal crisis, is lunacy in the extreme. Unfortunately, both Congress and the White House are fully committed to near-term belt-tightening.

So, how does Bernanke fit in all of this? The Fed's loose monetary policies are stimulating speculation without really improving conditions in the underlying economy. The record amounts of debt the hedge funds have taken on are just one sign of this. (According to nasdaq.com: "At the end of January, margin debt totaled $289.6 billion, up from $276.6 billion at the end of December and the highest level since September 2008, according to Big Board data for customers of NYSE-member securities firms.") The problem for heavily-levered hedge funds is that if the market falls even a small amount, they can be wiped out. That means the Fed would have to come to the rescue again to prevent the defaults from dominoing through the system. Once again, the public would be called on to bail out unregulated financial institutions because the Fed's policies spawned a culture of risky behavior. And this phenomenon is not limited to hedge funds either. Just look at bond yields; it's the same thing there, too. Here's an excerpt from the Wall Street Journal:

"The rally in junk bonds has notched a new milestone: yields on the low-rated securities are now at their lowest levels on record.

The average junk bond yield has fallen to 6.837%, according to Merrill Lynch's high yield index, slipping under the previous low of 6.863% in December 2004.

Yields fall as prices rise. And prices of junk bonds have been soaring for the past two years, a reflection of demand from investors seeking securities that yield more than U.S. Treasurys. Investors have poured billions of dollars into the market for speculative-grade debt." ("Junk Yields Hit New Low", Wall Street Journal)

What a surprise, another Bernanke record. Investors are shifting into high-risk junk bonds because they're sick of getting zilch-interest on their "risk free" CDs. But the stampede into lower quality bonds has also lowered the rate of return. Bernanke sees this as a triumph, because, by keeping rates low, he has forced the rats (you and me) back onto the flywheel pushing yields down and stocks up. It all fits in the Fed's grand plan, but it's tough medicine for retirees who feel like they've been coerced into taking a chance with their hard-earned savings just so they could meet their modest retirement goals. These are the people who stand to lose the most by Bernanke's endless meddling.

Also, just look what's happening with mortgage-backed securities (MBS), which were at the center of the financial meltdown. Now they've become Wall Street's "darling", a favorite of the big banks and brokerages. How did that happen? Keep in mind, that the Dodd-Frank reforms have done nothing to standardize loans or force the banks to retain a portion of the credit risk on the MBS. That means that the paper that the banks are now purchasing could be as "toxic" (Liar's loans, ARMs, subprimes etc) as it was before. Nothing has changed, but that hasn't stopped the latest buying spree. Here's the scoop from the Wall Street Journal:

"Investment banks and hedge funds are once again making money from a sector that was defunct only 18 months ago: U.S. mortgage-backed securities, the loan products that spread the credit crunch throughout the world.

Only two years later, and despite the fact that many U.S. cities are on the edge of bankruptcy, these securities have turned into one of the most lucrative profit areas for banks, such as Credit Suisse Group, UBS AG or Société Générale SA.

"In large part, the buoyancy comes from government support for the U.S. mortgage market, both for agency securities backed by the government and also for deals which don't have direct government backing," said Deepak Narula, a former Lehman Brothers Holdings mortgage-bond trader, who now runs New York-based hedge fund Metacapital Management. "The successful attempts by the central bank to bring down mortgage rates, along with many other programs aimed at reviving housing have also helped." ("Toxic Securities Turn Lucrative for Banks", Wall Street Journal

So, yes, government underwriting has made garbage mortgages look more attractive to investors (Lipstick on a pig) but it's Fed zirp policy which forces investors to seek a better return on their investment, which is why they are willing to take a chance and risk everything on these MBS turkeys.

Did you ever imagine that just two years after the biggest market blowout in 7 decades, there would be a gold rush for mortgage-backed securities?

And, that's not all. Bernanke's zero rates have also breathed new life into other Wall Street speculators, like Private Equity (PE). These are the high-fliers who buy up companies on-the-cheap via leveraged loans (LBOs) and then strip the meat from the carcass. It's bare-fang capitalism at its worst. Here's a clip from an article in Bloomberg's Businessweek:

"The biggest leveraged buyouts from the takeover boom, once seen as almost certain bankruptcies by derivatives traders, are seeing borrowing costs tumble to the lowest since 2007....

As the Federal Reserve holds benchmark interest rates near zero to stimulate the economy, Blackstone Group LP, KKR & Co. and other private-equity firms are taking advantage of record investor demand for high-yield debt to refinance buyout-related loans and bonds. Last year saw $93 billion worth of leveraged buyouts worldwide, more than triple the figure in 2009, according to Bloomberg data....

"You have a lot of money searching for yield, and when that happens, a lot of folks can get money regardless of the situation of their balance sheet and income statement," said Lon Erickson, a money manager who helps oversee $9 billion of fixed-income assets for Thornburg Investment Management Inc. in Santa Fe, New Mexico." ("Near-Death LBOs Thrive in Bernanke Bond Market: Credit Markets", Bloomberg)

Once again, the hidden costs of cheap money should be fairly obvious. These LBOs do not add a thing to the nation's productive capacity, nor do they increase employment. In fact, people are usually fired as the company is strip-mined of its value and loaded up with low-interest financing. In other words, it's another subsidy provided to Wall Street hucksters via the Federal Reserve.

Then, there's this from GoBankingRates.com:

"For the first time since the financial crisis, people with a credit score below 680 are able to get their hands on new car loans again. Some are even obtaining loans for larger amounts than in previous years. While it's great that individuals in need have access to reliable vehicles again, some concern has been expressed over the possibility of more loan defaults as a result of the increased leniency in borrowing standards....

General Motors is one of the companies able to regain profits after its bankruptcy. One of the ways it did so was by getting back into lending, specifically the subprime business. After struggling to convince Ally Financial Inc.–which had taken control of its financing business after the bankruptcy–that it should get back into subprime lending, GM acquired AmeriCredit Corp. and began presenting car financing options to subprime borrowers.

Many financial institutions associated with auto manufacturers have decided to redistribute the bad credit auto loan. According to a Dec. 2010 report from Experian, the percentage of loans going to subprime buyers rose 8 percent in the third quarter.

So while 63 percent of all auto loans went to buyers with prime credit scores of 680 or above, more than in previous months went to people with no-so-great credit....

Is it possible that loosening up too much result in more people taking on debt they can't handle? Could giving people with lower credit scores access to a subprime loan cause more problems than it fixes?...("Will Increased Subprime Auto Lending Result in Another Financial Crisis?", GoBankingRates.com)

Hell, no. Why would it be a problem to loan money to people who can't pay it back? After all, what could go wrong?

Do you see the pattern here? Do you see how the Fed is feeding this monster and putting the system at peril with its easy money policies and light regulations? Households need to trim their debt and increase their savings, but all-the while the Fed is trying to lure them into another credit-binge by dangling low rates before their eyes. And the same rule applies to student loans, too, where our young people who are taking on mountains of debt they'll never be able to repay or repudiate through bankruptcy. They're stuck for life, a generation of debt slaves. Here's an excerpt from the Financial Times:

"One example is Corinthian College's Genesis Lending Program, which is described in its 2010 SEC filing:

In the face of this change in policy, we created a new student lending program with a different origination and servicing provider, Genesis, who specializes in subprime credit. This new Genesis loan program has characteristics similar to our previous "discount loan" programs. Under this Genesis loan program, we pay a discount to the origination and servicing provider. As with our previous discount loan program, we record the discount as a reduction to revenue, as the collectability of these amounts is not reasonably assured.

So what? Well, according to the earnings call transcript available on seeking alpha, the discount rates on this $150m worth of lending is a whopping 56 – 58 per cent. According to Corinthian, this equates to anticipating a default rate of 56-58 per cent, of its own students who go into this programme." ("The biggish short — subprime student loans", FT.Alpahville)

Let's be clear, any lender that anticipates a default rate of 50% or more, is just a con-artist bent on ripping people off. Period. The reason why so many young people have returned to college in the first place is because they swallowed that bunkum about a "high-paying job waiting for them after they graduate". Baloney. That's a bigger load of horsecrap than that other myth that "No one ever lost money on real estate".

So, whether it's subprime auto loans, student loans, LBOs, mortgage-backed securities or junk bonds; the Fed's malign and meddlesome influence can be seen throughout. And to what end; more borrowing, more speculation, more asset bubbles? Is that the goal?

Whether QE pumps liquidity directly into the financial system or merely exchanges one asset for another is beside the point. The fact is, the Fed has changed investors expectations, and in doing so, triggered another boom in debt-instruments and other exotic securities. That's increasing instability and making a crisis-prone system even more wobbly. It would be much better to enact a second round of fiscal stimulus targeting the sectors of the economy that are in greatest distress, the labor and housing markets. By extending unemployment benefits, providing funding for the shortfall in state revenues, and creating jobs programs aimed at rebuilding dilapidated infrastructure, the congress could reassert its control over economic policy and deliver money directly where it's needed rather than "trickling" it down through the financial system. (The Fed's method) Another slug of stimulus would have the added benefit of reducing bulging inventories and boosting demand. That would lead to more investment and hiring, in other words, a virtuous circle.

If there's one thing we can all agree on, it's that the market is not a self-correcting mechanism that eventually finds its own equilibrium. That's nonsense. The housing and labor markets need help, and not the kind of bubble-help that Bernanke has in mind. The government has a role to play when people are out of work and the economy's on the ropes. It's just a matter of seeing what needs to be done and doing it.

http://www.counterpunch.org/