BEST OF DOUG NOLAND

July 20, 2005

The GSE debt Bubble has some defining characteristics. Despite the explosion of agency debt and MBS guarantees (not to mention accounting irregularities), the marketplace perceives little risk in agency obligations. Understandably, market participants fully expect the U.S. government to stand firmly behind the GSEs. This moral hazard was certainly emboldened by Fed governor Bernanke’s 2002 market promises that the Fed would take all steps necessary – including "helicopter money" and other "unconventional measures"! – to ensure that deflationary forces would never be allowed to take hold. This was the "all’s clear" signal that the Fed was fully behind the GSE and Wall Street finance liquidity juggernaut (liquidity juggernaut safeguarded…then buy junk, stocks, emerging markets, commodities…!)

But the GSEs became too powerful and too corrupt, bringing this historic Credit and liquidity-creating mechanism to at least a temporary impasse. This would have been a major systemic blow had GSE problems materialized in, say, the late-nineties. But by 2003 Mortgage Finance Bubble dynamics were well-entrenched. Several years of unrelenting mortgage lending excess and collapsing interest-rates had imparted a strong inflationary bias throughout real estate finance. Home prices had risen significantly in most regions which, along with the ease of refinancing and equity extraction, had fostered an environment of reduced foreclosures and minimal charge-offs. Lenders were printing money.

From years of experience Wall Street mastered the art of catering its instruments and "structures" to changing environments - and was well-prepared to take full advantage. The Mortgage Finance Bubble was in full bloom, while the ballooning leveraged speculating community was in desperate search for sufficient quantities of instruments to leverage (no easy task!). Huge amounts of asset-backed securities without GSE backing would have been a hard sell during the nineties. Such was definitely no longer the case in the frenetic "post-Bernanke" environment.

While this view is open to debate, I do believe that the Greenspan Fed was (is) very concerned about GSE exposure to rising rates and interest-rate derivatives (especially considering their major accounting irregularities). It was Greenspan’s intention to countenance the flight of households into variable-rate mortgages, in the process shifting problematic interest-rate risk away from the GSEs, banks, and the ambiguous derivatives marketplace. Holding short-term interest rates significantly below long-term yields - with "real" after-tax borrowing costs a fraction of housing inflation - incited a stampede into ARMs and myriad variable rate mortgages. And perhaps Mr. Greenspan was intent upon having the system primed to assure a seamless transition away from the troubled GSEs, institutions and market processes that had grown to so dominate the Credit system. Whether the Fed planned it this way is unknown, but what transpired evolved into a major financial system development.

Collapsing rates and the proliferation of new mortgage products pushed key housing markets already demonstrating powerful inflationary biases (including California, Las Vegas, Washington DC, Manhattan, South Florida and generally anything near water or in the more appealing neighborhoods throughout the entire country) into full-fledged speculative manias. And the low monthly mortgage-payment-inspired price spikes incited only greater "innovation" in the option-ARMs and other "exotic" mortgage products necessary to sustain the Bubble. With volume surging and minimal boom-time losses, huge lending "profits" encouraged a veritable Mortgage Arms Race. An unlimited supply of loanable funds and ultra-loose lending standards fueled record subprime mortgage and home equity lending growth. And the more outrageous the lending excesses and resulting higher home prices, the stronger the economy – and the greater lending and speculating "profits"!

The Fed’s astonishingly accommodative monetary policy incited a stampede into risky variable rate mortgages. Meanwhile, the yield hungry clamored for securities to acquire and leverage at decent spreads to Treasuries. Adjustable-rate loans - especially non-prime, home equity and subprime - provided just the ticket for the aggressive leveraged players seeking strong returns but mindful of the Fed’s inevitable move to higher short-term rates. Leveraging variable-rate products with a nice spread above the (variable-rate) cost of funds ("repo") became the hot game – seemingly perfect for borrower, lender and speculator, alike. There was, as well, huge demand for top-rated short-term instruments. They at least provided some return to satisfy institutional demand as they "dis-intermediated" out of money market funds. Indeed, there was a confluence of factors that hoisted ABS to the Credit Bubble vanguard position….

As we witnessed with the telecom debt Bubble, the problem with unlimited amounts of under-priced finance is that it stubbornly fuels spectacular boom and bust dynamics. The Mortgage Bubble is today demonstrating all the characteristics of precarious "blow-off" dynamics. Too similar to NASDAQ Bubble dynamics, excesses went to unimaginable extremes - only now to "double." Today’s buyer (marginal price-setter) of properties in the highly inflated markets is forced to resort to risky interest-only or negative amortization mortgages. The new mortgage is backed by a vulnerable borrower acquiring a grossly over-valued property. Moreover, the attendant price spike creates the capacity for neighbors to then borrow against inflated equity or use inflated equity as a downpayment for a more expensive home, in the process significantly undermining the soundness of many more mortgages. And with the extraordinary level of mortgage churning – transactions, refis, and home equity loans – the potential to impair huge quantities of mortgage loans (the asset backing ABS) during "blow-off" excesses is unparalleled. The potential to create enormous liquidity and Monetary Disorder to destabilize the global system is similarly unprecedented….