BEST OF DOUG NOLAND

August 25, 2005

I have a difficult time believing that American households are about to all of a sudden wake up one morning and ponder the possibility that housing prices aren’t destined to rise forever. That would defy the nature of manias. The system must instead somehow restrict liquidity from eager real estate borrowers, a development that today does stretch the imagination (with too many livelihoods depend on the perpetuation of lending excess). Importantly, Mortgage-related securities and instruments remain the key asset class for a massive (and still growing!) leveraged speculator community desperate for yield and positive returns. This facet of the analysis is today more fundamental than any housing metric.

Late-stage Credit Bubble dynamics create a fascinating and analytically challenging environment. The massive ongoing Financial Sphere expansion ensures that only more excessive amounts of finance chase increasingly risky/extended borrowers (financing ever more inflated asset prices). The unprecedented influx of players into the mortgage business guaranteed today’s narrowing lending margins, while late-cycle Credit risks grow exponentially (due to leveraged marginal borrowers, minimal downpayments and loose terms, over-building, price inflation, generally maladjusted economy, increasing financial fragility, etc.). All the same, the most prominent influence on lending decisions during this final phase of the boom is the necessity to sustain short-term reported accounting profits (inflated by under-reserving for future, post-Bubble Credit losses). A deteriorating financial backdrop – in this age of unlimited liquidity – ironically spells increased lending volumes, further asset inflation and greater economic distortions.

For the massive leveraged speculating community, too much finance is chasing inflated asset markets and meager little risk premiums. Today and going forward, there is no avoiding the serious dilemma posed by significantly limited opportunities for acceptable returns. There may have in the past been some legitimacy with respect to marketplace "arbitrage" opportunities, but no longer. The Massive Mortgage Carry Trade is a combination Credit spread and the classic borrow-short-lend-long. But borrowing costs are rising, while thin Credit spreads defy escalating Credit risk. Nevertheless, the most prominent influence on today’s speculating decisions is the necessity to achieve positive returns. A deteriorating financial backdrop – in this age of unlimited liquidity – ironically spells only greater speculator leveraging and risk-taking – as we have witnessed.

On many levels, late-stage Credit Bubble dynamics foment powerful liquidity-creating and risk-taking behavior, irrespective of deteriorating underlying fundamentals. This is an essential facet of the analysis of why Monetary Disorder imparts progressively deleterious effects upon the system pricing mechanism, and why such Bubbles end inevitably in busts. Today’s Credit system does not function like the banking system of years past – when bank loan officers and Fed open market operations dictated system liquidity. Can today’s securities and speculator-driven marketplace/Credit system effectively regulate Credit creation and marketplace liquidity? It certainly does not appear that it can. While a spike in yields would abruptly and perhaps radically change liquidity and speculative dynamics, is there some market rate below the crisis point that would stabilize Mortgage Credit excess without bursting the Bubble? I doubt it’s possible.