Doug Noland A Must Read

This excerpt is the heart of our current predicament, so you understand better what environment we are currently in.
Duratek

http://www.prudentbear.com/archive_comm_article.asp?category=Credit+Bubble+Bulletin&content_idx=57477

To get started, where’s the heightened risk aversion one would expect late in a tightening cycle? Where are the tightened “financial conditions” after 17 Fed rate increases? Where are the chastened borrowers, lenders, financiers, and speculators? Well, the leveraged speculating community flourishes and hasn’t missed a beat, and with this growth comes a thus far insatiable appetite for risky assets. Combining the powerful Wall Street firms, the global money center securities/insurance/”banks,” and thousands of hedge funds and you’ve got one almighty juggernaut “speculator community” that controls $10’s of Trillions of U.S. and global assets. To be sure, players today operate with an incentive structure unrecognizable to the traditional bank loan officer. Hedge funds typically take 20% of (realized and unrealized) fund gains at year-end, while Wall Street traders, investment bankers, derivative specialists and the like enjoy a share of booked profits with the arrival of their generous year-end bonuses. Such incentive structures nurture an all-consuming institutional inflationary bias.

It is, apparently, going to take a more intimidating housing slowdown to alarm speculators enticed by higher-yielding mortgage securities. The conspicuous excess that has of late beset corporate finance is anything but dissuading speculation in risky PIK (payment in kind) debt and other high-yielding corporate securities – especially not with the convenient embracement of “mark-to-model” pricing. And the incentive to write insurance (and immediately book much of the premium as “profit”) is simply too enticing to pass up, whether it is catastrophic weather reinsurance, Credit default derivatives, market hedges, or the myriad types of financial insurance/guarantees that have taken the U.S. and global Credit systems by storm. It is also clear that the perception of ongoing Federal Reserve accommodation has emerging market securities again in hot demand.

The current Financial Structure, dominated by Wall Street securitizations, leveraging, derivatives, and asset/securities speculation, inherently incites and then feeds runaway Credit, asset and speculative Bubbles. Under present conditions, the nature of this energized financing mechanism is not going to change, but rather only the sectors and asset classes where over-financing ensures spectacular boom and bust cycles.


“It appears that the current housing slowdown, which we first saw in September ‘05, is somewhat unique: It is the first downturn in forty years – in the forty years since we entered the business that was not precipitated by high interest rates, a weak economy, job losses or other macroeconomic factors. Instead, it seems to be the result of an oversupply of inventory and a decline in confidence. Speculative buyers who spurred demand in ‘04 and ‘05 are now sellers; builders who built speculative homes must now move their specs; and nervous buyers are canceling contracts for homes already under construction.” Robert Toll, Chairman & CEO Toll Brothers

In a predictable replay of the Technology Bubble, the U.S. homebuilding industry now faces the inevitable consequences from a period of spectacular over-finance and over-speculation (including massive industry overcapacity, collapsing profit margins and acute price uncertainty and instability). Industry executives have not previously experienced similar dynamics to this downturn specifically because there has never been a Financial Structure so capable of completely inundating the entire housing and mortgage arenas with cheap finance for such an extended period – never. As we witnessed with tech, destabilizing speculative flows appear seductively miraculous until they don’t.

Ultra-easy finance incited and then fed a speculative Bubble in home buying. At the same time, the nature of the Financial Structure saw to it that the homebuilders were also overwhelmed with finance, ensuring an enormous, destabilizing and self-reinforcing building boom. And the higher homebuilder stock prices ran and the cheaper their debt financings became, the greater the incentive to ignore the warning signs and race to develop more properties – to keep the dream alive and the liquidity spigot wide open. Moreover, the greater the boom the more the various segments of the ballooning U.S. Financial Sphere that wanted their piece of the action. And the resulting creative financing arrangements and instruments – and greater Credit Availability generally – the easier it became to finance ballooning transactions at higher prices (yet with lower individual mortgage payments!). Households inevitably succumbed to panic buying.

Many analysts these days hone in on the housing slowdown and the likelihood that the Fed has already raised rates too much to sustain the economic boom. My focus and concerns are instead directed at the precarious nature of a prevailing Financial Structure that ensures Serial Bubbles and Cumulative Economic Impairment and Financial Fragility. With acute vulnerability pervading some key housing markets - as well as the general risk to the Mortgage Finance Bubble - in the spotlight, the Fed is poised to accommodate the ongoing profligate financing environment. I find it astounding that our policymakers have absolutely no inclination – or demonstrate any sensitivity to their responsibility - to discipline or subdue “Wall Street finance.” Instead, they are determined to safeguard a highly improvident and destabilizing financial backdrop and incentive structure. This may very well perpetuate the current aged boom somewhat, but their will be no avoiding the painful aftermath. Today’s Menacing Financial Structure has decisively sealed such a fate.