April 13, 2005
Have you wondered why analysts are arguing about
bubbles? Of course, we lived
through a speculative equity bubble only a few years ago. Even the young turks on Wall Street can remember that one.
However, economists become concerned when borrowed
money has been cheap for a long time. If
the price of over-night money is not right, the portfolios created from that
money also may not be right for stable, sustained economic growth.
Indeed, Fed Chairman Alan Greenspan has been worried
that the balance sheets in the government agencies that finance about $2
trillion in mortgages may not be adequate for the risks in those mortgages.
A few quarters ago, the Federal National Mortgage Corporation did not
match the maturity profile of the bonds they offered to Wall Street with the
mortgages they were gathering from Main Street.
In the process of realigning the risk associated with
changing interest rates for both their assets and liabilities, FNMA may have
lost more than $9 billion in earnings.
A truly large mismatch of maturities on their entire $1.2 trillion in
assets could erode their capital so rapidly that the economic impact might
dwarf the fallout from the collapsing thrifts that occurred less than two
Another area of concern arose when GM announced that
its cash flow may not be sufficient to pay its dividend and meet its
obligations to its benefit programs. Such
cash shortfalls bother bond rating agencies, who promptly dropped the
ratings on GM bonds to one grade above high yield status.
Many bond funds have large holdings of GM bonds.
They also have constraints on the types of bonds they can hold for
their investors. If GM’s
rating falls any further, a lot of bonds will come out of traditional bond
funds. They must then be
absorbed by high yield funds.
However, investors have been seeking yield in this low
interest rate environment. High
yield bonds have been bid to less than 3.5 percentage points above
treasuries of comparable maturity. If
the GM bonds lose further stature, these funds will need to accept
substantial losses on their existing bonds while they scramble to find
enough liquidity to absorb the additional GM bonds.
A dramatic change in yield on those high yield bonds could occur.
Bond losses certainly are part of the investment
environment. What makes this
problem so risky is that hedge funds have been borrowing cheap short term
money to buy high yield funds. Normally,
the hedge funds can liquidate their positions without much problem.
However, if everyone is liquidating at the same time and the funds
are simultaneously experiencing withdrawals of investment cash, no liquidity
will be available to absorb the GM bonds.
(Actually, the GM bonds will be absorbed but only by
selling the weakest holdings of other bonds held by the funds.
Bond price adjustments from these sales could dramatically reduce the
ability of small companies to borrow in the high yield market.)
Similar problems exist in the emerging markets for
international government bonds. Recently,
some Russian bonds became so popular that their yields fell to less than the
comparable maturities on Mexican bonds, which are considered investment
We can also see excess speculation in the commodities
markets. A year ago, when
previous year crop inventories were lean and North American production was
unsure, farm prices surged to their highest levels in a century. Today, inventories are stronger and early production
indicators are satisfactory. Yet,
another surge in commodity prices is being financed by speculators.
I already have mentioned in this column the magnitude of investing in oil futures. Last year the market peaked at 85,000 open contracts. A couple of weeks ago, the open contracts were 236,000. These are purchases of oil for future delivery. Of course, the speculators are hoping that prices will continue to climb so that when their delivery date arrives, they will sell their positions for a substantial gain.
In one way or another, all of these speculations have
been supported by interest rates that have been too low. Perhaps the commodity positions will be unwound without
serious fallout in any markets. Maybe
FNMA has righted their ship and will not be exposed to changing interest
rates again. GMs bonds might be
absorbed without any other companies discovering that they no longer have
access to high yield capital.
But the reason why economists are searching for bubbles is because maybe something worse might happen.