The Great Deformation

by David Stockman

  THE GREENSPAN AXIOM:

  HOW THE FED GIFTS THE 1 PERCENT

  The financial market rebound since March 2009 is replete with evidence that bubble finance leads to a profoundly destructive perversion of free markets. We are in the Fed’s third wealth effects levitation of financial assets and the resulting gift to adroit speculators has now become crystal clear. In each cycle the Fed has eventually lost control of the speculative Furies, resulting in a spectacular bust and thumping decline in the price of the most risky asset classes; that is, junk bonds, growth-oriented commodities (e.g., copper), emerging market currencies, commercial real estate, high-beta equities, and endless Wall Street wagers embedded in over-the-counter swaps.

  In the bust phase there is a bonfire of losses which are mainly absorbed by slow-footed Main Street investors and their proxies including pension funds, mutual funds, and other institutional fiduciaries. Within the circle of hedge funds and trading houses further losses are absorbed by the most reckless and leveraged punters among them, along with true believers who are too slow to let go of losing trades.

  The key feature of the bust phase is that it is short and violent. Approximately 95 percent of the stock market sell-off in 1998, for example, occurred during just four trading days. Likewise, 80 percent of the dot-com-NASDAQ meltdown in 2000 transpired within fifteen weeks. Even more dramatically, 90 percent of the 45 percent sell-off between the Lehman event and the March 2009 bottom occurred during just eight trading days when risk assets were crushed by waves of panicked selling.

  Following hard upon the capitulation sell-offs came massive liquidity injections by the Fed and elongated periods of bottom fishing that generated spectacular returns to adroit and usually leveraged speculators. Needless to say, the objects of their speculations were exactly those risk-asset classes which had been taken to the woodshed and beaten to a pulp during the short intervals of panic. In this respect, the violently erratic run over the past decade of the Russell 2000 index of small-cap (mainly) domestic stocks provides a striking example of the manner in which the Fed’s arbitrary cycling of the financial markets and the macroeconomy creates fantastical windfalls to the 1 percent.

  The Russell 2000 composite index is about as close a proxy for Main Street America’s small-business sector as can be found on the public markets. Hundreds of companies in the index have market caps of only $100–$200 million, and the median is just $500 million; only a small slice of the Russell 2000 companies have market caps of over $1 billion, and 95 percent of its composite sales and earnings are US based.

  Moreover, a random sample of Russell 2000 company names literally resonates its broad diversity of Main Street business addresses. Covering the waterfront from manufacturing to transportation, retail, banking, and services, it includes Alaska Air, American Axle, Applied Micro Devices, Bank of the Ozarks, and Beaver Homes. Moving down the list there is also Bob Evans Farms, Carmike Cinemas, Freight Car America, Ethan Allen Interiors, James River Coal, Maidenform Brands, Red Robin Gourmet Burgers, and Vanda Pharmaceuticals.

  Needless to say, the Russell 2000 index was a winner during the Second Greenspan bubble, rising from 340 at the bottom in October 2002 to 820 exactly five years later at the market peak in October 2007. This amounted to nearly a 20 percent compound return for the 401(k) investor; and for Wall Street speculators employing leverage, options, and advanced market-timing algorithms, returns ranged between 50 and 100 percent annually for a half decade running.

  These giant gains did not reflect a Main Street economy which was getting 2.5 times better. As has been seen, this five-year period was one of Fed-engineered faux prosperity where there were no new breadwinner jobs and much inflated consumer spending owing to trillions of MEW. There was also a veritable hemorrhage in the nation’s current account with deficits totaling $3 trillion and a corresponding enfeeblement of the tradable goods sector. So, too, the Greenspan bubble period witnessed tepid investment in capital assets outside of commercial real estate, the accumulation of $7 trillion of new household and business debt, and a drastic deterioration of public finances owing to the two Bush wars and tax cuts.

  None of this mattered, of course, because the market was trading off the liquidity injections of the Fed, the Greenspan Put, and the daily chatter of economic data “prints” which were falsely spun to suggest a robust and sustainable recovery. Accordingly, when the Lehman event unexpectedly shattered the bubble illusions, the Russell 2000 violently plunged back close to its October 2002 bottom, reaching a level of about 360 on March 9, 2009. This was a thundering 55 percent loss from the pre-crisis peak, but it was not the result of price discovery on the free market.

  Instead, it was the consequence of an inside job: the temporary loss of confidence in the Fed’s money machine by the inner ring of Wall Street traders and hedge funds. These fast money traders liquidated giant positions with lightning speed, leaving Main Street home gamers and their mutual fund proxies grasping at straws before they could even turn on their trade stations. Indeed, the fast money was quickly on the other side of the trade, pouring into short positions with malice aforethought and quietly duplicating a thousand times over the windfall gains being made on the “big short” in subprime mortgages so famously publicized by financial journalists.

  The astounding truth is that nearly all of this ruinous 55 percent decline in the Russell 2000 index occurred during just twelve brutal trading days between the Lehman event and the March 2009 bottom. Worse still, during most of those days the correlation within the index reached 0.95, meaning that two thousand companies with vastly divergent business prospects traded sharply lower in exact lockstep. Laughably, the Nobel Prize for economics had been awarded to nearly a dozen glorified math modelers over the last decades who have espied in such moments the glories of “efficient markets” at work.

  This is balderdash. Only a financial system addicted to and whipsawed by central bank money printing can produce such erratic, capricious, and correlated results. What is implicated here is not the doings of the free market but the corruption of free money. For that reason, the Greenspan axiom that financial bubbles can’t be prevented but only punctured and then bailed out afterward is downright perverse. Now in its third iteration, this policy is, in fact, the backstage mechanism by which society’s income and wealth are being redistributed to the top 1 percent.

  It goes without saying that during the Russell 2000 crash the fast money traders did not lose 55 percent—not by a long shot. It was the Main Street “investors” and their proxies—mutual fund managers like Bill Miller—who got fleeced, owing to the naïve belief that they were investing in stocks for the long run and that picking good companies mattered. So the true evil of the Fed’s financial bubble-making sits right here: Main Street investors had no clue that their cherished “stock picks” could drop 55 percent in a matter of months because in an honest free market share prices wouldn’t inflate to absurd heights in the first place, nor plunge irrationally during a monetary panic afterward.

  Main Street investors thus inexorably become “bottom bait” as the fast money feverishly forces bursting bubbles to capitulation lows. Eventually overcome by desperation and fear, these “investors” are the last ones off the boat, selling into the bottom layer of losses and retreating to the sidelines measurably poorer. It is no wonder then that Wall Street has a bad name and that with each round of financial boom and bust fewer and fewer real money investors come back to the casino.

  LEVITATION WITH SHADOW BANKING CREDIT, NOT REAL SAVINGS

  It doesn’t really matter, however, because the liquidity bailout phase of the Fed’s bubble finance cycle generates unlimited fuel for the carry trades. Indeed, virtually free short-term money means that stocks and other risk assets can be margined, optioned, and re-hypothecated over and over. Thus, when the fast money regains confidence in the central bank “put” the market can be reflated on shadow banking system credit. Real savings from Main Street households are essentially unnecessary.
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  During the Bernanke bubble the reflation has been fast, furious, and absurdly unwarranted, as underscored by the phony recovery evidence highlighted above. Yet this time it took the Russell 2000 only twenty-five months to scream past its former high, reaching 850 by early April 2011. This meant that vanilla traders generated 50 percent annual returns during the period, and state-of-the-art hedge funds employing leverage, options, and charting algorithms easily tripled or quadrupled their money.

  The data make abundantly clear that in goosing the “risk on” trade the nation’s central bank was doing no favors for the Main Street rank and file. The second thundering financial market crash within a decade had been more than enough to keep the home gamers on the sidelines and mutual fund managers begging for investors. During the twenty-five months of the miraculous Bernanke reflation, in fact, domestic equity mutual funds experienced a $200 billion outflow and daily share volume collapsed, especially when robotic HFT (high frequency trading) volume is removed from the figures.

  There is not much doubt, therefore, that the overwhelming bulk of the $1.5 trillion gain in the Russell 2000 during the short interval between March 2009 and April 2011 was captured by Wall Street traders and hedge funds. And it is also evident why Wall Street has loudly brayed for more quantitative easing (QE), ZIRP, and other liquidity injections ever since; namely, these massive gains in the index of Main Street businesses represent liquidity-driven momentum trading, not the repricing of a fundamental improvement in small-company profitability.

  In fact, the great fiscal contraction ahead owing to Peak Debt means that small-business profits are heading south. The fact that the Russell 2000 was sitting at another all-time high just under 900 in early 2013, was thus striking evidence that the stock market is being massively propped up by speculators counting on the Fed to continue to juice the “risk on” trade.

  Needless to say, the 2012 election outcome bolstered hopes for new rounds of money printing and Wall Street coddling from the Eccles Building; that is, the top 1 percent ended up with the best friend they ever had returned to the White House. After all, Bernanke is now Obama’s Fed chairman and the open market committee is increasingly populated with raging money printers, like Vice Chairman Janet Yellen, who were appointed by the current White House.

  While this is seemingly ironic given that Obama was reelected essentially on a platform of “fairness” for the middle class, that was content-free campaign rhetoric. The true irony is that political progressives are so indentured to Keynesian theories of demand stimulus that they have eagerly turned the nation’s central bank over to Wall Street lock, stock, and barrel.

  Under this perverse arrangement, the ministerial work of keeping interest rates at zero and Wall Street flooded with fresh cash from massive Fed bond buying is performed by befuddled academics like Bernanke and career policy apparatchiks like Yellen. So in the name of encouraging the people to borrow and spend, these hired hands keep the carry trades well lubricated and generate continuous opportunities for speculators to extract vast economic rents from deformed financial markets.

  JUNKYARD OF WINDFALLS

  In this respect the Bernanke bubble since September 2008 has been a fantastic moveable feast which conferred upon speculators innumerable opportunities to scalp windfalls from the crash-and-reflation template described above with respect to the Russell 2000. As previously indicated, the junk bond market was an especially egregious case. In May 2008 the $950 billion of junk bonds outstanding traded to a yield of about 10 percent according to the leading (Merrill Lynch) market index, but by the bottom of the financial crash in March 2009 yields had soared to 23 percent.

  Since yield is the inverse of price, the implicit meaning is that the outstanding pool of junk bonds had lost roughly half of its market value, or a staggering $450 billion. Needless to say, millions of 401-K investors, who had been flushed into junk bond mutual funds by the Fed’s “risk-on” promises, were now being carried off the field on their shields.

  Yet while Main Street was still licking its wounds, Wall Street greeted the Fed’s announcement of quantitative easing in March 2009 as the equivalent of a horn call at a fox hunt. Speculators flocked into the smoldering ruins of the junk bond market and by the end of 2009 had driven the Merrill index yield all the way back down to 10 percent. This meant that the market value of these busted bonds had doubled in nine months, and that fast-money speculators employing leverage had quadrupled their money, or more.

  Self-evidently, the debt-laden companies which had issued these junk bonds hadn’t recovered miraculously during that thirty-nine-week interval, but Wall Street confidence in the Bernanke Put had. In fact, the $1.1 trillion QE1 bond-buying campaign announced by the Fed in early 2009 was a powerful signal to Wall Street that the Bernanke reflation would aim to drive up bond prices as well as stocks. Accordingly, junk bond prices continued to soar and by mid-2010 the Merrill index yield had fallen to 7 percent, meaning that leveraged speculators had doubled their money again.

  This explains how the Bernanke Fed has showered speculators with windfalls again and again in the various risk asset classes, yet the problem is not merely the unfairness of these massive unearned rents and the resulting further skew of societal wealth to the top 1 percent. In truth, the Fed’s radical financial repression policies cause vast economic deformations, even as they generate gratuitous upward redistributions of the wealth. That is because interest rates are the price of money, and the Fed’s drastic manipulation of the bond market has caused massive unnatural flows into risky debt—a distortion that has opened even more lucrative post-bubble gambling venues for Wall Street speculators.

  Thus, by the end of 2009 Main Street was still struggling to stabilize itself, but junk bonds had been the return champions of the year. So once again, Main Street investors were lured back into the chase for riches. Accordingly, fresh money flowed into high-yield bond funds like never before, totaling a record $35 billion in 2009 at a time when the nation’s purported brush with Armageddon was still fresh, and then kept rising to a $100 billion inflow over the four years ending in 2012.

  New money needed an outlet, of course, and the result was the greatest boom in junk bond issuance ever recorded. During 2009–2012 approximately $1 trillion of junk bonds were issued, or two times the issuance during the Greenspan reflation of 2003–2006. Even more importantly, about 60 percent of this huge volume was devoted to the refinancing of existing bonds. So this was the mother of all “refi” booms, and it meant that speculators in busted junk bonds were taken out at par or even premiums to book value.

  Never before had so much cash been hauled home by speculators—literally hundreds of billions—for so little valued added. Indeed, the junk bond windfall of the past several years has been wanton, but that is not all. It has also facilitated an unprecedented junk bond maturity extension—that is, a can-kicking exercise—that has unleashed, in turn, even greater windfall gains on the more junior preferred stock and common equity securities of these issuers.

  Thus, as of December 2010 there were nearly $850 billion of junk bond maturities pending for 2013–2116. This amounted to a so-called maturity cliff that threatened the financial viability of many, if not most, of the “debt zombie” LBOs previously described. Owing to the junk bond refi boom fostered by the Fed, however, by late 2012 the “maturity cliff” had been smashed down to only $375 billion, or by nearly 60 percent.

  Accordingly, the day of reckoning has been pushed back toward the end of the current decade. In the meanwhile, however, private equity shops have experienced a massive windfall: the value of their thin slices of equity of these born-again debt zombies have soared, often by 3X and even 10X orders of magnitude. Likewise, a comparable refi boom in commercial real estate has unleashed a similar drastic rebound of what had been underwater equity investments in struggling strip malls and office buildings.

  Needless to say, this is bubble finance at work, not sustainable economic recovery. But pending the next finan
cial meltdown it means that the entire arena of busted leverage—junk bonds, leveraged loans, LBO equity, commercial mortgage-backed securities, underwater mall investments, and much more—has given rise to several trillions of windfall gains to adroit speculators. When coupled with 115 percent recovery in the broad equity markets, and 200–400 percent gains in high-beta equities, it can be well and truly said that the Fed has engineered a fulsome recovery—for the top 1 percent.

  HOW THE TOP 1 PERCENT FOUND RICHES IN THE AUTO CRASH

  One of the great untruths of the 2012 election campaign was the Obama claim that the auto bailout was a great victory for the people. As has been seen, it was actually just a heist by the aristocracy of organized labor whereby 50,000 auto jobs were shifted from south of the Mason-Dixon Line to its north. But it was also much worse than that. In combination, Washington’s fiscal bailouts and the Fed’s massive gifts to carry traders generated truly obscene speculator profits in the burned-out districts of the auto belt.

  Thus, in the case of the GM bailout the only group that gained beyond GM’s 48,000 active UAW members and 400,000 retirees was a few dozen suppliers. Crucially, however, the windfalls even here went to financial speculators. The preponderance of auto parts makers were pulled into bankruptcy, so it was the “distressed” paper of their Chapter 11 estates that reaped the gains. As it happened, speculators in the various classes of their busted loans and securities harvested spectacular upsides literally within months of the White House–orchestrated quick rinse bankruptcy of GM.