Bubbles On The Horizon?

 |  Includes: DIA, SPY
by: John M. Mason

Are we starting to see more and more bubbles on the horizon? Earlier on in the Fed's quantitative easing cycle we worried about bubbles appearing in such markets as commodities and emerging market securities. Currently, we are seeing behavior that could be attributed to "bubble-like" behavior that could enlarge in the future into full-blown bubbles.

For example, we read in the Wall Street Journal that private equity companies are "adding debt to the companies they own in order to fund payouts to themselves." This is not a new practice, but it is one that has been revived given the financial conditions that exist in the market place today. It is not illegal, but it is controversial.

The companies, in the process of being re-tooled, issue debt, "high-yield debt", which investors scrambling for yield go for. This cash gained from this debt is distributed in the form of dividends to the buyout groups owning the companies. This is called "dividend recapitalization."

The deals are risky because the default rate can be higher than on debt issues that are not used just for dividend payments. The Journal article reports that the default rate on some of these bonds was 13 percent during the 2006 to 2010 period.

Another place we are seeing some kind of a "boom" taking place is in the housing market. Housing starts were up by 15 percent in September to their highest level since September of 2008. This increase has gotten a lot of people all worked up because they believe that this is providing additional evidence that the housing market is staging a rally.

This euphoria is being transferred to some stock market analysts. (See "U.S. Stocks Rally Spurs Predictions of All-time Peak" in the Financial Times.)

"Momentum is a powerful force. U.S. stocks have smartly outperformed analyst expectations this year riding a wave of central bank intervention and an improving housing market. Now, making up for their earlier downbeat forecasts, some strategists are predicting the market could hit a record high in 2013."

But, what seems to be happening? I have written about this in an earlier post, "Here We Go Again: the Goosing of the Mortgage Market."

It seems as if many of the largest banks in the country are benefiting from an increase in mortgage lending. Both Wells Fargo (NYSE:WFC) and JPMorgan Chase (NYSE:JPM), along with several of the other larger banks in the United States, posted strong earnings. The strength of these earnings have been attributed to their creation (and sale) of many new mortgages.

But, a substantial portion of these origins are going into mortgage-backed bonds, structured credits. Who are getting the mortgages? They are wealthier homeowners who satisfy the banks' new higher credit qualifications.

And others? Well, they are not so lucky. As is mentioned in an editorial in the Financial Times: "Roughly a fifth of U.S. homeowners are still trapped in negative equity, where their mortgages are worth more than their homes. And large parts of the house-buying population remain shut out by hyper-cautious banks."

And, who else might be benefiting from all the "loose" money rumbling around in the U.S. economy? Well, it seems as if some hedge funds are also profiting from the mortgage "boom." See, for example, "Hedge Funds Reap Gains from MBS" and "Funds Enjoy Fed Boost for Bundled Debt Deals." In this latter article we read, "One hedge fund strategy has stood out for its performance ahead of all others this year: 'structured credit."

However, there is no indication that the housing pickup is going to result in a lot faster economic growth. According to the Financial Times, "Housing Pickup Shows Limits." Even a full scale housing recovery "may not be enough to spur rapid growth in the economy."

The reason for this is that "construction and house prices have fallen so far that even rapid growth adds only slowly to the total output, while worries such as the end-of-2012 "fiscal cliff" of tax rises and spending cuts threaten large and immediate harm."

"Housing offsets but doesn't overwhelm a lot of the other headwinds," says Michael Hanson, senior U.S. economist at Bank of America Merrill Lynch in New York.

The danger is that the credit inflation created by the federal government and the Federal Reserve System may be moving from the government right into the hands of the big banks, the hedge funds, private equity funds, and wealthier individuals. It might be moving right into the hands of these institutions and people with little impact on economic growth.

This process was recognized by Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System in the 1980s as he attempted to lead the battle against the inflation being experienced in the United States at that time. (See my review of the new book on Paul Volcker by William Silber.) Volcker observed that expectations can be transferred right into prices or increased credit expansion with little or no impact upon economic production or output. Once these expectations "kick in", monetary policy, to be effective, must overcome the impact that these expectations have on economic decisions.

This, to me, is the danger we face in the economy and financial markets at this time. "Helicopter Ben" and the Federal Reserve have inserted massive amounts of funds into the financial system. They are in the process, through QE3, of injecting even more liquidity into the economy.

Right now, these injections are starting to produce "profits" in the financial area. The injections are having little or no impact on economic growth or the use of resources.

However, they are starting to produce outcomes that look a little bit like the start of some "bubbles." If they continue to keep the "foot on the accelerator" it would seem like these beginnings could turn into real bubbles. And, guess who is going to benefit from the bubbles? It is not going to be the unemployed and the less wealthy

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.