02/01/2002 Partnoy on Plastic Surgery and Lemonade Stands *

As accounting issues and the health of the U.S. financial system took center stage this week, the wild volatility affliction made its way to financial stocks. For the week, the Dow added 1%, while the S&P500 and the Transports declined 1%. Economically sensitive issues (without accounting issues) generally outperformed, as the Morgan Stanley Cyclical index gained 2%. The Morgan Stanley Consumer index advanced 1%, while the Utilities were unchanged. The broader market was unimpressive, with the small cap Russell 2000 largely unchanged and the S&P400 Mid-Cap index declining 1%. Technology stocks were weak, with the NASDAQ100 declining 2%, the Morgan Stanley High Tech index dropping 3%, The Street.com Internet index declining 6%, and the NASDAQ Telecommunications index sinking 7%. Semiconductors stocks bucked the trend, gaining 3% for the week. The Biotechs generally declined about 3%. Financial stocks performed poorly, with the AMEX Securities Broker/Dealer index declining 2% and the S&P Bank index sinking 4%. With faltering confidence in the U.S. financial sector providing solid support, bullion was up $6.70. The HUI Gold index surged 10%.

Corporate debt woes supported the Treasury market, as 2-year Treasury yields declined 11 basis points to 3.07% and 5-year yields declined 11 basis points to 4.30%. Ten-year yields dropped 9 basis points to 4.98% and long-bond yields dropped 9 basis points to 5.39%. Mortgage-backs and agencies benefited from the flight away from accounting concerns, with yields dropping about 12 basis points. The spread to Treasuries for Fannie Mae’s 5 3/8% 2011 bonds were unchanged at 65, while the 10-year dollar swap spread was about 2 wider at 72. In an important escalation in the unfolding systemic crisis, corporate spreads widened this week, and in some cases (accounting issues!) substantially. Companies such as Tyco, IBM, Worldcom, Ford, and Williams Companies were particularly impacted. And indicative of the troubled corporate sector, Computer Associates today paid 350 basis points over Treasuries to sell its $1 billion 10-year bond issue. Bloomberg quoted one money manager: “There’s pandemonium and panic in the markets now.”

Jan. 31, Reuters – “In a fresh sign that the credit woes of companies worldwide have not abated, Standard & Poor’s said on Thursday that 41 issuers defaulted on $31.3 billion of rated bonds in January. Both totals set records for a single month.”

“Record high yield defaults finally took their toll on the CDO market in 2001. Whereas there were only 20 CDO deals downgraded in 2000, this past year saw the downgrading of 130 CDOs with 129 placed on negative review.” Bank of America

Jan. 30, Moody’s – “For the first time, the amount of US Asset Backed Commercial Paper (ABCP) outstanding has surpassed unsecured corporate CP, Moody’s Investors Service reports in its annual ABCP market review issued this week. At year-end 2001, US ABCP outstandings reached approximately $745 billion, compared to $695.6 billion of unsecured corporate CP last year the agency said…Moody’s is expecting issuance this year to total roughly $825 billion, based on its survey of potential issuers. That amount, which represents approximately 11% growth for the year, is down from last year’s 16% growth and is a significant drop from the 20% market growth in 2000.”

Jan. 28, Moody’s – “Jumbo residential mortgage-backed securities (RMBS) issuance faces a decline of between 10% and 20% in 2002 from last year’s issuance of $152 billion, said Moody’s… Turning to last year’s record volume of issuance, which more than doubled 2000’s volume of $66 billion… The decline in interest rates spurred refinancing activity, while the strong housing market resulted in a near record level of house sales. Loan refinancings jumped to an estimated 50% of total originations from less than 25% in 2000.”

Jan. 29, Moody’s – “During 2002, public issuance of vehicle-backed asset-backed securities is expected to go to $90 billion, up 4.65%, from 2001’s $86 billion, analysts at Moody’s Investors Service say, powered by volumes from the Big 3 auto makers in the U.S… Public issuance in 2001 of vehicle-backed asset-backed securities reached a record $86.0 billion, an increase of 17% over $73.3 billion in 2000.”

Jan. 28, Bloomberg – “Mortgage-backed securities are poised to benefit as investors bet interest rate reductions are over and the rally in corporate bonds will fade. The $2.6 trillion market for securities backed by mortgage loans received a boost last week when analysts at Merrill Lynch & Co. recommended bond investors keep 40.1 percent of holdings in mortgage-backed debt…Fannie Mae current coupon mortgage-backed debt with 7 percent coupon yields almost 2.5 percentage points more than Treasuries ofsimilar maturity… Here’s another benefit. Investors holding mortgage-backed debt can borrow money to finance their holdings at the lowest rates in 40 years. With the Fed’s target for overnight loans between banks expected to stay at 1.75 percent in coming months, investors make almost 5 percentage points on the difference between financing costs and the yield earned on the securities. With the cost to finance debt low, ‘there’s tremendous benefit when all you do is clip the coupon,’ said… a strategist at Fidelity Capital Markets’ Vestigo Associates. ‘The fact of the matter is rates will be low, low, low’ this year so ‘there’s been a lot of buying.’”

I have not focused on money supply changes over the past month or so due to year-end fluctuations. Broad money supply expanded $30.7 billion last week, with savings deposits up $18.7 billion, large time deposits up $16.6 billion, and repurchase agreements up $5.8 billion. Money supply has jumped $57.7 billion in two weeks, largely reversing what had been a meaningful decline around year-end.

December new home sales jumped a better than expected 6% from November to the strongest level since March. Sales have now increased 11% over the past two months to 946,000 units annualized. With sales in the West region jumping 35% during the month, the average (mean) price jumped 8% to a record $225,400. For 2001, a record 900,000 new homes were sold, about double 1990’s 464,000 sales. New and existing home sales combined for 6.15 million units during 2001, surpassing the previous record set during 1999 at 6.09 million units. In a development to monitor closely, today’s January employment report had (“adjusted”) job losses of 54,000 in the construction sector and 89,000 additional job losses in manufacturing. Service-producing jobs, on the other hand, jumped 56,000, with retail trade up 62,000 (the strongest performance since April) and finance up 10,000. The booming health care sector saw job gains of 25,000, about its typical monthly increase. Average hourly earnings were up 0.3% for the month, consistent with its 4% year-2001 increase.

Today’s ISM (formerly National Association of Purchasing Manager’s) manufacturing index increased to 49.9 (the highest level since August 2000), with the prices-paid component jumping more than 10 points to 43.9. December construction spending was up 0.2% from November to an annual rate of $863.6 billion, with spending up 3% from December 2000. Year-over-year, residential spending was up 6%, with multi-family jumping 17.8%. Nonresidential spending was down 11.7%, with spending on “Industrial” sinking 23.9%, “Office” down 25.7%, and “Hotels, Motels” down 14.6%. The public-sector construction boom continues, with spending on “Housing” up 16%, “Educational” 11.8%, “Hospital” 25%, “Roads” 19.7%, “Water Supply” 21.4% and “Other Public” 15.2%. For the year, public construction spending surged 11.5%, the strongest gain since 1980. Private-sector construction spending increased 4.2% during 2001, down from 2000’s 7.4% and 1999’s 8.1%. Today’s January Detroit ISM manufacturing index jumped almost six points to 48.6 (up from October’s 35.3) to the highest level since October 2000.

Wednesday’s GDP report makes for interesting perusing, as well as providing strong evidence of an acutely imbalanced and maladjusted economy. For the quarter, personal spending rose at an annualized rate of 5.4%, the strongest since year-2000’s first quarter. Business investment in computers and software declined at a rate of 5.2%. Government spending surged at a 9.2% rate, while non-residential fixed investment contracted at a 12.8% rate. Inventories dropped at a torrid annual pace of $120.6 billion, as analysts begin to question the extent to which businesses underestimated prospective demand. With imports dropping by $12.6 billion and exports contracting $34.2 billion, our net trade position deteriorated to an annual deficit of $432.6 billion. Year over year, fourth quarter GDP was up almost 2%. Led by an 11% jump in durable goods expenditures, personal goods expenditures were up 4.3%. Non-durable spending was up 1.0%. With medical care up 6.4%, spending on services jumped 4.6% y-o-y. Private domestic investment plunged 14.8%, with “info processing” down 16.2% and “equipment and software” declining 11%. Non-residential construction declined 7.8%, while residential construction jumped 5.7%. Government spending jumped 6.1% y-o-y, with expenditures rising 5.8% at the federal level and 6.2% for state and local governments.

Yesterday’s personal income data was similarly interesting. December personal income increased at a stronger expected 4.7% annual rate. Wages and salaries rose at a noteworthy 6.9% rate, led by 10.7% and 6.0% increases in service sector and government wages. At the same time, “goods producing” wages inched up at a 1.7% annualized rate with “manufacturing” wages declining at a 0.3% rate. Year over year, total wages increased 2.9%, with services up 5% and government up 6.6%, while manufacturing wages declined 3.7%. The numbers are as dramatic over two years, with service sector wages and salaries up 16.4%, government 11.8%, and manufacturing 2.8%. When pondering GDP and income data, it is worth considering that an inflationary bias continues to emanate from the service and government sectors, offset by countervailing forces from our nation’s hollowed industrial sector. Last year’s automobile sector dichotomy continued into January, as y-o-y sales declined 9% at Chrysler, 10% at Ford, and 13% at GM. Yet BMW, Mercedes-Benz, Lexus, and Audi all enjoyed record Januarys, with sales up 16%, 19%, 10% and 2.5%. Toyota sales were up 7% y-o-y, Volkswagen 6%, Nissan 10%, Hyundai 22% and Kia 32%. Honda sales were 1.5% below last year’s record January.

Reading through Frank Partnoy’s (attorney, law professor, former Morgan Stanley derivative salesman, and author of F.I.A.S.C.O) candid and informative testimony (http://www.senate.gov/~gov_affairs/012402partnoy.htm) presented this week before the Committee on Governmental Affairs, I could not help but ponder to what extent Enron exemplifies a microcosm of the contemporary U.S. Credit system. We can only hope that fraudulent activities have not risen to epidemic proportions but, regrettably, we just have no way of knowing. Fraud and malfeasance have a way of only making their way to the surface after a particular asset class falters (like energy and Enron!). We are today forced to wait for the protracted boom in mortgage finance and asset-backed securities to run its course. Yet the profound shift to off-balance sheet entities and vehicles, derivative contracts, and other sophisticated instruments, certainly makes any discussion of transparency or accurate risk assessment a bad joke. It is surely not comforting to learn how entangled our nation’s largest accounting firm and bank, not to mention Wall Street and Washington, were in the Enron sham.

I remember back to early 1998 when I read in the Financial Times of the explosion in ruble derivative hedging contracts throughout the Russian banking system. This piece of information, along with the knowledge that the global leveraged speculating community had been aggressively accumulating large holdings of high-yielding Russian government bonds, was sufficient to appreciate that the Russian financial system had “drunk the poison.” There was, nonetheless, no way of knowing when crisis would erupt – in fact, the boom survived for many months – only that when the speculative flows eventually reversed this Bubble would quickly implode into illiquidity, dislocation and financial collapse. The structure of the debts and degree of systemic leverage, the nature of the hedging instruments, and the character of the financial players involved ensured it. The day the foreign speculators began any meaningful attempted to liquidate holdings (get their money back!), the Russian debt market and ruble would tank. The Russian banks would then be called upon to pay against their derivative “insurance,” although they would by then be hopelessly insolvent. The ruble and government bond market would swiftly collapse and this sordid financial scheme would be over.

The Russian debacle offered a potent mixture of fraud and wild speculative excess (wrapped in the presentable garb of contemporary finance), with the critical assumption that Western policymakers would not tolerate a market collapse. It is worth noting how the most spectacular Bubbles and consequent devastating busts occur to markets holding the most faith in the muscle of authority. Ignoring the fraud, it was at best a complex contemporary financial scheme with the age-old problem that foreign players would have no opportunity to exit the Bubble quietly. The idea that legitimate insurance protection could be purchased from highly leveraged and exposed financial players was similarly ridiculous, in an intriguing contemporary twist to traditional schemes. It is unfortunate that there has been little appreciation for the critical role the availability of such “insurance” played in fostering the speculative Bubble. It was a key enticement that altered risk perceptions for the leveraged speculators, while presenting irresistible opportunities to Russian bankers and fraudsters alike. This “insurance” thus guaranteed the degree of interrelated market excess and malfeasance that would end in spectacular simultaneous collapse in the bond, currency, and “insurance” markets - Russian financial collapse. There were critical pertinent lessons from the Russian experience that were not learned.

A sense of “déjà vu all over again” came over me this week when I read David Gonzales’ article, “Enron Footprints Revive Old Image of Caymans,” in Monday’s New York Times: “Today, there are more than 400 banks and 47,000 partnerships registered or licensed in the Cayman Islands. The banks include about a dozen full-service institutions, with the rest being offshore banks that by law must be affiliated with either a local or overseas bank… By some estimates, Cayman banks hold $800 billion in American money – a figure that last year led Robert M. Morgenthau, the district attorney in Manhattan, and others investigating tax cases to question how much of it was there to keep it from the reach of tax collectors. But Cayman bankers and officials, long accustomed to these criticisms, said that most of that figure represents money from major American banks that has been booked in Cayman accounts in order to gain interest, among other advantages. ‘Those $800 billion are not physically in the Cayman Island, it is all in New York,’ said Conor O’Dea, managing director of Bank of Butterfield. ‘ It is booked with banks in the Cayman Island. It is not a wire transfer. We would love to have $800 billion in deposits.’”

And this week from the Bank of International Settlements (BIS): “Banks in the BIS reporting area continue to make use of credit risk mitigants to limit their exposure to the United States. As a result, even though total contractual claims on the United States remained stable at $2.6 trillion during the third quarter, banks ultimate risk exposure fell further to 95% of contractual claims. The sectoral composition of international claims on the United States shifted further towards the non-bank private sector and away from the public sector. During the first three quarters of 2001, claims on the non-bank private sector rose by 5 percentage points to 58% while claims on the public sector fell by 2 percentage points to 12%. Purchases of US agency securities, in particular bonds issued by Fannie Mae and Freddie Mac, appear to be behind this shift…

Consolidated claims on offshore financial centers rose by 4% between end-June and end-September to $893 billion, driven by lending to financial intermediaries in the Caribbean. The events of 11 September increased insurance companies demand for bank finance, thereby boosting claims on Bermuda, an important center for international insurance. Hedge funds, many of which are domiciled in the Cayman Islands and other offshore financial centers, enjoyed large inflows of funds during the three quarter of 2001, and this supported increased borrowing from banks. Securitization activity in offshore centers also lifted bank claims.”

We don’t know a lot, but we do know that offshore financial centers are the motherland for the explosion of off-balance sheet “special purpose vehicles,” derivative trading and financial insurance. Out there somewhere are over $100 trillion notional OTC derivative contracts, as well as hedge funds with “capital” are in the range of one-half trillion and positions some multiple of “capital.” We know, as well, that the offshore centers have come to account for a significant portion of trading in U.S. debt and equities. We see that there was $724 billion of total trading in long-term U.S. securities during November in the “Caribbean,” about one-third of total foreign trading. The Cayman Islands alone accounted for $102 billion, or 45%, of total foreign trading in U.S. agency securities during the month. In addition, we know that many mortgage and asset-backed securities trusts, along with the myriad of sophisticated securities and instruments, are domiciled offshore. This is especially noteworthy in regard to the asset-backed security market that saw outstanding issues balloon from about $850 billion to surpass $2 trillion in less than five years. Inarguably, these offshore centers have become the critical, if undecipherable, financial engineering epicenter in a sophisticated tangled web of unprecedented Credit and speculative excess - the debt, derivatives, “insurance” sanctum instrumental in providing the attractive face of legitimacy to the body of a monstrous financial scheme. It is today asking too much to give Wall Street the benefit of the doubt…

It has been fascinating to watch the marketplace’s determination to ignore accounting issues slowly evolve into fear of widespread irregularities. All the while, there is careful tip-toeing around the fact that if you don’t like the accounting at Williams Companies, Tyco, IBM and GE (to name just a few) you are bound to absolutely despise the financial statements presented by the major U.S. financial institutions.

Let’s return to Mr. Partnoy’s testimony: “The first answer to the question of why Enron collapsed relates to derivatives deals between Enron and several of its 3,000-plus off-balance sheet subsidiaries and partnerships… Such special purpose entities might seem odd to someone who has not seen them used before, but they actually are very common in modern financial markets. Structured finance is a significant part of the U.S. economy, and special purpose entities are involved in most investors’ lives, even if they do not realize it. For example, most credit card and mortgage payments flow through special purpose entities, and financial services firms typically use such entities as well… The key problem at Enron involved the confluence of derivatives and special purpose entities. Enron entered into derivatives transactions with these entities to shield volatile assets from quarterly financial reporting and to inflate artificially the value of certain Enron assets…

Specifically, Enron used derivatives and special purpose vehicles to manipulate its financial statements in three ways. First, it hid speculator losses it suffered on technology stocks. Second, it hid huge debts incurred to finance unprofitable new businesses, including retail energy services for new customers. Third, it inflated the value of other troubled businesses, including its new ventures in fiber-optic bandwidth...”

We have no doubt that the use of derivatives and off-balance sheet entities for the purpose of hiding losses has become a widespread practice. How else can one explain that a historic bursting of the NASDAQ Bubble and telecom debt collapse, as well as the endless barrage of non-tech corporate bankruptcies and defaults, has not resulted in huge losses for a large number of U.S. financial intermediaries? Many even go so far as to celebrate the lack of bank failures and the supposed strong capital position of the U.S. banking system, while we are left instead to ponder “the dog that didn’t bark” – the who, what, and where of massive loss concealment.

“Transactions designed to exploit…accounting rules have polluted the financial statements of many U.S. companies. Enron is not alone… In short, derivatives enabled Enron to avoid consolidating these special purpose entities… Enron used financial engineering as a kind of plastic surgery, to make itself look better than it really was. Many other companies do the same.”

Mr. Partnoy’s Plastic Surgery analogy is wonderful analysis. I can only add that when it comes to financial engineering and excess making things appear much better than they are, the issue is not Enron but the entire U.S. financial system and economy. And I do apologize, but when it comes to analogies I can muster no literary discipline. For years, the scalpel of Wall Street finance worked like magic as it imparted on the skin of the U.S. economy a new seductively youthful and vibrant appearance. Seemingly, the system could on a daily basis bask in the intense rays of Credit and speculative excess without a care in the world. After awhile, a game of pretend turned to neurotic self-delusion, with the recipient believing the New Age look and deep, dark complexion were natural and everlasting. But time does have a way of flying by, and that dangerous bedfellow denial becomes increasingly powerless in deflecting the toll of accumulating degeneration. Wall Street surgeons now work frantically in a desperate attempt to hide the multiplying skin cancers that seem to increasingly pop up all over. At some point the patient stops worrying about his appearance and becomes acutely focused on survival. We’re just not there yet. We’re still very much in denial.

“Enron is not the only example of such abuse; accounting subterfuge using derivatives is widespread. I believe Congress should seriously consider legislation explicitly requiring that financial statements describe the economic reality of a company’s transactions. Such a broad standard – backed by rigorous enforcement – would go a long way towards eradicating the schemes companies currently use to dress up their financial statements.”

“Enron’s risk management manual stated the following: ‘Reported earnings follow the rules and principles of accounting. The results do not always create measures consistent with underlying economics. However, corporate management’s performance is generally measured by accounting income, not underlying economics. Risk management strategies are therefore directed at accounting rather than economic performance.’”

Enron as microcosm? There is absolutely no doubt that the true health of the entire U.S. economy has been both severely distorted and misrepresented. As Partnoy pointed out, “most of what Enron represented as its core businesses were not making money.” Accounting subterfuge disguised this key fact. We would strongly argue that the true wealth creating capacity of the U.S. economy has been grossly misrepresented. Ignoring the issue of fraud, there is absolutely no doubt that throughout the entire U.S. system financial “profits” mask what should be considered a distressing decline in true economic profits. While Wall Street strategists are unvexed as they net Fannie Mae’s almost $2 billion 4th quarter “profits” against some huge losses suffered throughout the goods producing sector, this gimmickry only masks profound structural deterioration in the soundness of the real economy. The Enron situation provides a very apt illustration: “While Enron gained more than $16 billion from these [derivative] activities in three years,” cash flows waned and debt structures became increasingly perilous. Only the continued conspiratorial charade played by management, the auditors, bankers, rating agencies, and Wall Street analysts could keep the pyramid from collapsing. It is really only a case of once you begin living a lie it’s very difficult to return to honesty. In finance lies tend to mushroom, but the truth of cash flows and debt structures does come out in the end.

“The credit rating agencies in particular have benefited greatly from a web of legal rules that essentially require securities issuers to obtain ratings from them (and them only), and at the same time protect those agencies from outside competition and liability under the securities laws. They are at least partially to blame for the Enron mess… An investment-grade credit rating was necessary to make Enron’s special purpose entities work, and Enron lived on the cusp of investment grade… The importance of credit ratings at Enron and the timing of Enron’s bankruptcy filing are not coincidences; the credit rating agencies have some explaining to do.”

We have myriad problems with the reality that structured finance has come to absolutely dominate the U.S. Credit system. Some of our concerns are clearly illuminated with the Enron debacle. Financial schemes are really leveraged confidence games, so debt ratings become an instrumental component of the manipulation. And the longer the scheme plays out, the larger the borrowings, the greater the expropriation of value from shareholders and creditors, and the more paramount becomes the perception of soundness for the underlying financial structure. In the case of Enron, despite the deterioration of the core businesses and cash flows, the rating agencies were obviously very reluctant to cut the debt ratings lifeline. Surely they understood that any move against Enron would be catastrophic. This is such a conspicuously flawed process, and we certainly will not be relying on the accuracy of rating agencies’ assessment of the key players throughout the “structured finance” edifice, including the GSEs, Credit insurers, securitizers, money center banks, and Wall Street securities firms, along with all the various related entities, vehicles and instruments. Instead of more objective and appropriate ratings, the pressure on the agencies will become only more intense, as the wagons are circled around a faltering Credit system confronting an increasingly serious crisis of confidence. Like Enron, the U.S. Credit Bubble won’t survive without the preponderance of top ratings throughout “structured finance.”

“Derivatives based on credit ratings – called “credit derivatives” – are a booming business and they raise serious systemic concerns. The rating agencies seem to know this. Even Moody’s appears worried, and recently asked several securities firms for more detail about their dealings in these instruments. It is particularly chilling that not even Moody’s – the most sophisticated of the three credit rating agencies – knows much about these derivatives deals.”

Credit derivatives are a major accident in the making. We have discussed on several occasions our view that writing insurance against potential Credit or market losses is not a legitimate business (see Its Wildness Lies In Wait – 10/12/01). Such losses are not “insurable events,” since they are particularly non-random, highly interdependent, and unpredictable. And unlike true insurers, players in this arena are not accumulating pools of insurance reserves to settle calculable future claims, but are instead relying on sophisticated models and dynamic hedging strategies. We view Credit derivatives more in terms of a speculative financial scheme than an insurance marketplace. There are, no doubt, already huge losses hidden somewhere in the darkness of Credit default swaps and other derivatives, but this arena has become such a critical cog in the greater Credit scheme that the guise of legitimacy must be staunchly defended. Our greatest fear, however, is that Credit and “swap” derivatives and arrangements have become an integral aspect of “hedging” the massive and unrelenting U.S. current account deficits. We certainly cringe when we read in BIS pronouncements that international banks “continue to make use of credit risk mitigants to limit their exposure to the United States.”

There is the distinct possibility that these “risk mitigants” have become the KEY factor accommodating the Credit-induced flood of dollars into the global financial system that have thus far been so easily “recycled” back to the aggressive U.S. financial players. It is an unusual circumstance of the U.S. financial sector inundating the global system with dollar denominated liquidity that then finds a home, likely with either speculators or financial institutions hedging dollar exposure (or planning to hedge when the dollar weakens). Why not play the U.S. Credit Bubble while “insurance” is cheap and readily available? And as Mr. Partnoy testified, “The temptations associated with derivatives have proved too great for many companies, and Enron is no exception.” Indeed, writing “insurance” against rising interest rates and/or a declining dollar has been extremely rewarding, with the consequence an increasingly subverted market processes. This, in reality, reeks of a Russian-style precarious financial Bubble.

I continue to read imaginative conjecture as to recent dollar strength, but we see it disturbingly consistent with the type of market dynamics associated with dangerous speculative excess and the consequent prevalence of “dynamic hedging” strategies. In truth, our fears would be somewhat allayed if revelations of the massive Enron fraud, rising concern of systemic accounting irregularities, and heightened stress throughout the U.S. financial sector would have by now given impetus to some air coming out of the dollar Bubble. But degenerative speculative markets have a strange but telling propensity for simply overpowering the sway of deteriorating underlying fundamentals - for a while. At the same time, we are only more resolute in our view that little of the unrelenting foreign flows into dollar assets are stable long-term investment. Rather, flows are almost certainly of a short-term, speculative “hot money” variety playing U.S. interest rates and spread trades. Secondly, there are corresponding unfathomable currency and related derivative positions that are locked in trend-following trading strategies. Thus, the greater the speculative flows into U.S. dollar assets, the greater the derivative positions to be dynamically traded, the greater their self-reinforcing character dominates the market, and the greater the gulf between market prices and true underlying fundamentals. But that’s precisely why they’re called Bubbles and why the end with accidents. The consequences of such dysfunctional monetary processes are a precarious proclivity toward market dislocation, speculative blow-offs, and market collapse, such as we have witnessed repeatedly throughout the emerging markets, Russia, the Internet, telecom and technology sectors, the energy markets, and elsewhere. These precarious dynamics should by now be recognized as an inherent feature of contemporary finance.

So if “risk mitigants” have been so widely used by foreign banks to offload U.S. exposure, may we ask to whom? This line of analysis becomes particularly troubling when all signs point to the thinly capitalized and highly exposed U.S. financial sector and leveraged speculators as the repositories for escalating dollar risk. These acutely vulnerable entities have plenty of direct U.S. Bubble exposure to manage, and clearly lack the wherewithal to provide any meaningful systemic dollar protection for the global financial community. Come the day the dollar Bubble bursts, there will a very limited market for the dynamic hedgers to offload risk, as these strategies dictate. Market dislocation appears guaranteed, with only the timing in doubt. Using Mr. Partnoy’s comparison of LTCM to Enron, I will say that if my fears prove justified, the U.S. financial sector has the potential to make the Russian collapse look like a “lemonade stand.” I make such a statement with the utmost seriousness, and I am likely one of the few analysts that will take great satisfaction if proved absolutely wrong.

We have found ourselves, once again, at an important crossroads. The question as to the soundness of the U.S. financial sector is proceeding to the forefront. In the past, any hint of a dampening of confidence in the U.S. financial system was greeted with visions of aggressive Fed rates cuts and salivations for speculative trading profits. For some time, faltering technology stock prices and escalating corporate debt problems was a boon to Wall Street “structured finance” that deals predominantly in the fabrication of “top-rated” securities and the design, marketing and implementation of interest rate “arbitrage.” I once wrote, rather incorrectly, “financial crisis is not Christmas.” In fact, acute financial fragility has been a gift to Wall Street, providing the impetus for financial engineering to expand tremendously over the past few years. It is today very important to appreciate that this several year speculative blow-off of an historic bull market in “structured finance” has had profoundly negative consequences for the structure of both the U.S. financial system and economy. It has been a desperate elevation of the lie we have been living.

Yet the bullish contingent blindly and erroneously interprets the proliferation of financial engineering as a sustainable manifestation of valuable “innovation” and financial system “efficiency.” Today, however, the spotlight is being turned on the murky world of Wall Street finance and the myriad of off-balance sheet “special purpose” vehicles, agreements, and instruments. We don’t expect illumination to be comforting for anyone. There is furthermore the harsh reality that the Fed today has little room to grease the market’s concerns with another dab of speculative profits. During structured finance’s bull run the lack of transparency was of considerable advantage. Now, with confidence waning, opaque is transformed into a distinct disadvantage with potentially momentous ramifications for the Credit apparatus. There is quite a dilemma, as Wall Street structured finance must continue to run on all cylinders to generate the enormous Credit required to sustain the Bubble, in the face of what will be heightened scrutiny. This will prove no small feat. Whether it was by default or otherwise, financial engineering commands the U.S. Credit system and there is no turning back.

The euphoria and wild Credit market excess over the past year has easily been the most intense since that experienced during the second half of 1993. The unavoidable consequence of that melee was 1994’s market dislocation that nearly brought the U.S. financial system to its knees (while rocking Mexico and the global financial system). If it weren’t for the GSEs ballooning their balance sheets – establishing their role as buyers of first and last resort to speculators trapped in leveraged holdings of mortgage securities and related derivatives - the world would be a much different place today. But how much longer will they maintain this most extraordinary capacity? There is absolutely no doubt that the amount of systemic leverage and speculation makes 1993’s Credit market speculation look like a “lemonade stand.” These types of speculative Bubbles breed irrational exuberance, and the extreme exuberance has been commensurate with the degree of speculation. It is our view that the marketplace has underestimated the impact its own euphoria (and consequent Credit excess) would impart onto the U.S. economy, in terms of demand, pricing and maladjustments. The liquidity and speculation-driven marketplace has been all too anxious to disregard the ramifications of last year’s extreme excesses throughout mortgage finance, the $1 trillion money supply expansion, and the extremely easy conditions throughout consumer finance, in combination with booming government and service sectors. We remember all to well the “efficacy” of the Mexican and LTCM bailouts (and other “reliquefications”) and will be waiting to spot consequences of the most recent round of excess.

So we have today a confluence of faltering confidence in “structured finance,” an increasingly impaired U.S. financial sector, an exceedingly maladjusted (hence unpredictable) U.S. economy hinting that the near-term surprise could come on the upside, unprecedented leverage and speculation permeating the U.S. financial sector, unparalleled foreign liabilities and related derivative positions, and a Fed that shot its bullets. There is furthermore the wildcard of foreign economies and central bankers, and the potential that this most unusual period of intense synchronized monetary ease could be interrupted. I am, I believe justifiably, sticking with my analysis that we have been witnessing the worst-case scenario unfold right before our eyes. The wild volatility that has inflicted the financial stocks should be recognized as a clear warning of approaching trouble. We have stated in the past that rising rates, widening spreads and a weak dollar are manageable, but not in confluence. We’ll be monitoring closely for such a development. But the stakes could not be higher and, hence, the “system” will surely “pull out all the stops” to keep this scheme from imploding. We should expect no less.