03/09/2001 A Gain of 364000 vs. a Loss of 190000 *

A week where a top Japanese policymakers discusses the possibility of financial collapse, technology leader Intel announces an even more dreadful forecast, another technology rally ends in disappointment, global equity markets demonstrate continued wild volatility, and throw in a surging gold price and there should be enough here to keep everyone on edge. It is also likely that today’s stronger than expected February employment data – with continued significant service sector job growth and stronger than expected wage gains – could lead to an important change in perceptions as to the true flexibility afforded the Federal Reserve to respond to the unfolding technology collapse and manufacturing sector downturn. In short, clearly there is risk in aggressive Federal Reserve accommodation, and today’s report could prove instrumental in more clearly illustrating the severe imbalances that have come to dominate the U.S. economy (and perhaps a greater appreciation of the dilemma now facing the Fed). Yet, despite today’s more than 200-point decline, the Dow ended the week with a gain of about 2%. Weighed down by faltering technology stocks, the S&P500 ended unchanged for the week. In what should be unfriendly to the bond market, economically sensitive stocks continue to outperform. For the week, the Morgan Stanley Cyclical index gained 4%, increasing year-to-date gains to 8%. The Transports added 2% this week, while the Utilities were unchanged. The Morgan Stanley Consumer index increased 2%. The broader market was particularly volatile, with both the small cap Russell 2000 and the S&P400 Mid-Cap indices giving up strong gains in today’s sell-off to end the week largely unchanged.

The unfolding technology debacle took another turn for the worst this week, with the bellwether mega-cap names coming under intense selling pressure. At this point, we will assume that there are "behind the scenes" severe equity derivative problems. For the week, the NASDAQ100 dropped 4%, the Morgan Stanley High Tech index declined 2%, while the Semiconductors actually posted a 2% advance. The Street.com Internet and the NASDAQ Telecommunications indices slipped 2%. Biotech stocks declined 9%. Financial stocks also came under pressure as the week came to an end, with the weak Wall Street firms’ stocks appearing an ominous harbinger of things to come. For the week, the AMEX Securities Broker/Dealer index sank 7%, while the S&P Bank index added 1%. Gold stocks continue to trade well, with the HUI gold index adding 7% this week.

The credit market was volatile as well, with the Treasury market giving up gains from earlier in the week. It is worth noting today’s poor credit market performance in the face of sinking stock prices. This is something not seen too often of late. For the week, 2- and 5-year yields ended basically unchanged. 10-year yields declined about one basis point. The long-bond saw its yield increased 4 basis points. The yield on the benchmark Fannie Mae mortgage-back security was unchanged, while agency yields increased about one basis point. The dollar index had a slight gain for the week, while gold jumped $8.40.

New credit numbers are out for the fourth quarter, and don’t let the headlines of a sharp slowdown in credit – "Debt Growth Slowest in Six Years" - fool you. Sure, the Federal government paid down debt at a rate of almost 10% during the fourth quarter, but the real story is the continued historic credit expansion by the non-federal sector. Actually, The Great Credit Bubble is quite conspicuous in the fourth quarter data. During the quarter, corporations borrowed at an 8.7% annualized rate, up from the third quarter’s 6.8%. Non-mortgage consumer credit expanded at an 8.4% pace, also up from 6.8%. Consumer credit expanded by almost $135 billion during 2000, compared to $99 billion in 1999 and $67 billion during 1998. The real estate credit boom continues, with household mortgage debt expanding at an 8.1% rate. For the entire year, household mortgage borrowings increase by $581 billion, similar to the previously unprecedented borrowing booms experienced during both 1998 and 1999. To appreciate the degree of this historic mortgage credit expansion, however, one can compare recent growth to 1997’s $283.5 billion. Household mortgage debt has increased by almost $1.2 trillion during the past three years, or about 31%. No surprise that prices have risen similarly.

The key fuel for the Great Credit Bubble can be found in the continued gross leveraging of the U.S. financial sector. And, once again, we see the phenomenon that when financial markets come under heightened stress, the financial sector responds by "going into overdrive." During the fourth quarter, the financial sector borrowed at an annualized rate of $1.079 trillion, or 13.2%. This compares to a pace of $733 billion (9.2%) during the third quarter. The financial sector has now expanded borrowings by almost $3 trillion during the past three years, a stunning increase of 55% to $8.431 trillion. Non-traditional lending now completely dominates the credit creation mechanism, with "Federally related mortgage pools" expanding credit at an annualized pace of $307 billion (vs. $225 during the 3rd quarter) during the fourth quarter and "asset-backed issuers" increasing credit at a rate of $298.8 billion (vs. $155.6 billion). And, of course, the government-sponsored enterprises continue to lead the charge in financial credit excess, with the GSEs expanding holdings at an annualized rate of $350 billion during the fourth quarter, compared to $278 billion during the third quarter, $239 billion during the second quarter, and $127 billion during the first quarter. Over the past three years the GSEs expanded their holdings of financial assets by a simply unbelievable $870 billion. I will go out on the limb a bit and predict that the current quarter will prove the climax for the GSE/mortgage bubble.

"Since the launch of FM Watch June 1999, members of the FM Watch board of directors have been subject to attempts of intimidation and threats by both Fannie Mae and Freddie Mac management and employees. Each member of our board of directors has been systematically approached and threatened by the government-sponsored enterprises. In each instance, the message was the same: Stop supporting the activities of FM Watch or be prepared to see your business opportunities and products suffer.

In order to remove the focal point of the Fannie Mae and Freddie Mac threat, we are today disbanding the FM Watch board. FM Watch will persist in shining the light on the GSEs. The association and companies that belong to FM Watch are more committed than ever to its goals. The policies and strategies of the organization, as they have in the past, will continue to be managed and implemented by the members of our executive committee." Gerald Friedman, executive director of FM Watch, March 8, 2001

"Wells Fargo Chief Executive Richard Kovacevich said in a statement that, ‘I am personally aware of an instance involving our company in which we were removed, without cause, from the list of approved bidders for Fannie Mae bonds based, we were told, on our overall relationship with Fannie Mae…It is one more example of tactics Fannie Mae has used to restrain or influence the Market." Bloomberg, March 8, 2001

So, they are getting a bit panicked with the Frankenstein they’ve created…this is but only one of a long list of reasons why it is not good policy to nurture financial institution behemoths of enormous power. Much more important reasons will surface come the bursting of the real estate bubble. An ambitious Congressman could get a good head start by going back and reading the transcripts from post-1929 crash Congressional hearings…

Although looking particularly vulnerable, The Great Credit Bubble not only lives, it is living the illusion of the "good life." This week from the country’s largest mortgage originator: "Countrywide capitalized on the refinance market’s growing momentum to achieve record-breaking performance in February," said Stanford L. Kurland, chief operating officer. "Average daily applications for the month were $666 million, the highest total in Countrywide’s 32-year history. This massive wave of applications pushed our pipeline of loans in process to $15.4 billion, an 82 percent increase over the same date last year. Consolidated mortgage fundings were $7.4 billion, the highest level thus far in the current refinance cycle and a 102 percent increase over February 2000."

At $4.2 billion (57% of total fundings), refinance volumes jumped 36% from January’s booming numbers and were an astounding 360% above last February. Year over year, February "e-commerce Fundings" increased 300% to $3.33 billion. Total purchase fundings increased 16% to $3.2 billion, while home equity fundings increased 40% to $367 million, and sub-prime 23%, to $489 million. And while the number of units refinanced has not yet reached 1998’s extremes, obviously (and not surprisingly) the average size of new mortgages has increased significantly to get this kind of dollar volume. This is one heck of a lending boom and it is amazing it doesn’t get more attention. I think it explains a lot.

There are increasing signs that this mortgage-refinancing boom is leading to more serious market disruptions. Yesterday, Dale Westhoff, research head for Bear Sterns’ mortgage unit was quoted by Bloomberg: "There’s a good possibility you are stepping in front of a freight train investing in mortgages. The market is going to get hammered." The already wide spreads between mortgage-backs and Treasuries continue to widen. This is a curious predicament considering we are in the midst of record mortgage lending. There is the strong possibility that derivatives and hedging programs are playing a critical role in fueling lower yields on agency debt and interest rates generally – creating artificial (unsustainable) demand. All eyes on interest rate derivatives going forward.

The consequence of current market distortions is a continued massive over-expansion in real estate lending. Interestingly, the National Association of Realtors Wednesday revised its estimate of January existing home sales due to "software problems." After reporting two weeks ago that homes sold during January at an annualized rate of 4.65 million units, a decline of 6.6% from December, the Association adjusted the figure to a 3.8% increase, or 5.13 million units. So, what’s a 10% adjustment amongst friends? Bloomberg quoted the ever-quotable Robert McTeer: "The future keeps changing. And apparently the past does too. And that’s encouraging." It is good to keep the housing sales numbers in perspective. Last year’s 906,000 new homes sold was 36% above 1995 levels; the 5,113,000 existing home sales were 31% above those of 1995.

This week Freddie Mac announced another week of declining mortgage rates, with one-year adjustable rates dropping to the lowest level since October of 1999. One-year adjustable rates dropped 10 basis points last week to 6.29%, compared to 7.11% one year ago. The Mortgage Bankers Association reported that the yield on the popular 5-year balloon mortgage dropped to 6.65%, down from 8.06% last year, while the conventional 30-year mortgage dipped again below 7.0% compared to 8.25% one year ago.

Lower rates keep the temperature rising in an already hot national housing market. In its weekly index of mortgage applications, the Mortgage Bankers Association reported Wednesday that applications jumped 15% from last week. Confirming the continuation of an enormous refinancing boom, the index of refinance applications jumped almost 19% and is now almost 6 times last year’s level. Importantly, however, there is more going on here than simply taking advantage of low rates to refinance. Purchase applications jumped more than 10% last week and are currently running 10% above strong levels from last year. The real estate boom lives, for now. What’s more, there is absolutely no mystery behind the continuation of this bubble, with historically low unemployment; exceptional wage growth, low interest rates and truly incredible availability of mortgage credit. There are spots of weakness, but the key aspect of the current environment is its general strength.

For example, Toll Brothers, the largest U.S. builder of upper-end homes, announced its strongest January orders on record, with orders 21% above last year. The average selling price jumped to $472,000, an increase of 13%. Bloomberg quoted the company’s CEO last week: "For the moment, we appear to be bulletproof to what otherwise would seem to be a nasty gathering storm…"

There was an interesting story earlier this week from PRNewswire – Homestretch Plan to Help Homebuyers Stretch Dollars Further. "HomeStretch Plan by GMAC Mortgage: Building Neighborhoods is an FHA fixed-rate first mortgage for lower- or middle-income, and move-up home buyers, which provides an additional 4% second loan to cover down payment, closing costs or pre-paid items…the 30-year term first mortgage is fully amortized and the second mortgage is zero interest, no payment and fully forgivable after 10 years occupancy in the home…Household income cannot exceed 150% of area median income (165% in New York City, and 170% in Hawaii). As we’ve said, mortgage credit could not be more freely available.

The momentous California economy continues to fascinate. BusinessWire ran an interesting story earlier in the week – (California) State Construction Tops $6.37 Billion Level for January. On the back of two new power plants, California’s statewide construction activity jumped to an "unprecedented month level of $6.37 billion, up 32.9 percent, or $1.58 billion more than in January 2000…Normally the weakest construction month of the year seasonally and weather-wise, January’s construction activity showed overall gains in both private and public works. The state’s private building construction (residential and nonresidential) totaled $4.231 billion, up 10.8% percent from December, while public works construction, which includes highway-heavy construction (nonbuilding) as well as the public building sector (government-owned buildings) totaled $2.146 billion, up 56.9 percent, or $778 million more than December." And while this data is somewhat distorted by the commencement of construction on two new major projects, one cannot ignore the strength of these numbers. This highly maladjusted economy is desperately short of energy production capacity, and tremendous sums will be spent in this area.

And while the "oil patch" commences another lending boom, problems mount from previous bubble excess now going bust. Comptroller of the Currency John D. Hawke Jr., quoted by Bloomberg: "Almost every week, some bank announces a new round of writedowns and charge-offs. Future earnings will almost certainly be impacted. He told the bankers that delinquent commercial loans at national banks with assets of more than $1 billion have nearly doubled during the past three years, from 0.73 to 1.38 percent of total business loans. The percentage of bad loans for smaller banks has dropped during that same time, from 1.63 percent to 1.59 percent, Hawke said…Loan-loss rates at large banks more than tripled over the three-year period, from 0.17 to 0.63 percent…"

Elsewhere (also from Bloomberg), "the FDIC released a preliminary report on fourth-quarter bank earnings yesterday that blamed bad loans for much of the profit decline last year. The drop was the first for the banking industry in nine years. The FDIC said banks set aside $9.5 billion to cover possible loans losses during the fourth quarter, the largest quarterly loss provision since 1991." This is but a hint of what is to come.

Wednesday the Federal Reserve reported that consumer borrowing jumped to an eye-opening $16 billion during January. This was almost double estimates, and more than twice December’s rise of $7.2 billion. During January, consumer borrowing expanded at a 12.6% annual rate, this after growing by almost 10% during 2000. Credit card debt increased at its most rapid pace since August, increasing by $6.7 billion (compared to December’s $2.4 billion). Other consumer loans jumped by $9.4 billion (12.9% annualized), more than double December’s $4.8 billion. This is nuts but unfortunately, precisely what the Federal Reserve was hoping for. Amazingly, Greenspan looks the other way to clearly ugly consumer borrowing excess, while pinning current credit losses on previous excesses. What gives? Quoting Greenspan: "The effect of these (previous lending) excesses are likely to continue for much of this year in the form of moderately deteriorating asset quality and earnings at some of the larger banks…Lenders and their supervisors should be mindful that in their zeal to make up for past excesses they do not overcompensate and inhibit or cut off the flow of credit to borrowers with credible prospects." In a clear bout of wishful thinking, Greenspan also said bad loans hopefully "prove modest both by historical standards and relative to the resources of these institutions." The U.S. financial sector will need all the reserves it can muster come the day when this consumer/real estate bubble bursts.

Earlier in the week, the Labor department reported more favorable productivity data. During the fourth quarter, worker productivity increased a "faster than expected" 2.2% creating the strongest year of productivity growth (according to Bloomberg) since 1983. We see productivity gains as rather nebulous, but rising wages much less so. From Bloomberg: "Slower growth meant a surge in unit labor costs. The measure of wages and other expenses tied to productivity rose at a 4.3 percent annual rate in the fourth quarter compared with a 4.1 percent pace originally estimated. In the third quarter, labor costs rose at a 3.2% pace. The fourth-quarter increase was the biggest since a 5.5% percent rise in the fourth quarter of 1997…Fourth-quarter compensation per hour rose at an unrevised 6.6% percent annual rate, the largest since the first quarter of 1992. That compares with a 6.2 percent growth pace in the third quarter." There should be little mystery as to why are manufacturers are having increasing difficulty competing globally.

Since this is such a key time for analyzing the complex U.S. economy, it is also worth noting this week’s report on the National Association of Purchasing Management non-manufacturing business index. Demonstrating continued expansion within the monstrous U.S. service sector, the non-manufacturing index jumped almost 2 points to 51.7. New orders jumped back above 50 (indicative of growth), while backlogs added 3 points to 45.5. The pricing index remained quite strong at 60.5. There is some interesting detail in this report, as the number of respondents seeing lower business activity during February dropped 5 points to 23 and the number seeing lower orders dipped 6 points to 22. Looks like firming in the non-manufacturing sector. We are not surprised by today’s strong service sector job growth.

The manufacturing sector, however, is a much different story. This week, Moody’s reported that February corporate bond defaults jumped to $10.6 billion, the highest rate since July 1999, and the third-largest month on record. Junk bonds, not surprisingly, continue to suffer the brunt of defaults, with 17 company defaults accounting for the highest rate of defaults in this sector since 1992. Moody’s is forecasting that nearly one in ten junk issuers will default in the next year. There were three large defaults in February: Finova, Sunbeam and Loews Cineplex. Fitch this week also predicted record defaults this year. From Fitch’s director of loan products: "We anticipate a record number of fallen angels this year (companies rated investment grade within 12-months preceding the default). One industry group which had a zero default rate in 2000 was the utilities sector. That’s ironic because that’s changing this year." One characteristic of highly imbalanced economies is how quickly the financial condition of an individual company or industry can deteriorate.

I could only chuckle when I read an introduction to a research report by Jude Wanniski and Michael T. Darda titled "Greenspan in Denial." "Federal Reserve Chairman Alan Greenspan’s testimony this morning before the House Financial Services Committee indicates he is in complete denial of the Fed-induced weaknesses in the economy and the steps that must be taken to end the monetary deflation." There is certainly the strong possibility that this Great Credit Bubble ends in "monetary deflation," but it’s not happening yet. With broad money supply exploding, and record mortgage lending fueling the prices of trillions of dollar of real estate and credit market instruments higher, one has to be imaginative to view monetary deflation. The fuel for financial asset inflation, however, is not all too difficult to spot. The Chicago Mercantile Exchange reported a record month for futures and options trading, with volumes surging 41%. Trading in interest rate products jumped 48%, with Eurodollar futures contract volume surging 33%. From Bloomberg: "CME trading got a boost from speculators betting whether the Federal Reserve would cut interest rates for a third time this year." I say this is pretty good evidence of a speculative bubble.

Curiously, "strange" things appear to be unfolding in the gold market. Gold lease rates have more than tripled during the past week to the highest level in 18-months. Increasingly, there appears something behind the talk of an unfolding shortage of physical gold. There is, of course, an infinite supply of "paper gold," or derivative contracts that can promise delivery of the commodity or cash settlement. But if there is ever a rush to hold physical bullion and a resulting panic to cover short/derivative positions, things could quickly get interesting. Over the past few years the gold market has developed into a critical derivative market, as well as possibly a key source of cheap financing for some in the leveraged speculating community. This greatly elevates the importance of gold prices. The current gold situation takes on even greater significance in the current environment, where it is likely that a severe dislocation has likely developed in the equity (tech/NASDAQ) derivatives marketplace. There is also the issue of a credit market engulfed in unprecedented leverage and derivative activity. This is undeniably an acutely fragile financial environment, where problems in one market (especially in derivatives) can quickly transfer to other markets.

So, I am sure you are saying, "Doug, you’re throwing a lot of ‘stuff’ at us, but what are we supposed to make of it?" Good question! Well, while this is not very useful analysis, I think it is nonetheless worth keeping in mind that this is a truly extraordinary period – a critical inflection point in financial history. Such a momentous development, however, is not going to be "clean" or "precise." The bulls and the Fed would like us to believe that this is an inventory correction – a pause that refreshes a long-term productivity and technology-induced prosperity. The bears, on the other hand, believe that the enormous wealth destroyed in the collapse of the technology bubble and the abrupt termination of a once-in-a-lifetime capital spending cycle are a clear and present unmitigated disaster for the economy. The bulls are just flatly wrong, while the bears are not all too keen to the true source of the bubble. The bears are a bit early (as bears tend to be) with the economic collapse scenario.

The acute sensitivity of the financial system and economy to lower interest rates continues to go unappreciated. And for heaven’s sake, let’s not lose sight of the fact that we are in the midst of an historic and endemic real estate bubble where inflation psychology is now clearly ingrained. The real estate sector is both a "sponge" and a "black hole" for capital. After years of boom, powerful monetary processes are in place to direct massive capital and speculative flows into the credit market at any whiff of Fed ease. The leveraged speculative community is quite keen to the fact that Greenspan is in the mood to move aggressively to lessen the impact of the technology collapse, while desperate to avoid recession. And with the corporate bond market in tatters, these speculative flows are directed predominantly to agency securities. At the same time, the GSEs are in overdrive as an historic credit explosion runs unabated. And as a major refinancing boom shifts mortgage paper onto the balance sheets of the GSEs, investors and the leveraged speculating community are provided the liquidity to acquire credit card and other "backed" securities. It’s one massive bubble. The result is the same type of flood of speculative capital into mortgage finance and consumer credits that drove the spectacular technology bubble that now goes bust. Again, there are powerful forces that must be considered.

I continue to believe that the highly speculative and leveraged U.S. credit system is the proverbial accident waiting to happen. Today’s stronger than expected employment data is not constructive for this market. The bottom line is that we are dealing with a massive speculative bubble that will, in time, burst. In the meantime, this major refinancing cycle is subtly working its magic and the U.S. dollar has generally benefited from an accelerating global manufacturing downturn. Ironically, the precariously distorted U.S. economy is today relatively less exposed to manufacturing problems. This buttresses the dollar short-term, but only allows the dangerous perpetuation of the Great Credit Bubble. While it may not appear to be playing a significant role, I would argue that it is the waves of mortgage refinancings, and real estate lending boom generally, are sustaining spending in the face of a historic destruction of perceived wealth in tech stocks and a manufacturing slowdown. Moreover, it is the gross expansion of real estate credits that has primarily been responsible for sustaining financial market liquidity in the face of what is likely a collapse of tremendous leverage that had been a crucial underpinning for the NASDAQ bubble. The bears will say, "four trillion dollars of wealth has disappeared!" and "look at collapsing consumer confidence." Yet, these powerful forces are mitigated by what can only be described as the incredible raw power of mortgage credit excess. However, this financial sector/real estate bubble is precariously unsustainable, with profound ramifications for the U.S. economy and financial system.

A critical question then becomes: will the current mortgage refinancing boom spark a strong economic response as it did in 1998? I doubt it, specifically because of the bursting of the technology bubble. However, I certainly do not rule out the possibility of some surprisingly strong data in the near term. Mortgage refinancing booms are very stimulative and, confident or not, the American household sector is addicted to spending. I could not help but notice all the references to "pricing pressures" in yesterday’s Beige Book. Some economists can talk "monetary deflation" all they want, but this really is just silly chatter today. Inflation psychology is returning, and in some critical examples (housing, energy) have already returned with a vengeance. And the Fed may wish it was a productivity-induced phenomenon, but inflationary psychology is playing the major role today in rising wages. Let’s not forget in many areas there remain acute shortages for technology specialists, teachers, policemen, nurses, etc. And remember, the unemployment rate is only 4.2%, with the service sector creating jobs faster than the manufacturing sector is losing them.

During the two-month period of January and February, jobs were created at the strongest pace since the government census hiring back in April/May. 174,000 construction jobs have been added in the past two months. The booming service sector created 364,000 jobs during January and February, with 37,000 retail and 16,000 financial services jobs added in February alone. The Great Credit Bubble is today the fuel for the service-sector dominated U.S. economy, a situation completely ignored by the economic community. The factory sector, however, is a much different story, with seven consecutive months of job losses and 190,000 jobs lost in the past two months. Yet, importantly, average hourly wages increased a much stronger than expected 0.5% during February, something that should lead to a bit of rethinking by some analysts. And with companies throughout various industries quietly regaining pricing power, it is getting more and more difficult to ignore the deteriorating inflation outlook. There will undoubtedly be more talk of Stagflation going forward. Much of the U.S. economy is today an inflation tinderbox, albeit with a credit system that could buckle into a debt deflation collapse at any point. But in the meantime, it should be becoming more apparent that Greenspan does not have all the flexibility to cut rates as Wall Street has always assumed. We live in interesting times…