05/02/2002 The Bundling of Risk and Dollar Vulnerability *

It was another volatile week for an especially two-tiered U.S. stock market. In the face of a collapsing technology sector, the small-cap Russell added 2% this week, increasing year-to-date gains to about 5%. For the week, the Dow gained 1% and S&P500 was about unchanged. The Transports, Morgan Stanley Cyclical, and Morgan Stanley Consumer indices added about 1%. The Utilities gained 2%. The S&P400 Mid-Cap index increased 1%, with 2002 gains surpassing 5%. But gains are nowhere to be seen in the technology sector. For the week, the NASDAQ100 dropped 4% and the Morgan Stanley High Tech index declined 4%. The Semiconductors sank 7%, The Street.com Internet index 8%, and the NASDAQ telecommunications index 6%. Biotech stocks are also in liquidation mode, with losses of about 4% this week. The financial stocks, while appearing vulnerable, continue to hold their own. For the week, the AMEX Securities Broker/Dealer index added 1%, while the Bank index gained 2%. With bullion up 40 cents for the week, the HUI Gold index was basically unchanged.

The Credit market again benefited from heightened financial risk. For the week, the implied yield on the December eurodollar contract declined 7 basis points to 3.04%. This yield has now collapse 99 basis points since its March 25 high. The two-year Treasury yield declined 6 basis points to 3.15%, and the five-year yield declined 2 basis points to 4.35%. The 10-year Treasury yield was unchanged at 5.05%. Benchmark Fannie Mae Mortgage-back yields declined one basis point, while implied yields on agency futures dropped five basis points. The spread on Fannie Mae’s 5 3/8 2011 note narrowed 5 to 58. The benchmark 10-year dollar swap spread declined 3 to 55, the narrowest spread since mid-1998. Today the dollar suffered its worst decline against the euro since January, with the euro rising to the highest level since early October. The dollar is now at 7-month lows against the British pound and 8-month lows against the Swiss franc. The dollar index declined about 1% for the week.

March construction spending was reported slightly below expectations. The story continues to be the significant sectoral divergences. Year-over-year, March spending was up 1% from last year’s. Spending on new housing construction was up 8% y-o-y, with single-family rising 7% and multi-family up 16%. Home improvement spending was up 7%. At the same time, private non-residential spending continues to be dismal, with y-o-y expenditures down 19%. By largest categories, “other” was down 9%, office buildings down 32%, and industrial down 43%. Private “educational” construction was up 12%. The public sector construction-spending boom tempered a bit in March, a development to follow over the coming months. Nonetheless, public sector spending was up 11%, y-o-y, with educational up 19%, public housing up 33%, roads up 1%, and “other” up 10%.

The April ISM (formerly NAPM) index was indicative of continued recovery for the manufacturing sector, although the headline number declined from 55.6 to 53.9. Production increased slightly to 58, while new orders (59 vs. 65.3) and backlog (56 vs. 65.3) both eased after March’s surge. Exports increased about one point to 51.9, while imports added 2.4 points to 55.7. The most noteworthy aspect of this report was the 8.4 point jump in prices paid to 60.3, the highest since January 2001. The prices paid component is up 18.8 point in two months, and 27.1 points in 4 months. There was a similar point move in 1999, although it was over a six-month period. Today’s non-manufacturing index was somewhat weaker than expected at 55.3, but the prices component jumped from 53 to 59.5. The non-manufacturing prices component has surged 21.5 points in four months.

April vehicle sales were reported at a much stronger than expected seasonally adjusted and annualized 17.4 million rate (vs. estimates of 16.5 million). This was up from March’s rate of 16.4 million and April 2001’s 16.6 million, and is the strongest reading since November. GM was the big surprise. On the back of surging retail buying, GM sales jumped 13% year over year (versus estimates of flat sales!). GM truck sales were up a blistering 24%. While Ford’s sales to the retail channel were about flat y-o-y, a 24% slump in fleet sales led an overall 8% decline. Chrysler enjoyed solid performance, as sales rose 3% from year ago levels. It was a record April for Toyota and Honda, with sales up slightly y-o-y. With sales up 8%, Mitsubishi also recorded a record April. I find the monthly auto data particularly interesting, as they are timely and informative as to the nature of consumer spending patterns. The striking aspect of auto sales continues to be the stellar performance of the luxury brands. April was the strongest month EVER for BMW, with sales up 12% y-o-y. Year-to-date sales are running 17% above last year’s record. Mercedes set a new April record as sales surged 12% y-o-y (y-t-d up 8%). It was, as well, a record April for Lexus, Acura, Infinity (up 60%!), and Audi. Jaguar sales were up 71% y-o-y, and SAAB sales were up 20%. With California traditionally the largest market for luxury autos, this boom has tracks of the Golden State real estate Bubble written all over it. At the lower end, sales were up 26% at Kia and 17% and Hyundai. It is worth noting that auto sales are booming in Canada as well. Up 34%, BMW enjoyed its best month ever (y-t-d up 22%).

April saw a stronger than expected $22 billion of asset-backed security issuance. Year-to-date sales of $109 billion are now running up 16% from last year’s record issuance. April saw another huge month of home-equity loan securitizations, with y-t-d issuance of $40.5 billion running an eye-opening 68% above last year’s record. There has been a surge in adjustable-rate home equity lending. The auto-backed securitization boom runs unabated, with y-t-d issuance of $31.2 billion up 33% from 2001. Credit card securitizations of about $18 billion are down about 16% y-o-y. Almost as if it was on cue, broad money supply (M3) jumped $22.8 billion last week. With systemic stress increasing, the old stalwart of last year’s money supply explosion – institutional money market fund assets – surged $18.9 billion. Demand deposits increased $9.4 billion, while savings deposits declined $4.8 billion. Large time deposits declined $8.4 billion, while repurchase agreements added $5.5 billion.

Freddie Mac’s weekly U.S. Mortgage Rates report had 30-year fixed borrowing rates at 6.78%. This was down 10 basis points for the week and a decline of 30 basis points in four weeks, as well as being the lowest rates in two months. It didn’t take long for declining rates to impact the Mortgage Bankers Association’s weekly application index. Refinancing applications were up 16.1% for the week to the highest reading in seven weeks. The purchase application index jumped almost 5% to 368.4, the third-highest level ever and only 2% below the peak set back in January. Last week’s mortgage purchase applications were 19% above year ago levels.

As analysts, we must appreciate that the news generally follows market direction. Recently, the media has explained the declining stock market as a response to a less robust recovery. I see things differently. While the first-quarter’s 5.8% growth rate is clearly not sustainable and today’s employment report confirms that job growth is lagging, I do not yet observe a decline in economic activity that would justify the recent sharp decline in Treasury yields. It would appear that sinking yields are more a reflection of heightened underlying financial stress.

In light of the abrupt change in dollar fortunes, the Treasury’s monthly report of “Foreign Purchases and Sales of U.S. Long-Term Securities” takes on considerable relevance. February’s report certainly makes for interesting reading. While two months do not a trend make, February data confirms January’s marked slowdown of foreign flows after the fourth-quarter’s boom. Net monthly inflows into U.S. securities averaged $53.6 billion during the fourth quarter and $42 billion for all of 2001. For the first two months of 2002, net flows have ebbed markedly to $14.6 billion. After being net monthly buyers of $12.7 billion Treasuries during the fourth quarter (avg. $1.5 billion buyers for 2001), foreigners have turned sellers to the tune of $8.5 billion. During 2001, foreign-sourced purchases accounted for a monthly average of $13.8 billion of agency bonds and $19.7 billion of U.S. corporates. So far for 2002, these average monthly inflows have dropped to $5.1 billion and $11.4 billion. Foreigners purchased a net $2.4 billion of stocks each month last year, but have averaged only $638 million so far this year.

During the fourth quarter, the financial centers of the U.K, Japan, and the Cayman Islands combined to average $25.6 billion of monthly long-term U.S. security purchases (48% of total global purchases). During the first two months of 2002, these flows have declined precipitously to average only $3.0 billion (21% of total). After averaging $8.6 billion in monthly net purchases of agency bonds during the fourth quarter, January and February purchases have averaged just $270 million. This is despite the Cayman Islands averaging about $130 billion, or 57%, of total average monthly agency trading volume. Is there a relationship between the abrupt decline in flows from the three major financial centers and escalating corporate Credit problems?

Any discussion of the consequences of Credit excess is advanced by the inclusion of insights from Dr. Henry Kaufman. From his 1986 book, Interest Rates, the Markets, and the New Financial World:

“The integrity of credit is being chipped away by a financial revolution that is helping to lower credit standards and muting the responsibilities of both debtors and creditors. One reason for this is that we are failing to correctly define the role of financial institutions in our society and how this role can best be performed. Instead, we have responded in ad hoc fashion whenever market forces or strong vested interests have exerted pressure. For the most part, the long-run consequences of market, regulatory, and legislative changes have been ignored...

We are drifting toward a financial system in which credit has no guardian. We began moving in this direction when deposit insurance was legislated in the thirties. This measure, generally laudable when viewed against the financial disaster of that period, removed the disciplining link between the creditor of the financial institution (that is, the depositor) and the institution itself... Increased “securitization” of credit obligations is another development that has had unfortunate consequences...what was a “private” loan becomes part of a “public” marketable security. This loosens the link between creditor and borrower. In a nonmarketable relationship, the creditor is tied to the borrower for the life of the loan; of necessity, under these circumstances, credit scrutiny at the inception of a loan or investment is likely to be quite intensive. The same degree of credit investigation is not likely to take place when the relationship between lender and borrower is to be temporary. In a securitized arrangement, many market participants fail to distinguish between the essence of liquidity and marketability. Liquidity means being able to dispose of a financial asset at par, or close to it, while marketability provides the holder an opportunity to sell at some price. The illusion of marketability is that holders believe they will be able to sell their investments before a significant deterioration in credit quality is generally perceived. Thus the initial pressure to be highly circumspect in the creation of the obligation is absent. A world of relatively unrestrained credit growth is also encouraged by the use of credit lines and guarantees. These assurances lead investors to make commitments based on the strength of the guarantor and not on that of the borrower... The heroes of credit markets without a guardian are the daring – those who are ready and willing to exploit financial leverage, risk the loss of credit standing, and revel in the present casino-like atmosphere of the markets.”

These are especially pertinent insights, with the “long-run consequences of market, regulatory, and legislative changes” Dr. Kaufman warned of in 1986 having arrived at our doorstep. Henry Kaufman was ahead of his time. There is this penchant in the media for portraying Dr. Kaufman (“Dr. Doom”) as some kind of “old school” doomsayer that was run over by extraordinary contemporary financial and economic developments. However, for those of us who have read his brilliant 1986 and 2000 books and studied his other writings, we appreciate that few others were as profoundly prescient of the “New Financial World” that has evolved since the eighties. He’s like the old coach that, while others are enamored with the most fashionable aspects of the game, sticks to “mastering” the basic fundamentals. I admire and respect the wisdom, experience and discipline of old coaches. I chose to highlight a bit of “The Master’s” wisdom on Credit as it is becoming increasingly apparent that there is a serious unfolding systemic problem in the Credit derivatives area that is the manifestation of risks Dr. Kaufman explained so clearly - but were nonetheless disregarded - years ago. The ramifications are today enormous.

When discussing derivatives, Alan Greenspan often uses the terminology “the unbundling of risk.” Recently (April 22, 2002) he remarked, “New financial products have enabled risk to be dispersed more effectively to those willing, and presumably able, to bear it. Shocks to the overall economic system are accordingly less likely to create cascading credit failure.” We take the exact opposite view: Derivatives and “financial engineering” generally isolate, extract, and specifically “Bundle” risk (interest rate, Credit, currency, equity, gold, etc.). And this is not some arcane intellectual debate, as it is our view that this “Bundling” has now set the stage for precisely the types of “cascading credit failure” and inevitable “shock to the overall economic system” that Greenspan apparently believes are “less likely.” Despite assurances otherwise, there is no doubt that “unguarded” Credit excess has created unprecedented risk that is increasingly concentrated with the GSEs, Credit insurers, and within the murky realm of global derivative markets. Furthermore, this “Bundling” reached new extremes last year, as financial intermediaries lent aggressively while issuing liabilities amounting to about $900 billion of new broad money supply. There was also unprecedented growth in the Credit derivatives market. We believe the Credit issue is now becoming critical, as recent developments have witnessed a dramatic escalation of the unfolding telecom and U.S. corporate bond market dislocation. We see indications of a serious developing problem with the “Bundling” of Credit risk – a dislocation in the global Credit derivatives area.

From the International Swaps and Derivatives Association (ISDA) April 17, 2002: “Notional principle outstanding amounts for interest rate swaps and options and currency swaps were $69.2 trillion at the end of 2001 compared with $57.3 trillion at mid-year and $63 trillion at the end of 2000. These numbers represented a 20% increase since the Mid-Year Survey... Among the top dealers, volume increased 20% from $34.7 trillion at the end of 2000 to $43 trillion at the end of 2001; virtually all of the increase occurred during the second half... Credit default swaps, which ISDA began to survey at mid-year 2001, grew 45% to $918.9 billion from the $631.5 billion reported in June. ‘The credit derivative numbers show impressive growth during a difficult period,’ said Keith Bailey, Chairman of the Board of ISDA. ‘This is testimony to the value that these products bring to market participants in managing risk in times of volatility and uncertainty.”

Outstanding Credit derivatives have increased more than five fold in four years. There is a fascinating dynamic that appears to be an inherent feature of contemporary finance, and specifically involves the interplay of Credit creation, speculation, and derivative trading: In the simplest terms, Credit growth engenders economic expansion. This expansion - in the contemporary financial world of unharnessed Credit and extraordinary speculative impulses - sets in motion self-feeding Credit and speculative excess. During the boom, derivatives play a critical role in the perception of enhanced risk management, which occasions risk-taking and heightened general Credit availability. Derivatives also play a major role in fostering financial sector leveraging and speculative trading, instrumental factors fueling the unsustainable Bubble demand for securities, while over time creating acute financial fragility. Derivatives greatly accentuate the boom, only later to play an instrumental role in exacerbating the bust.

Importantly, and we saw this dynamic throughout SE Asia, Russia, Argentina and elsewhere, right when the boom appears to be at its most vulnerable stage there tends to be an exponential (and terminal) rise in derivative activity. It is almost as if there is one final flurry of derivative trading that amounts to a mad scramble of “Bundling” risk created during the boom and placing it with weak hands. I have mentioned before a Financial Times article in early 1998 that illuminated what had been an explosion in currency derivatives positions in Russia. It presaged the coming financial crisis. Ruble derivative protection was in integral aspect of speculator strategies incorporating leveraged holdings in high-yielding securities with currency derivative “insurance”. Ironically, as Russian rates began to rise (in a sign of developing systemic risk) during the first half of 1998, this only stoked speculative impulses, although players were keen to try to offload ruble risk. Throughout the boom, and especially during the speculative blowoff, derivative trading and the accumulation of ruble hedging positions were part and parcel of destabilizing speculation in the Russian securities markets.

There are myriad and complex forces involved. But certainly during the life of a protracted boom an entire infrastructure evolves where supposed “risk management” and speculative trading combine to create a nebulous derivative market as a key repository of systemic risk. Then, with the final flurry of activity, the concentration of risk (“Bundling”) becomes untenable, although this harsh reality is not readily apparent because the market has seemingly functioned flawlessly throughout the boom. This dynamic has repeated itself in the murky world of Credit derivatives. It is no coincidence that last year’s enormous increase in Credit derivatives was a harbinger for this year’s telecom debt collapse and general U.S. corporate bond market dislocation.

First of all, it is important to recognize that a market for Credit protection alters lending and speculating behavior. During the telecom and corporate debt Bubble, players were heartened by the burgeoning market in defaults swaps and Credit derivatives. The perception of cheap and readily available “insurance” played a significant role in nurturing lending excess, with the residual a wildly maladjusted technology sector, a mountain of unstable debt structures, and, hence, the accumulation of momentous risk left to be “mitigated” at some point down the road. The problem, however, is that when Bubbles burst there is simply no way of “hedging” the risk of an enormous maladjusted industry/market/economy. There is simply no escaping collapse, and all that aggressive Fed accommodation accomplishes is to ensure that similar dynamics spread to other sectors and it evolving into a more problematic systemic issue.

As was experienced in SE Asia and Russia, it is precisely when the risk of a bursting financial Bubble begins to manifest (in their cases with higher interest rates and increased “premiums” for writing Credit and currency “insurance) that a booming speculative market takes hold between those looking to off-load risk accumulated during the boom and the captive audience of speculators believing they can profit handsomely by taking the other side of these trades (the hefty premiums available from insuring against risk). It is this final “Bundling” of untenable risk in weak hands that sets the stage for eventual collapse.

The unfolding telecom debt collapse is an historic development and, alarmingly, the amount of debt involved dwarfs the Russian debacle. And while it has received virtually no attention in the general or financial media, the past two weeks has witnessed what appears a major dislocation in the Credit derivatives area. And since we hear nothing about this development, we are left to fear that U.S. market participants do not appreciate the significance of recent developments. In this regard, this is uncomfortably reminiscent of the SE Asia and Russia crises. At the same time, it appears that currency markets do have a keen appreciation of the seriousness of unfolding U.S. risk.

First of all, there is major problem when an enormous industry (or economy) is comprised of negative cash flow companies. Recently, as Credit derivative players have been forced to scramble to sell short telecom bonds to hedge their escalating exposure to industry defaults, already scant liquidity quickly evaporates. Faltering liquidity then sees the next marginal company lose access to finance, with default then a likely possibility. The domino collapse gains momentum, and it becomes a panic for those that have been merrily pocketing premiums for writing default insurance. With the market for default protection in increasing dislocation, the debt market that is the life-source for the (hopelessly cash-flow deficient) telecommunications industry quickly grinds to a halt (too many sellers and few buyers). For leveraged players in need of finance, this is the kiss of death. Sinking equity prices are a consequence of industry illiquidity, and it should be appreciated how stock market disarray further augments general industry collapse. Derivative players that were selling default protection for pennies on the dollar (believing their derivative book was diversified, that only a fraction of industry debt would eventually default, and that recoveries from these limited number of bankruptcies would be significant), are now faced with a much different equation: A general industry collapse and the possibility of upwards of a dollar of loss on a dollar of insurance written (as opposed to pennies!). Credit loss models can be thrown out the window as potential losses quickly grow exponentially.

As we have highlighted previously, Credit losses are not an insurable event, and this fact is now coming back to haunt the thinly capitalized players that relied on flawed models and dynamic hedging strategies to hedge the “insurance” they sold. Over the past week or so, the prices of default protection have surged for the likes of Worldcom, AT&T, Nortel, Alcatel, Eriscsson, and for global telecommunications companies across the board. The cost of WorldCom default protection has skyrocketed from about 3 cents on the dollar in March, to 8 cents in April, to 15 cents this week. The cost of hedging against defaults for companies such as AOL, Motorola, and JPMorgan have risen appreciable as well, with major borrowers like IBM and GE impacted. Somewhere, enormous losses have been suffered, with recent mark-to-market declines in Credit derivatives seriously compounding an already precarious situation. It has become a systemic problem.

A story today from Bloomberg caught our eye. “U.K. financial regulators are considering making companies disclose more information about credit derivatives after insurance companies used the instruments to assume as much as $400 billion in risk from banks. Companies use the $1 trillion credit-derivatives market to juggle the risk of owning a bond or loan. Buying the instruments offers protection against missed payments, and sellers can use the derivatives to profit from bonds or loans without buying them... Banks are transferring the risk of owning corporate debt to insurance companies based in less-regulated countries, the FSA said. The financial watchdog found that insurers have a 20 to 25 percent share of the credit-derivatives market. About half of all trades take place in London... Credit derivatives are the fastest-growing part of the $1.4 trillion-a-day derivatives market...”

We absolutely cringe at the thought of offshore insurance companies as major players in Credit derivatives, and just hope this has not been a replay of the Russian fiasco where speculators calling themselves banks comprised the heart of the ruble derivative marketplace. We hope offshore derivative players are not just calling themselves “insurance companies,” but nothing would surprise us. All the same, we have now crossed the threshold into a vital market reaching dislocation, and if history is any guide this will prove a catalyst for domino impairment of related markets (where these derivative players are active). This dislocation does have troubling similarities to the Russian crisis, so it may be helpful to remind readers of the timeline of the Russian collapse and its reverberations throughout U.S. and global markets. It took some time for the marketplace to fully appreciate the seriousness of what was unfolding.

Russian dislocation commenced with interest rates rising noticeably in May 1998. Players initially saw higher rates as an opportunity, and there was seemingly no fear of default. The following are analysts’ quotes from the first week of June 1998 (indicative of a complete lack of appreciation for the nature of the unfolding crisis): “There’s no comparison to Mexico. Mexico had fundamental reasons to have a cheaper currency. It had a balance of payments problem and a current account problem. Russia doesn’t. Russia has a trade surplus and a current account that, at worst, will run a modest deficit in 1998... Currency crises are balance-of-payments driven. A currency is overvalued when exports can’t compete anymore.” Participants were absolutely oblivious to the nature of the unfolding crisis, which is exactly the type of environment vulnerable to panic. That same week Goldman Sachs underwrote a 5-year Russian Eurobond issue at a spread of 650 basis points to Treasuries. These spreads quickly widened to 1000 basis points by the end of June. With the IMF coming forward with major financial assistance in mid-July, sentiment remained that Russia was experiencing only short-term troubles, and spreads narrowed to 870. Participants remained stubbornly convinced that global authorities would never allow a Russian collapse. But by the end of July spreads had surged to almost 1200 and the ruble was under pressure. In the U.S., complacency reigned supreme, with the stock market generally buttressed by declining interest rates. There was seemingly no recognition that events in Russia could impact U.S. markets, although the apparent resolution to the Russian problem in mid-July saw U.S. bank stocks in a strong rally. Amazingly, in the face of a serious unfolding financial crisis, bank stocks rallied about 10% from mid-June to mid-July to a new record high. By the end of August Russian debt spreads had widened to 4,000 basis points and only then did global markets begin to appreciate the seriousness of the unfolding dislocation. It was, however, not until October that U.S. financial markets experienced a serious liquidity crisis.

The key to recognizing the great U.S. risk developing in Russia back in 1998 was to appreciate the unfolding impairment of the leveraged players, how a vulnerable leveraged speculating community irreparably linked various markets, and that these players had become instrumental to the liquidity position of U.S. securities markets. A serious impairment of the speculators in one market became a problem for all markets, and posed especially acute risk for the dollar and the grossly over leveraged U.S. Credit market. We think this dynamic holds true today, but in a somewhat different form. We fear the dangerous leverage (and link) today is not as much gross LTCM-type leveraging in securities markets, but a similarly dangerous “leveraging” of risk in global derivatives markets. Especially post-WTC, there are impaired financial players throughout the global “insurance” industry, and additional losses in Credit derivatives holds the clear possibility of pushing some into insolvency (if they are not already there). We see a problematic situation where Credit risk has been “Bundled” in especially weak (and rapidly weakening) hands. The enormity of the problem immediately raises the issue of counterparty risk, and any time counterparty exposure becomes a major issue there becomes clear and present danger to systemic stability. Problems in “Bundled” risk in Credit derivatives has linked “Bundled” risk in various derivative markets.

For good reason, the analytical focus for much of the discussion of systemic risk has been on the unfathomable size of interest rate derivative positions, and the ramifications for the marketplace in the event that derivative players were forced to hedge risk in a rising rate environment. The Fed clearly recognizes this risk, and is responding accordingly. The market knows the Fed knows, and complacency runs high. The thought seems to be as long as rates remain low, there’s no problem. And as far as interest rate derivatives go, they have a point. Unwittingly, however, the Fed and markets have only been accommodating the serious escalation of the other two critical derivative risk components: Credit and dollar risk.

To appreciate the dynamics involved, recall how it was the Fed’s aggressive rate cuts and GSE liquidity operations post-Russia/LTCM that fueled the parabolic explosion in telecom debt and technology speculation. The ongoing collapse of this Bubble will result in unprecedented Credit losses. As we have been following, this round of Fed and GSE “reliquefication” is directing Credit and speculation predominately to consumer and mortgage debt. We’ll go on the record and predict that real estate Credit losses – particularly in the precarious California housing Bubble – will eventually significantly surpass telecom losses. Fed policies and resulting market dynamics are, regrettably, ensuring this outcome. With market perceptions that the Fed will hold rates low, speculative finance is providing unlimited cheap Credit to this sector. As conspicuous as this Bubble has become, Wall Street “research” departments are busy creating propaganda arguing against the Bubble hypothesis. And with speculative interest and resulting Credit excesses in high gear, Wall Street is heartened with the reality that this mortgage finance Bubble has room to run. This also buttresses general market complacency.

So this brings us to the key issue of dollar risk. Our hunch is that this is precisely where the wildness lurks, and recent market action supports this view. I sense that there is not much appreciation for the character of the most recent Fed/GSE “reliquefication” or its ramifications. The post-Russia/LTCM systemic bailout (and Credit Bubble), of course, ushered in an historic technology Bubble. This, importantly, acted as a magnet for global speculative financial flows, perversely imparting strength to a dollar that should have been vulnerable in the face of unprecedented and reckless domestic Credit excess. The bursting of the tech Bubble, ironically, later supported the dollar, as speculators recognized that Greenspan would respond by aggressively cutting rates. Although not readily apparent, today’s inflationary manifestations are nonetheless profoundly different. While the scale of domestic Credit creation remains enormous, no longer do we see much of a “magnet” to attract global finance (recycle dollars). Sure, we witnessed a flurry of speculative finance rushing to U.S. securities during the fourth quarter to play more aggressive cuts, but that’s fully run its course. Moreover, with consumer and mortgage finance at the epicenter of Credit and speculative excess, there is every reason to believe that imports – and the consequent global deluge of dollars – could finally become a problem. Moreover, with lenders and speculators favoring the U.S. consumer over the lowly producer, the prospect of a marked deterioration in the U.S.’s overall trade position appears virtually assured. 2002 is no 1999. The halcyon days of the Fed enjoying the luxury of a strong dollar have ended.

The near and longer-term risks emanating from Fed policies and U.S. financial sector practices are clearly with the dollar. And while a case can be made that the telecom debt collapse is a global phenomenon and not a U.S. dollar issue, we are not so sure. The Russian collapse was transmitted to the U.S. securities markets through the hedge funds and global speculators. Today, we fear that the transmission mechanism may prove to be through the derivative players comprising the global swaps market. We have conjectured that a significant portion of the enormous inflows from the financial centers of London and Japan were likely more speculative “hot money” flows than true long-term investment. We have also highlighted repeatedly the troubling circumstance that has had a significant portion of foreign financial flows into U.S. securities emanating from the Cayman Islands and other offshore financial centers. We don’t believe it is coincidence that these flows emanate from the very same locations that are the bastion of unregulated hedge funds, “special purpose vehicles,” and “insurance” companies that have become key derivative players. We don’t believe it is coincidence that the accumulation of unprecedented U.S. foreign liabilities (the creation of dollar risk) has corresponded with the enormous accumulation of derivative “swap” positions (the Bundling of this risk). We see a problem

It is certainly our belief that Credit derivatives written by offshore financial players have played an instrumental role throughout U.S. structured finance (transforming risky loans into “safe” money and highly-rated securities). It has been demand for these top-rated securities (at least partially financed with foreign-sourced borrowings) that has buttressed the dollar, and any development that impairs the writers of these derivatives would pose risk to dollar stability. There is also the issue of offshore “special purpose vehicles” as repositories for Credit default swap agreements. If these types of structures begin to “blow up,” the upshot could be further waning demand for U.S. securities and likely a forced liquidation of leveraged vehicles. Such vehicles have played a significant role in “recycling” Bubble Dollars back to U.S. securities markets, and we would expect any disruption in this arena to reverberate to the dollar.

Our greatest fear, however, is that the same players that have been writing Credit swaps (insurance against default) are also major players in currency swaps (insurance against a decline in the dollar). This is where things could get especially dicey. If this proves to be the case, the losses these players have suffered in Credit and equity derivatives leave them with even less wherewithal to absorb any risk from a declining dollar. We fear that the Bundling of dollar risk with swaps players creates various serious problems. Again, the specter of counterparty risk becomes an issue. At the minimum, there is clearly enormous currency derivative exposure outstanding that incorporates dynamic hedging trading strategies. Such trend following trading dynamics (increased buying/selling to hedge exposure to a rising/declining market) certainly fed dollar overvaluation on the upside, while now posing a threat of dislocation with the trend having reversed. If a significant portion of “the market” has hedged its dollar exposure in the swaps market, we are now faced with the prospect of a serious market dislocation.

It is not hyperbole to say that the derivatives industry is looking increasingly like a basket case, or at the minimum a potential accident. In an example of how the complexion of risk has changed of late, the Wall Street firms are now faced with the indefinite prospect of scores of attorneys licking their chops from an ever-lengthening list of misdeeds. Wall Street must now manage its various risks especially carefully. They have become “weak hands.” There is also what must be a festering issue of enormous losses lurking out there somewhere in equity derivatives. Adding insult to injury, the gold derivative market has also turned rather inhospitable to any derivative player short bullion or gold stocks. And then there are hints of unfolding tumult and losses in the obscure world of convertible arbitrage. Convertible bonds, down 1.4% in April, were the worst performing sector in fixed- income for the month, and recent telecom bond problems augers poorly. It is worth noting that “convertible arbitrage” – the top performing hedge fund strategy last year – experienced negative returns during February and March. We’ll be monitoring hedge fund performance closely going forward. More weak hands? There is also this curious collapse in dollar swap spreads, agency spreads, and the TED spread. Since these spreads traditionally widen in the face of heightened systemic risk, we will interpret the fact that they have done the exact opposite as a further development aggravating the lives of derivative players. If writers of Credit derivatives were using the liquid dollar swap market in their hedging operations, these hedging strategies have been a dismal failure. And it is the failure of one strategy that leads to the liquidation that exacerbates market disorder and strategy failures elsewhere. Dislocation begets greater dislocation. That’s where we stand today.

It certainly appears that the recent rally in the Treasury market is a flight to safety, and is increasingly indicative of derivative trading running amuck. This is conjecture, but it is consistent with what we view as a serious unfolding market dislocation. At this point, a 1998-style panic into Treasuries, and the resulting dislocation in various sophisticated leveraged strategies looks like an increasingly possibility. And with the dollar’s recent swoon appearing to have caught players unprepared, it seems rather obvious we have now entered an especially dangerous market environment. That these lower yields are playing right into the hands of today’s “hot game” - the consumer and mortgage finance Bubbles - makes this period even more precarious. We are witnessing a dysfunctional system having set course for a serious financial accident.