Two-year government yields rose 3.5 bps to 4.71%. Five-year yields gained 3.5 bps to 4.585%, and 10-year Treasury yields jumped 5 bps to 4.68%. Long-bond yields rose 5 bps to 4.85%. The 2yr/10yr spread ended the week inverted 3 bps. The implied yield on 3-month December ’07 Eurodollars rose 3.5 bps to 5.115%. Benchmark Fannie Mae MBS yields gained 3 bps to 5.81%, this week somewhat outperforming Treasuries. The spread on Fannie’s 5% 2017 note narrowed one to 38, and the spread on Freddie’s 5% 2017 note narrowed one to 37. The 10-year dollar swap spread increased 0.2 to 54.0. Corporate bond spreads were mixed, with the spread on a junk index increasing 2 bps.
May 9 – Bloomberg (Warren Giles and Mark Pittman): “ Bank of America Corp. Chief Executive Officer Ken Lewis said a so-called credit bubble is about to break after six years of historically low interest rates and relaxed lending criteria. ‘We are close to a time when we’ll look back and say we did some stupid things,’ Lewis said… ‘We need a little more sanity in a period in which everyone feels invincible and thinks this is different.’ Lewis isn’t the only U.S. bank executive who expects that credit conditions will change. Wells Fargo & Co. CEO Richard Kovacevich said in December that ‘I am not a forecaster of the future; I’m a historian. And history says this will blow up. It always has. And there will be some blood on the street.’”
Debt sales slowed somewhat this week to a still robust $26bn. Investment grade issuers included Goldman Sachs Capital Trusts $2.25bn, Oracle $2.0bn, Lehman Capital Trusts $1.5bn, Credit Suisse $2.0bn, Chubb $800 million, Polar Tankers $645 million, Genworth Financial $600 million, MidAmerica Energy $550 million, Mellon Funding $500 million, Northgroup $500 million, Public Service E&G $350 million, and Huntington Capital $250 million.
Junk bond funds reported $82 million of inflows this week. Issuers included GMAC $2.0bn, MGM Mirage $750 million, Constellation Brands $700 million, Spansion $550 million, Wisconsin Energy $500 million, Noranda Aluminum $500 million, Deluxe Corp $200 million, and Broadview Network $90 million.
This week’s convert issuers included Chesapeake Energy $2.0bn, Sciele Pharma $285 million, Chemed $180 million, CACI Intl $300 million, L-1 Identity Solutions $150 million, and Alesco Financial $115 million.
International issuers included RSHB Capital $1.25bn, HBOS PLC $750 million, BBVA Bancomer $500 million, Temirbank $500 million, Transport de Gas $500 million, and Alto Palermo $170 million.
German 10-year bund yields gained 2 bps to 4.21%. Japanese 10-year “JGB” yields rose 2 bps to 1.64%. The Nikkei 225 increased 0.9% (up 1.9% y-t-d). Emerging markets were mixed. Turkey’s ISE equities index settled down and ended the week about unchanged (up 14.6% y-t-d). Brazil’s benchmark dollar bond yields rose 2 bps this week to 5.58%. Brazil’s Bovespa equities index added 0.6% (up 14.5% y-t-d). The Mexican Bolsa gained 0.2% (up 13.7% y-t-d). Mexico’s 10-year $ yields rose one basis point to 5.42%. Russia’s RTS equities index dropped 4% (down 4% y-t-d). India’s Sensex equities index declined 1% (up 0.1% y-t-d). China’s amazing Shanghai Composite index jumped 7.0%, increasing y-t-d gains to 50% and 52-week gains to 162%.
Freddie Mac posted 30-year fixed mortgage rates dipped one basis point to 6.15% (down 43bps y-o-y). Fifteen-year fixed rates were unchanged at 5.87% (down 30bps y-o-y). One-year adjustable rates jumped 6 bps to a 10-week high 5.48% (down 14bps y-o-y). The Mortgage Bankers Association Purchase Applications Index added 2.6% for the third straight week of gains. Purchase Applications were up 5.4% from one year ago, with dollar volume 8.2% higher. Refi applications gained 4.9% for the week, with dollar volume up 54% from a year earlier. The average new Purchase mortgage increased to $238,300 (up 2.7% y-o-y), while the average ARM rose to $395,500 (up 13.8% y-o-y).
Bank Credit jumped $18.8bn (week of 5/2) to a record $8.484 TN. For the week, Securities Credit declined $8.5bn. Loans & Leases surged $27.3bn (2-wk gain of $40.4bn) to $6.219 TN. C&I loans rose $9.0bn, and Real Estate loans added $2.0bn. Consumer loans increased $1.7bn, and Securities loans rose $4.3bn. Other loans gained $10.4bn. On the liability side, (previous M3) Large Time Deposits expanded $13.4bn.
M2 (narrow) “money” dropped $25.4bn to $7.212 TN (week of 4/30). Narrow “money” has expanded $168bn y-t-d, or 6.9% annualized, and $427bn, or 6.3%, over the past year. For the week, Currency added $0.2bn, and Demand & Checkable Deposits increased $15.7bn. Savings Deposits fell $42.2bn, while Small Denominated Deposits added $0.7bn. Retail Money Fund assets were about unchanged.
Total Money Market Fund Assets (from Invest. Co Inst) jumped $19.2bn last week to a record $2.466 TN. Money Fund Assets have increased $84bn y-t-d, a 9.7% rate, and $422bn over 52 weeks, or 20.6%.
Total Commercial Paper surged $34.1bn last week to a record $2.082 TN, with a y-t-d gain of $108bn (15.0% annualized). CP has increased $227bn, or 18.4%, over the past 52 weeks.
Asset-backed Securities (ABS) issuance slowed to $7.4bn. Year-to-date total US ABS issuance of $243bn (tallied by JPMorgan) is running 2% ahead of comparable 2006. At $133bn, y-t-d Home Equity ABS sales are 23% below last year’s pace. Meanwhile, y-t-d US CDO issuance of $130 billion is running 24% ahead record 2006 sales.
Fed Foreign Holdings of Treasury, Agency Debt last week (ended 5/9) increased another $4.4bn to a record $1.931 TN, with a y-t-d gain of $179bn (28% annualized). “Custody” holdings expanded $310bn during the past year, or 19.1%. Federal Reserve Credit last week declined $13.4bn to $854bn, reversing much of last week’s large increase. Fed Credit was up $1.3bn y-t-d and $28.8bn y-o-y, or 3.5%.
International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $519bn y-t-d (29% annualized) and $936bn y-o-y (21.3%) to a record $5.330 TN.
The dollar index rallied 0.5% to 82.02. On the upside, the Australian dollar gained 1.2%, the Mexican peso 0.8%, the Brazilian real 0.7%, and the Taiwan dollar 0.5%. On the downside, the Swedish krona declined 1.1%, the Norwegian krone 1.0%, the Swiss franc 0.6%, the Euro 0.5%, and the Danish krone 0.5%.
For the week, Gold fell 2.5% to $671.05, and Silver declined 1.7% to $13.305. Copper dropped 4.1%. June crude added 58 cents to $62.51. June gasoline jumped 6.1%, while June Natural Gas dipped 0.5%. For the week, the CRB index was unchanged (up 1.3% y-t-d), and the Goldman Sachs Commodities Index (GSCI) slipped 0.2% (up 7.1% y-t-d).
May 10 – Bloomberg (Toru Fujioka): “Japan’s lending growth slowed for a third month as cash-rich companies ignored the lowest borrowing costs among major economies and used their own funds to invest. Loans excluding trusts rose 1% in April from a year earlier…”
May 11 – Bloomberg (Nipa Piboontanasawat): “China’s trade surplus swelled 63% in April from a year earlier to $16.9 billion… Exports jumped 26.8% and imports climbed 21.3%... The trade surplus for the first four months was $63.3 billion, 88% higher than a year earlier.”
May 10 – Financial Times (Jamil Anderlini): “The value of shares traded on China’s stock markets yesterday was greater than the rest of Asia combined - including Japan… Analysts said this was almost certainly the first time that turnover at the Chinese bourses had exceeded that of the rest of Asia. They also topped London. The Shanghai stock exchange recorded Rmb255.3bn ($33.2bn) in turnover yesterday, while the smaller Shenzhen exchange saw Rmb121.6bn worth of shares change hands, bringing the combined total for the mainland Chinese market to Rmb376.9bn – 21% higher than the previous record set at the end of April. Six months ago, trading volume on the Chinese markets was $5bn a day, and as recently as March 30 it was only $16.4bn. The huge increase is a result of revived retail interest in a market that has climbed 300 per cent in less than two years and continues to defy gravity, in spite of government moves to talk it down.”
May 6 – Bloomberg (Zhang Dingmin and Gabi Thesing): “China’s central bank governor Zhou Xiaochuan expressed concern that share prices may be rising to unjustified levels. ‘Yes,’ Zhou told reporters when asked if he’s worried that a share-market bubble may be building.”
May 8 – Market News International: “China’s central bank raised the amount of foreign currencies that lenders must hold as reserves, banking sources said… The forex reserve ratio was raised to 5% of foreign-currency deposits from 4%...”
May 11 – Bloomberg (Irene Shen and Tian Ying): “China’s automakers boosted car sales 16% last month as they cut prices to win customers in the world’s second-largest vehicle market.”
May 7 – Bloomberg (Nipa Piboontanasawat): “China’s retail sales rose 15.5% in the Golden Week holiday period from a year earlier, the government said.”
May 8 – Bloomberg (Luo Jun): “China’s bank card transactions surged 60% during last week’s national holidays from a year earlier, according to China UnionPay Co., the operator of the country’s bank card payment system. Purchases made using credit and debit cards totaled 46.2 billion yuan ($6 billion) during the holiday…”
May 11 – Bloomberg (Cherian Thomas): “India’s industrial production growth unexpectedly accelerated in March, as the highest interest rates in five years failed to damp consumer spending. Output at factories, utilities and mines gained 12.9% from a year ago after a revised 10.8% increase in February…”
Asia Boom Watch:
May 10 – Financial Times (Sundeep Tucker): “A combination of strong economic growth, corporate ambition and a limited pool of managers and specialists has plunged Asian companies into a battle for top talent, from casinos in Macau gearing up for business to boom towns in resource-rich western Australia desperate to attract mining engineers. Salaries for top performers are being bid up to unheard of levels. Even Indian software engineers in Silicon Valley are returning home attracted by high ex-pat salary packages and senior positions, as are Chinese and Japanese-born bankers working in London and New York.”
May 7 – Bloomberg (Denise Kee and Junko Fujita): “The Asian Development Bank may boost bond sales to as much as $8 billion, the highest since 1998, as lending in the region soars to meet economic growth.”
May 10 – Bloomberg (Seyoon Kim): “South Korea’s economy is forecast to expand 4.4% this year, helped by rising exports and a pickup in consumer spending, state-run think tank Korea Development Institute said. Economic growth is likely to accelerate to 4.5% in the third quarter and 4.7% in the fourth quarter from a 4% expansion in the first three months…”
Unbalanced Global Economy Watch:
May 8 – Bloomberg (Brian Swint and Sophie Kernon): “It cost Richard Stansfield 2,000 pounds ($4,000) to prepare the paperwork to buy a four-bedroom townhouse in south London’s Balham neighborhood. When the seller got a better offer, the deal was lost, and so was Stansfield’s money. Suddenly, the rival bidder pulled out and the house again appeared within his grasp for 595,000 pounds. As the…television producer finalized his finances, he lost out once again to a buyer who was offering cash. Stansfield is a victim of what’s known in the U.K. as ‘gazumping,’ where someone swoops in with a higher offer at the last minute and breaks the home purchase deal.”
May 7 – Bloomberg (Ben Sills): “The European Commission raised its forecasts for economic growth and inflation this year as increasing investment adds to domestic demand. The euro-area economy will expand 2.6% in 2007, faster than the 2.4% growth predicted in February…”
May 7 – Bloomberg (Andreas Cremer): “Germany’s economy is experiencing its most dynamic upswing in two decades, the IW research institute said, raising its outlook for growth this year by a full percentage point. Europe’s largest economy may grow 2.5% in 2007, the Cologne-based IW said…”
May 7 – Bloomberg (Simone Meier): “The number of people unemployed in Switzerland declined last month, keeping the jobless rate at a one-year low, suggesting consumer spending will help support economic growth this year. The number of jobless dropped by 636 to 112,762, keeping the unemployment rate at 2.9%...”
May 10 – Bloomberg (Jonas Bergman): “Swedish unemployment slipped for a third month in April as companies added workers to keep up with demand amid the fastest economic expansion in seven years. The…jobless rate fell to 3.7% from 4% in March…”
May 8 – Bloomberg (Marta Waldoch and Ewa Krukowska): “Poland’s economic growth exceeded 6% the first quarter and will expand for the next five years, Finance Minister Zyta Gilowska said.”
May 10 – Bloomberg (Hans van Leeuwen): “Australian employment increased four times as much as economists estimated and the jobless rate fell to a 32-year low as miners, retailers and banks expanded… The unemployment rate fell to 4.4% from 4.5%...”
May 9 – Bloomberg (Hans van Leeuwen): “Australia’s house prices climbed 1.1% in the first quarter from the previous three months…matching the increase in the fourth quarter. House prices rose 8.6% from a year earlier…”
May 10 – Bloomberg (Tracy Withers): “New Zealand employers hired more than twice as many workers as economists expected in the first quarter, keeping the jobless rate close to a record low… The jobless rate was 3.8%...”
Latin American Boom Watch:
May 10 – Bloomberg (Adriana Brasileiro): “Brazil’s credit rating was raised to BB+ by Fitch Ratings, leaving the South American country on the cusp of investment grade as it uses surging dollar inflows to pay down foreign debt.”
Central Banker Watch:
May 11 – Financial Times (Chris Giles and Ralph Atkins): “European central bankers signalled they would act to control inflationary pressures across the Continent yesterday as the Bank of England raised interest rates and the European Central Bank indicated it would move rates higher in June. The Bank of England increased its main interest rate by a quarter point to 5.5%, a six-year high, citing strong investment and ‘signs that businesses are more able to push through price increases’. Jean-Claude Trichet, ECB president, committed it to ‘strong vigilance’ - a phrase widely understood to mean an interest rate rise is a month away. Eurozone interest rates are currently 3.75 per cent.
With the US Federal Reserve reiterating its main concern that ‘inflation will fail to moderate as expected’…and the Bank of Japan’s governor yesterday making the case for gradual increases in interest rates, all the world’s big central banks have now flagged that their focus remains the control of inflation.”
May 10 – Financial Times (Jamie Chisholm): “UK interest rates hit their highest level in more than six years on Thursday after the Bank of England raised the cost of borrowing to 5.5 per cent. The 25 basis point increase, which had been expected by most economists, means Britain has now overtaken the US to shoulder the steepest borrowing costs of the G7 group of industrialised countries. The move will pile more pressure on homeowners, with payments on a £200,000 repayment mortgage likely to rise by £30.45 a month, according to the Council of Mortgage Lenders. In its statement accompanying the rise the Bank said it made the move because ‘output growth has remained firm. Business investment has been stronger than expected and, although indicators of consumer spending have been volatile, the underlying picture is one of steady growth.’”
May 10 – Market News International: “The European Central Bank Governing Council was unanimous in its decision… to send a message of ‘strong vigilance’ ahead of its June meeting, according to ECB President Jean-Claude Trichet. ‘We were unanimous... I think that what I said speaks by itself and that there is absolutely no ambiguity. We are in a posture of strong vigilance.’”
Bubble Economy Watch:
May 10 – Bloomberg (Seyoon Kim): “Former U.S. Treasury Secretary Lawrence H. Summers comments on global imbalances and the U.S. current account deficit. Summers spoke to investors at a conference in Seoul… The shortfall in the U.S. current account, the broadest measure of trade because it includes transfer payments and investment income, was $195.8 billion in the first quarter, amounting to about 5.8% of the economy. The U.S. needs to attract about $2.1 billion a day to fund the gap. ‘The current account deficit is not financing investment, it is financing consumption. ‘It’s important to understand the current account deficit is not being financed by private long-term investment flows. It is being overwhelmingly financed by short-term debt flows from official sectors of countries in Asia and oil-producing countries.’”
May 8 – Bloomberg (Lindsay Pollock): “A growing breed of art buyer – the ‘flipper’' -- will be out in force along with new and established collectors and dealers…when aggressively priced Rothkos, Warhols and Picassos go under the hammer at Christie’s and Sotheby’s in New York. The auction houses predict that they will move almost $1.4 billion of Impressionist, modern and contemporary artworks during the high-stakes spring sales, 60% more than last May’s record $854.9 million. Not surprisingly, gallerists, collectors, auction-house executives and art advisers say they are hopeful, even confident, that the boom will continue. But almost everyone agrees that the rapid rise in prices -- especially for contemporary art -- has to do less with a love of art than with an influx of art investors.”
May 9 – The Wall Street Journal (Thaddeus Herrick): “Airports, roads, rail, bridges and other transit infrastructure are deteriorating across the U.S. because of insufficient investment, according to a report. Chicago needs $6 billion to bring its subways into good repair, says the…Urban Land Institute and Ernst & Young LLP. Rehabilitation or replacement of the Tappan Zee Bridge north of New York City could cost as much as $14.5 billion. And in Atlanta, current rush-hour trips by car could take 75% longer by 2030. The report, entitled ‘Infrastructure 2007: A Global Perspective,’ says the failure to address…an emerging crisis in mobility will undermine the ability of the U.S. to compete internationally. ‘At some point, the system is going to grind to a halt,’ says Dale Ann Reiss, global director of real estate at…Ernst & Young…”
May 4 – Bloomberg (Michael McDonald): “The final cost of Boston’s Big Dig highway tunnel project may increase another $333 million, reaching about $15 billion by the time it’s completed in 2010, Massachusetts state officials said… The Big Dig was originally estimated to cost $2.8 billion in 1985.”
Financial Sphere Bubble Watch:
May 11 – Financial Times (David Oakley and Anuj Gangaharin): “Exchange-traded equity derivatives volumes surged to record levels in the first four months of the year in Europe as hedge funds and ‘black box’ traders increasingly sought new ways to boost returns. Equity derivatives, one of the fastest-growing financial products, are also being used more by traditional funds, such as pension and life companies, as they take advantage of European regulations that give them more freedom to invest. Equity derivative volumes rose by 22 per cent, with 127m contracts traded in the first four months of the year on Euronext Liffe, the international derivatives exchange.”
May 7 – Dow Jones (Daisy Maxey): “Americans are expanding their nest eggs at a strong pace, thanks in large part to individual retirement accounts and employer-sponsored defined-contribution plans, including 401(k) accounts. Overall U.S. retirement assets rose by $1.7 trillion in 2006 to $16.4 trillion, according to the… Investment Company Institute… The 12% increase outpaces the growth in retirement assets from 2004 to 2005, when investors added about $1 trillion to their nest eggs, according to the ICI.”
Mortgage Finance Bubble Watch:
May 11 – Reuters: “Allstate, the largest publicly traded home and car insurer in the United States, said Thursday it will no longer offer new homeowner and landlord coverage in California.”
May 7 – Bloomberg (Bob Ivry): “U.S. homeowners entered the foreclosure process in April at more than double the rate of a year ago as tightening credit made it more difficult to refinance and a swelling supply of unsold homes made it tough to sell. The number of homeowners in all three phases of foreclosure rose last month over the same period a year ago, according to …Foreclosures.com… Those receiving their first notice of foreclosure from a bank climbed 127%, those with homes going up for sale by auction jumped 164% and those whose homes were repossessed by banks went up 40%...”
May 10 – Financial Times (Richard Beales): “In a Midtown Manhattan conference room stands a small abacus. It is labelled ‘Correlation Model’. The label is a geeky in-joke. The owner of the abacus, hedge fund BlueMountain Capital Management, specialises in the credit derivatives market, where investors can make or lose money by taking or protecting themselves from credit exposures - for example, to companies - without buying or selling bonds or loans. In this world, ‘correlation’ is crucial to the pricing of complex credit derivatives and it is at the heart of the clever math investment banks use to minimise credit exposures. Yet quantifying correlation can be a matter of guesswork, calling into question the reliability of valuation and hedging strategies. This is more than a little alarming given the explosive growth of credit derivatives and their broader impact on global markets. From a standing start a few years ago, $15,000bn of new contracts were written last year. ‘Correlation’ in credit is not the same as in the rest of finance, where it refers to how closely the price movements of two securities are related. In credit, it usually means the extent to which default by one credit makes default by another more likely. The real complexity comes with portfolios of dozens or hundreds of credits, for example in credit derivative indices or collateralised debt obligations (CDOs). As it happens, the standard model for analysing such portfolios is dauntingly known as a Gaussian copula.”
Real Estate Bubbles Watch:
May 8 – Bloomberg (Kathleen M. Howley): “U.S. home prices will fall this year for the first time since the Great Depression because of the decline in subprime mortgage lending and stricter loan standards, the National Association of Realtors said. The 2007 median price for an existing home likely will slip 1% to $219,800 from a year ago…”
May 9 – The Wall Street Journal (James R. Hagerty): “The supply of houses and condominiums available for sale continues to grow quickly in much of the U.S., reflecting weak sales. The number of homes listed for sale in 18 major metropolitan areas at the end of April was up 7% from March, according to data compiled by ZipRealty Inc… Some of the biggest increases last month were in the metro areas of San Francisco, up about 19%; Washington, 17%; Orange County, Calif., 15%; and Seattle, 14%.”
May 9 – Bloomberg (Bob Ivry): “The U.S. housing slump has hit New York City’s richest suburbs. The average price in Westport, Connecticut…fell 8.2% to $1.56 million in the first four months of 2007 from the same period last year…”
M&A and Private-Equity Bubble Watch:
May 10 – Financial Times (James Politi): “Global mergers and acquisitions volumes leapt over the $2,000bn mark yesterday, as the pace of corporate dealmaking in 2007 continued to exceed even the rosiest predictions on Wall Street and in the City of London. According to Dealogic, M&A activity since January 1 this year is now 63% higher than in 2006… In addition, April was the busiest month in history for the M&A business, with the announcement of $647bn worth of deals.”
May 4 – Bloomberg (Tan Hwee Ann and Stuart Kelly): “BHP Billiton Ltd., the world’s biggest mining company, could be stripped and sold for $201 billion to provide a 34% return to any private equity groups that make a takeover bid, according to Merrill Lynch… Any bid would likely be at a 30 percent premium to Melbourne-based BHP’s market value of $140 billion…”
Energy Boom and Crude Liquidity Watch:
May 9 – Bloomberg (Arif Sharif): “Saudi Arabia, the United Arab Emirates and four other Arab Gulf states will spend $1.3 trillion on infrastructure projects over the next six years, the Khaleej Times reported…”
May 10 – Bloomberg (Vincent Del Giudice): “The government’s budget surplus for April, when tax payments are due, rose to the highest in six years as swelling revenue outpaced spending on the military and health care. The surplus for the month increased 50% to $177.7 billion from $118.8 billion in April 2006… For the first seven months of the 2007 financial year, the deficit narrowed 56% to $80.8 billion from a year before.”
After 7 months of the fiscal year, total federal government receipts are running 11.2% ahead of comparable 2006. Individual income tax receipts are a notable 17.3% above the year ago level, with corporate tax receipts up 15.2%. On the spending side, total y-t-d federal expenditures are up 3.2%. By largest category, Social Security spending is running 5.7% ahead, National Defense 6.0%, Income Security 4.3%, Medicare 17.4%, Health 7.0%, and Interest 5.2%.
May 8 – Washington Post (Lori Montgomery): “The global war on terror, as President Bush calls the fighting in Iraq and Afghanistan and related military operations, is about to become the second-most-expensive conflict in U.S. history, after World War II. Since the Sept. 11, 2001, terrorist attacks, Congress has approved more than $609 billion for the wars… Requests for $145 billion more await congressional action and would raise the cost in inflation-adjusted dollars beyond the cost of the wars in Korea and Vietnam… And this time, the war bill is going directly on the nation’s credit card. Unlike his predecessors, Bush is financing a major conflict without raising taxes or making significant cuts in domestic programs. Instead, he has cut taxes and run up the national debt. The result, economists said, is a war that has barely dented the average American’s pocketbook and caused few reverberations in the broader economy.”
Checks and Balances:
Merrill Lynch filed its first quarter 10Q this week. We now know that Total Assets expanded $140.5bn, or 67% annualized, to $982bn during the quarter. Assets were up $250bn, or 34%, y-o-y. This puts combined Big Five (Morgan Stanley, Merrill Lynch, Goldman Sachs, Lehman, and Bear Stearns) first quarter asset growth at an incredible $379bn (41% growth rate) to $4.033 TN. Big Five Assets inflated $843bn over the past year, or 26%. For comparison, Bank Credit is up about $580bn y-o-y.
Identical to their Wall Street brethren, Merrill’s growth was predominantly in the area of securities finance. On the Asset side, “Securities Financing Transactions” jumped $114bn during the quarter to $410bn. On the Liability side – the IOUs created through the expansion process - “Payables under Repurchase Agreements” jumped $66bn to $289bn. Adding JPMorgan and Citigroup to the mix, “Big 7” combined “repo”/“fed funds” Liabilities expanded an unprecedented $267bn during the quarter, or 62% annualized. Forget the traditional M2 and M3 aggregates - the current monetary expansion is dominated by a historic yet unrecognized inflation in “repo” instruments.
From the New York Fed’s weekly Primary Dealer Transaction Report, we see that Primary Dealer “repo” positions (in Treasuries, agency, and MBS) are up an astounding $533bn y-t-d, or 45% annualized, to $3.981 TN. This is another key data point (along with $520bn y-t-d growth in foreign reserves, 17.3% fiscal y-t-d growth in individual federal tax receipts, 160% y-o-y Chinese stock market gains, $2.0TN y-t-d global announced M&A, and a prospective $900bn U.S. Current Account Deficit, to name a few) confirming the degree to which the monetary system has run amok. And it is certainly no coincidence that “repos” are these days expanding in similar degree to foreign central bank reserves.
It is my view that U.S. securities finance has evolved into a primary source of system liquidity creation, the finance that then inundates the world’s market and economies, only to be “recycled” by foreign central banks back to our securities (and “repo”) markets - where it again provides the liquidity to sustain more Credit creation and Bubble excess. Wall Street securities lending operations at the same time provide an endless supply of Treasuries to “mop up” global dollar liquidity, while creating an unending supply of cheap liquidity for securities leveraged speculation.
Some years back (1999) I proposed the concept of an “Infinite Multiplier Effect.” Having been unleashed from traditional bank reserve and capital requirements (not to mention a gold standard!), contemporary (electronic) finance (certainly including non-banks) had evolved to the point of attaining the potential for unfettered expansion. This potential is now being fulfilled.
Let’s recall the standard Econ 101 example of fractional reserve banking: In the process of loaning money, Bank A creates $100 deposit money when it “Credits” the borrower’s account in the process of extending a new $100 loan. This new deposit/finance is then spent, and this $100 flow ends up as a new deposit in Bank B. Here, in the case of a 10% reserve requirement, $90 is then available to lend to a new borrower. When this $90 loan is made, the new deposit/purchasing power flows to Bank C where an additional $81 is available to be lent. And so on…
Today, when, for example, a foreign central bank “recycles” dollar liquidity through the purchase of Treasuries, this finance is immediately available to be “multiplied” infinitum in the modern day securities finance arena. Let’s say the Bank of Japan buys $100 million of Treasuries from a hedge fund, a (“carry-trade”) speculator using this short-sale as a source of finance for the purchase of higher-yielding securities. Here, a $100 million of dollar liquidity that the Bank of Japan initially acquired by exchanging yen finance with, say, Toyota then flows to the hedge fund. For the hedge fund, this liquidity becomes buying- power for the purchase of ABS from, let’s say, Merrill Lynch. Merrill would then have liquidity for its investment banking clients to finance a jumbo mortgage or perhaps an acquisition. This entire $100 million of finance can then follow various paths as it flows back out to the world financial system whereby it can again be recycled in its entirety right back to our securities markets.
In the traditional “multiplier” example, (closely regulated) bank finance circulated within the Credit/banking system, creating new deposit IOUs during the lending process. Bank liabilities were the principal component of system “money,” where they could at least be easily tallied and monitored.
Today, (unrestricted) securities market finance/liquidity circulates through an expansive and increasingly non-transparent Credit system (certainly including Wall Street, “repos”, securities and derivatives markets, and off-balance sheet “special purpose vehicles,” along with foreign central banks). From securities transaction to securities transaction, this process creates myriad new debt instrument IOUs through a multitude of lending processes (some financing the real economy but most financing the securities and asset markets). This unchecked expansion of a broad range of sophisticated securities market-based liabilities, intermediated globally through various types of institutions and vehicles, now comprises the vast majority of system “liquidity.” This finance cannot be readily accounted for or monitored, let alone regulated by monetary authorities.
Witnessing extraordinary monetary developments, I’ve lately been thinking a lot about Checks & Balances. For good reason, there exists today unwavering conviction that Checks & Balances and the Separation of Powers are fundamental to freedom and democracy. From a government website:
“One of the most important contributions to democratic practice has been the development of a system of checks and balances to ensure that political power is dispersed and decentralized. It is a system founded on the deeply held belief that government is best when its potential for abuse is curbed and when it is held as close to the people as possible.”
Our Founding Fathers were incredibly wise and masterful statesmen. When it came to the scourge of the abuse of power, unsound money ranked right up there with tyranny. They were hard money men who would be appalled by the current state of monetary affairs, the power concentrated in the hands of the Wall Street “money”-men, and the untenable debt load we owe to foreign governments and financiers.
And from the Department of Political Science at Auburn University:
“A fundamental principle undergirding the design of American government is that of the separation of powers, which prescribes the parcelling out of the various powers and functions of government to separate and relatively independent levels and branches of the federal system in order to prevent their all being controlled at the same time by any potentially tyrannical political faction. But, to the way of thinking of the Framers of the Constitution, the long-term survival of free popular government would require more than simply a purely formalistic separation of governmental functions and powers into completely independent organizational jurisdictions. Ambitious and unscrupulous office holders in one or another of the various branches and levels of government could be expected to encroach upon the powers and authority of the other branches and levels from time to time, and this would gradually bring about a tyrranical concentration of powers unless the leaders in the other parts of the government could be given the necessary constitutional means and personal motives to resist the encroachments of the others. ‘Ambition must be made to counteract ambition. The interest of the man [the officeholder] must be connected with the constitutional rights of the place.’
From this the Framers concluded there was a need for the Constitution to include a built-in set of ‘checks and balances’ -- the necessary legal weaponry for each branch to defend itself against encroachments on its independence and authority by the others. In most cases, this contervailing power is purely negative, usually taking the form of some special constitutional grant of authority for one branch to say ‘no’ to at least some of the specific decisions of the other branches in their own fields of specialization and then make it stick.”
Unfortunately, money and finance are not conducive to the necessary “built-in set of Checks and Balances” – the required “legal weaponry”. Finance is always changing and evolving at a pace that ensures that very few actually understand the new instruments and methods and even fewer the true course of monetary developments (until it’s too late). And you can be certain that when the boom catches a head of steam there will be fanciful talk of a New Era coupled with steadfast intolerance for checking monetary excess.
Today, “money” or "liquidity" cannot even be adequately defined, let alone monitored and regulated. Worse yet, in this Credit-induced boom-time euphoria, rabid ideologues (ok, think Kudlow and Laffer) equate free markets in goods and services (the Economic Sphere) with a “free” marketplace in unrestricted finance (the Financial Sphere). Checks and Balances and the Separation of Powers are recognized as absolutely paramount to a healthy democracy, yet these principles are somehow viewed with intense disdain when it comes to modern finance-based Capitalism. To be sure, when exuberance in the private-sector’s capacity to create wealth (and expand finance!) reaches its most fanatical extremes, there will be general antipathy toward any effective governmental monetary control. A great amount of historical precedent has me convinced that unchecked money and Credit pose the greatest risk to free market Capitalism.
The economic literature from the thirties, forties and fifties is replete with invaluable insight into such matters. The experience of the financial crash and Depression left deep emotional and analytical scares with respect to the damage inflicted by the unscrupulous “money changers” and reckless speculators. Glass-Steagall and the Banking Act of 1933 were to ensure that power over the U.S. financial system and economy were never again concentrated in the hands of “Wall Street.” But by the sixties, memories had begun to fade; Milton Friedman emerged with alluring historical revisionism; and the adoption of a statistical and quantitative “hard science” approach radically changed the nature of monetary analysis. Let’s return briefly to the pre-Friedman/“quant” days of Henry Simon’s classic 1936 article, "Rules Versus Authorities in Monetary Policy", and then to the concluding paragraph of Alan Sproul’s 1955 paper, "Changing Concepts in Central Banking."
Henry C. Simons, The Journal of Political Economy, 1936
“We must avoid a situation where every business venture becomes largely a speculation on the future of monetary policy. In the past, governments have grossly neglected their positive responsibilities of controlling the currency; private initiative has been allowed too much freedom in determining the character of our financial structure and in directing changes in the quantity of money and money-substitutes. On this point there is now little disagreement. In our search for solutions of this problem, however, we seem largely to have lost sight of the essential point, namely, that definite, stable legislative rules of the game as to money are of paramount importance to the survival of a system based on freedom of enterprise.”
“In a free-enterprise system we obviously need highly definite and stable rules of the game, especially when it comes to money. The monetary rules must be compatible with the reasonably smooth working of the system. Once established, however, they should work mechanically, with the chips falling where they may.”
“What matters is the character of the financial structure which banking creates – and the fact that, in the very nature of the system, banks will flood the economy with money-substitutes during booms and precipitate futile efforts at liquidation afterward.”
Allan Sproul (President of the NY Fed 1941-56), Readings in Monetary Theory, 1951
“I think we must all hope that this relatively happy state will continue, and that the modest revival of the powers and influence of the central bankers, which has been taking place in these postwar years in the United States, will have some permanence. It may have an important bearing upon that central problem of our political, economic, and social system, namely, how far Government guidance and control can go in seeking the public welfare, without destroying the effective functioning of our private economy. In this country, with our traditions of individual enterprise, we have preferred to keep such guidance to a practicable minimum, and to have it exercised largely through broad and impersonal controls – controls which affect the general environment. One cornerstone of such a philosophy is a competent and adequately powered monetary authority which can administer an effective monetary policy. In making monetary policy work to the limit of its capacity, we have one of the best defenses against control by Government intrusion in our personal and private affairs.”
I’ll conclude this query into the issue of unchecked finance and the concentration of financial power with a few closing thoughts. In practice, the “Infinite Multiplier Effect” is restrained by the natural limitations in the demand for borrowed funds. In the case of traditional lending, finance will expand at a rate to satisfy the demand for funds for real economic endeavors (i.e. business capital investment). And despite some rather outrageous lending excesses, even the expansion of mortgage finance was limited to a degree by the capacity of households to borrow.
Today is different. The prevailing demand for borrowing emanates from securities markets activities – specifically for M&A and leveraged securities speculation. In both cases, “the sky’s the limit.” As such, we’re in a period of extraordinary capacity for finance to mount a powerful burst of expansion - which it has been doing. The Credit infrastructure has developed incredible capabilities over the past few years; Wall Street and the global leveraged speculating community have become enormously big and powerful; foreign central bank “recycling” of dollar liquidity has evolved into one of history’s most remarkable (and dangerous) Monetary Processes; and Wall Street has begun to position for the next easing cycle with tens of trillions of securities available for such an endeavor.
The monetary backdrop has clearly become extremely unstable – I’ll refer to it as an “Unchecked Liquidity Dislocation.” The question then becomes, can monetary affairs settle down to a less unwieldy posture? Or are we instead now firmly locked in a Minsky Ponzi “deviation amplifying system” - that at some unpredictable time and in some unpredictable fashion comes to a predictably devastating conclusion?