05/24/2001 The Son of Portfolio Insurance *

It was a mixed week in the equity market, with the more speculative stocks and groups again outperforming the blue chips. For the week, the Dow shed almost 3%, while the S&P500’s loss was a much more modest 1%. The Morgan Stanley Consumer index declined about 1%, the Transports fell 2%, and the Morgan Stanley Cyclical index dropped 3%. The Utilities were largely unchanged. The broader market was relatively flat, with the small cap Russell 2000 and the S&P400 Mid-Cap index both with fractional gains. Technology stocks enjoyed another week of gains, with the NASDAQ100 and the Morgan Stanley High Tech indices adding 2%. The Semiconductors and the NASDAQ Telecommunications index were about unchanged for the week, while The Street.com Internet index jumped 5%. The Biotech rally continues, with the AMEX Biotech index gaining 3% this week. Despite today’s declines, financial stocks were also on the plus side with the S&P Bank and the AMEX Securities Broker/Dealer indices both increasing about 1%. With gold bullion giving back almost $8 of recent gains, the HUI Gold stock index dropped almost 8% this week.

The credit market was mixed but again unimpressive, with the short end of the Treasury yield curve outperforming. The yield curve continues to steepen. For the week, 2-year Treasury yields actually declined 10 basis points, while the 5-year increased 2 basis points. The key 10-year Treasury yield jumped 11 basis points to 5.51%, as long-bond yields increased 9 basis points to 5.85%. Interestingly, mortgage securities performed poorly, as the benchmark Fannie Mae mortgage-back yield jumped 11 basis points to the highest level since late December. Agency yields generally increased about 9 basis points. The 10-year dollar swap spread widened one basis point to 77. With year-to-date gains of almost 6%, TIPS (Treasury inflation protection securities) are dramatically outperforming other Treasury securities. Also ominous, global currency markets continue to demonstrate extraordinary instability. With the combination of a sharp rally in the yen and steep decline in the euro, those financing speculations in Europe with cheap Japanese funding suffered significant losses this week.

Broad money supply expanded by $25 billion last week, making an astounding $810 billion expansion, or 12%, during the past twelve months of unrelenting monetary excess. The volatile bank credit data has total bank credit expanding by almost $30 billion over the past two weeks, with "other securities" jumping $21 billion. Commercial and Industrial loans were basically unchanged, although this series will generally understate actual lending during periods of significant securitizations. There were 366,841 bankruptcy filings during the first three months of the year. This was a record number for a first quarter and up almost 18% versus a year ago. It should then not be surprising that credit card charge-offs jumped again during April. Also as expected, some of the most aggressive lenders are seeing the most rapid deterioration in credit quality. Citigroup saw its charge-offs jump from March’s 3.73% to 5.14%, Advanta 6.80% to 7.93%, Capital One 3.0% to 4.03%, Metris from 13.49% to 14.47%, and Providian 7.80% to 8.75%.

The deluge of corporate issuance runs unabated, with even Nextel Communications provided accommodative financing. Nextel issued $1 billion of 10-year convertible notes, with a 6% yield and convertible at about $24. Already this month, companies have issued a record $14.2 billion of convertible debt, surpassing the previous record of $11.1 billion set in February. Year-to-data, $50 billion of convertible issuance is running at an annual pace of $160 billion, more than double last year’s issuance of $70 billion.

Well, clearly all the money being thrown at the real estate sector is beginning to "burn a whole in pockets". From Bloomberg: "Real Estate Trusts Set Sights on Manhattan’s Apartment Market - ‘REITs, across the board, are looking to get their hands on New York properties,’ said Robert Eychner, head of New York property brokerage firm Eychner Associates. ‘New York is proving to be somewhat insulated from the valleys and peaks in other markets.’ Manhattan rents rose an average of 15 percent last year, up from 7 percent in 1999… Nationwide, rents rose an average of 8.7 percent in 2000."

The following are excerpts from George Soros’ April 13, 1994 testimony before the US House Banking Committee:

"I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do they can be very disruptive, exactly because they affect the fundamentals of the economy…

The trouble with derivative instruments is that those who issue them usually protect themselves against losses by engaging in so-called delta, or dynamic, hedging. Dynamic hedging means, in effect, that if the market moves against the issuer, the issuer is forced to move in the same direction as the market, and thereby amplify the initial price disturbance. As long as price changes are continuous, no great harm is done, except perhaps to create higher volatility, which in turn increases the demand for derivatives instruments. But if there is an overwhelming amount of dynamic hedging done in the same direction, price movements may become discontinuous. This raises the specter of financial dislocation. Those who need to engage in dynamic hedging, but cannot execute their orders, may suffer catastrophic losses.

This is what happened in the stock market crash of 1987. The main culprit was the excessive use of portfolio insurance. Portfolio insurance was nothing but a method of dynamic hedging. The authorities have since introduced regulations, so-called ‘circuit breakers’, which render portfolio insurance impractical, but other instruments which rely on dynamic hedging have mushroomed. They play a much bigger role in the interest rate market than in the stock market, and it is the role in the interest rate market which has been most turbulent in recent weeks.

Dynamic hedging has the effect of transferring risk from customers to the market makers and when market makers all want to delta hedge in the same direction at the same time, there are no takers on the other side and the market breaks down.

The explosive growth in derivative instruments holds other dangers. There are so many of them, and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated of investors. Some of these instruments appear to be specifically designed to enable institutional investors to take gambles which they would otherwise not be permitted to take…"

I would like to suggest moving Bruce Jacobs’ excellent book, Capital Ideas and Market Realities to the top of reading lists. From the forward by Nobel Laureate Harry M. Markowitz: "Many observers, including Dr., Jacobs and me, believe that the severity of the 1987 crash was due, in large part, to the use before and during the crash of an option replication strategy known as ‘portfolio insurance.’ In this book, Dr. Jacobs describes the procedures and rationale of portfolio insurance, its effect on the market, and whether it would have been desirable for the investor even if it had worked. He also discusses ‘sons of portfolio insurance," and procedures with similar objectives and possibly similar effects on markets, in existence today."

From Dr. Jacobs’ introduction: "This book sifts through the recent history of financial markets to unravel the complex ways in which investment ideas, and the products born of those ideas, are linked to each other and to the behavior of capital markets. In particular, it examines how some investment strategies, especially those based on theories that ignore the human element, can self-destruct, taking markets down with them. Ironically, the greatest danger has often come from strategies that purport to reduce the risk of investing. The summer and fall of 1998, for example, witnessed some of the most turbulent markets the world has ever seen. The troubles began with investor panic in the wake of the collapse of the Russian currency and bond market. As investors flew to safety, the contagion of fear spread, first to the other emerging markets, then to the equity markets of more developed nations. Contributing to the general disorder, however, were trading activities related to the supposedly low-risk investment strategies of many large investors…"

"In 1987, as in 1998, strategies supported by the best that finance theory had to offer were overwhelmed by the oldest of human instincts – survival. In 1929, in 1987, and in 1998, strategies that required mechanistic, forced selling of securities, regardless of market conditions, added to market turmoil and helped to turn market downturns into crashes. Ironically, in 1987 and 1998, those strategies had held out the promise of reducing the risk of investing. Instead, they ended up increasing risk for all investors."

Dr. Jacobs (doctorate in finance from Wharton,), co-founder of Jacobs and Levy Equity Management, subtitled his book (published in 1999) "Option Replication, Investor Behavior, and Stock Market Crashes." Much could certainly be written today regarding the critical role that equity derivatives played in the NASDAQ bubble and near collapse. The proliferation of OTC derivatives, in particular, were clearly a powerful destabilizing factor behind the spectacular technology boom and bust, and certainly hold potential to exacerbate a future U.S. stock market crisis. For this commentary, however, I am more keenly interested in interest rate derivatives. Specifically, I would like to explore the concepts behind the current dangerous fad of derivatives as a mechanism to insure against rising interest rates, as well as the momentous ramifications to both financial market and economic stability from these instruments that rely on dynamic hedging strategies. From Jacobs: "Option replication requires trend-following behavior – selling as the market falls and buying as it rises. Thus, when substantial numbers of investors are replicating options, their trading alone can exaggerate market trends. Furthermore, the trading activity of option replicators can have insidious effects on other investors."

Dr. Jacobs adeptly makes the important point that the availability of portfolio insurance during the mid-1980s played a significant role in fostering speculation that led to the stock market bubble and the crash that followed in October 1987. "Rather than retrenching and reducing their stock allocations, these investors had retained or even increased their equity exposures, placing even more upward pressure on stock prices. And, of course, as equity prices rose more, ‘insured’ portfolios bought more stock, causing prices to rise even higher…Ironically, the dynamic trading required by option replication had created the very conditions portfolio insurance had been designed to protect against – volatility and instability in underlying equity markets. And, tragically, portfolio insurance failed under these conditions (because…it was not true insurance). The volatility created by the strategy’s dynamic hedging spelled its end."

It is both perplexing and frustrating that critical lessons were not learned from either the 1987 stock market crash or the severe credit market and interest-rate derivative dislocation (George Soros testimony above) that unfolded after the Federal Reserve raised rates in early 1994 (ending a protracted period of extreme accommodation). In fact, we are now well into the second decade of disregarding what should be ear-piercing warning sirens: the 1987 stock market crash, 1989 "mini-crash", 1992 global currency turmoil, 1994 mortgage dislocation and credit market tumult, 1995 Mexico/Orange County debacles and dollar/yen dislocation, 1997 SE Asia collapse, 1998 Russia and LTCM collapse, interest rate and currency dislocations, 1999 Brazil and emerging market woes, gold and swaps market dislocation, 2000/01 NASDAQ dislocation, Turkey, Argentina, and U.S. corporate debt crisis. Of course, after crisis hits there is often the establishment of commissions, hearings and some limited debate, but interest quickly wanes with the recovery in the financial markets (fueled, of course, by accommodative monetary policy). "In the months following the (1987) crash, a number of investigative reports examined the trading data for the crash period. The Securities and Exchange Commission and the Brady Commission (the Presidential Task Force), for two, found that the evidence implicated portfolio insurance as a prime culprit." Ironically, former Federal Reserve vice-chairman and Long-Term Capital Management principal David Mullins was associate director of the Brady Commission. Yes, "lessons that were not learned"…inexcusable.

Dr. Jacobs’ wonderful effort explains not only the intricacies of portfolio insurance and dynamic hedging strategies, but also elucidates brilliantly how "the story of portfolio insurance is one of sophisticated marketing winning out over common sense. It is a story of the potential dangers of a complex financial theory taken up with little appreciation of its suitability for real-world conditions and applied mechanistically with little regard for its potential effects. It is a story about how a relatively small group of operators, in today’s complicated and interconnected marketplaces, can wreak havoc out of all proportion to their numbers…it is a story of unintended consequences. For synthetic portfolio insurance, although born from the tenets of market efficiency, affected markets in very inefficient, destabilizing ways. And option replication, although envisioned as a means for investors to transfer and thereby reduce unwanted risk, came to be a source of risk for all market participants."

Unfortunately, this language seems at least as applicable to today’s interest rate derivative market as it was for equity portfolio insurance. It is certainly our view that the contemporary U.S. and global financial system characterized by unfettered money, credit and speculative excess creates unprecedented risk for all market participants, as well as citizens both at home and abroad. Not only have flawed theories prevailed and past crises been readily ignored, derivatives (interest rate in particular) have come to play a much greater role throughout the U.S. and global financial system. The proliferation of derivative trading is a key element fostering credit excess and a critical aspect of the monetary processes that fuel recurring boom and bust dynamics, as well as the general instability wrought by enormous financial sector leveraging and sophisticated speculative strategies. This certainly makes the proliferation of interest rate derivatives significantly more dangerous than stock market derivatives. Under these circumstances, it does seem rather curious that more don’t seriously question the soundness of this unrelenting derivative expansion. Unfortunately, ignoring the dysfunctional nature of the current system does not assist in its rectification - anything but. Indeed, it is my view that these previous market dislocations will prove but harbingers of a potentially much more problematic crisis that is quietly fermenting in the U.S. (global) credit system.

"By the time of the 1987 crash, for example, portfolio insurance had fueled a fad that threatened market stability. It had attracted up to $100 billion in assets (about 3% of the market’s capitalization at the time). Almost every major asset management firm offered some form of insurance." Proponents could argue, at 3% of market cap, portfolio insurance was insignificant to the marketplace. While seemingly reasonable, this was nonetheless erroneous thinking. Sound analysis would have focused specifically on the fact that "…the volume of underlying shares (to be dynamically hedged by insurance programs) represented by the average daily volume of trading in all index futures contracts equaled 150 to 200 percent of the trading volume on the New York Stock Exchange. Futures markets had come to be perceived as extremely liquid…" Importantly, it was the high ratio of assets to be hedged dynamically compared to normal volume that should have been the clue of the potential for serious trouble. The perception of extreme liquidity was soon to be shattered in a spectacular market crash.

It is certainly no exaggeration to say that the $100 billion or so of portfolio insurance back in 1987 appears absolutely trivial compared to what has developed throughout global derivatives markets. According to recent data from the Bank of International Settlements (BIS), total OTC derivative positions now surpass $95 trillion. Total interest rate derivatives ended year-2000 at $54.7 trillion, up 20% for the year. The notional value of interest rate swaps jumped 27% last year to almost $49 trillion. And while European swap volume actually contracted by 5% during the fourth quarter, U.S. positions jumped 10%. Yesterday, Swaps Monitor published the notional derivative exposure for the leading U.S. investment banks. Goldman Sachs had total interest rate derivatives of $4.7 trillion, with interest rate swap positions jumping almost 40% during the past year to about $3.6 trillion. Merrill Lynch had total interest rate positions of almost $3.5 trillion, with interest rate swaps expanding 20% during the past year to almost $3 trillion.

The Office of the Comptroller of the Currency reported $33 trillion of total commercial bank interest rate derivatives at the end of the year, compared to the $7.2 trillion outstanding going into the 1994 credit market dislocation. Interest rate derivatives have jumped almost $13 trillion, or 64% since the second-half of 1998. Interest rate swaps of $22 trillion have doubled since the second-half of 1998 and are up more than 6-fold since the end of 1993. J.P. Morgan Chase has a swaps book of a staggering $14.2 trillion, comprising a majority of its more than $24.5 trillion of notional derivative positions at year-end. Citigroup and Bank of America each have about $4 trillion of interest rate swaps.

The recent BIS derivative report also provided some noteworthy categorization. Of total positions, interest rate swaps "with other reporting dealers" comprised $24.5 trillion, swaps "with other financial institutions" totaled $20.1 trillion, and "with other non-financial customers" at $4.2 trillion. Clearly, the gigantic interest rate derivative market should be recognized as a very unusual beast. Instead of providing true interest rate hedging protection, this is clearly the financial sector having created a sophisticated mechanism that, despite its appearance, is limited to little more than "self insurance" – "The Son of Portfolio Insurance." I have written repeatedly that markets cannot hedge themselves, and that derivative "insurance" is different in several critical respects from traditional insurance. From Dr. Jacobs: "Synthetic portfolio insurance differs from traditional insurance where numerous insured parties each pay an explicit, predetermined premium to an insurance company, which accepts the independent risks of such unforeseeable events as theft or fire. The traditional insurer pools the risks of many participants and is obligated, and in general able, to draw on these premiums and accumulated reserves, as necessary, to reimburse losses. Synthetic portfolio insurance also differs critically from real options, where the option seller, for a premium, takes on the risk of market moves." Such exposure to unrelated events is far different from exposure to a market dislocation. Quoting leading proponents of portfolio insurance from 1985, "it doesn’t matter that formal insurance policies are not available. The mathematics of finance provide the answer…The bottom line is that financial catastrophes can be avoided at a relatively insignificant cost."

Amazingly, such thinking persists to this day. The above language, of course, is all too similar to the flawed analysis/erroneous propaganda that is the foundation for the proliferation of hedging strategies and the explosion of derivative positions. Dynamic hedging makes two quite bold assumptions that become even more audacious as derivative positions balloon: continuous markets and liquidity. As writers of technology puts (Apple provided an excellent example) experienced, individual stocks often gap down significantly on earnings or other disappointing news, not affording the opportunity to short the underlying stock at levels necessary to successfully hedge exposure. And when the entire technology sector was in freefall, market illiquidity made it impossible for players to dynamically hedge the enormous amount of technology derivatives (put options) that had been written over the boom (especially during the final stage of gross speculation). The buying power necessary to absorb the massive shorting necessary for derivative players to offload exposure (through shorting stocks or futures) was nowhere to be found – so much for assumptions.

Granted, derivatives can be a very effective mechanism for individual participants to shift risk to others, but a proliferation of these strategies significantly influences their effectiveness and general impact. The availability of inexpensive "insurance" heightens the appetite for risk and exacerbates the boom. This characteristic has significant ramifications for both the financial system and real economy. It also creates completely unrealistic expectations for the amount of market risk that can be absorbed/shifted come the inevitable market downturn. Many adopt strategies to purchase insurance at the first signs of market stress. Once again, the market cannot hedge itself, and the tendency is for derivative markets operating in a speculative environment to transfer risk specifically to financial players with little capacity to provide protection in the event of severe financial market crisis.

The lack of liquidity experienced by the derivative players in the technology sector should have come as no surprise. Going back to the near debacle in the U.S. credit system in 1994, the BIS estimates that "from October 1993 to April 1994, dynamic hedging of MBS (mortgage-backed security) risk resulted in Treasury market sales of over $300 billion in ten-year Treasury equivalents." From data I presented above, it should be clear that current derivative exposure, hence potential dynamic hedging-dictated sales, is a multiple of 1994. Total mortgage debt has increased by almost $3 trillion since the end of 1993. There is another key factor that greatly accentuates today’s risk of a serous market dislocation, that was actually noted by the BIS: "Net repayments of US government debt have affected the liquidity of the US government bond market and the effectiveness of traditional hedging vehicles, such as cash market securities or government bond futures, encouraging market participants to switch to more effective hedging instruments, such as interest rate swaps."

This is actually a very interesting statement from the BIS. First, it is an acknowledgement that "liquidity" and the "effectiveness of traditional hedging vehicles" have been impaired, concurrently with the exponential growth of outstanding derivative positions. This is not a healthy divergence. We have posited that the explosion in private sector debt, having been the leading factor fueling U.S. government surpluses, has produced The Great Distortion. As such, the viability of hedging strategies such as those that entailed massive Treasury securities sales in 1994 is today suspect. There are fewer Treasuries and a much less liquid Treasury market, in the face of unimaginable increases in risky private-sector securities and hedging vehicles. And while this momentous development has not yet created significant market disruption, the true test will come in an environment of generally increasing interest rates. Rising market rates will dictate hedging-related securities sales, and will test the liquidity assumptions that lie at the heart of derivative strategies. It is certainly my view that models that rely on historical relationships between public and private debt are increasingly inappropriate in today’s bubble environment, as are the associated assumptions of marketplace liquidity. Importantly, dynamically shorting securities in the liquid Treasuries market is no longer a viable method for the financial sector to hedge the enormous interest rate risk that they have created. The "answer" to this dilemma, apparently, has been an explosion of "more effective hedging instruments, such as interest rate swaps (from the BIS)." We very much question the use of the adjective "effective." As mentioned last week, there have been three episodes of problematic illiquidity in the swaps market during the past three years. This is not a track record that breeds confidence.

All the same, the interest rate swaps market remains Wall Street’s favorite "Son of Portfolio Insurance." A similar pre-’87 Crash perception of a "free lunch" conveniently opens the door to playing aggressively in a speculative market. But an interest rate swap is only a contact to exchange a stream of cash flows, generally with one party agreeing to pay a fixed rate and the other party a floating rate (settling the difference with periodic cash payments). With characteristics of writing an option, the risk of loss is open ended for those taking the floating side of the swap trade. There’s no magic here, with one party a loser in this contract in the event of a significant jump in market rates. In such an event, this "loser" will certainly plan to dynamically hedge escalating exposure. If you are on the "winning" side, you had better accept the fact that the greater your "win," the higher the probability of a counterparty default. Somewhere along the line, these hedging strategies must be capable of generating the necessary cash flow to pay on derivative "insurance" in the event of higher interest rates. Obviously, the highly leveraged and exposed financial institutions that comprise the swaps market have little capacity to provide true insurance. In a rising rate environment, these players will have enough problems of their own making as they are forced to deal with their own bloated balance sheets, mark-to-market losses, and other interest rate mismatches, let alone enormous off-balance sheet exposure. As I have written previously, purchasing large amounts of protection against sharply higher interest rates from the U.S. financial sector makes about as much sense as the failed strategy of contracting with Russian banks for protection against a collapse in the ruble. Sure, one can play this game, but we are all left to hope that the circumstances never develop where there is a need to collect on these policies.

The unrelenting Credit Bubble and the amazing creation of debt securities assures an eventual market disturbance and mad scramble to off-load risk. In 1994, as is evidenced by the estimated $300 billion of Treasury sales to hedge mortgage-backs, proceeds from shorting in the liquid government debt market provided the means to generate the cash flow to pay on hedges written, as well as protect against rate-induced losses in mortgage-backs and other debt instruments.

Similarly, at some point, higher interest rates will force the financial sector to short securities to dynamically hedge the massive interest rate exposure that has been created. What securities will be sold and from where will buyers be found with the necessary $100s ($ trillion plus?) of billions of liquidity? Will agency securities be aggressively shorted? What are the ramifications of such a development to a market that is almost certainly highly leveraged with enormous speculative trading? I can assure you that these are questions that the derivative players would rather not contemplate, let alone discuss. But then again, perhaps the Federal Reserve can ensure that interest rates never move higher again. Many would like to believe that Greenspan could do as much.

The problem is that the strong perception that has developed that holds that the Fed will ensure that interest rates and liquidity conditions remain market friendly is actually the key assumption fostering the explosion in interest rate derivatives and reckless risk-taking. It should be clear that the assumptions of liquidity make no sense whatsoever without the unspoken assurances from the Federal Reserve. The resulting proliferation of derivatives, then, has played a momentous role in the intermediation process whereby endless risky loans are transformed into "safe" securities and "money." The credit system’s newfound and virtually unlimited capability of fabricating "safe" securities and instruments is the mechanism providing unbounded availability of credit – the hallmark of "New Age Finance." It is the unbounded availability of credit that, at this very late stage of the cycle, that creates extreme risk of dangerous financial and economic distortions, including the distinct possibility of heightened inflationary pressures. Ironically, the proliferation of interest rate derivatives has created the very conditions that they had been designed to protect against – volatility and instability in the underlying credit market, as well as acute vulnerability to the real economy.

Nowhere are monetary processes as powerful and precarious as those associated with the government-sponsored enterprises. And while both sides fuss over the largely irrelevant issue regarding the estimated size of the government subsidy, critically important issues are ignored. For one, why is there not some discussion as to the reasonableness of these institutions’ interest rate exposure (mismatched balance sheets) and hedging activities? Sure, with the Fed aggressively cutting rates, few perceive even a remote possibility that the GSEs or their counterparties could be surprised by higher borrowing costs. But, then again, it is precisely these bullish perceptions of near invincibility that has everyone sitting merrily on one side of the interest rate boat. Moreover, the extraordinary willingness to accept interest rate risk is playing a key role in the massive security issuance and mortgage-lending boom, similar to 1993 but even more dangerous. With heightened wage and inflation pressures, an over accommodative Fed, unprecedented money growth, surging energy prices, a terribly maladjusted U.S. economy, and the massive ballooning and hedging of GSE balance sheets, I would argue that the risk of higher market rates is much greater than generally recognized. Furthermore, with truly unprecedented financial imbalances – massive financial sector leveraging, endemic speculation, gross asset and liability mismatches, and unfathomable derivative positions – the credit market is today acutely vulnerable to a serious dislocation. This is indicative of extreme financial fragility.

It is certainly reasonable to contemplate who is in fact on the other side of GSE derivative contracts and exactly how they plan on hedging the unprecedented and growing GSE interest rate exposure. The "Big Three GSEs" (Fannie Mae, Freddie Mac, and the FHLB), ended the first quarter with almost $1.9 trillion of assets. These bloated balanced sheets were funded with over $700 billion of short-term debt and "insured" by almost $1.4 trillion of interest rate derivatives. I see that the Federal Home Loan Bank System expanded assets by $20 billion during the first quarter, a 13% annualized rate, to $674 billion. The most rapid asset growth was "Federal Funds Sold" that expanded almost $10 billion to $65 billion (70% annualized growth rate). To finance this massive balance sheet, discount notes (short-term borrowings) increased $25 billion to $185 billion. At the end of last year, almost half of the FHLB’s long-term debt had maturities of two years or less. The FHLB ended the first quarter with total notional derivative positions of about $550 billion, with $340 billion of interest rate swaps.

The GSEs, either directly or indirectly, are mainly financing long-term mortgages. Granted, in this most unusual environment that has prevailed over the past few years - with the combination of very hot real estate markets and low rates affording consumers the opportunity to refinance like never before - the average mortgage has not performed much like a long-term instrument. However, it does not take much imagination to see how a surprise move in mortgage rates, an abrupt end to the refinancing boom, and a cooling of real estate markets could see the average life of the mountain of recently created mortgages lengthen rather abruptly and significantly. Throw in a steepening yield curve and widening mortgage spreads, and these cuddly little mortgages everyone has come to love quickly metamorphose into thoroughly vicious creatures despised by all. Mortgages are particularly difficult instruments to hedge in a volatile rate environment, and will be increasingly suspect during economic downturn. Remembering all the grief experienced in the difficult market environment back in 1994 sure does make us wonder how the much larger mortgage and interest rate derivative markets will function the next go around. Perhaps we will have to wait for a Fed rate hike to see if the swaps market functions as planned and all the hedging works as expected. Could be, but I sense potential for an unwelcome surprise. Certainly, market players cannot be too pleased with how these Greenspan cuts have been playing out so far – record securities issuance but a dearth of trading profits to show for all the excitement. Isn’t a period of such extraordinary rate cuts supposed to be a lot more fun and much easier to make money than this?

I will end by admitting I had a bit of an epiphany this week. For some time I have looked at the ridiculousness of the Great Credit Bubble, with reckless money and credit growth, the gross and unrelenting excesses perpetrated by the GSEs, the unfathomable derivative positions, endemic leveraged speculation, an increasingly distorted U.S. economy, and the Federal Reserve, incredibly, committed to sustaining these excesses. How could this situation not incite a stampede of investors fleeing dollar assets? Then it hit me – "doug, you’re looking at his all wrong. You gotta ‘think like a gopher.’" This has absolutely nothing to do with investing; gotta think like a speculator.

It is precisely because the Fed and the GSEs are committed at all costs to sustain the bubble, and that the contemporary US credit system has the means and willingness to perpetuate the inflationary monetary expansion necessary to keep asset prices levitated, that has placed the U.S. credit system firmly as the last great refuge for the monstrous global leveraged speculating community. The speculators have learned that liquidity is absolutely a necessity for playing, while loving monetary inflation as long as they can profit from it. No reason to play in Europe, with the sometimes-feisty ECB much less amenable than the Greenspan Fed (besides, they don’t have GSEs!). No safe place to play in emerging markets, especially with the demise of pegged currency regimes and global currency markets so unsettled. Certainly there is no reason to play in Japan, or anywhere in Asia for that matter, with their historic bubbles already having burst. The speculators know what they like, a central banker that will surprise them with timely "treats," while giving them plenty of advance warning in the unlikely event of needing to administer a bit of a "trick". And with Greenspan and the GSEs providing assurances of marketplace liquidity that no other country can come even close to matching, there simply is little reason to place bets anywhere else – there’s only one hot casino left in town. The good news is that all this "hot money," does wonders for what should be an acutely vulnerable dollar. The bad news is that there sure is a lot riding on what appears to be one massive and increasingly vulnerable speculation and derivative bubble that fuel the perpetuation of the historic U.S. Credit Bubble. I have said before that I see the current bets placed in the U.S. interest rate market as probably "history’s most crowded trade." Furthermore, I see the dollar acutely vulnerable when this speculation falters and the "hot money" runs for cover.

Greenspan may believe that holding the "may require additional rate cuts" carrot in front of the speculators may keep them excited about a game that hasn’t been such a good money maker of late. He sure does seem a bit too anxious to please…