06/06/2002 Point, Counter Point *

The equity bear market took on more urgency this week, with corporate debt problems and the ongoing technology debacle taking its toll. For the week, the Dow declined 3% and the S&P500 dropped 4%. The Transports dipped 2% and, interestingly, the Utilities dropped 5%. The Morgan Stanley Cyclical index declined 3% and the Morgan Stanley Consumer index retreated 2%. The broader market suffered as well, with the small cap Russell 2000 declining 3% and the S&P400 Mid-Cap index dropping 4%. The technology sector was hammered, with the NASDAQ100 and Morgan Stanley High Tech indices dropping 6%. The Semiconductors and The Street.com Internet indices declined 7%, and the NASDAQ Telecommunications index sank 8%. The biotech stocks were clobbered, with the major index sinking 11%. The financial stocks were weak, with the AMEX Securities Broker/Dealer and S&P Bank indices declining 4%. With bullion down $2.10, the HUI Gold index dropped 5%. The dollar index declined about 1% this week.

The Credit market was again volatile, with the front end (short maturities) of the Treasury curve again enjoying faltering stocks and continued corporate debt woes. For the week, December 3-month Eurodollars saw their yield sink 10 basis points to 2.81%. The two-year Treasury note saw yields decline 6 basis points to 3.13% and 5-year yields declined 3 basis points to 4.32%. At the same time, 10-year Treasury yields added 2 basis points to 5.07%, while long-bond yields increased 5 basis points to 5.66%. Benchmark mortgage-back yields increased five basis points, while the implied yield on agency futures rose one basis point. The spread on Fannie Mae’s 5 3/8 2011 note widened one to 55, while the benchmark 10-year dollar swap spread widened four to 55.

Brazilian bonds and currency slumped to seven-month lows this week. Yesterday, a disappointing government debt auction saw benchmark 10-year yields surge to 17.22%. Yields began the week at 14.54%, and ended April at about 13%. Nervous markets are especially rattled by comments from the leading opposition presidential candidate suggesting the possibility of future debt default.

The U.S. bond market saw earlier gains turn to losses today as the stock market recovered. Economic activity points to vulnerable global bond markets. Money supply is accelerating rapidly in most economies, with the ECB’s Wim Duisenberg commenting, the “economy is awash in liquidity.” UK home prices rose in May at the strongest pace since 1989 (up 17.9% y-o-y), with record consumer borrowing. European manufacturing is now growing at the strongest pace in 15 months, with consumer confidence at 9-month highs and business confidence at 10-month highs. The Canadian economy is quite strong, with first-quarter GDP growth at 6%. April residential building permits were a record, up 66% y-o-y, while today’s Canadian employment report had another 30,500 jobs created. Booming housing markets helped fuel 4.2% annualized first-quarter GDP growth in Australia. Australian May vehicles sales were up 12% y-o-y. The New Zealand economy continues to surprise on the upside. Throughout SE Asia, signs point to recovering exports and stronger growth. Taiwan today reported that May exports, up 9% y-o-y, were the strongest in 15 months. Philippine exports were up 22.4% and Malaysia 6.4%. Even Japan reported first-quarter growth of 1.4%. Central banks in Canada and Australia moved again this week to raise interest rates.

Broad U.S. money supply (M3) jumped $27.7 billion last week, and is now up $123.2 billion over the past six weeks. Demand and checkable deposits increased $11.7 billion and savings deposits added $3.9 billion, while large time deposits dropped $13.8 billion. The old mainstay institutional money fund deposits surged $23.3 billion. According to Convert.com, 2002 year-to-date convertible security issuance of $38.8 billion is down 30% from comparable 2001. The week saw $5.1 billion of asset-backed security issuance, with y-t-d sales of $153 billion running 17% above comparable 2001. Bloomberg’s weekly tally of U.S. domestic debt issuance had $22 billion sold last week.

Today’s May jobs report had manufacturers shedding the fewest jobs since November 2000, with overtime increasing to the highest level since the same month. The service sector added 64,000 jobs on top of April’s 78,000. Today’s report on consumer Credit had borrowings growing a stronger than expected $8.9 billion (6.3%), the largest rise since November.

Led by record residential expenditures, April construction spending came in marginally higher than expected. Year-over-year, residential spending was up 8.5%, with this sector now having posted five straight months of expansion. One-unit spending was up 6.5% y-o-y, with multifamily spending up 19.1%. Home improvement spending was also 19% above year ago levels. Single-unit and multifamily spending has jumped 50% and 60%, respectively, from pre-Bubble April 1997 levels. The public sector construction boom, while remaining strong, appears to be losing some of its vigor. April public spending was up 6.8% y-o-y, with housing up 22.6%, educational 18.6%, and hospital up 34.6%. Public sector industrial spending was down 12.5%, with road construction down 1.6%. Private non-residential spending continues to be very weak, with industrial spending down 43.5% y-o-y, hotels/motels down 24.8%, and spending on office buildings down 27%.

The ISM (formerly National Association of Purchasing Management) manufacturing index came in at a stronger-than-expected 55.7, the strongest reading since February 2000. Production, New Orders, Backlog, and Export components all increased. The Prices component jumped to 63, up from November’s reading of 32, and to the highest reading since July 2000. ISM Export Orders rose to 53.5, the highest level since May 2000. Interestingly, a nine-point jump in Export Orders (to 61.5) led the ISM Non-Manufacturing index to a stronger-than-expected reading of 60.1

May auto sales were reported at a weaker than expect 15.7 million rate (down 5.7% y-o-y). GM and Ford sales were down 12% y-o-y, while Chrysler sales declined 4%. At the same time, Toyota and BMW both enjoyed their best months ever in the U.S. Lexus, Acura, and Infinity had their best Mays ever. Kia sales were up 14% y-o-y and Hyundai 10%. Auto sales are booming in Canada, with BMW sales up 15% y-o-y for a record month.

The Mortgage Bankers Association’s weekly purchase application index surged 19% last week to a new record (up 20% y-o-y). According to data from the Office of Federal Housing Enterprise Oversight (OFHEO), nationwide home prices increased 6% during the past year, led by a 9.6% gain in New England. On average, American home prices jumped 36.6% over the past five years. Prices surged 59.86% in California, 50.92% in Colorado, 45.06% in New York, 52.81% in Minnesota, 42.36% in New Jersey, 60.67% in New Hampshire, 65.61% in Massachusetts, 61.09 in Washington D.C., 44.35% in Rhode Island, 39.65% in Connecticut, 38.45% in Michigan, 37.88% in Florida, and 37.58% in Georgia, to name some of the leading gainers. Since 1980, prices are up 322% in New England (56.2% over 5 years), 231% in the Middle Atlantic (36.9%), and 220.6% in the Pacific (49%).

June 6 Bloomberg – “Hedge fund managers are using the bond market to raise money in a new type of product that mimics asset-backed debt and selling it to investors who want to avoid the risk of credit rating downgrades. Man Group Plc, the world’s largest hedge fund manager, yesterday finished selling $500 million of seven-year bonds, using the proceeds to invest in 35 hedge funds... Investcorp, a Bahrain-based hedge fund group, sold the first public issue of such securities two weeks ago with a $250 million transaction. So-called collateralized fund obligations represent a new way for hedge funds to borrow. The $500 billion-a-year hedge fund business is growing because the funds can make money whether stocks fall or rise. Investors are considering CFOs because they are less likely to be hit by ratings downgrades than bonds backed by corporate debt.” (What a nutty idea...)

The Federal Reserve released its always-interesting “flow of funds” report for the first-quarter. The Fed’s Credit data once again paint a clear picture of an exceedingly maladjusted financial system and economy. While business sector market borrowings slowed markedly to an annualized rate of 1.8% (from Q4’s 5.3%), total Household borrowings accelerated to a 9.0% annual rate (from Q4’s 8.3%). Total Credit market debt outstanding (financial and non-financial) grew at an annualized rate of $1.848 trillion, or 6.3%. The U.S. financial sector continues to balloon, with borrowings increasing at an $878 billion, or 9.9%, annualized rate.

Not surprisingly, mortgage finance continues to be the leading sector of Credit excess. Total mortgage borrowings increased at a seasonally adjusted annualized rate of $698.3 billion (9.2% annualized), up from 2001’s first-quarter annualized borrowings of $544 billion. This is at a rate more than double 1997’s mortgage growth of $337 billion. Total mortgage borrowings during the first-quarter comprised 70% of total domestic non-financial debt growth, compared to 36% during 1997 and 64% during 2001. First-quarter home mortgage borrowings of (annualized) $593.6 billion (10% growth rate) compares to first-quarter 2001’s $429.9 billion, and year-2001’s record home mortgage growth of $533.3 billion. Commercial mortgage borrowings increased at an annualized rate of $65.6 billion (5%), about half the pace of last year’s record growth.

To put the Great Credit Bubble into proper perspective, it is helpful to view the expansion since the beginning of 1998 (the past 17 quarters). Over this period, total Credit market borrowings have increased $8.625 trillion, or 40%. Domestic-nonfinancial Credit market borrowings increased $4.362 trillion, or 29%, to $19.6 trillion. Household sector borrowings increased $2.24 trillion, or 40%, to $7.8 trillion, while non-financial corporate borrowings expanded $1.483 trillion, or 44%, to $4.866 trillion. Yet, the heart and soul of the Credit Bubble is most conspicuous with the explosion of financial sector borrowings. Since the beginning of 1998, the U.S. financial sector has increased borrowings by $4.145 trillion, or 76%, to $9.603 trillion. During the past 17 quarters, the GSEs have increased borrowings by $1.17 trillion, or 117%, to $2.162 trillion. “Federally-Related Mortgage Pools” (GSE mortgage-back securities) have expanded $1.13 trillion, or 62%, to $2.96 trillion, while “ABS Issuers” (asset-backed security trusts) have grown $1.124 trillion, or 104%, to $2.2 trillion.

As we have in the past, we view it as helpful to combine the GSEs, “Mortgage Pools,” and “ABS Issuers” together as “Structured Finance.” Since the beginning of 1998, “Structured Finance” has expanded $3.42 trillion, or 88%, to $7.317 trillion. We have explained repeatedly how these Credit creators have been instrumental in sustaining the Credit Bubble, especially during times of heightened marketplace risk aversion. Never has this been more the case than it has been of late. It is worth noting that “Structured Finance” expanded at an annualized rate of $1.063 trillion, or 15%, during the first quarter. The issuance of mortgage-backed securities has been eye opening. “Mortgage Pools” expanded at a record seasonally adjusted pace of $502 billion, or 18%, during the first quarter. For comparison, “Mortgage Pools” expanded $170.3 (annualized) billion during 2001’s first quarter. For all of 2001, “Mortgage Pools” increased by a record $338.5 billion, up almost three-fold from the $114.6 billion growth during pre-Bubble 1997. “ABS Issuers” expanded at a seasonally adjusted pace of $370 billion, or 18%, during the first quarter. For comparison, “ABS Issuers” expanded by a record $288 billion during 2001, and $202.2 billion pre-Bubble 1997. GSE growth was actually somewhat tempered during the quarter (because of mortgage-back issuance), with Credit market borrowings increasing at an annualized pace of $191 billion, or 9%. For comparison, the GSE expanded by a record $290.8 billion during 2001.

It is rather discomforting to analyze the composition of assets underlying the Bubbling asset-backed securities (ABS) sector. Inarguably, the data strongly support our view of a runaway boom in non-productive debt issuance. During 1997, a total of $200 billion of ABS were issued (up from 1996’s $146 billion). “Loans to Business” comprised 12.2% of underlying ABS trust assets, “Trade Credit” 18.1%, “Commercial” mortgages 10.2% and “Agency” securities 2.2%. “Home Mortgages” comprised 27% and “Consumer Credit” 23.6%. Of first-quarter 2002’s almost $371 billion annualized ABS issuance, “Loans to Business” comprised just 7.6%, “Trade Credit” 6.9%, and “Commercial” mortgages 4.0%, while “Agency” securities jumped to 20.7%. “Consumer Credit” declined to 10.6%, while “Home Mortgage” surged to 47.4%. Combined “Agency,” “Consumer Credit,” and “Home Mortgage” increased to 79% during the first quarter from 1997’s 53%.

Depending of market conditions, ABS issuers will choose to issue short-term or long-term asset-backed securities. Looking back to 1997, 45% of that year’s ABS issuance was short-term “Asset-backed Commercial Paper” (ABCP). Year-2000 saw 61% of ABS issuance short-term in duration, although this ratio then dropped to 36% for all of 2001. During the tumultuous fourth quarter of 2001, 41% of enormous total ABS issuance was short-term, which played a meaningful role in that period’s rapid money supply expansion. However, during this year’s first quarter, long-term bond issuance was 103% of total ABS issuance, as there was a net pay down ($13.9 billion decline to $731 billion) in short-term ABCP. This should be recognized, along with the GSE’s strong bond issuance, as an important explanation for the first-quarter’s money supply stagnation. There is now no question that the first quarter’s money supply slowdown was largely a financial sector liability management issue rather than related to a meaningful reduction in lending. With unsettled market conditions and accompanying risk aversion, we expect the financial sector has commenced another period of aggressive issuance of short-term “monetary” liabilities.

One can also look to the composition of total “Corporate and Foreign Bonds” issued to see the dominance of the financial sector, “structured finance,” and asset-backed securities. Of total first-quarter annualized bond issuance of $676 billion, the financial sector was responsible for 68% of issuance, or $458 billion annualized. ABS Issuers sold bonds at an annualized rate of $382 billion, compared to the fourth-quarter’s $213.7 billion and 2001’s first-quarter $211 billion. For comparison, ABS issuers sold $185 billion of bonds during 2001 and $75 billion during 2000. ABS bonds comprised 57% of total “Corporate and Foreign Bonds” issued during the first quarter, up from 26% during 1997, 19% during 2000, and 29% during 2001. Who purchased this slug of bonds during the first-quarter? The household sector (flush with cash from mortgage refi/home equity loans) acquired bonds at an annualized rate of $180 billion, life insurance companies at a rate of $131 billion, and mutual funds at $86 billion. The largest class of buyers, however, was the “Rest of World” that acquired bonds at an annual rate of $195 billion.

Foreign-sourced purchases (“Rest of the World”) of U.S. securities continued to be enormous, although the first-quarter’s annualized “net acquisition of financial assets” of $480.9 billion was down considerably from 2001’s $791 billion. The “Rest of World” (ROW) purchased (seasonally adjusted and annualized) $120 billion of agency securities and $195 billion of corporate bonds (which would include asset-backed securities) during the quarter. Since the beginning of 1998, ROW has increased holdings of agency securities by 200% to $746 billion. Over the same period, ROW increased U.S. equity holdings by 90% to $1.75 trillion, although first-quarter net equity purchases ran about 55% of 2001 purchases and only 36% of record year-2000 purchases. If foreign demand for agency securities or U.S. corporate bonds wanes (or heaven forbid they become net sellers of American equities or Credit instruments!), ramifications for U.S. financial markets and the dollar would be enormous.

During the two quarters since WTC, the GSEs, mortgage-backs, and asset-backed securities sectors (“structured finance”) combined to increase Credit at an annualized rate of just over $1 trillion. This was 95% of our economy’s total non-financial borrowings over the same period. In fact, combined annualized “Structured Finance” Credit market borrowings accounted for 106% of total U.S. non-financial borrowings during the first quarter. For comparison, this “Structured Finance Ratio” was 52% during 1997, 73% during 2000, and 84% during 2001. Let there be no doubt as to the profound role “Structured Finance” is playing in sustaining levitated U.S. asset prices, consumer borrowing and spending, and over-liquefied conditions throughout the U.S. Credit system.

Tuesday, Alan Greenspan, the European Central Bank’s Wim Duisenberg and Ernst Welteke, the Bank of Canada’s David Dodge, Bank of England’s Edward George, Bank of France’s Jean-Claude Trichet, and the Bank of Japan’s Yutaka Yamaguchi spoke at the 2002 International Monetary Conference. I have transcribed brief segments from the question and answer session, as I believe they are worthy of consideration and historical record. I find it amazing that, at this Point, Fed Chairman Greenspan has become the most outspoken champion of the bull case and unflinching proponent of the New Economy Point of view. Indeed, he sounds today more convinced of the New Paradigm than ever. And after reading his speeches and comments for years, I must admit that I have made zero progress in my efforts to determine if he is hopelessly misinformed as to the health of the system, or the Grand Master of Spin. My hunch is the latter, but I wouldn’t place any bets... To be sure, there is a great deal at stake if his Point of view proves fallacious.

Question: “Do members of the panel view the rising use of financial leverage in their economies as a factor which has fueled economic growth, and what limits there might be to increased leverage both in the household sector and the business sector, especially when you consider that there’s a lot off-balance sheet financing in the business sector; so the normal statistics might hide the amount of financial leverage that’s used Is this a concern...or put another way, is there a structural reason why this extra leverage is ok, or at some point will it cause a slowing down in growth?”

Greenspan: “I’ll speak for the United States. In the household sector, it is certainly true that debt as a ratio of disposable income has been rising quite considerably. Part of the problem in interpreting the previous, however, has been this really quite pronounced move toward home ownership. And as a consequence, you end up with the situation in which rent is displaced with debt and debt service charges. Disposable income, the denominator, obviously has not changed, so you get a higher ratio. To be sure, there is also the other side of that problem in which automobile leasing has taken on a fairly significant part of the American household consumption sector... Overall, if you make all the relevant adjustments, the degree of debt service burden on the American household is not historically high. It’s higher than it’s been, obviously. Then again, you’ve got the asset side of the household balance sheet, which has been moving up quite considerably, especially for those who own homes. And the degree of equity in the household sector has been rising materially, which enables those households to support levels of debt service over and above the income levels which essentially one thinks of for servicing them. So, I do think that its difficult to read the degree of stress in the household sector, but there’s a tendency, I think, to presume its much greater because some of the numbers do look pretty much outsized, until you look at the details and the combination of the increasing net equity of households plus the shift in forms in which activities take place suggests that while we are clearly in less flexible state than we were several years ago, we are nowhere near in a position where one can seriously state that debt constraints are going to materially restrict the growth rate.”

Duisenberg: “All I can say is that given the degree that Alan is, may I call it, playing down the leverage and risks associated with it for the United States, I’m inclined to do the same and play it down even further for the Euro-area for the very different structure of financing of both households and corporations in the Euro-area as compared to the United States.”

Question: “It appears today that the U.S. recession that began in March 2001 will have been the mildest in terms of GDP loss of any in the U.S. for the past 50 years. Despite two consecutive quarters of positive GDP growth, however, doubts remain with regard to the expansion’s strength and sustainability. Nonetheless, some investors and analysts are worried that inflation and currency risk have been underestimated in light of the impressive combination of the very low Fed funds rate and powerful fiscal expansion. Finally, admiration is universal for the striking U.S. productivity surge, but there is substantial uncertainty about the prospective case of productivity. How do you assess the U.S. economy’s prospects and the attendant risks?

Greenspan: “...in order to get a sense of where the U.S. economy is going, I think it is first important for us to understand how we managed to get through what was an extraordinary period the last 18 months and, as you put it, end up with the most narrow recession in 50 years and, indeed, there are obviously some people who are quibbling as to whether there was in fact a recession... What is important is that the United States economy exhibited a remarkable degree of flexibility and resiliency in the face of the types of shocks that in past history would have upended the economy, breached the fabric of confidence of both business and consumers and set us tumbling into a recession far deeper than anything we have obviously experienced in the most recent period.

The dramatic decline in stock prices in the United States starting in the early months of 2000 would ordinarily have had a very marked effect in the United States, more sensitive to asset value changes, as best we can judge, than our other economies with the possible exception of the sensitivity of the British economy to the residential capital gains issue. Yet, we experienced that with some difficulties, but essentially a reflection of the sharp declines in the rate of growth. And then, of course, we had the tragic events of September 11th, which for a very short period of time induced a very sharp contraction in economic activity in the United States. We came back really quite dramatically and, indeed, in the aggregate figures, which we publish on a quarterly basis, a goodly part of that change was obscured.

The question I think we have to ask ourselves is, how is it possible? What happened and what does that portend about the future of the American economic structure? First, we obviously have to ask and hopefully answer why were we able to do it when we were not in comparable periods in the past able of doing so? One clearly is the dramatic improvement in information technology, which I have argued elsewhere has been an extraordinarily important element in creating real-time reaction to economic imbalances. There is very little evidence that we as economic forecasters have improved our capacity to forecast very well, or very much better. But we are far more capable in the business sector of identifying and responding to economic imbalances before they deepen and fester into very difficult problems. And as a consequence of that, we are getting a degree of flexibility when shocks hit us, which we did not have previously.

The technology and, indeed, the deregulation that has occurred in the United States in the last twenty years, especially in the financial area, have also been a major contributor to the flexibility of the system. Indeed, it’s hard to remember the notions about derivatives, which were fairly negative as recently as a year ago. Yet, the experiences that we have had with the proliferation of derivatives, which, as you know, on the latest worldwide reading at notional values of $100 trillion. It means somebody found these things very useful. And indeed, we found looking at the pattern of the dispersion of risks, especially from financial intermediaries, during the period such as this, we ran into remarkably few dislocations. Indeed, even though credit derivatives are still a small element within the system, we are clearly aware of the importance that they have been in essentially dispersing risks beyond the initiator of the risk-taking. And we have had a really quite remarkable experience, especially in Europe, where there were these extraordinarily large loans that were made to telecommunications companies - that in excess of $1 trillion over a period of a couple or three years – and while a number of them were in very serious difficulty and, indeed, the carnage is all over the place. But they did not manage to undermine a major financial institution.

And the reason is that the advent of collateralized debt obligations and credit derivatives, basically enabled a dispersion of risks to those who did not have highly leveraged balance sheets and were able to absorb the losses in a materially easier way than those who in the past have found their capital under very severe strain. So that the system is clearly improving and I think in a permanent way. Once you have knowledge – once you have information technology – you cannot reverse it. So our capacity to respond to these things has materially improved. Now, I’m not going to say - because there are a lot of other issues involved which relate to the question of whether the United States is permanently in a more flexible and a posture for which we are not subject to shocks in the extent that we had been in [other] periods. There are other elements which are working in the other direction, and I often discuss them, namely the question of major change toward conceptualization of GDP which, without getting into the details, creates a higher degree of leverage than otherwise would be the case and makes the system subject to mistakes more readily than in the past.

How this all unwinds I am not sure, but one of the things I am reasonable sure of is that the very considerable improvement in productivity we have seen in the last, especially, six months - and there are questions about the data which I don’t think are a real problem - something fundamental is going on in our system which is remarkably improved: The underlying productivity growth in the economy, and that is going to be a materially positive factor for long-term growth.”

Well, I am not going to do my usual and ramble on for pages, but instead will try to keep my “Counterpoint” concise. In short, I don’t see how it would be possible for Alan Greenspan to adopt more flawed analysis, although we all should hope he is proved correct. The resiliency of the U.S. economy is not due to “something fundamental going on in our system, which is fundamentally improved.” We surely don’t buy into the productivity story, not for a consumption and import-based de-industrialized “service sector” economy – no way. And we certainly don’t accept that there has been some miraculous fundamental improvement over the past six months; not with profits and capital spending in virtual collapse, while surging government spending, a Bubbling housing sector, and a strong “service” sector have been responsible for increased “output.” We are similarly no fans of New Age notions of the “conceptualization of GDP.” (For one, it reminds us too much of Enron, Tyco, and the like). When this long period of Credit excess wanes, we will be left facing the harsh reality that a significant amount of “output” that finds its way into GDP and productivity calculations is tied specifically to financial excess and consequent asset inflation. Our incredibly “productive” service sector (real estate agents, appraisers, securities brokers, insurance salespeople, investment professionals, attorneys, accountants, consultants, media participants, athletes and entertainers, chefs, auto and retail salespersons, etc.) will not appear so impressive with the bursting of the Credit Bubble. We tend to believe the issue is more accurately described in terms of the “quantification in GDP of inflationary Credit creation.”

The responsibility for the resiliency of “output” lies with a financial system that has thus far sustained extreme Credit excess, and this view is strongly supported by the Fed’s own “flow of funds” data detailed above. “Why were we able to do it when we were not in comparable periods in the past able of doing so?” Because never in history has a financial sector enjoyed the completely unconstrained capacity for creating “money” and “safe” securities. Never before has there been such a gigantic captive audience of aggressive financial speculators, reacting immediately to Fed-orchestrated rate cuts with powerful tools for leveraging and liquidity creation. Never before has there been such a monetary, asset-based economy, where Credit inflation manifestations are interpreted as wealth creation. Never before has excess gone to such extremes for a protracted period without the Credit mechanism coming under restraint from market forces or buckling under the impairment of mounting loan and speculative trading losses. Never before has a fiat international reserve currency so dominated the global monetary regime.

And after witnessing an historic episode of reckless borrowing and spending excess throughout corporate America (especially in the telecom and technology sectors), it is simply not credible to commend the “business sector [for] identifying and responding to economic imbalances before they deepen and fester into very difficult problems.” Our attention, again, would be directed to the financial sector, where we are convinced that unrelenting lending and speculative excess is encouraging systemic rot to “deepen and fester.” We saw this dangerous dynamic with the telecom/technology Bubble, and we are witnessing it today in mortgage finance. When it is obvious that things are going to problematic excess, somehow the speculation-based Credit system only then floods the booming sector with a “terminal” bout of extreme over-liquidity (and the bullish spin plays right along). What Dr. Greenspan erroneously interprets as “flexibility” and “resiliency” is, regrettably, in reality only uncontrolled Credit creation, with a dangerous propensity for excess that has thus far only postponed the inevitable Day of Reckoning.

Considering the extreme nature of the boom and bust dynamics we have experienced throughout equity, corporate bond, and energy markets (and elsewhere), one would hope that there would be today some questioning as to the role derivatives have played in fostering reckless lending, endemic overleveraging, speculative excess, and wildly unstable market conditions. Instead, Alan Greenspan has somehow become an even stronger proponent of derivatives and structured finance. This is simply astonishing, and does lend support to the quite minority view that our Fed Chairman is delusional. Ironically, he this week boasted of how successful derivatives have been in “dispersing” risk away from the “leveraged” institutions. We are of the view that, if truth be told, this dispersion has been anything but as effective as Greenspan envisages, and mounting losses are in the process of coming home to roost. At the minimum, that some Credit losses have thus far been offset by his unprecedented rate cuts is no grounds for overconfidence – precisely the opposite. The resulting extreme Credit and speculative excess only sets the stage for inevitable market dislocation and much larger losses down the road. And there is little room left for lower rates. We are now in an environment especially susceptible to an accident.

During the past 5 years (plus one quarter), asset-backed security issuance has increased from $855 billion to almost $2.2 trillion. Nowhere has the intermediation process of transforming risky loans into “safe” securities been seemingly more successful. Demand for these securities has been unrelenting, as aggressive foreign purchases have played an instrumental role in “recycling” our massive trade deficits. Many of the trusts that issue ABS are domiciled in offshore financial centers. Many incorporate sophisticated structures, along with Credit insurance/default swap protection, liquidity protection, and other derivatives protection. We would be surprised if myriad losses are not accumulating in this arena, with counterparty issues an increasing concern. It has been our fear that this sector is susceptible to fomenting a derivative-related market dislocation. We would suspect that many ABS trusts catering to foreign players are structured with protection against a declining dollar (one of the reasons they have proved so popular). We would also expect that many foreign-sourced financial players with large ABS holdings have a strategy of hedging against a declining dollar. We will stick with our belief that there are huge and growing losses in the system thus far unrecognized. We also believe that recent Credit and dollar losses only exacerbate the overhang of risk that speculators and derivative players are now eager to offload to someone else. The murky world of asset-backed securities and “structured finance” is certainly one place where we suspect significant problems are festering, with ramifications for the U.S. financial sector and dollar.

We will conclude with a final exchange from this week’s International Monetary Conference.

Question: “I wonder if the governments believe we can now look forward to decade of low inflation. And if they have doubts, what are the main changes that they would like to see to secure low inflation over the long-term.

Greenspan: “I think anyone who feels confident about projecting a decade-long inflationless world economy is treading on very precarious grounds. The ability to forecast the upsurge of inflationary forces is not all that impressive. Inflation comes upon you regrettably by stealth in the beginning. And when you are acutely aware of its existence, it’s a very difficult thing to handle, as our experience too often has demonstrated. It’s therefore important, I think, for central banks to be focused on making certain that the base of the system - the degree of liquidity and the confidence in the purchasing power of currency - be sustained. We can only maintain policies which lower the probabilities of inflation reemerging. But there are always events over which central banks do not have control that can occur, which can emerge that can create difficulties. I think we all try assiduously to keep in mind that [with] fiat currency throughout the world as we do, inflation is the bias more profoundly than deflation. And as a consequence of that, and even though both are possible, it is important to maintain a policy which tries to create a platform in which stable prices persist and they can be self-generating if monetary policies throughout the world are correctly formulated. I guess one can say the last decade has been pretty good. If we become complacent as a consequence of that, I fear we are treading on dangerous ground.”

This is one response we take no issue with, although we do ponder how Greenspan can remain so complacent of financial fragility as the U.S. financial system rattles beneath him.