| Just when everyone was getting all bulled up… For the week, the Dow sank 3% and the S&P500 declined 2%. Economically sensitive issues were slammed, with the Transports down 5% and the Morgan Stanley Cyclical index declining 4%. The Utilities gained 1%, while the Morgan Stanley Consumer index slipped 2%. The broader market was under moderate selling pressure at week’s end. For the week, the small cap Russell 2000 and S&P400 Mid-cap indices declined 2%. The NASDAQ100 dropped 2.4%, although technology stocks generally held their own. The Morgan Stanley High Tech, Semiconductors, and NASDAQ Telecommunications indices slipped about 1%. The Street.com Internet index fell 2.5%. The Biotechs declined 1.5%. The financials were mixed but generally resilient. The Broker/Dealer index surged 4%, while the Banks declined 1%. Although bullion added $2.10 to $439.95, the HUI Gold index declined 1.5% this week. Buying returned to global bond markets with a vengeance, led by collapsing European bond yields. For the week, two-year Treasury yields fell 11 basis points to 3.58%. Five-year government yields sank 16 basis points, ending the week at 3.70%. The 10-year Treasury yield dropped 15 basis points for the week to 3.92%. Long-bond yields declined 14 basis points to 4.22%. The spread between 2 and 30-year government yields declined 2 to 64. Benchmark Fannie Mae MBS yields sank 13 basis points. The spreads (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note was unchanged at 31, and Freddie’s 5% 2014 note was unchanged at 30. The 10-year dollar swap spread declined 1.25 to 39.75. Corporate bonds continue to trade well, although auto bond and CDS markets were somewhat on the defensive. Junk bond spreads widened slightly. The implied yield on three-month December Eurodollars dropped a notable 10 basis points to 3.855%. Corporate issuance surpassed $21 billion for the strongest week of sales in five months. Investment grade issuers included GM's Residential Capital $4.0 billion (up from $3.5bn), Goldman Sachs $3.0 billion (up from $2.5bn), MetLife $2.0 billion, HSBC $2.0 billion, IBM $1.5 billion, Bear Stearns $1.0 billion, Pricoa Global Funding $475 million, American General $400 million, Southern Cal Edison $350 million, Marshall & Ilsley $350 million, Kansas Gas & Electric $320 million, Public Service Electric & Gas $250 million, Reckson $250 million, Southwestern Electric Power $150 million, and Con Edison $125 million. Junk bond fund reported inflows of $56.3 million (from AMG). Junk issuers included Qwest Communications $800 million, RJ Reynolds $500 million, Goodyear $400 million and Chiquita Brands $225 million. Convert issues included Calpine $650 million, GSC Capital $85 million and Evergreen Solar $75 million. Foreign dollar debt issuers included Abbey National $2.0 billion, Brazil $1.6 billion, KFW $1.0 billion, Hynix Semiconductor $500 million, Banco BMG $175 million, Eletropaulo $200 million and Ocean Rig Norway $150 million. June 24 – Bloomberg (Steve Rothwell): “German 10-year government bonds rose, pushing yields to a record low, on speculation the European Central Bank will lower interest rates this year to help spur growth in the dozen economies using the euro. The yield on the German 10-year bund fell 2 basis points…to 3.13 percent… It fell as low as 3.10 percent earlier today, the lowest since Bundesbank records began in 1973.” Japanese 10-year JGB yields dropped 10 basis points this week to 1.20%. Emerging debt markets were mixed. Brazilian benchmark dollar bond yields jumped 8 basis points to 7.72%. Mexican govt. yields ended the week down 9 basis points to 5.34%. Russian 10-year dollar Eurobond yields dipped 4 basis points to 6.00%. Freddie Mac posted 30-year fixed mortgage rates declined 6 basis points to 5.57%, down 68 basis points from one year ago. Fifteen-year fixed mortgage rates fell 6 basis points to 5.20%. One-year adjustable rates dipped 2 basis points to 4.23%. Reversing much of last week’s big gain, the Mortgage Bankers Association Purchase Applications Index declined 9.4%. Yet Purchase applications were up 6% compared to one year ago, with dollar volume up almost 17%. Refi applications dropped 13.2%. The average new Purchase mortgage dipped to $241,300. The average ARM declined to $347,900. The percentage of ARMs slipped slightly to 30.7% of total applications. Broad money supply (M3) rose $16 billion to $9.70 Trillion (week of June 13), with a notable four-week gain of $80 billion. Year-to-date M3 growth has accelerated to a 5.1% growth rate, with M3-less Money Funds expanding at a 6.7% pace. And I suggest caution for those analysts associating stagnant MZM (“money of zero maturity”) growth with economic weakness. While MZM components include the shrinking money market funds (disintermediation), they do not include Large Time Deposits which have been expanding at an almost 30% pace so far this year. Nor does MZM incorporate the surge in CP borrowings and ABS issuance, or the continued rapid growth in “repos.” Clearly, even accelerating M3 growth is not indicative of the ongoing rapid Credit expansion. For the week, Currency added $0.2 billion. Demand & Checkable Deposits declined $16.5 billion. Savings Deposits slipped $3.9 billion. Small Denominated Deposits increased $4.1 billion. Retail Money Fund deposits added $0.4 billion, and Institutional Money Fund deposits jumped $15.1 billion. Large Denominated Deposits rose $17.4 billion. For the week, Repurchase Agreements declined $4.9 billion, while Eurodollar deposits increased $4.4 billion. Bank Credit declined $46.2 billion last week, reducing the year-to-date expansion to $406.2 billion, or 13.0% annualized. Interestingly, Securities Credit sank $85.5 billion during the week, with the year-to-date gains dropping to $71.7 billion (8.1% ann.). Loans & Leases have expanded at a 15.0% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 19.5%. For the week, C&I loans added $7.6 billion, and Real Estate loans rose $10.5 billion. Real Estate loans have expanded at a 15.4% rate during the first 24 weeks of 2005 to $2.72 Trillion. Real Estate loans were up $329 billion, or 13.8%, over the past 52 weeks. For the week, Consumer loans added $1.2 billion, while Securities loans gained $3.9 billion. Other loans jumped $16.2 billion. Total Commercial Paper jumped $7.0 billion last week to $1.546 Trillion. Total CP has expanded $131.7 billion y-t-d, a rate of 19.4% (up 16.8% over the past 52 weeks). Financial CP surged $11.3 billion last week to $1.397 Trillion, with a y-t-d gain of $112.5 billion (18.2% ann.). Non-financial CP declined $4.3 billion to $148.7 billion (up 30.8% ann. y-t-d and 22% over 52 wks). ABS issuance jumped to a booming $23 billion (from JPMorgan). Year-to-date issuance of $361 billion is 26% ahead of comparable 2004. At $228 billion, y-t-d home equity ABS issuance is 33% above the year ago level. Fed Foreign Holdings of Treasury, Agency Debt were about unchanged at $1.437 Trillion for the week ended June 22. “Custody” holdings were up $100.8 billion, or 15.7% annualized, year-to-date (up $213bn, or 17.4%, over 52 weeks). Federal Reserve Credit was about unchanged at $787.9 billion. Fed Credit has declined 0.7% annualized y-t-d (up $39.4bn, or 5.3%, over 52 weeks). International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi - were up $580 billion, or 18.0%, over the past 12 months to $3.815 Trillion. China’s foreign reserves rose $20.2 billion during May to $691 billion, with a one-year rise of $232 billion (51%). Currency Watch: The dollar index gained better than 1%. On the upside, the Mexican peso added 0.5%, the Turkish lira 0.4%, and the Chilean peso 0.2%. On the downside, the Swedish krona was hit for 3.3%, the Norwegian krone 2.4%, New Zealand dollar 1.7%, Danish krone 1.6%, and the euro 1.5%. Commodities Watch: June 23 – Financial Times (Darrly Thomson): “The copper market is threatening to turn disorderly as stockpiles, which are at 30-year lows, drive prices into uncharted territory. Anyone with $113.5m to spare could buy up all the stock on the books of the London Metal Exchange, even at Monday’s record high of $3,435 a tonne. About 95 per cent of the world’s copper is traded on the LME. ‘Given the pace at which stock is coming off the LME, it is not inconceivable that within the next couple of months, there might be no inventory left,’ Nick Moore of ABN Amro warned. ‘Would we then have a disorderly market?’” June 24 – Bloomberg (Wing-Gar Cheng and Xiao Yu): “China, which accounted for 32 percent of global oil demand growth last year, increased imports 8.2 percent in May as local production failed to meet soaring demand, boosting prices to records. China’s oil imports in May rose to 10.4 million metric tons…” June 23 – AP: “China will start filling its first strategic petroleum reserve this year, state television said Thursday amid efforts to ensure energy supplies for the country’s booming economy. Plans call for China to build groups of storage tanks at four locations… The reserve is meant to cushion China against possible interruptions of foreign supplies. Previous reports said Beijing plans to stockpile up to 100 million barrels of petroleum, or the equivalent of almost a month’s national consumption.” June 21 – Bloomberg (Koh Chin Ling): “China, the world’s biggest textile exporter, may process 20.5 million metric tons of chemical fibers such as polyester and rayon by 2010, 18 percent more than in 2005, the China Chemical Fiber Association forecast. Chinese textile makers may handle 17.4 million tons of synthetic fibers this year, compared with 15.57 million tons last year…” June 20 – Bloomberg (Koh Chin Ling): “China, the world’s biggest cotton producer and consumer, may increase imports of the fiber by more than 60 percent in the year starting Sept. 1 on rising demand from textile makers and a declining crop. The country may need to import 2.7 million metric tons of cotton in the next marketing year…” June 24 – Bloomberg (Jason Gale): “Sugar prices, which have risen 21 percent in New York the past year, may hold gains in 2005-06 amid signs of a global supply shortfall, F.O. Licht said. Smaller cane crops in China, Thailand and Cuba, will probably lower global production to the equivalent of 143.5 million metric tons of raw sugar in the year ending Sept. 30, compared with 143.7 million tons a year earlier…” August crude oil added 66 cents to $59.84. Corn, wheat and soybeans were strong on weather concerns. For the week, the CRB index rose 0.4%, increasing y-t-d gains to 10.0%. The Goldman Sachs Commodities index added 0.3%, with 2005 gains rising to 27.9%. China Watch: June 22 – Bloomberg (Nerys Avery): “Chinese industrial companies’ profits grew at a faster pace in May, led by gains in earnings at metals and energy companies. Combined net income grew 15.8 percent from a year earlier to 497 billion yuan ($60 billion) in the first five months of 2005… That followed a 15.6 percent increase for the first four months…” June 23 – Bloomberg (Allen T. Cheng): “Cisco Systems Inc., the world’s largest maker of computer networking equipment, said it plans to increase production in China to 40 percent of its combined output to cut costs. Of the company’s total production in 2004, 25 percent, worth $5 billion, was made in China, the company said…” Asia Boom Watch: June 22 – Bloomberg (Theresa Tang): “Taiwan’s jobless rate stayed at a four-year low in May as government efforts to spur hiring helped counter the impact of manufacturers moving factories to China. The seasonally adjusted jobless rate was 4.2 percent for a third straight month…” June 23 – Bloomberg (Theresa Tang): “Taiwan’s export orders rose in May at the slowest pace in more than a year because high oil prices left consumers and companies in China and the U.S., the island’s biggest overseas markets, with less to spend. Orders -- indicative of shipments in one to three months -- rose 13 percent from a year earlier to $19.5 billion after climbing 15 percent in April…” June 20 – Bloomberg (Chan Tien Hin): “Vehicle sales in Malaysia, Southeast Asia’s biggest passenger car market, rose for a 16th straight month in May, gaining 17 percent…” Unbalanced Global Economy Watch: June 23 – Dow Jones: “New investments by U.S. companies overseas reached a record high of $252 billion in 2004, up from $141 billion in 2003, the Organization for Economic Cooperation and Development said… The U.S. once again became the main destination for overseas investments by non-U.S. companies, attracting $107 billion in inflows, up from $67 billion in 2003.” June 21 – Dow Jones (Don Curren): “Unexpectedly strong Canadian retail sales data for April show a domestic economy that continues to flourish in the benign interest-rate environment provided by the Bank of Canada. As reported earlier Tuesday, retail sales in Canada rose by 1.5% from March, dramatically outpacing the expected 0.5% increase…” June 21 – Market News: “Total hourly labor costs in the 12-nation eurozone rose unexpectedly strongly by 3.1% y/y in 1Q after a revised +2.5% y/y in 4Q (vs +2.4%), Eurostat reported Tuesday. The 1Q rate for the entire economy thus rose to the highest level since the first quarter of 2004 (also +3.1%).” June 22 – Bloomberg (Marco Bertacche): “Italian retail sales fell the most in 11 months in April, indicating weak consumer spending is holding back growth after Europe’s fourth-largest economy slipped into recession in the first quarter. Retail sales fell a seasonally adjusted 0.8 percent from March… Sales shrank an unadjusted 3.9 percent from a year earlier, the steepest decline in at least nine years.” June 22 – Bloomberg (Tasneem Brogger): “House prices in Copenhagen have surged as much as 20 percent in the second quarter compared with a year earlier, Berlingske Tidende said… House prices in the greater Copenhagen area have on average risen by 1,100 kroner a day ($180), the Copenhagen-based newspaper said. The average price for a house in Copenhagen is now 2.85 million kroner, 400,000 kroner more than a year ago. Prices have risen 15 percent to 20 percent in some parts of the capital.” June 21 – Bloomberg (Hugo Miller): “Swiss watch exports rose 29 percent in May from a year earlier as wealthy consumers in China, Hong Kong and the U.S. snapped up more luxury watches from manufacturers including Swatch Group AG and Cie Financiere Richemont AG.” June 22 – Bloomberg (Halia Pavliva): “Russia’s inflation rate may exceed 11.5 percent this year, more than the government's 10 percent target, because food prices are rising faster than planned, Andrei Klepach, director of economic forecasting at the country's Economy Ministry, said…” June 20 – Bloomberg (Halia Pavliva): “Russia’s economy grew an annual 5.2 percent in the first three months of the year, the slowest rate in almost three years, as oil production sputtered and investment declined.” June 23 – Bloomberg (Tracy Withers): “New Zealand’s taxation collection figures for May were released… They showed the total collected in the 11 months ended May 31 was NZ$46.42 billion ($33.2 billion). That’s 10.6 percent more than the year earlier.” June 23 – Bloomberg (Tracy Withers): “New Zealand’s current account deficit widened to a record in the year ended March 31 as a surging economy buoyed demand for imports and fueled earnings of foreign-owned companies. The annual gap widened to NZ$10.35 billion ($7.4 billion), or 7 percent of gross domestic product…” Latin America Watch: June 21 – Dow Jones: “Retail sales in Mexico rose twice as fast as expected in April as the consumer sector continued to fuel economic growth going into the second quarter. The National Statistics Institute…said Tuesday that retail sales rose 8.9% from April 2004, more than double the 4.1% estimate…” June 16 – Bloomberg (Daniel Helft): “Argentina’s economy grew for a ninth straight quarter at the beginning of the year, led by exports. Gross domestic product expanded 8 percent in the first quarter from a year earlier after growing 9.1 percent in the fourth quarter of 2004.” June 20 – Bloomberg (Andrea Jaramillo): “Colombia’s retail sales jumped 16.3 percent in April, to the highest level in at least five years, as a growing economy and improved public safety led to a rise in consumer spending.” Dollar Consternation Watch: Comments made on Bloomberg Television by Steven Roach: “The dollar call is a very, very tricky one. This is the fourth up-trade in a three-year plus downtrend in the dollar. And like the other three, I think this one will be short lived. I think the big call on the dollar, given our current account deficit, is down, down, down. And once global investors, whether they are central banks or private portfolio investors, perceive this ongoing currency risk they will demand to be compensated for taking that risk and push U.S. rates higher.” “If the dollar’s structural decline is over and starts to rise from here, that will put more pressure on U.S. real interest rates to fix America’s current account problem. It means that any rally in our long-term interest rate structure will be short-lived and the next move will be higher and possibly significantly higher. We’ve got to fix our current account problem.” “The most positive case (for the U.S. economy) is that we have an irresponsible, reckless monetary policy that is keeping real interest rates artificially low and we’re fooling asset-dependent American consumers to keep on binge-buying.” ”What’s the Fed doing. They’ve got the funds rate up to 3%. The forward-looking inflationary expectations from the University of Michigan is 3%. The funds rate is zero. Don’t give the Fed all this credit. They have taken rates from negative to zero. They’re still providing a lot of candy for the carry trade and all these other speculative activities that are keeping the U.S. economy afloat artificially… The degree of liquidity that the Federal Reserve Board is injecting into the U.S. and global economy right now with its unconscionably accommodative monetary policy is a very dangerous long-term development. It will give us a little bit more time, but we're living on borrowed time and that’s a dangerous way to run any country… The Fed’s got to be tough. We need a guy like Paul Volker at the Fed who’s not afraid to put the real interest rate to a level that deals with the excesses of U.S. financial markets and the economy… We have a politically independent central bank. We need politically independent central bankers. That’s what’s missing right now… I would like the Fed to get real on the real federal funds rate and take it to a level that helps us deal with our biggest imbalance we’ve ever had, this massive record current-account deficit. This is an unconscionable excess in the U.S. for a central bank to pretend is not a problem.” (An adept and outspoken analyst after my own little analytical heart.) June 22 – Market News: “(ECB President Jean-Claude) Trichet called global imbalances resulting from high current account deficits of most of the industrialised countries -- especially the US -- a ‘major risk’ to global growth, saying that ‘this is no time for complacency and that we currently find ourselves in a challenging situation.’ ‘The global economy is expanding at a comfortable pace, but there are large global imbalances, which have actually widened in recent years. These imbalances involve the industrialised countries as a whole, which have a large aggregate current account deficit and amongst them, more particularly, the United States, whose current account deficit has reached levels not seen before. The increase in the current account in recent years has occurred against the background of a decline in national savings, in turn attributable to rising budget deficits and a household savings rate that has fallen to levels not far above zero.’ ‘The financing of the current account deficit ... takes place largely through Asia. Central banks in the region have been intervening heavily for various reasons ... and they have become large-scale purchasers of US debt securities in recent years. While the current situation is rationalised by some observers, in particular as it supports strong growth in both regions and smoothes the adjustment path, it clearly raises questions regarding the sustainability of recent developments and associated policies.’” Bubble Economy Watch: June 23 – Financial Times (Christopher Swann ): “Since 1974 US lawmakers have created about 20 separate tax breaks to encourage Americans to squirrel away more of their money. Yet over this time Americans have gone from saving about 10 per cent of their disposable income to saving less than 1 per cent. According to the latest data, Americans save as little as 40 cents for every $100 of disposable income.” June 20 – The Wall Street Journal (Joseph Schuman): “Alan Greenspan recently described the U.S. housing market as a ‘collection of only loosely connected local markets’ that have no direct pricing relationships and therefore harbor little national risk of a bubble. But what if the bubbles proliferate enough to make one big foamy mess? The most overheated local housing areas in the U.S. -- 22 major metropolitan markets -- now account for 35% of the value of the country’s residential real estate, such a large chare of the total market that a sharp fall in their values could stall or slow national economic growth… That share of the national real-estate market -- for just a fifth of the U.S. population -- has risen quickly, according to the data from the Federal Deposit Insurance Corp. In 2000, the 22 markets accounted for 27% of all U.S. residential real estate. In 1995, the figure was 24%. Some economists -- backing Federal Reserve Chairman Greenspan -- say local bubbles are less worrisome than a nationwide one because they are more likely to pop individually, in response to local events, reducing the national fallout. But the latest data suggest that real-estate values in these 22 markets are getting so large that the distinction between them and the national market could become meaningless…” June 21 – Bloomberg (Kristen Hallam): “Americans with private health insurance got no reprieve from cost increases last year as medical expenses for each person rose 8.2 percent, roughly the same rate of increase as 2003… The annual increase in health spending peaked at 11.3 percent in 2001 and has leveled off at a high rate, the study by the Center for Studying Health System Change.” June 24 – Bloomberg (Liz Willen): “Boston University Athletic Director Warren Dexter smiles as he surveys the scene in the school’s new $100 million, five-level recreational center one morning in May. About 18 students soak in the heated whirlpool, while others jog against the current in the ‘lazy river,’ a churning channel of water. Professors in their 70s swim laps in the 16-lane pool. A line of rock climbers forms near the 35-foot-tall artificial mountain… The BU gym is among hundreds of luxurious new amenities rising on U.S. college campuses -- and few of these projects are directly related to education.” June 22 – Bloomberg (Alan Katz and Miles Weiss): “NetJets Inc. Chief Executive Officer Richard Santulli can’t buy enough corporate planes to meet the needs of companies and rich fliers. He’s ordered 98 aircraft for next year to add to a fleet of 562, and is still looking. ‘I’d like to have, say, 20 more,’ says Santulli, whose… company is owned by billionaire Warren Buffett’s Berkshire Hathaway Inc. and is the world’s biggest buyer of business aircraft. ‘I just can’t find them.’ NetJets, which sells time-shares in planes, had to charter 150 extra aircraft to meet client demand on New Year’s Eve, up from about 60 in previous years, Santulli says.” June 21 – PRNewswire: “Organizers of the World Series of Poker, the richest sporting event on the planet, today predicted the total prize pool at this year’s tournament will reach $100 million, more than doubling the record the event set just a year ago.” Speculative Finance Watch: June 24 – Bloomberg (Amy Strahan): “U.S. banks took in $4.4 billion of revenue from trading derivatives and other contracts in the first quarter, double the previous quarter’s amount, as they took on more risk at the start of the year… Trading revenue from derivatives doubled from $2.2 billion in the fourth quarter of 2004, according to the Office of the Comptroller of the Currency… ‘Their appetite for risk is greater at the beginning of the year, so we’re not surprised to see high first-quarter revenues,’ said Kathryn Dick, the agency’s deputy comptroller for risk evaluation. The previous record for trading revenue was $3.9 billion in the first quarter of 2001…” Mortgage Finance Bubble Watch: Existing Home sales were down slightly from April’s booming rate to 7.13 million annualized units. Average (mean) Prices were up $6,000 from April to a record $260,000. With y-o-y prices up 10.2% and volume up 3.5%, Existing Homes Calculated Transaction Value (CTV) was up 14% from one year ago to a record $1.854 Trillion. CTV was up 47% over two years, 67% over three years, and 113% over six years. May New Homes Sales were up from April to a near record 1.298 million annualized pace. Average (mean) Prices were down slightly from April to $281,400. Year-to-date New Home Sales are running 5% above last year’s record pace. With prices up 8.1% and volume up 4.4%, New Homes CTV was up 12.8% to $365.3 billion. CTV was up 39% over one year, 65% over three years, and 119% over six years. Combined New and Existing Home y-t-d sales are running 6.5% above last year’s record pace. Combined May CTV was up 13.8% from one year ago to a record $2.22 Trillion, with y-t-d CTV running 17% above last year’s record. Freddie Mac expanded its “Book of Business” $19.6 billion, or 15.2% annualized during May to $1.568 Trillion. This was the strongest one-month growth since June 2004, with the two-month increase ($20.3bn) the largest since Oct./Nov. 2003. The Book of Business has now expanded at a 10% rate y-t-d. Freddie’s Retained Portfolio expanded at an 11% rate to $668.1 billion, with y-t-d growth at a 5.6% pace. Holdings of “private-label” MBS jumped a notable $9.0 billion during the month. Outstanding Freddie MBS has expanded at a 23.2% rate so far this year. June 22 – Wall Street Journal (James R. Hagerty): “Standard & Poor’s Ratings Services, responding to a loosening of mortgage-lending standards, said the risks of defaults are growing for some types of home loans. The ratings concern… announced a tightening of its criteria for assessing the risks of certain types of home loans that are bundled into mortgage-backed securities for sale to investors. The tightening applies to so-called option adjustable-rate mortgage loans, known as option ARMs. Such loans allow borrowers lots of flexibility to reduce their initial monthly payments. The loans have surged in popularity in recent months, largely because rapidly rising house prices have made it more difficult for many Americans to afford homes, and the high prices have led buyers to seek ways to hold down monthly payments… Option ARMs give borrowers several choices each month. They can make payments that cover the interest and chip away at the principal. They also can make payments of only the interest due that month. Or they can make minimum payments that don’t cover all of the interest due; in that case, the loan balance increases, or ‘negatively amortizes…’Eventually, though, the borrower must pay off both the interest and the principal, and monthly amounts due can soar if interest rates rise and the borrower has paid minimal amounts in the early years of the loan. Michael Stock, an analyst at S&P in New York, said some borrowers will face rises in their monthly payments of 50% to 90%.” June 22 – New York Times (John Holusha): “The demand by investors seeking to acquire office space in Manhattan remains intense, especially for properties in Midtown. With the first half of the year almost over, the dollar value of sales of commercial property is on a pace for the best year ever, exceeding even the record level of 2004, when $15.1 billion worth of buildings changed hands… ‘A banner year used to be in the $10 billion range,’ said Scott Latham, an executive director of Cushman & Wakefield… ‘Last year, we were 50 percent above that.’ The company estimates that $12.67 billion of property was sold through mid-June. If current trends continue, 2005 will far exceed last year’s total. Office rents in Midtown Manhattan have recovered almost to the peak levels of early 2001, providing some rationale for the lofty sales prices.” June 21 – BusinessWire: “Keller Williams Realty Inc., the fifth-largest and fastest growing residential real estate company in North America, continues on a record-breaking growth pace in the first quarter of 2005. Keller Williams Realty's agent roster grew to 42,691 associates across the United States and Canada -- a 50 percent increase from the first quarter of 2004. This marks the third consecutive year that the company’s growth has averaged more than 50 percent.” Thinking Minsky: “Capitalism is essentially a financial system, and the peculiar behavior attributes of a capitalist economy center around the impact of finance upon system behavior.” Hyman Minsky, “Financial Intermediation in the Money and Capital Markets,” 1967 “The financial structure of the American economy has undergone significant evolution over the history of the republic. In the initial era of commercial capitalism, external finance was used primarily to facilitate commerce by financing goods in process or in transit. The present period, in contrast, is one of money-manager capitalism, where financial markets and arrangements are dominated by institutional investors.” Hyman Minsky, “Economic Insecurity and the Institutional Prerequisites for Successful Capitalism,” Journal of Post Keynesian Economics, Winter 1996/97 “Looking at the economy from a Wall Street board room, we see a paper world – a world of commitments to pay cash today and in the future. These cash flows are a legacy of past contracts in which money today was exchanged for money in the future. In addition, we see deals being made in which commitments to pay cash in the future are exchanged for cash today. The viability of this paper world rests upon the cash flows…that business organizations, households, and governmental bodies, such as states and municipalities, receive as a result of the income-generating process. The focus will be on business debt, because this debt is an essential characteristic of a capitalist economy.” (p. 63) “Central Banking has always been a major determinant of what is known with certainty, what is probable, and what is purely conjectural in financial markets. The evolution and development of central banking has not been solely a reaction to an independently-evolving financial structure, but has been also a determinant of this evolution.” Hyman Minsky, “The New Uses of Monetary Power,” 1969 “It should be noted that [the] stabilizing effect of big government has destabilizing implications in that once borrowers and lenders recognize that the downside instability of profits has decreased there will be an increase in the willingness and ability of business and bankers to debt-finance. If the cash flows to validate debt are virtually guaranteed by the profit implications of big government then debt-financing of positions in capital assets is encouraged.” Minsky, “Inflation Recession and Economic Policy,” 1982 (p. 43) “As the period over which the economy does well lengthens, two things become evident in boardrooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event it becomes apparent that the margins of safety built into debt structures were too great. As a result, over a period in which the economy does well, views about acceptable debt structure change. In the deal-making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activities and positions increase. This increase in the weight of debt financing raises the market price of capital assets and increases investment. As this continues the economy is transferred into a boom economy… Innovations in financial practices are a feature of our economy, especially when things go well… In our economy, it is useful to distinguish between hedge and speculative finance.” “Inflation Recession and Economic Policy,” (p. 66) “Three financial postures for firms, households, and government units can be differentiated by the relation between the contractual payment commitments due to their liabilities and their primary cash flows. These financial postures are hedge, speculative, and ‘Ponzi.’ The stability of an economy’s financial structure depends upon the mix of financial postures. For any given regime of financial institutions and government interventions, the greater the weight of hedge financing in the economy, the greater the stability of the economy whereas an increasing weight of speculative and Ponzi financing indicates an increasing susceptibility of the economy to financial instability.” Hyman Minsky, Finance and Profits: The Changing Nature of American Business Cycles, 1980 (Simplifying the analysis, a hedge unit enjoys cash inflows above contractual payment commitments in all periods. A speculative financing unit’s cash flows are positive in most periods, although the unit must speculate that additional finance will be available for those occasional deficit periods. A Ponzi unit lacks sufficient cashflows to service its debt. Its debt level must increase to successfully meet its commitments, irrespective of income generating capacity.) “Viability of a representative Ponzi unit often depends upon the expectation that some assets will be sold at a high enough price some time in the future.” “The debt structure is a legacy of past financing conditions and decisions. The question this analysis raises is whether the future profitability of the business sector can support the financial decisions that were made as the current capital-asset structure of the economy was put into place.” “Inflation Recession and Economic Policy,” (p. 25) “For speculative and especially for Ponzi finance units a rise in interest rates can transform a positive net worth into a negative net worth. If solvency matters for the continued normal functioning of an economy, then large increases and wild swings in interest rates will affect the behavior of an economy with large proportions of speculative and Ponzi finance.” “Inflation Recession and Economic Policy,” (p. 29) “The big conclusion of these papers (combined in “Inflation, Recession and Economic Policy”) is that the processes which make for financial instability are an inescapable part of any decentralized capitalist economy – i.e., capitalism is inherently flawed – but financial instability need not lead to a great depression; ‘It’ need not happen…” The brilliant Hyman Minsky viewed Capitalism as “a dynamic, evolving system… Nowhere is this dynamism more evident than in its financial structure.” He saw long periods of stability as breeding grounds for increasingly destabilizing behavior. Economic agents progressively reach for profits, risk and leverage, in the process constructing more fragile debt structures. When he died in 1996 he had spent much of his life hypothesizing as to whether the financial backdrop could reach a sufficiently fragile state where “It” (a depression) could happen again. If only he had lived another decade. I have proposed a “Minskian” evolution from Money Manager Capitalism to “Financial Arbitrage Capitalism.” Command over the Credit system – hence the “capitalist economy” – has shifted away from “corporate boardrooms” and “institutional investors” to investment bankers, derivative players, and the “leveraged speculating community.” Moreover – and in a momentous departure from Minsky’s era – the consumer loan has become the locus for system Credit creation, supplanting business borrowing to finance capital investment. Thinking Minsky, one can confidently suggest that such historic financial system change provides monumental implications for the nature of both economic development and system stability. The current environment is remarkable in so many ways. For one, many knowledgeable and seasoned analysts speak today of a “secular decline in volatility.” After the global tumult experienced during the second half of the nineties and the first few years of the new millennium, there is now expectation that we have commenced a period of financial and economic stability (confirmed by economic resiliency and minimal marketplace risk premiums and “implied volatilities”). Yet, Thinking Minsky, the extraordinary advance in risk-taking and debt that transpired over the past decade is much more consistent with mounting financial fragility and system instability. Indeed, one can make a strong “Minskian” case for the progression over the past decade to a perilous state of Systemic Ponzi Finance. What gives? Evolution to Financial Arbitrage Capitalism gained significant momentum during the early nineties. A flurry of major financial innovation was well underway, with securitization, derivatives and securities-lending operations beginning to gain clout on Wall Street. This process then accelerated rapidly when the banking system’s hangover (from late-eighties excesses) provoked a remarkable response from the Greenspan Fed (Fed funds declined from 9.75% in June of ‘89 to 3% by Sept. ’92). Powered by cheap and abundant liquidity, Wall Street was willing and able to step into the Credit system void created by bank and S&L impairment. Moreover, easy money provided a bonanza for the fledgling hedge fund community, borrowing artificially cheap short-term "money" and lending long. Treasury bonds and mortgage-backed securities quickly became coveted commodities for the leveraged players. Leveraged speculator and derivative player tumult in 1994 only conditioned the Fed to approach future rate increases in a more cautious and transparent manner. An audacious symbiotic relationship was born. And if Fed policies played the leading role in nurturing the evolution to Financial Arbitrage Capitalism, the government-sponsored enterprises were right on their coattails. Wall Street and the fledgling arbitrage establishment were in need of a securities boom that only “big government” could bestow – while savvy politicians were keen for a booming economy. The GSEs provided government backing for the blossoming MBS marketplace, at the same time offering huge quantities of perceived government guaranteed debt (with a stable spread to Treasuries!) as they ballooned their balance sheets. GSE liabilities actually increased $1.269 Trillion during the nineties, expanding 280% to $1.723 Trillion. GSE debt expanded 24% ($151bn) during the hedge fund rout of 1994, with a 28% gain ($305bn) during infamous 1998 and 23% in less infamous 1999 ($317bn). Not only had the burgeoning leveraged speculating community received the bounty of unlimited low-cost and predictable short-term finance, the GSEs offered central bank-style “buyers of first and last resort” operations for the entire MBS marketplace. The character of the marketplace – the nature of financial arrangements as well as market perceptions of risk and uncertainty - was altered radically. A revolutionary new type of Credit system emerged. “Big government” pegged the cost of cheap liquidity, while at the same time cultivating “The Moneyness of Credit.” Innovations in securities finance provided unlimited capacity to leverage financial instruments, while no quantity of MBS or GSE debt issuance would put at risk their coveted AAA rating (and stable spread/risk premium!). There were no restraints on liquidity creation. Better yet, Wall Street had developed its own system to create its own liquidity. All it lacked was an unlimited supply of new loans (enter asset-based lending and The Mortgage Finance Bubble!). Financial history had witnessed nothing remotely similar. Not only had Financial Arbitrage Capitalism ushered in a New Era of Credit Availability, the capacity for unrestrained marketable securities-based Credit expansion divorced the demand for borrowings from its cost. Instead, the price of finance was set through interplay between the Federal Reserve and the expansion of leveraged speculating community holdings. And the greater the system succumbed to speculative and leveraging excess, the more the Fed pandered to The New Capitalists. The more powerful the “arbitrageurs” the more expedient it became for the Greenspan Fed to use them as the key mechanism for stimulating/inflating the markets and economy. (I am, strangely enough, reminded of the Aaron Neville lyrics “Oh just keep on using me until you use me up.”) Especially after the telecom and corporate debt debacles of 2001/2002, the financial arbitrageurs needed no further convincing that mortgage and government debt were superior to corporates for leveraging and trading. And with the Fed again collapsing interest rates, The Crusade for Yield harbored unprecedented demand for subprime, ARM, and increasingly exotic mortgage loans. Then later, when the Fed forewarned of a gradual increase in rates, the entire Credit system had adequate time to gravitate to adjustable-rate loans (no '94 crisis here!). The speculative mania for mortgage paper in the financial sector was, predictably, matched by an unfolding National Housing Mania altering the underlying structure of the real economy. By the time the GSEs stumbled, ongoing rampant mortgage Credit and housing inflation assured that “private label” MBS and ABS garnered “moneyness” attributes (and predictable spreads!). The new financial apparatus has made certain that mortgages and consumer spending have ridden roughshod over the traditional mainstay - business loans and investment. This has been a profound development with respect to both the nature of economic development and system stability, although the ramifications are today barely noticeable. After all, an unprecedented explosion in mortgage debt, huge government borrowings, ballooning central bank balance sheets, and untold speculator leveraging together provide a seductive wall of liquidity/cash flow to corporate America. This has given the New Paradigmers a new (short) lease on respectability, this time mistakenly believing that “productivity,” “efficiency,” superior investment and “intellectual capital” are responsible for the American profit windfall. Market analysts are wont to extrapolate today’s abundant liquidity, low rates and reduced “volatility,” while leading policymakers trumpet a “global savings glut.” Caution and previous thin margins of safety are deemed dangerous to one’s financial health. Thinking Minsky, today’s Mortgage Finance Bubble is history’s most spectacular bout of Ponzi Finance. Household Net Worth has never been higher, as huge increases in borrowings are rewarded with multiples of nominal dollar asset inflation. Still, massive and unrelenting debt growth are necessary to sustain the housing mania, while the U.S. Bubble economy is vulnerable to any reduction in mortgage Credit growth or reversal in housing price inflation. The Credit losses associated with atrocious lending standards and inflated prices are held at bay only by expanding quantities of Ponzi Mortgage Credit. Narrow risk premiums – and the viability of mortgage securities “arbitrage” – are dependent upon unending mortgage lending excess. Meanwhile, maladjusted U.S. and global financial markets are susceptible to any compression in marketplace liquidity. And, “If solvency matters for the continued normal functioning of an economy, then large increases and wild swings in interest rates will affect the behavior of an economy with large proportions of speculative and Ponzi finance.” Sure enough, system fragility has the Fed Locked in Feeble Baby-Step Tightening-Lite and the speculators fat, happy and complacent. And, curiously, the inflationists – so Enthusiastically Cheerleading the Evolution to Precarious Mortgage Ponzi Finance Excess – today argue that the economy is too vulnerable and the system too leveraged to raise short-term rates above 3.5%. Apparently, these Proponents of Perpetual Ponzi believe it is preferable public policy for this scheme to grow to eternity. Minsky wrote that “Ponzi financing units cannot carry on too long.” In his analytical world, the inflationary boom would abruptly run up against overheated demand for borrowings and resultant upward pressure on interest rates - the kiss of death to Ponzi Finance units. Ironically, “Minskian” innovation in central banking and financial arrangements abrogated a central facet of his analysis. And Minsky’s analytical framework also did not incorporate $700 billion U.S. Current Account Deficits or $3.8 Trillion global central bank holdings of foreign reserve assets. Minsky was, however, keenly focused on how central bank validation of speculative practices guaranteed a more precarious inflationary boom. Never has such excess been “validated” and on such a global scale. Financial Arbitrage Capitalism, with its fixation on asset-based lending, leveraged speculation, U.S. consumption and massive Credit inflation, has taken the world by storm. Finance has evolved from vulnerable and less than “robust” to exceedingly “fragile” on a global scale, although this fragility is masked by robust housing inflation, ballooning central bank balance sheets, and overly-abundant global liquidity. Until rising rates, a dollar crisis, or some other major development exposes the acute frailty inherent in Historic Systemic Ponzi Finance, we should be on guard for fascinating developments. Sixty dollar crude is indicative of the swapping of inflating global monetary units for less abundant real things with inherent value and inflating market prices. This could prove contagious. And while the Japanese were content to trade our IOUs for Pebble Beach, Los Angelles office buildings, movie studios, and other overvalued properties, the Chinese are keen on energy, commodities, capital equipment and other resources. Thinking Minsky, he was keen to have policymakers recognize the “flaw” in Capitalism. I am more inclined to underscore Capitalism’s “vulnerabilities.” However, the critical flaw in Financial Arbitrage Capitalism is that speculation and leveraging excess begets greater excess, with the marketplace woefully incapable of self-adjustment and central banks unwilling to risk reining in The Powerful Speculator Class. And while the leveraged speculating community may be indefinitely satisfied to expand leveraged holdings of increasingly suspect and fragile U.S. (“Ponzi”) mortgage securities and instruments, the rest of the world surely is not. Moreover, the risks associated with a higher cost of finance may have been taken out of the equation, but this only elevates the key issue of how overly abundant cheap finance is utilized in regards to economic development. A prolonged period of Systemic Ponzi Finance – with all the associated weakened debt structures and global financial and economic fragilities - ensures that “It” can happen again. |
Monday, September 8, 2014
06/23/2005 Thinking Minsky *
