| While the major averages may have been relatively unchanged, things seemed to be percolating somewhat below the surface. For the week, the Dow was slightly negative and the S&P500 was unchanged. Economically sensitive issues performed well, with the Transports gaining 3% (up 5% y-t-d), and the Morgan Stanley Cyclical index up 1.5% (up 2.8% y-t-d). The Utilities added 1%, and the Morgan Stanley Consumer index was about unchanged. The broader market was stronger. The small cap Russell 2000 jumped 3%, increasing 2004 gains to 5.5%. The S&P400 Mid-cap index added 1.5%, with y-t-d gains of 4.8%. Technology stocks rallied, with the NASDAQ100 up 2.3%, the Morgan Stanley High Tech index up 3.6%, and NASDAQ Telecommunications index up 1.6%. The Semiconductors jumped 6%. The Street.com Internet index added 2%, increasing 2004 gains to 12.6%. The Biotechs were up 3% (up 5.6% y-t-d). Financial stocks were unimpressive, with the Broker/Dealers and Banks about unchanged. With Bullion up $6.70 to close the week at $401.25, the HUI Gold index added 2.5%. The Treasury market seems to have regained its composure. For the week, 2-year Treasury yields declined 9 basis points to 2.29%, while 5-year Treasury yields dropped 10 basis points to 3.84%. Ten-year yields declined 7 basis points to 4.64%, and long-bond yields dipped 4 basis points to 5.33%. Benchmark Fannie Mae MBS yields declined 7 basis points. The spread (to 10 year Treasuries) on Fannie’s 4 3/8% 2013 note was unchanged at 40, and the spread on Freddie’s 4 ½ 2013 note was unchanged at 38 basis points. The 10-year dollar swap spread widened 0.75 to 49.25. Corporate spreads generally lagged this week, with AT&T debt spreads widening 20 basis points. The implied yield on 3-month December Eurodollars declined 5.5 basis points to 2.565%. Corporate issuance rose to $14.4 billion this week, the strongest sales in five weeks (from Bloomberg). Investment Grade issuance included Wells Fargo $2.5 billion, Bank of America $1.5 billion, HBOS Capital Funding $750 million, Harrahs $750 million, Bellsouth $700 million, Kerr-McGee $650 million, Boston Scientific $600 million, US Cellular $540 million, Popular Inc. $400 million, KB Home $350 million, Arizona Public Service $300 million, Monumental Global $300 million, Felcor Lodging $290 million, John Deere Capital $200 million, Ohio Casualty $200 million, K2 Corp. $200 million, Curtis Palmer $190 million, Public Service Electric & Gas $175 million, Appalachian Power $125 million, Paramount Resources $125 million, and United Dominion Realty $50 million. Junk bond funds reported outflows of $70 million for the week (from AMG). Junk issuance included Pride Int. $500 million, Medical Device $175 million, Ames True Temper $150 million, Warnick $125 million, Pierre Foods $125 million, and Range Resources $100 million. Convert issuance included American Financial $300 million, Per-Se Tech $100 million, Kulicke & Soffa $65 million, Labone $90 million, Priceline.com $90 million and Infocrossing $60 million. Foreign dollar debt issuers included Malaysia International Shipping $1.1 billion, Italy $2 billion, Brazil $750 million, Turkey $750 million, and Kabel Deutschland $610 million. Japanese 10-year JGB yields dipped 2 basis points for the week to 1.835%. Brazilian benchmark bond yields declined 18 basis points to 10.87%. Russian 10-year Eurobond yields jumped 14 basis points to 6.57%, with Mexican govt. yields down 12 basis points to 6.14%. Freddie Mac posted 30-year fixed mortgage rates declined 7 basis points this week to 6.25%, the lowest rate in seven weeks. Fifteen-year fixed rates dropped 6 basis points to 5.64%. One-year adjustable-rate mortgages could be had at 4.13%, unchanged for the week. The Mortgage Bankers Association Purchase application index gained 1% last week. Purchase applications were up 11% from one year ago, with dollar volume up 22%. Refi applications rose almost 2%. The average Purchase mortgage was for $219,000, and the average ARM was for $295,100. ARMs accounted for 33.5% of applications last week. Broad money supply (M3) surged $38.9 billion. Year-to-date (24 weeks), broad money is up $428 billion, or 10.5% annualized. Over the past seven years, M3 has ballooned almost $4.1 Trillion, or 80%. For the week, Currency was up $300 million. Demand & Checkable Deposits gained $11.3 billion. Savings Deposits added $1.6 billion. Saving Deposits have expanded $259.8 billion so far this year (17.8% annualized). Small Denominated Deposits dipped $400 million. Retail Money Fund deposits declined $2.3 billion. Institutional Money Fund deposits rose $10.3 billion, while Large Denominated Deposits jumped $17.1 billion. Repurchase Agreements gained $2.5 billion. Eurodollar deposits dipped $1.3 billion. ABS issuance surged to $19 billion (from JPMorgan) this week, with y-t-d issuance of $217 billion 30% ahead of comparable 2003. Year-to-date Home Equity ABS issuance of $167 billion is running 70% above a year ago. Bank Credit jumped an additional $25.9 billon for the week of June 16, with four-week gains of $80.8 billion. Bank Credit has expanded $324.9 billion during the first 24 weeks of the year, or 11.3% annualized. Securities holdings added $4.2 billion. Commercial & Industrial loans rose $6.0 billion for the week, while Real Estate loans expanded $5.8 billion. Real Estate loans are up $173.9 billion y-t-d, or 17.0% annualized. Consumer loans gained $2.0 billion, while Securities loans jumped $8.3 billion. Other loans were about unchanged. Elsewhere, Total Commercial Paper declined $13.8 billion to $1.324 Trillion. Financial CP declined $9.6 billion, with Non-financial CP down $4.3 billion. Year-to-date, Total CP is up $55 billion, or 9.1% annualized. Fed Foreign “Custody” Holdings of Treasury, Agency Debt dipped $3.4 billion to $1.224 Trillion. Year-to-date, Custody Holdings are up $157.2 billion, or 31% annualized. Currency Watch: The dollar index dipped about 0.25%. The Japanese yen gained 1.1%, rising to the highest level against the dollar in more than two months. The “commodity currencies” performed the best, with the Chilean peso up 2.1%, the Australian dollar 1.6%, the South African rand 1.5%, and the New Zealand dollar 1.4%. Commodities Watch: June 23 – Bloomberg (Claudia Carpenter): “Copper futures in New York had their biggest gain in a week on concern that the two-year decline in global inventories shows no sign of slowing as the U.S. economy accelerates, spurring demand for metals. Mining shares surged. Stockpiles in warehouses approved by the London Metal Exchange fell 1.4 percent to 109,375 metric tons, the lowest since December 1996. An industry group said May 19 demand will exceed mine output through 2005, forcing metal fabricators to use more inventories… Prices are up 56 percent from a year ago…” The CRB index was up almost 1% for the week (up 6.6% y-t-d). Hurt by a pull-back in energy prices, the Goldman Sachs Commodities index dropped 1.5%, lowering y-t-d gains to 12.0%. Central Bank Watch: June 21 – Bloomberg (Theresa Tang): “Taiwan has no urgent need to raise interest rates as its banking system has adequate liquidity, the Commercial Times reported, citing unidentified government officials. Taiwan may raise its rates after the U.S. lifts its interest rates by more than 50 basis points… The island’s central bank has kept its monetary policy in step with the U.S., its second-biggest export market, over the past four years, matching the Federal Reserve's 11 rate cuts in 2001 and the cut in June 2003.” China Watch: June 23 – Bloomberg (Jianguo Jiang): “The average transportation cost in China rose about a third in June from May because of rising fuel prices, Taiwan’s Commercial Times said…citing unspecified Chinese government statistics. The cost of transporting goods rose almost 27 percent to 0.67 yuan per ton for every kilometer of road traveled, the report said. The cost of transporting coal rose almost 35 percent and the price of moving live poultry rose almost 27 percent in June, Commercial Times said. Surging transportation costs were also caused by the Chinese government’s crackdown on overloading, which forced freighters to buy trucks and expand their fleet, the report said.” Asia Inflation Watch: June 25 – Bloomberg (Heather Burke): “Major Japanese banks have increased loans to companies in China and other parts of Asia, especially Japanese businesses with ventures in these countries, Nikkei English News reported. Loans to companies in China by the four major Japanese banks rose 6.3 percent…for the year ended March 31… This growth increases more after factoring in the yen’s rise of 10 percent against the dollar… Japanese banks also have increased credit to other Asian countries… Sumitomo Mitsui Banking Corp.’s loans to South Korea have risen 16.8 percent and those to Thailand 6.1 percent. Some banks plan to set up new branches in China and other Asian countries, Nikkei said.” June 23 – Bloomberg (Lily Nonomiya and Bernard Lo): “Japanese exports rose 7.3 percent to a record in May, led by demand for cell phones and flat-panel displays in China, helping sustain the economy’s longest expansion since 1997. Exports rose to 5.24 trillion yen ($48.2 billion) from April, seasonally adjusted, while imports rose 1.5 percent to a record, the Ministry of Finance said in Tokyo. The surplus widened to 1.28 trillion yen, a four-year high…” June 25 – Bloomberg (Theresa Tang): “Taiwan’s bank lending rose 10.3 percent in May… the biggest since an 11.3 percent gain in March 1998 and marked the ninth consecutive month of growth.” June 21 – Bloomberg (George Hsu): “Taiwanese companies’ investment in China tripled in May from a year ago as companies such as AU Optronics Corp. and Taiwan Semiconductor Manufacturing Co. expanded their factories in the world’s seventh-largest economy.” June 24 – Bloomberg (James Peng): “Taiwan’s money supply grew in May at its fastest pace in almost five years as companies increased borrowings to fund expansion amid surging overseas demand. M2, the broadest measure of the island’s money supply, expanded 8.6 percent from a year earlier after growing 8.5 percent in April…That was its biggest gain since August 1999.” June 24 – Bloomberg (George Hsu): “Taiwan’s export orders rose less than expected in May as a government clampdown on industrial expansion in China cooled demand in the island’s biggest overseas market. Export orders -- indicative of shipments in one to three months -- increased 26 percent from a year earlier to $17.3 billion after climbing 34 percent in April…” June 25 – Bloomberg (Laurent Malespine): “Thailand’s May exports rose 19.7 percent to a record, helping the nation post a monthly trade surplus of $130 million after two months of deficits, Deputy Commerce Minister Pongsak Raktapongpaisal said… Imports rose 33 percent… Thailand, Southeast Asia’s biggest economy after Indonesia, predicts rising exports and consumer spending will help the economy expand as much as 7 percent this year…” June 21 – Bloomberg (Philip Lagerkranser): “Hong Kong’s consumer prices fell 0.9 percent last month, the slowest pace in almost three years, as rising household spending and booming tourism enabled stores, hotels and restaurants to slash discounts.” June 21 – Bloomberg (Cherian Thomas): “India’s exports rose 29 percent in May as automobile companies such as Maruti Udyog Ltd. sold more cars overseas and steel companies stepped up sales to China. Exports in May were $5.8 billion…Imports rose 28 percent to $7.7 billion. The trade deficit widened to $1.9 billion from $1.5 billion in May last year.” Global Reflation Watch: June 24 – Bloomberg (Francois de Beaupuy): “French households continued to take on a ‘high’ level of home loans in the first half after a record amount of new borrowing to buy real estate last year amid rising rents and falling interest rates, the Bank of France said. ‘Distribution of new home loans should hold at a high level in the first half of this year, given figures seen on the residential market in the first months of 2004,’ the central bank said… New home loans rose 22 percent to 95.8 billion euros ($117 billion) in 2003, the Bank of France said. Prices of existing homes rose 69 percent between 1997 and 2003, the Paris-based bank said…” June 24 – Bloomberg (Simon Packard): “France’s economy will probably grow at its fastest rate since 2000 this year, the national statistics office Insee said, predicting that demand from China and the U.S. will boost exports and encourage corporate investment. French gross domestic product will expand 2.3 percent this year, Paris-based Insee predicted, after growth of 0.5 percent in 2003.” June 23 – Bloomberg (Francois de Beaupuy): “France’s annual inflation rate climbed to a 12-year high of 2.8 percent in May, led by rising oil and fresh fruit prices, a final government estimate showed.” June 25 – UPI: “Hungarian retail sales surged by 8.2 percent year-on-year in April, well above market expectations, official figures showed Friday. The April figure compared with retail sales growth of 4.5 percent year-on-year in March.” June 21 – Bloomberg (Todd Prince): “Russia’s foreign currency and gold reserves may top $100 billion by the end of the year, Interfax reported, citing Central Bank First Deputy Chairman Alexei Ulyukayev. Russia’s reserves may grow by $20 billion to $25 million this year, the news agency cited Ulyukayev as saying.” June 25 – Bloomberg (Tracy Withers): “New Zealand’s economy grew 2.3 percent in the first quarter, driven by a housing boom and consumer spending. The fastest growth in 4 1/2 years…” June 23 – Bloomberg (Nick Benequista): “Mexican exports surged 21 percent in May from a year earlier, giving the country its first trade surplus in more than a Year… Mexican imports rose 18 percent to $16.07 billion last month, the release said.” June 23 – Bloomberg (Inti Landauro and Nick Benequista): “Mexico’s government raised its forecast for economic growth this year on rising U.S. demand for Mexican goods ranging from raw metals to electronics. Mexican Finance Minister Francisco Gil Diaz…said his government expects the economy to expand 4 percent this year, up from a previous forecast of growth between 3 percent and 3.5 percent.” June 23 – Bloomberg (Carlos Caminada): “Brazilian banks increased lending by the most in at least 18 months in May, a sign that the recovery in South America’s biggest economy is quickening after the central bank cut the benchmark lending rate to a three-year low.” June 23 – Bloomberg (Carlos Caminada): “Brazil had a record current account surplus in May as exports surged to a record high. The surplus in the current account, the broadest measure of a country’s trade in goods and services, was $1.48 billion in May, reversing a $735 million deficit in April… The surplus, higher than the $1.33 billion median forecast…is the biggest since the government began keeping monthly records in 1980.” June 25 – Bloomberg (Julie Ziegler): “Argentina’s economic growth reached 10 percent in the first quarter, bringing the nation closer to its output level before the economy started to contract in 1998, the International Monetary Fund said.” June 23 – Bloomberg (Andrew Barden and Eliana Raszewski): “Argentina raised its 2004 economic growth forecast to 6 percent from 5.5 percent, Economy Minister Roberto Lavagna said.” California Bubble Watch: The California Association of Realtors this afternoon reported May sales data, confirming the existence of one of history’s great asset inflations. Statewide Median Prices rose $11,550 during the month – up $36,880 over two months! – to a record $465,160. Over the past twelve months, prices were up an astonishing $97,530 (from $367,630), or 26%. Median prices are up 46% ($145,570) over two years, 81% ($208,100) over three years and 129% ($262,200) over six years. Buyers’ Panic impacted statewide condo prices as well, with prices up $15,120 for the month ($33,150 for two months!) to $366,770. Condo prices were up $84,190 over the past year (29.8%), $125,580 over two years (52%), $160,320 over three years (78%) and $208,860 over six years (132%). Only 2.1 months inventory of was available. U.S. Bubble Economy Watch: June 24 – The Wall Street Journal (Anne Marie Chaker): “College tuition will continue its upward pace next year, but the increases at many schools will be lower than in recent years. In Arizona, for instance, parents of resident undergraduate students will pay a 13% to 14% increase in tuition and fees at the state’s three public universities. Last year, Arizona students faced a 39% rise in tuition and fees… This year, the average increase at state schools will probably be somewhere between 9% and 10%, Mr. Reindl says. Last year, tuition jumped by an average of 14%. In normal years, increases typically range somewhere between 4% and 8%.” June 25 – Las Vegas Review-Journal (Hubble Smith): “Las Vegas home builders pulled a record 4,501 new-home permits in May, bringing the year-to-date total to 17,074, a 70 percent increase from a year ago… Don’t expect the inventory of new homes to grow, though, as most of those permits are already under sales contracts, said Dennis Smith, president of Home Builders Research.” U.S. Financial Sphere Bubble Watch: Morgan Stanley reported Net Income of $1.223 billion for the quarter ended May 31, an increase of 104% from comparable 2003. Net Revenues were up 32% from a year ago. Investment Banking Income was up 83% to $983 million, Principal Transactions 24% to $2.064 billion, Commissions 24% to $877 million, and Interest & Dividends 6% to $3.663 billion. Compensation & Benefits was up 29% to $2.923 billion. Morgan Stanley Total Assets surged a record $72.6 billion, or 44% annualized, to $729.5 billion. Total Assets were up $126.7 billion over six months (42% annualized) and $142.6 billion (23%) y-o-y. Total Assets were up 141% since the beginning of 1998. Goldman Sachs reported Net Income of $1.187 billion for the quarter ended May 28, up 71% from the comparable period last year. Investment Banking Revenues were up 67% from the year ago period, Trading & Principal Transactions 59%, and Asset Management & Securities Services 52%. Compensation & Benefits were up 38% from a year ago to $2.76 billion. Goldman did not release balance sheet data, although “assets under management increased 20% from a year ago to a record $415 billion…” Freddie Mac expanded its Book of Business (retained portfolio and MBS sold into the marketplace) by $11.9 billion during May (10% annualized) to $1.444 Trillion, the strongest expansion since January. Freddie’s Retained Portfolio increased $2.4 billion (5% ann.) to $633.9 billion, the first expansion in seven months. For the year, Freddie’s Book of Business has expanded at a 4.5% rate, with Outstanding MBS increasing at an 11.6% rate. The Retained Portfolio has decreased at a 3.9% rate. The Mortgage Finance Bubble May New Homes sold at a record seasonally-adjusted annualized rate of 1.369 million units, up 15% from April and 20% above the consensus forecast. To put these spectacular sales into perspective, New Homes sold at a rate of 534,100 during May of 1990, 517,000 during May 1991, and 554,000 during May 1992. In fact, last month’s sales were double the average for May sales during the decade of the nineties (687,710). Sales Volumes were up 25% from one year ago, 40% from May 2002, and 55% from May 2001. With Average Prices up 5.3% from a year ago and Sales up 25%, annualized Calculated Transaction Value (CTV) was up 32% to $351.4 billion. CTV was up 58% from May 2002, 88% from May 2001, and 116% from May 1998. Year-to-date sales are running an amazing 22% above last year's record pace. With blistering sales volumes, the Inventory of unsold homes dropped to a record low 3.3 months. May Existing Homes sold at a record annualized rate of 6.8 million units, up 15.8% from one year ago. Year-to-date, Existing Sales are running 9.5% above comparable sales for a record-breaking 2003. May sales volumes were up 20% from May 2002, and were 60% above the average May during the nineties (4.02 million). Sales were up 12.7% in the Northeast, 12.6% in the Midwest, 18.2% in the South, and 20.4% in the West. Average (mean) Prices rose to a record $235,500, up 10.1% over one year and 18% over two years. Average Prices were up 13.2% in the Northeast, 4.0% in the Midwest, 10.3% in South, and 13.6% in the West. Annualized Calculated Transaction Value (CTV) was up a notable 28% from a year ago to $1.60 Trillion (Volume up 15.8% and Prices 10.1%). CTV was up 41% over two years (Volume up 20% and Prices up 18%), 62% over 3 years (Volume 26% and Prices 28%), and 106% over six years (Volume up 39% and Prices up 48%). The supply of available inventory dropped to 4.2 months, the lowest since December 2001. Combined New & Existing Homes sold at a record pace of 8.17 million. This was up 17.2% from May 2003, 23% from May 2002, and 30% from May 2001. Year-to-date Combined Sales are running 11% above last year’s record pace. May Combined CTV was up 28% from one year ago to a rate of $1.953 Trillion. CTV was up 66% from three years ago and 108% from May 1998. CTV is an effort to quantify the dollar value of annual home sales/ “turnover,” providing us the best indication of the general direction of mortgage Credit growth. With CTV surging, we are clearly on our way to yet another record year of mortgage borrowings. Understandably, housing markets are these days the subject of much attention, pontification, and absolutely frenetic buying interest. Reminiscent of the late-nineties manic stock market environment, the issue “Is Housing a Bubble” has become a hot topic for newsletter writers, journalists, policymakers and investment analysts. Research from the Federal Reserve Bank of New York – “Are Home Prices the Next ‘Bubble’?” proves that, despite considerable focus on the issue of asset Bubbles, the Fed has made little progress in comprehending or addressing Bubble dynamics. Amazingly, this report provides not a single mention of what should be the focal points of Bubble analysis – Credit growth, loosened lending standards, speculative psychology and finance, and marketplace liquidity. I would aver that Fed researchers made a crucial analytical error by using Joseph Stiglitz’s definition of a Bubble: “If the reason the price is high today is only because investors believe that the selling price will be high tomorrow – when ‘fundamental’ factors do not seem to justify such a price – then a bubble exists.” “Fundamental factors” is an analytical black hole. During the technology Bubble, price-to-earnings ratios became the focal point of a winless “Is it or is it not a Bubble” debate. The bears argued prices were much too high from a historical perspective, while the bulls retorted that such valuations were justified by stupendous earnings growth and future prospects (and low interest rates!). The reality of the situation was that earnings were grossly inflated by unsustainable financial flows (much of it of speculative character) that were inundating (and distorting!) both the marketplace (the “financial sphere”) and industry (“economic sphere”). Fruitful analysis would have avoided valuation and instead focused on the dimensions and character of the surge in junk bond finance, syndicated bank lending (especially to telecom), margin debt, hedge fund and proprietary trading leveraging in both tech equities and debt, derivative-related leveraging, aggressive industry vendor financings, and the general profligate Credit environment. As we appreciate, Asset Bubbles are Always and Everywhere a Credit Phenomenon, and to ignore Credit and speculative dynamics is to invalidate one’s research and pontification on the subject. I won’t spend a lot of time on the Fed’s research because it is clearly more propaganda (supporting chairman Greenspan’s view) than serious analysis. From the report: “Our analysis of both cash flow affordability and a simple asset valuation model suggests that, given the steep decline in interest rates, home prices do not appear to be at unusually high levels. Moreover, the housing market does not appear to be driven by expectation of rapid future price appreciation.” Such conjecture is simply at odds with the reality of the general marketplace. The proliferation of no downpayment mortgages, downpayment “assistance” programs, negative amortization loans, and adjustable-rate mortgages leaves little doubt that prices and affordability are major issues for a large and growing number of buyers. “Our analysis indicated that a home price bubble does not exist. Nonetheless, home prices could fall because of deteriorating fundamentals, and thus it is useful to gauge the magnitude of previous declines. Nationally, nominal price declines have been rare. Moreover, real price declines – an important consideration during this period of low inflation – have been mild. For example, the early 1980s and early 1990s featured weak fundamentals – slow income growth and high nominal interest rates and unemployment – yet real home prices declined only about 5 percent.” Similar analysis of NASDAQ toward the end of 1999 would surely have been as sanguine. Price collapses would have been seen as rare. There was certainly an overriding perception that prices were supported by truly extraordinary fundamentals –incredible earnings growth, low interest rates, strong economic expansion, low inflation, and confidence in policymakers. But it is the very defining nature of Asset Bubbles to fool the masses and their policymakers with alluring “fundamentals.” And despite the fact that Fed researchers use low interest rates as a primary positive fundamental factor arguing against the housing Bubble scenario, it is an economic fact of life that the greatest Bubbles develop specifically in environments characterized by seductively low consumer price inflation and interest rates. “As for the likelihood of a severe drop in home prices, our examination of historical national home prices finds no basis for concern.” Historical models would have forecasted a very low probability for a NASDAQ collapse back in early 2000, while sound analysis of Bubble dynamics would have proffered that the degree of excess dictated that a spectacular bust was unavoidable (although the timing would have been much less clear). “One reason for the moderate volatility of national home prices is that the housing market comprises many heterogeneous regional markets.” Researchers and policymakers should tread carefully with this popular line of reasoning. While it is true that housing markets vary by region – and by neighborhood for that matter – housing finance is today a profoundly centralized marketplace and more nationally homogeneous than ever. With huge national banks, the powerful GSEs, the enormous MBS marketplace, the major national home builders, and now the expansive Internet lenders (Countrywide!), a system has evolved that provides basically unlimited mortgage finance and a low national lending rate - irrespective of local Credit demands. This New Age system is having a profound – and I could argue somewhat uniform - impact on these so-called “heterogeneous” local housing markets. How this “evolution” has altered housing markets would make for a lengthy book. Nonetheless, it is today flawed analysis for the Fed and pundits to mindlessly use historical experience as a guide for the future. Extrapolating asset inflation during periods of Acute Monetary Instability is precarious business, as was the case during the late-twenties, the late-eighties in Japan, SE Asia during 1996, Russia during early 1998, and NASDAQ and the telecom industry during 1999. This is definitely the case today with housing. Err on the side of caution. “Our evidence thus suggests that changing demand fundamentals should cause prices to fluctuate more in California and the northeast than in other areas. Therefore, the strong home price appreciation over 1999-2003 in those areas is a consequence of improving economic conditions combined with relatively unresponsive supply. Our evidence also implies that recent state price fluctuations can be explained through an expanded model of fundamentals.” Well, the Great California Housing Inflation over the past few years – in the face of a notably weak economic backdrop – strongly suggests factors other than “fundamentals” are at work. First of all, the contemporary mortgage finance system has evolved to the point of supplying unlimited quantities of ultra-cheap finance – Ultra-easy Credit Availability. And Bubble analysis garners us the valuable insight that we should therefore expect the most intense inflationary manifestations in locations presently or traditionally demonstrating the strongest inflationary biases (including speculative impulses/"inflationary psychology"). This would certainly include markets throughout the Golden State, as well as Greater New York, Boston, and all along the east coast. And, importantly, the nature of the improvident mortgage finance marketplace will also ensure rampant price gains for the most appealing properties throughout “heterogeneous” regional, metropolitan, and neighborhood markets across the country. Property on creeks, rivers, lakes, bays, oceans or virtually any body of water is prone to strong inflationary gains, from coast to coast. Home prices in the most prestigious neighborhoods will skyrocket, whether it is in Boise, Dallas, St. Louis, or Washington D.C. And while these “heterogeneous” markets will, of course, have varying valuations, the national Mortgage Finance Bubble ensures that the relative prices of choice properties are all bid up to unreasonable extremes. Housing dynamics in Dallas provide important insights. Virtual buyers’ panic has fueled intense housing inflation in the prestigious “Park Cities” communities. But with vast quantities of developable land in the expanding suburbs (as the circumference of the circle enlarges), regional home price indices post only small gains. I suggest similar dynamics mask the extent of inflationary effects in communities across the country – spectacular pricing Bubbles for the limited quantities of the most sought-after properties in favored areas, while over-building prevails in the outlying suburbs. All the while, Fed researchers can examine aggregate price data – especially the OFHEO series that uses only the price-capped “conventional” mortgages that have been previously sold or refinanced – and completely miss the essence of contemporary mortgage finance excesses. As I have argued for some time, the Mortgage Finance Bubble is the crucial issue. And the evidence of historic Credit excess is anything but inconspicuous. Over the past seven years (Q1 1997 to Q1 2004), Total Home Mortgage Debt has surged 94% to $7.376 Trillion. Total Mortgage Debt, including commercial and multi-family, is up over the same period by 93% to $9.618 Trillion. Looking at the source of mortgage finance, Bank Real Estate loans have doubled in seven years to $2.386 Trillion. Over the past 53 months (for which I have data), combined Fannie and Freddie Books of Business have surged 78% to $3.677 Trillion. Over the past six years, Federal Home Loan Bank Assets have surged 140% to $857 billion. And while the consequences of this massive inflation of Mortgage Credit are not always obvious, there is certainly sufficient evidence to support a simple Bubble thesis. As was noted above, over the past six years, home sales (New and Existing) Prices have jumped about 50% and Volumes 40%. Dollar transaction volume has doubled. But these data do not do the Mortgage Finance Bubble justice. Total Mortgage Credit increased $1.0 Trillion last year. This compares to the average annual increase of $206 billion during the first eight (pre-Bubble) years of the nineties. The heart of Bubble analysis lies with the impact this deluge of new Credit has had - and could continue having - on both the “financial sphere” and the “economic sphere.” I would strongly argue – and this is where Bubble analysis is necessarily more an art than a science – that massive inflation of mortgage Credit has been the instrumental fuel behind liquid financial markets, economic expansion, and income growth. And the reason “Bubble” terminology applies is not because home values are detached from “fundamentals,” but rather because of the dangerously self-reinforcing and inevitably unsustainable nature of the underlying Credit expansion, asset inflation, speculative excess and economic maladjustment. As mentioned above, the Fed’s housing Bubble research does not mention Credit. Nor does it address speculative holdings of mortgage-backed and agency securities, the ballooning derivatives market, GSE exposure, the mushrooming Current Account Deficit or the underlying structure of the U.S. economy. Yet these are the fundamental issues that will determine the sustainability of The Great Mortgage Finance Bubble. With interest-rates remaining quite low and housing markets booming, the system is poised to generate the required $1.1 Trillion plus of new mortgage Credit this year (to sustain the financial and economic Bubbles). But with prices being aggressively bid up in California and throughout other markets around the country, next year will require only larger Credit growth to sustain levitated prices, and the year after even more. And, importantly, the nature of this type of Credit inflation will continue to foster over-consumption and severe investment distortions within the “economic sphere.” The pricing structure of the U.S. economy becomes only less competitive, while limited“investment” spending focuses on housing, as well as domestic consumption and services rather than internationally tradable goods and services. The day that the additional purchasing power associated with $1 Trillion or so of new mortgage borrowings is not forthcoming will be the day the system will be faced with the reality of scores of uneconomic businesses and an enormous amount of problematic debt. In the meantime, the “financial sphere” is faced with the specter of incessant ballooning to finance this ongoing Credit inflation. The banking system is performing yeoman’s work in this regard so far this year, but for how long? Prolonging the Bubble will require the resumption of GSE balance sheet ballooning, with all eyes on the leveraged speculating community and their massive holdings of mortgage and agency instruments. Let’s keep in mind that the Fed has not yet commenced the process of returning to more “normalized” rates. And with funds continuing to flow to the hedge fund community, along with ongoing Wall Street expansion, I believe at this point “de-leveraging” is more a myth than reality. But the reversal of speculative flows and the associated unwind of leveraging is an inescapable aspect of financial Bubbles – when and from what degree of excess, not if. And while the Mortgage Finance Bubble does possess considerable momentum today, it remains acutely vulnerable to higher rates. The Fed is keenly aware of this dynamic and keenly hoping to administer “Tightening Lite.” And the markets are keen that the Fed’s keen, and leveraging in the U.S. Credit market is at least as popular as ever. But the dilemma overhanging the Mortgage Finance Bubble at this point – that goes completely unrecognized in Housing Bubble research and pontification – is that there is a major foreign component involved. The requisite $1 Trillion plus annual Mortgage Credit inflation will occasion $600 billion plus current account deficits for the duration of the Bubble. This is assured by the nature of Dysfunctional Monetary Processes – asset and consumption-based lending and Bubble Economy Dynamics. Dollar balances will continue to inundate the world, and foreign central banks will be forced to acquire/monetize these flows. And as long as these processes hold, the likely upshot will be continuing inflationary effects for China, Asia, and economies across the globe, along with general Global Monetary Disorder. This week the dollar weakened against the yen, which conjures up images of Japanese dollar support and a resumption of Treasury purchases, which conjures up marketplace visions of stable to lower U.S. yields, which conjures up hopes for the beloved status quo – the perpetuation of U.S. imbalances, global reflationary dynamics and speculator nirvana. But it all does leave one wondering how high California home prices can go; how big the primary dealer outstanding repurchase agreement position can mushroom; how long the U.S. financial sector can continue to balloon; how enormous the leveraged speculating community can become; and how long foreign central banks, speculators and investors will play along. Wither the dollar? At the minimum, Acute Financial Fragility. The harsh reality is that we are dealing with an historic and quite energized Bubble, and the severity of distress and dislocation associated with the inevitable bust will be commensurate with the degree of excess from the (out-of-control) boom. |
Saturday, September 6, 2014
06/24/2004 The Mortgage Finance Bubble *
