| Stocks came charging back. For the week, the Dow and S&P500 gained 3%. Economically sensitive issue performed well, with the Transports up 4% and the Morgan Stanley Cyclical index up 4.5%. The S&P Homebuilding index gained 4.5%, increasing year-to-date gains to 7%. The Morgan Stanley Consumer index rose 2.5%, and the Utilities added 1.0%. The broader market was quiet strong, with the small cap Russell 2000 jumping 6% and the S&P400 Mid-cap index up 4.3%. Technology stocks rallied sharply, with the NASDAQ100 up 4.5% and the Morgan Stanley High Tech index up 6%. The Semiconductors were up 5%, and the Street.com Internet index was up 6%. The NASDAQ Telecommunications index gained 7%. The Biotechs surged 10% for the week. Financials were also strong, with the Broker/dealers up 8% and the Banks up 3.5%. With bullion up $14, the HUI index gained 10%. Bonds were impressive in the face of rallying equity markets. For the week, 2-year Treasury yields dipped 3 basis points to 2.43%. Five-year Treasury yields were down 1 basis point to 3.41%. Ten-year yields were unchanged at 4.23%. Long-bond yields ended the week at 5.03%, up 1 basis point on the week. Benchmark Fannie Mae MBS yields rose 2 basis points, again underperforming Treasuries. The spread (to 10-year Treasuries) on Fannie’s 4 3/8% 2013 note narrowed 1 to 32, and the spread on Freddie’s 4 ½ 2013 note narrowed 1.5 to 30.5. The 10-year dollar swap spread declined 1.25 to 45, the narrowest spread in four months. Corporate bond spreads were generally little changed for the week. The implied yield on 3-month December Eurodollars increased 0.5 basis points to 2.175%. Corporate debt issuance totaled a slower $8.0 billion (from Bloomberg). Investment grade issuers included RBS Capital Trusts $1.5 billion, Eli Lilly $1.0 billion, United Overseas $1.0 billion, Pacific Corp $400 million, Duke Capital $400 million, PPL Energy $300 million, LG-Caltex Oil $300 million, XL Capital $300 million, Caterpillar Finance $250 million, Public Service Electric & Gas $250 million, Alabama Power $250 million, Arden Realty $200 million, Carramerica Realty $200 million, Parker Drilling $150 million, Berkley Corp $150 million, Secunda International $125 million, and International Lease Finance $100 million. Junk bond funds reported modest outflows of $25.9 million for the week (from AMG), the third straight week of withdrawals. Junk issuance included Standard Aero Holdings $200 million, Securus Tech $155 million, Ply Gem Industries $135 million, and MQ Associates $135 million. Convert issuance included American Tower $345 million and Aquantive $70 million. Japanese 10-year JGB yields were about unchanged for the week at 1.56%. Brazilian benchmark bond yields sank another 22 basis points to 9.77%, with yields down about 100 basis points over four weeks. The Brazilian real enjoyed its fourth straight weekly gain against the dollar. Mexican govt. yields dropped 11 basis points this week to 5.40%, the lowest yields since April 16. Russian 10-year Eurobond yields dipped 4 basis points to 6.36%. Freddie Mac posted 30-year fixed mortgage rates declined 4 basis points this week to 5.81%, with rates down 27 basis points in four weeks to the lowest level in more than four months. Fifteen-year fixed mortgage rates fell 5 basis points to 5.19%, down 30 basis points in three weeks. One-year adjustable-rate mortgages could be had at 4.01%, down 7 basis points for the week. The Mortgage Bankers Association Purchase application index rose 6.2% last week. Purchase applications were up 20% from one year ago, with dollar volume up almost 35%. Refi applications jumped about 21% to the highest level since the first week of May. The average Purchase mortgage was for $219,500, and the average ARM was $298,100. ARMs accounted for 33.6% of applications last week. Broad money supply (M3) declined $17.5 billion (week of August 9). Year-to-date (32 weeks), broad money is up $447.9 billion, or 8.3% annualized. For the week, Currency dipped $0.1 billion. Demand & Checkable Deposits dropped $19.2 billion. Savings Deposits rose $10.7 billion. Saving Deposits have expanded $267.2 billion so far this year (13.7% annualized). Small Denominated Deposits added $0.3 billion. Retail Money Fund deposits dipped $1.5 billion. Institutional Money Fund deposits declined $3.4 billion. Large Denominated Deposits declined $9.8 billion. Repurchase Agreements gained $3.0 billion and Eurodollar deposits rose $2.7 billion. Bank Credit jumped $20.5 billon for the week of August 11, the strongest gain in almost two months. Bank Credit has expanded $321.3 billion during the first 32 weeks of the year, or 8.3% annualized. Securities holdings gained $4.8 billion, and Loans & Leases rose $15.8 billion (up $73.4 billion over six weeks). Commercial & Industrial loans were up $1.1 billion, while Real Estate loans jumped $10.2 billion. Real Estate loans are up $192.9 billion y-t-d, or 14.1% annualized. Consumer loans dipped $1.1 billion for the week, and Securities loans declined $1.8 billion. Other loans rose $7.2 billion. Elsewhere, Total Commercial Paper dipped $2.0 billion to $1.349 Trillion. Financial CP declined $2.6 billion, while Non-financial CP added $0.6 billion. Year-to-date, Total CP is up $80.5 billion, or 10% annualized. ABS issuance was again quite strong at $15 billion (from JPMorgan) this week. Year-to-date ABS issuance increased to $384.3 billion, 38% ahead of comparable 2003. Year-to-date Home Equity ABS issuance of $236.4 billion is running 85% above a year ago. Fed Foreign “Custody” Holdings of Treasury, Agency Debt jumped $9.3 billion to $1.266 Trillion. Year-to-date, Custody Holdings are up $198.8 billion, or 29.4% annualized. For comparison, Federal Reserve Credit has expanded $7.7 billion so far this year, or 1.6% annualized, to $754.2 billion. Economic Nonsense Watch: Treasury Undersecretary John Taylor responding to questions on Bloomberg television: “In fact, Germany is about the only part of the world where things are not pretty strong and steady right now.” Bloomberg’s Erin Burnett: “Another part of the world where some would say things are not strong and steady is right here at home in the United States. The United States (has) a record trade deficit; the current account at another record. Even over at the Fed, we’ve started to hear some signs that they are concerned about these numbers. Is that concern fair?” Treasury Undersecretary John Taylor: “The current account deficit we have reflects how much investment opportunities there are here in the United States. America is an attractive place for foreigners to invest. That creates this deficit between investment and saving, and as long as our productivity growth is strong, as long as we have a strong economy – and we want to get it strong and we want to create more jobs – then it is going to be an attractive place for foreigners to invest. And that’s really the source of this deficit. Of course you want to continue to make the United States attractive – continue to try to find ways to raise saving and create more jobs in the United States. But right now, I think we’ve got this steadiness and sustainability of the economy which is so valuable to have, so you prevent the kinds of recessions and slowdowns that occurred in 2000.” Bloomberg’s Erin Burnett: “So right now, what region are you most concerned about. If you had to pick a region - you even had to pick a country that you think is the biggest problem you are focusing on right now overseas. What is it?” Treasury Undersecretary John Taylor: “There’s no single country. Right now – again I would emphasize the balance – emerging market spreads – that is the spreads between the interest rate that emerging market countries have to pay and U.S. Treasuries – is remarkably low. It’s as low as it’s been for a long time. There doesn’t seem to be that kind of contagion we saw in the 1990s. There’s no major financial market crisis right now. Remember the nineties. You had the Asian crisis, you had the Russian crisis, you had the Tequila crisis. Right now we’re in the situation were there’s no real major crisis, and that’s good. But you’ve always got to be on the lookout. And I think there’s no single place to look for that lookout. You look a little bit at Asia, you look in Latin America. You want the countries of the world that are not doing so well to grow faster. And there you have some in Africa, the Middle East. More economic success in those areas would be very, very welcome.” Currency Watch: The “commodity currencies” were strong this week. The Brazilian real gained almost 2%, with the Chilean peso, Australian dollar, New Zealand dollar, and Canadian dollar all up about 1%. The yen gained 1.34 %. The British pound declined 1.4% and the South African rand 1.56%. The dollar index posted a small gain for the week. Commodities Watch: August 20 – Bloomberg (Rob Delaney): “China’s crude oil imports rose 41 percent to 9.6 million metric tons in July compared with a year earlier, according to customs data. China’s crude oil imports in the first seven months of the year rose 40 percent to 71 million tons, it said.” August 20 – Bloomberg (Meggan Richard and Hector Forster): “Japan’s electricity sales rose for a fifth consecutive month in July, gaining 12.5 percent because record summer weather increased use of air conditioning, the Federation of Electric Power Companies of Japan said.” August 18 – Bloomberg (Claudia Carpenter): “Lumber prices in Chicago rose to the highest in 10 years as Florida’s homeowners and businesses rebuild after Hurricane Charley, the second most-destructive U.S. hurricane after Andrew in 1992. Lumber futures for September delivery rose $15, the maximum allowed by the Chicago Mercantile Exchange, to $442 per 1,000 feet of two-by-fours, the highest for a most-active contract since March 1994. The 3.5 percent gain was the biggest in seven months. Before Friday, lumber prices gained 36 percent in the past year as North American housing demand surged.” August 20 – Bloomberg (Thomas Black): “Florida’s efforts to rebuild from the destruction of Hurricane Charley probably will exacerbate a year-long shortage of cement in the state and slow construction, according to Cemex SA, the biggest producer in the Americas. Cement demand exceeded supply by as much as 20 percent before last week’s storm…” Gold today posted its highest close since April 12. The CRB index jumped 2.7% this week (y-t-d gains of 8.3%). And despite today’s reversal and 92 cent decline, October crude rose 69 cents this week to a record $46.72. The Goldman Sachs Commodities index added 1% for the week, increasing year-to-date gains to 22.2%. China Watch: August 18 – Bloomberg (Philip Lagerkranser and Tian Ying): “Investment in China’s factories, roads and other fixed assets rose 31 percent in the first seven months of this year, suggesting government lending curbs failed to cool industrial expansion in July. The increase, which took the investment tally for the year to 2.71 trillion yuan ($327 billion), matched the gain for the first half, the Beijing-based National Bureau of Statistics said… That indicates July’s increase exceeded June's 23 percent gain.” August 18 – Bloomberg (Joshua Fellman): “China’s rising rural incomes are creating a labor shortage at factories in Guangdong province, the country’s manufacturing hub, as migrant workers stay home, according to executives at companies… Manufacturers in Guangdong -- a province bordering Hong Kong where factories churn out goods for companies including Wal-Mart Stores Inc. and Nike Inc. -- have relied on a steady flow of laborers from China’s interior to produce cheap exports. They’re now under pressure to raise wages to lure workers, threatening to curb cost savings, lift export prices and stoke inflation that's already at a seven-year high. Incomes in rural China -- home to about 60 percent of the country’s 1.3 billion people -- rose 16 percent in the first half from a year earlier…” August 19 – Bloomberg (Jianguo Jiang): “China’s property prices grew at their fastest pace since 1996 in the first seven months of this year, suggesting government lending curbs have failed to rein in an investment boom in the industry. Residential and commercial prices rose 12.9 percent from a year earlier in the January-July period, after climbing 11.6 percent in the first half, the Beijing-based National Bureau of Statistics said… Investment climbed 29 percent, matching the gain for the first half.” August 19 – Bloomberg (Philip Lagerkranser and Le-Min Lim): “Foreign direct investment in China rose in the first seven months as companies including Siemens AG and Ford Motor Co. expanded to take advantage of low wages and tap rising demand… Investment from abroad increased 15 percent from a year earlier to $38.4 billion in the seven months through July after gaining 12 percent in the first six months, the Beijing-based Ministry of Commerce said… Contracted investment, a sign of future investment, rose 40 percent to $82.7 billion.” Asia Inflation Watch: August 20 – Bloomberg (Issei Morita): “Sales at Japan’s convenience stores rose a record 6.8 percent in July from the same month last year as customers bought more ice cream, soft drinks and cold noodles amid higher summer temperatures.” August 17 – Bloomberg (Kartik Goyal): “India’s exports rose 19 percent in July from a year earlier as automobile companies shipped more to overseas markets and steel companies stepped up sales to China. Exports were $5.43 billion last month… Imports rose 32 percent to $7.43 billion, boosted by higher oil costs. The trade deficit widened to $2 billion from $1.07 billion in July last year.” August 20 – Bloomberg (George Hsu): “Taiwan raised its 2004 economic growth forecast after record exports and surging investment helped the economy expand at its fastest pace in more than four years in the second quarter. Gross domestic product rose 7.7 percent from a year earlier in the April-June period after climbing a revised 6.7 percent in the previous three months, the statistics bureau said… The government raised its full-year growth forecast to 5.9 percent, which would be the fastest expansion since 1997.” August 17 – Bloomberg (Amit Prakash): “Singapore’s exports rose more than expected in July as companies such as Chartered Semiconductor Manufacturing Ltd. and Pfizer Inc. shipped more computer chips and drugs to the U.S., China and Europe. Non-oil domestic exports gained a seasonally adjusted 2.6 percent from June, after shrinking 6.9 percent that month… From a year earlier, exports rose 17.6 percent….” August 18 – Bloomberg (Khoo Hsu Chuang): “Malaysia’s vehicle sales rose more than a fifth in July to their highest this year as consumers, buoyed by a strengthening economy, bought more cars. Sales of passenger cars and commercial vehicles rose 22 percent from a year earlier…” August 16 – Bloomberg (Shanthy Nambiar and Amit Prakash): “Indonesia’s economic growth slowed more than expected in the second quarter as government spending fell and inflation curbed household purchases. Record oil prices may slow expansion further this quarter, the government said. Southeast Asia’s biggest economy expanded 4.3 percent from a year earlier in April through June, after growing a revised 5 percent in the first quarter…” August 19 – Bloomberg (Francisco Alcuaz Jr.): “Philippine imports rose in June at their fastest pace in more than a year as high oil prices increased the cost of the nation's fuel purchases from abroad. Imports increased 18 percent to $3.46 billion, the National Statistics Office said in Manila. That was the biggest gain since February 2003…” August 16 – Bloomberg (Francisco Alcuaz Jr.): “The Philippine economy expanded as much as 6 percent in the second quarter as manufacturing and services picked up, according to official estimates.” August 16 – Bloomberg (Katia Cortes): “Philippine inflation may average more than the government's 5 percent limit this year, an official said at a press briefing in Manila. ‘In 2004 we now have the possibility of breaching the upper end,’ Assistant Economic Planning Secretary Gay Cororaton said…” Global Reflation Watch: August 19 – Bloomberg (Reed V. Landberg): “U.K. banks and building societies provided home loans at a record rate in July, reflecting the strength of the housing market and consumers’ desire to lock in borrowing costs as interest rates rise, the Council of Mortgage Lenders said. Banks and building societies loaned 29.2 billion pounds ($53 billion) in mortgages last month, up 3 percent from June and 13 percent higher than a year ago…” August 17 – Bloomberg (Gonzalo Vina and Duncan Hooper): “U.K. house prices grew at their slowest pace in a year in July and the number of property sales fell for a fourth consecutive month, as higher borrowing costs begin to cool demand, the Royal Institution of Chartered Surveyors said.” August 17 – Bloomberg (Vladimir Todres): “Russia attracted 35 percent more foreign direct investment in the first half than in the year-earlier period as the country’s businessmen continued bringing home money they parked in offshore havens… Direct investment totaled $3.43 billion in the first half, the Federal Service of State Statistics said… Total foreign investment, including portfolio investments and loans, rose 50 percent to $19 billion…” August 20 – Bloomberg (Halia Pavliva): “Russia’s retail sales increased 12.3 percent in July from the same month a year ago, faster than expected, as the growing economy expanded domestic demand, the State Statistics Service said.” August 19 – Bloomberg (Vladimir Todres): “Russia’s foreign currency and gold reserves probably will rise to $100 billion by the end of the year, central bank Chairman Sergei Ignatyev said. Higher-than-expected oil prices have accelerated the growth in Russia's reserves, Ignatyev said in Moscow. Russia’s foreign currency and gold reserves rose to a record $89.6 billion in the week to Aug. 13…” August 19 – Bloomberg (Tina Morrison): “New Zealand house price increases slowed for a third quarter in the three months ended June 30… The national house price index provisionally rose 1.9 percent in the second quarter following a revised 5 percent increase in the three months ended March 31… From a year earlier, prices rose 22 percent.” August 18 – Bloomberg (Nick Benequista): “Mexico’s economy grew in the second quarter at its fastest pace since 2000 on resurgent demand from the U.S. for the country’s electronics, oil and metals. Mexican gross domestic product, the broadest measure of output of goods and services, grew 3.9 percent from the same period last year after expanding 3.7 percent the previous quarter…” August 18 – Bloomberg (Romina Nicaretta and Jeb Blount): “Brazilian retail sales rose at their fastest pace in at least three years in June as falling unemployment boosted sales of food and declining rates on consumer loans increased sales of furniture and appliances. Retail, supermarket and grocery store sales, as measured by units sold, rose 12.8 percent from the year-earlier period after increasing 10 percent in May…” August 17 – Bloomberg (Katia Cortes): “Brazil’s federal tax revenue rose 20 percent in July from a year earlier, as a stronger economy led more people to pay taxes and the government increased social security contributions from companies.” California Bubble Watch: August 18 – Los Angeles Times (Annette Haddad): “Last month, for the first time in seven months, the pace of home-price appreciation in Los Angeles County finally slowed down. The median price clocked in at $406,000, only a 23.8% increase from July 2003… And to some, even the tiniest dip in a housing heat wave statistic spelled relief. The July numbers ‘may be an indication that the market is cooling a little bit,’ said John Karevoll, chief analyst with DataQuick… ‘But when you say ‘cooling,’ it’s like the surface temperature of the sun cooling a notch.’” August 18 – San Diego Union-Tribune (Lori Weisberg): “When the median price of a resale home in San Diego County hit $500,000 for the first time, the question arose: What does half a million dollars buy these days? The answer: a 720-square-foot 1920s charmer in South Park, a gentrifying neighborhood five minutes from downtown San Diego. That was in May. The home is about to close escrow this week, selling for $497,000 – $18,000 under the initial $515,000 listing price. While the two-bedroom, one-bath home stayed on the market for 39 days, the sellers still were able to capture a profit of $220,000 on a home they bought three years ago. The median price of a resale home has since jumped to $520,000, making it increasingly harder for aspiring buyers to purchase a piece of the American Dream in San Diego County.” August 18 – AP: “Hundreds of thousands of applicants are competing for 3,000 temporary jobs at the ports of Long Beach and Los Angeles, hoping for lucrative wages in an otherwise weak labor market. The jobs, which pay $20 to $28 an hour, were created to handle a record amount of cargo coming through both ports. A Long Beach post office spokesman said Tuesday that a conservative estimate put the number of mailed-in applications at 220,000 to 250,000.” U.S. Bubble Economy Watch: August 19 – New York Times (Eduardo Porter): “A relentless rise in the cost of employee health insurance has become a significant factor in the employment slump, as the labor market adds only a trickle of new jobs each month despite nearly three years of uninterrupted economic growth. Government data, industry surveys and interviews with employers big and small indicate that many businesses remain reluctant to hire full-time employees because health insurance, which now costs the nation's employers an average of about $3,000 a year for each worker, has become one of the fastest-growing costs for companies. Health premiums are sapping corporate balance sheets even more than the rising cost of energy. In the second quarter, the cost of health benefits rose at a 12-month rate of 8.1 percent - more than three times the inflation rate and the rate of increases in wages and salaries… The increase in health insurance premiums reflects the rising cost of health care, which is being driven by expensive new drugs, many of them heavily advertised to consumers; medical advances including diagnostic tests that require costly new machines; and a reaction to past restrictions in managed care health plans that sought to rein in costs.” August 18 - Dow Jones (Janet Whitman): “Spending on advertising in the U.S. rose 6.4% in the first half of the year to $49.6 billion, lifted by increased political advertising and a rise in demand from traditional advertisers… The top 10 advertisers spent $8 billion on advertising this year through June, an 11.3% increase from the same period a year ago…” August 17 – Market News International (Steve Beckner): “A Federal Reserve survey of banks released Monday found conflicting indications on credit conditions for companies and households over the past three months. In a potentially positive sign for the economy the Fed’s quarterly senior loan officer survey found demand for all types of business loans increased significantly over the past three months. But despite somewhat eased terms for households, lending to that sector generally weakened. At the same time banks indicated a greater willingness to make business loans by further easing loan terms and standards.” August 19 – Market News International (Gary Rosenberger): “Demand for new trucks is back to levels unseen in five years, pushed up by a robust manufacturing recovery, a massive import surge, a delayed replacement cycle, and a railway system beset by severe capacity constraints, truck industry officials say. Factories are pushing out new trucks as fast as they can but supply constraints are extending lead times anywhere from three months into early next year, slowed by shortages of engines, axles, steel and other components and raw materials, the officials say. Strong demand and higher input costs are raising prices at wholesale -- factories have instituted non-negotiable raw material surcharges valued at between $3,000 and $5,000…” August 16 – BusinessWire: “Factory-to-dealer deliveries of recreation vehicles (RVs) are up 20 percent for the first half of 2004 compared to the same period last year--on pace to set a quarter-century record, according to newly released data from Recreation Vehicle Industry Association (RVIA).” Mortgage Finance Bubble Watch: Both July Housing Starts and Permits were much stronger-than-expected. Total Housing Starts were reported at an annualized rate of 1.978 million, up sharply from June’s 1.826 million. Total Starts were up 4.5% (single-family up 7.5%) from July 2003 and 38% from July 1997. Single-family Starts were up 22.8% from July 2003. Total Building Permits were reported at 2.055 million annualized, up from June’s 1.945 million and compared to the consensus estimate of 1.95 million. Permits were up 9% from last July and up 43% from July 1997. At 1.234 million units annualized, Homes Under Construction were up 14.5% from the year ago period to a new record (up 48% from July 1997). Golden West Financial reported record originations of $4.9 billion during July, up 54% from July 2003. Loans expanded at a 35% rate during the month to $91.7 billion and were up 32% from one year ago. On the liability side, Borrowings from the FHLB have expanded at a 66% rate over the past four months and were up 31% from July 2003. Deposits have expanded at a 15% rate over the past four months and were up 9% over 12 months. Ninety-nine percent of July originations were ARMs. A stronger June was followed by a slow July at Fannie Mae. The company’s Total Book of Business expanded at a 2.6% rate to $2.256 Trillion, with a y-t-d growth rate of 4.5%. Fannie’s Retained Portfolio expanded at a 2.0% pace to $892.7 Trillion. Fannie Mae chief economist David Berson revised higher his estimates for 2004 New and Existing Home Sales, as well as net mortgage lending growth. The Mortgage Bankers Association (MBAA) this week also revised 2004 forecasts higher, including Housing Starts, New and Existing Home Sales and Median Prices. Comparing recent MBAA forecasts to those made in late January, it is worth noting that estimates for New Home Sales for the year have increased 18% and Existing Home Sales 10%. The forecast for 2004 Single Family Starts has risen 10%. Third quarter New Home Median Prices have been revised 7% higher and Exiting Home Prices 2% higher. Pondering Nuances of Contemporary Speculative Finance: August 18 - Dow Jones (Michael Mackenzie): “The desire to chase better returns in a low yield environment is driving already strong demand for structured credit derivative deals. Not surprisingly, hedge funds, who usually stand to reap 20% of the profits they make for clients, are leading the way. Underperforming hedge funds are looking to load up on credit risk via collateralized debt obligations or the fast maturing high yield debt market, say credit derivative traders. Whether the strategy backfires or pays off depends on how risky corporate borrowers fare over the coming quarters as the Federal Reserve hikes interest rates into what appears to be a decelerating economy… So for hedge funds not faring well, a choice looms between making bigger sized bets or increasing their appetite for high yield, or riskier corporate credit, said a credit derivatives trader at an investment bank in New York. ‘The underperforming guys face having to take a swing at the market.’ As a result, demand for higher exposure to such debt via collateralized debt obligations - built upon credit default swaps - has been buoyant in recent months.” The New York Times this morning reported that Barton Biggs’ Traxis Partners has posted losses this year (down 7% through July), “partly because of a bearish bet on the price of oil…” There seems to be little doubt that some speculators and derivative players have faced a painful squeeze as energy prices have surged higher. A few analysts have argued that commodity prices were being pushed artificially upward by speculative buying. That said, there have as well been significant bearish bets placed – oil and gold, for example – whose unwind supports higher prices. Welcome to the Unstable World of Speculative Finance. I would conjecture that Mr. Biggs succumbed to placing a wager on lower crude prices because he lacked conviction as to how stellar returns could be achieved elsewhere for his $2 billion hedge fund. Coming into the year, the bond market offered an unattractive risk/return profile, and prospects for equities were dicey at best. Commodities had already made a major move, with the near-term outlook especially uncertain. Yet poor return prospects did nothing to slow the torrent of liquidity flowing into the speculative community. And for many speculators that have been stung this year by bad bets (i.e. technology stocks and interest-rates), there is now the inclination to reach for stronger returns (and risk) wherever they can be garnered. The CDO (collateralized-debt obligations) and Credit default swap markets (see the excerpt from the Dow Jones story above) fit the bill, augmenting already ultra-easy Credit Availability. Similar to writing catastrophic risk insurance policies, Contemporary Finance does empower a speculator with the opportunity to enjoy the fruits of receiving large risk premiums, all the while hoping that inevitable losses are delayed for at least a few years (earning 20% of “profits” along the way). However, the problem with a boom in writing Credit insurance (or “flood” protection) is that the resulting Credit boom ensures both financial and economic distortions, along with eventual busts. I find the nature of speculative finance absolutely fascinating. I have done battle and studied speculative dynamics on the short-side now for almost 15 years. In the process I have witnessed innumerable spectacular squeezes (including the historic technology and Internet melt-ups during 1999/early 2000) followed generally by rather abrupt and often only more spectacular collapses. Speculative Bubbles do create their own liquidity, although long periods of liquidity over-abundance can end quite suddenly. And now - as shorting myriad securities, instruments, commodities, and markets has become such a prominent aspect of contemporary, securities-based finance - I do ponder the ramifications with respect to systemic stability. Examining the mechanics of an equity short position will hopefully provide some basic insight. To short a stock, we must first call the stock loan department at our prime broker. Shares are borrowed from a pool of available securities (from institutions seeking extra remuneration, or perhaps holders that purchased their shares on margin). These borrowed shares are then sold into the marketplace. A couple of additional facets of this simple example are worth noting. First, additional shares circulating in the marketplace (“float”) are created by selling borrowed securities, and a heavily shorted stock could experience a significant increase in outstanding “float.” Second, proceeds from the short-sale are segregated into a restricted account at the brokerage (to be invested in money market-type instruments). The sale of borrowed securities creates (after settlement) immediately available funds at the brokerage. Conceptually, it would seem that shorting stock – because of the selling pressure and the creation of an additional supply of shares - would weigh on the stock price. At the same time, selling additional shares would seem to impinge marketplace liquidity. But, as is often the case in life, things are generally not as simple as they appear. First of all, despite an increase in the supply of shares, market dynamics often dictate upward pressure on shorted stocks. Markets are, after all, truly an ongoing battle between greed and fear. If a heavily shorted stock continues to rise, the longs will be emboldened while the shorts will fear escalating losses. The actual supply/float may play a less than important role in determining short-term prices. Rising asset prices generally create their own speculative demand, often irrespective of supply. And when a heavily shorted stock surges higher, keep in mind that there are greater quantities of inflating shares and a larger amount of perceived wealth creation. As for system-wide liquidity, shorting can have divergent and unexpected impacts. First of all, proceeds from the short-sale are placed in restricted accounts and these funds are then used to purchase short-term liquid instruments, including asset-backed securities and “repos”. As such, funds from short-sales provide a source of additional finance elsewhere, including for speculative purposes. In addition, unfolding “short squeezes” will commonly attract keen speculative interest. Aggressive long positions will be taken, often with leverage (augmenting system liquidity). Contemporary finance and derivatives also provide a (too) convenient mechanism with which to handily satisfy the impulses of either greed or fear. Options and other derivatives certainly were a major factor in fueling the technology “blow-off.” On the one hand, they provided highly leveraged instruments whereby one could easily participate in the parabolic rise on the long side (and, at the time, who wasn’t hankering to do that!). On the other hand, options and derivatives were also used (sometimes in desperation) to mitigate disastrous bearish short positions that were being squeezed (to the moon). In either case, rising prices forced the writers of these instruments to implement leveraged long positions to hedge escalating risk. And, all the while, liquidity flush technology companies were buying back their stock and often dabbling in the derivatives market. The upshot was a self-reinforcing speculation and liquidity melee that propelled a period of acute Monetary Disorder. Securities market dynamics had come to marshal a massive liquidity bulge that was both destabilizing and unsustainable. From stratospheric “blow-off” over-valuation, prices and speculative dynamics eventually reversed. And with the bursting of the Bubble, inflated quantities of shares trading in the marketplace, huge leveraged speculative long positions, and massive derivative-related leverage provided a powerful confluence of forces that assured collapse. As it was, it took only a few short months for a manic and historic Bubble to give way to a devastating marketplace illiquidity and an industry bust. A strong argument can be made today that shorting, derivatives, leveraging and speculative dynamics have taken firm hold throughout the largest market in the world - the U.S. Credit market. And while I certainly cannot profess to understand and appreciate the various facets of this most opaque and complex marketplace, I do strongly believe that market dynamics have once again fostered a massive destabilizing liquidity bulge – a bulge that is over-liquefying various markets and keeping global market rates at artificially low levels (and in the process, accommodating and exacerbating dangerous imbalances). According to most recent Fed data, primary dealer “repo agreements” have almost reached $3.0 Trillion. These securities financing arrangements are up an astonishing $446 billion over the past year, an 18% increase. The only comparable growth throughout the world of finance is the approximate $690 billion, or 27%, y-o-y increase in global central bank currency reserve positions. And I certainly do not view these two Bubbles as unrelated coincidences. Massive Credit market leveraging (of which the “repo” market is likely the most significant) is the instrumental source of excess domestic and global liquidity that is then (buyer of last resort) “monetized” and “recycled” right back into U.S. securities markets. I have little doubt that the “repo” market and ballooning central bank balance sheets are at the epicenter of today’s unwieldy liquidity creation. Yet the specifics are not easily comprehended. There are, after all, many extraordinary facets to the analysis of contemporary liquidity, including the predominance of the securities markets (as opposed to traditional bank lending and “money” supply). Let’s ponder a few examples. For example #1, the Bank of Japan purchases newly issued notes from the U.S. Treasury. Treasury uses this liquidity to pay government employees year-end bonuses. Government workers then use these bonuses to fund their pensions and buy imports. The liquidity is then quickly directed right back to U.S. securities markets, perhaps completely bypassing the monetary aggregates, while providing the impetus for additional credit creation and securitization. For example #2, a hedge fund borrows and shorts Treasuries and then uses sales proceeds to take a leveraged position in mortgage-backed securities (MBS). Here, unlike when proceeds from equity short positions were segregated into restricted accounts, a good hedge fund client can use the funds generated from Treasury shorts to acquire higher-yielding securities (MBS, agencies, corporates, CDOs, junk, emerging market debt, etc.) And in this example, the Bank of Japan purchases the Treasuries (using dollar balances exchanged for yen with Toyota’s Japanese bank). Having bought new MBS from the proceeds of the Treasury short sale, the hedge fund transaction provided liquidity to Countrywide to make additional mortgage loans. These additional mortgage loans provided the finance for consumers to sustain consumption, including the acquisition of more Toyota and Lexus vehicles. And liquidity goes round and round… Note that central bank Treasury purchases create liquidity for the risk-taking hedge fund (and, more generally, the Leveraged Speculating Community) and then the MBS marketplace, thus creating new Credit/purchasing power for the household sector. This liquidity could then flow right back to Toyota, the Bank of Japan, the hedge fund community, the MBS marketplace and/or the American consumer. Liquidity expands unrestrained right along with the increase in marketable debt (increasing quantities of MBS and Treasuries “float”). And with rapid mortgage Credit growth fueling the economy and home prices (keeping Credit losses minimal), the attractiveness of the spread trade – shorting Treasuries and buying MBS – only increases over time. The Great Mortgage Spread trade balloons over the years. Let’s ponder a more complex example: Here, a hedge fund uses “repo” financing to take two $1 million leveraged positions in mortgage-backeds. In this example, there are six players: the hedge fund, the securities dealer, a pension fund, an MBS trust, Bank of Japan, and household sector. First, the securities dealer borrows $1 million of bonds from the pension fund. The dealer then shorts these Treasuries, selling them to the Bank of Japan. The dealer then uses this liquidity to finance the hedge fund’s MBS “repo.” The hedge fund then purchases mortgage-backeds held by the pension fund. The pension fund, now with $1 million of immediately available funds, chooses to invest these funds temporarily in money market instruments. In this example, these funds are borrowed by the securities dealer, and immediately lent to the hedge fund as it acquires $1 million of new MBS from MBS Trust. This purchase provides liquidity for the Trust to acquire additional mortgages from mortgage brokers across the country, providing the liquidity to finance additional household borrowing and spending (and more trade deficits and foreign central bank securities purchases). And as long as speculative leveraging expands, the economy grows, interest-rates remain low, and foreign demand for U.S. securities is sustained, liquidity will be abundant throughout the entire Credit system. In a world of Debit and Credit journal entry Contemporary Finance, securities finance – whether it is through shorting Treasuries or borrowing in the “repo” market – creates seemingly endless system liquidity. Liquidity and Credit excess work to seductively underpin the value of the underlying securities. Liquidity empowers the issuance of additional marketable securities, and securities leveraging exacerbates liquidity excess. And that is why they are called Bubbles. And, in similar dynamics to the short squeeze example examined above, the increasing supply of securities and leverage in the marketplace remains seemingly benign, at least as long as the price of these securities is not declining. Today, massive trade deficits foster unprecedented foreign Treasury buying. Domestically, a steep yield curve and heightened systemic risk boost demand for Treasuries. Indeed, there is today a virtually insatiable appetite for Treasury securities. This dynamic is quite accommodative for speculator funding of higher-yielding risky securities through government bond short-sales. And these transactions then create abundant liquidity that is dispersed throughout the Credit system, in the process sustaining the Credit and economic Bubbles. But acute demand for Treasuries in the face of a massive and growing short position does create a rather volatile mix of unpredictable market dynamics - including inherent volatility and acute short squeeze vulnerability. And contemplating my experience with short squeezes, it is fascinating how they often go “parabolic” right when it should be apparent that fundamental deterioration is accelerating. This was conspicuously the case in early 2000 for the Internet, telecom and technology sectors. Indeed, negative fundamental developments encourage short sales and hedging, although market dynamics often dictate that the bulls and “greed” inertia maintain the upper hand in the marketplace well beyond the point when fundamentals have turned south. Understandably, with the dollar sinking, energy prices surging, inflation rising, market rates extraordinarily low and demand for mortgage Credit exceptionally strong, many hedges were implemented to protect against higher rates (especially in the mortgage arena). And, wouldn’t you know it, the imbalanced U.S. Credit system and economy have proved incapable of generating robust job creation and expected (balanced) economic performance. The hyper-sensitive Treasury market (over-liquefied markets and insatiable demand for govt. debt) have rallied, and it would appear a major short squeeze has developed. It is again worth noting that the terminal “blow-off” technology squeeze and resulting final liquidity bulge sealed the fate for much of the industry. Similar dynamics are now in play throughout mortgage finance. |
Saturday, September 6, 2014
08/19/2004 Speculative Finance and Liquidity Bulges *
