Things are sure challenging and interesting, with cross-currents galore. For the week, the Dow and S&P500 posted slight declines. The Morgan Stanley Cyclical index declined 1.4%, while the Transports added 0.3%. The Utilities gained 1.5%, while the Morgan Stanley Consumer index dipped 0.7%. The broader market was somewhat weaker than the major averages. The small cap Russell 2000 declined 0.9%, and the S&P400 Mid-cap index fell 0.7%. The NASDAQ100 dipped 0.4%, and the Morgan Stanley High Tech index declined 0.5%. The Semiconductors were hit for 1.5%. The Street.com Internet Index was down 0.6%, and the NASDAQ Telecommunications index slipped 0.3%. The financial stocks outperformed. The Broker/Dealers added 0.4% (up 16% y-t-d), and the Banks gained 0.8%. With bullion surging $10.65 to a 17-year high, the HUI gold index jumped about 8%. Inflation fears? For the week, two-year Treasury yields increased 10 basis points to 3.97%, and five-year government yields jumped 13 basis points to 4.06%. Bellwether 10-year yields surged 15 basis points for the week to 4.27%, with a two-week gain of 24 basis points. Long-bond yields jumped 17 basis points to 4.57%. The spread between 2 and 10-year government yields widened 5 to 30 basis points. Benchmark Fannie Mae MBS yields rose 14 basis points, almost in line with 10-year Treasuries. The spread (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note was little changed at 30, and the spread on Freddie’s 5% 2014 note was unchanged at 30. The 10-year dollar swap spread increased 1.5 to 44.25. Corporate bond spreads were generally little changed, although junk bond spreads narrowed somewhat. The implied yield on 3-month December Eurodollars rose 10 basis points to 4.185%, and December ’06 Eurodollar yields rose 12 basis points to 4.40%. It has been a couple wild weeks in the Eurodollar pits. September 15 – Bloomberg (Mark Tannenbaum): “Wall Street’s biggest bond firms traded a record amount of U.S. government securities last week as Hurricane Katrina fueled a debate about whether the Federal Reserve will raise interest rates this month. The $765 billion daily trading average in the week through Sept. 7 was 75 percent higher than two weeks earlier.” This week’s investment grade corporate issuance jumped to a robust $19.3 billion. Issuers included Santander US $4.0 billion, JP Morgan Chase $1.75 billion, Marsh & Mclennan $1.3 billion, Medtronic $1.0 billion, ING Global Funding $550 million, Citigroup $500 million, PNC Bank $500 million, Codelco $500 million, Public Service Enterprises $375 million, Genworth Financial $350 million, Harris Corp $300 million, New Plan Excel $250 million, Independence Community Bank $250 million, Health Care Properties $200 million, and Equity One $120 million. Junk bond funds reported outflows of $119.6 million (from AMG). Issuers included E*Trade $450 million, Kerzner International $400 million, Continental Airlines $310 million, Insight Health $300 million, Ikon Office $225 million, NTBY $200 million, San Pasqual Casino $180 million, Select Medical $175 million, Restaurant Co. $190 million, Panolam Industries $150 million, Pacific Energy $175 million, Ashton Woods $125 million, and Metallurgical Holdings $118 million. September 12 – Bloomberg (Susanna Ray and John Hughes): “The global airline industry will post a 2005 loss of $7.4 billion, 23 percent more than expected, as rising fuel costs hurt U.S. carriers in particular, the International Air Transport Association said. Airline fuel bills may rise 54 percent from last year to $97 billion in 2005, based on an average price of $57 a barrel for Brent crude oil…U.S. airline losses will top $8 billion this year…” September 16 – Bloomberg (Hamish Risk): “Standard & Poor’s cut the credit ratings on 15 collateralized debt obligations backed by credit-default swaps on companies including General Motors Corp., Ford Motor Co. and Delphi Corp. The rating company today said it may lower the rating on another 12…” Convertible debt issuers included Encore Capital $90 million. Foreign dollar debt issuers included Temasek Holdings $1.75 billion, Colombia $1.0 billion, Natexis Banques $1.0 billion, Gerdau S/A $600 million, Banespa $500 million, and Molson Coors $300 million. September 16 – Dow Jones (Shumita Sharma): “Major emerging market stock indexes scaled new heights Friday, with those in Brazil, India, Russia and South Korea among those breaking records yet again. The extent of the rally has surprised many market watchers, who had expected rising U.S. interest rates to raise risk aversion and lure money out of emerging market assets this year.” Japanese 10-year JGB yields added 1.5 basis points this week to 1.355%. Emerging debt and equity markets continue to trade exceptionally well. Brazil’s benchmark dollar bond yields declined 8 basis points to 7.58%. Brazils Bovespa equity index rose 1.7% to a new all-time high (up 14% ytd). The Mexican Bolsa gained 2.5% to a new record high, increasing y-t-d gains to almost 20%. Mexican govt. yields rose 12 basis points to 5.29%. Russian 10-year dollar Eurobond yields added one basis point to 5.97%. The Russian RTS equity index jumped 2% to a new record (up 50% y-t-d). Freddie Mac posted 30-year fixed mortgage rates increased 3 basis points to 5.74%, down one basis point from one year ago. Fifteen-year fixed mortgage rates rose 2 basis points to 5.32%. One-year adjustable rates added one basis point to 4.46%, up 43 basis points from the year ago level. The Mortgage Bankers Association Purchase Applications Index slipped 2.9%. Year-over-year data are impacted by the Labor Day holiday. Refi applications declined 6.7%. The average new Purchase mortgage increased to $243,900, while the average ARM declined to $366,900. The percentage of ARMs increased to 28.2% of total applications. Broad money supply (M3) jumped $32.4 billion to a record $9.91 Trillion (week of September 5), with a noteworthy 16-week gain of $321 billion, or 10.8% annualized. Year-to-date, M3 has expanded at a 7.1% rate, with M3-less Money Funds expanding at an 8.3% pace. For the week, Currency dipped $1.3 billion. Demand & Checkable Deposits dropped $23.0 billion. Savings Deposits surged $31.4 billion, and Small Denominated Deposits added $3.0 billion. Retail Money Fund deposits gained $1.6 billion, and Institutional Money Fund deposits rose $3.7 billion (3wk gain of $24.4bn). Large Denominated Deposits jumped $10.0 billion, with a 5-week gain of $76.4 billion. Year-to-date, Large Deposits are up $228 billion, or 30.6% annualized. For the week, Repurchase Agreements increased $7.5 billion, while Eurodollar deposits dipped $0.5 billion. Bank Credit rose $14.4 billion last week. Year-to-date, Bank Credit has expanded $622.9 billion, or 13.3% annualized (up 10.4% from a year earlier). Securities Credit declined $10.8 billion during the week, with a year-to-date gain of $156.8 billion (11.8% ann.). Loans & Leases have expanded at a 14.3% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 16.9%. For the week, C&I loans added $0.8 billion, and Real Estate loans gained $7.7 billion. Real Estate loans have expanded at a 15.9% rate during the first 36 weeks of 2005 to $2.822 Trillion. Real Estate loans were up $371 billion, or 15.1%, over the past 52 weeks. For the week, Consumer loans increased $2.3 billion, while Securities loans gained $5.8 billion. Other loans rose $8.4 billion. Total Commercial Paper jumped $10.8 billion last week to $1.61 Trillion. Total CP has expanded $196 billion y-t-d, a rate of 19.5% (up 20% over the past 52 weeks). Financial CP rose $10.9 billion last week to $1.465 Trillion, with a y-t-d gain of $181.1 billion, or 19.8% annualized, and up 21% from a year earlier. Non-financial CP dipped $0.1 billion to $144.4 billion (up 16.2% ann. y-t-d and 9.0% over 52 wks). ABS issuance slowed to $15 billion (from JPMorgan). Year-to-date issuance of $533 billion is 21% ahead of comparable 2004. Home Equity Loan ABS issuance of $346 billion is 27% above comparable 2004. Fed Foreign Holdings of Treasury, Agency Debt declined $6.8 billion to $1.459 Trillion for the week ended September 14. “Custody” holdings are up $124 billion y-t-d, or 13.0% annualized (up $168bn, or 13.0%, over 52 weeks). Federal Reserve Credit expanded $1.3 billion to $800.6 billion. Fed Credit has expanded 1.8% annualized y-t-d (up $32.1bn, or 4.2%, over 52 weeks). International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi - were up $630.4 billion, or 18.9%, over the past 12 months to $3.965 Trillion. Malaysia’s reserve assets have jumped 31% over the past year to $74 billion. Currency Watch: The dollar index gained 1.3% this week. “Commodity currencies” generally performed well. On the upside, the Iceland krona rose 1.4%, the Brazil real 0.9%, the Canadian dollar 0.7%, the Chilean peso 0.5%, and the New Zealand dollar 0.3%. On the downside, the Mexican peso lost 1.4%, the Swedish krona fell 1.1%, the Swiss franc 0.9%, and the Japanese yen 0.9%. Commodities Watch: September 15 – Bloomberg (Jack Kaskey): “Dow Chemical Co., the largest U.S. chemical maker, plans to boost prices for all chemical and plastic products amid surging costs for energy and raw materials. The price increases are needed to sustain U.S. chemical production as the industry grapples with ‘astronomically high’ oil and natural gas costs that show no signs of receding, Andrew Liveris, chief executive…” September 15 – Dow Jones: “Citing an anticipated further increase in oil prices, DuPont & Co. plans to raise the selling prices for all of its products, as its principal raw material, chemical feedstocks, have gotten more expensive. …The Wilmington, Del., chemical giant said every $10 gain in the price of oil adds $2.6 billion to the U.S. chemical industry's variable costs.” October crude oil declined $1.08 to $63.0. October Unleaded gasoline fell 7% this week and is now below pre-Katrina levels. For the week, the CRB index fell 2.1%, reducing y-t-d gains to 11.1%. The Goldman Sachs Commodities index declined 1.1%, with 2005 gains falling to 40.2%. China Watch: September 12 – XFN: “China’s exports rose 32.1% year-on-year to $67.82 bln in August, the Commerce Ministry said. …Imports were up 23.4% from the same period last year at $57.78 bln, leaving a trade surplus of $10 bln, up 122.1% from a year earlier.” September 12 – XFN: “Exports of Chinese high-technology products rose 32.9% year-on-year to $129.5 bln in the eight months to August…” September 15 – Bloomberg (Nerys Avery): “China’s fixed-asset investment grew 27.4 percent in the first eight months as the government encouraged spending on coal mines and power plants to ease energy shortages in the world’s fastest-growing major economy. Investment in factories, roads and other fixed assets in urban areas rose to 4.1 trillion yuan ($507 billion) in the year to Aug. 31, after increasing 27.2 percent in the first seven months…” September 14 – Bloomberg (Nerys Avery): “China’s industrial production rose 16 percent in August, led by cars and steel, as companies including Honda Motor Co. and Baoshan Iron & Steel Co. expanded.” September 13 – Bloomberg (Nerys Avery): “China’s money supply grew in August at the fastest pace in more than a year, exceeding the official 15 percent target for a third month. M2, which includes cash and all deposits, grew 17.3 percent from a year earlier to a record 28.1 trillion yuan ($3.47 trillion), after expanding 16.3 percent in July… That’s the biggest gain since May 2004 and marks a sixth straight month that growth has accelerated.” September 13 – Bloomberg (Nerys Avery): “China’s retail sales rose 12.5 percent in August as higher incomes and tax cuts spurred spending on products including Lenovo computers and Snow beer… China’s government is encouraging spending by consumers to drive expansion in the world’s fastest-growing economy as it curbs corporate investment to ease power shortages.” Asia Boom Watch: September 15 – UPI: “Soaring oil import costs drove up India’s trade deficit, during the April through August period, by 79.2 percent. During that period India’s trade deficit widened to $17.4 billion, a 79.2 percent hike, the Economic Times reported Wednesday. All but $1 billion was for oil imports.” September 13 – Bloomberg (Anand Krishnamoorthy): “India’s total vehicle sales rose 18 percent last month, the Society of Indian Automobile Manufacturers said…” September 13 – Bloomberg (Manash Goswami): “India’s oil product consumption rose 13.1 percent in August, led by an increase in demand for diesel and gasoline, according to figures from Indian Oil Corp.” September 13 – Bloomberg (Cherian Thomas): “India’s exports growth in August kept pace with the previous month’s rise as carmakers sold more vehicles abroad and companies including Tata Steel Ltd. Stepped up sales to China. Exports rose 25 percent to $7.3 billion in August from a year earlier…” September 16 – Bloomberg (William Sim): “Sales at South Korea’s Lotte Department Store Co. and its two nearest competitors rose in August at the fastest pace in more than three years, the latest sign consumption may be recovering from a two-year slump.” September 15 – Bloomberg (Sara Webb): “Singapore’s retail sales rose 10.1 percent in July from a year earlier, exceeding economists’ expectations, as residents bought more cars and higher visitor arrivals boosted department-store sales.” September 12 – Bloomberg (Anuchit Nguyen): “New car sales in Thailand, Southeast Asia’s biggest auto market, rose 21 percent in August from a year earlier…” September 14 – Bloomberg (Soraya Permatasari): “Automobile sales in Indonesia rose 31 percent in August from a year earlier, said PT Astra International, the nation’s biggest auto distributor…” September 15 – Bloomberg (Stephanie Phang): “Vehicle sales in Malaysia, Southeast Asia’s biggest passenger car market, rose at the fastest pace in five months in August… Sales of passenger cars and commercial vehicles surged 19 percent last month to 50,079 units…” September 14 – Bloomberg (Stephanie Phang): “Malaysia’s inflation rate accelerated in August to the highest since February 1999 after the government raised fuel prices for the third time this year amid soaring energy costs. The consumer price index rose 3.7 percent from a year earlier after increasing 3 percent in July…” September 12 – Bloomberg (Le-Min Lim): “Hong Kong’s luxury real estate market is hotter than even New York and London. Prices on the Peak, the top of Hong Kong island, are rising as China’s economic growth spawns a new generation of buyers looking to rub shoulders with Western executives and the city’s richest families. Prices at the Peak start at HK$15 million ($1.9 million) for a two-bedroom, 1,200-square-foot apartment and exceed HK$200 million for houses.” Unbalanced Global Economy Watch: September 14 – Bloomberg (Chad Thomas): “European new car sales in August rose 7.5 percent as redesigned models by German automakers Volkswagen AG, Bayerische Motoren Werke AG and DaimlerChrysler AG enticed buyers.” September 13 – Bloomberg (Tasneem Brogger): “Danish car sales surged in August from a year earlier as consumers took advantage of near-record low interest rates to take on car loans. Sales rose 29 percent to 11,762 from 9,105 a year earlier…” September 13 – Bloomberg (Laura Humble): “U.K. inflation accelerated at the fastest pace since at least 1997 last month as oil prices surged, lessening the chance the Bank of England will lower interest rates to spur growth. The annual rate of consumer-price increases rose to 2.4 percent from July’s 2.3 per…” September 15 – Bloomberg (Ben Sills): “Spain’s current account deficit widened to a record in June as strong economic growth boosted demand for imports and pushed up costs for exporters, the Bank of Spain said. The deficit grew to 7.1 billion euros ($8.7 billion) from 5.3 billion euros in May…” September 13 – New York Times (Sophia Kishkovsky): “In the heart of the city, just around the corner from the Kremlin, Cafe Freud offers insights into one of the most prominent manifestations of post-Soviet Russia: ornate, over-the-top bathrooms. Restaurants are outdoing one another to create the most elaborate restroom in this booming city awash in oil money, with such things as gold-plated toilets, walls of padded leather, urinals with spectacular skyline views and toilet bowls resembling Gzhel porcelain, the Russian version of Delft. It might seem to be the final validation of Lenin’s 1921 prediction that the masses would one day sit on gold toilets, although as of last year, a state construction official said, 40 million Russians, nearly 30 percent of the population, were living without indoor plumbing.” September 12 – Bloomberg (Ben Holland): “Turkish passenger car sales rose 15 percent in August, the third straight monthly increase, as low interest rates encouraged borrowing.” September 15 – Bloomberg (Tracy Withers): “New Zealand’s central bank left the benchmark interest rate at a record-high 6.75 percent and said it may raise borrowing costs as surging fuel prices fan inflation to a five-year high. ‘The risk of higher medium-term inflation has increased,’ Reserve Bank of New Zealand Governor Alan Bollard said… ‘Further policy tightening may still prove necessary. Certainly there remains no prospect of a cut in the foreseeable future.’” September 12 – Bloomberg (Tracy Withers): “New Zealand house prices rose 14.7 percent in August from a year earlier, bettering the increase in July…” September 13 – Bloomberg (Andy Critchlow): “Saudi Arabia needs to invest $500 billion on plants that purify seawater for household use to meet rising demand by 2015, Arab News reported. The country gets only 100 millimeters (4 inches) of rain a year and relies on desalination plants that evaporate seawater in boilers to remove salt before re-condensing and filtering the water for drinking…” Latin America Watch: September 16 – Bloomberg (Elzio Barreto): “Brazil’s wireless phone market expanded 34 percent in August from a year ago, as companies such as Telecom Italia Mobile SpA and Vivo offered discounts to lure new customers…” September 12 – Bloomberg (Alex Kennedy): “Mexico’s industrial production unexpectedly fell in July as Hurricane Emily forced state oil company Petroleos Mexicanos to scale back output. Industrial output dropped 1.1 percent from the year-earlier period after increasing 0.7 percent in June.” September 13 – Bloomberg (Alex Kennedy): “Venezuela’s economy may grow twice as fast as the official forecast this year after record oil prices fueled a surge in government and consumer spending, a central banker said. …Gross domestic product will probably grow between 8 percent and 10 percent this year…” September 15 – Bloomberg (Alex Emery): “Peru’s economy grew at the fastest pace in four years the 12 months through July, spurred by rising copper and gold production. Growth in the 12 months through July rose to 5.9 percent…” Bubble Economy Watch: The second quarter Current Account Deficit of $195.66 billion is only somewhat smaller than the $214 billion for all of 1998. Over the past year, the Deficit has swelled to an unprecedented $750 billion, up 32% when compared to the previous four quarters. It is also worth noting that last quarter’s Deficit was 64% higher than during Q2 2002, when the dollar commenced its descent. The September Philly Fed Price index jumped 26.8 points to 52.7. According to Bloomberg, this was “the biggest gain since 1973.” New York’s (“Empire State”) price index surged 24.4 points to 53.4, “the largest increase since record-keeping began in 2001.” August Producer Prices were up 5.1% from a year ago. The Consumer Price index was up 3.6% from August 2004. August Retail Sales were up 7.9% from August 2004, with Sales ex-autos up 9.4%. Fiscal year-to-date Total Federal Spending is up 6.8% from 2004 to $2.54 Trillion. Year-to-date Total Receipts are up 13.7% to $1.902 Trillion. September 16 – Market News (John Shaw): “The Congressional Budget Office released a report Thursday that shows that the Pension Benefit Guaranty Corporation is facing a $142 billion funding shortfall over the next 20 years.” September 14 – Bloomberg (Kristen Hallam): “The percentage of U.S. companies providing medical coverage to their workers fell…as surging health-care costs prompted small businesses to cut benefits, a new survey found. Sixty percent of the 2,995 employers polled said they offered medical coverage this year, down from 69 percent in 2000, according to… the Kaiser Family Foundation… A 73 percent jump in health insurance premium costs since 2000 is eroding the principal source of benefits in the U.S. health-care system, the report said.” September 13 – The Wall Street Journal (Timothy Aeppel): “Many U.S. manufacturers are gearing up for another storm surge, this one in demand for everything from wallboard and washing machines to water towers. But while rebuilding hurricane-ravaged regions will eventually mean more orders, it's also bringing more immediate supply glitches and rising prices, particularly for petroleum-based raw materials. Certain manufacturers are building inventory of steel, plastic resins and cardboard boxes and such stockpiling could eventually lead to even higher prices in the near term.” September 13 – The Wall Street Journal (Jessica E. Vascellaro): “Wages rose briskly last year for a small percentage of highly skilled workers, including nurses and airline pilots. But they failed to keep pace with inflation for musicians, elementary-school teachers and most other workers. These are among the findings of the Department of Labor's 2004 National Compensation Survey…” September 13 – Financial Times (Doug Cameron): “US mining groups could face a skills shortage as hiring reaches levels not seen for more than 20 years… The labour challenge mirrors that seen in the oil and gas industry, where the average age of engineers is nearing 50 and a lack of replacement staff is pushing up costs across the sector. The pressures facing the mining industry, which is in the midst of a boom driven by demand from emerging markets, are revealed in the quarterly outlook from Manpower…” Speculator Watch: September 13 – Dow Jones (Michael Mackenzie): “This week’s meeting between credit derivative dealers and the Federal Reserve Bank of New York comes at a crucial time in this market’s youthful tenure. Since 2000, ever rising trade volumes and widespread acceptance among many debt investors, particularly hedge funds, has pushed credit derivatives from the margins of financial rocket science to the mainstream. It’s a journey that has left the crucial and time consuming business of accounting for trades in a timely manner way behind.” California Bubble Watch: September 14 – Los Angles Times (Annette Haddad): “Southern California’s hot housing market reheated in August as prices rose at a faster pace for the second month in a row after slowing earlier this year… The median home price in the six-county region rose 17% to $476,000 last month compared with the year-earlier period, after year-over-year increases of 16.7% in July and 15% in June, according to DataQuick… The volume of transactions also regained steam after tapering off in recent months. The faster appreciation and higher sales volume suggested that the anticipated deceleration of the housing market might take longer to develop.” September 14 – SF Chronicle (Kelly Zito): “Just when it seemed Bay Area home prices couldn’t jump any higher, they bounded to another new peak in August… The median price for a single-family home in the nine counties reached $651,000 last month and nearly 19 percent above last August’s median, according to…DataQuick. In July, the median was $643,000. The number of sales of both detached homes and condos fell 4.1 percent from the year-ago level, which was the highest volume decline since at least 1988.” Mortgage Finance Bubble Watch: August was a huge month for Countrywide. Mortgage fundings jumped to a record $53.5 billion (up from July’s $44.1bn), up 21% from July and an eye-opening 72% from August 2004. Purchase fundings were up 41% to a record $25.1 billion. Non-purchase (refi) fundings were up 110% to $28.0 billion, the highest since the summer 2003 refi boom. ARM fundings were up 49% to $27.3 billion, 51% of total fundings. Home Equity fundings were up 35% from a year earlier to $4.1 billion, with Subprime fundings up 5% to $4.5 billion. Bank Assets expanded $2.9 billion during the month to $72.5 billion, up 135% from August 2004. “On a consolidated basis, Countrywide funded $10.4 billion in pay-option ARM loans and $9.4 billion in interest-only loans for the month of August 2005.” September 14 – Dow Jones (Dawn Kopecki): “Hurricane Katrina’s impact on the broader U.S. housing industry won’t be nearly as swift as the destruction of the Gulf Coast, and it’s expected to linger long after most evacuees are placed in permanent homes. Federal agencies, trade groups and private corporations are all struggling to head off a potential housing crisis in the wake of Hurricane Katrina -loosening restrictions on federal housing programs, easing mortgage terms and freeing up foreclosed homes for evacuees. Mortgage companies are preparing for a sharp rise in delinquencies beginning in the fourth quarter and a potential surge in defaults and credit losses next year.” Borrowing Short & Lending Short: I will be the first to note the irony of Lehman Brothers reporting a 74% surge to record earnings the same day that Delta and Northwest Airlines file for bankruptcy. It certainly provided a rather salient example of the widening divide between the winners and losers of the Wall Street finance-led inflationary boom. Lehman Brothers, a Credit-creating juggernaut these days firing on all cylinders, reported a rather remarkable quarter. Net Income ballooned to $879 million, with Total Revenues up 71% to $8.639 billion. Principle Transaction Revenues were up 71% to $2.085 billion. Investment Banking Revenues were up 55% to a record $815 million. Commissions were up 21% to $420 million. Asset Management Revenues were up 26% to a record $241 million. But the really astonishing number is the $5.078 billion of Interest & Dividends – for the quarter! Interest & Dividends were up 83% from the year earlier period, with Interest Expense up 97% to $4.787 billion. Lehman enjoyed record debt underwriting; record CMBS originations; a record $44 billion of real estate securitizations; and equity underwriting up 90%. Compensation & Benefits were up 46% to $1.906 billion. The company repurchased 9.3 million shares of stock during the quarter. Total Assets expanded at an 11.2% pace during the quarter to $381 billion. Total Assets were up 11.8% over the past year and 43.7% over three years. With Total Stockholders’ Equity of $16.3 billion, the company’s “Gross Leverage Ratio” stands at 23.3. From Lehman’s earnings conference call: Question: “Looking forward, given what we’re seeing in the interest-rate environment, could you comment to us on what you think the impact could be of a flatter or even inverted yield curve in the US should that materialize?” Chief administrative officer David Goldfarb: “As we have all seen over the past 18 months, the yield curve has been flattening. And certainly throughout that period we certainly have seen resiliency in our fixed income franchise. Let me first talk to the elements of our balance sheet. As you know, our balance sheet is an activity driven balance sheet. We use our balance sheet predominantly to warehouse our client activities and our client assets. So when we think about what is the effect on our balance sheet, largely we hedge most of the interest risk we take. We’re trying to drive economics based on extracting economics from our client-based activities. And so for the assets that stay on the balance sheet for any length of time, we try to mitigate the risk of interest rate movement. For instance, if you were to look at our balance sheet, most of our assets turn over several times a day. The elements of our balance sheet that don’t, for instance whole loans mortgages, which we may originate through our platform, that needs to go through a seasoning period to be securitized…we’re hedging interest-rate risk.” I should be at the point where I am not surprised by anything. I will admit, however, that I am a little struck by the notion of a Wall Street balance sheet of almost $400 billion “turn[ing] over several times a day.” Clearly, the brokerage business has evolved profoundly over the past few years, feeding and being well-fed by the booming global leveraged speculating community. Lehman’s largest Asset as of May 31 was “Collateralized Agreements” ($175bn) and its largest Liability was “Collateralized Financing” ($174bn). The Bubble expanding rapidly throughout Wall Street finance is one of history’s spectacular monetary inflations. Sharing characteristics of its predecessors, there are new “wrinkles” and “twists” in the underlying Credit instruments and resulting Inflationary Manifestations that both foster gross over-issuance and muddle conventional analysis. Yet, fundamentally, it is the perception of relative safety and liquidity - with respect to the new financial instruments, financing arrangements and evolving markets - that is most culpable for the proclivity of securitization issuance to go to gross excess. This dynamic is, today, in extraordinary force throughout Wall Street “structured finance.” As I have noted many times previously, The Moneyness of Credit – the capacity for creating Credit instruments with the perceived attributes of safety, stores of nominal value, and near-absolute liquidity – is an invaluable analytical tool, as we grasp for clearer understanding of the current peculiar inflationary boom. The “Moneyness” dynamic is especially precarious with regard to Wall Street finance. The greater the inflation of issuance, the seemingly more stable the underlying (inflated) collateral values, the more abundant general marketplace liquidity, and the more ingrained the market’s perception of the safety, soundness and liquidity of “structured finance.” Admittedly, it is easy these days to gloss over the details of this most protracted of Credit Bubbles. Analytically, this is certainly no time to relax, but instead we must maintain our determined analytical focus on the type and nature of Credit instruments being created in the most powerful Credit system ever conceived. The evolution from bank loan-dominated to Wall Street “structured finance” commanded Credit systems may have transpired over decades. But now having been fully received as mainstream, the evolution within structured finance is occurring at an accelerated pace. There are many things we simply don’t and can’t know. Especially with the proliferation of derivatives and increasingly sophisticated securitization vehicles, the types and characteristics of the underlying assets (loans, securities, Credit instruments, and derivatives) collateralizing these structured products are opaque. Who is buying them is similarly anyone’s guess. In the past, I could somewhat get a handle on the latest “hot trade” and areas of greatest lending and speculative excess. This endeavor has become much more challenging. But there are some key things we do know and others where we can make some relatively educated presumptions. For one, mortgages continue to absolutely dominate the Credit creation process. Second, the leveraged speculating community expansion continues in earnest, while the pressure to generate returns becomes only more intense. Third, chairman Greenspan’s ultra-cautious approach to rate increases – along with the marketplace’s perception that the Fed is hamstrung (by system fragility) in its capacity to tighten - has been fully exploited and embedded into the structuring and financing of recent securitizations and other “structured products.” What we do know: Outstanding Primary Dealer Repurchase (“repo”) Agreements (as reported by the NY Fed) are up almost $440 billion over the past year to $3.43 Trillion. We know this “repo” system is “stretched,” with ongoinng huge “failures” to delivere underlying securities. We know of recent tumult in the Treasury futures market. We know that Financial Sector commercial paper (CP) borrowings are up $256 billion over the past year, or 21.2%, to $1.465 Trillion, including asset-backed commercial paper (ABCP) that has ballooned 24% to $850 billion. We know that over the past year about half of the enormous amount of mortgage debt creation has been variable-rate. Looking at Countrywide (the nation’s largest mortgage originator), we know that approaching 40% of record fundings during August were either “pay-option” or interest-only mortgages. From what will be record mortgage Credit growth this year, an unprecedented amount of the new loans will be variable-rate and non-conventional. Moreover, an unprecedented amount will be collateral for “private-label” (non-GSE) securitizations. And while the scope of mortgage Credit excess these days outclasses developments in corporate finance, it is also clear that the trend of variable-rate borrowings has taken hold in corporate America as well, especially with major financial institutions. Examining recent investment grade corporate issuance data provided by JPMorgan, I see that 54% of total year-to-date issuance ($390bn) is “floating.” And while Industrial and Utility companies borrow largely fixed-rate, the corporate sectors comprising today’s largest borrowers have shifted to predominantly floating-rate. Leading the charge, of the $85 billion y-t-d debt issued by “US Banks,” 78% has been floating; followed by 96% of the $70 billion “Yankee Banks” issuance; 71% of $62 billion “Broker Dealers” issuance; and 67% of the $26 billion “Other Financial” issuance. The sector “Structured Investment Vehicles” has issued $42.4 billion of debt y-t-d, of which 81% was floating. And, as examples, we see this week that JPMorgan issued $1.35 billion floating-rate notes, Santander US a $4.0 billion floating-rate deal, and last week HSBC issued $2.35 billion of floating-rate notes. Structured finance is extraordinarily flexible and, by its very nature, compliant to the wants and needs of the marketplace. When, such as in 2000 and 2001, the marketplace desired longer-term, fixed-rated securities in anticipation of aggressive Federal Reserve accommodation, Wall Street (in conjunction with the GSEs, corporate America, and fixed-rate mortgagees) easily obliged. For about two years now, the marketplace has been anticipating the Fed’s “tightening” cycle. Here again, a forewarned Wall Street has had no problem accommodating the marketplace’s desire for the attractive risk profile of large quantities of floating-rate instruments. And this process has certainly been heavily championed by Mr. Greenspan’s words and deeds. Fed policies ensured that variable-rate mortgages were, on the one hand, too good for households to pass up and, on the other, a necessity for purchasing increasingly over-priced homes in California and elsewhere. On the lending side, the leveraged speculating community and REITs have been than more than content to aggressively borrow short-term to purchase variable-rate mortgage instruments. This key facet of the Mortgage Finance Bubble has been a boon for Wall Street. The Street’s financing of these lenders/interest-rate “arbitrageurs” has become an unparalleled bout of Borrowing Short & Lending Short. The risks associated with the traditional “borrow short/lend long” interest-rate speculation; the “borrow cheap/lend dear” Credit risk speculation; and various combinations of the two have been well analyzed over the decades and centuries. I contend that Borrow Short/Lend Short is a completely different animal - an evolutionary by-product of contemporary (inexhaustible) Wall Street finance. In a Credit system with unlimited amounts of short-term securities (i.e. “repo”) funding, why would our major financial institutions (such as Lehman Brothers) not aggressively borrow “overnight” funds to lend short-term to their clients (to finance the purchase of their top-rated securitizations!) for a few basis points premium? The “brokerages” earn easy spread profits irrespective of interest rates and yield curves, their investment bankers win, their hedge fund clients win, marketplace liquidity wins, and the Bubble Economy enjoys a remarkably resilient source of cheap finance. Who loses? Traditionally, Credit booms are brought to their knees by higher interest rates. For a system constrained by a limited supply of finance, heightened boom-time demand for borrowings pushes up its price (market rates). In booms of old, policy tightening would have Fed open-market operations withdraw reserves from the banking system. This would immediately restrict liquidity, both forcing lending rates higher and directly imposing (reserve) restrain on the banking system as a whole. Today, the expansive financial sector (as opposed to the “banking system”) – encompassing international banks and securities firms, the GSEs, myriad insurers, finance companies, captive finance subsidiaries, public mutual funds, hedge funds, pension funds, ABS, MBS, “structured finance,” central banks, and others - operates unrestrained by reserve or capital requirements. Liquidity is dictated by the unrestricted expansion of financial sector liabilities, with Fed operations reduced to little more than a symbolic gesture. And the longer and larger this Credit Bubble inflates, the greater marketplace confidence that the Fed will not risk piercing it. Fed assurances of ample marketplace liquidity, measured policy responses, and unprecedented transparency have created the perfect environment for Borrowing Short & Lending Short. Households have little fear of variable-rate mortgages, believing that they will always enjoy equity appreciation and the option to refinance (to negative amortization if necessary!). The leveraged speculators beckon and Wall Street aggressively structures products to profit from mortgage and financial sector Credit spreads, with little concern for anything other than measured and moderately higher mortgage rates, and no fear of faltering liquidity or a Fed-induced housing/economy slowdown. And if Borrowing Short & Lending Short spreads/returns appear rather meager, well, the perceived safety of this trade guarantees that it will be put on with greater leverage – creating only more surplus system liquidity! Again, who loses? The loser is system stability. In the now 15-months of Tightening Lite, the US Credit system will have added approximately $1.5 Trillion of risky mortgage debt. Millions of households have and continue to purchase inflated properties on highly risky mortgage terms. Over this period, the median price of a home in California has inflated another $73,000, with major gains in many markets nationally. Our accumulated Current Account Deficit over the six quarters of Tightening Lite has surpassed $900 billion. The prices of crude and natural gas have both almost doubled, while inflationary pressures are broadening. Unprecedented global liquidity has fueled debt, equity and real estate booms encompassing markets large and small, developed and developing. It’s become a runway global Credit Bubble. Borrowing Short & Lending Short is liquidity and interest-rate destabilizing. On the one hand, unprecedented real estate and securities lending creates enormous liquidity (and this has absolutely nothing to do with the so-called “global savings glut.”). On the other hand, this financing mechanism dictates that the vast majority of securities created during the Credit expansion will be short-term/variable-rate. Additionally, a significant amount of these securities will be horded by highly leveraged financial speculators. Over time, this dynamic has radically distorted the interest-rate markets, with a confluence of surplus liquidity interplaying with an increasing shortage of longer and fixed-rate securities. Rates out the yield curve have been held down artificially, with low mortgage rates in particular only exacerbating Mortgage Finance Bubble excesses. Importantly, Borrowing Short & Lending Short has to this point proved an exceedingly resilient Credit creating mechanism. It is an outgrowth of Fed Tightening Lite and is, hence, impervious to it. To actually tighten system liquidity and Credit conditions – something long past due – would now require real restraint to be imposed directly on securities/”repo”/hedge fund/derivatives finance – the “heart and soul” of the Great Credit Bubble. And, surely, restraint imposed on such a highly speculative marketplace risks dislocation. This is a contemporary manifestation of the heavy costs associated with monetary policy falling badly “behind the curve.” Going forward, short-term rates need to move higher and, likely, considerably higher to rein in today’s destabilizing real estate and securities lending and speculative excesses. And to those arguing that the system is too fragile and housing too vulnerable for higher rates, I can only respond by reiterating that there is today no way of avoiding the bursting of the US Mortgage Finance, Credit and economic Bubbles. |
Tuesday, September 9, 2014
09/15/2005 Borrowing Short and Lending Short *
