10/04/2001 An Exceedingly Troubling Circumstance *

U.S. stocks rallied broadly this week, with the Dow and S&P500 adding 3%. The Utilities jumped 6%, while the Transports gained 1%. The Morgan Stanley Cyclical index rose 3%, as the Morgan Stanley Consumer index gained 2%. The small cap Russell 2000 and S&P400 Mid-Cap indices added better than 2%. The Biotechs also gained about 2%. Technology stocks generally rallied sharply, with the NASDAQ100 and Semiconductors jumping 9% and the Morgan Stanley High Tech index 10%. The Street.com Internet index surged 13%. Simply atrocious fundamentals kept the telecom sector from participating, as the NASDAQ Telecommunications index declined 2%. The financial stocks are also battling fundamentals, as deteriorating earnings prospects were behind a 2% decline in the S&P Banking index. The AMEX Securities Broker/Dealer index added 2%. Bullion declined $1.50 and the HUI Gold index declined about 1%.

The spectacular Treasury market melt-up continued this week, as the 2-year saw its yield sink another 14 basis points to 2.70%. Five-year Treasury yields declined 7 basis points to 3.72% and the 10-year yield dropped 9 basis points to 4.50%. The long-bond saw its yield sink 11 basis points to 5.31%. Mortgage-back and agency yields continue to decline as well, with the benchmark Fannie Mae mortgage-back yield dropping 10 basis points and agency yields generally declining 9 basis points. The benchmark 10-year dollar swap spread widened one to 68. Spreads continue to diverge between sectors, with lower-rated telecom and industrial debt underperforming.

Broad money supply (M3) increased $8.7 billion last week, failing to reverse any of the nearly $166 billion increase from the previous week. While extraordinary bank and thrift deposits expansions were somewhat reversed with about a $94 billion decline from the previous week, money market fund assets surged an astonishing $100 billion (institutional funds $80.6 billion, retail funds $19.7 billion). Broad money supply has increased $229 billion during the past five weeks, $609 billion over 28 weeks (15.5% annualized), and $960 billion (13.9%) during the past 52 weeks. Almost 40% of 12-month broad money supply expansion is explained by one component, institutional money market fund assets. During the past year institutional money funds have surged $360 billion, or about 50%. It is also worth noting that outstanding asset-backed commercial paper (ABCP) has increased $28.8 billion over the past two weeks to $696.5 billion, with year-to-date growth at 11%. There was less than $51 billion of ABCP issued as of the end of May 1994.

From Bloomberg: "Japan bought about $24.8 billion of U.S. dollars and euros last month to reverse a rise in the yen…(Japan’s) foreign reserves, the biggest in the world, have risen about $173 billion since July 1999 (to $397 billion)." The Mortgage Bankers Association reported that applications to purchase homes jumped 9%, while applications to refinance surged 27% to the highest level since the peak of the refi boom in October 1998.

The Wall Street Journal reported (Thomson Financial Service data) that third-quarter U.S. stock and bond issuance jumped 21% to $609 billion, "the fourth busiest quarter ever…" Year-to-date, total combined U.S. debt and equity issuance surpassed $2 trillion, up 31% from last year. Thomson Financial services reported that straight long-term debt issuance surged 60% to $930.5 billion, while convertible bond issuance was up 97% to $70.1 billion. Equity issuance sunk 46% to $79.8 billion.

August construction spending, at an annualized rate of $845.5 billion, was up 5.5% from year ago levels. Total August construction spending was up 51% from August 1995. Spending on new housing was up 7.7% year over year, led by a 15.4% increase in multi-family units. Private non-residential construction was down 7.8%, with spending on industrial projects down 5.5%, hotels/motels 11.3%, and office construction sinking 15.5%. Notably, the public sector construction boom runs unabated, with a record $21 billion spent during August. This was up 8% from July, the previous record, and 16% above year ago levels (and up 53% from August 1995!). Spending on education-related construction surged 26% (y-o-y), water supply projects 25%, and sewer systems 12%. Public construction has been driven by state and local governments that increased spending to $19.7 billion during August, up 17% from last year. It is also worth noting that state and local construction spending jumped 30% between 1996 and last year, driven by a 52% increase in education projects and 32% expended on highways and streets.

As one would expect, the public-sector construction boom is being driven by surging municipal debt issuance. According to CFSB, third-quarter muni issues jumped to $55.1 billion, up 13.4% year over year. The comparison would have been even greater had it not been tempered by a 19% decline in September issuance as the market came to a standstill post September 11th. Year-to-date, municipal issuance of $187 billion is up 29% from last year. New money (issuance less muni refinancings) raised of $136.9 billion is running up 15% from last year. It is worth noting that almost one-half of muni issuance is insured by one of the credit insurers.

The Argentine "death spiral" continues, with the government reporting a 14% decline in September tax revenues. Having committed a balanced budget to the IMF, previous planned spending cuts are to be doubled. September auto sales were down 47% from a year ago, as a 16% unemployment rate and draconian wage cuts take their toll. For good reason, the market is increasingly fearful of currency devaluation and default on $132 billion of Argentine government debt. There are now market unfriendly calls for economic minister Domingo Cavallo to step aside. And with a sinking currency and collapsing foreign direct investment, the Brazilian financial system and economy become more fragile by the week. The government’s ability to service dollar-linked debt becomes more suspect with each weakening of the Brazilian real. The region is once again at the brink.

There are numerous other trouble spots – countries, companies, industries, and states - that were festering long before September 11th, with recent events only pushing them further toward the edge. With $55 billion of total assets, it is worth following the continuing saga at Conseco. "Fitch has placed all ratings of Conseco, Inc. and its insurance subsidiaries, as well as the ratings of Conseco Finance Corp., on Rating Watch Negative. The rating action follows an announcement by Conseco that it will incur after-tax charges of $475 million in the third quarter of 2001. Such charges equate to approximately 9% of shareholders’ equity as reported at June 30, 2001, and fall outside of previous ratings expecations…The financial profile of Conseco Finance remains weak given its undercapitalized balance sheet and the significance of secured funding facilities and wholesale borrowings. The secured facilities effectively encumber most of the company’s asset base at the present time."

This quarter’s write-offs, including charges for junk bond, CDO, and mortgage security losses, make for a total of $2.1 billion "one-time" charges since 1999. The company is also going to take a $40 million charge related to loan guarantees. From a recent company 10-Q: "We have guaranteed bank loans totaling $548.7 million to approximately 160 current and former directors, officers and key employees. The funds were used by the participants to purchase approximately 18.3 million shares of Conseco stock…" Also from the "Q": "On April 28, 2000, Conseco and Stephen C. Hilbert, the Company’s former Chairman and Chief Executive Officer, entered into an agreement pursuant to which Mr. Hilbert’s employment was terminated. As contemplated by the terms of his employment agreement, Mr. Hilbert received: (i) $72.5 million (prior to required withholdings for taxes), an amount equal to five times his salary and the non-discretionary bonus…"

The global telecom debt meltdown runs unabated, with particularly negative ramifications for the CDO, credit derivative and credit insurance markets. From Moody’s: Oct. 03 – "Moody’s Investors Service has lowered the ratings on long term debt issued or guaranteed by Nortel Networks Limited (senior unsecured to Baa2 from Baa1, subordinated to Baa3 from Baa2 and preferred stock to Ba1 from Baa3) and has placed both the long term ratings and the Prime-2 short term ratings on review for possible further downgrade. The rating actions are in response to the dramatic fall off in revenues and our belief that revenue levels for the foreseeable future will be below our previous expectations." Oct. 04 – "Moody’s Investors Service downgraded the ratings of Nortel Networks Lease Pass-Through Trust, Pass-Through Trust Certificates, Series 2001-1 to Baa2 from Baa1 and has placed the Certificates on review for possible further downgrade. The Certificates were downgraded to Baa2 based on the support of the triple net leases guaranteed by Nortel Networks Limited, which was downgraded to Baa2 by Moody’s on October 3, 2001 and placed on review for possible further downgrade."

While off the headlines, the stunning deterioration of California’s fiscal position calls for close monitoring. We will admit to having a bad feeling about prospective Golden State finances and the State’s economy generally. Last week California executed a $5.7 billion bond offering, the largest ever U.S. muni bond issue, helping to fund what is now estimated to be a $9.3 billion fiscal year deficit. This week the Sacramento Bee ran an editorial "Wreck Ahead – Sell the Power Bonds, or Face Fiscal Chaos - If war and recession weren’t enough, an inept Public Utilities Commission and a greedy Pacific Gas & Electric Co. are threatening to plunge California into a fiscal abyss." The Los Angeles Times quoted California Assembly Budget Committee vice chair George Runner: "There’s an Armageddon approaching." Last week State Treasurer Phil Angelides warned, "People do not see the freight train of fiscal chaos coming." Some of this is likely politics but there is no denying the State will be hit very hard by unfolding circumstances. Today, Moody’s placed the rating of the State’s $31.6 billion of general obligation bonds on its Watchlist for what would be the second downgrade this year. The State’s "heavily economically-sensitive revenues," including forecasts of "stock market-related tax revenues" totaling $12.5 billion (16% of total general revenues) "now appears risky."

From Wednesday’s San Francisco Chronicle: "More than a quarter of San Francisco’s pricey Financial District office space could be sitting empty by the middle of next year if the economy keeps sliding downhill, according to a hot-off-the-presses Grubb & Ellis Research report. In layman’s terms, that’s the equivalent of 23 empty Transamerica Pyramids." "According to the firm’s third-quarter report, downtown San Francisco office space – now at 15.2% vacancy – is also experiencing rent declines of 46 % to 56%…" It is little wonder the commercial mortgage-backed securities market has cooled markedly, with it seemingly only a matter of time until a period of problematic defaults commences.

It is a central facet of Credit Bubble analysis that future financial and economic problems can be accurately anticipated through the recognition and careful analysis of previous credit and speculative excesses. Since their popularity is relatively recent and reporting scant, it is difficult to assess the size and degree of risk inherent in the complex markets for credit derivatives. Previous articles do, however, confirm that it has been the "hot" area, disconcertingly similar to the boom in complex derivative trading preceding the Asian crisis and Russian collapse.

From Bloomberg, April 6 – "The credit default swaps market will expand this year as global economic growth slows, boosting demand for insurance against bankruptcies and bond defaults, derivatives bankers said. A credit default swap is a contract to pay if a company defaults on its bonds, goes bankrupt, or some other similar ‘trigger event’ occurs. It works like insurance, with the seller of the swap only paying the swap’s buyer after a trigger event." The article quoted an industry specialist: "It depends on the severity of the downturn we’re in, or about to enter. It’s tough to see credit derivatives not being a very important product over the next few years because of what we’re seeing economically and due to regulatory changes." Quoting a former Wall Street CFO ("former chief financial officer at J.P. Morgan, who’s setting up a derivatives venture with Warren Buffett’s General Re Corp)": "The reinsurance industry has been a massive buyer of credit derivatives. Whatever company you are, these are powerful tools, although coming with that power is the potential to make mistakes which could be costly." From the article: "The British Bankers Association, one of the only organizations to track statistics, last year estimated the global credit derivative market would expand to $1.58 trillion by 2002, compared with $586 billion in 1999. That would be a nine-fold increase between 1997 and 2002…‘Credit derivatives and equity derivatives are the fastest growing areas…"

From Bloomberg, May 2 – "Global revenue from credit derivatives may grow to an annual $9 billion in coming years from about $2 billion currently, said Goldman Sachs…‘Given that credit derivatives tend to provide better margins than the cash business for corporate bonds, these products will gain a much higher profile,’ Goldman said… ‘The rocky credit markets -- the first quarter set a record for corporate defaults -- only serve to increase demand for protection.’ Credit derivatives allow banks and companies to transfer credit risk. They’re securities whose prices are based on underlying assets. The most popular are credit default swaps, collateralized debt obligations, and total return swaps. As they become more popular, the derivatives are becoming increasingly important to fixed income businesses because they’re so profitable, Goldman said. ‘Over the next five to seven years, if notionals can grow to $10 trillion, revenues could conceivably reach $9 billion.’ While credit derivatives only account for about 1 percent of the global derivatives market currently, they’re the fastest-growing part of the market. They may show the same growth trajectory as interest-rate swaps, Goldman said. CDOs, a cross between derivatives and asset-backed securities, have the potential to be the most lucrative credit derivative, used by fund managers to leverage themselves and buy high-risk assets, and banks to off-load loan credit exposure. The market has grown at 55 percent a year for the past five years, Goldman said."

From Bloomberg, June 25 – "The market for credit derivatives, used to transfer the risk of a borrower defaulting, has increased to about $1 trillion, the Bank of England said. Expansion of the market suggests investors are increasingly concerned about the risk of default from companies, particularly in the phone industry. Royal KPN NV, British Telecommunications Plc, and other phone operators have had their credit ratings cut in recent months, as they increased borrowing to buy other companies and mobile phone licenses. That has boosted their borrowing costs. ‘Large increases in debt to finance acquisitions and (mobile phone) licenses’ is partly responsible for expansion in the market for credit derivatives, the central bank said…Growth in the market will lead to the transfer of more information about the companies, helping banks to price loans. Banks can bundle together loans and bonds and sell them as a package, transferring the risk of default, or spreading it among a wider group of lenders… ‘The range of new credit (derivatives) has the potential to increase the robustness of the global financial system,’ the central bank said."

June 21 – "The average volume of trading done by European institutional fixed-income investors in credit derivatives nearly tripled in 2000, while the proportion of product users in the market nearly doubled. A recent study by Greenwich Associates reveals galloping momentum toward broader and more robust use of credit derivatives in the near future… Liquidity is also improving. ‘It s a classic virtuous circle’…as usage grows, the products become increasingly useful, more institutions use them, and usage continues its growth. The development of the credit derivatives market…is becoming increasingly comparable to the interest-rate derivatives market, which grew from virtually nothing in the early 1990s to trillions of dollars today… A chief reason for the growing popularity of credit derivatives is that investors see them as nearly as useful for seeking incremental returns…and investing, behind only hedging bond credit risk… Until recently, credit derivatives were very esoteric products… In the last couple of years, credit derivatives have been marketed more actively and purchased by investors nearly as much for profit as for hedging purposes."

It is again worth highlighting a few of this week’s ratings actions: "October 3 – Moody’s placed the ratings of fifteen lodging and leisure related companies on review for possible downgrade. At the same time, Moody’s placed the ratings of four gaming related issuers on review for possible downgrade, and revised the rating outlook on three gaming-related issuers to negative from stable. Moody’s action is in response to the expected deterioration in credit quality resulting from the tragic events of September 11, 2001, and signals a change in Moody’s overall outlook for the lodging, leisure and gaming related industry sectors to negative from stable. This rating action follows Moody’s decision last week to place five lodging and four gaming companies on review for possible downgrade."

From Bloomberg: "Bonds backed by Hawaii and Disneyland’s home, Anaheim, California, may face downgrades because of reduced tourism, Standard & Poor’s said."

From Bloomberg: "Oct. 4 -- Ratings on $934 million of bonds sold to build the international arrivals terminal at New York’s John F. Kennedy International Airport were cut by Moody’s Investors Service, which cited a drop in air travel. The rating company said it lowered the bonds’ underlying credit grade to ‘Baa3,’ to one notch above junk, from ‘Baa2.’ Insurance from MBIA Corp. gives the securities a ‘Aaa’ rating… Some of the JFK terminal’s biggest tenants, including El Al Israel Airlines Ltd. and Swissair Group, in recent weeks ‘have either reduced operations or have gone out of business,’ Moody’s said. Moody’s also noted that the terminal lost its insurance against acts of war and terrorism after the attacks. ‘In the event such an act was perpetrated in the terminal, the terminal operator could become bankrupt as a result of liability claims,’ Moody’s said."

From Fitch: Oct. 3 -- "Massachusetts Port Authority’s $955 million in revenue bonds’ are placed on Rating Watch Negative and the ‘AA’ rating is affirmed. The Rating Watch Negative reflects the uncertainty surrounding operating margins at Boston-Logan International Airport (Logan) and potential liability resulting from the events on Sept. 11, 2001. The bonds are secured by the net revenues generated from the Authority’s assets…Fitch also put approximately $240 million of Massachusetts Port Authority passenger facility charge (PFC) revenue bonds on Rating Watch Negative and affirmed the ‘A’ rating… Fitch has underlying ratings on approximately $42 billion of debt for 64 U.S. airports, including 28 of the 30 largest airports in the U.S. Fitch is individually evaluating the impact of the attacks on each of the 64 Fitch-rated airports."

From Fitch: Oct. 4 -- "Fitch has placed the following emerging market airline ticket receivable transactions on Rating Watch Negative: AeroMexico Receivables US Trust, rated ‘AA’ Rating Watch Negative. Mexicana Receivables US Trust, rated ‘AA’ Rating Watch Negative. Pelican Series 1999-1, rated ‘AA’ Rating Watch Negative. Each of these transactions are guaranteed by a surety bond provided by Centre Solutions (Centre). The ratings of the transactions are tied to the financial strength and claims paying ability of Centre Solutions. Though Fitch does not publish an insurer financial strength rating on Centre Solutions, Fitch closely monitors Centre’s financial strength and maintains an internal credit opinion on Centre for use in structured transactions. The Rating Watch on these transactions is thus linked to Fitch’s concerns that losses from the Sept. 11 attacks for both Centre and the worldwide Zurich Insurance organization could prove to be higher than is consistent with current expectations supporting Fitch’s credit opinion on Centre. Centre is ultimately a wholly owned subsidiary of the Zurich Financial Services Group of Zurich, Switzerland. The Rating Watch also acknowledges certain unfavorable operational trends within the Zurich organization as a whole."

From Fitch: Oct. 2 -- "Fitch has downgraded two classes of notes issued by BAC Synthetic CLO 2000-1 Limited, a synthetic cash flow CDO established by Bank of America to provide credit protection on a $10 billion portfolio of investment grade, corporate debt obligations… Fitch’s rating action reflects higher than expected defaults in

the underlying assets. This has resulted in higher than expected credit protection payments under the credit default swap agreement with Bank of America CLO Corporation II, and a diminished level of credit enhancement for the class D and E

notes."

From PRNewswire: Oct. 1 -- "Standard & Poor’s today placed its ratings on the class B-1, B-2, C-1, C-2, and D notes issued by Triumph Capital CBO I Ltd., and co-issued by Triumph Capital CBO I Inc. on CreditWatch with negative implications. The triple-‘A’ ratings on the class A-1A, A-1B, and A-2 notes, based on a financial guarantee insurance policy issued by Financial Security Assurance Inc. were unaffected by the action. The CreditWatch placements reflect the significant deterioration in the collateral pool’s credit quality, and an additional $41.5 million of new defaults since July 16, 2001 when ratings were lowered… According to the Sept. 14, 2001 trustee report, a total of $25.5 million, or approximately 4.9% of the total collateral pool is listed as defaulted. In addition, the issuer’s credit ratings on four bonds ($27.05 million), listed as performing assets on the trustee report, have been lowered to ‘D’ by Standard & Poor’s within the last two months. Also, obligors with ratings in the triple-‘C’ and double-‘C’ range comprise more than 12.87% of the total collateral portfolio. Furthermore, approximately 20.8% of the obligors in the collateral pool are currently on CreditWatch with negative implications… The weighted average recovery rate associated with the $57 million of defaulted securities sold to date is approximately 8%, well below the recovery rate assumed at the transaction’s closing."

And extracted from an excellent global insurance conference call sponsored by Nomura’s office in London, Matthew Maxwell, credit analyst, Nomura International: "Estimates for the total cost for the eleventh of September terrorist attacks for the global insurance industry have been revised upward from an initial estimate of $14 billion. One of the most recent estimates we see comes from Berkshire Hathaway which thinks that its own losses of $2.2 billion are about 3 to 5% of the total industry loss, which implies losses of between $44 and $73 billion for the whole industry…invariably, experience has shown that initial assessments of the costs of large catastrophes tend to be inaccurate due to the range of (inaudible) costs and the time it takes to apportion them. For example, the final costs of the Northridge earthquake in California in 1994 were more than six times the initial estimate, and moreover it took seven years to resolve…given that the terrorists attacks on the eleventh of September were a series of events in different places rather than a single event, the final costs will be even more difficult to estimate. Apart from P&C (property and casualty) insurance and the reinsurance, other related insurance exposure will include workers’ compensation policies for deaths and injuries, and claims under travel and accident insurance may be made against AMR corporation and UAL corporation by the families of those on their aircraft if it can be proven that the airlines were negligent in their security arrangements. There could also be claims by companies under general liability cover and cover for contingent business interruption. For example, New York hotels, restaurants, and stores are estimated to have lost up to $500 million per day when much of lower Manhattan was closed down.

Quite clearly though, the eventual losses will exceed any of the other major losses insured by the global insurance industry to date, including the near $20 billion cost of hurricane Andrew. In fact, estimates will rise not just as more information becomes available but also for more technical reasons. For example, insurers tend to assess their losses on a net basis if they see the insurance they have ceded will be collectable. But for some reinsurers now placed under pressure, as evidence by the insured’s financial strength ratings, these assumptions may not hold in all cases. So, initial insurers of relevant risk and the reinsurers who were subsequently under-rated, may well be drafted into protracted legal disputes about their respective liabilities. One complicating factor which we think may arise will be whether claims are classified as being the result of a separate incident, therefore a new claim against a principal insurer, or part of the initial claim and part to reinsurance (inaudible). A major example of this problem has emerged today with news that the lessor of the World Trade Center has asked insurers to pay up on part of the policy that covers the Twin Towers. The Insurers claim that the terrorist attacks are one event; the lessor claims they are two events. Moving on, there is also some debate over whether insurers may attempt to avoid payout of P&C claims by invoking contractual clauses that exclude acts terrorism or war. For acts of war, the exact definition required is unclear. For example, do acts of war require formal declaration of war and can war only exist between states rather than between states and terrorist organizations."

As to another issue, it is quite disappointing to listen to the current dialogue regarding monetary and fiscal stimulus. From my vantage point, a strong consensus has developed that is cautious on fiscal stimulus, while quite favorably viewing lower interest rates as without cost or risk. Additionally, there is the view that monetary stimulus can be "easily reversed down the road when necessary." I view the consensus as having it wrong. I actually have no problem with a $70 billion spending appropriation under the circumstance of a national catastrophe. Besides, this amount of increased government borrowing corresponds to about one month’s net increase in mortgage debt in the context of the current lending boom. I do, however, have a big problem with the Fed throwing additional gas on the mortgage finance bonfire. There are some very smart people cheerleading the Fed’s aggressive rate cuts that should be very well aware of the dire future consequences of feeding this real estate Bubble.

Under the circumstances, it is just very frustrating that there is not some recognition that the acute credit and financial problems afflicting the U.S. and global financial systems (and, increasingly, economies) - especially those emanating from the telecom/Internet/tech sector - are directly associated with the ultra-easy money and global systemic reliquefication following the 1998 crisis. The considerable negative consequences of previous credit and speculative excess are today palpable, and to conveniently ignore the momentous future costs of exacerbating the historic mortgage Credit Bubble is most unfortunate. Much more of the same is clearly not the way to go. And not "mincing words," I am left pondering if a desperate Fed sees no other option, or if this is simply the continuation of truly inept monetary management.

Returning to the misconception that lower interest rates are "costless" and "easily reversed," it is as well worth highlighting how only a slight tempering of "easy money" was sufficient to pierce what had become an increasingly vulnerable telecom/Internet/tech Bubble. The key to appreciating the fragility of such Bubbles is to recognize how significantly credit and speculative excess have distorted the underlying structure of demand and monetary processes. Throughout the technology sector, extreme excess led to extraordinary self-reinforcing financial flows throughout the industry. These monetary processes financed excessive industry demand and, thus, fostered additional investment, greater speculative financial flows, and only more demand and a spectacular industry spending Bubble. Credit excess begets only greater excess, with financial flows (and risk) expanding exponentially over the life of the boom. And while the technology Bubble had been expanding steadily for several years, by far the greatest financial and economic damage was inflicted during the 18-month "terminal stage" of excess fueled directly by post-1998 crisis reliquefication. After such a dynamic Bubble is accommodated over a protracted period, any move that tightens financial conditions and leads to any reduction of outsized financial flows is immediately problematic. Reduced investment, faltering demand, a destabilizing reversal of speculative flows - a piercing of the spending and speculative Bubble - sees the seeming "virtuous" abruptly transformed into "vicious cycle." Depending on the extent of the Bubble, only a marginal reversal of flows can set in motion catastrophic consequences. It should be obvious to central bankers that such precarious dynamics are to be avoided like the plague.

But with the collapse of the NASDAQ/tech Bubble necessitating another 1998-style reliquefication, extreme efforts by the Federal Reserve and GSEs have ushered in the "terminal stage" of credit and speculative excess throughout the enormous mortgage and consumer finance superstructure. Not coincidently, this was the remaining sector offering the requisite dimensions with the potential for the enormous credit creation to sustain the greater systemic Credit Bubble. Here, self-reinforcing Bubble dynamics have witnessed massive speculative financial flows (particularly from the global leveraged speculating community) into agency debt, mortgage securities and related conduits, with corresponding collapsing interest rates inciting unprecedented mortgage refinancing and other borrowings. In this case, massive credit inflation has manifested into self-reinforcing real estate inflation, sustaining boom-time consumption excess with concomitant huge and endemic trade deficits. Like the tech Bubble, the focal point of the analysis is to appreciate the degree that financial Bubble dynamics have altered and accentuated the underlying structure of demand and cemented dysfunctional monetary processes. In the case of the mortgage finance Bubble, it is critical to recognize the degree to which mortgage borrowings have increasingly altered consumption patterns, and consequent over/malinvestment in consumption-based production and structures (domestically and internationally).

We also see protracted asset inflation as having played a key role in what will prove the most profound (and difficult to rectify) maladjustment, the structural shift of the U.S. away from production and into a "service sector" economy. It is also inarguable at this point that mortgage credit excess, particularly through the extraction of equity during refinancings and home-equity borrowings, has significantly accentuated and distorted financial flows, again both domestically and internationally.

We will have more to say on the issue in the future, but a central aspect of current U.S. structural vulnerability also lies with the ongoing disproportional increase in luxury and discretionary spending that has gone to particularly dangerous extremes over the past few years. As we have seen post-WTC attack, spending on travel, hotels, casinos, leisure and entertainment, luxury goods and such have potential to drop precipitously with any break in confidence. Fragility becomes a critical issue for a maladjusted Bubble economy/financial sector to the extent that spending distortions have been exacerbated by protracted (and self-reinforcing) credit excess and asset inflation (particularly equity and real estate), and the consequent investment excesses into related industries. As such, and importantly, it is of no coincidence that the airlines, hotel, gaming, and auto sectors were at the same time acutely vulnerable to both faltering (discretionary) demand and excessive (Bubble-induced) overleveraging/financial fragility. It appears an unappreciated characteristic of the contemporary U.S. credit system that credit and speculative excess tend to impart inflationary manifestations within sector booms and busts rather than put pressure on general prices.

So today, with scores of companies, various sectors, and many countries in desperate straits having basically lost access to new borrowings with their respective busts, credit could not be more easily and cheaply thrown at the U.S. consumer. Eighteen months ago the liquidity spigot was flooding the U.S. and global technology sector, today it drowns the U.S. homeowner/consumer. As we have argued repeatedly, the situation could not be more dysfunctional and, hence, unsustainable. Current debate seems to naturally fall back into "inflation versus deflation." Yet, at least as long as we are in the midst of historic U.S. mortgage credit excess, I tend to view the critical consequence of such a distorted financial and economic environment as a continuation of extreme and unstable divergences in relative prices. Or, said differently, an out of control U.S. credit system is locked in a hopeless cycle of fueling recurring booms and subsequent unavoidable busts. I am not willing today, with the ongoing explosion of mortgage credit and money supply, to label the subsequent busts "deflation."

We have, of course, argued strongly for some time that a frantic Fed was only digging deeper into a pit of failed policy. This has never appeared as conspicuous as it does today. The analogy would be a person caught in a lie later forced to concoct increasingly far-fetched tales desperately hoping somehow the mess will fade away before it is all exposed. Unfortunately, this huge mess will not be resolved with only more preposterous monetary fudging. The insurmountable dilemma really boils down to the fact that the extremely maladjusted U.S. Bubble economy and financial system require enormous new credit creation basically just to keep from imploding. At the same time, a maladjusted economy and faltering credit system are providing increasingly limited avenues to expand credit, with bursting Bubbles not at all conducive to credit expansion. It’s not an interest rate issue outside of the powerful impact lower rates have in prolonging the great mortgage-lending Bubble.

Quite ominously, we have witnessed unprecedented mortgage credit creation and monetary expansion over the past year succeed only to the point of keeping the U.S. economy sputtering along and financial system from buckling. Furthermore, we have for three years watched (in disbelief) unrelenting and extreme liquefication from the GSEs. Seeing such powerful monetary fuel increasingly lose its potency has signaled to us that the U.S. Bubble is approaching the end of its rope. As everyone knows, the Fed, GSEs and global central bankers have mastered the art of sustaining an overliquefied U.S. financial system and dollar Bubble. What people don’t seem to appreciate is the degree of damage being imparted on financial systems and economies in the process. In the end, there is grossly insufficient real economic wealth to support the continuing unprecedented inflation of financial claims, particularly problematic with respect to ballooning foreign claims on U.S. assets. There are as well unmistakable signs of acute stress emanating from the global financial system, and at home from the equity to CDO to Repo markets. It sure looks to us today like an awfully thin line is being drawn between the continuing massive increase in financial claims necessary to keep this sordid game going and the maintenance of confidence in the sustainability of the system. This is An Exceedingly Troubling Circumstance.