| It was nothing if not dizzying. For the week, the Dow declined 0.7%, and the S&P500 dipped 0.6%. The Transports were down 0.4%, and the Utilities were hit for 1.3%. The Morgan Stanley Cyclical index fell 0.6%, and the Morgan Stanley Consumer index declined 0.3%. The broader market was quite volatile, although the small cap Russell 2000 ended the week with only a slight decline and the S&P400 Mid-cap index ended with a slight gain. Technology stocks were strong. The NASDAQ100 gained 1.3%, and the Morgan Stanley High Tech index rose 1.6%. The Street.com Internet index gained 2% and the NASDAQ Telecommunications index increased 0.7%. The Semiconductors, however, declined 0.2%. The Biotechs fell 1.1%. Financial stocks posted strong gains. The Broker/Dealers jumped 2.9%, and the Banks rose 1.2%. With bullion down $2.80, the HUI gold index was hit for 3.4%. Treasuries enjoyed a strong Thursday afternoon and Friday. For the week, two-year Treasury yields declined 5 basis points to 4.20%. Five-year government yields dropped 9 basis points to 4.25%. Bellwether 10-year yields sank 10 basis points for the week to 4.38%. Also dropping 10 basis points, long-bond yields fell to 4.60%. The spread between 2 and 10-year government yields dropped 5 to 18 bps. Benchmark Fannie Mae MBS yields declined 7 basis points, once again underperforming Treasuries. The spread (to 10-year Treasuries) on Fannie’s 4 5/8% 2014 note and the spread on Freddie’s 5% 2014 note both widened one to 33. The 10-year dollar swap spread added .25 to 48.50. Corporate bonds performed well, with investment grade, auto and junk bond spreads all narrowing slightly. The implied yield on 3-month December Eurodollars declined 2 basis points to 4.405%. December ’06 Eurodollar yields dropped 9.5 basis points to 4.625%. Investment grade corporate issuance jumped to $13.3 billion. Issuers included Morgan Stanley $5.5 billion, GE Capital $2.0 billion, Citigroup $1.5 billion, Wells Fargo $1.5 billion, Gulfstream $850 million, PSI Energy $350 million, LG-Caltex Oil $300 million, PPL Energy $300 million, John Deere $250 million, RPM International $150 million, and Entergy Louisiana $150 million. Junk bond funds saw outflows slow to $255 million (from AMG). Issuers included Del Laboratories $185 million. Convert issues included PMC-Sierra $225 million and Enpro Industries $170 million. Foreign dollar debt issuers included Depfa ACS Bank $1.0 billion. Japanese 10-year JGB yields declined 6 basis points this week to 1.505%. Emerging debt and equity markets diverged somewhat this week. Brazil’s benchmark dollar bond yields sank 19 basis points to 7.74%. Brazil’s Bovespa equity index declined 2% (up 11.4% y-t-d). The Mexican Bolsa was unchanged (up 15.4% y-t-d). Mexican govt. yields declined 16 basis points to 5.66%. Russian 10-year dollar Eurobond yields dipped 2 basis points to 6.46%. The Russian RTS equity index fell 2.5% this week (up 44.6% y-t-d). Freddie Mac posted 30-year fixed mortgage rates jumped 7 basis points to 6.10%, up 39 basis points in six weeks. Thirty-year fixed rates were up 41 basis points from one year ago. Fifteen-year fixed mortgage rates increased 3 basis points to 5.65%, up 58 basis points in a year. One-year adjustable rates added 4 basis points to 4.89%, up 43 basis points in five weeks (high since April 2002). One-year ARM rates were up 87 basis points from the year ago level. The Mortgage Bankers Association Purchase Applications Index jumped 7.3%. Purchase Applications were up 9% from one year ago, with dollar volume up 19%. Refi applications gained 4.5% during the week. The average new Purchase mortgage declined to $243,700, and the average ARM slipped to $357,600. The percentage of ARMs was little changed at 29.3% of total applications. Broad money supply (M3) declined $8.4 billion (week of October 10). Over the past 21 weeks, M3 has surged $400.8 billion, or 10.3% annualized. Year-to-date, M3 has expanded at a 7.3% rate, with M3-less Money Funds expanding at an 8.6% pace. For the week, Currency dipped $0.6 billion. Demand & Checkable Deposits dropped $40 billion. Savings Deposits jumped $27.9 billion. Small Denominated Deposits added $1.4 billion. Retail Money Fund deposits declined $1.0 billion, and Institutional Money Fund deposits fell $4.2 billion. Large Denominated Deposits jumped $16.7 billion (up $41.2bn in 3 wks). Year-to-date, Large Deposits are up $257.9 billion, or 30.3% annualized. For the week, Repurchase Agreements declined $5.6 billion, and Eurodollar deposits dipped $2.9 billion. Bank Credit increased $3.3 billion last week. Year-to-date, Bank Credit has inflated $633.3 billion, or 11.9% annualized (up 10.2% from a year earlier). Securities Credit declined $6.8 billion during the week, with a year-to-date gain of $153.8 billion (10.2% ann.). Loans & Leases have expanded at a 12.9% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 17.5%. For the week, C&I loans rose $3.6 billion, and Real Estate loans increased $7.1 billion. Real Estate loans have expanded at a 14.8% rate during the first 41 weeks of 2005 to $2.839 Trillion. Real Estate loans were up $353 billion, or 14.2%, over the past 52 weeks. For the week, Consumer loans dipped $3.1 billion, and Securities loans fell $1.8 billion. Other loans expanded $4.4 billion. Total Commercial Paper jumped $14.7 billion last week to $1.629 Trillion. Total CP has expanded $215.0 billion y-t-d, a rate of 18.8% (up 20.0% over the past 52 weeks). Financial CP surged $16.0 billion last week to $1.484 Trillion, with a y-t-d gain of $200.1 billion, or 19.3% annualized (up 21.5% from a year earlier). Non-financial CP dipped $1.2 billion to $144.4 billion (up 14.2% ann. y-t-d and 6.6% over 52 wks). ABS issuance rose to $16.5 billion (from JPMorgan). Year-to-date issuance of $615 billion is 20% ahead of comparable 2004. Home Equity Loan ABS issuance of $400 billion is 21% above comparable 2004. Fed Foreign Holdings of Treasury, Agency Debt increased $1.25 billion to $1.468 Trillion for the week ended October 19. “Custody” holdings are up $132.5 billion y-t-d, or 12.3% annualized (up $174.1bn, or 13.4%, over 52 weeks). Federal Reserve Credit declined $0.426 billion to $800.9 billion. Fed Credit has expanded 1.6% annualized y-t-d (up $30.4bn, or 3.9%, over 52 weeks). International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi - were up $594 billion, or 17.6%, over the past 12 months to $3.978 Trillion. Singapore’s reserve assets were up 13.3% from one year ago to $116.37 billion. Currency Watch: The dollar index gained almost 1%. On the upside, the Iceland krona added 0.9%, the Uruguay peso 0.8%, Philippines peso 0.7%, and New Zealand dollar 0.5%. On the downside, the Swedish krona fell 1.7%, the Czech koruna 1.7%, the Japanese yen 1.6%, and the South Korean won 1.5%. Commodities Watch: October 20 – AFP: “Copper prices surged to a record, breaching 4,000 dollars per tonne here, lifted largely by ferocious demand from China, the world’s biggest metals consumer. Three-month copper prices jumped to an intra-day high point of 4,008 dollars per tonne on the London Metal Exchange. That was the highest level since copper was first listed in its current format in 1870. Copper futures in London have jumped by around 27 percent since the start of 2005.” October 17 – Bloomberg (Simon Casey): “Zinc rose to an eight-year high in London after stockpiles shrank, curbing supplies of the metal which is mostly used to protect steel from corrosion. Inventory tracked by the London Metal Exchange fell 2,525 metric tons, or 0.5 percent, to 502,900 tons…. The total has dropped 20 percent this year.” Commodities were generally on the defensive, although orange juice futures traded to a 6-year high on Wilma worries. December crude oil fell $1.33 to $60.63. November unleaded gasoline fell 5% this week to the lowest levels since early August. November Natural Gas dropped 4% to a one-month low. For the week, the CRB declined 1.6%, reducing y-t-d gains to 13.6%. The Goldman Sachs Commodities index fell 2.7%, with 2005 gains slowing to 39.7%. China Watch: October 16 – New York Times (David Barboza): “Move over, New York. This year alone, Shanghai will complete towers with more space for living and working than there is in all the office buildings in New York City. That in a city that already has 4,000 skyscrapers, almost double the number in New York. And there are designs to build 1,000 more by the end of this decade. China’s real estate market is so hot that miniature cities are being created with artificial lakes, and the country’s nouveau riche suddenly seem eager to put down as much as $5.3 million for a luxury apartment in skyscrapers with names like the Skyline Mansion… Since the early 1990’s, Shanghai and other cities have been making up for lost time. And this year the building boom is at a frenzy, with the nation expected to lay down the finishing blocks on 4.7 billion square feet or more of construction, a record, up from 2 billion in 1998. ‘There’s no doubt what is happening in parts of China is on a scale we’ve never seen before,’ said Richard Burdett, professor of architecture and urbanism at the London School of Economics. ‘But more importantly, it’s the fastest pace of development in the past 50 or 100 years.’” October 20 – Bloomberg (Philip Lagerkranser and Rob Delaney): “China’s economy grew 9.4 percent in the third quarter as rising wages spurred consumer spending and the government encouraged investment in coal mines and railways… Growth will be at least 9 percent this quarter, Zheng Jingping, a National Bureau of Statistics spokesman said… The Chinese economy, which accounted for a 10th of global growth in 2004, has defied expectations for a slowdown as consumers spent more on goods such as Nokia cell phones and services including China Eastern Airlines flights.” October 18 – Bloomberg (Matthew Miller): “China needs to do more to encourage its people to spend instead of save, central bank Governor Zhou Xiaochuan said, reiterating a call for the nation to boost consumption and reduce reliance on exports for economic growth. ‘We hope our economy will be driven by domestic consumption,’ Zhou said in a speech…in Beijing.” October 20 – Bloomberg (Philip Lagerkranser): “China’s industrial production growth gathered pace in September, according to figures from the National Bureau of Statistics. Production rose 16.5 percent last month after climbing 16 percent in August…” October 20 – XFN: “China’s retail sales in nominal terms rose 13.0% year-on-year to 4.5 trillion yuan in the first nine months, the National Bureau of Statistics said…” October 17 – China Knowledge: “The number of China’s passenger cars sold reached 286,400 in September, 36.8% higher than same period in 2004 and 16.2% higher than August, according to data released by China Passenger Car Association.” Asia Boom Watch: October 17 – Bloomberg (Cherian Thomas): “India’s exports grew in September… Exports rose 7.5 percent to $7.3 billion…from a year earlier…India’s imports rose 17.3 percent to $10.5 billion…” October 17 – Bloomberg (William Sim): “South Korea’s department store sales rose for an eighth consecutive month in September, the latest sign consumer spending is picking up after a two-year slump. Combined sales at Lotte Department Store Co., Hyundai Department Store Co. and Shinsegae Co., South Korea’s three-biggest department store chains, grew 8.7 percent from a year earlier, the biggest gain since May 2002.” October 21 – Bloomberg (Theresa Tang): “Taiwan’s jobless rate unexpectedly fell to a four-year low last month… The seasonally adjusted jobless rate was 4 percent…” October 18 – New Straits Times: “Malaysia’s manufacturing sales in August rose 16.8 per cent year-on-year… For the first eight months of 2005, the manufacturing sector recorded a total sales value of RM304.8 billion, an increase of 16 per cent…” October 19 – Bloomberg (Anuchit Nguyen): “Thailand’s central bank raised its benchmark interest rate by half a percentage point, more than expected, to help curb inflation amid higher fuel prices. The Bank of Thailand increased the 14-day bond repurchase rate to 3.75 percent from 3.25 percent…” October 18 – Bloomberg (Jun Ebias): “The Philippine economy grew faster in the third quarter as farm output recovered and record remittances from Filipinos working overseas boosted spending, a government official said… Gross domestic product rose at least 5 percent from a year earlier…” October 21 – Bloomberg (Jason Folkmanis): “Vietnam’s exports to the U.S., its top market, climbed by more than a fifth in the first eight months of the year as strong growth in shipments of footwear, furniture and crude oil outweighed a drop in clothing exports. Shipments to the U.S. through the end of August rose 22 percent to $4.11 billion…” Unbalanced Global Economy Watch: October 18 – Bloomberg (Fergal O'Brien): “European consumer prices rose in September at the fastest pace in more than three years after oil prices reached a record, making it more likely the European Central Bank’s next shift in interest rates will be an increase. Consumer prices in the dozen nations using the euro climbed 2.6 percent from a year earlier, after gaining 2.2 percent in August…” October 17 – Bloomberg (Andreas Scholz and Simone Meier): “European Central Bank Chief Economist Otmar Issing said inflation may breach the central bank’s 2 percent ceiling next year as the ECB edges closer to raising interest rates for the first time in five years. ‘Rising oil prices are not only affecting current inflation rates but they’re also overshadowing next year. It can’t be ruled out that risks for price developments will deteriorate that much over the medium term that we might have to expect the annual inflation rate to slightly exceed 2 percent.’” October 18 – Bloomberg (Laura Humble): “U.K. inflation accelerated in September at the fastest pace in at least eight years as oil prices surged… The annual rate of consumer-price increases in Europe’s second-largest economy rose to 2.5 percent, the fourth straight increase…” October 20 – Bloomberg (Tom Lavell): “Deutsche Post AG, Europe’s biggest postal service, will raise postage rates for sending standard letters from Germany to the rest of the region by 27 percent next year, charging more than for domestic delivery for the first time in four decades.” October 19 – Bloomberg (Jacob Greber): “Swiss car sales rose 7.2 percent in September amid signs consumers are spending more as Europe’s eighth-largest economy strengthens.” October 21 – Bloomberg (Joao Lima): “House prices in Spain rose 13.2 percent in the 12 months through September, driven by increases in the region of Castilla La Mancha, Spain's housing ministry said…” October 20 – Bloomberg (Halia Pavliva and Bradley Cook): “Russia’s economy is Expanding faster than expected and will ‘confidently’ beat the government’s growth target of 6 percent for this year, Finance Minister Alexei Kudrin said. The expansion is on a ‘positive, sustainable trend...’ Russia’s economy will expand between 5.5 percent and 6.5 percent in each of the next three years, a projection based on oil prices staying ‘about the same as they are now,’ he said.” October 21 – Bloomberg (Halia Pavliva): “Russian September producer price growth accelerated to 2.8 percent in the month amid a rise in fuel costs… In the year, producer prices rose a preliminary 18.6 percent, accelerating from 17.8 percent in the previous month…” October 18 – Bloomberg (Ayla Jean Yackley): “Home sales in Turkey in the first nine months of the year reached 21.6 billion lira ($15.9 billion), a surge of 170 percent over the same period last year…Home loans, including mortgages, helped boost sales, jumping 64 percent in the period from the year before…” October 20 – Bloomberg (Tracy Withers): “New Zealand’s house price inflation slowed in the second quarter… The national house price index rose 2.7 percent from the first quarter when they increased 5.3 percent… From a year earlier, prices rose 14 percent.” October 18 – Bloomberg (Greg Quinn): “The Bank of Canada raised its benchmark interest rate for the second time in six weeks and said more increases will be needed to control inflation driven up by energy prices. The quarter-point increase in the target rate for overnight loans between commercial banks to 3 percent narrows the gap with the 3.75 percent U.S. federal funds rate.” Latin America Watch: October 18 – Bloomberg (Elzio Barreto): “Brazil’s wireless phone market expanded 38 percent in September, telecommunications regulator Anatel said. Wireless companies added 1.05 million users in September, ending the month with 80 million clients, up from 58.2 million in the same period a year ago…” October 20 – Dow Jones: “Argentina’s economy showed robust growth in August, regaining some steam after a mild deceleration in July. National statistics agency INDEC released its monthly gross domestic product estimate Thursday, showing an 8.9% increase on the year and an 0.9% rise from July.” October 18 – Bloomberg (Alex Kennedy and Peter Wilson): “Venezuela, the world’s fifth-largest oil exporting nation, plans to boost spending at least 25 percent next year after a 35 percent rise this year, Finance Minister Nelson Merentes said.” Bubble Economy Watch: The September CPI index was up 4.7% y-o-y, a high since June 2001. The September PPI was up 6.9% y-o-y, a high since November 1990. The Philly Fed index “Prices Paid” component rose to the highest level since November 1980. September Housing Starts were up 10.3% from September 2004 to the highest level in seven months. September Building Permits were up 7%, to the strongest level since February 1973. Units Under Construction were up 10% from one year ago. October 18 – Bloomberg (Paul Basken): “U.S. public and private colleges increased tuition and fees at a faster pace than growth in student grant money, raising concern that low-income families may be losing access to college, the College Board reported. The cost of a four-year education rose by 7.1 percent from a year ago to an average $5,491 at public institutions, and by 5.9 percent to an average $21,235 at private schools…” California Bubble Watch: October 18 – Los Angeles Times (Bill Sing): “Southern California home prices and sales once again defied the skeptics by notching strong gains in September, although rising mortgage rates and softness in a key market are stoking fears of a slowdown in the months to come. The median price paid for a Southern California home was $475,000 last month, up 16.1% from a year earlier (from DataQuick)… Sales volume rose 6% year over year. Orange County led the six-county region with a median price of $610,000, while San Bernardino County was the cheapest at $352,000. However, closely watched San Diego County — once the state’s hottest regions — posted just a slight gain in price and a decline in sales…” October 19 – San Francisco Chronicle (Kelly Zito): “Bay Area home prices jumped nearly 19 percent on a year-over-year basis in September, but there is some evidence…that the housing market is moderating. The median price for an existing, single-family home in the nine-county region was $646,000 last month, 18.8 percent above the year-ago level…according to…DataQuick. A total of 11,205 houses and condos changed hands, a 7.2 percent decrease from August 2004 and the sixth month in a row that sales have fallen year over year.” “Project Energy” Watch: October 15 – New York Times (Damon Darlin): “With home energy bills expected to rise almost 50 percent this winter, the frugal American may face a tough call: the most effective way to cut that expense may be to spend thousands of dollars to replace an inefficient furnace. That one device uses nearly half of the energy piped into your home… Furnace makers like Carrier or Trane will tell you that you can save as much as 35 percent of your heating bill with a new one. But replacing your old one could cost $2,000 to more than $7,000 depending on its size, type and energy efficiency, as well as local labor rates and the amount of ducting and retrofitting that must be done.” Mortgage Finance Bubble Watch: October 20 –Oahu Star-Bulletin: “The median price paid for a single-family home on Oahu jumped 31.1 percent to $615,000 during the three months ended Sept. 30, according to new quarterly data released yesterday by the Honolulu Board of Realtors.” Earnings Watch: From Wells Fargo: “Average loans of $295.6 increased $21.4 billion, or 8 percent, from the third quarter of 2004. Excluding real estate 1-4 family first mortgages – the loan category impacted by ARM sales over the past several quarters - total average loans grew $37.6 billion, or 20 percent… Commercial loan growth also was strong, with average commercial and commercial real estate loans up $13.0 billion, or 14 percent, year-over-year.” “[Y-t-d] Mortgage originations of $103 billion, up 51 percent from prior year.” Total Assets expanded at a 17% annualized rate during the quarter to $454 billion, the strongest growth since Q2 2004. Deposits expanded 15% annualized during the quarter to $289 billion. Washington Mutual reported third-quarter total loan volume of $70.73 billion, up 14.4% from the year ago quarter. Total Assets expanded at a 12% rate to $333.6 billion and were up 15.5% y-o-y. On the Liability side, Deposits expanded at a 13% rate during the quarter to $190.4 billion and were up 13% y-o-y. The company repurchased two million shares of stock during the quarter. WAMU loan volume included $10.8 billion “home equity loans and lines of Credit,” and $16.4 billion “Option ARMs.” Citigroup repurchased 124 million shares during the quarter ($5.5 billion). Third quarter Capital Markets and Banking Revenues were up 39% y-o-y to $5.2 billion. “Fixed income markets revenues increased 52%, driven by strong performance in interest rate products, foreign exchange, and commodities. Equity markets revenues increased 78%, driven by improved performance and growth in cash trading, alternative execution, and derivatives products. Investment banking revenues increased 22%...” Merrill Lynch third quarter Net Earnings were up 49% from the year ago period to a record $1.376 billion. Net Revenues were up 38% to $6.7 billion. Third quarter Interest & Dividend Revenues were up 94% from a year earlier to $7.039 billion. Compensation & Benefits jumped 43% to $3.251 billion. “Global Markets net revenues increased 73% from the 2004 third quarter and 9% from the second quarter. Debt Markets achieved record quarterly net revenues, and Equity Markets generated its strongest net revenues in 18 quarters.” Bank of America repurchased 10.6 million shares during the quarter. Net Income was up 10% from the year ago period to $4.13 billion. “Trading-related revenue climbed to $800 million in the third quarter from $584 million in the third quarter of 2004, boosted by improved results in equities and fixed income and interest rate-related trading. Investment banking income on a consolidated basis increased 19 percent…” “First mortgage loans originated…rose to $27.5 billion, $10.9 billion higher than the third quarter of 2004.” Total Assets expanded 2% annualized during the quarter to $1.252 Trillion. Deposits actually declined almost $9 billion during the quarter to $626.5 billion, while “Federal funds purchased and securities sold under agreements to repurchase” jumped $9 billion to $217 billion. In a trend that will be more problematic for BofA and others going forward, “Net Charge-offs were $1.15 billion… This compared to $880 million…in the second quarter…and $719 million…in the third quarter of 2004.” JPMorganChase repurchased 14.4 million shares during the quarter. Investment Bank “net revenue of $4.5 billion was a quarterly record, up $1.8 billion, or 65%, from the prior year and up 62% from the prior quarter. Investment Banking fees of $985 million were up 8% from the prior year… Advisory fees of $300 million were up 10%... Debt underwriting fees of $475 million were roughly flat…, while equity underwriting fees of $210 million were up 24%... Fixed Income Market revenues of $2.4 billion represented a record quarter, more than double the prior year and up 71%, or $1.0 billion, from the prior quarter… Client-related and proprietary trading were very strong across all asset classes…” “Mortgage loan originations of $39.3 billion were up 15% from the prior year and up 27% from the prior quarter.” Total Assets expanded at an 11% rate to $1.203 Trillion. A Rather Volatile Mix: Thus far, I have not found financial sector earnings reports all too enlightening. Perhaps the most notable development is the pervasive rise in Credit losses – albeit from a low base. The hurricanes and new bankruptcy legislation might somewhat cloud the issue, but the case is becoming stronger that the consumer Credit cycle has peaked. Yet, we see again this week – particularly with Merrill Lynch and JPMorganChase – capital market businesses relishing in historic boom. And we see the big mortgage lenders’ – Wells Fargo, GoldenWest, Washington Mutual and others – ongoing bonanza courtesy of the Great Mortgage Finance Bubble. While margins are nothing to write home about, mortgage earnings are being driven by staggering origination volume. Third quarter earnings also provide further evidence that commercial lending is strong, both in real estate and business lending. From CSFirstBoston Research (Moshe Orenguch, Douglas Harter and Kerry Hueston): “Originations for the group [10 major mortgage lenders] were $474 billion, up 38% from the year ago quarter and 16% sequentially. Countrywide further strengthened its #1 market share position against its competitors, as originations improved 59% year over year and 21% sequentially to $146 billion (a record high). These 10 originators comprise just over half of the market.” Wells Fargo originations were up 51% y-o-y to $68.0 billion, Washington Mutual 14% to $61.8 billion, JP Morgan Chase 12% to $48.0 billion, National City 9% to $23.2 billion, CitiGroup 46% to $22.9 billion, and Bank of America 63% to $16.9 billion. Analyzing today’s Mortgage Finance Bubble does bring to mind speculative dynamics at play during the late-eighties commercial real estate Bubble. Despite increasing signs of late-cycle stress and fundamental deterioration (rising vacancy rates, over-supply, and sagging rents), it took quite some time to pacify (and then quickly crush) the speculative spirits that had blossomed during the boom. The boom-time financial infrastructure and the resulting Wall of Liquidity continued to finance additional building, with both the quantity and quality of the projects guaranteeing a devastating down-side of the Credit cycle. We saw similar dynamics at work throughout the tech and telcom industry during that fateful period 1999/2000. Today, the system is basically preordained to finance and construct at least two million new residences a year, notwithstanding fundamental developments (rising inventory of unsold units!). Too many of these homes will be oversized, upscale, and constructed in the hot/susceptible markets (California, greater Washington D.C., Miami, Las Vegas, etc.). The vulnerable condo, investment property and vacation home sectors will see more than their share of construction activity. And the reality of the situation is that this housing juggernaut is destined to pressure exiting home prices and exacerbate post-Bubble system impairment. You can throw any notion of a self-adjusting and correcting system out the window. There is a school of thought out there that we are in the midst of a healthy “mid-cycle slowdown” similar to the 1994/95 tightening, implying little necessity for any wrenching system adjustment period. Let me briefly touch on why I believe the odds that this view is correct are low. The 1994 hedge fund tumult and subsequent Mexican crisis/bailout ushered in The Golden Age of Wall Street Finance. Importantly, the GSE’s unparalleled expansion - blossoming with 1994’s speculative de-leveraging - created a new and powerful marketplace liquidity backstop. This (quasi-central bank) market support mechanism – with virtually unlimited capacity to issue essentially government debt – bolstered the fledgling Mortgage Finance, hedge fund and “structured finance” Bubbles. And, importantly, the “disinflationary” global backdrop gave the U.S. Credit system and monetary policymakers extraordinary leeway to pursue their expansionary ambitions. Outside of Fed “tightening,” the contrasts between now and 1994/95 could not be starker – or more fascinating. We are today in Bubbleville, and I am simply not able to contemplate a reasonable scenario that would place us today in “mid-cycle” Bubbleville. The Mortgage Finance, hedge fund, and “structured finance” Bubbles have gone to astonishing excess and are today acutely vulnerable. Wall Street is today heavily exposed to a leveraged speculating community boom turning to bust and, importantly, there is today no GSE liquidity backstop. The banking system is these days heavily exposed to inflating housing markets and dangerous Mortgage Finance Bubble dynamics, imbued with the false confidence that it (and the system) possesses the capacity to off-load meaningful amounts of this risk (notably, Credit and interest rate) to “the market.” The maladjusted U.S. Bubble economy has become acutely susceptible to any slowdown or interruption in Credit creation or system liquidity. Meanwhile, system liquidity is today dependent upon the ongoing rapid expansion of suspect (late-cycle) financial claims including mortgage-related ABS, “private-label” MBS, CDOs, “repo” liabilities, and other financial sector liabilities created in the process of financing leveraged securities speculation. To be sure, the inflationary backdrop – both domestic and globally – is significantly more problematic today than 1994/95. The global environment today is one of an historic Credit Bubble that makes 1993 excesses appear inconsequential. Global Credit systems are almost universally “firing on all cylinders,” liquidity is abundant, risk premiums are meager, inflationary pressures are strong and building, and central bankers across the globe are falling further behind the curve. A barrel of crude oil averaged $18.40 during 1995, with natural gas averaging $1.69. And let’s not forget that the Japanese Credit system was fighting for survival back in 1994/95 and the Chinese were hardly a global factor. Importantly, the U.S. Current Account Deficit has spiraled completely out of control. To put things into perspective, the U.S. ran a Current Account Deficit of about $325 billion during the five years 1990 through 1994. Over the past five years, our Deficit has swelled to almost $2.5 Trillion, and will soon surpass $800 billion annually. New York Federal Reserve President Timothy Geithner should be commended for his speech this week that focused on the risk of associated with the U.S. Current Account Deficit (and global imbalances). It is, today, the key defining issue. The “bullish” consensus view is that housing is slowing, the consumer is in the process of retrenching, the underlying economy is weak, inflationary pressures are transitory, and there will soon be pressure on the Fed to reverse course. Some argue the Fed is already too tight. But these views ignore the clearest evidence that monetary conditions remain highly accommodative – the massive Current Account Deficit. And it is this deficit that is most responsible for fueling global inflationary pressures, as well as providing the liquidity for the ever-expanding – and destabilizing – global pool of speculative finance. The notion that we are approaching the end of Fed “tightening” ignores the reality that today’s Current Account Deficits are both destabilizing and unsustainable. Unfortunately, the nature of current lending and speculating patterns (Monetary Processes) coupled with the ill-structured U.S. Bubble economy ensure that real restraint will be required to rein in Current Account Deficits and initiate the necessary adjustment process. Such restraint could be imposed by the Fed or, more likely, by the markets. The bottom line is that dysfunctional Monetary Processes must be crippled, which implies financial dislocation and recession. There is certainly every indication that the U.S. financial sector is absolutely determined to perpetuate the boom – fed dysfunctional processes. Third quarter earnings releases confirmed that the U.S. financial sector is anything but backing away from mortgage lending. Sure, there was some marginal “tightening” of standards by a few institutions, but at this point it seems clear that there are ample lenders able and willing to provide option-ARM and “exotic” mortgages that the Wells Fargos of the world may no longer fancy. So I am left – for now – to lean toward assuming that mortgage debt growth will remain resilient, that housing markets stay resilient, the consumer demonstrates surprising resiliency, the economy hang tough and liquidity excess probably remains resilient - that is, until the bond market falters. I say “probably resilient” because financial markets increasingly exhibit an undertone of instability. Equity markets are turning hyper volatile, with currency and commodities markets similarly treacherous. The favored sectors – energy in particular – have recently been hammered, with managers now liquidating positions to save their years. “Market neutral” strategies are struggling of late, as the favored stocks and groups lose ground faster than the disfavored (shorted) ones. And with hedges not performing as expected, there is pressure to unwind positions – creating more selling pressure for the favorites and an upward bias for the fundamentally weaker companies. It’s been a rough year for the dollar bears, while the Treasury market has offered only meager returns. The auto and airline bond and Credit default markets laid many a landmine. Whether we have commenced the long-awaited hedge fund unwind or if this is just more marketplace “cat and mouse” – it’s darn tough to say. The stock market began the year catching everyone – bulls and bears – off-balance. The market is now doing its best to keep us all on our heels. Curiously, you have the Bear Camp smelling some real vulnerability. The optimists, on the other hoof, anticipate a year-end running of the bulls. And the legions of traders and managers desperate for returns anywhere they can be scrounged – well, they will be forced to play it either way. System Credit and liquidity creation remains robust (underpinning bond prices and markets generally), yet vulnerability to a bout of marketplace speculative de-leveraging seems quite high. In the real economy, the inflationary bias still holds sway over caution and retrenchment. It’s all a rather volatile mix and, I might add, not an opportune time to be a “hero” – analytically, financially, or otherwise. As interesting as things are sure to be in the stock market through year-end, bond market dynamics could be even more intriguing. Additional rate increases are in the offing; there is a new and inexperienced Fed chairman to contemplate; there’s a financial sector absolutely determined to grow earnings and support their stock prices; and the old Mortgage Finance Bubble is demonstrating typical Bubble resiliency. Good old fashioned supply and demand of finance analysis would pinpoint some price vulnerability in the MBS sector. And if all this volatility and uncertainty finds Treasuries running far ahead of mortgages (MBS/ABS spreads are already widening, especially at the fringes), then at least I’ll have something more interesting to write about. |
Tuesday, September 9, 2014
10/20/2005 A Rather Volatile Mix *
