11/02/2001 Hero Turns Spoiler-Or, Mcteer 'Getting Nothing' *

Unsettled conditions continue to dominate the marketplace in a most extraordinary environment. Volatility runs unabated in equity, credit and currency markets. For the week, the Dow, S&P500, and Morgan Stanley Cyclical indices dropped 2%. The Transports and Morgan Stanley Consumer indices were unchanged, while the Utilities declined 1%. The broader market was under moderate selling pressure, with the small cap Russell 2000 and S&P400 Mid-Cap indices dipping about 1%. The NASDAQ100 declined 2% and the Morgan Stanley High Tech index lost 1%. The Street.com Internet index sank 10% and the NASDAQ Telecommunications index dropped 3%. The Semiconductors bucked the trend gaining 2%. The Biotechs dipped 5%. Financial stocks were weak, with the AMEX Securities Broker/Dealer index declining 2% and the S&P Bank index dropping 3%. With bullion up $2.50, the HUI Gold index added about 5%.

The Treasury market rallied strongly on the back of dreadful economic news and the Treasury’s interesting decision to halt new long-bond issuance. Long-bond yields enjoyed their best two-day performance since the 1987 stock market crash, with rates declining 32 basis points to 4.95% for the week. Two-year Treasury yields dipped 13 basis points to 2.49%, the 5-year 11 basis points to 3.62%, and the 10-year 16 basis points to 4.36%. The Treasury decision created havoc in the mortgage-backed security market, with the prospect of a massive new wave of mortgage refinancings. Benchmark mortgage-back yields dropped 18 basis points Wednesday and jumped 15 basis points today. For the week, yields declined 9 basis points as mortgage spreads to Treasuries widened significantly. Agency securities continue to attract aggressive buyers, with yields declining 20 basis points this week. It must have been quite a frantic week in the world of hedging interest-rate derivatives. Bloomberg quoted PIMCO’s Paul McCulley:

"At the end of the day it’s Uncle Sam effectively trying to reduce long-term interest rates." Paul McCulley, managing director at PIMCO. European bonds rallied, with yields dropping to 30-month lows.

The crisis in Argentina has taken a sad turn for the worse, with the government effectively defaulting on $95 billion of debt. With overnight interest rates shooting to 250%, and yields on floating-rate government bonds due in 2005 surging to 55%, it is difficult to see how the government will hold together its dollar-backed currency regime. The problem of acute uncertainty, hence the issue of capital flight, has not been resolved. October tax revenues were reported down 11.3% year over year and vehicle sales were said down 60%.

Oct. 30 (www.marketnews.com) - "Standard & Poor’s chief economist David Wyss said in a statement Tuesday that U.S. credit card losses could reach 8.0%--sharply above the 6.9% rated that had been expected only three months ago. ‘Even before Sept. 11, an increasing number of consumers were defaulting on their credit card debts,’ Wyss said. ‘When people lose their jobs, they can’t pay their bills. This is even more disconcerting since American consumers are very highly leveraged, with debt at a record share of disposable income.’ In a statement, Wyss noted that credit card losses, which were already moving higher, will rise even more sharply as the unemployment rate climbs." This week’s consumer credit casualty was Internet credit card issuer NextCard that was ordered to increase its loan loss reserves as defaults skyrocketed.

Oct. 30 (Bloomberg) -- The U.S. office vacancy rate rose to its highest point since 1996 in the third quarter as companies continued to shed space they accumulated during economic expansion in the 1990s. The rate rose to 12.3 percent from 10.8 percent at the end of June and from 8.1 percent a year earlier, according to Boston-based Torto Wheaton Research, a unit of CB Richard Ellis Services Inc., the nation's largest property broker." The article included several telling quotes from industry executives. "Everyone has been running hard for eight years and now they are all trying to rationalize their space needs." And from Ray Torto, principal of Torto Wheaton: "This is payback for all the speculative leasing done in 2000."

Wednesday the National Conference of State Legislatures released its update report State Fiscal Outlook for FY 2002. "These are the highlights from the NCSL survey: *State revenue growth has slowed dramatically. Forty-four states reported that revenues were below forecasted levels in the opening months of FY 2002. * Nineteen states report that spending currently is exceeding budgeted levels, with another seven reporting that overspending in some program areas is likely. Medicaid continues to exceed budgeted levels, proving to be an ongoing problem in many states. *At least 28 states have implemented or are considering budget cuts or holdbacks to address fiscal problems. *Twenty states may tap reserve funds to balance their FY 2002 budgets. *Fourteen states have implemented belt-tightening measures that include hiring freezes, cancellations of capital projects and travel restrictions. *Seven states will convene or have convened in special sessions to address budget problems. Several others are considering special sessions. *The budget outlook for the rest of FY 2002 is worrisome for most states because fiscal conditions are expected to get worse before they get better. *Much of the information currently available does not yet include the economic effects of the Sept. 11 terrorist attacks."

"The warning signs of state fiscal problems began emerging late last year when sales, personal income and corporate income tax collections slowed and failed to meet projected levels. By spring, it was apparent that the revenue bonanza had come to an end. Across the nation, forecasters are reporting declines in most major tax sources, especially the sales and use tax and personal and corporate income taxes. In some states, the drops are significant… In Arizona, general fund revenue collections were $86.5 million (5 percent) below estimates for the first quarter. Sales and use tax collections were 6 percent below target and personal income tax revenues were 8 percent below target. Administration and legislative forecasters lowered FY 2002 revenues by $675 million, a 10.3 percent decrease. In California, first quarter collections were down $700 million, or 4.6 percent below forecast. In Florida, declining sales tax, estate tax and corporate tax collections caused estimators to reduce the general fund forecast by $1.3 billion, a 2.6 decline from FY 2001. General fund revenue collections were $474 million below estimate during the first quarter of FY 2002 in Illinois. Kentucky revised its forecast down by $467 million (7.5 percent) in October…"

Nov. 1 (Bloomberg) – "A U.S. economic rebound will be slower than most forecasters anticipate because the dollar is overvalued and banks have toughened lending standards, said Jerry Jasinowski, president of the National Association of Manufacturers. ‘We continue to think that economic fundamentals are such that the dollar is overvalued,’ Jasinowski told reporters. Tougher lending standards at the nation’s financial institutions are also ‘undermining the economy…’ ‘The expectations of CEOs paint a grim picture of the months ahead,’ Jasinowski said. In June, Jasinowski said that the dollar was 25 percent to 30 percent overvalued and called upon Treasury Secretary Paul O’Neill to dump Treasury’s long-standing strong dollar policy. O’Neill has refused… A strong dollar ‘harms exports, hurts manufacturing,’ Jasinowski said. ‘That harms the fundamentals of the economy and that hasn’t been fully recognized’ by financial markets.

Tighter lending standards are also ‘impeding recovery’ in economic activity following the Sept. 11 terrorist attacks, he said. ‘I've heard from a wide variety of CEOs that many good companies with sound balance sheets are not able to get credit because banks have tightened standards,’ he said."

Going forward, it will be advantageous to look at economic data with the intention of "disaggregating," and in terms of appreciating maladjustments and sectoral distortions, under the premise that this is one terribly disjointed economy. The September jobs report had payrolls declining 415,000, the largest decline since 1980. Service job had their largest decline in almost 18 years. Personal income data from earlier this week had wages and salaries up 4.7% year over year, with service wage income rising 7% while manufacturing wage income declined 0.1%. Stoked by interest-free financing and other aggressive incentives, auto sales surged to a record annualized rate of 21.3 million units last month, with Toyota enjoying a 28% jump in sales. September’s "Construction Spending Declines Fifth Straight Month" release provides some interesting detail to explore. Construction spending remains up 3.4% from year ago levels, although the most notable aspect is the wide divergences between categories. While Private Non-Residential spending is down 8.8% year over year, expenditures on New Housing has jumped 8.1%. On the back of ultra-easy credit availability, multi-family construction has been booming, up 16.1% from last year. At the same time, spending on office buildings is down 15%, hotels/motels down 14.7%, and "other private" spending down 21.2%. The Public Sector continues to spend like crazy, with record Public Construction during September (up 14.4% y-o-y). Public spending on housing is up 22.6% from last year, industrial 22.6%, educational 28.5%, and water supply 22.2%. Bloomberg ran a headline yesterday, "Voters to Consider $12 Billion Muni Bonds Next Week, Sixth-Highest Ever."

Credit insurer MBIA reported that third-quarter earnings jumped 18%, with "gross premiums written" increasing 20% during the first nine months (with record muni activity). Earnings benefited from lower loss reserve provisions, which is an interesting development considering the environment. "Net debt service outstanding" (insurance written less amount ceded/"reinsured") ended the quarter at almost $718 billion, for a "capital ratio" of 147 to 1. MBIA has $900 million of exposure to Providian’s Gateway Master Trust.

From a Wall Street fixed income research report titled "Time to Take Advantage of Low FHLB (Federal Home Loan Bank) Rates": "The bull (yield curve) steepening that has taken place in 2001 has resulted in low FHLB funding rates and created an appealing opportunity for financial institutions to employ leverage strategies…now is the opportune time for financial institutions to take advantage of low FHLB funding rates...Leveraged strategies are used by financial institutions to enhance their earnings and return on equity…with each of these three strategies, the capital ratio is decreased and net income is increased…" Six-Month FHLB Fixed Rates are offered at a too good to pass up 2.22%, offering a nice spread to mortgage-backs, agencies, or virtually any debt instrument. The FHLB ended June 30th with $665 billion of total assets, including $54 billion of "Federal funds sold."

The following are comments from Robert D. McTeer, President of the Federal Reserve Bank of Dallas, speaking before the Fort Worth Chamber of Commerce: "From a monetary standpoint, you’d want to do for them (the emerging markets) the same you’d want for your own country, that is you’d want them to have a very stable monetary system, with very low inflation that gives a good environment for investment and capital flows. A lot of the conference in Mexico City that I was at had to do with things like, are they better off with fixed exchange rates or floating rates. Is a country like Argentina that has had a currency board, would it be better off fully dollarizing? Would Mexico do well to dollarize? Things like that. And basically, if all the developing countries will continue the progress they are making toward free markets and monetary stability, one way or the other, whether it is through sound monetary policy or by linking their currency to a sounder currency, that’s about all that they can do. They need to attract capital; to attract capital they need to have sensible government policies and good private property rights, they need a good rule of law, and so on. Regards to dollarization, I had a little poem; see if I can remember it. ‘There once was a hyperactive central banker who needed a stronger anchor, his boat was small and the ocean was large, so he tied his anchor to a tanker.’"

"The main long-run problem that Japan has is that they had a banking crisis similar to ours but they still have it. They didn’t get the RTC (Resolution Trust Corp), they didn’t get the bad loans off the books. So they have been limping along with a wounded banking system for ten years now. Meanwhile, they went into a period of actual deflation, so prices are actually going down in nominal terms. And under those circumstances, people find it advantageous to save now to spend later, because you are going to have lower prices later. So it is a self-fulfilling thing; the more people slow down on their spending, the more income falls. And they are having a hard time getting out of it. And they’ve also got a fairly old population, pension problems and so forth. And the age factor also probably helps in that decision to save rather than spend. But we are front-loading monetary policy here to get out of this thing fast. We are not going to do it in dribs and brads, and let it linger on. We are not going to go into deflation."

"We went into this crisis with the banking system very healthy. It is probably not as healthy as it was a couple years ago, but it’s real healthy. It’s liquid, got a lot of capital, not all that many bad loans and so forth."

"Regarding poetry. I really had a faux pas yesterday. I gave a speech in Mexico City to a group sponsored by the Cato Institute. And normally these international conferences are done in English, but most of the audience didn’t speak English and they were listening to simultaneous translations. I had never really thought about that very much, but things don’t rhyme when they’re... So I’m starting out saying, ‘From the backseat of a Grand Marquee, my colleagues laughed at me, for having the temerity, to suggest the possibility, that Europe could have a New Economy, if only the ECB would set them free.’ And then I had to tap on the microphone to see if it was working because I was Getting Nothing."

Believe me, I don’t make this stuff up. And while I will admit to chuckling, this is like central bankers’ "The Far Side." I just wish that Mr. McTeer would spend as much time studying credit systems as he does writing his comedy material. At the minimum, and certainly under present circumstances, such comments are unprofessional and indicative of a lack of the seriousness of purpose from a key member of the Federal Reserve that has been repeatedly mentioned as a possible successor to Dr. Greenspan.

As the unfolding crisis now moves to a more precarious state, I continue to see little indication that the Federal Reserve has any idea what it’s up against. Amazingly, the Fed, oblivious to the Bubble as it developed, remains somehow incapable of recognizing the forces involved, the consequences of their unrelenting accommodative policies, or the dysfunctional financial system and hopelessly maladjusted economy they have nurtured. It almost appears to me a sad case of the institution of the Federal Reserve stubbornly refusing to budge, not willing to give up an inch to the learning curve. Having accepted with blind faith the very dubious "New Economy" and "productivity miracle" analyses of its leadership (Greenspan and McTeer, in particular), the analytical blinders have been tightly secured, the trenches of intellectual justification carefully dug, and a mindset of denial and blind optimism solidified with the acceptance that there is at this point no turning back.

Back in 1999 as David Tice and I were attempting to convince three economists from the Federal Reserve Bank of Dallas that we were in the midst of a very dangerous Japanese-style Bubble, one of them explained to us that the problem in Japan was that their banks owned stocks. And, as the analysis went, it was key that U.S. banks do not really invest in equities. Thus, the two systems were not comparable and the Bubble analysis was inapplicable to the U.S. I was rather shocked by the shallowness and inaccuracy of the analysis of the Japanese Bubble, and will never understand why the Fed did not diligently study the intricacies of the Japanese predicament from inception to collapse. There were invaluable lessons simply ignored. It was also clear in 1999 that these economists had absolutely no clue as to the profound developments that had been unleashed throughout the U.S. credit system.

Today, the critical flaw in Mr. McTeer’s and others’ analysis is that they refuse to recognize the historic nature of the U.S. Credit Bubble. They were oblivious to the forces fueling the boom at the time and remain oblivious to this day. And to actually believe that our nation solved its financial problems with the early-1990s RTC activities and bad loan write-offs will go down as one of the greatest misplaced bouts of wishful thinking. The unavoidable consequences following the late-1980s excesses were merely monetized and "papered" over, setting the stage for a protracted period of unprecedented excess and today’s acute financial fragility. The excesses embedded in $1.4 trillion of mortgage credit expansion during 1986 to 1990’s five year lending boom pale in comparison to the almost $2.7 trillion mortgage credit increase during the five and one-half year period ended at June 30th of this year. We are not, today, in a position to again "paper over" the problem.

Yet, the Fed and Treasury apparently believe they can resolve the current financial predicament with a prescription of the early 1990’s treatment, a blunt instrument pounding down interest rates. It’s not going to work, however, with the "one trick pony" Fed faced with a very problematic misdiagnosis. It should be appreciated that the serious dilemma facing the U.S. banking system about a decade ago was largely real estate- related. There were significant credit problems, as sinking real estate prices were fueling a mini debt collapse. But at least there were generally real assets supporting the debts. As troubling as the crisis appeared at the time, it was basically a garden-variety real estate credit crunch (I will have more to say about this resolution shortly) and cyclical economic downturn – exactly the kind of circumstances well suited to monetary stimulus. Back in July 1990, with short-term interest rates at 8%, the Fed possessed considerable firepower (rates were cut to 3% by September 1992).

The current environment could not be more dissimilar to 1990/91, with it difficult to imagine cheap mortgage finance more readily available than it is today. Accordingly, real estate prices remain buoyant and at this point unproblematic, although clearly increasingly vulnerable. Nonetheless, this time around we have already seen rapid-fire extinguishments of Fed ammo as rates have collapsed to 2.5%. We would also state that economic problems are of a severe structural nature, the consequence of a protracted period of excess. Perhaps to the blurry-eyed optimist the U.S. banking system appears "very healthy," but this is the illusion dawned at the peak of what has been enormous real estate inflation (I remember how sanguine analysts were with regard to the "well-capitalized" Japanese banks in 1990!). And while general economic weakness is rapidly becoming a factor for the U.S. financial system, systemic stress thus far has generally been related to the collapse of the speculative technology Bubble and, specifically, the telecommunications debt quagmire.

Wednesday Bloomberg ran a story with comments warning that as much as 80% of the $900 billion U.S. telecommunications debt-load may never be repaid. Quoting Leo Hindery Jr., former Chief Executive at Global Grossing, "You’re going to lose easily $600 billion here just on the debt side." From the article: "Carriers issued $900 billion in debt in three years starting Jan. 1, 1998, said Hindery…"Essentially, anybody who had a backhoe and a blueprint could get funding to build a network,’ said Tim Burke, an analyst at Edward Jones." Again quoting Hindery: "We find it (overcapacity) in literally every sector and segment of the business environment, and the problem with overcapacity is, it doesn’t just ravage (profit and loss statements), but it ravages banks and employment."

This telecom fiasco has left an ugly hole in the U.S. (and global) financial system, leaving it in an unfortunately weakened position as we now run head on into unfolding real estate and consumer debt problems. And quite unlike the monetary policy "success" that grows out of inflating home and office building prices, lower interest rates and nurturing additional credit excess simply will not transform these bad telecom loans into good credits. "Ain’t gonna happen." The Fed could go so far as commencing money drops from helicopters, but there will be no economic value created to support much of this debt. What is, anyway, the value of hopelessly negative cash-flow business? This, importantly, is not an interest rate or credit availability issue. We have witnessed no less than Mutually Assured Destruction after a most reckless Communications Arms Race. Fed policy is impotent, and the most we can hope for is that the Fed doesn’t mindlessly compound the problem. We ask too much.

There is another critical difference between today and the early 1990’s that goes unappreciated. A decade ago we were in the midst of major institutional developments and profound "innovations" throughout the financial services industry. In fact, the "stiff headwinds" buffeting an impaired banking system provided a fantastic window of opportunity for Wall Street firms, hedge funds, the fledgling asset-backed security market, non-bank finance companies, derivative players and, of course, the enterprising government-sponsored enterprises. I don’t think one can overstate the crucial role played by "deregulation" and the proliferation of Wall Street "structured finance" in transforming painful Credit crunch and recession into the greatest Credit expansion, stock market Bubble, and economic boom in U.S. history. From 1996 through this year’s second-quarter (5 ½ years), outstanding asset-backed securities increased from $709 billion to $1.26 trillion, or 173%. Finance company assets increased 67% to $1.12 trillion, while securities broker/dealer assets surged 135% to $1.33 trillion. Total "federal-related" mortgage credit almost doubled to $4.7 trillion, with GSE assets expanding from less than $900 billion to $2.1 trillion (up 137%) and "mortgage pool" (mortgage-back securities) assets increasing from $1.57 trillion to $2.63 trillion (68%). Total financial sector credit market borrowings more than doubled to an astounding $8.82 trillion. Over this period we also witnessed an historic explosion in derivative trading and outstanding positions. And, importantly, over the past decade we have witnessed a 10-fold increase in hedge fund community equity (to an estimated $500 billion), and unimaginable growth in the positions held by the international "leveraged speculating community."

It should be obvious that right here with this data one isolates the unmistakable source for, first, overcoming the real estate credit crunch and then fueling an historic financial and economic Bubble. There is no mystery or need for nebulous analysis. But is this unprecedented Credit explosion sustainable? Or, could the Bubble today be in serious jeopardy? Is it friend or foe for a speedy Fed-orchestrated "V" recovery? This, by the way, leads directly to what I believe is key Credit Bubble analysis: The rapidly expanding markets in asset-backed securities, sophisticated Wall Street "structured products," and the extraordinary growth of finance company and Wall Street balance sheets (all sources of rampant credit creation) - having played the critical, if unappreciated, role of "Hero" in the 1990’s recovery turned historic boom - is now in the process of emerging as "The Spoiler" for hopes of foreseeable recovery. Instead of the powerful source of credit creation, providing endless marketplace liquidity and credit availability at the margin, a dramatic change in fortunes will see a faltering "structured finance" complex hasten financial crisis.

This analysis presupposes that the Great Experiment in Wall Street "financial engineering" is today in most serious jeopardy, and that this will continue to unfold into a problematic market dislocation with profound ramifications for the U.S. financial sector and economy. Mr. McTeer may fixate on reported bank earnings and book values, but he fails to appreciate the much more important issue of the acute fragility for trillions of dollars of marketable debt, sophisticated structures and instruments, and the derivatives positions that have proliferated hand in hand with the U.S. Bubble. The popular notion that banks are protected after off-loading significant amount of risk onto the marketplace ignores the fact that the non-bank credit explosion has generally stoked the asset values underlying bank assets, while creating the financial market liquidity that has developed into the lifeblood of the U.S. economy. We saw "structured finance" fire on all cylinders during this year’s first half on the back of aggressive Fed rate cuts, but the situation has of late soured abruptly. In this respect, the Consecos, Providians, and Enrons – leaders in aggressive financial engineering and credit creation during the boom – are today the perishing "canaries in the mineshaft" (thanks Chad Hudson!).

A careful reader might have noticed that the above analysis thus far has left the prospective role of the GSEs and the "leveraged speculating community" unclear. At this point I would like to incorporate the current Argentina crisis into the discussion. The Argentines, with the support of the U.S. and IMF, in the mid-90s instituted what appeared to be a sound monetary plan. They created a currency regime backed by the U.S. dollar that would carefully regulate money supply expansion (the banking system’s creation of deposits) and guard against inflation. As hoped, the introduction of this regime and the consequent stabilization in consumer prices incited huge capital inflows. It didn’t hurt that the mid-1990s were a period of enormous speculative flows throughout world. The economy responded favorably to the newfound liquidity, with growth in the range of 6% to 8% between 1996 and 1998. A virtuous cycle was launched. With credit so easily available in the international markets, the Argentine governments (federal, provinces and cities) and corporations borrowed aggressively by issuing dollar-denominated debt. These issues, sporting yields above U.S. market rates, were understandably popular fodder for the speculators and investors, and the money flooded in. Capital inflows drove credit growth, the asset markets and fueled economic boom, with only moderate additional domestic credit creation necessary. The plan went off without a hitch.

There was, unfortunately, one fatal flaw: the strategy presumed that as long as the country was disciplined and stuck with its plan, international markets would remain accessible to Argentine borrowers. Well, speculative "hot money" flows are tenuous at best, and always susceptible to global developments. At some point (as witnessed in Mexico, SE Asia, Russia, Brazil, Turkey, etc.), "hot money" inevitably reverses, often making a heated dash for the exits. For Argentina, that these inflows turned to outflows quickly changed the whole game, bringing what appeared to be a smoothly functioning credit system to a screeching halt. And with domestic credit expansion harnessed tightly by the currency board regime, the economy was strangled of new finance. The more the economy faltered, the less appealing Argentine assets looked to international speculators/investors. A vicious spiral took hold.

There was another factor at work that elucidates very clearly the dysfunctional nature of the current global monetary apparatus. As international flows reversed and the Argentine economy began to gasp, this dilemma only incited weakness in the neighboring free-floating Brazilian real. Just this year, with the Argentine peso remaining "pegged" to the dollar, the real has dropped about 30%. This has been very much a stake through the heart of Argentine manufacturers already weakened by faltering domestic demand. Mr. McTeer may want to believe that Argentina’s predicament could have been resolved by full adoption of the dollar "anchor," but this is ridiculous "analysis." The responsibility for unrelenting global crisis and hardship lies more appropriately with a rudderless global financial system drifting hopelessly without a solid anchor. In an age of uncontrolled U.S. monetary expansion and the resulting enormous and destabilizing global capital flows, it is worth pondering how things might have developed differently for both Argentina and Brazil had they been mutual participants in some type of a gold-backed monetary regime. Instead, Argentina placed its fortunes in the hands of a dysfunctional international system that could not have proved less up to the responsibility.

Interestingly, the Fed and IMF appear to have a rather sanguine view of events in Argentina, especially considering the circumstances. I had been rather perplexed by this seemingly inexcusable complacency. It now seems to me that this attitude is explained by a perception that this, being basically one of the few remaining meaningful "pegged currencies," will conclude the string of busted "pegs" and consequent financial crisis. There is further thinking that, despite Argentina’s status as a significant economy with considerable debt, the U.S. and global systems have survived much more intense and comprehensive crises. And without other vulnerable currency regimes, the "optimists" can take comfort that the Argentine crisis is apparently devoid of contagion effects. In terms of financial tumult, this is very much "crisis-lite." The "optimists," as they have a tendency to do, overlook critical details.

In my unfortunately typical "roundabout" fashion, we will return the GSEs and "leveraged speculating community" to the analysis. I will throw out the contention that the minimal "contagion" effect in other markets is not related so much to the fact that previous "pegged" currency regimes imploded. Instead, the key issue is that as went the "pegs," so went the speculating community’s "hot money" and precarious leveraged positions. In fact, I see the lack of contagion ironically as confirmation of my premise that the massive global leveraged speculating community has in substance abandoned placing bets around the world to converge in droves on the Great U.S. Credit Market Money Machine. After all, why on earth would anyone play elsewhere when you’ve got the powerful American contingent comprised of the Federal Reserve, U.S. Treasury and the government-sponsored enterprises basically guaranteeing uninterrupted marketplace liquidity and huge profits for the leveraged players? Who can compete with that? For a speculator, it has today been made an irrational act to not place leveraged bets in U.S. agency and other debt securities. But if all the speculators are already here and aggressively positioned, do they have the capacity for playing a significant role in fostering U.S. Credit expansion and recovery going forward (as their huge growth did in the early to mid-90’s)? And what are the ramifications when their trades lose their attractiveness? It is not difficult to envisage how the speculators could easily become a factor in a market dislocation and Credit contraction.

Whether the Fed recognizes this or not, it is playing right into the hands of the speculators. We can’t see how this is anything but a serious mistake. I will even claim that the Fed and GSEs are making the same fatal error as was made by the Argentine authorities when they assumed that there would always be a global market for their dollar denominated debt issues. Today, executives from Fannie Mae and Freddie Mac can travel the world and market their securities with ease, just as government officials and executives from Argentina could do not all too long ago. The American credit system, like Argentina’s, has become hostage to the vagaries and uncertainties of international capital markets. Sure, one can argue it is one thing selling Argentine dollar-denominated debt and quite something else selling U.S. agency securities. But Credit Bubble analysis is focused specifically on the extreme nature of speculative "hot money" flows that have flooded into the U.S., having financed unprecedented current account deficits and other distortions while sustaining the U.S. Bubble. Knowing that there is only one game in town, and that everyone’s placed big bets, it’s now time to ponder the inevitable reversal. This especially becomes the case when one views widening cracks in the foundation of the U.S. Bubble economy and serious fissures developing throughout Wall Street "structured finance."

The bottom line is that the greatest effect of current failed policies is only to sustain rampant real estate credit excess and distorting/destabilizing speculative flows. Yes, it does extend a seductive lifeline to the Credit Bubble in the short-run, but with disastrous long-term consequences. Most regrettably, our credit system’s addiction to speculative "hot money" flows will come to no good end. This is the very nature of markets and finance, with escape not coming from the subversion of these powerful forces. This is the very essence of the Fed’s monumental policy blunder. Besides, even with these flows running at full force, the dysfunctional U.S. credit system floods the GSE/real estate sector as manufacturing and commerce lose access to new finance. Profits are created for the speculator as they disappear for the businessman. That this is exacerbating massive structural economic maladjustments should no longer appear esoteric analysis. The Argentines, after issuing significant dollar-debt to international players, became desperate hostages to their currency "peg." The U.S. has fallen into the same trap, increasingly forced to sacrifice its manufacturing base and global competitiveness to pacify foreign debt holders and, for now, sustain a precarious Credit Bubble. At the same time, it appears that the crisis enveloping "structured finance" has gained enough momentum that even huge GSE credit creation and speculative flows are turning impotent. We suspect that this explains the aggressive response from the authorities, and reason enough for us to be extremely concerned.