| The Dow gained 1.1% (up 16.1% y-t-d), and the S&P500 rose 1.2% (up 14.3% y-t-d). The Utilities increased 1.4% (up 16.7% y-t-d), while the Transports dipped 0.4% (up 12.0% y-t-d). The Morgan Stanley Consumer index gained 0.8%, and the Morgan Stanley Cyclical index added 0.1%. The small-cap Russell 2000 (up 17.7% y-t-d) and the S&P400 Mid-Cap (up 10.6% y-t-d) indices were little changed. The NASDAQ100 rose 1.3%, and the Morgan Stanley High Tech index gained 1%. The Semiconductors dipped 0.3%. The Street.com Internet Index jumped 2.8% (up 20.6% y-t-d), and the NASDAQ Telecommunications index rose 2.0% (up 30.2% y-t-d). The Biotechs declined 1.1%. The Broker/Dealers dipped 0.5% (up 23.8% y-t-d), while the Bank surged 2.6% (up 12.8% y-t-d). With bullion down $9.80, the HUI index declined 1.6%. Quite a war being waged in the interest-rate markets… Two-year government yields rose 5 bps to 4.72%. Five-year yields gained 4 bps to 4.57%, and 10-year Treasury yields increased 4 bps to 4.59%. Long-bond yields jumped 6 bps to 4.71%. The 2yr/10yr spread ended the week inverted 13 bps. The implied yield on 3-month December ’07 Eurodollars rose 5.5 bps to 4.795%. Benchmark Fannie Mae MBS yields were unchanged at 5.69%, this week outperforming Treasuries. The spread on Fannie’s 5 1/4% 2016 note ended the week little changed at 34, and the spread on Freddie’s 5 1/2% 2016 note widened one to 32. The 10-year dollar swap spread declined 1.8 to 47.5. Corporate bond spreads were little changed, with junk spreads narrowing moderately. Investment grade issuers included Home Depot $5.0 billion, C5 Capital $1.25 billion, MetLife $1.25 billion, Monument Global $500 million, Commonwealth Edison $345 million, UBS $390 million, Liberty Property $300 million, Fifth Third Bank $750 million, Kimberly-Clark $200 million, Avista $150 million, Assured Guaranty $150 million, and NY State E&G $100 million. Junk bond funds saw outflows of $46.6 million this week. The crowd of issuers included Ford Motor Credit $3.0 billion, Georgia Pacific $1.25 billion, GMAC $1.0 billion, Aleris International $1.0 billion, Tropicana Entertainment $960 million, MGM Mirage $750 million, HanesBrands $500 million, Sunoco $400 million, Esco $300 million, Tristan Oil $300 million, PPL Energy Supply $300 million, UCI Holdco $235 million, Neenah $225 million, and Geokinetics $110 million. The convertible securities market is back! This week’s issuers included International Game Technologies $825 million, Peabody Energy $675 million, Beckman Coulter $600 million, Cadence Design $500 million, ON Semiconductor $480 million, Tech Data $325 million, Acquicor Technology $145 million, Credence System $125 million, and First Potomac $125 million. International dollar debt issuers included SMFG Preferred $1.65 billion, Quebecor World $400 million, AES Panama $300 million, Redwood Capital $275 million, Navios Maritime $300 million, Transener $220 million, Dollarama $200 million, and Banco Macro $150 million. Japanese 10-year “JGB” yields dipped 3 bps this week to 1.66%. The Nikkei 225 index jumped 3.0% (up 5.0% y-t-d). German 10-year bund yields rose 7 bps to 3.79%. Emerging debt markets were generally stable and equities generally higher. Brazil’s benchmark dollar bond yields dipped 2 bps this week to 5.95%. Brazil’s Bovespa equities index gained 1.4% this week (up 30.3% y-t-d). The Mexican Bolsa added 0.5%, increasing 2006 gains to 44.7%. Mexico’s 10-year $ yields were little changed at 5.49%. Russia’s 10-year Eurodollar yields added one basis point to 6.55%. The Russian RTS equities index increased 0.2% (up 64.6% y-t-d). India’s volatile Sensex equities index declined 1.3%, reducing 2006 gains to 44.9%. China’s Shanghai Composite index surged 8.6%, increasing y-t-d gains to 95.8%. Freddie Mac posted 30-year fixed mortgage rates added one basis point to 6.12%, down 18 bps from one year ago. Fifteen-year fixed mortgage rates increased 2 bps to 5.86% (up one bp y-o-y). And one-year adjustable rates gained 2 bps to 5.45% (up 30bps y-o-y). The Mortgage Bankers Association Purchase Applications Index jumped 8.7% this week to the highest level since January. Purchase Applications were down only 3% from one year ago, with dollar volume up 1.7%. Refi applications surged 15.8% to the highest level since September 2005. The average new Purchase mortgage increased to $331,400 (down 1.7% y-o-y), and the average ARM surged to a record $404,000 (up 17.1% y-o-y). Bank Credit rose $22.8 billion last week (3-wk gain of $88.7bn!) to a record $8.257 TN. Year-to-date, Bank Credit has expanded $769 billion, or 10.9% annualized. For the week, Securities Credit gained $5.4 billion. Loans & Leases jumped $17.4 billion, with a y-t-d gain of $582 billion (11.3% annualized). Commercial & Industrial (C&I) Loans have expanded at a 13.9% rate y-t-d. For the week, C&I loans jumped $7.8 billion, and Real Estate loans rose $2.6 billion. Real Estate loans have expanded at a 13.7% rate y-t-d. For the week, Consumer loans gained $5.4 billion, and Securities loans increased $2.3 billion. Other loans dipped $0.6 billion. On the liability side, (previous M3 component) Large Time Deposits declined $6.3 billion. M2 (narrow) “money” supply jumped $16.1 billion to a record $7.001 TN (week of 12/4). Year-to-date, narrow “money” has expanded $322 billion, or 5.1% annualized. For the week, Currency was unchanged, while Demand & Checkable Deposits expanded $9.6 billion. Savings Deposits increased $4.8 billion, and Small Denominated Deposits added $1.0 billion. Retail Money Fund assets increased $0.6 billion. Total Money Market Fund Assets, as reported by the Investment Company Institute, jumped $19.1 billion last week to $2.377 Trillion. Money Fund Assets have increased $320 billion y-t-d, or 16.2% annualized. Money Fund Assets have expanded at a 22.3% rate over the past 20 weeks. Total Commercial Paper surged $32.6 billion last week to a record $1.965 Trillion. Total CP is up $324 billion y-t-d, or 20.6% annualized. Total CP has expanded at a 25% rate over the past 20 weeks. Asset-backed Securities (ABS) issuance was stable this week at $17 billion. Year-to-date total ABS issuance of $713 billion (tallied by JPMorgan) is running about 8% below 2005’s record pace, with 2006 Home Equity Loan ABS sales of $474 billion about 5% under comparable 2005. Also reported by JPMorgan, y-t-d US CDO (collateralized debt obligation) Issuance of $338 billion is running 80% ahead of 2005. Fed Foreign Holdings of Treasury, Agency Debt jumped $17.7 billion during the week to a record $1.730 Trillion (week of 12/13). “Custody” holdings were up $211 billion y-t-d, or 14.5% annualized. Federal Reserve Credit declined $4.8 billion to $838 billion. Fed Credit is up $11.2 billion y-t-d, or 1.4% annualized. International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $755 billion y-t-d (19.4% annualized) to a record $4.801 Trillion. Singapore reserves were up 17.7% y-o-y to $135 billion. Currency Watch: December 12 - Bloomberg (Jonathan Ferziger): “Former Federal Reserve Chairman Alan Greenspan said the dollar will probably keep falling because it’s unlikely that international fund managers will continue to increase their allocations to the U.S. currency… ‘The dollar will continue to drift downward until there is a change in the U.S. current-account balance,’ Greenspan said… It’s imprudent to hold everything in one currency.’” The dollar index gained 0.5% to 83.75. On the upside, the South African rand gained 1.7%, the Paraguay guarni 1.6%, the Iceland krona 1.1%, and the Thai baht 1.0%. On the downside, the Japanese yen declined 1.5% the Swiss franc 1.4%, the Norwegian krone 1.4%, and the Euro 1.2%. Commodities Watch: December 12 - Bloomberg (Christopher Donville): “Uranium prices, after surging this year because of supply concerns, may top a record high this week when a private mine in Texas auctions 260,000 pounds of the radioactive metal used to fuel nuclear-power plants. Mestena Uranium LLC…is selling supplies from its Alta Mesa mine to the highest bidder… The price of uranium has risen 81 percent this year to $65.50 a pound because demand is rising and power-plant operators are concerned that new supplies may not be available fast enough to fuel new reactors planned for construction around the world.” December 14 - Bloomberg (Chanyaporn Chanjaroen): “Nickel rose to its highest in London since at least 1987 on speculation disruption at mines and plants will keep production lagging behind demand through 2007.” Gold fell 1.6% to $615.35, and Silver sank 6.6% to $12.98. Copper declined 3.4% (low since June), reducing y-t-d gains to 56%. January crude gained $1.17 to end the week at $63.20. January Unleaded Gasoline rose 3.6%, while January Natural Gas declined 1.8%. For the week, the CRB index added 0.3% (down 5.6% y-t-d), and The Goldman Sachs Commodities Index (GSCI) gained 0.7% (up 4.1% y-t-d). Japan Watch: December 13 - Bloomberg (Toru Fujioka): “Japan’s current-account surplus unexpectedly widened for a fourth month in October as demand for fuel-efficient automobiles and a weaker yen spurred earnings from overseas. The surplus grew 5.2 percent to 1.51 trillion yen ($13 billion) from a year earlier…” December 15 - Bloomberg (Lily Nonomiya): “Confidence among Japan’s largest manufacturers rose to a two-year high in December, easing concern that growth in the world’s second-largest economy is losing momentum.” China Watch: December 11 - Bloomberg (Nipa Piboontanasawat): “China had its second-largest trade surplus ever in November after the pace of exports growth unexpectedly accelerated. The gap narrowed to $22.9 billion from a record $23.8 billion in October…bringing the surplus for the first 11 months to $156.5 billion… Exports surged 32.8 percent in November from a year earlier, the biggest increase in three months, to a record $95.9 billion, while imports gained 18.3 percent to $72.9 billion…” December 14 - Bloomberg (Nipa Piboontanasawat): “China’s spending on factories, real estate and other fixed assets grew at a slower pace for the fifth straight month in November after the government curbed lending and project approvals. Fixed-asset investment in urban areas rose 26.6 percent in the first 11 months from a year ago to 7.9 trillion yuan ($1 trillion), after gaining 26.8 percent through October…” December 13 - Bloomberg (Nipa Piboontanasawat): “China’s industrial production grew at a faster pace in November as exports picked up and consumer spending rose. Output rose 14.9 percent from a year earlier to a record 793.6 billion yuan ($101 billion) after climbing 14.7 percent in October…” December 13 - Bloomberg (Irene Shen): “China’s passenger car sales grew 40 percent in the first 11 months of the year as economic growth and price cuts further boosted a market that has tripled in size in five years. Passenger car sales rose to 3.41 million vehicles in the 11 months ended Nov. 30… Total vehicle sales, including trucks and buses, rose 25.5 percent to 6.45 million in the period…” December 14 - Bloomberg (Nipa Piboontanasawat): “China’s money supply grew at a slower pace in November after the central bank stepped up efforts to remove funds from the financial system. M2…rose 16.8% last month from a year earlier after gaining 17.1% in October…” December 12 - Bloomberg (Kelvin Wong): “Hong Kong’s prime office rent rose 21.6 percent in the first 11 months…according to figures provided by Jones Lang LaSalle Inc.” India Watch: December 13 - Bloomberg (Cherian Thomas): “India will overtake China next year as the world’s fastest-growing major economy on rising consumer and government spending, Credit Suisse’s chief Asia economist Dong Tao said. Credit Suisse raised its 2007 growth forecast for India’s $775 billion economy, Asia’s fourth biggest, to 10 percent from 8.5 percent… China’s $2.2 trillion economy is expected to grow 9.9 percent next year from 10.4 percent in 2006…” Asia Boom Watch: December 13 - Bloomberg (Seyoon Kim): “South Korea’s unemployment rate fell to a six-month low in November…The jobless rate dropped to 3.4 percent from 3.5 percent in October…” December 15 - Bloomberg (Clarissa Batino and Catherine Yang): “Philippine bank lending accelerated at the fastest pace in more than eight years in October, adding to signs that increased borrowing may help expand the economy…The pace was the fastest since May 1998. Bank loans grew 6.1 percent in the previous month.” Unbalanced Global Economy Watch: December 11 - Bloomberg (Craig Stirling): “London house prices rose in the past month at the fastest annual pace in at least four years, fueled by demand from bankers as bonus season approaches, according to Rightmove Plc, the U.K.’s biggest property Web site. Average asking-prices in the U.K. capital rose 24% to 355,097 pounds ($697,000)…” December 12 - Bloomberg (Brian Swint): “Britain’s inflation rate rose to the highest in almost nine years in November, increasing speculation that the Bank of England will raise interest rates next year. Consumer prices rose 2.7 percent from a year earlier, the most since the index was introduced in 1997…” December 15 - Bloomberg (Dara Doyle): “Irish retail sales surged in October as consumer spending helped propel the fastest-growing economy of the 12 nations sharing the euro. Seasonally adjusted sales at Irish stores…rose 4.7 percent from September and were up 9.2 percent from a year earlier…” December 14 - Bloomberg (Nadja Brandt): “German federal tax revenue, excluding communal taxes, climbed 8.1 percent in November, Handelsblatt said…” December 11 - Bloomberg (Jonas Bergman): “Sweden’s unemployment rate declined for a fourth consecutive month in November to the lowest in four and a half years, raising pressure on the central bank to pick up the pace of interest-rate increases. The jobless rate fell to 3.7 percent, the lowest since May 2002, from 4 percent in October…” December 11 - Bloomberg (Tracy Withers): “House price inflation in New Zealand’s 16 biggest cities accelerated, adding to signs that a buoyant property market may fan inflation and prompt the central bank to raise interest rates next year. Prices of houses in the main urban areas rose 8.8 percent in the three months ended Nov. 30 from a year earlier…” Latin American Boom Watch: December 15 - Bloomberg (Fabio Alves): “Brazilian retail sales rose in October after 12 straight consecutive cuts in the benchmark lending rate prompted consumers to buy more goods such as cars, furniture, and appliances. Retail, supermarket and grocery store sales, as measured by units sold, rose 7 percent in October from the year-ago month…” December 14 - Bloomberg (Eliana Raszewski): “Argentina’s economic expansion quickened in the third quarter… Gross domestic product…grew 8.7 percent from the same period a year earlier after expanding 7.7 percent in the second quarter…” Central Banker Watch: December 14 - Bloomberg (Gabi Thesing): “The European Central Bank said interest rates remain ‘low’ after it raised borrowing costs for the sixth time in a year… ‘Monetary policy continues to be accommodative,’ the…bank said…‘with the key ECB interest rates remaining at low levels.’ The bank has raised the benchmark lending rate to 3.5% to quell price increases as the fastest economic expansion in six years spurs higher wage demands.” December 13 - Bloomberg (Robin Wigglesworth): “Norway’s central bank raised its benchmark interest rate by a quarter-point for the seventh time since June last year, and indicated more increases will come to damp inflation in the world’s third-largest oil exporter. Norges Bank raised the deposit rate to 3.5 percent…” December 15 - Bloomberg (Jonas Bergman): “Sweden’s central bank raised its benchmark interest rate by a quarter-point for a sixth time this year and said increases will continue into 2007… Policy makers raised the repurchase rate to 3 percent, the highest since July 2003…” Bubble Economy Watch: December 12 - Bloomberg (Steve Matthews): “U.S. companies plan to increase investment in plants and equipment in 2007 to keep up with rising sales, a survey by the Institute for Supply Management showed… Manufacturers plan to increase capital spending by 8.5 percent in 2007 amid a projected 6.4 percent increase in revenue… Other companies, mostly in service industries, plan to increase investment by 8.2 percent next year and forecast a 6.4 percent jump in sales.” December 12 – The Wall Street Journal (Pui-Wing Tam): “In the late 1990s, the epicenter of Silicon Valley’s dot-com boom was this city’s South of Market neighborhood, where hundreds of Web firms set up shop. When the bubble burst, the neighborhood emptied out. Now the gold rush is on again in the Soma neighborhood -- and particularly in the four-story office building at 625 Second St. Since April, more than a dozen tiny technology start-ups have moved into the red-brick building, which had been nearly half empty. The 135,000-square-foot property now houses about 400 workers, up from 250 several years ago. Many work in start-ups selling online poker, online video, blogging software and other Web businesses that are bubbling up in the new Internet boom… The flurry of activity is a sign of the Internet’s roaring comeback…” December 14 - Bloomberg (Sharon L. Crenson): “The median rent for apartments in New York City, the most expensive urban U.S. real estate market, surged 21 percent from 2002 through 2005, according to…the Community Service Society of New York. The median annual income of renters rose 6 percent during the same time period…” Real Estate Bubble Watch: December 13 - Bloomberg (Kathleen M. Howley): “U.S. foreclosures begun on adjustable-rate mortgages rose to a four-year high in the third quarter as borrowers struggled to pay higher interest rates. The share of the loans entering foreclosure… climbed to 0.30 percent for so-called prime borrowers… The rate for sub-prime borrowers rose to 2.19 percent. Both are the highest since the second quarter of 2002, according to a report today from the Mortgage Bankers Association…” December 14 - Bloomberg (Daniel Taub): “U.S. commercial real estate investment is likely to set a record this year, driven by rising rents and occupancies in office and industrial buildings, the National Association of Realtors said. More than $236 billion in commercial real estate transactions were recorded in the first 10 months of 2006, up from $231.9 billion a year earlier…” December 14 - National Association of Realtors (NAR): “The commercial real estate markets are continuing to grow with record investment, and individual sectors in many areas seeing tighter vacancy rates and higher rents… David Lereah, NAR’s chief economist, said… ‘The office and industrial markets continue to shine, supported by job growth and trade, while the rental apartment sector is seeing healthy rent increases…The retail sector is essentially flat, but the hotel industry is doing better than at any time since 2001.’ James Marrelli, NAR vice president…said there is a record flow of capital into commercial real estate. We’re setting another record this year for investment in commercial real estate… Institutional investors, pension funds and foreign investors have focused on commercial grade properties to diversify portfolio assets, with expectations of solid long-term gains.’” M&A and Private-Equity Bubble Watch: December 15 - Bloomberg (Netty Ismail): “Blackstone Group LP, manager of the world’s biggest buyout fund, and Citigroup Inc. are in talks with the Indian government to start a $5 billion fund that will invest in the nation’s infrastructure projects.” Financial Sphere Bubble Watch: December 15 - Bloomberg (Christine Harper): “Morgan Stanley gave Chief Executive Officer John Mack the biggest bonus for the head of a Wall Street firm, awarding him $40 million as the company headed for the best profit in its 71-year history.” Energy Boom and Crude Liquidity Watch: December 15 - Bloomberg (Winnie Zhu): “China’s crude imports may rise 10.2 percent this year because of rising domestic demand, China Securities Journal reported, quoting a government official. The nation may import 140 million metric tons of crude this year, equivalent to 48 percent of total demand…” Climate Watch: December 9 – Financial Times (Haig Simonian): “From Arosa in Switzerland to Avoriaz in France, one thing is clear in the European Alps this skiing season: the lack of snow. After the warmest and driest autumn on record, snow levels are at record lows, casting a shadow over the tourism and sporting goods industries and potentially turning skiers into an endangered species if global warming worsens.” December 13 - Bloomberg (Matthew Craze): “Buenos Aires suffered energy shortages as temperatures soared to more than 34 degrees Celsius (93 degrees Fahrenheit), prompting record use of air conditioners and refrigerators… Electricity use in Buenos Aires set a record…” Fiscal Watch: December 14 - Bloomberg (Tony Capaccio): “The Defense Department has requested $99.7 billion more in emergency funding for Iraq, Afghanistan and the war on terrorism that, if approved, would bring war spending in fiscal 2007 to a record $170 billion… Congress since the Sept. 11 attacks has approved a total of $507 billion for the war on terror…” Speculator Watch: December 12 - Bloomberg (Shannon D. Harrington): “Credit derivatives outstanding may approach $40 trillion by the end of 2008, with the net value of contracts potentially surpassing that of the underlying bonds, Deutsche Bank AG credit strategist John Tierney said. Trading in indexes based on credit-default swaps and other variations of derivatives that allow investors to speculate on the ability of companies to repay their debt, will drive the increase…” Financial Sphere Profits: Goldman Sachs’ fiscal 2006 EPS ($19.69) were about equal to combined EPS from 2004 and 2005. Net Earnings of $9.398 billion were up 68% from fiscal 2005. Net Revenues were up 49% to $37.665 billion. “Investment Banking generated record net revenues of $5.63 billion, 5% higher than the previous record set in 2000 (up 53% from 2005)… Net revenues in Trading and Principal Investments were $25.56 billion for the year, 52% higher than 2005…[as] Fixed Income, Currency and Commodities (FICC) produced record net revenues of $14.26 billion, 60% higher than the previous record set in 2005. Equities generated record net revenues of $8.48 billion, 50% higher than the previous record set in 2005. Principal Investments achieved record net revenues of $2.82 billion. Asset Management achieved record net revenues of $4.29 billion (up 45% y-o-y). Assets under management increased $144 billion or 27% to a record $676 billion, with net asset inflows of $94 billion in 2006… Securities Services net revenues were $2.18 billion, 22% higher than 2005… Compensation and benefits expenses were $16.46 billion for 2006, 40% higher than 2005.” Goldman repurchased 20.8 million shares during the quarter and 50.2 million shares during the fiscal year. Highlights from Lehman Brothers’ earnings release: “Reported record net revenues, net income and earnings per share for the third consecutive year. Achieved record net revenues across all business segments and regions for the year.” Fiscal 2006 Total Net Revenues were up 20% y-o-y to $17.6 billion. Capital Markets Revenues increased 22% y-o-y to $12.006 billion, with Fixed Income up 15% to $8.447 billion and Equities up 44% to $3.559 billion (Q4 Fixed Income Revenues up 31% y-o-y). Net Income increased 23% to $4.0 billion. For the fiscal year, revenues increased 26% in Principal Transactions to $9.80 billion; 9% in Investment Banking to $3.16 billion; 19% in Commissions to $2.05 billion; 59% in Interest & Dividends to $30.3 billion; and 50% in Asset Management to $1.41 billion. Assets under management were up 29% y-o-y to $225 billion. Compensation expense increased 20.2% to $8.7 billion. Total Assets expanded $30.0 billion during the quarter, or 25% annualized, to $503.7 billion, with a y-o-y gain of $93.7 billion (22.9%). The company repurchased $13.8 million shares during the quarter and 52.9 million for the fiscal year. Bear Stearns’ fiscal 2006 Total Net Revenues were up 24.5% y-o-y to $9.227 billion. “Net income for the fiscal year 2006 was $2.1 billion, up 40% from the $1.5 billion earned in the twelve-month period ended November 30, 2005… Capital Markets net revenues were a record $7.0 billion for fiscal year 2006, an increase of 25%... Institutional Equities net revenues for the fiscal year…were up 33% to a record $1.9 billion… Equities derivatives, risk arbitrage, energy/commodity activities and international sales and trading all delivered record results. Fixed Income net revenues were a record $4.0 billion…up 23%... The credit franchise delivered its best results ever as the high yields, leveraged finance and credit trading areas all produced record revenues. Investment Banking reported net revenues of $1.2 billion for fiscal 2006, up 19%... Wealth Management net revenues were $850 million for fiscal 2006, an increase of 25%...” Compensation expense was up 22.2% from fiscal 2005 to $4.344 billion. The company repurchased 2.8 million shares during the quarter and 10.6 million shares for the fiscal year. Combined Goldman Sachs, Lehman Brothers, and Bear Stearns Q4 Net Revenues were up 37% from comparable 2005 to a record $16.353 billion. Combined Net Income for the quarter was up 63% from Q4 2005 to a record $4.471 billion. The epic inflation in Wall Street Profits is better illuminated in the annual data. Goldman, Lehman and Bear combined for 2006 Net Revenues of $64.475 billion, up 36% from record 2005 revenues. Combined 2006 Net Income surged 51% from the previous year’s record level to $16.691 billion. Since 2002, Net Revenues have inflated 157% and Net Income 300%. The profit motive is fundamental to free-market Capitalism. Profits – current and prospective - motivate risk-taking, investment, Credit expansion and economic development. Yet the corrosive distortion of asset prices and system Profits fomented by runaway Credit and speculative excess is contemporary Capitalism’s paramount vulnerability. The current global profits boom is unmatched for its scope, intensity and peril. The primary source of the boom is an unsustainable expansion of non-productive U.S. debt, predominantly originating in mortgage and securities finance. Especially because of the power of “Wall Street” financial alchemy to transform increasingly risky U.S. Credits into perceived safe and liquid instruments (“Moneyness of Credit”), there is today no effective check on the Credit Bubble – either in the marketplace, by U.S. monetary authorities or through global currency adjustment. And we see today that the greater the Credit expansion the more alluring the asset price and Profits inflation - that motivates only greater speculative excess and global financial and economic mal-adjustment. When contemplating contemporary “Profits,” it may be helpful to think in terms of the Financial Sphere/Economic Sphere framework. Traditionally, economic Profits reined supreme throughout the system, providing the predominant motivation for investment and Credit expansion. While this mechanism certainly didn’t prevent self-reinforcing Credit booms, it did at least tend to inhibit those most pernicious Credit inflations that evolve over prolonged periods to severely distort underlying economic and financial structures. Importantly, bountiful economic profits impel investment and increased capacity. Added output coupled with heightened boom-time input prices tend to over time weigh on economic profits, in the process occasioning self-correction and adjustment. Financial Profits predominately flow from Credit expansion. Thus they are a much different beast. Credit inflation – the creation of additional purchasing power/liquidity through the expansion and dissemination of new financial claims – boosts Financial Profits through a variety of channels. For one, lenders and investment bankers will take, as their “service fee,” a slice of newly “minted” Credit instruments. Financial profits are also boosted mightily by Credit-induced asset inflation, offering opportunities to gain from speculation, brokerage services, and asset-based financing. Additionally, asset Bubbles provide great opportunities to Profit from a booming financial services industry – including offering “wealth” management and advisory services and providing insurance. Contrast the self-correcting nature of Economic Sphere Profits to boom-time processes that work to enthrall the ballooning Financial Sphere. As we are witnessing these days, rampant Credit inflation drives a Financial Sphere Profits bonanza that only incites greater Credit inflation, Risk Embracement, and speculative excess. There is little in the way of self-correction or adjustment; quite the opposite. Indeed, inflating Profits seemingly validate and legitimize audacious practices, certainly including the proliferation of new financial instruments, strategies and leveraging techniques. While overcapacity may eventually weaken profitability in some financial operations (today in mortgages, traditional bank lending, and risk spreads), there is an overwhelming proclivity for boom-time exuberance to impel financial operators (today mortgage brokers, bankers and hedge fund managers) to respond to faltering margins with only greater volumes. Heightened leverage then creates additional system financial Profits that promote only further leveraging (Minsky’s Ponzi Finance). The powerful propensity for financial Profits to foster progressive Credit inflations is today a much more pressing issue than ever before. From a Financial Sphere perspective, we live these days in an (experimental) environment of unlimited and permanently cheap finance. The Fed no longer controls or even bothers to manage “money” and Credit expansion. There are no effective bank reserve or capital requirements that check domestic lending or Credit growth. Meanwhile, the proliferation of global securitization markets, derivatives, and leveraged speculation create an unrestrained liquidity-creating mechanism unlike anything available in the past. Global finance operates without a stabilizing monetary regime such as the gold standard or Bretton Woods - systems that would have provided some measure of discipline to U.S. or others’ financial profligacy. Moreover, the unparalleled inflation and global flow of dollar finance over the past five years has unleashed Credit systems around the globe from the previous discipline imposed by fear of potential currency runs and resulting financial dislocation. Rampant Credit inflation in competing currencies has, especially of late, then worked to somewhat stabilize the dollar. And, as noted above, contemporary finance provides an unparalleled capacity for fabricating perceived safe and liquid money-like debt instruments, a seminal development in the history of finance and economics. “Wall Street” finance and the “Moneyness of Credit” issue are now taking the world by storm. From an Economic Sphere perspective, there have been major developments that have increased the capacity of the U.S. economy to neatly conceal the deleterious effects of gross Credit excess. Clearly, the shift to a “services”-based economy, while relying on imports for a large portion of required goods and energy resources, has profoundly altered the nature of inflationary manifestations in the domestic economy. Furthermore, Credit inflations and asset Bubbles, by their nature, redistribute wealth, and today’s gross disparities work to circulate purchasing power in an especially lumpy and atypical manner. Instead of an inflating aggregate price level (CPI), flows of added purchasing power today may very well lead to the procurement of higher valued services (i.e. medical specialists, consultants, attorneys, private education), upscale services (more expensive restaurants, spas and health clubs, entertainment), upscale goods (more expensive homes, luxury autos, organic foods), collectables, better communications (i.e. cable vs. DSL Internet, HDTV), media/digital products (music, video and other online content), technology products and, of course, more imports (certainly including luxury goods). Unlimited global finance, as one would expect, has profoundly boosted export-oriented investment (“Investment Inflation”), especially in China and throughout Asia. In short, it may be a very long time before CPI provides any meaningful gauge of either general inflationary pressures or Financial Conditions. Eventually, Financial Sphere Profits become the commanding influence over system Credit expansion and investment, along with being a powerful influence over spending generally (fueling income growth and gains in financial wealth). This is where things get dangerous. The financial boom incites a self-reinforcing investment boom, as well as general liquidity excess and asset inflation. Financial excess masks the underlying vulnerability of profitability in the real economy. Or, stated differently, the Economic Sphere becomes progressively dependent upon Financial Sphere ballooning. The runaway Financial Sphere Profits boom at the same incites Investment Inflation (including over- and mal-investment) while progressively distorting financial flows and inflating real economy profitability. A strong case can be made that this fateful Credit Bubble “blow-off” phase evolved out of the Fed’s overzealous response to faltering corporate profitability and resulting debt problems back in 2001/2002. And this year’s gross global liquidity excesses have been very much an outgrowth of a bloated and energized Financial Sphere’s push to capitalize on the U.S. Bubble economy’s susceptibility to a housing bust (get ahead of the next easing cycle!) The upshot has been another banner year of Credit expansion of sufficient scope to artificially inflate economic Profits at home and abroad. And these inflated Profits coupled with the loosest global Financial Conditions imaginable have fueled this year’s global M&A boom. For sometime now I’ve been failing in uncharted analytical waters. It’s been a case of contemplating and conjecturing how far the confluence of unrestrained Credit, momentous financial innovation (including Wall Street “money” alchemy), pivotal technological and communications advancements, and contemporary economic “output” – all on a global scale - could run before it hit the wall. As Wall Street earnings clearly demonstrate, the only wall hit thus far has been a Wall of Financial Sphere Profits. But the stakes are inflating right along with Credit, liquidity and general financial excess. Wall Street will now be occupied with creating sufficient Credit, liquidity and speculative excess to maintain grossly inflated global equities, bonds, real estate, (compressed) Credit spreads, along with inflated economic Profits for the coming year. The Financial Sphere is clearly geared up for the endeavor, although the enormous scope of the required global Credit expansion ensures escalating Monetary Disorder, including tumultuous currency markets going forward. |
Wednesday, September 10, 2014
12/15/2006 Financial Sphere Profits *
