04/17/2003 Firing on Most Cylinders *

For the week, the Dow gained almost 2%, with the S&P500 up about 3%.  The Transports surged 6%, and the Utilities added 3%.  The Morgan Stanley Cyclical index was up better than 3%, while the lagging Morgan Stanley Consumer index added about 1%.  The broader market enjoyed strong gains, with the small cap Russell 2000 and S&P400 Mid-cap indices up 3%.  The technology sector came to life again, with the NASDAQ100 jumping better than 5%.  The Morgan Stanley High Tech index was up 6%, as the Semiconductors surged 10%.  The Street.com Internet index jumped 6% and the NASDAQ Telecommunications index 5%.  The Biotechs were up 3%.  The financial stocks were strong as well, with the Securities Broker/Dealer index up 5% and the Banks up 4%.  While bullion dipped about a dollar, the HUI Gold index added 2%. From March lows (generally March 12th), the Dow has jumped 12% and the S&P500 13%.  The Transports have surged 21%, and the Utilities have gained 9%.  The Morgan Stanley Cyclical index is up 16%, and the Morgan Stanley Consumer index is up 10%.  The Russell 2000 has gained 12% and the S&P400 Mid-cap index 11%.  The NASDAQ100 is up 14.4% and the Morgan Stanley High Tech index 11.5%.  The Semiconductors and The Street.com Internet index have both jumped about 20%.  The NASDAQ Telecommunications index is up 14% and the Biotechs 9%.  The Securities Broker/Dealer index has surged 26% and the Banks almost 18%.  Curiously, the Treasury market this week seemed to take the energized stock market in stride.  Two-year Treasury yields increased four basis points to 1.68%, and five-year yields added three basis points to 2.93%.  The ten-year Treasury yield actually declined two basis points to 3.96%, while the long-bond saw its yield dip six basis points to 4.89%.  Benchmark mortgage-back yields jumped 10 basis points, while implied yields on agency futures were about unchanged.  The 10-year dollar swap spread narrowed one to 41, while the spread on Fannie’s 4 3/8% 2013 note narrowed two to 43.  The dollar declined about 1%, while the CRB index gained almost 2%.   Corporate issuance slowed during the holiday-shortened week.  JPMorganChase boosted the size of its bond issue by 25% to $1.25 billion.  Nordic Investment Bank raised $1 billion and BHP Finance issued $850 million of bonds.  Hilton Hotels issued $500 million of bonds, Cox Enterprises $500 million, Alabama Power $195 million, and Ohio Edison $325 million.  Lower-tier debt has developed into quite a hot commodity.  XTO Energy raised $400 million, Alpharma $220 million, Equistar Chemical $450 million, Ethyl Corp $150 million, Susquehanna Media $$150 million, and Rite Aid $360 million.  Bloomberg’s total y-t-d U.S. Domestic debt issuance of $633 billion is running 20% ahead of last year.  With issuance of $3.7 billion, it was a relatively light week for the booming asset-backed security marketplace.  However, year-to-date issuance of $129 billion is running 22% ahead of last year’s record pace. April 15 - Dow Jones (Nicole Bullock):  “The high-yield market remains a fertile ground for new issues as cash continues to pour in and the supply pipeline fails to keep up. This week, several junk bond deals have been increased in size, are being priced at tight spreads to Treasuries and still trade higher after launch.  ‘The demand, I guess you could say, is pretty much unprecedented and the supply of new bonds, quite frankly, is limited,’ said Harry Resis, director of U.S. fixed-income at Henderson Global Investors… ‘All you have to do is look at the price action.’ … So far this year, junk funds have seen inflows of about $12.2 billion, already surpassing the $11.7 billion take-in for all of 2002, according to AMG…” AMG reported this morning that an additional $555 million flowed into junk bond funds this week. April 18 – New York Times (Jonathan Fuerbringer):  “With war winding down, investors have poured more money into stock mutual funds than they have in a year… Stock mutual funds had a net inflow of $5.7 billion, with much of it devoted to the riskiest investments, in the week ended Wednesday.  According to AMG Data Services, $1 billion went into aggressive growth funds and $472 million into technology funds.” April 17 – Bloomberg:  “China’s economy expanded at the fastest pace in seven years after factories boosted production to meet surging export demand. Gross domestic product grew a higher-than-expected 9.9 percent from a year ago to 2.36 trillion yuan ($285 billion) in the first quarter, the National Bureau of Statistics said… Retail sales rose 9.2 percent to 1.11 trillion yuan… Increasingly, the mobile phones, computers and toys made in China are also being sold to a growing middle class in cities such as Beijing and Shanghai. The per capita disposable income of China’s 500 million urban residents rose 8.4 percent in the first quarter to 2,355 yuan… During the quarter, factory production increased 17 percent, foreign direct investment rose 57 percent, fixed-asset investment, about three-quarters coming from the government or state-backed companies, grew 28 percent and exports surged by a third… Growth may be too fast in areas such as real estate. Property investment rose more than a third in the last quarter and home sales increased by more than half. Earlier this month, Vice Premier Zeng Peiyan warned developers to stop making luxury villas, while former premier Zhu Rongji warned last year that a real estate ‘bubble’ was forming in some parts of the country.” Recent anecdotes from China are consistent with the nature of Credit booms:  Initial inflationary manifestations can be quite positive: an investment boom, rampant productivity increases, surging employment and income growth, and general economic prosperity.  But extraordinary booms never remain placid.  Further into the boom cycle, inflationary manifestations become increasingly unpredictable and often problematic.   There’s been considerable talk of China exporting global “deflation.”  I would be cautious when extrapolating this phenomenon too far into the future.  For one thing, they’ve got a lot of inflated U.S. dollars to spend. April 17 – Bloomberg:  “Russia’s economy expanded 6.4 percent in the first quarter, the fastest growth since the last three months of 2000, after oil, gas and metals producers boosted exports and service companies tapped soaring domestic demand.” April 15 - Dow Jones (Arden Dale):  “Standard & Poor’s took sweeping pensions-related actions Tuesday, putting 13 U.S. companies on watch for possible credit downgrade based on concerns about their post-retirement obligations.  S&P acted partly out of its belief that the companies may have to dedicate a greater portion of their cash-flow to fund benefit obligations.  The ratings agency also revised its long-term outlook for three companies to negative from stable, and for another to stable from positive, due to pension-related concerns.   The 13 companies placed on credit watch negative are Alcoa Inc., Allegheny Technologies Inc., Caterpillar Inc., Caterpillar Financial Services Corp., Consol Energy Inc., Cummins Inc., Delphi Corp., Eaton Corp., Kimberly-Clark Corp., Pittston Co., PPG Industries Inc., SBC Communications Inc. and Visteon Corp.” Broad money supply (M3) dropped $37.9 billion last week.  This is not unexpected in an environment of heightened demand for risk assets, with the corresponding diminished pressure on the financial sector to expand “safe” monetary liabilities.  For the week, Demand and Checkable Deposits declined $19.3 billion (tax payments?).  Savings Deposits surged $25.9 billion, while Retail Money Fund Deposits declined $10.4 billion.  Institutional Money Fund Deposits declined $11.2 billion.  Large Denominated Deposits declined $1.8 billion, Repurchase Agreements dropped $17.1 billion, and Eurodollars dipped $2.8 billion. Elsewhere, total outstanding Commercial Paper jumped $10.5 billion to $1.33 Trillion (the highest level in nine weeks).  Non-financial CP added $2.6 billion and Financial CP gained $7.9 billion.  Total Banking System Net Assets declined $15 billion, although Bank Credit expanded by $15.5 billion.  Loans and Leases surged $27.1 billion, yet Commercial and Industrial loans declined $7.9 billion.  Real Estate Loans jumped $20.8 billion, with two-week gains of $40.7 billion.  Security loans expanded $12.9 billion.  Year-over-year, Real Estate loans are up 18%, while Commercial and Industrial loans are down 6.5%. Security loans are up 24% y-o-y. For our Diligent Observation, we take note that retail surveys from both Redbook and Bank of Tokyo-Mitsubishi posted strong gains last week.  With sales up about 2% y-o-y, these were the first positive year-over-year comparisons in seven weeks and basically the strongest gains since early January.  Redbook had sales up an impressive 4.4% from a month ago. Manufacturing and employment remain weak, but we should be mindful that these are generally lagging indicators. March provided interesting data from the two major West Coast ports.  After a relatively subdued February, total imports into the Ports of Los Angeles and Long Beach jumped 10%.  Inbound containers were up 22% y-o-y.  Outbound containers surged 12% to a new record, and were up 5% y-o-y.  Nonetheless, 256,075 containers departed the two ports empty, up 23% y-o-y and fully 54% of inbound containers.  The U.S. Treasury today reported March's federal deficit at $58.7 billion.  Half way through the fiscal year, Total Spending is up 6.7% to $1.078 Trillion, while Total Receipts are down 6.1% to $825 billion.  The six-month deficit is up 92% to $253 billion.  By major department, y-t-d Defense spending was up 12.9%, Social Security 4.1%, Health & Human Services 9.3%, Agriculture 1.3%, Education 44%, and Labor 26%.  Interest expense was down 2.3%. Bankruptcy filings declined markedly last week to 32,839, while remaining up 6% y-o-y.  Blow-off week 44 saw both mortgage Refi (down 10%) and Purchase applications (down 6.2%) decline, although total application volume remains robust (up 141% y-o-y).  Refi applications were up 345% y-o-y, and Purchase applications were up 11.5% y-o-y.  March CPI increased 0.3%, with year-over-year consumer price inflation of 3%.  This equals February’s 3.0% y-o-y rise, which was the strongest reading since June 2001. April 15 – Bloomberg:  “New York apartment prices fell 3.7 percent in the first quarter and the number of sales declined 8.4 percent to the lowest level since the 2001 terrorist attacks, as the city's recession weakened demand for homes.  The average price fell to $779,112 from $808,657 in the previous quarter, the second consecutive quarterly decline… The cheapest apartments showed a price gain… The average price for studios rose 10 percent to $282,431, and the price for one-bedroom units rose 2 percent to $462,917.” April 17 – American Banker (Erick Bergquist):  “Interest-Only Loans Becoming More Popular – Here’s the pitch: You’re an upwardly mobile, financially savvy borrower managing your own investments.  Interest rates are at historic lows, home values continue to magically rise, and you do not plan to be living in the same house in five years.  What about taking out an interest-only loan?  With the lowered monthly payments, you could buy a bigger house, and in a few years, when you’re ready to refinance or trade up, you won’t be in any worse shape for equity than you would have been if you had taken out a 3-year fixed-rate loan.  Across America, more lenders say they have struck a gold mine with interest-only loans.” April 18 – Bloomberg:  “Robert Shiller, the economist whose book warning of a stock bubble was published within days of the market's peak in 2000, isn’t loading up on equities yet. The 57-year-old Yale University professor said in an interview that only about 5 percent of his wealth is invested in public companies. He bought a Connecticut vacation home with a view of Long Island Sound last year.  ‘Certain kinds of real estate do have great long-run prospects,’ Shiller said in an interview. ‘One of them is possibly real estate in rare, beautiful places; that is what I just bought.’” Housing Starts were reported at a stronger-than-expected rate of 1.78 million, up 6% y-o-y.  The 8.3% m-o-m rise largely reversed February’s weather-induced 10% decline and was the largest gain since September.  March Starts were up 22% from (pre-Bubble) March 1997 and compare to a trough level of 798,000 back in 1991, as well as an average rate of about 1.1 million during the early nineties recession.  Homes Under Construction rose to a record 1.06 million, up 4% y-o-y.  March Homes Under Construction were up 31% from (pre-Bubble) 1997 levels and compare to the average of about 650,000 during much of the 1991/92 recession.  Single-family Homes Under Construction were up 7% y-o-y.  And after a few very strong months, Building Permits settled back to a more reasonable but nonetheless quite strong 1.685 million annual pace (up 4% y-o-y).  It is again earnings season, providing our best opportunity to analyze the behavior of the nation’s leading financial institutions.  Are the lenders, financial insurers, and “risk players” becoming, at the margin, more risk averse or instead demonstrating a heightened appetite for risk?  At what pace are financial sector balance sheets (money and Credit) expanding?  From what sector(s) do we see the most aggressive expansion, and where is the created purchasing power generally being directed (Monetary Processes)?  Are we seeing increased lending to commercial enterprise, or do asset markets (real estate) continue to play the major role in the Credit creation process?  And we must ask, “Where are the greatest financial profits being generated?” as this provides us important clues as to where the greatest excesses are building.  Well, I have yet to grasp any real surprises: Completely dominating the Credit mechanism, the Mortgage Finance Bubble runs unabated.  The conspicuous inflationary manifestations include over-consumption and the augmentation of the maladjusted monetary (“service-sector”) U.S. Bubble economy.  Fannie Mae reported first quarter Net Income of $1.94 billion, up 61% from the 2002Q1.  Bloomberg’s Brian Sullivan: “Tell us what is the greatest underlying factor behind your ability to boost your earnings forecast for this year?” Fannie Mae’s Chairman Franklin Raines:  “Well, the biggest factor was the very strong market for mortgage originations.  People are still buying homes and they’re refinancing their homes.  And that has increased our business in the first quarter by about 24 or 25 percent, which allowed us to increase our overall revenue by about 27 percent and bring 24 percent EPS growth to the bottom line.  So it’s simply strong fundamentals.  It’s a part of our disciplined growth strategy, and it's working very well.” Brian Sullivan: “Are you concerned that the pace of the growth of your mortgage portfolio is faster than the pace of growth of mortgages as a whole?  At what point will you say, maybe we’ve gotten a little bit too big, and we’re going to slow down the pace of growth?” Franklin Raines:  “Well, actually, we’re growing at about the pace of the market right now.  The market simply is growing very, very fast.  And so, traditionally, we’ve been taking about a point of market share a year.  But that’s pretty much - has not accelerated over the last couple of years.  So what we are growing with is with the market.  And that has been quite impressive, because this is a very strong market.  It has an underlying growth rate of 8 to 10 percent.  But in the last years it’s been growing faster than 10 percent and that means that Fannie Mae can then grow faster than 10 percent. Fannie’s Book of Business (mortgages held and guaranteed mortgages sold into the marketplace) surged a record $103 billion (32% greater than the previous record growth set during 2002’s fourth quarter) to $1.923 Trillion.  This 22.7% annualized growth rate during the quarter increased Fannie’s y-o-y Book of Business growth to $295.3 billion, or 18%.  This amount is greater than total household mortgage debt growth for any year prior to 1998.  Two-year Book of Business growth of $557 billion was an increase of 41%.  Five-year growth of $1 Trillion saw the Total Book of Business doubled (109%).  With intense marketplace demand for mortgage-backs throughout, Fannie’s balance sheet expanded by (only) 12% annualized during the quarter to $913 billion.  Total Assets have increased $105 billion, or 13%, in twelve months.  Total Assets have inflated 30% over two years and 126% over five years.  Wells Fargo enjoyed “Record revenue up 9.3% from the prior year.”  “Most business lines continued to exhibit strong sales during the quarter, including sales of consumer loans, mortgages, deposits and credit cards.”  “Home equity sales up 25% from a year ago.”  “Residential mortgage originations of $103 billion, 2nd highest quarter ever.”  “The response of American homeowners to the lowest mortgage rates in forty years generated a record $157 billion in applications for the quarter.  Driven by a monthly record $62 billion of applications in March, Home Mortgage ended the quarter with a record pipeline of $89 billion, up 29% from year-end.”  For the quarter, Total Assets expanded by $20.4 billion, or 23% annualized, the largest increase in more than three years.  Year-over-year Total Assets were up 19%.  For the quarter, Total Consumer Loans expanded at a 23.3% annualized rate.  “Real Estate- 1 to 4 family first mortgage” loans expanded at a 34% rate, with Home Equity Loans increasing at 24% annualized.  Commercial Loans were up only 1.6% y-o-y, but did expand at a 7.2% annualized rate during the quarter.  Interestingly, of the $27.5 billion y-o-y increase in Total Loans, Commercial loans increased by only $759 million.  Year-over-year, “Real Estate – 1 to 4…” increased 44% to $44.5 billion, and Home Equity loans were up 31% to $33.2 billion.    Bank America saw Total Assets expand at a 12% annualized rate during the quarter.  Year-over-year, Total Commercial Loans dropped 11% to $143.0 billion, while Total Consumer Loans jumped 21% to $202.9 billion.  From “Financial Highlights”:  “Mortgage banking income rose 108 percent to $405 million.”  “Card income was up 18% to $681 million.”  “Investment banking income rose 11 percent to $378 million.”  BAC repurchased 18 million shares during the quarter.  Bank One’s Total Assets jumped $10.5 billion, or 15% annualized, the strongest growth since year-2000’s third quarter.  “Average home equity balances increased $3.3 billion, or 13%, from the prior year…”  End-of-period Card Services managed loans were up 12% y-o-y to $72.8 billion.  Washington Mutual originated $106.6 billion of loans during the quarter ($214 billion in six months), up 62% from the year earlier period.  National Century originated $4.7 billion of new mortgages during the quarter, up 54% from 2002Q1.  Total Assets expanded at a 62% annualized rate to $2.8 billion, with 12-month gains of 74%. Citigroup Total Assets expanded by $39.8 billion, or 15% annualized.  Global Consumer income of $2.15 billion was up 26%.  “Cards income of $735 million increased 27%” and “Retail Banking income of $942 million, jumped 54%.”  “Consumer Assets also benefited from continued high demand for mortgage refinancings, and 53% growth in student loan originations.”  For the quarter, Trading Account Assets jumped 12% to $173 billion, while Loans declined 2% to $426.5 billion.  Year-over-year, Total Corporate Loans declined 8% to $131.1 billion, while Total Consumer Loans jumped 25% to $307 billion (partially explained by the acquisition of Golden State Bancorp). JPMorganChase surprised the Street with Net Income of $1.4 billion, its strongest showing in almost three years.  “Sharp revenue growth in the Investment Bank and Chase Financial Services…”  From Chase Financial Services:  “Operating revenues of $3.74 billion for the quarter were up 21% from the first quarter of 2002 reflecting higher production volumes across all national consumer credit businesses.  Home Finance generated record revenues for the quarter, up 116% from the first quarter of 2002, due to record mortgage originations… Auto Finance also generated record revenues in the first quarter, up 17% from the first quarter of 2002… Cardmember Services revenues were up 9% from the prior year primarily reflecting growth in average outstandings; over one million new accounts were originated during the first quarter.”  “Commercial loans were down 3%, or $3.1 billion, from year-end and decreased 13%, or $13.3 billion, from March 31, 2002.  Managed consumer loans increased 3% from year-end and 18% from March 31, 2002.”  Chase Home Finance End-of-Period Outstandings were up 23% annualized during the quarter and 25% y-o-y.  Also worth noting, Derivative Receivables were up 37% y-o-y to $86.6 billion, and Securities were up 39% y-o-y to $85.2 billion.  Loans were up 1% y-o-y, as Total Assets expanded 6% to $755 billion.  On the liability side of the balance sheet, (average) Federal Funds Purchased and Securities Sold jumped 24% y-o-y to $191.2 billion. It is especially interesting to analyze the business practices of the Credit insurers.  It has been a case of waiting to see if these acutely exposed risk players would “retrench” – with major ramifications for the Credit creation process - or instead simply put peddle-to-the metal and attempt to race past festering systemic problems? Ambac is racing.  The company reported Net Income up 19% y-o-y, as total Adjusted Gross Premiums Written surged 52% y-o-y (Public Finance up 20%, Structured Finance 36%, and International 114%).  It is truly amazing to witness the continued transformation of the Credit insurers from institutions guaranteeing low risk municipal debt to Structured Finance Kingpins.  Looking back at Ambac’s Financial Guarantee Portfolio distribution at the end of year-2000, we see that Public Finance accounted for 65.3% of total exposure, Structured Finance 23.4% (Mortgage-back and Home Equity 13.8% and Asset-backed and Conduits 8%), and International 11.3%.  During the this year’s first quarter – observing the distribution of new guarantees put in force - Public Finance accounted for 29%, Structured Finance (Mortgage-back and Home Equity 25.4% and Asset-backed and Conduits 10.4%) 43.7%, and International 27.3%.  For the quarter, Net Financial Claims in Force (NFCF) increased $18 billion, or about 13% annualized, to $575 billion.  Year-over-year, NFCF jumped $91.3 billion, or 19%, while Qualified Statutory Capital increased $560 million to $3.9 billon (Total Claims Paying Resources increased $1.4 billion to $8.5 billion).  NFCF is up $148 billion, or 35%, in twenty-four months.  And, viewing the balance sheet, we see that Total Assets increased at a 26% annualized rate during the quarter to $16.3 billion.  Year-over-year, Total Assets jumped 27%.  Mortgage Insurer MGIC continues to struggle.  While total Insured Loans increased 1% y-o-y to 1.64 million, Total Loans Delinquent surged 36% to 76,837 (from 3.48% to 4.69%).  Delinquencies were up 24 bps during the quarter.  Delinquencies excluding Bulk Loans rose eight bps during the quarter to 3.27%, up from the year earlier 2.53%.  Losses Incurred rose slightly during the quarter to $142 million, but were up 138% y-o-y.  Total Assets expanded at a 9% rate during the quarter and were up 11% y-o-y to $5.4 billion.  MGIC increased its risky mortgage “pool” exposure by 12% during the quarter (up 40% y-o-y). Mortgage Insurer Radian saw Debt Service Outstanding grow at a 16% annualized rate to $109 billion, the strongest pace of growth since the third quarter of 2001.  Total Assets expanded at a 29% annualized rate to $5.8 billion.  Direct Claims Paid (losses) were up 44% y-o-y to $53.3 million.  The insured portfolio’s risk profile changed markedly, as the number of risky “A Minus and below” insured loans surged 34% during the quarter (107,181), while the number of Prime loans declined by 12% (690,647).  Delinquencies declined 21 basis points during the quarter (up 46 bps y-o-y).   This week General Motors reported better-than-expected earnings, led by huge gains from its mortgage operations.  Financing arm GMAC saw earnings surge 33% sequentially (q-o-q) to $699 million, fully 47% of total General Motors net income. While GM’s North American auto revenues were up 2% y-o-y, GMAC revenues jumped 15%.  GMAC earnings were up 59% y-o-y.  “GMAC Mortgage Group, Inc. earned a quarterly record $371 million in the first quarter of 2003, up 151% from the $148 million earned in the same period of 2002.  The higher earnings reflect exceptional production volumes across all three divisions of the group.” Although convoluted earnings-per-share “met expectations,” General Electric saw consolidated revenues declined 1% y-o-y.  This aggregation, however, cloaks dramatic and significant sector divergences.  Indeed, GE’s results provide our analytical minds an excellent microcosm of the imbalanced U.S. (monetary) economy.  Year-over-year, GE Capital Services revenues (GECS) were up 6%, while the remainder of GE posted 5% y-o-y revenue declines.  Interestingly, and a “sign of the times,” GECS accounted for 56% of General Electric Net Earnings.  By major GE Operating Segment, we see that Aircraft Engines experienced an 8% y-o-y revenue drop, with Consumer Products revenue down 7%, and Power Systems sinking 20%.  Yet, Commercial Finance Revenues were up 8% y-o-y, Consumer Finance 16%, Insurance 10%, and Medical Systems 15%.  These revenue figures rather clearly demonstrate the economic imbalances impacting the U.S. economy, as well as the ongoing inflationary biases throughout finance and healthcare (at the expense of manufacturing).  Thus far, quarterly earnings reports confirm my view that the Credit system is increasingly Firing on Most Cylinders.  First quarter Credit growth will be strong, with another quarterly mortgage debt growth record quite possible.  There is today no mystery surrounding the economy’s “resiliency,” and this Credit Bubble attribute is no virtue. Truly extraordinary monetary looseness now pervades the system, providing an energized financial backdrop for the thus far despondent economy.  The good news is that this should be expected to stimulate economic “output” over the near-term.  The bad news is that this distasteful monetary stimulus will only exacerbate Bubble economy distortions and imbalances.  The precarious Mortgage Finance Bubble has monopolized the financial sector and is increasingly the master of the real economy.  There will be a huge price to pay.  Moreover, the rampant inflation of non-productive Credit (financial claims) will only augment both dollar vulnerability and, eventually, general financial fragility.  We should expect significant inflationary manifestations going forward, imparting unpredictable and distorting effects on imbalanced domestic and global economies and markets.

04/10/2003 The Reasons *

Financial markets remain unsettled. For the week, the Dow dipped less than 1%, while the S&P500 declined just over 1%. The Transports were barely in the black, while the Morgan Stanley Consumer, Morgan Stanley Cyclical and Utilities were down slightly. The broader market was about unchanged, with the small cap Russell 2000 posting a marginal decline, and the S&P400 Mid-cap index declining about 1%. The NASDAQ100, Morgan Stanley High Tech, and NASDAQ Telecommunications indices declined about 2%. The Street.com Internet index dipped 1%, while the Semiconductors declined 4%. The Biotechs dropped about 5%. The financial stocks were mixed. The Securities Broker/Dealer index was down about 2%, while the Banks were slightly positive for the week. With bullion up $2.50, the HUI Gold index added 3%. The Treasury market was uneasy. For the week, two-year Treasury yields rose eight basis points to 1.64%, with five-year yields increasing five basis points to 2.89%. The 10-year yield added two basis points to 3.97%, while the long-bond saw its yield decline one basis point to 4.95%. Mortgage-backs and agencies performed well, with benchmark yields declining four and one basis point, respectively. The 10-year dollar swap spread declined two to 41, while the spread on Fannie’s 4 3/8 2013 note narrowed three to 45.5. Corporate spreads were mixed, with junk issues widening marginally after recent strong performance. The dollar and CRB index were about unchanged. Today from Bloomberg: “Some 30 corporations and sovereign borrowers sold more than $13 billion of new corporate bonds as yields on investment-grade company debt touched a 19-month low of about 1.5 percentage points relative U.S. Treasuries Monday…” This week brought confirmation that the convertible debt market is back. Wells Fargo sold $3 billion of floating rate convertible securities, Disney $1.15 billion, and Photronics $125 million. Meanwhile, John Deere sold $225 million of bonds, Southwestern Electric Power $100 million, FPL Group $500 million, Amerigas $360 million, Georgia Power $100 million, and PSEG Energy $350 million. United Mexican States raised $2.5 billion, Republic of Colombia $750 million, International Finance Corp. $1 billion, Landerwirtschaft Rentenbk $1 billion, Kazkommertsbank $350 million, and Mercantile Banks $300 million. The junk bond issuance boom runs unabated, with Six Flags selling $430 million, Sun Communities $150 million, Park Place Entertainment $300 million, Town Sports International $255 million, Fiserv Inc. $150 million, Senior Housing $150 million, DR Horton $200 million, Sealed Air $300 million, Iron Mountain $400 million, and Manor Care $200 million. Bloomberg’s running tally of total 2003 Domestic Debt issuance closed yesterday at $594 billion, up 20% from comparable year ago issuance. The booming asset-backed securities market saw $14 billion of new issuance this week. Year-to-date issuance of almost $125 billion is up an eye-opening 25% from last year. April 9 – Bloomberg: “Munich Re, the world’s biggest reinsurer, may be able to ward off threats to its credit ratings by boosting capital with the largest subordinated debt sale ever by a European insurer, investors said. The reinsurer set prices today on 3 billion euros ($3.2 billion) of subordinated debt. The sale, increased from 2 billion euros yesterday, eclipses a 2 billion-euro issue by rival Allianz AG in May 2002… Munich Re was able to increase the sale after underwriters led by Deutsche Bank AG and UBS AG collected orders for 6 billion euros of the bonds yesterday.” Munich Re raised another $471 million today in the U.K, as over-liquefied markets provide extraordinary opportunities to raise much-needed capital. Allianz is preparing for a $3.8 billion rights offering and ING today issued $1 billion of subordinated bonds in the U.S. April 11 – Bloomberg: “Emerging market bond fund assets jumped by a record 2.2 percent in the past week… Investors poured $219 million into mutual funds holding Russian, Brazilian and other developing-nation debt in the week ending April 9, beating the previous weekly record of $173 million in mid-March… Funds investing in emerging debt received more than $1.2 billion this year…more than all of 2002. The demand sent developing nation bonds soaring 20 percent during the past six months, their longest rally since early 1998…” April 8 - Dow Jones: “Emerging market bond issuance totaled $25.8 billion during the first quarter of 2003, marking a 8% jump from the previous quarter and a 16% increase from the same period last year, according to research firm Dealogic. The rise in new bond deals coincided with a sharp rally in emerging market debt, which saw returns soar up to 7.6% in the first quarter.” April 10 – Wall Street Journal: “Mexico has placed $2.5 billion in international debt markets as the government moves to close the books emphatically on a default-riddled past. Investors weren’t afraid to enter the fray, snapping up $1.5 billion and $1 billion in global bonds maturing in 2008 and 2003… “We had an [order] book in excess of $6 billion…” (said) Alonzo Garcia, Mexico’s director general of public credit… The 2008 bonds were priced to yield 4.75%, the longer-dated debt 7.625%...U.S. buyers were particularly active.” April 8 - Dow Jones: “Russian bank lending grew 3.1% in January and was up 38.6% on the year, the Russian Central Bank said Tuesday. The figures reflect booming demand for credit by the private sector against a background of greater macro-economic stability, as well as a high degree of liquidity in the banking sector caused by the country’s large current account surplus.” April 8 - Dow Jones (Nina Koeppen): “Volatility? What volatility? While Western bond and equity markets are painfully fickle as war rages in Iraq, credit securities by Middle Eastern countries are a haven of tranquility. Eurobonds from the region - mostly Iran, Bahrain, Qatar and Egypt - have been rock-solid, trading at a premium above par, thanks to healthy demand from foreign and local investors.” April 10 - Associated Press: “The Oakland school district, on the brink of bankruptcy, begged lawmakers Wednesday for a $100 million loan in what would be the largest school bailout in state history. Oakland Unified School District officials blamed high salaries, rising expenses and an antiquated accounting system for their troubles and said the district will run out of money by May, leaving employees without pay and 47,000 students with an uncertain future… The district’s budget problems, which originated with its accounting system, worsened as enrollment fell, health care expenses skyrocketed and the district’s school board gave teachers a 24% raise over three year.” April 11 – Dow Jones (Christine Richard): “Investors holding some of the nearly $1 billion in bonds backed by the credit-card receivables of a unit of bankrupt Spiegel Inc. have been hit with a few unsettling surprises lately. Key assumptions behind these credit card deals have crumbled under stress, exposing potential vulnerabilities in the subprime sector of the $300 billion credit card securitization market, industry experts said... Surprises include the unpredictable behavior of both U.S. bank regulators and of the consumers who ran up charges through Spiegel’s First Consumers Bank unit buying merchandise out of the Spiegel Catalog and through retailer Eddie Bauer.” Indicating a post-war bounce, the University of Michigan preliminary April Consumer Confidence jumped 5.6 points to 83.2 (vs. estimate of 79), the highest reading since December. The Economic Conditions component gained 4.8 points to 94.8, and the Economic Outlook added 6.1 points to 75.7 (highest since December). March Producer Prices jumped 1.5%, five times the consensus estimate from 69 economists (from Bloomberg). This follows February’s 1.0% rise and January’s 1.6% jump. Producer Prices were up 4.2% y-o-y, the strongest rise since January 2001. Year-over-year, Total Intermediate Goods prices were up 8.0% and Crude Goods 47.3%. And dissecting year-over-year Finished Goods by category, we see that Consumer Goods prices were up 5.6%, Capital Equipment up 0.4%, and Energy up 26.5% Today’s March retail sales gain of 2.1% compares to estimates of 0.6%, and was the strongest gain since October 2001. Sales Less Autos were up 1.1% vs. estimates of 0.4%. The surprising strength emanated from vehicle and the housing sectors. Auto dealers reported a 5.6% jump in sales, while Furniture sales gained 1.5%. Building material sales were up 7.9%. March Retail Sales were up a respectable 3.8% y-o-y, led by a 7.1% gain in Vehicles & Parts, 7.2% rise in Building Materials, 4.0% gain in Eating and Drinking establishments, and 18.4% surge in Gasoline Stations. General Merchandise sales were up only 0.6%. Broad money supply (M3) declined $5 billion last week. Currency declined $1 billion, and Demand and Checkable Deposits added $5.9 billion. Savings Deposits dropped $5.7 billion and Small Denominated Deposits dipped $1.6 billion. Retail Money Fund deposits declined $1.9 billion and Institutional Money Fund deposits dropped $3.3 billion. Large Denominated Deposits sank $17 billion, while Repurchase Agreements jumped $16 billion. Eurodollars added $3.7 billion. Elsewhere, Bank Assets jumped $27.4 billion. Securities holdings gained $11.4 billion. Real Estate loans surged $20.3 billion, while Commercial and Industrial loans declined $1.7 billion and Securities loans dropped $6 billion. April 9 – American Banker (Erick Bergquist): “The Mortgage Bankers Association has revised its forecast for this year’s originations and now expects a total of $2.6 trillion. That would be 4% more than last year’s record volume. As recently as January, the trade group was calling for 2003 production to drop to $1.77 trillion… The industry posted first-quarter originations volume of $800 billion – 41% more than it did in the same period last year… Another upbeat prediction…: Home sales, which last year ‘hit an all-time record, should be flat’ for the year, instead of declining. ‘The first-quarter numbers were higher than the first quarter of 2002…’” April 8 – Bloomberg: “Bear Stearns Cos., an also-ran among the top securities firms in the 1990s, has become the world’s most profitable investment bank by dominating the fastest growing market for either stocks or bonds: packaging and trading collateralized mortgage obligations. ‘In 1999, all everyone cared about was equities and we felt like a red-headed stepchild,' said Nicholas Letica, 40, co-head of CMO trading at Deutsche Bank AG… More than $1 trillion of CMOs -- bonds backed by collections of home mortgages that pay different rates of interest depending on maturity date -- will be sold this year, a five-fold increase from 2000, according to Tom Marano, 41, head of Bear Stearns’mortgage department… CMO issuance in 2002 soared to a record $835 billion as compared with $547 billion in 2001 and $181 billion in 2000. That’s the fastest growth of any security class on Wall Street. By comparison, municipal bond issuance grew from $241 billion in 2000, to $342 billion in 2001 and $430 billion in 2002. Corporate bond issuance actually shrank in 2002 to $160 billion from $220 billion in 2001, and $172 billion in 2000. ‘The past two and a half years have been unprecedented and have created massive volume,’ said Bear Stearns’ Marano. ‘I’d much rather be an investor in mortgages than telecoms or even financial service companies.’” First-quarter CMO issuance of $302 billion was up 57% from the year earlier first quarter (from Bloomberg data). March numbers from Countrywide Financial are worth reading twice and contemplating: “Loan fundings for March reached $38 billion, up 23 percent over February 2003 and up 149 percent over the prior year…First quarter 2003 fundings mark a new company milestone at $102.4 billion; The March mortgage loan pipeline closed at $59 billion, up 20 percent over February 2003 and up 176 percent over last year, indicative of continued growth in fundings for the near-term; Average daily applications in March reached $2.7 billion, up 23 percent over February 2003, and up 216 percent over last year, fueled by persistent low mortgage rates; Purchase fundings reached an all-time high of $9.5 billion, an increase of 62 percent over last year.” Notably, March Purchasing fundings were up 44% from February and 22% from January. Year-over-year, Non-Purchase (refis) fundings were up 203%, Home Equity up 53% and Subprime up 94%. And there are indications that mortgage finance is off to a strong start in April. Blow-off Week 42 saw the Mortgage Bankers Association’s Purchase application index jump almost 10% to the fourth-highest ever. Purchase applications were at the strongest level since early September and were up 20% y-o-y. Also noteworthy, last week’s Purchase applications were up 22% from February’s average and 11% above March’s. And while the Refi application index declined 5% last week, it remains four times the year earlier level. With consumer borrowing and consumption running rampant, February’s appalling $40.3 billion Trade Deficit was to be expected. The deficit was up 22% from February 2002. Year-over-year Goods Imports were up 12%, while Good Exports were up 5%, with Goods Imports 77% greater than Goods Exports. Total Exports were up 6.7% y-o-y, with Capital Goods exports up 2.5% and Industrial Supplies 13.7%. Total Imports rose 11.2%, led by an 84% y-o-y increase in Crude Oil. Consumer Goods imports were up 10.2% (pharmaceuticals 22.8%), Automotive 3.7%, and Food & Beverage 11%. Increasingly it appears that trade flows are being buoyed by heightened inflationary pressures. Import Prices were up another 0.5% during March, with three month gains of 4%. Year-over-year, All Import Prices were up 6.7%. Notably, March Ex-petroleum Import Prices jumped 0.9%, the strongest monthly rise in more than a decade, with y-o-y gains (2.4%) the strongest since November 1995. Export Prices have been rising as well, with Agriculture up 9.2% y-o-y, Foods, Beverages 9.0%, and Industrial Supplies 9.4%. Capital Goods prices were down 1.1% y-o-y. There were 36,995 bankruptcy filings last week, up 22% y-o-y to a 52-week high. Comments yesterday from U.S. Treasury Secretary John Snow: “Later today and the rest of this week I’ll be meeting with G7 ministers. We’re hosting the G7 ministers this time, and the World Bank meetings and the IMF meetings. And I intend to introduce one broad theme to my colleagues in the ministries. And that is the United States isn’t growing fast enough and neither are you, and we’re growing a lot faster than you are. And our growth should be important to you, and your growth is important to us. And can’t we find a way to reach agreement – a consensus on the need for the world economy to grow faster. We get complaints – Glen Hubbard is here with us - he’s heard these complaints from our friends around the world who say, ‘your current account deficit is so high.” And our response is, “Yea. You know why? Because you don’t buy enough from us. And because we provide the highest risk-adjusted returns on capital in the world, so your capital flows over here. So why don’t you take steps to improve your domestic economy so you’ll be stronger and can buy more from us. And you might think as well (about) steps to improve returns on invested capital, and then capital would flow your way as well as to the United States. The fact is the American economy is strong. The underpinnings are good.” It is difficult to believe that our financial policymakers are instilling much confidence in the rest of the world these days. To blame others for our huge and incessant current account deficits may play well domestically, but it is simply not credible. Yet it is consistent with the current contemptible state of economic discourse. This week Fed chairman Greenspan delivered a speech at the Ronald Reagan Library in Simi Valley, California. During the question and answer session he addressed two issues near and dear to our analytical hearts: the real estate boom and the issue of Japan and its post-Bubble quagmire. It is, of course, my view that we are in the midst of committing truly monumental errors in central banking. The chairman’s comments provide clear evidence of a flawed and dangerous analytical framework. The amazing thing is that his carefully crafted arguments come across as almost reasonable. Question: Is the housing market overvalued, and if so, what effect would it have if it collapsed? Chairman Greenspan: “First let me just say, that there’s one unusual thing about homes: that we all tend to want a house that’s different from our neighbor's. And that means what we tend to have is custom-built housing in the United States, which is exactly the opposite of what you’d want to do if productivity was your purpose. In other words, if it’s only one of a kind, you don’t learn and build productive capabilities. This means that output per hour – or productivity in residential construction – its growth is very low. It is very substantially lower than the average rate of productivity in our economy; which essentially means that unit costs of producing homes tends to go up progressively year after year, decade after decade, at a pace faster than the average price level. And so when we look at the price level for homes – which over the past few years has been going up a good deal – remember that, first of all, there is a long-term uptrend in the ratio of house prices to the existing price level. And so there’s a tendency to, I think on occasion, to over-judge whether or not a housing bubble is building – which other people have raised issues of. I personally don’t think that there’s a housing bubble similar to that which exists in stocks. First, because the transaction costs of selling a home are far larger than they are in stocks. Besides, you have to move. You don’t have to do that (with stocks). And it’s fairly evident that, unlike the stock market, the housing market in the United States is really a whole series of metropolitan area markets. Portland, Oregon’s housing market does not compete with the housing market of Portland, Maine. Yet, stock prices do. So you have regional, localized markets. And it is perfectly possible, and indeed it happens on occasion, that you get a housing bubble in a localized region – I think we have had some in this particular state (California). But it is very hard to make the case that you get a bubble created for the country as a whole, and therefore a significant contraction in overall housing prices and, therefore, if it were to happen, a significant damper on economic activity. I don’t deny that overall – after running up quite a good deal – that the rate of increase in housing prices could slow very dramatically and even decline modestly. But that’s not likely to be a major negative for us. It’s a removal of a positive force, because the rise in housing prices has been a very important factor in galvanizing house turnover and the extraction of equity out of homes, which has been a major factor in support of consumer markets. As I said in that speech a few weeks ago, I think it’s been so extraordinary that the presumption that it continues is just not all that credible. As a consequence, I can see some effects from housing impacting the economy, but I would be very doubtful about a major problem with the economy as a result of some retrenchment in the housing markets. Remember that we have got a very strong rate of household formation in this country, and indeed, immigration accounts from somewhere between a third and perhaps even as high as a half of the total increase in the number of households... Housing has been an extraordinarily positive force in the American economy, especially during this period when we have been under stress from significant weakness in stock prices and the various shocks… I think it is going to be tough to keep that process going, but I would be most surprised if it came off more than just very modestly.” Question: If a Japanese-style deflation were to occur in the United States, is there anything the Federal Reserve can do? Chairman Greenspan: “As I have said publicly, the odds of that happening we perceive as to be quite small. But as I said to a colleague the other day, we spend a very small fraction of our time at the Federal Reserve and at the Federal Open Market Committee in actually being engaged in operational monetary policy. The rest of our time we ask ourselves every sort of question of what could go wrong and how would we respond to that event if it happened. And needless to say, the experience that the Japanese have exhibited to the rest of the world has not only gotten our attention but every central banker’s attention, largely because [all] of us presumed that a fiat currency - which of course is one not backed by gold or some other commodity or physical wealth - is prone to excess and inflation. And, indeed, the evidence subsequent to the 1930s into the 1950s was clear evidence of that fact. What we have learned is that indeed prudent policies can replicate the type of environments that are created under a gold standard or under a commodity standard, and therefore, you can have deflation as we had in the nineteenth century for example. And indeed, the Japanese demonstrated that it’s possible and there are other countries who are having similar characteristics. So we have examined what type of policies we at the Federal Reserve would engage in were that low probability event to emerge. And we’ve been looking at a number of different operational procedures which I and my colleagues have been discussing on and off in public recently. And we will continue to evaluate all the various different types of procedures… In summary, it’s not one of the things that we are very much concerned about happening. But should it happen, I trust we will be fully prepared from the central bank’s point of view to address it the best way we know how.” I don’t want to go off on a rant here, but is the Fed chairman really claiming that the Japanese quagmire is the consequence of “prudent policies” whereby a fiat currency system replicated “the type of environment that (is) created under a gold standard”? And that a gold standard and its “replicated” descendants were prone to deflation? Wow. At this point, this really is astonishing, reckless reasoning, but fully consistent with the propaganda streaming from the Federal Reserve. It is also a “clever” refinement of the Milton Friedman contention that monetary policy mistakes needlessly transformed the sound Twenties prosperity into deflation and depression. Yet, the Japanese financial authorities would be the first to admit that they gravely erred by imprudently accommodating historic financial and economic excess. Things ran completely out of control, and only the most brazen revisionist would nowadays claim otherwise. The issue in Japan during the late eighties and the U.S. today is anything but a system replicating a gold standard. Rather, they are both historic examples of uncontrolled Credit systems that fueled self-reinforcing asset inflation, rampant destabilizing speculation, and the resulting highly maladjusted economies. Just as one would expect, when the Japanese Bubble burst, over-borrowed and chastened households and businesses retrenched. Collapsing asset prices then forced the impaired Credit system into full retreat. The very essence of a gold standard is to harness money and Credit creation, thus tempering destabilizing excess and processes. A sober Credit system specifically does not incite the type of wild financial and speculative excesses that, over time, impart intensifying distortions to the scope and nature of demand and the structure of (mal and over) business investment/spending. In stark comparison, today’s fiat currency and uncontrolled Credit systems are the archenemy to the type of stable financial and economic environment that would emerge from a well-functioning gold standard. As was witnessed clearly in Japan, unharnessed Credit systems are prone to self-reinforcing excess, especially with regard to asset inflation. Credit excess begets assets inflation, which begets higher collateral values, heightened speculative impulses, a financial sphere increasingly engrossed by speculative profits in the assets markets, and only greater Credit inflation and speculative vehemence. A Credit Bubble begets asset Bubbles and an increasingly deranged Credit System. A restrained Credit system, conversely, does not occasion financial fragility nor economy vulnerability. Business cycles remain, but without major booms and busts. Another critical attribute of a gold or commodity-backed monetary system is that it is not dependent on discretionary central bank policies. As such, Mr. Greenspan’s above-noted “analysis” of the U.S. housing market provides strong evidence as to why it is inadvisable - and in certain instances utterly dangerous - to rely on one individual’s judgment. As I have noted often, the trouble with discretionary central banking is that mistakes engender only greater error. We are watching this play out in an historic manner. Incredibly, the lesson Mr. Greenspan has taken from the miserable Japanese experience is to never let the Bubble burst. He could not be a poorer student. We are today in the midst of unprecedented excess and an historic Mortgage Finance Bubble; the chairman has chosen to avoid meaningful discourse and expound absolute gibberish. It’s never been so clear that he’s BSing us. Indeed, Mr. Greenspan’s housing propaganda is increasingly sounding all too similar to the late nineties “stock prices always go up over the long-term.” And it is worth noting that this silly mantra became boilerplate doctrine during the destructive final stock market blow-off. And as much as Mr. Greenspan conveniently disregards the critical role of lending excess (and rampant Credit market speculation), we are clearly operating in an environment dominated by a desperately overheated national mortgage Credit system. Accordingly, we should expect inflationary manifestations countrywide. As we are observing, lending excesses are national in scope; speculation endemic to the U.S. Credit system. And the desire for “custom” homes could not be further removed from today’s critical issues. Importantly, Bubble dynamics remain near full force. And the longer excesses run uncontrolled, the more certain that this ends in a devastating crash, as opposed to Greenspan’s hope and expectation that things come off only “just very modestly.” That’s the nature of highly speculative, Credit excess-induced markets, whether the Fed accepts this reality or not. The household sector is today thoroughly captivated by housing as the superior “risk free” investment, while inflating home equity is the recognized best-source for permanent wealth creation to be tapped at will. As enamored as the household sector was in trading technology stocks for fun and profit just a few years back, playing mortgage rates and the refi boom is today a much more commanding inflationary psychology. In the late nineties the Greenspan Fed nurtured manic behavior by spouting New Era propaganda, while massive Credit (junk bonds, syndicated bank loans, margin debt, derivative-related borrowings, household debt, etc.) and speculative excess fueled a runaway technology/equity Bubble. Amazingly, a more conspicuous, momentous, and precarious Bubble today throughout mortgage finance incites only more outrageous central bank propaganda and acquiescence. As mentioned above, the Mortgage Banker’s Association this week increased its estimate for 2003 originations by 47% to a record $2.6 Trillion. Paralleling the technology and equity Bubbles – and doing precisely what Bubbles do - the Great Mortgage Finance Bubble has taken on a precarious life of its own. Powerful inflationary psychology has become ingrained, affecting millions of potential first-time homebuyers, legions of homeowners wishing to upgrade or acquire a vacation home, and speculators using ultra-cheap finance to buy properties with inflating market values. Just as sending money to technology funds seemed more than reasonable not too many years ago, today most feel it completely rational to stretch to purchase the most expensive home (“investment”) possible. At the same time, a powerful inflationary psychology has captivated the entire mortgage banking super-structure, with lenders, builders, appraisers, insurers, guarantors, investors, speculators and investment bankers predictably enamored by incredibly easy and enormous profits. Only our central bank had the power (and responsibility) to nip these inflationary expectations in the bud. They choose instead to continue to nurture them. The Fed is locked in hopelessly failed policies of ultra-easy money, fixated on sustaining unsustainable financial and economic Bubbles. Many, apparently including Mr. Greenspan, believe that the Great Depression and devastating deflation could have been avoided simply by creating additional money supply. And I know from my own thinking about the early thirties, I have often pondered The Reasons why it would not have been possible for the Fed to simply create new money and successfully recapitalize the faltering banking system and reliquefy the economy. Well, if we focus carefully on our analysis we are today beginning to witness The Reasons. Sure, our contemporary financial system today retains the will and capacity to inflate money and Credit. And although it requires an enormous amount of new Credit to keep the U.S. Bubble economy wheels in motion, the Mortgage sector has thus far provided ample spending power for the household sector and liquidity for the financial sector. And each week brings evidence that this flood of liquidity is working its magic, in particular by “recapitalizing” impaired financial institutions, domestic and international. Money is again flowing into junk and emerging market bond funds. The appetite for risk has returned with a vengeance. Speculators, once again, have been emboldened. But what about The Reasons inflation will not prove the magic elixir? Well, we are today witnessing how even alarming quantities of new Credit have only a muted impact on the aged Bubble economy (Credit growth vs. GDP growth). We are witnessing how this newly created finance is spread quite unevenly over the real economy (i.e. housing vs. manufacturing). We are witnessing irregular effects on “investment” (i.e. millions of new residences while our goods-producing capacity is gutted). We are witnessing how Credit inflation has disparate influences on prices (i.e. oil vs. semiconductors). We are witnessing how Credit inflation has a quite uneven influence on income (i.e. mortgage brokers/attorneys/real estate agents vs. manufacturers). We are witnessing how continued ultra-easy money has its greatest impact on inflating the size and destabilizing influence of the leveraged speculating community (“money” continues to flood into the hedge fund community). We are witnessing how continued rampant Credit inflation has a much greater impact on the animated financial sphere (inciting speculation) than it does on the despondent economic sphere (spurring sound investment). We are witnessing how this newly created finance gravitates specifically to inflating asset classes (real estate, mortgage-backs, agencies, and Treasuries), exacerbating distortions. We are witnessing how Credit inflation, after earlier manifestations (rising stock and bond prices) attracted financial flows, at this stage of the cycle instead exacerbates dollar weakness. We are witnessing how money and Credit excess is the problem and definitely not the solution. We can today better appreciate how continued inflation at this stage of the cycle further destabilizes the financial and economic systems. Most importantly, we have a clear sense how the ballooning financial sector becomes, over time, increasingly wedded to inflating real estate and fixed-income prices – Monetary Processes from the Credit system to asset markets become only more indelible. A Credit system with dominant Monetary Processing financing sound investment is relatively constrained and stable; today’s deranged Credit system with Monetary Processes feeding and being sustained by asset inflation is hopelessly unrestrained and acutely unstable. Yes, the contemporary Monetary Regime is capable of inflating at will and recapitalizing troubled lenders and borrowers alike. But this in no way avoids the reality that The Regime is now held hostage to levitated real and financial asset prices. Japan’s Bubble could have survived to this day had they only continued inflating already exorbitant real estate and stock prices to the moon. But inescapable financial and economic crisis would wait patiently and confidently. Faltering asset prices would have at some point stymie requisite Credit growth and the house of cards would have come tumbling down. We should also today better appreciate how recapitalizing the U.S. banks in the early thirties would in no way have resolved the critical issue of the deep domestic and global financial and economic imbalances that had developed over several decades. Keeping this game going will require enormous and continuous Mortgage Credit growth. Inflated housing prices, especially the conspicuous housing Bubbles in California and the East coast, demand unrelenting lending excess. Nationally, free-flowing mortgage Credit will be necessary to sustain boom-time consumption. And, importantly, mortgage Credit has become the key liquidity source for the speculative financial markets. Yes, “reflation” is working, at least sufficiently to prolong The Great Credit Bubble. But there is no escape afforded through the massive inflation of non-productive Credit. There is no escaping the damage inflicted upon the real economy. Asset inflation is no panacea but only a seductive and addictive narcotic. And there is no possibility for miraculously circumventing acute financial fragility – a respite yes, but no more. The dollar remains the obvious weak link, but the highly over-leveraged and speculation-rife Credit market bears watching. May we live in interesting times…

04/04/2003 Reflation Watch or The Necessity of Diligent Observation *

For the week, the Dow, S&P500, Morgan Stanley Cyclical and Morgan Stanley Consumer indices jumped 2%.  The Transports and Utilities added 1%.  The small cap Russell 2000 and S&P400 Mid-Cap indices added about 1%.  The technology sector was its usual volatile self, although most groups ended the week relatively unchanged.  The NASDAQ100, Morgan Stanley High Tech, and The Street.com Internet indices all ended about flat for the week.  The Semiconductors added less than 1%, and the NASDAQ Telecom index declined about 1%.  The Biotechs gained about 1%.  The financial stocks were this week’s big winners, with the Securities Broker/Dealer index up 4% and the Banks up 3%.  With bullion down $6.40, the HUI Gold index dipped 2%. Interest rates were relatively tame, with two-year Treasury yields inching one basis point higher to 1.55%.  The five-year Treasury yield added three basis points to 2.84%, and the 10-year Treasury yield added five basis points to 3.95%.  The long-bond saw its yield gain five basis points to 4.96%.  Benchmark mortgage-back yields rose about five basis points, while implied agency yields were impressively unchanged.  The spread on Fannie 5 3/8% 2011 note narrowed four basis points, while the 10-year dollar swap spread declined 1.5 to 43.  Corporate spreads narrowed meaningfully, with junk bonds generally performing exceptionally.   Elsewhere, emerging market spreads narrowed (collapsed?) sharply this week, with dramatic moves for several borrowers (Argentina, Brazil, and Turkey).  Credit Default Swap (CDS) prices remain in retreat virtually across the board.  Citigroup default protection could be purchased for 23 basis points (23 cents per $100 dollars of coverage), JPMorganChase 55 basis points, and GE 53 basis points.  This compares to 52, 95, and 88 basis points respectively back in October.  AOL protection that went for 545 basis points back in October was available this week for 170; Sprint insurance has collapsed from 815 basis points to 300.  It’s also worth noting that CDS prices have similarly collapsed for international banks, including the troubled European financial conglomerates.  If we didn’t know better, we could almost be convinced that they have discovered a cure for the acute financial fragility virus.  (Reflation Watch) April 4 – Bloomberg:  “Brazil’s currency was headed for its biggest weekly gain of 2003 after Banco Bradesco SA, the country’s largest non-government bank, sold bonds, raising expectations capital flows to the Brazil will rise. The real climbed 1.2 percent… The real has gained 4.6 percent this week (7.9% y-t-d), the best performance among 59 currencies tracked by Bloomberg, its biggest weekly gain since the week of Dec. 20…  ‘Managers are greedy for yield and the debt has a high yield, high spread and Brazil is a political story that is easy to sell, at least in the short term.’” Other Bloomberg excerpts of note:  “Brazilian companies sold or announced about $2 billion of foreign bonds and loans in the last two weeks.”  “The Mexican government’s revenue rose 19 percent in the first two months of the year because of higher oil prices and improved tax collection, helping the country to post a 13.2 billion-peso ($1.2 billion) surplus.” “The Russian ruble rose to a 11-month high against the dollar as oil exporters increased sales of the dollars they earn abroad following a surge in crude prices…” April 1 – Bloomberg:  “Mutual funds that buy bonds from Russia and other emerging markets received more money this year than in all of 2002 as investors sought alternatives to sinking stocks and the lowest U.S. Treasury yields in 50 years.  Investors boosted emerging-market debt fund assets by 11 percent since Jan. 1, plowing in $948 million, more than the $648 million received during all of last year…Individual and institutional investors probably will add $5 billion in total this year, more than twice the amount of last year… Record investment has sent developing-nation debt prices up 19 percent in the past six months, their longest rally since early 1998…” The corporate bond liquidity spigot remains wide open.  In a noteworthy sign of the times, Yahoo Inc. sold $750 million of zero-coupon convertible bonds.  The notes come due in 2008 and are convertible at $41 per share (68% premium!).  This is the first capital market funding by Yahoo since 1996 and the first converts issued.  From Bloomberg:  “Chief Financial Officer Susan Decker said in an e-mailed statement that the company is ‘taking advantage of historic pricing levels’ for convertible bonds.”  Other bond issuers this week included Computer Sciences that sold $300 million, Toys R Us $400 million, Scholastic Corp $175 million, Canwest Media $200 million, Allied Waste $450 million.  GE Capital issued $1.65 billion, US Bank $500 million, Met Life $300 million, Franklin Resources $420 million, Countrywide $500 million, National City $200 million, and Monumental Global $300 million.  Asian Industrial giant Hutchinson Whampoa raised $2.5 billion, Vodafone Group $900 million, and Vivendi Universal $935 million.  The energy sector remains hot, with Florida Power & Light selling $500 million, Commonwealth Edison $395 million, Union Electric $100 million, Becton Dickinson $400 million, and (natural gas distributor) KeySpan $300 million.    (Reflation Watch) April 2 - Dow Jones (Jessica Berthold):  “A number of distressed energy companies have managed to refinance their debts in recent weeks, showing that banks are willing to forbear in order to give the sector some breathing room.  But while the deals have quashed for now predictions that as many as half a dozen power generators and traders could end up in bankruptcy court, they don’t necessarily signal better times ahead for the troubled sector.  ‘It’s log-rolling,’ said…(the) managing director…(of) a private equity and advisory firm. ‘The banks have finally realized how bad things are and, rather than resorting to extortion which is what happened in the first round of refinancings, they are giving reasonable rates....because they don’t want to have to deal with the consequences of defaults.’ Energy companies have been under severe financial pressure from mountains of debt and slim profit margins on producing power. The credit ratings of many have been downgraded to junk, as liquidity has been seriously pinched.  In recent weeks, however, many of the sector's hardest hit companies - including Dynegy Inc., Reliant Resources Inc. and Allegheny Energy - have closed deals with creditors to extend the maturities on their debt. In the optimistic case, those extensions could allow the companies to stay afloat until the current supply glut is worked out of the power markets and electricity prices improve.” (Reflation Watch) April 4 - Dow Jones (Tom Barkley):  “The flood of money into high-yield bonds continued unabated this week, with junk mutual funds reporting about $1.2 billion in inflows… according to AMG… With investors hungry for yield, nearly $6.7 billion has poured into the market in just the last six weeks, and the pace has accelerated over the past month. Last week, just over $1 billion in new investments entered the market.  Meanwhile, the more than $10.5 billion of inflows in the first quarter is only about $1.1 billion short of the total for all of 2002.  Those flows have been a big factor in the outperformance of high-yield funds in the quarter, boasting an average return of 5.61%, according to…Lipper Inc.” First-quarter junk bond issuance of $30 billion was up 46% from the year earlier quarter.  (Reflation Watch) April 3: “The global speculative-grade corporate bond default rate fell to 6.9% in March, from 7.7% in February, the twelfth monthly decline since the default rate peaked in January 2002, Moody’s Investors Service reported today. Over the first quarter 2003, the Global bond default rate tumbled to 6.9%, from 8.3% at the quarter’s beginning. The drop of 1.4% represents the largest one-month decline since the second quarter 1992.” (Reflation Watch) April 1 – Bloomberg:  “Massachusetts collected $1.39 billion in tax revenue in March, 5.6 percent above the state’s lowered forecast, according to Revenue Commissioner Alan LeBovidge. That’s an increase of 7.75 percent from March last year, and was bolstered by $11 million from a tax amnesty program and from additional taxes brought in because of the $1.1 billion tax increase the legislature passed last year.” Bankruptcy filings jumped to 36,260 last week, up 11% y-o-y.  Year-to-date bankruptcies are running 8% above the year ago record levels.  The temporary spike in mortgage rates was surely responsible for the Mortgage Bankers Association’s weekly refi index dropping 20% to the lowest level in five weeks (up 410% y-o-y).  The Purchase application index declined 5% for the week, while remaining 4% above the year ago level.  Total first-quarter mortgage refinancings surpassed the previous record established during the fourth-quarter by a notable 31% (from Moody’s John Lonski).  Recalling that record fourth-quarter annualized Home Mortgage debt growth of $855 billion was 60% greater than 2001’s annual record of $531 billion, it appears certain that first-quarter mortgage lending will be another one for the history books.      While it understandably received little attention, March auto sales bounced back notably from a weak February.  Strong late month purchases put the month’s seasonally adjusted sales at a respectable 16.2 million units, up from February’s 15.4 million.  To put this sales level into perspective, seasonally adjusted sales did not surpass 16 million units between August 1989 and February 1997 (according to Bloomberg data).  For March, GM sales were down 3.3% y-o-y, Ford down 4.8% y-o-y, and Chrysler down 3.4% y-o-y.  Yet many foreign nameplates enjoy booming sales (indicative of a highly imbalanced Bubble economy).  “American Honda posted a new record for total vehicles and light truck sales in March…up 20.7%, and light truck sales reaching an all-time record of 47,049, up 41.8%.”  “Toyota Motor Sales USA…reported best-ever March sales of 165,081, and increase of 9.2% from last year’s record March…the Lexus Division enjoyed a strong March…”  “March Sales for the BMW Group were up 14 percent…”  “Mercedes-Benz USA reported the best first-quarter in company history…”  “Infinity, the luxury division of (Nissan), saw the best month ever in its 13-year history…”  “Kia set a first quarter sale record…” Hyundai saw March sales jump 20.3% y-o-y.  Volvo sales were up 30% y-o-y, and Porsche 25.9%.  “Thanks to three consecutively strong sales months, Saab Cars USA reported sales of 10,885 in the first quarter – the company’s best first-quarter sales in its 47-year history (up 19% to comparable y-o-y).”  And for April, the Big Three announced aggressive incentives.  GM’s new “Zero to Sixty” incentive plan is called the “most sweeping offer in its history.”  The ISM Manufacturing index was reported at a weaker-than-expected 46.2.  However, the Prices Paid component jumped 4.5 points (12.5 points in two months) to 70, the highest since April 2000.  In fact, Prices Paid has only been higher during four months (January through April of 2000) since early 1995.  The Chicago Purchasing Managers index was reported down 6.5 points to 48.4, the lowest reading since October.  New Orders dropped 6.5 points to 52.5, while Prices Paid jumped 7.9 points to 62.8.  Yesterday’s ISM Non-manufacturing index was similarly bleak, with the composite index sinking six points to 47.9.  New Orders declined 5.3 points, as New Export Orders sank 10 points to 48.5.  Non-Manufacturing Prices Paid added 1.1 to 62, the highest reading since October 2000.  February New Factory Orders declined 1.5%, with Total New Orders up 1.9% y-o-y.  Year-over-year, Non-defense Capital Goods Orders were down 2.4%, while Defense Capital Goods orders were up 8.4%.  Consumer Goods orders were up 5.2%.  February construction spending was down a better-than-expected 0.2%.  Total Construction Spending was about unchanged year-over-year, hampered by a 13.3% y-o-y decline in Private Non-residential building (down 26% since Feb. 2001).  Yet the residential building boom runs unabated, with spending up 9.9% y-o-y to a record pace.  Single-family Construction Spending was up 12% y-o-y, 17.8% over two years, and 69% over six years (pre-Bubble Feb. 1997).  Multi-family construction was up 8.7% y-o-y, 21% over two years, and 57% over six years. The Public Sector construction boom continues to slow, with y-o-y spending down 5.2%.  Spending, however, remains up 32% from six years ago.  Public Housing construction was up 24% y-o-y, and Military was up 30%, while Industrial was down 21% and Roads down 9%.  The data are certainly indicative of a severely imbalanced economy.  April 4 – American Banker (W.A. Lee):  “Despite assurances from card companies that they can keep losses under control during an unsteady credit cycle, analysts are clearly worried about portfolio deterioration, which they call the inevitable product of a souring economy… ‘Consumer credit quality is one of the biggest questions right now.  How much leverage can the consumer take on, and how can credit card balances still be growing when consumers are taking all this equity out of their houses?’” April 2 – Rocky Mountain News:  “Home foreclosures in the Denver area rose by 38% percent in the first quarter compared with the first three months of 2002.”  Yet, “last year foreclosures accounted for about 1.1% of all the homes on the market, while in 1988 they accounted for about 3.8%.” (Data to keep things in proper perspective.) March payroll data was not encouraging, but no disaster either.  Total Private Nonfarm Payrolls declined 68,000, down from February’s 370,000.  Manufacturing lost another 36,000 jobs, while Service Producing Jobs dropped 94,000 (Eating and Drinking establishment employment down 38,000).  Construction jobs added 21,000, the strongest gain since August.  Finance and Insurance added 12,000 (3,000 additional Mortgage Bankers and 4,000 more Real Estate agents!), the most since September.  Health Services added 22,000 jobs and Social Services gained 11,000.  March Private Average Weekly Earnings were up 0.7%, with year-on-year gains of 3.4%.  Manufacturing Weekly Earnings were up 2.1% y-o-y, with Service Producing enjoying a 4.9% gain (Finance, Insurance up 8.1%!). Broad money supply (M3) declined $27.5 billion (following last week’s $46.8 billion jump).  Currency increased $1.9 billion and Demand Deposits increased $3.7 billion.  Savings Deposits dropped $16.9 billion, with Small Denominated Deposits and Retail Money Fund deposits each declining $1.1 billion.  Institutional Money Fund deposits declined $6.8 billion and Large Denominated Deposits dropped $8.8 billion   Repurchase Agreements added $1.9 billion.  Elsewhere, Bank Assets declined $7.7 billion.  Securities holdings added $2.2 billion, while Loans and Leases declined $2.0 billion.  Security loans jumped $8.4 billion ($25.8 billion in five weeks), while Real Estate Loans dipped $7.5 billion.  Commercial and Industrial loans contracted $1.8 billion. March 31 –Reuters:  “U.S. asset-backed issuance in the first quarter of 2003 surged to $127.2 billion, up over 20 percent from the previous year, as issuers have leapt to take advantage of low rates, according to data released on Monday by Thomson Financial.” March 31 –Reuters:  “U.S. mortgage lenders and Wall Street packaged $232.5 billion  of U.S. mortgage-backed securities in the first quarter of 2003 … Thomson Financial said… Issuance of U.S. mortgage-backed bonds in the first three months was higher than the $178.3 billion…(up 30% from Q1 2002!)” March 28 - Dow Jones (Stan Rosenberg):  “Aided by a rush of tobacco financings, municipal bond volume spurted 20.6% from year-earlier levels to a new peak of $81.7 billion in the first quarter, Thomson Financial said Friday.” March 31 Bloomberg:  “Moody’s Investors Service cut credit ratings by three levels on $19 billion of municipal bonds backed by a 1998 tobacco settlement after Philip Morris USA warned it may not make its next payment to U.S. states.  Moody’s took the action after cutting its rating on the senior unsecured rating of Altria Group Inc., parent of Philip Morris, to Baa1 from A2. Philip Morris must post a $12 billion appeal bond after losing a lawsuit in Illinois accusing the company of deceiving smokers by advertising light cigarettes as safer alternatives to full-flavor cigarettes.” March 31, 2003 – Business Wire:  “Student loan securitization set a record in 2002, driven by increased issuance from established issuers (primarily Sallie Mae) and new entrants to the market, according to…Standard & Poor’s Ratings Services.  Moreover, the student loan market is expected to continue its pattern of strong growth in 2003, bolstered by long-term demographic trends and a broadened investor base for these securities.  During 2002, Standard & Poor’s rated $27.2 billion of student loan ABS (both public and private), up sharply from $11.4 billion in the prior year, the report notes.” (Reflation Watch) April 2 – American Banker (Michael Williams, president of Fannie Mae’s eBusiness division):  “Last year, close to 10 million homeowners refinanced their mortgages.  They cashed out almost $200 billion of their accumulated home equity, far exceeding any previous record.  Low mortgage rates and rising home values made cash-out refinancing attractive.  But it took a revolution in financial services to make it possible on that record scale…  …originations in 2002 topped $2.6 trillion – more than two and a half times the 1993 level.  Because of advances in technology and in the free flow of capital, lenders were able to handle these huge volumes with less paperwork, less uncertainly, and lower costs.  Streamlining has made it possible for borrowers to close on a refinancing in a as little as five days.  The cash-out wave has not left Americans highly leveraged…  By 2002, over 90% of lenders used automated underwriting systems and more than 75% of applications were approved in two to three minutes.” The Federal Home Loan Bank System (FHLB) finally reported 2002 results.  For the year, total assets increased 10%, while Net Income dropped 16%.  Over two years, total assets were up 17% to $764 billion.  Meanwhile, 2002 Net Income was down 19% from 2000 to about $1.8 billion.  Net Income of only $1.8 billion on assets of $764 billion?  What kind of “business” are they running and at what risk?  And it is worth mentioning that FHLB’s Derivative Liability jumped from $7.2 billion to $16.3 billion in twelve months, while Derivative Assets increased $664 million to $2.8 billion.  Mortgage Loans Held for Portfolio jumped from $27.7 billion to $60.6 billion. This week’s Bulletin will have no ranting, no raving, no geopolitics nor any theoretical musings. There is no need to rehash old “debates” – and there’s not even a thought of resting on our analytical laurels.  It’s my sense that we are quickly approaching an analytical “crunch time.” And as my high school basketball coach Paul Halupa was fond of shouting, “Keep your head up and stay on your toes.” (He also seemed to enjoy saying, “It will quit hurting when the pain goes away.”)  He taught defense first, then offense. Above all, he believed in discipline, focus, and attention to detail.  The current environment beckons for fierce determination and commitment to sound analysis.. Paul McCulley, Pimco’s energetic managing director, commented on CNBC today that the corporate sector remains risk-averse in its hiring and investing practices.  Well, this certainly seems to be the case, but this does highlight a most extraordinary disconnect: While the economic sphere (at least the corporate sector) remains wary of risk, the financial sphere demonstrates an incredible expanding risk appetite.  The corporate bond market is hot, and the junk bond market is on fire.  Emerging bond markets have recovered spectacularly and Yahoo has access to “free money.”  We’re in the midst of record mortgage Credit creation and record asset-backed issuance.  With the exception of banks’ aversion to commercial lending, the Credit system is firing on all cylinders.  It hasn’t been this way in awhile. Then why is the economy (economic sphere) stuck in the mud?  How can the U.S. economy appear so poised for recession?  Have we finally reached the end of the line, or are there extenuating circumstances?  The simple answer is that all is well-explained by the enormous debt overhang weighing down the corporate and household sectors.  Yet the analysis is likely not this clean and easy.  Today, the Credit spigot is wide open.  As risk aversion ebbs dramatically, Credit Availability could not be easier for most households, many businesses, and all financial speculators.  But we must remind ourselves that this was not the case just a few months ago.  We may ask, is the economy’s recent poor performance then somewhat of a lagging indicator, with previous tightened Credit conditions - coupled with geopolitical considerations – hurting confidence and pressuring the economy?  If so, is the maladjusted (Dynamically Hedged) economy poised for a spurt of activity with the positive resolution of today’s acute geopolitical concerns?  Tough questions…and we really have no alternative but to wait and search for answers. I was ensnared in The Bear Trap of Group Think back in 1991.  I will err on the side of “staying on my toes” and thinking “defensively” until we have clearer indications of the correct answers to the above questions.  I do appreciate that some readers are drawn to particular writers because their work provides confirmation of predisposed views.  But we don’t want to play that game today – It’s “Crunch Time.”  We must commit ourselves to diligent observation and objective analysis.  We question everything and take nothing for granted.    There is today a very unusual anomaly – an energized financial sphere face to face with a despondent economic sphere.  This circumstance is unstable and likely short-lived.  It will be resolved either with the economic sphere belatedly engaged by the over-liquefied financial sphere, or with the financial markets at some point buckling under their own weight of gross liquidity and speculative excess.  Either the stock and Credit markets are discounting a pickup in economic activity, or perhaps this is one heck of a short-squeeze (stocks, bonds, credit default swaps, etc.) that will leave the marketplace poised for considerable disappointment.  It is today difficult for me to contemplate that the economy will not respond somewhat to the animated financial markets.  It always has in the past.  Nevertheless, the critical analysis is to recognize that we have reached the point where it requires extreme monetary and fiscal stimulus to render even a tepid economic response. There’s no good news here, only postponing an inevitable day of reckoning.  And while I can envision the scenario where a faltering consumer sector leads the economy into recession, I can as easily imagine the abundant financial fuel sparking the economy.  The latter would be the most problematic scenario, with the Fed trapped in Easy Money Forever and the Credit market hostage to Eternal Speculating, Leveraging and Hedging Excess.  The wildly distorted economy will not react to extreme financial stimulation in an even and sustainable manner, but rather quite to the contrary.            The bottom line is that the Credit system remains extraordinarily over-liquefied, with investors and the momentous speculating community chasing performance and desperate for yield.  The Mortgage Finance Bubble inflationary “blow-off” endures.  Moreover, an inflationary bias is sustained throughout some key sectors of the economy (defense, government, healthcare, home construction, and financial services).  Still, there’s this nagging and critical issue of the faltering consumer.  Will today’s extreme financial excesses temporarily postpone the piercing of the consumer borrowing and spending Bubble?  This is where the analysis gets especially challenging – and where we must “keep our heads up and stay on our toes.”  A hardy consumer sector demands a continuation of housing inflation and likely requires a boost of confidence that only rising stock prices can provide.  A lot has to go right, but the financial markets do appear accommodative to the Fed's inflationary endeavors.  We are keenly on Reflation Watch.