06/26/2003 Coming Next Year to Madison Square Garden... *

With the bond market in a fuss over the caliber of its gift from the Fed, equities gave back some of their recent gains.  For the week, poor performance from Disney, GM, and Honeywell pushed the Dow 2.3% lower.  The S&P 500 followed suit, giving back 2%.  The Transports fell 1% and the Utilities were pared back by 2%.  The Morgan Stanley Cyclicals dropped 2.5% and the Consumer index lost 1.8%.  However, the broad market was less volatile and more resilient than the major averages.  The small-cap Russell 2000 was unchanged, while the S&P 400 Midcap dipped only 0.5%.   The tech-heavy Nasdaq100 declined 1.5% this past week.  The Morgan Stanley High Tech index fell 2.1% and the ever-volatile Semiconductors declined 3.3%.  The Street.com Internet index was about unchanged, while the Nasdaq Telecom index declined less than 1%.  The Biotechs sold off 2.5%.  Sinking bond prices weighed on the financial stocks.  The Broker/Dealers were hit for 2.4% and the Banks shed 1.5%. The HUI Gold Bug index had a rough week, losing 4.4% of its value, as bullion sank $11.20. The Treasury market was pounded, now having suffered the largest two-week decline since October.  For the week, two-year Treasury yields added 19 basis points to 1.35%, while five-year yields rose 18 basis points to 2.45%.  The ten-year Treasury note closed the week at a yield of 3.54%, up 23 basis points.  The long-bond saw its yield jump 25 basis points to close the week at 4.58%.  Benchmark mortgage-backed securities gained some relative performance, with yields increasing 15 basis points.  Implied yields on agency futures rose 11 basis points.  The spread on Freddie’s 4 ½ % 2013 note narrowed about 1.5 to 35, while the spread on Fannie’s 4 3/8% 2013 note narrowed less than one to 35.  The 10-year dollar swap spread narrowed 2.5 to 34.5.  Thus far, tumultuous trading in the Treasury market has caused little grief in the corporate market.  Spreads generally narrowed moderately this week, with junk bonds outperforming.  The dollar index gained better than 1%, while the CRB index declined over 1%. Long-term rates shot higher globally.  Japanese benchmark 10-year yields increased 13 basis points to 0.725% (up 28 basis points in two weeks!).  Australian 10-year yields jumped 22 basis points to 5.03%, while New Zealand yields gained 17 basis points to 5.37%.  European yields generally increased 11 to 15 basis points.  Hungarian bonds saw yields jump 20 basis points, with Russian Eurobond yields up 15 basis points.  Yields were up moderately in Brazil and noticeably in Argentina. General Motors this week completed the largest ever debt offering by a U.S. company.  With bids surpassing $30 billion, GM raised the size of its issuance by about a third to $17.6 billion.  The three-year GMAC $ tranche was priced at 290 basis points over Treasuries, the GM $ 10-year tranche plus 375 basis points, the GM $ 20-year plus 383 basis points, and the GM $ 30-year plus 400 basis points.  Issuance also included GM EUR 2.5 billion, GM GBP 600 million, and GMAC EUR 3.0 billion.  GM also raised the size of its convertible offering to $4 billion.  Spreads narrowed after the sale, with the 10-year US$ bonds contracting 20 basis points to 355 and the 30-year US$ bond spread narrowing 14 basis points to 386. June 26 - Reuters:  “This is a wonderful example of the success the Fed can point to in bringing liquidity back in the corporate bond market,” said Mitchell Stapley, chief fixed-income officer at Fifth Third Investment Advisors.  “It’s a sign of less restrictive financial conditions in the economy.”  “The order books for the various euro tranches of the deal were between 2.5 and four times oversubscribed, said an official at one of the lead managers.” Debt issuance remained quite strong, with the higher the yield the better.  HSBC Capital Funding raised $1.25 billion, EDS $1.1 billion, Sealed Air $850 million, Caterpillar Financial Services $350 million, Entergy Gulf States $240 million, Fiserv $100 million, and Cytec $200 million.  The list of junk issuers seems to lengthen by the week:  Reliant Resources $1.1 billion, PG&E $600 million, FPL Energy $380million, Gerdau Ameristeel $405 million, Arrow Electric $350 million, LNR Property $350 million, Worldspan $280 million, Vought Aircraft, Bally Fitness $200 million, GulfTerra Energy $250 million, Merisant $225 million, New World Restaurants $160 million, Mortons Steakhouse $105 million, Huntsman Advanced Material $100 million, Availl $200 million, Digitalnet $125 million, Danka $175 million, Alaris Medical $175 million, Avondale Mills $150 million, and Mobile Mini $150 million.  And the list of convertible issuers includes Halliburton at $1 billion, EDS $690 million, Sealed Air $300 million, RF Micro Devices $200 million, Meristar Hospitality $155 million, IMC Global $125 million, McMoRan $100 million, and Nektar Therapeutics $100 million.    June 25 - Dow Jones:  “Global bond issuance reached record levels in the first half of this year as borrowers locked in low interest rates and investors flocked to fixed-income assets.  International debt capital market volume rose 16% in the first six months of 2003 to a record $2.5 trillion, according to preliminary figures compiled by Dealogic… The rising bond issuance included a 50% rise in global corporate junk bonds to $71.7 billion, the sector’s largest volume in five years. Investment-grade bond issuance posted a more subdued 10% gain in the first half to $693.1 billion.   Dealogic said the volume of mortgage-backed securities rose 12% to $476.4 billion in the first half of the year.”   June 23 - Dow Jones:  “U.S. dollar-denominated bond issuance in Asia, excluding Japan, could rise almost 20% from 2002 as issuers move to take advantage of favorable market conditions, Lehman Brothers said Monday.  New supply picked up after the war in Iraq, with an estimated $6 billion of issuance in May and June, taking the gross amount in the first half of 2003 to roughly $11 billion.   For the whole of 2003, Lehman predicted gross issuance to reach $21 billion, near 1996 levels, and up from $18.2 billion last year, driven by record low rates, tight spreads and declining external risk… Minus redemptions, net issuance is expected to nearly double to $14 billion, from $7.8 billion.”       June 24 – Bloomberg:  “Romania raised 700 million euros ($810 million) in a sale of Eurobonds as investors build stakes in countries preparing to join the European Union in 2007. The former communist country priced the seven-year bonds to yield 5.975 percent, or 2.6 percentage points more than the mid-swap rate, a benchmark for international borrowing. That compares with 10.63 percent when the government sold debt of the same maturity two years ago. Investors who profited from soaring Polish, Hungarian and Czech bond prices as EU membership was confirmed for 2004 are seeking the same returns in Romania, Bulgaria and Croatia, which are bidding to be among the next wave of member nations… Romania last year received more than 2 billion euros of orders for a sale of 700 million euros of bonds due 2012. The bonds have risen since then, with the yield dropping to 6 percent from 8.8 percent at issue. The yield on Poland’s 2012 euro-denominated bonds has dropped to 3.9 percent from 6.3 percent a year ago.” June 26 – Bloomberg (David Evans):  “On April 3, J.P. Morgan Chase & Co. held a conference in Manhattan, drawing about a thousand people to discuss one of the fastest-growing and least understandable financial markets in the world: credit derivatives.  ‘We outgrew the Waldorf and had to go to the Sheraton Towers,’ says Andy Brindle, global head of credit derivatives at J.P. Morgan. ‘Next year, we’ll have to go to Madison Square Garden, I think.’  …The global credit derivatives market, which wasn’t even tracked until 1997, has ballooned to $2 trillion based on the so-called notional value of the debts that underlie the contracts, according to Fitch…That market, Fitch predicts, will grow to $4.8 trillion by next year.  The entire derivatives market -- including transactions based on stocks, bonds, loans, commodities, currencies and mortgages -- has a notional value of about $100 trillion, according to the International Swaps and Derivatives Association. Those numbers are only guesses. Nobody knows how much money is actually at risk. Banks don’t have to report the details of their exposure, which leaves regulators in the dark. ‘This market is completely unregulated,’ says Randall Dodd, director of the Derivatives Study Center, a nonprofit research organization in Washington, and a former economist at the Commodity Futures Trading Commission.  ‘No reporting requirements, no collateral requirements, no licensing of traders,’ Dodd says. ‘There’s no supervision of this activity. Even if you’re a regulator and you want to see what’s happening, you can’t.’” The Federal Reserve, of course, cut short-term rates to the lowest level since 1958.  It happened to coincide with the announcement of an all-time monthly record for New Home Sales, and the same week that saw the largest ever U.S. corporate debt issuance.  For those that missed it, I’ll share some of the commentary provided on CNBC from one of our list of outspoken inflationists.  Larry Kudlow:  “I don’t think the Fed sets interest rates.  I think the market will set those rates.  But the Fed can purchase two-years, five-years, ten-years.  In fact, when you take a look, year-to-date they have actually bought $10 billion of notes…  I just want them to add cash.  I don’t want them to control interest rates.  Just add excess reserves to the economy and the banking system and let this recovery really develop.”  CNBC’s Bill Griffith: “And when the Fed goes out and buys Treasury securities that way, that is what they are doing:  they are putting cash into the system. Kudlow:  “That is correct.  They buy them and they pay for them literally with reserves that they create out of thin air.  And it’s kind of a cool system.  Too bad you and I can’t do it.”  Kudlow:  “To me I was hoping for more of a shock and awe statement from the Fed.  Something that would have suggested they’re determined to keep pushing liquidity in.  They’re determined to move to an excess reserve position.  They’re determined to finance the economy and the tax cuts that are going to raise demand for liquidity.  And they are determined to keep this position for a good long time.  To me, they should have been thinking outside the box.  This was very much inside the old box and therefore quite boring… What we really got…was a silent prayer. What the Fed really needed was a Hail Mary...” Central bankers may not (yet) directly set long-term interest rates, but I would strongly argue that leveraged speculators keying off of Fed policy have evolved as the market’s price-setters.  The critical issue is not creating “an excess reserve position,” but the Fed’s capacity to engender adequate and balanced system liquidity.  Yet our system has for some time suffered specifically from excessive, speculative, and wildly unbalanced liquidity.  Mr. Kudlow, the Fed several years ago began throwing Hail Marys.  They now mindlessly just keep lobbing them, having discarded the tried and true game plan for a hope and a prayer.  (And it’s working as effectively as it would on the gridiron) While unimpressive, the economic data seems to demonstrate gradual improvement by the week.  Initial jobless claims dropped 22,000 last week (44,000 in three weeks) to 404,000.  This was the lowest reading in 13 weeks.  Weekly bankruptcy filings were at 31,461, only slightly ahead of the year ago level.  Year-to-date filings are up 9.3%.  University of Michigan Consumer Confidence increased a stronger-than-expected 2.6 points to 89.7.  Current Economic Conditions added 2.7 points to 94.7, the strongest reading since April.  May Personal Income was reported up 0.3%.  Year-over-year, Personal Income has gained 2.9%, with Wage and Salary up 2.0%.  Manufacturing wages were down 2.0% y-o-y, while Service wages gained 3.1%.  Government wages jumped 4.7% from a year earlier and Transfer Payments gained 6.4%.  With a declining tax burden, Disposable Income was up 3.7% y-o-y.  Personal Spending increased 0.1% during May.  The unbalanced nature of the economy is again illuminated.  Spending on Durables declined 0.7%, while spending on Services increased 0.5%.  Year-over-year, Personal Spending was up a respectable 4.6%, with Durables up 5.2% (to $889 billion), Non-durables up 4.3% (to $2.19 Trillion) and Services up 4.6% (to $4.5 Trillion).  Personal Spending has surged almost 39% since May 1997. Broad money supply (M3) rose $19.9 billion last week, with nine-week gains of $168.2 billion (11.4% annualized).  Demand and Checkable Deposits jumped $16.0 billion and Savings Deposits gained $15.2 billion.  Savings Deposits were up $498 billion, or 20%, to $3.0 Trillion over the past 52 weeks.  Last week, Small Denominated Deposits dipped $1.7 billion and Large Denominated Deposits declined $15.5 billion.  Retail Money Fund deposits dipped $6.0 billion, while Institutional Money Fund deposits added $5.3 billion.  Repurchase Agreements added $8.2 billion, while Eurodollars declined $1.2 billion.  Elsewhere, Total Bank Assets declined $52.6 billion, reversing the previous week’s $56.6 billion increase.  Securities holdings declined by $11.9 billion, while Loans and Leases added $5.1 billion (up $30.4 billion in three weeks).  Consumer loans rose $7.6 billion, and Commercial and Industrial loans added $500 million.  Atypically, Real Estate loans declined $9.2 billion. Mortgage insurer PMI Group announced this week that they would not meet Wall Street earnings estimates.  The company now believes Expected Claims Payments will be approximately 20% above earlier estimates at a range of $210-$220 million.  Also, “The company continues to evaluate the carrying value of its investment in Fairbanks Capital Holding Corporation, which totals approximately $140 million.” From Goldman Sachs’ quarterly earnings report:  “Fixed Income, Currency and Commodities (FICC) produced net revenues of $1.59 billion, its second best quarter ever…  Net revenues in Trading and Principal Investments were $2.01 billion compared to $1.44 billion for the second quarter of 2002 and $2.15 billion for the first quarter of 2003.  FICC revenues of $1.59 billion increased 39% compared to the same 2002 period, reflecting higher net revenues across nearly all businesses, particularly credit products, interest rate products, currencies and mortgages.  FICC continued to operate in a favorable environment, characterized by tightening credit spreads, declining interest rates, a steep yield curve, volatile currency markets and strong customer demand.” New Home Sales surged 13% during May to a record 1.157 million pace.  This was 11% above the consensus estimate.  The average price jumped $7,500 to a record $242,500 (up $11,400 over two months).  And with New Home volume up 17.9% y-o-y and the average price up 7.1% y-o-y, New Homes “Calculated Transaction Volume” (CTV) was up an eye-opening 26.3% y-o-y.  For two years, volume was up 31%, prices up 15%, and CTV up 50%.  The average price is up 42% from the May 1997’s $170,700.  And while the Months Supply of New Home inventory sank to a record low 3.5, the dollar value of this inventory is up 30% in twenty four months (volume up 14% and prices up 15%).  Existing Home Sales were also impressive.  Sales were up 7% over two months to a near record level, with the average price up $8,700.  Year-over-year, May sales were up 4.4%, with y-t-d sales running 2% above last year’s record pace.  And with prices up 7.1% y-o-y, Calculated Transaction Volume was up 11.8% y-o-y to an annualized $1.255 Trillion.  CTV is up 28% over two years, 38% over three years, and a noteworthy 95% from May 1997.  The Midwest saw average prices surge $10,800 over two months (up 14.9% y-o-y), as sales volume jumped almost 11% to a new record.  Average (mean) Prices were up (y-o-y) 10.7% in the Northeast, 4.3% in the South, and 3.0% in the West.  The Months Supply of Existing Home inventory declined from April’s 5.1 to 4.7 months. While backing off moderately, the Mortgage Bankers Association application index remains at historic levels.  The Refi index dipped 10% last week, although it was up 180% from a strong year ago level.  Purchase Applications declined 2.8%, but were up 4.6% from the year earlier.  In dollar terms, Purchase Applications were up 10.7% from a year ago.  The average fixed-rate mortgage loan was made at $170,600 last week, with the average adjustable rate mortgage at $322,300.   The Florida Association of Realtors reported May sales up 6% y-o-y, with median prices up 8% to $149,900.  “In May 1998, the statewide median sales price was $99,800, resulting in a 51.5% increase…”  Year-over-year price gains included Daytona Beach’s 20%, Panama City’s 21%, Miami’s 15%, and West Palm Beach-Boca Raton’s 14%. From the Illinois Association of Realtors:  “Buyers continued to boost Illinois home sales to new heights in May… The statewide median cost of a resale home in May rose 8.7 percent to reach $172,290; it was $158,500 in May 2002… This May was the strongest May on record since the association began reporting statistics in 1990, and the current pace continues to amaze even the veteran sales agents...  The median existing single-family home price in the Chicagoland last month was $225,800, up 9.5 percent from $206,200 in May 2002.” According to the California Association of Realtors, “The median price of an existing, single-family detached home in California during May 2003 was $369,290, a 15.6 percent increase over the revised $319,590 median for may 2002 (up $5,330 for the month and $49,700 y-o-y!).”  “But with the median price…posting double-digit increases in 22 out of the past 24 months, affordability concerns are increasing for many families in California”  “While we don’t anticipate sales to top last year’s record level, 2003 looks to be the second best year for residential real estate on record.”  A Long Beach real estate agent summed it up:  “The problem is, is that there’s just nothing to sell.  Supply and demand is killing us.”  The most notable price gains continue at the “lower end.”  Los Angeles enjoyed 19.8% y-o-y price inflation, Central Valley 19.4%, Riverside/San Bernardino 19.4%, Sacramento 17.7% and High Desert 16.9%.  Other notable y-o-y gains include Ventura’s 25.6%, North Santa Barbara County’s 26.5%, and Northern California’s 16.1%.  The statewide inventory of unsold homes is at 2.3 months, less than half the national average. The Nelson A. Rockefeller Institute of Government (Nicholas W. Jenny) this week issued its June 2003 report, “State Tax Revenue – Slowing Again”.  First quarter state revenues increased 1.4% sequentially, an unimpressive gain after 2002’s third quarter rise of 2.5% and fourth quarter gain of 1.9%  (2002’s third quarter gain ended four straight quarters of sequential revenue declines).  This year’s first-quarter rise of 1.4% compares to the year earlier 7.8% decline.  By category, personal income taxes declined 3.1% y-o-y, a notable improvement from first quarter 2002’s 14.3% drop.  Corporate income taxes were up 10.3% during the first quarter, versus the 16.1% decline the year earlier.  Sales tax receipts were up 1.9% during the first quarter, compared to a 1.0% decline during 2002’s first quarter.   State revenues suffered an average quarterly decline of 3.5% during 2002, with only a 0.5% gain during 2001.  This is quite a turnaround from the 6.1% average revenue gain posted during 1996 and 1997.  Revenues surged an average 7.6% during 1998, before dipping slightly to 1999’s 5.8%.  Average quarterly annualized growth surged to 8.1% during the climax of stock market-related revenue gains enjoyed during year-2000 . The consequences of Credit excess-induced boom-turned-bust are nowhere more problematic than in the tarnished Golden State.  During the five-year period (fiscal years 1995/96 to 1999/00), California revenues surged 68% ($29 billion) to $71.9 billion (according to state data).  This financial flow melee culminated with fiscal 1999/00’s historic one-year 22.7% surge.  On the expenditure side, state politicians (and rapidly rising costs) could hardly keep pace.  During the five-year period, total expenditures jumped 58% ($24.5 billion) to $66.5 billion.  The number of workers on the state payroll increased by about 20% in four years.  Overall spending rose 8.2% during ‘95/96, 8.1% during ‘96/97, 7.7% during ‘97/98, and 9.4% during ‘98/99.  With the torrent of tax receipts and the seduction of New Era banter, expenditures surged 15% during ‘99/00.  Yet the fiscal year ended with a large budget surplus and giddy politicians.  And then came fiscal 2000/01.  State spending surged 17.4%, but the bull market-induced revenue spigot ran dry.  Receipts actually declined almost 1% for the fiscal year - prospective surpluses as far as the eye could see instantly morphing into a deficits black hole.  Boom had turned bust, although various makeshift financing mechanism papered over the expanding hole for a couple of years. Now, with a budget crater of somewhere between $29 billion and $38 billion, state coffers nearly depleted of cash, and lenders increasingly apprehensive, the Golden State is finally approaching The Wall.  Yet because the state has been in financial quagmire for some time and has repeatedly averted financial crisis, there is understandable complacency in the media and markets.  I would advise against complacency, although the state does appear to have resources to operate through much of the summer.  Last week the state’s finance director stated, “California is broke.  We are operating as of today completely on borrowed money, and we have no collateral left for additional borrowing capacity.”   For the past two years, the state has used myriad financial gimmicks (including selling tobacco settlement bonds) to postpone the day of reckoning.  But the much anticipated recovery in revenues failed to materialize, while several years of hoping allowed the state’s fiscal position to spiral completely out of control (analogous to an unemployed individual that risks ballooning Credit card balances to sustain his lifestyle).  Earlier this month (June12), the state issued (with bank support and extra fees) $11 billion of warrants to meet short-term cash requirements.  This was the largest-ever issue of such warrants.  California now receives the lowest S&P Credit rating of any state, with yields about 40 basis points wider than bonds issued by fiscally challenged New York and Texas.  Last week the state sold 30-year bonds at 5.0% (8.4% tax-adjusted yield), about 64 basis points wider than AAA state credits.  This spread was up 14 basis points from April, as virtually every other spread narrowed sharply.  A Fitch spokesperson was quoted by Bloomberg:  “California can’t go on forever living on borrowed money.  At some point, the market is going to change its mind” about lending.  June 12 - Sacramento Bee (Alexa H. Bluth):  “‘We are perilously close to losing the trust of the market,’ (state finance director) Peace said. ‘This was a sale that was clearly against the credit rating of the banks, not the credit rating of the state.’  The warnings came as divisions intensified between Democratic and Republican lawmakers and as a new statewide poll showed little public support for sweeping tax increases. Republican lawmakers - whose votes are needed to meet the two-thirds requirement to approve a budget - said they will not budge from their position against tax hikes…  The Democratic governor’s budget plan calls for a temporary half-penny sales tax increase to pay off $10.7 billion in proposed deficit bonds, as well as increases to cigarette taxes and income taxes for top earners…  Davis defended his budget blueprint, despite the lackluster showing in the poll for many of its components.  ‘If I have to choose between maintaining our progress in public education, continuing to provide health insurance for children, and continuing to protect you against both crime and terror or raising taxes, I am going to raise taxes,’ Davis said.” The governor is now under serious recall risk, while Republican lawmakers are resolute in their pledge to not allow tax increases.  The democrats are equally resolved to avoid the draconian program cuts that would be required to get the state’s fiscal house in any semblance of order.  A recent attempt at a bi-partisan solution collapsed with virtually no support.  From Bloomberg:  “The plan…would cut 23,000 state jobs (the state has 295,000 workers), raise $6 billion in taxes, and slash $20 billion from state programs.”  The only Republican that has announced publicly that he would support a tax increase was quoted:  “Without bipartisan cooperation, we’re heading for a fiscal train wreck.   Sadly, there is little hope for change.” Los Angeles Times (Evan Halper and Erika Hayasaki):  “During budget crises in previous years - last year’s budget was not signed until Sept. 5 - the state has not had to cut off as much money, but this year is different. A California Supreme Court ruling in May gives Westly very little flexibility.  That decision came in response to Howard Jarvis Taxpayers Assn. lawsuit to force lawmakers to take the budget deadline seriously. The court said the state has no legal authority to make many payments if no spending plan is in place.  The court also ruled that state workers can be paid no more than federal minimum wage until a budget is passed. The ruling gives state finance officials some time to reprogram their payroll system to make that possible. Westly said the computers will be updated by early September and, if no budget is in place by then, all state workers’ pay will be cut.  ‘A no-budget situation is not just academic,’ Westly said. ‘It will create real problems and hardships. This is going to be real hurtful for the state of California.’ Trial courts, child development programs, some mental health services and mandated payments to local governments cannot legally be paid after July 1 until a budget is in place, Westly said. Once the budget is passed, however, all payments will be made retroactively.” More yesterday from the Los Angeles Times:  “On Wednesday, State Controller Steve Westly warned that California’s cash reserves are drawing down, and banks are refusing to lend the government any more money until it straightens out its budget mess.”  “Roughly $1.5 billion in state money will stop flowing to schools, colleges, transportation projects and medical providers.” June 26 - Sacramento Bee (Alexa H. Bluth):  “If there is no budget after Tuesday, (state Controller) Westly said:  California will not make monthly payments beginning in July that total more than $200 million for K-12 schools and $200 million for community colleges.  State employees face drastic pay cuts as soon as late August.  Vendors will not receive payments for services rendered to the state after July 1.  Westly will continue a tradition of withholding pay from elected officials…  Westly said he is limited by a recent California Supreme Court ruling that dictates most state workers be paid the federal minimum wage - $5.15 per hour – when the state is running without a budget.”  Quoting the Chancellor of California Community Colleges:  “We’re talking about massive shutdowns in access and services that will begin to occur as early as August.”  Westly was quoted:  “This will create enormous hardships for literally thousands of vendors around the state who are absolutely innocent to the gyration of the budget battles of Sacramento.”  On the revenue side, car registration fees have been raised sharply.  From Bloomberg:  “Owners of the 26 million registered automobiles in the state will begin to pay on average $158 more a year starting October 1…”  Yet, quoting a Republican lawmaker:  “This tax increase is not only a bad idea, it clearly violates the California constitution.  I’m convinced that the courts will ultimately force the governor to give all the money back.”  And so goes the battle… Los Angeles Times (Dan Weikel):  “In a hearing room filled to capacity, customers of Orange County’s largest sewer agency Wednesday both praised and criticized a proposal to double their rates over the next five years to help finance a $2.36-billion capital-improvement program…  ‘Our vehicle license fees have just tripled,’ said Paul Durazo of Westminster, who said he has been unemployed for 11 months. ‘It seems like everyone is screaming for more money. Why do we keep getting saddled with the bills?’” It may prove to be months away, but there is an accident unfolding out in California.  And while the Golden State is faced with the largest and most pressing fiscal dilemma, it should be clear at this point that the root of the problem is systemic and structural.  Today from the Washington Post (Dale Russakoff):  “State governments’ financial health, which hit the lowest point since World War II last year, has worsened in the past six months, all but ensuring continuing cuts in priority programs such as education, Medicaid and aid to towns and cities, according to a survey released yesterday by the National Governors Association.  Budget cuts and layoffs this year produced the deepest state spending reductions in dollar terms since the governors began their fiscal survey in 1977… Still, with revenue declining more steeply and longer than in the previous two recessions -- and with Medicaid costs rising sharply -- many governors are likely to follow the lead of Maryland’s Robert L. Ehrlich Jr., who on Wednesday ordered a spending cut of as much as 10 percent...  Medicaid spending - which takes up 20 percent of state budgets - grew 13 percent in 2002, (and) 8 percent this year… ‘Medicaid is becoming the Pac-Man of state government, eating up each additional dollar generated in revenue,’ (executive director of the governors association) Scheppach said.” The great late-nineties inflation imparted severe distortions.  As politicians are bound to do, inflated receipts were immediately spent and extrapolated far into the future. (One of the many reasons it is the crucial role of a prudent, independent central bank to contain excesses!)  It is instructive to note that the financial health of our states has actually worsened over the past six months, this despite the Fed’s “reflation” “successes”.  But this should be no surprise.  After all, the nature and manifestations of Credit inflation are characteristically altered over time, leaving the Fed powerless to regenerate the “favorable” old buoyant (stock market and option-induced) flow to state coffers.  Out in California, ultra-easy system-wide Credit conditions are having minimal impact on state revenues.  They are, however, severely inflating the price of housing, with generally rising costs for insurance, medical care, tuition, energy and other utilities.  Such inflationary manifestations are anything but conducive to either fiscal balance or economic health.  And while the budget quagmire garners some attention, there is a more momentous development unfolding insidiously: the cost of doing business in the Golden State - for businesses as well as state and local government - continues to rise.  This is one hell of an intractable structural problem, only aggravated by current monetary policies and dysfunctional Monetary Processes.  And there is absolutely no way for the Fed to now even out inflationary effects, with continued rampant Credit inflation only exacerbating terribly distorted price structures and economic maladjustments.     In this regard, California is surely more than a mere microcosm of the general maladjusted U.S. economy, where inflated cost structures find it only more difficult for business to compete globally. With respect to boom and bust dynamics and the great risk of flawed monetary policies, California will prove an historic case study.  And while I am no fan of juxtaposing our economy’s predicaments with those of Japan (altogether different economic structure and culture), there is one major similarity:  conventional inflation measures completely failed to capture the profound increase in the “cost of doing business.”  And as Japan has learned, this is a key structural problem impervious to even the most extreme monetary and fiscal policy measures.  It is also a most important issue disregarded by Mr. Greenspan in his serpentine plan to fight a collapsing stock market Bubble with only greater monetary accommodation.  This conundrum of an inflated “cost structure” and substandard growth also provides a good example of why learned European central bankers often expound that monetary policy is an ineffective mechanism for rectify structural problems, although it is quite prone to exacerbate them. As analysts, we’ll follow the goings on in California with keen interest.  The state was at the very heart of the late-nineties Bubble, and we are today provided with a case study of how implausible it is to readily (as opposed to requisite arduous adjustment periods) abrogate past inflationary distortions with further inflation.  Furthermore, the Golden State remains at the very epicenter of the Fed’s continued failed monetary experiment – with only more desperate measures attempting to sustain an unsustainable Bubble.  After all, the Great California Real Estate Bubble has about the strongest inflationary bias today of any asset class.  And as difficult as things are today, the very serious trouble arrives when this historic Bubble finally succumbs. I am convinced that a tottering California housing market was one of the key early-nineties factors that incited a panicked Fed to collapse interest rates (setting in motion the Great Credit Bubble).  Ironically, and quite ominously, when the gargantuan Golden State real estate market inevitably falters the Greenspan Federal Reserve will have already frittered away its ammo.  The Fed will lack even the sufficient arm strength to dump a little screen pass, let alone muster a last-second Hail Mary from deep in its own endzone.

06/19/2003 Following in Dr. Fisher's Footsteps *

It was another positive week for stocks.  Strong performance by Merck, Microsoft and GM offset Kodak’s decline and helped move the Dow almost 1% higher on the week. The S&P500 added another 0.7% this week, increasing its year-to-date gain to 13.2%. The Transports dipped 0.5% while the Utilities performed well, adding 2.4%.  The Morgan Stanley Cyclical index added 1.5% and the Consumer index gained 0.6%.  The broader market was relatively quiet, with the small-cap Russell 2000 flat for the week. The S&P400 Midcap index added 0.4%.  The highflying technology sector pushed the NASDAQ100 1.6% higher (up 24% y-t-d).  The Morgan Stanley High Tech index rose 3%, while the Semiconductors recovered almost 3% after last week’s 7% decline.  The Internet stock frenzy continues, with The Street.com Internet Index adding 3.1%.  This brings its 2003 gain to 43%.  The NASDAQ Telecom Index added 1.5%.  The speculative Biotechs finally showed restraint and gave back 4.2%. The financial stocks looked less bulletproof this week, with the Broker/Dealers dipping almost 3% on the back of Morgan Stanley’s disappointing earnings report.  The resilient Banks added 0.4%.   Although bullion gave up 50 cents, the HUI Gold index posted a strong weekly return of 3%. The Treasury market was finally hit with meaningful selling.  Two-year Treasury yields jumped 8 basis points to 1.16% and five-year yields rose 23 basis points to 2.26%.  Ten-year Treasury yields closed the week at 3.37%, up 25 basis points, while the long-bond saw its yield surge 26 basis points to 4.43%.  Benchmark mortgage-backed securities had a rough go of it, with yields jumping 30 basis points.  The implied yield on agency futures added only 17 basis points.  The spread on Fannie’s 4 3/8% 2013 note was about unchanged at 36, while the spread on Freddie’s 4 ½% 2013 note narrowed almost two to 36 basis points.  The benchmark 10-year dollar swap spread increased 2.5 to 37.  Interestingly, rising Treasury yields worked to the advantage of corporate relative performance.  Junk spreads narrowed sharply this week, with investment grade spreads narrowing moderately.    Japanese bonds suffered their worst week in nine months.  Benchmark 10-year yields surged 13.5 basis points to 0.58%.  Yields moved higher globally, with European bond yields rising 20-25 basis points.  Benchmark yields jumped 20 basis points in Australia and 15  basis points in New Zealand.  The hot emerging bond market cooled a bit, with benchmark Mexican yields jumping 28 basis points and Brazilian yields increasing 60 basis points.  The dollar index added about 2% and the CRB index gained marginally. The debt issuance boom runs unabated.  Bear Stearns this week sold $1.5 billion (up from $750 million) of bonds, Banc One $1 billion, Baltimore Gas & Electric $200 million, Tennessee Valley Authority $500 million, Pitney Bowes $375 million, Petro-Canada $600 million, Vodafone $500 million, United Utilities $250 million, Entergy Arkansas $115 million, DR Horton $100 million, Qantas Airways $450 million and Avon Products $250 million.  It was another huge week for junk:  Nextel Partners issued $450 million, Centennial Cellular $500 million, Rogers Cable $350 million, Bowater $400 million, Dominos $400 million, Science Applications $300 million, Doubleclick $135 million, Lattice Semiconductor $200 million, Le-Natures $150 million, Psychiatric Solutions $150 million, American Color Graphics $280 million, Arch Western Finance $700 million and Genesco $75 million.  It was also quite a week for convertibles:  Xerox $800 million (up from $650 million), ICOS $250 million, Cooper $100 million, WebMD $300 million, Advanced Medical Optics $100 million, Amylin Pharmaceuticals $150 million, and Biomarin Pharmaceuticals $125 million.    General Motors will take advantage of over-liquefied markets to issue $13 billion of new debt, $10 billion earmarked for its $25 billion under-funded pension deficit.  Part of the issuance includes plans to issue $3.5 billion of convertible bonds maturing in 15 years.  While it may help alleviate GM’s financial shortfall, issuing securities will not provide the means for feeding and clothing our future retirees. June 20 - Bloomberg:  “Xerox Corp., the world’s biggest copier maker, and wireless telephone service provider Nextel Partners Inc. led borrowers in the biggest week for U.S. junk-bond sales in more than two years, as investor demand for the lowest-rated securities pushed down debt costs.  Borrowers rated below investment grade - considered to have a higher chance of default - sold about $6 billion of debt this week, the most since May 2001… Offerings by companies rated lower than Baa3 by Moody’s Investors Service and below BBB- by Standard & Poor’s made up almost half the week’s $13.3 billion of total corporate issuance in the U.S… In a sign of investors’ increased appetite for risk, about 19 companies rated at or lower than Caa1 by Moody's and CCC+ by S&P - in the lowest third of the junk-ratings scale - have issued bonds so far this year. That’s the same number as was sold in all of 2002, according to Bloomberg data. ‘Six months ago, there was no chance for those kinds of issues,’ said Mike Difley…(of) American Century Investment Management… ‘People are looking for yield and are moving down the credit-quality spectrum to find it.’ Overall, junk-rated companies have sold $69 billion of debt this year, up from $40 billion in the same period a year ago… The difference in yield between junk bonds and Treasuries has dropped to 6 percentage points on average, the lowest so-called spread since July 2000, according to Merrill Lynch & Co. data. The average absolute yield to maturity on the debt, at 8.9 percent, is the lowest since January 1998…” June 18 – Bloomberg: “Russia’s economy may grow 6 percent in the second quarter and as much as 5.5 percent for the full year of 2003, Economy Minister German Gref said in St. Petersburg. The government official forecast for economic growth for this year was between 4.5 percent and 5 percent. Industrial production grew 8.5 percent in May… ‘The positive economic results of the past months of this year strengthen our confidence that the fundamental direction of our policies is correct, (Prime Minister) Kasyanov told the St. Petersburg Economic Forum.  Russia’s economy expanded 6.4 percent in the first quarter, the fastest growth since the last three months of 2000, as oil, gas and metals producers boosted exports and service companies tapped soaring domestic demand.” June 20 - Bloomberg:  “China imported 8.8 percent more crude oil in May than in the same month a year earlier. China bought 6.04 million metric tons of crude oil worth $1.23 billion from abroad last month, compared with $1.04 billion tons last May, customs statistics showed. For the first five months of the year, China's crude oil imports rose 36 percent to 36.15 million tons.”        Broad money supply (M3) declined $7.0 billion last week.  Demand and Checkable Deposits dipped $2.9 billion, while Savings Deposits added $7.7 billion.  Small Denominated Deposits declined $1.7 billion and Retail Money Fund deposits dropped $3.9 billion.  Institutional Money Fund deposits declined $3.2 billion and Large Denominated Deposits gained $5.6 billion.  Repurchase Agreements dropped $11.3 billion and Eurodollars added $1.0 billion.  Elsewhere, Total Commercial Paper outstanding declined $6.9 billion last week.  Non-financial CP dipped $2.2 billion and Financial CP declined $4.7 billion.  Total Bank Assets jumped another $49.9 billion last week, with seven-week gains of $210 billion.  Real Estate loans increased $18.6 billion, while Commercial and Industrial loans declined $4.0 billion. The Mortgage Bankers Association Application index was about unchanged for the week, again at a near-record level.  Year-over-year, the Refi index is up 420%.  Purchase Application volumes are up almost 18% y-o-y, with the dollar volume up 26.5%.  The Purchase Application index is more than double the level from June 1997.  The average loan size for a Purchase Application last week was $193,800, and the average adjustable-rate mortgage was for $327,100. June 14 - Los Angeles Times (Bonnie Harris): “Home prices in Los Angeles County shot up to another record in May, but sales fell significantly from the same month a year earlier amid a rapidly diminishing supply of less-expensive homes.  The median sales price of new and existing homes in L.A. County jumped 21% on a year-over-year basis to $313,000 last month, according to…DataQuick.  All categories of homes showed strong appreciation: Existing single-family houses rose 20% to $325,000, and new homes climbed 22% from a year earlier to $400,000. Condominiums, the most affordable option for home buyers, posted the largest gain, increasing 25% to $245,000.  Actual sales in the county, however, dropped almost 8% to 10,863 properties. Housing experts and brokers said the slowdown wasn’t a sign of weakening demand; rather, they blamed it on a persistent shortage of homes for sale and a storm of refinancings that is clogging up the system and delaying escrow closings…  DataQuick said the biggest sales drop in May, about 28%, came in the segment of homes priced below $300,000. With fewer lower-priced properties on the market, sales tumbled in areas such as San Fernando, Covina and South-Central Los Angeles.  ‘Clearly there is a massive supply constraint in that segment, and unfortunately it’s the more affordable segment,’ said G.U. Krueger, research director at Institutional Housing Partners… ‘Buyers are essentially skipping over that range and going straight to the next level.’” May Housing Starts and Building Permits were both reported stronger-than-expected.  Starts jumped 6% from April, with Multi-family Starts the strongest since November.  Permits increased 4% to the strongest pace since December.  Housing Completions jumped 10% over two months to the strongest level since January 1987.  For comparison, May Housing Completions were up 27% from May 1997, and were almost 80% above the trough level from late 1991.  Units under construction were up 3.1% y-o-y, with Single-family up 5.2% and Multi-family down 1.3%.  By region, the Northeast was down 0.1%, the Midwest up 7.3%, the South up 1.7%, and the West up 3.5%.  The National Association of Home Builders index jumped five points in May to the highest reading since February.  The Future Sales (next six months) component gained seven points (up 13 points in two months) and has not been higher since November.  The Consumer Price Index was unchanged (core up 0.3%) for the month and up 2.1% y-o-y.  By category, Food prices were up 1.7% y-o-y, Transportation 2.2%, and Recreation 1.1%.  Apparel prices were down 3.6% and Computers sank 21.7% y-o-y.  Energy prices increased 9% y-o-y, Medical Care 4%, and Housing 2.7%.  The quite moderate Medical and Housing price increases lack credibility.  June 18 – Wall Street Journal (Greg Ip):  “Statistical quirks may be the cause. To compute the cost of home ownership, the Bureau of Labor Statistics examines the rental market to estimate how much an owner could charge to rent out his house, and calls this ‘owners’ equivalent rent.’  Some rents include the cost of natural gas, so the bureau subtracts estimated gas charges from them. But in practice, rents often stay the same when gas charges fluctuate. That means when the cost of gas soars, as it has this year, owners' equivalent rent appears to drop, or in any event rise less rapidly than regular rents, which aren't affected.” After eight months of the fiscal year, federal government receipts are down 4.8% from comparable 2002.  Individual Income Taxes have declined 7.9% and Corporate Taxes have sunk 26.7%, partially offset by a 2.2% increase in Social Insurance receipts.  Year-to-date spending increased by 6.4%.  By largest department:  Social Security was up 4.1%, Health & Human Services up 8.2%, Defense up 15%, Agriculture up 3.1%, Labor up 13%, and Education up 23.9%.  Interest payments declined 3.8%.   The year-to-date deficit of $292 billion is double last year’s.  Goldman Sachs this week increased their estimate for the full-year deficit to $475 billion. Several of the major Wall Street securities firms had quarters ended May 31st.  So we were this week provided with a good indication for how aggressively the financial sector is playing the Fed-orchestrated “ulta-easy money” environment.  From Bear Stearns:  “Fixed Income net revenues were $765.2 million, up 47.5% from $518.6 million reported for the quarter ended May 31, 2002.  The Fixed Income Division continued to benefit from a low interest rate environment, a steep yield curve, a narrowing of corporate credit spreads and high market volatility.  Record revenues were achieved again in both the credit and interest rate product areas.  The high yield, high grade, distressed and foreign exchange areas all produced strong results.  In addition, mortgage-backed securities revenues continued to perform well.” From Morgan Stanley:  “Fixed income sales and trading net revenues increased 48 percent from second quarter 2002 to $1.3 billion.  The increase resulted from strong performances across the Company’s credit products, interest-rate and currency products, and commodity groups.  The revenue increases in credit and interest rate products reflected tighter spreads, strong investor demand and an improved trading environment.” From Lehman Brothers:  “The Firm’s Fixed Income Capital Markets business recorded its highest level of quarterly revenues ever, driven by increased customer flow activity across most products, including derivatives, credit products, and mortgages.”  Principal Transaction Revenues, or “trading with its own money,” surged to $1.275 billion.  This was up 66% from the previous quarter and double the year ago quarter.  By business segment, Capital Markets Fixed Income Net Revenue surged 75% y-o-y to $1.186 billion.  Compensation jumped 34% sequentially. It is also worth noting that Lehman expanded Total Assets during the quarter by $35.7 billion to $304 billion, a record increase and a notable 53% annualized growth rate.  Lehman Total Assets have doubled since the beginning of 1998 (22 quarters).  We see that Morgan Stanley expanded Total Assets by $27.5 billion, or 20% annualized, to $587 billion during the quarter.  Morgan Stanley Assets are up 94% since 1998.  With the securities firms and banks so aggressively expanding, second-quarter Financial Sector borrowings are sure to accelerate from the first quarter’s 9.7% annualized pace.  There is then no mystery surrounding the source for the torrent of liquidity sloshing around the markets. We are reading that there’s now nothing but clear skies ahead for a multi-year bull market.  Ignore the pessimists and aggressively buy stocks we are told.  Failsafe models inform that the only risk is not jumping on board the new bull.  Well, I will avoid climbing out on a limb and predicting when this liquidity-driven rally will fizzle, but anyone who dismisses the great and escalating risks inherent to our fragile financial system and maladjusted economy is not doing his homework.  There will be an enormous loss of financial wealth over the coming years, and this most atypical environment is poised to ambush those fearless model adherents. June 17 - Financial Times – Commentary from American economist David Hale:  “One of the most remarkable features of the current financial cycle has been the resilience of the US banking system. It has performed far better over the past two years than during the recession of 1990-91 and after previous periods of great stock market weakness.  In the last economic slump, there was a big upsurge of bank failures. In 1989, there were 205 bank failures, 160 in 1990 and 109 in 1991. During the present cycle, bank failures have been very rare. There were seven in 2000, four in 2001, 11 in 2002 and two so far this year… There are four main factors that explain why the current cycle has not been accompanied by big bank failures. First, there was far less margin borrowing during the recent stock market bubble than during the bubble of the late 1920s. At the peak in March 2000, margin debt was less than 2 per cent of gross domestic product. At the peak in late 1929, margin debt was nearly 9 per cent of GDP… Second, the banking system did not finance the speculative capital-spending boom that drove the economy’s growth during the late 1990s. It was financed instead through a process of securitisation that transferred risk from banks to insurance companies, mutual funds, pension funds and retail investors… Third, US banks restrained themselves from property lending during the recent cycle far more than they did during previous business cycles… Last, the overall level of loan delinquency was only 3.99 per cent in the most recent quarter - compared with 5.38 per cent in the early 1990s - because of a strong performance by the US corporate sector…  It is the resilience of America’s banks, not just the Federal Reserve’s monetary policy, that will set the stage for economic recovery later this year.” There are of course valuable insights garnered from comparing recent financial and economic experiences to the Roaring Twenties excesses and their horrid consequences. Certainly, the dynamic of unsound financial and economic underpinnings impelling catastrophic central bank accommodation is at the top of the list.  But contemporary analysts have been ensnared in one critical analytical trap:  They’ve got the wrong Bubble!  The stock market was the epicenter for the gross leveraging and speculation during the late twenties (the key dysfunctional Monetary Process), with its collapse setting in motion powerful debt deflation dynamics.  However, for the recent episode of historic financial folly, the U.S. Credit system is definitely at the “epicenter.” Sanguine “post-Bubble” analysis begins with the mistaken premise that THE Bubble has in fact burst.  It has not.      And before we get too carried away with regard to the “resilience” of our banking system, let’s keep in mind that Total Bank Assets have expanded about 12% over the past year and are up 50% since the beginning of 1998.  Real Estate loans are up 17% over twelve months and 43% since the beginning of 2000.  As always, delinquencies and losses are seductively well-behaved during the boom.  But they will surge with the inevitable abatement of lending excesses – exactly the nature of boom and bust dynamics.  And while current runaway excesses would be expected to spark an “economic recovery later this year,” there are more poignant issues.  First, why’s the economy been so despondent even to rampant financial excess?  Second, will an upsurge in activity be sustainable or a further destabilizing flash in the pan?  Understandably, many are amenable to the notion that the financial system and economy are now begrudgingly emerging from a bad spell similar to that experienced in the early nineties.  And following this line of reasoning, it’s less painful this go round compared to the early nineties specifically because the system is today more robust and stable.  We take strong exception, arguing that it is much more a case of the Fed and an aggressive U.S. financial sector thus far postponing the greater part of the necessary adjustment.  And while there are similarities to the early nineties (including the Greenspan Fed “changing the rules” to enhance financial profits, speculation, and Credit growth), I believe the differences are today more worthy of contemplation.  Importantly, the early nineties economic stagnation and financial dislocation were part of a wrenching adjustment period necessary to work through (financially and economically) post-eighties excesses.  The Milken junk bond juggernaut, including Drexel Burnham, collapsed in disrepute.  The reckless real estate lenders from the Northeast and California collapsed, along with scores of (flimflam) Savings and Loans.  The lending spigot that that been aggressively financing asset Bubbles, unprofitable business enterprise, and fraudulent endeavors was largely shut down.  There was painful dislocation, the Credit system was brought to its knees, and punishment was meted out for previous misdeeds.  Dysfunctional financing mechanisms were (somewhat) squelched and more disciplined lending practices returned to vogue, setting the stage for a new cycle of expansion. Today, rather than trumpet the lack of recent bank failures as an indication of a wholesome and vibrant financial system, we’ll protest that myriad misdeeds have gone unpunished.  We don’t see any major lenders, even those that cohabitated with the Enrons and Worldcoms of the world, in any hot water today.  Looks like more of the same – business as usual.  And as long as the Fed grants amnesty for most past, current, and future financial transgressions, the allure of easy gains will naturally perpetuate unsound excess.  And that’s an enormous systemic problem – the insoluble dilemma that will come back and bite the bullish optimists where it counts.  Again, the story remains that the system is hopelessly unsound, and we are left to look nervously to the future for the inevitable post-Bubble adjustment period.  Yet there is great pressure today to stick one’s head in the sand and disregard only increasing financial fragility. The harsh reality is that our fragile financial system and maladjusted economy are sustained only by enormous financial sector expansion.  It receives no attention, but the paramount issue is the enormity of the new Credit necessary to achieve only minimal economic expansion, and how monstrous the financial sphere has become since the commencement of the previous (early nineties) business recovery. First of all, Total Credit Market Debt (financial and non-financial) as a percentage of GDP has surpassed 300%, compared to 240% back in 1990.  How about 400% by 2008? Total Credit Market Debt has increased almost 8% over the past year, compared to 4.7% during the year 1991.  1991’s Total Credit Growth of $648 billion, or 11% of GDP, compares to 2002’s $2.3 Trillion, or 22% of GDP.  Comparing Non-financial Credit growth, 1991’s $462 billion, or 4.3% increase, is about one-third 2002’s $1.385 Trillion, or 7.2% increase.  And contrasting Non-financial Credit growth as a percentage of GDP, 2002’s 13% compares to 1991’s 8%.  Comparing the growth in Total Financial Sector Borrowings, 1991’s $171 billion (2.9% growth rate) is about 18% of 2002’s increase of $924 billion (9.8% growth rate).  In a truly historic inflation of financial claims, Total Financial Sector borrowings increased from 1991’s 47% of GDP ($2.8 Trillion) to today’s 99% ($10.6 Trillion).  Observing Total Bank Assets, we see 1991 growth of 2.5% ($83 billion) and 1992’s 2.8% ($95 billion).  This annual growth was about 1.5% of GDP.  In contrast, Bank Total Assets have surged $807 billion, or 12.4%, over the past year.  This is approaching 8% of GDP.  Analyzing “Structured Finance,” or the GSE, ABS, and MBS sectors, we see that combined assets increased about $230 billion (growth of about 3.5% of GDP) both during 1990 and 1991.  And Structured Finance ended 1991 at $2.0 Trillion, or 33% of GDP.  During 2002, Structured Finance assets increased $838 billion, or growth equal to 8% of GDP, and ended 2002 with total assets of $8.1 Trillion, or 77% of GDP.  As we appreciate, this intractable financial inflation has fueled (unsustainable) over-consumption, intractable current account deficits, and an unprecedented accumulation of foreign-held claims on our economy.  The $510 billion Current Account deficit over the past four quarters compares to 1991’s $7 billion surplus.  But, then again, balancing one’s trading position is a fundamental aspect of the post-boom adjustment process.  We see that the Rest of World increased holdings of US financial assets by $99.5 billion during 1990 and $131 billion (2.2% of GDP) during 1991.  Total Rest of World holdings ended 1991 at almost $2 Trillion, or 34% of GDP.  “The World” increased holdings of U.S. financial assets by $523 billion (5% of GDP) last year to $7.48 Trillion, or 72% of GDP.  These holdings have surged 54% since the beginning of 1998.  In my mind, the Critical Issues seem to be crystallizing by the week:  First, is it sound analysis to presume that the financial sector will maintain at least its current rate of expansion, in the process creating the Credit necessary to stimulate a “recovery”?  Second, will foreign creditors continue to accommodate this inflation by acquiring only larger quantities of devalued dollar claims?  One can always justify the assumption that the future will look much like the recent past.  In this case, that the financial sector will continue to effortlessly inflate financial claims, which our foreign creditors will gladly accumulate.  Well, in the past I wrote a piece titled “How could Irving Fisher have been so Wrong?”  Why did America’s preeminent economist see permanent prosperity when the system was rapidly approaching the financial and economic abyss?  Well, as I see it, he made the common but fatal analytical error of extrapolating the spectacular effects emanating from a terminal period of gross financial excess.  Many are today merrily Following in Dr. Fisher’s Footsteps. It is my view that a multi-year extension of the financial sector Bubble expansion is fraught with such danger that it is very likely unattainable.  Yes, it has expanded by about 90% over five years, while the recent 10% annualized growth rate proceeds swimmingly.   And, sure, over the past five years foreign Creditors have increased U.S. financial asset holdings by more than 50%.   But I would argue that we are today well into the terminal stages of the financial sector inflation and foreign holders’ tolerance with this claims debasement. Keep in mind that this historic financial inflation has unfolded during a collapsing rate environment.  The supply of new financial claims has been enormous and unrelenting, yet demand for these price-inflating assets has been even more intense.  This will prove an anomaly.  Despite rumblings of possible “unconventional” policy measures, the Fed has about run out of room to inflate Credit market prices.  And while the dollar has declined meaningfully over the past 18 months, our foreign creditors’ currency losses have been heavily mitigated by surging bond prices.  But going forward I don’t envisage runaway financial sector expansion functioning smoothly in a stable or rising rate environment.  Moreover, the Fed’s desperate move to manipulate market perceptions, collapse interest rates, and debase the dollar was necessarily too conspicuous. June 17 – Bloomberg: “Jamaludin Jarjis, Malaysia’s second finance minister, comments on…Malaysia’s ringgit peg and euro: ‘The peg is working nicely for us. Our concern is our competition with China. Malaysia should remain competitive. The moment our products lose competitiveness with other countries in Asia, then we really will have to look at it. Now, we are comfortable.  ‘Of course, we have to be careful on our assets because if we keep our assets in U.S. dollars, they will be depreciated in value.  ‘On the debt side, it’s okay, they can be in U.S. dollars.  But all the revenue should be in euro. Debt obligations can remain in U.S. dollars, but we advise corporations their revenue should be in euros. Government agencies have been advised already.’” The World is now keen to dollar debasement.  And while global central bankers have of late risen to the occasion and accumulated massive dollar holdings unwanted by the international private sector, this is one more development that should not be trumpeted nor extrapolated.  It is a sign of impending trouble (diminishing private demand for dollar claims), but that for now ironically acts to foster global over-liquefication.  Yet the day Japanese, Chinese, Asian and other central banks lose their appetite for these inflating dollar balances will mark a key inflection point in financial history.  And we don’t see it taking several years. The stock market optimists today see nothing but blue skies, while unwittingly extrapolating the effects from the terminal stage of rampant Credit inflation and the Fed’s desperate measures to prolong it.  How quickly they forget that it wasn’t all too many months ago that unfolding financial crisis had the Fed terror-stricken. Our (and global) central bankers responded by hitting the panic button, provoking an abrupt and dramatic change in market perceptions.  Almost overnight, the Fed’s maneuver made it more profitable to be long Ford bonds rather than to be short them; much more enticing to be leveraged in junk bonds and converts than to be short stocks.  But be especially careful extrapolating today’s extreme over-liquefication, and don’t mistake liquidity effects for true financial or economic regeneration.  Pushing the panic button certainly didn’t cure anything. Rather, there’s been a confluence of one heck of a short-squeeze and rampant leveraged Credit market speculation, with the Bubble granted one more new lease on life.  The Achilles Heel of Financial Fragility is only further imperiled by the Fed negligently inciting manic behavior that will, again, end in disappointment and revulsion.  That’s the inherent nature of speculative markets, manipulated but not subverted by Fed actions.  Yes, the historic financial sector expansion has accelerated, but the nature of the dynamics fueling today’s liquidity excesses are much more likely of a late-stage “blow-off” variety than the (early nineties-style) beginning of a new Credit cycle.  After all, the preponderance of Credit creation nowadays continues to finance real estate, household consumption, and leveraged speculation.  These “sectors” have been over-borrowing for years.  The probability that current excesses throughout mortgage finance can be sustained for a few more years is remote.  And, importantly, there are further indications that years of aggressive financial sector expansion is increasingly problematic.  We certainly don’t expect the major issues of derivative accounting and the lack of transparency to end with Freddie Mac.  Is the Pandora’s Box of financial accounting about to be unlatched? Yesterday, Countrywide Financial released a statement that “management firmly believes that there is no basis whatsoever for these rumors (“related to accounting matters and its financial statements”) and stands behind the integrity of its accounting practices.”  Well, the company’s balance sheet has ballooned 73% over the past four quarters to $73.6 billion (up from $15.8 billion to end year-2000).  This expansion is a microcosm of the U.S. financial sector, with ballooning assets of indeterminable true economic value.  And with interest rates at such extreme lows and leveraged speculation conspicuous, going forward we would expect the marketplace to look at huge trading positions and inflating balance sheets with a more skeptical eye.  And if this week’s reversal proves to a major turn in yields, then U.S. financial sector expansion has surely commenced a much more arduous period.  A strong case can be made that the requisite financial sector expansion will function effectively only in a stable or declining interest rate environment.  The Fed has thrown one heck of a party, with fun and games and gifts galore.  We don’t think the best is yet to come.

06/12/2003 Contemplating the Evolution From the Way We Were to the Way It Is *

This week numerous corporate governance issues dominated the headlines, generally holding the bulls in check.  IBM and AT&T helped guide the Dow higher by 0.6% for the week, while the S&P ended flat.  The Transports gave up 1%, while the Utilities added 0.6%.  The Morgan Stanley Cyclical index fell slightly, and the Morgan Stanley Consumer index gave back 0.4%.  The broader market was under only moderate pressure.  The small-cap Russell 2000 dipped less than 1% and the S&P400 Midcap index declined 0.4%.  The NASDAQ100 dropped 0.8% on the week.  The Morgan Stanley High Tech Index fell 2.6%, while the highflying Semiconductors dropped sharply by 7.0%.  The Street.com Internet index fell 2.8%, while the resilient NASDAQ Telecom Index added 1.3%.  The Biotechs gave back some of last week's gains, sliding 2.8%. The financial stocks remain strong.  The Broker/Dealers gained 1.7% for the week (up 30% y-t-d) and the Banks added 0.7%.  Although bullion dropped $7.30, the HUI Gold index posted a notable 1.8% gain.

The historic Credit market melt-up continues.  Two-year Treasury yields declined 16 basis points this week to 1.08%, and five-year yields sank 24 basis points to 2.03%.  Wow… The 10-year Treasury note saw its yield sink 24 basis points to 3.11%, a 45-year low.  The long-bond yield dropped 22 basis points to 4.17%.  Agency and mortgage-backs this week lost some ground to surging Treasuries.  Fannie Mae benchmark mortgage-back yields dipped 17 basis points, with implied yields on agency futures declining only 10 basis points.  The 10-year dollar swap spread widened a moderate 1.5 to (a still quite narrow) 34.5.  

It was another solid week of corporate debt issuance.  American General sold $500 million, Met Life $500 million, Cardinal Health $500 million, Con Edison $400 million, Verizon $300 million, Eastman Chemical $250 million, National City $250 million, Entergy Gulf States $275 million, and Cincinnati Gas & Electric $400 million (to name a few).  Strong liquidity continues to buttress the junk bond market.  According to AMG, this week saw inflows of $1.33 billion, following last week’s $1.45 billion.  From Bloomberg: Junk “sales have averaged $2.7 billion a week, compared with $1.7 billion last year.”  Capital One doubled the size of its debt sale to $500 million.  Tenneco raised $350 million (up from $300 million), XM Satellite $175 million, Cooperative Computing $157 million, Teco Energy $300 million, Omnicare $250 million, IOS Capital $350 million, CBD Media $150 million, and MSW Energy $200 million. The convertible boom runs full steam ahead.  This week’s new issues included Lamar’s $287 million, Keane $125 million, Quanta Computer $300 million, FEI $150 million, Guitar Center $90 million, Tekelec $125 million, and NPS Pharmaceuticals $170 million.  

Corporate spreads were mixed this week.  Investment-grade spreads were little changed near three-year lows.  Junk spreads, however, widened notably.  Moody’s reduced its ratings on GM bonds, with spreads widening about five basis points for the week to 310.  Yet Ford bonds yields sank about 30 basis points this week, with spreads narrowing nine basis points to 317.

The ailing dollar index dropped more than 1% this week.  The Canadian dollar gained almost 2% against the dollar as it traded to a 6 ½ year high.  The Mexican peso regained its composure this week with a gain of just under 2%.  The Brazilian real traded to an 11-month high and is now sporting a 25% y-t-d gain against the dollar.

June 11 – Dow Jones (Angela Pruitt):  “Brazil became the latest emerging market country to take advantage of favorable rates and a seemingly insatiable appetite for high-yield debt among investors, issuing a $1.25 billion (up from $1 billion) 10-year bond Tuesday…  Brazil’s transaction, a deal that had been anticipated for more than a week, is part of a parade of new issues from emerging market sovereigns seen recently, including a EUR650 million deal from Turkey Tuesday and foreign bond offerings from Ukraine, Mexico and Belize last week.  ‘The market is wide open for pretty much anybody,’ said…an analyst… ‘Brazil is definitely a name people like because it’s still high yielding. Every deal is oversubscribed in emerging markets, most recently it was the Ukraine issue.’”

June 11 – Bloomberg:  “Austria sold $1 billion of dollar-denominated bonds, the latest European borrower with the highest credit ratings to take advantage of falling yields to lock in borrowing costs for at least a decade.  The sale ‘wasn’t planned’ in advance, said Helmut Eder, who runs Austria’s Federal Financing Agency. ‘We saw appetite, so we did it. There was huge demand from Asia.’”

June 11 – Bloomberg:  “The Indian rupee gained to a 26-month high on demand from overseas investors buying domestic stocks and bonds and from companies borrowing abroad, traders said.”

June 11 – Bloomberg:  “Croatia’s borrowing costs plunged in a sale of 25 billion yen ($212 million) of bonds, as confidence grows that the former Yugoslav republic will join the European Union. The six-year Samurai bonds were sold at par to yield 1.23 percent…”

Viewing the surging price of Freddie Mac bonds, one is not left thinking there is much of a problem.
Freddie’s 10-year (4.5% of 2013) yields sank 12 basis points this week to 3.50%, with a two-week decline of 23 basis points.  But this note’s spread did widen 12 basis points this week to 38.  This places Freddie’s spreads back to the level from early last month, while remaining considerably narrower than where they began the year (55 bps).  The spread on Fannie Mae 4 3/8 2013 bonds widened six to 35 this week, basically taking back last week’s sharp narrowing.    

I don’t this evening have any great insights on the Freddie situation.  The GSEs are, of course, an accident waiting to happen. Their derivative positions are clearly market destabilizing.  Perhaps there will be an announcement of a big derivative loss or a serious accounting scandal at Freddie, but there is at this point not much that would indicate such a scenario is unfolding.

It is worth noting that mortgage players including Washington Mutual (up 25% y-t-d) and Golden West Financial (up 16% y-t-d) enjoyed strong gains this week, while the bank and broker equity rally didn’t seem to miss a beat.  There is apparently little worry today that the Freddie problem will pierce the Mortgage Finance Bubble. The market does, however, appreciate that intense scrutiny will likely hold GSE balance sheet growth in check for awhile.  But this is much less of an issue today than it would have been in the past.  The banks and S&Ls are aggressively ballooning their balance sheets with mortgages, while speculative demand for mortgage-backs seems insatiable.  Amazingly, the market today doesn’t require strong GSE asset growth to sustain the Bubble.  So the systemic ramifications thus far are rather muted.  All the same, this melt-up in Treasuries has all the earmarks of a derivative type dislocation.  It trades as if someone big is caught on the wrong side of an interest rate bet or (derivative) hedge.

This week Freddie Mac-posted 30-year mortgage rates dipped another five basis points to 5.21%, with 15-year fixed mortgage rates declining six basis points to 4.60%.  Thirty-year rates have dropped almost 50 basis points in six weeks and are down 150 basis points from a year earlier.  It is also interesting to note that benchmark mortgage rates are down about 340 basis points from the bursting of the NASDAQ Bubble during the first half of 2000.  Not surprisingly, mortgage applications last week remained in the stratosphere.  Total applications were up 191% year-over-year.  Refinancings were almost double from a year earlier.  The number of Purchase applications was up almost 18% from the strong year ago level, while Purchase application dollar volume was up a notable 25.6%.

Broad money supply (M3) expanded $9.9 billion last week, with seven-week gains of about $153 billion.  Demand and Checkable Deposits dipped $7.4 billion.  Savings Deposits surged $17.5 billion.  Savings Deposits have expanded at a 20.5% rate thus far during 2003, with a 52-week expansion of 9.4% ($258 billion).  Small Denominated Deposits dipped $1.9 billion, while Retail Money Fund deposits declined $2.5 billion.  Institutional Money Fund deposits dipped $1.1 billion, and Large Denominated Deposits were virtually unchanged.  Repurchase Agreements added $5.1 billion, while Eurodollars declined $3.9 billion.  Elsewhere, Total Commercial Paper borrowings declined $8.2 billion last week.  Non-financial CP dipped $2.0 billion, and Financial CP dropped $6.2 billion.  

Total Bank Assets added $7.2 billion this week, with six-week gains of $176 billion.  Securities holdings added another $19 billion ($78.5 billion in six week), with 52-week gains of $306 billion (19.7%).  Loans and Leases jumped $14.7 billion.  Year-to-date, Loans and Leases have expanded at a 9.6% rate.  Commercial & Industrial loans declined $10 billion last week, with C&I loans down 7.4% ($74.2 billion) y-o-y to $922 billion.  Real Estate loans surged $23.4 billion last week to $2.14 Trillion, with 52-week gains of $310 billion (17%).

May Retail Sales were reported slightly ahead of expectations.  Year-over-year, sales were up a not too shabby 5.1%.  By major category, Auto Dealer sales were up 10.6% y-o-y, Gasoline Stations 17.0%, Eating & Drinking establishments 8.2%, Electronic Stores 5.0%, and Furniture & Home Furnishings 4.0%.  Not as impressive, Food & Beverage sales increased 2.8%, Clothing Stores 3.1%, and General Merchandise 3.5%.

Bankruptcy filings remained strong last week at 34,529.  University of Michigan preliminary June Consumer Confidence was reported at a disappointing 87.2 (vs. forecast of 93).  Curiously, Economic Conditions declined 1.2 points to 92, while Economic Outlook sank 7.2 points to 84.2. Perhaps it’s related to all the media focus on the risk of deflation.

The April Trade Deficit was reported at $42 billion, up 23% y-o-y.  Imports were up 7% y-o-y to $103.8 billion, while Exports rose less than 1% to $57.22 billion.  Imports were 81% larger than Exports during the month.  Year-over-year, Capital Goods exports declined 4.7%, while Food & Beverage gained 7.9%.  Looking at Imports, Capital Goods increased 1.6%, Crude Oil 22.5%, Consumer Goods 11.0% (Pharmaceuticals up 25%), and Food & Beverage 16%.  Year-to-date Imports from Canada are up 8.7%, Mexico 5.2%, China 30.1%, Japan 0.2%, and Germany 13.4%.  Imports are also up 79% from Saudi Arabia, 69% from Russia, 26% from Brazil, and 18% from India.  There are indications that May was a big month for imports.  

Fannie Mae enjoyed another huge month.  “Total business volume was a strong $129 billion ($604 billion y-t-d), the second highest on record.  Retained commitments surged to a record $73.8 billion from $41.4 billion in April… Lender-originated MBS issuance of $108.4 billion is the third month this year that volume exceeded $100 billion.”  Fannie’s book of business surpassed $2 Trillion during May, increasing at an 18.1% annualized rate.  It took less than five-years for Fannie’s book of business to double from $1 billion.  Year-to-date, Fannie’s book of business is up $181 billion ($435 billion annualized), or a rate of 25.6%.  

Yesterday I presented at the Undiscovered Managers’ Wealth Management Symposium in Chicago.  I would like to thank Mark Hurley for inviting me to speak, as well as the attendees for attentively listening to my long presentation.  I have included my talk in its entirety below.

 Contemplating the Evolution From the Way We Were to The Way It Is

“I generally try not to venture too far from my Bloomberg screen, and I’m not much for public speaking.  Actually, when the folks from Undiscovered Managers initially invited me to speak, I at first hesitated.  But they cleverly enticed me with the words “Paul McCulley is going to be presenting.”  Well, that’s all it took, and I immediately signed up.  There was no way I was going to pass up the opportunity to go head-to-head with my analytical nemesis - the most outspoken “inflationist” on Wall Street.  And despite my disappointment that Mr. McCulley is not speaking, one of my objectives this morning is to convincingly refute his call for only greater monetary and fiscal stimulus.  Such policies are little more than administering greater doses of narcotic to the desperate junky, while disregarding the underlying malady.  It is my view that The Inflationists are indeed engaged in a desperate – and perilous - crusade to sustain an unsustainable Credit Bubble.

I imagine most everyone would agree that we are faced with an exceptionally challenging environment.  There are these perplexing, contradictory views – are we facing deflation or inflation?  Is this post-bubble or bubble; recession or recovery; bear market rally or the return of the bull?  Is the economy fundamentally healthy or an unfolding disaster?  Is the financial system sound or hopelessly unstable?  There are convinced pundits and seemingly convincing analyses supporting diametrically opposed views.  So, what the devil is going on here, and is there any hope for making some sense of it all?

Well, I want to be quite upfront on this:  I am here today as a salesman.  But don’t worry; there’s no need to hide your wallet.  I am hoping to sell you on an analytical framework. It’s very much a work-in-progress, but I’m convinced that there is a better mouse trap.  I believe The Inflationists are wrong – dead wrong.  I believe the recent focus on “deflation” risk is misguided.  I believe the generally sanguine consensus view is flawed and confused, specifically because it stems from an outdated and inadequate analytical framework.

While recognized by few, years of study have me absolutely convinced that we are in the midst of one of history’s great Credit Bubbles.  As such, the greatest risks today are associated with the continuation of runaway lending, speculation and financial leverage.  Failing to appreciate the root cause of the boom, the optimists invariably extrapolate unsustainable Bubble excess.  Examples include the Internet stocks, NASDAQ, the dollar, and now the housing markets.  We now are in the throes of a historic Mortgage Finance Bubble that, like the preceding telecom debt and equity Bubbles, will end in tears.  The consensus view that the U.S. financial system and economy are fundamentally sound is dangerously mistaken.  The U.S. Credit system today is truly out of control, and the Fed is trapped in disastrous policies perpetuating the Bubble.

I believe that if one views the world through the lens of a sound analytical framework, it becomes clear that the Credit Bubble places the U.S. financial system, economy, and dollar at great risk for years to come.      

I chose not to use a lot of slides today.  My various charts of Credit growth all look quite similar; they are all mountains that just grow more steeply toward the sky.  Some of my favorites are included in your material, but it’s not a valuable use of our time to go through them individually.  I’m here to sell concepts – to push a way of thinking about this most fascinating environment.

But I will begin by throwing out a few figures to put the ongoing Credit Bubble into some perspective.  During the past six years total Credit market borrowings have surged $10 Trillion, or about 50%, to more than $32 Trillion.  Over the same period, financial sector Credit market borrowings – including the banks, Government-sponsored Enterprises, Securities firms, asset-backed securities issuers, and mortgage-backed securities trusts – have doubled to $10.5 Trillion.  Total mortgage borrowings are up $3.5 Trillion, or 66%, since the beginning of 1998.

And just last week the Federal Reserve released Credit data from the first quarter.  I will briefly share a few highlights.  Total mortgage borrowings increased at an annualized pace of $916 billion or 10.8%.  To put this into perspective, this is about three times the rate from 1997.  And the first quarter’s $900 billion plus pace compares to the $204 billion average during the first eight years of the 1990’s.  Financial sector borrowings expanded at a 9.7% rate during the first quarter.  State & Local governments increased borrowings at a 10.1% pace.  In contrast, non-financial corporate borrowings expanded at 3% annualized.

Importantly, while attention these days is focused on the potential for deflation and the apparent necessity for even more aggressive fiscal and monetary stimulus, what is not appreciated is that we have commenced a period of major divergence between weak economic performance and only greater Credit excess.  I would argue this is indicative of the terminal stage of a protracted Bubble.

The consensus view holds that this is a post-Bubble recovery environment.  But my analytical framework conveys to me that the previous corporate bond, telecom, and equity Bubbles were off-shoots of a much more momentous Bubble that today runs out of control through the Credit system.  I would argue that the Federal Reserves’ aggressive accommodation, to mitigate the fallout from booms turned bust in Mexico in 1995, Russia and LTCM in 1998, and then the technology and equity collapses, has nurtured only much larger and dangerous Bubbles in Mortgage Finance, Leveraged Speculation, and Risk Intermediation.  

To hopefully bring some clarity and continuity to this unconventional and sometimes confounding analytical framework, I have chosen to break my presentation into four sections:  First, The Way We Were.  Second, The Way It Is.  Then, Ramifications for The Way It Is.  And I will finish up with Today’s Critical Issues.

The Way We Were:

Traditionally, the monetary system was a Decentralized System Dominated by Local Bankers. Bankers operated with a prudent, “Loans for the Long-term” perspective. Gain on sale accounting and marked-to-market did not exist.  It was a controlled banking/monetary system.  Loan growth was limited by reserve requirements and there was a limited supply of loanable funds. Supply and demand for these limited funds dictated interest rates, with the price of Credit a fundamental stabilizing force.  Credit Availability was generally dictated by business profitability and the expected return on investment.
 
Bank deposits were the primary liability created during the lending process.  Or, stated differently, deposits were the major monetary IOU issued during financial sector expansion.  Hence there was a strong correlation between “money” supply, the general Credit environment, and economic performance.

Within this monetary regime, the Federal Reserve governed currency expansion and the payment system.  The monetary system was anchored by bank reserves.  The Fed carefully controlled these reserves that were “multiplied” during the lending process into new deposits.  Management of bank reserves was basically control over system liquidity and the broader financial environment.

The economy could be analyzed as an Industrial Economy.  Goods-producing industries were at the epicenter of the economic system – the horse pulling the financial and services carts. Financial expansion paralleled GDP expansion, or stated differently, the expansion of financial claims was largely matched by the expansion of production capacity.  The trade position was normally balanced.  Excesses were temporary and largely self-correcting.

Let’s focus for a minute on Monetary Processes, or the means and channels whereby liquidity is directed from the Credit system to the economy and markets.  They were relatively unambiguous back during The Way We Were.  Liquidity was generally injected through bank lending to fund business and capital investment.  It was a Decentralized (“local banker”) Credit system, spreading liquidity fairly evenly throughout the real economy. Business profits were the driving force for monetary expansion. These processes demonstrated cyclicality, but were generally self-regulating.  Asset inflation was the cart and not the horse, pulled by business lending.  Finance flowed first to business, then to income growth, and then to asset prices.  In stark contrast to today, the financial sector was lackluster.  The “action” was in the real economy.

It is worth highlighting the notion of “stabilizing speculation.” With a controlled and self-adjusting Credit system, emerging imbalances would actually be held in check by speculators placing bets that these imbalances would be corrected and short-lived.  In fact, Milton Friedman years ago asserted that “destabilizing speculation” was implausible.  This is a most important and pertinent issue.  Dr. Friedman’s premise was almost tenable under The Way We Were’s monetary system, but such a hypothesis would be absurd today.  More on the contemporary prominence of “destabilizing speculation” shortly.

And this leads us to Inflationary Manifestations, or the consequences of monetary inflation.  Previous causes were not difficult to identify, and it was generally a case of Too Much Money – chiefly bank deposits and currency - Chasing Too Few Goods.  Excessive lending and resulting money growth was the culprit, precipitated by the industrial sector bargaining for limited resources. A deficit running government sector inflated prices generally as it imposed larger demands on resources, while pressuring interest rates as it competed for limited loanable funds.  Government deficits led to a general “crowding out.”

Trade deficits were an issue, but they were self-correcting.  With a limited supply of loanable funds, heightened demand for borrowings pressured interest rates and tempered demand.  At the same time, international central bankers recognized the benefits of, and were committed to, a balanced global system.

Pricing pressures were generally controllable through the straightforward management of bank reserves and government spending.  Carefully managed bank reserves provided a Credit system anchor.  And it was not unreasonable to focus on an aggregate price level, with Inflation Manifestations observable and generally indisputable.

On a Side Point:  This simple Credit system, comprised of inert bank loans, a cautious central bank managing bank reserves, and balanced liquidity predictably entering the economy through the industrial sector, was conducive to economic modeling.  But that was The Way We Were.  We live in a profoundly changed world today.  I will refer to it as The Way It Is.  This section of my analytical framework draws heavily from the brilliance of Hyman Minsky, and specifically from his groundbreaking theories of the Wall Street Paradigm and Money Manager Capitalism.

The Way It Is:

We operate today with a dynamic, expansive securities-based Credit system, with myriad institutions, Credit instruments, vehicles, and markets.  The contemporary financial system is profoundly distinct from The Way We Were’s bank lending-dominated monetary system.  We are thus today forced to take a very broad-based view of finance and the divergent consequences of an especially vigorous and enterprising financial system.

Over time, the Enterprising Loan Originator and the Aggressive Investment Banker supplanted the Traditional Prudent Local Banker.  This evolution has transformed the old boring bank loan into a prized speculative asset.  Loans are absolutely no longer “inert,” but rather a treasured commodity in the age of aggressive marked-to-market, gain on sale, securitization, and the “repo” market.  This evolution has witnessed the cautious “Loans for the Long-term” perspective remade to the aggressive “It’s All About Volume.”  There is today little concern for Credit quality as long as the loan can be sold.  Credit quality is “managed” on a portfolio diversification basis, with individual loan quality virtually irrelevant.

Decades of notable financial evolution have culminated with what I refer to as Wall Street Alchemy.  This wizardry of transforming endless risky loans into precious “money” and “safe” securities is subtle yet profound.  Our system today operates with virtually insatiable demand for loans, with contemporary risk intermediaries the major players.  Look at the GSEs:  Fannie and Freddie’s books of business have more than doubled to $3.1 Trillion in six years, and if we include Federal Home Loan Bank System assets, we’re now talking almost $4 Trillion of GSE intermediation.  The assets of “Structured Finance” – or, at least, the combined GSE, ABS, and MBS footings – have more than doubled since 1998 to $8.3 Trillion.

This Unbounded Risk Intermediation imparts momentous changes throughout the Credit creation process.  First of all, the system today enjoys an Unlimited Supply of Loanable Funds.  This offers a stark contrast to The Way Were Were’s tightly controlled banking system liquidity.

These days financial sector expansion is in no way constrained by bank reserve requirements.  First of all, money market deposits are “multiplied” outside reserve requirements (“infinite multiplier effect”).  The GSEs, as quasi-government entities with implicit debt guarantees, have unlimited access to market borrowings.  They enjoy unconstrained IOU expansion, or liquidity creation.  Leveraged speculators also create liquidity - the creation of loanable funds - through the expansion of financial sector liabilities. The broader financial sector possesses a blank checkbook to issue additional IOUs - contemporary “money” and Credit.  Banks are now only one player in the “money” and Credit creating process and no longer the most dominant.  The GSEs and “structured finance” have been bestowed Kings of “money”, Credit and liquidity.

And, importantly, there has been a complete breakdown in the relationship between the supply and demand for loanable funds and the price of Credit.  As we have witnessed over the past year, it is possible to enjoy unprecedented demand for mortgage borrowings satisfied at collapsing rates.  And with an unlimited supply of loanable funds in the marketplace, government fiscal deficits inflate financial claims without any offsetting “crowding out.”  This is a Brave New Financial World.

With an unlimited supply of loanable funds at Fed-orchestrated “pegged” borrowing rates, it is perfectly rational for the financial sector to go for volume and aggressively leverage.  These dynamics have nurtured a systemic focus on asset and consumption-based lending, with real estate and financing leveraged speculation as today’s most conspicuous examples. And with the explosion in risk intermediation and speculation, key risks are now managed principally through the derivatives markets.  But these New Age risk markets are viable only with the specious assumptions of liquid and continuous markets.

Financial evolution has fed, and been fed by, the evolution of Federal Reserve policies.  With the transformation to a non-bank, market-based Credit system and the resulting irrelevance of bank reserves, there has been corresponding fundamental revolution with regard to the Fed’s policy “tool kit.”  Our central bank is now compelled to peg short-term interest rates and promise to forewarn the marketplace of any intention to adjust the peg.  It has also become necessary for the Fed to guarantee marketplace liquidity.  Especially to accommodate the explosion of the derivatives markets, the Fed must guarantee continuous and liquid markets.

Nowadays, Federal Reserve operations work mainly by aggressively manipulating rates, yield spreads and, increasingly, market perceptions.  In the process, the new “tool kit” bolsters leveraged speculation and unparalleled Credit Availability.  The key analytical point is that the effects of today’s operations are so much more disparate and unpredictable than when the Fed was managing the bank reserve “anchor”.   I would argue that the Fed is now held hostage to the markets - financial and real estate - and particularly to endemic Credit market leveraged speculation.  In short, financial and central bank evolution has parented a mutant, uncontrollable Credit system.  There is no financial system anchor, while the Fed’s new “tool kit” emboldens speculators and nurtures excess.

I would argue that this unrestrained financial environment has over many years affected major structural changes to the real economy – foremost fueling the evolution to a Service Sector Bubble Economy.

I view the service sector economy foremost as a “monetary” (in the broadest terms) economy.  The nucleus of today’s economic system is boundless Credit expansion and resulting asset inflation, rather than goods production and business (capital) investment.  It is my view that the significance of this transformation cannot be overstated.  I was not surprise that a recent surge in television advertising and ad rates were one of the early indications of reflation’s “success”.  This will also be another banner year for attorneys, real estate agents, insurance salesmen, and mortgage brokers, all direct beneficiaries of Credit and asset inflation.

I would argue that while profits remain the centerpiece of Capitalistic processes, financial and speculative profits today reign supreme.  Manufacturing and capital goods profits become less relevant to the economic system by the year; financial and speculative profits seemingly become more commanding by the month.

And while the New Economy has proved resilient and appears at times almost miraculous, there is no avoiding the reality that our system is acutely vulnerable to any slowdown in Credit growth.  The “seizing up” of the Credit market during the LTCM crisis, the Telecom debt collapse, and last year’s general corporate Credit crisis are examples of inherent systemic fragility.

It is important today to appreciate what I believe have degenerated into Dysfunctional Monetary Processes.  We operate with a centralized, uncontrollable Credit system.  There is a systemic propensity to channel excess liquidity to sectors and asset classes that offer the best opportunity for volume and/or demonstrate an inflationary bias.  Such processes consistently - virtually by definition – foster runaway booms and unavoidable busts.

Today, liquidity is injected into the real economy primarily through the asset markets, as opposed to financing business spending and capital investment.  During the past year, total mortgage Credit has increased a record $937 billion, ten times the increase in non-financial corporate borrowings.  Our financial system has become hopelessly disposed to fueling destabilizing asset Bubbles, and our central bank steadfastly refuses to address this most critical issue.

Importantly, financial speculators have come to dictate Credit Availability and system liquidity, with today’s Mortgage Finance Bubble a most conspicuous case in point.  Recognizing that we have experienced an historic evolution in both the Credit system and the structure of the real economy, we then must appreciate that contemporary financial excess creates quite divergent consequences – or Atypical Inflationary Manifestations.
                                                       
Sound analysis demands that we look broadly at the consequences of Credit growth.  The key is the concept of Credit inflation - the new financial claims that create purchasing power - and Credit inflation’s divergent effects.  These include myriad price effects throughout the economy and markets, with recognition that financial and non-financial asset inflation is a fundamental manifestation of contemporary financial excess.  And, importantly, Credit inflation will also impact both the amount and nature - or, better said – the quantity and quality of economic “output.”  Our focus is the inflation of a broad range of financial claims, with keen attention to the expansion of financial sector liabilities.  We therefore minimize the relevance of narrow measures of money supply, the Fed’s balance sheet and, especially, bank reserves.

Today, the system suffers most from a case of Too Much Credit and Liquidity Chasing Inflating Assets.  With financing asset markets the dominant Monetary Process, there is a strong systemic bias for Credit inflation to manifest into Asset Bubbles.  We now see exactly this dynamic throughout real estate finance, as well as in the Credit market with inflating Treasury, agency, and mortgage debt prices.

Financial excess will manifest into over-investment in the “hot” sectors.  Unbridled speculation dominates, thus we face incurable sectoral boom and bust dynamics.  If it’s not technology or telecom, it will be real estate, healthcare, or energy.

Mortgage finance excesses stoke over-consumption and resulting interminable trade deficits.  Consequences include the massive accumulation of foreign liabilities and a vulnerable dollar.  I would add that this was a seductively manageable problem when U.S. asset markets were the vehicle of choice for the global speculators (recycling global dollar liquidity immediately and directly back to the U.S. financial sector), but this is no longer the case today.

Importantly, our dysfunctional Credit system distorts pricing mechanisms, creating extreme and unsound divergences.  For example, the global economy suffers from widespread industrial overcapacity and downward pricing pressures throughout the manufactured goods arena.  At the same time, there is strong domestic price inflation in major sectors such as housing, energy, tuition, insurance, and healthcare.

Similarly, there are extreme divergences in sectoral performance that impart major structural distortions to the real economy.  Obvious examples include the protracted real estate boom versus the ongoing manufacturing bust. But, then again, this is the very nature of maladjusted Bubble economies.

Returning to my earlier side point, there is absolutely no way to effectively model the contemporary Credit system or economy.  The economics profession must adapt and move beyond “The Way We Were” and its fixation on modeling and econometrics.  Analyzing a complex, evolving market-based financial system with myriad institutions and instruments is surely at least as much art as it is science.
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Ramifications for The Way It Is:

“Updating” Minsky’s “Money Manager Capitalism,” I have coined the term “Financial Arbitrage Capitalism.” The focal point is the current eminence of Credit market speculation.  We operate today with an energized marketable securities-based financial system.  At this point, it should be inarguable that contemporary finance incessantly nurtures leveraged speculation and resulting asset Bubbles.

This atypical strain of inflation is quite problematic as it is seductive and off-limits.  After all, who in Washington today would be willing to call for restraint in mortgage lending?  Not the Fed and certainly not Congress.  To make matters worse, most mistake asset inflation for “wealth creation” and covet it rather than fear it.

Asset-based lending is self-reinforcing.  Credit excess begets higher asset prices that provide greater collateral values that beget only greater Credit and speculative excess.  Early economic thinkers a few hundred years ago appreciated that a monetary system backed by real estate was inevitably unstable.  It may work like magic at first, as the added collateral promotes increased lending.  But such monetary backing provides unlimited collateral for borrowing, with lending excess eventually inflating land prices and stimulating only greater destabilizing inflation.  They knew that once commenced, there was neither a way to control the nature of the inflation nor a generally acceptable way to turn it off.  The old economic thinkers clearly understood inflation dynamics much better than our contemporary economists.

The Way It Is operates with uncontrolled “money” creation.  This really is an extraordinary experiment with money.  It is not backed by gold, precious metals, or even constrained by reserve requirements; nor is there any effort whatsoever to restrict its supply.   The critical function of “money” creation has been assumed by enterprising loan originators and risk intermediaries focused on asset-based lending, commanding an anchorless system supplying unlimited liquidity.  Lacking the discipline and fortitude to deal with lending and speculating excess, the Federal Reserve is today impotent to manage our “money.”  

Today’s Dysfunctional Credit System responds abnormally to stimulus. Under Financial Arbitrage Capitalism, financial speculators have come to dictate system-wide Credit Availability.  The Fed now must basically peg borrowing costs and guarantee a positive spread for the speculators in agency and mortgage-backed securities.  This has created an environment where it is much more attractive “playing” financial spreads than it is investing in the real economy with its uncertain business profits.

We experience today a most virile strain of Destabilizing Speculation.  Federal Reserve accommodation nurtures unmanageable and dangerous lending and speculative excess.  And, in an important contrast to The Way We Were, the emboldened speculators nowadays confidently place enormous bets that these excesses will run unchecked.

A couple of contemporary dynamics are worth briefly mentioning.  First, “Liquidity Loves Inflation.”  Finance tends to flow in self-reinforcing excess to the sectors demonstrating an inflationary bias.  Today, the Fed wields impressive power to “reliquefy.”  However, this new purchasing power adores the mortgage markets - homes, as well as securities - but despises manufacturing and capital investment.  Secondly, market dynamics rule.  Asset inflation – or what we refer to as bull markets – will tend to gain momentum and become increasingly unstable over time, culminating with dangerous speculative “blow-offs.”  We have witnessed these dynamics repeatedly.  Examples include SE Asia, Russia, Argentina, junk bonds, emerging market debt, Internet stocks, telecom debt, NASDAQ, and equities generally.  Recently, a classic speculative “blow-off” has commenced throughout mortgage finance – a Bubble of historic dimensions.

The key point is the following:  If greater amounts of liquidity are released throughout this dysfunctional financial system, the results will be only further destabilizing speculation and more spectacular booms and busts.  The Inflationists dangerously disregard this unfortunate reality.

Perhaps it is helpful to think in terms of a Manic Financial Sphere face-to-face with a Despondent Economic Sphere.  It is today much easier to achieve financial profits than true economic profits.  So any liquidity deluge flows to, and “animal spirits” fixate on, the “business” of finance.  The realm of Financial Arbitrage Capitalism is specifically fixated on financial and speculative gains, with no regard for true economic investment or profits.  Moreover, the degree of “easy money” and financial excess necessary to stimulate the maladjusted and Despondent economy will excite only more dangerous excesses for the Manic financial system.

This leads us to the critical issue of Financial Fragility.  First of all, there are distinct “Problems with Volumes.”  The system that has evolved will basically do everything in excess.  Accordingly, consumption and asset-based lending win the popularity contest, as they offer seemingly limitless profit opportunities and less perceived risk than financing business investment.  One consequence is weak debt structures created by too much debt of increasingly poor quality – underpinned by inflating asset prices.  There is, as well, the paramount issue of Endemic Financial Leveraging, which I view as a gross Bubble of speculation.  And there is the systemic fragility associated with heightened risk intermediation, with systemic risk expanding exponentially as greater quantities of increasingly risky loans are extended and “intermediated.”

There are important issues related to the Proliferation of Structured Finance.  For one, there is heightened risk intermediation by thinly capitalized institutions not appreciating Credit Bubble dynamics.

Regarding the Proliferation of Derivatives, I have in the past used a flood insurance analogy:  If inexpensive and easily accessible flood insurance becomes available, this development will arouse a self-reinforcing building boom along the river.  The newly offered insurance will increase individual risk-taking behavior and set in motion dynamics that pyramid systemic risk.  Yet the insurance business will thrive, the riverside economy will boom, and it will appear to happy onlookers as a “miracle economy.”  That is, until the inevitable flood arrives.

For the system, derivatives provide the means for altering, disguising and transferring risk, but not the mitigation of risk.  And, unfortunately for systemic stability, this risk is too often transferred to speculators and highly leveraged players without the wherewithal to manage this risk in the event of a systemic crisis.  Moreover, derivatives and structured finance nurture risk-taking.  Specifically, they cultivate aggressive lending and leveraged speculation.

And a few comments are in order regarding the Government-sponsored Enterprises (GSEs).  These are very problematic, unmanageable institutions at the very heart of today’s Bubbles.  The GSEs enjoy unlimited access to Credit, thus operating with an extraordinary capacity to expand liabilities and create system liquidity.  They are the major force fueling a historic Mortgage Finance Bubble, fostering destabilizing asset-inflation, over-consumption, endless trade deficits, and severe economic maladjustment.  Moreover, they are the leading creators of system liquidity.  This role becomes paramount during periods of systemic stress.  I argue that they now operate as the key “Buyers of First and Last Resort” throughout the Credit market, essentially functioning as a Dual Central Bank. They have evolved into the Liquidity Backstop, emboldening the leveraged speculating community.  This is an especially powerful and dangerous role for the GSEs.  But, at the same time, they are the “Guardians of the American Dream.” Especially in today’s environment, the GSEs are politically invulnerable, and the debt market knows this.

And this transitions smoothly to the U.S. Bubble Economy.  Recall the old adage “You are what you eat”?  Well, I say “An Economy is How it Lends.”  Financial Arbitrage Capitalism and its Dysfunctional Monetary Processes guarantee endemic unsound lending and the wholesale misallocation of resources.  The character of liquidity now significantly impacts the nature of demand. The underlying structure of the economy is dictated by, and developed for, Credit-induced over-consumption, while the general economy has evolved to be asset inflation and services-centric.  This ensures extreme investment and structural distortions.    

The outcome is a lot of non-tangible “output” and “productivity,” along with an enormous inflation of financial claims.  The problem is there is little in the way of true economic wealth to support this inflation.  Therefore, today’s “monetary” economy is acutely vulnerable to any reduction in the growth of Credit.

Today’s Critical Issues:

The paramount issue is the intractable Credit Bubble – the antithesis of the stability offered by The Way We Were.  The old banking system was relatively simple to govern, while today’s complex, expansive Credit system is virtually unmanageable. There are today three interrelated Bubbles.  First, the Mortgage Finance Bubble.  Second, the Leveraged Speculation Bubble throughout the Credit system.  And third, the Risk Intermediation/“Structured Finance” Bubble

There is also the critical dilemma that we Can’t Even Turn These Bubbles Down, Let Alone Turn Them Off.   Mortgage Finance is today the horse, while the economy is the cart.  The Bubble throughout mortgage finance has become the overriding source for system liquidity and income growth.

Regarding GSE risk intermediation: The thinly-capitalized GSEs balloon exposure and use resulting boom-time experience to claim they will never suffer severe Credit losses.  The GSEs have basically become the market, and the day they turn more cautious is the day the Bubble is in serious jeopardy.  Unprecedented mortgage Credit growth has national prices levitated and many major localities in dangerous Bubbles.  Any reduction in liquidity risks setting in motion a telecom-style bust.

Closely related is the issue of the Credit insurers.  These thinly capitalized financial guarantors have written well over $1 trillion of insurance.  But what would be the consequence - what impact on Credit Availability - if the insurers were to back away from writing new policies?  I argue this is yet another Bubble; it only functions well during expansion.

We have nowadays a Hot and Cold Problem.  There is no functioning thermostat to even the temperature throughout the economy.  Speculative finance will feed over-heating in one area, while out of favor areas freeze.

We face extreme divergences in relative prices.  ECB chief economist Otmar Issing made some pertinent comments recently when he stated that the issue today was not deflation but the divergence of relative prices inherent to Capitalistic systems. I would argue that our deranged Credit system is fostering extreme and destabilizing price divergences.  A few examples include:  Healthcare versus manufactured goods prices; Silicon Valley home prices compared to Dallas; natural gas versus computers.  And there is the divergence between stagnant wage growth of goods-producing workers versus surging income for real estate agents and mortgage brokers.

We face Unrelenting Credit booms and Busts:  The U.S. and global financial systems are anchorless and rudderless.  I would argue that uncontrolled Credit systems cultivate price distortions that are malignant to Capitalistic economies.  Free markets and the effective allocation of resources require a stable monetary regime.  Here at home, the unstable U.S. financial system and economy are trapped in historic Mortgage Finance excess.  To maintain this Bubble and the attendant Bubble economy will require enormous unrelenting Credit expansion. This inflation of financial claims portends a serious dollar problem.

I would argue that the Demise of King dollar changes “everything.”  We will now face rising prices for our massive imports.  There will be an ongoing inflationary bias in commodity prices, especially for energy and precious metals.  The specter of endless U.S. Credit inflation – dollar debasement – has also set in motion significant speculative flows to non-dollar assets and markets.  This dynamic has already played a crucial role in the collapse of global yields and risk premiums, evidenced by heightened Credit Availability for many economies including China, India, Brazil, and Russia.

I am not sure what it all means, but this is not “deflation.” In aggregate, we remain in a protracted period of enormous Credit and speculative excess, with ultra-easy Credit Availability for most individuals, companies, governments, economies, and certainly the global speculators.  Moreover, this inflation is accelerating.  We today face a Bubble crisis not a deflation problem. Could the bursting of these Bubbles end in a deflationary Credit collapse?  Absolutely.  But I want to make what I believe is an important point:  While it may be possible to mitigate deflation risk with further monetary accommodation, there is absolutely no curing runaway Bubbles with only greater Credit and financial excess. It’s impossible, impossible, impossible.  The Fed and The Inflationists are fighting a losing battle.  They have not only misidentified the adversary, they are aggressively Arming the true Enemy.

This is truly a case of The Implausibility of Federal Reserve and Inflationists’ Ambitions.  Additional money and Credit will not right previous wrongs.  With current institutional and market structures, it is absolutely impossible to evenly disburse inflation throughout the economy.  Today is not “The Way We Were,” with a stable monetary transmission mechanism and a functioning aggregate price level.  “The Way It Is” operates with Dysfunctional Monetary Processes, severe structural economic imbalances, and Atypical Inflationary Manifestations.  Additional stimulus is only further destabilizing.

First of all, more stimuli feed unsustainable asset inflation.  It augments non-productive Credit creation, the inflation of dollar claims with little corresponding increase in true economic wealth.  Additional inflation also creates erratic and unsustainable income growth throughout the economy.  It fosters an unsustainable divergence between Credit expansion and the wealth-creating capacity of the real economy, intensifying already acute financial fragility.  The point being, reflationist policies only exacerbate Bubbles and distortions, while further inflating the unserviceable debt held by our foreign creditors.  As an economy, we are not adequately investing – and our domestic price structure makes it very difficult to compete globally.  But we at some point will no longer enjoy the wonderful privilege of trading dollar financial claims for imported goods. We will need to trade goods for goods.

I believe we risk an Unfolding Dollar Debacle. The key analytical issue is the unrelenting and uncontrollable inflation of non-productive Credit – dubious dollar claims on the U.S. economy.  This is the dollar debasement that will continue to weigh on our currency.  And with the passing of King Dollar we face endless oversupply of new dollar claims in the face of waning global demand.  The recent dollar speculative Bubble – with resulting artificial demand supporting the dollar in the face of ballooning supply - has now burst. But rather than adjusting to the new supply/demand dynamic, the Fed and U.S. financial sector are inflating the supply of dollar claims only more recklessly.  These dynamics ensure a most serious dollar crisis.

The Fed is Playing a Very Dangerous game.  Since 1998, the “activist” Federal Reserve has been aggressively engaged in Sustaining an Unsustainable Bubble.  They almost reached the end of their rope this past fall.  Even ultra-low rates and extreme Credit and speculative excess were insufficient to bolster the financial system and stabilize the economy.  A desperate Fed responded by again changing the rules of the game.  It not only implicitly promised the marketplace that it would maintain the short-term rate peg indefinitely, but the Fed would consider capping long-term yields as well.  This is a truly historic development – and another huge mistake in a series of flawed policies.  I fear this maneuver has recklessly opened the lending and speculating floodgates, inciting the final parabolic “blow-off” for the Great Credit Bubble.  If this is the case, we are witnessing the absolute worst-case scenario unfold right before our eyes.

In conclusion, I actually sympathize with intensive “Keynesian” stimulus policies, but only as measures to assist the system through the difficult post-Bubble adjustment process.  Aggressive stimulation today, on the other hand, is little more than John Law-style inflationism that foolishly perpetuates Bubble excess.  Postponing the Day of Reckoning only ensures a more catastrophic crisis and painful adjustment later on.”