09/16/2004 Q2 2004 'Flow of Funds' *

The week seemed to confirm the resiliency of “global reflation,” with prices of things real and financial biased upward (inflating).  As for U.S. equities, the Dow dipped slightly, while the S&P500 gained less than 0.5%.  The Transports added 1%, increasing y-t-d gains to 8.3%.  The Utilities added 0.4%, with 2004 gains of 8.5%.  The Morgan Stanley Cyclical index was about unchanged, while the Morgan Stanley Consumer index declined 1%.  The broader market remains resilient, with the small cap Russell 2000 and S&P400 Mid-cap indices up about 0.5% (y-t-d about 3%).  The NASDAQ100 gained 1%, while the Morgan Stanley High Tech index rose 1.3%.  The Street.com Internet index gained 2%, increasing y-t-d gains to 9.3%.  The NASDAQ Telecommunications index declined 1.7% for the week.  The Biotechs surged 5%, increasing 2004 gains to 9.5%.  The financial stocks were mixed, with the Broker/Dealers down 1% and the Banks slightly positive.  With bullion up $2.90 to $405.65, the HUI gold index gained 1%. Despite today’s setback, the Treasury market (“squeeze”) rally continued this week.  For the week, 2-year Treasury yields were about unchanged at 2.48%.  Five-year Treasury yields were down 5 basis points to 3.45%.  Ten-year yields dropped 6 basis points to 4.13% to the lowest yields since early April.  Long-bond yields ended the week at below 5% at 4.92%, down 6 basis points on the week.  Benchmark Fannie Mae MBS yields dipped 4 basis points, underperforming Treasuries.  The spread (to 10-year Treasuries) on Fannie’s 4 3/8% 2013 note narrowed 1.5 to 27.5, and the spread on Freddie’s 4 ½ 2013 note narrowed 2.5 to 25.5.  The 10-year dollar swap spread declined 1.75 to 43.5, the narrowest level in almost 5 months.  Corporate bonds remain impressive, especially in the face of this week’s huge issuance.  The implied yield on 3-month December Eurodollars added 0.5 basis points to 2.215%.  Corporate debt issuance surged to $21.7 billion this week, the strongest sales since March.  Investment grade issuers included GE Capital $2 billion, Berkshire Hathaway $1.1 billion, Prudential $1 billion, Washington Mutual $1 billion, First Data $1 billion, RBS Capital Trust $1 billion, KFW $1 billion, Home Depot $1 billion, Vanguard Health $790 million, Clear Channel $750 million, Allstate $550 million, TM Global $500 million, JPMorgan $375 million, Southwest Air $350 million, Connecticut Light & Power $280 million, and DR Horton $250 million.           Junk bond funds reported inflows of $258 million for the week (from AMG), with four-week inflows at an impressive $919 million.  Issuers included Ainsworth Lumber $450 million, Oil Casualty $200 million, CNS Islands (special-purpose vehicle) $200 million, and Fisher Communication $150 million. Convert issuance included Sepracor $500 million and Vitesse Semiconductor $90 million. Foreign dollar debt issuers included Republic of Korea $1 billion, Republic of Columbia $500 million, El Salvador Republic $285 million, and Banco Do Brazil $300 million.  September 16 – Bloomberg (Alex Kennedy):  “Venezuela’s benchmark bond maturing in 2027 rose to a record high as a rally in oil prices boosted the foreign reserves of the world's fifth-largest crude supplier. The 30-year bond rose 1.70 cents on the dollar to 98.20, paring the yield to 9.44 percent…” Japanese 10-year JGB yields dipped less than one basis point to 1.504%.  It was generally a quite impressive week for “emerging” bonds.  Brazilian benchmark bond yields sank 45 basis points to 8.79%.  Mexican govt. yields ended the week at 5.25, down 14 basis points.  Russian 10-year Eurobond yields declined 2 basis points to 6.20%.  September 16 – Bloomberg (Lianne Gutcher):  “The performance of hedge funds is at its worst in six years, the Financial Times reported, citing the CSFB Tremont hedge fund index. Hedge funds returned an average 2.75 percent in the year to date, down from the 11 percent recorded over the past decade, the FT said. In August, the average profit was 0.1 percent… Not since 1998, the year Long-Term Capital Management collapsed, have hedge funds performed so badly…” Freddie Mac posted 30-year fixed mortgage rates dropped 8 basis points this week to 5.75%, the lowest rates since the first week of April.  Fifteen-year fixed mortgage rates declined 9 basis points to 5.13%, with rates now down 49 basis points in 11 weeks.  One-year adjustable-rate mortgages could be had at 4.03%, down 3 basis points.  The Mortgage Bankers Association Purchase application index dipped 4.3% last week.  The holiday week again this week distorts year-over-year comparisons.  Refi applications added 1.2%.  The average Purchase mortgage was for $218,300, and the average ARM was at $298,200.  ARMs accounted for 33.0% of total applications last week.  Broad money supply (M3) declined $7.9 billion (week of September 6).  Year-to-date (36 weeks), broad money is up $458.5 billion, or 7.5% annualized.  For the week, Currency added $2.1 billion.  Demand & Checkable Deposits sank $31.3 billion.  Savings Deposits surged $37.2 billion.  Saving Deposits have expanded $287.4 billion so far this year (13.1% annualized).  Small Denominated Deposits added $1.2 billion.  Retail Money Fund deposits declined $4.7 billion, while Institutional Money Fund deposits dipped $0.9 billion.  Large Denominated Deposits declined $2.4 billion (up 26.5% annualized y-t-d).  Repurchase Agreements dropped $11.2 billion, while Eurodollar deposits added $2.1 billion.            Bank lending is surging (see “flow of funds” analysis below).  Bank Credit jumped $27.6 billion for the week of September 8 to $6.67 Trillion (up $94.6 billion over five weeks!).  Bank Credit has expanded $395.4 billion during the first 36 weeks of the year, or 9.1% annualized.  Securities holdings rose $8.7 billion ($22.1bn over 2 weeks), while Loans & Leases jumped $18.8 billion ($59.8 billion over three weeks).  Commercial & Industrial loans added $1.3 billion, while Real Estate loans expanded $7.1 billion.  Real Estate loans are up $210.9 billion y-t-d, or 13.7% annualized.  Consumer loans gained $0.9 billion for the week, while Securities loans rose $4.9 billion. Other loans increased $4.7 billion.  Elsewhere, Total Commercial Paper declined $13.0 billion to $1.342 Trillion.  Financial CP dropped $14.9 billion to $1.21 Trillion, expanding at a 5.9% rate thus far this year.  Non-financial CP added $1.9 billion (up 31.9% annualized y-t-d).  Year-to-date, Total CP is up $73.5 billion, or 8.1% annualized.  “One of the busiest weeks of the year” (all time?) saw ABS issuance of $18 billion (from JPMorgan).  Year-to-date ABS issuance increased to $434 billion, 42% ahead of comparable 2003.  2004 home equity ABS issuance of $265 billion is running 81% ahead of comparable 2003. Fed Foreign “Custody” Holdings of Treasury, Agency Debt rose $450 million to $1.291 Trillion. Year-to-date, Custody Holdings are up $224.6 billion, or 29.6% annualized.  Federal Reserve Credit jumped $4.0 billion last week to $768.4 billion, with y-t-d gains of $21.9 billion (4.1% annualized).  Currency Watch: Major currencies remain choppy and range-bound (for now).  The dollar index posted a gain of about 0.5%.  The “emerging” currencies (at the “periphery”) continue to perform very well.  The Indonesian rupiah gained 2.6% this week, the Uruguay peso 2%, Brazilian real 1.3%, Mexican peso 1.2%, and Chilean peso 1.1%.  On the losing end, the Turkish lira declined 1.6% and the Norwegian krone 1.4%. Commodities Watch: September 14 – XFN:  “China’s imports of crude oil in the first eight months of this year rose 39.3% year-on-year to 79.96 million tons, the Xinhua News Agency reported, citing figures from the General Administration of Customs.” September 17 – Bloomberg (Tan Hwee Ann):  “BHP Billiton, Rio Tinto Group and rival miners may be able to raise contract prices for iron ore by 20 percent next year to cover rising costs and as Chinese demand continues to rise, Goldman Sachs JBWere Pty said… The brokerage had earlier forecast a 10 percent increase…  Iron ore prices rose to a record this year, boosted by rising Chinese demand for the raw material to make steel.” For the week, the CRB index rose 1.0% (y-t-d gains of 7.5%).  October crude was up $2.78 to $45.59, a near four-week high.  The Goldman Sachs Commodities index jumped 4.6% this week, increasing y-t-d gains to 20.5%.  China Watch: September 14 – AFX:  “China’s August enterprise commodity prices, a  measure of wholesale prices, rose 0.6% from July and 9.5% year-on-year, the People’s Bank of China said.  The central bank said in a statement that Jan-Aug enterprise commodity prices rose 8.6% year-on-year, while wholesale prices for investment goods rose 0.7% from July and 9.7% year-on-year.” September 13 – Bloomberg (Philip Lagerkranser and Tian Ying):  “China’s export growth unexpectedly picked up in August, suggesting slowdowns in the U.S. and Japanese economies have yet to curb demand for toys, clothes and electronics goods made in the world's most-populous nation. Overseas sales increased 38 percent from a year earlier to $51.4 billion last month, the commerce ministry said… That’s up from 34 percent growth in July…” September 15 – Bloomberg (Philip Lagerkranser):  “Foreign direct investment in China rose in the first eight months as companies including Toyota Motor Corp. and Akzo Nobel NV expanded to take advantage of low wages and tap rising demand. Foreign investment increased 19 percent from a year earlier to $43.6 billion in the eight months through August after gaining 15 percent in the first seven months, the Beijing-based Ministry of Commerce said…” September 17 – Bloomberg (Jianguo Jiang):  “China’s property prices in the first eight months grew at their fastest pace in eight years. Prices for homes, offices and other commercial real estate surged 13.5 percent from a year ago to an average 2,749 yuan ($332) a square meter (10.764 square feet), the National Bureau of Statistics said…” September 16 – Bloomberg (Tian Ying):  “Investment in China’s factories, roads and other fixed assets grew more slowly in August as government lending curbs damped industrial expansion. Investment rose 30.3 percent to 3.22 trillion yuan ($389 billion) in the first eight months of this year after climbing 31.1 percent through July, according to Beijing-based Mainland Marketing Research Co.” September 15 – Bloomberg (Philip Lagerkranser and Tian Ying):  “China’s retail sales  increased 13.1 percent last month as higher incomes made holidays, cell phones and computers more affordable. Sales rose to 426 billion yuan ($51.5 billion), the Beijing based National Bureau of Statistics said… The gain followed a 13.2 percent increase from a year earlier in July…” September 15 – Bloomberg (Jianguo Jiang):  “China’s restaurants had combined sales of 60.6 billion yuan ($7.3 billion) in August, an increase of 20 percent from a year earlier, the commerce ministry said. Restaurant sales rose 23 percent to 456.1 billion yuan in the first eight months, accounting for 14 percent of the country’s retail sales…” September 16 – Bloomberg (Samuel Shen):  “More urban Chinese are willing to increase their spending even after consumer prices rose for a second month, a People’s Bank of China survey found. The bank found that 32.3 percent of people surveyed think that it’s more reasonable to step up spending this quarter, even by borrowing from banks, given current interest rates and consumer prices. That’s an increase of 1.1 percentage points from the previous quarter… The bank said that even though residents are less satisfied with current consumer prices ‘willingness for consumption continues to rise.’” September 13 – Bloomberg (Philip Lagerkranser):  “China plans to boost spending on research by government-owned companies fivefold as part of efforts to upgrade and restructure state industry, the nation’s top official in charge of state assets said.  Research spending will rise to 5 percent of revenue from 1 percent last year…” September 15 – Bloomberg (Philip Lagerkranser):  “Goldman Sachs Group Inc. cut its 2005 economic growth forecast for China, citing slowing export growth, and said the outlook may worsen unless the government replaces lending curbs with higher interest rates. The forecast was lowered to 8.1 percent from 8.3 percent…” Asia Inflation Watch: September 15 – Bloomberg (Meggan Richard and Hector Forster):  “Japan’s power  generation rose for a fifth consecutive month in August, gaining 4.4 percent from a year earlier because of increased use of air conditioners and higher demand from industrial customers.” September 17 – Bloomberg (Cherian Thomas):  “Indian exports rose 28 percent in August from a year ago as Gujarat Ambuja Cements Ltd. and rival cementmakers sold more overseas and steel companies stepped up shipments to China. Exports were $5.6 billion last month, the Commerce and Industry Ministry said… Imports rose 25 percent to $7.1 billion, boosted by higher oil costs.” September 14 – Bloomberg (Anand Krishnamoorthy):  “India’s vehicle sales rose 13 percent in August as consumers used cheap credit to buy new cars and motorcycles, boosting sales at Maruti Udyog Ltd., the nation’s No. 1 carmaker and Hero Honda Motors Ltd., the country’s biggest motorcycle maker.” September 17 – Bloomberg (Amit Prakash):  “Singapore’s exports unexpectedly rose in August, boosting an economy that the manpower minister said may grow by more than 10 percent this year for the first time in a decade.” September 17 – Bloomberg (Seyoon Kim):  “South Korea’s foreign-exchange reserves, the fourth biggest in the world, rose to a record... Reserves, including foreign currency, gold and drawing rights in South Korea’s International Monetary Fund reserve account, rose $1.9 billion since the start the end of August to $172.4 billion…” September 15 – Bloomberg (Jun Ebias):  “Philippine government debt jumped by a fifth in March from a year earlier because the state sold bonds overseas to help fund an estimated 198 billion peso ($3.5 billion) budget deficit for this year.” September 15 – Bloomberg (Soraya Permatasari):  “Indonesia’s auto sales in August rose 29 percent from a year before, aided by record low interest rates and an expanding economy, PT Astra International said, citing figures from the Association of Indonesian Automotive Industries.” Global Reflation Watch: September 16 – Bloomberg (Julie Ziegler):  “The world economy will expand by at least 5 percent this year, the strongest performance in two decades, the Institute for International Economics said. The projection is up from an April forecast of 4.75 percent.” September 14 – Bloomberg (Tim Kelly):  “Corporate bankruptcies in Japan fell 13 percent in August from a year earlier to 1,097 cases, the lowest for the month in a decade as five quarters of economic growth boosted profits, Tokyo Shoko Research Ltd. said.  The number of bankruptcies fell for a 24th consecutive month…” September 17 – Bloomberg (John Fraher):  “German producer prices rose the most in three years in August as the price of oil climbed to a record, contributing to euro-region inflation that exceeded the European Central Bank’s 2 percent ceiling for a fourth month.  Prices for goods ranging from toys to machine tools advanced 2.2 percent from a year earlier…” September 16 – Bloomberg (Dylan Griffiths):  “South African business confidence rose to a 16-year high in the third quarter of 2004, following six interest rate cuts in the past 16 months, a survey showed.” September 16 – Dow Jones – “Brazil's tax receipts rose 22% in real terms in August compared with the same period a year ago as government coffers continued to benefit from economic growth and a welfare tax rate increase earlier in the year.” September 17 – Bloomberg (Romina Nicaretta):  “Brazilian retail sales rose for a eighth month in July as falling unemployment boosted sales of food and declining rates on consumer loans increased sales of cars and appliances such as refrigerators and television sets.” September 16 – Bloomberg (Daniel Helft and Andrew Barden):  “Argentina said it plans to increase spending 14.4 percent next year to compensate utilities for higher energy costs, build roads and housing and make its first payments on international bonds since the government’s 2001 debt default.” California Bubble Watch: September 14 – Los Angeles Times (Annette Haddad):  “Los Angeles County housing prices continued their more than yearlong run of double-digit increases last month, with the median price paid for all homes rising 20.4% to $407,000 from a year ago.  To be sure, the pace of appreciation has slowed from the peak reached earlier this year… August also saw 10,710 sales of new and existing houses and condominiums. That made August the sixth straight month that more than 10,000 transactions occurred…”  September 17 – San Francisco Chronicle (Kelly Zito):  “The Bay Area housing market re-entered the record books in August as the median price jumped to $520,000 and sales for the month hit their highest level in at least 16 years… Defying long-held expectations that demand would taper off, the boom continues apace, reigniting debate about whether the Bay Area housing market is reaching unstable heights… The median price for a single-family home, as opposed to the overall median, was $549,000…” U.S. Bubble Economy Watch: September 16 – Dow Jones (Rob Wells): “A new report finds U.S. multinational corporations socked away profits of $149 billion in 18 tax havens in 2002, nearly double the level three years earlier.  Tax Notes, an industry magazine, said in a report Monday the money is being funneled to Bermuda, Ireland, Luxembourg and Singapore instead of the U.S. Treasury.   ‘That means those 18 tax havens were home to 58% of the foreign  profits of those multinationals - a figure that far exceeds the share of economic activity that multinationals conduct in those low-tax countries," according to the report by Tax Notes correspondent Martin Sullivan.  ‘Subsidiaries of U.S. corporations now generate profits mainly in tax havens rather than in the locations in which they conduct most of their business,’ the report said.” Mortgage Finance Bubble Watch: September 17 – AP:  “Fraud is running rampant in the nation’s mortgage industry, with nearly three times as many reports of suspicious activity so far this year compared with 2001, a top FBI official said Friday.  ‘It has the potential to be an epidemic,’ said Chris Swecker, FBI assistant director for criminal investigations.  Through the first nine months of 2004, mortgage companies and banks have reported more than 12,100 instances of suspicious activity compared with only 4,220 in 2001… Law enforcement officials say the lending and refinancing boom that accompanied record low interest rates in the past few years is a key reason for the increased fraud. The FBI has identified several ‘hot spots’ around the country where fraud is especially prevalent, including Florida, California, Nevada, Michigan, Missouri and Illinois.  ‘You can find this anywhere in the country,’ Swecker told reporters.  One common mortgage fraud scheme is ‘property flipping,’ in which property is purchased, appraised fraudulently at a much higher price and then quickly sold.” California ARM lender Golden West Financial enjoyed another record month of originations ($4.87bn) during August.  Loans expanded at a 37% rate during the month to $94.5 billion, with loans growing at a 33% pace during the past five months.  On the liability side, Deposits were up $3.48 billion over the past five months (17.6% ann.) to $50.9 billion and borrowings from the FHLB were up $7.0 billion (67% ann.) to $31.78 billion.  Over the past year, Loans have expanded 34%, financed by 11% deposit growth and a 66% increase in FHLB advances. Q2 2004 “Flow of Funds” The Fed yesterday released the second quarter Z.1 “Flow of Funds” report.  Total Credit Market Borrowings (non-financial and financial) increased at a $2.59 Trillion seasonally-adjusted annualized rate (22% of GDP) to $35.18 Trillion.  First-half total net additional borrowings were at a $2.67 Trillion annual pace, compared to the nineties yearly average of $1.28 Trillion.  While second quarter borrowings were down slightly from the first quarter, they compare to total borrowings of $1.70 Trillion during 2000, $1.97 Trillion during 2001, $2.16 Trillion during 2002, and $2.64 Trillion during 2003.  After beginning 1998 at 250%, Total Credit Market borrowings have increased to 302% of GDP. Total Non-financial Credit expanded at a 7.7% annualized rate during the second quarter, down from the first quarter’s 9.1% rate.  Still, one has to go all the way back to 1988 for a year of stronger non-financial Credit expansion (9.1%).  And it is worth noting that non-financial growth averaged 5.4% during the last decade.  The Federal Government expanded debt at a 10.7% (seasonally-adjusted) pace during the quarter, with first-half borrowings expanding at an 11.5% rate.  We must go back to the deficits from the early-nineties (recession and S&L bailout) to find anything comparable.  Federal debt has expanded 22% over the past 24 months to $4.27 Trillion.  State & Local governments borrowed at a 7.2% rate during the first-half (4.6% during the 2nd quarter).  The Household sector expanded borrowings at a 9.5% annual rate during the quarter to $9.74 Trillion, with debt expanding at a 10.5% pace during the first-half.  Total Household Borrowings are up an eye-opening 22% (matching federal debt growth) over the past 24 months.  Meantime, Total Corporate borrowings expanded at a 4.4% rate during the quarter (4.6% first-half pace), with non-financial Corporate debt expanding at a 2.9% rate.  It is worth noting that Federal and Household borrowings have over the past two years increased a combined $2.50 Trillion, while non-financial Corporate debt has risen $287 billion.  During the decade of the nineties, Federal and Household debt growth combined for an average annual increase of $454 billion (debt growth that took more than 5 yrs during the nineties now takes 2 yrs).  There is, then, no mystery surrounding the fountainhead for robust corporate cash flows and profits.  But I would warn against extrapolating the effects of historic federal and household sector debt booms too far into the future.  The Great Mortgage Finance Bubble certainly runs unabated.  Total Mortgage Debt expanded by $283.4 billion during the quarter ($1.076TN seasonally-adjusted, annualized) to $9.85 Trillion.  Total annual Mortgage debt growth averaged $276 billion during the nineties (what used to take a year now is done in a quarter).  The first quarter’s expansion was second only to last year’s second quarter, with a growth rate of 11.8%.  Total Mortgage Credit was up $1.03 Trillion over the past year (12.0%), $1.92 Trillion over two years (24%), and $4.82 Trillion over seven years (97%).  Household Mortgage borrowings expanded at an 11.9% rate during the quarter to $7.57 Trillion (up 12.3% from a year ago).  Home Equity borrowings (a component of Household mortgage debt) expanded by $53.6 billion, or 30% annualized, during the quarter to $766.2 billion (up 23% y-o-y).  Commercial Mortgage Borrowing increased at an 11.8% rate to $1.61 Trillion.  Total Mortgage Debt has inflated from 64% of GDP at the start of 1998 to 86% by the end of this year's second quarter. The U.S. financial sector increased borrowings at a 7.9% rate during the first quarter to $11.47 Trillion.  Financial sector debt has now doubled in size since the beginning of 1998.  It is fascinating to follow the evolution of the financing mechanisms fueling the Credit Bubble.  Years of asset inflation (securities and real estate) was fueled in large part by spectacular GSE and money market fund expansion.  Yet, today, these liquidity sources have been supplanted by aggressive Bank Credit expansion (real estate and securities), ballooning foreign central bank holdings, and the mushrooming “repo” (securities financing) market.  Asset inflation begets myriad institutions and individuals that aggressively seek their share of easy financial “profits.”      Commercial Bank Total Assets expanded at a 7.8% rate during the quarter to $8.2 Trillion.  Bank Assets were up 8.2% from a year earlier.  Bank Loans expanded at a blistering 10.9% rate during the quarter, with Loans growing at an 8.9% rate during the first-half to $4.6 Trillion.  For comparison, Bank Loans expanded by 5.6% annually during 2002 and 2003.  Of course, mortgage lending is leading the way.  Total Bank Mortgage assets expanded at a notable 18.3% rate during the quarter to $2.44 Trillion, with mortgage loans increasing at a 16% pace during the first-half.  Total Bank Credit expanded at a 10.7% rate during the first half to $6.53 Trillion, with Government Securities holdings expanding at a 21% rate to $1.25 Trillion. Examining Bank liabilities, total deposits (checkable, savings and time) expanded at an 11.4% rate during the quarter to $4.8 Trillion.  Total deposits were up 8.3% y-o-y and 17% over two years.  Fed Funds & Repurchase Agreements (net) expanded at a 16% rate during the quarter to $1.01 Trillion, with two-year growth of 32%.  With cheap deposit and repo finance abundant, Bank Credit Market Borrowing slowed sharply to a 4% growth rate during the quarter to $710 billion, with y-o-y gains of 11.1% (up 23.6% in 2-yrs).    There continue to be interesting developments throughout “Structured Finance.”  And keep in mind that, with buoyant bank lending and deposit growth, there is today somewhat less reliance on the (non-ABS) securitization marketplace.  GSE assets expanded at a 6.4% rate during the quarter to $2.83 Trillion, following two quarters of uncharacteristically slow growth (about 2%).  GSE assets were up 6.9% y-o-y and were up 158% since the beginning of 1998.  FHLB “Other Loans and Advances” expanded at an extraordinary 32% rate during the quarter to $558.1 billion.  Issuance of GSE mortgage-backeds remained slow during the quarter (1.5%), with y-o-y growth of 7% to $3.52 Trillion.  GSE MBS is, however, up 93% since the beginning of 1998.  The hot game has become “non-conforming” (higher-yielding) mortgages securitized in the ABS (asset-backed securities) marketplace.  Non-GSE mortgage ABS expanded at an unprecedented seasonally-adjusted and annualized pace of $326.2 billion (more than Total Mortgage borrowings increased during any year prior to 1998).  For comparison, mortgage loans comprised $80.8 billion of ABS issues during 1999, $68.7 billion during 2000, $116.8 billion during 2001, $90.1 billion during 2002, and $184.5 billion last year.  In total, outstanding ABS expanded at a 12.8% rate during the quarter to $2.49 Trillion, up sharply from the first-quarter’s 3.9% growth.  Total ABS was up 8.1% y-o-y and a stunning 152% since the beginning of 1998.    Other financial sector developments are worth noting.  Federal Reserve assets expanded at a 10% rate during the quarter to $807.8 billion, increasing 12-month gains to 5.0%.  Savings Institutions (ARM lenders) expanded assets at a 9.3% rate during the quarter to $1.55 Trillion, with assets up 11% over one year.  REIT assets expanded at a 30% annualized rate during the quarter to $143 billion, with y-o-y gains of 42%.  Credit Unions expanded assets at a 5.4% rate during the quarter to $643 billion (up 5.5% y-o-y).  Finance Company assets declined at a 4.1% rate to $1.386 Trillion, although assets were up 11% during the past 12 months.  The disintermediation from Money Market Funds (MMF) continues.  MMF assets declined at a 12% rate during the quarter to $1.912 Trillion, and were down $208.5 billion during the past year.  But keep in mind that many institutions have decided to invest in money market instruments (short-term Treasuries, CP, ABS, agency debt, and “repos”) directly rather than through a fund.  And while the nature of the intermediation of this Credit expansion/inflation would tend to reduce the growth rate of the monetary aggregates, it would not at all impinge marketplace liquidity. The Broker/Dealer sector balance sheet remains quite “fluid.”  After the first-quarter’s $115.8 billion surge to $1.676 Trillion (29% annualized growth), Broker/Dealer assets declined $53.3 billion during the second quarter (as interest rates spiked).  This drop was almost completely explained by Treasury security sales.  The Liability side saw an $87 billion reduction in Security RP (repo) to $408.3 billion, while Due to Affiliates increased by $46.1 billion (30% annualized) to $651.7 billion.  Over the past year, Broker/Dealer assets have increased $163.4 billion, or 10.8%.  Funding Corp assets expanded at a 9% rate during the quarter to $1.242 Trillion, with y-o-y gains of 8.6%.  Funding Corp. “Investment in Brokers and Dealers” rose $37.5 billion (38% annualized) to $428.3 billion.  After two big quarters, total Federal Funds and Security Repurchase Agreements declined at an 11% rate to $1.585 Trillion.  This reduced the 12-month increase to $144.3 billion, or 10.0%.  Rest of World (ROW) – the foreign sector – remains a fascinating and challenging area for analysis.  Our foreign Creditors’ “Net Acquisition of Financial Assets” dipped slightly to a seasonally-adjusted annualized $956.4 billion during the quarter.  Holdings have expanded at a 16% pace over the previous three quarters and were up $994.2 billion, or 12.7%, over the past year.   “Official” holdings of Treasuries and Agencies expanded at a 21% rate during the quarter to $1.33 Trillion (ROW Treasury holdings increased more than Treasury issuance).  “Official” holdings were up $361.6 billion, or 37%, over the past year.  Holdings of “Security Repo” expanded at a 16% pace during the quarter to $552 billion, an increase of 51% from one year ago and up from $91 billion at the end of 2000.  Foreign holdings of U.S. corporate debt (including ABS) expanded at a 13.7% rate during the quarter to $1.61 Trillion, with a y-o-y gain of 16%.  Foreign Direct Investment increased $34.5 billion during the quarter, or 8.9% annualized, to $1.60 Trillion (up 3.3% over one year).  Confusing the issue, there were some major revisions to ROW U.S. liabilities (foreign borrowings in the U.S.).  For example, last quarter’s Z.1. report had ROW Total Liabilities of $3.255 Trillion that one could net against the $8.427 Trillion of Total U.S. Financial Assets held, with net U.S. holdings of $5.17 Trillion.  Yesterday’s release revised Q1 Total Liabilities a mere $905 billion higher to $4.160 Trillion.  And while Foreign Assets were also revised somewhat higher, last quarter’s net foreign holdings has been revised down to $4.49 Trillion.  Second quarter net foreign holdings, then, were up $658 billion, or 17%, from one year ago to $4.55 Trillion.     The Household Sector (including non-profits) remains a fruitful venue for Credit Bubble analytical insight.  Household Asset holdings increased at a 6.5% rate during the quarter, while Household Liabilities expanded at a 10.8% rate.  Imminent trouble?  Well, it is critical to appreciate that asset values continue to inflate by nominal amounts significantly above surging liabilities – demonstrating the powerful self-reinforcing nature of Credit and asset inflations.  During the second quarter, the value of Household asset holdings increased by $900.4 billion to a record $55.97 Trillion.  Meanwhile, Liabilities increased by less than one third of this amount at $263.4 billion, to end the quarter at $10.16 Trillion.  Over the past year, Household assets increased $5.50 Trillion, or 10.8%, while Liabilities expanded $857 billion, or 9.3%.  So despite record borrowings, Household Net Worth increased $637 billion during the quarter to a record $45.91 Trillion.  Net Worth was up $4.59 Trillion over the past year, or 11.1%.  Household Financial Asset holdings were up $369 billion (4.2% ann.) to $35.2 Trillion during the quarter, with 12-month gains of $3.48 Trillion (11%).  Household Real Estate holdings increased by $467 billion during the quarter, or 11.2%, to $17.14 Trillion and were up $1.77 Trillion, or 11.5% over the past year.  Since the beginning of 1998, Household real estate holdings have increased 76%, as inflating nominal market values more than doubled the increase in mortgage debt.   But the bottom line is that Household debt has increased more than 60% since the beginning of 1999, and this historic borrowing surge has actually accelerated of late.  And while there continues to be a debate as to whether the consumer is “tapped out,” it is my view that this line of analysis misses the point.  During this fateful Mortgage Finance Bubble “blow-off” period, extraordinary gains in both asset values and liquidity lend great support to consumer spending.  I continue to expect consumer retrenchment to follow some type of negative financial development, rather than precipitating one.  How long with the Rest of World accumulate U.S. financial instruments at a nearly $1 Trillion annual pace?  And while they are acquiring the vast majority of Treasuries issued, what types of financial and economic distortions are nurtured by artificially low yields and rampant global liquidity excesses?  Does the U.S. economy’s vulnerability to inflated Household Sector New Worth become only more precarious by the year?  Are market participants fooling themselves with notions that tame U.S. and global inflation lies behind the recent decline in yields?  Is the Treasury market in the midst of a major “short-squeeze” and hedging/derivatives dislocation that now leaves the marketplace and the highly-leveraged U.S. financial sector acutely vulnerable to an abrupt reversal?  Well, the “flow of funds” reports quite effectively illuminate the ongoing Credit inflation and financial sector leveraging that have fostered unparalleled financial fragility and specific interest-rate and currency market vulnerability.

09/08/2004 Bubble Bubble Mortgage Trouble *

Back in 2000, I wrote an article for The International Economy titled “The Great Experiment.” The focus of the analysis was the nuances of contemporary finance, in particular the ramifications for unchecked growth from the government-sponsored enterprises (GSEs). Four years later, sufficient data and observations from this “experiment” warrant an update and further analytical examination.

From January 2000 through May of this year, Fannie Mae and Freddie Mac’s combined “books of business” (retained portfolios and guaranteed mortgage-backed securities sold into the marketplace) have ballooned 77 percent to $3.66 trillion. Fannie and Freddie total assets have increased 186 percent to $2.83 trillion since the beginning of 1997, with Federal Home Loan Bank System assets up 193 percent to $857 billion. And according to Federal Reserve “flow of funds” data, total mortgage debt has increased 93 percent to $9.62 trillion, jumping from 61 percent to 84 percent of GDP in seven years.

Total mortgage borrowings expanded $1.0 trillion or 12 percent last year, with 2004 on track to surpass 2003’s record. For comparison, mortgage debt increased on average about $200 billion annually during the first eight “pre-bubble” years of the 1990s. Total U.S. home sales are currently on track to surpass last year’s record by 10 percent, with the dollar value of housing transactions up approximately 65 percent over three years and 100 percent from six years ago. The nation’s average (mean) price of existing homes sold has increased 28 percent over three years and 48 percent over the past six years. In California, median home prices were up an astonishing $97,530 during the past twelve months (through May) to $465,160. Golden State home prices have surged 46 percent over two years, 81 percent over three years, and 129 percent over six years, in what has developed into one of history’s spectacular asset inflations.

The GSEs have played the instrumental role in the development of a historic mortgage finance bubble. And while the GSE debate tends to concentrate narrowly on the values of the federal subsidy and the implicit government backing of agency debt, the broader—and crucial—issue of the consequences of a momentous expansion of mortgage finance is neglected, if at all recognized.

Reminiscent of the late-1990s manic stock market environment, the issue “Is housing a bubble?” has become a hot topic for the media, investment analysts, economists, and policymakers. Federal Reserve Bank of New York economists Jonathan McCarthy and Richard W. Peach recently published “Are Home Prices the Next ‘Bubble’?” This research suggests that, in spite of significant attention directed to the issue of asset bubbles, our central bank has made scant progress in comprehending or addressing either asset inflation or bubble dynamics.

Messrs. McCarthy and Peach concluded that “there is little evidence to support the existence of a national home price bubble.” Yet, their article—and Federal Reserve research generally—ignores what should be the focal points of bubble analysis: credit growth, speculative finance, marketplace liquidity, and various financial and economic distortions.

Analyses of the GSEs and mortgage finance should begin with an appreciation for the extraordinary capacity of key lenders these days to issue unlimited quantities of new liabilities (chiefly, agency and asset/mortgage-backed securities) with no impact on the market’s perception of these instrument’s “Triple-A” quality status. Indeed, it is a defining characteristic of contemporary Wall Street “structured finance” that virtually inexhaustible quantities of risky loans can be transformed into perceived top-quality, safe and liquid securities. This alchemy is dependent upon a daisy-chain of explicit and implicit guarantees, credit insurance, liquidity agreements, and the expansive derivatives marketplace. The GSEs are very much the nucleus, while the market’s faith in the Fed and Treasury to stand behind Fannie, Freddie, and the FHLB provides the backbone of this peculiar market structure.

From a theoretical perspective, financial evolution has attained a renown I will refer to as the “moneyness of credit”—a pinnacle achievement conceptually and an unexplored quandary in reality. Throughout history, faith in the relative safety of fiat money has left it inherently susceptible to over-issuance. And with the creep of monetary inflation comes the specter of myriad inflationary effects, currency debasement, and progressive monetary disorder. These days, GSE and Wall Street securities fabrication has supplanted the government printing press as the paramount source of monetary inflation. Total “structured finance”—combined GSE assets, along with outstanding mortgage and asset-backed securities—has over seven years mushroomed an astonishing 126 percent to $7.46 trillion.

Traditionally, bank lending to fund business spending and investment provided the predominant source of finance. In the process, bank loans expanded the money supply through the creation of new bank liabilities/deposits. But no longer do banks and their deposit “money” hold sway over either the financial system or economy.

Financial systems have evolved profoundly. Especially over the past decade, this evolution has radically altered the character of lending and intermediation, along with the types of financial sector (in contrast to bank) liabilities issued. Importantly, non-bank asset-based lending is today the commanding mechanism, creating the liquidity that drives both financial markets and economies.

Total “structured finance” has jumped from 41 percent to 65 percent of GDP in just seven years. During this period, total bank loans and leases rose from 35 percent to 40 percent of GDP, expanding 60 percent to $4.54 trillion (real estate loans accounting for two-thirds of bank loan growth). Examining the nature of lending, it should be clear that contemporary “money” is today increasingly comprised of agency securities and agency-related instruments, along with Wall Street structured products. “Money” is big business.

It is worth emphasizing the current historical anomaly that, domestically as well as globally, there is no mechanism, effort, or regulatory mandate to control either the quantity or the quality of contemporary money and credit expansion. As such, I would argue that there is today an overriding top-down predicament associated with contemporary finance: There exists a powerful dual capacity and propensity for debt to be issued in excess by myriad profit-seeking financial intermediaries. What’s more, seemingly limitless profit potential will ensure that asset markets—both real and financial—will attract the lion’s share of lending and finance. How can a limited universe of profitable investment opportunities compete for lender enthusiasm against those available from bountiful—and inflating—asset markets?

Throughout the lending process, the preponderance of financial-sector liabilities created—contemporary money and credit—will be perceived to be of the highest quality and liquidity. This “moneyness” attribute predicates virtually insatiable demand for the underlying debt instruments, which impels lending excess, over-issuance and self-reinforcing asset inflation.

Such inflation provides a boon to enterprising speculators, also enjoying unparalleled access to finance as they play a decisive part in advancing self-reinforcing asset bubbles. Mortgage finance bubble analysis includes two distinct facets of asset speculation: Exuberant borrowing to finance home and property purchases, as well as aggressive speculator leveraging in agency and mortgage-backed securities. “Speculator” in this context would include the expansive hedge fund community, securities broker/dealer proprietary trading, mutual funds, banks, insurance companies, corporate finance departments, pension funds, and various individuals and institutions (domestic and international) employing “carry trades,” “repos,” derivatives, and myriad leveraged strategies. Evolving insidiously over time, the liquidity created in the process of leveraged asset speculation emerges as a governing source of finance for both the markets and the general economy—i.e., the 1990s tech/telecom bubble and today’s housing/consumption bubble. To ignore asset inflation, speculative finance, and bubble dynamics is really to disregard the very essence of contemporary finance and economics.

The GSEs have enjoyed virtually unbounded capacity to finance expanding asset holdings through the issuance of perceived risk-free liabilities. Their liquidity-creating powers have on numerous occasions proven invaluable in ameliorating acute systemic stress. In reality if not by statute, the GSEs evolved to attain the all-powerful status of quasi-central banks. Their aggressive expansions during the 1994 bond market dislocation, the 1998 Long-Term Capital Management debacle, the 1999 Y2K scare, and the tumultuous 2000–2002 period were certainly invaluable in rectifying jeopardous market conditions.

Chairman Greenspan often asserts that the U.S. economy’s ability to persevere—and indeed excel—despite a series of shocks and setbacks is largely attributable to its extraordinary “productivity” and “flexibility.” Yet a strong case can be made that any accolades should be directed foremost to the Herculean resiliency of contemporary finance.

Above all, abundant and unabated credit and liquidity creation fueled home price inflation. The Federal Reserve collapsed rates and orchestrated a steep yield curve that, along with assurances of liquid financial markets, incited unparalleled leveraged speculation. Truly unprecedented system credit expansion underpinned buoyant asset markets: From the household and government sectors, on the one hand, and financial sector leveraging on the other. And asset inflation was certainly instrumental in stimulating demand to sustain the consumption and services-based American economy.

There is another critical facet to GSE market power and influence that goes unappreciated. As quasi-central banks intervening to stabilize the U.S. credit market, Fannie and Freddie have attained the prominence of “buyers of first and last resort” for speculators leveraged in mortgage-backed and other debt securities. Repeated aggressive market interventions over the years were instrumental in averting dislocations, and in the process enriched and emboldened the speculating community. Why not take full advantage of a steep yield curve by leveraging mortgage securities when Fannie and Freddie stand ready to aggressively purchase these holdings in the event of unfolding market stress? GSE market influence has been instrumental in nurturing the hedge fund and proprietary trading communities, and with them the ballooning global pool of speculative finance.

Furthermore, the GSE’s aggressive securities purchases—at critical junctures circumscribing interest-rate spikes and dislocation otherwise associated with speculative de-leveraging—have played a definitive, yet surreptitious, role in the explosion of derivative positions. Here as well, the GSE liquidity backstop has emboldened risk-taking and distorted the marketplace. The viability of much of the derivatives marketplace rests on the assumptions of continuous and liquid markets—specious premises thus far affected legitimate by unending and timely GSE expansion.

Mushrooming derivatives markets have, in turn, played an instrumental role in the historic ballooning of GSE and mortgage debt generally. The GSEs have accumulated more than $1 trillion of short-term debt, while relying extensively on derivatives to hedge a potentially catastrophic asset/liability mismatch. On one hand, GSE interventions underpin marketplace liquidity. On the other, the GSEs and mortgage-backed securities holders are the largest buyers of derivative protection. Meanwhile, GSE counterparties rely predominantly on dynamic hedging strategies, with computer hedging models calculating the quantities of securities to buy or sell in the event of changing interest rates.

The major problem is that the larger GSE balance sheets, mortgage debt, speculative leverage, and derivative positions balloon, the less viable this entire hedging (“portfolio insurance”) mechanism becomes. It is simply not feasible for a large segment of the marketplace to move concurrently to hedge exposure in a rising rate environment. After all, marketplace liquidity would be inadequate to accommodate the enormous hedging-related selling into a faltering market. Moreover, rapidly rising rates render derivative traders and leveraged players increasingly aggressive sellers, competing for limited and waning liquidity. I am therefore left with the disconcerting view that the GSEs have evolved into the linchpin for a massive mortgage finance bubble encompassing endemic—and eventually untenable—financial sector leveraging, speculating, and derivative trading.

Yet the ramifications of the mortgage finance bubble are anything but confined to the financial arena. Indeed, the bubble’s effects on the real economy may very well prove the most intractable. Mortgage credit excess and asset inflation today foster household over-borrowing and over-consumption. Investment decisions are similarly distorted. About two million residential units will be constructed this year, approximately 45 percent higher than the 1990s average of 1.37 million. The ongoing multi-year construction boom also includes retail, restaurant, hotel and gaming, sports venues, and other consumption-related structures. Regrettably, we are witnessing a replay of the late-1990s telecommunications and technology boom-and-bust experience, where a surfeit of speculative finance fosters destabilizing over-spending in the “hot” sectors.

It is the very nature of speculative finance that inflated boom-time profits seductively induce only greater speculative flows, and in the process evoke notions of New Eras and New Paradigms. The destabilizing torrent of finance assures systemic vulnerability to the inevitable reversal of speculative flows (i.e. the tech bubble’s stock and junk bond boom and collapse), exposing the extent of previous uneconomic investment. The abrupt adjustment of distorted boom-time spending patterns proves especially destabilizing—most economic agents are caught heavily exposed and flat-footed after extrapolating the boom far into the future. Bursting bubbles also invariably uncover significant waste and fraud. Indeed, a confluence of factors is set in motion that rectifies the divergence between perceived financial wealth and true economic wealth that had become so distended during the maniacal phase of the boom.

Today, the size of the pool of speculative finance is significantly larger than what fueled the tech bubble just a few short years ago. The housing and the consumer sectors have become the magnets for truly momentous financial flows. Asset inflation and associated spending and investment have evolved to become the driving force behind heady household income growth (rising at a 6.7 percent rate year-to-date through May!). And recalling how inflated boom-time technology profits were extrapolated to justify gross equities overvaluation (as well as over-borrowing), inflated household income growth is these days used to assert the reasonableness of both inflated housing values and surging consumer debt loads. A pernicious circularity is a work here, as sufficient purchasing power to sustain inflated asset prices and an unbalanced economic expansion is generated only through unrelenting and enormous mortgage borrowings.

Bubble excesses, including over-consumption and maladjusted investment, have engendered an increasingly untenable trade position. Unrelenting U.S. current account deficits beget dollar weakness and a swelling pool of global dollar liquidity. Yet one is hard-pressed to glean analysis linking the GSE and mortgage finance bubbles to ballooning U.S. foreign liabilities and destabilizing global “hot money” flows. No less an authority than Alan Greenspan proclaims confidence that the market pricing mechanism will function over time to innocuously rectify U.S. imbalances.

Analysis of the nature of bubble dynamics, however, leaves one anything but complacent. Categorically, asset bubbles require ever-increasing quantities of credit expansion. As for housing, rising borrowings are necessary to finance booming transaction volume and maintain inflated values. This is most conspicuous currently with the hyper-bubble markets in California and along the East Coast. And liquidity emanating from the mortgage finance bubble these days fuels inflated and vulnerable financial asset prices. There is, as well, the critical issue of bubble economies, prolonged only by escalating credit creation. The consumption, services, and finance-based U.S. bubble economy—with huge trade deficits, scores of uneconomic enterprises, and myriad general imbalances—is an absolute credit and liquidity glutton.

Importantly today, inflating asset markets have evolved to become the key mechanism for generating liquidity and income growth system-wide, rendering the entire financial and economic system acutely vulnerable to any diminution of credit growth.

Current complacency is understandable. The U.S. economy has indeed overcome a series of shocks. Presuming that technology and the stock market were the bubble, the consensus view trumpets the resiliency of the “post-bubble” U.S. economy. The harsh reality, however, is that the tech and equity boom was only an appendage of a mammoth bubble progressing uninhibited throughout the U.S. credit system. Today, I would strongly argue that the credit bubble is in the midst of its “terminal” stage of excess. Credit inflation manifestations have turned increasingly destabilizing and difficult to manage.

It is worth contemplating that from the late 1990s through 2001, the U.S. economy and markets were the favored destination for global investors and speculators. The “king dollar” period was anomalous for the ease with which escalating U.S. current account deficits were recycled back to American assets. There have been, however, some rather momentous changes over the past couple of years. Not only have U.S. current account deficits ballooned to historic extremes, investor and speculator funds now flow enthusiastically to various non-dollar markets and asset classes. The environment for recycling dollar balances has abruptly inverted from extraordinarily favorable to increasingly problematic.

Our nation’s annual current account deficit is approaching $600 billion. The dollar has suffered a sharp two-year decline against the euro and most major currencies, with the dollar index sinking 25 percent since 2002’s first quarter. Arguably, only unprecedented central bank dollar purchases have extricated currency markets from the scourge of illiquidity, dislocation, and crisis. Global central banks expanded international reserve assets by approximately 27 percent the past year to $3.25 trillion, with the major Asian central banks increasing largely dollar reserves in the neighborhood of $545 billion, or 38 percent, to $1.97 trillion.

The consequences of this unparalleled monetary inflation include an unwieldy boom in China and throughout Asia, rising global energy demands and prices, manic commodities markets with examples of depleting inventories, and generally heightened price pressures globally. Importantly, the global pricing environment has been transformed from “dis-inflationary,” to “re-flationary,” to the current distinctly inflationary. There is today, then, the issue of the consequences of open-ended massive foreign central bank dollar support and monetization. Going forward, central bankers will have no alternative than to weigh the competing risks associated with ongoing dollar support and resulting inflationary effects, versus a faltering dollar, unstable currency markets, and U.S. financial and economic fragility.

I made the case four years ago that uncontrolled GSE excess posed a threat to our policymakers’ strong dollar policy. I today advise that the U.S. mortgage finance bubble creates a clear and present danger to the stability of our financial system and economy, as well as the soundness of our currency.

09/02/2004 Credit Bubble Bulletin *

Despite technology weakness, stocks finished the week mildly higher.  For the week, the Dow gained 0.6% and S&P500 gained 0.5%.  The Transports added 1.1%, while Utilities rose 1.7%.  The Morgan Stanley Cyclical index gained 1.4% and the Morgan Stanley Consumer index added 1.1%.  The broader market performed well, as the small cap Russell 2000 and S&P400 Mid-cap indices rose 0.8%.  Technology stocks faltered, led by the semiconductors.  For the week, the NASDAQ100 fell 1.2% and the Morgan Stanley High Tech index dropped 1.7%.  The semiconductors dropped 6.4% for the week. The Street.com Internet Index fell 0.9% and the NASDAQ Telecommunications index retreated 1.2%.  The Biotechs were off 0.7%.  Financial stocks were mixed, as the Broker/Dealers declined 1.7%, while the banks were slightly positive.  With bullion sinking $2.75, the HUI index declined 0.7%. Today’s drubbing took some wind out of the Treasury market’s sails.  For the week, 2-year Treasury yields rose 8 basis points to 2.57%.  Five-year Treasury yields were up 7 basis points to 3.49%.  Ten-year yields added 6 basis points to 4.28%.  Long-bond yields ended the week at 5.05%, up 4 basis points on the week.  Benchmark Fannie Mae MBS yields added 3 basis points, relatively in line with Treasuries.  The spread (to 10-year Treasuries) on Fannie’s 4 3/8% 2013 note widened 1 to 32, and the spread on Freddie’s 4 ½ 2013 note was about unchanged at 30.  The 10-year dollar swap spread added 1.5 to 47.75.  Corporate bond spreads were again little changed for the week and continue to perform well.  The implied yield on 3-month December Eurodollars jumped 10 basis points to a one-month high 2.315%.  September 3 – Bloomberg (David Russell):  “Procter & Gamble Co. and SBC Communications Inc. led borrowers of almost $39 billion in the U.S. last month, the most in an August since 2001, as companies took advantage of a drop in borrowing costs to four-month lows.” Corporate debt issuance was virtually nonexistent this week.  Investment grade issuers included Metlife $450 million.         Junk bond funds reported inflows of $269 million for the week (from AMG), with two-week inflows a notable $533 million.     September 3 – Bloomberg (Eddie Baeb):  “Municipal bond mutual funds had their first week of cash inflow from investors since March as returns improved because concern has lessened that that Federal Reserve will raise interest rates rapidly. Municipal bond funds had net inflows of $91 million for the week…(from) AMG… after 22 weeks of consecutive outflows when investors pulled a cumulative $9.46 billion out of municipal bond funds.” September 2 – Bloomberg (Ed Leefeldt):  “Bank of America Corp. is among lenders seeking investors for $9.75 billion in financing for General Growth Properties amid record demand for high-risk, high-yield loans in the U.S. General Growth Properties, the second-largest owner of shopping malls, is borrowing to fund its $7.2 billion purchase of the Rouse Co. and to refinance existing debt.” Japanese 10-year JGB yields declined 3 basis points to 1.54%.  Brazilian benchmark bond yields declined 7 basis points to 9.42%.  Mexican govt. yields dropped 5 basis points this week to 5.39%.  Russian 10-year Eurobond yields added one basis point to 6.27%.  Freddie Mac posted 30-year fixed mortgage rates declined 5 basis points this week to 5.77%.  This is the lowest level since the first week of April and down 67 basis points from one year ago.  Fifteen-year fixed mortgage rates were down 6 basis points to 5.15%.  One-year adjustable-rate mortgages could be had at 3.97%, down 8 basis points for the week to the lowest level in 14 weeks.  The Mortgage Bankers Association Purchase application index was about unchanged last week.  Purchase applications were up 12% from one year ago, with dollar volume up 28%.  Refi applications dipped 1%.  The average Purchase mortgage was for $215,900, and the average ARM was $293,500.  ARMs accounted for 33.1% of applications last week.  Broad money supply (M3) surged $36.5 billion (week of August 23).  Year-to-date (34 weeks), broad money is up $496.9 billion, or 8.6% annualized.  For the week, Currency added $1.3 billion.  Demand & Checkable Deposits jumped $18.3 billion.  Savings Deposits declined $10.4 billion.  Saving Deposits have expanded $267.9 billion so far this year (13% annualized).  Small Denominated Deposits gained $0.8 billion.  Retail Money Fund deposits rose $4.3 billion.  Institutional Money Fund deposits increased $4.8 billion.  Large Denominated Deposits rose $9.3 billion, increasing at a 26% rate so far this year.  Repurchase Agreements gained $6.1 billion, while Eurodollar deposits added $2.1 billion.         Bank Credit expanded $15.7 billion for the week of August 25 to $6.61 Trillion.  Bank Credit has expanded $336.8 billion during the first 34 weeks of the year, or 8.2% annualized.  Securities holdings declined $7.1 billion, while Loans & Leases jumped $22.8 billion.  Commercial & Industrial loans gained $4.9 billion, while Real Estate loans added $0.5 billion.  Real Estate loans are up $190.1 billion y-t-d, or 13.0% annualized.  Consumer loans rose $4.1 billion for the week, while Securities loans added $2.2 billion. Other loans declined $1.3 billion.  Elsewhere, Total Commercial Paper rose $2.3 billion to $1.363 Trillion (up $13.6bn over 2 weeks).  Financial CP gained $3.3 billion to $1.234 Trillion, expanding at a 9.4% rate thus far this year to the highest level since May 2001.  Non-financial CP dipped $1.0 billion (up 28.1% annualized y-t-d).  Year-to-date, Total CP is up $94 billion, or 11.0% annualized.  Year-to-date ABS issuance increased to $401.2 billion, 39% ahead of comparable 2003.  Year-to-date Home Equity ABS issuance of $248.8 billion is running 82% above a year ago. Fed Foreign “Custody” Holdings of Treasury, Agency Debt rose $4.9 billion to $1.283 Trillion. Year-to-date, Custody Holdings are up $215.9 billion, or 30% annualized.  Federal Reserve Credit jumped almost $9 billion last week to $764 billion, raising y-t-d gains to $17.5 billion (3.5% annualized).  Currency Watch: Today’s nearly 1% gain took the dollar index back to almost even for another volatile week in the currency markets.  The South African rand gained 2%, while the Canadian dollar and Brazilian real increased 1% against the dollar.  On the downside, the Australian dollar declined 1.7% and the New Zealand dollar 1%, while the Mexican peso and British pound dipped nearly 1%. Commodities Watch: It was another wild week in commodity trading.  But despite today’s decline, the CRB jumped 1.2% this week, increasing y-t-d gains to 7.1%.  With October crude gaining 81 cents to $43.99, the Goldman Sachs Commodities index added 0.5% (year-to-date gains of 15.2%).       China Watch: September 3 – Bloomberg (Wing-Gar Cheng):  “China’s economy may grow 9 percent in the third quarter, the Ministry of Commerce said, slowing from the previous three months as government efforts to curb lending to industries such as steel and cement take effect. The world's seventh-largest economy, which expanded at a 9.6 percent rate in the second quarter, is still growing at a ‘fast pace,’ the ministry said…” August 30 – Bloomberg (Amit Prakash):  “Chinese demand for commodities, including coal and steel, pushed global shipping prices to a four-month high, signaling that government-imposed lending limits aren’t abruptly slowing China's economy. The Baltic Dry Index, which measures the cost of shipping coal, iron ore and other raw materials globally, has risen 61 percent since June 22. China will account for 36 percent of this year’s worldwide demand for iron ore, the main raw ingredient in steel…” August 30 – XFN:  “China is expected to invest a massive 4.64 trillion yuan in the power sector by 2010 to boost installed generating capacity and to resolve a critical energy shortage, the official Xinhua news agency reported. The official news agency, citing Wang Yonggan, the general secretary of the China Electricity Council, said that the nation is expected to spend an average 658.8 billion yuan a year between 2003 and 2010, with investment growing at an annual rate of 25%.” August 30 – Bloomberg (Allen T. Cheng):  “China’s stockpile of automobiles rose to a record last month, the Worker’s Daily reported, citing a study from the China Automobile Industry Association. The number of unsold cars held by automakers and dealers was more than 620,000 at the end of July…” Asia Inflation Watch: September 3 – Bloomberg (Theresa Tang):  “Taiwan’s foreign-currency reserves, the third-highest in the world, rose in August for the 38th month to a record $231.6 billion, the central bank said. The reserves, which rank behind those of Japan and China, rose 0.5 percent from $230.4 billion in July…” September 1 – Bloomberg (Joshua Fellman):  “Hong Kong-based toy manufacturers are facing ‘heavy monetary losses’ because of rising raw materials prices and shortages of labor and electricity at their factories in China, according to industry association officials.  The prices of common plastic raw materials used to make toys have risen more than 30 percent in about the past month, after most toy orders were placed earlier in the year, Hong Kong Toys Council Chairman Samson Chan said…” September 1 – UPI:  “South Korea’s consumer prices in August climbed 4.8 percent year-on-year, reaching a 37-month high, a government report said… The sharp increase is raising concerns about stagflation as consumer price hikes accompany a stagnant economy. The August consumer price index was 4.8 percent higher than a year earlier, the biggest rise since the year preceding July 2001…” August 31 – Bloomberg (Anuchit Nguyen):  “Thailand’s factory production grew more than expected in July as electronics manufacturers boosted production to meet rising overseas orders. Manufacturing production expanded 9.3 percent from a year earlier, faster than June’s revised 9.2 percent increase…” August 30 – UPI:  “The Philippines economy expanded 6.2 percent in the second quarter, slightly above the government’s target of 6.0 percent. Romulo Virola of the National Statistical Coordination Board said Monday the economy was boosted by growth in personal consumption and the services sector.  Personal consumption jumped 6.0 percent while services rose 7.3 percent…” September 2 – Bloomberg (Stephanie Phang):  “Malaysia’s exports unexpectedly accelerated in July as manufacturers such as Unisem (M) Bhd. shipped more computer chips and other electrical and electronics goods to the U.S., Asia and Europe. Stocks rose. Exports surged 29 percent from a year earlier to 42.63 billion ringgit ($11 billion), the quickest pace in seven months…” September 3 – Bloomberg (Cherian Thomas):  “India’s inflation rate accelerated for a fourth week in five as food prices rose and increasing fuel costs pushed up prices of manufactured goods, intensifying pressure on the central bank to raise interest rates.  Wholesale prices rose 8.17 percent from a year earlier…up from a 7.94 percent gain in the previous week and the biggest increase since Feb. 17, 2001 …” September 1 – Bloomberg (Kartik Goyal):  “India’s tax revenue rose 20 percent in the first four months of the fiscal year from a year earlier as companies increased production, boosting incomes, the Controller General of Accounts said…” August 30 – Bloomberg (Gautam Chakravorthy):  “India’s central bank expects bank loans to expand by as much as 16.5 percent in the year to March 31, 2005, on increased demand for credit to fund public works such as roads and electricity plants. ‘The industrial recovery currently underway has been broad-based and qualitatively robust,’ the Reserve Bank of India said in its annual assessment of the economy.” Global Reflation Watch: August 31 – Bloomberg (Greg Quinn):  “Canada’s economic growth accelerated to a 4.3 percent annual rate in the second quarter, the fastest in two years, and the government increased its estimate of expansion in the first three months of the year. Surging exports pushed Canada’s gross domestic product, the sum of goods and services produced by the world’s eighth-largest economy, to an annualized C$1.12 trillion ($851 billion) between April and June…” September 2 – Dow Jones:  “European securitization is on track for another record year, after six months of record activity in the asset-backed market.  Issuance of securitized debt reached EUR125.6 billion in the first half of the year, easily outstripping 2003’s EUR95.1 billion total by 32.2%, the European Securitization Forum said Thursday.” September 1 – MarketNews:  “Home construction in France remained buoyant in July, as three-month housing starts posted a 15.1% rise on the year, while permits for the same period were up 23.5%, according to non-seasonally adjusted data released Tuesday by the Construction Ministry.  For the month of July alone, starts were up 14.2% on the year…” August 31 – Bloomberg (Fergal O’Brien):  “Irish mortgage lending growth rose at a record annual pace in July, as the lowest borrowing costs in 50 years boosts demand for property…  Mortgage lending grew an annual 31.7 percent in July compared with 27.3 percent in June, Ireland's central bank said…” August 31 – Bloomberg (Gonzalo Vina):  “U.K. home loans rose at their slowest pace in almost a year in July and fewer mortgages were approved than at any time since November 2000, suggesting higher borrowing costs are beginning to damp the housing market.” September 3 – Bloomberg (Sam Fleming):  “U.K. house prices fell for the first time in two years in August, HBOS Plc said, indicating that five interest-rate increases since November are beginning to damp property demand. House prices fell 0.6 percent from July, the first drop since August 2002, leaving the price of an average house at 160,565 pounds ($286,921), according to the U.K.’s biggest mortgage lender.” September 1 – Bloomberg (Mark Bentley):  “Turkey’s exports increased 22 percent in August from a year earlier, the Turkish Exporters’ Association said… The country had exports of $4.7 billion in the month… Exports for the January-August period jumped 34 percent from 2003 to about $40 billion.” August 31 – Bloomberg (Romina Nicaretta):  “Brazil’s economy expanded at its fastest pace in almost eight years in the second quarter… Gross domestic product, the broadest measure of a country’s production of goods and services, grew 5.7 percent from a year earlier after expanding 2.7 percent in the first quarter, the government said.” August 31 – Bloomberg (Guillermo Parra-Bernal and Katia Cortes):  “Brazilian President Luiz Inacio Lula da Silva will ask lawmakers to increase spending by 15 percent next year to pay for higher state wages, road construction and new schools and hospitals, Planning Minister Guido Mantega said.” U.S. Bubble Economy Watch: September 2 – Bloomberg (James Kraus):  “Starbucks Corp., the largest U.S. coffee-shop chain, plans to raise its prices for the first time in four years to cover higher rent, health insurance costs and higher milk prices, the Wall Street Journal reported, citing chairman Howard Schultz.” September 2 – UPI:  “Texans like to say everything is bigger in their state, and when it comes to monthly car and truck payments, they’re correct. Houston and Dallas lead the country in the size of auto loans and payments, averaging $441 in Houston and $424 in Dallas, according to a review of 3 million consumer profiles by Experian Consumer Direct.” September 3 – Bloomberg (Dianne Finch):  “Massachusetts tax receipts reached $1.19 billion in August, an increase of 9.4 percent from a year earlier and $16 million more than budget forecasts, the Boston Herald reported. Income tax receipts rose 8 percent to $650 million and sales tax receipts increased 7 percent to $334 million, the newspaper reported.” Personal Income was up a weak 0.1% for the month of July, although Compensation was up 0.4% (Transfer Payments down 0.8%, Proprietors Income down 0.5% and Rental Income down 0.6%).  Yet Personal Income is up 4.9% y-o-y.  This compares to July 2003’s 3.1% y-o-y increase, 2002’s 1.9% y-o-y rise, and 2001’s 2.8%. Personal Spending was up a notable 0.8% during July, with a year-over-year gain of 5.9%.  Mortgage Finance Bubble Watch: September 2 – Dow Jones (Christine Richard and David Feldheim):  “Given the boom in mortgage funding on Wall Street, it was only a matter of time before negative amortization mortgages made a reappearance.  Considered one of the most aggressive loan structures on the market, these loans currently are being made in sufficient numbers to back billion dollar-plus securitized bond transactions.  This week, Pasadena, Calif.-based IndyMac Bancorp, Inc. completed the sale of $1.2 billion in bonds backed by negative amortization mortgages, and …Washington Mutual, Inc. sold $1.25 billion in bonds backed by such loans. …Countrywide Financial Corp. included some negative amortization mortgages in two mortgage securitizations sold in recent weeks totaling $4.5 billion.” September 3 – Bloomberg (James Tyson):  “Former Freddie Mac Chief Executive Leland Brendsel urged a judge not to delay release of more than $50 million in compensation withheld during a probe into a $5 billion earnings restatement by the mortgage-finance company. A prolonged freeze on Brendsel’s assets would prevent him from selling his Freddie Mac stock and expose him to losses from a possible fall in the share price, Brendsel said in a filing in the U.S. District Court in Washington.” July Construction Spending was reported at a record annualized rate of $997 billion. Year-to-date, Construction Spending is running 8% ahead of last year’s record.  Total spending was up 9.7% from July 2003.  Spending on Residential construction was up 13.9% from one year earlier and was up 26% from July 2002.  Nonresidential spending was up 5% y-o-y, with Healthcare up 16.3%, lodging 12.9%, and Power 16.8%.  Nonresidential Spending for Public Safety declined 8.5%, Conservation down 6.4%, and Communication down 3.5%. “OFHEO House Price Index Shows Largest One Year Increase Since 1970’s:”  “Average U.S. home prices increased 9.36 percent from the second quarter of 2003 through the second quarter of 2004,” the strongest rise since inflationary year 1979.  Second quarter inflation of 2.21% was up from the first quarter’s 1.45%, while the 5-year national gain increased to 43.59%.  “The House Price Index is based on transactions involving conforming, conventional mortgages purchases or securitized by Fannie Mae or Freddie Mac… The conforming limit for single-family homes in 2004 is $333,700.”  It is worth noting that this methodology misses much of the housing inflation in California (up 4.85% for the quarter and 18.39% y-o-y), especially throughout Southern CA.  Still, consequences of the California housing Bubble are apparent in neighboring Nevada’s (#1 state price gains) 7.53% second quarter price gain (22.92% over one year; 53.06% over 5 years).  Even Oregon (up 2.38% for the quarter) and Washington (2.43%), states underperforming economically, posted strong price gains.  Also benefiting, prices in Arizona were up 2.61% for the quarter and 1.84% in New Mexico.  Following Nevada, Hawaii was number two at an 18.9% 12-month gain.  California was third, followed by Rhode Island’s 17.86% rise.  The comes the District of Columbia (16.07%), Maryland (15.4%), Florida (14.23%), New Jersey (12.75%), Virginia (12.21%), Maine (12.01%), Vermont (11.78%), Delaware (11.52%), New York (10.95%), Connecticut (10.7%), New Hampshire (10.39%) and Massachusetts (9.79%). Still the Financial Market “Horse” and Economy “Cart”? I apologize, but an unavoidable time constraint today has made this an especially feeble “holiday edition” CBB.  But, then again, for the long weekend there are better uses of one’s time than reading a rambling Bulletin.  Curiously, an apparent slowdown in economic growth has had minimal impact on economically-sensitive stocks.  The Dow Jones Transportation Average has posted a nearly 5% y-t-d gain.  The S&P Homebuilding index is up 9% y-t-d and the S&P Retailing index has gained 6%.  The Morgan Stanley Cyclical index has a 2004 gain of better than 2%.  Why are stocks resilient in the face of disappointing economic news?  Well, I will argue that financial markets continue to act as the “horse” and the economy the “cart.”  Despite today’s backup in rates, ten-year government bond yields are almost 50 basis points below highs from three months ago.  Mortgage borrowing costs have sunk right back to quite attractive levels, and it is not unreasonable to expect mortgage Credit growth to continue to surprise on the upside.  Today’s employment report and upward revisions suggests the economy is not slowing significantly.  Prior to February’s gain, manufacturing jobs had been lost for 42 consecutive weeks.  Over this period, manufacturing payrolls had declined by over 3 million.  This year, manufacturing has gained jobs in 6 of 8 months, although only 97,000 have been added to manufacturing payrolls.  It is also worth noting that August’s 144,000 payroll increase compares to a decline of 25,000 from one year ago, 11,000 added during August 2002, 141,000 lost during August 2001, and 28,000 added during August 2000. And although the 144,000 increase in non-farm payrolls was about in line with expectations, hypersensitive financial markets (ex-equities) nonetheless responded as if there was some big surprise.  Ten-year Treasury yields jumped 16 basis points, the euro and other major currencies dropped better than 1%, gold sank $6, and commodities were hammered.  I would argue that the payroll data was especially important to the markets, not for what is suggested about the economy but rather for what it conveyed about near-term financial stability.  Until some type of development reins in Credit system excess, the financial “horse” appears determined to drag the “cart” along for the ride. I have attempted to develop analysis that “Trouble at the Core” has fostered an historic episode of Monetary Disorder.   My thinking is that Mortgage Finance Bubble “blow-off” excesses and requisite massive foreign central bank ballooning of dollar reserves have created quite powerful and unusual dynamics.  For one, liquidity excess emanating from The Core has over-liquefied the Periphery (globally and domestically).  Moreover, it appears at this point that even heightened stress at The Core tends only to exacerbate this dynamic (flows to the Periphery).  It was certainly a curious situation today when a meaningful U.S. bond market decline was met with yawns throughout the emerging markets.  It was not that long ago that emerging bonds would have been hammered on a day like today.  And this line of analysis turns only more challenging when it comes to examining Financial Fragility.  On the one hand, since financial excesses today primarily emanate from “triple-A” agency securities, ABS, MBS, and Wall Street “structured products” financing inflating real estate assets, there has been to this point an unparalleled Stability of Monetary Disorder (basically unlimited demand for “money-like” Credit instruments – whereby the financial sector in concert with foreign central banks create demand/liquidity for self-sustaining expansion).  On the other hand, the dynamics of “blow-off” excess are unstable, dangerous, and unpredictable in the near-term.  In this regard, one can look to manic borrowing and home buying in California, along with the leveraging of the REITs and speculators for evidence of precarious “blow-off” dynamics.  A strong case can be made that NASDAQ1999-style excesses (financial and economic) have taken firm hold throughout mortgage finance.  But I will make one more attempt at using this “Trouble at the Core” analytical framework to help explain the current market environment.  First of all, Mortgage Finance Bubble excess entails unprecedented Credit creation, with attendant risk intermediation and speculative leveraging.  The Great Mortgage Spread Trade (shorting Treasuries or borrowing short-term to speculate in higher-yielding mortgage assets) has created acute market distortions, including a massive short position in Treasuries.  There has been, as well, a massive creation and transfer of risk to highly leveraged players that rely predominantly on the derivatives market for interest-rate hedging.  As the same time, dollar liquidity excesses (trade deficits combined with speculative outflows) necessitate huge foreign official Treasury and agency debt purchases.  The end result is an upward bias in the Treasury market (“inflationary bias”) that tends to anchor mortgage borrowing costs at an artificially low (and stimulating) level.  As we have witnessed over the past few months, the bond market is sensitive to weaker economic data.  Even after the past two days bond sell-off, 10-year Treasury yields are significantly below June highs.  Importantly, the bond market rally has exacerbated Mortgage Finance Bubble “blow-off” excess.  The environment has added significantly to financial fragility – greater quantities of increasingly risky loans, more speculative leveraging, and heightened systemic leverage, risk intermediation and more vulnerable debt structures.  And, in the process, dollar vulnerability has become more acute, although market dynamics also dictate that an abrupt dollar short-squeeze could develop at any time. The defining feature of contemporary finance is the capacity for the unlimited expansion of perceived money-like dollar Credit instruments.  In the process, there are three distinct financial risks created:  interest-rate, dollar, and Credit.  And while Credit risks are held at bay during this ongoing period of “blow-off” excess and real estate inflation, interest-rate and dollar risks are today prominent.  Clearly, massive derivative protection has been acquired, and this “insurance” market now plays an instrumental role in interest-rate and currency market trading dynamics.  It is this situation that creates such unsettled trading conditions.  This type of environment works as a war of attrition for traders and speculators, with marketplace liquidity suffering along the way. And while today’s employment data was generally “in-line” with expectations, the absence of economic weakness necessitated a reversal of risk hedges.  The bond market was under meaningful selling pressure, as were foreign currencies.  Market yields rose, along with the dollar.  And with a stronger dollar, commodities were under selling pressure.  And so goes another week in the world of speculative finance, with trading becoming only further detached from underlying fundamentals. I believe it was last week that I made reference to the issue “how long market ebb and flow can hold market dislocation at bay?”  To be more precise in my analysis, I believe the current Credit Bubble “blow-off” has created an untenable expansion in interest-rate, dollar and Credit risk.  Much of this risk now resides in ballooning derivative markets and is “managed” through unsound dynamic trading strategies.  At this point, huge buy or sell programs will exacerbate market moves either up or down, especially in the interest-rate and currency markets.  But we also know that unprecedented foreign central bank purchases have acted to contain dollar and bond market declines.  This exacerbates Credit excess and market risks (interest-rate, dollar, Credit), fostering only greater derivative hedging.  Watching the recent market environment, I am reminded of the 18 months preceding the Argentina financial crisis.  There was no doubt in my mind that the Argentine Credit system had become acutely fragile – with an untenable currency derivatives/hedging marketplace.  Credit and speculative excess had inflicted great vulnerability upon the financial system and severe structural distortions to the real economy.  At the same time, it was impossible to predict how long the authorities and financial players could hold crisis at bay by sustaining excesses.  Throughout, very few appreciated either the market dynamics involved or the acute financial and economic fragility that had developed.  With so much at risk, extraordinary measures were taken to sustain the boom, support its currency system, and ward off bust.  But it was all for not.  Indeed, a very strong case could be made that postponing the unavoidable financial and dislocation added greatly to the severity of the Argentine bust.  The nature of current U.S. excesses and maladjustment far exceed those that buried Argentina.  But, for now, it does seem to be a question of how long the U.S. Financial Sector “Horse” can drag along the Economic “Cart.”