11/29/2002 The Delta Hedged Economy *

The Dow enjoyed its eighth consecutive week of gains, adding about 1%. The S&P500 and Morgan Stanley consumer indices gained less than 1% this week. The economically sensitive issues caught fire, with the Morgan Stanley Cyclical index jumping 4% and the Transports increasing 2%. The Utilities dipped about 1%. The broader market rally runs unabated, with the small cap Russell 2000 adding almost 2%, and the S&P400 Mid-Cap index gaining 1%. And while the NASDAQ100 was unchanged for the week, the technology stocks generally enjoyed another solid performance. For the week, the Morgan Stanley High Tech index jumped almost 2.5% (q-t-d gain of 43%) and the Semiconductors 3% (q-t-d 59%). After recent heady gains, The Street.com was unchanged this week, while the NASDAQ Telecom index gave up almost 1%. The Biotechs ran into some selling pressure this week, dropping better than 2%. Financial stocks also underperformed, with the Securities Broker/Dealer and Bank indices dipping about 1%. With bullion dropping about $4, the HUI Gold index declined less than 1%.

The Credit market remains unsettled. For the week, two-year yields dipped five basis points to 2.01%, while five-year yields added two basis points to 3.26%. The 10-year Treasury note saw its yield increase three basis points to 4.21%, while long-bond yields increased two basis points to 5.04%. Benchmark mortgage-backs saw yields add two basis points, while the implied yield on agency futures declined two basis points. The benchmark 10-year dollar swap spread increased one to 49, as the spread on Fannie’s 5 3/8% 2011 note remained unchanged at 48. The implied yield on March three-month Eurodollars declined three basis points to 1.48%. The dollar index was about unchanged for the week.

Broad money supply (M3) surged an eye-opening $95.7 billion last week, with six-week gains of $216.7 billion. This boosts 31-week M3 annualized growth above 10%. For the week, Demand Deposits increased $4.2 billion, Small Time Deposits $2.2 billion, and Savings Deposits $19.5 billion (and up $66.2 billion over three weeks). Large Time Deposits declined $12.9 billion, Repurchase Agreements dropped $6.3 billion, and Eurodollar Deposits slipped $1.9 billion. Retail Money Fund Deposits increased $4.5 billion. The action, however, was with Institutional Money Fund Deposits. This money supply component surged $86.1 billion, with two-week gains of $110.2 billion. Today from Dow Jones: “It may be less marked than the recent rebound in major stock indexes, but the commercial paper market is staging a comeback of its own.” On the surface, this may be true. Commercial paper increased $3.9 billion last week and has jumped $21 billion over the past three weeks. However, we have yet to see any evidence that access to the CP market is improving for most companies. Over the past three weeks, financial Sector CP borrowings have jumped $22 billion, while non-financial CP has actually declined $1 billion. After recent significant gains, Total Bank Assets declined $49.8 billion last week. Total Bank Credit contracted $28.7 billion, with Securities holdings declining $27.3 billion. In what has become seemingly inconsequential to other extraordinary Credit market developments, Bank Loans and Leases dipped $1.4 billion last week. Total Bank Assets have expanded at an almost 9% rate thus far in 2001.

Global dollar balances emanating from Credit excess-induced U.S. current account deficits are necessitating enormous monthly accumulations of U.S. securities. And despite unrelenting propaganda to the contrary, these purchases are not forcing American consumers to run out and purchase foreign goods (while the U.S. economy posts massive and intractable trade deficits). Many analysts have clearly reversed cause and effect. It is instead the creation of additional dollar balances by the U.S. financial sector – Credit creation directed of late at the mortgage and household sectors – that are spent and dispersed to financial intermediaries worldwide. These balances must then find a home in dollar denominated assets (“recycling”), and here we get right to the root cause of ballooning U.S. securities positions held by foreigners.

It is worth noting, however, that recent heightened risk aversion is responsible for the Treasury and Agency arena seeing the preponderance of foreign buying. During September, foreign-sourced purchasers acquired $46 billion of long-term U.S. securities ($49 billion monthly average over the past five months). Treasuries ($26.3B) and Agencies ($21.1B) basically accounted for all of net foreign purchases during the month. Foreigners actually sold almost $6.5 billion of U.S. stocks during the month (compared to 2001’s $9.7 billion of monthly average purchases), the largest sales since September 2001. At the same time, they purchased only $4 billion of U.S. corporate bonds (including asset-backed securities), down significantly from 2001’s $19 billion monthly average. Over the past five months, foreign purchasers have accumulated $244 billion of long-term U.S. securities (up 35% y-o-y and consistent with escalating current account deficits). Agency purchases over this period account for about $81 billion (33%), Treasuries $59 billion (24%), and corporate bonds (including asset-backs) $70 billion (29%). There were $11.5 billion of net purchases of U.S. stocks (5%) and $24 billion of foreign stocks and bonds (9%). Foreigners were, on average, net sellers of $9 billion of Treasuries during the comparable five-month period last year. Foreigners were also huge purchasers of U.S. corporate bonds last year, to the tune of $86 billion (48% of total U.S. long-term securities purchases) over the five comparable months. Foreign-sourced buyers also acquired $57 billion of agencies (31%) and $35 billion of U.S. stocks. Foreigners made net purchases of $13 billion of non-U.S. stocks and bonds (7%). We’ll wait to see if their appetite for U.S. risk assets returns.

The dimension of U.S. securities trading in the Caribbean continues to amaze. A total of $1.04 Trillion of agency securities traded in the Caribbean over the past six months, a monthly average of $173 billion. For comparison, total agency trading averaged $59.4 billion during the first six months of 2001. Indeed, the Caribbean has accounted for 62% of total agency trading during the past six months, compared to 36% during the first six months of last year.

The toll from previous Credit excesses is conspicuous and mounting. Weekly bankruptcy filings were reported at 31,461 last week, and the third quarter saw a record 391,873 bankruptcy filings. This was up 11.6% from an elevated level from last year’s third quarter. For comparison, there were 308,718 bankruptcies during the third quarter of 2000. And arriving this week in my mailbox: “Owe more than your car’s worth? …we have the opportunity to help customers that owe too much on their current car loan. We realized that 75% - 80% of our customers with trade-ins owe much more at the bank than it is worth. So, we asked the Mazda Corporation to help. They did…with CASH!!... and lots of it… So, bottom line is this… if you’ve been told that you owe too much on your car – RELAX!! Give us a chance to help you own your brand new Mazda TODAY!”

This week, October Personal Income was reported up a weak 0.1%, but remains up 4.1% y-o-y. Disposable Income was actually up 7.5% y-o-y. October Personal Spending was up a stronger than expected 0.4%. Indicative of severe economic imbalances, year-over-year spending on durable goods was down 5.4%, while spending on non-durables was up 4.1%. Continuing to drive spending growth, Services expenditures were up 5.4% y-o-y (almost 60% of total personal spending). The pundits were encouraged by a stronger than expected report on durable goods – up 2.8% (after September’s 4.9% decline) versus expectations of up 1.5%. But this number is not impressive. Year-over-year it is unchanged, and October durable goods orders actually remain almost 10% below those of October 1999. Third-quarter GDP had nonresidential investment down 5.1%, with residential fixed investment up 3.7%. Stoked by ultra-easy auto finance, Durable Goods Consumption expanded at a 12% annualized rate during the quarter. With National Defense spending rising at a pace of 10.2%, Federal Government consumption rose at an 8.1% annualized rate. Goods Imports grew at a 7.5% rate during the quarter, with Goods Exports increasing at 1.8%.

November 26 - Standard & Poor’s: “Standard & Poor’s Ratings Services today affirmed New York City’s ‘A’ GO rating. However, the outlook is changed to negative from table, reflecting the escalating out-year gap estimates and the risks associated with the current plan to balance the fiscal 2004 budget. ‘The outline of the plan put forward by Mayor Michael Bloomberg to address the fiscal 2003 and 2004 budget gap of $7.36 billion is a balanced approach to dealing with the sizeable deficit, but it contains significant risk…’ The city council has approved an 18.5% property tax increase, which is a positive development, but the increase was less than the 25% increase put forth by the mayor. State legislative approval of the restructured income tax/revenue enhancement represents another major component of a balanced budget for fiscal 2004. State legislative action on this matter will be a significant challenge and progress on this proposal is largely outside of the city’s control. These revenue-enhancement proposals account for half of the gap-closing plan and will be critical elements of future structural budget balance for the city.”

October Existing Home Sales were reported at an annualized pace of 5.77 million units, the third-highest on record. Sales were up 9.5% y-o-y, while average prices (mean) jumped 11.4% to $202,600 (reportedly the strongest y-o-y gain since 1987!). Calculated transaction volume (average prices multiplied by annualized sales volume) was up 22% y-o-y to $1.17 Trillion. While down moderately from September’s record, October new home sales remained above one million units annualized and were 16.4% above year ago levels. The average sales price was up 8.7% y-o-y to $225,100.

This week from the California Association of Realtors: “The median price of existing homes in California in October increased 22.7 percent and sales rose 17.0 percent compared to the same period a year ago… ‘Although the median price of a home increased by double digits again last month compared to a year ago, it’s held steady in the $320,000 range since May,’ said C.A.R. President Toby Bradley. ‘Sales are up dramatically in percentage terms compared to a year ago in large part due to the ‘wait-and-see’ period that followed Sept. 11 last year. The lowest interest rates in more than four decades also contributed to October's sales increase, which was the seventh highest monthly sales volume on record…” The median price was up an eye-opening $59,710 during the past twelve months, a y-o-y increase of 22.7%. The median condo price was up $43,650, or 21%, to $247,980.

From Bloomberg: “Fannie Mae and Freddie Mac raised the limit on the size of single-family home mortgages they buy from banks by 7.3 percent to $322,700, widening the field of homebuyers eligible for lower-cost financing. The new loan ceiling, up from $300,700, matches the increase in the U.S. average home price in October from a year earlier, according to the Federal Housing Finance Board. The government charters for Fannie Mae and Freddie Mac require them to base annual increases in their maximum loan size on the October price increase. ‘It will definitely spur more refinancing as people jump from higher cost jumbo loans…’” These rising lending limits will also likely spur additional housing inflation.

November 25 – National Governors Association (NGA): “Saying states face the most dire fiscal situation since World War II, the National Governors Association and the National Association of State Budget Officers released a report today that concludes many states have exhausted budget cuts and drawing down rainy-day funds and that the most difficult decisions still lay ahead. The associations’ biannual report, The Fiscal Survey of States, found that despite significantly curtailing state spending, 37 states were forced to reduce their enacted budgets by about $12.8 billion in fiscal 2002. About mid-way through the current fiscal year, 23 states plan to reduce their net enacted budgets by more than $8.3 billion. ‘The fiscal crisis is affecting states across the country,’ said NGA Executive Director Raymond C. Scheppach. ‘This is a result of a convergence of four major factors that have battered almost every state budget to the point where there just are no easy choices left. The combination of long-run deterioration in state tax systems coupled with an explosion of health care costs are creating an imbalance between revenue and spending. To make matters worse we’ve had a collapse of capital gains tax revenues added to the overall loss of revenue attributable to slow economic growth.’

Today from Bloomberg News: “November was the busiest month for corporate bond sales since June… Investors snapped up more than $44 billion of bonds, almost double the amount sold in October, as signs the U.S. economy is stabilizing encouraged them to move cash into riskier assets, and away from the safety of government debt.

I think it is fair to say that we have never had an economy so tightly linked to the securities markets. Yes, record numbers of Americans have enormous exposure to the equity market. But more importantly, never before has the Credit market so dictated the availability of finance for both U.S. businesses and households. Back in October, the Credit system was under intense stress, with the much of the corporate bond market virtually grinding to a halt. Collapsing stocks and faltering liquidity in the corporate bond market were reinforcing. And with acute financial stress at the brink of impacting the key market for asset-backed securities, systemic risk was escalating rapidly. Bond spreads for many key financial institutions (including Household International, Ford, Sears, and Capital One) were widening significantly, while prices for Credit default protection were surging throughout. Heightened stress was compelling risk-averse investors to reduce exposure, while at the same time forcing the derivative players and Credit insurers to sell/short securities to hedge their ballooning exposures. Moreover, sinking global stock markets were exacerbating heightened stress in various “risk” markets in a self-feeding collapse of confidence that even impacted the previously “safe-haven” U.S. structured finance arena. In short, the U.S. Credit system was in the process of dislocating, with hedging and speculative selling overwhelming buyers throughout the Credit market. There was also the specter of corporate debt woes quickly migrating to the behemoth U.S. consumer sector, with the U.S. consumer Bubble at the precipice. The systemic risk “trade” was being pressed (by hedgers and speculators), and faltering Credit availability was becoming a critical issue for the U.S. economy.

The Credit system went to the edge and has since recoiled. The overwhelming selling afflicting the corporate bond market has receded, and perhaps a sustainable period of accumulation has commenced. For now, pressure has reversed, with those short corporate bonds, stocks, and on the wrong side of sinking Credit default swap prices feeling the heat. Market dynamics have swung to the other direction, and the pressure is now to unwind the systemic risk “trade” (by both dynamic hedgers and speculators). Consequently, liquidity has returned and corporations are again tapping the markets for debt and equity, in dynamics for now as self-reinforcing on the upside as they were for months on the downside.

But before we get too carried away, it is worth noting that we are expecting some strong cross-currents over the coming months. Corporations will likely enjoy greater access to finance in the near-term, while recent stock market gains will likely boost confidence. But at the same time, we should be mindful that the historic expansion in mortgage Credit is at a late stage. Indeed, the timing of the stock and bond market recovery could not have been more fortunate. And with 30-year mortgage rates likely back to near 6.25% next week, it is at this point safe to predict that the peak in mortgage refinancings has been passed. How quickly refis taper off is unknown. Ramifications of this development with respect to the housing markets and consumption are today important but open questions. We continue believe that the fact that auto and retail sales have of late stagnated in the face of a record refi boom offers ominous portents. Again, the stock and corporate bond market recoveries were quite fortunate.

The perception is growing that acutely stressed securities markets have now commenced a financial recovery similar to the post-LTCM and post-9/11 experiences. We’re skeptical. Keep in mind that the reliquefied and over-stimulated post-LTCM Credit system hit a U.S. economy poised to fire on all cylinders and a technology/stock market Bubble hankering to go into speculative blow-off. In other words, the expansive NASDAQ Bubble was teed up and the economy momentum-driven on the upside. The reliquefication and over-stimulated post-9/11 Credit system fed perfectly into a financial system and mortgage sector raring to go to unprecedented excess. The expansive mortgage finance Bubble was teed up and the leveraged speculators ready.

We are today at a loss to recognize a new Bubble lying in wait for the latest round of reliquefication. Certainly, there is nothing on the horizon of the dimensions necessary to mollify a receding historic mortgage finance Bubble. It is also our impression that the leveraged speculators are fully loaded. Sure, corporations will line up to borrow and American governments of all shapes and sizes will finance expanding deficits. And in the short-run – while mortgage borrowings remain enormous – combined Credit creation is sufficient to sustain the Great Credit Bubble. Money supply growth is certainly indicative of continued rampant monetary excess and over-liquefied conditions. But looking out past a few months, things are not so clear. Our hunch is that a negative surprise on the consumption side lurks: As goes the mortgage finance Bubble, so goes the consumer spending Bubble. And after years of over-consumption and mal-investment, the consumption/service-sector U.S. economy is addicted to household over-borrowing and over-consuming. The vulnerable U.S. economy may be “out of the woods” for now, but we fully expect unrelenting money and Credit excess to prove only more distorting to the fragile U.S. financial system and hopelessly maladjusted economy.

Whether it is mortgage refinancings, auto sales, retail sales, durable goods orders, business confidence, or GDP growth, we have been witnessing extraordinary economic volatility. The pundits would like us to believe that these unsettled conditions are only evidence of a sound although “uneven” recovery. We tend to see things differently. In our view, the economy has become hostage to an unstable securities and speculation-driven U.S. Credit system. When bullishness flows, easy Credit availability stokes spending and economic “output.” The relative degree of stimulation is determined by whatever is the hot sector (NASDAQ stocks and telecom debt, or agency and mortgage-backs, for example). But when bullishness ebbs and risk aversion holds sway, the Credit spigot can rather abruptly run dry for many sectors (but apparently never in mortgage finance). With the contemporary Credit system absolutely dominated by leveraged speculation, “structured finance,” and sophisticated hedging strategies, weakening Credit market conditions foster enormous securities selling and a self-reinforcing contraction of Credit availability for many companies and sectors. Faltering Credit conditions incite additional selling (“Delta-Hedging”), with declining bond and asset prices fostering a self-feeding mountain of short-positions. Liquidity then vanishes for most companies and many sectors.

But despite the gross debt overhang and acute financial fragility, market dynamics will necessitate intermittent reversals of these hedging programs. During these periods, the semblance of abundant liquidity will return almost as if by divine intervention. Surging stocks and the return of liquidity to the corporate bond market are reinforcing, especially in over-liquefied financial markets. And most will interpret market action as a confirmation of rapidly improving fundamentals, when in fact rising financial asset prices have almost everything to do with market dynamics. The performance chasing money managers and speculators will jump on board.

We see good reason today to make reference to The U.S. Delta-Hedged Economy. Speculative trading strategies have come to dominate the Credit system, thus assuring a destabilizing roller-coaster ride of speculation, sophisticated hedging-related securities trading, Credit availability, and attendant economic “output.” We have no idea how long this upward ride will last this go around, but we are confident that there is a steep and potentially breathless decline waiting on the other side. We have absolutely no doubt that maintaining Credit, speculative, and spending Bubble excesses are simply not going to rectify the problem. It’s a roller coaster from here on out. Let’s not forget that it takes enormous amounts of unrelenting Credit creation and leveraged speculation to sustain the Great Credit Bubble. And we certainly don’t expect rampant excess to all of the sudden turn stabilizing. In fact, we are expecting a rather wild ride from here on out as a confluence of unprecedented monetary and speculative excess - along with an unstable Bubble-impaired economy - creates an especially unpredictable and volatile mix. Going forward will require that we study the intricacies of the maladjusted U.S. economy very carefully.

11/22/2002 Death to the 'Bubble Poppers' *

This is one incredible financial and emotional roller-coaster, with good and bad days, weeks, months and quarters. We are, however, afforded an extraordinary opportunity to truly live financial history on a daily basis. For the week, the Dow enjoyed its seventh consecutive gain, adding 3%. The S&P500 gained 2%, with the Utilities and Morgan Stanley Cyclical indices up 3%. The Morgan Stanley Consumer index added 1%, while the Transports declined 1%. The strong rally in the broader market continued, with the small cap Russell 2000 gaining 4% and the S&P400 Mid-Cap index adding 3%. The technology rally turned into a buyers’ panic, as the NASDAQ 100 jumped 5%, the Morgan Stanley High tech index 7%, and the Semiconductors 13%. The Street.com Internet index and the NASDAQ Telecommunications indices gained 7% and 4%. The tech sector is putting together a rather respectable showing, with the NASDAQ100, Morgan Stanley High Tech, Semiconductors, and The Street.com Internet indices sporting quarter-to-date gains of 34%, 40%, 52%, and 46%. For the week, the Biotechs were up 7%, the Securities Broker/Dealer 6%, and the Banks 4%. Although bullion ended the week unchanged, the HUI Gold index dropped 5%.

The Treasury market was none to pleased by it all. For the week, two-year Treasury yields jumped 19 basis points to 2.06%, and five-year yields jumped 22 basis points to 3.24%. The 10-year Treasury note saw its yields rise 15 basis points to 4.18%, while the long-bond yield added 11 basis points to 5.02%. Benchmark mortgage-back yields increased 11 basis points, and the implied yield on agency futures jumped 12 basis points. The spread on Fannie Mae 5 3/8% 2011 notes narrowed two to 48, while the benchmark 10-year dollar swap spread narrowed one to 48. December three-month Eurodollar rates added 1.5 to 1.425%. With stocks sprinting, the dollar jogged cautiously to a 1% gain for the week. Corporate spreads generally narrowed significantly this week. Whether stocks (especially companies with fundamental issues/short positions), corporate bonds, or Credit default swaps, the timely news of a buyer for Household International has proved a catalyst for a major reversal of “risk” bets and hedges. Or, stated differently, it’s been one heck of a squeeze for anyone short stocks, corporate bonds or Credit protection. Markets will be markets, and we are today dealing with truly extraordinary financial market dynamics.

Broad money supply (M3) jumped $41 billion last week to $8.4 Trillion, with five-week gains of $111.2 billion. Over the past 30 weeks, broad money supply has jumped $369 billion, or at an 8% annualized rate. Led by surging Savings Deposits (y-t-d growth rate of 22.1%), M2 has expanded at a 10.5% rate over 30 weeks. Since the beginning of 1997, broad money has ballooned $3.4 Trillion, or 68%. For the latest week of monetary inflation, Savings Deposits increased $24.5 billion, while checkable deposits declined $9.3 billion. Large Time Deposits declined $14.4 billion, while Small Time Deposits added $1.7 billion. Institutional Money Fund deposits jumped $24.5 billion and Retail Money Fund Deposits were about unchanged. Repurchase Agreements gained $11.8 billion (up $25.9 billion in three weeks), and Eurodollars were up $2.4 billion. Commercial paper borrowings increased $4.6 billion last week ($17 billion in two weeks), with financial sector issuance up $6.4 billion ($19.5 billion in two weeks). Bank Credit jumped $38.9 billion, with “other” securities holdings up $27.4 billion. Total Bank Securities Holdings have surged $107.7 billion over four weeks to $1.72 Trillion, with year-to-date growth of $238 billion (18% annualized). Loans and Leases increased $17 billion, with Real Estate Loans up $14.5 billion. Commercial and Industrial Loans declined $1.7 billion. Total Bank Assets jumped another $65.1 billion to $6.98 Trillion. Total Bank Assets are up $164.8 billion over five weeks and $592.1 billion over the past 30 weeks, or 16% annualized.

Weekly bankruptcy filings declined to 30,181; although they remain 16% above the year ago level. Housing starts dropped 11% to the lowest point in six months, although new permits were strong. The Mortgage Bankers Association’s Refi Application index jumped 27.9% (up 23.5% y-o-y) to the fourth highest level on record. The Purchase Application index rebounded 3.5% from the previous week’s nearly 10% decline and remains almost 17% above the year ago level. The annualized growth of Freddie Mac’ total “book of business” slowed to 5.9% during October (to $1.27 Trillion), with its retained mortgage portfolio expanding at a 12.9% rate (to $536 billion).

Fiscal year 2003 is off to a discouraging start with respect to federal government finances. October’s fiscal deficit of $54 billion - a record for the first month of a fiscal year – compares to the year ago deficit of $7.6 billion. Government spending was up 8.6% (defense spending up 15%), while revenues were down 20%. The timing of corporate tax payments apparently explains part of the revenue shortfall, but it is worth noting that individual tax receipts were down 13% y-o-y.

This week from the Bond Market Association: “Domestic bond issuance totaled $3.8 Trillion in the first three quarters of 2002, a 19.6% increase over the $3.2 Trillion issued in the same period of 2001, itself a record year. Gains were seen across all sectors, with the exception of the corporate market, where issuance decreased 26% when compared to the first nine months of 2001… Treasury gross coupon issuance totaled $424.6 billion in the first three quarters of 2002, up from the $238.6 billion issued during the same period last year… Daily trading volume by primary dealers averaged $361.4 billion during the first three quarters of 2002, up 26.4%...from the same period of 2001… Long-term debt issuance by federal agencies totaled $740.0 billion for the first three quarters…up 12% (from last year’s same period)…

“Continuing what will be a record year for municipal bond issuance, state and local bond sales totaled $302.5 billion in the first three quarters of 2002, topping the previous record of $264.3 billion set in the same period of 1993. Municipal issuance increased 26.5% (from last year’s same period)… The surge in issuance resulted from the need to meet ongoing infrastructure requirements and finance new projects. In addition, state and local governments are using the proceeds to fill budget gaps resulting from lowered tax receipts brought about by slow economic growth.” Average daily muni trading volume jumped 31% to $10.6 billion. Total corporate issuance dropped 26% to $491.1 billion, with investment grade issuance down 20.6% (to $430B) and junk issuance down 39.7% (to $43.4B). Corporate trading volume was down 14.3%.

“Issuance in the asset-backed securities (ABS) market is on pace to break the record set in 2001. New issue activity totaled $357.9 billion in the first three quarters of the year, up 11.9% (from last year’s same period)… Among the major sectors, home equity loans experienced the largest increase…with volume totaling $115.9 billion during the first three quarters, up 32.5% (from last year’s same period)… Total issuance in the auto loan sector increased 20.2% to $71.6 billion… Issuance in the credit card sector decreased 19% to $52.8 billion… Mortgage-related securities issuance, which includes agency and private-label pass-throughs and CMOs, is on pace to break the record of $1.67 Trillion set in 2001. Issuance totaled $1.54 Trillion in the first three quarters of the year, up 39.4% from the $1.1 Trillion issued (y-o-y)…On a quarterly basis, new issuance volume totaled $532.1 billion in the third quarter… Daily trading volume in agency mortgage-backed securities by primary dealers averaged $145.4 billion in the first three quarters of 2002, up 39.5%... The average volume of total outstanding repurchase (repo) and reverse repo agreement contracts totaled $3.64 Trillion for the first three quarters of 2002, an increase of 20.6% over the average volume of $3.02 Trillion during the same period of 2001. Outstanding repo agreements averaged $2.10 Trillion through September of 2002, an increase of 21.0%...” Outstanding repurchase agreements are up 81% since the end of 1997 and 46% since the end of 2000, claiming title to the “epicenter” of the Great Credit Bubble.

From the Consumer Federation of America (CFA): ‘Nearly one-third of adult Americans are very concerned about making debt payments, and that percentage is up significantly from last year,’ said Stephen Brobeck, CFA executive director. From last year to this one, consumer concern about ‘meeting your monthly payments on all types of debt other than your mortgage’ rose from 39% to 46%. And those ‘very concerned’ about making these debt payments rose even more sharply, from 19% to 30%...” At the same time, “Nearly three-quarters (73%) of those with incomes over $50,000 say they plan to use credit cards for holiday purchases, and 37% say they intend to use plastic for most holiday purchases.”

November 21 American Banker: “In markets where demand is outstripping the supply of homes for sale, and where soaring land prices are pushing up builders’ costs, there’s just no reason to worry about a so-called bubble.” The president of the National Association of Home Builders (I guess that’s one way to look at it)

November 20 – PRNewswire: “‘Overall, (California) luxury home values remained stable throughout California in the third quarter, but there are signs of softening,’ said Katherine August-deWilde, Chief Operating Officer of First Republic Bank. ‘Inventory is rising, days on the market are lengthening, and multiple offers are infrequent. Given the softness of the economy and uncertainty about world events, we remain cautious about values as we look ahead.’”

November 18 - The Indianapolis Star (Shannon Tan): “Weeds snarl the yard of the house at 814 E. 24th St., and yellowed newspapers lie abandoned on the front porch. Inside, electrical wires poke through the torn blue carpet and shattered fixtures crowd the bathroom. Purchased for $16,000 in April, the home just north of downtown Indianapolis sold a month later, unimproved, for $323,000. The mortgage brokers who created the fake appraisal for that sale have been charged with fraud, while the two-story house sits empty - one of 500 properties ‘sold’ in Indianapolis for greatly inflated prices in recent years... Bad as the problem is in Indiana, it is worse in other parts of the country. Reports of appraisal fraud nationwide tripled in the past six years, according to the Mortgage Asset Research Institute… The fraud most commonly involves a team of professionals faking paperwork to cheat a lender… Such fraud would seem difficult, since people - and banks - rely on expert professionals to oversee the purchase of a home. But if all those pros are working together to defraud a buyer or lender, it can be hard to tell.”

November 18 – Bloomberg: Comments from David Coles, a managing director at restructuring firm Alvarez & Marsal, appointed chief executive at National Century Financial Enterprises Inc.: “It’s all very unfortunate. We had, inadvertently, become the sole source of financing for many of the providers. We were supposed to be a receivables financing operation, but we were lending against equipment, future receivables, pro forma receivables, and providing advances that weren’t secured. I imagine that some of the providers will have difficulty obtaining collateral financing quickly enough to avoid bankruptcy proceedings… The scale of the deficits are quite staggering, about $500 million to $700 million in NPF VI and $1.5 billion to $2 billion in NPF XII, which has been a shock to many people… An average of about $30 million a day was coming into NPF XII in mid October. That has dribbled to about a million.”

November 19 - Bloomberg: “ING Bank NV, which is part of the biggest Dutch financial-services company, has helped fund $500 million of debt for National Century Financial Inc., a health-care financing company… ING’s commitment is through an asset-backed commercial paper program that it administers, Dow Jones said, citing Jay Eisbruck, a managing director at Moody’s Investors service… Credit Suisse First Boston funded a similar program for $225 million, Dow Jones said. Under such programs, banks package a variety of debt products into an off-balance sheet securitization which funds itself by selling commercial bonds…”

There is now no doubt that National Century Financial was an outright fraud involved in misappropriating funds, self-dealing, and fraudulent accounting on a massive scale. Asset-backed securities that were top-rated until recently are destined to suffer heavy losses. Cash-flow into ABS “lockboxes” has slowed to a trickle. One health care official was quoted by USAToday: “Millions are missing. It’s a health care Enron. Health care providers from sea to shining sea are involved in this thing.” But unlike Enron, there were no opaque off-shore vehicles, arcane derivative trading, sophisticated financial engineering or complex accounting. And that’s what troubles us the most. Two JPMorgan Chase bankers were on National Century’s board (one ran the audit committee!) and Morgan was trustee on one of the company’s main funding vehicles. Bank One was trustee on the other. CSFirstBoston was National Century’s investment banker and Moody’s was there to confer its top-rating to NCFE’s asset-backed securities. Deloitte Touche had been certifying the company’s accounting statements. Like Enron and too many other situations, we are troubled that our major financial institutions are all too comfortably partners in “business” with crooks – rather conspicuous ones at that.

And somehow the Greenspan “Teflon” Fed’s perpetual ultra-easy money policies and Bubble accommodations are not held responsible for what will surely be unending revelations of widespread financial shenanigans (just wait until fraudulent activity surfaces in the mortgage area). Yet, history tells us in no uncertain terms that an environment of rampant uncontrolled money and credit growth (with consequent Bubbling asset markets) promotes fraud and mismanagement. It is then no coincidence that the current era with the most lax and acquiescent to Wall Street Federal Reserve since the Roaring Twenties is also the period with the most pervasive financial corruption since the 1920s. Has the public interest been served by the Federal Reserve ceding control over the nation’s financial system to the leading Wall Street firms and their coterie of accomplices? Who is minding the bustling ABS and MBS store?

November 21 - Federal Reserve governor Ben S. Bernanke: “I think it is extraordinarily dangerous for the Fed to make itself the arbiter of security values. And I think, moreover, that if the Fed tries to, quote, “Pop Bubbles” it’s likely that it creates disasters. The example I gave in my speech (Asset-Price “Bubbles” and Monetary Policy, October 15, 2002) was the 1929 (experience). The Fed during that period was concerned about a bubble in the stock market. And it raised interest rates so much that it not only killed the stock market, it also killed the rest of the economy. I think in general that the right way to address an asset price bubble is not with monetary policy but rather by structuring your financial markets in a way to make them as safe and sound as possible. For example, by having good regulations and provisions on your banks – making sure they are not lending against dubious collateral; by increasing transparency in accounting and other forms of revealing information about firms and about shares. History shows, and theory I think supports the view, that attempting to manipulate asset prices with monetary policy is really a loosing game.”

Truly dangerous is what passes for sound monetary thinking these days. Dr. Bernanke, a career academic economist, has given two major speeches since he was appointed Federal Reserve governor in July. From what I have read thus far, he approaches the closest yet to the incarnate of the accomplished monetary theorist and great inflationist John Law. And as Law learned the hard way, “attempting to manipulate asset prices with monetary policy is really a loosing game.”

From his speech yesterday – “Deflation: Making Sure ‘It’ Doesn’t Happen Here:” “As I have already emphasized, deflation is generally the result of low and falling aggregate demand. The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending, in a manner as nearly consistent as possible with full utilization of economic resources and low and stable inflation. In other words, the best way to get out of trouble is not to get into it in the first place.”

“As I have mentioned, some observers have concluded that when the central bank’s policy rate falls to zero - its practical minimum - monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero…”

“The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.”

“What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation… If we do fall into deflation…we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”

We appreciate that Dr. Bernanke speaks his mind, and he certainly leaves little room for doubt as to where he stands. And I will salute him for diving headfirst into the critical economic issues of our time. We live in a democracy and these things need to be discussed and debated. But he is both a blatant historical revisionist and wolf in sheep’s clothing inflationist - what he professes is generally both reasonable and seductive, therefore potentially quite harmful. We won’t let this get out, but I guess we should be rather thankful that such an individual exists. He embodies, in a single contemporary economist, a rather inclusive package of the flawed analyses we are most eager to argue against: the antithesis to sound money and prudent central banking. Although it is one more disturbing sign of the times that he is one of our newest Federal Reserve governors. From what I have seen thus far, Dr. Bernanke is well on his way to creating a place for himself in economic history.

From his October speech: “New eras bring new challenges… As you know, the Fed has two broad sets of responsibilities. First, the Fed has a mandate from the Congress to promote a healthy economy - specifically, maximum sustainable employment, stable prices, and moderate long-term interest rates. Second, since its founding the Fed has been entrusted with the responsibility of helping to ensure the stability of the financial system… Policy tightening might therefore be called for - but to contain the incipient inflation not to arrest the stock-market boom per se…

“Let me discuss the two parts of this recommendation in a bit more detail. The first part of the prescription implies that the Fed should use monetary policy to target the economy, not the asset markets. As I will argue today, I think for the Fed to be an ‘arbiter of security speculation or values’ is neither desirable nor feasible…”

“The second part of my prescription is for the Fed to use its regulatory, supervisory, and lender-of-last-resort powers to protect and defend the financial system. In particular, alone and in concert with other agencies, the Fed should ensure that financial institutions and markets are well prepared for the contingency of a large shock to asset prices. The Fed and other regulators should insist that banks be well capitalized and well diversified and that they stress-test their portfolios against a wide range of scenarios… If necessary, the Fed should provide ample liquidity until the immediate crisis has passed. The Fed’s response to the 1987 stock market break is a good example of what I have in mind.”

“Taken together, (these two principles) provide a strategy for policy that has a number of advantages: It keeps monetary policy focused on the appropriate goal variables, economic activity and inflation. It is transparent and easy to communicate to the public. It does not require that central bankers be systematically better than the market at valuing financial assets nor substitute policymakers’ judgments of company prospects for those of investors. Finally, and crucially, it is a robust strategy, in that - although it certainly does not eliminate all economic and financial instability - it protects the economy against truly disastrous outcomes, which history has shown are possible when monetary policy goes severely off the track. ”

While most of what he asserts is reasonable, we take strong exception to the most critical aspect of Dr. Bernanke’s analysis: Categorically, his prescription for contemporary central banking to ignore asset-prices Bubbles, while being quick to both inject liquidity into faltering markets and stimulate a weakening economy, is precisely the course where “monetary policy goes severely off the track” and fosters “truly disastrous outcomes.” A monetary regime of uncontrolled fiat money and Credit requires strict central bank regulation of lending and speculative excess. Nurture Credit market speculation and you have a problem; resort to sheltering and, worse, inciting leveraged speculation for policy purposes (stimulating the financial markets and economy) and you court disaster. I would argue that the Fed’s conduct of ignoring gross Credit excess, rampant speculation, and Bubbles generally, while guaranteeing the aggressive financial players liquidity support in the event of systemic stress - and artificially stimulating spending to circumvent the business cycle - is PRECISELY the prescription for eventual disastrous financial and economic collapse. The “How To” for depression…

Dr. Bernanke acknowledges that “a number of critics have argued that monetary policy should be more proactive in trying to correct incipient ‘imbalances’ in asset markets.” “This debate is clarified considerably, in my view, by recognition that, in practice, the advocates of a more vigorous monetary policy response to asset prices fall into two broad camps, differing primarily in how aggressive they think the Fed ought to be in attacking putative bubbles. The first group, who favor what I will call the lean-against-the-bubble strategy, agree that the Fed should take account of and respond to the implications of asset-price changes for its macro goal variables… the Fed should try to gently steer asset prices away from the presumed bubble path… My sense is that this more moderate camp comprises the great majority of serious researchers who have advocated a monetary-policy response to bubbles...”

Well, at this point we would have zero faith in the effectiveness of “leaning against” the Bubble. There’s simply no painless short-cut to sound finance. “The second group of critics is those preferring a more activist approach, which I will call here aggressive bubble popping. Aggressive bubble-poppers would like to see the Fed raise interest rates vigorously and proactively to eliminate potential bubbles in asset prices. To be frank, this recommendation concerns me greatly, and I hope to persuade you that it is antithetical to time-tested principles and sound practices of central banking.”

Where did they find this guy – the consummate antithesis to sound money? I hope to persuade you that Dr. Bernanke’s views are “antithetical to time-tested principles and sound practices of central banking.”

Dr. Bernanke : “Aspiring bubble poppers cannot get around the fact that their strategy requires identifying bubbles as they occur, preferably quite early on. Identifying a bubble in progress is intrinsically difficult… If we nevertheless persist in trying to measure bubbles, what indicators might be useful? Several have been suggested, including the rate of appreciation of asset prices, various ratios that attempt to measure the return on stocks, and growth in bank credit. None of these provides a reliable indicator of a developing bubble.”

Well, it is always our belief that economists make this much more difficult than it need be. Why can’t we look at total Credit growth, both non-financial and financial, to better appreciate the quantity of new purchasing power created? The focus must be broadly on the creation of financial sector liabilities (money and Credit creation), identifying the institutions, entities, securities, instruments, mechanisms and sectors responsible for the new financial claims (Credit/purchasing power). At the same time, analysis should attempt to identify the sector(s) most-likely to be at risk from the associated inflationary distortions (such as extraordinary GSE Credit creation and attendant inflationary manifestations in rising home prices, over-consumption and trade deficits). Greenspan spoke of incipient stock and bond market Bubbles behind closed Fed doors back in 1994, with the fledgling financial Bubble conspicuous with regard to the 1993 bond issuance boom and proliferation of leveraged speculation. The expansive Credit Bubble has become only more obvious in the data by the year. Without a doubt, the analytical focus must be on the Credit system and NOT stock prices. Arguing appropriate P/E ratios is like debating religion, politics or abortion.

Interestingly, Dr. Bernanke meanders closely to the heart of the issue: “Another possible indicator of bubbles cited by some authors is the rapid growth of credit, particularly bank credit (Borio and Lowe, 2002). Some of the observed correlation may reflect simply the tendency of both credit and asset prices to rise during economic booms. However, to the extent that credit expansion is indicative of bubbles, I think that empirical linkage points to a better policy approach than attempts at bubble-popping by the central bank. During recent decades, unsustainable increases in asset prices have been associated on a number of occasions with botched financial liberalization, in both emerging-market and industrialized countries. The typical pattern is that lending institutions are given substantially expanded powers that are not matched by a commensurate increase in regulatory supervision - think of the savings and loans in the United States in the 1980s. A situation develops in which institutions can directly or indirectly take speculative positions using funds protected by the deposit insurance safety net--the classic ‘heads I win, tails you lose’ situation.

“When this moral hazard is present, credit flows rapidly into inelastically supplied assets, such as real estate. Rapid appreciation is the result, until the inevitable albeit belated regulatory crackdown stops the flow of credit and leads to an asset-price crash. Bubbles of this type may be identifiable to some extent after they have begun, but the right policy is to do the financial deregulation correctly - that is, in a way that does not allow speculative misuse of the safety net - in the first place. Or failing that, to intervene and fix the problem when it is recognized. ”

The real story of the Great Credit Bubble is the explosion of non-bank Credit creation by quasi-governmental organizations. With “Big Three GSE” exposure at an unimaginable $3.8 Trillion (Fannie and Freddie’s “book of business” plus FHLB assets), are we not seeing an S&L-type “moral hazard” play out in historical proportions throughout mortgage finance? So where’s the “regulatory crackdown?” And now that this Bubble is completely out of control, how will it be possible “to intervene and fix the problem?” Who is willing to take responsibility? The answer is no one.

From Dr. Bernanke: “Although neither I nor anyone else knows for sure, my suspicion is that bubbles can normally be arrested only by an increase in interest rates sharp enough to materially slow the whole economy. In short, we cannot practice ‘safe popping,’ at least not with the blunt tool of monetary policy… A truly vigorous attempt by a central bank to rein in a supposed speculative bubble may well succeed but only at the risk of throttling a legitimate economic boom or, worse, throwing the whole economy into depression.”

Again, this is dangerous analysis – it implies absolute disregard for asset inflation and asset Bubbles; that is, until they eventually begin to collapse on their own accord (NASDAQ). The goal of sound monetary management must to promote financial stability and nip incipient Credit, speculative, and Bubble excess in the bud. A healthy economy and financial system can handily weather small, correctable central bank errors. Errors on the side of caution are easily reversed. Errors on the side of accommodating financial excess, as we have witnessed, do not reverse but compound seductively and exponentially. Somehow contemporary thinking at the Fed and in academia have the costs of potential small central bank errors of caution as unacceptably high, and the costs of stimulating and inflating non-existent. Apparently, with China now an endless source of cheap goods, the absence of CPI risk affords the opportunity to inflate money and credit “till the cows come home.” This is very warped, although certainly expedient, “analysis.”

What we must avoid at all cost – because it risks financial derangement, severe economic maladjustment, systemic collapse and depression – is the major mistake of not dealing forcefully with Credit and speculative excess to the point of unleashing uncontrollable and precarious financial and economic Bubbles. And it must also be recognized that the longer Credit excess compounds upon Credit excess, the tinier the Fed’s “little” balance sheet becomes next to the soaring Mount Everest of financial claims. Last week’s total Federal Reserve Assets of $685 billion compare to total outstanding Credit market debt surpassing $34 Trillion. When that fateful day arrives, the antiquated and feeble helicopter will need replaced with a large fleet of super-jumbo cargo airships. All the same, if I were a Fed governor I’d be more careful throwing around the “always” word, as in the power of the Fed to “always be able to generate increased nominal spending and inflation.”

The more easy money encourages households to take on the debt necessary to buy a new car (artificially distorting demand) and upgrade to a larger home (or acquire stocks or munis, for that matter), the less likely they will be cajoled into a repeat performance any time soon (government electronic “printing press” notwithstanding). And finally, it is today worth pondering an issue that continues to stoke gale force economic headwinds throughout Japan. Post-Credit and assets Bubbles, risk-averse households are nonetheless holding enormous and growing quantities of government debt and other financial claims. With all this perceived financial wealth, why would we not expect Japanese consumers to play it safe – temper spending and focus on reducing borrowings? The only way many are not ok is to take on risk. At times people just feel better about grabbing the money dropping from the helicopters and stuffing it securely inside the mattress for a rainy day.

After promulgating dubious prescriptions for contemporary monetary management, Dr. Bernanke then commits a most atrocious act of historical revisionism by blaming the Great Depression on the “Bubble Poppers.” I kid you not.

From Dr. Bernanke: “The U.S. experience of the 1920s illustrates many of the points I have been making. As you know, the ‘Roaring Twenties’ was a prosperous decade, characterized by extensive innovation in technology and in business practices, rapid growth, American economic dominance, and general high spirits. Stock prices rose accordingly. As early as the mid-1920s, however, various policymakers and commentators expressed concern about the rapidly rising stock market and sought so-called corrective action by the Federal Reserve. The corrective action was not forthcoming, however. According to some authors, this was in large part because of the influence of Benjamin Strong, long-time Governor of the Federal Reserve Bank of New York and America’s pre-eminent central banker of that era. Strong resisted attempts to aim monetary policy at the stock market, arguing that raising interest rates sufficiently to slow the market would have highly adverse effects on the rest of the economy. ‘Some of our critics damn us vigorously and constantly for not tackling stock speculations,’ Strong wrote about the debate. ‘I am wondering what will be the consequences of such a policy if it is undertaken and who will assume responsibility for it.’ However, Strong died from tuberculosis early in 1928, and the Fed passed into the control of a coterie of aggressive bubble-poppers…”

“The correct interpretation of the 1920s, then, is not the popular one - that the stock market got overvalued, crashed, and caused a Great Depression. The true story is that monetary policy tried overzealously to stop the rise in stock prices. But the main effect of the tight monetary policy, as Benjamin Strong had predicted, was to slow the economy -both domestically and, through the workings of the gold standard, abroad… This interpretation of the events of the late 1920s is shared by the most knowledgeable students of the period, including Keynes, Friedman and Schwartz, and other leading scholars of both the Depression era and today… monetary policy had already turned exceptionally tight by late 1927… A small compensation for the enormous tragedy of the Great Depression is that we learned some valuable lessons about central banking. It would be a shame if those lessons were to be forgotten.”

This is stunning, misguided commentary. The harsh reality is that we learned absolutely the wrong lessons from the Great Depression, and I would suggest Dr. Bernanke and others go to the Mises.org website and order the recent compilation of Murray Rothbard’s writings, The History of Money and Banking in the US. It is wonderfully written, brilliant and exceedingly pertinent history (although the long introduction misses this critical point!). Diligent true students of this seminal period (and money and Credit generally) will have a very difficult time refuting Rothbard’s cogent and comprehensive analysis that the Depression was the consequence of years of inflationary policies, monetary mismanagement, and the Fed’s accommodation of rampant financial excess on Wall Street. It was a long road to unsound money, a dysfunctional Credit system, and perilous financial and economic Bubbles. “Exceptionally Tight” money no more caused the crash in 1929 than it did the bursting of the NASDAQ Bubble in 2000. Instead, there was a dilemma distressingly similar to today’s, with Bubbles only sustained by looser money and greater Credit and speculative excess. It is only a matter of when, at what cost, and under what circumstance Bubbles meet their inevitable fate. The “printing press,” Dr. Bernanke, is the problem and not the solution.

Again using Dr. Bernanke’s own words (but from our antithetical analytical framework): “In other words, the best way to get out of trouble is not to get into it in the first place.” Precisely! And that is what Dr. Richebacher has been preaching for years. Paraphrasing the good doctor, “There is no cure for a Bubble other than not letting it begin in the first place.” If the Wall Street darling Benjamin Strong would have acted responsibly to safeguard sound money and financial stability – thus thwarting financial and economic excess in the mid-twenties as things began running completely out of control - it is likely that financial collapse and depression could have been avoided. And applying Dr. Henry Kaufman’s quote regarding the Greenspan era: “The Fed missed its timing.” Well, Benjamin Strong bet the farm and lost. Greenspan has lost the ranch, although the “house” apprehensively consents to his gambling on his neighbors’ homesteads. Blaming the Great Depression on those that were rightly fearful of escalating dangerous financial and economic imbalances – those dreadful “Bubble Poppers” – is such a gross distortion of the facts and an injustice to sound economic analysis. Long live the Bubble Poppers!

11/15/2002 Weak Links *

Market action was choppy, but the bulls sustained their rally. For the week, the Dow added less than 1%, while the S&P500 gained almost 2%. The Utilities, Morgan Stanley Cyclical and Morgan Stanley Consumer indices all added about 1%, while the Transports declined 1%. The broader market was strong, with the small cap Russell 2000 and the S&P400 Mid-cap indices up 2%. The technology rally resumed, with the NASDAQ100 gaining 5% and the Morgan Stanley High Tech index increasing 4%. The Semiconductors jumped 7%, The Street.com Internet index 5%, and the NASDAQ Telecommunications index 6%. The Biotechs were up about 1%. The financial sector also caught fire, with the Securities Broker/Dealer index up 6% and the Banks up 3%. Gold was volatile but resilient, as bullion dropped about 80 cents for the week. The HUI Gold index added less than 1%.

The Credit market remains extraordinarily unsettled. Ten-year Treasury yields surged an unusual 22 basis points yesterday, after collapsing 18 basis points last Thursday. The mortgage and interest rate derivative players have their work cut out, and perhaps they are now feeling the Fed may have a few inflationary tricks up their sleeve. For the week, 10-year Treasury yields jumped 20 basis points to 4.02%. Two-year Treasury yields increased 3 basis points to 1.87%, while the five-year yield jumped 16 basis points to 3.02%. The long-bond saw its yield rise 12 basis points to 4.91%. Benchmark Fannie mortgage-back yields jumped 16 basis points, while the implied yield on agency futures rose 17 basis points. The spread to Treasuries for Fannie’s 5 3/8 2011 note widened 3 to 48, while the 10-year dollar swap spread increased 1.5 to 49. The three-month December Eurodollar saw its yield rise 3.5 basis points to 1.41%. The news of troubled Household International’s acquisition by a strong foreign banking institution provided needed good news for the vulnerable corporate bond, Credit default swap, and asset-backed securities marketplaces.

This week from Larry Kudlow: “The Fed lowered the target interest rate to 1.25% this week, which was fine in itself. But the action was made sweeter by the announcement that accompanied it: The Federal Reserve ‘continues to believe that an accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity.’ The crucial reference to productivity suggests that the old Alan Greenspan is back. In the late 1990s, the Fed chairman consistently – and correctly – argued that rapid productivity gains were increasing the economy’s potential to grow. Therefore, the Fed could afford to be more generous with the cash without being concerned about inflation… Why Greenspan departed from this script in 2000 is one of the great mysteries of monetary history. For about 18 months, into the middle of 2001, the estimable Fed chairman worried that too-high stock prices and too-strong growth were reviving inflation. So, rather than keeping the economy’s money-pump primed, he deflated the money supply, all while ignoring clear recessionary signals… And over at the Federal Reserve, the recent decision to link productivity with monetary policy strongly suggests that Dallas Fed president Robert McTeer is being groomed to succeed Greenspan…” What? And you’ve got to be kidding…

November 11 Bloomberg: “Asia-Pacific-based insurers face an increased threat of collapse next year amid tumbling equity markets and lower fee income, Standard and Poor’s Rating Services said. ‘The sector is challenging, unsettled and rife with competition,’ Ian Thompson, head of Standard & Poor's Asia-Pacific Ratings Group, said in an e-mailed statement. At the bottom end of the rating scale, we are seeing a number of players fighting to survive.’”

November 14 – Bloomberg: “National Century Financial Enterprises Inc., which faces lawsuits over mismanagement of cash reserves, sold $725 million of bonds to two money-market investment programs, said a managing director at Moody’s… The bonds, whose credit ratings were cut to junk status three weeks ago, were pooled with other securities to create so-called asset-backed commercial paper. Investors in asset-backed debt are repaid by dedicated revenue streams such as payments on credit cards, loans and customer bills. One program holds $500 million of National Century’s debt, said Sam Pilcer, a managing director in charge of commercial paper ratings for Moody’s… The program is guaranteed by a ‘highly-rated bank’ so investors won’t suffer losses on the commercial paper, Pilcer said. He declined to name the programs and the bank. The other commercial paper program sold $225 million of National Century’s debt two weeks ago.”

November 13 – Bloomberg: “National Century Financial Enterprises Inc., which is facing lawsuits over mismanagement of cash reserves, sold almost $50 million of bonds to three money-market investment programs, analysts at Fitch Ratings said. The bonds were then pooled with other securities to create so-called asset-backed commercial paper… ‘There’s $40 million of exposure in one program and less than $10 million in the other two,’ said Deborah Seife, who rates asset-backed commercial paper at Fitch. She declined to name the affected programs. Many unrated or low-rated companies find the asset-backed market an easier place to raise money by promising lenders revenue from bills due from customers as collateral. There is about $710 billion of asset-backed commercial paper outstanding, representing about 52 percent of the total market… In the asset-backed commercial-paper program that holds $40 million of National Century debt, a swap counterparty rated F1+ covers any losses on the underlying assets, Seife said.”

November 14 – Dow Jones: “Janus Capital Management LLC, the mutual-fund company owned by Stilwell Financial Inc. (SV), purchased $85 million of investment-grade commercial paper from its Institutional Janus Money Market Fund, according to a regulatory filing Thursday. Janus made the purchase Oct. 31 because the credit rating of the commercial paper was downgraded below the level that Janus management believed was prudent for the fund to own the investment, Stilwell said in its third-quarter report filed with the Securities and Exchange Commission. Janus funded the transaction with $41 million from its credit line and a $44 million short-term borrowing arrangement, the filing said.”

Yesterday from the Bureau of Economic Analysis: “The 2001 economic slowdown was mild by historical standards because of strong growth in real GDP for private services-
producing industries that helped to offset sharp declines in real GDP for private goods-producing industries, according to a report released by the Bureau of Economic Analysis (BEA) of the U.S. Department of Commerce. In 2001, real GDP for private services-producing industries increased 1.7 percent, while private goods-producing industries dropped 4.2 percent, primarily reflecting a 6.0-percent drop in manufacturing. Real GDP grew 0.3 percent in 2001, though growth rates varied widely among industries. Growth was led by such large private services-producing industries as communications (12.3 percent); retail trade (4.6 percent); finance, insurance, and real estate (FIRE) (2.8 percent); and services (0.9 percent). Declines, particularly in the manufacturing industries, were steep. Durable-goods manufacturing decreased 5.2 percent, and nondurable-goods manufacturing decreased 7.1 percent.” It is today helpful to think in terms of the “quality of GDP” similar to the important issue of the “quality of earnings.” Furthermore, as analysts, whether it is a company or economy, we focus first on the balance sheet (and contingent liabilities) then to the “earnings” statement. The poor quality of corporate “earnings” is playing a key role in the ongoing corporate debt collapse, as the deficient quality of GDP “growth” will going forward for non-corporate debt.

November 14 – Bloomberg: “New Jersey plans to remove the head of its pension management division after state funds lost more than $6 billion last quarter and $20 billion over the last three years, people familiar with the matter said. The top manager in the Division of Investment…would cease overseeing $56 billion in pension funds and move to a new government job until he takes early retirement on June 30, the people said. Lawyers were negotiating an agreement, which would be reached as early as today, the people said… ‘Many other state pension funds have had losses because they have similar investment strategies as New Jersey’s,’ said Parry Young, an author of a Standard & Poor’s analysis titled ‘Public Pension Funds Under Stress.’ Some states ‘are re-evaluating how they invest as well,’ Young said. New Jersey pension funds lost $20 billion, or 24 percent, during the past three years.”

November 13 – Salem, Oregon, Statesman Journal: “The stock market swoon has caused a $9.72 billion shortfall at the state pension system, much higher than earlier estimates, the system’s actuary reported Tuesday. Whittling away that funding gap will require Oregon governments to shell out nearly 40 percent more for employee pensions next year, barring other policy changes. The dismal news came from actuary Mark Johnson’s annual review of Public Employees Retirement System accounts (PERS)… Nearly all the increase in PERS’ shortfall can be traced to the stock market slide of 2000 and 2001, Johnson said. He stressed that Oregon’s plight is not unique. “Every pension system in the country is experiencing almost the same situation,” he said. But the rising employer costs and mushrooming shortfall don’t reflect the pummeling that stocks have taken so far in 2002. And the rate increases of nearly 40 percent don’t reflect some of the 2000 and 2001 market losses that PERS is deferring, via a process called ‘smoothing.’”

November 14 Bloomberg: “New York Mayor Michael Bloomberg said he would seek a 25 percent increase in the city’s property tax and reduce the workforce by 8,000 during the next 19 months to help close budget gaps.”

November 11 Associated Press: “Eighteen months ago, the city’s economic engine was chugging along so mightily that a record $3 billion surplus allowed City Hall to cut taxes, hire thousands of people and plan two new baseball stadiums costing $800 million each. Today, New York City is looking at its worst fiscal crisis since it went to the brink of bankruptcy in the 1970s. The city faces a projected $6 billion deficit next year, thousands of layoffs and big tax increases. The thought of new ballparks has become the most anachronistic of pipe dreams.”

November 14 Dow Jones (Stan Rosenberg): “At some point, sick people have to swallow bitter medicine. It’s no different in New York, where the city has been diagnosed with looming fiscal insufficiency... Fitch Ratings’ Vice Chairman Claire Cohen also felt that strong medicine was the right approach. ‘What they’re facing is big,’ Cohen said. ‘The easier measures and reserves have kind of been tapped out, and the income tax has collapsed,’ given the loss of capital gains from Wall Street, she said. Cohen also used the New York City situation to warn other cities and states facing budget difficulties that it’s time for them, too, to face up to the cure. Speaking of larger municipal governments, generally, and citing a $6 billion hole in Texas’ next budget biennium, as well as a New York State deficit that’s estimated anywhere between $5 billion and $10 billion, Cohen told Dow Jones Newswires: ‘Whether it’s New York City or the states that we rate, we’ll be watching the ‘04 budgets real closely. The time has come to start figuring out what to do because there’s nothing to indicate that revenues will come back in amounts sufficient to solve their problems.’”

November 14 – Associated Press (Alexa Bluth): “California faces a more than $20 billion budget deficit for the second straight year, according to projections released Thursday by Legislative Analyst Elizabeth Hill. Lawmakers will be forced over the next 19 months to fill in a $21.1 billion deficit - one quarter of the state’s total operating budget - and could face $12 to $16 billion deficits for at least six more years, said Hill, the Legislature’s nonpartisan economic adviser. ‘There is no easy way out of this predicament,’ Hill said. Gov. Gray Davis signed a $98.9 billion budget Sept. 5 - a record 67 days late - that used a combination of cuts, borrowing and increases to the state’s revenues, including the suspension of a tax break that allows businesses to write off losses, to fill a $23.6 billion gap. But many, including Hill, predicted continuing deficits and said that Davis and lawmakers have exhausted easier, one-time fiscal fixes such as tapping into future funds from a nationwide tobacco settlement. Now, slumping revenues, a plunge in exports and the dismal performance of the stock market have translated to a $6.1 billion deficit in the current year that will grow - if not addressed - to $21.1 billion in the new fiscal year that begins July 1… Plus, Davis’ current-year budget is out of balance partly because federal funds and savings built into the current spending plan never materialized.”

Broad money supply increased $5.2 billion last week. Demand Deposits declined $16.5 billion, while Savings Deposits jumped $21.7 billion. Retail Money Fund assets declined $3.1 billion. Institutional Money Fund assets increased $2.0 billion. Repurchase Agreements added $3.8 billion. In the commercial paper market, borrowings increased $12.4 billion last week, with financial sector CP borrowings up $13.1 billion. Bank Credit jumped another $47 billion last week, with Securities Holdings up $31 billion. Loans and Leases jumped $16 billion, with “other” real estate loans up $13.9 billion. Total bank assets are up about $83 billion over the past three weeks. And in another monetary development to monitor closely, the Investment Company Institute reported that money market fund assets surged $85 billion this week to $2.24 Trillion, with two-week gains of $129 billion.

Today, Fannie Mae reported a record $95.1 billion of “Total Business Volume” (mortgage purchases) for the month of October ($1.14 Trillion annualized pace!). Fannie’s Total Book of Business (mortgages held plus mortgage-backs outstanding in the marketplace) expanded at a 21% annualized rate during the month to $1.77 Trillion (up $206 billion, or 16%, y-t-d). Outstanding mortgage-back securities (MBS) expanded at a 39.6% rate during the month to surpass $1 Trillion. So far this year, Fannie’s outstanding MBS have increased $159 billion, or at a 22.7% rate (after increasing 21.5% during 2001). It has been a truly incredible MBS issuance boom, and we should not now be the least bit surprised by acute indigestion problems suffered in the Credit and derivatives markets.

We see that the Federal Home Loan Bank System (FHLB) expanded assets by $39 billion during the third-quarter to $761 billion, the largest growth since the $40 billion increase during the pre-Y2K fourth quarter of 1999. The FHLB’s record asset growth of $45.6 billion was set during the (infamous) fourth-quarter of 1998. Since the beginning of 1997 (23 quarters), FHLB assets have surged $469 billion, an increase of 161%. Total “Big Three GSE” (FHLB, Fannie, Freddie) assets jumped $88 billion during the third quarter, the largest increase since the third quarter of 1999. “Big Three” third-quarter annualized growth of 16% compares to the second quarter’s 6.6% and the first quarter’s 8.1%. Total “Big Three” assets have expanded an historic $1.46 Trillion over 23 quarters to $2.28 Trillion, an increase of 179%.

The FHLB’s just completed third-quarter annualized growth rate of 22% compares to 11%, 3%, and 3% for the preceding three quarters. For the three months ended September 30, “Advances” to member institutions expanded at a 17% annualized rate to $490 billion. “Fed Funds Sold” grew at a 48% rate to almost $54 billion, while total securities holdings increased at an 8% annualized rate to $132 billion. Mortgage loans held expanded at a 92% annualized growth rate to $47 billion, and Deposit assets at a 77% rate to $26.9 billion. So far this year, Mortgage loans have increased at a 94% rate, Securities 20%, Fed Funds sold 15%, and Deposits 52%.

On the liability side, we see that short-term FHLB “Discount Notes” are basically unchanged since year-end at $140 billion, while “Bonds” are up $46 billion to $528 billion. There is, however, a liability line item that gives us pause. We see that “Derivative Liability” almost doubled during the quarter to $17.3 billion (up from $7.8 billion at year end). This compares to the “Derivatives Asset” that has increased about $1.1 billion to $3.8 billion. The company’s explanation: “The $9.5 billion or 120.9 percent increase in derivative liabilities from December 31, 2001 to September 30, 2002, is the result of interest rate changes and the small growth in derivative volumes.” Well, that’s one heck of a ballooning liability – about one-half Total “Capital” of $36 billion – and a pretty feeble “explanation.”

Even Fannie Mae, with all the questions (some legitimate) regarding its hedging operations, ended the third quarter with a “Derivatives in Loss Position” liability of $7.8 billion. This was, however, offset by “Derivatives in Gain Position” asset of $3.1 billion. And while Fannie is forced to mark its derivative loss to market (calculate/estimate a gain or loss based on current market conditions), at least it enjoys unrealized gains on its $760 billion mortgage portfolio. Looking at the FHLB balance sheet, we are puzzled by the scope of interest rate hedging that would lead to a $17 billion liability (loss?). The vast majority of assets comprise “Advances” to member institutions and short-term Fed funds sold. On the liability side, we see the preponderance of long-term borrowings. We don’t get it…but they do admit to “intermediating” in derivatives for their member banks.

Yesterday Freddie Mac reported 30-year mortgage rates at a record low 5.94%. One-year adjustable rate mortgages were had a 4.09%. The Mortgage Bankers Association’s weekly index had purchase applications dropping about 10% to the lowest level since early April. Refi applications were down slightly, although remain quite elevated. Bankruptcy filings jumped to 33,525, an increase of 2,000 from last week and up 9% y-o-y. This was also only slightly below the 52-week high for filings.

November 14 – American Banker: “With demand for residential mortgage loans soaring, bankers are tightening underwriting standards, appraisals are becoming more conservative, and the expectation of ever-higher home prices is fading. According to the Federal Reserve Board’s periodic poll of senior loan officers, 10% tightened standards on residential mortgage loans in the past three months – the largest share of surveyed domestic banks in a decade. But twice as many told the Fed that they expect average home prices in their markets to decline over the next twelve months.”

The National Association of Realtors’ quarterly home price report was released yesterday. Nationally, the median home price of $161,800 was up 7.2% y-o-y. During the past year prices have inflated 10.7% in the Northeast ($166,200), 8.6% in the West ($214,800), 8.4% in the South ($151,600), and 5.1% in the Midwest ($140,700). By leading metropolitan area, Monmouth NJ was up 26%, Sacramento 24.6%, Providence 24.1%, Nassau/Suffolk NY 23.9%, San Diego 21.5%, New York/New Jersey/Connecticut 19.4%, Los Angeles 17.6%, Newark NJ 17.2%, and Washington DC 17%. Also posting double-digit y-o-y gains were the likes of Miami, Milwaukee, Baltimore, New Haven, San Bernardino, Ft. Lauderdale, Boston, Tucson, Honolulu, Philadelphia, San Francisco, Minneapolis, Madison, and Jacksonville.

From Chairman Greenspan’s November 13th testimony before the Joint Economic Committee, U.S. Congress:

Jim Saxton, chairman Joint Economic Committee: “Can you expand on the temporary nature, or as opposed to the permanent nature, of this downturn that we’re experiencing in the fourth quarter of the year?”

Chairman Alan Greenspan: “Mr. Chairman, as I point out in my written testimony, our best judgment is that we’re going through a soft patch. That is not something which is the precursor of far more significant weakening. The reason for it, as best we can judge, is a combination of the after effects and still marginally important issues of the decline in stock prices, but increasingly to the fallout from corporate governance malfeasance problems and, of course, more recently and perhaps most importantly, currently the geopolitical risks surrounding the negotiations with Iraq.

The economy as such is not evidently significantly out of balance. That is, we do not have excess inventories. We do not have, as best we can judge, a debilitating large overhang of capital stock from over-building of plant and equipment. We don’t have the usual internal weaknesses that presage an economy going down in a cumulative manner. But we do have is a very large degree of uncertainty, both as a consequence of corporate governance and as a consequence of geopolitical risks. And they are creating some significant hesitation mainly in the business sector, but presumably at least in part amongst consumers, as well.

Our judgment is when this uncertainty is lifted, when this risk premium essentially is restored to normal, as it will, that a number of the activities which are basically built in to the type of market economy that we have will take force and begin to increase the rate of growth. And while I, obviously, cannot speak for other forecasters around the country, you’re quite right that the general consensus is for a gradual pickup in the rate of growth next year. But that, I suspect, pretty much rests on the presumption that that overhang of uncertainty is lifted.”

Not surprisingly, chairman Greenspan does not address unfolding Credit market problems as THE critical issue for financial markets and the U.S and global economies. Mr. Greenspan and most economists retain great faith in the U.S. economy’s inherent growth bias. Repeatedly, he and others have trumpeted the economy’s “resilience,” and we have regularly rebutted that the leading forces at work were an abnormal monetary/service sector economy stoked by unhealthy and unsustainable Credit and speculative excess. It is the monetary regime of “contemporary finance” that has been amazingly resilient. We see only further evidence that this “regime” is unstable and increasingly vulnerable.

With our view of escalating Credit problems, we see little possibility for anything other than brief respites from the “uncertainty overhang.” With liquidity abundant, these respites will feed intermittent stock market rallies and an attendant boost in confidence (and spending). The true ongoing problem, however, is anything but investor psychology, and no amount of positive thinking will rectify gross structural impairment. As analysts, we think in terms of the created edifice of fragile debts structures and financial and economic Bubble distortions. Unlike Dr. Greenspan, we view the U.S. economy as grossly imbalanced. Looking through the eyes of a traditional business cycle economist, he sees little cyclical inventory overhang in the industrial sector. Yet, Greenspan remains blind to deep structural maladjustments in the New Age “Service Sector” economy. The acutely fragile financial system impaired by many years of gross speculative and Credit excess – and the residual irreparable damage done to the real economy – that will keep “risk premiums” extraordinarily high going forward. The problem is not “uncertainty,” but bad debt. The great system “overhang” is found in leveraged speculations.

Watching the unfolding financial and economic crisis develop for several years now, the manner of its eventual resolution is becoming somewhat more visible. The degree of leveraged speculation in the U.S. Credit system increased the possibility for a systemic (LTCM-style) unwinding/dislocation and liquidity crisis. The Fed and GSEs, however, mastered the art of maintaining over-liquefied markets, keeping the leveraged players keen to stay in what became basically the only game in town. What speculator would not want to stick around for the greatest central bank rate cuts in history with multiple “buyers of first and last resort”?

After watching the SE Asian dominos collapse in the 1996/97, we saw the possibility for The Weak Link being similar “hot money” speculative flight out of dollar financial assets. After viewing the mechanism of leveraged speculating community distress transferred to LTCM and the U.S. Credit market after the pummeling in Russia, he saw the possibility of post-U.S. stock market Bubble hedge fund losses being The Weak Link causing a domino liquidity crisis in the U.S. Credit system and global markets. Greenspan assured this did not transpire. Instead, the outcome has been (blow-off) Credit and speculative excess beyond our imaginations. Mastering market liquefication and fostering continued excess, the Fed and GSEs assured unmanageable systemic Credit losses. And that’s where we are today.

As I wrote, unfolding developments are becoming somewhat clearer. A Weak Link is found with the Credit insurers and Credit derivatives. In “text-book” speculative blow-off fashion, the Credit insurers became major players in guaranteeing against losses throughout the Bubbling asset-backed securities marketplace (and collateralized debt obligations) at the late stage of an historic Credit Bubble (the high price to be paid for prolonging this dangerous Credit cycle). For the Credit insurers, it was most unfortunate timing. We now find out they are on the hook for myriad of the weakest Credits imaginable, including (apparently fraudulent) loans to truck driving schools, National Century asset-backs, subprime Credit cards, and lord knows what to surface later.

The immediate problem is that the marginal borrower is being denied Credit – the very same weak Credits that have played such a crucial role in sustaining boom-time spending (the “resilient” economy). Think of it this way: if the increasingly risk averse market had not shied away from extending new Credits to National Century, then the Credit losses associated with their specious securities (and other health care Credits) would have remained hidden. But instead we have billions (?) of losses now to recognize, with some being shouldered by the Credit insurers. Many healthcare providers will suffer from faltering Credit availability. Importantly, we expect ABS and “structured finance” losses will now be a significant issue for the Credit insurers. And when confidence wanes for these key insurers, we’ve got a catalyst for financial dislocation. Remember, these thinly capitalized companies’ insurance buttress truly enormous quantities of securities. In this regard, it does not take a deranged imagination to see a potential train wreck developing in muni finance; faltering finances, mushrooming underfunded pension liabilities, and huge borrowing needs for as far as the eye can see. And with the Credit insurers playing such a critical role throughout municipal finance, we think it is now fair to identify this area as a Weak Link for future systemic dislocation.

Today from Bloomberg: “Three companies advised by Alliance Capital Management Holding LP own $50 million of bonds sold by National Century Financial Enterprises Inc., the target of lawsuits alleging financial mismanagement, people familiar with
the situation said. The companies -- ASAP Funding Ltd., MPF Ltd. and MPF Two Ltd. -- sold short-term debt and used the health-care financing company’s bonds as collateral, the people said… Money-market mutual funds, considered among the safest investments, might also lose as a result. ASAP Funding, MPF and MPF Two pooled National Century’s debt with other securities and created so-called asset-backed commercial paper, the people said… Radian Group Inc., a seller of financial guarantee insurance, is one company that insures ASAP Funding…”

Earlier this week from Bloomberg: “National Century Financial Enterprises Inc.’s use of cash reserve may close the $1.2 trillion asset-backed bond market as a funding option for companies without publicly traded shares and credit ratings, investors said… ‘It is pretty scary’ for as much as a quarter of the market made up of bonds backed by ‘off the run’ assets such as health-care receivables, said…an analyst…” A managing director at Moody’s averred: “The market overall will be looking much harder at smaller, thinly capitalized originators or services, especially if they’re unrated or below investment grade.”

From the Asset Securitization Report: “The implications of this are frightening, one source argued. If NCFE is found to have violated contracts with these healthcare providers, the contracts may be ruled invalid, and the providers would have a strong case in court.”

“Frightening,” indeed. Credit issues have now made their way to the “Heart of the Matter” - the asset-backed securities market and the expansive money-market fund arena. The marketplace even appears to taking a more cautious approach to behemoth money market borrowers Fannie Mae, Freddie Mac, and GE. We also believe this development is the impetus for the Fed’s 50 basis point rate cut.

It is also worth noting the $1.44 billion loss reported this week by Credit Suisse, a major player in asset-backs (National Century’s investment banker!) and U.S. “structured finance” generally. But they are only one of an expanding number of troubled foreign financial institutions operating in U.S. financial markets. It is today important to appreciate that the big international financial conglomerates became major U.S. Credit Bubble operators. They are now beginning to suffer the consequences. It is our view that it was these and other leveraged speculators that played the instrumental role in what was the painless recycling of increasingly massive U.S. current account deficits (“Bubble Dollars”) back to the U.S. Credit system. Evidence of their key role is found by scanning the list of borrowers in one’s money market fund, while also pondering the quality of assets underpinning hundreds of “funding corps” managed by these same institutions (and held in huge quantities by the money fund complex). It is also worth noting that the recently released Shared National Credit Review of U.S. syndicated bank loans stated that 45% of these Credits were held by foreign-sourced institutions. This is a problem, and their problem is our problem. As we have written repeatedly, there is a lot of bad paper out there somewhere.

Whether it is large amount of poor Credits extended or their over-enthusiasm for the fledgling market in Credit default swaps, foreign players acquired enormous U.S. Credit risk as they aggressively played the Great Credit Bubble. How much of this risk lies hidden in American investment portfolios (in funding corps, special purpose vehicles and elsewhere) – and how much of this risk has been re-insured by the U.S. Credit insurers, Banks, GE and others – only time will tell. However, one way or another, these unfolding Credit losses are quite likely a critical Weak Link. Despite this week’s curious bid to acquire Household International, we would now expect that, on the margin, the reeling foreign financial conglomerates will attempt a quiet retreat from the faltering U.S. Bubble. If so, this will prove a seminal development for the Great Credit Bubble and its twin, the Bubble dollar. Again repeating previous analysis, “As goes structured finance, so goes the dollar.” And if, as we expect, the dollar proves a Weak Link, Dr. Greenspan’s inflationary goals become more challenging and considerably more risky.