| For the week, the Dow declined 0.9%, and the S&P500 dipped 0.3%. Yet the Transports gained 1.0% to a new record high, increasing y-t-d gains to 13.1%. The Morgan Stanley Cyclical index added 0.2% to a new high (up 8.7% y-t-d), and the Utilities traded up 1.3% to a record high (up 5.0% y-t-d). The Morgan Stanley Consumer index fell 0.8%. The broader market was stronger. The small cap Russell 2000 and S&P400 Mid-Cap indices gained 1.0% - both to all-time highs. The NASDAQ 100 rose 1%, and the Morgan Stanley High Tech index increased 0.5%. The Semiconductors jumped 3.1%. The Street.com Internet index gained 0.5%, and the NASDAQ Telecommunications index rose 0.8%. The Biotechs dipped 0.2%. The Broker/Dealers fell 1.2%, and the Banks declined 0.8%. With bullion up $13.40 to a 9-month high, the HUI Gold index gained 2.9%. Two-year government yields declined 2 bps to 4.80%. Five-year yields fell 2 bps to 4.66%, and 10-year Treasury yields dipped one bp to 4.67%. Long-bond yields declined one bp to 4.78%. The 2yr/10yr spread ended the week inverted 13 bps. The implied yield on 3-month December ’07 Eurodollars increased 1.5 bps to 5.06%. Benchmark Fannie Mae MBS yields fell 2 bps to 5.75%, this week performing about in line with Treasuries. The spread on Fannie’s 5 1/4% 2016 note was unchanged at 33, and the spread on Freddie’s 5 1/2% 2016 note was unchanged at 32. The 10-year dollar swap spread increased one to 52.25. Corporate bonds traded with Treasuries, although junk spreads widened a couple basis points this week. Investment grade issuers included Hewlett-Packard $2.0 billion. February 23 - Financial Times (David Oakley): “Company default rates among junk-rated debt have fallen to their lowest level in 26 years… Default rates among speculative-grade issues are an important indicator of the health of the world economy, as these are from the weakest companies. Last year, just 1.57 per cent of all junk-rated debt defaulted, down from 1.8 per cent in 2005, Moody’s…said. This level is the lowest in any year since 1981… But in its annual global corporate default study, Moody's warned default rates would almost double to 3.07 per cent by the end of 2007. Although this is still comfortably below the historical average of 4.9 per cent…” Junk issuers included Huntsman Int. $350 million, American Axle & MFG $300 million, American Railcar $275 million, Esterline Technologies $175 million, and Key Plastics $115 million. International issuers included Vodafone $3.5 billion, Peru $3.5 billion, and Digicel Group $1.4 billion. February 22 – Financial Times (Joanna Chung): “A frenzy of investor activity in local bond markets helped send trading volumes of overall emerging market debt to a record high of $6,500bn in 2006… Participants in the survey by EMTA, the principal trade group for the emerging markets trading and investment community, reported that trading volumes rose 19 per cent…Trading in local market instruments hit an all-time high of $3,687bn in 2006, accounting for 57 per cent of overall volume compared with a 47 per cent share in 2005 and 45 per cent in 2004. The figures highlight the increasing shift of yield-hungry investors from dollar and euro-denominated debt to local currency-denominated debt. The surge in overall activity also reflects the growing pool of investors in emerging markets, which now includes central banks, pension funds, life assurance groups and retail investors.” Japanese 10-year “JGB” yields declined 3 bps this week to 1.67%. The Nikkei 225 gained 1.8% (up 5.6% y-t-d). German 10-year bund yields were unchanged at 4.04%. Emerging markets were mixed to higher. Brazil’s benchmark dollar bond yields declined 2 bps this week (to a record low 5.83%). Brazil’s Bovespa equities index rose 0.4% to a new record high (up 3.5% y-t-d). The Mexican Bolsa added 0.1% to a new record, increasing y-t-d gains to 7.8%. Mexico’s 10-year $ yields declined 2 bps to 5.60%. Russia’s 10-year Eurodollar yields were unchanged at 6.71%. India’s Sensex equities index dropped 5.0% (down 1.1% y-t-d). China’s stock exchanges were closed for the New Year (2007 gain of 12.0%). Freddie Mac posted 30-year fixed mortgage rates dropped 8 bps last week to a six-week low 6.22% (down 4 bps y-o-y). Fifteen-year fixed mortgage rates fell 6 bps to 5.97% (up 8 bps y-o-y). And one-year adjustable rates declined 3 bps to 5.49% (up 17 bps y-o-y). Perhaps impacted by inclement weather, the Mortgage Bankers Association Purchase Applications Index fell 4.8% this week. Purchase Applications were down 7.2% from one year ago, with dollar volume up 0.3%. Refi applications declined 5.4%. The average new Purchase mortgage rose to $240,700 (up 8.0% y-o-y), and the average ARM increased to $384,100 (up 13.0% y-o-y). Bank Credit expanded $18.0 billion (week of 2/14) to a record $8.372 TN. Bank Credit has expanded at a 6.8% annualized rate y-t-d (7 wks), with a one-year gain of $741 billion, or 9.7%. For the week, Securities Credit added $0.6 billion. Loans & Leases jumped $17.4 billion to a record $6.147 TN. Commercial & Industrial (C&I) Loans expanded 11.3% over the past year. For the week, C&I loans added $0.7 billion, and Real Estate loans increased $8.1 billion. Year-to-date, C&I loans have expanded at a 6.1% rate and Real Estate loans at a 9.3% pace. Bank Real Estate loans expanded 14.5% over the past year. For the week, Consumer loans gained $1.9 billion, and Securities loans rose $12.6 billion. Other loans declined $3.6 billion. On the liability side, (previous M3) Large Time Deposits rose $12.4 billion. M2 (narrow) “money” increased $4.8 billion to a record $7.097 TN (week of 2/12). Narrow “money” expanded $374 billion, or 5.6%, over the past year. M2 has expanded at a 7.3% pace during the past 20 weeks. For the week, Currency added $0.2 billion, while Demand & Checkable Deposits dropped $29.1 billion. Savings Deposits jumped $28.3 billion, and Small Denominated Deposits increased $2.2 billion. Retail Money Fund assets rose $3.1 billion. Total Money Market Fund Assets (reported by the Invest. Co. Inst.) jumped $27.3 billion last week to a record $2.420 Trillion. Money Fund Assets have risen $174 billion over the past 20 weeks (20.2% annualized) and $354 billion over 52 weeks, or 17.1%. Total Commercial Paper declined $17 billion last week to $2.016 Trillion, with a y-t-d gain of $41.2 billion (13.6% annualized). CP has increased $107.5 billion (15% annualized) over 20 weeks, and $332 billion, or 19.7%, over the past 52 weeks. Asset-backed Securities (ABS) issuance was little changed this week at $19 billion. Year-to-date total ABS issuance of $95 billion (tallied by JPMorgan) is running behind the $104 billion from comparable 2006. Year-to-date Home Equity ABS issuance of $53 billion is slower than last year’s comparable $71 billion. Year-to-date US CDO issuance of $35 billion is ahead of comparable 2007’s $33 billion. Fed Foreign Holdings of Treasury, Agency Debt surged $15.5 billion last week (ended 2/21) to a record $1.827 Trillion, with a y-t-d gain of $74.5 billion (28% annualized). “Custody” holdings were up $254 billion y-o-y, or 16.2%. Federal Reserve Credit last week jumped $4.5 billion to $851.7 billion. Fed Credit was up $35.9 billion y-o-y, or 4.4%. International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $829 billion y-o-y (19.9%) to a record $4.997 Trillion. February 22 – Bloomberg (Maria Levitov): “Russia’s foreign currency and gold reserves rose for a fifth week to a record, as the world’s largest energy exporter reaped revenue from oil sales. The reserves, the world’s third biggest, rose to $311.2 billion, gaining $1.7 billion in the week…” Currency Watch: The dollar index was unchanged this week at 83.99. On the upside, the South African rand gained 1.3%, the New Zealand dollar 1.3%, the British pound 0.7%, the Iceland krona 0.7%, and the Australian dollar 0.7%. On the downside, the Japanese yen declined 1.3%, the Thai baht 0.7%, the Mexican peso 0.6%, and the Indonesian rupiah 0.4%. Commodities Watch: February 23 – Bloomberg (Brett Foley): “Copper rose in London, heading for a third weekly gain and the largest since July, on speculation demand from China will increase when buying resumes after a weeklong holiday. Lead and nickel advanced to records… Copper has risen 8.7 percent this week, moving above $6,000 a metric ton for the first time since Jan. 2 and erasing the losses so far in 2007. ‘Everyone is massively short of copper at the moment, funds and consumers alike,’ David Thurtell…analyst at BNP Paribas…” February 22 – Financial Times (Fiona Harvey, Kevin Morrison and Mark Mulligan): “High grain prices are threatening the nascent biofuels industry, raising input costs and making the fuel less economic compared with oil. Agricultural commodity prices have reached long-term highs in recent days, based on forecasts of hot and dry weather conditions this year in the US which could result in lower grain yields. This comes after oil prices have fallen by a quarter from their record peaks last year. Corn prices reached another 10-year high for the second successive day… But the doubling of corn, a main feedstock for US ethanol producers, over the past year at a time when oil prices are at the same level they were 12 months ago has raised questions over the viability of the biofuels industry without heavy government support.” February 20 – Bloomberg (Brett Foley): “Nickel rose to a record…on speculation that supply may lag behind demand after stockpiles fell for the first day in 10. Tin gained to a 17-year high and lead traded at its highest ever for a second day.” For the week, Gold jumped 2.0% to $682.55 and Silver 4.2% to $14.715. Copper surged 7.4%. April crude rose $1.07 to $60.93. March Gasoline jumped 6.7%, and March Natural Gas gained 2.9%. For the week, the CRB index rose 2.6% to a 2-month high (up 2.4% y-t-d), and the Goldman Sachs Commodities Index (GSCI) jumped 3.1% (up 3.7% y-t-d). Japan Watch: February 22 – Bloomberg (Lily Nonomiya): “Japan reported an unexpected trade surplus for January, buoyed by a 50 percent surge in exports to China and a drop in oil imports. The surplus was 4.4 billion yen ($36 million), compared with a deficit of 353.5 billion yen the same month a year earlier… Exports climbed 18.9 percent, twice as fast as economists expected.” China Watch: February 21 – China Knowledge: “China’s advertising revenue reached RMB 386.6 billion last year, up 22% year-on-year from 2005, according to statistics from Nielsen Media Research. Income was up in all media sectors…” February 20 – Bloomberg (Lee Spears): “China’s ports handled 15% more cargo by weight in 2006 than a year earlier the official Xinhua News Agency reported… Cargo volume was 5.6 billion tons…” February 20 – Bloomberg (Lee Spears): “China Petrochemical Corp. and other Chinese state-owned petroleum and petrochemical companies spent 396 billion yuan ($51 billion) last year, 19 percent more than forecast due to overseas acquisitions and exploration…” India Watch: February 22 – Bloomberg (Oliver Biggadike and Denise Kee): “Indian companies may quadruple bond sales abroad this year after S&P raised its rating to investment grade, according to Deutsche Bank AG… Companies are rushing to fund the expansion of the world’s fastest-growing major economy after China. Borrowing in dollars, euros and yen may rise to between $8 billion and $13 billion…” Asia Boom Watch: February 21 – Bloomberg (Jason Folkmanis): “Vietnam’s exports to the U.S. rose by almost a third last year, the fastest pace of growth since 2003 for shipments to the Southeast Asian nation’s largest market. Vietnamese shipments to the U.S. rose 30 percent in 2006 to $8.46 billion…” Unbalanced Global Economy Watch: February 21 – Bloomberg (Greg Quinn): “Canadian retail sales surged in December, adding to gains in exports and wholesaling and suggesting holiday shoppers helped the economy end the year in a broad-based expansion. Sales advanced 2.3 percent, the fastest rate in nine years…” February 23 – Bloomberg (Brian Swint): “The U.K. economy grew at the fastest pace in 2 1/2 years in the fourth quarter as household spending and investment surged. Gross domestic product increased 0.8 percent from the previous three months, the most since the second quarter of 2004… The annual growth rate was 3%...” February 20 – Bloomberg (Gonzalo Vina): “The U.K. Treasury had a 10.3 billion pound ($20 billion) surplus in January, the biggest in five years, helping Chancellor of the Exchequer Gordon Brown keep a lid on government borrowing.” February 22 – Bloomberg (Matthew Brockett): “Booming exports drove an unexpected acceleration in German economic growth in the fourth quarter, capping the best year for Europe’s largest economy since 2000. Sales abroad jumped 6 percent from the third quarter…” February 22 – Bloomberg (Chris Malpass): “Swiss employment increased to the highest level since 1999 in the fourth quarter last year as companies added workers to meet foreign demand.” February 23 – Bloomberg (Robin Wigglesworth): “Norway’s jobless rate fell to 2.8 percent in December, the lowest since at least 1989, adding to pressure on the central bank to raise the pace of interest rate increases.” February 21 – Bloomberg (Aaron Eglitis): “Latvia’s economic growth, the fastest in the European Union, will slow to around 9 this year, compared with 12 percent in 2006, the Economy Ministry said…” February 21 – Bloomberg (Tasneem Brogger and Christian Wienberg): “Iceland’s annual wage growth accelerated in January for the first month in four, reaching 10.1%, as unemployment remained close to 1% and economic growth was more robust than expected.” February 21 – Bloomberg (Hans van Leeuwen and David McIntyre): “Australian wages growth picked up in the fourth quarter as a worker shortage stoked pay increases in the Asia-Pacific region’s fifth-largest economy. The wage price index…rose 1.1% from the third quarter…” February 21 – Bloomberg (Nasreen Seria and Lukanyo Mnyanda): “South African inflation accelerated for the first time in four months, rising to a higher than expected annual 5.3 percent in January, boosted by higher gasoline and food cost.” Latin American Boom Watch: February 22 – Bloomberg (Fabio Alves): “Brazil’s unemployment rate rose to 9.3 percent in January… Unemployment in Brazil’s six largest metropolitan areas increased from 8.4 percent in December…” Central Banker Watch: February 21 – Financial Times (Richard Beales): “By lifting overnight rates by 25 basis points to 0.5 per cent, the Bank of Japan has tried to regain some of the credibility it lost after apparently bowing to political pressure not to raise rates last time around. On the surface, the move makes “carry trades”, in which speculators borrow in yen and invest in higher-yielding currencies, a notch less attractive. But in reality, the BoJ’s dovish outlook could set the stage for yet more activity…In short, the BoJ’s rate rise…looks like the one that should have happened last month… The outlook is for only “gradual” further moves… Nor does the extra 25bp of borrowing costs much undermine the profitability of the carry trade. In fact, it is outweighed by rising rates elsewhere. Two-year German government bonds…now offer 315bp more yield than the Japanese equivalents – up from less than 300bp three months ago and about 250bp a year ago. Against two-year US Treasuries, the gap has held steadier at around 400bp…even if they avoid more exotic currencies like the New Zealand dollar or riskier equities.” Bubble Economy Watch: February 23 – Bloomberg (Jeff Wilson): “Farmland from Iowa to Argentina is rising faster in price than apartments in Manhattan and London for the first time in 30 years. Demand for corn used in ethanol increased the value of crop land 16 percent in Indiana and 35 percent in Idaho in 2006, government figures show. The price of a Soho loft appreciated only 12 percent, while a pied-a-terre in Islington near London’s financial district gained 11 percent, according to realtors. Farmland returns ‘will take a quantum leap over the next 18 months,’ after corn prices surged to a 10-year high in February, said Murray Wise…chairman and chief executive officer of Westchester Group Inc…. Average U.S. farm prices increased by 15 percent in 2006…The cost of buying corn farms in Argentina, the world’s second-largest exporter of the grain, jumped 27%...” February 21 – Financial Times (Joshua Chaffin, Paul Taylor and Daniel Pimlott): “Since they launched this decade, XM and Sirius - the United States’ two subscription-based satellite radio services - have spent hundreds of millions of dollars trying to establish their product, but have yet to record a profit. Together, they have lost about $6bn over the past five years while building a subscription base of roughly 14m, compared with the estimated 200m people who listen to terrestrial radio stations.” February 23 – Washington Post (John Solomon and Matthew Mosk): “Former president Bill Clinton, who came to the White House with modest means and left deeply in debt, has collected nearly $40 million in speaking fees over the past six years…Last year, one of his most lucrative since he left the presidency, Clinton earned $9 million to $10 million on the lecture circuit… His paid speeches included $150,000 appearances before landlord groups, biotechnology firms and food distributors, as well as speeches in England, Ireland, New Zealand and Australia that together netted him more than $1.6 million. On one particularly good day in Canada, Clinton made $475,000 for two speeches, more than double his annual salary as president.” Financial Sphere Bubble Watch: February 22 – Dow Jones (Damian Paletta): “The banking industry reported $888 million in net charge-offs during the fourth quarter - a three-year high - and troubled mortgage loans grew 15.6% to $3.1 billion, the FDIC said… The industry also posted a record net income of $145.7 billion for 2006, up from $133.9 billion in 2005.” February 22 – Financial Times (Ben White): “Goldman Sachs yesterday solidified its position as the best-paying publicly traded investment bank in Wall Street history, disclosing that it awarded co-presidents Gary Cohn and Jon Winkelried about $53m each in cash and stock compensation last year. The sum is a whisker shy of the $54m paid to Lloyd Blankfein, chief executive…Goldman also disclosed that it awarded Hank Paulson, who left as chief executive in June to become US Treasury secretary, $110m in cash to cover his remaining stock options and restricted stock. Goldman paid an additional $51m to repurchase stakes owned by Mr Paulson and his wife in several Goldman-managed private equity and hedge funds. The payments are on top of the approximately $500m in Goldman shares Mr Paulson last year said he would sell in order to comply with federal ethics rules.” Mortgage Finance Bubble Watch: February 20 – Financial Times (Saskia Scholtes): “Investors in mortgage-backed bonds and other complex debt products could be left nursing substantial losses as troubles grow in the risky US subprime mortgage market. But the investment banks that fuelled the craze of lending to borrowers with weak credit histories look like they are escaping relatively unscathed. Amid increasingly ominous signs of a shakeout in the subprime mortgage industry, investors in securities backed by these risky mortgages have seen the value of their holdings slide this year. Risk premiums - or the spreads over government bonds - on the lowest-rated cash securities have risen by up to 400 basis points, while the cost of insuring such deals against losses through the derivatives market has doubled. The problem for investors who bought last year’s crop of high-risk mortgage originations was that, after several years of booming house price appreciation, the US housing market last year hit a wall. In response, mortgage lenders - financed by the Wall Street banks that can sell this debt into capital markets - relaxed their standards to prop up sagging origination volumes, lending to ever-riskier borrowers on ever more favourable terms. Last year, 38 per cent of new subprime mortgages were for 100 per cent of the value of the home. ‘Years ago, the banks had to live with what they underwrote, so if they got too aggressive they had to bear the consequences,’ says David Hendler, analyst at CreditSights. ‘Now the worst losses will be held by a handful of hedge funds who thought they knew better.’” Real Estate Bubbles Watch: February 21 – Bloomberg (Daniel Taub): “Billings by U.S. architecture firms rose last month, indicating that development of commercial buildings likely will be strong throughout 2007 even as housing construction remains weak… The billings gain suggests construction of industrial buildings, shopping centers, office buildings and other nonresidential properties will be strong throughout the year…” February 22 – National Association of Realtors: “A forward looking index for the commercial real estate market, the Commercial Leading Indicator for Brokerage Activity, has increased for seven consecutive quarters and is holding at the highest level on record…” February 23 – Bloomberg (Dan Levy): “Sales of second homes in California, the nation’s most expensive real estate market, fell 37 percent last year as slowing appreciation of primary residences caused potential buyers to hold back on vacation purchases, DataQuick…reported. The drop in second-home sales was the lowest since…DataQuick began compiling statistics in that category in 1998. Sales fell by more than 34 percent in the major resort markets of greater Palm Springs, the Sierra mountains and foothills and Lake Arrowhead/Big Bear…. Second-home sales statewide totaled 13,798 last year…The peak for vacation home sales was 24,916 in 2004.” M&A and Private-Equity Bubble Watch: February 22 – Financial Times (Paul J Davies): “Kohlberg Kravis Roberts is used to wielding financial clout in the stock markets, where it has been involved in some of the biggest and boldest leveraged takeovers for years. But in the first months of this year, the firm, along with many of its rivals, is finding that it has ever more power in the debt markets, where private equity sponsors raise the bulk of capital for their deals. This week, KKR is set to close the loan financing for its purchase of a majority stake in PagesJaunes…. Demand among specialist investors for the debt allowed KKR not only to cut the interest it would pay on senior secured loans but also to increase their size. This meant it could chop back heavily on the much more expensive subordinated mezzanine loans it had expected to issue.” February 21 – Bloomberg (Harris Rubinroit): “Henry Kravis and Stephen Schwarzman never had an easier time getting the lowest interest rates on loans from their bankers. Just three months after borrowing $12.8 billion to pay for hospital operator HCA Inc. in November, Kohlberg Kravis Roberts & Co. and its partners negotiated a new loan with lower rates.” February 21 – Bloomberg (Larry Edelman): “Providence Equity Partners Inc., a buyout firm focused on media and communications investments, raised $12 billion for its largest-ever fund. Investors include pension funds, university endowments and wealthy individuals, the…firm said… The money was gathered in four months.” Energy Boom and Crude Liquidity Watch: February 21 – Financial Times (Peter Thal Larsen ): “When property developers in Saudi Arabia last summer announced an offering of shares to fund the building of a new city, private investors flocked to the issue. An estimated 10m Saudis - half the country’s population - signed up for shares in the $680m offering to help fund the construction of the King Abdullah Economic City, a new development just north of Jeddah on the Red Sea. Offerings such as these have attracted the attention of the world’s largest investment banks. Though financial institutions have for years pursued Saudi capital, their main effort was on recycling the country’s oil wealth through financial markets in the West.” February 21 – Bloomberg (Arif Sharif): “Qatar’s inflation rate rose to a record 11.83 percent in 2006, driven mainly by soaring residential rents, the Gulf Times reported…” February 22 – The Wall Street Journal (David Bird): “When it comes to supplying the U.S. with oil, Africa is quietly trumping the Middle East. U.S. crude-oil imports from Africa topped supplies from the Middle East in 2006 for the first time in 21 years, government data show. As recently as 2001, U.S. imports from the Middle East topped African supplies by more than 10%...” Climate Watch: February 23 – New York Times (Keith Bradsher): “Until recently, it looked like the depleted ozone layer protecting the earth from harmful solar rays was on its way to being healed. But thanks in part to an explosion of demand for air-conditioners in hot places like India and southern China — mostly relying on refrigerants already banned in Europe and in the process of being phased out in the United States — the ozone layer is proving very hard to repair. Four months ago, scientists discovered that the “hole” created by the world’s use of ozone-depleting gases — in aerosol spray cans, aging refrigerators and old air-conditioners — had expanded again, stretching once more to the record size of 2001. An unusually cold Antarctic winter, rather than the rise in the use of refrigerants, may have caused the sudden expansion, which covered an area larger than North America.” February 23 - Financial Times (Clive Cookson): “Severe water shortages are likely to constrain future expansion of population, agriculture and industry in the south-western US, the fastest growing part of the country, according to a report by the National Academy of Sciences. The study focused on the Colorado River, which supplies water to about 25m people and millions of acres of farmland in seven states. It concluded that droughts would be longer and more serious than had been previously assumed… ‘Severe drought conditions have affected much of the region since the late 1990s, with 2002 and 2004 being among the 10 driest years on record in the upper basin states of Colorado, New Mexico, Utah and Wyoming,’ the report says. ‘Water storage in the basin’s reservoirs dropped sharply during this period due to low streamflows; for example, 2002 water year flows into Lake Powell were roughly 25 per cent of average.’ Meanwhile the population is growing rapidly.” February 20 – United Press International: “The drought in Australia has led to a 60% drop in overall summer crop production. The latest forecast by the Australian Bureau of Agriculture and Resource Economics says production for 2006-07 will be down to 1.9 million metric tons, making it the smallest summer crop in more than 20 years.” Fiscal Watch: February 21 – The Wall Street Journal (Jane Zhang and Vanessa Fuhrmans): “As pressure grows for the government to pick up more of the nation’s health-care tab, new data show its contribution is already at 45% and is expected to approach 50% within 10 years. The government’s widening role in financing health care stems from the recent expansion of Medicare to include prescription drugs, the growth of relatively new initiatives like the State Children’s Health Insurance Program, increased spending by enrollees in programs like Medicaid…and cutbacks in employer-sponsored health coverage. Overall, health spending in the U.S. is expected to double to $4.1 trillion by 2016…” Speculator Watch: February 23 – New York Times (Stephen Labaton): “The Bush administration said Thursday that there was no need for greater government oversight of the rapidly growing hedge fund industry and other private investment groups to protect the nation’s financial system. Instead, the administration, in an agreement it reached with the independent regulatory agencies, announced that investors, hedge fund companies and their lenders could adequately take care of themselves by adhering to a set of nonbinding principles. The principles, many already being followed by the sharpest investors and best-run companies, say that investors should not take risks they cannot tolerate and should carefully evaluate the strategies and management skills of hedge funds. They also call for funds to make clear and meaningful disclosures to investors. The decision came after months of study by a presidential working group of top officials and regulators. They looked at both the hedge fund industry…and the management of private equity firms… The group’s conclusions reflected both the strong antiregulatory ideology of the administration and the formidable influence of Wall Street and the increasingly wealthy hedge fund industry among both Democrats and Republicans in Washington. Three of the administration’s most senior economic policy makers… Henry M. Paulson Jr., his top deputy, Robert K. Steel, and White House chief of staff Joshua Bolten— are alumni of Goldman Sachs…” Indictments: The market today decided that the subprime meltdown matters – at least a little. The Bank index, after reaching a record high earlier in the week, dropped almost 1%. The Broker/Dealers were hit for about 2%. Stocks concentrated in the so-called “prime” mortgage business – including Fannie, Freddie, Countrywide, and MGIC all traded lower. Even Credit insurers MBIA and Ambac declined better than 1%. Meanwhile, Treasury prices rallied sharply, generally pushing narrow spreads somewhat wider. The dollar index dropped back below 84, and gold shot briefly above $688. The bulls would retort, “Don’t get carried away; the S&P500 declined only 0.36% and NASDAQ 0.39%. The broader market was up strongly on the week.” And, curiously, the Morgan Stanley Cyclical index closed the day higher (up 8.7% y-t-d), with only small declines for the Morgan Stanley Retail Index (up 8.6% y-t-d) and the S&P Supercomposite Restaurants Index (up 2.5% y-t-d). Financials may have been a worry, but the consumer was not. And technology stocks were generally unchanged to higher, with today’s small advance in the Credit-sensitive NASDAQ Telecommunications index pushing y-t-d gains above 6%. The market is not yet inclined to connect the dots of subprime woes spreading to the prime mortgage market, in the process creating a meaningful tightening of Credit conditions for the consumer economy as a whole. That would be expecting too much from an over-liquefied market undoubting of Goldilocks, the power of contemporary finance, and the capabilities of the Fed. After all, with the exception of subprime, U.S. and global Credit systems remain firing away on all cylinders. Worries about the general economic impact of mortgage problems are assuaged by lower market yields and the prospect of a more generous Fed. Yet the market now has good reason to ponder subprime’s financial contagion effects. This week’s news from NovaStar confirmed that profitability has vanished across the board for the mono-line subprime originators. An ensuing industry liquidity crisis is feeding a self-reinforcing markdown of distressed loans and originator retained portfolios, with negative ramifications for subprime ABS and securitizations. At the minimum, the specter of rapidly tightening subprime Credit conditions is beginning to foment heightened uncertainty throughout the mortgage finance super-industry. The derivatives market for hedging subprime exposure has badly dislocated, with agonizing pressure to acquire protection (or reinsure/unwind “insurance” previously written) but few willing providers (think panic buying of flood insurance during torrential rains and rapidly rising waters). It may take some time before mortgage tumult expands to the point of significantly impacting the general economy. However, recognition that the unfolding subprime debacle is an Indictment of Contemporary Wall Street Finance should be more immediate. The almighty Wall Street securitization and distribution machines were directly responsible for millions borrowing more than they could reasonably be expected to ever repay. The issue was never that it didn’t make sense for an individual borrower to bury himself in debt to participate in an obvious Bubble. Instead, it was all about whether scores of such loans could be pooled together and structured in a fashion that ensured that holders made above-market returns for awhile – and, later, with the eventual blow-up, that risks had been spread sufficiently so that nobody suffered too big a hit. We’ll wait to see how effectively risk was dispersed and how well related Credit “insurance” markets function. And let’s see to what extent Wall Street can simply pack up its gear and move it on over to the next nascent Bubble. As for the Fed, they were happy to take a hands-off approach as long as most subprime risk was seen to be dis-intermediated away from the banking system. The subprime debacle is certainly an Indictment of Federal Reserve policy. The Greenspan Fed knowingly fueled the mortgage finance Bubble (post-tech Bubble "mop-up" reflation). Worse yet, I am convinced that Mr. Greenspan promoted variable-rate mortgages to the masses as part of a strategy to extricate potentially catastrophic interest-rate risk associated with normalizing rates after an extended period of ultra-accommodation (especially for the highly-exposed GSEs and derivatives markets!). The sophisticated were certainly forewarned and well positioned to profit immensely from Fed (telegraphed) policies, while so many less fortunate destroyed themselves financially at the grimy hands of housing Bubbles and “teaser-rate”, “option-ARM”, negative amortization and zero-down mortgages. The flaw in Greenspan/Bernanke Inflationism has always been that it further empowers the flourishing booms in Wall Street “structured finance,” leveraged speculation and asset inflation, generally. The Federal Reserve and their apologists couched the “debate” in terms of some dire risk of “deflation.” We were instructed that expansionary policies were required to elevate the general price level to a much less risky 2% or so – as if once it got there they would - or could - turn down the inflationary spigots. The amount of Credit, leveraged speculation, general financial excess and economic distortion associated with this so-called “price stability” was a moot issue. And the ballooning Current Account Deficit was the consequence of our economy’s “excess of investment over savings” – a blessing of “globalization” that works to boost our standard of living while at the same time containing inflationary pressures. The principal consequence – the actual inflation fostered by inflationist monetary policies – has been massive Credit and speculative excess, along with resulting dependency. Deluding conventional analysts, the impact on the so-called “general” price level has been token. But the effect on the financial and economic structure – what really matters and is conspicuously indicated by our disastrous Current Account Deficits - has been momentous. Subprime mortgage finance today provides an instructive microcosm of the degree to which securitization-based finance, derivatives, and leveraged speculation foster egregious Credit excesses that contort price signals in both the Financial and Economic Spheres. The boom was fun and games while it lasted, but the bust will be an utter mess. Prior to today’s rally, the bond market’s concern for the week had been the 2.7% y-o-y rise in January core-CPI. Confidence that the worst inflation data was in the rear view mirror is now being supplanted by justified concern for a problematic ratcheting up in price pressures. Gold prices have shot higher, while crude prices have jumped back above $60. The global backdrop is strongly inflationary. Knock-on affects from higher energy prices (i.e. corn, soybeans, meats, foodstuffs, etc.) are garnering more attention. And from the minutes of the 1/31 FOMC meeting: “Many participants observed that labor markets remained relatively taut, with significant wage pressures being reported in some occupations. In addition to the continuing shortages of skilled workers in technical and professional fields, recent reports suggested a scarcity of less skilled and unskilled workers in some areas of the country.” I’ll take Fed officials at their word that they actually are focused on inflation risk, and I found interesting Dallas Fed President Richard Fisher’s comment today that “globalization is helping less in inflation fighting.” His comments were, however, followed a few hours later by dovish San Francisco Fed President Janet Yellen, stating the Fed “should not take” the risk of raising rates. The markets will likely rubberneck at subprime carnage and take Yellen’s comments as indicative of the true sentiments harbored by many on the FOMC – including its chairman. The prevailing analysis will be that the Fed talks tough on inflation but can be expected to quickly rationalize away inflation risks at the first whiff of systemic stress. It’s tempting this evening to suggest that we witnessed this week a meaningful step toward the scenario of the markets perceiving that mortgage-related financial fragility has finally hamstrung the Fed. For some time the markets have presumed that the Fed would not actually ratchet rates to the point of tightening financial conditions. This was a safe bet, recognizing the predominant role encompassing asset inflation, leveraged speculation, and Ponzi-like finance had come to play in sustaining our financial and economic booms. The Fed had become hostage to the markets and the powerful leveraged speculating community, and would be forced to back off come the first sign of trouble. We might be close. It is a defining characteristic of current U.S. financial and economic booms that they are dependent upon enormous and uninterrupted Credit and speculative excess. Wall Street and the U.S. financial sector create (through inbridled Credit expansion) and disseminate the requisite liquidity/purchasing power – not the Fed. The Fed does retain the power to impose its will on the Financial Sphere – enticing expansion with the carrot of financial profits or by exacting restraint with its blunt instrument of threatening financial loss. As we have witnessed, telegraphed baby (carrot) steps have been perfectly in accord with ballooning Financial Sphere profits. At this point, the Fed doesn’t even dare remove the vegetable platter (modern-day version of the “punch bowl”). As I’m writing, I see the headline cross the tape that KKR is bidding for TXU Energy. While Credit conditions tighten in subprime, they couldn’t be looser throughout corporate finance. Indeed, the M&A boom, and the corporate debt Bubble generally, could additionally benefit from lower rates (or at least no Fed tightening) and the marginal flow of speculative finance from mortgages to corporates. And here we see the Fed’s dilemma: Not only is there no general price level to manipulate, the heart of the (Wall Street-dictated) Credit system is locked in aggressively financing one asset Bubble after another. Bubble ("Ponzi") finance is not reconcilable with moderation. The upshot is Monetary Disorder and resulting price instability that seem to worsen by the week. A New York Times article this week highlighted the recent resurgence in the local housing market. Meanwhile, condo markets in Miami, Las Vegas, Washington DC and elsewhere appear nothing short of unfolding debacles. Following in the footsteps of energy properties, farm prices are shooting higher. At the same time, homebuilders are cancelling options on and liquidating billions worth of land held for residential development. Most housing markets are posting moderate price declines, while Sam Zell speaks of upper single-digit and perhaps even double-digit residential rent increases nationally this year. The residential construction boom goes bust, yet this provides only greater firepower for the non-residential (echo) boom; same dysfunctional financial infrastructure – just a new target. Meanwhile, some key labor markets are demonstrating acute wage pressures, as workers in many industries don’t even keep up with the rising cost of living. The Fed is not in control of any “general price level” and they certainly aren’t in command of Credit Bubble and speculative asset market boom and bust dynamics. And there is no interest rate that could today rectify the Bubble Dilemma. Contrast the old banking system where Fed tightening would reduce both liquidity and industry loan portfolio profitability, thereby inducing a general system tightening - to that of the current securities and speculation-based system where waning financial profits in one asset class simply induces greater lending, securitizing and speculating elsewhere (one boom and bust leads naturally to the next). And I’ll further hypothesize that the more protracted the global Credit boom, the less reliant the world becomes on the U.S. economy and Credit excess. This has important implications for prospective U.S. and global inflation, dynamics increasingly outside the purview of our policymakers. I wouldn’t go rambling on about the Fed’s lack of control if grossly inflated asset markets weren’t so convinced of the polar opposite. Perhaps the greatest Indictment should be reserved for highly over-liquefied and speculative marketplaces. |
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