| CDO and hedge fund worries pressured U.S. stocks, with the Dow (up 7.2% y-t-d) and S&P500 (up 5.9%) both declining 2% this week. The Transports declined 1.3% (up 12%), and the Utilities were hammered for 4.1%. Interestingly, the Morgan Stanley Cyclical index declined only 0.7%, reducing 2007 gains to 21.2%. The Morgan Stanley Consumer index fell 1.8% (up 4.4%). The small cap Russell 2000 declined 1.6% (up 6.0%) and the S&P400 Mid-Cap index 1.7% (up 11.4%). Technology stocks generally outperformed. The NASDAQ100 declined 1.1% (up 9.4%), while the Morgan Stanley High Tech index actually posted a slight gain (up 9.7%). The Semiconductors added 0.4% (up 7.9%). The Street.com Internet Index declined 1.2% (up 8.4%), and the NASDAQ Telecommunications index dipped 0.9% (up 7.9%). The Biotechs were hit for 4.4%, reducing y-t-d gains to 2.4%. Financial stocks were under pressure. The Broker/Dealers dropped 3.6% (up 5.8%), and the Banks declined 2.6% (3.4%). With Bullion down $1.20, the HUI gold index slipped 0.1%. Two-year U.S. government yields declined 11 bps to 4.91%. Five-year yields fell 7 bps to 5.01%. Ten-year Treasury yields dipped 3 bps to 5.13%, as the yield curve further steepened. Long-bond yields ended the week down one basis point to 5.25%. The 2yr/10yr spread ended the week at 22 bps, with widest since October 2005. The implied yield on 3-month December ’07 Eurodollars fell 9 bps to 5.29%. Benchmark Fannie Mae MBS yields were unchanged at 6.29%, this week underperforming Treasuries. The spread on Fannie’s 5% 2017 note widened one to 42, and the spread on Freddie’s 5% 2017 note widened about 2 to 42. The 10-year dollar swap spread increased 2.2 to 62. Corporate bond spreads widened, with the spread on a junk index 16 wider. Investment grade issuers included United Healthcare $1.5bn, Great River Energy $1.3bn, Regions Financial $1.1bn, BP AMI Leasing $930 million, Quest Diagnostics $800 million, JP Morgan Chase $750 million, Meridian Funding $750 million, Sprint Nextel $750 million, Lazard Group $600 million, Kinder Morgan Energy $550 million, Northern State Power $350 million, Marriot $350 million, Pactiv $500 million, Idaho Power $140 million, and Partners Healthcare System $100 million. June 21 – Dow Jones (Michael Aneiro and Cynthia Koons): “By any account, $300 billion is a lot of money. It should be an especially daunting sum when you’re lending it to someone else, even more of a cause for alarm when it’s going to a borrower with a less-than-stellar credit rating. This is the amount coming to the risky debt markets in the next six to nine months, much of it to foot the bill for the eye-popping volume of leveraged buyouts announced this year. Yet it seems that after all the hubbub over how large LBOs were getting, investors aren’t that worried about actually ponying up the $300 billion necessary to get the deals done. About $100 billion in bonds and $200 billion in loans are slated to hit the market through the first quarter of next year, a sizable chunk of which is even expected by the end of June.” June 22 – Bloomberg (Caroline Salas): “U.S. high-yield debt investors, after snapping up a record $600 billion in new loans and bonds this year, are starting to push back. Thomson Learning…this week cut its bond offering to $1.6 billion from $2.14 billion, removed the riskiest portion of the deal and agreed to pay more interest on its planned loan… US Foodservice…also raised the interest on its planned loan to attract lenders…” Junk issuers included UAL $700 million, Smithfield Foods $500 million, Shingle Springs Tribal Gaming $450 million, CMS Energy $400 million, Surgical Care Affiliates $300 million, Americredit $200 million, and Blaze Recycling and Metals $115 million. This week’s convert issuers included Verifone Holdings $275 million, Stewart Enterprises $250 million, Dollar Financial $175 million, and Novamed $75 million. International dollar bond issuers included Dubai Ports $3.25bn, Telefonica Emisiones $2.3bn, Northern Rock $2.2bn, BNP Paribas $1.1bn, Majapahit Holding $1.0bn, Transneft $500 million, Ukraine $500 million, ABH Financial $500 million, BW Group $500 million, Hynix Semiconductor $500 million, and Delhaize Group $450 million. German 10-year bund yields were little changed at 4.65%, while the high-flying DAX equities index gave up 1.0% (up 20.5% y-t-d). Japanese 10-year “JGB” yields declined 4 bps to 1.895%. The Nikkei 225 rose 1.2%, increasing y-t-d gains to 5.6%. Emerging equities markets mostly held their own, while debt markets remained under moderate pressure. Brazil’s benchmark dollar bond yields added 2 bps this week to 6.08%. Brazil’s Bovespa equities index dipped 0.5%, reducing y-t-d gains to 22.0%. The Mexican Bolsa declined 1.5%, reducing 2007 gains to 19.6%. Mexico’s 10-year $ yields gained 3 bps to 5.95%. Russia’s RTS equities index gained 0.7% (down 1.3% y-t-d). India’s Sensex equities index rallied 2.2%, increasing 2007 gains to 4.9%. Today’s 3.3% sell off left China’s Shanghai Composite index down 1.0% for the week (up 52.9% y-t-d and 156% over 52-weeks). Freddie Mac posted 30-year fixed mortgage rates declined 5 bps to 6.69% (down 2bps y-o-y). Fifteen-year fixed rates fell 6 bps to 6.37% (up one bp y-o-y). One-year adjustable rates dropped 9 bps to 5.66% (down 9bps y-o-y). The Mortgage Bankers Association Purchase Applications Index declined 3% this week. Purchase Applications were up 8.8% from one year ago, with dollar volume 14.7% higher. Refi applications fell 4.2% for the week, although dollar volume was up 23.3% from a year earlier. The average new Purchase mortgage dropped to $237,000 (up 5.4% y-o-y), and the average ARM declined to $396,200 (up 16.5% y-o-y). Bank Credit jumped $28.9bn (week of 6/13) to a record $8.584 TN. For the week, Securities Credit rose $32.1bn. Loans & Leases dipped $3.2bn to $6.266 TN. C&I loans declined $6.1bn, and Real Estate loans dipped $3.5bn. Consumer loans added $3.6bn. Securities loans fell $2.0bn, while Other loans gained $4.7bn. On the liability side, (previous M3) Large Time Deposits declined $15.9bn. M2 (narrow) “money” gained $7.5bn to $7.248 TN (week of 6/11). Narrow “money” has expanded $204bn y-t-d, or 6.3% annualized, and $448bn, or 6.6%, over the past year. For the week, Currency dipped $0.2bn, and Demand & Checkable Deposits fell $25.1bn. Savings Deposits jumped $26.5bn, and Small Denominated Deposits increased $0.4bn. Retail Money Fund assets gained $6.0bn. Total Money Market Fund Assets (from Invest. Co Inst) rose $4.2bn last week to $2.534 TN. Money Fund Assets have increased $152bn y-t-d, a 13.3% rate, and $428bn over 52 weeks, or 20.3%. Total Commercial Paper rose $11.4bn last week to a record $2.132 TN, with a y-t-d gain of $158bn (16.6% annualized). CP has increased $355bn, or 20.0%, over the past 52 weeks. Asset-backed Securities (ABS) issuance rose moderately to $12bn. Year-to-date total US ABS issuance of $342bn (tallied by JPMorgan) is running slightly behind comparable 2006. At $162bn, y-t-d Home Equity ABS sales are 35% below last year’s pace. Meanwhile, y-t-d US CDO issuance of $177 billion is running 17% ahead of record 2006 sales. Fed Foreign Holdings of Treasury, Agency Debt last week (ended 6/20) jumped $11.7bn to a record $1.967 TN. “Custody holdings” were up $215bn y-t-d (25.5% annualized) and $330bn during the past year, or 20.1%. Federal Reserve Credit last week increased $2.3bn to $852.3bn. Fed Credit is about unchanged y-t-d, with one-year growth of $26.4bn (3.2%). International reserve assets (excluding gold) - as accumulated by Bloomberg’s Alex Tanzi – were up $607bn y-t-d (26% annualized) and $965bn y-o-y (22%) to a record $5.418 TN. Currency Watch: June 18 – Bloomberg (Kosuke Goto): “Japanese businessmen, housewives and pensioners betting against the yen in their spare time are wrecking the forecasts of the world’s biggest currency traders. The yen has slumped 4.6% to a 4 1/2-year low against the dollar this quarter, making it the worst performer among 72 major currencies and confounding predictions by strategists… The banks didn’t reckon on the risk appetite of Japanese individuals, who are borrowing money like never before to buy currencies with higher yields. They tripled their trading in the year ended March to a record $11 billion a day… Globally, currency trading by retail investors rose 54% in 2006, according to research firm Greenwich Associates in Greenwich, Connecticut.” The dollar index declined 0.6% to 82.13. On the upside, the Swedish krona gained 2.3%, the Romanian leu 1.6%, the Hungarian forint 1.8%, the Norwegian krone 1.6%, and the New Zealand dollar 1.4%. The Swiss franc rose 1.0% and the euro 0.6%. On the downside, the Colombian peso declined 2.0%, the Brazilian real 1.9%, the Indonesian rupiah 1.8%, the Israeli shekel 1.1%, and the Mexican peso 0.6%. The yen sunk to a record low against the euro and a four and one-half year low against the dollar. Commodities Watch June 19 – Bloomberg (Madelene Pearson and Fergus Maguire): “Australia, the world’s third-largest wheat shipper, cut its production forecast by 10% on concern of dry weather in its main export wheat-growing area, adding to a squeeze that's driven prices to an 11-year high.” For the week, Gold declined 1.2% to $654 and Silver 1.8% to $13.02. Copper fell 1.1%. August crude added 60 cents to $69.14. July gasoline gained 1.2%, while July Natural Gas sank 10%. For the week, the CRB index declined 1.4% (up 2.4% y-t-d), and the Goldman Sachs Commodities Index (GSCI) also declined % (up 12.6% y-t-d). Japan Watch: June 21 – Bloomberg (Lily Nonomiya): “Japan’s trade surplus widened in May as export growth accelerated, indicating the slump in U.S. demand that cooled shipments in April was temporary. The surplus rose 9.3% to 389.5 billion yen ($3.2 billion) from a year earlier… Exports rose 15.1% in May, more than the 11.8% median estimate…” China Watch: June 19 – Financial Times (Richard McGregor and Jamil Anderlini): “Chinese housing prices rose in May by 6.4%, the fastest year-on-year monthly increase in 18 months, in the latest sign that the economy is outpacing both the government’s and the market’s expectations. The World Bank and Morgan Stanley in recent days have revised upwards their growth forecasts for 2007 to above 10%... ‘The latest data indicate buoyant activity in almost every aspect of the economy, including investment, retail sales, external trade, and industrial production,’ said Qing Wang, of Morgan Stanley. One of the most disturbing signs for the government has been the surge in power consumption, now rising at about 16% annually, well ahead of overall growth.” June 19 – Financial Times (Richard McGregor and Jamil Anderlini): “Eight years ago, China’s technocrats came up with an idea for what to do with the government’s vast stockpile of corn reserves, a stockpile that was going stale. The plan was to transform the corn into starch, sweeteners or ethanol, which could be blended with gasoline to run cars. The move would create valuable products and potentially reduce China’s oil dependency. Now there is growing concern that creating biochemical and biofuels industries worked too well. The stale corn reserves are used up and there is increasing competition for fresh supplies between rapidly growing industrial processors and livestock farmers who rely on it as feed for animals… In April, the food price index rose 7.1%... The search for corn sent China, the world’s second-biggest corn producer, back into international markets in 2005 for the first time since the mid-1990s. Only 70,000 tonnes were imported last year but that amount is likely to soar to 24m tonnes by 2020.” Asia Boom Watch: June 20 – Bloomberg (Kim Kyoungwha): “South Korea’s economic growth will top 4% in the second quarter, central bank Assistant Governor Lee Ju Yeol said.” June 20 – Bloomberg (Suttinee Yuvejwattana): “Thailand’s trade surplus widened in May as rice, sugar and electronics pushed exports to a record, outpacing imports, the commerce ministry said. The trade surplus rose to $800 million in May… ‘All of our export items are rising, especially the agricultural products…’ Exports rose 20.9% from a year earlier to a record $13.1 billion…” June 20 – Bloomberg (Stephanie Phang and Angus Whitley): “Malaysia’s economy may expand 6% for a second straight year in 2008, the government said, reducing the need for an interest-rate cut to fuel growth.” Unbalanced Global Economy Watch: June 20 – Bloomberg (Gabi Thesing): “The pace of global economic expansion is the strongest in decades, fueling demand for German goods, Handelsblatt reported, citing an interview with Hans-Werner Sinn, president of the Munich-based Ifo Institute. Sinn said that if this year proves, as forecast, to be the fourth straight year in which the global economy has grown about 5%, it will be the first time since the 1950s that that has been the case, the newspaper said.” June 18 – Bloomberg (James Kraus): “Rising global demand for cranes is slowing the U.S. construction industry and creating a backlog of orders for manufacturers, the Wall Street Journal said. Manitowoc Co., one of the largest crane manufacturers in the world with more than 6,000 people in its crane division, has added about 500 employees in North America in the last three years and a third shift at factories in the U.S. to keep up with demand…” June 20 – Bloomberg (Svenja O’Donnell): “U.K. money supply growth accelerated in May to the fastest pace in seven months, suggesting the Bank of England may have room to further increase interest rates. M4, which is the broadest gauge of U.K. money supply…rose 13.8% from a year earlier, accelerating for a third month…” June 19 – Bloomberg (Marcel van de Hoef): “Dutch unemployment fell to 4.7% in the three months ended May 31, the lowest in four years.” June 20 – Bloomberg (Simone Meier): “Swiss producer and import prices, an early indicator of consumer price inflation, rose more than expected in May led by higher costs for mineral oil products. Prices for factory and farm goods as well as imports rose 0.9% from the previous month… In the year, prices increased 2.8%.” June 18 – Bloomberg (Simone Meier): “Swiss industrial production rose for an eighth quarter as demand for machines and chemicals increased. Production in the first three months of 2007 increased 7.3% from a year earlier…” June 19 – Bloomberg (Monika Rozlal): “Poland’s average corporate wages rose an annual 8.9% in May, boosting the chance that interest rates may be lifted as soon as this month to curb inflation.” June 20 – Bloomberg (Mahmoud Kassem): “Egypt’s economy expanded 7.2% in the third quarter of the fiscal year that ends June 30, Al-Alam al-Yom reported… The economy grew 6.9% in the first nine months of the fiscal year…” Latin American Boom Watch: June 21 – Bloomberg (Patrick Harrington): “Mexico’s unemployment rate fell in May from the previous month. The jobless rate fell to 3.2% from 3.6% in April…” June 20 – Dow Jones: “Brazil’s federal tax receipts rose 18.2% in real terms in May compared with the same month a year ago…” June 21 – Bloomberg (Bill Faries and Daniel Helft): “Argentina’s economy, the second-largest in South America, grew faster than expected in April… Argentina’s economy expanded 8.4% in April from the same period a year earlier…” June 17 – Bloomberg (Daniel Helft): “Argentina revenue will reach 200 billion pesos ($65 billion) this year as the economy expands at more than 8%, the newspaper Clarin reported, citing economy ministry officials... Tax collections will be 32% higher…” Central Banker Watch: June 21 – Financial Times (David Ibison): “Sweden’s central bank has raised interest rates by a quarter percentage point to 3.5% and adopted a more hawkish stance after indicating there will be two more quarter point increases before the year is over. The Riksbank also raised its medium-term interest rate forecast to 4.4% by the end of 2009, well above the 3.7% it forecast in February. The increases are attributable to strong growth domestically and overseas, decreasing unemployment, higher-than-expected wage costs and a buoyant lending and housing market.” Bubble Economy Watch: June 20 – Dow Jones (Irwin Kellner): “Will it take double-digit percentage price increases to convince the markets that inflation is rapidly becoming a major economic problem? Over the past three months, the annual rate of inflation has been running anywhere from 7% to 9%. That’s no typo, folks: Since March, prices have gone up at a 7% clip at the consumer level and at an 11% pace at the producer, or wholesale, level. By contrast, last year consumer prices rose 2.5%, while producer prices inched up just 1.1%. Of course, I am referring to the headline figure in each instance; in other words, all the prices that are contained in these indexes.” Financial Sphere Bubble Watch: June 21 – Bloomberg (David M. Levitt): “JPMorgan Chase & Co.’s new trading floors at Manhattan’s World Trade Center site would jut out 127 feet beyond the building’s facade, hovering above a park and a church, according to renderings released today. The six cantilevered trading floors would extend in a six-story shelf from the north face of the 42-story tower, towards the World Trade Center Memorial. JPMorgan…last week agreed to build a 1.3 million square foot tower just south of Ground Zero. ‘As a physical matter, it’s very difficult to get a trading floor that big on a 32,000 square-foot site,’ said Anthony Shorris, executive director of the [Port] authority, which controls the site.” June 19 – Dow Jones: “The nation’s largest public pension fund is doubling its investment in hedge funds…to $10B from $5B. The California Public Employees’ Retirement System, Calpers, also plans to double to $10B its investment in funds that seek to improve returns by bettering companies’ corporate governance.” June 19 – Financial Times (Richard McGregor and Jamil Anderlini): “American regulators may be forced to clamp down on activity in the so-called repurchase, or repo, market involving US government bonds if the industry does not clean up its behaviour, a senior official has warned… The comments will be closely watched by the market since it comes at a time of widespread investor interest in the US government bond sector, which has seen heavy trading volumes in recent days as a result of sharp price swings. American finance officials attach a huge importance to maintaining the reputation of the $4,000bn-plus Treasury market and the related repo market. In the repo market, traders do not buy or sell bonds but use them as collateral for short-term financing. However, last year there was criticism from the US Treasury and others that traders had been trading to make profits by hoarding specific securities or manipulating the timing of trades.” Mortgage Finance Bubble Watch: June 22 – Bloomberg (Jody Shenn and Yalman Onaran): “Bear Stearns Cos. offered to provide $3.2 billion in loans to bail out one of its money-losing hedge funds, the biggest rescue since 1998, after creditors started seizing assets. The firm will provide a credit line to the High-Grade Structured Credit Strategies Fund that will be backed by the fund’s assets. Bear Stearns made the offer after creditors including Merrill Lynch… JPMorgan… and Lehman…put some of their collateral up for sale to investors.” Foreclosure Watch: June 18 – Bloomberg (John Taddei): “More New York City homeowners are missing payments on their subprime loans and entering the foreclosure process, the New York Post reported. In Brooklyn’s Bedford-Stuyvesant, one-fifth of subprime mortgages were more than 60 days in arrears as of April, and 10% of all subprime loans were in foreclosure, The Post said. In one part of Bedford-Stuyvesant, the percentage of subprime loans 60 days or more in arrears rose from 15% in June 2006 to 23% in April 2007, said The Post.” MBS/ABS/CDO/Derivatives Watch: June 21 – Bloomberg (Jody Shenn): “David Castillo, a senior managing director who trades asset-backed, commercial-mortgage and CDO bonds in San Francisco at Further Lane Securities, comments on the collateralized debt obligation market… On valuations assigned to CDO holdings: ‘The CDO market is where it’s is happening right now. Subprime isn’t the story’ because the main driver of subprime-mortgage bond prices, and main holders of the securities, are CDOs and, in turn, their owners… ‘If nothing’s trading and nobody’s pressuring you about it, why would you make it an issue? Nobody wants to look at the truth right now because the truth is pretty ugly.’” June 21 – Bloomberg (Mark Pittman): “Scott Simon, head of mortgage- and asset-backed securities… at Pacific Investment Management Co. … comments on the deterioration in the U.S. subprime mortgage bond market and the liquidation of two Bear Stearns Cos. hedge funds… ‘The question is: Is this the tip of the iceberg?’ ‘When you get nervous is when you have $600 million of money that’s got $15 billion of positions.’ ‘The problem with these bonds is that there’s no market… The bonds are so sensitive to assumption, that little assumptions make an enormous difference in valuation. The difference between 60 and 90 is a very small deviation in path between now and five years from now. The bonds are incredibly levered.’” June 20 – Bloomberg (Patricia Kuo and Junko Fujita): “Credit-default swaps linked to loans will be more actively traded in the U.S. than the loans themselves within a year, according to analysts at Citigroup Inc… Trading of loan credit-default swaps now accounts for 50% of the volume of loan trades handled by Citigroup…” Real Estate Bubbles Watch: June 20 – Bloomberg (Hui-yong Yu): “Morgan Stanley and Goldman Sachs Group Inc. raised $12 billion for global real estate funds, tapping a surge in investor demand for high-return assets outside the U.S.” June 20 – Bloomberg (Will McSheehy and Bradley Keoun): “Merrill Lynch & Co. plans to raise funds to invest in global real estate and infrastructure, chasing rivals Goldman Sachs Group Inc. and Morgan Stanley in offering clients alternatives to takeover funds. ‘There’s no doubt the infrastructure space is an opportunity that's evolving,’ Ahmass Fakahany, co-president of Merrill, said…” June 20 – Bloomberg (Simon Packard): “Merrill Lynch & Co. Inc., the world’s biggest brokerage, sold its London offices to the government of Singapore for $954 million, and will rent the property back under a 15-year lease at an unspecified rent.” June 21 – PRNewswire: “California’s real estate downturn will be deep and long lasting, with home prices falling 15 to 30% during the next 36 to 42 months, according to a prominent real estate expert. Bruce Norris, who correctly forecast both the real estate boom that began in 1997 and the subsequent doubling of home prices, said the downturn will reflect a perfect storm that includes record numbers of foreclosures, a sharp decline in migration to California, substantial increases in unsold inventory, and, of course, falling prices. ‘We are in for a very rough ride in California’s real estate market, which is likely to be far more severe than analysts, state officials and real estate industry associations have acknowledged… Foreclosures alone are likely to be more numerous than anything we’ve ever experienced, with bank repossessions ultimately accounting for as high or as many as 25-30% of all homes sold during the next three years. But like any storm, this, too, shall pass’” M&A and Private-Equity Bubble Watch: June 22 - Dow Jones (Margot Patrick): “Volume in European mergers and acquisitions deals will hit a record $1.02 trillion in the first half, according to preliminary figures… [from] Thomson Financial… The activity in Europe puts the region neck and neck with the U.S., where volume was $1.025 trillion as of June 21. It is the fifth consecutive year that first-half M&A volume has risen globally…” June 21 – Financial Times (Ben White, James Politi, Francesco Guerrera, and Eoin Callan): “Blackstone’s $7.8bn initial public offering was about seven times subscribed on Wednesday with strong investor demand for the units, especially from Asia, the Middle East and Europe, despite concerns over the US private equity group’s valuation. People close to the offering said orders for Blackstone units had significantly outstripped supply. However, they added that demand from big US mutual funds had been limited by concern over a possible increase in Blackstone’s tax liability.” June 19 – Financial Times (Gillian Tett): “The use of so-called ‘cov-lite’ deals is snowballing in Europe and the US, in spite of warnings from regulators and financiers that these instruments could produce new dangers for investors if the credit cycle turns. In recent weeks London bankers have sold a flurry of financing packages for European companies that feature reduced use of covenants – stipulations, such as minimum levels of interest coverage, to protect lenders… In the US, more than a third of all loan issuance this year has been cov-lite, according to Standard and Poor’s Leveraged Commentary Data… ‘Talk is that arrangers [investment banks] are being told not to bother calling [private equity] sponsors for new mandates unless they are prepared to do cov-lite,’ says S&P LCD. The trend has horrified traditional financiers, who warn that it will leave investors exposed to losses if the credit cycle turns. Regulators and central bankers fear it indicates that credit markets are in a bubble.” June 19 – Financial Times (Richard McGregor and Jamil Anderlini): “The chief executive of UBS, the Swiss banking group, warned that the growing number of risky loans investment banks are making could lead to lawsuits and damaged reputations. The warning by Peter Wuffli highlights increasing concern among senior executives that a boom in leveraged finance could drag banks into litigation and damaging disputes with clients if the credit cycle turns. His comments…are the latest in a series of warnings by investors, bankers and regulators… Mr Wuffli compared the potential consequences of the lending boom with the fallout from the stock market bubble of the late 1990s, when investment banks became embroiled in a series of accounting scandals and regulatory investigations that proved more damaging than their financial losses.” June 21 – Financial Times (Jeremy Grant and Eoin Callan): “The political momentum behind efforts to get private equity to pay more tax gathered pace last night even as Blackstone was pricing its initial public offering, with leading Democrat Barney Frank saying it was ‘an outrage’ that the industry was being ‘under-taxed’. His comments came as a new bill to increase US taxes on private equity emerged in the House of Representatives from Vermont congressman Peter Welch, who took aim at a ‘gaping tax loophole’. It also emerged that the Senate finance committee was considering toughening a bill introduced last week that would force listed private equity groups to pay corporation tax.” Energy Boom and Crude Liquidity Watch: June 19 – Bloomberg (Daryna Krasnolutska): “Azerbaijan’s economy, the world’s fastest growing, will probably expand more than 35% this year as oil exports accelerate, Economic Development Minister Heydar Babayev said.” Climate Watch: June 20 – Bloomberg (Alex Morales): “China in 2006 overtook the U.S. as the world’s biggest emitter of carbon dioxide, the greenhouse gas blamed for the bulk of global warming, a policy group that advises the Dutch government said. China produced 6,200 million metric tons of carbon dioxide from burning fossil fuels and producing cement last year, the Netherlands Environmental Assessment Agency said… That pushed it past the U.S., which produced 5,800 million tons of the gas, the agency said.” Speculator Watch: June 19 – Bloomberg (Linda Sandler): “Claude Monet’s painting of Waterloo Bridge doubled its top estimate while a view of his rose garden in France fell short of its low valuation at a Christie’s International sale last night in London. The world’s largest auction house took in 121.1 million pounds ($240 million), including commissions, beating its top target. Monet’s 1904 ‘Waterloo Bridge, Temps Couvert’ sold for 17.9 million pounds…” Uncertainty Reigns Supreme: This should be an easy Bulletin to write: The apparent collapse of two hedge funds -highly leveraged (at least 10 to 1) in illiquid collateralized debt obligations (CDOs) and other “structured” instruments. Escalating losses induce the fund’s (“repo”) lenders to hit The Street with bid lists of CDO collateral apparently loaded with subprime exposure. The dearth of buyers willing to pay anything close to “market” (“marked”) prices then forces the specter of revaluation and downgrades of similar securities and a possible contagion de-leveraging of CDO exposures throughout. Smelling blood, scores of enterprising speculators of various stripes move to place assorted bets seeking profits from the expected forced liquidations, generally widening Credit spreads, and the potential snowball unwind of leveraged speculations. The Wall Street firm that sponsored the funds is forced to step up and loan the funds $3.2 billion, increasing its risk profile in an increasingly Uncertain marketplace. And with the CDO market having evolved into a critical source of system Credit and liquidity creation, the potentially dire Credit ramifications certainly could have rocked U.S. and global markets. Yet, even after today’s drubbing the Dow is only about 2% off its record high and the S&P500 only a few percent below its own. The NASDAQ100 is within a percent or so of its six-year high. The emerging equities boom hasn’t missed a beat, with Brazil’s Bovespa index up 22% y-t-d, Mexico’s Bolsa almost 20%, and China’s Shanghai Composite up 52%. Emerging debt spreads remain near record lows. Junk spreads aren’t far off recent lows. It would be easy this week to just stick with the obvious: marketplace complacency has become deeply ingrained. I’ll shoot for something a bit more thought-provoking, delving deeper into possible reasons behind the markets’ nonchalance. First of all, market participants have become conditioned to seek added risk during these occasional periods of “risk” market tumult. Buying stocks and bonds back in the dark days of the 1994 MBS/bond/interest-rate derivatives rout worked wonderfully. Ditto for the LTCM debacle in October 1998, the corporate Credit dislocation in 2002, the auto bond/derivatives dislocation in 2005, last year’s Amaranth collapse, or even the February subprime implosion. It has been a case of each “profit opportunity” emboldening a little deeper. “Resiliency” is today’s watchword. But there is certainly more to market behavior than a simple Pavlovian response. After all, the global economy is booming and Inflationary Biases proliferate at home and abroad. For example, Goldman and Morgan Stanley combined to raise $12 billion this week for their latest global real estate funds. So far, the historic global M&A boom hasn’t missed a beat. And despite subprime and housing angst, U.S. and global debt issuance runs at or near record pace. Junk issuance was robust again this week. Even CDO issuance remains strongly above last year’s unprecedented level. The bulls (that tend to remain contently oblivious to Credit and speculative dynamics) are comfortable that the U.S. economy is in decent shape; that the global economic boom has a powerful head of steam; and that liquidity remains abundant. Naturally, they would expect powerful Wall Street to fix problems as they arise. Yet below the surface of mostly impressive market performance there are troubling signs. Notably, recent risk market turbulence has been noteworthy for failing to ignite aggressive Treasury purchases. Ten-year yields declined only a few basis points this week, and Treasuries outperformed agency debt and MBS. For years, the Credit market has been bolstered by the awareness that any indication of heightened systemic stress would be met with an immediate rally in Treasuries, agencies, MBS and other “top-tier” securities. I’ve always seen this predictable drop in yields (increase in bond prices!) as a key dynamic supporting leveraging and risk-taking generally. A change in this dynamic would be a significant Credit Bubble and market development. Clearly, U.S. markets are coming to the realization that global forces these days play a much more prominent role than ever before. Robust Credit systems globally, general liquidity overabundance, and increasingly determined international central bankers are pressuring global as well as U.S. bond yields. Importantly, this is forcing participants to rethink how quickly (and freely) the Fed might respond to heightened financial stress, especially if it is largely isolated to a particular segment of the U.S. Credit system. I can imagine the manager of Bear Stearns’ troubled hedge funds - and most speculators in risky assets - have for some time built into their thinking (and models) the presumption that any meaningful stress in asset markets (certainly including housing, stocks, and “structured finance”) would quickly impel lower Fed funds rates and sinking market yields. Today’s scenario of a subprime implosion, faltering U.S. housing markets, an unparalleled global M&A boom, record debt issuance, an escalating global economic boom, $70 crude, heightened inflation pressures, and rising bond yields would have been considered a remote possibility not many months ago. But things these days move so quickly and unpredictably. Issues that were not even on the radar screen six months ago are now front and center. The Blackstone Group as a public company with a $38bn market capitalization? The prospect for wide-ranging legislation that would significantly raise the tax burdens for hedge funds, private equity firms, and venture capitalists? “Sovereign wealth funds” that will quite likely prefer the acquisition of companies, resources, and other strategic assets to freshly “minted” debt securities courtesy of our Department of the Treasury and the GSEs? June 21 – Financial Times (Krishna Guha): “The US is growing wary of the new fashion for sovereign wealth funds, amid concern among policymakers about potential negative effects on the international financial system. Officials worry that the creation of such funds – which invest excess foreign exchange reserves – by non-oil exporters such as China may reduce the incentive for these countries to reform their currency regimes. They are also concerned that the existence of more large state-owned investment vehicles, with opaque holdings and objectives, could create problems for private investors operating in global markets… A former senior administration official said: ‘A year ago they were not on anyone’s radar screen.’ Now, he said, the US was trying to figure out how to engage with countries eager to set up these funds. John Taylor, undersecretary for international affairs in the first term of the Bush administration, told the FT ‘it is definitely a concern’. ‘One of the things clearly is the motivation, rationale and transparency of the funds,’ he said…. the spread of giant public sector funds ran contrary to the longstanding US agenda of promoting a private sector market-based global financial system. ‘A world where the private sector is making investment decisions is more dispersed, there is less concern about concentration of power. This has worked well,’ he said… The former senior administration official said there was nothing intrinsically ‘villainous’ about sovereign wealth funds. But there were concerns, not just in the US, that ‘China is going to want a device to make strategic acquisitions around the world that will trigger a political backlash’.” He said sovereign wealth funds could operate as ‘a big honeypot’ for governments.” The subprime implosion, CDO problems, faltering hedge funds, China Bubble worries, the global M&A and securities Bubbles, prospering hedge funds and leveraged speculators, ballooning Wall Street, “tax the rich”, enterprising sovereign wealth funds, wildly inflating global asset markets and heightened uncertainty are anything but random and independent developments. I hope readers will contemplate that the world economy, financial flows, and markets have been commandeered by Precarious Global Credit Bubble Dynamics - and the pursuit of free-flowing but highly inequitable financial riches. At its Core, to sustain U.S. Financial and Economic Bubbles requires ever increasing amounts of already colossal Credit creation. The global effects emanating from this global inundation become more pronounced and unwieldy by the month. In relation to subprime, CDOs, derivatives, and highly leveraged hedge funds, keep in mind that the task of intermediating (transforming risky Credits into palatable securities) ever rising quantities of increasingly risky debt instruments has become quite a challenging endeavor. This process – whether in relation to mortgage finance or corporate M&A – implies greater system leveraging, risk-taking, and the implementation of more sophisticated risk instruments and strategies. Contemporary Credit booms work too magically on the upside, but the enigmatic world of derivatives and aggressive speculative leveraging ensure great Uncertainty at some (turning) point. How secure is the collateral supporting Bear Stearns’ $3.2bn hedge fund loan? How great is the risk of an unwind and contagion collapse of leveraged CDO and risky MBS/ABS holdings? How quickly could tumult in the CDO marketplace spread the fear of risky mortgages to fear for risky corporate Credits and a faltering M&A Bubble? To what extent will the global “leveraged speculating community” hedge against and/or speculate on widening spreads and heightened Credit system stress? On several fronts, the Credit Bubble and U.S. Current Account Deficit-induced ballooning pool of global finance was inevitably going to lead to major market Uncertainties. That day has arrived – the comforting and dependable flow (deluge) of finance into U.S. debt securities can’t now be so mindlessly taken for granted. Will the global speculator community generally remain cohesive in pursuit of risk assets, or will we look back on the subprime implosion as marking the onset of dog-eat-dog opportunism, forced liquidations, hedging, and de-leveraging? Does the recent rise of the powerful sovereign wealth funds create, as the bulls believe, an inexhaustible pool of finance for stocks and risk assets? Or, perhaps, as it seems our government officials fear, does their advent mark an inflection point where a meaningful portion of the global pool of speculative finance abandons automatic Treasury/agency purchases in pursuit of better returns however they may be attained (including shorting, hedging, and bear trading). Not uncharacteristically, over-zealous financiers and speculators have greatly exacerbated late-stage Bubble risk and Uncertainty. The M&A boom got too hot. Global stock, real estate and assets markets turned too hot. The Chinese, Asian and general global economy became too hot. Billions were made too effortlessly; the CDO game was too easy. And robust economies and myriad spectacular asset and debt Bubbles are by their nature gluttons for additional Credit and marketplace liquidity. Inevitably, things turn tenuous, and the line between runaway boom and unwinding Bubble turns troublingly thin. For the semblance of order is maintained only as long as speculation and leverage-induced demand for risky debt instruments meets the ever escalating supply. Most of the ingredients for Credit crisis are within reach, yet heightened volatility is likely still the best short-term bet. I would expect the gigantic pool of speculative finance to be increasingly keen to short securities and bet on/hedge against systemic stress. This is a notably unbullish dynamic, one that likely alters that nature of speculative flows - and that could at any point initiate a rush for the exits, market dislocation and panic. Big down days seem inevitable, the kind that really shake confidence and instill fears that the “wheels are coming off.” But there will almost surely also be days of panicked short covering and euphoric buying. And those days will reinvigorate notions of goldilocks, New Eras and unlimited finance. There will be days when the hedge funds and sovereign wealth funds are perceived as bull market friendly and days when their supporting role is seriously questioned. Uncertainty Reigns Supreme. |
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