12/19/2003 No Inflating Out of this Quagmire *

It was a good week for financial assets.  The Dow gained 2.3%, increasing 2003 gains to 23%.  The S&P500’s better than 1% advance increased y-t-d gains to 24%.  The leading S&P groups this week were Steel, Office Electronics, Construction & Farm Machinery, and Aluminum.  The Transports were unchanged (up 29% y-t-d), while the Utilities added 2% (up 17% y-t-d).  The Morgan Stanley Cyclical index surged another 3%, with quarter-to-date gains of 22% and y-t-d gains of 48%.  The Morgan Stanley Consumer index rose 2% (up 9% y-t-d).  The small cap Russell 2000 (up 43% y-t-d) and S&P400 Mid-cap (up 32% y-t-d) indices were little changed. The NASDAQ100 (up 45% y-t-d) and Morgan Stanley High Tech (up 60% y-t-d) indices rose about 1%.  The Semiconductor’s 1% decline reduced y-t-d gains to 69%.  The Street.com Internet Index was slightly positive (up 72% y-t-d) and the NASDAQ Telecommunications index added 1% (up 60% y-t-d).  The Biotechs’ 1% advance increased 2003 gains to 41%.  The Broker/Dealers (up 53% y-t-d) and Banks (up 28% y-t-d) rose about 1%.  Although bullion added 50 cents to $409.35, the HUI Gold index dropped 5%.  Credit market instrument prices rose also.  For the week, 2-year Treasury yields dipped 3 basis points to 1.78%.  Five-year Treasury yields declined 7 basis points to 3.15%.  Ten-year yields sank 10 basis points to 4.13%, the lowest yields since early October.  The long-bond saw its yield drop 13 basis points to 4.96%.  Benchmark Fannie Mae mortgage-backed yields declined 11 basis points.  The spread on Fannie’s 4 3/8 2013 note widened 1 to 36, and the spread on Freddie’s 4 ½ 2013 note was unchanged at 36.  The 10-year dollar swap spread increased 1.25 to 38.  Corporate spreads were generally little changed, with spread indexes at near 5-year lows.  The implied yield on December 2004 Eurodollars declined 2.25 basis points to 2.20%. Debt issuance, at about $8 billion, was double the comparable week from one year ago (according to Bloomberg).  Investment grade issues:  BB&T $1 billion, Exelon Generation $500 million, Berkshire Hathaway $500 million, L-3 Communications $400 million, Piedmont Natural Gas $200 million, Hyundai Motor $400 million, Oakmont Asset Trust $350 million, and Huntington National $200 million.  Junk bond funds enjoyed their seventh consecutive week of inflows, although flows of $170 million (from AMG) were about half of the previous week.  Junk issues:  NRG Energy $1.25 billion, Telenet Communications $1.1 billion, CSN Islands VIII $350 million, Asbury Auto Group $200 million, Suburban Propane $175 million, Resolution Performance $140 million, Nexstar Finance $125 million, and El Pollo Loco $110 million. Foreign dollar debt issuers included Region of Sicily $981 million and Autopista Central $250 million. Convert issues:  Adaptec $200 million, Agco $175 million, Kroll $150 million, Mentor $125 million, and Fleetwood Enterprises $80 million.  Commodities Watch: December 19 – Bloomberg:  “Soybean futures rose in Chicago after U.S. exporters reported a record purchase by China, the biggest customer for U.S. beans.   The U.S. Agriculture Department said Chinese buyers bought 1.8 million metric tons, or 66.1 million bushels, of soybeans, the biggest sale ever in a single day… Rising demand from China has helped fuel a 37 percent rally in prices in the past year. Yesterday officials from the Chinese Commerce Ministry agreed to purchase 2.5 million metric tons of U.S. soybeans and took an option for another 2.5 million tons. ‘China’s back, we’re friends, everybody’s happy,’ said Tim Hannagan, an analyst with Alaron Trading Company…” December 16 – Bloomberg:  “China paid 45 percent more for a ton of imported iron ore in September than a year earlier amid surging demand for the commodity used to make steel, the Tex Report said, citing Chinese government statistics.” December 18 – Bloomberg:  “U.S. Energy Secretary Spencer Abraham said more than $100 billion needs to be invested in liquefied natural gas projects to meet the nation’s energy needs by 2025. ‘The U.S. will have to become a much larger importer of LNG than it is today,’ Abraham said in a speech at a government-sponsored LNG summit in Washington. He said LNG imports could reach 13 billion cubic feet a day -- more than 20 times today’s rate -- in 2025, and account for 15 percent of total natural gas supplies.” The CRB index was unchanged this week at 7-year highs.  Depleting inventories saw crude oil rose to prices not seen since war-worried March.  Fears of shortages were behind 14-year highs in nickel prices.  China Watch: December 16 – Bloomberg:  “China’s retail sales rose about a 10th for a fifth straight month in November as rising incomes and a credit boom enabled consumers in cities such as Beijing and Shanghai to buy more cars, homes and cell phones.  Sales increased 9.7 percent from a year earlier to 420 billion yuan ($50.7 billion) after growing 10.2 percent in October, their fastest pace in two years…” December 16 - Financial Times (James Kynge):  “China’s boundless commercial energy has begun to bump up against finite capacity.  It is too early to tell how soon and to what extent these capacity constraints will start to slow the world’s fastest-growing large economy. But it is clear that shortages - in some areas - of electricity, transport capacity, coal, grain and other commodities are forcing up prices and restraining new investment… The clearest capacity constraint to growth is in the power industry. Broad swathes of China’s industrial heartland are now chronically short of electricity. The State Power Information Network, a government organisation, has forecast worse shortages and more power rationing next year… One reason for the shortage of electricity has been the soaring price of coal, which supplies 70 per cent of China’s energy needs.  Although official figures show coal prices have risen by just 3 per cent this year, this measure is misleading because it does not include the vast volumes sold on the black market. The price of black-market coal has risen at least 20 per cent, industry executives said… There are 390 Chinese cities that depend on coal mining, but the mines in 80 per cent of them are already mature or in decline, according to statistics from the China Mining Association.  Bottlenecks are also apparent on China’s vast network of railways, which transport 60 per cent of the country’s staple foodstuffs and 80 per cent of the coal at tariffs largely fixed by the state… The lack of rail capacity has shifted the burden to road transport, where prices are set by the market and have therefore been climbing. Indeed, one reason behind the sharp increase in the price of soybeans, maize, wheat, rice, vegetables and pork has been the rising cost of transport.” The consensus remains generally fixated on the “China exporting deflation” story.  But the truth of the matter is that China is providing us with an extraordinary example of Credit inflation and boom dynamics.  An out of control investment boom is now challenged by expanding bottlenecks and shortages.  In turn, runaway Credit excess has nurtured a real estate boom, general asset inflation, and rampant speculation.  China fever has afflicted the world.  What had appeared a healthy, stable and easily manageable boom is being transformed to something more capricious and unwieldy.  And with cautious authorities understandably hesitant to “slam on the brakes” (a boom of this ferocity, breadth and duration will not succumb to inhibited monetary management), we will now have the opportunity to follow and analyze an economy with increasingly problematic Inflationary Manifestations.  At some point, perhaps Chinese authorities will come to recognize that the over-liquefied global financial system and faltering dollar compound their unfolding dilemma.  The Bank of Japan can buy mountains of dollars – adding liquidity to their domestic financial system – seemingly without an inflationary care in the world.  The same is certainly not true for the Chinese with myriad inflationary biases throughout their economy and markets.        Global Reflation Watch: December 20 – Bloomberg:  “Parmalat Finanziaria SpA hired Weil, Gotshal & Manges LLP to advise it on a possible bankruptcy reorganization after Bank of America Corp. contested documents claiming the Italian food company had a $4.9 billion account at the bank, people familiar with the matter said.  Parmalat, which owns Europe’s largest dairy, hired the New York law firm as it begins talks with creditors owed more than $7.1 billion, the people said.”  There is Parmalat exposure in the structured finance and derivatives markets, so this could prove an interesting development. December 19 – Bloomberg:  “Japan’s economy needs to sustain about 2 percent real economic growth in order to overcome deflation, Economic and Fiscal Policy Minister Heizo Takenaka said. Japan should also work toward achieving 2 percent nominal economic growth by the fiscal year starting April 2006, Takenaka said... Takenaka added that the government and the Bank of Japan would need to work together to create conditions in which money supply would rise.” December 18 – Bloomberg:  “Japan’s plan to use 61 trillion yen ($567 billion) to protect exports by weakening its currency may only stem the yen’s appreciation, said strategists at ABN Amro Holding NV and Goldman Sachs Group Inc.  The Ministry of Finance will ask the cabinet for 21 trillion yen in an extra budget for the year ending March 31, said a ministry official familiar with the matter. Another 40 trillion yen will be earmarked for sale to buy currencies such as the dollar and the euro the following fiscal year, said the official. Japan, pulling out of 12-year slump, has spent more than 17.8 trillion yen, a record, in an effort to stem the yen’s 10 percent rise against the dollar this year…” December 18 – Bloomberg:  “German business confidence rose in December to the highest in almost three years, indicating the recovery in Europe’s largest economy is strengthening, a survey by the Ifo economic institute showed.  Ifo’s index of western German executive optimism, one of Europe’s most-watched economic indicators, rose to 96.8 from 95.7 in November. The increase is the eighth in a row.” December 18 – Bloomberg:  “China’s economy will probably expand more than 8 percent next year, according to Li Xiaochao, a director at the National Bureau of Statistics.  ‘Economic growth will likely exceed 8 percent in 2004,’ he said. ‘It is expected to be about 8.5 percent this year.’ China’s economy grew 9.1 percent in the third quarter, giving 8.5 percent growth for the first nine months of 2003.  Citigroup predicts the economy will grow 8.7 percent next year, Goldman Sachs Group Inc. forecasts a 9.5 percent expansion and Deutsche Bank AG is projecting growth of 8.4 percent.”      December 18 – Bloomberg:  “Hong Kong’s jobless rate in November had its biggest drop in 20 years, sliding more than expected as a tourism boom helps revive the city’s economy. The rate fell to 7.5 percent -- the lowest it’s been since March -- from 8 percent in October, the government said in a statement. That’s the largest decline since July 1983, when the British and Chinese governments began formal negotiations over Hong Kong's return to China. ‘The economy is clearly picking up quite strongly. Corporates are hiring workers,’ said Joe Lo, a Hong Kong-based economist at Citigroup Inc.” December 19 – Bloomberg:  “Shares of Shipping Corp. of India Ltd. and Great Eastern Shipping Co. may extend their gains as accelerating global growth and China’s need of oil and gas allow Indian tanker owners to raise charter prices… Tanker owners Worldwide are headed for their most profitable year since 1973, according to ship brokers such as London-based Simpson, Spence & Young.” December 18 – Bloomberg:  “South Korea’s economy will probably grow more than 5 percent in both the first and second halves of next year, according to Korea Development Institute, a state-funded research group… The central bank, which predicts full-year growth of 5.2 percent, forecasts growth will accelerate to 5.6 percent in the second half of next year from 4.8 percent in the first six months.” December 19 – Bloomberg:  “Argentina’s economy grew at its fastest pace in at least nine years in the third quarter, led by a surge in manufacturing and construction, the government said. Gross domestic product expanded 9.8 percent in the July to September period from the same period a year ago after growing 7.6 percent in the second quarter.” December 18 – Bloomberg:  “Brazil’s state development bank, the country’s biggest bank, plans to boost lending 39 percent to 47.3 billion reais ($16.1 billion) next year in an effort to help pull the nation out of the worst economic slump in seven years.” December 17 – Bloomberg:  “Latin America’s economy is set for its fastest economic expansion in four years in 2004, fueled by increased demand from the U.S. and higher prices for the region’s commodities, the United Nations said.  The region will expand 3.5 percent in 2004, up from this year’s growth estimate of 1.5 percent. For the first time since 1997, the UN’s Economic Commission for Latin America and the Caribbean said none of the 19 economies it tracks in the region will shrink.”      December 18 – Bloomberg:  “Brazil has cut its domestic dollar-linked debt by more than two-thirds this year, taking advantage of growing investor confidence to sell more debt in local currency.”      December 18 – Bloomberg:  “Russia paid $17 billion on its external debt this year, President Vladimir Putin said in remarks broadcast by state-owned television Rossiya.” Domestic Credit Inflation Watch: December 19 – Reuters:  “U.S. stock funds could have their second best year of inflows, although six firms connected to improper trading scandals suffered combined outflows of $21.3 billion in November…  Despite the scandals, U.S. equity mutual funds enjoyed inflows overall of $22 billion in November, down from $23.8 billion inflows in October, said Lipper… ‘In the equity funds arena, a very strong December could bring the year’s total inflow to near $200 billion – better than the 1999 total and the second best on record.  And the recent monthly paces, when annualized, have been near or above the record high of $270 billion set in calendar 2000.’ (From Lipper’s Don Cassidy)  Another fund research firm, Strategic Insight, said Thursday that inflows into all long-term mutual funds are projected to reach $300 billion for 2003, ‘the highest pace since 1997 and just shy of an all-time record.’” December 17 – Bloomberg:  “Wall Street firms, flush with profits amid a revival in stocks and investment banking, will increase bonuses in 2003 by 25 percent from a year earlier, New York State Comptroller Alan Hevesi said.  Brokerages and investment banks will award bonuses of about $10.7 billion, or an average $66,800 per employee, to the 161,000 New York City workers in the industry, up from $8.6 billion last year, Hevesi said in a statement. Bonuses peaked at $19.5 billion, or an average $101,000 per employee, in 2000.” Economy Watch:  December 19 – Bloomberg:  “Michael Randles’s Christmas tree is so big it took a crane to erect it on the front lawn of his Stone Mountain, Georgia, home. Randles, owner of M&M Mortgage Corp., spent more than $50,000 to buy the 60-foot Norway spruce, truck it from Sugar Mountain Nursery in Newland, North Carolina, and decorate it with 30,000 lights and 500 red and gold ornaments, some as big as basketballs. ‘Without the year I’ve had in my business, I would not have been able to afford it,’ said Randles, 36, who also has a shorter tree inside his house.  U.S. homeowners are buying bigger, more expensive Christmas trees, and some are taking home a second or third tree, according to growers… Sales of Christmas trees will rise as much as 25 percent this year to 28 million, after three years of decline, according to the National Christmas Tree Association…” December 17 – Bloomberg:  “The U.S. government will probably run a budget deficit next year of around 4-4.5 percent of gross domestic product, a top White House economic adviser said… Mankiw’s prediction for the year that ends Sept. 30 means that the federal government would run a higher deficit in percentage terms than they did this current year.  The fiscal 2003 deficit, reflecting increased government spending, tax cuts and slower economic growth, grew to a record $374.2 billion -- about 3.5 percent of GDP.” November Housing Starts jumped to an amazing annualized 2.07 million units, the strongest level since February 1984 (when homes were smaller and much less expensive!).  Single Family Starts were up a stunning 20.8% y-o-y to a new all-time record.  Multi-family Starts were up 5.0% y-o-y.  It is also worth noting that Housing Starts were up 25% from April.  November Housing Permits were up 6.2% y-o-y. The Philly Fed’s factory activity index surged to the highest level in 10 years.  The index of New Orders shot to the best reading in 23 years.  The pricing index was the highest in more than 4 years.  The index of Employment surged and Prices Paid was up strong,   November’s stronger-than-expected 0.9% rising in Industrial Production was the largest increase since October 1999.  Industrial Production is the highest since March of 2001.  Capacity Utilization has not been higher since August 2002. The four-week average of continuing unemployment claims dipped to the lowest level since September 2001.  There were 27,811 bankruptcy filings last week. The November Consumer Price index posted a 0.2% decline, with y-o-y gains of 1.8%.  Historically, consumer prices have been one of many indicators of general monetary conditions.  Yet it has evolved into likely the least effective tool for judging the appropriateness of monetary policy (Japan in the late-eighties and the U.S. in the late-nineties, as cases in point).  Ironically, it has become Wall Street’s and the Fed’s favorite “inflation” indicator.  Foreign Net Purchases of U.S. Securities jumped from September’s dismal $4.19 billion to a more respectable, although insufficient, $27.65 billion.  Foreign Official Institutions purchased $19.5 billion of Treasuries (the Bank of Japan accounted for more than $17 billion), up from September’s $8.0 billion.  The bottom line is that the $15.9 billion September and October average foreign Net Purchases compares to the $62.6 billion monthly average over the preceding 12 months.  And digging into a bit of detail, we see that the (financial center) UK accounted for $13.5 billion of total Net Purchases.  With net Treasury purchases of $21.5 billion, total Japanese Net Purchases surpassed $18 billion.  Following September’s net liquidations of $2.3 billion, Chinese Net Purchases of U.S. Securities almost reached $5 billion.  Curiously, Total Caribbean saw $2.9 billion of net liquidations following September’s $10.7 billion net sales.  Total Caribbean had averaged $14.4 billion of Net Purchases over the preceding six months.  At $199 billion, Total Caribbean accounted for 65% of total agency transactions for the month.  It is worth recalling that Securities Broker and Dealers' holdings of Total Financial Assets expanded at a 25% annualized rate during this year’s first half to $1.5 Trillion.  This asset growth was associated with a major increase in leveraged speculation (especially in the mortgage-backed arena).  Tumult in the Credit and interest-rate derivatives markets brought this expansion to an abrupt halt during the third quarter.  There are indications, however, that (with Fed assurances) aggressive leveraged speculation has returned.   Lehman Brothers’ Total Assets increased $19.0 billion during the quarter, or 25.8% annualized, to $314.0 billion.  This more than reverses the previous quarter’s $7.4 billion contraction.  Total Assets were up $53.7 billion over 12 months, a 20.6% expansion.  From the beginning of 1998, Total Assets have more than doubled (up 107%).  Net Revenues almost doubled from the year ago quarter, with Net Income up 157%. Morgan Stanley saw Consolidated Net Income surge 43% from the year ago quarter to $1.04 billion.  From the company:  “Institutional Securities posted net income of $753 million, an increase of 69% versus fourth quarter 2002.  Net revenues rose 42 percent to $2.6 billion… Fixed income sales and trading net revenues were $977 million, up 66 percent from fourth quarter 2002.  Tighter credit spreads, a steeper yield curve and increased interest rate, currency and commodities market volatility – drove the overall increase.  Equity sales and trading net revenues of $919 million were up 48 percent from the prior year’s fourth quarter.”  Trading (principal transactions) income more than doubled to $894 million.  Compensation and Benefits were up 55% to $1.782 billion.  Morgan Stanley Total Assets increased $22.2 billion, or 15.3% annualized, to $602.8 billion.  This follows the previous quarter’s $6.2 billion contraction.  Year-over-year, Total Assets were up $73.3 billion, or about 14%. Goldman Sachs’ fourth quarter earnings almost doubled to $971 million, with Trading accounting for more than half of total revenues.  “Net revenues in Trading and Principal Investments were $2.62 billion, 48% above the fourth quarter of 2002…”  For the year, “Fixed Income, Currency and Commodities (FICC) generated record net revenues of $5.60 billion.” This was up 20% from the previous year.  With special thanks owed to the Fed, 2003 Interest Income declined 5% to $10.751 billion, while Interest Expense dropped 14% to $7.60 billion.  Net Earnings for the year were up 42% to $3.01 billion.  (Goldman asset data is not yet available) Bear Stearns’ quarterly Net Income was up 51.3% from the year ago period to $288.3 million.  Principal Transaction revenues were up 28.7% from a year ago to $790.5 million.  Interest and Dividends were down 1.9% to $495.5 million for the quarter, while Interest Expense declined 15.3% to $333.8 million.  Employee Compensation and Benefits jumped 32.5% to $748.9 million. (Asset data not yet available)  Major California mortgage lender GoldenWest Financial grew its loan portfolio at a 27% annualized rate during November to $75.6 billion.  Over the past three months, Golden West’s loan portfolio has expanded at a 29% rate.  This compares to the 4% growth rate during the preceding three month period.  Fannie Mae had a somewhat slower November.  The company’s Book of Business expanded $18.5 billion, or 10.8% annualized, to $2.171 Trillion.  Year-to-date, Fannie’s Book of Business has surged $350.8 billion, or 21.0% (up $591bn or 37% since Jan. 02).   And while Fannie’s Retained Portfolio contracted $6.3 billion during the month to $906.4 billion, MBS sold into the marketplace surged.  For the month, non-retained MBS increased $24.7 billion, or 26.8% annualized (indicative of heightened leveraged speculation).  Over two months, non-retained MBS were up $53.6 billion, or 27% annualized.  This is quite a reversal from August and September’s $37.8 billion contraction (when the leveraged players were liquidating).  December 17 – Los Angeles Times (Mary MacVean and Roger Vincent):  “Home buying should continue to be a - perhaps unwelcome - thrill in Southern California in the months ahead as the still-heated market continues to drive quick sales and reward decisive, competitive buyers.  Median home prices in November jumped 14.1% in Orange County and 20.6% in Los Angeles County from the same period a year ago, according to a report by DataQuick… ‘We have a lot of buyers who aren’t able to act fast enough,’ said Mike Cocos, general manager of ERA Real Estate in north Orange County. ‘Eventually they do get a house after they lose out on three or four properties.’ The chronic shortage of homes for sale coupled with attractively low mortgage rates will keep the pressure on buyers, said Leslie Appleton-Young, chief economist for the California Assn. of Realtors.  ‘The message is ‘Boy, this is the time,’ Young said. ‘It doesn’t look like the situation is going to change any time soon.’  November was the strongest month of the year for home sale closings in his office, Cocos said. Factors fanning the market are an improving economy, steady low interest rates, a shortage of new housing and high demand. ‘There’s a perfect storm in Orange County,’ said Cocos… ‘We’re always looking for a turn in the market, but there’s no way to cook the books and come up with the conclusion that prices are going to decline,’ said Karevoll. ‘Any signs of distress are virtually absent.’” Freddie Mac posted 30-year mortgage rates declined 6 basis points last week to 5.82% (down from the year ago 6.03%).  This is the lowest average rate in 11 weeks.  The average 15-year fixed-rate mortgage declined 10 basis points to 5.14% (down from the year ago 5.42%).  One year adjustable-rate mortgages could be had at 3.77%, unchanged again for the week (vs. year ago 4.07%).  The Mortgage Bankers Association application index jumped 12.6% last week.  Purchase applications increased 9.4% to a strong 437.2 (up 15.7% y-o-y).  Purchase applications dollar volume was up 24.9% from the comparable week one year ago.  Refi volume increased 16.8% this week and we should expect recent rate declines to spur increased refi activity.   Bank Credit increased $5.9 billion.  Securities holdings declined $5.4 billion, while Loans & Leases expanded $11.3 billion.  Commercial & Industrial loans increased $2.5 billion, Real Estate loans added $3.6 billion, and Consumer loans gained $2.3 billion.  Security loans declined $2.4 billion and Other loans increased $5.2 billion. Broad money supply (M3) declined $14.1 billion for the week ended December 8.  Demand and Checkable Deposits added $6.7 billion, while Savings Deposits declined $5.7 billion.  Retail Money Fund deposits declined $3.5 billion.  Institutional Money Fund deposits dropped $4.5 billion, with a two-week declined of $22.5 billion.  Large Denominated Deposits added $5.5 billion.  Repurchase Agreements dropped $11.0 billion and Eurodollar deposits dipped $1.2 billion.  With all my liquidity indicators pointing to abundance, and with debt issuance remaining heavy, I will stick with the view that the declining “Ms” are definitely not indicative of either waning liquidity or tepid Credit growth.  Instead, I believe that issuance and (investor and speculator) flight into long-term debt instruments, ballooning foreign central bank balance sheets, and disintermediation out of money market mutual funds go far in explaining the recent money contraction.  Importantly, there are indications that the leveraged speculating community is “releveraging,” – expanding speculative positions.    The Fed’s Foreign (Custody) Holdings of U.S. Debt, Agencies increased $9.1 billion.  Custody Holdings are up $51.8 billion over the past five weeks. No Inflating Out of this Quagmire: This truly is a most incredible environment; we’re in uncharted, turbulent waters, where – with the occasional lifting of the dense fog - things just aren’t as they seem.  A lot of the “old rules” simply no longer apply.  Reputations will be confidently wagered in the face of extraordinary uncertainty, and there will be losers.  And it is fascinating to watch these dynamics in play and to sort through such divergent views.  The discerning Bill Gross recognizes that the U.S. is leading the worldwide charge to reflate.  He sees opportunities in commodities, tangible assets, foreign currencies, real estate, TIPS, and non-dollar bond and equities.  Robert Prechter, focused on the recent contraction in the monetary aggregates and fixated on his own analytical framework, takes the opposite view:  “Deflation – a drop in the money supply – is now a reality…”  ISI’s renowned Ed Hyman has a much different take:  declining money supply “may reflect a portfolio shift into stocks, bonds, and real estate.”  He has a sanguine view on stable prices and continued economic expansion.  Barton Biggs recently averred to a CNBC audience, “I think we’re having a perfect recovery, and we’ve got a perfect economic environment.”  And then there’s Art Laffer making Mr. Biggs appear a pessimist by comparison.  He, this time, takes direct aim at the “latest negativism” propagated by those of us worried about our devaluing currency.  His take is that the Fed is following masterful monetary policies, with the Fed’s tight reins on the monetary base adeptly controlling the inflationary engines.  According to Laffer, the dollar is declining because of improving economic and investment prospect around the globe. These seasoned players are all examining the same environment through their individual analytical prisms and coming to extremely divergent conclusions.  My sense is that incorporating a sound analytical framework has never been more important.  From my own Credit Bubble Analytical Framework, I am compelled this evening to give strongest weight to the analysis of Mr. Gross (while completely dismissing the ruminations from Art Laffer).  Mr. Gross resides in the Credit system’s “Catbird seat” and fully appreciates the precarious nuances of contemporary finance and the risks of excessive debt at home and abroad.  And he certainly hits the nail mostly on its head when he writes this month that “when too much debt infects the heart of capitalism you either default or inflate it away and the latter is by far the easiest (although not necessarily the wisest) policy.” (Mr. Gross’s parenthetical remarks) I would argue that attempting to inflate away global debt problems, while definitely the “easiest” course, is as well definitely the un-wisest.  Such follies only postpone the inflating amount of pain associated with the inevitable day or reckoning.  The gist of the dilemma is that central bankers some years back lost control of the processes of Credit inflation, as well as inflation's manifestations and consequences.  American central bankers are, instead, under the control of the U.S. financial and economic Bubbles, as are the Chinese of theirs.  And the Bank of Japan - with one bleary eye on U.S. Bubbles and the other on its own post-Bubble financial and economic quagmire - apparently sees little alternative than a massive inflation.  The resulting Credit, liquidity, and speculative excess are now distorting borrowing, spending, and investing decisions all over the world.  Today, global central bankers are not achieving a traditional (re)inflation as much as they are, at this point, successfully sustaining myriad Bubbles.  I believe this is a most important analytical distinction.  Especially with respect to contemporary finance, inflation is a Credit phenomenon and not a central bank-controlled monetary base phenomenon.  Central banks can nurture, incite and energize Credit inflation, but these days have little capacity to manage or control its manifestations.  Moreover, the general Credit system and systemic liquidity creation have been commandeered by Wall Street speculative finance.  The Fed, and global central bankers to a lesser extent, retains incredible power.  But this power is wielded through the blunt object of empowering the speculative community.  The Fed does today definitely enjoy a captive audience – a global speculating community and sophisticated financing operations - unlike anything experienced in history.  A year ago this past summer this community was increasingly betting against systemic stability (shorting stocks, corporate bonds, buying derivative insurance against deflating asset prices).  The vicious dynamics of debt collapse were in play.  The Fed and central bankers responded in force (fighting “deflation”), and the speculative community reversed bearish plays to place bets on “reflation.”  The results were sea changes in risk-taking, Credit availability for corporate America, and (in the face of major dollar devaluation) liquidity for economies and markets across the globe.  Reflation speculations have been huge winners.  As always, successful speculating is self-reinforcing and captivating.  The ever-expanding speculator community has burst forth with larger size and much greater domination.  One major risk – the potential for higher rates to incite problematic deleveraging and derivative problems – began to manifest over the summer.  The GSEs, once again, responded forcefully, and the Fed has since taken this risk out of the equation (for now).  A second major risk – a rampant U.S. Credit inflation-induced flight out of the dollar, impacting U.S. interest rates and securities markets – has been quelled by unprecedented foreign central bank purchases.  Resulting historic liquidity excess has inflated asset prices globally. Things have never appeared so good – to the naked analytical eye. Today, the Powerful Speculator Community has good reason to believe it has three important things working in its favor.  1) The Fed will act in their (the speculator’s) best interest, keeping short-rates low for as long as possible, while moving quickly to lower rates in the event of future systemic risk.  2)  The Enormous and Powerful GSEs will continue to act as quasi-central banks, aggressively buying unlimited quantities of securities in the event of any systemic liquidity/interest rate stress.  The implied Fed and GSE liquidity guarantees have never appeared as credible.  3)  The Bank of Japan, the Bank of England, the Fed, Asian central banks generally, and perhaps global central bankers en masse, are today committed to sustaining the global speculative Bubble in Credit instruments.  These powerful, unprecedented, layers of market support have evolved over time; they are revered by the fortunate speculators; and they are an important fact of life for economies and markets all over the world.  The Great Credit Bubble is clearly now a global phenomenon.     And while this week’s market action brings holiday cheer, there were unmistakable signs of a new degree of excess.  Despite surging stocks and continued strong economic data, Treasury and corporate prices rose (yields sank). The general financial and economic environment beckons for higher rates and restraint, but receives the opposite.  Yet we should not be surprised, as we’ve witnessed dysfunctional (boom and bust) market dynamics for years now.  Boom and Bust Dynamics are an unfortunate reality of contemporary finance. The stock market is, as well, demonstrating conspicuous speculative Bubble dynamics.  Typical and healthy pullbacks are not forthcoming, giving way instead to price surges and speculative runs.   And I would argue that speculative Bubbles in both the equity and Credit markets place the faltering dollar at significant risk.  The dollar sinks in the face of booming financial markets and unprecedented foreign central bank purchases.  The worst is yet to come. Over the years we’ve witnessed several of these “reliquefications.”  This one, however, is much more extreme and global.  Previous “reliquefications” usually ran their course in a year to 18 months, creating only bigger problems and bigger forthcoming “reliquefications.”  The current one is no youngster, but it is, admittedly, a different animal than we’ve analyzed before.  Global reflation has taken firm hold.  Yet, as I have followed developments closely, I am more convinced than ever that it is simply not possible for central banks to Inflate Their Way Out of this Quagmire.  There is no general price level to raise, and there is no general income level to inflate.  Such notions are from a bygone era.  And, importantly, central banks have been playing right into the hands of the Commanding Leveraged Speculating Community.  The harsh reality is that the longer and more aggressively global central bankers accommodate inflation, the greater the leverage and speculation; the greater the size of weak debt structures; the greater systemic financial fragility.  Importantly, there is no inflating out of gross financial leveraging and major speculative Bubbles. Global speculative stock markets are increasingly destabilizing, and I would strongly argue that there has been renewed vigor in leveraged Credit market speculation. Resulting inflationary manifestations are sporadic and especially uneven.  Global central bankers, more than ever, are held hostage to inflating asset markets.  And sure, asset Bubbles do foster income growth.  One need only ponder how much California (and national) real estate brokers have made this year.  It has been a banner year for those profiting from asset inflation, including real estate agents, Wall Street bankers, builders, farmers, mortgage brokers, and insurance salesmen.  But let’s not get carried away and convince ourselves that this is either healthy or sustainable (or just).  One dynamic of asset Bubbles is that they are sustained by only increasing amounts of new Credit creation.  And with each new inflation and speculation – commodities, equities, farm land, emerging markets, fine art, etc. – come additional Credit growth requirements.  The more global central bankers stimulate Credit inflation, the greater next year’s requisite Credit inflation to sustain mushrooming Bubbles, distortions and imbalances.  And having monetary policy fuel speculative Bubbles is risky, reckless business.  The higher home prices, the greater stock and bond values, and the more extreme commodity inflation, the greater the required Credit and speculative excess to sustain them and the increasingly vulnerable financial and economic systems.  Global central bankers have painted themselves into a dark corner.

12/12/2003 OFHEO on Fraud at Freddie *

The stock market demonstrated dynamics of a vulnerable speculative Bubble this week. Volatility was extraordinary, especially in the more speculative areas of the marketplace. For the week, the Dow gained 2% and the S&P500 added 1%. The Transports jumped 2.5%, increasing y-t-d gains to 29%. The Utilities were about unchanged. The Morgan Stanley Cyclical index added 2.5% (up 43% y-t-d) and the Morgan Stanley Consumer index increased 1%. The leading S&P groups were Steel, Movies & Entertainment, and Automobile Manufacturers. The broader market was exceptionally volatile, but ended the week with decent gains. For the week, the small cap Russell 2000 added 1.5% (y-t-d up 43%) and the S&P400 Mid-cap index rose 1%. The NASDAQ100 added 1%, increasing 2003 gains to 44%. The Morgan Stanley High Tech and Semiconductor indices were about unchanged. The Street.com Internet index increased 1.5% and the NASDAQ Telecom index added 1%. The Biotechs were little changed for the week. Financial stocks rose, with the Broker/Dealer and Bank indices up about 1%. Although bullion gained $2.50 to $408.85, the HUI gold index sank 6%. Rather than being bothered by the sinking dollar or surging commodity prices, the Credit market ended a volatile week comfortable that the Fed remains on hold for a considerable period. As such, the yield curve steepened this week. Two-year Treasury yields declined 6 basis points (to 1.81%), while long-bond yields rose 3 basis points (5.09%). The implied yield on December 2004 Eurodollars sank 12.5 basis points to 2.225%, the lowest rate since October 3. Five-year Treasury yields declined 2 basis points to 3.19%. Ten-year yields added 1 basis point to 4.24%. Benchmark Fannie Mae mortgage-backed yields increased 4 basis points. Spreads on Fannie’s 4 3/8% 2013 note narrowed 1 to 36 and Freddie 4 ½ 2013 note narrowed 1 to 35. Corporate spreads generally widened slightly, although remaining a near 5-year lows. The 10-year dollar swap spread declined 1.5 to 36.75, the narrowest since mid-July. It was another strong week of debt issuance. Investment grade issuers included Wyeth $3 billion (up from $2.5 bn), International Paper $1 billion, Procter & Gamble $700 million, Bunge Finance $500 million, Diageo Finance $500 million, Raytheon $500 million, Harrahs $500 million, Pricoa Global Fund $500 million, SBA Telecom $400 million, MDC Holdings $350 million, Cleveland Electric $300 million, Southern Cal Gas $250 million, Virginia Elect & Power $225 million, Caterpillar Finance $200 million, Wisconsin Public Service $125 million, RLI $100 million, and Washington REIT $100 million. Junk bond funds received inflows of $384.5 million, the sixth straight week of positive flows. The buying craze, however, is not being led by the mutual funds (hedge funds?). The extraordinary list of debt issues - imparting little impact on interest rates or spreads - is testament to the truly incredible amount of liquidity sloshing around the system. This week’s junk issuers included Ship Finance International $580 million, Granite Broadcasting $405 million, Couche-Tard $350 million, Valeant Pharmaceuticals $$300 million, Sensus Metering $275 million, Young Broadcasting $230 million, United Agric Products $225 million, Bombardier $200 million, Vaisystems $200 million, Simons $200 million, Hanover Compress $200 million, WMC Finance $200 million, Kraton Polymers $200 million, Land O Lakes $175 million, Great Lakes Dredge&Dock $175 million, Mariner Health $175 million, Equinox Holdings $160 million, Tenneco Automotive $125 million, FPL Energy Wind Funding $125 million, Blue Ridge Paper $125 million, Semco Energy $50 million, and Pathmark Stores $50 million. Foreign dollar junk issuers included Tele Norte $300 million, Axtel $175 million, and Embratel $275 million. New converts included: Sepracor $600 million, Emulex $450 million, Apogent Tech $300 million, Centerpoint Energy $225 million, Serena Software $220 million, Akamai Tech $175 million, Hanover Compress $144 million, Magnum Hunter $100 million, and Affymetrix $100 million. Another strong week of sales pushed asset-backed security (ABS) issuance to a new yearly record. Total y-t-d issuance of $431.8 billion is running 19% above last year’s record pace. By collateral type, 2003 Auto loan ABS is running down 14% at $14.4 billion and Credit card ABS is down almost 9% at $47.3 billion. Home Equity loan ABS, however, is running up almost 59% to $179 billion. Commodities Watch: December 11 - Dow Jones: “Imported oil will account for half of China’s oil consumption by 2007 from little over 30% now due to low-level domestic oil production, a recent study by the Chinese Communication Ministry said Thursday, Kyodo news service reported. The official Xinhua News Agency, citing the study, said China’s oil production has increased only 1.7% a year on average in recent years is projected to boost the nation’s dependence on imported oil to more than half of its oil consumption by 2007…” December 11 – Bloomberg: “The U.S. left its estimate for the soybean surplus before next year’s harvest unchanged at 125 million bushels, the lowest since 1977…” The CRB Commodities index jumped 2% this week, with 2-week gains of 5%. The CRB today closed at the highest level since April of 1996 and is up 44% from the lows of October 2001. Today saw $33 crude (strong global demand and a possibly intransigent OPEC) and $7 natural gas (cold weather and depleting inventories). According to Bloomberg, natural gas has surpassed $7 “for just the third time in the 13-year history of the Nymex contract,” with 2-week gains of about 45%. With energy prices on the rise, the Goldman Sachs Commodity Index surged 5% this week, increasing two-week gains to 9%. Gold ended at a 7-year high, copper at a 6-year high, soybeans at 6-year highs and platinum at a 23-year high. Dollar Watch: The widely anticipated dollar rally will have to wait for at least another week. The dollar index dropped another 1% this week to the lowest level since the first week of 1997. It was interesting to listen to “Kudlie and Cramie” passionately beg Secretary Snow to intervene in the markets to support the dollar (“knock the heads” of the speculators). First of all, it will likely require a determined concerted intervention by global central bankers to even begin to turn the tide. And perhaps the Europeans are in no mood to participate, especially after watching the incredible financial resources expended by the Japanese (with ominously limited impact). Moreover, Messrs. Kudlow and Cramer should be careful for what they wish for: An unsuccessful major intervention would illuminate the Treasury’s weak hand and likely precipitate a less orderly dollar decline. As you read through this week’s “watches,” please take note that the dollar is at 6 to 7-year lows, gold prices at 6 to 7 year highs, commodity indexes at 6 to 7 year highs, Chinese inflation at 6 to 7 year highs, and even Japanese business confidence at 6 to 7 year highs. While inflationary manifestations are unbalanced, diverse and foolhardy, it is increasingly difficult to argue that an historic global reflation is not having a major impact. And it is also worth noting that the authorities in Washington, Beijing, and Tokyo (and, to a seemingly lesser extent, Frankfurt) have their individual motivations for perpetuating the current inflation. It has been a long time since inflation enjoyed such widespread adulation. Global Reflation Watch: December 12 – Bloomberg: “Japan’s large manufacturers are the most optimistic in 6 1/2 years and plan to increase capital spending as accelerating global economic growth boosts demand for their cars, DVDs and mobile phones. Sentiment rose to 11 points this quarter from 1 point in the third quarter, the Bank of Japan’s Tankan survey showed in Tokyo.” The Tankan index is up 29 points in six months and 49 points from a year earlier. November corporate bankruptcies were down 22% from the year ago level. December 8 – Bloomberg: “U.K. house price growth accelerated in October, the Office of Deputy Prime Minister John Prescott said, adding to the case for another interest rate increase as early as next month.” December 11 – Bloomberg: “French and German inflation accelerated in November, confirming the European Central Bank’s view that consumer prices will rise faster than it had previously estimated. The French inflation rate, measured by European Union methods, rose to 2.5 percent from 2.3 percent in October, Paris-based national statistics office Insee said. Inflation in Germany speeded up to 1.3 percent from 1.1 percent…” December 11 – Bloomberg: “Russian industrial production rose by 7.2 percent in November, Interfax reported, citing the State Statistics Committee. Industrial output increased by 6.8 percent in the first 11 months of the year, almost twice as fast as the 3.7 percent annual growth in the same period of 2002…” December 8 – Bloomberg: “Taiwan’s exports rose in November at their fastest pace in nine months, climbing to a record as electronics makers shipped more components to factories in China, and laptop computers and flat-panel displays to Europe. Exports rose 16 percent from a year earlier to $13.8 billion… Taiwan’s sales to China and Hong Kong rose 33 percent in November to $5.1 billion…” December 11 – Bloomberg: “India’s economy may expand 6.7 percent in 2003, the Asian Development Bank said, raising its growth forecast for Asia’s No. 3 economy from 6.3 percent. ‘India is entering the upswing of a business cycle, implying an expected growth rate of around 7 percent or more during the next few years,’ said Sudipto Mundle, chief economist for India at the Manila-based lender.” December 9 – Bloomberg: “Malaysia’s economy will grow 4.9 percent this year, after exports rebounded and factories boosted production to meet overseas demand, the Malaysian Institute of Economic Research (MIER) said, raising its forecast from 4.3 percent. MIER…also raised its 2004 growth forecast to 5.7 percent from 5.4 percent.” December 9 – Bloomberg: “Thai consumer confidence rose to a record in November on optimism that rising exports and consumer consumption will boost economic growth, a survey showed.” December 8 – Bloomberg: “Turkey’s industrial production jumped a larger-than-expected 12.3 percent in October from the same month last year, on surging exports and a pickup in domestic demand.” China Watch: December 10 – Financial Times: “Investors have applied for nearly US$30bn worth of shares in China Life, 10 times the amount to be offered in next week’s listing, in the latest sign of strong appetite for initial public offerings from Chinese companies.” December 10 – Financial Times: “In 1793 Lord Macartney, King George III’s ambassador, led a 700-strong delegation to seek trade privileges from Qianlong, the fourth emperor of the Qing dynasty. Now, 210 years later, the traveling diplomats of the modern business world – investment bankers – are retracing his steps to curry favour with the current generation of Chinese leaders. In recent weeks Beijing has witnessed a glut of limousine motorcades as the heads of the big Wall Street investment houses made pilgrimages to the Chinese capital.” December 10 – Financial Times: “China looks increasingly under siege as it fights pressure to revalue its currency. Exporters are bringing back ever bigger dollar receipts and banks, according to the Bank of International Settlements, are repatriating funds and seeing more domestic deposits. The build-up of pressures is evident in gently rising prices and annualized money supply growth running at about 21 per cent. Now one of China’s favourite tools to stem the tide – short-term bills used to sterilize foreign exchange intervention – appears to have been blunted. China, given its inflexibility on currency revaluation and interest rates, has relied heavily on sterilization bills, issuing some Rmb600bn worth since April. But buyers, deterred by the modest yields on offer, are shunning the paper. Other measures to control the money supply have had mixed success.” December 10 – Bloomberg: “China’s money supply grew faster than the central bank’s targeted rate for an 11th straight month in November, which may prompt the authorities to take additional action to curb lending in coming months. M2, the broadest measure of money supply rose 20.4 percent from a year earlier to 21.6 trillion yuan ($2.6 trillion), after climbing 21 percent in October, the People’s Bank of China said.” December 12 – Bloomberg: “China’s consumer prices rose 3 percent in November from a year ago, the fastest rate of inflation in 6 1/2 years, after wheat and soybean shortages drove food prices higher. The biggest increase since April 1997 followed a 1.8 percent climb in October… Food costs, which account for about a third of the index, rose 8.1 percent.” December 9 – Bloomberg: “China’s exports grew by more than a third for a second straight month in November as companies such as Huawei Technologies Co., the nation’s top maker of phone equipment, won more orders from abroad. Overseas sales rose 34 percent from a year earlier after gaining 37 percent in October, while the growth in imports slowed to 29 percent from 40 percent…” “China’s exports rose 32.9 percent in the first 11 months of this year and its imports rose 39.1 percent, Liu Wenjie, vice minister of customs, told reporters in Beijing. That left a trade surplus for the period of $19.7 billion, he said. China’s exports totaled $293.7 billion in the first 11 months of 2002 and its imports were $266.5 billion, the government reported a year ago.” December 10 – Bloomberg: “China’s factory production grew in November at its fastest pace in nine months, surging as overseas companies move factories there to take advantage of wages less than one-twentieth those in the U.S. Production rose 18 percent from a year earlier to 397 billion yuan ($48 billion)…” December 11 – Bloomberg: “China’s economy will probably grow more than 10 percent in the second half of 2003 as its industrial sector expands to meet rising demand at home and abroad, Standard & Poor’s said.” Domestic Credit Inflation Watch: December 8 – MarketNews (Gary Rosenberger): “Businesses renewing their health benefit plans for next year should run into more double-digit increases and workers will likely assume a bigger chunk of the cost of those policies, say health insurance executives. Health insurers say the average rise in premiums dropped a couple of percentage points from a year ago. But the increases remain substantial -- in the low to mid teens -- even after plans are redesigned to reduce benefits... Regina Nethery, vice president of investor relations for Humana Inc., estimates commercial premiums for Humana customers will be in the range of 11% to 13% higher for 2004…” December 12 – Bloomberg: “Texas’s sales tax collections, the largest revenue source for the second most-populous U.S. state, have risen for the past three months as retail sales growth returned to levels before Sept. 11 2001. November sales tax revenue rose 4.3 percent to $1.36 billion in November, compared with the same period a year earlier, the fastest growth rate since August 2001.” December 11 - Dow Jones (Michael Derby): “The head of the world’s biggest bond fund says it’s time to start investing as if inflation were right around the corner. Bill Gross, managing director of PIMCO, which controls around $350 billion in fixed-income investments, told investors in his December research note that their investments should likely be moving away from things like stocks and bonds to holdings such as commodities and one of his old favorites, Treasury inflation-indexed bonds… To profit in this environment where prices are likely to start rising, Gross said he’s advocating investment in commodities and ‘tangible assets,’ foreign currencies, real estate, inflation-indexed Treasury securities, and global bonds and foreign currency equities.” The Office of the Comptroller of the Currency released third quarter derivatives data today. For the quarter, total notional derivative positions expanded at an 8% annualized rate to $67.1 Trillion. Total positions were up 26% from a year earlier. By type, Interest Rate derivatives expanded at a 9% rate during the quarter (up 28% y-o-y) to $58.3 Trillion. Currency derivatives declined at a 10% rate during the quarter (up 18% y-o-y) to $6.9 Trillion. Credit derivatives increased at a 33% rate during the period (up 52% y-o-y) to $869 billion. By Product, Swaps increased at a 33% rate during the quarter (up 39% y-o-y) to $41.2 Trillion. By institution, JPMorganChase’s total derivative positions expanded at an 18% rate during the quarter (up 26% y-o-y) to $34.2 Trillion. BofA’s positions were about unchanged (up 17% y-o-y) to $13.8 Trillion, while Citigroup positions actually declined at an 8% rate during the period (up 16% y-o-y) to $10.8 Trillion. Economy Watch: December 11 – MarketNews (Gary Rosenberger): “Imports surged to monumental proportions in October and continued to inundate U.S. shores through most of November, while exports maintained their grinding pace of recovery, say cargo and port executives.” University of Michigan Consumer Confidence surprised on the downside, with the early December reading giving back all of November’s 4 point gain. Producer Prices declined 0.3% during November, with a year-over-year increase of 3.4%. MarketNews’ Denny Gulino noted that “November’s 4.3% increase in core crude materials prices (was) the strongest since June 1978…” Small business optimism as measured by the National Federation of Independent Business increased 1.3 points in November to the highest reading since at least 1986. The Mortgage Bankers Association reported third quarter commercial mortgage lending of $29.686 billion, up 45% y-o-y. The stubborn Trade Deficit increased marginally to $41.8 billion during October, up almost 19% from one year ago. Year-over-year, Goods Imports were up a notable 11.1% to $108.8 billion, while Goods Exports rose 7.1% to $61.36 billion. In nominal dollars, Goods Imports were up $10.8 billion from a year ago, compared to Goods Exports that increased $4.1 billion. By category, Capital Goods Imports were up 14.0% y-o-y, Consumer Goods 13.8%, Automotive 7.9% and Industrial Supplies 9.3%. These large and broad-based increases lead me to question the government's 2.1% y-o-y increase in the Import Price Index. All the same, Goods Exports would need to rise 73% to match Imports. November retail sales were up a stronger-than-expected 0.9%. Retail and Food Service Sales were up 6.9% y-o-y (steepest November y-o-y sales increase since 1999, according to Moody’s John Lonski). Retail ex-autos were up 6.5% y-o-y. Electronic Stores sales were up 14.3% y-o-y, Building Materials 11.0%, Auto dealerships 8.5% and Bars and Restaurants 9.5%. Also according to Moody’s, third quarter corporate revenues were up 8.4% y-o-y, which will likely and not coincidently be close to total non-financial Credit growth during the period. November Import Prices were up a stronger-than-expected 0.4%. By category, Fuels and Lubricants were up 12.0% y-o-y, Building Materials 12.8%, Unfinished Metals 6.3%, Agricultural 3.7%, and Industrial Supplies ex petroleum up 6.4%. Capital Goods Import Prices were down 0.9% y-o-y. Freddie Mac posted 30-year fixed mortgage rates declined 14 basis point this week to 5.88%. Fifteen-year fixed rates declined 12 basis points to 5.24%. One-year adjustable-rate mortgages could be had at 3.77%, unchanged for three weeks. The Mortgage Bankers Association application index dropped to the lowest level since June of 2002. Purchase Applications declined 9% for the week, while remaining 12% above the year ago level. Purchase Application Dollar Volume was up 23.7% y-o-y. Adjustable-rate mortgages accounted for 29% of total applications, with an average loan amount of $281,800. Adjustable-rate mortgages were less than 14% of the total at the beginning of July. Countrywide Financial Average Daily Fundings declined 5% from October to $1.479 billion. And with Non-purchase/Refi fundings down 49% y-o-y, Total Fundings for the month were down 33% to $38.8 billion. At the same time, Purchase fundings were up 27% y-o-y to $9.85 billion. November Home Equity fundings were up 52% y-o-y to $1.6 billion, while Subprime fundings were up 97% to $2.0 billion. “Adjustable-rate loan production of $8.5 billion accounted for 38 percent of monthly fundings, an increase of 125 percent over the prior year period… Total assets at Countrywide Bank…rose 4 percent over the prior month to $18 billion.” Washington Mutual disappointed The Street with lower guidance. It should come as little surprise that mortgage origination volumes have slumped dramatically over the past few months. This has clearly negative implications for the rapidly-expanding Washington Mutual and scores of other institutions that had been making easy money from the refi boom. Yet we must be mindful that with near record home sales at record prices, along with record home equity borrowings, total mortgage Credit continues to grow at a very brisk pace. Fannie Mae today raised their estimates for both 2003 and 2004 total home sales. Fannie now expects 7.09 million sales this year, 8.4% above 2002’s record. Fannie forecasts sales to moderate somewhat next year to 6.73 million units. After two months of the fiscal year, total federal government receipts are up 3.9% from the comparable period last year. Total spending is running up 2.5%, with a total deficit of almost $113 billion. An Administration official this week forecasted a fiscal deficit in the “$500 billion range.” Last week’s 28,674 bankruptcies were down about 3% from the comparable week one year ago. Total Bank Credit declined $25.4 billion. Securities holdings added $7.3 billion, while Loans & Leases sank $32.6 billion. Commercial & Industrial loans declined $6.0 billion and Real Estate loans were about unchanged. Consumer loans declined $1.3 billion and Security loans dropped $18.2 billion. Elsewhere, Commercial Paper declined $3.8 billion. Non-financial CP dipped $1.0 billion and Financial CP declined $2.8 billion. Broad money supply (M3) declined $11 billion. Demand and Checkable Deposits dropped $11.4 billion. Savings Deposits increased $13.7 billion, and Small Denominated Deposits dipped $0.6 billion. Retail Money Fund deposits declined $5.5 billion. Institutional Money Fund deposits sank $18.0 billion. Large Denominated Deposits added $7.6 billion. Repurchase Agreements dipped $1.3 billion and Eurodollar deposits declined $1.1 billion. Foreign (Custody) Holdings of U.S. Debt, Agencies increased $8.0 billion last week, with six-week gains of $49 billion. Custody Holdings are up almost $210 billion, or 25%, from a year earlier. Fraud at Freddie: I have erred by trying to give Freddie Mac the benefit of the doubt. Financial institutions today must deal with complexities and the generally poor state of derivative accounting (including the implementation of FAS 133, accounting for derivative contracts). Freddie has also been operating in an extraordinary interest rate environment. In the back of my mind, I presumed that Freddie’s management had likely been forced into using questionable accounting to counterbalance imperfect and confused accounting regulations that, if used as prescribed, would have misrepresented the true economic situation of the company. What they did was clearly wrong, but I have hesitated to think of it in terms of a malicious fraud. I have been wrong. The 185 page report released Wednesday by the Office of Federal Housing Enterprise Oversight (OFHEO) paints a rather clear picture: Freddie Mac top management, over a number of years, had orchestrated an increasingly sophisticated fraud. They not only flagrantly disregarded accounting rules and moved repeatedly to deceive the public; there was a clear effort to undermine the quality and effectiveness of the entire accounting function throughout the organization. The long-term interests of the American taxpayer and the global marketplace were jeopardized. Arthur Anderson was complicit and negligent, as was the Board of Directors (disregarding conspicuous red flags, while pressing for stronger earnings growth.). After reading through the report, I am left with the uncomfortable feeling that had interest rates risen meaningfully (rather than dropping to 40 year lows), Freddie would have had the clear potential to make the Enron debacle look insignificant in comparison. But the Fed pushed rates down, essentially turning Fraud at Freddie moot to the marketplace – for now. Ironically, if it were not for the collapse of Enron it is quite likely that The Fraud at Freddie would have continued to this day. Arthur Anderson had been Freddie’s “auditor” since the seventies and played an instrumental role in the accounting fraud. It was not until PriceWaterhouse arrived to replace a failing Anderson that the scheme began to unravel. And perhaps the years of conscious neglect, general incompetence, and outright negligence throughout the accounting and reporting functions were, indeed, in stark contrast to adroit and diligent risk management at Freddie Mac. Seems like quite a stretch, knowing what we know today. I will definitely no longer give the company the benefit of the doubt. At the minimum, I will assume that Freddie is more financially vulnerable, with some potentially serious holes in its risk management strategies and implementation. I will also give some credence to the minority view that perhaps the Fed is sticking with short-term rates to protect the financially fragile GSEs. And, importantly, we haven’t heard the last from OFHEO’s Director, Mr. Falcon. His organization is in a continuing examination of the role played by the Wall Street firms and appears poised to take a much closer look at Fannie. He is even threatening to limit Freddie’s retained portfolio growth and require additional capital until the mess is resolved. As a regulatory body – with congress incapable of surmounting the powerful GSE lobby – Mr. Falcon and OFHEO have an exciting new lease on life. Perhaps they will even develop the teeth that a disgraceful Washington has never allowed them to grow. The Fraud at Freddie is certainly another clear indictment of Wall Street. It still amazes me that there has been so little backlash, despite the instrumental role The Street played in a series of major frauds including the hideous Enron affair. But, then again, contemporary finance has Wall Street in firm control of the purse strings, as well as the power center for sustaining the revered financial and economic Bubbles. The Wall Street/”beltway” partnership is stronger than ever; The Street has never seen itself as more bulletproof. The markets were completely disinterested in this week’s OFHEO revelations that the large Wall Street firms aided and abetted Freddie’s fraudulent activities. All the same, OFHEO specifically named Morgan Stanley, UBS Warburg, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Salomon Smith Barney as counterparties to derivative trades transacted specifically to misrepresent and deceive. These firms made millions from fraudulent transactions involving little if any financial risk. Regrettably, I do not have the time to do this lengthy document justice. Hopefully some extractions and brief comments will shed light as to the nature of the Fraud at Freddie. I encourage readers to peruse the document available at www.ofheo.com. “In the early 1990’s, Freddie Mac promoted itself to investors as “Steady Freddie,” a company of strong and steady growth in profits. During that period the company developed a corporate culture that placed a very high priority on meeting those expectations, including, when necessary, using means that failed to meet its obligations to investors, regulators and the public. The company employed a variety of techniques ranging from improper reserve accounts to complex derivative transactions to push earnings into future periods and meet earnings expectations. Freddie cast aside accounting rules, internal controls, disclosure standards, and the public trust in the pursuit of steady earnings growth.” “Leland Brendsel (former CEO and Chairman) told interviewers acting on behalf of the Board of Directors that Freddie Mac adopted the goal of steady earnings growth in the early 1990s after some investors, including Berkshire Hathaway, told management that the Enterprise needed to communicate clear and simple messages that the public could easily understand. Fifteen to sixteen percent earnings growth was the simple message that management began to propagate. According to Mr. Brendsel, that goal was fairly easy when Freddie Mac was primarily a securitizer of mortgages. However, as the retained mortgage portfolio of the Enterprise grew and its earnings became more sensitive to interest rates, steady mid-teens growth became a more challenging goal.” (page 21) “Simply stated, the quality and quantity of accounting expertise was too weak to assure proper accounting of the increasingly complicated transactions and strategies being pursued by Freddie Mac. From 1993 through 1996, the first four years of rapid retained portfolio growth, management actually reduced accounting and reporting personnel by nearly 20 percent… in 1996 Corporate Accounting still managed the entire portfolio accounting process on Excel spreadsheets. That system was improved slightly in 1997, but repeated requests for a more robust Treasury accounting system were denied until 2000.” (page 14) “Senior management and the Board of Freddie Mac failed to provide adequate resources to the corporate accounting function, even though they were continuously informed of those weaknesses…” (page 85) “…Freddie Mac senior management and the Board were quite aware that the skills and systems in Corporate Accounting were challenged and that the derivatives group lacked sufficient knowledge and training.” “The information obtained during the special (OFHEO) examination indicates that a thorough review and update of accounting policies had not occurred at Freddie Mac in over twelve years.” (page 91) “The weaknesses in accounting policies at Freddie Mac created an environment that allowed for and even encouraged transacting around GAAP. The resulting accounting errors committed were pervasive and persistent.” (page 92) “In 2001, Arthur Anderson received $1 million for its audit work and $3.7 million for its consulting fees…” (page 97) “David Glenn (former president and vice chairman) recounted an ‘ugly’ meeting that took place in the fall of 2000 between himself, Bob Ryan (assistant to Mr. Glenn), and Messrs. Dossani (Sr. V.P.) and Parseghian (exec V.P. and chief investment officer, later to briefly become President and CEO). At that meeting, the group discussed potential difficulties in continuing to meet the publicly stated goal of mid-teens earning growth without changes to the risk management practices of the Enterprise. According to Mr. Glenn, at that meeting and other meetings that followed, management consciously decided to change its risk profile and take more convexity risk – that is, speculate on interest rates – in order to maintain mid-teens earnings growth.” (page 44) “Management executed several interest rate swap transactions that moved $400 million in operating earnings from 2001 to later years. Those transactions had virtually no other purpose than management of earnings – specifically, making operational results appear to be less volatile than they were.” “Management created an essentially fictional transaction with a securities firm to move approximately $30 billion of mortgage assets from a trading account to an available-for-sale account… Freddie adopted, and then quickly reversed, a dubious change in its methodology for valuing swaptions. That change had the effect of reducing the value of the derivatives portfolio…by $730 million. On at least one occasion, a (‘earnings management swaps’) transaction was entered into (with Goldman Sachs) at the instruction of management for the purpose of disguising the effective notional amount of the Freddie Mac derivatives portfolio and thereby allay the concerns of an investor… Pressure to sustain earnings growth may have provided the impetus for a program to change the ‘geography’ of income. That program including selling of short-dated options to shift unrealized gains from the swaptions portfolio of Freddie Mac to its net interest income account…there was no disclosure of the short-dated options portfolio in the Annual Report…” “In 1994, Freddie Mac management created a reserve account to cushion against the fluctuations caused by the unpredictable amortization of premiums resulting from changing mortgage prepayment speeds… Getting the amortization numbers to fall within the range was sometimes an all-night process; according to one employee, it was ‘classic’ for Freddie Mac to ‘play with the numbers until they got the right one.’” (page 56) “On November 22, 2000, CFO Vaughn Clark met with employees from Corporate Accounting and Funding & Investment to minimize the FAS 133 transition gain. The agenda identified their strategic objective: ‘Recognize book losses in 1Q01 that offset the FAS 133 transition gain AND replace lost earnings in subsequent periods. The plan anticipated an exchange of $10 to 15 billion of PCs (MBS) with embedded losses in the retained portfolio for either a REMIC (real estate mortgage investment conduit) or a Giant (MBS) security… That memo outlined nine steps that would need to be executed in order to effectively recognize a loss on the ‘sale’ of the securities and then bring the same securities back to the portfolio… The problem for Freddie remained, however, that leaving the securities in the trading account would subject the Enterprise to significant exposure to earnings volatility… To eliminate that risk, the PCs were to be transferred to a counterparty – Salomon Smith Barney – and swapped for a Giant security… (held by Salomon ‘with virtually no risk’ ‘only for a few hours’ for a fee of between $4.7 and $18.8 million)” “Numerous financial institutions, including some of the largest investment banks on Wall Street, were counterparties to transactions initiated by Freddie Mac in order to shift and smooth the reported earnings of the Enterprise. Those transactions had little legitimate business purpose and were structured to achieve a certain accounting result and to mislead investors about the finances of Freddie. OFHEO has not concluded its investigation of the role of the counterparties in those improper transactions. The agency is reviewing whether the counterparties met their obligation to ensure that they were not part of a scheme to mislead investors and whether they encouraged improper conduct in any way. In addition, OFHEO will examine the willingness of the counterparties to accommodate Freddie Mac in order to maintain other profitable business relationships.” “There is evidence to date that one or more of the counterparties to the transactions that Freddie Mac undertook to manage earnings may not have acted properly… In at least one instance, a trader at a counterparty – Morgan Stanley – suggested to Freddie Mac a plausible-sounding business purpose for a pair of linked swaps that were executed for the sole purpose of moving large amounts of operating income into the future. Given that many of the deals generated substantial commissions with minimal risk, the counterparties may have had a strong disincentive to inquire about the actual purpose of the transaction.” (pages 74/75) “Trades between Freddie Mac and Blaylock & Partners and between the Enterprise and Salomon Smith Barney raise serious questions about the quality of internal controls at Freddie Mac.” (page 107) “The deliberate disdain of Freddie Mac for appropriate disclosure standards in the face of its asserted compliance with best practices misled investors and constituted conduct that undermined market awareness of the true financial condition of the Enterprise.” (page 123) “On November 21, 2003, Freddie Mac announced the results of its ($6.5 billion) restatement and its need to delay publication of its audited financial statements for 2003. That delay is due to the need to correct many problems described in this report related to weak accounting functions and a poor internal control environment. Undoubtedly, the desire to manage earnings played a major role in the creation of those problems, as the focus of senior management and the Board of Directors was more on the growth of earnings and the share price rather than best practices in accounting, controls, and operating infrastructure. Thomas Jones, Chairman of the audit committee, recalled expressing his views to Leland Brendsel in March 2003: ‘Leland, with all due respect, in my view you’ve put the company in a very difficult situation. You’ve effectively lost control of our accounting and financial reporting status and we’re now sitting in a situation where we don’t have audited financial statements in the market and we’re one of the most critical financial entities in the capital markets. In my view it is unpardonable to not have audited financial statements that investors can rely upon and in my view in this league you don’t get second chances. You’ve been paid a lot of money to do this job and to me it’s unacceptable that we don’t have audited financial statements that investors can rely upon.’ The intense efforts to manage reported earnings at Freddie Mac drained the skills of many of the most talented employees of the Enterprise. Those efforts compromised the integrity of many employees and damaged the effectiveness of the internal control structure at Freddie Mac. The quest to manage earnings eventually led to the termination of the most senior executives of the Enterprise, and resulted in one of the largest restatements in U.S. corporate history.” (page 59) I’ll wrap this up with a conversation documented by OFHEO in its report between a Freddie Mac employee and a Morgan Stanley derivative trader executing one of the sham derivative transactions: Mr. Lavelle (Morgan Stanley): “We’ve been trained whenever people come in and start doing this kind of stuff, we’ve gotta ask why. Like not why, but like, everything’s yeah. I don’t want to be taken off in handcuffs here for doing something that’s not kosher.” Mr. Powers (Freddie Mac): “How much are you making off this trade? (laughs)” Mr. Lavelle (Morgan Stanley): “I don’t know.” Mr. Powers (Freddie Mac): “You haven’t even looked at it. (laughs)” Mr. Lavelle (Morgan Stanley): “I’m just…You know what I’m saying…I mean, I don’t mind if there’s an accounting reason for you to do this and it makes you guys money. That’s fine. You know, we’re ok with it.” Mr. Powers (Freddie Mac): “That’s where we are. We have an accounting reason for doing it. And, um, we’re basically…we’re offsetting some… Mr. Lavelle (Morgan Stanley): “I mean you could tell me there’s some asset liability reasons for you to be doing this, and I’m ok with that.” Mr. Powers (Freddie Mac): “I think that’s a much as I’d…I don’t want to tell you…” Mr. Lavelle (Morgan Stanley): “I don’t want to be taken into a courtroom, though, Ray, is what I’m saying, okay?” Mr. Powers (Freddie Mac): “Yeah…No, no, no. This is not… This is basically an asset liability, cash flow management issue.” Mr. Lavelle (Morgan Stanley): “Okay, I’m with you.” Mr. Powers (Freddie Mac): “The thing is…because of the shape of the curve, um the geography of our carry in terms of the calendar gets screwed up. So all of a sudden, we have an uneven carry picture to manage and we strive for stability…” Mr. Lavelle (Morgan Stanley): “If that’s what you want to do, I’m, we’re ok with that and we’re happy to do it with you, so we can do a lot of this if you want.”