02/13/2004 Simply Not Credible *

It was rather choppy, but the major indices generally ended the week little changed. The Dow, S&P500 and Utilities posted slight advances. The strongest S&P groups were Oil & Gas Drilling, Steel, and Aluminum. The Transports, Morgan Stanley Cyclical, and Morgan Stanley Consumer indices added about 1%. The Russell 2000 was slightly positive, while the S&P400 Mid-cap index gained 1%. The technology sector was unimpressive. The NASDAQ100 and Morgan Stanley High Tech indices dipped about 1%. The Street.com Internet index was unchanged. The Semiconductors and NASDAQ Telecom indices dropped 2%. The Biotechs’ 2% rise increased 2004 gains to 8%. The financial stocks were generally impressive, with the Broker/Dealers up 3% (up 9% y-t-d). The Banks were slightly positive. With bullion up $6.80, the HUI index added 2%. The Treasury market was strong. Two-year Treasury yields dipped almost 7 basis points to 1.67%. Five-year Treasury yields dropped 10 basis points to 2.98%, while 10-year yields declined 5 basis points to 4.02%. Long-bond yields were about unchanged at 4.92%. Benchmark Fannie Mae mortgage-backed yields sank 11 basis points. There was a new 10-year Treasury note issued this week, so spread calculations are tricky. The 10-year dollar swap spread narrowed 2 to 38.5. The yield on December Eurodollar futures sank 14.5 basis points this week to 1.78%, 32 basis points below the January 29th high. Corporate spreads were mixed, with investment grade spreads little changed. Junk bonds generally recovered some of recent lost ground. Bloomberg tallied $14.6 billion of corporate issuance, the strongest week in a month (weekly avg. of $12.8 billion). Investment grade issuers included Goldman Sachs $2.75 billion, Wal-Mart $1.25 billion, Assurant $975 million, Duke Energy $875 million, CIT Group $750 million, Time Warner $440 million, Con Edison $400 million, MidAmerican Energy $250 million, National City Bank $200 million, Infinity Property & Casualty $200 million, Private Export Funding $200 million, Russel Metals $170 million, John Hancock Global $160 million, Huntington National $150 million, Overseas Shipholding $150 million, Marshall & Ilsley $200 million, Alabama Power $200 million, Georgia Power $150 million, Compass Bank $125 million, and SLM $100 million. Junk bond funds suffered their second straight week of $1 billion outflows (from AMG). All the same, junk Issuers included AES $500 million, Solo Cup $325 million, Pantry $250 million, GCI $250 million, BF Saul REIT $250 million, North Atlantic Trading $200 million, Phillips Van-Heusen $150 million, Erico International $140 million, WII Components $120 million, and North Atlantic Holdings $95 million. A Merrill Lynch junk spread index has widened 36 basis points over the past three weeks. The convert issuance market really came to life this week. Issuers included Solectron $450 million, AMR $300 million, Fluor $300 billion, Citadel Broadcasting $300 million, Sirius Satellite $250 million, Alliant Techsystems $250 million, Dick’s Sporting Goods $250 million, Intermune $150 million, Safeguard Scientific $125 million, and CuraGen $100 million. Foreign dollar debt issuers included Republic of Philippines $1.3 billion, Kredit Wiederfaufbau $1 billion, Ubiquitel $270 million, Banco Mercantil Norte $250 million, and Brasil Telecom $200 million. The ABS market enjoyed a strong week with $12 billion of issuance (from JPMorgan). Year-to-date issuance of $50 billion is running a third higher than comparable 2003. Half of this week’s new ABS was said to be from home equity loan securitizations. February 12 – Dow Jones (Emily Barrett): “Pakistan’s Eurobond launch lived up to high expectations Thursday, as a heavily oversubscribed $500 million deal reopened the international market for the nation’s debt. The bonds priced at par, to pay a coupon of 6.75%, well below initial guidance of 6.875%. ‘The bond offers investors exposure to an improving credit with great scarcity value. Most people were content to buy bonds at the tight end of the range because they were committed to participating,’ said George Niedringhaus, syndicate official at ABN Amro. Pakistan last visited the international debt market in 1999, with $623 million in Eurobonds due 2005. The new bond presented a rare opportunity for investors whose appetite for high-yielding emerging-markets assets has been tested by a heavy $17 billion of new issuance so far this year. Word from the road show was that the order book filled almost immediately, and orders reached $2 billion… the yield on Pakistan’s bond compares closely with Turkey’s dollar bond due 2009. The Turkish bond launched in November last year with a much higher coupon of 11.75%, and currently yields 6.51%.” Freddie Mac posted 30-year fixed mortgage rates declined 6 basis points last week to 5.66%. Fifteen-year fixed rates dropped 7 basis points to 4.96%. One-year adjustable-rate mortgages could be had at 3.57%, down 4 basis points. The Mortgage Bankers Association Purchase application index dipped 4.2% to a one-month low. Purchase applications were, however, up 21% y-o-y, with dollar volume up 37% y-o-y. The Refi index dipped about 5%, while remaining above 3,000 for the fourth straight week. The average Purchase application was for $214,600. The average adjustable-rate mortgage was for $295,800. Broad money supply (M3) declined $8.7 billion for the week of February 2nd. M1 was up less than $1 billion, with Currency up $0.4 billion and Checkable Deposits up $0.2 billion. M2 rose $7.3 billion, as Savings Deposits gained $7.8 billion, Small Denominated Deposits declined about $1 billion, and Retail Money Fund deposits added $0.4 billion. M3 components Institutional Money Fund deposits declined $3.9 billion and Large Denominated Deposits declined $12.9 billion. Repurchase Agreements added $1.8 billion, while Eurodollar deposits dipped $1.5 billion. Fed “custody” Holdings of U.S. Debt, Agencies added $8.6 billion. Since the end of July, “Custody” holdings have surged $193.8 billion, or almost 39% annualized. Total Bank Credit rose $16.2 billion, with 5-week gains of a notable $103.0 billion. Security holdings jumped $18.0 billion, while Loans & Leases dipped $1.7 billion. Commercial & Industrial loans were about unchanged, while Real Estate loans gained $6.5 billion. Consumer loans declined $3.4 billion and Security loans dropped $4.0 billion. Elsewhere, Commercial Paper outstanding jumped $12.7 billion last week. Non-financial CP actually declined $3.9 billion, while Financial CP surged $16.6 billion. Financial CP is up $35 billion since year end. Currency Watch: It was another volatile week in currency markets. The dollar approached record lows against the euro today before reversing. The British pound this week traded to an 11 ½ year high and the Australian dollar to a 7-year high. The dollar index this morning traded below 85, although an afternoon recovery cut its loss for the week to less than 1%. February 10 – The Asian Wall Street Journal (Michael R. Sesit): “Maybe it is about time U.S. and European government officials came clean. When they complain about Asian countries intervening in foreign-exchange markets to keep their currencies from rising against the dollar, they invariably talk about Western companies becoming less competitive and about lost jobs. Rarely, if ever, do they finger the enormous accumulation of foreign-exchange reserves that often accompanies the intervention. Yet, explains Steve Barrow, the expansion of global reserves creates excess liquidity, which in turn is the fuel that feeds financial-market bubbles, and, during the long run, threatens to destabilize the global economy. ‘The rise in reserves that we are seeing right now suggests that the world is on the verge of boom-and-bust cycles that could exceed anything we have seen before,’ says the chief currency strategist at Bear Stearns in London. In aggregate, global reserves first reached $1 trillion during 1991. Eight-and-a-half years later, they had ballooned to $2 trillion. Just three years after that, they rose to $3 trillion. By the end of 2003, the top 11 Asian central banks had accumulated $1.94 trillion in reserves, an increase of $514 billion, or 36%, from a year earlier.” February 10 – Bloomberg (Heather Harris): “European Central Bank Chief Economist Otmar Issing said the euro’s gains improve the prospects for low inflation and there is no point in short-term action by central banks to try and influence exchange rates, German daily Sueddeutsche Zeitung reported. ‘The stronger euro lowers import prices and the prospects for the general price development improve,’ Issing told the newspaper… ‘The best contribution we can make is to inflation-free growth. There is no point in unleashing a short burst of fire.’ Regarding the U.S. budget and current account deficits, Issing said it’s ‘questionable’ how long central banks in Asia will continue to finance U.S. spending. ‘In the long term, investors will question whether they desire a risk premium for their investments.’” Commodity Watch: The CRB index added 2%, and the Goldman Sachs Commodity index jumped 4%. Copper prices rose to the highest level in eight years. Copper is already up 16% y-t-d, with 12-month gains surpassing 60%. From Bloomberg (referencing a Morgan Stanley research report): “The world will produce 426,000 tons less (of copper) than it will use this year, forcing manufacturers to dig deeper into inventories…” Zinc reached a three-year high yesterday. Lumber futures surpassed $380 this week. Lumber prices are up 15% so far this year to the highest level since mid-1999. Crude oil futures (March) jumped better than $2 this week to close at $34.56. February 11 – Bloomberg (Jim Coulter): “Oil demand this year is rising faster than expected as a surging Chinese economy begins to spur growth in surrounding nations, the International Energy Agency said. The Paris-based group, which advises 26 nations on energy policy, boosted its estimate of the rise in oil use this year by 220,000 barrels a day to 1.4 million. Consumption will total 79.9 million barrels a day… Oil inventories in the 30 nations of the Organization for Economic Cooperation and Development are falling, leaving consumers vulnerable, the IEA has said. Stockpiles fell further in December, losing 1.26 million barrels a day, to 2.52 billion.” Global Reflation Watch: February 12 – Bloomberg (Tian Ying): “China’s industrial production grew last month at a record pace, surging as companies such as Siemens AG and BOE Technology Group Co. expand to meet rising demand in the world’s sixth-largest economy. Production rose 19 percent from a year earlier after an 18 percent gain in December…” February 13 – Bloomberg (Tian Ying): “China’s money supply grew in January at its slowest pace in at least 11 months, suggesting government efforts to damp investment may be working. M2, the broadest measure of money supply, grew 18 percent from a year earlier after expanding 20 percent in December…” February 12 – Wall Street Journal (James T. Areddy): “Stepping up China’s efforts to cool down the economy before it overheats, the government has asked banks to cut the pace at which new loans are made this year. But analysts question how well the tactic will work without more flexibility in the exchange rate.” February 12 – Bloomberg (Mayumi Otsuma): “Japanese machinery orders rose 8.1 percent in December, bolstering economists' predictions that growing business investment is fueling growth in the world’s second-largest economy. The greater-than-expected gain in private machinery orders, excluding shipping and utilities, contributed to a record 11.3 percent increase in the fourth quarter.” February 12 – Bloomberg (Shanthy Nambiar): “Indonesia’s fourth-quarter growth was probably the fastest in three years as low interest rates boosted consumer spending… Southeast Asia’s biggest economy probably grew 4.5 percent from a year earlier…” February 12 – Bloomberg (Cherian Thomas): “Indian industrial production accelerated in the first three quarters of the fiscal year after a record harvest put money in farmers’ pockets, spurring demand for appliances made by Electrolux Kelvinator Ltd. and other goods. Production at factories, utilities and mines rose 6.3 percent in the nine months to Dec. 31, from 5.5 percent growth a year earlier… ‘There is intrinsic momentum in the economy and growth is visible,' said Rajeev Karwal, chief executive of Electrolux Kelvinator… ‘Demand in villages and smaller towns are driving growth.’” February 13 – Bloomberg (Andy Mukherjee): “The last piece in India’s growth jigsaw seems to be finally falling into place. On Tuesday, ICICI Bank Ltd., India’s second-biggest lender, said it plans to sell as much as 35 billion rupees ($773 million) worth of new shares, to finance increased lending. The ICICI share sale, which will be the country’s biggest- ever equity offer by a private company, is the clearest signal so far that India’s banks, wading in surplus cash, may finally be lending enough to worry about running out of money.” February 12 – Bloomberg (Francois de Beaupuy): “France’s economy, Europe’s third-largest, expanded 0.5 percent in the fourth quarter from the third, the quickest pace in 1 1/2 years, suggesting export growth made up for a slowdown in consumer spending.” February 11 – Bloomberg (Theophilos Argitis): “Greece’s economy expanded by 5 percent in the fourth quarter from the previous year on increased spending for the 2004 Olympic Games, making the nation the fastest growing in the European Union. The annual growth figure in the fourth quarter matched the pace of the previous three months, the Athens-based Economy Ministry said in a preliminary report. The economy grew 4.7 percent for all of 2003, the fastest rate in 25 years…” February 10 – Bloomberg (Halia Pavliva): “Ukraine’s economy probably will expand faster than earlier expected because of rising exports and strengthening domestic demand, the central bank said. Gross domestic product will grow from 8.5 percent and 9 percent in 2004, faster than earlier expected range of from 6 percent to 6.5 percent, the central bank said at a press conference.” Bubble Economy Watch: Belying hopes that we’d “turned the corner,” December’s Trade Deficit surged to $42.5 billion (up from November’s $38.4 billion), the second-largest on record. Goods Imports jumped to a record $111.1 billion, up 7.6% from one year ago. Goods Exports declined about $800 million for the month to $62.9 billion, though were up an impressive 12.8% y-o-y. Nonetheless, Goods Exports would need to increase 77% to match Goods Imports. For all of 2003, our Trade Deficit surged 17% above 2002’s record to an atrocious $489.4 billion. An early February reading on Consumer Confidence was not encouraging. The University of Michigan index sank an unexpected 10.7 points, giving back most of January’s sharp gain. Gauges of both Current Conditions and the Outlook sank. Weak January auto sales hurt Total Retail Sales (up 5.0% y-o-y), yet it is worth noting that Retail Sales Ex-Autos were up 6.6% y-o-y. Our federal government’s finances are a mess. Last month’s $1.4 billion shortfall was the first January deficit since 1992. It also compares poorly with last year’s $10.6 billion January surplus. Fiscal year-to-date Revenues were up 1.6% to $625.0 billion, while Total y-t-d Spending was up 5.9% to $755.1 billion. The y-t-d deficit was up 33% to $130.1 billion, with tax refund checks destined to quickly push the deficit much higher. Domestic Credit Inflation Watch: From the Bond Market Association’s most-recent Research Quarterly: “New issue activity in the U.S. bond markets topped last year’s record, totaling $6.92 trillion in 2003, an increase of 27.9 percent from the previous record of $5.41 trillion set in 2002. The continued trend of strong debt issuance across most sectors reflects the effects of the low-interest rate environment, increased demand for capital in the corporate sector and continued financing requirements in both the federal government and state and local entities… Long-term federal agencies set a new record in 2003, totaling $1.28 Trillion, up 21.7 percent from the $1.04 trillion issued in 2002… Mortgage-related securities issuance, which includes agency and private-label pass-throughs and CMOs, set yet another record in 2003, totaling $3.2 Trillion, up 39.2 percent from the previous record of $2.30 Trillion in 2002… Issuance of agency mortgage-backed securities increased to $2.13 Trillion in 2003, up 47.6 percent… New Issuance of non-agency MBS increased 50.1 percent in 2003, to $466.9 billion… New (corporate bond) issuance volume grew 13.9 percent, to $743.6 billion, up from $652.7 billion in 2002… New issue volume of non-convertible high-yield debt was especially strong, increasing 113.6 percent during 2003, to $122.9 billion… Issuance in the asset-backed securities (ABS) market set a new record in 2003, totaling $584.2 billion, up 19.4 percent from the previous record of $489.1 billion set in 2002. The increase in new issue activity was led by the growth in the home equity loan (HEL) securitization market, which increased almost 50 percent… Municipal bond issuance (of $452.4 billion) set a record in 2003, topping the previous record of $430.0 billion set in 2002. Gross coupon issuance of U.S. Treasury securities totaled $745.2 billion during 2003, a 30.4 percent increase over the $571.6 billion issued in 2002… The average daily volume of total outstanding repurchase (repo) and reveres repo agreement contracts totaled $4.04 trillion in 2003, a 6.7 percent increase… In excess of $262.7 Trillion in repo trades were submitted by (Government Securities Clearing Corp) participants in 2003, with an average daily volume of approximately $1.1 Trillion… In 2003, foreign investors purchased a net $639.5 billion in fixed income securities as of the end of November, 28.6 percent higher than the net purchase in 2002.” From Freddie Mac’s February Economic & Housing Outlook: “Our models predict another record year of total home sales, on the order of 7.28 million units in 2004. We expect families will take advantage of extremely low mortgage rates and focus on their current living arrangements from both a consumption and investment perspective. By 2005, total sales will ease to 7.24 million units. Similarly, housing starts will be very robust in 2004, coming in near the 2003 level of 1.85 million units… House price appreciation should fair well in 2004, averaging about 6.5%, well above the general rate of inflation. In addition, we increased the third quarter 2003 growth estimate by over two percentage points to 7%, owing to the strength in home sales and refinance volume during the quarter… Residential mortgage debt growth should exceed double digits over the next year, rising by around 12% in 2004.” February 13 – New York Times (Jonathan Fuerbringer): “Americans poured a near record amount into stock mutual funds in January, suggesting that last year’s rebound from a three-year rout had restored investors’ confidence in stocks. But the inflow of $40.8 billion last month may not be as positive as it appears. Some analysts consider it a sign that investors may be too bullish, too willing to expect last year’s enormous gains to be repeated. The mutual fund data show that many investors are jumping into 2003’s best bets, like foreign and smaller company stocks, which have already had big runs.” February 13 – Bloomberg (Liz Willen): “Tuition at some of New York’s top private kindergartens will exceed $26,000 for the first time in September, almost as much as the cost of attending Princeton University and twice the price of the state universities. ‘It’s supply and demand,' said Nina Bauer, a counselor at Ivy Wise Kids, a service that for $5,000 will coach parents on how to prepare four- and five-year-olds for tests and interviews. ‘Wall Street got big bonuses this year. Everyone is just dying to get in. No one has ever once asked me about tuition.’ Parents of the 30,000 students at the city’s private schools are receiving contracts this week showing next year’s tuitions will rise to record levels after five years of annual growth of as much as 7 percent.” February 11 – Dow Jones: “Official results from New Jersey’s Casino Control Commission indicate that gaming revenue in January increased 9.7%, to $366.5 million, from $333.9 million in the same period a year earlier…” Countrywide Financial posted Average Daily Applications of $1.78 billion during January, up a third from December. The Total Pipeline increased 16% during the month to $38.4 billion. Average Daily Applications were down 11% from January 2003, with Non-purchase/refi fundings down 56%. Purchase fundings were up 19% from January 2003 to $9.3 billion. Home Equity fundings were up 41% from 12 months earlier, while Subprime fundings were up 80%. “Adjustable-rate loan production of $9 billion jumped 138% over the month of January 2003 and accounted for 46 percent of total monthly fundings.” Adjustable-rate mortgages accounted for 12% of funding during January 2003. “Total Assets at Countrywide Bank rose 5 percent over the prior month to $20 billion,” and were up 290% y-o-y. February 10 – Reuters (Richard Leong) - Fannie Mae and a consortium of lenders aim to revive a U.S. manufactured housing industry that has been battered in recent years by high loan defaults and a bloated inventory of repossessed homes. ‘We want to strengthen the market for manufactured housing financing, and eliminate predatory and anti-consumer features that have contributed to instability in the marketplace over time,’ Fannie Mae Chairman and Chief Executive Officer Franklin Raines said…Fannie Mae, the biggest buyer of U.S. home loans, and the lending group will make it more affordable to obtain a mortgage to buy a manufactured home, the company said. A consumer could access 30-year financing for such a home with down payments as low as 5 percent. Total Assets expanded $33.3 billion, or 21% annualized, to $681 billion at insurance behemoth AIG Group. Total Assets were up 21% y-o-y. Weekly bankruptcy filings jumped to 30,512, the highest level since November. Monetary Management According to Dr. Greenspan “Fear over US Treasuries sales [by foreigners] misplaced – Greenspan”; “Greenspan – Fed not concerned about weak dollar”; "U.S. consumer debt under control – Greenspan.” These Reuters headlines captured the essence of Greenspan’s Wednesday appearance before the House Financial Services Committee. He downplayed the current account deficit; he downplayed mortgage Credit excess; he downplayed today’s acute economic and financial vulnerability. And our apparently sanguine Fed chairman remains on a roll when it comes to re-writing central banking theory - and making history in the process. “Monetary Management According to Dr. Greenspan” is extraordinarily experimental and radical, as well as being hopelessly flawed. It is, as well, captivating. He remains analytically focused on nebulous (and “experimental”) concepts such as economic and financial “flexibility,” “productivity,” and “conceptual output.” Curiously, however, he chose (out of character) this time to also venture into traditional central banking terrain, with comments on money and Credit. But don’t get your hopes up… From Chairman Greenspan: “In the process of assessing risk, we monitor a broad range of economic and financial indicators. Included in this group are a number of measures of liquidity and credit creation in the economy. By most standard measures, aggregate liquidity does not appear excessive. The monetary aggregate M2 expanded only 5-1/4 percent during 2003, somewhat less than nominal GDP, and actually contracted during the fourth quarter. The growth of nonfederal debt, at 7-3/4 percent, was relatively brisk in 2003. However, a significant portion of that growth was associated with the record turnover of existing homes and the high level of cash-out refinancing, which are not expected to continue at their recent pace. A narrower measure, that of credit held by banks, also grew only moderately in 2003. All told, our accommodative monetary policy stance to date does not seem to have generated excessive volumes of liquidity or credit.” I found the preceding paragraph the most important aspect of Dr. Greenspan’s testimony. “Liquidity does not appear excessive”? “Accommodative policy stance…does not seem to have generated excessive volume of liquidity or credit”? This is Simply Not Credible (yet it is these days quite market-friendly blather). He certainly knows better than to claim M2 as a contemporary indicator of liquidity, and Dr. Greenspan is also well aware that the greatest Credit excesses emanate these days from non-bank sources (GSE, MBS, ABS, Wall Street firms, captive finance, foreign central banks, etc.). As for indicators of excess liquidity, we can begin with collapsed corporate spreads, surging stock prices, major equity fund inflows, the California Real Estate Bubble, $1 Trillion of 12-month mortgage debt growth, record total Credit growth, 4% 10-year Treasury yields, unprecedented marketable debt issuance, record junk and emerging market debt sales, $34 crude oil, surging prices for metals and many commodities, a dollar index near 7-year lows, and rampant speculation in myriad markets at home and abroad. To make matters more interesting, this (specious) testimony follows on the heels of a G7 meeting where there was clearly no meeting of the minds on how to deal with U.S. imbalances. In addition, it is also worth keeping in mind that it follows by only two weeks the dropping of “considerable period.” Our Fed chairman had an opportunity to send a clear signal to the markets and our global partners that the Federal Reserve had commenced a move toward a less excess-inducing policy stance, but did nothing of the sort. Indeed, it was almost as if he was gesturing to the marketplace that it had over-reacted to the removal of “considerable period.” I found myself scratching my head, contemplating the possibility that our faltering currency and the unfolding global Credit/speculative boom are more than agreeable to our radical central bank. In response to a question regarding hedge funds, Dr. Greenspan made further astonishing comments: “I think that hedge funds, which I would define as financial institutions in which investors are only of high income levels -- the value that these institutions have is to create a very significant amount of liquidity in our system and I think that while they have a reputation of being sort of peculiar type of financial group, I think they’ve been very helpful to the liquidity and hence the international flexibility of our financial system. We have to be very careful that we make sure that they don’t become an investment vehicle for people in lower and moderate incomes because that appropriately requires registration and SEC oversight. I grant you that registering advisers in and of itself is not a problem, but the question is what is the purpose of that unless you’re going to go further and therefore I feel uncomfortable about that issue.” It is Simply Not Credible – especially post-LTCM – that our chief central banker takes such a Pollyannaish view towards the expansive hedge funds and the Leveraged Speculating Community. Yet such a perspective is music to the ears of the speculative marketplace. And the key issue is certainly not the type of hedge fund investors (whether they are “sophisticated” or not), but rather the nature of market impact and systemic vulnerability associated with the historic proliferation of highly-leveraged, short-term trading oriented speculators. There are many infamous examples throughout history (The South Sea Bubble and “Roaring Twenties” quickly come to mind) that clearly demonstrate the risk of succumbing to the seduction of liquidity created through leveraged speculation. Accordingly, the acquiescence of leveraged speculation ranks near the very top of the list of the radical Fed’s most grievous errors. It is fascinating to have the former Goldman Sachs co-chairman posing questions to our Fed chairman. I found the following discussion – and Dr. Greenspan’s apparent “impatient” demeanor – especially intriguing. Senator Jon Corzine: “With regard to top 10 countries holding our national debt. I have a particular curiosity about the Caribbean banking centers and what their implications are with respect to our concern about funding of all kinds of miscellaneous problems that could potentially exist. And I would love to hear an analysis of what is driving the fourth-highest concentration of our debt being held by Caribbean banking centers.” Alan Greenspan: “I’m sorry, was that a question to me?” Senator Corzine: “Yes, that is a question that we can ask if there could be an analysis that...” Alan Greenspan: “One has to look at it.” Senator Corzine: “Yes, please.” Alan Greenspan: “And in the context of, as you are far more aware than I, that the amount of information that those individual institutions in those various areas produce is less than we would like to see. But we’ll take a look at it and see what we can find.” Senator Corzine: “I think the issue in the funding of global terror, one wonders why so much of the external debt the United States is getting housed in among institutions that we have very little idea about. I think it’s a fair...” Alan Greenspan: “We’ll see what we can find.” My comment: It is Simply Not Credible that the Fed has not by now spent significant resources delving into the issue of ballooning holdings of U.S. securities at off-shore banking centers. And it is again worthwhile highlighting the ongoing dialogue between Congressman Ron Paul and Dr. Greenspan: Congressman Ron Paul: “I want to call attention to the committee that I certainly was pleased that you brought up the subject of deficits, because deficits obviously do cause a problem. And you mentioned that deficits may eventually cause interest rates to go up. But I also would like to suggest that deficits alone are not the problem, because whether you borrow the money or tax the money out of the economy, it still puts pressure on the capital market. So deficits alone are not the problem. It’s big government; it’s big spending, and the amount we spend here that really, really counts. But you said that deficits could -- future expectations of deficits -- could raise interest rates -- and I certainly would agree with that. But we also must remember that future expectations of the inflation rate and the future expectations of the value of the dollar also can raise interest rates. And those are monetary policy causes. And, therefore, the pressure or the emphasis or the blame for high interest rates that will come can’t be put on the deficit alone. It has to be put on those who manage monetary policy. Also, you warned on page seven that the printing presses won’t run indefinitely. You used the word ‘indefinitely.’ And that’s good, because if they do run this fast indefinitely, we all know what will and can happen. So that’s good that eventually you will turn the printing presses off. But for now, you said you can be patient. And that means we’ll just let the money flow and see what happens, which I think is a risky proposition. But you mentioned the condition of protectionism. You worry about protectionism, which I think is characteristic in all societies that destroy their currencies, and especially when you have fluctuating fiat currencies. People yield to the temptations of protectionism. But once again, there are different ways of bringing about protectionism. There are the tariffs, but there is also the competitive devaluations and the exchange rate of the dollar, which is a reflection of monetary policy.” “But my question is related a little bit to the wording of indefinitely and being patient, because they’re arbitrary, they’re subjective. And in January, your FOMC report omitted two words -- two words that were subjective, and that was ‘considerable period.’ And I find that very interesting, and also very alarming, the amount of clout, the amount of power that we as a nation, and we as a committee have allowed to get into the hands of one or two individuals or a committee. From the time the market was up to the release of that report, the stock market lost $250 billion as a reflection of the concern about the dropping of two words.” “Frederick Hayek was fond of saying that the managed economy was in danger because it was based on a pretense of knowledge: that certain things the economic planners don’t know. And for instance, he would agree with me that we don’t know, you don’t know, the Congress doesn’t know what the overnight rates ought to be, and that we reject the marketplace. But it’s part of the system. And I understand that.” “But doesn’t it ever occur to you that maybe there’s too much power in the hands of those who control monetary policy. The power to create the financial bubbles. The power to, maybe, bring the bubble about. The power to change the value of the stock markets within minutes. That to me is just an ominous power and challenges the whole concept of freedom and liberty and sound money.” Alan Greenspan: “Congressman, as I’ve said to you before, the problem you’re alluding to is called the conversion of a commodity standard to fiat money. We have statutorily gone onto a fiat money standard, and as a consequence of that, it is inevitable that the authority which is the producer of the money supply will have inordinate power. And this is one of the reasons why I’ve indicated because of that and because of the fact that we are unelected officials, it is mandatory that we be as transparent as we conceivably can. And remember that we are accountable to the electorate and to the Congress and the power that we have is all granted by you. We don’t have any capability whatsoever to do anything without the agreement or even the acquiescence of the Congress of the United States. We recognize that. And one of the reasons I am here today is to endeavor to convey why we are doing what we are doing. And I will continue to do that and I’m sure that all of my colleagues are fully aware of the responsibility that the Congress has given us. And I trust that it will be adhered to, principles of the Constitution of the United States more so than one would ordinarily do.” In a speech a few weeks back, Dr. Greenspan made reference to Walter Bagehot’s classic work on early central banking theory, Lombard Street. Mr. Bagehot would be no fan of Monetary Management According to Alan Greenspan. From Mr. Bagehot’s Lombard Street (1873): “A permanent Governor of the Bank of England would be one of the greatest men in England. He would be a little ‘monarch’ in the City; he would be far greater than the ‘Lord Mayor.’ He would be the personal embodiment of the Bank of England; he would be constantly clothed with an almost indefinite prestige. Everybody in business would bow down before him and try to stand well with him, for he might in a panic be able to save almost anyone he liked, and ruin almost anyone he liked. A day might come when his favour might mean prosperity, and his distrust might mean ruin. A position with so much real power and so much apparent dignity would be intensely coveted. Practical men would be apt to say that it was better than the Prime Ministership, for it would last much longer, and would have a greater jurisdiction over that which practical men would most value, -- over money.” These great insights resonate today at least as well as they have at any time since they were written more than 130 years ago (including the late-twenties period with the ‘monarch’ Benjamin Strong!). Today’s Monarch, Sir Alan Greenspan, has become the embodiment of the entire U.S. financial sector, the U.S. economy, and, increasingly, the entire global financial system. He is the Master of the Speculator Class. His immense real power has quelled panic more than a few times; in the process his favour has meant unimaginable prosperity. But might distrust mean ruin? I would strongly argue that Dr. Greenspan is tottering down a course of the dubious and incredible. He has lost his bearings, and our system has lost its bearings. Having others lose faith is dangerous. And a loss of trust would be truly ruinous.

02/06/2004 The Pay Option Arm *

It was another adventure through treacherous financial markets. For the week, the Dow and S&P 500 added 1%. The Morgan Stanley Consumer index gained 2% and the Morgan Stanley Cyclicals added less than 1%. The Transports were about unchanged, while the Utilities declined 1%. The broader market was especially volatile, while ending the week with small gains. The small cap Russell 2000 added less than 1%, increasing 2004 gains to 5%. The S&P400 Mid-cap index was up 1%. The NASDAQ100 and Morgan Stanley High tech indices finished slightly positive. The Semiconductors added 1%. The Street.com Internet index gained 1% (up 7% y-t-d), while the NASDAQ Telecom index declined 1% (up 6% y-t-d). The Biotechs added 1%, increasing 2004 gains to 6%. The Broker/Dealers were unchanged (up 6% y-t-d), while the Banks added 1% (up 3% y-t-d). With bullion (also volatile) up 90 cents, the HUI gold index recovered almost 6%. In the face of solid economic data, the bond market thumbed its nose and shot higher. For the week, 2-year yields dipped 7 basis points to 1.75%, and 5-year yields declined 6 basis points to 3.085%. Ten-year yields dropped 5 basis points to 4.08%, almost returning to pre-death of "considerable period” levels. Long-bond yields declined 4 basis points to 4.91%. Benchmark Fannie Mae MBS yields declined 8 basis points. The spread on Fannie’s 4 3/8 2013 note narrowed 1 to 32, and the spread on Freddie 4 ½ 2013 note was unchanged at 34. The benchmark 10-year dollar swap spread added 1.0 to 40.5, the widest margin in about three months. The implied yield on December Eurodollars declined 12.5 basis points to 1.925%. Corporate spreads generally widened moderately, with volatile conditions apparent in the junk bond market. Investment grade issuers this week included Citigroup $1 billion, Abbott Labs $500 million, Countrywide $500 million, Wachovia $500 million, United Health $500 million, Merck $350 million, LB-Baden $300 million, Keycorp $250 million, American Axle & Mfg. $250 million, Fifth Third Bank $200 million, Cullen/Frost $100 million, and First Citizens $100 million. Junk bond funds reported a notable $1.57 billion outflow last week (from AMG). This follows 13 straight weeks of inflows totaling about $4 billion. Junk issuance didn’t seem to miss a beat. Sellers included Playtex $500 million, Argosy Gaming $350 million, Ply Gem Industries $225 million, GCI Inc. $230 million, Affinity Group $200 million, Pinnacle Foods $195 million, Ormat Funding $190 million, Inverness Medical $150 million, Dunlop $120 million, and Ameripath $75 million. Convert issuers included Delta Airlines $325 million, Mesa Air $170 million, American Axle & Manufacturing $130 million and Equinix $75 million. Foreign dollar debt issuers included Export-Import Bank of Korea $1 billion, Rabobank $500 million, and Woori Bank $400 million. According to JPMorgan, asset-backed security issuance “picked up towards the end of January, bringing total volume to $37.5 billion,” about 10% ahead of January 2003. “Home Equity, Global RMBS (residential MBS) and Student Loans have dominated issuance…” Freddie Mac posted 30-year fixed mortgage rates rose 4 basis points this week to 5.72% (up 8bsp in two weeks). Fifteen-year fixed mortgage rates rose 6 basis points to 5.03%. One-year adjustable mortgages could be had at 3.61%, up 2 basis points last week and up 5 basis points in two weeks. The Mortgage Bankers Association Purchase Application index declined by less than 2%. Purchase applications were 18% above the year ago level, with dollar volume up almost 39%. Refi applications also declined slightly, with volume down 42% from a year earlier. It is, however, worth noting that the Refi application index has been above 3,000 (historically high level) for three straight weeks for the first time in five months. The average Purchase mortgage was for $205,400, with the average adjustable-rate mortgage at $310,900. The percentage of adjustable-rate mortgages rose slightly to 27.2%, about double the year ago percentage. Broad Money Supply jumped $34.1 billion to a record $8.95 Trillion, with four-week gains of $116.3 billion. Demand and Checkable Deposits gained $4.0 billion and Savings Deposits added $5.5 billion. Small Denominated Deposits were about unchanged. Retail Money Fund deposits dipped $1.7 billion and Institutional Money Fund deposits declined $2.8 billion. Large Denominated Deposits jumped $9.2 billion and Repurchase Agreements surged $17.4 billion. Eurodollar deposits added $2.1 billion. Fed Foreign “Custody” holdings of U.S. Debt, Agencies increased $4.4 billion. Total Bank Credit expanded $13.7 billion for the week of January 28, with 5-week gains of a notable $92.4 billion. Security holdings declined $5.4 billion. Loans & Leases surged $19.1 billion. By category, Commercial and Industrial loans were about unchanged, and Real Estate loans added $0.9 billion. Security loans jumped $12.4 billion and Other loans were up $5.4 billion. Elsewhere, Total Commercial Paper declined $4.3 billion. Non-financial CP increased $0.7 billion, while Financial CP dropped $5 billion. Currency Watch: Currencies, along with seemingly everything else, vacillated by the hour. For the week, unrelenting Japanese dollar buying kept this week’s dollar decline to a minimum. But the dollar sank about 2% against the Euro, with the dollar index suffering a 1.5% decline. The dollar must hold recent lows or it is likely to abruptly embark on another precarious bear market descent. Emerging debt markets remain unsettled, although most seemed to somewhat stabilize by week’s end. The Brazilian bond market gave up more ground this week. Commodities Watch: February 3 – Bloomberg (Christian Baumgaertel): “Dollar-based commodity prices on the world market rose 5.8 percent in January from the previous month, led by a 6.8 percent gain in the cost of industrial raw materials, the HWWA economic institute said. From a year earlier, global commodities prices including those for agricultural products, industrial raw materials, as well as metals and energy commodities rose 11.7 percent…” The CRB index declined about one-half percent, while the Goldman Sachs Commodity index declined better than 1% this week. Pork belly prices jumped 11% this week to a seven-month high. Global Reflation Watch: February 4 – Bloomberg (Petter Narvestad): “Knightsbridge Tankers Ltd. and other owners of the largest oil tankers are collecting as much as 50 percent more than break-even on multiyear contracts as spot-market rates surge close to 30-year highs.” “Freight rates for dry-bulk cargoes such as iron ore and coal are at a record after rising in January for the ninth month in 12 as an expanding Chinese economy boosts demand for raw materials and port delays tie up ships. The Baltic Dry Index, a measure of the price paid for shipping dry-bulk goods, climbed for a seventh session today to 5,681 points. The index, which gained 17 percent in January, has more than tripled in the past year as demand outpaced growth in the world’s bulker fleet. ‘We are seeing close to a 100 percent utilization in the dry bulk market,’ said Nicolai Hansteen, an analyst at Oslo-based shipbroker Lorentzen & Stemoco… ‘It’s made rates go through the roof and the situation may last into the second half of this year.’” February 4 – Bloomberg (Guy Faulconbridge): “Russian consumer prices rose at the fastest pace in a year in January, as prices for services soared after the government allowed increases in the cost of electricity, gas and local services. Russian consumer prices rose 1.8 percent in January from December…” February 4 – Bloomberg (Seyoon Kim): “South Korean producer prices rose in January at their fastest pace in more than five years because holiday demand bid food prices higher and crude oil costs rose, making fuel, chemicals and other industrial goods more expensive. Producer prices rose 3.8 percent from a year earlier after climbing 3.1 percent in December… Rising food and energy costs may push up prices of everything from restaurant meals to cars and computers, causing consumer-price inflation to accelerate.” February 6 – Bloomberg (Clare Cheung): “Hong Kong’s retail sales had their biggest gain in almost a year in December as tourists arrivals surged to a record, and falling unemployment and rising asset prices made people more willing to spend. Sales climbed 6.7 percent from a year earlier…” February 4 – Bloomberg (Duncan Hooper): “U.K. house prices rose last month at the fastest pace since October 2002, HBOS Plc said, suggesting consumers’ willingness to borrow hasn't been dented by November’s interest-rate increase. The average cost of a home rose 2.2 percent to 145,610 pounds ($267,405), following a 2 percent gain in December… Annual house-price inflation accelerated for a second month to 16 percent in the quarter ended Jan. 31…” (and this is in the face of central bank tightening!) February 6 – Bloomberg (Sam Fleming): “The number of U.K. shoppers last month rose the most in 2 1/2 years as Britons ramped up spending on home-entertainment systems, mobile phones and home-improvement products, a survey showed. The number of consumers visiting stores in January swelled 5.3 percent from a year ago, the biggest monthly climb since June 2001…” February 2 – MarketNews: “Excess money and credit supply in the euro area mean the European Central Bank should raise interest rates, according to a group of leading German ECB watchers…. The professors believe that excess liquidity could bring an asset bubble which would then drive up consumer prices. They warn that the inevitable need to correct such a development could prove ‘highly costly’ as far as jobs and growth are concerned. ‘In particular, we see the risk that excess liquidity in the US as well as in the euro area could cause, in a first wave, asset price inflation (on the stock, bond and housing markets) before driving up consumer prices. The inevitable correction of such a development could prove highly costly as far as output and employment are concerned, and thus warrants attention by monetary policy makers. This is why we conclude: ‘Too much money is chasing too few goods.’” Economy Watch: The bond market believes 112,000 jobs created is consistent with the Fed remaining on the sidelines. The stock market celebrates being in a "sweet spot" of solid growth and stable low interest rates. Yet, when I look at recent data I see potential for overheating. January retail sales were impressive, and when I see better-than-expected gains from Wal-Mart and double-digit same-store sales gains from McDonalds and others, I take notice. The January ISM Manufacturing index rose for the eighth straight month to the highest level since December 1983. Prices Paid surged an eye-opening 9.5 points to 75.5, the highest since booming March 2000. The Prices Paid index is up 22.5 points in five months. Production rose almost 2 points to a blistering 71.1. New Orders remain exceptionally strong (although down 2 points) at 71.1, with three consecutive months above 70. The January ISM Non-manufacturing index jumped a much stronger-than-expected 7.1 points to 65.7, the strongest reading on record (since inception in July 1997). Up 5.4 points to 64.9, New Orders were the second strongest ever. Factory Orders were up a stronger-than-expected 1.1%, with orders up 8.0% y-o-y. Non-defense Capital Goods orders were up 9.1%, with total Capital Goods orders up 10.5% y-o-y. December Total Construction Spending was up (a slightly less-than-expected) 0.4% to a record annualized $933.2 billion. Total Construction Spending was up 8.0% y-o-y, with Private Residential Spending up 16.2%. Total Private Construction Spending was up 9.4% from December 2002. Expenditures on Office construction were down 4.9% y-o-y, with Commercial Construction up 4.0%. Total Public Construction Spending was up 3.7% y-o-y, led by Commercial up 23.7%, Power up 19.6% and Highway/Street up 10.7%. December Personal Income was up 0.2%, and Personal Spending was up 0.4%. From one year ago, Personal Income is up 3.80%, the strongest y-o-y performance since May 2001. Disposable Income was up 4.7% from December 2002 and up 10.3% over two years. For 2003, Personal Income was up 3.1%, a notable rise from 2002’s 2.3%. Up 5.0%, spending posted its strongest yearly gain since 2000. By category, spending on Durable Goods was up 5.1%, Non Durables 6.4%, and Services 4.2%. Spending was up 4.8% during 2002, 4.5% in 2001, and 7.3% during 2000. Domestic Credit Inflation Watch: February 4 – American Banker (Damian Paletta): “Domestic lenders are reporting stronger business loan demand, snapping three years of declines, according to a Federal Reserve survey… ‘According to domestic respondents, the most important reasons for the strengthening of loan demand over the past three months were increased customer investment in plant and equipment and increased customer needs to finance accounts receivable and inventories,’ the Fed said in summing up its latest Senior Loan Officer Opinion Survey… Overall demand for commercial loans increased as many banks made them easier to obtain. In the past three months 18% of domestic banks reported easing their lending standards on commercial and industrial loans for large and middle-market firms; none reported a tightening. The Fed said the net easing was the largest since late 1993… Industry observers said the commercial lending market was finally catching up with the rest of the economy.” February 3 – Bloomberg (Brendan Murray and Simon Kennedy): “The U.S. plans to borrow a net $177 billion from January through March, a record for any quarter and more than the Treasury Department forecast three months ago, to help finance an unprecedented budget deficit. The borrowing will help the U.S. finance a shortfall that the White House today said will swell this fiscal year to $521 billion, the biggest ever in dollar terms.” February 3 – The Asian Wall Street Journal (Phillip Day and Hae Won Choi): “Asian Central banks, among the biggest and most important investors in U.S. securities, are finding other ways to use their vast dollar holdings -- a move that could make it harder for the U.S. to keep financing its fiscal deficit while keeping interest rates low… Asian central banks aren’t going to dump their estimated holdings of nearly $1 trillion of U.S. government bonds overnight. But even if they shifted some of their holdings, or just slowed their rate of buying, the results could be felt globally, most notably by the U.S… The percentage of U.S. government debt owned by foreigners rose to 37.3% last year from less than 4.7% in 1965. Foreign central banks hold more than $800 billion in Treasurys -- $1 of every $5 the U.S. government owes. For the U.S. debt market, foreign buying is ‘critical – it’s probably the biggest driver’ of the Treasury market recently, says Michael Ryan, strategist with UBS in New York.” February 3 – Bloomberg (Keith Snider and Will Edwards): “Health-care costs at Thomas Built Buses have jumped between 10 percent and 15 percent each of the past three years. For workers, that means two things: smaller raises and longer hours as the company puts off hiring… U.S. companies’ health insurance premiums surged 42 percent in three years to $9,100 for an employee and family last year, according to… Henry J. Kaiser Family Foundation. This year, employers face a further jump of 14 percent... Coming on top of rising liabilities for retirees’ health care, such expenses are becoming a drag on hiring, according to companies such as Ford Motor Co. and employers surveyed by the Federal Reserve Board.” February 3 – Bloomberg (Daniel Taub and Rodney Jefferson): “American Financial Realty Trust acquired an office building in Boston occupied by fund management company State Street Corp. for $705 million. The price per square foot was about $675, the highest ever paid in the city, real estate brokers said… Last year’s biggest acquisition in Boston, the John Hancock Tower, New England’s tallest skyscraper, sold for about $314 a square foot. Chief Executive Nicholas Schorsch said in December the trust had $1 billion to spend on property and was looking at branches that may be left after Bank of America Corp. buys FleetBoston Financial Corp. With the purchase of the building, which opened less than a year ago, American Financial is assured stable revenue worth more than $1 billion over two decades.” February 5 – American Banker (Erick Bergquist): “Home appraisers are usually selected and paid by commissioned loan officers and mortgage brokers, who have an incentive to close as many loans as possible for the highest amount possible. So it is almost inevitable that some appraisers would complain about pressure from originators to overstate property values. But several appraisers interviewed by American Banker said such pressure intensified during the refinancing boom of the last three years. As more consumers sought to take equity out of their homes, the appraisers say, loan officers and mortgage brokers increasingly leaned on them to come through with values high enough to make cash-out refis worthwhile. If the appraisers held their ground, they said, they lost business to others who did not. The perception appears to be held by appraisers nationwide… Of the 500 appraisers October Research Corp. surveyed last year, 55% said they felt pressure to overstate home values…” January 28 – United Press International: “At the current median price of $560,240 for a Bay Area home, California’s housing costs seem to have gone through the roof. At that rate, one would need an annual household income of at least $124,000 to buy an average home, says KPIX-TV, quoting California Budget Project, an advocacy organization for low and middle-income groups. The group says the state’s affordable housing crisis is now on an emergency footing. The group says the qualifying income of $124,000 is about $47,000 higher than the average income of an Oakland household, and $32,000 higher than the average income of a San Francisco household. The organization says home prices continue to rise much faster than incomes, keeping many potential buyers in rental housing.” February 6 - Sierra Sun (Truckee, CA – Alisha Wyman): “It’s a modest home - one story, 1,400 square feet, located in Tahoe Donner. Six years ago, it sold for $164,000. Today, it’s listed for $450,000. The difference between the prices alone is enough to buy a house in most markets… According to the Truckee Affordable Housing Land Use Evaluation Study conducted by Bay Area Economics, a four-member family with an income of $70,800 could afford a home for $234,692. The medium cost for a home in Truckee is $383,000.” Perhaps I am completely out of touch, but $124,000 income to purchase the median-priced $560,000 home in the San Francisco Bay Area? Even with the magic elixir of historically low mortgage rates, spending 450% of annual income seems like quite a financial stretch. All the same, we are witnessing extraordinary housing inflation in California (and elsewhere) – in the face of minimal income growth (in contrast to 70’s and late-eighties heady income inflation). Clearly, aggressive lenders are playing the instrumental role in this historic Bubble, easing lending terms sufficiently to arm new and move-up buyers for paying ever-increasing prices. There are anecdotes that should have our financial authorities in a cold sweat, but they are instead dusty-dry as they fixate on the miraculous “productivity” and CPI data. Yet this environment recalls 1999/early-2000 more with each passing week. Back then, the “stock market: Bubble or not” debate aroused and absorbed. Meanwhile – under the radar screen – truly egregious excess ran completely out of control throughout the Credit system. Junk bond issuance exploded with increasingly suspect Credits taking full advantage. The likes of Enron, Tyco, Global Crossing, Calpine and Cisco borrowed and expanded aggressively; the stock market celebrated. Aggressive vendor financing provided windfall liquidity to scores of uneconomic enterprises, while fueling extraordinary accounting profits for the technology industry. And Wall Street “structured finance” went into overdrive to transform hundreds of billions of risky loans into securities enticing to inebriated Leveraged Speculators and investors alike. The holders of these instruments enjoyed stellar financial profits, for awhile. Mr. Kudlow provided proof (again) this week that we haven’t learned a bloody thing with this comment, “This can’t be a Bubble with huge profits.” Well, I would strongly argue that profits are today, as they were in ’99-2000, both a fundamental Bubble prerequisite and phenomenon. The issue, instead, is the source and sustainability of the finance that is the driving force behind surging business revenues and marketplace liquidity. In this regard, the Greenspan Fed is dead wrong in its expedient assertion that Bubbles are only identifiable after the fact. Those of us that recognized that the late-nineties tech boom was being fueled by massive junk bond issuance, reckless lending, accounting chicanery and wild speculation, questioned only the timing of the bust. The Fed’s late 1998 bailout of LTCM and aggressive accommodation set the stage for destabilizing blow-off excesses in debt and equity markets. History again rhymes, as the Fed’s late-2002 corporate bond market bailout and accommodation incited blow-off excess for the Great Mortgage Finance Bubble, as well as for asset markets worldwide. And let there be no doubt that runaway lending excess – this time throughout mortgage finance with increasingly suspect Credits, paralleling late-stage tech Bubble developments – is the overriding source of finance driving today’s booming corporate profits and speculative markets. It is seductive and especially dangerous, as it fuels self-reinforcing asset inflation and liquidity creation. And in cadence with 1999 and early 2000, reckless lending excess has gone to unimaginable extremes in terms of both quantity and quality. The lending Bubble is, in the end, unsustainable, yet, for now, powerfully self-feeding. And, once again, it all goes mysteriously unrecognized. The Bottom Line is that the U.S. Mortgage Finance Super Industry is the most powerful financial mechanism orchestrating the greatest financial scheme in history. And, importantly, it is able to adapt to and accommodate evolving conditions, thus ensuring continued sufficient Credit and liquidity to sustain The Bubble. February 2 – Dow Jones (Julie Haviv): “With volumes of new mortgages and refinancing shrinking, lenders have been putting more efforts into marketing products such as interest-only mortgages to attract consumers… With an interest-only mortgage, the borrower is allowed to pay only interest payments early in the term of the loan, with payment on principal deferred to later years. That means smaller monthly payments for the homeowner in the first years of a mortgage’s life. A couple of years ago, there was little demand for interest-only mortgages, but recently, volumes have picked up dramatically. For example, at internet broker Quicken Loans - which last year originated about $12 billion in mortgages - currently about 40% of new loans are interest only, with most of the growth emerging over the past six months, according to its chief economist, Bob Walters. Two years ago, the lender registered zero interest in the loans. Other brokers report a similar pickup. Wells Fargo, one of the U.S.’s leading mortgage lenders, says interest-only mortgages account for one fifth of new loan applications. ‘A few years ago, interest-only loans were mostly targeted to the wealthy and sophisticated,’ Quicken’s Walters said. ‘Today they are being offered to a much wider audience that wants to lower their monthly payment.’ And the savings are substantial: Interest-only mortgages are typically variable-rate loans that range from 4.25% for a three-year adjustable to 6% for a 10-year… Homeowners can lower their monthly payment by about 20% to 25% by skipping principal payments in the early years of the mortgage…with the mortgage industry facing a drop of one-third in business volumes this year from last year, when the refinancing boom boosted volumes to record levels, there is clearly pressure on brokers. ‘There is no doubt that there are lender abuses going on out there because people are currently being offered mortgages that they otherwise may not qualify for,’ said Paul Bennett, certified financial planner and president of Private Wealth Advisers in Virginia, said.” So, Wells Fargo – the originator of $470 billion of mortgage loans last year – is seeing 20% Interest-only mortgage applications these days? Wow, things have really taken a decided turn for the worst over the pasts few months. And consistent with so many Exacting Bubble Ironies - the passing of the historic Refi boom did not, as one could have reasonably presumed, usher in the downfall of the Great Mortgage Finance Bubble – anything but. Rather, I would today strongly argue that the recent surge in Interest-only and no-down-payment loans is the lending industry’s aggressive response to assure the continued rapid growth of the mortgage business. It is also a major recent development adding fuel to the National Mortgage Finance and California Housing Bubbles. After reading Ms. Haviv’s informative article (on the recent popularity of Interest-only mortgages), my first thought was, “What about Countrywide Financial?” They are the most innovative and aggressive, and surely determined to expand and grow market share (above their 2003 originations of $435 billion!). Moreover, they have built an enormous lending and servicing infrastructure. They also have an inflated stock price and ballooning balance sheet to sustain. What have they been up to? (They did not return my phone call requesting information on the extent of their Interest-only lending.) Probing “current rates” at Countrywide’s website proved informative. I first put in a Dallas zip code and checked for a $200,000 purchase mortgage. The quick response was rather standard, with 30 and 15-year fixed mortgage rates, along with one and 5-year adjustable mortgages. Things, however, turned more interesting when I input a $500,000 mortgage with a Southern California zip code. Right there, featured prominently along side traditional fixed and adjustable rates, were rates for “Interest Only – 30-year adjustable, Fixed for Five Years.” As for monthly payments on a $500,000 loan, a 30-year fixed mortgage at 6.125% calculated a monthly payment of $3,038. An adjustable-rate mortgage fixed for 5 years at 4.875% produced a payment of $2,646. Meanwhile, the Interest-Only mortgage fixed a 5.0% (4.136% APR) for five years produced an enticing payment of only $2,083. Wow, a half million dollar home for $2,000 a month (excluding taxes, insurance, etc.)! But it gets “better.” There is also a drop-down menu that provides 10 additional mortgage options including 10 and 15-year fixed mortgages, as well as Interest Only – Fixed for 30-years. Yet another mortgage option that caught my eye: “The Pay Option ARM.” From the website: “This program (Pay Option ARM) combines the low interest rate of an adjustable rate mortgage with added flexibility that can keep your monthly payment affordable if interest rates should rise. You can pay down the loan as quickly as you like, but need only pay the interest for the first 10 or 15 years… Initial payment is based on paying off the loan over 30 years with a low introductory interest rate. After the three-month introductory period, you have the option of maintaining your monthly payment even if this falls below the interest due on the outstanding balance. You may always increase your monthly payment to pay off your balance more quickly, or to at least cover the monthly interest due. The interest rate is reviewed and can adjust monthly. The rate is based on the LIBOR rate plus a margin. The minimum payment is reviewed annually and is limited in the amount that it can increase each year. This is a great product for a consumer who only intends to own the property for a short time, who wants the lowest possible monthly payment in the short term, and who prefers affordability and flexibility in the monthly payment. Pay Option ARM loan product features: Low monthly payment gives you greater control in managing your cash flow and financial assets; Pay down your principal balance at your own pace and reduce future monthly payments; Afford a larger home; Greater flexibility in monthly payments when personal income fluctuates; Combines the low initial rate of an Adjustable Rate Mortgage with stability in the monthly payments should interest rates rise.” With a “low introductory rate” of 1.75%, the monthly payment on the $500,000 mortgage is calculated at only $1,786 (less than many (millions?) are paying for rent throughout the Golden State!). And while the “small print” describes a 20% down payment, a pop up appears with the caption, “Worried about your down payment? Would 100% financing help stop the worry? With our 80/20 Loan programs, you might be able to afford that dream home sooner than you think.” “Countrywide is now offering 100% home financing with no income documentation. Our 80/20 Stated Program allows qualified borrowers with excellent credit to get an 80% first mortgage and a 20% Home Equity Line of Credit to equal 100% financing on their home… And with the 80/20 Stated Program, qualified borrowers don’t even need to provide W-2’s, tax returns, or any documentation of income. Simple. Our 80/20 Stated Program features: 100% financing up to $500,000 (80% 1st up to $400,000 and 20% 2nd up to $100,000). No mortgage insurance (PMI) required. Reduced documentation.” So I think I am beginning to understand… It would appear that purchasers are afforded the opportunity to borrow 100% of the $500,000 mortgage, perhaps with a monthly payment of less than $1,800. “What about closing costs,” you ask? Interestingly, The Pay Option Arm even comes with negative points, or a $1,250 Credit. And as is illustrated in detail on the “estimated closing costs’ worksheet, this Credit reduces out-of-pocket Total Estimated Closing Costs to a mere $1,185. A deal simply too good to refuse, especially in markets with rapidly inflating prices. Countrywide has other “hot loan options,” including the “FlexSaver ARM featuring “interest only” “flexible monthly play options” – “loan amounts up to $1,000,000” – “loans up to $400,000 with 5% down.” “Interest Only Products” with “loan amounts available up to $2,000,000." And, of course, there’s the EasyWay Flex mortgage providing 100% financing up to the GSE’s $333,700 limit. What ever happened to the GSE’s 70% loan-to-value requirements? At Wells Fargo, the Interest Only mortgage option “increases your cash flow – making homeownership more affordable… Redirect your cash flow to supplement your savings or investment funds, maximize contributions to your 401k or other tax-deferred retirement accounts… It’s your money to use as you see fit.” Well, it may be the borrowers’ “money” to use as they wish, but for the system as a whole these latest mortgage developments are worth pondering for providing the marginal liquidity sustaining financial and economic Bubbles. For now, “Interest Only” may be the elixir – on the margin - for perpetuating the Great Credit Bubble. And let’s not forget the evolving “non-profit” Down Payment Assistance Programs. Hundreds of these programs have sprouted up all across the nation, taking “contributions” from home builders and sellers, and “gifting” these funds to buyers for “down payments.” The alliance between these groups and the expanding national homebuilders has become a powerful force for sustaining Bubble excess. At Nehemiah (www.getdownpayment.com), one can “click here to view new home communities where you can purchase a home with gift funds from The Nehemiah Program. Participating Nehemiah homebuilders will be happy to help you find the home of your dreams.” “Clicking” sends the viewer to a national map. “Clicking” on the state of California provides links to participating homebuilders including Beazer Homes, Centex Homes, Pulte Homes and Heller Development. “Clicking” on Texas provides links to 15 builders, including Beazer, DRHorton, Centex, Lennar, Century, Pulte and Engle. “Clicking” Florida links to twelve builders and Colorado twenty-four. We have reached the point of our system providing unlimited funds for zero down-payment, minimal payment mortgages. We should not underestimate the ramifications for this late-stage, Credit cycle "blow-off" development. As we approach “G7 Weekend,” I will conclude with brief remarks addressing how truly ridiculous this has all become. Our nation’s authorities have cowardly decided that they will not move to correct conspicuous and ballooning imbalances – Not Gonna Do It. Instead, they espouse the view that imbalances must be rectified by more aggressive stimulus and growth from our global trading partners. This is the most dangerously flawed analysis of global finance and economics in history. It is also insulting to our Creditors and the global community at large. The overriding problem in the world today – and I’m choosing these words carefully - can be traced directly back to the unsound practices of Countrywide, Wells Fargo, Fannie Mae, Freddie Mac, Citigroup, JPMorgan, Bank of America, Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman, American Express, MBNA, Capital One, and the U.S. financial sector generally. Acute financial and economic fragility is homegrown and will be resolved at home. Greater inflation and stronger growth in Europe and Japan will in no way change the fact that our financial system is lending recklessly. A stronger Chinese currency will not assuage the speculative impulses of an incredibly powerful and expansive global Leveraged Speculating Community. Heightened Credit growth overseas will not alter the reality that U.S. lending and asset Bubbles now demand unrelenting new Credit/dollar claims inflation. And stronger U.S. exports will not ameliorate the acute risk propagated upon millions of unsuspecting borrowers stretching to afford grossly inflated home prices in California and elsewhere. We’re fully in the process of absolutely burying our middle class in mortgage debt. Pressing for continued global Credit excess will surely exacerbate, not mitigate. It will be interesting to examine the wording of the Group of Seven’s final statement. Will the Europeans bend? Will the ECB soon buckle and lower rates to support the dollar? Well, I have absolutely no idea. But I do believe it is today important to appreciate that ECB analysis and policy is grounded in the paramount role played by sound money and Credit. Somehow this fundamental framework has been completely discarded by our central bankers and politicians. Is this, then, a case of Irreconcilable Differences between American and European policymakers regarding a critical issue that few understand and that would not likely be contested in public? Well, in the final analysis, I just don’t see how it will be possible to forge a meeting of the minds between the U.S. and Europe with regard to dealing with onerous global imbalances. We’ve only been biding time, and the markets have taken full advantage. Which leads me to fear that the unavoidable adjustment process will invariably be instigated by tumultuous financial markets. And every time I think through the dynamics of our out-of-control Mortgage Finance Bubble – and see things such as major lenders hawking interest only/no down-payment mortgages to sustain the California Housing Bubble - I instinctively fear for our currency.