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May 02, 2008

Revisting Financial Arbitrage Capitalism
by Doug Noland

For the week, the Dow gained 1.3% (down 1.6%) and the S&P500 1.1% (down 3.7%). The Transports jumped 3.7% (up 16.1%), and the Morgan Stanley Cyclicals rose 0.9% (down 0.9%). The Utilities gained 1.7% (down 3.9%), and the Morgan Stanley Consumer index added 0.3% (down 5.0%). The small cap Russell 2000 added 0.3% (down 5.3%) and the S&P400 Mid-Caps 0.8% (down 0.9%). The NASDAQ100 jumped 3.3% (down 4.9%) and the Morgan Stanley High Tech index 2.4% (down 4.9%). The Street.com Internet Index rose 3.6% (down 2.7%); the NASDAQ Telecommunications index jumped 4.5% (down 0.2%); and the Semiconductors gained 2.2% (down 2.0%). The Biotechs added 0.8% (down 3.7%). The financial stock surge continued, with the Broker/Dealers jumping 4.3% (down 12.0%) and the Banks rising 2.6% (down 2.6%). With Bullion sinking $29.85, the HUI gold index declined 2.7% (down 2.4%).

One-month Treasury bill rates jumped 39 bps this past week to 1.21%, and 3-month yields gained 6 bps to 1.50%. Two-year government yields added 4 bps 2.46%. Five-year T-note yields were little changed at 3.18%, while ten-year yields dipped one basis point to 3.86%. Long-bond yields declined one basis point to 4.58%. The 2yr/10yr spread ended the week at 140 bps. The implied yield on 3-month December '08 Eurodollars declined 16 bps to 2.98%. Benchmark Fannie MBS yields fell 13 bps to 5.42%. The spread between benchmark MBS and 10-year Treasuries narrowed 10 to 156 bps (low since early February). The spread on Fannie's 5% 2017 note narrowed one to 55 bps, while the spread on Freddie's 5% 2017 note was little changed at 55 bps. The 10-year dollar swap spread declined 3.25 to 61.0. Corporate bond spreads were narrower. An index of investment grade bond spreads sank 11 to a four-month low 88 bps. An index of junk bond spreads widened 2 to 637 bps.

Investment grade issuance included Bank America $6.0bn, Credit Suisse NY $4.0bn, Lehman Brothers $2.0bn, Bristol-Myers Squiibb $1.6bn, Chubb $1.2bn, New York Life $1.0bn, Dow Chemical $800 million, KLA Instruments $750 million, Prologis $600 million, and Centerpoint Energy $300 million.

Junk issuers included Ford Motor Credit $1.1bn, Markwest Energy $500 million, Range Resources $250 million, and Axcan Intermediate $235 million.

I saw no convert issuance this week.

International dollar bond issuance included Oester Kontrollbank $1.0bn, and Pearson PLC $900 million.

April 30 - Bloomberg (Lester Pimentel): "Argentine bonds show growing speculation that the country will default for the second time this decade as inflation and anti-government protests swell. The nation's $10.8 billion of floating-rate dollar bonds due in 2012 yielded 7.60 percentage points more than Treasuries..."

German 10-year bund yields added 2 bps to 4.20%, as the DAX equities index rallied 3.3% (down 12.7% y-t-d). Japanese 10-year "JGB" yields rose another 4 bps to 1.64%. The Nikkei 225 surged 3.8% (down 8.2% y-t-d and 19.2% y-o-y). Emerging debt markets were mostly quite firm, while equities were generally higher. On the back of the country's new investment-grade rating, Brazil's benchmark dollar bond yields sank 25 bps to 6.0%. Brazil's Bovespa equities index surged 7.4% (up 8.6% y-t-d). The Mexican Bolsa fell 3.8% (up 3.4% y-t-d). Mexico's 10-year $ yields declined 8 bps to 4.85%. Russia's RTS equities index fell 1.7% (down 7.3% y-t-d). India's Sensex equities index rose 5.3%, reducing y-t-d losses to 13.2%. China's Shanghai Exchange rallied 12.7%, cutting 2008 losses to 29.8%.

Freddie Mac 30-year fixed mortgage rates rose 3 bps to 6.06% (down 10bps y-o-y). Fifteen-year fixed rates dipped 3 bps to 5.59% (down 28bps y-o-y). One-year adjustable rates were unchanged at 5.29% (down 13bps y-o-y).

Bank Credit slipped $1.0bn to $9.411 TN (week of 4/23). Bank Credit has expanded $198bn y-t-d, or 6.6% annualized. Bank Credit posted a 40-week surge of $767bn (11.5% annualized) and a 52-week rise of $945bn, or 11.2%. For the week, Securities Credit increased $1.9bn. Loans & Leases declined $2.8bn to $6.878 TN (40-wk gain of $554bn). C&I loans fell $5.8bn, with one-year growth of 21.8%. Real Estate loans dropped $7.4bn (up 3.9% y-t-d). Consumer loans dipped $0.7bn, while Securities loans rose $10.8bn. Other loans were little changed. Examining the liability side, Deposits jumped $54.4bn, while "Net Due to Foreign" fell $27bn.

M2 (narrow) "money" supply jumped $27.9bn to $7.693 TN (week of 4/21). Narrow "money" has expanded $231bn y-t-d, or 10.0% annualized, with a y-o-y rise of $469bn, or 6.5%. For the week, Currency was unchanged, while Demand & Checkable Deposits surged $29.3bn. Savings Deposits gained $15.1bn, while Small Denominated Deposits declined $1.1bn. Retail Money Funds fell $5.4bn.

Total Money Market Fund assets (from Invest Co Inst) sank $65.4bn last week to $3.418 TN, while posting a y-t-d gain of $305bn, or 30% annualized. Money Fund assets have posted a 40-week rise of $834bn (42% annualized) and a one-year increase of $971 TN (40%).

Asset-Backed Securities (ABS) issuance increased to $6.6bn. Year-to-date total US ABS issuance of $68bn (tallied by JPMorgan's Christopher Flanagan) is running 25% of the comparable level from 2007. Home Equity ABS issuance of $303 million compares with 2007's $146bn. Year-to-date CDO issuance of $12bn compares to the year ago $151bn.

Total Commercial Paper dropped $21.3bn to $1.764 TN - the low since May 2006. CP has declined $460bn over the past 38 weeks. Asset-backed CP fell $17.7bn (38-wk drop of $446bn) to $749bn. Over the past year, total CP has contracted $285bn, or 13.9%, with ABCP down $349bn, or 31.7%.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 4/30) increased $10.5bn to a record $2.263 TN. "Custody holdings" were up $207bn y-t-d, or 29% annualized, and $337bn year-over-year (17.5%). Federal Reserve Credit declined $4.0bn to $864bn. Fed Credit has contracted $9.1bn y-t-d and $2.5bn y-o-y (0.3%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.377 TN y-o-y, or 25.9%, to a record $6.693 TN.

April 30 - Bloomberg (Maria Levitov): "Russia's foreign currency and gold reserves, the world's third largest, posted this year's biggest weekly gain on a surge of capital inflows, the central bank said. The value of reserves increased by $10.7 billion to a record $529.5 billion..."

Global Credit Market Dislocation Watch:

May 2 - Bloomberg (Scott Lanman): "The Federal Reserve expanded its cash- loan auctions for banks by 50% to $75 billion each after higher borrowing costs blunted the impact of the four-month-old program. The Fed also increased its currency-swap arrangement with the European Central Bank by two-thirds to $50 billion and doubled the amount with the Swiss National Bank to $12 billion... In a third move, the Fed will accept other AAA rated asset-backed securities as collateral for Treasury loans through another program."

April 30- Financial Times (David Oakley and Michael Mackenzie): "Bond issuance by banks reached its third-highest monthly level ever in April as the banks took advantage of improving credit conditions... A total of $303bn was raised globally by banks in April, a record for the month and the third-highest month of all time, according to Dealogic. The data provider added that dollar issuance of bonds in April was $142bn, while euro issuance totalled $119bn."

May 1 - Bloomberg (Jody Shenn): "Top-rated securities backed by subprime or home-equity loans last month returned more than U.S. Treasuries for the first time since December... The debt returned 0.42 percentage points more than government notes on average, according to Lehman Brothers... data. Agency mortgage bonds guaranteed by government-chartered Fannie Mae and Freddie Mac or federal agency Ginnie Mae outperformed Treasuries by 0.95 percentage point, the most in at least 20 years."

May 1 - Bloomberg (Shelley Smith): "Banks and companies in Europe seized on lower borrowing costs to sell 94.2 billion euros ($147 billion) of bonds in April in the busiest month on record. Sales jumped from 44.1 billion euros in March and 50.6 billion euros in April 2007... Deutsche Bank AG, UBS AG and JPMorgan Chase & Co. led 78.5 billion euros of bonds, more than 75% of the total."

April 29 - Financial Times (Michael Mackenzie): "After a banner run, global bond markets have run into a brick wall during April. The sharp rise in bond yields suggests that central bank efforts to quell the financial crisis appear to have worked. Safe-haven buying of government debt and the sale of global stocks and riskier fixed-income securities peaked in mid-March when Bear Stearns almost collapsed."

May 2 - Financial Times (James Mackintosh): "Traders making some of the safest bets on the planet - on tiny price moves in ultra- secure US government debt - were hammered in March as hedge funds scrambled to sell assets to cover losses in other markets. EMF Financial Products, a New York hedge fund, lost almost $100m of its $406m last month after it plunged 23.2%... although it has rebounded sharply this month... The problems for Treasuries and other government bond traders appear to have their roots in a crisis in part of the Japanese government bond (JGB) market, amplified by leverage and the crisis at Bear Stearns... 'When a heavily leveraged fund is deleveraging, everyone else will feel the effects,' says Nigel Blanshard, a partner at London fund of hedge funds Culross... The scale of borrowing on Treasuries is eye-popping: EMF, for example, started the year with leverage of 37 times its then assets of $294m, almost $11bn, not unusual for a Treasuries book. By the end of March it had reduced this to 25 times assets..."

April 30 - Financial Times (Ralph Atkins, Paul J Davies and Gillian Tett): "There is a growing conundrum at the heart of European money markets that is puzzling bankers, analysts and policymakers alike: the rates at which banks lend money to each other continue to creep ever higher. That is not supposed to be happening. The US Federal Reserve-led bail-out of Bear Stearns alleviated the worst fears of systemic risks, while regular and generous injections of liquidity by central banks on both sides of the Atlantic should have eased funding pressures. However, the problems remain and some interbank rates are approaching the highs of mid-December, a time when fears over counterparty credit risk coupled with the looming year-end pushed rates above levels seen when the liquidity crisis first hit in August and September of last year."

April 30 - Financial Times (John Reed): "In normal times, investors can count on carmakers' credit arms as a steady source of earnings that help to shield them from economic slowdowns and the riskier business of making and selling cars. As the credit crunch deepens, the tables are turning. Problems at carmakers' financing divisions are hitting their bottom lines even as many report record sales volumes around the world. Last week BMW...said sliding residual values for its cars in the US had prompted it to take a $369m charge... Ford Motor reported an 88% drop in earnings from its credit division... With hundreds of thousands of vehicles coming off lease in the US over the coming year, they could have a significant impact for carmakers, which typically earn about 20-40% of their operating profits from financial services."

April 29 - Bloomberg (Aaron Kirchfeld): "Deutsche Bank AG, Germany's biggest bank, reported its first quarterly loss in five years after writing down the value of loans for leveraged buyouts and asset- backed securities by $4.2 billion."

April 29 - Bloomberg (David Mildenberg): "GMAC LLC, the auto and home lender that General Motors Corp. sold to a private equity group, posted a $589 million loss in the first quarter and said it may not make a profit until next year."

Currency Watch:

May 2 - Bloomberg (Torrey Clark): "Russia, the world's second-largest oil supplier, produced the least amount of crude in 18 months in April as aging fields and rising costs threaten the country with the first annual decline in oil output in a decade. Production dropped to 9.72 million barrels a day, 0.8 percent less than in April last year and only slightly higher than in October 2006..."

May 1 - Bloomberg (Fiona MacDonald and Matthew Brown): "Gulf states are considering dropping their pegs to the dollar after the U.S. currency's decline stoked inflation across the region, Kuwaiti Finance Minister Mustafa al- Shimali said. 'Yes, there are some' Gulf Cooperation Council states considering dropping their pegs to the dollar, which has fallen 13% against the euro in the last 12 months, al-Shimali said..."

April 30 - Bloomberg (Ron Harui): "Emerging markets led a 40% gain in currency trading to $175 trillion last year... according to a Euromoney survey. Transaction volume in currencies increased 117% in Asia, 254% in central and eastern Europe, 42% in the Middle East and 145% in Latin America in 2007..."

May 2 - Bloomberg (Paul Tighe): "Millions of Afghans face shortages of basic foods because they can't afford gains of as much as 100% in the cost of wheat, the United Nations said. 'For the poorer segments of society, who spend up to 70% of their meager income on food, these food price rises put the basic necessities simply out of their reach,' Anthony Banbury, the regional director for Asia of the World Food Program, said..."

The dollar index rallied 1.0%, ending the week at 73.50. For the week on the upside, the Brazilian real increased 2.4% and the Mexican peso 0.1%. On the downside, the Swiss franc declined 2.2%, the Swedish krona 1.5%, the Euro 1.5%, the Danish krone 1.5%, the South Korean won 1.4%, the Japanese yen 1.2%, and the British pound 1.0%.

Commodities Watch:

April 28 - Bloomberg (Jeff Wilson): "As farmers confront mounting costs and riots erupt from Haiti to Egypt over food, Garry Niemeyer is paying the price for Wall Street's speculation in grain markets. Commodity-index funds control a record 4.51 billion bushels of corn, wheat and soybeans through Chicago Board of Trade futures, equal to half the amount held in U.S. silos on March 1. The holdings jumped 29% in the past year... Niemeyer, who farms 2,200 acres in Auburn, Illinois, won't use futures to protect the value of the crop he will harvest in October...he says the contracts are too costly and risky... 'It's the best of times for somebody speculating on grain prices, but it's not the best of times for farmers,' said Niemeyer... 'The demand for futures exceeds the demand for cash grains.'"

April 29 - Financial Times (Chris Flood): "Steel prices have almost doubled in the past year as steelmakers have passed on big increases in the costs of iron ore and coking coal to consumers. The jump threatens to create fresh problems for manufacturers and stoke inflationary pressures in emerging markets where demand is high, driven by urbanisation in China and infrastructure spending elsewhere in Asia and in the Middle East... Prices for steel billet, used to make reinforcing rods in construction and a benchmark for the industry, have surged this month to $900 a tonne, almost double in the past year... Key input costs have surged, with iron ore prices up 71%, and coking coal shooting up 240%."

April 30 - Bloomberg (Dale Crofts and Stewart Bailey): "U.S. steel-sheet prices rose in April... Hot-rolled steel sheet, the benchmark product used in cars and appliances, climbed to an average $850 a ton in April... Prices have gained 47% since January."

April 30 - Financial Times (Daniel Pimlott): "Tyson, the largest producer of beef, pork and chicken in the US, yesterday reported its first loss in six quarters in part because it had not been able to pass the cost of bird feeding its birds on to consumers... The company said that the higher price of corn and soyabeans would add about $600m to costs this year in its chicken business... Cooking oil, breading and feed ingredients such as vitamins could be among factors adding a further $400m to costs. Last year, corn and soy costs doubled to $2bn... 'We can't raise prices fast enough to keep up with the rising costs of our inputs,' said Richard Bond, chief executive."

Gold fell 3.4% to $886 and Silver 2.9% to $16.47. May Copper declined 2.3%. June Crude declined $2.02 to $116.50. June Gasoline dropped 2.7% (up 19.8% y-t-d), and June Natural Gas slid 2.9% (up 44% y-t-d). July Wheat declined 0.6%. The CRB index fell 2.3% (up 13.8% y-t-d). The Goldman Sachs Commodities Index (GSCI) declined 1.8% (up 19.9% y-t-d and 57% y-o-y).

China Watch:

April 29 - Bloomberg (William Bi): "Food prices in China...will rise by an average 10% or more this year as demand outpaces farm production and record global prices boost import costs, a state-run research institute said."

April 28 - Bloomberg (Li Yanping): "China's average urban wages rose 18.3% in the first quarter from a year earlier, the National Bureau of Statistics said."

April 28 - Bloomberg (Li Yanping): "China's urban jobless rate was four percent at March 31, the state-owned Xinhua News Agency reported..."

May 1 - Bloomberg (Zhang Dingmin): "Manufacturing in China, the world's biggest maker of steel and cement, expanded at the fastest pace on record, spurred by new orders from domestic customers as export demand eased."

April 30 - Market Wire: "In the first quarter of 2008, China's overall social power consumption reached 813.34 billion kilowatt-hours, up 13.04% compared with the same period last year, according to a report published this month by the China Electricity Council."

April 29 - Bloomberg (Nipa Piboontanasawat): "Hong Kong's retail sales grew at a faster pace in March as low unemployment and cuts to interest rates and taxes boosted household consumption. Sales by value rose 20% from a year earlier..."

India Watch:

April 29 - Bloomberg (Cherian Thomas): "India's central bank unexpectedly ordered lenders to set aside more reserves for the second time in less than two weeks to tame runaway inflation. The Reserve Bank of India raised its cash reserve ratio to 8.25% from 8%..."

May 2 - Bloomberg (Kartik Goyal): "India's inflation accelerated at the fastest pace in more than three years... Wholesale prices rose 7.57%... from a year earlier..."

May 1 - Bloomberg (Kartik Goyal): "India's exports slowed in March... March shipments rose 26.6% to $16.3 billion from a year earlier..."

Asia Watch:

April 28 - Bloomberg (Shamim Adam): "Central bank officials in Indonesia, the Philippines and Thailand may raise interest rates this year as higher oil and commodity prices feed into inflation, according to JPMorgan... 'The overall inflation trajectory in many cases is now expected to breach the inflation targets of the region's inflation-targeting central banks -- Indonesia and the Philippines in particular,' Singapore-based analyst Sin Beng Ong said."

May 1 - Bloomberg (Seyoon Kim): "South Korea's exports... the engine of more than half of the economy's first-quarter economic expansion, jumped 27% in April from a year earlier..."

May 1 - Bloomberg (Seyoon Kim and William Sim): "South Korea's consumer prices rose in April, exceeding the central bank's target for a sixth straight month... The consumer-price index jumped 4.1% from a year earlier..."

April 29 - Bloomberg (Dinakar Sethuraman and Sophie Tan): "Taiwan, Asia's fourth-largest importer of liquefied natural gas, increased imports of the fuel by 33% in March and paid record prices..."

May 1 - Bloomberg (Suttinee Yuvejwattana and Rattaphol Onsanit): "Thailand's inflation accelerated at the fastest pace since 2005 in April as food and oil prices surged to records... Consumer prices gained 6.2% last month from a year earlier..."

May 2 - Bloomberg (Aloysius Unditu and Arijit Ghosh): "Indonesia's inflation accelerated to a 19-month high... Consumer prices rose 9% from a year earlier..."

April 30 - Bloomberg (Wahyudi Soeriaatmadja and Arijit Ghosh): "Indonesia's President Susilo Bambang Yudhoyono said rising global energy prices pose a serious challenge to the economy.... 'I'd like to be honest and frank that the problem that we are facing is not light,' Yudhoyono said... 'Problems relating to our economy are serious.'"

Latin America Watch:

April 30 - Bloomberg (Fabio Alves and Carlos Caminada): "Brazil won an investment grade credit rating for the first time from Standard & Poor's... Faster growth in Latin America's biggest economy and a reduction in the country's international debt were cited for the increase in the long-term foreign currency debt rating to BBB- from BB+..."

April 30 - Bloomberg (Dan Levy): "Real estate lending in Brazil will increase 36% this year, driven by a housing shortage and a national economy growing at more than 5% a year, said Joao Teixeira, managing director of GoldenTree InSite Partners LP... 'We have an 8 million unit housing shortage,' Teixeira said. 'Demand is very strong.'"

April 30 - Bloomberg (Guillermo Parra-Bernal): "Petroleo Brasileiro SA, Brazil's state-controlled oil company, may quadruple bond sales to help fund development of the Western Hemisphere's biggest petroleum discovery since 1976... Petrobras, as the company is known, issued less than $800 million, on average, from 2001 through 2007. Petrobras plans to increase borrowings by $11 billion this year..."

Unbalanced Global Economy Watch:

April 29 - Bloomberg (Simon Kennedy): "Three Chinese shoppers were trampled to death in November as they battled for discounted cooking oil after the price had climbed about 40%... Haitian Prime Minister Jacques Edouard Alexis was ousted this month amid protests over soaring food prices, which the United Nations says surged 57% globally in March from a year earlier. Caterpillar Inc. plans to mark up its earthmoving equipment as much as 5 percent worldwide in July to deal with rising costs for steel, copper and oil. U.K. car enthusiasts paid an average of $151,000 for a Range Rover Vogue SE in 2007, a 20% jump from '06. In April, they spent an average of [16% more] per liter to fill it up... 'We're seeing a marked increase in inflation pressure everywhere,' says Harvard University professor Kenneth Rogoff, who was formerly chief economist at the International Monetary Fund. Rogoff says the threat may be the greatest since the 1980s."

April 29 - Bloomberg (Brian Swint): "Bank of England Governor Mervyn King said bonuses awarded by London's finance industry are so lucrative they're draining talent away from other parts of the economy. 'I do think it is rather unattractive that so many young people when contemplating careers look at the compensation packages available in the City and think that these dominate almost any other kind of career,' King told lawmakers...'Such a high proportion of young people naturally think of the City as the first place to work in. It shouldn't be.'"

April 29 - Bloomberg (Jurjen van de Pol): "European retail sales dropped the most in more than four years in April as rising fuel and food prices squeezed shoppers' budgets, the Bloomberg purchasing managers index showed."

April 28 - Bloomberg (John Glover): "European corporate credit quality is sinking at an 'alarming' rate as rising oil prices, the possibility of a U.S. recession and the euro's strength restrain the region's economic growth, Moody's...said."

April 29 - Bloomberg (Christian Vits): "German wages increased the most in 12 years in January as companies boosted hiring to meet orders. Salaries rose 3.3% in January from a year earlier, the Federal Statistics Office...said..."

April 28 - Bloomberg (Christian Wienberg): "Iceland's inflation rate rose to an 18-year high in April... The annual rate rose to 11.8% from 8.7% in March... Prices gained 3.4% in the month."

May 2 - Bloomberg (Steve Bryant): "Turkey's inflation rate rose in April to a 12-month high, adding to pressure on the central bank to reverse its earlier policy of cutting the benchmark interest rate. Inflation accelerated to 9.7% from 9.2% a month earlier..."

April 30 - Financial Times (Vincent Boland): "Turkey's central bank said on Wednesday that inflation in 2008 would be nearly double its official target in the face of rising energy and food prices... Durmus Yilmaz, central bank governor, said inflation for this year would probably come in at 9.3%..."

April 30 - Bloomberg (Steve Bryant and Ali Berat Meric): "Turkey won International Monetary Fund approval to increase spending on dams and roads this year as economic growth slows..."

April 30 - Bloomberg (Daniel Williams and Abeer Allam): "With opposition groups calling for a May 4 general strike, Egypt's President Hosni Mubarak proposed a 30% increase in wages for state workers. During a speech on May Day eve to the official Trade Union Federation in Cairo, Mubarak said, 'We had talked about a 15% raise, but decided on 30%. The government will have to find the resources.' He called on private companies to match the increase."

April 30 - Bloomberg (Massoud A. Derhally): "Jordanian producer price growth accelerated to an annual 29% in March, led by manufacturing and mining."

Bursting Bubble Economy Watch:

April 29 - The Wall Street Journal (Justin Lahart): " For the past three decades, finance has claimed a growing share of the U.S. stock market, profits and the overall economy. But the role of finance -- the businesses of borrowing, lending, investing and all the middlemen in between -- may be ebbing, a shift that would redefine the U.S. economy. 'The role of finance in the economy is going to come down significantly in the coming years,' says Carlos Asilis, chief investment officer at Glovista Investments... 'From a societal standpoint, we got carried away with finance.' ...'I think you're seeing a clear inflection point,' says Tom Gallagher, an ISI Group analyst. 'Whether it's financials as a share of the stock market or financials as a share of GDP, we've peaked.'"

April 30 - Bloomberg (Cynthia Cotts): "Skadden, Arps, Slate, Meagher & Flom and Latham & Watkins set records for law firms with gross revenue of more than $2 billion each in 2007, according to the American Lawyer, a trade magazine. The 100 highest-grossing U.S. law firms generated revenue of $64.5 billion in 2007, almost 14% more than the previous year... It was the fifth consecutive year of better-than-average growth in both revenue per lawyer and profits per partner..."

April 30 - USA Today (Dennis Cauchon): "Federal, state and local governments are hiring new workers at the fastest pace in six years... Governments added 76,800 jobs in the first three months of 2008...By contrast, private companies collectively shed 286,000 workers in the first three months of 2008."

May 1 - The Wall Street Journal (Gary McWilliams and David Kesmodel): "Ross C. Powell has found a novel way to counter rising grocery prices. He started an informal food cooperative out of his garage. The San Antonio project manager is currently stocking up on inexpensive beef, anticipating meat prices will follow dairy, egg and grain prices higher.... He recently installed a 22-cubic-foot freezer in his garage to go along with the shelves he built for deeply discounted food staples. Neighbors who once dismissed his frugal ways as overkill are now joining him to make bulk purchases of meat. Even as rising food prices have triggered protests in developing countries, Americans are rediscovering the economic virtues of a well-stocked food pantry and storage freezer... Stockpiling staples such as rice, meats and canned soup is coming into vogue again..."

Central Banker Watch:

April 28 - Bloomberg (Craig Torres): "Vincent Reinhart, a former senior policy adviser to Alan Greenspan and current Federal Reserve Chairman Ben S. Bernanke, said the central bank's rescue of Bear Stearns Cos. was the 'worst policy decision in a generation... The panicked decision jumped over other possibilities' and may prove as damaging as Fed policy errors that caused the 'great contraction' of the 1930s and the 'great inflation' of the 1970s, Reinhart said..."

May 2 - Bloomberg (Craig Torres): "A month after the Federal Reserve rescued Bear Stearns Cos. from bankruptcy, Chairman Ben S. Bernanke got an S.O.S. from Congress. There is 'a potential crisis in the student-loan market' requiring ``similar bold action,' Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms. Student loans are just the start. Former Fed officials and other Fed-watchers say that Bernanke's actions in saving Bear Stearns will expose the central bank to continuing pressure to use its $889 billion balance sheet to prop up companies or entire industries deemed important by politicians. 'It is appalling where we are right now,' former St. Louis Fed President William Poole...said... The Fed has introduced 'a backstop for the entire financial system.' ... 'There is no way to put the genie back in the bottle,' Minneapolis Fed President Gary Stern said... 'What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.' ... 'If there is a public purpose in lending to investment banks, and taking dodgy mortgage securities as collateral, then it is a question of degree about other potential lending,' Vincent Reinhart, former director of the Fed board's Division of Monetary Affairs, said... 'That's the consequence of crossing a line that had been well established for three- quarters of a century.'"

April 29 - Financial Times (Gillian Tett and Krishna Guha): "The Federal Reserve could use proposed new regulatory powers to try to stop credit and asset market excesses from reaching the point where they threaten economic stability, the US Treasury said... Nason, assistant secretary for financial institutions, said the Fed could even use its proposed 'macro-prudential' authority to order banks, hedge funds and other entities to curtail strategies that put financial stability at risk. By 'leaning against the wind' in this way, the US central bank could 'attempt to prevent broad economic dislocations caused by potential excesses', he said. His comments come amid debate inside the Fed as to whether it should try to do more to contain asset price bubbles, following the housing and dotcom busts. Some see enhanced regulatory powers as a better tool for this than interest rates."

April 28 - Bloomberg (Simone Meier and Simon Kennedy): "European Central Bank President Jean- Claude Trichet said the bank must set interest rates with the sole goal of maintaining price stability... 'It's crucial that the Governing Council sets the appropriate monetary policy stance on the basis of no other considerations than the delivery of price stability in the medium term,' Trichet said..."

MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:

April 29 - Bloomberg (Jody Shenn): "About half of subprime and Alt-A mortgages made in 2006 and 2007 may be 'underwater' or close to it by midyear, putting about $800 billion of debt at greater risk of default, according to Barclays Capital. Subprime loans that exceed the value of the related homes jumped 5 percentage points to 19.8% in the fourth quarter, and may reach 26% if property-price drops continue at the same pace...analysts Ajay Rajadhyaksha and Derek Chen wrote... Such Alt-A loans, a grade better than subprime, would grow to 23% from 16.3%... 'Mortgage loans are moving underwater at a very sharp pace, far more than suggested by aggregate home price data.'"

April 29 - Financial Times (Paul J Davies): "The credit ratings of the troubled complex bonds that pool together slices of mortgage backed securities - so-called structured finance CDOs, or CDOs of ABS - are set to come under further pressure after changes introduced by Standard & Poor's. The ratings agency has cut its assumptions about the amount of money likely to be recovered by investors in US subprime mortgage backed bonds when the individual mortgagees default on their loans. This in turn has had a knock-on effect for the recovery assumptions for collateralised debt obligations built out of those bonds."

Mortgage Finance Bubble Watch:

April 29 - Bloomberg (Kathleen M. Howley and Dan Levy): "U.S. foreclosure filings more than doubled in the first quarter... Almost 650,000 properties were in some stage of foreclosure during the quarter, or 1 in every 194 U.S. households...RealtyTrac... said... Nevada, California and Arizona had the highest rates."

Real Estate Bubble Watch:

April 29 - Bloomberg (Shobhana Chandra): "Home prices in 20 U.S. metropolitan areas fell in February by the most on record... The S&P/Case-Shiller home-price index dropped 12.7% from a year earlier... The gauge has fallen every month since January 2007... Prices dropped 2.6% in February from a month earlier, after a 2.4% decline in January... Nineteen of the 20 cities in the index showed a year-over- year decrease...led by a 23% slump in Las Vegas and a 22% decline in Miami."

April 28 - Bloomberg (Kathleen M. Howley): "A record 18.6 million U.S. homes stood empty in the first quarter as lenders took possession of a growing number of properties in foreclosure. The figure is 5.7% higher than a year ago... About 2.3 million empty homes were for sale, compared with 2.2 million a year earlier, the report said."

GSE Watch:

The Federal Home Loan Banks (FHLB) expanded assets $48.5bn during the first quarter to $1.323 Trillion, or 15.2% annualized. Assets were up $303bn, or 30%, from a year earlier.

Muni Watch:

May 1 - Bloomberg (Michael McDonald and Adam L. Cataldo): "Pension bonds are making a comeback, as states and cities from Alaska to Philadelphia bet they can use the proceeds to help fill deficits in their retirement funds and still generate a higher return than what they pay in interest. Officials may sell a record $35 billion of the securities this year after offerings declined since 2003... With the economy slowing and states facing budget deficits that Standard & Poor's says will top $30 billion next year, officials are turning to the quick fix of borrowing even though the $50 billion of pension bonds sold produced mixed results for taxpayers. New Jersey sold $2.8 billion of the debt in 1997 and its pension gap has since ballooned to 10 times that amount."

Fiscal Watch:

April 29 - Dow Jones (Aparajita Saha-Bubna and Dawn Wotapka): "The Federal Housing Administration's efforts to help struggling homeowners - even those late with mortgage payments - is stoking fears of more troubled loans. The FHA's guideline changes are engineered to prevent foreclosures, key to aiding the new and used housing markets and halting the worst housing crisis in decades... But some worry that more-liberal rules will encourage loans to delinquent subprime borrowers... 'Will these FHA loans become the new subprime? It's the same borrowers that are being moved over to the FHA,' says Jeffrey Guarino, managing director of Gotham Capital Mortgage..."

April 30 - Bloomberg (Christopher Stern): "The U.S. Senate approved legislation designed to ensure that students will have access to federally guaranteed college loans amid a tightening global credit market. Under the measure, the Department of Education could buy federally guaranteed student loans that lenders can't sell to investors to inject liquidity into the market."

May 1 - The Wall Street Journal (Sudeep Reddy): "Weak consumer spending is pushing sales-tax revenue down in many states. Of the 36 states that have released sales-tax data for the first three months of this year, 21 showed outright declines, compared with the first quarter of 2007, according to a tally to be released ... by the Rockefeller Institute of Government... 'The sales-tax declines suggest that consumption, retail sales and the income needed to support spending are slowing considerably,' authors Donald Boyd and Lucy Dadayan say... Sales-tax revenue declined 0.1% versus last year for the 36 states that have reported figures so far. Excluding Texas, a big economy that is performing better than most, sales-tax revenues among the other 35 reporting states declined 1%."

May 1 - Bloomberg (William Selway): "U.S. state sales-tax collections fell in the first quarter for the first time in six years as consumers curbed spending, dealing a blow to state finances from Rhode Island to California, a study found. Sales taxes fell in 21 of the 36 states that have reported collections for the first three months of 2008, according to the study by the Nelson A. Rockefeller Institute of Government in Albany, New York. Southeastern states were the hardest hit, the study found, because of the subprime mortgage market collapse. Overall revenue, including income taxes, rose 1.7%. 'The widespread declines in the sales tax are a leading indicator of economic weakening, and a harbinger of further state budget troubles,' Don Boyd, one of the study's authors, said..."

Speculator Watch:

April 30 - Bloomberg (Tom Cahill): "Hedge fund returns rebounded in April after starting the year with the worst performance in nearly two decades, according to early results from Hedge Fund Research Inc. Overall hedge fund returns increased 1.5% for the month...according to...Hedge Fund Research's Global Hedge Fund Index, updated daily with a two-day delay. Funds dropped 2.46% in March and 3% in the first three months of the year, according to HFR's Weighted Composite Index."

May 1 - Bloomberg (Katherine Burton): "Drake Management LLC, the...firm started by former BlackRock Inc. money managers, is shutting its largest hedge fund... It plans to start a new fund later this year. The firm said it's winding down the $2.5 billion Global Opportunities Fund after it lost 25% last year and investors asked to pull money."

Crude Liquidity Watch:

April 28 - Bloomberg (Matthew Brown and Glen Carey): "Saudi Arabian annual inflation accelerated to a record 9.6% in March from 8.7% in February, the official Saudi Press Agency reported."

Revisting Financial Arbitrage Capitalism

I'll admit to occasionally being annoyed by the clan over at Pimco. Clearly, there's more than a little envy at work here. They are extremely smart, master market operators and skilled theoreticians. Those guys are really good at articulating the financial issue de jour, as well as backing it up with some reasonable-sounding solutions. But do they somehow not appreciate that they are part of the problem?

Pimco is - here we go again - the most vocal Wall Street proponent for strong reflationary policy measures and government interventions to battle so-called "deflation" risk. Back in 2002, they were the head cheerleader for reflationary measures that historians will surely view as a Monetary Policy Blunder for the Ages. Then, the deflation threat was said to reside with downside risk to the general price level; today it's with sinking home prices. Overwhelming force is again prescribed to fight the latest symptoms, while sidestepping diagnosis of the underlying ailment.

Furthermore, as someone who incorporates Minskian analysis deep into my analytical framework, I view their (and others') application of Minsky's work as largely superficial - and rather self-serving at that. For one, the often referred Minskian concept of "stability is destabilizing" simply hasn't been relevant to the U.S. Credit system in several decades. More importantly, implementing the Keynesian/Minskian policy toolkit to perpetuate Bubbles and existing malignant structures and processes - in contrast to instruments that would help buttress the system through arduous post-Bubble adjustment periods - has been a momentous analytical and policymaking failure over recent years.

I believe strongly that if Hyman Minsky were alive today he would see the huge investment fund managers, the hedge fund community, and Wall Street firms as the fundamental force behind today's Acute Financial and Economic Fragility. He would surely see the current financial order as dysfunctional and unsustainable. And I am quite confident he would view the current trajectory of financial system and policy development as laying the groundwork for the next crash and depression.

Back in late-2001, I titled a Bulletin "Financial Arbitrage Capitalism." I coined this term in what I referred to at the time as "updating" Minsky's stages of financial Capitalism. Minsky theorized that a troubling stage of "Money Manager Capitalism" had evolved from the earlier manifestations of Manager Capitalism, Financial Capitalism, and Commercial Capitalism.

Minksy on "Money Manager Capitalism:" "The emergence of return and capital-gains-oriented block of managed money resulted in financial markets once again being a major influence in determining the performance of the economy. However, unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits... As managed money grew in relative importance, more and more of the market for financial instruments was characterized by position-taking by financial intermediaries. These positions were bank-financed. The main financial houses became highly-leveraged dealers in securities, beholden to banks for continued refinancing. A peculiar regime emerged in which the main business in the financial markets became far removed from the financing of the capital development of the country. Furthermore, the main purpose of those who controlled corporations was no longer making profits from production and trade but rather to assure that the liabilities of the corporations were fully priced in the financial market...The question of whether a financial structure that commits a large part of cash flows to debt validation leads to a debacle such as took place between 1929 and 1933 is now an open question...

"In the present stage of development the financiers are not acting as the ephors of the economy, editing the financing that takes place so that the capital development of the economy is promoted. Today's managers of money are but little concerned with the development of the capital asset of an economy. Today's narrowly-focused financiers do not conform to Schumpeter's vision of bankers as the ephors of capitalism who assure that finance serves progress. Today's financial structure is more akin to Keynes' characterization of the financial arrangements of advanced capitalism as a casino. The Schumpeter-Keynes vision of the economy as evolving under the stimulus of perceived profit possibilities remains valid. However, we must recognize that evolution is not necessarily a progressive process: the financing evolution of the past decade may well have been retrograde." (Minsky, 1993)

I am even more convinced today than some six years ago that a whole new financial structure has evolved - and that it is definitely "retrograde." The title "Financial Arbitrage Capitalism" is fitting for a Credit system and economy now dominated by an expansive "leveraged speculating community" seeking profits from variations and permutations of "borrowing cheap and lending dear"; by bond and investment fund managers whose entire focus is beating some indexed return; by rapidly expanding Wall Street balance sheets and influence; and by the entire wave of new Credit instruments, derivatives, and sophisticated models and strategies used for the paramount purpose of capturing "above-market" returns and resulting huge financial rewards.

The current system has experienced a broad transformation to a Credit mechanism dominated by market-based instruments, in contrast to the traditional predominant position held by the banking system all the way through Minsky's "Money Manager" era. Today, the financial apparatus is "beholden" - not to a coherent banking system but instead - to an ambiguous thing called "marketplace liquidity" and the unwavering confidence such a mechanism requires. Importantly, momentous changes to the prevailing incentive system are also consistent with designating a new phase of Minskian Capitalism. Late in Minsky's life, he expounded upon the role rising stock and corporate debt prices were playing in dictating various behaviors in the Credit system, markets and real economy. With "Financial Arbitrage Capitalism," the bounty of seemingly limitless (until recently) speculative profits has created a reward system encouraging unprecedented debt creation, leveraging, and myriad forms and layers of financial intermediation.

I have labeled this current stage with the Minsky term "retrograde" specifically because only through the expansion of all facets of this Credit Bubble - debt creation, leveraging, and risk intermediation - will adequate new "profits" and debt service capacities validate and sustain the ever-increasing layers of debt and financial "arbitrage." Minsky noted a fundamental weakness of Money Manager Capitalism: "Unlike the earlier epoch of finance capitalism, the emphasis was not upon the capital development of the economy but rather upon the quick turn of the speculator, upon trading profits." Financial Arbitrage Capitalism takes these defects to an entirely new level. Today, the major financial incentives dictating behavior are largely disengaged from the process of "capital development" and, furthermore, operate completely divorced from real economic profits overall. Or, more simply stated, current rewards spur the over-expansion of non-productive Credit - specifically debt instruments not supported by underlying wealth-creating assets (think subprime and high-yielding mortgages generally).

Mortgage Credit is the bedrock of "Financial Arbitrage Capitalism." The Mortgage Finance Bubble provided - and continues offering to this day - the greatest bounty of speculative profits the financial world has known. It comes as no surprise that Pimco and Wall Street are these days fixated on home values and the pricing of mortgage-backed and mortgage-related securities and derivatives. That Trillions of real and financial resources were so badly misallocated through the Mortgage Finance Bubble years will definitely not dissuade the argument that Trillions more will be necessary to avert the scourge of "deflation". Apparently, the more egregious the misallocation and resulting impairment to the Financial and Economic Structures the more imperative it is to throw more non-productive Credit Inflation at the problem - the mandatory fight to avert "deflation".

For some time now, it has been my view that "Financial Arbitrage Capitalism" was sowing the seeds of its own destruction. The incentive structures were so deeply flawed; the analyses of the inner workings of this system were critically flawed; and policymaking was devastatingly flawed. The combination of rampant non-productive Credit growth, unprecedented system leveraging and speculative excesses, and resulting economic maladjustment ensured untenable system fragility. Still, the more apparent the underlying fragility becomes the greater the impetus to sustain the existing Financial and Economic Order. And the more conspicuous previous analytical and policy mistakes appear the greater the tendency to see no other alternative than to compound them. Mistakes beget ever-bigger mistakes. There is a desperate need to step back and come to grips with how dysfunctional this has all become.

Some seven or so weeks ago the existing Financial and Economic Order was in perilous jeopardy. Wall Street-backed finance was collapsing, and this implosion was about to invalidate our system's underlying debt structure as well as the structure of the underlying Bubble Economy. But the Federal Reserve and Washington policymakers stepped in with radical measures. These included the Federal Reserve's guarantee of ample liquidity for the Wall Street firms and virtually limitless "marketplace liquidity" throughout, as well as explicit and implicit federal backing for much of our mortgage Credit system. It may not have appeared momentous to most, but it basically placed Federal Reserve and federal government backing on trillions of securities and market liquidity risk more generally. In Minsky terminology, these measures at least temporarily "validated" the existing structure of "Financial Arbitrage Capitalism."

Will policymaking succeed over the intermediate- and long-term? Not a chance. Policymakers do today retain capacity to convince the marketplace of their power to inflate the value of debt securities and asset prices more generally. But reflationary polices and other assurances will not rescue the system, specifically because there is today nothing to stem the ongoing distortions to the underlying real economy. Validating the current structure of Financial Arbitrage Capitalism simply perpetuates the same dysfunctional incentives that got us into this mess. It may in the short-term spur the necessary Credit growth to buoy household incomes, corporate cash-flows and profits, government revenues, and securities and asset prices - but it will add relatively little in the way of real economic wealth creating capacity. And, in the end, it's only real economy fundamentals that will determine the soundness and sustainability of a system's Credit and Financial Structure.

Additional non-productive debt growth will definitely not alleviate the Acute Fragility associated with "Ponzi Finance" Credit system dynamics. Additional non-productive debt growth will also not stabilize dollar devaluation, nor will it help in stabilizing myriad problems at home and abroad associated with our monstrous Current Account Deficits. Instead, any extension of this period of Financial Arbitrage Capitalism will ensure the prolonging of borrowing and consuming excess, the gross misallocation of resources, massive trade deficits, a ballooning international pool of unwieldy speculative finance, and even wilder Global Monetary Disorder.

Indeed, Washington's validation of the current dysfunctional Credit system structure could very well lay the groundwork for extreme global price distortions, volatility, and social/political unrest. On the current course of things, it's difficult for me to not think in terms of NASDAQ 1999 or subprime 2006. Throw additional liquidity on overheated Credit, inflationary, and speculative "biases" and be prepared for the spectacular. When Financial Arbitrage Capitalism's excesses were spurring acute U.S. securities market inflation, the system enjoyed a period of perceived rising wealth to go with a boom in Wall Street securities issuance (to help offset inflated demand). When this Structure's excesses were directed at the Mortgage Finance Bubble, the upshots were inflating home prices along with attendant construction and consumption booms. Now, however, with acute inflationary effects prevailing throughout global markets for food, energy, and commodities, one should be prepared for the likes of problematic supply bottlenecks and shocks, hoarding, trade frictions and interruptions, and generally heightened geopolitical instability.

I argued back in 2002 that the overriding systemic issue was not "deflation" but rather myriad risks associated with an unfolding U.S. Credit Bubble. Now, some years later, these risks have expanded alarmingly, as runaway Credit Bubbles have ballooned both at home and abroad.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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