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April 17, 2009

Capitalism's Greatest Vulnerability
by Doug Noland

For the week, the S&P500 gained 1.5% (down 3.7% y-t-d), and the Dow added 0.6% (down 7.3%). The broader market was much stronger. The S&P400 Mid-Cap index rose 2.6% (up 2.2%), and the small cap Russell 2000 gained 2.4% (down 4.0%). The S&P Homebuilding index surged 16.0% (up 26.1%), and the Morgan Stanley Retail index increased 2.8% (up 26.2%). The Morgan Stanley Cyclicals surged 6.7% (up 1.3%), and the Transports jumped 3.5% (down 12.5%). The Nasdaq100 added 1.0% (up 11.7%), and the Morgan Stanley High Tech index gained 1.6% (up 19.6%). The Semiconductors were little changed (up 20.1%), while the InteractiveWeek Internet Index rose 2.4% (up 27.8%). The Morgan Stanley Consumer index jumped 2.8% (down 3.2%), while the Utilities declined 1.4% (down 12.4%). The Biotechs gained 1.8% (down 1.3%). The Broker/Dealers surged 8.0% (up 20.1%), and the Banks jumped 10% (down 16.1%). Although bullion was down only $13, the HUI Gold index was hit for 6.4% (down 9.0%).

One-month Treasury bill rates ended the week at 3 bps, and three-month bills closed at12 bps. Two-year government yields rose 3 bps to 0.935%. Five year T-note yields added one basis point to 1.86%. Ten-year yields gained 2 bps to 2.95%. The long-bond saw yields rise 4 bps to 3.83%. The implied yield on 3-month December '09 Eurodollars rose 3.5 bps to 1.37%. Benchmark Fannie MBS yields jumped 13 bps to 4.05%. The spread between benchmark MBS and 10-year T-notes widened 11 to 110 bps. Agency 10-yr debt spreads narrowed a notable 10 to 56.5 bps. The 2-year dollar swap spread increased 3.5 to 60.25 bps; the 10-year dollar swap spread declined 2.5 to 17.0 bps; and the 30-year swap spread declined 7 to negative 32.25 bps. Corporate bond spreads narrowed meaningfully. An index of investment grade bond spreads narrowed 13 to a 2-month low 236 bps, and an index of junk spreads narrowed 16 to a 5-month low 1,102 bps.

Investment grade issuance included JP Morgan $3.0bn, Emerson Electric $750 million and Portland General Electric $300 million.

Junk issuers included HCA Inc $1.5bn, CC Holdings $1.2bn, Seagate $430 million, Toll Brothers $400 million, and Plains All American Pipeline $350 million.

Convert issuance included Digital Realty Trust $260 million.

It was a huge week for International dollar debt issuance. Issuers included International Finance Corp $3.0bn, Rio Tinto $3.5bn, Inter-American Development Bank $2.5bn, GAZ Capital $2.5bn, Statoilhydro $2.0bn, Colombia $2.0bn, Industrial Bank of Korea $1.0bn, Telmar $750 million, and Indonesia $650 million.

U.K. 10-year gilt yields jumped 7 bps to 3.35%, and German bund yields added 2 bps to 3.27%. The German DAX equities index surged 4.1% (down 2.8%). Japanese 10-year "JGB" yields were little changed at 1.44%. The Nikkei 225 slipped 0.6% (up 0.5%). The emerging market rally held together pretty well. Brazil's benchmark dollar bond yields jumped 17 bps to 6.38%. Brazil's Bovespa equities index added 0.5% (up 21.9% y-t-d). The Mexican Bolsa rallied 8.3% (down 0.7% y-t-d). Mexico's 10-year $ yields declined 3 bps to 5.90%. Russia's RTS equities index increased 2.1% (up 32.1%). India's Sensex equities index rose 2.0% (up 14.3%). China's Shanghai Exchange rose 2.4% (up 37.5%).

Freddie Mac 30-year fixed mortgage rates declined 5 bps to 4.82% (down 106bps y-o-y). Fifteen-year fixed rates fell 6 bps to 4.48% (down 92bps y-o-y). One-year ARMs jumped 8 bps to 4.91% (down 19bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 13 bps to 6.33% (down 86bps y-o-y).

Federal Reserve Credit jumped $29.2bn last week to a 14-wk high $2.099 TN. Fed Credit has dropped $148bn y-t-d, although it expanded $1.232 TN over the past 52 weeks (142%). Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt last week (ended 4/15) surged $19.7bn to a record $2.641 TN. "Custody holdings" have been expanding at a 17.2% rate y-t-d, and were up $401bn over the past year, or 17.9%.

Bank Credit dropped $61.4bn to $9.705 TN (week of 4/8). Bank Credit was up $264bn year-over-year, or 2.8%. Bank Credit increased $312bn over the past 31 weeks. For the week, Securities Credit fell $30.1bn. Loans & Leases dropped $31.4bn to $7.035 TN (52-wk gain of $170bn, or 2.5%). C&I loans declined $7.0bn, with one-year growth of 3.4%. Real Estate loans fell $8.6bn (up 4.8% y-o-y). Consumer loans added $1.4bn, while Securities loans dropped $8.2bn. Other loans declined $8.9bn.

M2 (narrow) "money" supply dropped $63.5bn to $8.245 TN (week of 4/6). Narrow "money" has expanded at a 2.2% rate y-t-d and 8.2% over the past year. For the week, Currency added $1.2bn, and Demand & Checkable Deposits jumped $88.7bn. Savings Deposits plunged $141bn, and Small Denominated Deposits declined $4.2bn. Retail Money Funds fell $8.4bn.

Total Money Market Fund assets (from Invest Co Inst) dropped $29bn to $3.818 TN. The 52-wk expansion was reduced to $333bn, or 9.6%. Money Funds have declined at a 1.2% rate y-t-d.

Total Commercial Paper outstanding sank $60bn this past week to $1.474 TN. CP has declined $208bn y-t-d (43% annualized) and $336bn over the past year (18.6%). Asset-backed CP fell $24bn last week to $681bn, with a 52-wk drop of $120bn (15%).

Liquidity is returning to asset-backed securities. Year-to-date total US ABS issuance of $25.7bn (tallied by JPMorgan's Christopher Flanagan) is approaching half of the $56.4bn from comparable 2008. U.S. CDO issuance of $21bn compares to last year's y-t-d $13bn.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $38bn y-o-y, or 0.6%, to $6.699 TN. Reserves have declined $248bn over the past 26 weeks.

Global Credit Market Dislocation Watch:

April 14 - Bloomberg (Kim-Mai Cutler and Bo Nielsen): "The carry trade is making a comeback after its longest losing streak in three decades. Stimulus plans and near-zero interest rates in developed economies are boosting investor confidence in emerging markets and commodity-rich nations with interest rates as much as 12.9 percentage points higher. Using dollars, euros and yen to buy the currencies of Brazil, Hungary, Indonesia, South Africa, New Zealand and Australia earned 8% from March 20 to April 10, that trade's biggest three-week gain since at least 1999..."

April 17 - Bloomberg (John Detrixhe): "HCA Inc., the U.S. hospital chain purchased in a $33 billion leveraged buyout, and Crown Castle International Corp. led $3.1 billion in high-yield debt sales this week, the most since at least July as investors sought higher returns..."

April 15 - Bloomberg (Bryan Keogh and John Detrixhe): "Yields over benchmark rates on high-yield bonds narrowed to the least since October... The gap between yields on high-yield bonds and U.S. Treasuries narrowed 31 basis points yesterday to 15.85 percentage points, according to Merrill Lynch & Co. index data."

April 17 - Bloomberg (Bryan Keogh): "Yields relative to benchmark rates on U.S. bank bonds are falling at the fastest pace on record as better-than-expected earnings bolsters speculation the worst of the financial crisis is over. The extra yield investors demand to own bank debt has narrowed 66 bps this month to a two-month low of 717 bps..."

April 14 - Bloomberg (Christine Harper): "Goldman Sachs Group Inc. said it intends to keep selling low-interest debt backed by the Federal Deposit Insurance Corp., even after repaying the $10 billion of U.S. rescue funds it received last year. 'As far as we know they're not tied together -- there are participants in the FDIC-guaranteed program that do not have TARP capital today," Chief Financial Officer David Viniar said..."

April 17 - Bloomberg (Kateryna Choursina): "The International Monetary Fund and Ukraine have reached a 'staff-level' agreement that may allow the flow of funds from a loan to resume... The second installment of a $16.4 billion bailout... may be paid in mid-May..."

April 13 - Financial Times (Bertrand Benoit): "The world could face high inflation and a 'crisis after the crisis' when the global economy recovers, Peer Steinbrück, German finance minister, has warned. The comments... are the latest sign of concern from Germany at the extra-loose monetary policies conducted by central banks around the world and the ever-larger fiscal stimuli being unveiled by governments. 'I am concerned that the counter measures we are seeing around the world, financed by enormous amounts of debts, could be paving the road to the next crisis,' Mr Steinbrück told Bild, a tabloid daily. 'So much money is being pumped into the market that capital markets could easily become overwhelmed, resulting in a global period of inflation in the recovery.' Mr Steinbrück's warning comes after Angela Merkel, chancellor, told the Financial Times last month that pumping too much money into reviving global growth would create an unstable recovery."

April 14 - Bloomberg (John Glover): "Leveraged buyouts may help push corporate defaults in Europe to a record 14.7% this year, according to Standard & Poor's. Between 90 and 112 speculative-grade companies in western Europe rated by S&P may default this year, the... firm said... Defaults will be 'materially higher' among companies purchased in LBOs, where target firms are loaded with acquisition debt, S&P said."

Currency Watch:

April 14 - Bloomberg (Eugene Tang): "China, Japan and Korea should establish a routine mechanism to diversify the region's reserve currencies away from the dollar, the China Securities Journal reported, citing central bank adviser Fan Gang. The Asian countries need to consider setting up a transitional arrangement to help reduce reliance on the dollar before the problems in the international financial system are resolved..."

The dollar index added 0.2% this week to 85.98 (up 5.7% y-t-d). For the week on the upside, the South African rand increased 1.4%, the Japanese yen 1.1%, the Singapore dollar 1.0%, the Canadian dollar 1.0%, the British pound 0.9%, and the Australian dollar 0.4%. On the downside, the New Zealand dollar declined 1.7%, the Swedish krona 2.4%, the Brazilian real 1.2%, the Euro 1.1%, the Danish krone 1.1%, the Norwegian krone 1.0%, and the Swiss franc 0.9%. In the emerging currencies, the Hungarian forint declined 2.2% and the Polish zloty fell 1.7%.

Commodities Watch:

April 17 - Bloomberg (Eugene Tang): "PetroChina Co., Asia's biggest crude producer, plans to pay as much as $1.4 billion for a stake in an oil company in Kazakhstan... China and Kazakhstan signed 11 accords yesterday and agreed on $10 billion in loans to the Central Asian nation in return for the right to invest... China is securing energy resources to feed its economy... by providing loans to Brazil, Russia and Venezuela."

April 14 - Bloomberg (John Liu): "China, the world's second-largest energy user, aims to build emergency crude oil reserves to meet 90 to 100 days of domestic demand, said the head of the National Energy Administration. 'Our ultimate reserve target is to meet the level of countries in the Organization for Economic Cooperation and Development,' Zhang Guobao was quoted as saying..."

April 12 - Bloomberg (John Liu): "Chinese coal producers may get a 20% increase in price from the nation's power generators, news Web site Sohu.com reported... citing the China Times newspaper."

Gold declined 1.5% this week to $869 (down 1.5% y-t-d), and silver dropped 3.8% to $11.86 (up 5% y-t-d). May Crude fell $2.02 to $50.22 (up 12.6% y-t-d). May Gasoline added 0.9% (up 41% y-t-d), and May Natural Gas rose 3.5% (down 34% y-t-d). Copper gained another 5.1% (up 55% y-t-d). July Wheat was little changed (down 12% y-t-d), while July Corn declined 3.5% (down 5% y-t-d). The CRB index slipped 0.9% (down 1.6% y-t-d). The Goldman Sachs Commodities Index (GSCI) dipped 0.4% (up 8.2% y-t-d).

China Reflation Watch:

April 13 - Bloomberg (Chua Kong Ho): "The surge in China's March bank loans and money supply is 'cause for worry' as it means the increase in liquidity behind this year's stock rally will likely weaken, according to UBS AG. New loans rose to 1.89 trillion yuan ($277 billion) in March... M2... grew 25.5%, the most since Bloomberg began compiling data in 1998... 'The liquidity surge is already weakening and is cause for worry," Chen Li, a... strategist at UBS, said... 'Bank lending in the first quarter has almost reached last year's full-year target."

April 12 - Bloomberg (Kevin Hamlin): "China's new lending and money supply surged to records in March, adding to signs that government stimulus efforts are reviving the world's third- largest economy. Loans jumped more than sixfold from a year earlier to 1.89 trillion yuan ($277 billion)... Premier Wen Jiabao said China's economy showed better-than- expected changes in the first quarter after the government adopted a 4 trillion yuan spending plan, the official Xinhua News Agency reported... 'China is unusual in that it has this incredible capacity to mobilize all its institutions -- central government, local governments and the entire banking system -- to boost government-influenced investments,' said Vikram Nehru, the World Bank's... chief Asia economist."

April 13 - Financial Times (Kathrin Hille and Jamil Anderlini): "China's central bank yesterday warned it planned to 'strictly control' credit to some sectors of the economy after the country recorded a record surge in bank loans and money supply in March... The data appeared to confirm that Beijing's stimulus measures are revitalising the domestic economy but raised credit risk and inflation concerns. Banks extended Rmb1,890bn ($278bn) in loans last month, according to the...People's Bank of China, breaking the earlier monthly record set in January. This means bank lending is approaching the government's full-year target of Rmb5,000bn already after the first quarter..."

April 12 - Bloomberg (Kevin Hamlin): "China's foreign-exchange reserves, the world's biggest, had their smallest gain in eight years... Foreign-currency holdings rose about $7.7 billion in the first quarter to $1.9537 trillion... That was the smallest increase since the second quarter of 2001 and compares with a $40 billion jump in the fourth quarter."

April 16 - Bloomberg (Kevin Hamlin): "China's gross domestic product, battered by collapsing exports, grew at the slowest pace in almost 10 years, probably marking the low point for the world's third-biggest economy. GDP expanded 6.1% in the first quarter from a year earlier, after a 6.8% gain in the previous three months..."

Japan Watch:

April 16 - Bloomberg (Kyoko Shimodoi and Keiko Ujikane): "Japan may sell an additional 17 trillion yen ($171 billion) of bonds this fiscal year to pay for Prime Minister Taro Aso's third stimulus package and other projects, Finance Ministry officials said. The government may issue 16 trillion yen to 17 trillion yen of bonds on top of the planned 113.3 trillion yen of debt to be sold in the year... The sales will drive up Japan's public debt, already the world's largest..."

India Watch:

April 13 - Bloomberg (Paresh Jatakia and Kartik Goyal): "India's economy expanded at less than 7% last fiscal year, the slowest pace in six years...Prime Minister Manmohan Singh said. 'The slowdown is a matter of concern but our situation is very different from the deep recession being experienced elsewhere,' Singh told reporters... 'We have handled and will continue to handle the slowdown with determination, using both monetary and fiscal policy to stimulate the economy.'"

April 13 - Bloomberg (Kartik Goyal): "India's exports plunged the most on record in March, extending the longest declining streak in a decade... Merchandise shipments dropped about 31% from a year earlier to less than $12 billion last month..."

Asia Reflation Watch:

April 14 - Bloomberg (Shamim Adam and Andrea Tan): "Singapore said its economy may shrink as much as 9% this year, the most since independence in 1965... The economy may contract 6% to 9%, the trade ministry said... The government previously predicted a decline of as much as 5%."

Latin America Watch:

April 15 - Dow Jones (Darcy Crowe): "President Hugo Chavez is relying on private banks to feed Venezuela's increasingly anemic economy, underscoring a baffling affiliation between the country's banking chiefs and a socialist government that threatens them with nationalization. Chavez has all but ordered banks to buy the $15.8 billion the government plans to issue in local debt this year, the cornerstone of his administration's strategy to deal with the decline in the price of oil..."

Central Banker Watch:

April 13 - Bloomberg (Kevin Hamlin and Dune Lawrence): "China's central bank said it will ensure sufficient liquidity to sustain economic growth, damping speculation regulators may seek to restrain credit after new loans jumped by six times to a record in March. The People's Bank of China 'will implement moderately loose monetary policy and maintain the continuity and stability of policy," the central bank said... It pledged 'ample liquidity' to 'ensure money supply and loan growth meet economic development needs.'"

April 13 - Bloomberg (Rich Miller): "Federal Reserve Chairman Ben S. Bernanke is siding with John Maynard Keynes against Milton Friedman by flooding the financial system with money. If history is any guide, says Allan Meltzer, the effort will end in tears. Inflation 'will get higher than it was in the 1970s,' says Meltzer, the Fed historian and professor of political economy at Carnegie Mellon University... At the end of that decade, consumer prices rose at a year-over- year rate of 13.3%."

April 15 - Bloomberg (Jana Randow): "European Central Bank council member Axel Weber said cutting the bank's benchmark interest rate below 1% risks bringing the interbank money market to a standstill. 'I'm critical of reducing the main refinancing rate below 1%' because there would be practically no incentive for banks to lend to each other, Weber said... 'Therefore, the risk exists that the private interbank market would become completely paralyzed.'"

Fiscal Watch:

April 15 - Bloomberg (William Selway and Michael B. Marois): "California Governor Arnold Schwarzenegger and state finance officials plan to press the federal government to insure the short-term debt that local governments rely upon to pay their bills. California and its municipalities say they need to sell $15 billion of such obligations in the next several months. The officials want the federal government to provide guarantees that investors will be repaid if localities default on the notes..."

Real Estate Bubble Watch:

April 16 - Bloomberg (Andrew Blackman): "General Growth Properties Inc., the second-largest U.S. shopping-mall owner, filed for bankruptcy after failing to refinance more than $27 billion of debt... General Growth, which owns more than 200 shopping malls in the U.S., sought Chapter 11 protection... The company listed $29.5 billion in total assets and debts of about $27.3 billion, making it the largest real estate bankruptcy in U.S. history."

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

April 16 - Bloomberg (Dan Levy): "U.S. foreclosure filings rose to a record in the first quarter... RealtyTrac Inc. said. A total of 803,489 properties received a default or auction notice or were seized, 24% more than a year earlier... Filings for the month of March totaled 341,180, also a record in four years of RealtyTrac data."

Unbalanced Global Economy Watch:

April 14 - Financial Times (Norma Cohen): "The aggregate deficit of corporate UK pension funds soared past £250bn ($373bn) in March, setting a record for a shortfall... According to the Pension Protection Fund, the insurance scheme for the underfunded pension plans of insolvent employers, the aggregate gap between the value of scheme assets and the value of liabilities it guarantees rose to £253.1bn."

April 16 - Bloomberg (Jurjen van de Pol): "Industrial production in Europe contracted by the most on record in February as the deepening global recession curtailed demand for manufactured goods around the world. Output in the euro region fell 18.4% from the year-earlier month, the biggest drop since the data series began in 1986..."

April 17 - Bloomberg (Simone Meier): "Europe's exports to its main trading partners dropped by the most in at least nine years in January... Exports to the U.S... plunged 27% from the year-earlier month..."

April 15 - Bloomberg (Niklas Magnusson): "Sweden's government expects national debt to stand at 38.7% of gross domestic product this year and 41.4% of GDP in 2010..."

April 15 - Bloomberg (Emma O'Brien): "Russia's banks face an 'avalanche' of bad loans this year with 20% of the debt likely to be in or close to default by year-end, according to UniCredit SpA. 'Plunging asset quality is the main threat to the Russian banking industry and in fact to the economy as a whole,' UniCredit banking analyst Rustam Botashev wrote... He previously forecast non-performing loans would reach 9.5%."

April 14 - Dow Jones: "Russia's official forecast of a budget deficit of 5% of gross domestic product next year is 'dangerous,' the Kremlin's top economic adviser Arkady Dvorkovich said... 'It should be lower as not to threaten our macroeconomic stability," Dvorkovich said... Russia's government forecasts that the budget deficit will reach 8% of GDP this year..."

April 12 - Bloomberg (Alisa Odenheimer): "Israel's budget deficit may reach 7% of gross domestic product in 2009 and 7.5% in 2010 as tax revenue drops, Ma'ariv reported, without saying where it got the information."

April 15 - Bloomberg (Jacob Greber): "Few Australian home borrowers face 'negative equity' if property prices fall because tighter lending standards and tax rules encourage households to repay debt faster than other countries, a central bank official said. 'Australian households by and large have more of a financial buffer against falls in housing prices than their American counterparts did,' said Luci Ellis, head of the Reserve Bank's financial stability department."

Bursting Bubble Economy Watch:

April 17 - Bloomberg (Shobhana Chandra): "Indiana in March joined seven other U.S. states with a jobless rate of at least 10%... Indiana's jobless rate jumped to 10% last month... Michigan, with 12.6%, remained the state with the highest unemployment rate, followed by Oregon at 12.1%. The rate in California rose to 11.2%..."

April 14 - Bloomberg (Alexis Leondis): "A record low percentage of workers and retirees are very confident about being financially secure in retirement, according to a survey released today. The survey of 1,257 individuals in the U.S. found that 13% feel very confident about having enough money to live comfortably in retirement, the lowest level since the... Employee Benefit Research Institute started asking the question in 1993. Retirees who feel very confident about continuing to be financially secure in retirement also decreased to a new low of 20% from 29% a year earlier."

April 12 - Wall Street Journal (Avery Johnson and Kelly Evans): "Employment in health care, the only major industry outside the federal government still adding jobs, is succumbing to the recession... Across the country, hospitals are taking financial hits. They are seeing losses in the portfolios that they rely on for investment income. The number of uninsured patients is rising. Elective procedures -- which reap big profits -- are down at a third of hospitals nationwide. Nursing homes are trimming payrolls. And with state governments continuing to cut budgets and talk of health-care reform from Washington, industry executives are preparing for even leaner times. More than 16 million people -- one in eight workers on U.S. payrolls -- work in health care today, up from just 1% of the work force 50 years ago."

April 15 - Wall Street Journal (Suzanne Sataline and Tamara Audi): "The dire economy could make it harder to enjoy the great outdoors. From Nevada to New York, state parks across the country are facing budget cuts -- in some cases steep ones -- just as they are anticipating another busy season. Officials in several states say there will be less money to employ workers to clear trail brush or repair footpaths. Restrooms will be shuttered. Some lakes and pools will be closed weekdays, or altogether."

April 15 - Bloomberg (John Lauerman): "Harvard University's Faculty of Arts and Sciences, the teaching body for most undergraduate classes at Harvard College, will slice $220 million from its budget over the next two years because of endowment losses."

California Watch:

April 15 - Bloomberg (Dan Levy): "Southern California house and condominium sales climbed 52% in March from a year earlier as buyers took advantage of prices 35% lower than the same period in 2008, MDA DataQuick said."

Muni Watch:

April 15 - Wall Street Journal (Conor Dougherty): "State and local sales-tax revenue fell more sharply in the fourth quarter of 2008 than at any time in the past half century... The report by the Nelson A. Rockefeller Institute... underscores how swiftly the consumer slowdown has eaten into municipal budgets... State and local sales taxes, among the largest sources of revenue for municipalities, fell 6.1% in the fourth quarter of last year... Revenue from personal income taxes was down 1.1% in the fourth quarter; corporate income taxes dropped 15.5%, reflecting weaker profits."

April 14 - Bloomberg (Michael McDonald): "U.S. states' sales tax collection dropped the most in 50 years in the final three months of 2008, a result of the worst economic recession in a generation, according to the Rockefeller Institute of Government. Sales tax collections fell 6.1% in the fourth quarter compared with the same period the year prior... The institute's survey of the 50 states also found that overall state tax collections, including income tax, fell 4% in the fourth quarter last year."

April 16 - Bloomberg (Darrell Preston and Michael McDonald): "Houston's deputy controller, James Moncur, figured last May the fourth-largest U.S. city escaped the unraveling credit markets by refinancing some of its $1.8 billion of auction-rate bonds. Instead, Houston wound up paying 15% interest on the new securities... The so-called variable-rate demand notes backfired when investors fled the market in October...The $479 billion market for the securities, whose rates are typically reset by banks every day or week, is turning into a quagmire for local officials who embraced a financing strategy they didn't fully understand."

April 15 - Bloomberg (Stacie Servetah): "The funding deficit of New Jersey's public pension system climbed to $34.4 billion as of June 30, from $28.4 billion in mid-2007. The pensions were 72.6% funded as of June 30."

Speculator Watch:

April 14 - Bloomberg (Linda Sandler, Yuriy Humber and Christopher Scinta): "Lehman Brothers Holdings Inc. is sitting on enough uranium cake to make a nuclear bomb as it waits for prices of the commodity to rebound, according to traders and nuclear experts. The bankrupt bank, in the throes of paying off creditors, acquired uranium cake 'under a matured commodities contract' and plans to sell it when the market improves "to realize the best prices," Chief Executive Officer Bryan Marsal said."

Crude Liquidity Watch:

April 12 - Bloomberg (Camilla Hall): "Bahrain's M3 money supply growth, an indicator of future inflation, slowed to 17% in February from a revised 17.7% the previous month."

Capitalism's Greatest Vulnerability:

The great Hyman Minsky postulated that Capitalism was "flawed." Over the years I've taken exception with this particular view, countering that Capitalism is more appropriately described as "vulnerable." As part of this line of analysis, I have used the analogy of the human eye. We would not think of its delicate nature and susceptibility to injury as some "flaw" in our eye's design. Instead, this inherent vulnerability is fundamental to the nature of this important organ's functionality. We worry much less about our elbows, but they're not going to do an adequate job detecting light and transmitting visual signals to our brains.

I have argued over the years that an extraordinary backdrop has beckoned for keen focus in order to protect our Capitalistic system from its inherent vulnerabilities - just as one would don sun glasses on a sunny beach or ski slope or insist upon tight-fitting safety goggles before entering a metal-working shop. One must first recognize inherent vulnerabilities and then take more aggressive preventative measures as necessary in response to riskier environments.

We, as a society, failed to take preventive action. Now, Capitalism as we have known it is under fierce attack from many directions and on various levels. At the same time, there is regrettably scant indication that we now possess any clearer understanding of the nature of Capitalism or its inherent vulnerabilities. We're still entwined in Mistakes Beget Mistakes.

But there's lots of blame being bandied about. Many pinpoint "Wall Street greed." The securities firms, reckless traders, hedge funds, rank speculation and egregious leverage are viewed today as the major culprits. Executive pay and Wall Street bonuses are pilloried for fomenting dangerous excess. Others trumpet the failure of regulation and corporate governance. Some attribute the mess to the Asian propensity to save. There's a more sensible case that flawed banking and Wall Street risk models played an integral role in the fateful Bubble. Many that participated in the bountiful upside of the speculative Bubble these days posit that the rating agencies were at fault for garnishing "AAA" ratings on Trillions of risky securities and debt instruments. And a very strong argument can be made that hundreds of Trillions of derivatives played a fundamental role in the near financial implosion. But how could it be that so many things went so wrong all at the same time?

I have over the years expressed disdain with the "free market ideologues" for their steadfast refusal to even contemplate the possibility that "Capitalism" could possess vulnerabilities of need of recognition and corrective action. Yet, economic history is replete with boom and bust cycles, along with a bevy of post-Bubble writings providing us fertile ground for cogent analysis of system vulnerabilities. Contemporaneous analysis during the Great Depression focused clearly on the acutely susceptible U.S. Credit system that emerged from "Roaring Twenties" lending and speculative excesses. During the forties, fifties and even into the early sixties there was some adroit analysis of the Credit system's role in the boom and subsequent depression. This entire fruitful line of analysis was, however, stopped dead in its tracks with the emergence of a revisionist view of the twenties as the "Golden Age of Capitalism" needlessly terminated by post-crash policy blunders.

The Great Depression and today's turmoil expose Capitalism's vulnerabilities. And as easy (and accurate) as it would be for me to write that the problem lies first and foremost in the "Credit system," I have come to believe that it is vital to dig deeper to get to the root of the problem: Capitalism's Greatest Vulnerability lies with Risk Intermediation.

The essence of Capitalism is one of a predominantly private system of allocating resources based on market price signals. A private Credit mechanism is fundamental to financing the economic system in a manner that effectively allocates both financial and real resources. And we can stop right here and recognize potential pitfalls. First, Credit flows may be inadequate to finance sound investments or to sustain economic activity. Second, there may be too much Credit. I have for some time argued that Credit excess ("Credit inflation") is the Bane of Capitalism. Credit excesses distort the various costs of finance throughout the system, while inflating asset prices and fostering distorted spending and investing patterns (among other effects). And, importantly, Credit inflation inherently fosters self-reinforcing Credit inflation through asset price, economic, and speculative Bubble dynamics. In short, "Credit excess begets Credit excess," with its subtle but corrosive effect upon pricing mechanisms.

But how on earth does the always-existing nature of "Credit Begetting Credit" somehow morph into the history's greatest Credit Bubble? One way: Unfettered Risk Intermediation.

I often referred to "Wall Street Alchemy" - the process of various methods of intermediation (Wall Street securitization structures, myriad Credit insurance and financial guarantees, liquidity arrangements, dynamic hedging, explicit and implicit government backing, etc.) transforming risky loans into coveted instruments perceived by the marketplace as safe and liquid ("money-like"). I have also theorized that a boom predominantly financed by, say, junk bonds would never run too far before the market loses its appetite for the inflating quantity of (conspicuously) risky debt. In contrast, our recent Credit Bubble was financed by endless Trillions of "AAA" debt instruments (GSE debt, MBS, ABS, CDOs, CP, "repos", auction-rate securities, top-rated guaranteed muni debt, Treasuries, bank deposits and such) ran to unmatched excess.

Importantly, there was a direct relationship between our contemporary system's capacity to intermediate Credit risk and the expanding scope of the Bubble. Over years, risk was in varying degrees distorted, camouflaged, or deceptively concealed to the point that it was no longer even possible to monitor, analyze or regulate it. Worse yet, the risk intermediation process was self-reinforcing instead of self-adjusting and correcting. Wall Street "alchemy" was the true source of this period's "easy money."

Our Credit system's capacity to intermediate Trillions of mortgage and consumer debt into "money-like" instruments was instrumental in fueling real estate and asset Bubbles throughout. It was the capacity of Credit system intermediation to create Trillions of instruments (chiefly Treasuries, agency debt, MBS, and "Repos") perceived as safe and liquid by our foreign trading partners that accommodated our massive current account deficits (and attendant domestic and international imbalances). It was contemporary risk intermediation at the heart of a historic mispricing of finance for, in particular, mortgages and U.S. international borrowings. And it was the potent interplay of contemporary risk intermediation and contemporary monetary management/central banking (i.e. "pegged" interest rates, liquidity assurances, and asymmetrical policy responses) that cultivated unprecedented financial sector and speculator leveraging.

Most historical analyses of busts (going back about 300 years to John Law!) focus on banking ineptness, negligence, excesses and nuances. Banks, creating "money-like" (i.e. deposit) liabilities in the process of intermediating loans, have historically been at the center of boom/bust cycles. Contemporary finance - with its focus on marketable debt instruments - took intermediation risk to a completely new danger level. For one, traditional bank capital and reserve requirements no longer provided any restraint on the quantity of Credit that could be extended and intermediated (in the "market" or "off balance sheet"). Furthermore, the marketable nature of these instruments (created in the intermediation process) cultivated speculative demand for leveraging higher-yielding securities (i.e. hedge funds buying collateralized debt obligations that had acquired private-label subprime MBS). Cheap finance literally flooded the riskiest sectors of the economy

All of this led to extreme systemic distortions in the pricing of risk - along with the attendant massive over-expansion of Credit and the economy-wide (and global) misallocation of real and financial resources. Buyers of intensively intermediated instruments (say "AAA" senior CDO tranches or auction-rate securities) in many cases could not have cared less with regard to the type of underlying loans being financed. Elsewhere, the buyer (leveraged speculator or trade partner) of agency securities could not have been less concerned with GSE balance sheet issues or California home prices. This entire process of contemporary (marketable instrument-based) intermediation developed an overwhelming propensity for financing asset-based loans instead of real economic wealth-producing investment (unlimited supplies of mortgages were viewed as a more appealing asset class than limited amounts of corporate loans). It is not only in hindsight that this process of risk intermediation should be viewed as central to system asset price distortions and economic maladjustment.

I am tempted to write "I am as tired writing about the previous Credit Bubble as readers are reading about it." But I'm not tired. And this topic is not as much about rehashing the past as it is about providing a perspective as to why I believe the current course of policymaking will inevitably end in failure. Why? Because of the very complex and unresolved issue of Risk Intermediation.

Wall Street "finance" self-destructed in the process of intermediating Trillions of risky loans. It was the quantity of Credit and the nature of resulting spending patterns (resource allocation) that both doomed this endeavor and ensured a deeply maladjusted economic structure. This terribly flawed financial structure has morphed into a system where our government has stepped forward to supplant Wall Street as predominant risk intermediator. Basically, the Fed and Treasury are in the process of intermediating risk on a system-wide basis - to the tune of tens of Trillions - with little possibility of extricating themselves from this endeavor going forward.

This development may be welcomed by Wall Street and the markets - and it certainly goes a long way toward getting the Credit wheels rolling again. It would be expected to help spur some level of global economic "recovery." I would argue, however, at the end of the day we will see that it has only exacerbated the problems of risk mispricing, Monetary Disorder, financial and real resource misallocation, and economic maladjustment.

Our Capitalistic system has been severely injured. I don't expect meaningful structural recovery until there is some semblance of restoration to our Credit system's mechanism for the pricing and allocation finance. This, I believe, will require our system to wean itself both off of its dependence on enormous Credit expansion and away from Washington's newfound role of chief system risk intermediator and allocator (the "Government Finance Bubble).

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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