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September 18, 2009

Q2 2009 Flow of Funds
by Doug Noland

For the week, the S&P500 gained 2.5% (up 18.3% y-t-d), and the Dow rose 2.2% (up 11.9% y-t-d). The Banks surged 5.0% (up 7.6%), and the Broker/Dealers jumped 3.9% (up 53.8%). The Morgan Stanley Cyclicals increased 1.5% (up 58.3%), and Transports added 0.1% (up 12.5%). The Morgan Stanley Consumer index added 1.1% (up 16.1%), and the Utilities advanced 3.6% (up 1.0%). The broader market remains quite strong. The S&P 400 Mid-Caps jumped 3.3% (up 30.3%), and the small cap Russell 2000 surged 4.1% (up 23.7%). The Nasdaq100 gained 2.4% (up 42.4%) and the Morgan Stanley High Tech added 1.7% (up 58.2%). The Semiconductors gained 1.6% (up 53.9%). The InteractiveWeek Internet index rose 2.7% (up 62.9%). The Biotechs jumped 3.1% (up 47.9%). Although Bullion gained $2.30, the HUI gold index slipped 0.5% (up 40.2%).

One-month Treasury bill rates ended the week at 3 bps, and three-month bills closed at 8 bps. Two-year government yields rose 8 bps to 0.94%. Five-year T-note yields jumped 15 bps to 2.43%. Ten-year yields were 12 bps higher to 3.47%. Long bond yields gained 4 bps to 4.22%. Benchmark Fannie MBS yields increased 8 bps to 4.38%. The spread between 10-year Treasuries and benchmark MBS narrowed 4 to 91. Agency 10-yr debt spreads narrowed one to 17 bps. The implied yield on December 2010 eurodollar futures jumped 21 bps to 1.875%. The 2-year dollar swap spread increased 4.5 to 36.5 bps; the 10-year dollar swap spread increased 3.5 to 20.75 bps; and the 30-year swap spread increased 6.25 to negative 9.5 bps. Corporate bond spreads narrowed notably to pre-Lehman levels. An index of investment grade bond spreads narrowed 19 bps to 143, while an index of junk spreads narrowed 35 to 657 bps.

Corporate debt issuance was strong. Investment grade issuers included Morgan Stanley $3.0bn, Citigroup $5.0bn, Cenovus Energy $3.5bn, Newmont Mining $2.0bn, DirectTV $2.0bn, GE Capital $600 million, Exelon Generation $1.5bn, PNC $500 million, Markel $350 million, Kimco Realty $300 million, Toll Brothers $250 million, Avista $250 million, National Life Insurance $100 million, and Duke Energy $100 million.

Junk bond funds enjoyed inflows of $339 million (from AMG). Junk issuers included Newpage $1.7bn, Ford Motor Credit $1.0bn, CSN Island $750 million, Blockbuster $675 million, Felcor Lodging $630 million, Frontier Communications $600 million, Textron $600 million, Qwest $550 million, MGM Mirage $475 million, Del Monte Foods $450 million, Country Garden $375 million, Continental Resources $300 million, and Concho Resources $300 million.

I saw no convert issues.

International dollar-denominated debt issuance remained strong. Issuers included SFEF $4.5bn, Shell $4.0bn, Barclays Bank $2.0bn, Export Development Canada $1.0bn, Voto-Votorantim $1.0bn, Central American Bank $500 million, Axtel SAB $300 million and Corporacion GEO $250 million.

U.K. 10-year gilt yields jumped 13 bps to 3.74%, and German bund yields rose 14 bps to 3.37%. The German DAX equities index gained 1.4% (up 18.6%). Japanese 10-year "JGB" yields gained 4 bps to 1.34%. The Nikkei 225 slipped 0.7% (up 17.1%). Emerging markets were mostly strong. Russia's RTS equities index surged 4.1% (up 97.1%). India's Sensex equities index gained 2.9% (up 73.5%). China's Shanghai Exchange declined 0.9%, lowering 2009 gains to 62.7%. Brazil's benchmark dollar bond yields fell 7 bps to 5.12%. Brazil's Bovespa equities index jumped 4.0% (up 61.7% y-t-d). The Mexican Bolsa gained 2.1% (up 33.8% y-t-d). Mexico's 10-year $ yields bps to 5.5%.

Freddie Mac 30-year fixed mortgage rates declined 3 bps to 5.04% (down 74bps y-o-y). Fifteen-year fixed rates dipped 3 bps to 4.47% (down 88bps y-o-y). One-year ARMs dropped 6 bps to 4.58% (down 45bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates unchanged at 6.18% (down 75bps y-o-y).

Federal Reserve Credit rose $19.0bn last week to a 17-wk high $2.089 TN. Fed Credit has declined $158bn y-t-d, although it expanded $1.157 TN over the past 52 weeks (124%). Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 9/16) jumped $15.0bn to a record $2.843 TN. "Custody holdings" have expanded at an 18.2% rate y-t-d, and were up $434bn over the past year, or 18.0%.

M2 (narrow) "money" supply rose $12.6bn to $8.306 TN (week of 9/7). Narrow "money" has expanded at a 2.0% rate y-t-d and 8.0% over the past year. For the week, Currency increased $3.2bn, and Demand & Checkable Deposits rose $28.4bn. Savings Deposits declined $8.0bn, and Small Denominated Deposits fell $6.7bn. Retail Money Funds declined $4.3bn.

Total Money Market Fund assets (from Invest Co Inst) sank $61.0bn to $3.482 TN. Money fund assets have declined $348bn y-t-d, or 12.8% annualized. Money funds increased $70bn, or 2.0%, over the past year.

Total Commercial Paper outstanding increased $16.1bn (5-wk gain of $115bn) to a 13-wk high $1.190 TN. CP has declined $492bn y-t-d (41% annualized) and $6574bn over the past year (33%). Asset-backed CP rose $18.0bn to $502bn, with a 52-wk drop of $260bn (34%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $275bn y-o-y to $7.204 TN. Reserves have increased $440bn year-to-date.

Global Credit Market Watch:

September 18 - Bloomberg (John Detrixhe): "Citigroup Inc. and Morgan Stanley led the most U.S. corporate bond sales in four months this week... Borrowers sold at least $39 billion of debt... Including high-yield, high-risk, or junk, debt, companies have borrowed at least $932 billion in bonds this year, a 37% increase from 2008."

September 15 - Bloomberg (Laura Cochrane and Lester Pimentel): "Emerging-market borrowing costs fell to levels before the collapse of Lehman... The extra yield investors demand to own developing-nations' bonds instead of U.S. Treasuries dropped 13 bps today to 3.31 percentage points..."

September 17 - Bloomberg (Jeremy R. Cooke): "State and local government bonds returned 14% this year so far, beating their performance during the comparable period in every year since Merrill Lynch & Co.'s Municipal Master Index began in 1989."

September 17 - Bloomberg (Mary Schlangenstein): "AMR Corp.'s American Airlines, the world's second-largest carrier, said it raised $2.9 billion in cash and financing and will add flying at four U.S. hubs to focus on the most-profitable parts of its network."

September 14 - Bloomberg (Mark Deen and David Tweed): "Joseph Stiglitz, the Nobel Prize- winning economist, said the U.S. has failed to fix the underlying problems of its banking system after the credit crunch and the collapse of Lehman Brothers Holdings Inc. 'In the U.S. and many other countries, the too-big-to-fail banks have become even bigger,' Stiglitz said... 'The problems are worse than they were in 2007 before the crisis.' Stiglitz's views echo those of former Federal Reserve Chairman Paul Volcker..."

Government Finance Bubble Watch:

September 18 - Bloomberg (Thomas Penny): "Britain posted the biggest budget deficit for any August since modern records began in 1993 as the recession destroyed tax revenue and welfare costs soared. The 16.1 billion-pound ($26.3 billion) shortfall compared with a deficit of 9.9 billion pounds a year earlier..."

September 18 - Bloomberg (Caroline Hyde and Anchalee Worrachate): "Germany and Austria led governments and companies in Europe selling $21.7 billion of bonds in the U.S. currency this week to take advantage of the reduced cost of exchanging the proceeds back into euros. The sales were the most since February..."

September 18 - Bloomberg (Lester Pimentel and Veronica Navarro Espinosa): "Mexico sold $1.75 billion of bonds in its first international issue since it was forced to pull a 21-year debt offer seven months ago... Yields on Mexico's 2019 bonds have dropped to 5.16% from 6.36% in March..."

Currency Watch:

September 16 - Bloomberg (Dan Levy): "Tom Perkins, the venture capitalist whose firm helped finance Google Inc. and Amazon.com, paid $9.35 million for a penthouse condominium in the Millennium Tower, San Francisco's tallest residential tower. The 4,806 square-foot apartment is on the top floor of the 60-story building in the city's South of Market area... 'It's a good time to buy things other than paper,' Perkins, 77, co-founder of... Kleiner Perkins Caufield & Byers, said..."

September 15 - Bloomberg (Paul Abelsky): "Russia's government sees a handful of regional currencies emerging over the next decade to challenge the dollar, as long as emerging markets continue to grow, President Dmitry Medvedev's senior economic adviser said. The world will probably have 'five or six currency unions' similar to the euro region... Arkady Dvorkovich said..."

The dollar index slipped 0.1% this week to 76.51. For the week on the upside, the Swedish krona increased 2.0%, the Norwegian krone 1.3%, the Brazilian real 1.2%, the South Korean won 1.2%, the Danish krone 1.0%, the Swiss franc 0.8%, the Canadian dollar 0.7%, and the Singapore dollar 0.5%. On the downside, British pound declined 2.4% and the Japanese yen fell 0.7%.

Commodities Watch:

September 16 - Bloomberg: "Commodity demand in China, the largest metals user, 'is back on track in a very big way,' and copper and coking coal have the best prospects for price gains... according to CLSA Research Ltd. 'Commodities that give investors the most upside potential when the rest of the world demand recovers' are those with supply constraints, Andrew Driscoll...said... 'In the next twelve months, having exposure to copper is going to be a good investment.' China's $586 billion stimulus plan and a record $1.1 trillion of lending in the first half of this year have countered a 10-month slump in the nation's exports, helping Asia to lead a global rebound from the worst slump since the 1930s. Copper futures have more than doubled this year."

September 17 - Bloomberg (Glenys Sim): "Private investors in China, the world's largest metals user, have stockpiled 'substantial' quantities of copper as the government ramps up stimulus spending to spur the economy, according to Sucden Financial Ltd. Pig farmers and other speculators may have amassed more than 50,000 metric tons..."

September 16 - Bloomberg (Zijing Wu): "Chinese companies will step up the pace of overseas mergers and acquisitions in a 'new wave' of deals, said Xiong Weiping, chairman of Aluminum Corp. of China... 'Chinese companies will reinforce the going-out strategy and participate in this new wave of M&As,' Xiong said... There will be more mergers and acquisitions in the mining sector with the end of the financial crisis, he said."

September 14 - Bloomberg (Bernard Lo and Kim Kyoungwha): "Global banks are engaged in a hiring boom for commodity traders as they add staff to benefit from surging metals and energy prices, offering $1 million packages for top employees, recruiters Robert Walters Plc said. There's "huge demand for physical traders,' Gary Lai, manager of financial services at Robert Walters in Singapore, said... 'For top traders, especially investment bank traders, $1 million is not unexpected, it's easy to get,' Lai said..."

Gold added 0.2% to close at $1,008 (up 14.2% y-t-d). Silver gained 1.8% to $17.01 (up 51% y-t-d). October Crude jumped $2.0 to $71.79 (up 61% y-t-d). October Gasoline rallied 3.9% (up 72% y-t-d), and September Natural Gas surged 26.8% (down 33% y-t-d). December Copper declined 2.2% (up 97% y-t-d). December Wheat dropped 2.1% (down 25% y-t-d), and December Corn declined 0.5% (down 22% y-t-d). The CRB index jumped 3.5% (up 13.3% y-t-d). The Goldman Sachs Commodities Index (GSCI) surged 3.9% (up 34.3% y-t-d).

China Bubble Watch:

September 17 - Bloomberg (Chia-Peck Wong and Frank Longid): "Sun Hung Kai Properties Ltd., the world's largest developer by market value, raised the price of two penthouses in Hong Kong by 50% to a record HK$75,000 ($9,700) a square foot as demand surges for luxury apartments. The units will be offered for HK$300 million ($39 million) each..."

September 15 - Bloomberg (Chia-Peck Wong): "A one-bedroom apartment in Hong Kong's Kowloon district was bought by a local businessman for HK$30,025 ($3,874) a square foot, a record price for properties of that type in the city... The broker sold the property for HK$24.5 million ($3.2 million)."

September 17 - Bloomberg (Cathy Chan): "Sinopharm Group Co. raised the maximum HK$8.73 billion ($1.13 billion) sought in a Hong Kong initial public offering after investors in the city applied for almost 600 times the stock available to them."

September 16 - Bloomberg: "China... may have to spend an additional 1.7 trillion yuan ($249 billion) in 2050 to shift the country to a 'low-carbon' model of economic growth. 'China needs between 500 and 600 billion yuan annually to develop energy-conservation and low-carbon technologies, and the capital requirements are even greater in the reduction of carbon dioxide after 2020,' think-tanks led by the State Council's Development Research Center said... The cost of cutting China's emissions may reach $438 billion annually within 20 years, the Financial Times reported..."

India Watch:

September 17 - Bloomberg (Shobhana Chandra): "U.S. pension and private equity firms are 'excited' about financing India's $80 billion program to build roads and expressways, according to Minister for Road Transport and Highways Kamal Nath... 'The projects are not only viable, but profitable,' Nath told reporters in New York. U.S. investors 'are now not looking at real estate, not looking at equities; they're looking at infrastructure.' India will need $1.7 trillion to build infrastructure over the next decade to boost economic growth, Goldman Sachs Group Inc. estimated..."

Latin America Bubble Watch:

September 13 - Bloomberg (Andre Soliani and Paulo Winterstein): "Brazil proved to be a 'success case' among global economies as growing domestic demand and investments helped buffer that nation during the economic downturn, central bank President Henrique Meirelles said... Brazil is in a 'very strong position' now with bank loans being granted at pre-crisis levels, Meirelles said..."

September 15 - Bloomberg (Telma Marotto): "Morgan Stanley, the top adviser on takeovers in Brazil, doubled the investment-banking staff in Latin America's biggest economy and plans to add more as local capital markets develop, an executive said."

September 15 - Bloomberg (Joshua Goodman and Adriana Brasileiro): "Brazil's retail sales accelerated for the second straight month in July, reinforcing bets that domestic demand will power the country's economic rebound. Retail sales rose 5.9% from the year-ago period..."

September 16 - Bloomberg (Fabiola Moura and Veronica Espinosa): "Brazilian President Luiz Inacio Lula da Silva may reach the target of building 1 million homes for low-income workers by 2011... said the chief executive officer of homebuilder Construtora Tenda SA. 'The beauty of the government program is that for the first time it has set a goal,' Carlos Trostli said... 'It will be very difficult for someone to come and stop a program that's generating jobs and increasing fiscal revenue.' Lula announced a plan on March 24 to spend 34 billion reais ($18.8 billion) for low-income housing..."

Unbalanced Global Economy Watch:

September 16 - Bloomberg (Svenja O'Donnell): "U.K. unemployment jumped to the highest level since 1995... The number of people seeking jobs in the three months through July rose by 210,000 to 2.47 million..."

September 15 - Bloomberg (Dara Doyle): "The skeleton of an eight-story Dublin office block lays deserted on the north bank of the River Liffey, just next to the financial district that less than two years ago was the heart of Ireland's economic boom. Four cranes stand idle at the site, one of at least 35,000 unfinished or empty new offices and homes that dot Ireland's landscape after the collapse of its real estate market. Finance Minister Brian Lenihan will detail tomorrow how much Ireland will pay for about 90 billion euros ($131 billion) of real estate loans now crippling what as recently as 2006 was one of Europe's most dynamic economies."

September 17 - Bloomberg (Emma Ross-Thomas and Simone Meier): "Europe posted the largest trade surplus in five years in July... Exports from the 16-nation euro region rose a seasonally adjusted 4.1% from June..." July imports contracted 0.3% and the trade surplus jumped to 6.8 billion euros ($10bn)..."

U.S. Bubble Economy Watch:

September 17 - Reuters (Lisa Lambert): "The federal government and states are girding themselves for the next foreclosure crisis in the country's housing downturn: payment option adjustable rate mortgages that are beginning to reset. 'Payment option ARMs are about to explode,' Iowa Attorney General Tom Miller said... 'That's the next round of potential foreclosures in our country.'"

Central Banker Watch:

September 14 - Bloomberg (Frances Robinson): "European Central Bank President Jean-Claude Trichet said saving Lehman Brothers Holdings Inc. or American International Group Inc. from bankruptcy wouldn't necessarily have prevented the financial crisis from deepening. 'Lehman was a trigger, but you could have another trigger,' Trichet told CNBC... 'Even if Lehman and AIG had been saved, it would be a new entity that had problems... 'At the end of the weekend we knew it was unfortunately bankruptcy that would be the solution,' Trichet said... 'It triggered for us as well as all sister central banks the sentiment that we had to prepare for something that was really big.'"

September 14 - Bloomberg (Theresa Tang and Sophie Leung): "Hong Kong Monetary Authority Chief Executive Joseph Yam said central banks face a dilemma on when to tighten monetary policy. Doing so too soon has the potential to curb an economic recovery, while maintaining loose monetary policy may produce 'asset bubbles,' Yam said..."

September 16 - Bloomberg (Tasneem Brogger): "Sweden's Riksbank should start raising rates earlier than its current outlook indicates as the economy is set to recover faster than the bank's official forecast, two of the policy board's six members said. 'The repo rate might need to be raised during the late spring or summer 2010,' Riksbank Deputy Governor Barbro Wickman-Parak said..."

September 16 - Bloomberg (Timothy R. Homan): "Former Federal Reserve Chairman Alan Greenspan said he's worried that lawmakers will hamper U.S. central bank efforts to rein in its monetary stimulus, and that inflation might 'swamp' the bond market. 'It's the politics in the United States that worries me, whether the Congress will basically feel comfortable" with the Fed withdrawing its stimulus, Greenspan said...'if inflation rears its head, it will swamp long-term markets,' referring to bonds."

Fiscal Watch:

September 18 - Washington Post (Dina El Boghdady): "The Federal Housing Administration has been hit so hard by the mortgage crisis that for the first time, the agency's cash reserves will drop below the minimum level set by Congress... The FHA guaranteed about a quarter of all U.S. home loans made this year... 'It's very serious,' FHA Commissioner David H. Stevens said... 'There's nothing more serious that we're addressing right now, outside the housing crisis in general, than this issue.' ...The agency does not lend money; it insures lenders against losses. It has captured 23% of all new loans made so far this year, up from just 3% in 2006."

Muni Watch:

September 18 - Bloomberg (Jeremy R. Cooke): "Municipal bond sales rose to $9.7 billion, the highest in five weeks based on data compiled by Bloomberg..."

Speculator Watch:

September 17 - Bloomberg (Saijel Kishan): "The pace of hedge fund liquidations slowed in the second quarter as managers posted a 9.1% gain, according to Hedge Fund Research Inc. About 292 funds shut down, a 22% decline from the first quarter..."

Q2 2009 Flow of Funds

September 18 - Wall Street Journal (Peter Eavis): "More than half of U.S. residential mortgages are being made by just three large banks. It is a stunning change, but is it good for the housing market, and to what extent will it boost profits over the long term for this elite trio: Wells Fargo, Bank of America, and J.P. Morgan Chase? Right now, housing remains on government life support. Treasury-backed entities are guaranteeing about 85% of new mortgages, while the Fed buys 80% of the securities into which these taxpayer-backed mortgages are packaged."

The Federal Reserve's Z.1 "flow of funds" report remains a must "read" when it comes to grasping the happenings of the U.S. Credit system. Granted, the reams of data may not be quite as captivating now as compared to the Wall Street Bubble years. But the report never disappoints.

For the quarter, Non-Financial Credit growth accelerated to 4.9% annualized, up from Q1's 4.1% and compared to Q2 2008's 3.3%. In nominal seasonally-adjusted and annualized rate (SAAR) terms, Non-Financial debt expanded $1.646 TN. This was up strongly from Q1's $1.371 TN SAAR, but still below the $2.0 TN or so I deem necessary to (at least temporarily) stabilize the system. Keep in mind that the economy remained quite weak for much of Q2. I would expect Q3 Credit growth in the neighborhood of $2.0 TN annualized. For perspective, Non-Financial Credit expanded $865bn in 2000, $1.152 TN in 2001, $1.413 TN in 2002, $1.671 TN in 2003, $1.997 TN in 2004, $2.329 TN in 2005, $2.400 TN in 2006, $2.539 TN in 2007 and $1.888 TN in 2008.

And while the recovery in Credit is on the surface encouraging, the composition of this growth is disconcerting. For the quarter, Household debt contracted at a 1.7% rate, with Home Mortgage and Consumer Debt down 1.4% and 6.5% annualized - both worse than Q1 (declines of 0.1% and 3.7%). Corporate borrowings expanded at only 1.0% annualized, down from Q1's 2.1% and compared to 6.7% back in Q2 2008. Private sector Credit remains stuck in the muck.

Meanwhile, State & Local debt growth accelerated to 8.3% annualized, up from Q1's 4.9% and Q2 2008's 0.9%. State & Local governments expanded borrowings $187bn SAAR - a resurgence back to the peak borrowing level from 2007 ($186bn). Federal borrowings expanded at a blistering 28.2% pace, up from Q1's 22.6% and compared to Q2 2008's 5.9%. Federal borrowing increased to $1.895 TN SAAR during the quarter. State & Local and Federal combined debt growth reached $2.082 TN SAAR, significantly larger than the total system Non-Financial debt growth of $1.646 TN SAAR (with Household Credit and Mortgage debt contracting).

Over the past four quarters, Non-Financial Credit expanded $1.959 TN, or 6.1%, to $34.320 TN. This was no small amount of debt growth. Treasury borrowings increased $1.893 TN over the past year to $7.143 TN. And during this period Federal Reserve assets ballooned $1.111 TN, or 117%, to $2.063 TN. It is incredible to watch the emerging Government Finance Bubble take such command of U.S. Credit.

On an SAAR basis, the Federal Reserve increased Agency- and GSE-Backed Securities $1.088 TN during Q2 (nominal $272bn). In nominal dollars, Fed holdings of Agency (mostly MBS) securities increased from $20bn at year-end to $559bn by the end of Q2. And keep in mind that Home Mortgage debt actually contracted $53bn during this period (to $10.951 TN).

There is a perception that the Fed's agency MBS purchase program is specifically targeting stabilization of the conventional mortgage market. Yet, examining the data, one can see that the private-label MBS marketplace is perhaps the greater beneficiary of Federal Reserve largess. For the quarter, Issuers of Asset-Backed Securities (chiefly pools of private-label/non-GSE mortgages) contracted $499bn SAAR, this after a $614bn SAAR contraction in Q1. But this was offset by an increase in GSE MBS of $556bn SAAR in Q2 and $304bn SAAR in Q1.

So, the Fed is amassing quite a stockpile of "conventional" GSE MBS, but often these are "private-label" mortgages recently "refinanced" into GSE securities. And as the Fed buys the new GSE MBS, newly created funds become available to flow back to reliquefy the formerly illiquid ABS marketplace (along with agencies, Treasuries, corporates, and equities). To be sure, placing essentially federal government backing upon previously "private-label" mortgages dramatically changes the market's perception of these securities' worth ("moneyness") - especially with fed funds pegged for an extended period at near zero and the Fed in the midst of a $25bn weekly purchase program in order to fulfill it commitment to purchase $1.25 TN of mortgage securities.

During the quarter, outstanding GSE MBS expanded at a 10.4% rate to $5.173 TN. GSE MBS increased $414bn, or 8.7%, over the past year and $1.098 TN, or 26.9%, over two years. During Q2, the ABS market contracted at a 12.2% rate to $3.817 TN. ABS declined $525bn over the past year, or 12.1%, and $673bn, or 15%, over two years. Here we see confirmation that nationalization of mortgage Credit runs unabated. Not only is the vast majority of new mortgage Credit this year government-backed, Washington guarantees are being slapped on hundreds of billions of existing "nonconventional" mortgages. This intrusion and transfer of (Credit and interest rate) risk has terrible long-term ramifications. Although in the near-term this mechanism provides a powerful stabilizing force for both the Credit system and real economy.

Bank Credit contracted at a 1.4% pace during the quarter to $9.523 TN. Similar to the money supply numbers, I have tended this year to deemphasize private lending data in my analysis. After all, how much can we expect to discern from traditional Credit-related metrics when policymakers are issuing Trillions of Treasuries/agencies Credit and the Fed is monetizing a Trillion or so? It is, however, worth noting that Bank holdings of Government Securities expanded at a 16.2% pace during the quarter to $941bn. Mortgages increased at a respectable 4.6% clip to $3.899 TN. Business loans contracted at a notable 17.8% pace (to $2.031TN), although this may be somewhat explained by the thawing of the corporate debt securities marketplace (companies issuing debt to repay bank borrowings).

On the bank Liability side, total Deposits expanded at a 5.2% rate during the quarter to $7.278 TN (up 7.8% y-o-y). Credit Market borrowings were about flat at $1.720 TN. Fed Funds & Repo expanded ($133bn) for the first time in eight quarters (to $596bn). Meanwhile, Miscellaneous Liabilities contracted at a 24% rate to $2.468 TN.

Posting the strongest growth since Q2 2007, Securities Broker/Dealer assets expanded at a 14.5% pace to $2.00 TN. Broker Dealer assets increased $514bn SAAR during the quarter, although most of this is explained by an increase in Treasuries holdings (up $404bn SAAR). With the Fed's massive MBS buying program in mind, it's not surprising to see Broker/Dealer holdings of Agency and MBS declining $179bn SAAR. It is worth noting that, on the Liability side, Security Repos expanded $224bn SAAR, the first increase in repos since Q1 2008. "Other" Miscellaneous Liabilities increased $309bn SAAR.

Examining the miscellaneous categories, Finance Companies contracted 8.6% annualized to $1.777 TN (down 7.9% y-o-y). Credit Unions expanded 9.9% annualized to $877bn (up 9.1% y-o-y). REITs increased 13.3% annualized to $260bn (down 13.5% y-o-y). Money Market contracted at a 16.5% rate during Q2 to $3.584 TN, cutting y-o-y growth to 8.0%. Life Insurance assets grew at an 11.9% pace to $4.552 TN (down 6.6% y-o-y).

Rest of World holdings were down a rather insignificant $134bn SAAR to $14.200 TN. There were, however, some meaningful changes in the composition of foreign holdings of U.S. assets. Net Interbank Assets contracted $692bn SAAR, while Official Treasury holdings jumped $494bn SAAR. U.S. Corporate Bond holdings declined $110bn SAAR, while Miscellaneous Assets expanded $227bn SAAR.

In total, Rest of World purchased $403bn SAAR of Treasuries during Q2, about a quarter of total issuance ($1.896 TN SAAR). Who were the other major purchasers? The Fed monetized $647bn SAAR, the Household Sector bought $343bn SAAR, and Broker/Dealers accumulated $404bn. And while it is positive that American households are buying Treasuries and saving more, this does not change the fact that this so called "savings" was bolstered by income effects from massive government spending increases.

Examining income data, National Income stabilized during the quarter at $12.162 TN. After declining $347bn annualized during Q4 2008 and $225bn annualized during Q1, National Income slipped only $47bn annualized during the quarter. National Income was down 4.0% y-o-y. Total Compensation was down 3.8% y-o-y to $7.726 TN. National Income and Compensation began the decade at $8.358 TN and $5.354 TN. It is my view that, at this point, only massive federal deficits and government intrusions will stabilize system incomes at today's highly inflated levels.

Federal Q2 Receipts were down 6.6% y-o-y to $2.215 TN SAAR, while Federal Expenditures surged 35.9% to $3.510 TN SAAR. For comparison, federal expenditures were $2.393 TN in 2004, $2.573 TN in 2005, $2.728 TN in 2006, $2.897 TN in 2007 and $3.118 TN in 2008. So current spending levels are running almost 50% above where they were five years ago. Second quarter State & Local receipts were just slightly ahead of the year ago level to $2.004 TN. Spending was slightly down from a year earlier to $2.014 TN.

The media was quick to pick up on the quarter's $2.0 TN increase in Household Net Worth. For the bad news, Net Worth was still down $7.438 TN over the past year. With Household Liabilities essentially flat (down 1.0% annualized) at about $14.10 TN, changes in Household Assets dictate the increase/decrease in Net Worth. For the quarter, assets were up $1.964 TN, or 12.0%, to $67.208 TN. This jump places asset values back to mid-2005 levels. Real Estate holdings actually rose $157bn (nominal) to $20.026 TN, the first increase in 10 quarters. Yet, reflation's real impact was felt in the $1.777 TN (17.5%) jump in household holdings of Financial Assets. Over the past year, the value of Real Estate declined $1.759 TN and Financial Assets dropped $6.043 TN. It is worth noting that, despite the crisis, Household Net Worth was up about a third in seven years.

To summarize, there were no surprises in the Q2 2009 Flow of Funds. What I saw was confirmation of the Government Finance Bubble Thesis. "Uncle Sam Bets the House on Mortgages" was the headline for an insightful article in this morning's Wall Street Journal (Peter Eavis). It would as well make a good title for recent Z.1 Flow of Funds reports. My bet is that this massive government intrusion into mortgage finance eventually backfires. It puts Washington on course for bankrupting the country, while doing little to direct financial and real resources in a manner to spur needed economic restructuring.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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