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November 18, 2006

Derivatives
by Doug Noland

The Dow gained 1.9% (up 15.2% y-t-d), and the S&P500 rose 1.5% (up 12.3% y-t-d). The Transports jumped 2.4% (up 15.5%), and the Morgan Stanley Cyclical index added 1.1% (up 11.3% y-t-d). The Utilities increased 0.1% (up 13.3% y-t-d), and the Morgan Stanley Consumer index rose 1.4% (up 14.8%). The small cap Russell 2000 jumped 2.5%, increasing 2006 gains to 17.1%. The S&P400 Mid-Cap index gained 1.7% (up 9.2% y-t-d). The NASDAQ100 and Morgan Stanley High Tech Index both rose 2.8%. The Street.com Internet Index jumped 2.7% (up 19.8% y-t-d), and the NASDAQ Telecommunications index rose 2.5% (up 26.2% y-t-d). The Biotechs gained 3.3% (up 15.7% y-t-d). The Broker/Dealers surged 3.1%, increasing 2006 gains to 23.2%. The Banks this week added 0.4% (up 10.1% y-t-d). With Bullion down $7.0, the HUI index sank 4.1%.

In a notably volatile week in the interest-rate markets, two-year government yields ended up 2.5 bps to 4.76%. Five-year Treasury yields increased 3 bps, ending the week at 4.60%, and bellwether 10-year yields added one basis point to 4.60%. Long-bond yields dipped one basis point to 4.70%. The 2yr/10yr spread ended the week inverted 16 bps. The implied yield on 3-month December '07 Eurodollars rose 2.5 bps to 4.80%. Benchmark Fannie Mae MBS yields narrowed 3 bps to 5.72%, this week significantly outperforming Treasuries. The spread on Fannie's 5 1/4% 2016 note ended the week 4 narrower to 32, and the spread on Freddie's 5 1/2% 2016 note three narrower to 33. The 10-year dollar swap spread declined 3.5 to 49.5. Corporate bond spreads generally narrowed to Treasuries, with junk spreads narrowing significantly.

November 16 - Reuters (Richard Hubbard): "A surfeit of liquidity in the financial markets is tempting bankers to underwrite and finance deals that may come back to haunt them, a top banker at Goldman Sachs said... Eugene Leouzon, the chief underwriting officer for Europe and Asia at Goldman Sachs who sits on the investment bank's global credit committee, said the current conditions were unparalleled in his experience of investment banking. 'The markets are really, really red hot,' said Leouzon who approves new loans and debt deals to fund...M&A. 'The things we are seeing being done, both on the investment grade side and the non-investment grade side, are I would say borderline stupid,' he told the Reuters Investment Banking Summit..."

November 15 - Bloomberg (Robert Burgess and Caroline Salas): "The finance unit of HSBC Holdings Plc...and pharmaceutical company Bristol-Myers Squibb Co. led borrowers selling $17 billion of bonds in the U.S. today, the most since January... The sales added to what is already a record year for the U.S. corporate bond market as an expanding economy encourages companies to borrow to fund acquisitions. Through today, $731.5 billion had been sold, topping the previous high of $675.7 billion in all of 2001... 'The new-issue market backdrop is as good as we've ever seen it,' said James Esposito, head of investment-grade syndicate at Goldman Sachs Group Inc."

Investment grade issuers included HSBC $4.5 billion, Credit Suisse USA $3.0 billion, UBS $2.6 billion, Comcast $2.75 billion, Sprint Nextel $2.0 billion, Western Union $2.0 billion, CVS $1.3 billion, Bristol-Myers Squibb $1.25 billion, Bear Stearns $1.0 billion, American Morgan Stanley $1.0 billion, Federated $1.0 billion, Express $700 million, Black & Decker $300 million, Toledo Edison $300 million, Financial Security Assurance $300 million, Crane $200 million, and Southern Power $200 million.

November 15 - Dow Jones (Martin Fridson): "The year is turning out far more favorably for high yield bond investors than experts expected. Through November 13, the total return on Merrill Lynch's High Yield Master II Index measured 9.88%. That puts it on track for a full-year return of 11.35%. To say that strategists underestimated the market's strength would be an understatement."

November 16 - Bloomberg (Caroline Salas): "Freescale Semiconductor Inc. sold $5.95 billion of bonds today in the biggest offering to finance a leveraged buyout in 17 years. The deal tops the $5.7 billion in debt sold by hospital operator HCA Inc. last week."

Junk bond funds reported inflows of $48.7 million this week. Record junk issuance runs unabated, with issuers this week including Freescale Semiconductor $5.95 billion, Goodyear Tire $1.0 billion, Mosaic $950 million, Rental Services Corp $620 million, Reliance Steel & Aluminum $600 million, USG Corp $500 million, GNC Parent Corp $375 million, Kansas City Southern $175 million, and Americast Technology $105 million.

November 14 - Bloomberg (John Stebbins): "EMC Corp...priced $3.45 billion in convertible notes to pay for its RSA Security Inc. acquisition and a $946 million stock buyback. The sale...includes $1.725 billion of convertible senior notes maturing in 2011 and $1.725 billion of similar debt maturing in 2013... Both pay interest at 1.75 percent a year."

A resurgent convert issuance boom included EMC $3.5 billion, Vornado Realty Trust $1.0 billion, Duke Realty $575 million, Health Care REIT $300 million, Earthlink $225 million, School Specialty $175 million, China Medical Tech $125 million, Rare Hospitalities $110 million, and Decode Genetics $80 million.

International dollar debt issuers included DNB Nor Bank $2.3 billion, GAZ Capital $1.35 billion, Ukraine $1.0 billion, Elan $615 million, Korea National $500 million and Net Servicos $150 million.

Japanese 10-year "JGB" yields rose 3 bps this week to 1.71%. The Nikkei 225 index dipped 0.1% (y-t-d down 0.12%). German 10-year bund yields fell 2.5 bps to 3.72%. Emerging markets were mostly impressive. Brazil's benchmark dollar bond yields dipped one basis point to 6.12%. Brazil's Bovespa equities index added 0.5% this week (up 22.6% y-t-d). The Mexican Bolsa gained 1.0%, increasing 2006 gains to 35.9%. Mexico's 10-year $ yields rose one basis point to 5.63%. The Russian RTS equities index declined 1% (up 50% y-t-d). India's Sensex equities index added 1.1%, increasing 2006 gains to 42.9%. China's Shanghai Composite index surged 4.7%, increasing y-t-d gains to 69.8%.

November 14 - Bloomberg (Valerie Rota): "Mexico's cost to borrow in pesos for five years fell to the lowest in almost three years... The yield on the 8.5% bond that matures in June 2011 fell to 7.50% from 7.88% last month..."

This week, Freddie Mac posted 30-year fixed mortgage rates dropped 9 bps to 6.24%, the lowest borrowing rates since early March and down 13 bps from one year ago. Fifteen-year fixed mortgage rates fell 10 bps, to 5.94% (up 4 bps y-o-y). And one-year adjustable rates dipped 2 bps to 5.53% (up 33 bps y-o-y). The Mortgage Bankers Association Purchase Applications Index increased 2.7% this week to the strongest level since the first week of July. Purchase Applications were down 12.9% from one year ago, with dollar volume 11.6% lower. Refi applications jumped another 6.5% to the highest level since October 2005. The average new Purchase mortgage dipped to $227,900 (down 4.9% y-o-y), and the average ARM declined to $372,100 (up 5.4% y-o-y).

Bank Credit declined $11.1 billion last week to $8.175 TN, partially reversing the previous week's $49.8 billion increase. Year-to-date, Bank Credit has expanded $669 billion, or 10.3% annualized. Bank Credit inflated $767 billion, or 10.4%, over 52 weeks. For the week, Securities Credit declined $9.9 billion. Loans & Leases this week dipped $1.1 billion, with a y-t-d gain of $502 billion (10.6% annualized). Commercial & Industrial (C&I) Loans have expanded at a 14.7% rate y-t-d and 14.8% over the past year. For the week, C&I loans fell $6.6 billion, while Real Estate loans increased $2.9 billion. Real Estate loans have expanded at a 14.8% rate y-t-d and were up 14.7% during the past 52 weeks. For the week, Consumer loans increased $2.2 billion, and Securities loans jumped $11.6 billion. Other loans dropped $11.2 billion. On the liability side, (previous M3 component) Large Time Deposits expanded $2.1 billion.

M2 (narrow) "money" supply rose $11.3 billion to $6.963 TN (week of 11/6). Year-to-date, narrow "money" has expanded $276 billion, or 4.8% annualized. Over 52 weeks, M2 has inflated $333 billion, or 5.0%. For the week, Currency dipped $0.5 billion, and Demand & Checkable Deposits fell $19.2 billion. Savings Deposits jumped $22.5 billion, and Small Denominated Deposits rose $2.7 billion. Retail Money Fund assets increased $5.9 billion.

Total Money Market Fund Assets, as reported by the Investment Company Institute, jumped another $14.6 billion last week to $2.288 Trillion. Money Fund Assets have increased $231 billion y-t-d, or 12.7% annualized, with a one-year gain of $290 billion (14.5%).

Total Commercial Paper surged $30.2 billion last week to a record $1.931 Trillion. Total CP is up $290 billion y-t-d, or 20.0% annualized, while having expanded $283 billion over the past 52 weeks (17.2%).

Asset-backed Securities (ABS) issuance this week surged to $29 billion. Year-to-date total ABS issuance of $649 billion (tallied by JPMorgan) is running about 6% below 2005's record pace, with 2006 Home Equity Loan ABS sales of $434 billion about 4% under comparable 2005. Also reported by JPMorgan, y-t-d US CDO (collateralized debt obligation) Issuance of $298 billion is running 80% ahead of 2005.

Fed Foreign Holdings of Treasury, Agency Debt rose $7.7 billion during the week to a record $1.704 Trillion (week of 11/15). "Custody" holdings were up $185 billion y-t-d, or 13.7% annualized, and $216 billion (14.5%) over the past 52 weeks. Federal Reserve Credit dipped $0.4 billion to $834.8 billion. Fed Credit is up $8.4 billion (1.2% annualized) y-t-d, while having expanded 3.2% ($26.0bn) over the past year.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $665 billion y-t-d (18.6% annualized) and $706 billion (17.6%) in the past year to a record $4.711 Trillion.

November 17 - Bloomberg (Anoop Agrawal): "India's foreign-exchange reserves rose $1.17 billion to $168.3 billion in the week ended Nov. 10..."

Currency Watch:

November 17 - Bloomberg (Flavia Krause-Jackson): "United Arab Emirates Central Bank Governor Sultan Bin Nasser al-Suwaidi comments on the outlook for the euro overtaking the U.S. dollar as the dominant reserve currency for international trade... 'I would say the euro will definitely grow to dominate trade outside the euro area. I expect the euro to become the currency of international trade within 10 years. It will surpass the dollar by 2015.'"

November 15 - Bloomberg (Kevin Carmichael): "Robert E. Rubin...and former Federal Reserve Chairman Paul Volcker said foreign investors probably won't keep increasing dollar holdings... Volcker said the U.S. borrowing requirements raise the risk of a 'crisis' in the dollar as soon as the next two and a half years. 'It seems almost inconceivable that this will continue indefinitely,' Rubin...said..."

The dollar index added 0.5% to 85.29. On the upside, the Slovakia koruna gained 1.6%, the Australian dollar 0.9%, the New Zealand dollar 0.9%, and the Hungarian forint 0.9%. On the downside, the Iceland krona declined 1.6%, the Canadian dollar 0.8%, the Taiwan dollar 0.6%, and the Mexican peso 0.6%.

Commodities Watch:

November 16 - Bloomberg (Shruti Date Singh): "Orange-juice futures rose to a 16-year high on speculation that smaller orange crops in Brazil and Florida, the world's largest growers, will force processors such as Coca-Cola Co. to compete for dwindling supplies."

Gold slipped 1.1% to $622, and Silver declined 2.4% to $12.80. Copper dipped 0.9%, reducing y-t-d gains to 60%. January crude sank $2.61 to end the week at $58.93. December Unleaded Gasoline fell 1%, while December Natural Gas jumped 5.2%. For the week, the CRB index declined 1.6% (down 7.8% y-t-d), and The Goldman Sachs Commodities Index (GSCI) dipped 0.9% (up 1.4% y-t-d).

Japan Watch:

November 14 - Bloomberg (Lily Nonomiya): "Japan's economy grew twice as fast as expected in the third quarter, spurring gains in the yen on speculation the central bank will raise interest rates next month to cool surging corporate spending. Gross domestic product in the three months ended Sept. 30 grew an annualized 2 percent... Second-quarter growth was revised to 1.5 percent from 1 percent."

China Watch:

November 15 - Bloomberg (Lee Spears): "China will improve its macroeconomic control mechanism while maintaining stable, 'relatively fast' economic growth, the State Council said."

November 13 - Bloomberg (Nerys Avery): "China's money supply unexpectedly accelerated in October for the first month in five, suggesting the central bank may have to take more measures to soak up rising inflows of money from the nation's record trade surplus. M2...jumped 17.1 percent to 33.3 trillion yuan ($4.2 trillion) at the end of October after rising 16.8 percent in September..."

November 15 - Bloomberg (Nipa Piboontanasawat): "China's industrial output rose at the slowest pace in almost two years in October, indicating that a government clampdown on investment is succeeding... Production rose 14.7 percent from a year earlier to 760 billion yuan ($96 billion) after gaining 16.1 percent in September..."

November 15 - China Knowledge: "China's retail sales in October grew 14.3% from the previous year to RMB 699.8 billion, the highest in nine months... In the ten months to October this year, retail sales increased 13.6% from a year earlier..."

Unbalanced Global Economy Watch:

November 14 - Bloomberg (Rachel Layne and Brian McGee): "General Electric Co.... said revenue from developing countries will increase by about 15 percent this year, buoyed by demand in India and the Middle East. Sales from emerging markets will reach $27 billion, led by spending on the development of infrastructure ranging from airports and roads to water-treatment plants and hospitals..."

November 17 - Bloomberg (Fergal O'Brien): "Europe's trade deficit with China widened to a record... The trade deficit with China grew 21 percent in the eight months through August to 55.1 billion euros ($70.4 billion)..."

November 13 - Bloomberg (Craig Stirling): "U.K. house-price inflation reached an 18-month high in September as the $6.9 trillion residential property market absorbed rising interest rates... Home values rose 8 percent from a year earlier..."

November 14 - Bloomberg (Ben Sills): "Spanish economic growth accelerated at the fastest annual pace in almost five years... Europe's fifth-largest economy expanded 3.8 percent from the year earlier..."

November 16 - Bloomberg (Evalinde Eelens): "Dutch unemployment fell in October to the lowest rate in more three years... The jobless rate declined to 5.2 percent..."

November 15 - Bloomberg (Evalinde Eelens): "Belgian exports rose 13.9 percent in September on higher demand from countries in the European Union."

November 16 - Bloomberg (Jonas Bergman): "Sweden's unemployment rate fell to 4.6 percent in October as companies picked up hiring amid the fastest economic expansion in six years. The rate fell from 4.9 percent in September and from 5.6 percent in the same month last year..."

November 14 - Bloomberg (Matthias Wabl): "Austria's economy expanded 0.9 percent in the third quarter... Gross domestic product... grew 3.3 percent compared with the third quarter a year ago..."

November 14 - Bloomberg (Alistair Holloway): "Finland's economy expanded an annual 3% in September, the slowest pace since April... Growth slowed from 4.3% in August..."

November 14 - Bloomberg (Paul Tugwell and Maria Petrakis): "Greek economic growth accelerated at the fastest annual pace in almost two years as exports rose and household consumption remained strong. Preliminary figures show Europe's 12th-largest economy expanded 4.3 percent in the third quarter from a year earlier..."

November 15 - Bloomberg (Andrea Dudikova and Radoslav Tomek): "Slovakia's economy, the fourth largest of the European Union's eastern members, expanded a record 9.8 percent in the third quarter as exporters shipped more goods abroad..."

Latin American Boom Watch:

November 16 - Bloomberg (Thomas Black): "Mexico's economic growth weakened in the third quarter as a slowdown in the U.S. economy curbed demand for Mexican-made engine parts, cotton fabrics and telephones. Gross domestic product expanded 4.6 percent in the quarter from the year-earlier period after growing 4.7 percent in the second quarter..."

November 17 - Bloomberg (Fabio Alves): "Brazilian retail sales rose in September at their fastest pace in 21 months...units sold, jumped 10 percent in September from a year earlier..."

November 16 - Bloomberg (Eliana Raszewski): "Argentina's economy expanded at 8 percent or faster for a fifth month in September as increasing wages and declining unemployment buoyed consumer demand."

November 16 - Bloomberg (Alex Kennedy): "Venezuela's economy grew more than 10 percent for a sixth quarter in the July-through-September Period as a surge in government spending of record oil income fueled consumer demand for cars and mobile telephones."

November 15 - Bloomberg (Alex Emery): "Peru's annual growth rate jumped to an 11-year high in September as natural gas, fishing and silver output surged. Economic growth in the 12 months through September quickened to 7.5%..."

Bubble Economy Watch:

November 16 - Bloomberg (Adam Satariano): "New York City's unemployment rate fell to 4.1 percent in October, the lowest on record, from 5.8 percent a year ago, the state's chief economist said..."

November 15 - New York Times (David Leonhardt): "By the time the crowd began arriving in Rockefeller Center last Wednesday for the big auction at Christie's, rain had already been falling in New York for 19 consecutive hours... Once inside, a few hundred of the attendees were shunted off to one of two side rooms, where they would watch the auction on a video screen, because the 750 seats in the main room...weren't nearly enough for the crowd... Over the next three hours, a mere sketch by Mondrian sold for $3 million, while a Gauguin painting went for $40 million and a Klimt for $88 million. In all, the auction brought in $491 million, breaking the modern mark of $435 million (in today's dollars) set by Sotheby's in 1990, in the last bull market in art. There is no mystery about the causes of the new boom. The rich have done very well over the last decade, and some of them, including hedge fund managers like Steven A. Cohen, are spending large sums of their money on art. New billionaires in China, India and, above all, Russia, have also entered the market."

Real Estate Bubble Watch:

November 17 - Bloomberg (Joe Richter): "Housing starts in the U.S. tumbled in October to the lowest level in more than six years, raising the prospect that the economy will be further weakened after growing last quarter at the slowest pace since 2003. Builders broke ground on new dwellings at an annual rate of 1.486 million, down 14.6 percent from September... Building permits dropped to a 1.535 million pace, a record ninth straight decline and the lowest since December 1997."

November 14 - Los Angeles Times (Martin Zimmerman): "Home prices in Los Angeles County showed signs of life last month, rising 4.5% from a year ago to a median of $514,000... That beat September's 3% year-over-year price appreciation. It also was up from the previous month...according to...DataQuick... Meanwhile, home sales in the state's most populous county continued to fall, but at a slower pace. Sales of new and existing homes and condominiums fell 21.8% last month compared with October 2005... Buyers and sellers have been at a standoff, analysts say -- buyers waiting for lower prices, sellers holding out for maximum profit. 'People who thought they would get 15% to 20% off last year's sale price are just throwing in the towel' and buying a house, said Patrick Veling, president of Real Data Strategies, a Brea firm that tracks multiple-listing data."

November 16 - Associated Press: "The number of homes sold in California fell in October from a year earlier... A total of 42,750 new and existing houses and condos were sold in California in October, according to...DataQuick Information... The figure represents a 21.7% decline from October 2005... It was the slowest October since 1997... Statewide, home prices were fairly stable. The median price paid for a home in October was $467,000, up 2.9% from the same month last year..."

November 14 - USA Today (Noelle Knox): "Ouch. Naples' real estate market seems to be in a nose dive from last year's heights. Home sales in the first nine months of the year, for both single-family homes and condos, were off 50%. The inventory of properties on the market is up 300%, to a 21-month supply -- three times the national rate. Though the median home price is up 4% year to date, the median price fell 8% in September."

Energy Boom and Crude Liquidity Watch:

November 17 - Bloomberg (Matthew Leising): "Shares of Nymex Holdings Inc., owner of the world's largest energy market, more than doubled on their first day of trading, the biggest gain for an initial public offering in 15 months...Nymex's market capitalization of almost $12 billion...makes it the fifth-largest publicly traded exchange..."

November 14 - Bloomberg (Matthew Brown): "Saudi Arabia, the Middle East's largest oil producer, posted a budget surplus of 218 billion Saudi riyals ($58 billion) last year as oil prices rose..."

Speculator Watch:

November 14 - Financial Times: "When ABN Amro went public with the first of a new type of structured derivatives deal in late August, Steve Lobb, global head of structured credit marketing, was pretty excited about its prospects. He confidently told the Financial Times then that it could be "the most exciting development in credit investing since the single-tranche [collateralised debt obligation]", the instrument that revolutionised the market. But even he could not have expected the massive impact this new kid on the block would be having two months later, when only a couple of deals have actually seen the light of day. The credit derivatives market has been abuzz in recent weeks with fevered talk about constant proportion debt obligations, or CPDOs. It says they have been a significant factor in driving credit derivative indices to record low levels; they have rejigged the pricing of other structured products; investment banks have all been working frantically to mimic and improve on the first deals done; and every investor in the field has been seeking a piece of the action."

November 15 - Financial Times (Peter Smith and Gillian Tett): "An outspoken buy-out executive has described 200 European companies as 'headless chickens' because their private equity backers have already repaid themselves their entire equity investment. 'These companies could be left for dead,' Jon Moulton, head of Alchemy Partners... Moulton estimates there are $768bn of outstanding leveraged loans in Europe that have financed about 2,500 private equity-backed companies. He estimates that about 200 of those have undergone leveraged recapitalisations, a process allowing backers to cream off large dividends while simultaneously loading the companies with extra debt."

Derivatives "Insurance":

November 17 - Bloomberg (Hamish Risk): "The global market for derivatives soared to a record $370 trillion in the first half of 2006, boosted by trading in credit-default swaps, the Bank for International Settlements said. The amount of outstanding credit-default swap contracts jumped to $20.3 trillion from $13.9 trillion at the end of last year, the bank said. The securities are financial instruments based on bonds and loans that are used to bet on an increase or decrease in indebtedness... Trading in derivatives overall grew 24 percent in the first six months..."

A question Tuesday from a journalist: "How does the Fed view this growing (derivatives) market and can we continue to grow at the rapid clip without causing systemic risks?"

Federal Reserve Bank of St. Louis President William Poole: "I'm not speaking for the Fed as a whole. My own position is that the derivatives market is a very fine extension of the depth of our financial markets, because it allows firms to lay off risks and to assume risks at a very measured and targeted way. A lot of the derivatives market - although we often talk about it as creating risk - is actually designed to reduce risk. It allows firms to hedge various positions in ways they could not hedge in the conventional markets - the markets without derivatives. And this is a classic development - it actually goes back to the futures markets and commodities in the nineteenth century, where farmers found that they could lay off risks in wheat futures and corn futures and so forth. And it was productive on both sides because people who specialized in taking risks and understanding risk could be on one side of those transactions and others who want to lay off risk can be on the other side."

"So, I'm a big fan of the derivatives markets. I think that they perform a valuable service in our economy, and I would also say that the derivatives markets provide a lot of valuable information to the Federal Reserve, because we are able to make calculations on various odds of things happening as they are determined by active trading in the markets. So we can read information out of the option market, for example, with certain assumptions about the probabilities that investors are putting on various possible outcomes. And so the derivatives markets are an important source of information for us. I think that these markets are by and large inhabited by people who are very professionally competent in using those markets. Obviously there are some amateurs or people who after the fact will learn that they're amateurs in these markets. But by and large these are competitive and very good markets. I applaud the development of these markets. I think it's good for the economy and good for the Fed."

Clearly, Mr. Poole and the Federal Reserve are oblivious to the precarious mania that has unfolded throughout the Credit Derivatives/"arbitrage" arena. This lack of responsible oversight is not surprising considering the Greenspan Fed's role as vocal proponent for the burgeoning derivatives markets. Still, after the 1987 "portfolio insurance" melt-down, the 1994 mortgage derivatives fiasco, 1995 Orange County and Mexico debacles, the SE Asian dominos collapses, Russia, LTCM, NASDAQ, telecom debt, and Argentina - to list a few major derivative-related market dislocations - I find the Fed's current complacency rather astonishing.

It's fair to assume the Fed's sanguine view has been further hardened by the recent placid backdrop greasing interest-rate and currency derivatives markets, as well by the extended period of relative tranquility in the enormous markets that evolved to hedge mortgage and MBS risks. Currency and interest-rate derivatives expanded phenomenally, setting the stage, one would have thought, for major problems. Yet these marketplaces have been tested by a multiyear dollar decline and a 2-years plus interest-rate "tightening" cycle. In light of this apparent resounding success, emboldened proponents such as Dr. Poole today trumpet derivatives' ability to lay off risk to those better at managing it - in the process reducing overall systemic risk.

I warn, however, that the unfolding risks associated with the proliferation of strategies and explosion of Credit derivatives trading have characteristics that contrast materially to recent experience in currency and interest-rate markets. Let me attempt an explanation, first with respect to the currency derivatives marketplace. Importantly, currency markets have benefited incalculably from the foreign central bank liquidity backstop. This has ensured that, despite the ongoing dollar bear market, Derivatives "Insurance" to protect against a dollar decline has remained inexpensive and readily available.

Those writing/selling this "Insurance" have enjoyed the extraordinary luxury of a captive audience demonstrating insatiable dollar demand - buyers willing to take the other side of the dollar ("dynamic hedging") selling (risk transfer) required to hedge/"reinsure" protection written. And, amazingly, the more acute underlying dollar weakness the more willing they are to accumulate ever greater quantities of U.S. securities. In history's greatest market intervention, foreign central bank (chiefly dollar) reserve holdings have since 2001 ballooned from about $2 Trillion to today's $4.7 Trillion. On the back of virtually limitless central bank dollar support, market players - especially speculators writing Derivative protection - have operated both with the confidence that markets would remain highly liquid and without the fear of abrupt marketplace dislocations (that cause bloody havoc for derivatives hedging strategies). The resulting cheap and readily available "Insurance" has created a perception that fear of further dollar weakness is no cause to liquidate U.S. securities or assets. Instead, simply hedge with Derivatives!

The unprecedented foreign central bank market intrusion can be thought of along the lines of an escalation beyond the GSE mortgage/MBS market liquidity backstop. Previous to the (liquidity-creating) ballooning of foreign central bank balance sheets, the fledgling leveraged speculating community for years enjoyed the luxury of placing highly leveraged bets with the comfort that aggressive GSE buying would emerge at the first indication of market stress. Derivative players prospered from the perception of powerful marketplace liquidity support, a backdrop that fostered inexpensive and readily available Derivative "Insurance." This cheap protection played a major role in bolstering leveraged speculation. And the speculative Bubble that enveloped mortgage finance ensured limitless cheap mortgage finance that fueled housing inflation and an economic boom (and, to this point, minimal Credit losses). The relative calm in hedging MBS since 1994 is a byproduct of enormous quasi-governmental market intervention.

While there may be some justification for Dr. Poole's and the Fed's view, it is nonetheless a myth that Derivatives reduce risk overall. In fact, it's today quite the contrary. The booming Derivatives markets are part and parcel to the explosion of global leveraged securities speculation. A mania in writing market "Insurance" (interest-rate, currency, equities, Credit, etc.) has grossly distorted both the pricing of risk throughout the system - and the perception of ongoing availability of cheap Derivatives protection. The series of unprecedented interventions in the currency, mortgage, and interest-rate arenas over time nurtured what is now a proliferation of "Credit arbitrage" speculations - derivatives that profoundly increase systemic risk through the expansion of volumes of risky Credits at this late - exuberant - stage of the Credit cycle.

To make matters much worse, the speculators today writing Derivatives "Insurance" have little in the way of actual resources that could be made available in the event that this protection is called upon to mitigate losses. And while I've made similar claims with respect to the sellers of currency and interest-rate Derivatives, hedging these risks has to this point been made effortless by the massive market interventions noted above. It is not, however, at all clear who will step up to take the other side of ballooning Credit "Insurance" trade when a faltering Credit cycle inevitably forces speculators to rush to hedge (i.e. sell the underlying bond) or liquidate their positions.

Fundamentally, Credit losses are not even insurable - "Insurance" denoting the payment of a premium for protection by the writer of loss protection against independent and random risks. Insurance companies employ scores of actuaries - analyzing vast amounts of historical data - to calculate the probabilities and the expected costs of future claims for a variety of insurable risks - including auto collisions, home fires, health services and deaths. The insurers price premiums sufficiently to achieve profits beyond the accumulation of reserves to be available to settle expected future loss claims. The number of auto accidents across the country during a particular period can be estimated with a high degree of accuracy; these accidents are approximately random and independent events; losses are not generally cyclical; and the availability and pricing of insurance does not significantly increase the overall occurrence of losses.

Credit losses, on the other hand, are categorically non-random and non-independent. They are very much an outgrowth of the Credit cycle, with writing protection against future Credit losses a speculative endeavor rather than "Insurance." During the upside, abundant Credit ensures seductively minimal defaults and losses. The profits from "Writing Flood 'Insurance' During the Drought" entice a reflexive boom in Credit speculation, Availability, and excess. The environment, however, is prone to turn on a dime - with faltering liquidity, lender angst, speculator losses and revulsion, and reinforcing Credit Unavailability fomenting a flurry of defaults and ballooning losses. Unquestionably, data from the cycle's upside will misrepresent downside risks, and the longer the cycle's upside the greater the distortions.

The cycle's final "terminal" phase - replete with extraordinary Credit Availability, seemingly endless market liquidity, marketplace euphoria and resultant gross economic maladjustment - creates perilous distortions in the perception and pricing of myriad risks. In short, this backdrop fosters a massive expansion of risky Credits acutely vulnerable to the cycle's approaching downside. And the last thing we needed was a mania to develop with the speculating Crowd writing Credit protection. When participants from this latest Crowded Trade head for the exits, the lack of a liquidity backstop would seemingly ensure problematic market dislocation.

The problem as I see it today - a dangerous situation that goes largely unrecognized - is one of a freakish Credit cycle that has been perpetuated by a series of interventions (Fed, GSEs, and foreign central banks) - significantly extending the "terminal" phase of perilous excess. Over the life of this historic Credit cycle, the size and scope of leveraged speculation has ballooned, while repeated market interventions have precipitated an increasing focus on the Credit arena for speculative profits. In short, the greatest Credit cycle ever has its finale in highly leveraged speculations and myriad Derivative bets on the worthiness of risky Credits, in the process inciting an issuance boom in the most susceptible Credits.

At the same time, I think I understand the complacency. Beyond the "success" of hedging in the currency and interest-rate markets, the Credit wreckage from the telecom debt bust is today only a distant memory. If anything, the market perceives that the Fed learned from the experience that to stem crisis requires early and aggressive rate cuts. And now, a year past the housing peak, speculators, policymakers and others are emboldened from the reality that the system has yet to suffer from much of an increase in losses after a period of gross mortgage Credit excesses. Why, then, be wary of a bout of profligacy in corporate finance?

Again, it is important to contrast the risk characteristics of the current Derivatives "Insurance" Bubble. The U.S. mortgage finance marketplace is a strange animal, much of it having been effectively nationalized through massive GSE asset and guarantee expansion. Despite the housing downturn, mortgage Credit today remains abundantly available at the easiest terms. Despite the sliver of "equity" backing $Trillions of mortgage guarantees, the markets don't today fear a GSE failure. So, despite apparent housing risks, the marketplace continues to perceive that there is little Credit risk in the vast majority of mortgage securities. Overall, there is minimal fear in throughout the entire Credit system that a surge in Credit losses could lead to restricted mortgage lending. If nothing else, the Fed would aggressively cut rates at the first sign of faltering mortgage liquidity.

It is also worth noting some peculiarities of the corporate debt downturn from earlier in the decade. For one, the greatest excesses were isolated in the telecom/technology industry. When the boom turned to painful bust, much of the economic impact was contained within an important but relatively limited sector of the economy. This generally created a backdrop that gave the Fed much greater flexibility than I expect they will face when the current corporate lending boom falters. Back in 2001, the incipient Mortgage Finance Bubble was not yet promoting destabilizing excess, but was instead poised to become the key post-tech Bubble reflationary mechanism. Outside of technology, inflationary biases had yet to become problematic. Globally, "disinflationary" forces were at their apex. King Dollar was at its zenith, with most global Credit systems disciplined and restrained. Crude oil ended the year near $20. At about $390 billion, 2001's Current Account Deficits was less than half of what our economy will generate this year. The Fed, back in 2001, enjoyed the capacity to aggressively cut rates - eventually to an unprecedented 1% - and leave them at this level for a "considerable time" without inciting conspicuous or market-disturbing inflationary impulses.

Today, the unfolding Derivatives "Insurance" Bubble is creating one additional troubling facet to what has developed into a full-fledged global Credit Bubble comprising U.S. household, government and corporate finance, along with Credit systems and asset markets around the world. Global imbalances and associated liquidity excess are unprecedented, and the dollar vulnerable. Despite the recent energy price decline, the domestic and global backdrop remains inflationary as opposed to dis-inflationary. Here at home, productivity is waning and wage pressures are rising.

Surely, the Fed today lacks the flexibility it enjoyed in 2001. Housing Bubble vulnerability is keeping it from actually tightening financial conditions, leaving "terminal phase" Credit excesses to run unchecked. At the same time, one would assume that speculative excess will hold easing impulses at bay. I am left with the uncomfortable feeling that - with U.S. mortgage, govt., corporate and global Credit Bubbles now largely synchronized - the long-overdue initiation of the Credit cycle's downside will be systemic in nature and likely triggered by some market development.

Thinking back to Dr. Poole's comment that "derivatives markets are an important source of information," I believe that highly speculative Derivatives markets at key junctures provide especially misleading pricing signals. These days, for example, a squeeze on those on the wrong side of the global collapse in Credit spreads is only exacerbating the mis-pricing of Derivatives "Insurance" and risk generally. At the same time, an unwind of speculations is distorting the energy and commodities markets. Meanwhile, a short squeeze is inflating the stock market value of scores of companies - many with questionable fundamentals - in the process encouraging a misallocation of resources reminiscent of the 1990s (but much more broad based). And the Treasury market gyrates daily on rumors of hedge fund liquidations and problems, while currency traders bet on the prospect of the dollar bears getting squeezed.

I know of no other period marked by such pervasive market pricing distortions. As I've argued all along, unlimited Credit/"finance" and unchecked leveraged speculation are the bane of free market Capitalism. Yet it's amazing how recent Monetary Disorder (inflating stock markets) has the "free market" bullish crowd filling the airwaves with flawed analysis and wishful thinking.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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