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February 09, 2007

Subprime in Focus
by Doug Noland

The Dow dipped 0.6%, and the S&P500 declined 0.7%. Transports declined 1.7%, while the Utilities surged 2.6% to a new record high. The Morgan Stanley Cyclical index declined 0.6%, and the Morgan Stanley Consumer index fell 0.9%. The broader market was volatile but ended the week little changed. The small cap Russell 2000 dipped 0.3%, while the S&P400 Mid-Caps were up 0.3% (up 5.1% y-t-d). The NASDAQ100 declined 0.7%, while the Morgan Stanley High Tech index added 0.6%. The Semiconductors fell 0.7%. The Street.com Internet Index declined 0.5%, while the NASDSAQ Telecommunications index rose 1.5%. The Biotechs dipped 0.4%. Subprime mortgage problems weighed on financial stocks. The Broker/Dealers fell 2.1%, and the Banks declined 0.3%. With bullion jumping $19, the HUI gold index rallied 2.3%.

Interest-rate markets were also volatile. Two-year government yields dipped 3 bps to 4.90%. Five and 10-year Treasury yields declined 4 bps to 4.78%. Long-bond yields fell 6 bps to 4.87%. The 2yr/10yr spread ended the week inverted 12 bps. The implied yield on 3-month December '07 Eurodollars dipped one basis point to 5.14%. Benchmark Fannie Mae MBS yields declined 4 bps to 5.83%, this week performing in line with Treasuries. The spread on Fannie's 5 1/4% 2016 note widened 2 to 33, and the spread on Freddie's 5 1/2% 2016 note widened one to 32. The 10-year dollar swap spread increased 2 to 51.75. Corporate bond spreads were little changed, with junk spreads narrowing this week.

February 8 - Bloomberg (Darrell Hassler): "Sales of U.S. collateralized debt obligations may slow to a growth rate of 15 to 20 percent this year as the housing market takes more of a toll on a market that nearly doubled in 2006, Moody's...said. Issuance last year rose 90 percent to a record $320 billion in rated CDOs, led by pools of student, credit card, mortgage or car loans... Those types of asset-backed securities represented 38 percent of the value of CDO sales last year, followed by 22 percent for CDOs backed by corporate loans."

Investment grade issuers included Goldman Sachs $2.75 billion, GE Capital $2.0 billion, CIT Group $2.0 billion, Bank of America $2.0 billion, Citigroup $2.6 billion, International Lease Finance $500 million, Ace INA Holdings $500 million, Monument Global $850 million, AMBAC $400 million, Anheuser Busch $300 million, Berkley $250 million, Norbord Delware $200 million, and Northern Natural Gas $150 million.

Junk issuers included Level 3 $1.0 billion, Jarden $550 million, Terrestar Network $500 million, Seitel Acquisition Corp $400 million, Davita $400 million, PGS Solutions $190 million, Invacare $175 million, PNA Intermed $170 million, Calfrac Holdings $135 million, Ameripath $125 million, and Claymont Steel $105 million.

Convert issuers included Suntech Power $425 million, ArvinMeritor $175 million, Invacare $125 million, and Conceptus $75 million.

International issuers included Indonesia $1.5 billion, Totta Ireland $1.5 billion, Caixa Catalunya $1.2 billion, C8 Capital $750 million, Manitoba $600 million, Pampa Calichera $250 million, Minerva Overseas $200 million, GC Impsat $225 million, and Great Canadian Gaming $170 million.

February 9 - Financial Times (David Oakley ): "Banks and insurers drove euro-denominated financial bond issuance to record levels last month... Financials issued €24bn in unsecured bonds...in January - the highest amount since the launch of the euro in January 1999... Ben Bennett, credit strategist at Lehman, said: 'With little corporate issuance, there was a lot of pent-up investor demand, with people looking to spend their cash, even if it meant buying up relatively boring senior financial paper.'"

February 6 - Financial Times (Richard McGregor): "Risk premiums on emerging market bonds yesterday were close to record lows as hopes of a credit rating upgrade for Brazil spurred another round of buying. As bond prices rose, the risk premium on emerging market bonds, as measured by JPMorgan's EMBI+ index, a market barometer, touched an intraday low of just 164 basis points over US Treasuries during trading. The lowest close for the index - 165bp over US Treasuries - was reached on Friday."

Japanese 10-year "JGB" yields dipped 3 bps this week to 1.69%. The Nikkei 225 declined 0.2% (up 1.6% y-t-d). German 10-year bund yields gained 3 bps to 4.09%. Emerging debt markets performed well and equities were mixed. Brazil's benchmark dollar bond yields dropped 6 bps this week to 5.98%. Brazil's Bovespa equities index declined 1.6% (down 0.4% y-t-d). The Mexican Bolsa added 0.2% (up 5.5% y-t-d). Mexico's 10-year $ yields fell 5 bps to 5.71%. Russia's 10-year Eurodollar yields declined 2 bps to 6.75%. India's Sensex equities index rose 0.9% to a new record (up 5.5% y-t-d). China's Shanghai Composite index rallied 2.1% (up 2.1 y-t-d gains).

Freddie Mac posted 30-year fixed mortgage rates declined 6 bps last week to 6.28% (up 4 bps y-o-y). Fifteen-year fixed mortgage rates fell 4 bps to 6.02% (up 19 bps y-o-y). And one-year adjustable rates dropped 5 bps to 5.49% (15 up bps y-o-y). The Mortgage Bankers Association Purchase Applications Index dipped 0.8% this week. Purchase Applications were down 5.6% from one year ago, with dollar volume slipping 3.2%. Refi applications were little changed. The average new Purchase mortgage increased to $238,400 (up 2.5% y-o-y), and the average ARM declined to $380,300 (up 12.2% y-o-y).

Bank Credit jumped $18.2 billion (week of 1/31) to a record $8.330 TN. Bank Credit expanded $742 billion, or 9.8%, over 52 weeks. For the week, Securities Credit expanded $13.8 billion. Loans & Leases rose $4.4 billion to a record $6.109 TN. Commercial & Industrial (C&I) Loans expanded 10.7% over the past year. For the week, C&I loans dipped $2.7 billion, while Real Estate loans rose $8.1 billion. Bank Real Estate loans expanded 14.4% over the past year. For the week, Consumer loans declined $3.1 billion, while Securities loans jumped $11.2 billion. Other loans fell $8.9 billion. On the liability side, (previous M3) Large Time Deposits declined $3.2 billion.

M2 (narrow) "money" jumped $9.4 billion to a record $7.093 TN (week of 1/29). Narrow "money" expanded $368 billion, or 5.5%, over the past year. M2 has expanded at a 8.2% pace during the past 20 weeks. For the week, Currency dipped $0.3 billion, while Demand & Checkable Deposits rose $4.5 billion. Savings Deposits dipped $2.0 billion, while Small Denominated Deposits added $2.4 billion. Retail Money Fund assets gained $4.9 billion.

Total Money Market Fund Assets (reported by the Investment Company Institute) jumped $23.5 billion last week to $2.384 Trillion. Money Fund Assets inflated $343 billion over 52 weeks, or 16.8%. Money Fund Assets have expanded at an 18.4% rate over the past 20 weeks.

Total Commercial Paper jumped $16.3 billion last week to a record $2.011 Trillion, with a y-t-d gain of $36.8 billion (16.2% annualized). CP has increased $318 billion, or 18.7%, over the past 52 weeks. CP has expanded at an 18% pace over the past 20 weeks.

Asset-backed Securities (ABS) issuance increased this week to $15 billion. Year-to-date total ABS issuance of $61 billion (tallied by JPMorgan) is running behind the $69 billion from comparable 2006. Year-to-date CDO issuance of $15 billion is running behind last year's $21 billion.

Fed Foreign Holdings of Treasury, Agency Debt jumped $7.5 billion last week (ended 2/7) to a record $1.798 Trillion, with a 6-week gain of $45.6 billion. "Custody" holdings were up $254 billion y-o-y, or 16.4%. Federal Reserve Credit last week declined $2.7 billion to $841.5 billion. Fed Credit was up $32.4 billion y-o-y, or 4.0%.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $809 billion y-o-y (19.4%) to a record $4.975 Trillion.

Currency Watch:

The dollar index was little changed this week at 84.75. On the upside, the Thai baht increased 2.5%, the Iceland krona 0.9%, the Swedish krona 0.9%, the Canadian dollar 0.9%, and the Russian ruble 0.7%. On the downside, the Japanese yen declined 1.1%, the Mexican peso 0.8%, the Brazilian real 0.7%, the Turkish lira 0.6%, and the British pound 0.6%.

Commodities Watch:

February 9 - Bloomberg (Pham-Duy Nguyen): "Gold prices in New York rose to the highest in more than six months as a jump in energy costs boosted the appeal of the precious metal as an inflation hedge."

For the week, Gold jumped 2.9% to $666.85 and Silver 3.9% to $13.895. Copper rallied 3.9%. March crude rose 70 cents to $59.72. February Gasoline rose 2.6% and February Natural Gas 4.0%. For the week, the CRB index gained 1.3% (down 0.7% y-t-d), and the Goldman Sachs Commodities Index (GSCI) rose 1.9% (up 0.4% y-t-d).

Japan Watch:

February 9 - Financial Times (David Pilling): "The Bank of Japan's decision over whether or not to raise rates at a policy board meeting later this month is poised on a knife-edge, judging by comments from one of the board's more dovish members yesterday. Hidehiko Haru, one of nine board members, confirmed his moderate outlook when he said in a closely scrutinised speech it was 'imperative that we firmly maintain easy monetary conditions' to put 'the nation's economy on a sustainable growth path'. But he threw a bone to hawks, adding: 'We need to adjust rates gradually from their abnormally low levels.' Mr Haru is seen as one of the neutral voices on the bank's policy board and his comments are watched closely for indications of future decisions."

February 8 - Bloomberg (Toru Fujioka): "Japan's bank lending failed to accelerate, adding to signs the economy may not be strong enough to withstand an increase in interest rates... Loans excluding trusts rose 1.8% in January from a year earlier..."

China Watch:

February 9 - Bloomberg (Irene Shen and Nipa Piboontanasawat): "China, the world's fourth-largest economy, targets an 8 percent growth rate this year and is becoming more concerned over inflation, according to the central bank's quarterly monetary policy report. China will clamp down on credit growth and keep the increase in M2 money supply at 16 percent..."

February 6 - Bloomberg (Wing-Gar Cheng): "China, the world's biggest energy user after the U.S., used 14% more electricity last year as economic growth boosted demand, the nation's top economic planner said."

February 7 - Bloomberg (Ying Lou): "China, the world's biggest energy user after the U.S., plans to increase power generating capacity by 15 percent this year to meet rising demand... The nation will add 95 gigawatts of capacity by the end of 2007... The nation had a fourth straight year of power shortage last year when consumption peaked in summer. The nation's total installed capacity increased by 20 percent in 2006 to 622 gigawatts..."

February 6 - Financial Times (Richard McGregor): "China's soaring economic growth has been headlined in recent years by a single, attention-grabbing statistic: China each year adds new power generating capacity equal to the UK's entire electricity grid. But China surpassed this benchmark last year, according to new figures released quietly at the end of January by the China Electric Power News, the mouthpiece of the state industry. The paper reported that new power capacity in 2006 had expanded by 102 gigawatts, or roughly equal to the entire capacity of the UK and Thailand combined, or about twice the generating assets of California, the state with the biggest economy in the US."

February 5 - Bloomberg (Yanping Li): "China aims to keep its unemployment rate below 4.6 percent this year and to add at least 9 million new jobs, the Ministry of Labor and Social Security said."

India Watch:

February 7 - Bloomberg (Cherian Thomas): "India's economy may expand at a record pace in the year to March 31 as the nation's burgeoning middle class buy more cars, washing machines and phones, driving manufacturing growth to an all-time high. The world's second fastest-growing major economy after China is forecast to expand 9.2%..."

February 9 - Bloomberg (Kartik Goyal): "Inflation in India accelerated at the fastest pace in more than two years as prices of milk and oilseeds rose, raising concern the central bank may again review policy rates. The key wholesale price inflation rate rose to 6.58 percent..."

Asia Boom Watch:

February 7 - Bloomberg (Theresa Tang): "Exports from Taiwan, Asia's sixth-biggest economy, unexpectedly jumped 18 percent in January as China stocked up on electronics products ahead of the Lunar New Year holiday."

February 8 - Bloomberg (Stephanie Phang): "Malaysia's exports grew 10.3 percent to 588.9 billion ringgit ($169 billion) last year, as the country shipped more manufacturing, agriculture and fuel products..."

Unbalanced Global Economy Watch:

February 9 - Bloomberg (Alexandre Deslongchamps): "Canadian employers added the most jobs in eight months in January and almost seven times what economists forecast, further damping speculation that the central bank will cut interest rates this year. January's 88,900 new jobs represent the fifth-straight monthly gain..."

February 9 - Bloomberg (Brian Swint): "Britain's trade deficit unexpectedly widened in December to the most in seven months as an appreciating currency dented exports. The trade gap was...$13.8 billion, the most since May..."

February 8 - Bloomberg (Simone Meier): "Exports from Germany...unexpectedly declined for a second month in December, signaling a boom in foreign orders may have peaked. Sales abroad...fell 2% from November...Exports reached a record 893.6 billion euros in 2006, surging 13.7%."

February 7 - Bloomberg (Simone Meier): "Swiss unemployment unexpectedly declined last month, pushing the jobless rate to its lowest in more than four years, as companies added workers to meet increasing demand... The jobless rate dropped to 3 percent..."

February 9 - Bloomberg (Flavia Krause-Jackson): "Industrial production in Italy, the fourth-biggest economy in Europe, rose the most in almost two years in December, as consumer demand for everything from cars to clothing increased."

February 6 - Bloomberg (Jonas Bergman): "Sweden's economy will grow 3.7% this year, supported by rising consumer spending as the government cuts taxes and unemployment dips, SEB AB said."

February 7 - Bloomberg (Robin Wigglesworth): "Norway's jobless rate fell to the lowest in almost eight years...adding to pressure on the central bank to increase the pace of rate increases when it next meets in March. The...unemployment rate fell to 2.9% from 3.1%..."

February 8 - Bloomberg (Svenja O'Donnell): "Russia's foreign currency and gold reserves rose for a third week to a record, boosted by revenue from oil sales, as the country heads for a ninth year of economic growth. The reserves, the world's third biggest, rose to a record $304.6 billion..."

February 8 - Bloomberg (Tracy Withers): "New Zealand's unemployment rate fell in the fourth quarter...adding to signs the central bank will raise interest rates next month. The jobless rate declined to 3.7% from 3.8% in the third quarter..."

Latin American Boom Watch:

February 8 - Bloomberg (Fabio Alves): "Brazil's annual inflation rate dropped to its lowest rate since February 1999 as a currency appreciation cut the cost of imported goods. The annual inflation rate, as measured by the government's benchmark IPCA index, dropped to 2.99 percent in the 12 months through January..."

Central Banker Watch:

February 8 - Bloomberg (John Fraher and Gabi Thesing): "European Central Bank President Jean-Claude Trichet signaled the ECB will raise interest rates next month as the pace of economic growth threatens to fuel inflation. 'Strong vigilance remains of the essence so as to ensure that risks to price stability over the medium term do not materialize,' Trichet said..."

February 5 - Bloomberg (Shamim Adam): "Raising interest rates didn't work. So now Asia's central bankers and governments are trying curbs on bank lending, construction fees, even environmental regulations in an effort to combat asset bubbles that have made Seoul the world's second-priciest city and Mumbai apartments cost as much as Manhattan's."

Bubble Economy Watch:

February 6 - Financial Times (Richard McGregor): "When Picasso's 'Boy with a Pipe' fetched a record $104m at a Sotheby's New York auction in 2004, it was the talk of the town. Never before had an artwork commanded more than $100m and the deal made news outside the art world. Two years later David Geffen, the entertainment mogul, sold almost half a billion dollars' worth of paintings within a few months - one, Jackson Pollock's 'No.5, 1948', for $140m - and few blinked. The sales were merely the latest sign of a boom that has seen salerooms packed and art fairs proliferate. The year had already seen Ronald Lauder, the cosmetics heir, pay $135m for a work by Gustav Klimt, 'Adele Bloch-Bauer 1'... In a fitting climax, 50,000 people descended on Miami this month for a five-day frenzy of art sales under the umbrella of the Art Basel fair. More jets were rented for the event than for the Super Bowl. Art prices in the US rose this year by an average of 27 per cent - the steepest ever, according to Artprice.com..."

Financial Sphere Bubble Watch:

February 6 - Bloomberg (Steve Rothwell): "Credit derivatives, the fastest-growing business on Wall Street, are squeezing returns for bondholders to an all-time low. Contracts that protect investors against defaults are being sold in record numbers and then bundled into securities known as collateralized debt obligations. CDOs are driving down the cost to protect against non-payment so much that even the government of Argentina, which reneged on $95 billion of debt five years ago, is paying less than ever to borrow. 'CDOs are changing the economics of investing in corporate bonds,' said Lorenzo Isla, head of structured credit research at Barclays Capital in London. 'By expanding the investor base for corporate credit risk, they compress the spreads available to corporate bond investors.' Bondholders have halved the amount they charge high-risk companies in the past four years to a record-low 2.6 percentage points on average over U.S. Treasury notes... CDOs that invest in derivatives of investment-grade bonds return as much as 12 percent a year, three times more than the yields on the underlying notes, according to data compiled by Barclays Capital."

February 8 - Financial Times (David Oakley ): "Hedge funds paid up to $50bn in fees and interest to investment banks last year, according to research by Dresdner Kleinwort. They contributed a quarter of investment banking pre-tax profit, estimated Stefan-Michael Stalmann, banks analyst, eclipsing traditional activity such as dealmaking. However, he warned, they were certain to hit another Long Term Capital Management-style crisis. 'LTCM [bailed out by the Federal Reserve in 1998 after losing $4.6bn] was the blueprint.' Hedge funds have been attracting record amounts of new money as institutional investors such as pension funds race to invest alongside those who had long funded the industry... Fees come from prime broking, trading equity, debt and derivatives, lending and managing in-house funds. The payments to investment banks are equivalent to a 4 per cent annual fee on the industry's $1,300bn of assets..."

February 6 - Market News International (Steven K. Beckner): "The Federal Reserve's January survey of senior bank loan officers...shows a general softening of loan demand over the past three months, particularly for residential mortgages. Changes in lending terms and standards were 'mixed,' according to the Fed, which surveyed 57 domestic banks and 22 foreign banking affiliates. 'Demand for most loan types was reportedly somewhat weaker,' the Fed said..."

Mortgage Finance Bubble Watch:

February 8 - Freddie Mac: "Single-family mortgage originations are expected to decline almost 6% in 2007 to around $2.5 trillion and fall another 1% in 2008 to under $2.5 trillion; these declines reflect drops in refinance volumes of 19% and 25%, respectively. Owing to rapid house price growth, the FHA&VA share of single-family originations averaged 3% in 2006, but is expected to rise to 4% in 2007 and 5% in 2008. Growth in mortgage debt outstanding should be at a healthy clip of 8.1% for 2007 and 7.1% for 2008, down from the 8.9% estimated growth in 2006 and the double-digit growth we saw in 2001-2005 (averaging 12.8%)."

February 9 - Dow Jones (Anusha Shrivastava): "A steady stream of negative subprime mortgage headlines hammered a small corner of the credit markets Thursday where a key derivative index hit its weakest level ever. Though the derivative index, known as the ABX, continues to be an investment vehicle used by a small group of investors, market participants have used it as a gauge of sentiment on subprime home loans - the most vulnerable sector in the housing market."

February 8 - Bloomberg (Christine Harper): "HSBC Holdings Plc, Europe's biggest bank, said it's setting aside 20 percent more than analysts estimated for loan losses in 2006 because the company's U.S. mortgage business is deteriorating."

February 8 - Market News International (John Shaw): "Treasury Secretary Henry Paulson said...that negotiations continue with lawmakers on reforming government sponsored-enterprises, but said the talks have been difficult and contentious and may yield a bill that is not fully satisfactory for any of the parties. 'It's the closest thing I've seen to a Holy War,' Paulson said, regarding the GSE negotiations."

February 6 - Market News International (Steven K. Beckner): "The following is the statement released... by Freddie Mac on fourth-quarter refinancing activity: 'In the fourth quarter of 2006, 84 percent of Freddie Mac-owned loans that were refinanced resulted in new mortgages with loan amounts that were at least five percent higher than the original mortgage balances...This percentage is down from the third quarter of 2006, when the share of refinanced loans that took cash out was a revised 87 percent."

M&A and Private-Equity Bubble Watch:

February 9 - Bloomberg (Mariko Yasu): "Goldman Sachs Group Inc., the world's biggest securities firm by market value, may raise more than $18 billion for leveraged buyouts, almost double what it initially sought, said two people with knowledge of the plan."

Energy Boom and Crude Liquidity Watch:

February 7 - Bloomberg (Matthew Brown): "The Saudi Arabian Monetary Agency, the Persian Gulf state's central bank, increased its foreign currency reserves by 40 percent in the 12 months through January as the country accumulated oil wealth. The reserves rose to...$239 billion..."

Fiscal Watch:

February 6 - Financial Times (Stephanie Kirchgaessner): "The Bush administration went on a $5bn spending spree in Iraq in 2004 just six weeks before returning control of the government to Iraqis, according to a Democratic lawmaker investigating the payments. Huge sums were doled out, sometimes in dollar bills from the back of pick-up trucks, it was alleged. In a hearing before the chief House oversight committee, Democrats on Tuesday demanded answers from Paul Bremer, who headed the Coalition Provisional Authority, Iraq's first post-occupation government, and oversaw the disbursement of $12bn in cash in reconstruction funds in the months after the invasion... Mr Waxman said that, in a 13-month period, the US government had shipped 360 tonnes of cash to Iraq. "Who in their right minds would send 360 tonnes of cash into a war zone? But that's exactly what [this government] did.'"

Speculator Watch:

February 9 - Bloomberg (Elizabeth Hester and Jenny Strasburg): "Shares of Fortress Investment Group LLC, the first U.S. manager of private-equity and hedge funds to go public, soared 68 percent in their initial day of trading. The IPO, which raised $634.3 million, gives individual investors access to Fortresss profits from managing funds that are restricted to millionaires and institutions. It made the firm's three founders billionaires and may encourage rival managers to sell shares to the public."

February 8 - Financial Times (Paul J Davies): "Credit-focused hedge funds have had a strong start to the year with returns in January alone put at 1-2 per cent, but many are beginning to tell investors that this year is unlikely to be as stellar as 2006. Returns are forecast to be about 10 per cent following a strong 2006 that saw performance outstrip expectations with many funds making percentages in the high-teens or low 20s... The use of leverage in an environment of declining yields helped boost returns during a year in which many commentators had expected the credit cycle to turn. However, this leverage has also raised fears that when the cycle does turn it could do so sharply as hot money moves out, removing a large chunk of liquidity. 'No one seems to be under the illusion that repeating 2006's performance will be an easy task,' said Stephen Dulake, European credit analyst at JPMorgan. 'Target returns, based on our information, seem to be about 10 per cent...'"

February 7 - Bloomberg (Andrei Postelnicu): "New hedge funds around the world raised less money in 2006 for the second year in a row because of a rout in emerging markets and the collapse of Amaranth... The 86 largest new hedge funds gathered $31 billion, compared with 82 funds and $34 billion in 2005, and 81 funds and $40 billion in 2004, according to...HedgeFund Intelligence's Absolute Returns magazine..."

February 6 - Financial Times (Bertrand Benoit and Krishna Guha): "Germany has put hedge funds at the top of its agenda for this week's meeting of the Group of Seven finance ministers in Essen, a senior finance ministry official said...though he stressed Berlin wanted more transparency, not more regulation, of the sector. Germany, which holds the Group of Eight presidency this year, wants to start a debate about how to improve regulators' knowledge of hedge fund activities, which it thinks present a potential threat to the stability of the international financial system. "We want to put the facts on the table, see whether we all agree on them, how the participants weigh the possible risks and start a discussion on how we want to go ahead," Thomas Mirow, deputy German finance minister said."

Subprime in Focus:

I've long argued that Unlimited Finance is the Bane of Free-Market Capitalism. Of course, such a notion sounds absurd as the world frolics in a Sea of Global Credit and Liquidity Excess. To most, "bull markets" and various other asset inflations are proof positive of the economic system's underlying soundness.

The subprime mortgage space is only the latest example of the perils of profligate finance. Remembering back to the tech/telecom Bubble, it was a case of massive liquidity excess (certainly including speculative flows) promoting over/mal-investment, profligacy, chicanery and fraud. Yet latent fragility was allowed to compound as an onslaught of late-cycle speculative finance artificially inflated industry profits and cash-flows. The eventual bursting of the speculative technology Bubble then abruptly and radically altered industry liquidity, profits and Credit standing. A system that had so carelessly nurtured companies' dependency to easy access to marketplace finance summarily cut off the lifeline.

Dynamics within the Expansive Mortgage Finance Bubble are thus far - and not surprisingly - following a different course, a topic certainly worthy of further attention after this week's announcements from HSBC and New Century Financial. My focus will remain the "big picture" (broader Credit, market and economic impacts), a luxury I'm content with knowing that others (certainly including the great Jim Grant) are doing an most admirable job covering subprime industry developments.

The "blow-off" stage of the Mortgage Finance Bubble led to unprecedented excesses, no doubt about that. Scores of uninformed borrowers with meager incomes and little savings were enticed into the responsibilities of homeownership by a combination of surging home price inflation and offers of ultra-low "teaser" and/or adjustable-rate mortgages with minimal down-payments (compliments of the Greenspan Fed). Many loan originators were enticed into lending to poor Credits for the easy profits garnered by selling these loans to Wall Street (for pooling and securitizing). These pool operators were attracted to these suspect mortgages because of the insatiable demand for higher-yielding "structured" products.

Bubble dynamics were driven by the Fed, borrower, originator, Wall Street financial "alchemist," and the speculator/investor community. And I would further argue that the massive recycling of U.S. Current Account Deficits and global dollar liquidity flows back into Treasuries, agencies and investment-grade securities played a decisive role in distorting securities prices and returns, squeezing the speculator community into a self-reinforcing (and ongoing) Bubble in risky Credits.

In the context of Credit system blunders, 2006 was a historic doozy. After several years of increasingly egregious excess, the mortgage industry proceeded to open its arms extra wide. The marketplace welcomed millions to refinance problematic mortgages that were in process of payments resets, in many cases significantly higher. Never have so many atrocious Credit risks been offered such a handsome opportunity (to refinance and/or take our second mortgages). Clearly, many slipshod originators catered to these suspect Credits, and this dynamic helps explain why an extraordinarily large number of these ("bottom of the barrel") new mortgages - "Vintage 2006" - have quickly turned delinquent or fallen into default.

Last year's extreme mortgage Credit system largesse can be explained by a multitude of "Unlimited Finance"-related factors including massive mortgage industry overcapacity, the enormous scope of the leveraged speculating community, overzealousness throughout "structured finance," marketplace mispricing of mortgage risk and, certainly, perceptions that the Bernanke Fed would hastily initiate an easing cycle come the onset of housing market weakness.

I found yesterday's market's reaction to the HSBC and New Century subprime bombshells intriguing. Outside of the subprime lenders and the broader financial sector, the market brushed off the news. Goldman Sachs even trade up on the day, while the Morgan Stanley Retail index closed at an all-time record high. The Bank index was down only slightly from Wednesday's record high. The Utilities closed at a record high, and the Cyclicals were down only fractionally from Wednesday record. The small caps and midcaps closed at an all-time high, while the S&P500 only slightly off its six-year high. Tech stocks posted decent gains during the session.

I think I follow the basis for marketplace complacency. The subprime market is only a small segment of a huge mortgage market, and there is as yet little indication of serious impending mortgage problems outside of the riskiest Credits. And I do agree that there are some key company and industry "specific" issues. For one, subprime had degenerated into the Ultimate Credit Cesspool.

A strapped subprime borrower with payments about to reset higher (and with minimal or negative home equity) is at the mercy of the marketplace to refinance and stay afloat. Akin to the leveraged telecom company in 2001/02, the marketplace closing the loan window is immediately catastrophic for the subprime borrower. Again corresponding to the telecom debt bust, tightening Credit conditions quickly lead to escalating Credit losses and only more Credit tightening and losses.

At the same time, however, the vast majority of the mortgage market operates with risk essentially nationalized (through GSE and govt. guaranties). Notably, benchmark GSE MBS spreads barely budged yesterday from quite narrow levels and ended the week little changed. Employment is strong and incomes are growing robustly, underpinning the capacity of existing borrowers to make payments and new borrowers to sustain inflated home prices. In contrast to subprime, most "prime" mortgage borrowers are not today at the mercy of the marketplace. The vast majority have not fallen behind on their payments; Credit conditions have not been forced tighter; new "prime" mortgage finance remains readily available; and the mortgage market continues to abound with cheap ("unlimited") finance. For a large portion of the mortgage market, things haven't been much better.

Interestingly, the markets weren't as cavalier today. With Fed Presidents Poole, Pianalto, and Fisher all sporting rather hawkish demeanors and warning of the possibility that the Fed has more work to do, the marketplace was on edge. The specter of heightened consumer Credit and lender problems (on the margin) coupled with upward pressure on market yields is unsettling. This is not the bullish scenario envisioned, but neither is it the conventional bearish view.

The trend that emerged last year - trouble at the fringe of housing and mortgages actually promoting heightened excess in Corporate Credits - is still in play. Junk bond spreads narrowed yesterday and for the week, while risk premiums outside of lower-tier mortgages generally remain near historic lows. Importantly, mortgage developments so far have been a non-event with regard to general marketplace liquidity. Combined total mortgage, corporate, financial sector and global debt growth remain more than adequate - that is as long as the unfolding subprime crisis doesn't significantly escalate.

Subsequent to this week's developments, the markets should begin to demonstrate heightened concerned for the financial ramifications of imploding subprime lenders. To this point, failures have been small players with minimal market impact. If major operators find themselves confronting the traditional subprime liquidity squeeze, this so far isolated Credit event could pose unknown contagion risk. One or more major failures would likely prove a meaningful blow to the ABS and Credit derivatives market. Additional uncertainty with respect to the degree of leveraged speculator exposure to subprime Credits, Credit indices and other derivatives might also be expected to weigh on the markets. Any general tightening in the CDO market would likely mark a key inflection point in marketplace liquidity, with major systemic ramifications.

The bottom line is that the markets are now likely facing a bout of heightened uncertainty. The Credit default swap, CDO, and "credit arbitrage" markets have grown tremendously since the last bout of liquidity ambiguity. How these markets will operate in the event of some general financial sector tumult is all too unclear. That the "liquidity" markets are these days extraordinarily bifurcated between the loose corporate and "prime" mortgage arena and the increasingly tight "non-prime" creates significant uncertainty.

The expectation has been that tightened mortgage Credit conditions would sway the Fed into easing. But today's comments from Fed officials certainly lead one to believe that they are content to focus more on upside liquidity risks, while allowing subprime excesses to, in the words of Mr. Poole, "come home to roost." Hopefully the Fed demonstrates resolve, as the most problematic systemic fragilities are being exacerbated by ongoing Unlimited Finance available throughout markets in corporate Credits, securities leveraging, and for (over)financing asset markets globally.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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