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February 16, 2007

Subprime in Context
by Doug Noland

For the week, the Dow gained 1.5% and the S&P500 1.2%. Economically-sensitive issues continue to be strong. The Transports jumped 3.8%, increasing y-t-d gains to 12.0%. The Morgan Stanley Cyclical index rose 3.2%, increasing 2006 gains to 8.4%. The Morgan Stanley Consumer index gained 1.3%, and the Utilities added 0.2%. The broader market rose to new record highs. The small cap Russell 2000 gained 1.4% (up 3.9% y-t-d) and the S&P400 Mid-Cap index rose 1.6% (up 6.8% y-t-d). The NASDAQ100 increased 2% and the Morgan Stanley High Tech index 2.3%. The Semiconductors rose 2.2%. The Street.com Internet Index gained 1.5% (up 4.9% y-t-d), and the NASDAQ Telecom index jumped 2.6% (up 5.3% y-t-d). The Biotechs dipped 0.5%. The Broker/Dealers added 1.2% (up 5.0% y-t-d), and the Banks rallied 2.0% (up 2.6% y-t-d). With bullion up $2.30, the HUI gold index gained 2.1%.

Two-year government yields dropped 8 bps to 4.83%. Five-year yields declined 10 bps to 4.68%, and 10-year Treasury yields fell 9 bps to 4.69%. Long-bond yields declined 8 bps to 4.79%. The 2yr/10yr spread ended the week inverted 14 bps. The implied yield on 3-month December '07 Eurodollars sank 10.5 bps to 5.045%. Benchmark Fannie Mae MBS yields declined 6 bps to 5.77%, this week underperforming Treasuries. The spread on Fannie's 5 1/4% 2016 note was little changed at 33, and the spread on Freddie's 5 1/2% 2016 note little changed at 32. The 10-year dollar swap spread declined 0.7 to 51.1. Corporate bonds rallied in line with Treasuries, with junk spreads widening slightly this week.

Investment grade issuers included Costco $2.0 billion, JPMorgan Chase $1.0 billion, Citigroup $1.0 billion, and Comerica $500 million.

Junk issuers included Rite Aid $1.0 billion, and Jarden $650 million.

Convert issuers included Illumina $350 million, and Anixter $300 million.

International issuers included ATF Capital $450 million.

February 16 - Bloomberg (Jody Shenn): "A derivatives index used to bet on bonds backed by the riskiest U.S. mortgages fell for the fourth straight weekly decline as more lenders reported losing money... The tumble is being exacerbated by hedge funds using the index to make bearish bets and a dearth of investors willing to use it to make bullish bets..."

February 16 - Bloomberg (Shannon D. Harrington): "The perceived risk of U.S. corporate bonds fell for a sixth straight week after Federal Reserve Chairman Ben S. Bernanke indicated the economy is growing and inflation is under control, according to an index of credit-default swaps. The [CDS price] drop, which indicates improvement in the perception of corporate credit quality, was the biggest in the Dow Jones CDX North America Crossover Index since June."

February 15 - Bloomberg (Shannon D. Harrington and Hamish Risk): "The perceived risk of owning U.S. and European corporate bonds fell to a record low for the fifth day this month amid speculation that rising U.S. mortgage delinquencies will be contained, according to an index of credit-default swaps."

February 14 - Bloomberg (Mark Pittman): "Sarbanes-Oxley...is prompting more companies to keep secrets in the bond market. Siemens AG, Australian retailer Woolworths Ltd., Miller Brewing Co....and at least 100 other companies are selling bonds that aren't registered with the Securities and Exchange Commission instead of debt that requires more disclosure. The securities increased 50 percent in the past two years, five times faster than the rest of the U.S. market, according to data compiled by Lehman Brothers Holdings Inc. 'It's a darker world of the bond market,' said Matthew Eagan, who helps oversee $97 billion in fixed income, including unregistered bonds, at Loomis Sayles...'It's off the radar.'"

Japanese 10-year "JGB" yields added one basis point this week to 1.70%. The Nikkei 225 surged 3.4% (up 3.8% y-t-d). German 10-year bund yields declined 4 bps to 4.05%. Emerging markets were by and large impressive. Brazil's benchmark dollar bond yields sank 13 bps this week to a record low 5.85%. Brazil's Bovespa equities index jumped 3.5% to a new record high (up 3.1% y-t-d). The Mexican Bolsa gained 2.1% to a new record, increasing y-t-d gains to 7.7%. Mexico's 10-year $ yields dropped 11 bps to 5.61%. Russia's 10-year Eurodollar yields declined 3 bps to 6.71%. India's Sensex equities index declined 2.0% (up 4.1% y-t-d). China's Shanghai Composite index surged 9.8% to a new record, increasing 2007 gains to 12.1%.

Freddie Mac posted 30-year fixed mortgage rates added 2 bps last week to 6.30% (up 2 bps y-o-y). Fifteen-year fixed mortgage rates added one basis point to 6.03% (up 12 bps y-o-y). And one-year adjustable rates increased 3 bps to 5.52% (up 16 bps y-o-y). The Mortgage Bankers Association Purchase Applications Index dipped 1% this week. Purchase Applications were up 1.6% from one year ago, with dollar volume increasing 5.5%. Refi applications rose 4.5%. The average new Purchase mortgage declined to $237,000 (up 3.4% y-o-y), and the average ARM increased to $380,800 (up 13.0% y-o-y).

Bank Credit jumped $25.3 billion (week of 2/7) to a record $8.355 TN. Bank Credit has expanded at a 6.1% annualized rate y-t-d (6 wks), with a one-year expansion of $763 billion, or 10.0%. For the week, Securities Credit increased $4.1 billion. Loans & Leases rose $21.1 billion to a record $6.129 TN. Commercial & Industrial (C&I) Loans expanded 11.6% over the past year. For the week, C&I loans increased $5.7 billion, and Real Estate loans increased $6.4 billion. Bank Real Estate loans expanded 14.3% over the past year. For the week, Consumer loans increased $2.3 billion, while Securities loans dipped $0.1 billion. Other loans jumped $6.8 billion. On the liability side, (previous M3) Large Time Deposits added $0.4 billion.

M2 (narrow) "money" was little changed at a record $7.093 TN (week of 2/5). Narrow "money" expanded $378 billion, or 6.0%, over the past year. M2 has expanded at 7.9% pace during the past 20 weeks. For the week, Currency dipped $1.0 billion, while Demand & Checkable Deposits jumped $22.7 billion. Savings Deposits fell $23.8 billion, while Small Denominated Deposits added $2.3 billion. Retail Money Fund assets slipped $0.9 billion.

Total Money Market Fund Assets (reported by the Investment Company Institute) rose $9.8 billion last week to a record $2.393 Trillion. Money Fund Assets inflated $355 billion over 52 weeks, or 17.4%. Money Fund Assets have expanded at an 20.4% rate over the past 20 weeks.

Total Commercial Paper surged $21.4 billion last week to a record $2.033 Trillion, with a y-t-d gain of $58.2 billion (21.9% annualized). CP has increased $355 billion, or 21.1%, 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 $19 billion. Year-to-date total ABS issuance of $79 billion (tallied by JPMorgan) is running behind the $88 billion from comparable 2006. Year-to-date Home Equity ABS issuance of $41 billion is much slower than last year's comparable $63 billion. Year-to-date US CDO issuance of $29 billion is slightly below comparable 2006.

Fed Foreign Holdings of Treasury, Agency Debt jumped $13.4 billion last week (ended 2/14) to a record $1.811 Trillion, with a y-t-d gain of $59.0 billion (25% annualized). "Custody" holdings were up $254 billion y-o-y, or 16.3%. Federal Reserve Credit last week increased $5.7 billion to $847 billion. Fed Credit was up $31.3 billion y-o-y, or 3.8%.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $824 billion y-o-y (19.8%) to a record $4.990 Trillion.

February 16 - Bloomberg (Sam Nagarajan): "India's foreign-exchange reserves rose $5.03 billion in the week ended Feb. 9, the most in almost two years, to a record $185.08 billion..."

Currency Watch:

February 15 - Bloomberg (Kevin Carmichael): "The U.S. attracted the least investment in its long-term assets in December in almost five years as foreigners sold stocks and Americans sent a record amount of money abroad. Total purchases of equities, notes and bonds dropped to a net $15.6 billion, from a revised $84.9 billion in November, the Treasury Department said today in Washington. Including short-term securities, such as Treasury bills and so-called non-market transactions such as stock swaps, foreigners sold a net $11 billion."

The dollar index this week fell 0.9% to 83.99. On the upside, the New Zealand dollar gained 2.1%, the Norwegian krone 2.1%, the Japanese yen 2.0%, and the Australian dollar 1.4%. On the downside, the Swedish krona slipped 0.4%, the Jamaica dollar 0.2%, and the South Korean won 0.2%.

Commodities Watch:

February 14 - Bloomberg (Alan Bjerga): "Ethanol will consume more than 30% of the U.S. corn crop annually over the next decade, compared with current usage of about 20 percent, according to a 10-year government estimate of farm production and prices."

For the week, Gold added 0.3% to $669.15 and Silver 0.6% to $13.975. Copper rallied 4.7%. March crude declined 68 cents to $59.21. February Gasoline rose 1.6%, while February Natural Gas dropped 4.6%. For the week, the CRB index added 0.5% (down 0.2% y-t-d), while the Goldman Sachs Commodities Index (GSCI) was little changed (up 0.6% y-t-d).

Japan Watch:

February 15 - Bloomberg (Lily Nonomiya): "Japan's economy grew at the fastest pace in almost three years as consumer spending rebounded and business investment jumped, stoking speculation the central bank may raise interest rates. Gross domestic product in the world's second-largest economy expanded at an annual 4.8 percent pace in the three months ended Dec. 31..."

February 13 - Bloomberg (Lily Nonomiya): "An annual government survey will probably show land prices in some commercial areas of Tokyo rose as much as 40 percent last year, according to...Shukan Diamond, a weekly business magazine."

February 15 - Financial Times (Mariko Sanchanta): "Shares of Japanese real estate stocks have reached levels not seen since the country's asset bubble era, stoking concerns that the property sector is becoming overheated amid an unprecedented inflow of capital. Shares of Mitsui Fudosan, Japan's leading property company, surged 7 per cent yesterday to close at Y3,440, surpassing a lifetime high reached in December 1989. Shares of peers Mitsubishi Estate and Sumitomo Realty & Development reached lifetime highs early last month. 'Abnormally low interest rates are being used as justification for exceptionally high valuations,' said Peter Tasker, analyst at Dresdner Kleinwort. 'The result has been a parabolic ascent, similar to that [of] Nasdaq between 1996 and 2000.' Not only have individual and foreign investors been active buyers in recent months but many pension funds have increased their allocations to property, creating a wave of money targeting the sector. The Tokyo Stock Exchange Real Estate Sector index returned 13.4 per cent in 2006, dwarfing the 1.9 per cent returned by the broader Topix index."

China Watch:

February 12 - Bloomberg (Nipa Piboontanasawat and Yanping Li): "China's trade surplus widened to $15.9 billion in January as exports gained by the most in 17 months, adding pressure on the government to let the yuan rise faster. The gap...swelled by 65% from a year earlier."

February 16 - Bloomberg (Nipa Piboontanasawat): "China ordered banks to set aside more money as reserves for the fifth time in eight months to cool inflation and investment... Lenders must put aside 10% of deposits...up from 9.5%. Central bank Governor Zhou Xiaochuan is concerned that cash from a record trade surplus is stoking excess investment, raising the risk of asset bubbles and accelerating inflation."

February 14 - Bloomberg (Mark Drajem): "China passed Mexico as the second-largest U.S. trading partner in 2006, while the U.S. trade deficit with the Asian nation reached a record $232.5 billion. The China deficit was 30 percent of the total U.S. trade deficit with all nations, which reached $763.6 billion last year, a record for the fifth straight year..."

February 13 - Bloomberg (Josephine Lau): "Lending to China' real estate sector grew the most among all mid- to long-term bank loans made last year, the China Securities Journal said, citing a report by a central bank official. Real estate loans rose 41.9 percent to 335.9 billion yuan ($43.3 billion) last year..."

February 14 - Bloomberg (Yanping Li and Nipa Piboontanasawat): "China's January money supply growth slowed after the central bank tried to cool lending to stem inflation and avoid creating what it calls an asset bubble in the world's fourth-largest economy. M2...rose by 15.9% to 35.2 trillion yuan ($4.5 trillion), after gaining 16.9% in December..."

India Watch:

February 12 - Bloomberg (Cherian Thomas and Kartik Goyal): "India's industrial production surged 11.1% in December, more than expected, adding pressure on the central bank to raise interest rates."

February 16 - Bloomberg (Sam Nagarajan): "Money supply in India expanded at the fastest pace in more than nine years... The M3 measure of money supply increased 21.3% in the [2-wk] period from a year earlier... Loans given by Indian banks increased 296.24 billion rupees ($6.7 billion), or 20.3 percent, in the two weeks ended Feb. 2..."

February 15 - Financial Times (Jo Johnson): "New Delhi swung into inflation fire-fighting mode yesterday with a government ban on wheat exports throughout 2007, less than 24 hours after India's central bank tightened monetary policy for the second time in two weeks. 'The purpose of the ban is to keep prices under check as the procurement season is just starting. It will be effective until at least the 31 December,' said Shipra Biswas...[of] the commerce ministry. The jump in prices of essential foods, such as wheat, pulses and onions, has been a significant factor in pushing India's wholesale price inflation to a more than two-year high of 6.6 per cent. Wheat prices alone have risen 11.7 per cent year-on-year."

Asia Boom Watch:

February 14 - Financial Times: "From Seoul real estate to Vietnamese stocks and Chinese art, Asian asset prices are soaring. Are these bubbles waiting to pop? The liquidity outlook suggests otherwise. Relatively low interest rates, strong currencies and rapid money growth point to more funds piling into these assets. Asian trade surpluses are averaging about $30bn a month, Morgan Stanley calculates, while annual money supply growth is about 16 per cent. More firepower is coming. The Bank of Korea and the People's Bank of China are two of the bigger Asian central banks planning to diversify their massive foreign exchange reserves. Pension funds, too, are plotting more aggressive investment strategies. External liquidity, however, is more fickle. Recent flows of funds from China have contributed to two weeks of outflows from Asian funds, according to Emerging Portfolio Fund Research; US equity funds have benefited, suggesting a change in the way the wind is blowing. Asian countries also face the risk of policy blunders, particularly as central bankers start to raise rates."

February 15 - Bloomberg (Theresa Tang and Chinmei Sung): "Taiwan's economy, the fifth largest in Asia, grew at a faster-than-expected pace in the fourth quarter after stock market gains and a recovery from credit-card defaults boosted consumption. Gross domestic product rose 4% from a year earlier..."

February 14 - Bloomberg (Seyoon Kim): "South Korea's jobless rate remained at a four-year low in January as builders and finance companies hired workers, which may help stoke consumer spending in Asia's third-largest economy. The unemployment rate was unchanged at 3.3 percent..."

February 14 - Bloomberg (Shamim Adam): "Singapore raised its growth forecast for this year after the economy expanded in the fourth quarter at more than double the pace of the previous three months. Southeast Asia's fourth-largest economy may grow 4.5 percent to 6.5 percent in 2007..."

February 16 - Bloomberg (Aloysius Unditu and Arijit Ghosh): "Indonesia's economy grew at the fastest pace in two years in the fourth quarter on rising consumer demand and exports. Southeast Asia's largest economy expanded 6.1% in the three months ended Dec. 31..."

February 15 - Bloomberg (Clarissa Batino): "Philippine commercial bank loan growth quickened for a second month in three in December... Lending rose 10.1 percent from a year earlier..."

Unbalanced Global Economy Watch:

February 14 - Bloomberg (Daniel Taub): "Office rents rose an average 12% around the world last year, driven by worldwide economic expansion, with Mumbai increasing enough to make it the world's fifth most expensive city, a Cushman & Wakefield study found. That compares with a 4.3 percent increase in 2005..."

February 14 - Bloomberg (Greg Quinn): "Canadian existing-home sales rose to a record in January, boosted by warm weather and job creation... Sales in 25 major markets rose 3.4 percent to a seasonally adjusted 30,359 homes in January..."

February 14 - Financial Times (Gerrit Wiesmann): "The European economy grew faster than expected in the run-up to Christmas, outpacing fourth-quarter growth in the US and raising the likelihood of further interest rate rises from the European Central Bank. Eurozone gross domestic product rose 0.9 per cent in the last quarter... The region's gross domestic product growth hit 2.7 per cent last year..."

February 16 - Bloomberg (Jennifer Ryan): "U.K. wage settlements reached the highest in eight years last month as accelerating economic growth strengthens the bargaining power of workers... The median wage increase rose to 3.5 percent in the three months through January..."

February 12 - Bloomberg (Peter Woodifield): "The price of prime London homes rose at the fastest pace in at least 31 years last month as wealthy European, Indian and Middle Eastern buyers competed for houses and apartments... Prices of houses in central London valued at about 3 million pounds ($5.8 million) and apartments costing more than 1.5 million pounds rose % in January, London-based Knight Frank LLC...said..."

February 15 - Bloomberg (Brian Swint and Jennifer Ryan): "U.K. retail sales unexpectedly fell in January by the most in four years and a survey indicated house price growth slowed, suggesting a surprise interest-rate increase discouraged spending. Sales declined 1.8 percent, the biggest drop since January 2003..."

February 13 - Bloomberg (Simone Meier): "German economic growth unexpectedly accelerated in the fourth quarter as exports boomed and consumers increased spending ahead of a sales-tax increase. The economy grew 0.9% in the fourth quarter from the third..."

February 14 - Bloomberg (Andreas Cremer): "German companies are more optimistic on hiring and spending than at any time since 1991, the DIHK industry and trade chambers said, citing the 'staying power' of an export-led upswing in Europe's biggest economy."

February 13 - Bloomberg (Steve Scherer): "Italy's economy unexpectedly grew at its fastest pace in seven years in the fourth quarter as global growth and higher employment drove exports and consumer spending. Gross domestic product rose 1.1 percent from the third quarter..."

February 13 - Bloomberg (Ben Sills): "Spanish economic growth accelerated at the fastest annual pace in more than five years in the fourth quarter as higher exports supplemented domestic spending. Europe's fifth-largest economy expanded 4% from a year earlier..."

February 13 - Bloomberg (Maria Levitov): "Russia's trade surplus grew 15% last year as the world's biggest energy exporter benefited from oil and gas sales. The surplus ballooned to $164.4 billion from $142.8 billion a year earlier..."

February 15 - Bloomberg (Maria Levitov): "Russia's government is creating a development bank to channel $35 billion into infrastructure, power generation, agriculture, special economic zones and other areas through 2011, Vedomosti said."

February 13 - Sydney Morning Herald: "National Australia Bank (NAB) survey of 400 businesses in January 2007 has reported wages growth of 5.25%, the fastest rate since 1998. Another survey by St George Bank and the Australian Chamber of Commerce & Industry recorded the strongest quarterly growth in the 12-year history of that research."

February 15 - Bloomberg (Tracy Withers): "New Zealand house sales rose in January, adding to prospects the central bank will raise interest rates to a record in March. House sales rose 19 percent to 7,566 in January from the year-earlier month..."

Latin American Boom Watch:

February 16 - Bloomberg (Thomas Black): "Mexico's economic growth weakened in the fourth quarter, slowing for a third straight quarter, after automobile output slumped and U.S. demand for exports fell. Gross domestic product...grew 4.3%, down from 4.6% in the third quarter..."

February 15 - Bloomberg (Fabio Alves): "Brazilian retail sales rose in 2006 from a year earlier as lower lending rates fueled job and wage growth, prompting consumers to take out loans to buy more cars, furniture, appliances and other goods. Retail, supermarket and grocery store sales, as measured by units sold, rose 6.2 percent in the 12 months ended in December..."

February 15 - Bloomberg (Bill Faries): "Argentina's economy, the second largest in South America, expanded 8.5 percent in 2006, the National Statistics Institute reported."

February 16 - Bloomberg (Guillermo Parra-Bernal and Alex Kennedy): "Venezuela President Hugo Chavez's plan to curb inflation by lopping three zeros from the currency may backfire because the move fails to address production bottlenecks that are pushing prices higher, economists said."

Central Banker Watch:

February 15 - Bloomberg (Matthew Brockett): "The European Central Bank said 'strong vigilance' is required to ensure inflation doesn't accelerate, signaling it will raise interest rates next month. 'Strong vigilance remains of the essence so as to ensure that risks to price stability over the medium term do not materialize...The ECB's monetary policy remains accommodative, with the key ECB interest rates still at low levels.'"

February 15 - Bloomberg (Robin Wigglesworth): "Norges Bank Governor Svein Gjedrem said interest rates are set to rise as a labor shortage worsens and the housing market verges on a state of 'euphoria.' Speaking in his annual address...Gjedrem reiterated that Norges Bank envisaged 'a gradual interest rate increase toward a more normal level of a little more than 5 percent' in the benchmark rate from the current 3.75 percent."

February 15 - Bloomberg (Jonas Bergman): "Sweden's central bank raised its benchmark interest rate for the seventh time in 13 months and said that it will only increase once more this year as inflation remains subdued. Bonds surged and the krona fell. The repurchase rate was raised a quarter-point to 3.25 percent..."

Bubble Economy Watch:

February 15 - Bloomberg (Steve Matthews): "Employers are having more trouble finding qualified workers, even as business conditions show signs of slowing, according to a survey of U.S. chief executives... Forty-three percent of the 76 executives polled by the...Business Council said they are having trouble finding workers, up from a quarter a year ago. Engineers, scientists, managers, production workers and skilled crafts workers are among those in short supply."

February 15 - Bloomberg (Alan Bjerga): "Ethanol demand pushed up prices and drove down inventories for U.S. corn last year, increasing the crop's value 52 percent... The estimated worth of all crops, led by corn, rose to a record. The U.S. Department of Agriculture pegged the value of all crops in 2006 at $122.4 billion, up 15 percent from a revised $106.1 billion in 2005."

February 14 - Bloomberg (Chris Dolmetsch): "New Jersey Transit, the largest statewide public transportation agency in the U.S., will increase bus and train fares by an average of 9.6 percent in June to fill a $60 million budget shortfall."

Financial Sphere Bubble Watch:

February 12 - Financial Times (Paul J. Davies): "Investors are increasingly purchasing ultra-risky slices of complex derivatives known as 'synthetic' collateralised debt obligations (CDOs), helping to double the volume of issuance of such deals last year... Sales of public and private synthetic CDOs grew to $450bn in notional terms last year compared with $224bn in 2005, according to data from Creditflux... Synthetic CDOs are a twist on traditional CDOs, which pool bonds, loans or other kinds of debt instrument and sell notes representing different levels of risk. The defining features of synthetic deals is that they are backed by derivatives rather than actual cash instruments. In many cases banks sell only part of the potential debt in a structure to investors, with the rest remaining unfunded (or theoretical in nature)... Michael Peterson, managing editor at Creditflux, said that risk-weighted synthetic CDO volumes were growing much faster than notional volumes, which showed that more risk was being sold into the market. 'There are more junior tranches being sold and many more equity tranches particularly, especially towards the end of the year...Arrangers are having some success in reaching new kinds of investors.' On the risk-weighted basis - where the value of a CDO is calculated by multiplying the tranches by their risk weight - volumes grew from $648bn to $1,554bn.'"

Mortgage Finance Bubble Watch:

February 14 - Bloomberg (Jody Shenn): "Standard & Poor's said it's considering downgrades on 18 low-rated bonds from 11 separate securitizations of U.S. home loans last year because of a high level of early delinquencies. The underlying loans of some of the bonds have yet to be sold at losses following foreclosures, making today's alert a change from past practice... The types of loans at risk are so-called subprime and Alt-A mortgages, as well as some home equity loans. The bonds 'may be showing weakness because of origination issues, such as aggressive residential mortgage loan underwriting, first-time home-buyer programs, piggyback second-lien mortgages, speculative borrowing for investor properties, and the concentration of affordability loans,' S&P said."

Real Estate Bubbles Watch:

February 15 - Bloomberg (Kathleen M. Howley and Brian Louis): "Home prices fell in half of U.S. cities in the fourth quarter...the National Association of Realtors said. The median price for a single-family home fell in 73 of 149 metropolitan areas... The national median price for a previously owned house was $219,300 in the fourth quarter, down 2.7 percent from a year earlier..."

February 14 - Bloomberg (Daniel Taub): "The number of homes sold in Southern California fell 17 percent last month to the lowest level for a January in nine years, mirroring a national slowdown in the sale of houses and condominiums, DataQuick... said. A total of 18,128 new and existing single-family houses and condominium units were sold in Los Angeles, Riverside, San Diego, Ventura, San Bernardino and Orange counties last month, down from 21,895 a year earlier... Last month's sales count was the lowest for any January since 1998, when 17,692 homes were sold."

February 14 - Bloomberg (Sharon L. Crenson): "Home sales dropped 22 percent last year in the Hamptons, New York's summer resort haven for the rich and famous, as potential buyers waited to see if prices would fall, Town & Country Real Estate said."

Energy Boom and Crude Liquidity Watch:

February 13 - Bloomberg (Christopher Martin): "Oil and natural gas production costs have jumped 53% in the past two years, delaying some new projects, according to Daniel Yergin, chairman of Cambridge Energy Research Associates. The average cost to drill a new project has increased because of high offshore rig, shipbuilding and labor expenses, and the increases were greatest for deepwater projects in the Gulf of Mexico and West Africa... Costs will continue to rise for the next 12-18 months, he said."

February 14 - Bloomberg (Christopher Martin and Mathew Carr): "First Reserve Corp., the biggest private equity firm in the energy industry, expects a fivefold gain from rotting chickens and cow dung. That assumption is looking less preposterous. A consensus is emerging for U.S. legislation that encourages trading of credits earned from projects that reduce emissions of greenhouse gases and curb global warming. 'Giddy returns' are probable, predicts First Reserve Director Glenn Payne, who says the first sign of a new law will lead to a quintupling of credit values to around $19 per ton of carbon dioxide, from $3.50 now... 'Companies like First Reserve that get in now can make double or triple-digit returns annually,' said Josh Margolis, director of emissions trading at Cantor Fitzgerald LP in New York."

February 15 - Financial Times (Chris Nuttall): "The amount of electricity consumed by computer servers has doubled in five years and will increase another 75 per cent by 2010, according to a report published...by an energy efficiency expert... The total server electricity bill was about $7.3bn, of which the US made up $2.7bn."

Climate Watch:

February 15 - Bloomberg (Subramaniam Sharma): "India's monsoon, the South Asian nation's biggest source of water for irrigation, may be disrupted by the melting of glaciers and snow on the Himalayas, the world's highest mountain range, because of global warming."

Fiscal Watch:

With one-third of the fiscal year now completed, y-t-d federal Receipts are running 9.7% ahead of comparable 2006. Corporate tax receipts are running 21.8% ahead and individual income tax 12.6% ahead of last year's level. Indicative of the ongoing systemic Credit boom, y-t-d receipts are running 21% above comparable 2005. Fiscal 2007 y-t-d Spending is 2.1% ahead of 2006's level (up 9.7% from 2005).

Speculator Watch:

February 12 - Financial Times (Stacy-Marie Ishmael): "Funds continue to pour into the fund of hedge funds industry in spite of slowing investment performance, a survey has found. The industry grew by 29 per cent last year, drawing in $183,000m of assets from retail and institutional investors, according to InvestHedge... The growth was more than double the 13 per cent growth of 2005... The survey identified 142 'billion dollar' funds, up 30 per cent from 135 in 2005. Of these, 21 funds of funds have more than $10bn in assets under management."

February 15 - Financial Times (James Mackintosh): "Convertible arb has returned from the dead. Two years after investors abandoned one of the pillars of the traditional hedge fund portfolio, convertible bond arbitrage is once again attracting interest - and billions of dollars of new money. Hedge funds specialising in convertible bonds produced their best performance since 2000 last year, returning as much as the previous three years combined. According to the Credit Suisse/Tremont hedge fund index, convertible arbitrage was the fourth-best performing strategy, producing an average return of 14.3 per cent.... A survey by Deutsche Bank last month found 'convert arb' has moved from the least-liked strategy among investors to the fourth most popular in the space of 18 months. The bank predicts a 12 per cent jump in assets this year as investors such as funds of funds, wealthy individuals and institutions return to the style."

February 14 - Bloomberg (Shannon D. Harrington): "Investment banks, insurers and hedge funds including Aladdin Capital Management LLC and Deerfield Capital LP may create about two dozen new companies to manage portfolios of credit-default swaps, according to Moody's... Several of the so-called credit-derivative product companies may get the ratings they need to operate by mid-year, Moody's said... The ratings would allow them to start investing in credit-default swaps... The credit-derivative product companies, or CDPC, are seeking to tap into a market where outstanding contracts surged to more than $26 trillion last year. The new entities are driven partly by the ability to secure top AAA ratings, which allow them to sell protection without having to post collateral and gives investors on the other side of the trade counterparties with the highest ratings."

Subprime in Context:

The profit motive is fundamental to Capitalism. Not well understood, vulnerability to Credit-induced profit distortions is a Capitalist system's Achilles heel. To be sure, profits malformations develop with differing severities throughout the Economic Sphere. Yet, within the Financial Sphere, grossly inflated financial profits over the life of the Credit Cycle evolve to the point of commanding the real economy and imperiling systemic stability.

More specifically, major Credit booms are dictated by unyielding financial sector expansion, inflated profits, and resulting outsized power and influence. The longer they are accommodated the more entrenched they become. Coupling the impacts of surging financial earnings and pervasive asset inflation, Credit booms generate a "profits" bonanza for those fortunate enough to be employed in key industries - and certainly provide a windfall for the owners, operators, financiers, and brokers of inflating assets. The interplay between Financial Sphere profits and asset inflation creates an increasingly powerful impetus for problematic resource misallocation and economic maladjustment.

Subprime lending is today a microcosm of our financial and economic systems' vulnerability. Over the prolonged life of this boom, the subprime industry has expanded spectacularly, motivated by easy and seemingly unending profits. And, surely, few industries offer the capacity to grow earnings rapidly as lending to risky Credits during a boom. The industry was instrumental in financing a historic homebuilding Bubble, in the process playing a meaningful role in the ongoing economic expansion. Subprime industry insiders have made fortunes, as have Wall Street investment bankers (and shareholders!). And endless high-yielding mortgages have been a godsend to the collateralized debt markets, the leveraged speculating community, and derivatives markets generally. Today, subprime loan exposures have been disbursed throughout our system's financial institutions, securitizations, and derivative markets to an extent never before imagined.

It is my view that, at least for the most part, subprime is not a viable business over the entire life of the business cycle. Invariably during the boom - with cheap finance too readily available and a broadening cadre of aggressive lenders, financiers, and speculators actively pursuing their share of ballooning profits - subprime loans will be under-priced and grossly overextended. There will be dire circumstances. And the more protracted the boom, the greater will be the systemic impact of the mispricing and overexpansion of subprime finance. Inevitably, there is no escaping the reality that the industry is a Ponzi Finance Unit, acutely dependent upon new liquidity to sustain lending volumes and, hence, asset prices, borrower solvency and loan quality.

Importantly, amidst Credit Euphoria, the overextension of loans will inflate collateral values (home prices) and boost the general economy. With home prices up, unemployment down, and Credit all around, few will be forced into default and foreclosure. Subprime profits will be distorted both by inflated revenue growth (surging loan volumes, gain on sale at inflated prices, and attractive spreads on retained portfolios) and by artificially low Credit losses. The outstanding performance of subprime securitizations and related derivatives will entice only greater speculator interest and sector liquidity overabundance, pushing up the price (down the yield) of risky mortgages. In the real economy, easy finance and housing price inflation spur overbuilding, overspending, and a misallocation of resources.

Subprime lending notoriously understates future Credit costs (overstating current profits/returns), a profits distortion made much more consequential by "gain on sale" accounting, "mark-to-market," "mark-to-model," speculator leveraging, and other nuances of contemporary finance. And as long as individual lenders the industry overall each year expand the scope of lending, rising revenues (from new loans) can remain somewhat ahead of mounting Credit losses (from old loans). But the longer this inflationary process is allowed to proceed the greater will be the unavoidable (Ponzi) bust. Actually, it is my view that with our entire Credit system now operating as a Ponzi Finance unit, the "prime" mortgage market operates with similar dynamics as those noted above for subprime.

We are in the midst of a unique Credit cycle. The ability for originators to sell loans and immediately book profits; for investment bankers to buy, securitize and immediately book profits; and for leveraged speculators to acquire various securitizations and other derivatives and book easy profits from various spreads and "mark-to-model" - have all made this Credit boom unlike any other. In particular, the ability to securitize loans in the highly liquid ABS/MBS marketplace, as well as insure/speculate on Credit performance in booming derivatives markets, has - or perhaps in the case of subprime, had - radically altered the capacity to prolong the Credit cycle.

Today, Subprime mortgage originator profits are collapsing - lending volumes are sinking; "gain on sale" is turning to loss; Credit losses (especially from returned "early defaults") are surging; and the liquidity necessary to operate is disappearing overnight. This has initiated the ugly downside of operating as a Ponzi Finance Unit. The issue of early payment defaults - where investment bankers/securitization pool operators return problem mortgages in droves back to the originator - is rapidly bankrupting this thinly-capitalized industry. And the more acute the risk of insolvency, the greater the incentive for investment banks to rush to dump problem loans while the originator still has some liquidity (think "bank run"). Wednesday, California originator ResMae filed for bankruptcy after Merrill Lynch sought to return $520 million "worth" of mortgages.

This has enormous ramifications for the industry. Subprime Credit conditions are in the process of tightening - how tight only time will tell. Subprime borrowers this year facing payment resets will confront a changed industry. Those with second mortgages or hoping to add a home equity loan will face much tighter lending standards. Desperate borrowers stretched the truth in 2006 to get new mortgages approved. Such tactics won't be so easy in 2007. The weakest originators are disappearing and those left will, at the end of the day, be much more prudent and disciplined. Scores of borrowers will be left in the lurch.

But like everything else associated with this most extraordinary Credit Cycle, the analysis is infinitely more complex than what meets the eye. We are undoubtedly in the midst of a major liquidity event for the subprime originators. Additionally, the riskiest CDO and securitization tranches (and related derivatives) will suffer heavy losses. This is a decisive Credit event for the subprime industry, likely marking a major reduction in new subprime loans and escalating Credit losses. Thus far, however, there is little indication that the (paramount) market for "prime" mortgages is being impacted much at all. And when it comes to the subject of overall system liquidity, the current level of tumult could prove less than significant.

In a different - or perhaps typical - environment, recent subprime developments would prompt a nervous reaction from the markets. But today we operate in a most extraordinary backdrop of rampant global liquidity excess, evidenced by ongoing international booms in M&A, securities markets, real estate, energy, and most asset markets. Clearly, a strong inflationary bias permeates Credit systems around the globe. Here at home, continued strong growth in (non-subprime) real estate lending combines with robust corporate and government Credit growth to ensure - for now - continued sufficient non-financial debt growth. More ambiguous but equally important, indications point to the continued robust expansion in securities finance, at this stage of the Credit Cycle a liquidity-creating behemoth.

Global interest-rates declined markedly this week. Hawkish comments from chairman Bernanke in the face of subprime tumult would have been troubling. Instead, markets were reassured that the Fed is not poised to commence rate increases (and add to mortgage woes) anytime soon. And with mortgage Credit issues certain to worsen over the coming months, the bond market is again keen to relax and gird for the next loosening cycle. Markets have no doubt how the Bernanke Fed will respond to mortgage problems that risk heightened systemic stress, and this confidence certainly underpins leveraged speculation. The sound of collapsing mortgage companies is music to the ears of the more ambitious.

For now, it would appear the overall Financial Sphere profit motive is little diminished by subprime woes. There is a pocket of fear, yet the vast financial world is still largely dictated by greed. Importantly, however, faltering profits in subprime will entail a change in the flow of speculative finance - at least at the margin, a potentially disruptive development for related securitizations and derivatives. How the unfolding subprime debacle influences (exacerbates or weakens) the flow of finance to "prime" mortgage and corporates is decidedly up in the air, especially if this week's bond market rally presses on.

But another swath of the now enormous leveraged speculating community is in the process of being clipped, leaving the leveraged players at least somewhat more vulnerable. And perhaps even the Wall Street firms will decide to ratchet risk exposures down a tad at the margin. It is worth noting that the yen rallied abruptly this week, placing yen "carry trade" bets on somewhat less sure footing. The dollar index closed down almost 1% for the week, slipping again below 84. Sure, the bulls can celebrate the ongoing global equities market melt-up. This, however, doesn't alter the troubling reality that Monetary Disorder is in Full Swing. We should expect global markets to be unsettled and worthy of careful analysis. Subprime may not be a factor precipitating meaningful liquidity destruction, but it could nonetheless play a role in further destabilizing a highly unstable financial system.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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