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March 09, 2007

Q4 2006 Flow of Funds
by Doug Noland

The Dow rallied 1.3% and the S&P500 1.1%. The Morgan Stanley Cyclical index gained 1.9% (up 5.3% y-t-d), and the Transports added 1.0% (up 5.9% y-t-d). The Morgan Stanley Consumer index gained 1.3%, while the Utilities were about unchanged. The broader market rallied. The small cap Russell 2000 gained 1.2% and the S&P400 Mid-cap index 1.1%. The NASDAQ100 increased 1.1%, and the Morgan Stanley High Tech index added 0.8%. The Semiconductors jumped 3.0%. The Street.com Internet Index dipped 0.1%, while the NASDAQ Telecommunications index rose 2.0%. The Biotechs declined 1.3%. The Broker/Dealers gained 1.2%, and the Banks added 0.2%. With bullion gaining $7.80, the HUI gold index rallied 1.5%.

Two-year government yields jumped 13 bps to 4.67%. Five-year yields rose 11 bps to 4.55%, and 10-year Treasury yields gained 9 bps to 4.59%. Long-bond yields gained 8 bps to 4.72%. The 2yr/10yr spread ended the week inverted 8 bps. The implied yield on 3-month December '07 Eurodollars jumped 12.5 bps to 4.92%. Benchmark Fannie Mae MBS yields rose 10 bps to 5.74%, this week slightly underperforming Treasuries. The spread on Fannie's 5 1/4% 2016 note was little changed at 38, and the spread on Freddie's 5 1/2% 2016 note was about one wider to 38. The 10-year dollar swap spread declined 2.5 to 54.0. Corporate bond spreads were volatile and mixed, with junk spreads widening another 15 bps this week.

Investment grade issuers included CIT Group $2.5 billion, Eli Lilly $2.5 billion, Bank of America $2.0 billion, Citigroup $1.75 billion, Federated $1.6 billion, Istar Financial $1.05 billion, HSBC $1.0 billion, PG&E $700 million, Intuit $500 million, Praxair $325 million, Bre Properties $300 million, Reinsurance Group $300 million, Hospitality Properties $300 million, Lincoln National $750 million, Pacificorp $600 million, Georgia Power $250 million, and FBL Financial $100 million.

Junk issuers included NSG Holdings $500 million, Plains Exploration $500 million, Pioneer Natural Resource $500 million, and General Nutrition $400 million.

Convert issues included Cypress Semiconductor $600 million, Developers Diversified $600 million, West Pharmaceutical Services $150 million, Private Bancorp $100 million, and Barnes Group $100 million.

International issuers included BBVA $3.0 billion, Depfa Bank $1.25 billion, BP Capital $500 million, Jamaica $350 million and Banco Brades $200 million.

March 9 - Bloomberg (Kabir Chibber and Cecile Gutscher): "OAO Gazprom, the world's largest producer of natural gas, raised $2 billion of loans at its cheapest-ever rate, helping compensate for rising borrowing costs in the bond market."

Japanese 10-year "JGB" yields dropped 6 bps this week to 1.605%. The Nikkei 225 dipped 0.3% (down 0.4% y-t-d). German 10-year bund yields rose 2 bps to 3.955%. Emerging markets were mostly higher, with debt markets continuing to demonstrate notable resilience. Brazil's benchmark dollar bond yields fell 7 bps this week to 5.81%. Brazil's Bovespa equities index surged 4.2% (down 0.8% y-t-d). The Mexican Bolsa gained 3.0% (up 2.5% y-t-d). Mexico's 10-year $ yields dipped one bp to 5.56%. Russia's 10-year Eurodollar yields were unchanged at 6.69%. India's Sensex equities index was little changed on the week (down 6.5% y-t-d). China's Shanghai Composite index rallied 3.8%, increasing 2007 gains to 9.8%.

March 9 - Bloomberg (Darren Boey): "Withdrawals from emerging-market equity funds were a record $8.9 billion last week during a global stock market selloff, according to figures from Emerging Portfolio Fund Research Inc."

March 8 - Financial Times (Chris Hughes): "Global stock issuance surged last month, pushing activity in the equity capital markets this year to record levels before the sell-off.

Global share issuance rose 64 per cent year on year to $69.1bn, a record for February, including $17bn of initial public offerings, also a record for the month. The dramatic recovery from a relatively soft January for equity capital market activity has put total share issuance this year at $109bn, 11 per cent higher than the record first two months of 2000...."

Freddie Mac posted 30-year fixed mortgage rates dipped 2 bps last week to an 11-week low 6.14% (down 23 bps y-o-y). Fifteen-year fixed mortgage rates fell 6 bps to 5.86% (down 14 bps y-o-y). And one-year adjustable rates declined 2 bps to 5.47% (up 2 bps y-o-y). The Mortgage Bankers Association Purchase Applications Index added 1.0% this week. Purchase Applications were up 1.4% from one year ago, with dollar volume rising 5.3%. Refi applications jumped 15% to an 11-week high. The average new Purchase mortgage jumped to a record $243,100 (up 3.8% y-o-y), and the average ARM rose to a record $401,800 (up 15.4% y-o-y).

Bank Credit surged $33.3 billion (week of 2/28) to a record $8.410 TN. Bank Credit has expanded at a 7.9% annualized rate y-t-d (9 wks), with a one-year gain of $750 billion, or 9.8%. For the week, Securities Credit jumped $20.1 billion. Loans & Leases expanded $13.1 billion to a record $6.167 TN. Commercial & Industrial (C&I) Loans expanded 11.4% over the past year. For the week, C&I loans jumped $10.5 billion, while Real Estate loans declined $3.5 billion. Year-to-date, C&I loans have expanded at an 11.4% rate and Real Estate loans at a 7.6% pace. Bank Real Estate loans expanded 14.2% over the past year. For the week, Consumer loans dropped $6.8 billion, while Securities loans gained $11.2 billion. Other loans added $1.8 billion. On the liability side, (previous M3) Large Time Deposits increased $3.3 billion.

M2 (narrow) "money" jumped $34.2 billion to a record $7.145 TN (week of 2/26). Narrow "money" expanded $383 billion, or 5.7%, over the past year. M2 has expanded at an 8.2% pace during the past 20 weeks. For the week, Currency increased $1.6 billion, while Demand & Checkable Deposits declined $5.5 billion. Savings Deposits surged $33 billion, and Small Denominated Deposits added $1.1 billion. Retail Money Fund assets increased $3.5 billion.

Total Money Market Fund Assets (from Invest. Co. Inst.) increased $33.6 billion last week to a record $2.431 TN. Money Fund Assets have increased $170 billion over the past 20 weeks (19.5% annualized) and $375 billion over 52 weeks, or 18.2%.

Total Commercial Paper declined $17.9 billion last week to $1.993 TN, with a y-t-d gain of $18.6 billion (4.9% annualized). CP has increased $99 billion (13.8% annualized) over 20 weeks, and $297 billion, or 17.5%, over the past 52 weeks.

Asset-backed Securities (ABS) issuance rose modestly this week to $12 billion. Year-to-date total ABS issuance of $126 billion (tallied by JPMorgan) is running behind the $138 billion from comparable 2006. Home Equity ABS issuance is struggling, with y-t-d sales of $64 billion about a third behind last year's $93 billion. Yet year-to-date US CDO issuance of $64 billion is running 50% ahead of comparable 2006.

Fed Foreign Holdings of Treasury, Agency Debt jumped $15.0 billion last week (ended 3/7) to a record $1.848 Trillion, with a y-t-d gain of $96.3 billion (28.6% annualized). "Custody" holdings have expanded at a 23% rate over 20 weeks and 16.1% y-o-y ($257bn). Federal Reserve Credit last week declined $1.7 billion to $851.8 billion. Fed Credit was up $36.4 billion y-o-y, or 4.5%.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $834 billion y-o-y (19.8%) to a record $5.038 TN.

March 9 - Bloomberg (Zhao Yidi and Li Yanping): "China's government plans to set up an agency to help manage its $1.07 trillion of currency reserves and indicated the fund will invest in companies in a similar manner to Singapore's Temasek Holdings Pte. The agency will 'maximize the profits' of the reserves, Finance Minister Jin Renqing said today."

Currency Watch:

The dollar index gained 0.7% to 84.21. On the upside, the Thai baht gained 3.0%, the Turkish lira 2.1%, the Brazilian real 1.7%, the Colombian peso 1.3%, and the Hungarian forint 1.2%. On the downside, the Swiss franc dropped 1.5%, the Japanese yen 1.3%, and the Swedish krona 0.8%. The euro fell 0.6%.

Commodities Watch

March 7 - Bloomberg (Xiaowei Li): "China's wheat harvest, the biggest in the world, will fall this year because of drought during planting, the China National Grain and Oils Information Center said... Wheat production will fall to 99.5 million metric tons, down 4.2% from last year... China's domestic wheat prices have risen 23% in the past six months amid drought and warmer winter weather."

March 8 - Bloomberg (Chanyaporn Chanjaroen): "Nickel advanced to a record for a second day...on expectations dwindling stockpiles of the metal will create a second year of shortages. Copper and tin rose for a third day. Rising demand for industrial metals has left mining companies struggling to fill a supply gap, causing inventories to shrink. Nickel stockpiles monitored by the London Metal Exchange have plunged 90 percent in the past year and those of tin have fallen 34 percent."

March 7 - Bloomberg (Daniel J. Goldstein): "Cattle futures rose to the highest price since 2003, extending this year's rally, on speculation that supplies of steaks and fillets will decline because of high feed costs and storms. Hog prices also rose."

For the week, Gold gained 1.2% to $650.20 and Silver 0.4% to $13.01. Copper jumped 3.8%. April crude declined $1.68 to $59.96. April Gasoline dipped 0.3%, and April Natural Gas fell 2.9%. For the week, the CRB index declined 0.7% (up 0.3% y-t-d), and the Goldman Sachs Commodities Index (GSCI) fell 0.8% (up 1.8% y-t-d).

Japan Watch:

March 5 - Bloomberg (Lily Nonomiya): "Japan's largest companies increased spending at the fastest pace in at least four years last quarter, signaling the economy may have grown more than initially estimated by the government. Investment surged 16.8% in the three months ended Dec. 31..."

March 8 - Bloomberg (Mayumi Otsuma): "Japan's small- and medium-sized companies had increased difficulty in hiring new graduates for the year starting April 1, suggesting the nation's labor market is becoming tighter and could support wage increases. Sixty-four percent of companies surveyed said they failed to employ as many recruits as they had planned, 20% more than a year before..."

China Watch:

March 7 - Bloomberg (Yanping Li): "China's top economic planner, Ma Kai, said lagging rural incomes in the world's most populous nation are a 'very serious' problem that may damage stability. 'This problem may hurt social stability if it's allowed to worsen,' the National Development and Reform Commission head [said]... 'It's very serious in some areas.'"

March 8 - Bloomberg (Caroline Byrne): "U.S., U.K. and French law firms opened 20 offices in China last year, the most popular destination for lawyers seeking to profit from a surge in Asian buyouts. China ranked ahead of Germany and Dubai in 2006 as the value of Asian private equity transactions increased sevenfold compared with a year earlier..."

India Watch:

March 8 - Bloomberg (Kartik Goyal): "India's Finance Minister Palaniappan Chidambaram said the nation's gross domestic product is likely to surpass $1 trillion next year, making it the third Asian economy to go past that mark. 'We are on a high growth path. All indicators point toward another year of high growth,' Chidambaram [said]..."

March 8 - Bloomberg (Cherian Thomas): "India' economy may expand more than 9% the current financial year, Prime Minister Manmohan Singh said, adding that growth is a 'necessary condition' to eradicate poverty in the country."

Asia Boom Watch:

March 9 - Bloomberg (Francisco Alcuaz Jr. and Luzi Ann Javier): "Philippine exports grew at the fastest pace in more than seven years in January after falling in December as demand for Intel Corp. semiconductors and Toshiba Corp. hard drives made in the country revived. Shipments rose 27.3% from a year..."

Unbalanced Global Economy Watch:

March 6 - Bloomberg (Fergal O'Brien): "Europe' economic growth accelerated in the fourth quarter as exports increased at the fastest pace in six years. The gross domestic product of the euro area grew 0.9% in the fourth quarter from the third, when it expanded a revised 0.6%... Exports grew 3.7%, the most since the fourth quarter of 2000..."

March 8 - Bloomberg (Christian Wienberg): "Denmark's jobless rate, the lowest in the European Union, slid to 3.8% in January, fueling concern that a labor shortage is set to push up wages and inflation."

March 9 - Bloomberg (Sheyam Ghieth and Steve Scherer): "Italy's economy grew at the fastest pace in seven years in the fourth quarter as the euro region's expansion fueled exports and prompted more spending by businesses. Exports rose 4.5% from the third quarter..."

March 9 - Bloomberg (Jonas Bergman): "Swedish unemployment dipped in February as companies increased hiring to meet rising demand amid the fastest economic expansion in seven years. The...jobless rate fell to 4.3% from 4.6% in January..."

March 6 - Bloomberg (Adam Brown): "Romania's economy grew 7.7% in the fourth quarter of last year as investment and consumption advanced ahead of European Union membership on Jan. 1."

March 9 - Bloomberg (Todd Prince): "Russia's surging banking, retail and metals industries created 19 new billionaires as the former communist country challenges Germany for the European title in Forbes magazine's annual rich list."

March 8 - Bloomberg (Steve Bryant): "Turkey's industrial production surged 14.8% in January from the year earlier, the most since June 2004, as expanding European economies increased demand for exports."

March 7 - Bloomberg (Hans van Leeuwen and Fergus Maguire): "Australia's economy grew twice as much as forecast in the fourth quarter as consumers and companies increased spending. Gross domestic product rose 1% from the third quarter..."

Latin American Boom Watch:

March 8 - Bloomberg (Fabio Alves): "Brazil's imports will probably climb 25% this year, powered by the strong currency, Trade Minister Luiz Fernando Furlan said."

Central Banker Watch:

March 5 - Bloomberg (Vivien Lou Chen): "Federal Reserve Chairman Ben S. Bernanke is challenging the assumption that closer ties among the world's major economies have held down U.S. inflation. Globalization, which has reshaped America's economy in the past decade, isn't fully understood by the Fed and may complicate policy making, Bernanke acknowledged in a speech at the Stanford Institute for Economic Policy Research... The benefits of cheaper imported goods are, at least, countered by higher costs for commodities and energy. Economic expansions in China and India, by contributing to a rally in metals and crude oil in recent years, may even add to inflation, Bernanke added... 'When the offsetting effects of globalization on the prices of manufactured imports and on energy and commodity prices are considered together, there seems to be little basis for concluding that globalization overall has significantly reduced inflation... Indeed, the opposite may be true.'"

March 7 - Bloomberg (John Fraher): "European Central Bank President Jean-Claude Trichet has added another item to his list of inflation concerns: factories working close to their limits to keep up with orders. European manufacturing facilities are operating at the fastest pace in more than a decade, creating price pressures that Trichet's ECB will probably move to quell... Trichet highlighted tighter capacity as an important inflation risk for the first time a month ago, underlining concerns that supply bottlenecks may push up prices and managers may have to increase pay to attract new workers."

March 9 - Bloomberg (Steve Matthews and Vivien Lou Chen): "Federal Reserve Governor Randall Kroszner said a worldwide glut of savings and a commitment by global central banks to curb inflation may help to keep longer-term interest rates at relatively low levels. 'I believe that the forces behind the low level of long-term interest rates and hence the general flatness of yield curves around the globe will tend to persist for some time,' Kroszner said to the U.S. Monetary Policy Forum conference in Washington today."

Bubble Economy Watch:

March 6 - Bloomberg (Joe Richter): "U.S. workers were less productive last quarter than initially estimated and labor costs jumped, making it harder for the Federal Reserve to reduce interest rates even as manufacturing and housing continue to slump. Productivity, a measure of how much an employee produces for each hour of work, rose at an annual rate of 1.6%, down from the 3% pace reported last month... Labor costs climbed 6.6%, reflecting a one-time increase in bonuses."

March 7 - Bloomberg (Courtney Dentch and Lisa Kassenaar): "New York City parents are watching their mailboxes today for admissions letters they're convinced will determine their children's chances for successful and productive lives. Harvard? Yale? New York University? No, the 92nd Street Y, All Souls, Park Avenue Christian and other elite preschools for 2- and 3-year-olds. After months taking time off from work to appraise jungle gyms and mini-toilets, writing essays and trying to hide their anxiety during group play dates, today is D-day. Moms and dads across Manhattan are waiting for word from the 89 programs governed by the Independent Schools Admissions Association of Greater New York... 'It's a feeding frenzy,' said Amanda Uhry, founder of Manhattan Private School Advisors, which charges $10,000 to usher parents through the admissions process. 'If you don't do it right, you'll be one of those people whose kid doesn't get into a good kindergarten or private school.'"

March 7 - The Wall Street Journal (Jim Carlton): "While much of the U.S. frets over a residential real-estate slump, this small farming town on Washington State's plains has the opposite worry: A boom-town economy is inflating housing prices. Quincy has the Web to thank -- or to blame. The town's economic boom began with the arrival of three high-profile neighbors: Microsoft Corp., Yahoo Inc. and Intuit Inc. In 2006, the tech giants separately announced plans to build new computer-data centers here... Quincy is a town of 5,300 people and two traffic lights that, until now, has typically seen only one to four new homes built a year. Now, developers have filed plans for upwards of 1,000 new homes and a strip mall that would include a hotel and the town's first movie theater. Land prices have as much as quintupled over the past year and apartment rents have jumped as much as 50%."

Financial Sphere Bubble Watch:

See "Q4 2006 Flow of Funds" below...

Mortgage Finance Bubble Watch:

March 9 - Bloomberg (Alison Vekshin and Anthony Massucci): "The nation's banks are just beginning to feel the pain of defaults on risky mortgages they made at low introductory rates when housing prices were soaring, U.S. Federal Reserve Governor Susan Bies said. Bies...said today banks are likely to see more missed payments and foreclosures as consumers with weak credit histories begin to face higher monthly mortgage payments. 'What's happening is the front end of this wave of teaser-rate loans that are coming into full pricing...So what we're seeing in this narrow segment is the beginning of the wave. This is not the end, this is the beginning.'"

March 8 - Financial Times (Michael Mackenzie and Saskia Scholtes): "Issuance of securities backed by risky subprime mortgages has fallen by more than half this year, threatening an important source of revenue for Wall Street banks and leaving them holding poorly underwritten home loans they cannot sell on. Wall Street's mortgage securitisation business has been built on playing the middle-man in a chain, originating or buying subprime mortgages and then using the loans to back bonds sold to investors. In some cases, residential mortgage-backed securities (RMBS) are packaged with other kinds of loans into more complex debt products, known as collateralised debt obligations.

A surge in late payments and defaults on subprime and slightly less risky 'Alt-A' mortgages, has reverberated up this chain."

March 7 - The Wall Street Journal (Ryan Chittum and Serena NG): "Turmoil in the market for bonds backed by home mortgages is starting to infect its commercial cousins: mortgage bonds backed by office towers, hotels and shopping malls. The cost of insuring commercial-mortgage-backed securities as measured by an index known as the CMBX has jumped since late last month. The spread on the index that tracks riskier, BBB-minus-rated bonds has doubled to 1.64 percentage points this week from 0.84 percentage point on Feb 23... 'Moves of this magnitude and speed are uncommon in the unusually calm CMBS markets,' noted analysts from Lehman Brothers... As the index's spreads widened, spreads on CMBS bonds also widened, though by less."

Real Estate Bubbles Watch:

March 9 - Bloomberg (Brian Louis): "Rising mortgage defaults by subprime borrowers may add more than 500,000 homes to a residential real estate market already beset by slumping prices, according to CreditSights Inc."

March 7 - The Wall Street Journal (Ilan Brat and Thaddeus Herrick): "Farmland prices are soaring across the Midwest amid a surge in demand for corn driven by the ethanol boom. In the past year, cropland prices have climbed by double-digit percentages in many parts of the Heartland... Some outside real-estate investors also are seeking agricultural land, but the most recent aggressive buyers have been established farmers who want to expand. At the same time, the price run-up has raised costs and could squeeze profit margins for farmers who rent land, if they have a poor crop. The phenomenon is yet more evidence of the extent to which the rise of renewable, corn-derived ethanol is reshaping the Midwestern landscape."

Energy Boom and Crude Liquidity Watch:

March 7 - Bloomberg (Joe Carroll): "Exxon Mobil Corp., the world's biggest oil company, plans to spend almost $21 billion exploring for oil and expanding refineries this year as a worldwide shortage of drilling rigs inflates costs. The company plans to begin pumping oil or gas from 20 projects in the next three years after seven start-ups in 2006... The capital budget marks an increase of about 5.5%..."

Fiscal Watch:

March 7 - Dow Jones: "The U.S. ran a $123 billion budget deficit in February, the Congressional Budget Office estimated... That is roughly $4 billion higher than the deficit incurred in February 2006, but the deficit for the fiscal year is still on track to be lower than the $248 billion deficit amassed for fiscal 2006... Including the estimated deficit results for February, the U.S. incurred a $165 billion deficit for the first five months of fiscal year 2007. That is $52 billion less than the amount incurred for the same time period in 2006..."

Speculator Watch:

March 7 - Bloomberg (Andrei Postelnicu): "A record number of new hedge funds in Europe raised $38 billion last year even as worldwide returns trailed market indexes... Hedge fund startups last year totaled 423, 27% more than the 330 new funds created in 2005, according to a survey by Hedge Fund Intelligence's EuroHedge magazine... New capital increased 35% to a record. The record new money going to European hedge funds last year mirrors U.S. trends..."

Q4 2006 Flow of Funds:

Fourth quarter Credit data have arrived. Despite the deepening housing downturn, the year ended with Total Non-Financial debt expanding at a robust 7.9% pace, up from Q3's 6.5% and Q2's 6.8%. And while Total Household Borrowings decelerated to a 6.4% rate during the fourth quarter (down from Q3's 7.8%), Non-Financial Corporate borrowings surged to a 10.9% growth rate (up from Q3's 5.0%). Financial Sector Credit Market Borrowings increased at a 7.2% pace (up from 5.8%). Federal debt growth was stable at 3.3% during the quarter, with Receipts up 11% and Expenditures up 5.5% y-o-y. State & Local government borrowings accelerated to a 13.5% growth rate (up from Q3's 8.2%), as Receipts grew 5.5% and Expenditures 4.5% y-o-y.

After a prolonged Credit Bubble, percentage changes don't do justice. Nominal debt growth numbers are more illuminating, in the case of the fourth quarter "seasonally-adjusted and annualized rates" (SAAR). During Q4, Total Credit Market Borrowings jumped to $3.567 TN SAAR, up from Q3's $3.025 TN SAAR. For comparison, Total Credit Market Borrowings accelerated from $2.348 TN in 2002, to $2.725 TN in 2003, to $3.002 TN in 2004, to $3.403 TN in 2005, and to $3.555 TN for 2006. And while Household Sector borrowings slowed to $838bn SAAR (from Q3's $928bn), Non-Financial Corporate borrowings surged to $605bn SAAR (from $276bn). For perspective, Households borrowings increased $1.239 TN during 2005, and Non-Financial Corporate borrowings expanded $245bn.

Last year was an extraordinary year for Macro Credit Analysis. Non-Financial debt growth decelerated from 2005's 9.4% to 7.9%. In nominal dollars, Non-Financial debt growth slowed to $2.100 TN from the previous year's $2.279 TN. Students of Credit theory could have justifiably expected this development to be problematic for inflated asset markets and the US and global Bubble economies generally. Importantly, however, total system Credit and marketplace liquidity were buttressed by accelerating Financial Sector debt growth (from 8.7% to 9.3%). In nominal dollars, Financial Sector Credit Market debt growth (excluding, among others, bank deposit growth) increased from 2005's $1.040 TN to a record $1.200 TN, although this in no way reflect the entirety of Financial Sector liability expansion.

The ballooning Financial Sphere - financing robust mortgage and corporate Credit growth, and at the same time positioning in the securities markets to profit from unfolding Economic Sphere and Fed rate moderation - was a key Macro Credit theme for 2006. Rapid system Credit and liquidity creation way beyond the needs of the real economy fueled rampant financial asset inflation at home and abroad.

Nowhere was this dynamic more conspicuous than within the Broker/Dealer industry Balance Sheet. Broker/Dealer Assets expanded $515bn SAAR during the quarter, or 24.3% annualized. The Asset "Security Credit" grew $150bn SAAR, Treasuries $220bn SAAR, Corporate & Foreign Bonds $91bn SAAR, and Miscellaneous Assets $91bn SAAR. On the Liability side, Securities "Repo" ballooned $406.8bn SAAR during the quarter, financing the vast majority of rampant asset expansion.

For the year, Broker/Dealer Assets expanded a blistering (responsible?) 28.9% to $2.742 TN, posting an incredible 2-year gain of $897bn, or 49%. For perspective, Broker/Dealer Assets expanded $615bn during 2006, $282bn in 2005, $232bn in 2004, $278 in 2003, and declined $130bn during 2002. Keep in mind that 2006 Broker/Dealer asset growth was double the previous record (2005's $282bn) and approached triple 2000's $220bn (at the time a record). By Asset category, Credit Market Instruments were up 22.2% y-o-y to $583bn, Misc. Assets 33% to $1.60 TN, and Security Credit 25.7% to $292bn. On the Liability side, Security "Repos" (net) surged 46.1% y-o-y to $1.072 TN, "Due to Affiliates" increased 14% to $1.137 TN, and Security Credit 18.9% to $958bn.

In the Enigmatic World of Contemporary Securities Finance, there is an entangled interplay between the Wall Street firms, the securities "repo" market, "Funding Corps" ("Funding subsidiaries, nonbank financial holding companies, and custodial accounts for reinvested collateral of securities lending operations"), and the "money" market. The ongoing ballooning of these various securities financing vehicles is nothing short of stunning. "Federal Funds and Security Repurchase Agreements" Liabilities surged $484bn (24.2%) last year to $2.491 TN, with 2-year growth of $800bn (50.9%). This market has almost doubled since the end of 2002. For comparison, "Repos" increased $352bn during 2005, $83bn in 2004, $227bn in 2003, and $107bn in 2002. "Funding Corps" expanded $286bn (15.7%) to $2.001 TN, with a 2-year gain of $579bn (38%).

And while there is definitely a "double-counting" issue between the Fed's different debt and Credit intermediation categories, it is nonetheless worth noting that Open Market Paper (mostly commercial paper), expanded at a 24% rate during Q4 and 20.8% for the year to $2.216 TN. Open Market Paper has expanded $645bn (41.4%) during the past two years. Home for much of this new finance, Money Market Fund Assets expanded at a 27% pace during Q4. For 2006, Money Fund Assets jumped $306bn, or 15.2%, to $2.313 TN, second only to 2001's $429bn (the year, not coincidently, the GSE's expanded a record $344bn). At $608bn, Open Market Paper comprises the largest Money Market Fund holding, followed by Security RPs ($395bn), Municipal Securities ($370bn) and Corporate Bonds including ABS ($368bn). Funding Corps Assets declined $1bn in 2002, increased $78bn in 2003 and $70bn in 2004, then surged $293 billion in 2005.

It is interesting to compare the assets held by Money Market Mutual Funds at the end of the year to those at the conclusion of 2002 (MMFA having increased only $90 billion after peaking in 2002). Agency/GSE Securities have declined from $333bn to $131bn, and Treasuries have dropped from $142bn to $83bn. Meanwhile, Security RPs have jumped from $273bn to $395bn, and Corporate Bonds (including ABS) have increased from $228bn to $368bn.

Total Mortgage Debt (TMD) expanded $1.172 TN (9.7%) during 2006. This was an enormous expansion, especially considering the rapidly slowing housing markets, though a notable deceleration from 2005's blockbuster $1.462 TN (13.7%) growth. For perspective, TMD expanded an average $268bn annually during the nineties and $888bn annually during the first half of this decade. For the quarter, Home Mortgage borrowings slowed to a 6.1% pace, while Commercial Mortgages accelerated to a 15.6% rate. For the year, Home Mortgage borrowings increased 8.8% and Commercial 15.6%. Over two years, TMD jumped 25% (Home up 24%, Commercial up 32%). TMD more than doubled (109%) in seven years.

GSE Assets were little changed during Q4 and expanded only $35.6bn during 2006 (1.3%) to $2.841 TN. Agency MBS expanded $239bn SAAR (7.5% pace) during the quarter. For the year, Agency MBS grew $288bn (7.8%) to $3.965 TN, up sharply from 2005 to the strongest growth since 2003. Yet it remains the ABS market leading the Wall Street securitization boom. Outstanding ABS increased $523bn SAAR (16% pace) during Q4 and jumped $533bn, or 17.4%, for the year. The ABS market has inflated an incredible $1.197 TN, or 49.8%, in just two years, and has ballooned 174% so far this decade.

Wachovia's purchase of the thrift Golden West Financial inconveniently distorted Q4 bank Credit growth data. For the year, Bank Assets expanded $880bn, or 9.4%, to $10.204 TN (up 19.2% in 2yrs). Bank Credit surged $906bn, or 12.1%, to $8.363bn (up 23.5% in 2yrs), with Total Bank Loans increasing 13.5% during 2006 (up 26.6% in 2yrs) to $6.113 TN. Bank Mortgage loans (including the Golden West portfolio) expanded 15% during the year to $3.403bn. Bank holdings of Corporate Bonds jumped 13.8% to $781bn (2-yr gain of 40%).

On the Bank Liability side, Total Deposits expanded at a 13.7% pace during the quarter to $6.016 TN, with a one-year gain of $527bn, or 9.6%. Bank "Repos" (liabilities netted against assets) increased $149bn (13.7%) during 2006 to $1.240 TN. The Liability Credit Market Instruments expanded 21% y-o-y to $998bn. Miscellaneous Liabilities were up 7.2% during the year to $1.812 TN.

Elsewhere, Credit Unions expanded at a 4.4% pace during the quarter and 4.8% for the year to $719 billion, and Finance Companies grew 4.1% and 1.7% to $1.889 TN. REIT Liabilities expanded at 12.8% rate during the quarter and were up 14.0% for the year to $631bn. Life Insurance Assets expanded at a 12.1% during the quarter and 8.2% for the year to $4.709 TN. Federal Reserve Assets increased $29.6 billion last year (3.4%) to $908 billion, or less than 1% of the increase in total system Credit.

Definitely not as trivial, Rest of World (ROW) holdings of U.S. Financial Assets expanded $1.671 TN SAAR during the fourth quarter and $1.527 TN for the year. This was more than a 50% increase from 2005's $1.041 TN increase, and compares to 2004's $1.321 TN, 2003's $824bn, 2002's $771bn and 2001's $658bn. For the year, ROW Treasury holdings increased $141bn (7.1%) to $2.135 TN, and Agency holdings surged $220bn (23%) to $1.173 TN. For both Treasuries and Agencies, ROW purchases accounted for the majority of new issuance, and this has generally been the case now for the past several years (Conundrum?). Holdings of Corporate Bonds (including ABS) jumped $424bn (18.3%) during the year to $2.737 TN, with a 2-year gain of $676bn (32.8%). Foreign Direct Investment was up 11% y-o-y to $2.074 TN.

The Household (and Non-Profits) Balance Sheet, as always, provides invaluable Credit Bubble Insight. For the quarter, Total Household Assets expanded $1.641 TN, or 9.8% annualized, to a record $68.920 TN. This surge in financial wealth was led by a $1.356 TN (13.3% annualized) increase in Financial Assets. Mutual Fund holdings surged $320 billion (28% annualized) during the fourth quarter to $4.963 TN. This significantly offset the slowdown in housing inflation "wealth effect", which fell to $246bn during the quarter (4.4% annualized). And with Household Liabilities increasing "only" $266bn (8.2% annualized), Household Net Worth surged a robust $1.375 Trillion (10.1% annualized) during the quarter to a record $55.626 TN. For the entire year, Household Assets jumped $4.906 TN (7.7%), with Real Estate up $1.464 TN (6.9%) and Financial Assets inflating $3.230 TN (8.3%, with Mutual Funds up $841, or 20.4%). With Liabilities increasing $1.074 TN (8.8%) during 2006, Net Worth surged $3.832 TN (7.4%). Household Net Worth has inflated $15.937 TN, or 40%, over the past four years.

Fueled by prolonged Credit excess, National Income expanded 8.2% during 2006 to $11.698 TN, the strongest pace of growth since 1988. Total Compensation increased 6.4%, the largest gain since 2000's 7.9%. For comparison, Compensation increased 2.8% in 2001, 2.5% in 2002, 3.8% in 2003, 5.1% in 2004, and 5.7% in 2005.

There are key aspects of analysis that the Z.1 helps to confirm. First, in the context of ongoing Credit excesses, the 2006 moderation in mortgage Credit creation was more than offset by a sharp increase in Corporate and Financial Sector borrowings. Securities finance, in particular, exemplified by the growth in Broker/Dealer, "Repo," "Funding Corp," and "Open Market Paper," was nothing short of spectacular. Rampant domestic Credit growth was ample to finance an ongoing economic boom, unprecedented Current Account Deficits, and general asset inflation. Outflows from massive U.S. Current Account Deficits coupled with heightened speculative outflows were major sources instigating global liquidity excess, flows that were then recycled back to U.S. financial markets where they were "recycled" yet again into unrestrained financial excess.

The problems associated with the U.S. Mortgage Finance Bubble having evolved into Corporate Debt, Securities Finance, and Global Credit Bubbles are great. To sustain myriad Bubbles will require massive and uninterrupted Credit growth. Conditions for such an undertaking were actually quite favorable last year. Wall Street was firing on all cylinders, with the housing slowdown fostering expectations for Goldilocks and an imminent easing of Fed policy. But 2006 excesses have created a serious dilemma, one not well recognized. Post-Bubble Subprime and general mortgage Credit risks pose an increasingly recognized problem on one hand, while heightened Bubble excesses in Corporate and Securities Finance are equally risky on the other. Because of heightened inflation risks associated with domestic and global excesses, and one can envisage a scenario where the Fed remains quite hesitant to provide the easing cycle Wall Street is anxiously positioned for.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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