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March 23, 2007

The Smooth Flow of Credit
by Doug Noland

For the week, the Dow gained 3.1% and the S&P500 3.5%, pushing both averages back into the black for the year. The Transports surged 4.0%, increasing y-t-d gains to 9.1%, and the Morgan Stanley Cyclical index 3.2%, increasing 2007 gains to 8.0%. The Utilities rose 4.0% (up 8.2% y-t-d) and the Morgan Stanley Consumer index 3.3% (up 1.8% y-t-d). The broader market also rallied sharply. The small cap Russell 2000 and S&P400 Mid-Cap indices both gained 3.9%. The NASDAQ100 advanced 3.0%, and the Morgan Stanley High Tech index added 1.4%. The Semiconductors gained 1.5%. The Street.com Internet Index jumped 3.2%, and the NASDAQ Telecommunications index rose 1.3%. The Biotechs rallied 5.8%. The Broker/Dealers surged 6.4%, and the Banks jumped 3.6%. With Bullion up $4.00, the HUI Gold index rallied 4.2%.

Two-year government yields added one basis point to 4.60%. Five-year yields increased 4 bps to 4.51%, and 10-year Treasury yields jumped 7 bps to 4.61%. Long-bond yields surged 11 bps to 4.80%. The curve flattened this week, with the 2yr/10yr spread now positively sloped one basis point. The implied yield on 3-month December '07 Eurodollars rose 2.5bps to 4.885%. Benchmark Fannie Mae MBS yields rose 3 bps to 5.71%, this week reversing recent underperformance to Treasuries. The spread on Fannie's 5 1/4% 2016 note dropped 4 to 35, and the spread on Freddie's 5 1/2% 2016 note dropped about 4 to 35. The 10-year dollar swap spread declined 0.8 bps to 53.0. Corporate bond spreads generally were little changed, although junk spreads widened a couple basis points.

Investment grade issuers included Merrill Lynch $4.1 billion, Hospira $1.425bn, Bank of New York $750 million, CBS $700 million, Willis North America $600 million, American Honda $600 million, IBM $500 million, PNC $500 million, Southern Co. $400 million, Sovereign Bancorp $300 million, Conn Light & Power $300 million, Bunge $250 million, and UDR $150 million.

Junk issuers included Citizens Utility $750 million, Pinnacle Foods $575 million, Highwoods $400 million, Aventine Renewable Resources $300 million, Cleveland Electric $250 million, Sun Healthcare $200 million, and MSX International $205 million.

Convert issues included Vornado Realty Trust $1.4 billion, Prologis $1.1bn, Nortel Networks $1.0 billion, SL Green Realty $750 million, Host Hotels $600 million, SBS Communications $350 million, Extra Space Storage $250 million, Viropharma $225 million, Amerigroup $240 million, Komag $220 million, Diversa $100 million, and Pioneer $100 million.

International issuers included Panama $1.81bn, Shell $1.25bn, BBVA $600 million, Cerveceria Nacional $360 million, and GOL $225 million.

Japanese 10-year "JGB" yields rose 3 bps this week to 1.605%. The Nikkei 225 jumped 3.7% (up 1.5% y-t-d). German 10-year bund yields surged 10 bps to 4.00%. Emerging debt and equities markets were strong. Brazil's benchmark dollar bond yields dropped 13 bps this week to a record low 5.69%. Brazil's Bovespa equities index surged 6.6% (up 2.4% y-t-d). The Mexican Bolsa rose 5.2% (up 6.9% y-t-d). Mexico's 10-year $ yields dipped one basis point to 5.47%. Russia's 10-year Eurodollar yields declined one basis point to 6.67%. India's Sensex equities index rallied 6.9% for the week (down 3.6% y-t-d). China's Shanghai Composite index jumped 4.9% to a record high, increasing 2007 gains to 14.9%.

Freddie Mac posted 30-year fixed mortgage rates added 2 bps last week to 6.16% (down 16 bps y-o-y). Fifteen-year fixed rates increased 2 bps to 5.90% (down 9 bps y-o-y). And one-year adjustable rates declined 2 bps to 5.40% (up 8 bps y-o-y), the lowest level in almost a year. The Mortgage Bankers Association Purchase Applications Index dipped 0.9% this week. Purchase Applications were up 4.2% from one year ago, with dollar volume up 8.9%. Refi applications declined 4.5%. The average new Purchase mortgage declined to $241,000 (up 4.5% y-o-y), and the average ARM slipped to $405,200 (up 18.5% y-o-y).

Bank Credit data were impacted by the conversion of bank to a thrift institution, so I will exclude data this week.

M2 (narrow) "money" increased $24.4bn to a record $7.155 TN (week of 3/12). Narrow "money" has expanded $112bn y-t-d, or 7.5% annualized, and $409bn, or 6.1%, over the past year. For the week, Currency dipped $0.5 billion, and Demand & Checkable Deposits fell $8.9bn. Savings Deposits jumped $17.1bn, while Small Denominated Deposits added $1.3bn. Retail Money Fund assets increased $15.5bn.

Total Money Market Fund Assets (from Invest. Co Inst) jumped $23.3 billion last week to a record $2.431 TN. Money Fund Assets have increased $166 billion over the past 20 weeks (19.0% annualized) and $376 billion over 52 weeks, or 18.3%.

Total Commercial Paper added $1.9 billion last week to $1.997 TN, with a y-t-d gain of $22.8 billion (5% annualized). CP has increased $97 billion (13.3% annualized) over 20 weeks and $287 billion, or 16.8%, over the past 52 weeks.

Asset-backed Securities (ABS) issuance increased to $(12) billion. Year-to-date total ABS issuance of $153 billion (tallied by JPMorgan) is running behind the $169 billion from comparable 2006. At $77 billion, Home Equity ABS issuance 35% behind last years pace. Yet year-to-date US CDO issuance of $83 billion is running 38% ahead of comparable 2006.

Fed Foreign Holdings of Treasury, Agency Debt jumped $16.1bn last week (ended 3/21) to a record $1.876 TN, with a y-t-d gain of $124bn (30.6% annualized). "Custody" holdings have expanded at a 28% rate over 20 weeks and 18.2% y-o-y ($289bn). Federal Reserve Credit last week dipped $468 million to $851bn (down $1.1bn y-t-d). Fed Credit was up $30.3bn y-o-y, or 3.7%.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $833 billion y-o-y (19.7%) to a record $5.053 TN.

Currency Watch:

March 21 - China Knowledge: "China will stop stockpiling its massive foreign exchange reserves, China's central bank governor Zhou Xiaochuan said... Zhou said in an interview with Emerging Markets magazine published Tuesday that China's foreign reserves are large enough already, and that the government will accord a small piece of its reserves for the new agency that will be set up to manage the nation's foreign reserves."

March 20 - Bloomberg (Chris Young): "Australia's dollar rose to the strongest in a decade on speculation the central bank will raise interest rates, attracting global currency and bond investors."

The dollar index gained slightly to 83.0. On the upside, the South African rand gained 3.7%, the Thai baht 2.7%, the New Zealand dollar 2.1%, the Hungarian forint 1.9%, the Brazilian real 1.6%, and the Mexican peso 1.6%. On the downside, the Japanese yen declined 1.1%, the Swiss franc 0.9%, the Czech koruna 0.6%, and the Swedish krona 0.5%.

Commodities Watch

March 20 - Bloomberg (Feiwen Rong): "China, the world's biggest user of rubber, will increase imports of the natural commodity by 8.7% in 2007 to feed rising demand from tire and shoemakers, according to estimates by an industry group."

March 23 - Bloomberg (Jae Hur): "The forecast global supply deficit for uranium this year may be 72 percent wider than expected amid optimism environmental concern will prompt increased demand for the nuclear fuel, said Deutsche Bank AG."

For the week, Gold added 0.6% to $657.40 and Silver 0.2% to $13.227. Copper jumped 1.9%. May crude surged $2.70 to $62.28. April Gasoline jumped 4.8% and April Natural Gas 5.0%. For the week, the CRB index rose 2.1% (up 1.2% y-t-d), and the Goldman Sachs Commodities Index (GSCI) surged 2.6% (up 3.6% y-t-d).

Japan Watch:

March 22 - Bloomberg (Finbarr Flynn): "Land prices in Japan rose for the first time in 16 years as overseas and domestic investors competed to acquire properties in the country's three biggest cities. Gains in Tokyo, Osaka and Nagoya compensated for a drop in regional areas. Average commercial land prices in the three cities rose 8.9% and residential 2.8% in the year ending Dec. 31, the Ministry of Land, Infrastructure and Transport said..."

March 22 - Bloomberg (Lily Nonomiya): "Japan's trade surplus unexpectedly widened in February, suggesting exports to China and the U.S. will help extend the economy's longest postwar expansion. The surplus rose 7.7 percent to 979.6 billion yen ($8.3 billion)... Exports climbed 9.7%..."

China Watch:

March 21 - Bloomberg (Luo Jun and Simon Pritchard): "Deng Yijun, a cargo freight agency manager in Shanghai, faced a dilemma last December. 'I needed a car, but I didn't want to use up my savings as the stock market was booming,' she says. 'So I used credit cards.' Deng, 32, was eyeing a Ford Focus that cost about 200,000 yuan ($25,815), roughly equal to her savings. Maxing out three cards, she put 140,000 yuan on plastic and gained 56 days of interest-free credit..... Most of her remaining cash went into stocks... Deng is typical of Chinese who are using easy credit to fuel a stocks boom only briefly deflated last month by government threats to crack down on illegal lending. The willingness of banks to break the law to finance stock trades shows the blunt tools regulators wield as they try to manage China's markets."

March 19 - Bloomberg (Luo Jun): "China's banking regulator told medium-sized and smaller banks to slow loan growth to achieve 'healthy and fast' development in 2007. The China Banking Regulatory Commission also urged the nation's 12 joint-stock banks and more than 110 city commercial lenders to cut the number of fraud cases by 20%..."

March 22 - Bloomberg (John Liu): "China may account for one third of the world's most advanced chip-making factories built during the four years through 2010, said Novellus Systems Inc... Up to 57 foundries capable of making chips on 300 millimeter silicon wafers may be built worldwide by 2010, 19 of them in China, Novellus Chairman Richard Hill said..."

March 20 - Bloomberg (Clare Cheung): "Hong Kong's jobless rate declined to the lowest in more than eight years, fueling increases in wages and consumer spending that may help to extend the city's longest economic expansion since 1997. Seasonally-adjusted unemployment for the three months ended Feb. 28 was 4.3%..."

India Watch:

March 22 - Bloomberg (Archana Chaudhary): "Mumbai, India's commercial capital, may have its first daily blackouts in a century next month because the government failed to plan for soaring demand. Offices and households may lose electricity for 30 minutes a day starting mid-April, said Lalit Jalan, executive director at Reliance Energy Ltd., the city's main supplier."

Asia Boom Watch:

March 20 - Bloomberg (Suttinee Yuvejwattana): "Thailand's exports rose by 18% in January from a year earlier, Finance Minister Chalongphob Sussangkarn said..."

March 21 - Bloomberg (Stephanie Phang): "Malaysia's economy may expand in 2007 at the fastest pace in three years, spurred by higher investment and government spending and a recovery in mining output, the central bank said. Southeast Asia's third-largest economy is expected to grow 6% this year..."

Unbalanced Global Economy Watch:

March 22 - Bloomberg (Theophilos Argitis): "Canadian core inflation unexpectedly accelerated to a four-year high last month, raising the possibility the central bank will raise interest rates to temper the world's eighth-biggest economy. The core rate...rose to 2.4%..."

March 20 - Bloomberg (Brian Swint): "Annual growth in M4, the broadest measure of U.K. money supply, slowed in February as higher borrowing costs damp demand. M4, measuring currency in circulation and deposits at banks, rose 12.8% from a year earlier after a 12.9% annual gain in January..."

March 19 - Bloomberg (Brian Swint): "London house prices advanced in March as buyers snapped up properties at the fastest pace in almost three years, led by demand from wealthy foreigners and bankers. Average asking prices in the U.K. capital rose 1.8% to 366,302 pounds ($713,000) in the four weeks through March 10, and 22% from the previous year, Rightmove Plc...said... The average home stayed on the market for 65 days, the shortest period since July 2004."

March 19 - Bloomberg (Brian Swint and Craig Stirling): "U.K. inflation unexpectedly accelerated in February to the second-fastest pace in a decade, strengthening the case for a further interest-rate increase from the Bank of England. Consumer prices rose 2.8% from a year earlier..."

March 21 - Bloomberg (Hugo Miller): "Swiss watch exports rose 21% in February, helped by increased demand from Hong Kong and U.S. retailers that cater to wealthy Chinese and Americans."

March 20 - Bloomberg (Esteban Duarte and Charles Penty): "Vacation home prices in Spain, a leading indicator of Europe's property market, may face a slump that's worse than the real estate decline in the U.S., based on the loan terms banks are imposing on developers."

March 23 - Bloomberg (Robin Wigglesworth): "Norway's jobless rate fell to 2.7% in January, dropping for the 10th month in a row and fueling concern that inflation will continue to accelerate."

March 22 - Bloomberg (Maria Levitov and Svenja O'Donnell): "Russian retail sales growth quickened in February, as rising wages and a stronger ruble boosted consumers' spending power. Retail sales advanced an annual 14.4%..."

Latin American Boom Watch:

March 22 - Bloomberg (Carlos Caminada): "Brazil's economic growth has quickened and Latin America's biggest economy may expand 4.5% this year, Finance Minister Guido Mantega said. 'The economy has taken off and is accelerating,' Mantega said..."

March 22 - Bloomberg (Eliana Raszewski): "Argentina's trade surplus narrowed in February because of increased imports... The trade surplus in South America's second-biggest economy fell to $720 million in February from $742 million in the year-ago month, the National Statistics Institute said... Exports rose 14% to $3.5 billion while imports climbed 20% to $2.8 billion."

March 22 - Bloomberg (Bill Faries): "Argentina's quarterly current account surplus widened to the highest level in almost four years in the fourth quarter of 2006... The surplus in the current account...grew to $2.5 billion in the fourth quarter..."

Central Banker Watch:

March 21 - Bloomberg (Matthew Brockett): "European Central Bank President Jean-Claude Trichet said inflation will probably accelerate later this year as economic growth fuels wage increases. The economy of the 13 nations sharing the euro 'continues to expand robustly,' Trichet told the European Parliament... 'The outlook for price developments over the medium term remains subject to upside risks,' including 'stronger than currently expected wage developments.'"

Bubble Economy Watch:

Year-to-date Average Taxpayer Refunds are running 6.1% ahead of last year.

March 19 - Bloomberg (Curtis Eichelberger): "The New York Jets and New York Giants will borrow $650 million each to pay for the 82,000-seat football stadium they are building in East Rutherford... The Jets will sell $650 million in bonds through Citigroup Inc., while the Giants will sell $650 million in bonds through the Goldman Sachs... The National Football League, which caps team debt at $150 million, is likely to make an exception for the Jets and Giants when owners meet next week..."

Mortgage Finance Bubble Watch:

March 20 - Bloomberg (Bradley Keoun): "New Century Financial Corp., the second-biggest U.S. subprime mortgage lender, was ordered to halt operations in its home state of California, and Fannie Mae stopped buying the company's loans. California told New Century to stop taking mortgage applications and turn over pending loans to other lenders..."

March 22 - Bloomberg (Jody Shenn): "The subprime credit crunch is beginning to ensnare even borrowers with good credit. Lenders are increasingly refusing to lend to homebuyers who can't make a down payment of more than 5 percent, especially if they won't document their income. Until recently such borrowers qualified for so-called Alt A mortgages, which rank between prime and subprime in terms of risk. Last year the category accounted for about 20 percent of the $3 trillion of U.S. mortgages, about the same as subprime loans, according to Credit Suisse Group. 'It's going to be very difficult, if not impossible, to do a no-money-down loan at any credit score,' said Alex Gemici, president of... mortgage bank Montgomery Mortgage Capital Corp. Companies that buy the loans 'are all saying if they haven't eliminated them yet, they'll eliminate them shortly.'"

March 19 - Bloomberg (Hui-yong Yu): "U.S. homeowners, lenders and investors may lose as much as $112.5 billion through 2014 as mortgage payments go up on adjustable-rate loans, triggering defaults and foreclosures, according to a study by mortgage-risk data provider First American CoreLogic. An estimated $2.3 trillion of adjustable first mortgages were originated from 2004 to 2006, many of which will begin to reset in two to three years. As they reset at higher rates, about 1.1 million loans amounting to $326 billion may go into foreclosure, the study said."

March 22 - Bloomberg (Alison Vekshin): "The Office of the Comptroller of the Currency, regulator of the biggest American banks, said 'abusive' lending and fraud helped fuel a surge in subprime lending. Emory Rushton, the agency's senior deputy comptroller, told the Senate Banking Committee...that the OCC is working to correct lending standards that have slipped... 'It is clear that some subprime lenders have engaged in abusive practices and we share the committee's strong concerns about them... We are now confronting adverse conditions in the subprime mortgage market, including disturbing but not unpredictable increases in the rates of mortgage delinquencies and foreclosures.'"

Real Estate Bubbles Watch:

March 20 - Bloomberg (Hui-yong Yu): "Manhattan apartment prices, the highest in the U.S., gained 6.1% on average in 2006... The average sales price for cooperatively owned apartments and condominiums in the New York City borough climbed to a record $1.295 million, from $1.221 million a year earlier, residential appraiser Miller Samuel Inc. and real estate brokerage Prudential Douglas Elliman said... Prices rose 18.1% in 2005 and 21.6% in 2004..."

M&A and Private-Equity Bubble Watch:

March 19 - Dow Jones (Cynthia Koons): "In an era of easy money in the junk bond market, one seasoned financier has become a master of a new universe. Leon Black, as head of private equity giant Apollo Management LP, has orchestrated some of the most creative debt deals in the junk bond market in the past six months to secure hefty paychecks from recently purchased companies. It's no surprise considering Black learned the business running the mergers and acquisitions group of Drexel Burnham Lambert during the debt-funded buyout frenzy of the late 1980s."

March 20 - Bloomberg (Christine Harper): "Goldman Sachs...raised $3 billion from investors for its fourth fund dedicated to buying assets from private equity firms."

Energy Boom and Crude Liquidity Watch:

March 18 - Bloomberg (Matthew Brown and Arif Sharif): "The United Arab Emirates economy, the Arab world's second-biggest, grew 8.9% in 2006, the Ministry of Economy said."

March 20 - Bloomberg (Will McSheehy): "Shoppers in Dubai, United Arab Emirates, must more than double their spending by 2010 to make new malls being built in the emirate commercially viable, according to U.K.-based real-estate brokers Colliers CRE Plc. 'Dubai is set to become one of the most intensively shopped cities on the planet,' Stuart Gissing, Collier's regional retail director, said..."

Speculator Watch:

March 22 - Bloomberg (Bradley Keoun and Elizabeth Hester): "Farallon Capital Management LLC disclosed talks to buy Accredited Home Lenders Holding Co. before extending it a loan, joining rival hedge funds in the hunt for mortgage assets at bargain prices... Separately, Citadel Investment Group LLC, which bought bankrupt ResMae Mortgage Corp. two weeks ago, disclosed that it holds a 4.5% stake in Accredited."

Financial Sphere Earnings Watch:

Total Assets jumped $61.1bn, or 21.8% annualized, during the quarter to $1.182 TN. Total Assets expanded at a 30% rate during the past six months, with a one-year gain of $223bn, or 23.2%.

The Smooth Flow of Credit:

"The smooth flow of credit is 'essential for a healthy economy,' Federal Reserve Chairman Ben Bernanke said Thursday, amid continuing concerns about the impact of risky mortgage loans on the economy." (Associated Press)

Chairman Bernanke made this fundamental point yesterday at the opening of the Richmond Fed's 2007 Credit Market Symposium. Unfortunately, the critical role of the "smooth flow of Credit" receives scant attention these days in the age of Perceived Perpetual Liquidity Abundance. Instead, modern finance is today fixated on derivatives and the capacity for these instruments to effectively transfer and disburse risks. Little heed is paid to how profoundly derivatives and Wall Street "structured finance" impact the scope, directional flow and stability of finance through securities and asset markets and real economies.

Fundamental to the "smooth flow of Credit"/finance is the nebulous issue of Liquidity. The liquidity issue was central to presentations at this year's Credit Market Symposium, and Fed governor Jeffrey Lacker opened today's panel discussion on "Liquidity risk in Credit markets" with a definition:

"As a monetary and banking economist, I often wince at the word 'Liquidity'. It's a notoriously difficult word or concept to define crisply. It's a word and set of ideas that's thrown around with abandon, especially in the financial press. You hear phrases like, "The world is awash with liquidity; "There's a lot of excess liquidity in the markets." And it's never obvious what that means beside interest-rates are low... In the context of Credit markets... I'll offer this [definition]...: It has to do with the risk of the price you'll get from trying to sell the stuff you've got... The risk that it's not the price you want."

Fed Governor Randall Kroszner's presentation offered a more technical view:

"Credit markets have been evolving very rapidly in recent years. New instruments for transferring credit risk have been introduced and loan markets have become more liquid. Asset managers have become an important force in a wider range of credit markets. Taken together, these changes have transformed the process through which credit demands are met and credit risks are allocated and managed. ...I believe these developments generally have enhanced the efficiency and the stability of the credit markets and the broader financial system by making credit markets more transparent and liquid, by creating new instruments for unbundling and managing credit risks, and by dispersing credit risks more broadly."

"The evolution of the credit markets has been spurred by the astonishing growth of new credit instruments, particularly credit derivatives. The notional amount of credit derivatives outstanding has doubled each year for the past five years; it totaled $20 trillion at the end of June 2006..."

"The dramatic improvement in credit market liquidity has been spurred by credit derivatives. One way to measure the improvement in liquidity is with bid-ask spreads."

"Enhanced liquidity and transparency should promote better risk management by market participants and facilitate broader participation in credit markets. Liquid markets make it easier to access historical price data and thus permit better measurement of credit risks. Measuring a risk more accurately allows it to be priced more accurately. A more transparent market with more accurate pricing is attractive to a wider array of investors. In effect, better liquidity and transparency have lowered the cost of entry into the credit markets. In addition to enhanced liquidity and transparency, the recent developments in credit markets have equipped market participants with new tools for taking on, hedging, and managing credit risk."

While defining Liquidity is no easy task, it's one of those "you'll know it when you see it" things. I would also argue that, these days, the more important analytical focus should be with the myriad risks associated with excessive (inflationary) buying power rather than prospective markdown risks from asset liquidations. Certainly, there should be no disputing the extraordinary U.S. and global markets Liquidity backdrop. Despite the Fed having raised interest rates 17 times in two years, the capacity to aggressively expand Credit - especially riskier loans - with minimal impact on its price (or risk premiums actually declining!), along with the wherewithal to significantly bid up global asset prices, only increased over time. Markets became more "Liquid."

The source of the buying power - the "Liquidity" - is not all that ambiguous. We're coming off another year of record U.S. Credit and Current Account Deficit growth, along with synchronized robust Credit expansions ongoing across the globe. Here at home, the financial sector continues to expand at double-digit rates and, in fact, growth notably accelerated late last year. It is worth noting that the primary dealer "repo" positions, as reported by the New York Fed, have increased about $280bn y-t-d (to a record $3.73TN) Global central bank balance sheets are experiencing unprecedented expansion, with this ballooning also having accelerated as of late. Additionally, there is little indication that the global leveraged speculating community has toned down its aggressive posture or that the boom in global derivative markets has begun to wane - subprime notwithstanding.

Such rampant Credit expansion certainly creates the appearance of a fluid and well-functioning system. The key challenge for policymakers is not to extrapolate current Liquidity abundance - as evidenced by narrow bid/ask spreads and meager risk premia - but to work diligently to assess the stability and sustainability of current financial Flows. Indeed, Acute Credit Excess and accompanying aggressive Risk Embracement are too often precursors for an abrupt reversal of financial Flows and impending Liquidity dislocation (i.e. subprime). And how can a boom in Credit derivatives ("doubled each year for the past five years" to $20TN) not be quite alarming? Fundamentally, any facet of Financial Sphere growth of such magnitude should be analyzed with great judiciousness.

Excerpts from Fed governor Kohn's Credit Symposium presentation:

"At the Federal Reserve, we have considerable interest in credit risk and credit derivatives. As these markets develop and become more complete, they facilitate risk transfer and diversification, thereby increasing the resilience of our financial system."

"For example, in our roles as bank supervisors and protectors of financial stability, we monitor the credit spreads of financial institutions as early warning signs of possible financial stress."

"Credit derivatives, like all derivatives, are in zero net supply, and, abstracting from the very important issue of counterparty credit risk, they neither add to nor subtract from the stock of financial risk in the economy. They do, however, provide new and more-efficient ways for sharing and hedging the risks that do exist, and they facilitate the transfer of those risks to those who are most willing to evaluate and bear them."

That derivatives "neither add to nor subtract from the stock of financial risk in the economy" is a fundamental analytical flaw carried forward from the Greenspan Era. The Fed may disregard reality, but derivatives clearly foster heightened risk-taking, speculative leveraging, financial Credit growth, and Credit excess, generally. And ballooning derivatives markets have become absolutely fundamental to Liquidity (over) abundance. And while they certainly facilitate the transfer of risk, this risk "intermediation" dynamic tends to fashion a Dramatically Unsmooth Flow of Credit, while relegating Credit and market risk to participants with little willingness or capacity to absorb the type of losses induced by severe market declines.

According to Bear Stearns, subprime loan balances have grown to approach $1.5 TN. And there is another $1.1 TN in "Alt-A" and another $1.4 TN of "Jumbo" loans that have accumulated in the marketplace. Much of this risky mortgage exposure now resides in various securitizations and derivatives (including CDOs). It is, then, today not fair to ponder the facilitating role derivatives played in this huge and destabilizing Flow of Risky Credit. How significantly did the capacity of Wall Street "structured finance" to transform a large percentage of these weak Credits into highly-rated and liquid securitizations ("Moneyness of Credit") abet the boom in risky mortgage Credit? Clearly, derivative market risk intermediation was integral to the flood of finance into the subprime space. Marketplace risk perceptions were drastically distorted during the boom, and we're certainly seeing similar dynamics today throughout corporate and M&A finance.

Excerpts from today's Credit Symposium keynote address by Timothy Geithner, President of the New York Fed:

"By spreading risk more broadly, providing opportunities to manage and hedge risk, and making it possible to trade and price credit risk, credit market innovation should help make markets both more efficient and more resilient. They should help make markets better able to allocate capital to its highest return and better able to absorb stress...

Credit market innovation does not appear to have resulted in a large increase in leverage in the corporate sector, as some had feared. Indeed, nonfinancial corporate leverage in the United States is currently low by recent historical standards.

Credit market innovations have transformed the financial system from one in which most credit risk is in the form of loans, held to maturity on the balance sheets of banks, to a system in which most credit risk now takes an incredibly diverse array of different forms, much of it held by nonbank financial institutions that mark to market and can take on substantial leverage.

U.S. financial institutions now hold only around 15 percent of total credit outstanding by the nonfarm nonfinancial sector: that is less than half the level of two decades ago. For the largest U.S. banks, credit exposures in over-the-counter derivatives is approaching the level of more traditional forms of credit exposure. Hedge funds, according to one recent survey, account for 58 percent of the volume in credit derivatives in the year to the first quarter of 2006.

Financial shocks take many forms. Some, such as in 1987 and 1998, involve a sharp increase in risk premia that precipitate a fall in asset prices and that in turn leads to what economists and engineers call "positive feedback" dynamics. As firms and investors move to hedge against future losses and to raise money to meet margin calls, the brake becomes the accelerator: markets come under additional pressure, pushing asset prices lower. Volatility increases. Liquidity in markets for more risky assets falls."

I acknowledge the notion that derivatives and other Credit market innovations work to "make markets both more efficient and more resilient" and that they help "allocate capital to its highest return." I just adamantly disagree. Analytically, I would instead stress the proposition that Credit and speculative excesses foremost inherently distort market pricing mechanisms. The process of ongoing excess promotes, throughout the Financial Sphere, unsustainable financial flows, unrealistic expectations, and increasingly weak and susceptible debt structures. In the Economic Sphere, the inflationary process promotes a misallocation of resources and structural maladjustment. Again, the focus on "Liquidity" should be with its distorting inflationary effects during the boom and not the inevitable price markdowns experienced with the onset of the bust. Contemporary finance has mastered the art of incredibly efficient Credit expansion and incredibly efficient leveraged speculation, but at the (surreptitious) expense of market efficiency.

I am curious why Mr. Geithner would highlight the non-financial corporate balance sheet, when it has surely been the financial sector where derivatives and financial innovation have promoted unprecedented growth. Perceptions within the Financial Sphere that contemporary finance enables highly effective risk management have been instrumental in fomenting the boom. And, importantly, the expansion of financial sector assets and liabilities is at the epicenter of system Liquidity creation, liquidity abundance that has flowed with great inflationary vigor to corporate profits, cash flows and equity prices. It is certainly no coincidence that corporate earnings have inflated concurrently with derivatives markets and leveraged speculation.

Unlike Messrs. Koszner and Kohn, Mr. Geithner at least noted the role of hedge funds, "positive feedbacks," and financial shocks. Any serious discussion of derivatives and contemporary risk intermediation should devote significant time to the proliferation of trend-following "dynamic hedging" strategies. This entails managing hedging-related risks as the markets move, generally acquiring underlying financial assets when the markets are rising and then selling when they are declining. And the more prominent the role of derivatives on the upside the more likely the event of liquidity dislocation on the downside (when position liquidation and hedging-related selling abruptly alter marketplace perceptions of both risk and Liquidity).

This remains the most incredible period in financial history. A strong case can be made that the traditional Credit Cycle has turned - an especially momentous development considering the scope of previous Mortgage Credit Bubble Excesses and attendant economic imbalances. Can we, then, infer that the Liquidity Cycle has similarly turned? Are they not one and the same? Well, in the age of contemporary Wall Street securities finance, they are not. And the case for a Liquidity cycle turn is not yet as convincing.

To this point, there are few indications of waning derivatives growth; or a slowdown in financial sector expansion; or a meaningful moderation in global Credit growth. Worse yet, there is ample evidence of Wall Street's keen desire to push the envelope of leveraged speculation in preparation for the (non-financial) Credit slowdown-induced Fed easing cycle. Perhaps U.S. and global markets this week demonstrated to the Fed why Liquidity and speculative excesses should be the focus. Central bankers should be in no rush to appease. Cutting interest rates would likely temporarily accomplish a few things, but promoting a Smooth Flow of Credit would definitely not be one of them.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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