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June 08, 2007

Q1 2007 Flow of Funds
by Doug Noland

In a volatile week for global financial markets, the Dow declined 1.8% (up 7.7% y-t-d) and the S&P500 1.9% (up 6.3%). The Transports were smacked for 3.9% (up 12.3%), and the Utilities sank 5.6% (up 5.8%). The Morgan Stanley Cyclical index declined 1.8%, reducing y-t-d gains to 19.8%. The Morgan Stanley Consumer index fell 2.4% (up 5.7%). The small cap Russell 2000 fell 2.1% (up 6.1%) and the S&P400 Mid-Cap index 2.5% (up 11.8%). Technology stocks generally outperformed. For the week, the NASDAQ100 declined 1.1% (up 8.5%), with the Morgan Stanley High Tech index down only 0.8% (up 7.7%). The Semiconductors dipped 0.3% (up 4.4%). The Street.com Internet Index declined 1.5% (up 8.6%), and the NASDAQ Telecommunications index lost 1.7% (up 5.7%). The Biotechs skidded 4.3% (up 4.9%). The Broker/Dealers declined 1.7% (up 8.9%) and the Bank fell 2.0% (down 1.9%). With Bullion sinking $22.80, the HUI gold index sank 4.9%.

It was bloody out the curve. Two-year U.S. government yields increased 3 bps to 5.0%. Five-year yields jumped 13 bps to 5.05%. Ten-year Treasury yields surged 16 bps to 5.11% (11-mnth high). Long-bond yields jumped 16 bps to 5.22%. The 2yr/10yr spread ended the week at 11 bps - the most positively sloped curve (2/10) since May 2006. The implied yield on 3-month December '07 Eurodollars rose 2 bps to 5.355%. Benchmark Fannie Mae MBS yields surged 20 bps to an 11-month high 6.28%, this week underperforming Treasuries. The spread on Fannie's 5% 2017 note widened 3 to 42, and the spread on Freddie's 5% 2017 note widened 3 to 38. The 10-year dollar swap spread increased 3 to 60.50. Corporate bond spreads were mixed to wider, with the spread on a junk index 4 wider.

June 5 - Dow Jones (Laurence Norman): "Goldman Sachs Tuesday became the latest Wall Street dealer to reverse its call for a Federal Reserve rate cut in 2007, with economists at the firm now seeing growth picking up faster and the jobless rate ticking higher more slowly than they previously expected. The bank previously saw the federal funds rate falling to 4.50% by year end, with the easing starting in September. 'However, although real GDP (gross domestic product) growth has slowed as anticipated, the absence of any tangible evidence of rising unemployment makes it unlikely that Fed officials will cut' rates, Goldman economists said..."

Investment grade issuers included Wachovia $2.25bn, Wellpoint $1.5bn, Valero Energy $2.25bn, Janus Capital $750 million, BB&T $600 million, Cardinal Health $600 million, Jefferies Group $600 million, PNC Funding $500 million, Promise $500 million, FPL Group $400 million, Discover Finance $800 million, Genworth Financial $350 million, AGFirst Farm Credit $250 million, Pepco Holdings $250 million, and Gulf Power $85 million.

Junk issuers included Reliant Energy $1.3bn, Hub International $700 million, Sanmina-SCI $600 million, Outback Steakhouse $550 million, W&T Offshore $450 million, Pinnacle Entertainment $385 million, Bristow Group $300 million, and Actuant $250 million.

This week's convert issuers included Amylin Pharmaceuticals $575 million, Ciena Corp $500 million, Noranda Aluminum $220 million, Cogent Communications $200 million, Integra Lifescience $165 million and Dendreon $75 million.

International dollar bond issuers included Promise Co. $500 million, Tristan Oil $420 million, Alto Parana $270 million, Willow RE $250 million, Air Jamaica $125 million, and Nelson RE $75 million.

German 10-year bund yields jumped 11 bps to 4.57% (high since Oct. '02). Japanese 10-year "JGB" yields surged 13 bps to 1.89% (high since 2000). The Nikkei 225 declined 1.0%, reducing y-t-d gains to 3.2%. Emerging equities markets were under moderate pressure, while debt markets were slammed by the global yield maelstrom. Brazil's benchmark dollar bond yields surged 30 bps this week to 6.10%. Brazil's Bovespa equities index declined 2.0%, reducing y-t-d gains to 17.7%. The Mexican Bolsa declined 1.5%, reducing 2007 gains to 19%. Mexico's 10-year $ yields jumped 26 bps to 5.88%. Russia's RTS equities index fell 2.2% (down 6.9% y-t-d). India's Sensex equities index sank 3.5% (up 2.0% y-t-d). China's Shanghai Composite index declined slipped 2.2%, reducing y-t-d gains to 46% and 52-week gains to 146%.

Freddie Mac posted 30-year fixed mortgage rates jumped 11 bps to 6.53% (down 9bps y-o-y) - the highest borrowing rate since the week of August 11. Fifteen-year fixed rates rose 10 bps to 6.22% (down 1bp y-o-y), with a four-week gain of 35bps. One-year adjustable rates increased 8 bps to 5.65% (up 2bps y-o-y). The Mortgage Bankers Association Purchase Applications Index rose 1.5% for the week. Purchase Applications were up 9.8% from one year ago, with dollar volume 15.6% higher. Refi applications dropped 6.3% for the week, yet dollar volume was still up 33.6% from a year earlier. The average new Purchase mortgage dipped to $238,600 (up 5.3% y-o-y), while the average ARM declined to $402,400 (up 18.1% y-o-y).

Bank Credit surged $34bn (week of 5/30) to a record $8.575 TN (2-wk gain of $44.2bn). For the week, Securities Credit decreased $2.0bn. Loans & Leases jumped $36.1bn to $6.280 TN. C&I loans rose $6.7bn, and Real Estate loans gained $4.0bn. Consumer loans jumped $6.8bn, while Securities loans slipped $2.7bn. Other loans jumped $21.4bn. On the liability side, (previous M3) Large Time Deposits fell $17.4bn.

M2 (narrow) "money" dipped $2.8bn to $7.241 TN (week of 5/28). Narrow "money" has expanded $198bn y-t-d, or 6.6% annualized, and $441bn, or 6.5%, over the past year. For the week, Currency added $0.2bn, and Demand & Checkable Deposits increased $7.4bn. Savings Deposits dropped $14.1bn, while Small Denominated Deposits rose $1.6bn. Retail Money Fund assets gained $2.2bn.

Total Money Market Fund Assets (from Invest. Co Inst) surged $37.9bn last week to a record $2.526 TN. Money Fund Assets have increased $144bn y-t-d, a 13.7% rate, and $431bn over 52 weeks, or 20.6%.

Total Commercial Paper gained $1.6bn last week to a record $2.115 TN, with a y-t-d gain of $140bn (16.1% annualized). CP has increased $318bn, or 17.7%, over the past 52 weeks.

Asset-backed Securities (ABS) issuance rose to $16bn. Year-to-date total US ABS issuance of $316bn (tallied by JPMorgan) is running about 1% ahead of comparable 2006. At $152bn, y-t-d Home Equity ABS sales are 31% below last year's pace. Meanwhile, y-t-d US CDO issuance of $152 billion is running 19% ahead of record 2006 sales.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 6/6) declined $3.9bn to $1.955 TN, with a y-t-d gain of $203bn (26% annualized). "Custody" holdings expanded $330bn during the past year, or 20%. Federal Reserve Credit last week expanded $4.1bn to $857.9bn. Fed Credit has gained $5.7bn y-t-d, or 1.5% annualized, with one-year growth of $28.5bn y-o-y (3.4%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $599bn y-t-d (28% annualized) and $955bn y-o-y (21%) to a record $5.410 TN.

June 8 - Bloomberg (Anoop Agrawal): "India's foreign-exchange reserves rose $3.44 billion to $208.37 billion in the week ended June 1, the central bank said."

Currency Watch:

June 8 - Bloomberg (Jake Lee): "Hong Kong's government and de-facto central bank 'seriously' considered scrapping the city's currency link to the U.S. dollar during a financial crisis in 2002, former Financial Secretary Antony Leung said... Former Hong Kong Chief Executive Tung Chee-Hwa said ditching the peg was considered when 'financial sharks' were attacking the link in 2002, the Standard reported today..."

June 5 - Bloomberg (Matthew Brown): "The United Arab Emirates may be the next Middle Eastern country to stop pegging its exchange rate to the U.S. dollar, according to trading in currency forwards. The second-largest Arab economy may follow Syria and Kuwait, which both said in the past two weeks that they would dump the dollar peg to curb rising import costs and inflation. Middle East currencies have been dragged lower by declines in the dollar, pushing up the cost of imports from Europe and Asia."

The dollar index gained 0.5% to 82.69. On the upside, the New Zealand dollar gained 2.5%, the Australian dollar 1.4%, the Thai baht 1.3%, and the Belize dollar 1.0%. On the downside, the Iceland krona declined 4.2%, the Indonesian rupiah 3.1%, the Israeli shekel 2.9%, and the Brazilian real 3.0%.

Commodities Watch:

June 5 - Bloomberg (Angela Macdonald-Smith): "Uranium spot prices may reach $200 a pound within the next two years, buoyed by a shortfall in supply and increasing investment in the nuclear fuel by speculators, said Macquarie Bank Ltd., Australia's biggest securities firm. The price, which reached $125 a pound in mid-May, will probably average $125 a pound this year... Uranium prices have jumped 12-fold since early 2003..."

For the week, Gold dropped 3.4% to $648.85 and Silver 5.1% to $13.04. Copper fell 4.3%. July crude declined 52 cents to $64.56. July gasoline sank 5.2%, and July Natural Gas fell 2.7%. For the week, the CRB index declined 2.1% (up 0.1% y-t-d), and the Goldman Sachs Commodities Index (GSCI) dipped 1.1% (up 8.6% y-t-d).

Japan Watch:

June 4 - Bloomberg (Lily Nonomiya): "Spending by Japan's largest companies rose to a record in the first quarter, indicating the world's second-largest economy probably grew at a faster pace than the 2.4% initially estimated by the government. Capital spending climbed 13.6% in the three months ended March 31 from a year earlier..."

China Watch:

June 6 - Bloomberg (Zhang Dingmin and Josephine Lau): "China should expand local companies' fundraising options by letting commercial banks invest in the country's private-equity funds, the deputy central bank governor said. 'Our current capital market is insufficient in meeting the funding needs of our companies,' Wu Xiaoling said... 'Banks are institutions that manage risks anyway so they should be in the best position to judge the risks in these instruments.'"

June 8 - Bloomberg (Christina Soon): "China's inflation rate rose to a more than two-year high last month, Market News International reported... Consumer prices may have climbed to 3.5% in May..."

June 6 - Bloomberg (Li Yanping): "China's retail sales are expected to grow by about 14% this year, the Ministry of Commerce said... Sales may rise to 8.7 trillion yuan ($1.1 trillion)..."

June 4 - Bloomberg (Kelvin Wong): "Hong Kong's home sales rose 63.4% in May compared with a year earlier, according to the city's Land Registry."

India Watch:

June 8 - Bloomberg (Anil Varma): "Money supply in India grew at the slowest pace since December... The M3 measure of money supply increased 19.6% in the two weeks through May 25 from a year earlier..."

Asia Boom Watch:

June 4 - Bloomberg (Anuchit Nguyen): "Thailand's economic growth expanded faster than economists expected in the first quarter as rising exports of rubber, hard disk drives and automobiles countered a slump in consumption and investment. Southeast Asia's second-biggest economy expanded 4.3% in the three months..."

Unbalanced Global Economy Watch:

June 8 - Bloomberg (Greg Quinn): "Canada's April trade surplus widened to the biggest since July 2004, as exports fell slower than imports. The surplus widened to C$5.76 billion ($5.4 billion)..."

June 5 - Bloomberg (John Fraher): "A one-bedroom apartment in London's affluent Belgravia district has gone on sale for a record price of more than 3 million pounds ($6 million), the Evening Standard reported..."

June 8 - Bloomberg (Jennifer Ryan): "The Bank of England...may have to move faster to curb the U.K.'s worst bout of inflation in a decade. Manufacturers' optimism about their pricing power rose to a 12-year high in May... 'Inflation is high and sticky,' said Alan Clarke, an economist at BNP Paribas in London. 'Underlying prices will continue to accelerate throughout this year. The bank is behind the curve.'"

June 6 - Bloomberg (Sharon Smyth and Ricard Alonso): "Javier Usua and Ruth Graneda never got out of the car when they visited Sanchinarro and Las Tablas, two of Madrid's biggest new suburban developments. The concrete-block buildings and empty streets were all they needed to see. 'We came to look at apartments but found ghost towns,' said Usua, a 27-year-old taxi driver. 'You'd need to drive miles for a loaf of bread or cigarettes and my girlfriend found it creepy and unsafe so we turned around and left.' The abandoned developments are evidence of a housing glut that will lead to Spain's first decline in home prices since at least 1992..."

June 8 - Bloomberg (Jonas Bergman): "Swedish unemployment slipped to the lowest in 16 years... The...rate dropped to 3.3%, the lowest since 1991, from 3.7% in April..."

June 8 - Bloomberg (Torrey Clark and Michael Heath): "Russia's economic growth will accelerate faster than last year, perhaps exceeding 7%, President Vladimir Putin's economic adviser said..."

June 6 - Bloomberg (Hans van Leeuwen and Gemma Daley): "Australia's economy grew at the fastest pace in more than three years, pushing the nation's currency to the highest since 1989 on expectations the central bank will raise interest rates to ward off inflation. Gross domestic product rose 1.6% in the three months ended March 31..."

Latin American Boom Watch:

June 5 - Bloomberg (Eliana Raszewski): "Argentina's consumer prices last month rose 8.8% from May last year, the National Statistics Institute reported."

June 8 - Bloomberg (Alex Emery): "Peru's economy will expand more than previously expected this year, led by growth in manufacturing and retailing, central bank President Julio Velarde said. Gross domestic product will expand 7.2%..."

June 8 - Bloomberg (Jorge Rebella and Eliana Raszewski): "Uruguay's gross domestic product rose 6.7 percent in the first quarter from the same period last year, the country's Central Bank reported..."

Central Banker Watch:

June 6 - The Wall Street Journal (Marcus Walker, Greg Ip and Andrew Batson): "For the past decade, low-priced labor from China, India and Eastern Europe has helped much of the world enjoy economic growth without the sting of inflation. Now that damper on prices is beginning to reverse -- and global inflation pressure is starting to build. Companies in many countries are operating at close to full capacity, facing shortages of everything from land to equipment. Western workers and their low-cost rivals both are winning higher pay, thanks to rising demand. In some cases, the global links of the economy are increasing costs rather than lowering them, as far-flung businesses compete for the same resources. Central banks are increasingly worried about spare production capacity running out -- which could force them to raise rates to their highest level in years to stave off inflation."

June 8 - Bloomberg (Tracy Withers): "New Zealand's central bank unexpectedly raised its benchmark interest rate a quarter point to a record 8%, saying housing demand and consumer spending are fanning inflation... 'A sustained period of slower growth in domestic activity will be required to alleviate inflation pressures,' Reserve Bank Governor Alan Bollard said... A 60% surge in world prices of dairy products the past six months has boosted farmers' incomes and will stoke inflation next year, he said."

June 5 - Bloomberg (Craig Torres): "Federal Reserve Chairman Ben S. Bernanke commented on global liquidity and financial risks in a question and answer period...to the International Monetary Conference... On sources of liquidity: 'One of the fundamental forces driving the so-called wall of liquidity is the amount of gross saving in the world looking for return.'"

Bubble Economy Watch:

June 5 - Bloomberg (Curtis Eichelberger): "Jim Balsillie's $220 million purchase of the Nashville Predators last month may reflect renewed confidence in the future of the National Hockey League. In selling the Predators, Tennessee businessman Craig Leipold almost tripled the $80 million he paid for the expansion team in 1997, even though the club lost $15 million this season and is ranked in the bottom third of the league in attendance."

Mortgage Finance Bubble Watch:

June 5 - Bloomberg (Jody Shenn and James Tyson): "Fannie Mae and Freddie Mac, the once-derided white elephants of the mortgage market, are benefiting from the subprime lending debacle and trampling just about anything in their way. The government-chartered companies, the biggest source of money for Americans buying houses, accounted for 46.9% of all mortgage bonds sold through April, newsletter Inside Mortgage Finance says. Their share rose from a record low 37.3% in last year's second quarter. The biggest slump in U.S. home prices since 1991 is reviving Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac..."

Foreclosure Watch:

June 8 - Los Angeles Times (Annette Haddad): "On Kentucky Derby Drive in Moreno Valley, the houses with "for sale" signs on their lawns boast Craftsman-style facades, roomy floor plans and granite-countered kitchens. Four of the nine have something else in common: They're owned by lenders. Saddled with properties the borrowers could no longer afford, banks and mortgage companies have joined the legions of individual homeowners trying to sell on the open market -- and at a pace not seen in more than a decade... Currently, nearly 3% of the homes for sale in Southern California are owned by lenders, according to...ZipRealty, up from less than 1% a year ago. 'Volumes are increasing, definitely,' said Patrick Carey, the executive in charge of foreclosed properties at Wells Fargo & Co...."

Real Estate Bubbles Watch:

June 6 - The Wall Street Journal (James R. Hagerty): "Growing inventories of unsold homes continue to weigh on the U.S. housing market, portending more downward pressure on prices, the latest data show. The number of homes listed for sale in 18 major U.S. metropolitan areas at the end of May was up 5.1% from April, according to figures compiled by ZipRealty Inc...."

June 8 - Bloomberg (Sharon L. Crenson): "Manhattan landlords raised rents last month for studio and one-bedroom apartments by an average of 4% as graduates flocking to the largest U.S. city seeking work boosted demand for housing."

Energy Boom and Crude Liquidity Watch:

June 4 - Bloomberg (Grant Smith and Tom Cahill): "Oil companies including Exxon Mobil Corp., Royal Dutch Shell Plc and Chevron Corp. returned a total of $118 billion to shareholders last year, according to Moody's... The 16 integrated oil companies assessed by Moody's distributed 'generous' returns amid rising global energy prices, analysts...said ... 'We expect growth in dividends to continue,' they said."

Climate Watch:

June 7 - Reuters: "Los Angeles residents were urged...to take shorter showers, reduce lawn sprinklers and stop throwing trash in toilets in a bid to cut water usage by 10% in the driest year on record. With downtown Los Angeles seeing a record low of 4 inches of rain since July 2006 -- less than a quarter of normal -- and with a hot, dry summer ahead, Mayor Antonio Villaraigosa said the city needed 'to change course and conserve water to steer clear of this perfect storm.' It is the driest year since rainfall records began 130 years ago. The Eastern Sierra mountains, where Los Angeles gets about half of its water supply, marked its second-lowest snowpack on record this year. That and the lack of rainfall could force the nation's second largest city into full drought mode in coming months, officials said."

Fiscal Watch:

June 5 - The Associated Press: "States spent freely this year, though worries about tighter times ahead are resulting in more modest plans for the new fiscal year that starts this summer, the nation's governors reported Tuesday. Overall state spending rose this year well above average growth - up 8.6% nationally over the previous year, compared with 6.5% growth on average over the past three decades. That heavier spending helped states cover higher costs for health care, education and employee pensions, according to a new survey from the National Governors Association and the National Association of State Budget Officers. They were able to do so because revenues came in stronger than expected in the current fiscal year..."

Q1 2007 Flow of Funds:

The latest Federal Reserve Z.1 Report provides its usual interesting and illuminating "read". At $3.607, Total SAAR (Seasonally-Adjusted and Annualized Rates) Credit Market Borrowings remain enormous - although somewhat slower than Q4's SAAR $3.820 TN growth. For perspective, 2004 was the first year total borrowings surpassed $3.0 Trillion, with total borrowings averaging $2.292 TN annually during the decade 1996 to 2005. Total borrowings increased $3.706 TN during 2006, $3.463 TN in '05, $3.232 TN in '04, $2.896 TN in '03, $2.495 TN in '02, and $2.263 TN in '03. The trend of accelerating Credit expansion is unmistakable and, despite the housing slowdown, there's a legitimate possibility it runs through 2007.

Continuing last year's trend, Non-Financial Debt growth further moderated, while immoderate Financial Sector expansion gained additional momentum. Most analysts are focused on the slowdown in Non-Financial Debt and its negative economic implications. I'll instead suggest that the historic financial sector expansion is the predominant dynamic. At this point, sustaining this runaway Credit expansion will be no easy feat. Yet, as long as it perseveres, unstable financial markets will be buffeted by liquidity overkill - and the Bubble Economy will be further contorted by these unwieldy inflationary forces.

For the first quarter, Total Non-Financial Debt Growth slowed from Q4's 8.2% to 7.3%, while Financial Sector Credit Market Borrowings jumped from a robust 8.1% rate to a booming 9.3%. In nominal (SAAR) dollars, Non-Financial Debt growth slowed to $2.084 TN from Q4's $2.304 TN rate, while Financial Sector Borrowing jumped to $1.354 TN from Q4's $1.166 TN. And do keep in mind the mid-quarter subprime meltdown and market turbulence that for at least a few weeks threw some sand in the securities issuance gears.

Although slowing from last year's blistering pace, Broker/Dealer Assets expanded SAAR $540bn, or about a 20% rate during the quarter, to $2.866 TN. For perspective, the Broker/Dealers expanded $615bn last year; $282bn in 2005; $232bn in 2004; $278bn in 2003; declined $130bn in 2002; and increased $244bn in 2001 and $220bn in 2000. Two-year Broker/Dealer growth increased to $919bn, or 47%. On the Asset side, Misc. Assets expanded at a 27% rate during the quarter to $1.664 TN, with a y-o-y gain of $619bn, or 25%. Credit Market Instruments expanded at a 30% rate, with y-o-y gains of $130bn, or 26%. Corporate Bond holdings grew at a 24% rate during the quarter, with a y-o-y gain of $68bn, or 19.8%.

The Liability Side of the Broker/Dealer balance sheet remains today a focal point of Macro Credit Analysis. Wall Street-pioneered innovation has profoundly altered contemporary "money" and Credit. Clearly, the traditional expansion of Deposit Liabilities - during the process of banking sector (loan) expansion - some time back lost its role as the primary source of system liquidity creation. As analysts, we must take a broad view of financial expansion and examine a wide range of financial sector liabilities created in the process lending as well as securities leveraging.

The Broker/Dealer Liability "Repurchase Agreements" ("repos") expanded SAAR $372bn (in nominal dollars - 29.3% annualized) during the first quarter to $1.150TN. "Repo" Liabilities jumped $333bn, or 40.8%, over the past year and have doubled in about two years. The Liability "Security Credit" increased $30.2bn, or at a 12.6% rate during the quarter, with a one-year gain of $132bn, or 15.5%, to $988bn. The Liability "Due to Affiliate" was little changed during the quarter at $1.132 TN, with a y-o-y gain of $156bn, or 16.0%.

The Fed's Z.1 category "Funding Corporations" - "Funding subsidiaries, non-bank financial holding companies, and custodial accounts for reinvested collateral of securities lending operations." - Assets expanded a notable SAAR $498bn during the quarter to $2.199 TN. Funding Corp Assets were up $299bn y-o-y, with a 2-year gain of $596bn, or 37.2%. At $929bn, "Investment in brokers and dealers" was the biggest Funding Corp Asset. Primarily, these Funding Corps are vehicles used in securities financing operations, including the reinvestment of short sale (debt and equity) proceeds. And, in large part, it would appear that the "liquidity" acquired from a shorting transaction flows back to the broker/dealer community where it finances asset growth (i.e. securities holdings, lending to hedge fund and other clients, and derivatives operations).

The category "Federal Funds and Security Repurchase Agreements" expanded at a robust SAAR $470bn during Q1 to $2.610 TN. Over the past year, "Fed Funds and Repos" expanded $483bn, or 22.7%, with a 2-year gain of $828bn, or 46.4%. For perspective as to the systemic scope of the "repo" boom, total Bank Credit expanded $722bn y-o-y. Banks ended the quarter with a net "Fed Funds and Repo" Liability of $1.284TN, now only somewhat larger than the Broker/Dealer's $1.150 TN. For comparison, at the end of 2002 the Banks net "Fed Funds and repo" Liability of $902bn overshadowed the Broker/Dealers' $344bn. Interestingly, Rest of World (ROW) holdings of "Fed Funds and Repos" expanded SAAR $717bn during the quarter to $1.141 TN, having increased 60% over the past five quarters. ROW holdings have increased from 7.6% of total (net) "Fed funds and Repos" at the end of year 2000 to 43.7% to end the first quarter.

The Money Market Fund complex is again playing a prominent role in the ongoing Credit expansion, more recently in helping finance the Wall Street/securities boom. Money Market Funds expanded SAAR $428bn during the quarter to $2.390 TN. Money Funds grew $376bn over the past year, or 18.7%, with a 2-yr gain of 30%.

The ongoing boom in Wall Street "structured finance" showed no sign of abating. "Agency- and GSE-backed Mortgage Pools" expanded SAAR $468bn during the quarter to $4.076 TN, double the fourth quarter's pace to the strongest expansion in several years. This took one-year Agency MBS growth to a relatively robust $322bn, or 8.6%. This sector was bolstered by subprime woes and the resulting newfound appetite for perceived safer mortgage securities. At SAAR $604bn, the growth in Asset-backed Securities (ABS including "private-label" MBS) remained strong, although down from Q4's record SAAR $749bn. ABS increased $673bn, or 18.7%, over the past year to $4.268 TN. ABS has ballooned 62% over the past nine quarters. While the boom in their guarantee business has returned, GSE balance sheets remain contained. Asset growth was about flat for the quarter at $2.839bn, with a one-year gain of $24bn, or 0.9%.

A conversion of a commercial bank to a thrift apparently reduced Bank Assets by about $100bn during the quarter, somewhat muddying the analytical waters. All in all, Bank Assets were about unchanged during the quarter at $10.193 TN. Bank Credit rose $26bn (1.2% annualized), reducing y-o-y Bank Credit growth to 9.4% (2-yr gain of 20%). Loans were little changed for the quarter at $6.109 TN. Mortgage assets actually declined by $24bn, offset by a $24bn increased in Corporate Bonds. On a year-on-year basis, Total Loans were up $582bn (10.5%); Mortgages $354bn (11.7%); and Corporate Bonds $94.5bn (13.3%).

On the Bank Liability side, Total Deposits expanded at a 6.4% rate to $6.113 TN, with a one-year gain of 9.1%. Bank net "repo" Liabilities expanded at a 14.2% clip to $1.284 TN, increasing y-o-y gains to 13.5%. Bank Credit Market Borrowings slowed sharply during the quarter to $17bn. Yet, over the past year borrowings jumped 21.2% to $1.015 TN. Miscellaneous Liabilities declined $29bn during the quarter to $1.782 TN (up 3.6% y-o-y).

The historic Wall Street securities boom coupled with significantly slower mortgage Credit growth has taken the pressure off of bank Credit to sustain Bubble excess. Total Mortgage Debt (TMD) expanded SAAR $954bn during the first quarter, down from Q4's $1.101 TN, Q3's $1.242 TN, Q2's $1.236 TN, and Q1 2006's $1.318 TN. Yet keep in mind that TMD, on average, expanded $267bn annually during the nineties. Indeed, it is likely that 2007 will compete with $2003's $1.00 TN for the fourth largest annual increasing in TMD (trailing only 2004-2006). And while Household Mortgage Debt growth slowed to a 6.2% pace, Commercial Mortgage debt growth remained in the low double digits. Over the past year, Home Mortgages increased 8.4% to $10.426bn and Commercial Mortgages jumped 13.9% to $2.261 TN. In two years, Home Mortgages increased 24% and Commercial 31%. Home Mortgages have now increased 114% in seven years.

Examining other non-bank sectors, Life Insurance Assets grew at a 5.8% rate during the quarter to $4.764 TN. Savings Institution Assets gained at a 1.6% rate to $1.667 TN. Real Estate Investment Trust Assets expanded at an 8.5% pace to $412bn (up 19.2% y-o-y). Finance Company Assets were little changed at $1.889 TN (up 1.9% y-o-y). Credit Unions expanded at a 13.9% rate to $741bn (up 5.4% y-o-y). It's too bad there are not categories for hedge funds and CDOs.

Despite the moderation of both Non-Financial Debt and economic growth, there was little letup in the Rest of World accumulation of U.S. financial assets (not surprising, considering the boom in financial sector growth/liquidity creation). For the quarter, ROW increased U.S. asset holdings to the amazing tune of SAAR $1.316 TN to $12.931 TN, down only slightly from Q4's SAAR $1.327 TN. In just 13 quarters, ROW holdings of U.S. financial assets ballooned $4.343 TN, or 51%.

During the first quarter, the ROW accumulation of Credit Market Instruments actually accelerated to SAAR $1.041 TN (to $6.717TN), with Treasuries increasing SAAR $364bn (to $2.219TN); Agencies SAAR $174bn; and Corporate Bonds SAAR $436bn. ROW purchased more Treasuries during the quarter than were issued (SAAR $326bn), about 30% of Agencies issued (SAAR $516bn) and 40% of new Corporate Bonds (SAAR $1.003TN). Over the past year, ROW Credit Market holdings increased $892bn, or 15.3%. During this period, Treasury holdings swelled $193bn (9.5%); Agency $204bn (20%); and Corporate Bonds (including ABS) $442bn (18.3%). As mentioned above, the ROW "repo" holding jumped SAAR $717bn during the quarter, offsetting a SAAR $528bn decrease in "Net Interbank Assets".

And, as always, we'll attempt to glean Credit Bubble insights from the (ballooning) Household (including non-profits) Balance Sheet. For the quarter, Household Assets increased $725bn (4.2% annualized) to $69.608 TN. Real Estate Assets increased $212bn (a 3.7% rate) and Financial Assets jumped $463bn (4.4% rate) to $42.522 TN. And with Liabilities increasing "only" $137bn during the quarter, Household Net Worth rose a respectable $587bn to $56.176 TN. For the year, Household Asset gains of $3.914 TN (6.0%) were offset by Liability increases of $1.002 TN (8.1%), leaving a $2.912 TN (5.5%) rise in Net Worth. Over four years, Assets inflated $21.157 TN (44%); Liabilities $4.604 TN (52%); and Net Worth $16.552 TN (42%). We should not understate the ongoing influence on consumer behavior from the spectacular (4-year plus) inflationary windfall.

The windfall is also lining government coffers. Federal Government first quarter Receipts were up 6.9% from the year ago period, with State & Local Receipts gaining 4.6%. First quarter spending was up a robust 6.0% at the federal level and 7.6% locally. Despite booming tax receipts, federal government borrowings increased at a 6.6% rate during the quarter (after growing 3.9% during 2006). State & Local debt expanded at an 8.6% rate (after 2006's 8.2%).

The ongoing excesses confirmed in the Q1 2007 Flow of Funds leave little confusion with regard to surging global bond yields. It's just surprising bonds ignored rampant global liquidity excess for so long. The abrupt nature of the yield spike is surely problematic for those highly leveraged players (and curve speculators) caught on the wrong side of the market. Clearly, scores of players had positioned for the imminent start of a Fed easing cycle. It's never a smooth process when the crowd rushes to the exit an unsuccessful "crowded trade." But to what extent this unwind impacts liquidity (reduces gross excess) is difficult to assess at this point. The near-term market assumption will likely be that the jump in market yields is sufficient to keep the economy and inflationary pressures in check - holding the Fed at bay.

And while it was a painful week for fixed income, for the system as a whole it was anything but the worst case scenario (rates spiking, stocks collapsing, dollar sinking and spreads blowing out). The yen only rallied slightly, encouraging players that yen carry trade dynamics are still quite favorable. The dollar rallied and most spreads were only moderately wider for the week. Emerging market equities were ok. On a global basis, I doubt recent yield increases will have much influence on overheated Credit systems.

But the week can be viewed as another body blow to a vulnerable marketplace weakened by subprime and heightened volatility. This yield spike certainly comes at an especially poor time for fragile housing markets and mortgages. Yet for global equities, securities finance and M&A - today's prevailing booms and sources of new liquidity - the near-term outlook is anything but clear. I would be somewhat surprised if the current cost of funds meaningfully restrains the overheated M&A Bubble. I would also expect the equities bulls to play hardball, keen to keep the bears on their heels. But it should be increasingly obvious that this massive and unwieldy pool of global speculative finance is a serious problem.

As master of the obvious, I'll predict we're in store for A Long, Hot Summer of Volatility and Discontent. The bond market was content for some time to ignore unfolding fundamentals. The stock market has been gleefully disregarding reality. From Iraq to the entire Middle East to Russia - the disturbing geopolitical backdrop has curiously remained a non-issue. The enormous ongoing cost of national security and the global "war on terror" are brushed off as if they are inconsequential. But, then again, inflating financial markets create their own rationalizations, spin and reality. The latest round of bullish propaganda has really pushed the envelope, setting the stage for major disappointment and disillusionment. If history is any guide, expect a period of wild volatility leading to a financial accident.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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