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July 21, 2007

The Hand of Finance
by Doug Noland

In a volatile and rather ominous week, the Dow dipped 0.4% (up 11.1% y-t-d) and the S&P500 declined 1.2% (up 8.2%). The Transports dipped 0.2% (up 17.5%), and the Morgan Stanley Cyclical index declined 1.3% (up 24.2%). The Morgan Stanley Consumer index dropped 1.9% (up 5.1%), and the Utilities slipped 0.7% (up 8.8%). The broader market was under selling pressure. The small cap Russell 2000 was hit for 2.3% (up 6.2% y-t-d), and the S&P400 Mid-Cap index fell 1.3% (up 13.6%). Technology out-performance continued. The NASDAQ100 mustered a 0.2% gain (up 15.9% y-t-d), and the Morgan Stanley High Tech index rose 0.6% (up 15.0%). The Semiconductors gained 1.3% (up 14.7% y-t-d). The Street.com Internet Index declined 0.9% (up 13.0%), and the NASDAQ Telecom index fell 1.1% (up 17.6%). Financial stocks were under pressure. The Broker/Dealers were smacked for 5% (up 2.9%), and the Banks sank 3.1% (down 5.1% y-t-d). With bullion gaining $16.50, the HUI gold index advanced 3.8%.

Accelerating Flight to Quality. Two-year U.S. government yields this week fell 16 bps to 4.76%. Five-year yields dropped 17 bps to 4.84%. Ten-year Treasury yields sank 15 bps to 4.95%. Long-bond yields ended the week 13 bps lower at 5.06%. The 2yr/10yr spread ended the week at a positive 19 bps. The implied yield on 3-month December '07 Eurodollars declined 7 bps to 5.262%. Benchmark Fannie Mae MBS yields dipped 5.5 bps to 6.265%, this week significantly underperforming Treasuries (MBS spreads widening notably). The spread on Fannie's 5% 2017 note widened 5 to 51, and the spread on Freddie's 5% 2017 note widened 5 to 52. The 10-year dollar swap spread increased 4 to 68.8. Corporate bond spreads widened across the board, with the spread on a junk index this week widening another 15 bps.

July 20 - Financial Times (James Mackintosh): "Investor nervousness over subprime losses in the US, which estimates cited by Ben Bernanke...yesterday put at up to $100bn, is hurting demand for financial flotations. London's Man Group raised only $2.9bn against a target of $3.5bn-$3.8bn from floating MF Global, its brokerage arm.... The Man spin-off was the latest in a series of disappointments for initial public offerings of financial services, prompted by worries that credit could become tighter following the meltdown in the US subprime market. Third Point, a New York activist hedge fund, raised $525m yesterday from listing a fund in London after a 24-hour delay, well below its $690m target. Lehman Brothers injected an extra $45m of its own money into a fund of private equity funds it listed in Amsterdam on Wednesday, to ensure hitting its $500m goal... It remains unclear to what extent subprime contagion will spread into other markets, although widening credit spreads are already hurting some private equity buy-outs."

July 18 - Bloomberg (John Glover and Hamish Risk): "The risk of owning corporate bonds soared to the highest in two years in Europe after Bear Stearns Cos. said investors in two U.S. subprime hedge funds will get little or no money back, credit-default swap prices show."

It was an ominously light week of debt issuance. Investment grade debt issuers included Union Pacific $480 million.

Junk issuers included LBI media $230 million, Lea Power Partners $305 million, and Cardtronics $100 million.

Convert issuers included Health Care REIT $400 million and KKR Financial $300 million.

International dollar bond issuers included Banca Mifel million.

July 18 - Financial Times (Joanna Chung): "Egypt rarely captures the attention of the world's bond market investors. But the North African country came under the spotlight last week when it raised $1bn with the first international bond denominated in Egyptian pounds. The landmark sale sent the strongest signal yet of one of the defining trends in emerging market debt: a marked shift from debt denominated in hard currencies, such as the US dollar and the euro, to debt denominated in local currencies. The deal was two times subscribed in spite of the wider jitters in the market... One of the turning points came last year when trading in local market instruments hit a record high of $3,687bn, accounting for 57% of overall emerging market debt trading volume of $6,500bn - itself a record. This compares with a 47% share in 2005 and 45% in 2004, according to data from EMTA..."

German 10-year bund yields dropped 18 bps to 4.44%, and the highflying DAX equities index sank 2.7% (up 19.4% y-t-d). Japanese 10-year "JGB" yields fell 5 bps to 1.88%. The Nikkei 225 gained 1.0% (up 5.4% y-t-d). Emerging debt and equity markets were mostly resilient or better - but likely increasingly vulnerable. Brazil's benchmark dollar bond yields rose one basis point this week to 6.10%. Brazil's Bovespa equities index dipped 0.3% (up 29% y-t-d). The Mexican Bolsa fell 1.4% (up 20.7% y-t-d). Mexico's 10-year $ yields fell 4 bps to 5.89%. Russia's RTS equities index added 0.4% (up 7.7% y-t-d). India's Sensex equities index gained 1.9% (up 12.9% y-t-d). China's Shanghai Composite index ended the week 3.7% higher (up 51.7% y-t-d and 145% over the past year).

Freddie Mac posted 30-year fixed mortgage rates were unchanged this past week at 6.73% (down 7bps y-o-y). Fifteen-year fixed rates slipped one basis point to 6.38% (down 3bps y-o-y). One-year adjustable rates added one basis point to 5.72% (down 8bps y-o-y). The Mortgage Bankers Association Purchase Applications Index declined 1.6% this week. Purchase Applications were up 10.9% from one year ago, with dollar volume 17.5% higher. Refi applications jumped 4.9% for the week, and dollar volume was up 30.8% from a year earlier. The average new Purchase mortgage rose to $235,600 (up 6.0% y-o-y), and the average ARM jumped to $402,200 (up 19.9% y-o-y).

Bank Credit was about unchanged (week of 7/11) at $8.622 TN (last week's Bank Credit revised to a gain of $55.9bn). For the week, Securities Credit slipped $0.5bn. Loans & Leases added $0.4bn to $6.315 TN. C&I loans gained $1.6bn, and Real Estate loans jumped $13.4bn. Consumer loans added $0.7bn. Securities loans declined $2.5bn, and Other loans fell $12.9bn. On the liability side, (previous M3) Large Time Deposits increased $2.9bn.

M2 (narrow) "money" fell $12.8bn to $7.251 TN (week of 7/9). Narrow "money" has expanded $208bn y-t-d, or 5.5% annualized, and $420bn, or 6.2%, over the past year. For the week, Currency was about unchanged, while Demand & Checkable Deposits increased $7.4bn. Savings Deposits sank $26.6bn, while Small Denominated Deposits were little changed. Retail Money Fund assets increased $6.4bn.

Total Money Market Fund Assets (from Invest. Co Inst) declined $6.4bn last week to $2.573 TN. Money Fund Assets have increased $191bn y-t-d, a 14.4% rate, and $425bn over 52 weeks, or 19.8%.

Total Commercial Paper jumped an additional $15.8bn last week to a record $2.195 TN, with a y-t-d gain of $220bn (20% annualized). CP has increased $408bn, or 22.9%, over the past 52 weeks.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 7/18) increased $7.0bn to a record $1.996 TN. "Custody holdings" were up $244bn y-t-d (25% annualized) and $362bn during the past year, or 22.2%. Federal Reserve Credit last week dipped $0.4bn to $853.9bn. Fed Credit has expanded $1.66bn y-t-d, with one-year growth of $23.1bn (2.8%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $790bn y-t-d (29% annualized) and $1.052 TN y-o-y (23%) to a record $5.601 TN.

July 19 - Bloomberg (Maria Levitov): "Russia's foreign currency and gold reserves rose to a record $411.2 billion in the week ended July 13, the central bank said."

Currency Watch:

The spot dollar index fell 0.4% to a multi-year low 80.288. On the upside, the Thai baht increased 2.4%, the Colombian peso 1.7%, the Philippine peso 1.4%, the New Zealand dollar 1.2%, the British pound 1.1%, the Australian dollar 1.0%, and the Japanese yen 0.5%. On the downside, the Indonesian rupiah declined 0.9%, the Argentine peso 0.5%, and the Turkish lira 0.5%.

Commodities Watch

July 16 - Financial Times (Javier Blas and Jenny Wiggins): "A surge in the production of biofuels derived from corn, wheat and soyabeans is helping to push up food prices so sharply that the World Food Programme, the United Nations agency in charge of fighting famine, is finding it difficult to feed as many hungry people as it has in the past."

July 20 - Financial Times (Javier Blas): "The price of tin, which is used for soldering in the electronics industry, hit a record high yesterday, propelled by speculative money flows and supply disruptions. London Metal Exchange tin reached an all-time high of $15,700 a tonne... The metal, one of the most illiquid contracts on the LME, has risen 38.4% since January. Gains since the start of 2006 have reached 133%."

For the week, Gold rose 2.5% to $683.40 and Silver 2.2% to $13.403. Copper jumped 3.1%. September crude rose $1.66 to an 11-month high $75.79. August gasoline dropped 2.7%, and August Natural Gas sank 4.1%. For the week, the CRB index dipped 0.2% (up 5.6% y-t-d), while the Goldman Sachs Commodities Index (GSCI) added 0.7% (up 18.2% y-t-d).

Japan Watch:

July 19 - Bloomberg (Jason Clenfield): "Japan's department store sales rose in June at the fastest pace in nine years... Sales climbed 5.5% from a year earlier, the quickest pace since April 1998..."

China Watch:

July 19 - Bloomberg (Nipa Piboontanasawat): "China's economy grew at the fastest pace in 12 years in the second quarter and inflation surged, prompting speculation the government will raise interest rates and push the currency higher to cool growth. Gross domestic product expanded 11.9% from a year earlier... Inflation climbed to 4.4% in June, the fastest since September 2004, breaching the central bank's 3% target for a fourth month."

July 18 - Bloomberg (Li Yanping): "China's economy showed a 'more obvious' trend from fast growth to overheating in the first half of 2007, Xinhua News Agency said, citing a legislative committee. An 'excessive' trade surplus, lending growth and investment expansion were still 'prominent' problems in the economy during the first half..."

July 16 - Financial Times (Richard McGregor ): "Like tens of millions of shoppers across China, Zhou Benqi has had to change her buying habits to cope with sharply rising prices of pork and eggs, staple foods for any Chinese family. 'Because of price hikes, an ordinary meal is a big constraint on us, as my pension has already been eaten into by fees for electricity, water, broadband, gas and so on,' said Ms Zhou, a 53-year-old Shanghai native. 'We've seen officials talking about adjustment many times, but so far they have failed to control prices.'"

July 18 - Financial Times (Jamil Anderlini): "China's air pollution will cause 20m people a year to fall ill with respiratory diseases, the Organisation for Economic Co-operation and Development estimated... By 2020, the report forecast, pollution would cause '600,000 premature deaths in urban areas, 9m person-years of work lost due to pollution-related illness, 20m cases of respiratory illness a year, 5.5m cases of chronic bronchitis and health damage', which could cost 13% of gross domestic product.

Mario Amano, OECD deputy secretary-general, said: "Rapid economic development, industrialisation and urbanisation have generated severe and growing pressures on the environment.'"

July 18 - Bloomberg (John Liu): "China added 25 million Internet users in the first six months for a total of 162 million, narrowing the gap with the U.S., the world's biggest Internet market."

Asia Boom Watch:

July 19 - Bloomberg (Wahyudi Soeriaatmadja): "Indonesia's economy will grow more than 6% in the coming years helped by investment and consumer spending, President... Yudhoyono said."

Unbalanced Global Economy Watch:

July 19 - Bloomberg (Jennifer Ryan): "U.K. money supply growth slowed in June more than economists had forecast, giving the Bank of England scope to gauge the effect of previous interest-rate increases before increasing borrowing costs again. M4... rose 13% from a year earlier, compared with 13.9% in May..."

July 19 - Bloomberg (Rainer Buergin): "German tax revenue rose in June from a year earlier... Tax revenue in June for the national government and the 16 states gained 12.6% to 49.4 billion euros ($68.2 billion)..."

July 19 - Bloomberg (Thomas Mulier): "Swiss watch exports increased 19% in June compared with the same period a year ago as Chinese shoppers bought more timepieces in Hong Kong."

July 19 - Bloomberg (Simone Meier): "Switzerland's trade surplus widened in June as a decline in the Swiss franc fueled exports of machines, watches and metals. Imports fell. The surplus rose to 1.72 billion Swiss francs ($1.43 billion) from 1.04 billion francs in May..."

July 17 - Bloomberg (Simone Meier): "Swiss retail sales rose for a 12th month in May as households spent more on consumer and office electronics, furniture and beauty products. Sales...increased 7.2% from a year earlier..."

Latin American Boom Watch:

July 16 - Bloomberg (Katia Cortes): "Brazil's retail sales rose 10.5% in May from a year earlier, the national statistics agency said."

Bubble Economy Watch:

July 18 - Bloomberg (Mark Drajem): "Keeping track of U.S. imports has become more difficult as regulators' funding hasn't kept up with surging trade and booming Internet sales, officials said. 'The growth in imports has strained our resources and challenges us,' Nancy Nord, acting chairman of the Consumer Product Safety Commission, testified today."

July 19 - Bloomberg (Linda Sandler): "U.S. hedge-fund managers Steven Cohen, Kenneth Griffin, Adam Sender, David Ganek and Daniel Loeb are among the world's 200 most active art collectors, according to a list compiled by the magazine ARTnews. Griffin, who runs the $14 billion Citadel Investment Group LLC, also joined Cohen in the ranks of the 10 most active art buyers, as did buyout king Henry Kravis of Kohlberg Kravis Roberts & Co. and Charles Schwab... They displaced Leon Black, Stephen Wynn and Leslie Wexner from last year's list of the top 10 collectors... Hedge-fund managers in the art market 'combine the means, the aggression, the enthusiasm, and access,' Michael Findlay, a director of Acquavella Galleries in New York, told ARTnews. 'It's another forum to demonstrate the same kind of acumen' as they display in business."

Financial Sphere Bubble Watch:

July 18 - The Wall Street Journal (Peter A. McKay and Justin Lahart): "Companies are buying back their shares at a furious pace, one of the big reasons the Dow Jones...is pushing toward 14000... In the first quarter alone, companies in the S&P 500-stock index spent nearly $118 billion to repurchase their shares, more than in any previous quarter... Many analysts and investors question how long the buyback boom can continue, and how much support stock prices can derive from buybacks over the long haul. Some companies are financing their share repurchases with borrowed money, which is likely to get more expensive if interest rates continue to rise... The surge in buybacks began in late 2004, aided by low interest rates and easy access to cash, but it has since picked up pace. Share repurchases have topped $100 billion for six straight quarters... Companies announced $157.4 billion of buyback plans during the quarter, up nearly 58% from a year earlier, according to Thomson Financial."

July 16 - Financial Times (Martin Arnold): "Private banks are rushing into a surprising new market for lending to high-flying private equity executives who are strapped for cash to invest in their own funds. In Europe, the market for lending to private equity executives is estimated at €1bn... In the US market, thought to be bigger, JPMorgan, Deutsche Bank, Citigroup and RBS are said to be active. In the rush to win buy-out titans as clients, some banks are offering them attractive terms, with unsecured loans that sometimes have no recourse against personal assets. Demand for loans to buy-out executives has emerged as the size of funds raised by private equity firms has ballooned in recent years. Investors generally insist the professionals at a private equity firm put their own money into any fund they raise, usually equivalent to 1-5% of the total.... A leading UK private banker said: 'A 35-year-old graduate of Harvard or Cambridge joining a top firm in 2002, who is asked to put money into funds in 2002, 2005 and 2007 while they also have school fees and a mortgage, is often being caught short. 'We can lend to them, killing two birds with one stone, both supporting our investment bank and looking after the top guys in the industry.'"

July 18 - Bloomberg (Caroline Salas): "JPMorgan Chase & Co. CEO Jamie Dimon said demand for leveraged buyout debt is drying up and banks may be left holding more loans that they can't sell. There is 'kind of a little freeze in the marketplace,' Dimon said on a conference call... 'If you see this continue you will see the Street taking on a lot of bridge loans and more aggressive repricing of those things.'"

MBS/ABS/CDO/Derivatives Watch:

July 18 - Gretchen Morgenson (New York Times): "Bear Stearns told clients in its two battered hedge funds late yesterday that their investments, worth an estimated $1.5 billion at the end of 2006, are almost entirely gone. In phone calls to anxious investors, Bear Stearns brokers reported yesterday that May and June had been devastating months for the portfolios. The more conservative fund, the High-Grade Structured Credit Strategies Fund, was down 91% by the end of June, investors were told. The High-Grade Structured Credit Strategies Enhanced Leverage Fund, which used extensive borrowings and assumed more risk, has no investor capital left, the firm said. 'In light of these returns, we will seek an orderly wind-down of the funds over time,' a letter to Bear Stearns clients said.

Real Estate Bubbles Watch:

July 18 - Los Angeles Times (Annette Haddad): "Home sales plunged in Southern California last month, making it the worst June in 14 years and reflecting an increasingly soft housing market -- especially in outlying areas such as the Inland Empire and Antelope Valley. Overall, values are continuing to hold their own -- with the median price of a Southland home rising to $502,000, up 2.4% from a year ago. But prices fell in two-thirds of the region's ZIP Codes, reflecting greater weakness in lower-cost housing markets... Figures...show that the number of Southland home sales plunged 36% in June from the same month last year, marking 21 straight months of year-over-year sales declines. San Bernardino County posted the worst numbers, with sales diving 50%. Real estate experts attributed the drop to several factors, including tighter lending standards and a drop in speculative buying by house 'flippers.'"

July 18 - Bloomberg (Daniel Taub): "San Francisco Bay Area home and condominium sales plunged 26% last month to the lowest level for a June in 12 years, DataQuick... said... The median price paid for a home in the Bay Area rose to a record $665,000, up 0.8%... in May and up 2.6% from a year earlier."

July 18 - The Wall Street Journal (Ryan Chittum): "Strong cross-border acquisitions helped boost global investment in real estate to a record high in the first six months of this year... A study...by Jones Lang LaSalle Inc....found that investment activity in commercial real estate surged to $382 billion in the first half, up 16% from $328 billion a year ago."

July 19 - Bloomberg (Dan Levy): "Apartment rents in Silicon Valley, California, rose 11% from a year ago, the biggest jump in the U.S. West, and occupancy rose to 97.3%... 'Landlords have the ball in their court,' Chris Bates, sales and marketing director for...RealFacts... 'An occupancy rate of 97.3% is essentially fully occupied.'"

M&A and Private-Equity Bubble Watch:

July 17 - Bloomberg (Caroline Salas and Miles Weiss): "Goldman Sachs Group Inc., JPMorgan Chase & Co. and the rest of Wall Street are stuck with at least $11 billion of loans and bonds they can't readily sell. The banks have had to dig into their own pockets to finance parts of at least five leveraged buyouts over the past month because of the worst bear market in high-yield debt in more than two years... Bankers, who just a few months ago boasted that demand for high-yield assets was so great that they would have no problem raising debt for a $100bn LBO, are now paying for their overconfidence."

July 20 - Financial Times (Paul J. Davies and Saskia Scholtes): "Private equity firms can now be in no doubt that they are going to have to pay more to fund the debt for buy-out deals they have already sealed. This week alone has seen two of the biggest deals on either side of the Atlantic - buy-outs of Alliance Boots and Chrysler - forced to increase the premium, or interest rates, on loans they are trying to sell. Bankers in a flurry other deals have had to act likewise. Late on Tuesday it emerged that Chrysler was increasing the interest rate on a $2bn second-lien loan - part of its $22bn in debt financing - by 1 percentage point... On the same day it also emerged something similar was going on at Alliance Boots, the record UK leveraged buy-out, which is seeking some £9bn worth of loans from investors."

July 16 - Financial Times (Martin Arnold): "There is unlikely to be much sympathy for private equity executives falling into debt to finance investments in their own funds, however much the idea clashes with public perceptions about super-rich 'masters of the universe'. Debt and private equity are intricately entwined and there are few more fanatical fans of leverage than buy-out bosses, who sing its praises at every opportunity. Even so, few would imagine that, while these buy-out titans are agreeing whopping loans for their latest mega-deals, they would also need to go into hock themselves. Yet this is exactly what has created one of the newest niche markets for private banks, which are rushing to offer loans to buy-out executives facing a cash crunch. Many of those recruited to private equity firms in recent years have faced a string of demands to invest their own money, long before they are likely to receive any returns. For young buy-out executives in their 30s and 40s, who often face the high cost of living in London and New York, it can be a struggle to raise the cash."

Energy Boom and Crude Liquidity Watch:

July 15 - Bloomberg (Abdulla Fardan): "Arab oil-producing countries earned $393.3 billion from selling crude in 2006, a 24% increase from the year before, as they benefited from higher international prices, the Kuwait News Agency reported."

July 16 - Bloomberg (Matthew Brown): "Saudi Arabia, the largest Arab economy, and Kuwait had their sovereign credit ratings upgraded by Standard & Poor's due to their strong public finances. Saudi Arabia's foreign and local currency long-term sovereign credit ratings were upgraded to AA-, S&P's fourth highest rating..."

Fiscal Watch:

July 19 - Bloomberg (Tony Capaccio): "The cost of the war in Iraq will exceed the half-trillion dollar mark once Congress completes its work on a defense measure for the fiscal year beginning Oct. 1... The defense budget for fiscal 2008 that's in various stages of congressional deliberation requests $141.7 billion to fight terrorism including the wars in Iraq and Afghanistan. 'If Congress approves these requests, total funding would reach about $567 billion for Iraq, $157 billion for Afghanistan' with the remainder for enhanced U.S. homeland security, CRS analyst Amy Belasco said... Spending for the effort against terrorism since the Sept. 11, 2001, attacks is on a course to reach $758 billion after the House and Senate complete work on their respective bills..."

Speculator Watch:

July 17 - Bloomberg (Hamish Risk): "Hedge funds are borrowing too much to finance investments in credit derivatives, contracts based on debt, which may magnify volatility in a market downturn, according to a Fitch Ratings survey of 65 banks, insurers and money managers. Hedge funds' influence on credit derivatives and debt markets has continued to grow at a 'dramatic pace,' Fitch said... The funds are responsible for 60% of all trading in credit-default swaps and about 33% of collateralized debt obligations..."

The Hand of Finance:

Beginning with my early-January "Issues 2007," "It's All About Finance" has been the underlying theme of almost every one of this year's CBBs. For me, the important unanswered questions inevitably relate back to my December 2000 presentation "How Could Irving Fisher Have Been So Wrong?" Why are so many caught bullish - and completely oblivious to escalating risk - at major tops? And why is it that booms and bull markets cannot endure indefinitely? Clearly, the vast majority are today convinced they can and will. We're witnessing why they can't and won't.

Well, booms inevitably falter at The Hand of Finance. In this distant past the post-Bubble post-mortem would simplify the state of things to "the money went bad." People had lost confidence and "ran" from banks and the stock market. The Credit wheels had ground to a halt and the abundant liquidity that seemed as if it would always be readily available instead abruptly evaporated. Jump forward to today and perceptions have it that the Fed and global central bankers are waiting to ensure that confidence is maintained and liquidity remains always bountiful. We're apparently so much more enlightened today, especially with our sophisticated risk monitoring and mitigating systems. We have derivatives.

I have my somewhat different take on why Credit-induced booms are destined for bust. Bubbles are sustained only by increasing quantities of Credit creation - a rather simplistic proposition encompassing highly complex processes. Inevitably, the dilemma evolves (sometime late in the cycle) to the point where the quantity of requisite additional Credit turns enormous - and the rapid financial expansion accelerates to breakneck speed. At the same time, the risk profile of the marginal (late-cycle) new loan deteriorates, while the major financial intermediaries (right along with the vast majority of market participants) are caught reaching too aggressively for perceived easy profits. Too much Credit is financing speculative endeavors, highly inflated assets values, and enterprises that, at best, are economic only as long as boom-time conditions exist.

Underlying Credit risk eventually succumbs to parabolic growth tendencies - as we've witnessed this past year. Yet one critical upshot of this dynamic is the associated (Credit-induced) surge in overall system liquidity, especially in wild securities markets inflation. Naturally, this "Monetary Disorder" unfolds some number of years into the prosperous boom - after an entrenched inflationary bias has taken firm hold in the securities markets and the economy generally. Irving Fisher was making a fortune at the top. He was intoxicated by his inflating wealth and was as emboldened as the naysayers were fully discredited. Almost by cruel design, the Credit Bubble's "terminal phase" is guaranteed to entrap those willing to subscribe to New Eras.

The unappreciated predicament in 1929 and today is Risk Intermediation. Dr. Bernanke refers to the study of The Great Depression as the "Holy Grail of economics." He blames the "Bubble Poppers" and the Fed's subsequent failure to create enough money. Conventional thinking has it that if the Fed had only created $5 billion and filled the hole in bank capital the devastating downturn could have been avoided. But the issue at the time wasn't, as conventional monetary economist believe today, the few billion necessary to recapitalize the banks - but the ongoing tens of billions that would be required to sustain unsustainable Credit Bubble-induced inflated asset prices, inflated corporate profits, inflated earnings, and myriad worsening economic maladjustments.

Citigroup expanded its balance sheet by $200bn during the second quarter (to $2.22 TN). JPMorgan's Assets expanded $50bn during Q2 and Bank of America's $32bn. Goldman Sachs, Morgan Stanley and Lehman Brothers combined for $92bn of Q2 asset growth. Merrill's second quarter balance sheet is not yet available, but we do know that assets expanded $140bn during Q1. The four "broker/dealers" have combined for one-year growth surpassing $700bn. The "good news" is that they have to this point succeeded in supplying the necessary Credit to sustain global financial and economic booms. The bad news is that this Credit deluge is wildly inflating global asset prices and feeding an historic worldwide speculative Bubble in debt and equity instruments, real estate, and assets generally. We are witnessing in real time the dynamics of rapidly escalating late-cycle risk and the dilemma of how to intermediate it.

With few exceptions, the major financial firms have so far reported "better-than-expected" earnings. Almost without exception the market sold stock on the news. Citigroup's Q2 Revenues were up 20% from a year ago to $26.6bn. And while Revenues in its Global Consumer division expanded only 8% from Q2 2006, Markets & Banking was up 33%, Global Wealth Management 28%, and Alternative Investments 77%. Examining the balance sheet, Trading Assets surged $78bn (to $538bn), "fed funds/repo" $44bn (to $348bn), and Loans $50bn (to 743bn). Citigroup is a poster child for a major financial player responding to weakening profits and business fundamentals in its traditional lending business by pushing its capital markets activities to new extremes. Why not, all the other firms' stocks - until recently - were amply rewarded for doing the same. Now they're all fully exposed to market risk with nowhere to go. And, for their efforts to support the boom, their stocks are now under liquidation.

July 18 - Financial Times (Ken Fisher): "Headlines herald a US prime-time, subprime mortgage implosion leading to an upcoming credit-crunch crisis - destined to sink shares, raise interest rates and impale economies. But this is demonstrable nonsense. Yes, there have been media autopsies of the few notable subprime lenders that have gone belly up. More are certainly in the wings. But what makes this a systemic problem? If subprime is to ripple systemically into a crisis, it is a take-it-to-the-bank certainty that we will see vast credit-spread widening. Yet spreads between high quality and low quality debt of the same maturity - by any measure - are at near record lows, in spite of six months of subprime hand-wringing. And the biggest single days of upside volatility have been historically very subdued - about 10 to 20 basis points. Every true credit crisis in history had huge spikes in credit spreads early on and - while not always - usually well before equities implode. By contrast, wrong-headed credit fear babble blows through history like the wind without a ripple in credit spreads."

I'll assume that if Ken Fisher ever read my analysis he would pronounce me the "king of Credit fear babble." The title of Mr. Fisher's FT article was a rather catchy "Be Bullish and Watch the Bears Impale Themselves." Mr. Fisher did well to disregard previous Credit fears, but I suspect he will regret his current complacency. It's been a long and profitable bull market. Too long.

July 20 - Financial Times (Michael Gordon): "Will the troubles in the US subprime market pass by as a little local difficulty - or will they start a rout across capital markets and bring to an end the great bull run in a broad range of asset classes? That's the big question faced by those in capital markets right now. Can history teach us anything on this score? Well, it's certainly worth looking at the collapse of Long-Term Capital Management in -September 1998. The near-demise of this -mammoth hedge fund marked a turning-point for credit markets, hitting brokers and banks hard. The debacle is less than a decade ago, but banks were smaller and less diversified firms in those days and so less able to absorb large shocks. Also, their risk management systems were not as well developed as they are now... Wind forward to today. Does the collapse of confidence in the US subprime market have any similarities to the LTCM affair? Well, many of the weaknesses of the banks and brokers that emerged in 1998 have since been addressed. They are larger, more diversified institutions. They have also invested a great deal in risk management. Overall, the banks look far more resilient."

Like Ken Fisher, Michael Gordon seems blind to today's acute financial fragility. It is wishful thinking that "banks" are today "more resilient" than in 1998. The financial system today has unprecedented exposure to risky mortgage Credit, highly leveraged and speculative financial markets, an M&A Bubble and global asset Bubbles. The entire global Credit system is one vulnerable Minskian "Ponzi Finance Unit."

It may be valuable to do a little contrasting of today's backdrop to the LTCM crisis. The near LTCM debacle had its roots in highly leveraged speculation across many markets. It was a Credit issue only in the context of the impact of potential forced position liquidation and systemic de-leveraging. It was much more about the fear of contagious liquidations than of underlying Credit issues. The underlying Credit instruments were not in and of themselves suspect. The market dislocation was (in hindsight, easily) resolved by reversing the fear of de-leveraging and re-invigorating financial expansion.

Importantly, during the LTCM and other recent Credit scares the marketplace's faith in the evolving market in "structured finance" was not in question. Actually, it was a perceived strength. The GSEs were recognized as powerful pillars of strength (and willing and able to balloon assets holdings at a whim). Mortgage Credit in general was solid. The "financial guarantors"/Credit insurers (notably MBIA and Ambac) had relatively small exposure to insuring sophisticated Wall Street securitizations. The Credit derivatives market was small and a non-issue. There were, at the time, no festering domestic Credit issues. The U.S. economy was not remotely as susceptible as it is today. The dollar was in the midst of a multi-year bull run. The Current Account Deficit was running at about a $200bn pace.

The issues today are more serious and deep-rooted. Confidence in the dollar is faltering in the face of untenable $800bn annual Current Account Deficits. The Credit system is weakened by unprecedented impending subprime losses and acute vulnerability throughout "prime" mortgages. The GSEs are weak financially and extraordinarily vulnerable. The Credit insurers are highly exposed to myriad Credit and financial risks. The Wall Street firms and "money center banks" are heavily exposed to mortgage and capital market risk. The untested Credit derivative marketplace has been shaken by the rapidity and severity of the subprime implosion. The CDO market wasn't a factor in 1998, let alone a vital facet of system Credit creation and risk intermediation.

What appeared at the time (1998) a large leveraged speculating community seems today tiny in comparision. Today's vast global pool of speculative finance was but a little puddle, and a dollar bullish one at that. At the same time, the expansive marketplace for trading Credit exposures has created a major venue for placing aggressive bets on systemic Credit conditions - over-stimulating liquidity creation when the bets are bullish only to imperil liquidity when the bulls turn, as they are these days, to enterprising bears. Moreover, the coveted risk modeling and management systems are oblivious to end-of-cycle Credit Bubble dynamics.

The most important difference between today and 1998 is that the Credit system back then was not a full decade into problematic Credit Bubble dynamics. The amount of Credit necessary to support the economy and markets was a fraction of what it has become. Both the quantity and quality of risk to be intermediated was relatively small in comparison and, besides, there was a bevy of risk intermediators easily up to the task.

In contrast, today - and going forward - there will be an unrelenting torrent of risk that must be intermediated (risky Credits transformed into palatable debt instruments), and it is not at all clear who is in a position to absorb significant risk. The leveraged speculators are more than likely keen to shed risk. The big "banks" and "brokers" are already fully-loaded. And the general marketplace, well, it's reeling with the realization that much of structured finance today suffers from pricing and liquidity issues and, worse yet, not even debt ratings can be trusted. "Ponzi Finance" dynamics are in full play and the U.S. Bubble economy is incredibly exposed to a reversal in speculative finance and resulting liquidity crisis. These are very serious issues and indicative of the types of unavoidable risk intermediation problems that will stymie this historic Credit Bubble.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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