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August 24, 2007

Money Market Issues
by Doug Noland

For the week, the Dow (up 7.3% y-t-d) and the S&P500 (up 4.3%) each rallied 2.3%. The Tranports gained 3.1% (up 7.8%), and the Morgan Stanley Cyclical index jumped 4.3% (up 15.5%). The Morgan Stanley Consumer index rose 1.7% (up 3.4%), and the Utilities gained 2.2% (up 7.1%). The small cap Russell 2000 increased 1.6% (up 1.4%), and the S&P400 Mid-cap index jumped 3.1% (up 7.5%). The NASDAQ100 surged 3.8% (up 11.6%), and the Morgan Stanley High Tech index gained 3.1% (up 10.8%). The Semiconductors added 1.4% (up 5.8%). The Street.com Internet Index rose 2.7% (up 10.8%), and the NASDAQ Telecommunications jumped 3.9% (up 14.1%). The Biotechs rallied 2.1% (up 2.7%). The Broker/Dealers gained 2.3% (down 6.1%), while the Banks declined 1.0% (down 7.2%).

Three-month T-bill rates, trading as low as 2.53% during Monday's session, ended the week 38 bps higher at 4.25%. Two-year U.S. government yields rose 10 bps to 4.29%. Five-year yields gained 6 bps to 4.41%. Ten-year Treasury yields went the other way, declining 6 bps to 4.62%. Long-bond yields ended the week down 10 bps to 4.89%. The 2yr/10yr spread ended the week at 33 bps. The implied yield on 3-month December '07 Eurodollars surged 23 bps to 4.945%. Benchmark Fannie Mae MBS yields declined 10 bps to 6.00%, this week outperforming Treasuries. The spread on Fannie's 5% 2017 note narrowed 9 to 56, and the spread on Freddie's 5% 2017 note narrowed 9 to 56. The 10-year dollar swap spread declined 10 to 66. Corporate bond spreads generally narrowed late in the week, although the spread on a junk index ended the week 15 bps wider.

Investment grade debt issuers included Comcast $3.0bn, Merrill Lynch $2.75bn, Goldman Sachs $2.5bn, XTO Energy $2.25bn, Bank of America $1.5bn, American Express $1.5bn, MidAmerica Energy $1.0bn, General Mills $700 million, Starbucks $550 million, Con Edison $500 million, Kinder Morgan $500 million, Anheuser Busch $500 million, Union Pacific $500 million, Coventry Health $400 million, Lincoln National $300 million and Georgia Power $250 million.

August 24 - Bloomberg (Jeremy R. Cooke): "Risk-averse investors bailed out of high-yield U.S. municipal-bond mutual funds at the fastest weekly rate on record, Dow Jones reported, citing AMG... The funds reported net outflows of $303 million during the week ended Aug. 22, topping the previous record of $255 million for the first week of April 1994..."

August 24 - Dow Jones (Tom Lauricella): "The outflows continued apace in high-yield bond funds, which reported $379.7 million of net outflows in the week ended Wednesday, according to AMG... The week continued the summer-long unbroken trend of outflows, with each of the last 11 weeks posting outflows. One week ago, the funds reported a $274.5 million outflow."

Junk issuers included Sabic $1.5bn million.

International dollar bond issuance this week included Deutsche Bank $3.0bn.

German 10-year bund yields dipped 2 bps to 4.26%, while the DAX equities index rallied 1.7% (up 13.8% y-t-d). Japanese 10-year "JGB" yields added one basis point to 1.59%. The Nikkei 225 recovered 6.4% (down 5.7% y-t-d). Emerging debt, equity and currencies markets generally enjoyed strong rallies. Brazil's benchmark dollar bond yields sank 31 bps this week to 6.01%. Brazil's Bovespa equities index surged 9.1% (up 19.2% y-t-d). The Mexican Bolsa rallied 5.4% (up 13.6% y-t-d). Mexico's 10-year $ yields fell 19 bps to 5.73%. Russia's RTS equities index added 0.2% (down 3.0% y-t-d). India's Sensex equities index gained 2.0% (up 4.6% y-t-d). China's Shanghai Composite index gained five straight session, ending the week up a bubbly 9.7% (up 91% y-t-d and 215% over the past year).

Freddie Mac posted 30-year fixed mortgage rates dropped 10 bps this past week to 6.52% (down 4bps y-o-y). Fifteen-year fixed rates fell 12 bps to 6.18% (unchanged y-o-y). One-year adjustable rates declined 7 bps to 5.60% (also unchanged y-o-y).

Bank Credit surged $38.1bn (week of 8/15) to $8.734 TN (7-wk gain of $168bn). For the week, Securities Credit increased $10.8bn. Loans & Leases jumped $27.3bn to $6.410 TN (3-wk gain of $81bn). C&I loans rose $11.2bn, while Real Estate loans declined $12.9bn. Consumer loans dipped $0.5bn. Securities loans declined $2.3bn, while Other loans surged $31.8bn. On the liability side, (previous M3) Large Time Deposits increased $11.1bn.

M2 (narrow) "money" increased $6.5bn to $7.289 TN (week of 8/13). Narrow "money" has expanded $245bn y-t-d, or 5.5% annualized, and $442bn, or 6.5%, over the past year. For the week, Currency declined $1.1bn, and Demand & Checkable Deposits fell $18.1bn. Savings Deposits jumped $17bn, while Small Denominated Deposits dipped $0.5bn. Retail Money Fund assets jumped $9.1bn.

Total Money Market Fund Assets (from Invest. Co Inst) surged another $76bn last week (5-wk gain of $204bn) to a record $2.777 TN. Money Fund Assets have increased $395bn y-t-d, a 25.4% rate, and $564bn over 52 weeks, or 25.5%.

Total Commercial Paper dropped $90.2bn last week to $2.042 TN, now with a y-t-d gain of $67.9bn (5.3% annualized). Asset-backed commercial paper has declined $120.9bn during the past two weeks to $1.053 TN (up $96.6bn y-o-y). CP has increased $206bn, or 11.2%, over the past 52 weeks.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 8/22) dropped $18.4bn to $1.986 TN. "Custody holdings" were up $234bn y-t-d (20.5% annualized) and $316bn during the past year, or 18.9%. Federal Reserve Credit last week declined $16.1bn to $851.7bn. Fed Credit is little changed y-t-d, with one-year growth of $26.7bn (3.2%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $875bn y-t-d (27.8% annualized) and $1.108 TN y-o-y (24.2%) to a record $5.686 TN.

Credit Market Dislocation Watch:

August 24 - Financial Times (Peter Thal Larsen and Paul J. Davies): "HBO's annual report for 2006 covers almost 200 pages. But the document does not carry a single reference to Grampian Funding, the vehicle the bank uses to help lower its financing costs. So investors could be forgiven for expressing some surprise on Tuesday when HBOS announced that it would take direct responsibility for financing Grampian. Grampian, which has assets of about $37bn, is one of Europe's largest bank conduits. These are funding vehicles usually kept off a bank's balance sheets that have emerged as pivotal players in the current market turmoil... Across Europe, bank-owned conduits and other vehicles with investments in asset-backed securities are struggling to raise financing after the pension funds and insurance companies that normally buy their paper suddenly withdrew from the market... Investors' reluctance to buy commercial paper could have far-reaching consequences for the banking sector. Moody's estimates that conduits worldwide currently hold $1,200bn of assets. Most of this is guaranteed by the banks. So if the conduits were unable to issue commercial paper for several months, the majority of those assets would end up back on the banks' balance sheets."

August 23 - Bloomberg (Mark Pittman): "Banks worldwide have $891 billion at risk in asset-backed commercial paper facilities because of credit agreements that ensure investors are paid back when the short-term debt matures, Fitch Ratings said. The investment vehicles, which carry top credit ratings, sell debt that matures in one to 270 days and invest in longer-term securities with higher yields... Some of those securities are subprime mortgage bonds, which have been losing value as default rise to the highest in 10 years."

August 23 - Financial Times (Paul J Davies): "The fallout from the US subprime mortgage crisis has added further pressure to structured investment products, prompting ratings agencies to act on the deterioration in performance at a number of different vehicles. Standard & Poor's issued a string of downgrades and negative watch notices on a number of SIV-lite programmes... SIV-lites, a type of collateralised debt obligation that rely on short-term commercial paper to fund senior debt, have come under intense pressure due to falling values in their investments combined with a liquidity crunch in commercial paper markets. 'A vast majority of the portfolio of each of these market-value structures is invested in US mortgage securities,' S&P said."

August 24 - Financial Times (Gillian Tett, Peter Thal Larsen and Neil Hume): "A senior official in charge of a structured finance team at Barclays Capital has resigned this week in the midst of turmoil triggered by the meltdown in the US subprime mortgage market. Edward Cahill, a banker who ran the collateralised debt obligation division, which creates complex debt vehicles linked to assets such as subprime loans, left on Monday... Many structured investment vehicles and conduits - financing vehicles that typically invest in highly rated securities - have found they are unable to raise short-term funding because of a crisis of confidence among investors in asset-backed commercial paper market. Two SIVs created by Barclays Capital have collapsed in recent days, while other such vehicles face severe financial pressure... Mr Cahill's group was considered to be a leader in developing so-called SIV-lites, which fund themselves by issuing short-term commercial paper and using the proceeds to buy longer-dated securities. SIV-lites typically employ leverage of between 40 to 70 times, compared with leverage rates of 12 to 16 at normal SIVs."

August 20 - Financial Times (Saskia Scholtes): "Money market investors are emerging as drivers of the latest global financial drama, roiling credit markets and hurting corporate borrowers by shunning commercial paper and piling into short-term US government debt. Yields on short-term Treasury bills last week made their biggest two-day fall since the 'Black Monday' stock market crash of October 1987, as spooked commercial paper investors sought to put money in the safest and most liquid short-term assets."

August 24 - The Wall Street Journal (Tom Lauricella): "Mutual-fund investors have been bailing out of bank-loan funds in droves in recent weeks, amid negative headlines and losses in what are generally among the most conservative bond-market investments. Since the end of June, when troubles in the bank-loan market began to emerge, assets in bank-loan funds have fallen 33% to $18.2 billion, according to AMG... During this period the average bank-loan fund lost 4.1% of its value... That is a significant reversal of fortune for bank-loan funds, which have gained in popularity in recent years as a conservative holding for many investors... Since late 2002, the average bank-loan fund had chalked up positive returns in every month except one, according to Morningstar."

August 20 - Financial Times (Ivar Simensen): "The €17.3bn ($23.3bn) rescue of Sachsen LB was the second bail-out in three weeks of a German bank with structured credit market exposure and has raised fresh questions about the country's banking system. The German savings banks association assumed the whole of Sachsen LB's €17.3bn credit facility to a special investment fund, or conduit, that the Landesbank in the state of Saxony had supported and managed. The conduit, called Ormond Quay, was an asset-backed commercial paper (ABCP) conduit, which borrowed in the short-term commercial paper market and invested in longer-term asset-backed credit instruments. It was supported by a credit line from Sachsen LB. The rescue was triggered when commercial paper investors refused to refinance Ormond Quay and Sachsen LB was unable to provide the credit it had pledged."

August 22 - Financial Times (Michiyo Nakamoto): "The recent sharp moves in the foreign exchange markets have - at least for now - raised the question of whether the yen carry trade is doomed to extinction. Many market participants believe the volatility in the forex markets will make yen carry trades too risky for investors in the future. 'These are trades that everyone knew were going to come unstuck and they just did," says Mark Cutis, chief investment officer at Shinsei Bank. The yen carry trade, whereby investors borrow in yen at low interest rates and invest in higher-yielding assets in other currencies, was popular with hedge funds and Japanese retail currency traders as long as market volatility - and therefore foreign exchange risk - was low. But amid uncertainty about the broader impact of the subprime problem, volatility in the foreign exchange markets has surged, leading many investors to unwind their positions. 'The hedge funds have panicked,' says a managing partner at a large US hedge fund. Funds are shying away from risk because 'our mentality today is you have no idea what is going to happen in the world'."

August 20 - Financial Times (Francesco Guerrera and Victoria Kim): "Hundreds of US companies are facing sharply higher costs on the short-term debt used to fund their day-to-day operations, in the latest sign that the credit market turmoil is beginning to hit corporate America. Executives and Wall Street analysts say a recent credit squeeze could force several companies to reduce their exposure to the $200bn corporate market for commercial paper, which has traditionally been one of the safest sources of corporate funding. The problems in the commercial paper market, which is open only to investment-grade companies, will reopen fears that the current liquidity crunch is spreading from the housing market and the financial sector to other parts of the US economy."

August 20 - Dow Jones (Damian Paletta): "Examiners at the Office of Thrift Supervision recently set up a full-time presence in a conference room at the Calabasas, Calif., headquarters of Countrywide Financial Corp., according to two people familiar with the matter."

August 21 - The Wall Street Journal (Valerie Bauerlein): "Capital One Financial Corp., citing 'an unprecedented set of market circumstances,' plans to shut down its struggling GreenPoint mortgage unit -- keeping only pieces of a business valued at $6.3 billion just three years ago. The ninth-largest U.S. bank by market value, Capital One bought GreenPoint in last year's $13.2 billion purchase of North Fork Bancorp... In 2004, North Fork paid $6.3 billion for GreenPoint Financial Corp., then a large New York savings and loan specializing in mortgages."

Currency Watch:

The spot dollar index dropped 0.9% this week to 80.67. On the upside, the Brazilian real gained 4.9%, the South African rand 3.3%, the New Zealand dollar 3.0%, the Australian dollar 2.5%, and the Norwegian krone 1.8%. On the downside, the Japanese yen declined 1.3%. The Euro gained 1.4% and the Swiss franc 0.4%.

Commodities Watch:

August 24 - Financial Times (Javier Blas): "Wheat prices jumped to an all-time high yesterday as panicked buyers rushed into the market amid extremely tight supplies, raising fears of a global food inflation spike. Canada, the world's second-largest wheat exporter, warned output might be almost 20 per cent below last year as adverse weather damaged the crop as it had done in Europe and Australia. Japan and Taiwan, which depend on foreign wheat supplies, bought new cargoes in the international market while India launched a large tender to boost its inventories ahead of its peak demand season."

For the week, Gold recovered 1.7% to $668.38, and Silver rallied 2.5% to $12.10. Copper surged 7.7%. September crude managed to gain 51 cents to $71.98. September gasoline declined 2.8%, and September Natural Gas sank 22%. For the week, the CRB index dipped 0.2% (down 0.5% y-t-d) and the Goldman Sachs Commodities Index (GSCI) lost 0.8% (up 11.8% y-t-d).

Japan Watch:

August 24 - Bloomberg (Robin Wigglesworth): "Norway's jobless rate was unchanged in the three months through July at it lowest level since at least 1989 as companies struggle to find skilled workers, maintaining pressure on the central bank to raise interest rates. The...rate remained at 2.5%..."

China Watch:

August 20 - Bloomberg (Li Yanping): "China's exports figure may increase to $1.23 trillion this year, surpassing the U.S. as the world's second-largest, the China Securities Journal reported... China's 2007 trade gap may widen to become the world's largest surplus from last year's record $177.5 billion... Chinese exports, which totaled $968.9 billion last year, will probably exceed U.S. overseas sales by $50 billion in 2007..."

August 20 - Bloomberg (Wendy Leung): "Hong Kong's unemployment fell to 4.1%, the lowest rate in nine years, as the economy accelerated on consumer spending, exports and investment."

Asia Boom Watch:

August 23 - Bloomberg (Perris Lee): "Taiwan's export orders expanded at a faster than expected pace in July to a record... Orders...rose 23.5% from a year earlier..."

Unbalanced Global Economy Watch:

August 20 - Bloomberg (Brian Swint): "U.K. money supply growth unexpectedly gained pace last month, suggesting that five Bank of England interest-rate increases have yet to curb the expansion of credit. M4...rose 13% from a year earlier, compared with 12.9% in June..."

August 22 - Bloomberg (Tasneem Brogger): "Danish consumer confidence dropped in August to the lowest since March 2005 as households took a bleaker view of the economy amid signs security market gains are evaporating, undermining economic stability."

Latin American Boom Watch:

August 22 - Bloomberg (Bill Faries and Matthew Craze): "Argentina's jobless rate fell to its lowest level in almost 15 years in the second quarter... The unemployment rate declined to 8.5% in the second quarter from 10.4% in the same period a year earlier..."Bursting Bubble Economy Watch:

August 22 - Dow Jones (Dawn Wotapka): "For the first time, home builders are admitting that the crackdown on jumbo-mortgage lending is depressing sales. As a housing and mortgage crisis sweeps the nation, lenders are pulling back and raising the prices on jumbo loans bigger than $417,000. That particularly hurts Toll Brothers Inc., a luxury-home builder whose average delivered home was priced near $700,000 earlier this year, and WCI Communities, seller of oceanfront condos with multimillion-dollar price tags. 'With all the problems surrounding mortgage-market liquidity, there is the risk that home building could grind temporarily to a near halt,' said Gregory Gieber, an analyst with A.G. Edwards."

August 22 - Bloomberg (Jenny Strasburg and Christine Harper): "The credit-market freeze that's paralyzing leveraged buyouts, mergers and myriad computer-driven trading strategies may cut Wall Street bonuses for the first time in five years. 'There's a lot of pessimism out there,' said Gary Goldstein, chief executive officer of executive-search firm Whitney Group in New York. 'Looking at the world today as we see it and the impact the crunch is likely to have, it looks like bonus pools will decline.'"

August 22 - Associated Press: "Since the start of the year, more than 40,000 workers have lost their jobs at mortgage lending institutions, according to recent company layoff announcements and data complied by global outplacement firm Challenger, Gray & Christmas Inc. Meanwhile, construction companies have announced nearly 20,000 job cuts this year, while the National Association of Realtors expects membership rolls to decline this year for the first time in a decade."

August 23 - Financial Times (Felix Rohatyn and Warren Rudman): "The word 'infrastructure' has to be one of the most unfortunate of the English language. While it is intended to represent America's most important public assets, it does not convey any real meaning of its importance. 'Infrastructure' comprises our bridges, roads, water lines, sewers, dams, air traffic control system and electrical grid. It is vital to our economy and to our physical security, but it is neglected by our political leaders. The American Society of Civil Engineers, which audits the state of our national infrastructure, reported that it would take $1,600bn to bring it up to an acceptable standard over a five-year period, and gave it an overall grade of C-minus. The shortfall increased by $300bn in the past three years. Tragedies, local or national, remind us occasionally of these looming dangers but are soon overtaken by other more pressing interests. The levees of New Orleans, the underground steam pipes of New York City and the bridge collapse in Minneapolis are only some of the more recent catastrophes. It is easier for our government to spend hundreds of billions of dollars in Iraq than to raise $250m for Minneapolis."

August 22 - Bloomberg (Greg Bensinger): "U.S. auto sales this year may fall to their lowest level since 1998 as housing starts keep declining and consumers' debt mushrooms, a market forecasting firm said. The drop from 2006 may be 350,000 units, or about 2%, to 16.2 million, CSM Worldwide Inc. said..."

August 21 - Bloomberg (James Kraus): "The average U.S. income fell in 2005, marking the fifth consecutive year people had to live with less money than they had at the height of the most recent economic expansion, the New York Times reported, citing government data. Average income in 2005 was $55,238, almost 1% less than the $55,714 in 2000 after adjustments for inflation, the newspaper said."

Central Banker Watch:

August 22 - Financial Times (Krishna Guha and Saskia Scholtes): "Money markets yesterday staged a dramatic reversal of Monday's flight to safety, after an influential US senator fuelled expectations that the US Federal Reserve would soon cut interest rates. Christopher Dodd, the chairman of the Senate banking committee, told reporters after a meeting with Ben Bernanke, the Fed chairman, and Hank Paulson, US Treasury secretary, that Mr Bernanke had told him he would use 'all the tools' at his disposal to contain market turmoil and prevent it from damaging the economy. The revelation helped turn around investor sentiment after an earlier warning by Mr Paulson that there was no quick solution to the problems in credit markets."

Financial Sphere Bubble Watch:

August 23 - Financial Times (Ben White and Victoria Kim): "Lehman Brothers intends to shut down its subprime mortgage unit, BNC Mortgage, shedding 1,200 jobs and, at least temporarily, leaving a business that has been highly profitable across Wall Street in recent years. Lehman's decision raises questions about whether other investment banks that acquired subprime lenders in recent months will have to close them or take big losses. Merrill Lynch paid $1.3bn for First Franklin and other subprime businesses last September and Morgan Stanley paid $706m for Saxon Capital in December."

August 23 - Financial Times (Lina Saigol): "Investment bankers in the City of London and on Wall Street face a 10 to 15% cut in their year-end bonuses because of the credit crunch, compensation experts say Structured credit bankers, last year's highest-paid performers, are expected to be hardest hit - with remuneration specialists predicting up to a 25% cut for them."

GSE Watch:

August 24 - Bloomberg (Jody Shenn): "Fannie Mae's portfolio of mortgage assets grew at an 12.9% annualized rate last month... The portfolio grew $7.4 billion in July to $729.8 billion... Freddie Mac...said that its portfolio swelled by $8.5 billion to $720.6 billion. Fannie Mae's growth pushed it closer to a regulatory cap on its holdings."

Mortgage Finance Bust Watch:

August 22 - Bloomberg (Alison Vekshin): "U.S. banks and thrifts suffered the biggest increase in late loan payments in 17 years as more homeowners fell behind on mortgages, the Federal Deposit Insurance Corp. said. Loans more than 90 days past due rose 10.6% to $66.9 billion in the period ending June 30, the largest quarterly increase since 1990... 'The bottom line for banks is that the credit environment continues to be more challenging now than it has been in recent years,' FDIC Chairman Sheila Bair said... Loans more than 90 days past due grew 36.2% from $49.1 billion in the second quarter a year ago, the largest 12-month increase since 1991. Residential mortgage loans 90 days delinquent increased 12.6% to $27.5 billion in the second quarter from $24.4 billion in the first quarter... Lenders set aside $11.4 billion for potential loan losses in the second quarter, up 75% from a year earlier... The amount lenders wrote off for bad loans grew 51.2% to $9.16 billion in the second quarter... Insured banks and thrifts reported $36.7 billion in net income for the quarter, a decline of 3.4% from $38 billion a year ago."

August 21 - Bloomberg (Alison Vekshin): "U.S. savings and loans held more troubled assets in the second quarter than at any time in the past 14 years, as more families fell behind on their mortgage payments. U.S. thrifts held $14.2 billion in repossessed assets and loans that are at least 90 days past due, the most since 1993... the U.S. Office of Thrift Supervision reported... 'This is what is keeping us as regulators up late at night,' said James Caton, the agency's director of financial monitoring and analysis..."

August 23 - New York Times (Gretchen Morgenson): "Expanding rapidly as the nation's largest home mortgage company, Countrywide Home Loans quietly promised investors who bought its loans that it would repurchase some if homeowners got into financial difficulties. But now that Countrywide itself is struggling, it may not be able to do so, making it even harder for troubled borrowers to reduce their interest rates or make other changes to their loans to avoid foreclosure... The repurchase obligations are discussed in Countrywide's prospectuses and pooling and servicing agreements that cover about $122 billion worth of mortgages packaged and sold to investors from early 2004 to April 1 of this year. The agreements said that Countrywide...would buy back mortgages in the pools if their terms were changed to help borrowers remain current... Agreeing to buy back loans that are modified is highly unusual and perhaps unique among pools issued by companies like Countrywide... Pools backed by mortgages issued by Fannie Mae and other government-sponsored entities typically include such language."

Foreclosure Watch:

August 21 - Bloomberg (Sharon L. Crenson): "U.S. homes in the foreclosure process almost doubled in July from a year earlier as variable-rate mortgages reset higher, leaving more homeowners unable to make their payments, according to RealtyTrac Inc... Lenders sent 179,599 notices of default, scheduled auctions or bank repossessions last month, a 93% increase, with the highest rates per household in Nevada, Georgia and Michigan. California, Florida and Michigan had the most homes caught in the foreclosure process... 'We are estimating that we will see about 2 million foreclosure filings this year,' said Rick Sharga, RealtyTrac's executive vice president for marketing. 'We honestly don't see it getting much better before it gets a little bit worse.' California foreclosure filings totaled 39,013 in July, about triple the previous year.... Florida ranked second with a 78% increase to 19,179 foreclosure filings. Michigan replaced Ohio as the state with the third highest number foreclosures: 13,979."

MBS/ABS/CDO/CP/Money Funds and Derivatives Watch:

August 22 - The Wall Street Journal (Jane J. Kim): "It's not just mortgages. As it gets tougher to land a home loan, some people are also finding it harder and more expensive to get other types of consumer credit. Some lenders, such as USAA, are nudging up credit-score requirements across their auto loans, credit cards and personal loans. Bank of America Corp. and Capital One Financial Corp. recently raised fees and interest rates for some of their credit-card customers. And this month, Citigroup Inc.'s CitiFinancial Auto started charging higher auto-loan rates for borrowers with less-than-perfect credit. All this comes as lenders continue to tighten guidelines on mortgages and home-equity loans and lines of credit as investors back away from subprime loans and other perceived credit risks."

August 20 - Bloomberg (David Evans): "Money market funds were invented 37 years ago to offer investors better returns than bank savings accounts while providing a high degree of safety. Most of the $2.5 trillion sitting in these funds is invested in such assets as U.S. Treasury bills, certificates of deposit and short-term commercial debt. Unlike bank accounts, money market funds aren't insured by the federal government. They almost never fail. Unbeknownst to most investors, some of the largest money market funds today are putting part of their cash into one of the riskiest debt investments in the world: collateralized debt obligations backed by subprime mortgage loans. CDOs are packages of bonds and loans, and almost half of all CDOs sold in the U.S. in 2006 contained subprime debt, according to a March report by Moody's Investors Service."

Real Estate Bubbles Watch:

August 23 - Financial Times (Daniel Pimlott): "The chief executive of Toll Brothers said buyer interest in its homes in the latest quarter was at the lowest in 20 years, as the largest US luxury home builder warned yesterday that the housing slump could get even worse. Six weeks in the earlier part of the quarter, which ran until the end of July, saw the 'lowest traffic on a per community basis that we have ever had', Robert Toll said, meaning the company's housing developments had received on average fewer visitors than at any time since it went public in 1986."

August 24 - Bloomberg (David M. Levitt): "Financing for almost all large New York commercial and residential real estate projects is drying up, Crain's New York Business reported. Some investors are abandoning deals and walking away from hundreds of thousands of dollars in deposits, while others are doubling their down payments and paying higher interest rates,the weekly business publication said, citing real estate executives. Wall Street banks have reacted by shutting down sales of pooled commercial mortgages... Thirty-seven commercial transactions in the city worth $9.5 billion haven't closed, Crain's said..."

M&A and Private-Equity Bubble Watch:

August 22 - Financial Times (Lina Saigol): "Investment bankers walked into their usual Monday morning meetings with an air of resignation this week, as they gathered to discuss the impact of the credit crunch on mergers and acquisitions. For the past three years, companies have used strong earnings to embark on an unprecedented acquisition binge, surpassing even the heady days of the dotcom boom. At the end of July, the total value of European M&A reached $1,290bn, surpassing the total for the whole of 2006, according to Thomson Financial. Even without turmoil in the credit markets, most bankers knew such frenetic activity could not continue for much longer. But while it is clear that private equity deals will not get done for at least four to six months, the outlook for strategic transactions by companies is much less straightforward."

Fiscal Watch:

August 22 - Financial Times (Ivar Simensen and Ralph Atkins): "The US is a great nation, possibly the greatest of all time. Yet to keep America great, policymakers must learn certain lessons from history, notably the downfall of the Roman republic. The world has changed dramatically in recent years. The US is currently the sole superpower on earth but that exclusive status is likely to be short-lived. While the US is number one in many things, from the size of its economy to military might, it faces several big sustainability challenges. America's fiscal, healthcare, education, energy, environment, immigration and Iraq policies are in need of review and revision. Timely action is needed because Washington's historical crisis-management approach to dealing with hard public policy choices is no longer prudent. From a fiscal perspective, a few vital statistics underline the problems. First, while short-term federal deficits are coming down, they are still too high given the impending retirement of the 'baby boomers' and the fact that the cost of the global war on terrorism accounts for just a fraction of US operating deficits... Second, the nation's total liabilities and unfunded commitments for pension and health programmes for the elderly have mushroomed from about $20,000bn to about $50,000bn in the six-year period ending in fiscal 2006..."

Speculator Watch:

August 24 - Financial Times (Anuj Gangahar): "Turmoil in financial markets has inflicted significant damage on the investment performance of some of the biggest names in the hedge fund sector, with data showing DE Shaw and Goldman Sachs continuing to suffer losses. DE Shaw, a pioneer of quantitative investing based on complex mathematical and computer techniques, has been hit hard. Its Valence fund is down more than 22% cent in August, according to fund of hedge fund managers. These investors estimate that DE Shaw Composite, a multi-strategy fund, is down 7% for the month... The flagship Goldman Sachs Alpha fund was down 16% so far this month, investors said. According to Hedge Fund Research of Chicago, every fund strategy is in negative territory over August so far. Prominent vehicles that have suffered include those run by Barclays Global Investors and GLG. BGI's 32 Capital Fund was down 7% for the month to Monday last week. GLG's European long-short fund, one of the company's biggest with more than $2bn in assets, fell 4.4% in the first 10 days of August.

August 22 - Bloomberg (David Clarke): "Capital Fund Management, a Paris-based hedge-fund manager, said its Discus Master Fund could lose as much as 27% of its assets, or $407 million, after the bankruptcy of cash-management firm Sentinel Management Group Inc."

August 23 - Bloomberg (Jenny Strasburg): "HRJ Capital LLC, the investment firm whose partners include retired football players Joe Montana and Ronnie Lott, said one of its funds lost 12.3% in the first two weeks of August, erasing most of its 2007 gain... The investment pool farms out clients' money to hedge-fund managers. HRJ oversees $1.75 billion for clients in hedge funds, real estate and private-equity funds."

Money Market Issues:

Some still refer inaptly to the "subprime crisis". It should by now be evident that subprime was merely the point of initial risk market dislocation, in a crisis of debt contagion that has now engulfed The Epicenter of the Credit System - The Money Market. Global central bank interventions to the tune of $400bn or so have been instrumental in controlling what otherwise would have been a devastating "seizing up" of global financial markets. And it certainly didn't hurt that chairman Bernanke was quoted as saying he "intends to use all available tools." The markets delighted in the timely reminder of two of Dr. Bernanke's most famous speeches - his October, 2002, Asset-Price "Bubbles" and Monetary Policy, and his November, 2002, Deflation: Making sure "it" doesn't happen here.

With the past couple days of strong stock market gains and the perception that abundant liquidity has returned, scant attention will be paid to Bill Gross commenting yesterday that the asset-backed commercial paper market was likely "history." Wow! At the time, I thought to myself that in more normal market environments such a revelation would have been good for a 500 point drop in the Dow. But stock market complacency remains palpable - faith in the Fed and global central bankers resolute. According to the bullish consensus, economic fundamentals remain sound and, with assurances of ongoing Fed patronage, growth and corporate profits will hardly miss a beat.

Before I dive into the Money Market Issue, I am compelled to refute the notion that the Federal Reserve today enjoys great flexibility to lower rates to whatever level whenever necessary to sustain the economy and stock prices. In fact, a strong case can be made for quite the opposite. For one, I believe inflationary risks are greater than generally perceived by the bullish consensus. In stark contrast to the "dis-inflationary" nineties and the initial years of this decade, the global backdrop is inflationary and, perhaps, stubbornly so. Booms in China, India, Russia, Brazil, and elsewhere have respective heads of steam and, importantly, so far domestic Credit systems appear to possess atypical immunity to U.S. Credit tumult.

In spite of troubling illiquidity issues in cross-sections of the financial markets, the massive dollar reserves held in overabundance around the world will likely for some time buttress global energy and commodities prices. Note the price of crude, wheat, gold, copper, Chinese stocks and "emerging" markets, in general. I further believe that the vulnerable dollar will prove the proverbial Achilles heel for the upcoming easing cycle. The days of aggressive - and market-pleasing - Greenspan-style rate collapses could prove a luxury of the past.

The Bank of China Ltd dropped 5.4% today on the Hong Kong stock exchange after disclosing that it had $9.7bn of U.S. subprime exposure. The European banking system is under considerable stress as it struggles to deal with U.S. Credit woes. The market focus today may be on the apparent success aggressive interventions by the ECB and Fed are having in restoring liquidity. Yet the critical issues of private sector risk intermediation and U.S. Current Account Deficit "recycling" become murkier by the day.

Wall Street and Washington have been all too happy to perpetuate the myth that the world simply cannot get its fill of U.S. "investment." As the fable is told (and repeated), we consumers must gorge on imports to satisfy the requirements of a massive "global savings glut" that foreigners are almost desperate to bestow upon our (miracle) economy. Yet it is now emerging that the international banking community (especially European) has been a major participant in a massive speculative arbitrage in U.S. debt instruments - a financial scheme that is now unraveling. To what extent the dollar owes its resilience over the past few years of massive Current Account Deficits to speculation-based "SIVs", "conduits", and "carry trades" is today a legitimate question.

The primary dealer repurchase agreements ("repo"), as reported by the NY Fed, have ballooned $630bn over the past year. Money Market Fund assets have a one-year gain of $560bn. Prior to the decline over the past two weeks, Commercial Paper was sporting an unprecedented 12-month gain of $420bn. One-year CDO (collateralized debt obligations) issuance has been in the neighborhood of $600bn. These interrelated markets - "repo", "money funds", CP, and CDOs - were absolutely crucial in sustaining the aged Credit Bubble in the face of mounting financial and economic strain. In reality, they have amounted to the heart and soul of contemporary "Wall Street Finance" as it succumbed to perilous "blow-off" excess.

After years of financial innovation begetting soaring remuneration begetting ever greater risk-taking and innovation - Wall Street had fully mastered the "alchemy" on transforming endless risky loans (mortgages to consumer debt to corporate debt to leveraged loans) into securities that could be pooled to create highly-rated yet relatively higher-yielding CDOs (and other derivative instuments). Structured Investment Vehicles ("SIVs") and various types of "conduits" - equipped with offshore "bankruptcy remote" status and "liquidity agreements" from sponsoring "banks" - used their top (A1/P1) CP ratings to issue cheap short-term commercial paper to the money market funds and various (perceived safe and liquid) "money-like" investment vehicles. This Credit "arb" had been enormously profitable. The securities firms accomplished similar excess returns through various special purpose vehicles, along with the newfound strategy of using CDOs and other risky securities as collateral for "repos." This powerful Monetary Process was at the heart of the seduction of seemingly insatiable Credit supply and demand.

The subprime implosion and the resulting forced liquidation of various securities and structures set in motion the revelation that top ratings masked what were in many cases significant underlying Credit and liquidity risks. Newfound risk aversion and the resulting reversal of the flow of speculative finance immediately and dramatically altered Credit Availability and Marketplace Liquidity, with the upshot being ("Ponzi Finance") fragility and rapidly escalating Credit and liquidity risk. Suddenly, the marketplace lost trust in the securities, CDOs and structures used by the "SIVs" as collateral for their CP borrowings. There was a "run," and many "conduits" were unable to roll their commercial paper and other short-term borrowings.

It is my best guess that a large chunk of the $400bn or so central bank intervention has been provided in large part to the European banks as necessary liquidity to accommodate the repayment of "conduit" short-term borrowings (largely asset-backed CP). While the scope of the problem is alarming (global banks are estimated to have almost $1 TN of "conduit" liquidity agreement exposure), central banks are well-placed for providing such liquidity directly to the banking community. The markets can rejoice at the willingness of global central bankers to go to such extreme measures to restore liquidity, but at the same time I fear the market is overly complacent with respect to the ramifications and repercussions of the dislocation in this critical marketplace.

If the asset-backed commercial paper market is indeed "history" then I would expect this development to prove a seminal event for Wall Street "structured finance." All the SIVs and conduits worked marvelously to camouflage, distort, conceal and, in the end, perilously mis-price risk - and did all of the above in grand, historic excess. They played an instrumental role in late-cycle Risk Intermediation and they played recklessly. The underlying collateral was - despite their "AAA" and "AA" ratings - too risky and illiquid to be intermediated through the money market. Central banks do maintain the capacity to create the liquidity necessary to accommodate the unwinding of this specific Credit "arb." I question, however, the viability of this critical method of Risk Intermediation going forward.

The "money market" has traditionally been at the nerve center of financial crises. Especially late in the cycle, this marketplace will inevitably be the locus of the most enterprising - and often complex - Risk Intermediation Processes. Investors will look to this market for its traditional safety and liquidity, yet late-cycle complacency will tend to foster a level of risk acquiescence and gullibility. At the same time, the borrowing, investment banking, and brokering side of the market cannot resist the bounty from pushing the envelope. Eventually, the liquidity backdrop is interrupted and the degraded nature of underlying Credit conditions is revealed. And it will often be the case that an abrupt bout of risk intolerance in the "money market" - where risk-averse investors demand safety and liquidity - will spark a panic and liquidity crisis that quickly engulfs the riskier markets. Money market investors also tend to be less forgiving and longer memoried than risk speculators.

But I'll be the first to admit this is no typical financial crisis. It escalated at breakneck speed, with global equities, commodities, and general asset prices at or near record highs. Additionally, the global economy is in the midst of an unusual boom. Ironically, Acute Fragility in the relatively safe Money Market has so far proved a boon to highly inflated and vulnerable global stock markets. Dislocation and the risk of markets "seizing up" required immediate and extraordinary central bank intervention (agree or disagree, this is the accepted role of central banks).

And while an impending financial crash was fortunately circumvented for the time being, Bubbling U.S. and global equities markets cannot for long avoid vulnerability to altered Risk Intermediation dynamics. And this issue gets back to the flawed view of the Fed's role in the Great Depression: If only the Fed had created $5bn and recapitalized the banking system. More money, so they believe, would have provided a ("mopping up") remedy for disastrous boom-time excesses. It wouldn't have worked.

The issue then, as it is today, is not some finite amount of liquidity to keep the banks solvent and markets liquid, but instead the enormous ongoing Credit Creation and Intermediation necessary to sustain levitated asset prices, incomes, corporate earnings and government receipts. I personally believe it is at this point likely impossible to maintain these extremely inflated Credit and Economic Bubbles. The risk intermediation requirements are untenable, especially if trust in Wall Street finance - and, importantly, in contemporary "money" - is waning. Indeed, I expect the current backdrop to prove an absolute Credit and liquidity glutton. Central bankers will be faced with the dilemma of accommodating an insatiable appetite for liquidity injections or, at some point in the not too distant future, attempt to draw a line in the sand and hope for the best.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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