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November 02, 2007

Road to Ruin
by Doug Noland

For the week, the Dow declined 1.5% (up 9.1% y-t-d), and the S&P500 fell 1.7% (up 6.4%). The Utilities added 0.6% (up 13.2%), while the Morgan Stanley Consumer index dipped 0.8% (up 6.0%). The Transports declined 1.3% (up 5.3%), and the Morgan Stanley Cyclical index gave up 0.9% (up 16.9%). The small cap Russell 2000 was hit for 2.9% (up 1.3%), and the S&P400 Mid-Cap index declined 1.0% (up 10.2%). The NASDAQ100 gained 0.9% (up 26%), and the Morgan Stanley High Tech index added 0.6% (up 18.5%). The Semiconductors rallied 1.3% (down 2.1%). The Street.com Internet Index was about unchanged (up 22.4%), while the NASDAQ Telecommunications index gained 1.5% (up 24.7%). The Biotechs declined 1.2% (up 9.6%). Financial stocks were under heavy selling pressure. The Broker/Dealers sank 5.7% (down 9%), and the Banks were clobbered for 6.7% (down 17.9%). With bullion surging $19.95 to a 27-year high, the HUI Gold index jumped 4.5% (up 29.9%).

Three-month Treasury bill rates sank 38.5bps this week to 3.60%. Two-year government yields fell 10 bps to 3.67%. Five-year yields dropped 11 bps to 3.95%. Ten-year Treasury yields declined 9 bps to 4.315%, and long-bond yields fell 8 bps to 4.62%. The 2yr/10yr spread ended the week at 64.5. The implied yield on 3-month December '08 Eurodollars dipped 2 bps to 4.085%. Benchmark Fannie Mae MBS yields declined 3 bps to 5.756%, this week notably underperforming Treasuries. The spread on Fannie's 5% 2017 note widened 3.5 to 50.6, and the spread on Freddie's 5% 2017 note widened 2 to 50. The 10-year dollar swap spread increased 4.4 to 68.5. Corporate bond spreads were mixed, as the spread on an index of junk bonds ended the week 15 bps narrower.

Investment grade debt issuers included Coca-Cola $1.75bn, Motorola $1.2bn, McGraw-Hill $1.2bn, and Textron $400 million.

Junk issuers included Nuveen Investment $785 million, Wynn Las Vegas $400 million, Tenneco $250 million, and CII Carbon $235 million.

Convert issuers included Prologis $1.0bn, and Champion Enterprises $160 million.

Foreign dollar bond issuance included Tesco $2.0bn, Commonwealth Bank $1.0bn, Petrobras $1.0bn, and Panama Canal $100 million.

German 10-year bund yields were unchanged at 4.17%, while the DAX equities index slipped 1.5% for the week (up 18.7% y-t-d). The Japanese "JGB" market was volatile, with 10-year yields ending the week down 3.5bps to 1.58%. The Nikkei 225 was little changed (down 4.1% y-t-d). Emerging equities were mixed, while debt markets were for the most part surprisingly quiet. Brazil's benchmark dollar bond yields added one basis point to 5.73%. Brazil's Bovespa equities index rose another 2.7% (up 44% y-t-d). The Mexican Bolsa fell 3.4% (up 16.5% y-t-d). Mexico's 10-year $ yields dipped 2 bps to 5.39%. Russia's RTS equities index gained 1.6% (up 16% y-t-d). India's Sensex equites index rose another 3.8% (up 44.9% y-t-d). China's Shanghai Exchange added 3.4%, increasing y-t-d gains to 116% and 52-week gains to 212%.

Freddie Mac posted 30-year fixed mortgage rates declined 7 bps this week to 6.26% (down 5 bps y-o-y). Fifteen-year fixed rates fell 8 bps to 5.91% (down 11bps y-o-y). One-year adjustable rates sank 9 bps to 5.57% (up 4bps y-o-y).

Bank Credit increased $20.9bn during the week (10/24) to a record $9.067 TN. Bank Credit has now posted a 14-week gain of $423bn (18.2% annualized) and y-t-d rise of $770bn, a 11.2% pace. For the week, Securities Credit increased $16.6bn. Loans & Leases rose $4.3bn to a record $6.667 TN (14-wk gain of $342bn). C&I loans declined $11bn, reducing 2007's growth rate to 20.7%. Real Estate loans jumped $15.4bn. Consumer loans added $1.5bn. Securities loans declined $4.0bn, while Other loans increased $2.3bn. On the liability side, (previous M3) Large Time Deposits jumped $18bn.

M2 (narrow) "money" rose $9.9bn to $7.383 TN (week of 10/22). Narrow "money" has expanded $339bn y-t-d, or 5.8% annualized, and $437bn, or 6.3%, over the past year. For the week, Currency added $0.6bn, while Demand & Checkable Deposits declined $18.3bn. Savings Deposits jumped $21.6bn, and Small Denominated Deposits added $0.4bn. Retail Money Fund assets increased $4.1bn.

Total Money Market Fund Assets (from Invest. Co Inst) declined $23.8bn last week to $2.946 TN. Money Fund Assets have now posted a 14-week gain of $3,362bn (56% annualized) and a y-t-d increase of $564bn (28.0% annualized). Money fund asset have surged $681bn over 52 weeks, or 30.1%.

Total Commercial Paper rose $9.9bn to $1.882 TN. CP is down $341bn over the past 12 weeks. Yet asset-backed CP fell another $8.5bn (12-wk drop of $288bn) to $886bn. Year-to-date, total CP has dropped $92bn, with ABCP down $198bn. Over the past year, Total CP has declined $18bn, or 0.9%.

Asset-backed Securities (ABS) issuance slowed to $4.5bn this week. Year-to-date total US ABS issuance of $502bn (tallied by JPMorgan) is running a third behind comparable 2006. At $216bn, y-t-d Home Equity ABS sales are 55% off last year's pace. Year-to-date US CDO issuance of $278 billion is running 7% below 2006.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 10/30) increased $1.6bn to a record $2.032 TN. "Custody holdings" were up $280bn y-t-d (18.9% annualized) and $338bn during the past year, or 20%. Federal Reserve Credit expanded $3.9bn to $862.7bn. Fed Credit has increased $10.5bn y-t-d and $29.3bn over the past year (3.5%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.090 TN y-t-d (27% annualized) and $1.219 TN year-over-year (26%) to $5.901TN.

Credit Market Dislocation Watch:

November 2 - Financial Times (Gillian Tett): "The mood in credit derivatives markets turned ugly on Thursday, with the cost of insuring corporate debt hitting multi-week highs on both sides of the Atlantic. Speculation was rife that leading major investment banks were facing additional losses linked to complex mortgage-backed securities, while worries mounted over the health of major financial guarantors. 'It's scary out there - there's blood on the streets,' a trader at a US brokerage said. 'It's a real mess.' Five-year credit default swaps tied to Citigroup widened to 60 bps, meaning it cost $60,000 annually to insure Citigroup's debt against default for five years. A couple of weeks ago, that figure stood at $27,000. Contracts on Merrill Lynch...rose $18,000 to $103,000.... Bond insurers, or monolines, were also hit hard. '[These triple-A rated companies are] exposed to the crumbling housing market,' said Gavan Nolan, an analyst at derivatives data provider Markit... CDS on MBIA Insurance rocketed to a four-year high, of 345bp... Ambac Financial climbed to a five-year high of 310bp. In Europe, the iTraxx Crossover index of 50 mostly high-yield companies widened by 18 bp to 338bp, the biggest rise since August..."

November 2 - Bloomberg (Christine Richard): "Ambac Financial Group Inc. and MBIA Inc. were cut to 'in-line' from 'attractive' by Morgan Stanley, which raised the possibility that the bond insurers could face a 'downward spiral' if defaults on mortgages and home equity loans worsen."

November 1 - Financial Times (Stacy-Marie Ishmael and Gillian Tett): "The ongoing crisis in the US housing market is pushing a key mortgage-linked derivatives index to new lows, threatening to unleash a further bout of credit market upheaval. The price swing in the index, known as the ABX, is particularly significant, since it is starting to reduce the value of credit instruments that carried high credit ratings, and were therefore supposed to be ultra-safe... Until a couple of months ago, the part of the ABX index that tracks AAA debt was trading almost at face value. However, in the past three weeks it has fallen sharply due to downgrades by credit rating agencies and a slew of bad data from the housing sector... The swing could create real pain for investors, since in recent years numerous firms have created trading strategies which have loaded large debt levels onto these 'safe' securities, precisely because they assumed these instruments would never fluctuate in price. 'The last week has seen some of the worst falls in the ABX market this year, especially higher up the capital structure [with highly rated debt],' said Jim Reid, head of fundamental credit strategy at Deutsche Bank."

November 2 - Bloomberg (Shannon D. Harrington): "The risk of owning the debt of Merrill Lynch & Co. and Citigroup Inc. rose to the highest in at least five years on speculation that losses from the mortgage-market collapse will worsen."

November 1 - Bloomberg (Shannon D. Harrington and Hamish Risk): "The risk of owning corporate debt reached the highest in seven weeks as credit-default swap traders bet that companies, including Citigroup Inc., will further reduce the value of securities tied to subprime mortgages. The CDX North America Investment Grade Series 9 Index, a benchmark for the cost to protect debt that rises as investor confidence deteriorates, rose 5.75 basis points to 66.25 bps... Credit-default swaps tied to Citigroup and Merrill Lynch & Co. are at three-month highs, while those on bond insurers Ambac Financial Group Inc. and MBIA Inc. rose to the most in at least four years."

October 30 - Financial Times (Stacy-Marie Ishmael and Paul J Davies): "Investor worries are mounting that the next big casualties from the credit squeeze might be the specialist companies that act as guarantors for bond issuers. These companies, which write insurance to boost the credit ratings of various kinds of bonds, have seen their share prices pummelled and the cost of protecting their debt against default soar. Over the past week, sector leaders such as MBIA, Ambac, XL Capital Assurance, Radian and MGIC have all been hit hard. In recent years, these companies, known as monolines, have moved away from their role of guaranteeing, or wrapping, bonds issued by US municipalities towards writing business related to structured asset-backed finance deals, such as mortgage-backed bonds and collateralised debt obligations... 'Our conclusion is that MBIA and the rest of the financial guarantors are facing a prolonged period of stress,' said Rob Haines, an analyst at CreditSights..."

November 2 - Financial Times (Gillian Tett): "This week, a banking friend made a startling confession. In recent weeks he has been furtively unwinding some large investment portfolios linked to subprime securities. But as he has embarked on this sordid task, he has discovered that the only effective way to get rid of these distressed assets is to avoid putting any tangible price on the trade. Instead, he has resorted to using a tactic more normally associated with third world markets than the supposedly sophisticated arena of high finance: barter.

'Barter is the only thing that works right,' he chuckles grimly. 'It is like the Dark Ages.' ...Never mind the fact that the risky tranches of subprime-linked debt (the so-called BBB ABX series) have fallen 80 per cent since the start of the year; in a sense, such declines are only natural for risky assets in a credit storm. Instead, what is really alarming is that the assets which were supposed to be ultra-safe - namely AAA and AA rated tranches of debt - have collapsed in value by 20% and 50% odd respectively. This is dangerous, given that financial institutions of all stripes have been merrily leveraging up AAA and AA paper in recent years, precisely because it was supposed to be ultra-safe and thus, er, never lose value."

October 30 - Dow Jones (Anusha Shrivastava): "The higher-rated tranches of the subprime mortgage-based ABX index were being clobbered Monday after Fitch Ratings said the credit ratings of $23.9 billion of the highest-rated collateralized debt obligations could be downgraded. The AAA-rated slice of the index based on home loans from the second half of 2006 was quoted at 80.5 cents, according to one primary dealer. It had closed at 83.39 cents Friday, according to index administrator Markit. Its AA-rated slice hit 47.5 cents, down from a close of 52.04 cents Friday."

November 1 - Bloomberg (Deborah Finestone): "The Federal Reserve added $41 billion in temporary reserves to the banking system, the largest one-day cash infusion since the terrorist attacks of September 2001. The amount reflects the central bank's effort to push the effective rate lower after policy makers reduced their target yesterday by a quarter-percentage point to 4.50 percent."

November 1 - New York Times (Eric Dash): "Nearly three weeks after the country's biggest banks announced a $75 billion fund to help stabilize the credit markets, the reality is sinking in that the plan will provide hospice care to troubled investment funds, not resuscitate them. The reason, market participants say, is that the structured investment vehicles, or SIVs, that helped fuel the Wall Street loan-packaging boom hinged on confidence in the quality of the $400 billion in securities they bought and on easy credit from investors. Now, that trust has been shattered and most of the investors have fled. Many say that the business model is dead, or soon will be."

October 30 - Bloomberg (Neil Unmack): "Sachsen Funding 1 Ltd., a $2.2 billion debt fund set up by Landesbank Sachsen Girozentrale said the value of its assets fell, preventing it from being able to borrow in the commercial paper markets. The company, a so-called SIV-lite, is now in 'restricted issuance' after a 'recent reduction' in the market value of its assets... In the 'restricted issuance' state, the company is not allowed to sell further debt, or invest in assets other than deposits or short-term investments..."

October 30 - Bloomberg (Sebastian Boyd): "Axon Financial Funding, a $9.5 billion structured investment vehicle or SIV, had its debt ratings cut by Standard & Poor's after it sold assets at a loss. S&P cut its rating on the company's debt by eight steps to BBB, two steps above high-risk, high-yield, from the top AAA investment-grade ranking."

October 30 - Bloomberg (Jacob Greber): "UBS AG, Europe's largest bank by assets, reported its first quarterly loss in almost five years after declines in the U.S. subprime mortgage market led to $4.4 billion in losses and writedowns on fixed-income securities."

November 2 - Bloomberg (Allen Wan): "Merrill Lynch & Co., the world's biggest brokerage, may need to write off another $10 billion of losses in collateralized debt obligations, Deutsche Bank Securities said in downgrading the stock today. 'New CDO writedowns could approach $10 billion given a worse CDO market,' Deutsche Bank analysts wrote..."

October 30 - Bloomberg (Sebastian Boyd): "At Merrill Lynch & Co., a lot more was lost than the $2.24 billion, or $2.82 a share, Chief Executive Officer Stan O'Neal said would be subtracted from the third quarter. The real damage to shareholders came with Merrill's $8.4 billion writedown. It is the biggest in the history of Wall Street and wiped out four quarters of growth in shareholders' equity, according to Merrill's published figures. The charge, mostly for collateralized debt obligations and subprime mortgages, left the New York-based company with $38.8 billion of assets minus liabilities. Losing '20 percent of shareholders' equity in one fell swoop is a serious blow,' said Robert Willens, the accounting analyst at Lehman Brothers..."

November 2 - The Wall Street Journal (Susan Pulliam): "Merrill Lynch & Co., in a bid to slash its exposure to risky mortgage-backed securities, has engaged in deals with hedge funds that may have been designed to delay the day of reckoning on losses, people close to the situation said. The transactions are among the issues likely to be examined by the Securities and Exchange Commission. The SEC is looking into how the Wall Street firm has been valuing, or "marking," its mortgage securities and how it has disclosed its positions to investors, a person familiar with the probe said. Regulators are scrutinizing whether Merrill knew its mortgage-related problem was bigger than what it indicated to investors throughout the summer... In one deal, a hedge fund bought $1 billion in commercial paper issued by a Merrill-related entity containing mortgages, a person close to the situation said. In exchange, the hedge fund had the right to sell back the commercial paper to Merrill itself after one year for a guaranteed minimum return, this person said."

October 30 - Financial Times (Haig Simonian): "UBS committed itself on Tuesday to improving radically its risk assessment and control procedures as a bank once renowned for its risk awareness admitted it had slipped up grievously in the US credit turmoil... UBS will "de-emphasise" proprietary trading, and introduce measures to reprice capital put at traders' disposal. Staff in its investment bank will also receive a higher proportion of compensation in UBS shares in a further effort to underline the potential consequences of their decisions."

October 30 - Bloomberg (Gavin Finch): "The cost of borrowing euros for two months rose the most in eight years as banks sought loans that will cover their commitments through to the start of next year. The London interbank offered rate that banks charge each other for the loans climbed 28 bps to 4.59% today... It was the biggest one-day increase since Oct. 28, 1999, when it soared 54 basis points in the run-up to the new millennium on concern computer systems would crash at the turn of the year."

October 31 - Bloomberg (Caroline Salas): "Residential Capital LLC, the biggest privately held mortgage lender, is the worst performer of the 50 biggest issuers in the high-yield, high-risk bond market this month, according to index data compiled by Merrill Lynch & Co. ResCap's bonds lost 9.45% in October..."

Currency Watch:

November 1 - Bloomberg (Liz Capo McCormick): "Currency traders are betting in the forward exchange rate market that the Hong Kong Monetary Authority will abandon its currency's 24-year peg to the U.S. dollar as overseas investment floods into the city. In the forward currency market, an investor can buy Hong Kong dollars now for delivery in 12 months at HK$7.7096 per U.S. dollar, above the HK$7.75 top of the Hong Kong Monetary Authority's permitted trading range. The authority sold HK$7.828 billion ($1 billion) to defend the currency yesterday, twice as much as two previous interventions since Oct. 23."

November 1 - Bloomberg (Patricia Kuo and Aaron Pan): "The Hong Kong Monetary Authority denied market speculation that its officials have asked China to allow the city to revise its fixed exchange rate. Medley Global Advisors, founded in 1997 by Richard Medley, former chief political strategist at Soros Fund Management, said Hong Kong suggested widening the band..."

October 30 - Financial Times (Peter Garnham): "Is the dollar set to join the yen and the Swiss franc as a carry trade funding currency? Both the yen and Swiss franc have been pushed to multi-year lows this year as carry trade investors have sold the low-yielding currencies to fund the purchase of riskier, higher-yielding assets elsewhere. However, the dollar has come under similar pressure in recent weeks, hitting a series of multi-year troughs."

October 30 - Bloomberg (Abdulla Fardan): "The six-nation Gulf Cooperation Council will decide at a summit in December whether to abide by the proposed start date of 2010 for a single currency in the region, Al-Ayam newspaper said, citing a Bahraini official."

The dollar index declined 0.9% to 76.34. For the week on the upside, the Canadian dollar increased 2.2%, the British pound 1.3%, the Swiss franc 1.0%, the Danish krone 0.6%, and the Euro 0.6%. On the downside, the Norwegian krone declined 0.9%, the New Zealand dollar 0.3%, and the Japanese yen 0.2%.

Commodities Watch:

October 31 - Financial Times (Javier Blas and Chris Flood): "For a moment this week, it looked as if a sliding dollar and surging oil prices would drive gold through $800 dollars an ounce for the first time since 1980. Precious metals traders say that a move above this psychologically important level and towards the nominal record high of $850 an ounce reached in January 1980 is likely if an expected cut in interest rates today by the US Federal Reserve leads to further dollar weakness."

October 31 - Financial Times (Ed Crooks): "Shortages of skilled labour and capital investment mean oil supplies might fail to meet the expected growth in demand over the coming years, the head of the rich countries' energy watchdog has warned. Nobuo Tanaka, executive director of the International Energy Agency, told the Oil and Money conference in London: 'Despite five years of high oil prices, market tightness will actually increase from 2009. New capacity additions will not keep up with declines at current fields and the projected increase in demand.' He said that the IEA had revised up sharply to $5,000bn its estimate of the investment that the world's energy industries would need by 2030 to meet rising demand."

October 30 - Bloomberg (Gemma Daley and Jae Hur): "Australia cut its wheat harvest forecast for the third time as the nation's worst drought damaged crops, adding pressure to shrinking world supplies that drove up prices to a record last month. Output may be 12.1 million metric tons in the current harvest... That is 22% less than the 15.5 million tons estimate from Sept. 18. Last year's 9.8-million-ton crop was the country's lowest in 12 years. 'This is close to the worst case and will lend support to the market,' Kenji Kobayashi, an analyst at Kanetsu Asset Management Co., said... Still, 'this is not a big surprise as some had expected wheat harvest estimates to fall close to 10 million tons.'"

November 2 - Bloomberg (Jeff Wilson): "Soybeans rose, capping the 10th weekly gain in 11 weeks, on speculation that rising crude oil prices will boost demand for alternative fuels made from oilseeds including soybeans. Crude oil rose 2.6% to a record close on speculation that fuel consumption will increase after a government report showed higher-than-forecast U.S. employment growth last month. Soybeans have had a correlation of 0.7 against the price of oil in the past two months. A figure of 1 would indicate the two commodities move in lockstep. 'Crude oil is driving soybeans,' said Chad Henderson, a market analyst for Prime-Ag Consultants..."

November 1 - Financial Times: "Record-high dairy prices have eaten into margins at companies whose products list dairy as a primary ingredient. The US has stepped up production to counteract supply shocks in Europe and Australia, and prices should ease next year. But milk future prices suggest that the timetable for relief is moving further into 2008... Global population growth and booming consumption in developing countries have strengthened demand for dairy products... Costs have spiked for most commodities, but dairy has led the charge. November prices for the type of milk used to make cheese are up 85% from a year ago, while yoghurt milk is up 141% and skimmed milk powder 155%... Most dairy-dependent companies have responded by raising prices..."

October 29 - Financial Times (Javier Blas): "Rising food prices are likely to force developing countries to follow Russia's example and impose retail price controls to avoid social unrest, the United Nations' top agriculture official has warned."

For the week, Gold jumped 2.5% to $805.15, and Silver 2.2% to $14.60. December Copper sank 6%. December crude surged $4.07 to a record $95.93. December gasoline jumped 7.1%, and November Natural Gas rose 7.8%. December Wheat declined 2.7%. For the week, the CRB index jumped 2.2% (up 15.1% y-t-d). The Goldman Sachs Commodities Index (GSCI) surged 3.2%, increasing 2007 gains to 39.4%.

Japan Watch:

October 30 - Financial Times (Michiyo Nakamoto): "Three leading Japanese banks have become the latest victims of the US subprime woes, which are proving more trouble to the country's financial sector than initially expected. Mitsubishi UFJ Financial Group is expected to take a writedown on its subprime exposure of up to six times its initial forecast of Y5bn ($43.6m). Japan's largest banking group is likely to be forced to write down its subprime exposure by Y20bn-Y30bn as of the end of September..."

October 31 - Bloomberg (Mayumi Otsuma and Lily Nonomiya): "The Bank of Japan forecast slower economic growth and abandoned a prediction that consumer prices will increase this year, making it harder to raise the world's lowest borrowing costs. 'Downside risks are increasing,' Governor Toshihiko Fukui said... He repeated the bank's commitment to raise rates as long as the economy keeps expanding and prices resume gaining."

October 31 - Bloomberg (Toru Fujioka): "Japan's housing starts slumped to the lowest in four decades in September as stricter rules for obtaining building permits threaten to slow economic growth. Annualized starts tumbled 44% from a year earlier to 720,000 in September..."

China Watch:

November 2 - Financial Times (Jamil Anderlini): "The murder of a man who jumped a petrol queue in China's central Henan province on Wednesday is the stuff of nightmares for the authoritarian Chinese government. Faced with worsening fuel shortages across the country Beijing raised petrol, diesel and jet fuel prices at the pump by almost 10% yesterday, in an effort to boost domestic supplies and exorcise the spectre of social unrest. The policy reversal came as shortages spread to the capital, which is usually immune from the country's periodic supply crunches. But the government is unwilling to allow prices to rise too much because of a morbid fear of spiralling inflation, which has a history of toppling governments in China and is currently running at a 10-year high, above 6%... Soaring global crude oil prices...pose a serious dilemma for Beijing, which last raised its tightly controlled fuel prices in May 2006. China is the second-largest crude oil consumer after the US and although it was a net exporter as recently as 1993 it now relies on imports for nearly 5% of its crude supply. The current shortages, particularly of diesel, result from a combination of high global oil prices and strict government controls, causing huge losses for Chinese refiners that must pay more for oil but cannot raise prices at the pump."

October 31 - Bloomberg (Nipa Piboontanasawat): "China's current-account surplus widened 78% in the first six months of 2007 to $162.86 billion on increased overseas sales."

October 30 - UK Telegraph (Richard Spencer): "Wages in China's cities have risen by almost 20% since the start of the year, the government in Beijing said...adding to fears that the country's economy is overheating and might export inflation round the world... Rising prices and inflation are putting pressure on the government to rein in the economy."

November 1 - Bloomberg (Wendy Leung): "Hong Kong's retail sales rose by the most since May 2004 as a buoyant stock market stoked consumer confidence and spending. Retail sales by value climbed 15.8% in September from a year earlier..."

India Watch:

October 30 - Bloomberg (Cherian Thomas): "India's central bank unexpectedly ordered lenders to set aside more reserves for a fourth time this year to prevent 'unacceptably high' inflows of foreign cash from reigniting inflation. The Reserve Bank of India raised the ratio of deposits lenders must put aside by half a point to 7.5%, up from 5.25% at the start of the year.... Governor Yaga Venugopal Reddy said inflows rose after the U.S. Federal Reserve cut rates to stem subprime mortgage defaults, increasing the risk of 'financial contagion.' 'The move is to ensure the liquidity situation doesn't get out of control,' said Shuchita Mehta, senior economist at Standard Chartered Bank in Mumbai. 'India is still very attractive for foreign investors.'"

November 1 - Bloomberg (Kartik Goyal): "India's export of gems, textiles and other manufactured products rose at the fastest pace in five months in September. Exports rose 19.2% to $12.8 billion, while imports rose 2.3% to $17.2 billion..."

Asia Boom Watch:

October 31 - Bloomberg (Cherian Thomas and Nipa Piboontanasawat): "India and China may be forced to further restrict bank lending as declining U.S. interest rates prompt investors to pump record cash into the world's two fastest-growing economies. 'If the U.S. cuts rates, it will have Asia's blood on its hands,' said Marc Faber... 'The Fed is pursuing an easy monetary policy that is creating massive bubbles outside the U.S.' The Fed's actions threaten to spur inflation in India and China, where stocks have soared to records as a stampede of foreign money stokes share and property prices. Chinese and Indian shares have added $882 billion since the U.S. reduced rates on Sept. 18, almost a third of the $3 trillion gain in their combined market capitalization this year."

November 1 - Bloomberg (Seyoon Kim): "South Korean exports rose to a record in October as higher shipments to China and Europe helped the nation weather a slowdown in demand from the U.S. Exports climbed 24.2% from a year earlier..."'

October 31 - Bloomberg (Shamim Adam): "Singapore's jobless rate fell to the lowest in 9 1/2 years in the third quarter as the island's economic growth encouraged companies to increase hiring to meet demand for goods and services."

Unbalanced Global Economy Watch:

October 30 - Bloomberg (Ambereen Choudhury): "Mergers and acquisitions overtook last year's record as companies picked up the slack from private-equity firms hobbled by rising borrowing costs. The value of transactions inched ahead of last year's $3.55 trillion total this week, according to...Bloomberg. October was the busiest month in the past three, with $262 billion of deals..."

October 31 - Financial Times (Ralph Atkins): "Eurozone inflation lurched sharply higher in October and runs a significant risk of soon hitting 3%, putting pressure on the European Central Bank as growth in the 13-country economy starts to slow. The risk of soaring oil prices driving inflation higher while economic growth slides, yesterday prompted a warning of possible 'stagflation conditions' by Vitor Constancio, the Portuguese central bank governor. Energy and food prices drove annual inflation to a higher-than-expected 2.6% in October, from 2.1% in September... That was the fastest rate of price increases for more than two years."

October 28 - Bloomberg (Svenja O'Donnell): "U.K. house prices fell for the first time in two years in October, and mortgage approvals dropped to a 26-month low, signs the country's decade-long housing boom is coming to an end. The average cost of a home in England and Wales dropped 0.1 percent to 176,100 pounds ($361,462) from September, research group Hometrack Ltd. said today. Central London led the declines. Separately, the Bank of England said banks granted 102,000 loans for house purchase in September, the fewest since July 2005. A jump in credit costs is threatening to slow London's financial services industry and is adding to the debt burden on British homeowners."

October 31 - Bloomberg (Dara Doyle): "Irish mortgage lending grew at the slowest pace in a decade in September as rising borrowing costs and concerns about a property slump deterred homebuyers. Home loans rose an annual 16.1%..."

November 1 - Bloomberg (Dara Doyle): "Irish house prices fell the most in a decade in September as rising borrowing costs and concerns about a property slump deterred homebuyers. Prices fell 2.8% from a year earlier..."

November 1 - Bloomberg (Tasneem Brogger): "Denmark's jobless rate fell in September, setting a new 33-year low and threatening to push wages and prices higher as a shortage of workers crimps production. Unemployment fell to 3.1% from 3.3%..."

October 30 - Bloomberg (Ben Sills): "The inflation rate in Spain jumped to the highest in more than a year in October as the price of oil reached a record. Consumer prices rose 3.6 percent from a year earlier using European Union methods, compared with a 2.7% rate in September..."

November 1 - Bloomberg (Robin Wigglesworth): "Norway's jobless rate fell to 1.7% in October, the lowest in 20 years, adding to concern falling unemployment will drive wages higher and stoke inflation. The rate dropped from 1.8% in September..."

October 31 - Bloomberg (Robin Wigglesworth): "Norway's domestic credit growth slowed to 14.3% in September as six interest rate increases this year crimped people's willingness to take on more debt."

October 30 - Bloomberg (Maria Kolesnikova): "Russia's demand for food surged after producers agreed last week to introduce price caps on some products to help the government fight inflation, Kommersant said. Russians have trebled their purchases of sunflower oil, flour, cereals and canned meats from last week on anticipation prices..."

November 1 - Bloomberg (Steve Bryant): "Turkey's exports rose 37.1% in October from a year earlier, the Turkish Exporters' Assembly said."

Latin America Watch:

October 30 - Bloomberg (Thomas Black): "Mexico's government and private companies need to invest $50 billion over the next 10 years to meet the country's demand for power, an official with the state-owned electricity company said."

Bubble Economy Watch:

October 30 - Financial Times (David Wighton and Ben White): "Merrill Lynch on Tuesday boosted Stan O'Neal's departure package by almost $90m - taking it to $160m - by letting him retire as chairman and chief executive rather than sacking him... By casting his departure as a retirement, the board allows Mr O'Neal, who was paid $48m last year, to retain deferred compensation in the form of unvested stock worth $90m, giving him a total exit package of about $160m, including other compensation, shares and benefits."

Central Banker Watch:

November 1 - Bloomberg (Matthew Brown): "Gulf Arab oil producers Saudi Arabia, the United Arab Emirates, Kuwait, Bahrain and Qatar lowered interest rates today, following a cut by the U.S. Federal Reserve."

October 30 - Bloomberg (Jonas Bergman): "Sweden's central bank raised its benchmark interest rate to a five-year high and said it will lift it once more in the first half of next year on concern falling unemployment and surging wages will stoke inflation. The benchmark repurchase rate was raised by a quarter-point to 4%, the 10th increase from a record low in January 2006..."

November 1 - Bloomberg (Tasneem Brogger): "Iceland's central bank unexpectedly raised its key interest rate to a record 13.75% as the lowest unemployment rate in almost two decades and climbing house prices keep inflation above the target."

October 31 - Bloomberg (Jeffrey T. Lewis): "European Central Bank governing council member and Bank of Portugal Governor Vitor Constancio comments on the decline of the dollar against the euro: 'The risks related to the exchange rate are significant. There is in fact a situation of a continuing, ordered and gradual decline of the dollar, but it has risks because it's very dependent on financing from the exterior... One of the risks weighing on the world economy is if the fall of the dollar and the correction of imbalance will be gradual or if there will be surprises.'"

Structured Finance Earnings Watch:

November 1 - Bloomberg (Hugh Son and Josh P. Hamilton): "Radian Group Inc., the third-biggest U.S. mortgage insurer, reported a loss of $703.9 million, the largest yet in an industry roiled by claims from failed home loans...joining larger rivals, MGIC Investment Corp. and PMI Group Inc. in reporting its first quarterly loss as a publicly traded company. Radian...wrote down its $468 million stake in a unit jointly owned with MGIC that invested in subprime mortgages..."

GSE Watch:

October 31 - Bloomberg (Jody Shenn): "Fannie Mae, the government-chartered company that finances one-sixth of U.S. apartment-building debt, this month loosened its review process for multifamily-property loans it will buy, allowing lenders to act faster in a potentially weaker market. The first 'significant' changes to the Delegated Underwriting and Servicing program in 20 years will enable lenders to make more loans that Fannie Mae will buy without first looking at their details, said Michele Evans, vice president of multifamily corporate affairs at [Fannie]..."

October 30 - Bloomberg (James Tyson and Jody Shenn): "Banks shut out of the market for short-term loans are finding salvation in a government lending program set up to revive housing during the Great Depression. Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6%. The government-sponsored companies were able to make loans at about 4.9%, saving the private banks about $1 billion in annual interest. To meet the sudden demand, the institutions sold $143 billion of short-term debt in August and September..."

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

October 30 - Dow Jones (Rex Nutting): "Home prices in 20 major U.S. cities fell 4.4% in the past year as of August, according to the Case-Shiller price index released Tuesday by Standard & Poor's. Prices fell 0.8% in the 20 cities between July and August, the fastest monthly decline in the seven-year history of the 20-city index. Prices in the original 10-city index had fallen 5% since August 2006, the fastest annual decline since 1991. Prices have been down on a year-over-year basis for eight straight months. 'The fall in home prices is showing no real signs of a slowdown or turnaround,' said Robert J. Shiller, co-creator of the index and chief economist for MacroMarkets LLC."

November 2 - Bloomberg (Pierre Paulden): "Issuance of commercial mortgage-backed securities will fall 50% in 2008 from $220 billion this year as investors seek less complex securities, according to an analyst at Moody's... Collateralized debt obligations based on commercial real estate loans will decline from $30 billion this year to $10 billion next year, Tad Philipp, a managing director at Moody's...said..."

Mortgage Finance Bust Watch:

October 31 - The Wall Street Journal (Kemba J. Dunham): "Although underwriting standards in commercial lending have improved since April, the credit quality of the underlying loans that were issued in the third quarter was worse than ever, according to a new report by Moody's... Moody's in April issued a warning about commercial mortgage-backed securities, or pools of loans that are sliced up and sold to investors as bonds, stating that underwriting standards had become too lax during the real-estate frenzy."

October 31 - The Wall Street Journal (Jennifer S. Forsyth): "The amount of sublease office space available to tenants increased nationally for the first time in five years, an indication that commercial leasing is slowing in many markets across the U.S. The increase demonstrates that many businesses related to home-mortgage lending have returned space to the market."

Foreclosure Watch:

November 1 - Associated Press: "A soaring number of U.S. homeowners struggled to make mortgage payments in the third quarter, with properties in some stage of foreclosure more than doubling from the same time last year... A total of 446,726 homes nationwide were targeted by some sort of foreclosure activity from July to September, up 100.1% from...the year-ago period, according to...RealtyTrac Inc. The current figure was 33.9% higher than the 333,731 properties in foreclosure in the second quarter of this year... There was one foreclosure filing for every 196 households in the nation during the most recent quarter, RealtyTrac said..."

November 1 - Bloomberg (Dan Levy): "U.S. home foreclosures doubled in the third quarter from a year earlier as subprime borrowers failed to make higher payments on adjustable-rate mortgages, RealtyTrac Inc. said. There were 635,159 foreclosure filings in the quarter, or one for every 196 households, including default notices, auction notices and bank repossessions. California, Florida and Ohio accounted for 44% of the total... Forty-five of 50 states had increases. 'Given the number of loans due to reset through the middle of 2008, and the continuing weakness in home sales, we would expect foreclosure activity to remain high and even increase over the next year in many markets,' James Saccacio, chief executive officer at...RealtyTrac..."

Fiscal Watch:

October 30 - Bloomberg (Michael Quint): "New York state faces a budget gap of $4.3 billion next year, up from $3.6 billion estimated three months ago, as Wall Street job cuts and losses reduce tax revenue, the Division of Budget said. The state normally collects about 20% of its revenue from taxes on Wall Street companies and employees."

October 30 - Bloomberg (Henry Goldman): "New York Mayor Michael Bloomberg ordered agency heads to freeze all city hiring and cut their budgets this year and next, anticipating less revenue as Wall Street profits drop and real estate sales slow."

Speculator Watch:

November 1 - Bloomberg (Alison Fitzgerald and Ryan J. Donmoyer): "The Internal Revenue Service has begun an inquiry into suspected tax abuses at hedge funds and private-equity firms after determining many firm partners don't file returns and may have improperly characterized transactions. The tax-collection agency is studying whether funds improperly structured stock swaps to avoid withholding taxes, whether they dictated loan terms to banks before agreeing to buy loan portfolios, and whether they improperly classified income as capital gains to take advantage of the lower rate."

Crude Liquidity Watch:

October 29 - Financial Times (Andrew England): "An unprecedented construction boom is gaining momentum in Saudi Arabia as highly ambitious, multi-billion-dollar projects to upgrade infrastructure and meet pressing social challenges begin to have an effect. The boom may be less visible than in the kingdom's smaller Gulf neighbours, such as Dubai and Qatar, but the needs and the numbers are massive - thousands of kilometres of new roads and railways; billions of dollars of water, sewerage and electricity plants; and 4m new housing units over the next decade, with investment of $320bn estimated to be required in housing through to 2020, according to Sagia, the kingdom's investment authority."

October 30 - Bloomberg (Theophilos Argitis and Greg Quinn): "Canadian Finance Minister Jim Flaherty announced C$60 billion ($63 billion) in tax cuts through 2013, as surging oil prices and record corporate profits led to higher-than-expected revenue growth."

Road to Ruin:

The gentlemen at Pimco are, once again, the leading cheerleaders for another round of easier "money." Calling for the Fed to cut rates to 3.5%, Bill Gross commented Wednesday on Bloomberg television: "The nominal [third quarter] GDP number was 4.7%. Any time you get a nominal GDP growth less than 5% the economy is basically struggling. The U.S. needs at least 5% nominal growth in order to pay its bills on a longer term basis."

I will, once again, take the other side of their analysis. First of all, 4.7% traditional nominal GDP growth would have easily in the past "paid its bills." It doesn't get it done today - even with 4.7% unemployment - specifically because of a long period of gross monetary excess. For some time now, the U.S. economy has been hopelessly finance-driven, and the greater and more protracted the Credit excesses the greater the "transformation" of the economic structure. And it is the underlying real economy that today cannot "pay its bills" and is therefore hooked on ever increasing Credit inflation. This should at this point be recognized as the Road to Ruin. Contemporary finance and its operators should be held accountable.

The majority of contemporary "services" economic "output" is intangible in nature. The system creates various types of new financial claims (Credit), and this new purchasing power spins today's economic wheels. Nominal GDP would "pay it bills" today only in the context of monetizing additional debt - or inflating the quantity of Credit to inflate "purchasing power" to inflate incomes and earnings - all in order to service previous borrowing excesses.

Admittedly, the Fed has opportunely administered several bouts of "reflation." We have, however, reached the point where another round will be self-defeating. To throw out some numbers, from the Fed's Z.1 "flow of funds" report we know that Total Credit Market Borrowings (non-financial and financial) expanded at a $3.75 TN annualized rate during the first half. To put the immense scope of recent Credit inflation into perspective, Credit Market Borrowings expanded on average $1.233 Trillion annually during the nineties (see chart above). Total borrowings accelerated to $1.694 in 2000, $2.013 in 2001, $2.365 in 2002, $2.767 in 2003, $3.085 in 2003, $3.380 in 2003, and $3.825 last year. It is this degree of Credit creation that is today untenable and unsustainable.

Before I dive into the U.S. Credit system fiasco, I was struck by a story by Jamil Anderlini from today's Financial Times:

"The murder of a man who jumped a petrol queue in China's central Henan province on Wednesday is the stuff of nightmares for the authoritarian Chinese government. Faced with worsening fuel shortages across the country Beijing raised petrol, diesel and jet fuel prices at the pump by almost 10% yesterday, in an effort to boost domestic supplies and exorcise the spectre of social unrest. The policy reversal came as shortages spread to the capital, which is usually immune from the country's periodic supply crunches. But the government is unwilling to allow prices to rise too much because of a morbid fear of spiralling inflation, which has a history of toppling governments in China and is currently running at a 10-year high, above 6%... Soaring global crude oil prices...pose a serious dilemma for Beijing, which last raised its tightly controlled fuel prices in May 2006. China is the second-largest crude oil consumer after the US and although it was a net exporter as recently as 1993 it now relies on imports for nearly 5% of its crude supply. The current shortages, particularly of diesel, result from a combination of high global oil prices and strict government controls, causing huge losses for Chinese refiners that must pay more for oil but cannot raise prices at the pump."

I pose the following question for contemplation: How much would the Chinese government, with their $1.4 TN stockpile of chiefly dollar reserves, be willing these days to pay for the necessary energy resources to sustain their economy and stem social unrest?

The legacy of years of runaway U.S. Credit excess includes many trillions of dollar liquidity balances circulating around the globe. Chinese reserves, for example, have inflated almost seven-fold in just five years. On the back of unprecedented global Credit and liquidity excess, energy, food, precious metals and other commodities now attract intense demand and virtually unlimited purchasing power. Our economy - our financially stretched consumers and vulnerable businesses - will now have no option other than to bid against highly liquefied competitors for a lengthening list of resources. Failure to recognize that this situation is a major inflation problem is disregarding reality. The same can be said for suggesting that we can continue on this current course - with massive Current Account Deficits and rampant speculative financial outflows to the world.

Today's current backdrop is unique. There are literally trillions of dollars of liquidity slushing around the world keen to hold "things" of value, including the massive central bank reserve holdings as well as liquidity at the disposal of the sovereign wealth funds. And the more intense the U.S. financial crisis, the keener they are to stockpile "things". There is as well a global leveraged speculating community in control of trillions of liquid purchasing power. The speculators are also keen to acquire "things" as opposed to securities. Indeed, it should be noted that this is the Federal Reserve's first attempt at reflation where U.S. securities are not the speculators' or foreign central banks' asset class of choice.

Not only is the pool of potential global buying power unparalleled in scope. It is fervidly attracted to tangible assets - as opposed to U.S. securities - and is highly speculative in character. At the same time, an unwieldy global boom is stoking unprecedented demand in China, India, Asia generally, and the other "emerging" markets including Russia and Brazil. Throw in various weather related issues and energy production constraints and the prospect for some very serious bottlenecks and shortages has developed.

Granted, these dynamics have been evolving for some time now. What has changed is the speed and breadth of financial crisis enveloping the U.S. financial system. When I read of mounting energy and food shortages and witness the unfolding run on the U.S. financial sector, as an analyst I must contemplate the likelihood we have entered a uniquely unstable monetary environment. In short, the backdrop exists where incredible dollar liquidity flows could be released (from myriad sources) upon key things (notably energy, food, metals and commodities) already in severe supply and demand imbalance. Again, how much are the Chinese willing to pay for energy? The Russians for food? The Indians for commodities? How much will investors be willing to pay for precious metals as a store of value? How aggressively will the speculators "front run" all of them? Can the Fed afford to fuel this bonfire?

I have so far this evening purposely avoided the unfolding U.S. financial crisis, a historic fiasco that took a decided turn for the worst this week. I'll admit that I am rather amazed that key financial stocks - including the financial guarantors, "money center banks", and Wall Street firms - were hammered and the market nonetheless maintained its composure. NASDAQ was actually up on the week, as major technology indices added to their robust y-t-d gains. I'll assume there is a confluence of great complacency and gamesmanship, with operators determined to play aggressively through year-end.

I wouldn't bet on the stock market holding 2007 gains for another eight weeks. The Credit meltdown is now moving too fast. Importantly, confidence is faltering for the Credit insurance industry, including the mortgage insurers and the financial guarantors. This is a devastating blow for the securitization marketplace, already reeling from pricing, liquidity and trust issues. The Credit system has lurched to the edge of meltdown, and yet the economy hasn't even succumbed to recession. Last week I wrote that subprime and the SIVs were "peanuts" in comparison to the CDO market. Well, the CDO marketplace is chump change compared to Credit Default Swaps and other over-the-counter (OTC) Credit derivatives.

The scale of the Credit "insurance" problem is astounding. According to the Bank of International Settlements, the OTC market for Credit default swaps (CDS) jumped from $4.7 TN at the end of 2004 to $22.6 TN to end 2006. From the International Swaps and Derivatives Association we know that the total notional volume of credit derivatives jumped about 30% the past year to $45.5 TN. And from the Comptroller of the Currency, total U.S. commercial bank Credit derivative positions ballooned from $492bn to begin 2003 to $11.8 TN as of this past June. It today goes without saying that this explosion of Credit insurance occurred concurrently with the expansion of the riskiest mortgage (and other) lending imaginable. It's got "counter-party fiasco" written all over it.

The stocks of Ambac and MBIA collapsed this week. I can only surmise that part of the selling pressure emanated from players caught on the wrong side of rapidly widening Credit default swap prices. Since these companies have limited amounts of bonds trading in the markets - in debt markets generally suffering from illiquidity - those needing to hedge rising default risk in this industry had little alternative than to short the stocks. And the faster the stocks declined, the wider the CDS spreads and the more "dynamic" hedge-related selling required. This dynamic could play out throughout the financial sector and beyond.

The inability to hedge rising default risk has become and will remain a major systemic issue. Most playing in the Credit derivatives market lack the wherewithal to deliver on their obligations in the (now likely) event of a systemic Credit bust. The vast majority were "writing flood insurance during a drought, happy to book annual premiums while expecting to purchase reinsurance/hedge if and when heavy rains ever developed." Well, it all happened at a pace so much faster than anyone imagined. So abruptly, the flood is now poised to wreak bloody havoc the scope of which was unimaginable - and there's no functioning reinsurance market.

Unlike this summer, this week saw the Credit crisis engulf the epicenter of the U.S. Credit system. Not surprisingly, the Fed rate cut only seemed to exacerbate market tension, with oil, gold and commodities spiking and the dollar faltering. Those arguing that the Fed needs to cut rates aggressively to avoid recession are disregarding the much higher stakes involved. There is today no alternative to a wrenching recession. The economy is terribly maladjusted, while the financial sector is at this point incapable of intermediating the massive amount of ongoing Credit necessary to keep this Bubble Economy inflated. Wall Street "structured finance" is today faltering badly, now leaving the vulnerable banking system with the task of sustaining the ill-fated boom. The least bad course for the Federal Reserve at this point would have a primary focus on supporting the dollar and global financial stability.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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