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December 15, 2007

Financial Sector Credit
by Doug Noland

Things turn only more unsettled by the day. For the week, the Dow declined 2.1% (up 7.0% y-t-d) and the S&P500 2.4% (up 3.5%). Economically sensitive stocks were hit hard. The Transports fell 4.1% (up 2.6%) and the Morgan Stanley Cyclical index dropped 3.1% (up 10.6%). Yet even the Utilities were down 2.2% (up 16.7%), and the Morgan Stanley Consumer index fell 1.7% (up 7.4%). The broader market was under heavy selling pressure. The small cap Russell 2000 dropped 4% (down 4.3% y-t-d), and the S&P400 Mid-Caps were 3.4% lower (up 6.3%). The NASDAQ100 fell 2.7% (up 17.9%), and the Morgan Stanley High Tech index declined 1.5% (up 9.7%). The Street.com Internet Index was hit for 2.6% (up 13.6%), while the NASDAQ Telecommunications index was little changed (up 10%). The Semiconductors were down 3.5%, increasing 2007 loses to 11.5%. The Biotechs sank 3.2% (up 6.2%). The Broker/Dealers dropped 3.4% (down 14.7%), and the Banks were hammered for 6.9% (down 23.6%). And while Gold was little changed, the HUI Gold index sank 6.1% (up 14.4%).

Three-month Treasury bill rates fell 18 bps this week to an amazing 2.87%. Two-year government yields jumped 20 bps to 3.30%. Five-year T-Note yields rose 13 bps to 3.63%, and ten-year yields jumped 13 bps to 4.23%. Long-bond yields increased 9 bps to 4.66%. The 2yr/10yr spread ended the week at 97 bps. The implied yield on 3-month December '08 Eurodollars jumped 15.5 bps to 3.78%. Benchmark Fannie MBS yields rose 7 bps to 5.755%, this week under-performing Treasuries. The spread on Fannie's 5% 2017 note narrowed 10 to 50, and the spread on Freddie's 5% 2017 note narrowed 10 to 50. The 10-year dollar swap declined 3.6 bps to 68.4. Corporate bond spreads generally narrowed somewhat, with the spread on an index of junk bonds ending the week 7 bps narrower.

Investment grade debt issuers included Wachovia $1.95bn, Great Atlantic & Pacific $380 million, and CSX $380 million.

Junk issuers included NGPL Pipeco $3.0bn and Legends Gaming $220 million.

Convertible issuance included SPX Corp $500 million, Yingli Green $150 million and Network Equipment $85 million.

Foreign dollar bond issuance included Diageo $2.0bn.

German 10-year bund yields rose 4 bps to 4.35%, while the DAX equities index slipped 0.6% for the week (up 20.5% y-t-d). Japanese "JGB" yields dipped 2 bps to 1.545%. The Nikkei 225 dropped 2.8%, increasing 2007 losses to 9.9%. Emerging debt and equities markets were mostly lower. Brazil's benchmark dollar bond yields jumped 15 bps to 5.78%. Brazil's Bovespa equities index sank 4.9% (up 40.4% y-t-d). The Mexican Bolsa sank 4.0% (up 13.4% y-t-d). Mexico's 10-year $ yields rose 3 bps to 5.45%. Russia's RTS equities index dipped 0.7% (up 18.1% y-t-d). India's Sensex equities index added 0.3% (up 45.3% y-t-d). China's Shanghai Exchange declined 1.6%, lowering y-t-d gains to 87.29%.

Freddie Mac posted 30-year fixed mortgage rates jumped 15 bps this week to 6.11% (down 1 bps y-o-y). Fifteen-year fixed rates rose 13 bps to 5.78% (down 8bps y-o-y). One-year adjustable rates added 4 bps to 5.50% (up 5bps y-o-y).

Bank Credit increased $3.2bn during the week (12/5) to a record $9.209 TN. Bank Credit has posted a 20-week gain of $565bn (17% annualized) and a y-t-d rise of $912bn, a 11.7% pace. For the week, Securities Credit dropped $21bn. Loans & Leases jumped $24.2bn to $6.752 TN (20-wk gain of $427bn). C&I loans rose $9.0bn (2007 growth rate of 22%). Real Estate loans increased $7.3bn. Consumer loans gained $4.2bn. Securities loans declined $5.0bn, while Other loans rose $8.8bn. On the liability side, (previous M3) Large Time Deposits jumped $15.3bn.

M2 (narrow) "money" supply dropped $24.4bn to $7.440 TN (week of 12/3). Narrow "money" has expanded $397bn y-t-d, or 6.0% annualized. For the week, Currency declined $2.4bn, while Demand & Checkable Deposits jumped $21.4bn. Savings Deposits sank $55bn, while Small Denominated Deposits dipped $0.5bn. Retail Money Fund assets rose $12.1bn.

Total Money Market Fund Assets (from Invest. Co Inst) gained $4.3bn last week to a record $3.122 TN. Money Fund Assets have posted an unprecedented 20-week surge of $538bn (54% annualized) and a y-t-d increase of $74obn (31.3% annualized).

Total Commercial Paper declined $5.4bn to $1.839 TN. CP is now down $385bn over the past 18 weeks. Asset-backed CP fell another $10.2bn (18-wk drop of $404bn) last week to $791bn. Year-to-date, total CP has contracted $136bn, with ABCP down $253bn.

Asset-Backed Securities (ABS) issuance this week slowed to about nothing. Year-to-date total US ABS issuance of $526bn (tallied by JPMorgan) is running 39% behind comparable 2006. At $224bn, y-t-d Home Equity ABS sales are off 58% from last year's pace. Year-to-date US CDO issuance of $291 billion is now 21% below comparable 2006.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 12/12) increased $3.6bn to a record $2.040 TN. "Custody holdings" were up $288bn y-t-d (17.1% annualized). Federal Reserve Credit declined $3.2bn last week to $864bn. Fed Credit has increased $11.6bn y-t-d (1.4%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.281 TN y-t-d (27.7% annualized) to $6.092 TN.

Credit Market Dislocation Watch:

December 10 - Bloomberg (Shannon D. Harrington): "Bank of America Corp...froze a $12 billion enhanced cash fund after losses on holdings that included short-term debt sold by structured investment vehicles. The Columbia Strategic Cash Portfolio was closed last week and is being 'wound down,' Robert Stickler, a [BAC] spokesman...said... The net asset value of the fund, which had $33 billion two weeks ago, was 99.4 cents on the dollar as of today... Enhanced cash funds, which hold about $850 billion in assets in the U.S., are sold to wealthy individuals and institutions as an alternative to money-market funds... The Columbia fund had been the biggest of its kind, according to Peter Crane, founder of Crane Data LLC...publisher of the Money Fund Intelligence. 'This could be the death of enhanced cash funds,' he said."

December 10 - Bloomberg (Elena Logutenkova): "UBS AG will write down U.S. subprime mortgage investments by $10 billion, the biggest such loss by a European bank, and replenish capital by selling stakes to investors in Singapore and the Middle East. Europe's largest bank by assets plans to raise 13 billion francs ($11.5 billion)..."

December 10 - Financial Times (Stacy-Marie Ishmael and Saskia Scholtes): "Specialist bond insurance companies such as MBIA and Ambac face a moment of reckoning in the coming weeks. Rating agencies Moody's and Fitch will complete their reviews of how such companies are rated, and might conclude that mortgage losses have put the insurers' triple-A rating at risk. But the bond insurers' quest for new capital to secure their triple-A status could face significant challenges amid limited investor appetite for companies with exposure to structured securities backed by mortgage debt... The fate of bond insurers has emerged as a crucial concern in the credit crisis. These companies insure thousands of billions of dollars of debt, including securities backed by subprime mortgages, but hold relatively little capital to back these guarantees."

December 13 - Financial Times (Stacy-Marie Ishmael): "Bond insurer Security Capital Assurance risks losing its top-flight credit rating unless it raises at least $2bn within the next six weeks, Fitch Ratings said... SCA has four to six weeks to either obtain 'firm capital commitments' from a 'reliable source', or reinsure its portfolio, Fitch said."

December 13 - Bloomberg (Christine Richard): "Ambac Financial Group Inc., struggling to avoid the crippling loss of its AAA credit rating, took out insurance on $29 billion in securities it guarantees. The world's second-biggest bond insurer agreed to transfer the risk that the securities will default to Assured Guaranty Ltd... Reinsuring the debt will free up capital backing those bonds... Ambac guarantees $556 billion of securities and the loss of its AAA rating jeopardizes the rankings on that debt..."

December 11 - Financial Times (Stacy-Marie Ishmael): "Ratings agency Standard & Poor's has downgraded the capital notes of all its rated structured investment vehicles and said it does not expect the asset class to survive. It also put 18 of these off-balance sheet vehicles on 'ratings watch negative', meaning downgrades are likely in the near future. 'The SIV as a type of vehicle is unlikely to persist and thus we formally assigned negative outlooks due to the issues in this sector,' it said... S&P analysts expect continued erosion in the net asset values of these vehicles, and do not expect investors to return to the market in sufficient numbers to reverse the SIV funding problem."

December 14 - Bloomberg (Shannon D. Harrington and Elizabeth Hester): "Citigroup Inc. will take over seven troubled investment funds and assume $58 billion of debt to avoid forced asset sales that would further erode confidence in capital markets... Moody's Investors Service lowered the bank's credit ratings. The biggest U.S. bank by assets will rescue the so-called structured investment vehicles, or SIVs, taking responsibility for their $49 billion of assets..."

December 11 - Financial Times (Paul J Davies): "The decision by Société Générale to bail out its off-balance-sheet structured investment vehicle (SIV)means that six out of the original 10 banks have all rescued their sponsored vehicles as funding problems grip the sector. Of the four remaining banks, Citigroup's SIVs are still the largest, followed by Dresdner Bank and Bank of Montreal, which have similar-sized vehicles, and Banque AIG with a much smaller operation."

December 13 - Financial Times (Paul J Davies): "Downgrades and defaults of the complex debt securities that pool together mortgage backed bonds and other instruments have been breaking new records in recent weeks. According to Moody's...more than $45bn worth of collateralised debt obligations of asset backed securities (CDOs of ABS)...have now gone into default... Meanwhile, the number of CDOs that have suffered credit ratings downgrades was more than 2,000 in November alone, according to analysts at Morgan Stanley... 'November was the worst ever month for CDO downgrades since we have been tracking CDO rating actions,' analysts at Morgan Stanley said. 'There were 2,072 rating actions during the month, comprising 2,007 downgrades and only 65 upgrades.' Structured finance CDOs - also known as CDOs of ABS - were the worst affected segment of the industry, with 1,900 of the downgrades from the three ratings agencies being on these kinds of deals, the analysts said."

December 12 - Dow Jones (Aparajita Saha-Bubna): "Moody's...said...that tranches of collateralized debt obligations receiving default notices has jumped to $45 billion as of Dec. 11. This is nearly nine times higher than the $5.6 billion of CDO pieces that Moody's said were affected, as of the end of October, by these default notices. The increase in volume will likely trigger fresh concerns around forced liquidation of these complex securities by investors heading for the exits."

December 11 - Bloomberg (Jody Shenn): "Downgrades on collateralized debt obligations by Standard & Poor's, Moody's... and Fitch Ratings last month totaled 2,007, a record, according to a Morgan Stanley report. The November downgrades, mainly among CDOs affected by the surge in late payments on U.S. subprime mortgages, represented 56% of the total for the first 11 months of this year... November upgrades totaled 65, just 6% of the year-to-date total."

December 12 - Bloomberg (David Mildenberg and Hugh Son): "Bank of America Corp., Wachovia Corp. and PNC Financial Services Group said losses tied to bad debt will be worse than expected, providing fresh evidence that credit markets aren't returning to normal...Bank of America Chief Executive Officer Kenneth Lewis predicted disruptions will stretch into next year at his company... Wachovia...said it may set aside twice as much for loan losses than planned in this quarter and that writedowns already equal the third quarter's total. PNC, ranked 11th, said quarterly profit will be less than analysts estimated. Today's announcements show bankers see no quick end to losses and writedowns... Lewis said loan losses will increase in 2008 at Bank of America and Wachovia Chief Executive Officer Kennedy Thompson said conditions are the 'toughest' in his 32-year career."

December 13 - Financial Times (Norma Cohen): "The world's largest banks have around $212bn of assets at risk of default as a result of the severe contraction in lending on commercial property and the expected fall in real estate values, according to a new report from...Morgan Stanley. Sales of commercial real estate have ground to a halt in recent months, as lending markets have frozen and buyers disappeared. Property experts have said that the sharp rise in real estate values in recent years has been fuelled largely by access to cheap credit and its sudden withdrawal is expected to lead to declining property prices. Because the banks made loans against the property, a drop in values could leave them holding collateral worth less than borrowings. The biggest buyers of commercial mortgage-backed securities have included the specialised investment vehicles which are themselves facing a severe liquidity shortage... Morgan Stanley is forecasting a 73% drop in the issuance of new CMBS, an activity which has made a significant contribution to profits at some banks."

December 11 - Financial Times (Norma Cohen): "Bonds backed by commercial real estate have suffered their sharpest fall in value in recent months with new issuance down sharply and turnover among older issues crawling to a near halt. Mike Kirby, head of research at Green Street Securities...says: 'The CMBS [commercial mortgage-backed securities] market for the most part is shut down and dysfunctional right now. Banks still have an enormous amount of paper on their books from six months ago when lending standards were much looser.'"

December 14 - Bloomberg (Gavin Finch): "European money markets failed to respond for a second day to the biggest effort by central banks to restore confidence in the world financial system. The euro interbank offered rate banks charge each other for three-month loans stayed near a seven-year high, falling 1 basis point to 4.94%... That's 94 basis points more than the ECB's benchmark interest rate."

December 10 - Bloomberg (Gavin Finch and Agnes Lovasz): "Investors expect the global credit squeeze to continue beyond the first quarter of 2008, according to the Bank for International Settlements. Models using derivatives based on money-market rates signal 'expectations of a persistent lack of liquidity and lasting concerns about counterparty risk,' the BIS said... The three-month Euribor rate...is at a seven-year high of 4.89%..."

Currency Watch:

The dollar index jumped 1.5% to 77.44. For the week, the South African rand declined 3.2%, the Australian dollar 2.7%, the Swiss franc 2.2%, the New Zealand dollar 2.1%, the Brazilian real 2.0%, the Euro 1.9%, and the Danish krone 1.9%.

Commodities Watch:

December 14 - Bloomberg (Tony C. Dreibus): "Wheat rose to a record as a dry spell threatened crops in Argentina and renewed concern that the world's farmers may fail to deliver enough supply to meet rising demand for bread, pastas and livestock feed... Wheat futures for March delivery rose... 2.7% to $9.795 a bushel on the Chicago Board of Trade... The price has more than doubled in the past year. Most-active futures jumped 6.3% this week and have reached records 25 times since June 27..."

December 12 - Bloomberg (Eduard Gismatullin and Ayesha Daya): "Goldman Sachs Group Inc...raised its forecast for crude oil prices next year 12% on concerns that investment costs and weaker demand may prompt producers to limit supply. Goldman increased its average 2008 forecast for West Texas Intermediate crude oil to $95 a barrel from $85."

For the week, Gold was little changed at $794.65, while Silver fell 3.6% to $13.98. March Copper sank 5.4%. January Crude gained $3.12 to $91.40. January Gasoline rose 3.3%, while January Natural Gas declined 1.9%. December Wheat jumped 3.9%. For the week, the CRB index rose 1.7% (up 13.5% y-t-d). The Goldman Sachs Commodities Index (GSCI) jumped 2.8%, increasing 2007 gains of 37%.

China Watch:

December 13 - Financial Times (Richard McGregor): "Beijing turned the tables on Washington yesterday after years of US criticism over its handling of the Chinese economy, warning of the serious global implications of the weak dollar, recent US interest rate cuts and the subprime crisis. Beijing highlighted US economic problems at the opening of a twice-yearly meeting between ministers from both countries... Chen Deming, incoming commerce minister, said the falling dollar had pushed up costs of imported resources and been a destabilising factor. 'What I'm worrying about is the weakening dollar and its potential impact on global growth,' he said... Zhou Xiaochuan, the governor of the People's Bank of China, was...was closely watching the impact of US interest rate cuts and their impact on the world economy. 'For China, what we worry about more is that very accommodative US monetary policy could give rise to a new burst of excess liquidity in global markets... In China, we have already had an excess liquidity problem in the domestic market, which we know is somewhat connected to the global markets.'"

December 12 - Bloomberg (Nipa Piboontanasawat): "China's retail sales increased at the quickest pace in at least eight years on rising incomes... Sales climbed 18.8%...from a year earlier..."

December 10 - Bloomberg (Nipa Piboontanasawat): "China's money-supply growth exceeded the central bank's annual target for a 10th straight month as a ballooning trade surplus pumped cash into the world's fastest-growing major economy. M2... rose 18.5% to 40 trillion yuan ($5.4 trillion) in November from a year earlier..."

December 11 - Financial Times (Richard McGregor): "Chinese inflation reached a new 11-year high in November of 6.9%, a figure which will harden Beijing's resolve to tighten monetary policy... Although inflation continues to be driven primarily by food prices, because of a shortage of pigs and high global feed prices, broader underlying inflation was also up, to 1.4%, because of higher oil and coal prices. 'The inflation issue has evolved into more of a macroeconomic problem,' said Yiping Huang of Citigroup..."

December 11 - Bloomberg (Nipa Piboontanasawat): "China's inflation accelerated at the quickest pace in 11 years and the trade surplus swelled, adding pressure on the central bank to raise interest rates and let the currency appreciate faster to cool the economy... Surging food and fuel costs and a record $238 billion surplus in the first 11 months have prompted the government to name inflation and overheating as the biggest threats to growth."

December 10 - Bloomberg (Zhang Dingmin): "China faces 'big' inflation pressures in 2008 and an 'arduous' task in preventing price gains from broadening, the nation's top planning agency said. Increases in global commodity prices, strong domestic demand and planned changes to China's pricing of resources will add to the pressure, the National Development and Reform Commission said..."

December 11 - Bloomberg (Xiao Yu): "China's central bank has instructed the country's commercial banks to tighten rules for real estate loans to help rein in rising property prices and curb fraudulent lending..."

December 11 - Market News International: "Chinese banks should learn a lesson from the ongoing US subprime mortgage crisis and avoid risky property lending, government regulators warned... 'Current property lending growth is too fast and there is too much competition and too many irregularities. In particular, some commercial banks are offered second mortgage services without approval, which greatly increases the risks in the property lending business,' the People's Bank of China and the China Banking Regulatory Commission said... 'We should learn a lesson from the US subprime crisis ... (and) enhance risk management in the property lending business,' said Jiang Dingzhi, deputy chairman of the CBRC..."

December 11 - Financial Times (Richard McGregor): "The surge in Chinese electricity demand continued unabated this year, with the country building enough new power plants to surpass the capacity of the UK's entire electricity grid. About 85% of the new generating capacity of 90GW is coal-fired... Although its economy is one-quarter to one-third the size of the US, China will take over as the world's largest greenhouse gases emitter this year... Even with the surge in capacity, the newly generated power has easily been absorbed by a fast-growing economy still propelled by large investments in energy-intensive industries, such as steel, aluminium and cement... Power demand this year so far has grown at an annualised rate of 16.2%, well ahead of the 2006 rate of 13.7%..."

December 14 - Associated Press: "China may be losing its competitive advantage, mainly because of rising costs, according to a survey of companies compiled by the American Chamber of Commerce in Shanghai."

India Watch:

December 14 - Bloomberg (Kartik Goyal): "India's inflation accelerated to a three-month high as the prices of fruits, vegetables and oil products increased, the government said. Wholesale prices rose 3.75%..."

Asia Bubbles Watch:

December 14 - Bloomberg (Berni Moestafa): "Asian stocks fell this week, dragging a key stock index to its biggest decline in four months as a U.S. interest-rate cut failed to ease concern that the world's largest economy will slide into a recession... The MSCI Asia Pacific Index this week declined 4.7%..."

Unbalanced Global Economy Watch:

December 14 - Bloomberg (Fergal O'Brien): "European inflation accelerated more than initially estimated in November, to the fastest pace since May 2001, preventing central bankers from cutting interest rates as economic growth slows. The inflation rate in the 13-nation euro area rose to 3.1% from 2.6% in October..."

December 10 - Bloomberg (Brian Swint and Svenja O'Donnell): "U.K. factories increased prices at the fastest annual pace since 1991 in November as companies passed on higher costs of food and oil. Manufacturing output prices rose 4.5% from a year ago after a 3.8% gain in October... 'It's clear that inflation is going to go even higher,' said Samra Al Harthy, an economist at Standard Chartered Plc..."

December 13 - Bloomberg (Brian Swint): "Britons' inflation expectations rose to the highest in at least eight years in a Bank of England survey last month, making it harder for the central bank to lower interest rates further after the first cut since 2005. Consumers predict prices will increase 3% in the next 12 months, the highest median forecast since the report started in 1999..."

December 13 - Bloomberg (Svenja O'Donnell): "U.K. real-estate agents and surveyors became the most pessimistic about house prices since at least 1998 last month as a property-market decline spread to London, the Royal Institution of Chartered Surveyors said."

December 13 - Associated Press: "Inflation in Ireland rose last month to 5.0% -- the highest rate in Western Europe -- on the back of higher fuel and food prices... The rise from October's rate of 4.8 percent increased Ireland's long-standing run as the price-rise leader of Western Europe dating back seven years, when inflation peaked here at 7.0 percent. Only new euro-zone entrant Slovenia, with 5.8% inflation, has a higher current rate than Ireland within the 13-nation zone that uses the European common currency. Inflation throughout the euro zone is averaging 3.0%, itself a 6 1/2-year high that reflects global rises in the cost of oil and agricultural goods."

December 14 - Bloomberg (Gabi Thesing): "German inflation accelerated in November to the fastest pace in 12 years, led by surging oil and food costs. Consumer prices, measured using a harmonized European Union method, rose 3.3% from a year ago..."

December 11 - Bloomberg (Gabi Thesing): "Investor confidence in Germany dropped to the lowest in almost 15 years in December as rising credit costs dimmed the outlook for economic growth."

December 10 - Bloomberg (Tasneem Brogger): "Denmark's inflation rate rose to the highest in more than four years in November as fuel and food prices increased and accelerating wage growth added to pressure on costs. Inflation quickened to 2.5%, the highest annual rate since March 2003... 'We've quite clearly passed a milestone with this inflation rate,' said Jes Asmussen, chief economist at Svenska Handelsbanken AB..."

December 11 - Bloomberg (Jonas Bergman): "Sweden's inflation rate rose to a four-year high of 1.9% in November, adding to pressure on the central bank to raise interest rates further."

December 10 - Bloomberg (Robin Wigglesworth): "Norway's annual inflation rate rose to 1.5% in November as the fastest pace of economic growth in 22 years fuels wage growth and prices... The economy expanded 6.6% in the third quarter, the fastest since 1985, threatening to stoke inflation."

December 14 - Bloomberg (Kati Pohjanpalo): "Finland's annual inflation rate rose to 2.9% in November, the highest since June 2001, as higher oil costs began to show in fuel prices."

December 10 - Bloomberg (Marketa Fiserova): "The Czech inflation rate climbed in November to the highest in more than six years, driven by food and motor fuels... The rate gained to 5 percent..."

December 11 - Bloomberg (Balazs Penz): "Hungarian inflation accelerated in November because of rising food and oil prices... The inflation rate rose to 7.1% from 6.7%..."

December 11 - Financial Times (Vincent Boland): "Turkey's economic growth slowed in the third quarter to its lowest level since a devastating financial crisis six years ago... Gross domestic product in the third quarter of 2007 was 1.5%..."

December 14 - United Press International: "Australian Treasurer Wayne Swan said inflation is likely to remain a problem for the country for the next 18 months. Swan, making his first major address since the Labor Party's electoral victory three weeks ago, said the underlying inflation rate was running at about 3% and faced further pressure throughout 2008... Swan said the inflation threat was not just of interest to economists. 'It's one of those measures I think that Australian families are intensely interested in. They know as well as we do that inflation puts our prosperity - individual, business and national -- at risk,' he said."

Latin America Watch:

December 12 - Bloomberg (Guillermo Parra-Bernal): "Brazil's economy expanded in the third quarter at the fastest pace in more than three years, stoking speculation that the central bank may keep borrowing costs unchanged for most of 2008 to cap inflation. Gross domestic product rose 5.7% in the third Quarter..."

Bubble Economy Watch:

December 14 - Bloomberg (Shobhana Chandra): "U.S. consumer prices rose the most in more than two years last month on record energy costs, reinforcing the Federal Reserve's concern that inflation will erode confidence in the economy. The consumer price index increased 0.8% in November... Consumer prices increased 4.3% in the 12 months to November... 'It puts the Fed between a rock and a hard place,' Ethan Harris, chief U.S. economist at Lehman Brothers... 'They say they are worried about inflation, but that doesn't stop them from cutting rates."

December 12 - Dow Jones (Brian Blackstone): "U.S. import prices soared last month at their fastest pace since 1990 on sharp gains in petroleum, natural gas and industrial supply prices. And in a troubling sign for Federal Reserve officials, prices of other imported goods like consumer products, capital goods and automobiles also rose...a sign that the weak dollar is feeding into import prices. Import prices jumped 2.7% in November... In the 12 months through November, import prices soared 11.4%, a sharp acceleration from the 1.3% gain registered between November 2005 and November 2006 and the fastest annual increase since the series was first published in 1982."

December 13 - Dow Jones: "PPI soars in Nov, with price pressures seeping beyond just energy. Headline index up 3.2% vs. expected 1.7% rise, biggest gain since Aug. 1973. On the year, PPI up 7.2%, largest increase since Nov 1981. Core was up 0.4% on month and up 2% on year... Energy prices in Nov up a record 14.1%, gasoline prices up 34.8% also a record. Prices for passenger cars (+0.6%), trucks (+2.3%)and raw materials (+8.7%) all on the rise."

December 12 - Bloomberg (Joe Richter): "The U.S. trade deficit widened in October as the value of imported crude oil rose to a record. The gap grew 1.2% to $57.8 billion... Imports, exports and the shortfall with China were the biggest ever."

Central Banker Watch:

December 13 - Financial Times (Martin Wolf): "The central bank helicopters are planning a co-ordinated drop of liquidity on troubled market waters. The money to be dropped now is not that large. But if this does not work, more will surely follow. The helicopters will fly again and again and again. One point is clear: central banks must be pretty worried to take such a joint action. For what is remarkable about yesterday's statement is that five central banks - the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve and the Swiss National Bank - are co-ordinating their (different) interventions. Their hope must be that this action will trigger not panic ('What do the central banks know that I do not?') but confidence ('Now that the central banks are prepared to intervene in this way, I can at last stop worrying'). It is easy to understand why central banks should have decided to take heroic action. Confidence has fled the markets in a four-month long episode of 'revulsion'."

December 13 - Financial Times (Krishna Guha): "The Federal Reserve is prepared to increase the size of its new liquidity support operations beyond the $40bn in credit auctions and $24bn in currency swaps if necessary to contain pressures in the interbank money markets. Top Fed officials believe that once they have the new mechanisms in place, they will be able to ramp up the volume of funds distributed through them as required. The US central bank is also prepared to increase the term of future credit auctions, for instance to two or three months, if needed..."

December 13 - Bloomberg (Craig Torres and Anthony Massucci): "Federal Reserve Bank of New York President Timothy Geithner said central bankers are looking at 'additional instruments' to provide funds to banks in times of stress. Central bankers around the world have started a 'coordinated review' on how regulations may be influencing liquidity risk and whether they need 'additional instruments' to 'mitigate marketwide liquidity problems,' Geithner said..."

December 12 - Bloomberg (Matthew Brown): "Four Gulf states followed the U.S. Federal Reserve and cut their key interest rates by a quarter point, helping to maintain their currency pegs to the dollar... Saudi Arabia, the United Arab Emirates, Qatar and Bahrain cut rates today to stem speculation they would revalue their currencies following a slump in the dollar."

December 14 - Market News International: "With consumer prices spiking on the back of rising oil and food prices, there is a danger the eurozone economy could fall into an inflationary wage-price spiral despite the strength of the euro, European Central Bank Governing Council member Klaus Liebscher said... Liebscher...said he was 'worried' about the recent spike in eurozone consumer price inflation to above 3%. 'Something's gone amiss,' he said."

GSE Watch:

December 13 - Market News International (Margaret Chadbourn): "The federal regulator for Fannie Mae and Freddie Mac... said current mortgage market conditions have heightened the credit risks for the two companies and they have been stretched further by mortgage product models that were ill equipped to foresee a turn for the worse. 'It's no surprise that credit risk is increasing rapidly. The '06 books and the first half of '07 books were not well written across the industry. It's not just subprime, but I think the underwriting standards were lower because the competition on Wall Street and other places,' said the Director of the Office of Federal Housing Enterprise Oversight, James Lockhart. Although significant progress has occurred on managing operational risks, the government-sponsored enterprises have to make progress on monitoring model risks for pricing, evaluation, and accounting, he said. 'The enterprises, like every participant in the mortgage market, are facing growing risks,' he said."

December 12 - Financial Times (Krishna Guha, Saskia Scholtes, and Gillian Tett): "A little-known network of government-sponsored bank co-operatives founded during the Great Depression is playing a critical role keeping the private sector US mortgage industry open for business - and some mortgage lenders out of financial trouble - in spite of the brutal slump in the housing sector. The Federal Home Loan Banks are pumping hundreds of billions of dollars into the mortgage industry in the form of loans against mortgage collateral at a time when purely private sources of finance are offered only at punitive terms for many lenders... The scale of the cash infusion by the FHLBs vastly exceeds the few billion dollars of cash lent to banks by the Federal Reserve through its direct lending facility. Indeed some officials privately admit that the FHLBs have, in effect, replaced the US central bank as the lender of last resort for the financial system in the credit crisis. By making vast amounts of cash available on a routine basis against a wide range of mortgage securities, with none of the stigma associated with going cap in hand to the Fed, the FHLBs have reduced the risk of a liquidity crisis at the most stressed institutions... 'The Federal Home Loan Banks have been leading a minor revolution in the financing of the US commercial banking system, providing funding for mortgages when other markets have been closed,' said Steven Abrahams, head of liquid products research at Bear Stearns... Michael Feroli, an economist at JP Morgan, said: 'It is almost like the socialisation of housing finance.'"

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

December 13 - Bloomberg (Neil Unmack): "U.S. homebuilder credit rating cuts may force investors to unwind collateralized debt obligations with the top investment-grade rankings at a loss, according to a report by Barclays Capital analysts. CDOs that pool credit-default swaps tied to the debt of homebuilders may lose their AAA grades, triggering a selloff, if ratings firms 'significantly' downgrade the underlying debt... As much as $5 billion of CDOs sold since 2006 reference homebuilders... CDO ratings 'are particularly sensitive to downgrades in homebuilders,' the analysts led by Jeff Meli...wrote. Some deals 'could get downgraded to the point where ratings-conscious investors might choose to unwind their trades.'"

Mortgage Finance Bust Watch:

December 13 - Bloomberg (David Mildenberg): "Countrywide Financial Corp...said foreclosures doubled in November and late payments continued to rise amid the U.S. housing slump... Foreclosures measured by unpaid principal climbed to 1.3% from 0.6% a year earlier... Late payments of at least 60 days advanced to 6.5% of unpaid balances from 4.2%."

Real Estate Bubbles Watch:

December 10 - BusinessWire: "Single-family home sales in Connecticut continued their steady drop in October, reaching the lowest number of sales during that month since 1993...according to The Warren Group... 'Clearly, Connecticut's immunity to the national housing problem is over,' said Timothy Warren Jr., CEO of the Warren Group. 'The state is showing all the symptoms of having caught this housing flu, and it looks like the fever is getting worse.'"

December 10 - Bloomberg (Peter Woodifield): "Investment in U.K. commercial real estate may slump 60% in the fourth quarter as buyers shun large acquisitions of shops and offices, Jones Lang Lasalle...said... Investment for all of 2007 may fall 24%..."

Financial Sphere Bubble Watch:

December 13 - Financial Times (Chris Hughes and Ben White): "Goldman Sachs yesterday began celebrating confirmation of bumper bonuses for this year, with the chairman and chief executive, Lloyd Blankfein, expected to lead the pack with a 30% increase in his pay to about $70m."

December 12 - Bloomberg (Yalman Onaran): "Lehman Brothers Holdings Inc. awarded Chief Executive Officer Richard Fuld $35 million in stock for 2007 after the largest U.S. underwriter of mortgage bonds reported lower losses than its competitors from the collapse of the subprime home-loan market."

California Watch:

December 12 - Los Angeles Times (Jordan Rau): "Gov. Arnold Schwarzenegger told social service advocates Tuesday that the state's anticipated budget shortfall -- already feared to be the worst since he took office -- has widened to $14 billion, according to people at the meetings. That new figure indicates that the state's fiscal fortunes are declining even more rapidly than many leaders had expected. Less than a month ago, the Legislature's chief budget analyst calculated that California is on track to come up $10 billion short... A $14-billion budget gap would translate to more than 12% of the state's budget if spending continues to rise as projected."

December 14 - Bloomberg (Michael B. Marois): "California Governor Arnold Schwarzenegger will declare a state of fiscal emergency under never-before-used rules that would force lawmakers into a special session to address a $14 billion deficit. The governor...said he will declare the emergency in January when lawmakers return from recess. Under the action, the Legislature would have 45 days to find ways to plug the shortfall, including cutting spending from the current budget. If they fail to find a solution in that time, they are barred from doing any other legislative work or adjourn until they do."

Fiscal Watch:

December 12 - The Wall Street Journal (Peter R. Orszag, Director of the Congressional Budget Office): "The nation's economic outlook may look troubling in the short run, but these difficulties pale beside the economic consequences that will follow if we don't address the nation's long-term fiscal gap... The fiscal gap does not arise, as many believe, primarily from the coming retirement of the baby boomers. Rather, the rate at which health-care costs grow will be the primary determinant of the nation's long-term budget picture... CBO projects that under current law, federal spending on Medicare and Medicaid measured as a percentage of gross domestic product will rise to 12% in 2050 and almost 20% around 2080 from 4% today. The bulk of that projected increase arises from steadily growing health-care costs per beneficiary."

Crude Liquidity Watch:

December 10 - Bloomberg (Matthew Brown): "Saudi Arabian inflation accelerated to 5.4% in October from 4.9% in September as the cost of rents and food increased... Rents jumped an annual 12% in October... Food and beverage costs increased 7.5%..."

December 10 - Bloomberg (Matthew Brown): "Qatar's annual M2 money supply growth, an indicator of future inflation, slowed to 29% in June from 33% in May, the emirate's central bank said."

Speculator Watch:

December 14 - Bloomberg (Jenny Strasburg): "Tudor Investment Corp. clients pulled more than $1 billion from its Raptor hedge fund after manager James Pallotta lost 8.5% this year, mostly on U.S. equities, according to two of the firm's investors."

December 13 - Bloomberg (Jenny Strasburg): "Moore Capital Management Inc. closed its Canadian hedge-fund unit, which was run by former Amaranth Advisors LLC traders, after its managers lost 15% in November... The Toronto-based team of about 15 people 'did not meet the risk-reward parameters that have guided Moore since inception,' a spokesman for Moore founder Louis Bacon told Bloomberg..."

December 13 - Bloomberg (Saijel Kishan): "Red Kite Metals, the hedge fund that almost tripled investors' money last year, lost about 22% last month as copper prices fell, according to two investors in the fund. The drop brings Red Kite's decline to about 50% this year..."

Financial Sector Credit:

U.S. Consumer Prices were up 4.3% y-o-y in November. Our Producer Price index registered a 7.2% y-o-y surge. November Import Prices were up 11.4% from a year earlier. Euro-zone inflation jumped to 3.1% y-o-y, the strongest rate since May, 2001. German consumer inflation rose to an 11-year high (3.3%). Chinese inflation was at an 11-year high of 6.9% in November. Score of countries and regions - including Australia, Russia, Eastern Europe, and the Middle East - now confront heightened inflationary pressures, in what has developed into a powerful global phenomenon.

U.S. financial markets traded dazed and confused - understandably. For some time now, Wall Street has operated under a premise of how the Fed would respond to a financial crisis. Recent expectations had our central bankers poised to lower rates to whatever level necessary to rekindle "animal spirits" and spur the Credit system and Wall Street risk intermediation more generally. The overriding presumption has been that inflation was a moot issue: inflationary pressures were well contained and, in any event, would rapidly dissipate in the face of housing, Credit and economic woes. This week the market came face-to-face with the reality that inflation is not only a major issue; inflation is in the process of significantly limiting the Fed's flexibility and capacity to orchestrate another Wall Street bailout.

Markets boisterously protested the meagerness of the Fed's 25 bps cuts in Fed Funds and the Discount Rate. Wednesday morning's news of concerted global central bank unconventional liquidity injections garnered a curiously lukewarm reception. This was likely due to its limited scope as well as the recognition that such an approach indicated the Fed was exploring policy instruments outside of Greenspan-style zealous rate slashing. Many on Wall Street are calling the Fed's handling of the situation a "fiasco," while some are even asking for Dr. Bernanke's head. I would instead argue that unrealistic Wall Street expectations were once again instrumental in fostering marketplace instability.

There is certainly more than ample pontificating these days on the nuances of central banking. Meantime, there remains scant attention paid to underlying fundamental forces driving both the financial markets and monetary management. Last week's Z.1 "flow of funds" data go far in illuminating today's Market and Federal Reserve Dilemma: The enormous scope of Credit expansion necessary to sustain Wall Street's bloated securities markets - to keep the contemporary Credit mechanisms generally liquid and functioning - has become patently inflationary for the system overall.

The third quarter demonstrated how, in spite of double-digit system Credit growth, an acutely fragile Credit system came to the brink of imploding. In particular, ongoing rampant Financial Sector expansion could not ameliorate revulsion to Wall Street-backed securitizations. Double-digit expansion in "money-like" debt instruments - including Treasuries, agencies debt, GSE MBS, and bank and money fund Deposits - had become powerless in providing liquidity support for Wall Street's asset-backed commercial paper, CDO, ABS, and private-label (non-GSE guaranteed) MBS markets. Rapid expansion of Financial Market Credit (15.6% annualized!) was, at the same time, sufficient to adequately (over)finance the real economy, certainly including corporate cash-flows and household incomes and attendant ongoing massive Current Account Deficits.

Back in 2001/02, some Wall Street analysts (the "inflationists") were keen to argue that aggressive Fed reflationary policies were required to elevate "THE price level" to ensure that deflation was not allowed to take hold. Alluring, yes, but this was dangerously flawed reasoning. There was not and is not today an actual "price level" within the real economy to be manipulated by central banks. Instead, inflationary policies ensured the interrelated operations of Wall Street's asset-based lending, securitization, and leveraged securities speculation ballooned in unimaginable excess. Resulting Monetary Disorder saw wildly destabilizing price inflation and distortion, especially in housing, securities and asset markets generally. U.S. CPI may have remained tame, but massive Credit-induced Current Account Deficits and the depreciating dollar set in motion Credit and asset Bubble dynamics in economies around the globe.

Today, the Fed confronts bursting Credit Bubbles throughout Wall Street finance, with resulting acute asset market vulnerability. Yet the unusual structures that permeate the U.S. Financial Sector at this time foster continuing rampant inflationary Credit creation. First of all, "money-like" financial sector liabilities (i.e. agencies, "repos", and bank/money fund deposits) are proving thus far sufficient to sustain Bubble economy excesses. Second, the global recycling of ongoing massive Current Account Deficits and speculative outflows ensures over-liquefied markets (and artificially low interest rates!) for key debt instruments, certainly including Treasuries, agencies and other perceived low-risk securities. Bubble dynamics proliferate in the face of a Wall Street bust.

The extreme divergence in liquidity conditions between bursting Bubbles in Wall Street finance and still rapidly inflating Bubbles in "money-like" Financial Sector Liabilities poses both a major quandary and policy dilemma. Aggressive rate cuts would definitely further stoke the powerful Bubbles inflating in GSE, "repo", money fund, and bank deposit liabilities. Such ongoing Financial Sector Debt expansion would likely sustain destabilizing liquidity outflows to the world, further fueling myriad global bubbles and worsening an already problematic global inflationary backdrop. A rapidly expanding U.S. financial sector (with the accompanying heavy risk intermediation burden associated with transforming highly risky loans into perceived safe liabilities) also significantly increases the risk of an eventual catastrophic breakdown in U.S. and international financial systems. Besides, it is likely that lower rates would have only minimal effect on the investor and speculator revulsion that has taken hold throughout the Wall Street securitization marketplace.

Those arguing for a Greenspan-style rate collapse fail to appreciate the extraordinary circumstances and risks that have accumulated from years of Reckless Credit Bubble Excess. The outcry for an audacious policy response to avert a recession is misguided. Importantly, today's rampant Financial Sector expansion is unsustainable. There are today acute inflationary risks to go with major financial system stability issues. While the dislocation will be substantial, the sooner the Bubble in Financial Credit is reined in the better. We are today in the midst of dangerous "blow-off" excesses in "money-like" Financial Sector liability issuance. Few seem to appreciate that such a circumstance places the stability of the "bedrock" of the entire U.S. and global financial system at considerable risk. Wall Street is clamoring for a rate collapse and bold inflation in "money" to bailout its faltering securitization markets. At this point, this would equate to throwing massive (relatively) good "money" after bad - ensuring that a dreadful situation festers into a historic calamity. The least bad course for central bank policymaking would be to hold the line on rates, while injecting liquidity as necessary as part of a program to check Credit excess and permit the economy to commence its desperately needed adjustment period.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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