Q3 2008 "Flow of Funds"

By: Doug Noland | Fri, Dec 19, 2008
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For the week, the Dow slipped 0.6% (down 35.3% y-t-d), while the S&P500 added 0.9% (down 39.5%). The broader market was much stronger. The small cap Russell 2000 jumped 3.8% (down 36.5%), and the S&P500 Mid-caps rose 3.1% (down 39%). Economically sensitive stocks generally performed well. The Transports jumped 4.4% (down 25.6%), and the Morgan Stanley Cyclicals gained 2.1% (down 52.6%). The Morgan Stanley Consumer index increased 1.5% (down 26.9%), while the Utilities dipped 0.2% (down 31.5%). The NASDAQ100 added 0.9% (down 41.6%), and Morgan Stanley High Tech index gained 0.7% (down 44.7%), while the Semiconductor declined 0.5% (down 48.1%). The Street.com Internet Index gained 2.7% (down 35.7%), and the NASDAQ Telecommunications index increased 1.3% (down 42.7%). The Biotechs jumped 4.1%, reducing 2008 losses to 19%. The Broker/Dealers advanced 2.5% (down 63.9%), and the Banks added 0.3% (down 51.1%). With Bullion gaining $15.60, the HUI Gold index rallied 3.9% (down 33.7%).

One- and three-month Treasury bill rates ended the week at about zero. Two-year government yields were little changed at 0.70%. Five-year T-note yields dropped 18 bps this week to 1.27%. Ten-year yields sank 49 bps to 2.08%, and long-bond yields dropped 42 bps to 2.58%. The implied yield on 3-month December '09 Eurodollars fell 30.5 bps to 1.48%. Benchmark Fannie MBS yields declined 12 bps to 3.90%. The spread between benchmark MBS and 10-year T-notes widened 37 to 178 bps. Agency 10-yr debt spreads widened 11 to 81 bps. The 2-year dollar swap spread sank 26.5 to 79.25 bps, the 10-year dollar swap spread increased 8 to 27.5 bps, and the 30-year swap spread increased 23.5 to negative 8.25 bps. Corporate bond spreads were mixed. An index of investment grade bond spreads narrowed 40 to 239 bps, while an index of junk bond spreads widened 26 to 1,255 bps.

Investment-grade debt issuance included Bank of America $8.25bn, JPMorgan Chase $6.0bn, John Deere $2.0bn, PNC Funding $2.9bn, Procter & Gamble $2.0bn, Sovereign Bank $1.35bn, United Technologies $1.25bn, Disney $1.0bn, Altria Group $775 million, Energy Transfer Partners $600 million, Morgan Stanley $2.5bn, Goldman Sachs $1.0bn, Kraft Foods $500 million, Kinder Morgan $500 million, Safeway $500 million, Sovereign Bancorp $250 million and Rochester G&E $150 million.

Junk issuance included Kansas City Southern $190 million.

International debt issues included Mexico $2.0bn, Westpac Banking $2.4bn, and Swedbank $1.2bn.

German 10-year bund yields fell 29 bps to 3.00%. The German DAX equities index added 0.7% (down 41.8% y-t-d). Japanese 10-year "JGB" yields dropped 16 bps to 1.23%. The Nikkei 225 rallied 4.3% (down 43.9% y-t-d). Emerging equities were mixed, while bond markets improved markedly. Brazil's benchmark dollar bond yields sank 95 bps to 6.35% (3-wk drop 153bps). Brazil's Bovespa equities index dipped 0.8% (down 38.9% y-t-d). The Mexican Bolsa gainied 3.2% (down 25.2% y-t-d). Mexico's 10-year $ yields dropped 70 bps to 5.83% (3-wk decline 162bps). Russia's RTS equities index declined 2.8% (down 72.3% y-t-d). India's Sensex equities index rallied 4.2%, reducing y-t-d losses to 50.2%. China's Shanghai Exchange gained 3.3%, cutting y-t-d losses to 61.6%.

Freddie Mac 30-year fixed mortgage rates dropped 28 bps to 5.19% (down 95bps y-o-y), with a 6-wk declined of 101 bps. Fifteen-year fixed rates fell 28 bps to 4.92% (down 88bps y-o-y). One-year ARMs declined 15 bps to 4.94% (down 57bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates down 11 bps this week to 6.94% (up 23bps y-o-y).

Bank Credit declined $11.5bn to $9.965 TN (week of 12/10). Bank Credit has expanded $752bn y-t-d, or 8.5% annualized. Bank Credit has surged $572bn over the past 14 weeks (44% annualized). For the week, Securities Credit sank $45.6bn. Loans & Leases jumped $34.1bn to $7.207 TN (52-wk gain of $455bn, or 6.7%). C&I loans added $3.7bn, with y-t-d growth to 10.8%. Real Estate loans gained $7.3bn (up 5.9% y-t-d). Consumer loans were little changed, while Securities loans rose $6.9bn. Other loans increased $16.5bn.

M2 (narrow) "money" supply surged $73.9bn to surpass $8.0 TN for the first time ($8.062 TN for the week of 12/8). Narrow "money" has now expanded $600bn y-t-d, or 8.5% annualized. For the week, Currency added $0.8bn, and Demand & Checkable Deposits jumped $45.6bn. Savings Deposits rose $21.8bn, and Small Denominated Deposits increased $6.1bn. Retail Money Funds slipped $0.9bn.

Total Money Market Fund assets (from Invest Co Inst) dipped $3.0bn to $3.775 TN, with a y-t-d expansion of $661bn, or 22.1% annualized.

Total Commercial Paper outstanding gained $8.3bn this week to $1.709 TN, with CP down $76.6bn y-t-d. Asset-backed CP was unchanged at $739bn, with 2008 posting a decline of $34bn. Over the past year, total CP has contracted $75bn, or 4.2%.

Federal Reserve Credit expanded $12.3bn to a record $2.254 TN, with a historic 14-wk increase of $1.365 Trillion. Fed Credit has expanded $1.380 TN y-t-d (161% annualized). Fed Foreign Holdings of Treasury, Agency Debt last week (ended 12/17) rose $4.4bn to $2.498 TN. "Custody holdings" were up $442bn y-t-d, or 21.9% annualized.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - have dropped a notable $194bn over the past nine weeks. Over the past year, reserves were up $691bn, or 11.6%, to $6.752 TN.

Global Credit Market Dislocation Watch:

December 19 - Bloomberg (Elena Logutenkova and Victoria Richards): "Goldman Sachs Group Inc., UBS AG and Deutsche Bank AG are among 12 financial companies whose ratings or outlooks were cut by S&P, which cited increased risks for the whole banking industry. 'The downgrades and revised outlooks reflect our view of the significant pressure on large complex financial institutions' future performance due to increasing bank industry risk and the deepening global economic slowdown,' S&P said..."

December 19 - Financial Times (James Mackintosh, Francesco Guerrera and Henny Sender): "Leading banks from Britain, France and Japan helped investors treble or quadruple bets on Bernard Madoff by lending billions of dollars to 'feeder' funds, which placed their money with the alleged fraudster. HSBC, Royal Bank of Scotland, Nomura and BNP Paribas lent the money without spotting a fraud... Banks including Nomura and Spain's BBVA also helped create special 'notes', structured products that allowed small investors or those barred from investing in offshore vehicles to put as little as $50,000 into Madoff feeder funds... The banks earned hefty fees from their lending, leading to an increase in the size of the teams running fund derivative businesses over the past few years. John Godden, head of IGS, the consultancy, said: 'It became increasingly competitive and, every time a bit of capacity became available in the Madoff feeders, the banks had to lap it up and move quickly.'"

December 17 - Bloomberg (Bryan Keogh): "The volume of new bank loans rated by Moody's... fell 91% last month to the lowest in more than six years as financial companies hoard cash. Newly rated programs fell to $7.3 billion in November, from $17.1 billion in October and $82.3 billion a year earlier... The ratings company has ranked $217.5 billion of programs this year through November, 70% less than in the same period of 2007."

December 19 - Bloomberg (Roger Runningen and John Hughes): "General Motors Corp. and Chrysler LLC will get $13.4 billion in emergency government loans in exchange for substantially restructuring their businesses, President George W. Bush announced. Another $4 billion will be available to GM in February provided Congress releases the second half of the $700 billion Troubled Asset Relief Program fund originally set up to bail out financial institutions. The automakers have until March 31 to meet the conditions of the loans..."

December 15 - Bloomberg (Zachary R. Mider): "Apollo Management LP's exit from an agreement to buy chemical maker Huntsman Corp. brought the tally of scuttled North American leveraged buyouts in 18 months to more than $105 billion. The global economic slowdown and the widening of spreads on high-yield debt used to finance takeovers has put pressure on private-equity firms and banks to drop or renegotiate planned acquisitions."

December 16 - Bloomberg (Katherine Burton): "Tremont Group Holdings Inc., a hedge- fund firm owned by OppenheimerFunds Inc., had $3.3 billion, or more than half its total assets, invested with Bernard Madoff..."

December 15 - Dow Jones (Dan Molinski): "A sinking global economy may lead to the unraveling of additional Ponzi-style schemes around the world, although perhaps on a somewhat smaller scale than the alleged massive scam by Bernard Madoff. The size of Madoff's alleged ruse - $50 billion - and the fact that he was able to succeed for years and dupe some of the world's more powerful institutions and individuals, will certainly be hard to beat. 'We're going to see a lot more of this type of stuff,' said Peter Turecek, a managing director at risk consultancy Kroll. 'When the waters recede, you start to see the rocks beneath the surface.'"

December 15 - Bloomberg (Carli Lourens): "Anglo American Plc, the world's biggest platinum producer, may cut spending plans for next year by more than 40%, reduce platinum output and delay iron- ore projects as metals prices sink. 'Anglo will now be in cash preservation mode," Johann Pretorius, an analyst at Nedcor Securities..."

December 18 - Bloomberg (Warren Giles): "Swiss Reinsurance Co., the world's second-biggest reinsurer, said catastrophe-related claims across the industry will total more than $50 billion in 2008, making it the second-most expensive year of insured losses after 2005."

December 15 - Bloomberg (Lester Pimentel and Stephan Kueffner): "Ecuador may saddle investors with the biggest losses in a government bond restructuring since at least World War II after President Rafael Correa fulfilled a two-year pledge to default on debt he calls 'illegitimate.' The country's three dollar-denominated bonds, with a total face value of $3.9 billion, fell below 25 cents on the dollar..."

December 17 - Bloomberg (Lester Pimentel and Matthew Walter): "Ecuador's default on $3.9 billion of international bonds means it's only a matter of time before the country drops the U.S. dollar as its currency, Goldman Sachs Group Inc. says."

December 19 - Bloomberg (Aaron Kuriloff): "The New York Giants are 11-3 on the field. On Wall Street, they're down $300 million and counting. From a bond market collapse and skyrocketing interest rates to the bankruptcy of its investment bank, the Super Bowl champions have taken one hit after another financing what co- owner John Mara calls the world's most expensive sports venue: a $1.6 billion New Jersey stadium..."

December 19 - Bloomberg (Michael Bathon): "Polaroid, 2 1/2 months after the founder of its parent company was arrested on fraud charges, filed for bankruptcy protection from creditors."

December 18 - Bloomberg (Elizabeth Hester and Ari Levy): "Credit-card companies, facing an increase in defaults and a decline in consumer spending, are raising some rates, adding fees and cutting credit lines as the Federal Reserve is poised to make the most sweeping changes to the industry in 30 years."

Currency Watch:

December 18 - Bloomberg (Emma O'Brien): "The ruble slid to a record low against the euro and weakened against the dollar as the central bank devalued the currency for a second day... Bank Rossii let the ruble decline 1.3% versus the basket of dollars and euros used to manage currency swings... It's the eighth depreciation since Nov. 11... The currency has fallen 15% against the dollar this year."

December 18 - Bloomberg (Laura Cochrane and Emma O'Brien): "Ukraine's hryvnia plunged 16% in two days to a record low against the dollar after a government official said the weakening currency may trigger defaults on more than half of loans."

Currency markets have turned hyper-volatile. The dollar index sank 2.8% to 81.30. For the week on the upside, the South Korean won increased 6.4%, the Swiss franc 6.5%, the New Zealand dollar 5.1%, the Mexican peso 4.0%, the Euro 4.1%, the Danish krone 4.0%, the South African rand 3.4%, the Swedish krona 3.0%, the Singapore dollar 2.1%, the Canadian dollar 2.0%, and the yen 2.4%. On the downside, the Norwegian Krone declined 1.5% and the British pound 0.2%. In the emerging currencies, the Iceland krona dropped 4.1% and the Russian ruble 1.7%.

Commodities Watch:

December 18 - Bloomberg (Carli Lourens and Brett Foley): "The world's biggest mining companies are cutting expansion plans by about $200 billion as prices of metals, demand from factories and funding for projects collapse. 'It will be the biggest cutback in the history of the resources sector, an emergency stop,' Graham Birch, who helps manage $40 billion... at BlackRock... said... 'Any project that is not under way is going to be stopped.'"

December 16 - Bloomberg (Winnie Zhu): "Coal prices at China's Qinhuangdao port, a benchmark in the world's biggest producer of the fuel, tumbled 9% last week as an economic slowdown cut demand... The coal price has halved from the July record..."

Gold rose 1.9% to $838, while silver dropped 5.8% to $10.25. January Crude sank another $12.41 to $33.87, the low since February 2004. January Gasoline dropped 9.1% (down 45% y-t-d), and January Natural Gas declined 2.8% (down 29% y-t-d). March Copper sank 7.2%. March Wheat rallied 7.9% and Corn 1.9%. The CRB index dropped 3.6% (down 39% y-t-d). The Goldman Sachs Commodities Index (GSCI) sank 6.4% (down 45% y-t-d).

China Watch:

December 15 - Bloomberg (Kevin Hamlin and Li Yanping): "China's industrial production grew at the weakest pace in almost a decade as export growth collapsed, increasing pressure on the government to do more to revive the slumping economy. Output rose 5.4% in November from a year earlier..."

December 15 - Bloomberg (Li Yanping): "China will face 'very serious' employment conditions in 2009 as the global financial crisis cools economic growth, the state-run Xinhua News Agency reported, citing President Hu Jintao. The government will adopt an "even more active" policy to create jobs... Maintaining social stability is a more important task while the economy is 'in difficulty', he said."

December 15 - Bloomberg (Nipa Piboontanasawat and Li Yanping): "China's money supply grew at the weakest pace in more than three years after exports fell and foreign direct investment increased at a slower pace. M2... rose 14.8% from a year earlier to 45.86 trillion yuan ($6.7 trillion)..."

December 16 - Bloomberg (Li Yanping): "China's spending on factories and real estate rose at a slower pace as property sales fell and export growth collapsed because of the global recession. Fixed-asset investment in urban areas climbed 26.8% in the first 11 months from a year earlier to 12.76 trillion yuan ($1.9 trillion)..."

Japan Watch:

December 19 - Bloomberg (Mayumi Otsuma): "The Bank of Japan cut its benchmark interest rate to 0.1%, increased purchases of government debt and announced plans to buy commercial paper for the first time as the deepening recession starves companies of funds."

December 18 - Bloomberg (Naoko Fujimura and Tetsuya Komatsu): "Japan's vehicle sales next year may fall to the lowest in 31 years... Sales of trucks, buses, cars and minicars, may fall 4.9% to 4.86 million vehicles in 2009 from an estimated 5.11 million this year, the Japan Automobile Manufacturers Association said... The tally would be the lowest since 1978..."

India Watch:

December 16 - Bloomberg (Kartik Goyal): "Indian exporters have cut about 65,500 jobs as recession in the U.S. and Europe, the nation's biggest markets, damped overseas demand for products. A sample survey conducted by the department of commerce between August and October for 121 export-oriented companies revealed the loss of jobs, both direct and indirect, Trade Minister Kamal Nath said... India's exports fell in October for the first time in seven years."

December 19 - Bloomberg (Anil Varma): "India's foreign-exchange reserves rose $4.6 billion to $250.4 billion... Foreign-currency assets climbed $4.58 billion to $241.7 billion, while the nation's gold reserves remained unchanged at $7.86 billion..."

December 19 - Bloomberg (Anil Varma): "Money supply in India grew 20% in the two weeks ended Dec. 5 from a year earlier..."

Latin America Watch:

December 16 - Bloomberg (Jeb Blount): "Brazil's retail sales rose 10.1% in October from a year ago, the national statistics agency said."

Unbalanced Global Economy Watch:

December 18 - Bloomberg (Jennifer Ryan and Brian Swint): "U.K. mortgage lending fell an annual 51% in November, and next year borrowers will pay off more of their debt than banks lend out for the first time in at least four decades, the Council of Mortgage Lenders said... Britons may repay about 25 billion pounds more than they borrow next year, the first negative net lending figure since records began in 1965..."

December 17 - Bloomberg (Svenja O'Donnell): "U.K. unemployment rose at the fastest pace since 1991... The number of people receiving jobless benefits rose 75,700 to 1.07 million, the highest level since July 2000..."

December 16 - Bloomberg (Marco Bertacche): "European car sales fell 26% in November, the biggest monthly drop since 1999, as a global recession and tighter credit hurt purchases and people shunned vehicles made by bankruptcy-threatened General Motors Corp."

December 18 - Bloomberg (Simone Meier): "German business confidence dropped to the lowest in more than a quarter century in December as the credit crisis pushes Europe's largest economy deeper into a recession."

December 17 - Bloomberg (Rainer Buergin and Thomas Bauer): "The German government will borrow more money next year than ever before as a contracting economy hits tax revenue and inflates spending on unemployment benefits, a senior lawmaker... said. 'Next year we'll have the highest net and gross new borrowing in the history of the Federal Republic,' Steffen Kampeter... Gross borrowing will be close to 340 billion euros ($479 billion) "if things go really badly," he said."

December 16 - Bloomberg (Alex Nicholson): "Russian industrial production shrank the most since the economic collapse of 1998 in November as the global slowdown reduced demand for steel, pipes and fertilizers, pushing the nation to the brink of recession. Output contracted 8.7% after growing 0.6% in October..."

December 15 - Bloomberg (Henry Meyer): "Russian Prime Minister Vladimir Putin is facing a rising tide of social discontent as the economy heads into recession after a decade-long boom driven by oil prices. Thirty-nine percent of Russians express growing dissatisfaction with the government, according to a November poll... 'The worse the crisis gets, the more dissatisfaction will grow, especially with regional authorities," Lyudmila Presnyakova, the poll's organizer, said... 'As unemployment rises, so will the potential for mass unrest.'"

Bursting Bubble Economy Watch:

December 18 - Dow Jones: "Chrysler LLC confirmed it will idle all manufacturing operations at the end of the day Friday for at least a month in an effort to align production and inventory with U.S. market demand. The auto maker pointed to tight consumer credit conditions, adding that dealers have lost about 20% to 25% of their sales volume because many would-be buyers can't find financing... General Motors Corp., Toyota Motor Corp. and Honda Motor Co. have all announced steep production cuts in the past two weeks... Chrysler's financing arm has warned dealers it may have to temporarily stop the loans they use to pay for stocking vehicles on their lots as a result of a recent wave of withdrawals from a fund used to pay off those loans."

December 18 - Wall Street Journal (Conor Dougherty and Amy Merrick): "The worst budget crisis in decades is forcing states to cut funding to cash-strapped cities, which already are slashing police, firefighters and other services... In today's recession, both state and local revenues are suffering across the board. In the past 30 years, state spending has grown by an average of 6.3%. States cut a total of 0.1% from their budgets for fiscal 2009, which ends in June... States are facing $30 billion in budget deficits for the current fiscal year..."

December 18 - Wall Street Journal (Guautam Naik): "After a decade of uninterrupted increases, U.S. investment in research and development is set to fall next year...After accounting for inflation, total R&D spending in the U.S. is expected to fall by about 1.6% in 2009, according to... Battelle Memorial Institute... By comparison, R&D investment in the U.S. since the late 1990s has increased annually at rates of between 1% and 2%, including inflation."

December 17 - Bloomberg (Maria Ermakova): "Kira Plastinina, a 16-year-old Russian fashion designer whose father says he spent $80 million setting up stores under her name, will close almost all of her 12 U.S. outlets after less than a year as demand slumps. 'The number of shoppers in the U.S. fell significantly,' said Sergei Plastinin, Kira's father, the food entrepreneur who co-founded OAO Wimm-Bill-Dann. 'It also became much harder to find money for investment because of the financial crisis. We had enormous plans: New York, then India and China in 2009.'"

Central Banker Watch:

December 19 - Bloomberg (Scott Lanman and Craig Torres): "The Federal Reserve cut the main U.S. interest rate to as low as zero and said it will buy debt as the next step in combating the longest recession in a quarter-century and reviving credit. The Fed 'will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,' the FOMC said... 'Weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.' ...'The Fed is sending a message that it will print money to an unlimited extent until it starts to see the economy expanding,' William Poole, former president of the St. Louis Fed...said..."

December 17 - Bloomberg (Johan Carlstrom): "Norway's central bank cut its benchmark interest rate by 1.75 percentage points and signaled it will cut borrowing costs further next year, forecasting that the economy will slip into recession in the fourth quarter. The overnight deposit rate was reduced to 3%..."

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

December 17 - Bloomberg (James Sterngold): "American International Group Inc., which already has suffered more than $60 billion in writedowns and losses, may have to absorb almost $30 billion more because of flaws in the way its holdings are valued. An examination of AIG's credit-default swaps guaranteeing more than $300 billion of corporate loans, mortgages and other assets not covered by a $152.5 billion federal rescue shows the... insurer may value some of its positions at levels that don't reflect distress in the markets, according to... Gradient Analytics Inc. and a tax consultant who teaches at Columbia University... 'Every time I look at their statements I find something new,' said Donn Vickrey, executive vice president of Gradient Analytics... He estimated that AIG may need to take at least $28 billion in additional writedowns on swaps covering European corporate loans and prime residential mortgages, as well as collateralized loan and debt obligations."

December 18 - Bloomberg (Jody Shenn): "Americans seeking mortgages aren't getting the full benefit of record low yields on Treasuries and government-supported mortgage bonds... While the average rate on a fixed 30-year mortgage fell to 5.18% last week from 6.47% in October... the historical relationship between home loans and mortgage bonds shows rates should be at least half a percentage point lower."

Real Estate Bust Watch:

December 15 - UPI: "The value of U.S. homes is on target to fall by $2 trillion in 2008, a private research group said. The most recent Zillow Real Estate Market Report said home values fell 8.4% from a year ago by the end of the third quarter. At the end of the quarter, U.S. homes had already lost $1.9 trillion in value, the report said. At that point, one in seven homeowners were 'underwater,' with a total of 11.7 million owing more on their mortgages than their homes were worth..."

December 19 - SF Chronicle: "San Francisco office rents dropped 22% during the fourth quarter from the previous year, the largest decline in seven years, as the shrinking financial services industry flooded downtown with empty space."

December 19 - SF Chronicle: "Bay Area home values plummeted to an eight-year low in November... The median for existing single-family homes in the nine-county region fell to $350,000, a 47.8% drop from a year ago... according to... DataQuick. Nearly 50% of the houses that sold during the month had been repossessed in the last year. 'Bargains and foreclosures are still king,' said Andrew LePage, analyst with the... firm."

Speculator Watch:

December 18 - Bloomberg (Saijel Kishan): "Hedge-fund liquidations rose to a record in the third quarter..., according to Hedge Fund Research Inc. About 344 funds closed in the three months ended Sept. 30, the most since the... firm started tracking this data in 1996. Closures in the first nine months of 2008 rose 70% from the same period last year to 693... The $1.5 trillion hedge-fund industry is heading for its worst year, with the average fund losing 18% through November. Investor withdrawals could reach $400 billion in 2008, according to an estimate by Morgan Stanley. For the full year, 920 funds might shut down, topping the 563 closings in 2007 and the previous annual high of 848, set in 2005, HFR said."

December 15 - Bloomberg (Tom Cahill): "Almost a third of hedge funds will shut or merge after the $1.5 trillion industry posted its worst ever performance this year, according to IGS Group, which advises hedge funds on raising money. 'The failure rate is going to go up, the closure rate is going up, and the merger rate is going up,' IGS Chief Executive Officer John Godden said... 'It's going to be a 30% wipe out.' The number of hedge funds more than tripled in the last decade to a record 10,233 at the end of June, according to... Hedge Fund Research Inc."

December 18 - Dow Jones (Dan Molinski): "The number of hedge funds closing shop hit a record high...'We're at historical extremes with regards to risk tolerance, or the lack thereof, and investors are liquidating whatever assets they have ... selling indiscriminately,' Heinz said. Hedge funds have become a virtual ATM machine in recent months for investors looking to get their hands on cash amid a financial crisis that has tightened lending conditions around the world and caused liquidity to dry up. Several hedge funds have been forced to put up so-called 'gates' to slow or halt redemptions."

December 16 - Bloomberg (Saijel Kishan): "R3 Capital Management LLC's $1.5 billion hedge fund lost 31% in the first six months after it was founded by Rick Rieder mainly because its assets were frozen by the bankruptcy of his former employer, Lehman Brothers..."

December 18 - Bloomberg (John Rega): "The European Union stepped up scrutiny of hedge funds' investment practices and risk taking, opening a policy review that may lead to more disclosure and rules on capital and short-selling for the private investment pools."

Fiscal Watch:

December 18 - Bloomberg (Ryan J. Donmoyer): "Individual investors who lost money in Bernard Madoff's alleged $50 billion fraud may be able to recover some of their money by seeking tax refunds. 'The Madoff debacle will result in what amounts to another federal government bailout,' said Warren Kessler, an attorney at...Kessler & Kessler. "It is likely that the Treasury will wind up refunding taxes,' at least on the loss of money individuals invested with Madoff, he said. Capital-gains taxes paid by investors may be refundable for 2005 through 2007, lawyers said. In addition, they said investors probably can convince the Internal Revenue Service they are victims of theft, which would let them deduct losses from their income taxes dating back to 2006. Any unused theft losses could be used to reduce tax liabilities for the next 20 years."

Muni Watch:

December 15 - Bloomberg (Darrell Preston): "U.S. states are running out of cash to pay unemployment benefits to the rising number of workers losing their jobs, forcing officials to borrow from the federal government, cut benefits or raise payroll taxes. Nineteen states have less than the recommended year of reserves to pay benefits and four states -- Indiana, New York, South Carolina and Ohio -- are down to one to three months, according to U.S. Department Labor data."

December 15 - Bloomberg (William Selway): "U.S. state governments are reducing spending for the first time since 1983 as the recession erodes the tax collections that pay for schools, health clinics and other local programs, a national survey found. The budgets passed by states cut spending from their general funds, the pools of money not earmarked for specific purposes, by $380 million to $689 billion in the current budget year, which began in July for all but four states, according to a survey by the National Association of State Budget Officers..."

California Watch:

December 17 - Bloomberg (Michael B. Marois and William Selway): "'California's fiscal house is burning down,' Treasurer Bill Lockyer said... 'The people still wait for their elected leaders to pull them out of the fire, stop the blaze and rebuild the house on a solid, lasting foundation. Until that happens, the infrastructure work so vital to getting our economy back on track will lie crippled.'"

December 18 - Wall Street Journal (Jesse McKinley): "In another sign of California's fiscal morass, a state board charged with backing infrastructure projects voted... to halt some $3.8 billion in financing until a yawning budget gap is addressed... Bill Lockyer, the state treasurer, said the board's vote to suspend infrastructure financing was necessary to safeguard the dwindling government coffers, which he said could run dry as soon as February. 'We had to say we can't spend money we don't have,' Mr. Lockyer said. Nearly 2,000 projects could be delayed or halted, from multimillion dollar highway improvements to a $5,300 allocation for a Fresno school district. The list of projects that could be affected runs some 75 pages and includes veterans homes, prisons, roads, fire stations and environmental and housing projects."

December 18 - Wall Street Journal (Bobby White): "California may soon have more bankrupt towns on its hands. The city of Vallejo, Calif., gained national attention earlier this year by filing for Chapter 9 bankruptcy protection. Now, two neighbors are fighting to avoid the same fate, as the state's economic crisis spreads. Isleton and Rio Vista, small towns roughly 50 miles northeast of San Francisco, say they have begun consulting with bankruptcy lawyers as they draw up plans to deal with their mounting budget crises... California's troubled towns can't expect much help from the state. A state board voted Wednesday to shut off $3.8 billion in financing to hundreds of infrastructure projects to preserve cash... 'California's fiscal house is burning down,' State Treasurer Bill Lockyer said..."

December 18 - Bloomberg (Michael B. Marois and William Selway): "California lawmakers vote today on a plan to raise $9.3 billion in taxes to help ease the state's record budget deficit... The proposal would tax oil drillers, slap a 2.5% surcharge on income taxes and replace gasoline taxes with a flat 39-cents-a-gallon fee."

New York Watch:

December 15 - Bloomberg (Michael Quint): "New York Governor David Paterson says his plan for closing next year's record budget deficit of at least $13.3 billion to be presented tomorrow won't include higher income taxes. To help close the gap, Paterson will propose raising $4 billion with a variety of measures including a new tax on sugar- based soft drinks such as Coca-Cola, higher tuition at public universities, and ending the sales tax exemption for clothing costing less than $115..."

December 17 - Bloomberg (Chris Dolmetsch): "Fares and tolls for most of New York City's bridges, buses, trains and tunnels will increase by an average of 23% next year under the budget approved today by the transit authority."

December 18 - Bloomberg (Adam L. Cataldo and Henry Goldman): "The New York City Council reached an agreement with Mayor Michael Bloomberg today to send $400 rebates to owners of apartments and homes and raise property taxes 7% beginning next month."

Crude Liquidity Watch:

December 16 - Bloomberg (Anthony DiPaola and Camilla Hall): "Saudi Arabia cut its benchmark interest rate for the fourth time in less than three months... The Saudi Arabian Monetary Agency reduced its main repurchase rate to 2.5% from 3%..."

Q3 2008 Flow of Funds:

As I have highlighted in the past, Total Non-Financial Credit (NFC) expanded $578bn in 1994. By 1998, annual NFC growth exceeded $1.0 TN for the first time. After year 2000's pullback, by 2002 NFC growth was up to a record $1.412 TN, followed by 2003's $1.677 TN, 2004's $1.991 TN, 2005's $2.322 TN, 2006's $2.422 TN, and 2007's $2.523 TN. From my analytical perspective, it has always been a case of the inevitable predicament of an impaired (post-Bubble) Credit system not having the capacity to create sufficient new Credit to stem financial and economic implosion.

To this point, a barrage of unprecedented monetary and fiscal policy responses has restrained the forces of systemic collapse. On a quarterly basis the Federal Reserves Z.1 "Flow of Funds" report will help us better appreciate the profound effects the bursting of the Credit Bubble and resulting policymaking are exerting upon the underlying functioning of the Credit system and real economy.

Total Non-Financial Credit expanded at a surprising 7.2% rate during Q3, up sharply from Q2's 3.1% pace to the most robust Credit growth since Q4 2007. By sector, Household Debt actually contracted at a 0.8% rate, down from Q2's 0.6% growth and compared to 2007's annual increase of 6.8%. Household Mortgage Debt contracted at an unprecedented 2.4% rate. Corporate borrowings slowed to a 3.7% pace from Q2's 5.6%. This was a marked slowdown from the 13.2% surge in Corporate debt growth for all of 2007. State & Local Governments increased borrowings at a 2.9% pace. This was up from Q2's 0.8%, but was much slower than 2007's 9.3%. With private sector Credit growth struggling mightily, public finance really took up the slack. Federal Government debt expanded at a 39.2% pace, playing a decisive role in generating sufficient system-wide Credit expansion.

On a Seasonally-Adjusted and Annualized Rate (SAAR), Total Non-Financial Credit expanded $2.348 TN during the quarter - a quantity of new finance that would be in the analytical ballpark (down only marginally from $2007's $2.5 TN growth) to restrain the forces of systemic collapse. But of this amount, Federal Government borrowings accounted for SAAR $2.079 TN, or almost 90% of Q3's Credit expansion.

With even an unsustainable $2.0 TN annual pace of federal borrowings failing to reverse the downward economic spiral, the Federal Reserve this week was compelled to signal in no uncertain terms that policymakers "will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability."

In tandem with Treasury efforts, the Federal Reserve expanded "Fed Credit" SAAR $2.353 TN during Q3. This unprecedented ballooning accommodated deleveraging and helped offset a sharp decline in lending through the financial sector. "Fed Funds and Repos" contracted SAAR $969bn during the quarter, while "Open Market Paper" declined SAAR $580bn. Savings Institutions reduced assets at SAAR $1.281 TN, bank Credit at "Foreign Banking Offices in U.S." contracted at SAAR $415bn, and lending at Finance Companies dropped SAAR $113bn. The Asset-Backed Securities (ABS) market shrank at SAAR $419bn during Q3. After Q2's SAAR $913bn contraction, Security Brokers and Dealers expanded SAAR $12.6bn.

Yet the Fed was not all by its lonesome expanding system Credit. Total Bank Credit actually expanded at a robust SAAR $1.365 TN - at least somewhat receptive to the "buyer of last resort" roll for Open Market Paper (SAAR $413bn) and Mortgages (SAAR $688bn). On the Liability side, "Net Interbank Liabilities" expanded at an unprecedented SAAR $897bn, of which SAAR $515bn was borrowed from the Fed. Elsewhere, the GSEs expanded assets SAAR $85bn (about 2.5% annualized), and Agency MBS surged SAAR $508bn (11.2% annualized). Notably, Total Bank Assets were up $1.385 TN, or 12.7%, over the past four quarters.

The dollar was clobbered after Wednesday's bold "employ all available tools" pronouncement from the Federal Reserve. The way I see it, the Fed Board sent a direct message to the markets that it is resolved to do whatever is necessary to ensure sufficient system Credit will be forthcoming - a quantity that for our purposes is in the, say, $2.0 TN annual range. The dilemma for the Fed (and markets) is that while such an enormous amount of Credit would do little more than steady our maladjusted "Bubble Economy," it would perpetuate the massive flow of dollar finance out to the global financial system. In short, the Fed's determination to reflate ensures continued Monetary Disorder. And I would further argue that Ongoing Monetary Disorder - and associated corruption to various market pricing mechanisms - will impede system adjustment and extend the lengths of U.S. and global downturns and restructuring periods.

During Q3, Rest of World (ROW) accumulated U.S. financial assets at SAAR $816bn. Over the past year, ROW holdings increased a staggering $1.224 TN to $16.772 TN. And it is this nearly $17 Trillion number that I use in my mind as a rough proxy for what I refer to as the "Global Pool of Speculative Finance" - the source of unwieldy financial flows that continue to wreak bloody havoc on global markets and market pricing mechanisms. Over just the past 12 quarters, ROW holdings ballooned more than 50%.

It is also worth nothing that ROW Treasury holdings expanded SAAR $819bn during the quarter and were up $674bn, or 30%, over the past year to $2.913 TN. Ominously, ROW reduced holdings of U.S. Credit Market Instruments SAAR $547bn during Q3, with Commercial Paper down SAAR $273bn and Bonds down SAAR $291bn. Holdings of Agency Securities declined SAAR $241bn, reducing the one-year increase to $246bn. ROW holdings of "Security Repurchase Agreements" contracted SAAR $368bn during Q3, with a one-year drop of $254bn (22%). We continue to witness the astounding market extremes fostered by ROW risk aversion (zero T-bill yields vs. hopeless illiquidity in many risk markets).

The currency markets are shaping up as a major issue for the coming year. The dollar rallied sharply during the fourth quarter, although much of this gain was recently wiped away in six tumultuous trading sessions. I view the dollar's recovery in the context of a bear market rally. The dollar bear had become a crowded trade, and many were caught on the wrong side of various markets this year - certainly including the leveraged players in the currency markets.

There is a school of thought out there that the dollar bear has seen its lows. A consensus view seems to be taking shape that, at the minimum, the dollar wins (by default) the near-term battle against most currencies. Part of this analysis is the reasonable proposition that our currency benefits from the capacity of our policymakers to move earlier and more aggressively than their global counterparts. The euro-zone, in particular, is seen hamstrung by the constraints of its strange political and monetary structure.

My analytical framework takes a different approach. Especially after examining the most recent "Flow of Funds" report, I contemplate the dollar's prospects from a global flow of funds perspective. At this point I will assume that fiscal and monetary policies will succeed in generating $2.0 TN or so of new Credit in 2009 (Trillion dollar growth each in federal borrowings, the Fed's balance sheet, and commercial bank Credit would push the system much of the way there). In this scenario, the economy would likely still be mired in recession, short-term rates would remain near zero, and our Current Account Deficit would remain in the $600bn to $650bn range. Including other financial outflows, the Rest of World would be called upon to purchase another Trillion or so of our financial claims next year - and for years on end.

I will posit that the 2002-2007 dollar bear market did not manifest into a full-fledged currency crisis simply because of the massive purchases of U.S. securities by the Chinese (and to a lesser extent the OPEC, Russia, and India). At this point, I would not want to count on the Chinese (or others) accumulating another Trillion of our IOUs anytime soon. I don't expect the return of their appetite for U.S. securitizations, corporate bonds, and "repos" anytime soon. Indeed, these IOUs have lost their acceptability as a means of global payment remuneration. It also seems reasonable that this year's market dislocations have reduced the appeal of the strategy of holding U.S. securities while hedging underlying currency exposure in the derivatives market. And, at today's pitiful yields, there is little ongoing incentive to continue hording Treasuries.

It is impossible to know how much remains of the Crowded Dollar Bear Unwind. But if this dollar buying hasn't yet about run its course, when it eventually does global markets will again face the specter of massive and seemingly unending dollar liquidity flows. At the end of the day, I expect the dollar to suffer from its relative dismal position with respect to both financial flows and our economy's deep structural maladjustment. Years of egregious Credit and spending excesses have left an economic structure uniquely dependent upon, on the one hand, huge ongoing public sector Credit injunctions and, on the other, huge unending imports. This is a terrible predicament for a currency.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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