Mishkin on Asset Bubbles and Monetary Policy

By: Doug Noland | Fri, Jan 19, 2007
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For the week, the Dow and S&P500 were little changed, masking notable divergences between various groups. For example, the Semiconductors dropped 5.6%, while the S&P Homebuilding index jumped 4.3%. Generally, economically-sensitive sectors performed the best. The Transports jumped 2.0% (up 6.6% y-t-d), and the Morgan Stanley Cyclical index gained 1.4% (up 3.2% y-t-d). The Morgan Stanley Retail index rose 0.8%, increasing y-t-d gains to 5.9%. The Utilities added 0.7%, and the Morgan Stanley Consumer index gained 0.9%. The small cap Russell 2000 index fell 1.2%, and the S&P400 Mid-Cap index dipped 0.5%. Technology stocks suffered a sharp reversal of fortunes. The NASDAQ100 dropped 2.7% and the Morgan Stanley High Tech index 3.5%. The NASDAQ Telecom index sank 4.7%, reversing all of 2007's early gains. The Biotechs added 0.3%. Financial Stocks were mixed, with the Broker/Dealers down 1.1% (up 5.1% y-td) and the Banks up 0.1%. Although bullion rose $7.80, the HUI Gold index dipped 0.6% (down 5.9% y-t-d).

Two-year government yields rose 3.5 bps to 4.915%, pushing yields to the highest level since mid-August. Five-year yields added 1.5 bps to 4.78%, while 10-year Treasury yields were unchanged at 4.77%. Long-bond yields were flat at 4.86%. The 2yr/10yr spread ended the week inverted 14.5 bps. The implied yield on 3-month December '07 Eurodollars jumped 5.5 bps to 5.115%, the high since August 15th. Benchmark Fannie Mae MBS yields rose one basis point to 5.82%, this week slightly underperforming Treasuries. The spread on Fannie's 5 1/4% 2016 note narrowed 2 to 31, and the spread on Freddie's 5 1/2% 2016 note narrowed one to 30. The 10-year dollar swap spread increased 0.5 to 49.26. Corporate bond spreads generally narrowed further, with junk spreads narrowing as much as 10 bps.

Investment grade issuers included Bear Stearns $2.25 billion, Wells Fargo $2.25 billion, General Mills $1.5 billion, Health Care Properties $500 million and Monumental Global Funding $250 million.

January 18 - Bloomberg (Caroline Salas): "Aramark Corp. sold $1.78 billion of high-yield, high-risk bonds today to finance its $8.3 billion leveraged buyout by an investor group including Chairman Joseph Neubauer and private equity firm Thomas H. Lee Partners LP. The operator of concession stands in arenas from New York's Shea Stadium to Fenway Park in Boston issued senior unsecured debt... It dropped a plan to sell subordinated notes, which pay higher interest rates, because of strong demand for the senior debt..."

January 19 - Bloomberg (Harris Rubinroit): "Apollo Management LP is seeking $8.98 billion of debt financing to fund its leveraged buyout of Realogy Corp., the owner of the Century 21 and Coldwell Banker real-estate brokers, according to a regulatory filing."

January 14 - Financial Times (Saskia Scholtes and Richard Beales): "The amount of debt carrying the highest risk of default is rising as a proportion of the junk bond market, prompting fears the next cycle of corporate failures could be more severe than the last. In the US, nearly 16 per cent of bonds are rated CCC or below; up from about 13.5 per cent at the end of 2005, as measured by the Merrill Lynch high-yield index. High-yield or junk debt is rated below the BBB bracket, the lowest investment grade rating. Credit ratings of CCC or below are reserved for junk bonds with the highest risk of default."

January 19 - Bloomberg (Shannon D. Harrington): "The risk of owning corporate debt is the lowest in at least four years after housing data bolstered confidence that the worst of the residential real estate slump is over, according to traders who bet on corporate creditworthiness in the credit-default swap market."

Junk issuers included Aramark $1.8 billion, Open Solutions $325 million, Stallion Oilfield Services $300 million, Tube City $225 million, million.

This week's convert issuers included National Financial $200 million and Washington REIT $135 million.

Convert issuers included Headwaters $135 million and Isis Pharmaceutical $125 million.

International issuers included CAM Finance $2.0 billion, Nova Scotia $500 million, ISA Capital $550 million, Cosan Finance $400 million, Minerva Overseas $150 million, and GP Investments $150 million.

January 18 - Financial Times (David Oakley): "When two of the biggest borrowers in the credit markets went head to head last week with multi-billion-dollar bond deals, some bankers expected problems. Could the market digest two $3bn, 10-year issues from KfW, the German development bank, and the European Investment Bank, the European Union's funding arm, in one sitting? To make matters worse, two US agencies Fannie Mae and Freddie Mac were also looking to raise $3bn each in the same 10-year maturity.

Yet, in what can only be described as a remarkable demonstration of the strength and depth of the credit markets, all four deals ended up heavily subscribed. In short, the market had absorbed $12bn of 10-year paper from supranational and agency issuers without breaking into a sweat."

January 14 - Financial Times (David Oakley and Gillian Tett): "The euro has displaced the US dollar as the world's pre-eminent currency in international bond markets, having outstripped the dollar-denominated market for the second year in a row... Outstanding debt issued in the euro was worth the equivalent of $4,836bn at the end of 2006 compared with $3,892bn for the dollar, according to International Capital Market Association data. Outstanding euro-denominated debt accounts for 45 per cent of the global market, compared with 37 per cent for the dollar... That represents a startling turnabout from the pattern seen in recent decades, when the US bond market dwarfed its European rival: as recently as 2002, outstanding euro-denominated issuance represented just 27 per cent of the global pie, compared with 51 per cent for the dollar."

Japanese 10-year "JGB" yields dropped 8 bps this week to 1.655%. The Nikkei 225 gained 1.5% (up 0.5% y-t-d). German 10-year bund yields dipped one basis point to 4.05%. Emerging debt and equities markets were mostly impressive, as emerging debt market spreads tightened further into record territory. Brazil's benchmark dollar bond yields dropped 10 bps this week to 5.97%. Brazil's Bovespa equities index rallied 0.8% (down 2.4% y-t-d). The Mexican Bolsa dipped 0.4% (down 0.9% y-t-d). Mexico's 10-year $ yields dipped one basis point to 5.70%. Russia's 10-year Eurodollar yields rose 5 bps to 6.71%. India's Sensex equities index gained 0.9% (up 2.9% y-t-d). China's wild Shanghai Composite index surged 6.2% (up 5.9% y-t-d).

Freddie Mac posted 30-year fixed mortgage rates added 2 bps last week to 6.23%, up 13 bps from a year earlier. Fifteen-year fixed mortgage rates rose 2 bps to 5.98% (up 31bps y-o-y). And one-year adjustable rates jumped 7 bps to 5.51% (up 33bps y-o-y). The Mortgage Bankers Association Purchase Applications Index fell 7% this week. Purchase Applications were down 1.6% from one year ago, with dollar volume up 3.1%. Refi applications rose 6.3%. The average new Purchase mortgage increased to $232,300 (up 4.8% y-o-y), and the average ARM jumped to $387,400 (up 18.9% y-o-y).

Bank Credit gained $2.6 billion during the week (of 1/10) to $8.296 TN. Bank Credit expanded $798 billion, or 10.6%, over the past 52 weeks. For the week, Securities Credit was little changed. Loans & Leases rose $2.6 billion to a record $6.084 TN. Commercial & Industrial (C&I) Loans expanded 12.4% over the past year. For the week, C&I loans dipped $1.2 billion, while Real Estate loans surged $16.2 billion. Bank Real Estate loans were up 14.1% over the past year. For the week, Consumer loans increased $5.5 billion, while Securities loans declined $1.0 billion. Other loans dropped $16.8 billion. On the liability side, (previous M3) Large Time Deposits fell $19.4 billion.

M2 (narrow) "money" declined $4.3 billion to $7.057 TN (week of 1/8). Narrow "money" expanded $322 billion, or 4.7%, over the past year. M2 has expanded at a 6.9% pace during the past 20 weeks. For the week, Currency added $0.4 billion, and Demand & Checkable Deposits gained $4.3 billion. Savings Deposits dropped $17.3 billion, while Small Denominated Deposits added $0.1 billion. Retail Money Fund assets gained $8.0 billion.

Total Money Market Fund Assets, as reported by the Investment Company Institute, declined $11.3 billion last week to $2.379 Trillion. Money Fund Assets increased $323 billion over 52 weeks, or 15.7%. Money Fund Assets have expanded at a 21% rate over the past 20 weeks.

Total Commercial Paper gained $5.0 billion last week to a record $1.995 Trillion. Total CP has increased $313 billion, or 18.6%, over the past 52 weeks. Total CP has expanded at a 21% pace over the past 20 weeks.

Asset-backed Securities (ABS) issuance this week jumped to $20 billion. Year-to-date total ABS issuance of $28 billion (tallied by JPMorgan) is running ahead of the $24 billion from comparable 2006.

Fed Foreign Holdings of Treasury, Agency Debt gained $2.2 billion last week (ended 1/17) to a record $1.772 Trillion. "Custody" holdings were up $240 billion y-o-y, or 15.6%. Federal Reserve Credit added $1.5 billion to $846 billion. Fed Credit was up $29.6 billion y-o-y, or 3.6%.

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $804 billion y-o-y (19.5%) to a record $4.935 Trillion.

January 16 - Bloomberg (Nipa Piboontanasawat): "China's foreign-exchange reserves, the world's largest, topped $1 trillion for the first time, adding pressure on the government to let the yuan gain faster. Currency assets excluding gold climbed 30 percent from a year earlier to $1.07 trillion at Dec. 31, the People's Bank of China said..."

Currency Watch:

January 18 - Financial Times (Richard Beales): "US investors bought a record volume of foreign assets in November amid fears of a weakening currency, according to official data... External investment into US corporate bonds also hit a record, one notable indication that more foreign investors could be shifting their sights from ultra-safe but low-yielding Treasury bonds into higher-yielding corporate debt. The record net $39.1bn US investors put into foreign assets reflected both fears about the dollar and broader trends, according to Rick MacDonald of ActionEconomics. 'Recent weakness in the dollar may only be exacerbating already-strong diversification and return-seeking trends,' he said."

The dollar index dipped 0.2% this week to 84.68. On the upside, the Thai baht gained 2.0%, the Iceland krona 1.1%, the Mexican peso 0.8%, the Australian dollar 0.8%, and the South African rand 0.7%. On the downside, the Japanese yen declined 0.7%, the Colombian peso 0.6%, the Paraguay Guarani 0.5%, and the Kenyan shilling 0.4%.

Commodities Watch:

January 18 - Bloomberg (Chanyaporn Chanjaroen): "Nickel, the only gainer this year on the London Metal Exchange, rose to a record for a second consecutive day on speculation that a labor dispute in Canada will cut supply of the metal used in stainless steel."

January 18 - Bloomberg (Wendy Pugh and Yasumasa Song): "Oil will resume its march toward $100 a barrel after a 'correction,' said Jim Rogers, who predicted the start of the commodities rally in 1999. 'I'm just not smart enough to know how far down it will go and how long it will stay, but I do know that within the context of the bull market, oil will go over $100...It will go over $150. Whether that is in 2009 or 2013, I don't have a clue, but I know it's going to happen.'"

For the week, Gold gained 1.2% to $635.30 and Silver 0.4% to $12.93. Copper dropped 2.7%. February crude fell 86 cents to $52.02. February Gasoline dropped 2.2%, while February Natural Gas gained 5.3%. For the week, the CRB index was little changed, while the Goldman Sachs Commodities Index (GSCI) added 0.3%.

Japan Watch:

January 17 - Bloomberg (Jason Clenfield): "Japan's households became the most pessimistic they've been in more than a year in December after wages fell, signaling consumers may have tightened their purse strings in the lead-up to the New Year holiday."

China Watch:

January 18 - Bloomberg (Yanping Li): "China may surpass Germany this year as the world's second-largest trading country if imports and exports keeping growing at 20 percent or more a year, said the deputy trade minister."

January 18 - Bloomberg (Josephine Lau): "China may set up a $200 billion investment agency to help manage the nation's more than $1 trillion of foreign exchange reserves, Standard Chartered Plc economist Stephen Green said. The new institution may focus on private equity investments and buying 'strategic' raw materials, and be modeled on Singapore's state-owned investment company Temasek Holdings Pte..."

January 16 - Bloomberg (Nipa Piboontanasawat): "China's money supply grew in December at close to the slowest pace of last year after the central bank stepped up measures to cool the world's fastest-growing major economy by draining cash from the financial system. M2, the broadest measure of money supply which includes cash and all deposits, rose 16.9 percent to 34.6 trillion yuan ($4.4 trillion)..."

January 18 - Bloomberg (Nipa Piboontanasawat): "Hong Kong's jobless rate held at the lowest in almost six years, fueling wages growth and consumer spending among the city's 7 million inhabitants. ...Unemployment...was unchanged at 4.4 percent..."

India Watch:

January 19 - Bloomberg (Anil Varma): "Money supply in India expanded at the fastest pace in more than eight years... The M3 measure of money supply increased 20.4 percent in the period from a year earlier..."

January 19 - Bloomberg (Cherian Thomas): "India's inflation accelerated to a two-year high in the first week of January as prices of cotton textiles, fruits and vegetables rose... The key wholesale price inflation rate rose to 6.12 percent..."

January 18 - Bloomberg (Gautam Chakravorthy): "India expects to attract as much as 500 billion rupees ($11 billion) of investments from private developers for setting up power plants that aren't tied with long-term power purchase agreements. India's private developers may add as much as 15,000 megawatts of capacity under the so-called merchant power plant, as part of the country's plan to overcome power shortage..."

Asia Boom Watch:

January 17 - Bloomberg (Shamim Adam and Jean Chua): "Singapore's exports shrank the most in almost five years in December... Non-oil domestic exports fell 14.2 percent from a year earlier..."

Unbalanced Global Economy Watch:

January 16 - Bloomberg (Joshua Fellman): "Hong Kong was named the world's freest economy for a 13th year by the Heritage Foundation because of its low taxes, openness to investment and lack of trade tariffs. Singapore was second. Australia, the U.S., New Zealand, the U.K., Ireland, Luxembourg, Switzerland and Canada came next on the list..."

January 17 - Bloomberg (Alex Tanzi): "Canadian unit sales of previously owned homes in 25 major markets rose by 4.9 percent during the month of December... The number of new listings fell 0.6 percent last month, while the average home price was $294,190, an increase of 8.1 percent from last year."

January 18 - Bloomberg (Greg Quinn): "The Bank of Canada lowered its 2007 economic growth forecast because of a drop in U.S. demand for automobiles and building materials. Canada's gross domestic product will expand 2.3 percent this year, down from an October forecast of 2.5 percent..."

January 18 - Bloomberg (Brian Swint): "Gross [UK] mortgage lending increased to a record last year as house prices rose, the Council of Mortgage Lenders said... Gross lending against property rose 20 percent from 2005 to a record...$682 billion. House prices rose around 7 percent last year and home sales increased 14 percent..."

January 19 - MNI: "The UK's measure of broad money, M4, rose in December by 0.9% on the month and 12.8% over the past 12 months... M4 lending rose by...13.4% on the year."

January 16 - Bloomberg (Peter Woodifield): "The prices of London's most expensive homes rose last year at the fastest pace since Margaret Thatcher became prime minister in 1979, as bankers receiving record bonuses competed for a limited supply of properties. Prices of prime properties in the U.K. capital gained 2.6 percent in December, bringing the increase for the year to 28.6 percent..."

January 17 - Bloomberg (Craig Stirling and Jennifer Ryan): "U.K. unemployment claims fell more than expected in December to a nine-month low as expansion in service industries prompted companies to hire more workers."

January 19 - Bloomberg (Jennifer Ryan): "U.K. retail sales rose the most in 18 months in December as faster economic growth spurred shoppers to increase spending on electrical goods such as flat-screen televisions over the Christmas period."

January 16 - Bloomberg (Craig Stirling and Jennifer Ryan): "Britain's inflation rate rose to 3 percent in December, the highest in at least a decade, supporting the Bank of England's surprise decision to raise borrowing costs last week."

January 18 - Bloomberg (Fergal O'Brien): "Ireland' s opposition parties attacked Prime Minister Bertie Ahern's government for failing to keep price rises in check after inflation accelerated to the fastest in four years...Using an Irish measure, consumer-price growth accelerated to 4.9 percent in December, up from 4.4 percent the previous month..."

January 16 - Bloomberg (Simone Meier): "German investor confidence rose more than economists expected in January, reaching a six-month high, on the view that the economy will overcome a sales-tax increase and a global slowdown."

January 18 - Bloomberg (Fred Pals): "Dutch unemployment fell in December to the lowest in more than three years as the euro region's economic growth encouraged companies to hire. The jobless rate declined to 5 percent, compared with 5.2 percent in November..."

January 15 - Bloomberg (Simone Meier): "Swiss building permits surged to a record last year, a sign construction will add to economic growth this year, Tages-Anzeiger said, citing figures published by Baublatt magazine."

January 16 - Bloomberg (Alistair Holloway): "Finland's annual inflation rate rose to 2.2 percent in December, the highest level since September 2001, led by housing costs."

January 18 - Bloomberg (Daryna Krasnolutska): "Ukraine's economy advanced 7% last year, more than double the pace of 2005, as investments surged and rising steel prices helped boost output and the value of exports."

January 17 - Bloomberg (Michael Heath): "Moscow apartment prices fell for the first time in more than two years, Kommersant reported... Apartment prices in the Russian capital more than doubled in the previous 18 months..."

January 17 - Bloomberg (Hans van Leeuwen): "An Australian index of leading economic indicators increased at the fastest annual pace in almost seven years in November, signaling growth may accelerate in the Asia-Pacific region's fifth-largest economy."

Latin American Boom Watch:

January 18 - Bloomberg (William Freebairn): "Mexico's unemployment rate fell in December as retailers hired temporary workers for the holiday season. Mexico's jobless rate fell to 3.47 percent..."

January 18 - Bloomberg (Bill Faries): "Argentina's economy expanded 8.6 percent in November from the same month a year ago, the National Statistics Institute reported."

January 19 - Bloomberg (Eliana Raszewski): "Argentina's industrial output climbed 9.0 percent in December from a year earlier, the National Statistics Institute reported."

Central Banker Watch:

January 18 - Financial Times (Michiyo Nakamoto and David Turner): "The independence of the Bank of Japan was called into question on Thursday after the central bank held rates unchanged at 0.25 per cent, apparently under political pressure. Until Tuesday, the bank had been widely expected to increase rates by a quarter point to 0.5 per cent. But citing mixed signals over the economy, the Bank's board voted six to three against a rate rise. The decision sent the yen to a four-year low..."

Bubble Economy Watch:

University of Michigan Consumer Confidence jumped almost 6 points to the highest level since January 2004. Initial Unemployment Claims dropped to 290,000 last week, the low since the week of February 17. The December reading of the Consumer Price Index was up 2.5% y-o-y. The Producer Price Index was up 1.1% y-o-y.

January 18 - Bloomberg (Tom Randall): "New York City achieved its lowest yearly unemployment rate since state data collection began in 1976, an average of 5 percent for 2006, said Mayor Michael Bloomberg."

Financial Sphere Bubble Watch:

January 12 - Financial Times (Gillian Tett): "People who watch financial markets for a living tend to become blasé about big numbers. Nevertheless, the latest activity in the collateralised debt obligation (CDO) world, could make anybody blink. According to data released by JPMorgan this week, total issuance of CDOs - repackaged portfolios of debt securities or debt derivatives - reached $503bn worldwide last year, 64 per cent up from the year before. Impressive stuff for an asset class that barely existed a decade ago.

But that understates the growth. For JPMorgan's figures do not include all the private CDO deals that bankers are apparently engaged in too. Meanwhile, if you chuck index derivative portfolio numbers into the mix, the zeros get bigger: extrapolating from trends in the first nine months of last year, total CDO issuance was probably around $2,800bn last year, a threefold increase over 2005. These startling numbers will certainly not shake the world outside investment banking. For, as I noted in last week's column, the CDO explosion is occurring in a relatively opaque part of the financial system, beyond the sight - let alone control - of ordinary household investors, or politicians."

January 19 - Financial Times (Gillian Tett): "Last week I received an e-mail that made chilling reading. The author claimed to be a senior banker with strong feelings about a column I wrote last week, suggesting that the explosion in structured finance could be exacerbating the current exuberance of the credit markets, by creating additional leverage. 'Hi Gillian,' the message went. 'I have been working in the leveraged credit and distressed debt sector for 20 years ... and I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity will last indefinitely and that volatility is a thing of the past. 'I don't think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions ... with very limited capacity to withstand adverse credit events and market downturns. 'I am not sure what is worse, talking to market players who generally believe that 'this time it's different', or to more seasoned players who ... privately acknowledge that there is a bubble waiting to burst but ... hope problems will not arise until after the next bonus round.' He then relates the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds' money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. 'Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors' capital - a 2% price decline in the CDO paper wipes out the capital supporting it.'"

Mortgage Finance Bubble Watch:

January 16 - Bloomberg (Daniel Kruger): "Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co., has pared his Treasury holdings to the lowest in six months. Gross and a growing number of investors are reducing Treasury bonds in favor of mortgage-backed securities as expectations for lower interest rates this year fade."

Real Estate Bubble Watch:

January 17 - Market News International: "The following is the text of the December Architecture Billings Index released Wednesday by the American Institute of Architects: 'Following a six point jump in November, the Architecture Billings Index (ABI) increased even more in December and finished 2006 with its highest score. The commercial/industrial sector recorded its highest reading in the history of the survey that originated in 1995, while scores in the institutional market also showed improvement.'"

January 18 - Bloomberg (Sharon L. Crenson): "Apartment rents likely will rise in major U.S. markets this year, executives from five U.S. real estate investment trusts said at a conference in New York. 'We could see a nice run here in the next few years,' said Tim Naughton, president of...AvalonBay Communities Inc., the third largest U.S. apartment landlord... He predicted the company will raise its average rent by 5 to 6.5 percent in 2007 and 3 to 3.5 percent in coming years."

M&A and Private-Equity Bubble Watch:

January 18 - Financial Times (Rebecca Bream): "Mergers and acquisitions in the global gas and electricity sectors rose by 52 per cent to an all-time high of almost $300bn last year... According to research by PwC, the total value of deals announced in 2006 was $298.8bn, compared with $196bn in 2005."

Energy Boom and Crude Liquidity Watch:

January 17 - Dow Jones: "Oil and gas drilling in the U.S. hit a 21-year high in 2006, the American Petroleum Institute said Tuesday, with natural gas exploration and production the main driver. The API said in a press release that it estimated 49,375 oil wells, natural gas wells and dry holes were completed in 2006."

Fiscal Watch:

After three months of the new fiscal year, federal government receipts are running 8.2% ahead of the year ago level (to $530.2bn). Individual income tax receipts are running 8.9% ahead and corporate income taxes 22.5% above the year ago period. Year-to-date Total Spending is 0.7% ahead of comparable fiscal 2006. By major spending department, spending on National Defense is running up 9.3%, Social Security 6.2%, Income Security 1.1%, and Medicare 33.7%. Y-t-d Health was down 1.2% and Interest down 8.6% from last year.

Speculator Watch:

January 18 - Bloomberg (Jenny Strasburg): "Hedge-fund inflows declined 64 percent in the fourth quarter from the record pace of the previous three months as returns trailed market indexes and investors reacted to the collapse of Amaranth... Fund managers attracted $15.8 billion in the final three months of the year, compared with $44.5 billion in the third quarter, Chicago-based Hedge Fund Research Inc. said... Net deposits were $126.5 billion in the full year, the most ever and more than double the $46.9 billion raised in 2005."

January 18 - Bloomberg (Otis Bilodeau and David Scheer): "Madeleine Albright, the former U.S. secretary of state under President Bill Clinton, raised $329 million from a Dutch pension fund that her money-management firm will invest in emerging markets. Albright Capital Management LLC, an alternative-investment firm chaired by Albright in Washington, said it will make a 'long-term, multiclass investment...'"

Financial Sphere Earnings Bubble Watch:

Merrill Lynch reported Q4 Net Earnings of $2.296 billion, up 68% from Q4 2005. Total Net Revenues were up 27% to $8.609 billion. For the year, Total Net Revenues were up 33% to $34.659 billion, with Net Earnings up 47% to $7.499 billion. "Global Markets and Investment Banking (GMI) generated $18.9 billion in net revenues for the full year 2006, up 37% from 2005, driven by record revenues in both Global Markets and Investment Banking... GMI's fourth quarter 2006 net revenues were $5.4 billion, up 55% from the year-ago quarter... Fixed Income, Currencies and Commodities net revenues of $2.3 billion increased 70%, setting a quarterly record, driven by every major business line, in particular record revenues from Credit products, commodities and foreign exchange, as well as a strong growth from trading interest rate products... Equities Markets net revenues of $1.8 billion increased 49%, driven by nearly every major business line... Investment Banking net revenues of $1.3 billion set a quarterly record, up 41%..." The company repurchased 31.1 million shares during the fourth quarter.

At Wells Fargo, Q4 Net Income was up 13% from Q4 2005 to $2.18 billion. During the fourth quarter, Average Loans expanded at an 11% pace. "Average Commercial and Commercial Real Estate loans increased $11.5 billion, or 11 percent [y-o-y]...Excluding real estate 1-4 family first mortgages, average consumer loans increased $19.1 billion, or 16 percent, from a year ago. Average real estate 1-4 family junior lien mortgage, credit card, and other revolving credit installment loans grew at double-digit rates from a year ago." For the year, mortgage originations rose 9% to $398 billion. Non-Accrual Loans and Other Assets" increased to 0.76% of total loans, up from Q3's 0.68% and Q4 2005's 0.49%. Total Assets were little changed from the year ago period at $482.0 billion.

Mishkin on Asset Bubbles and Monetary Policy:

Chairman Bernanke testified yesterday before the Senate Budget Committee. He spoke clearly and forcefully about our nation's dire fiscal predicament, noting that we are in the "calm before the storm" of a major "fiscal crisis." Untenable contingent liabilities - most conspicuous today in retiree income and healthcare benefits - require a major system overhaul. But as much as the Fed and Budget Committee members may see eye-to-eye the severity of the problem, the environment is anything but conducive to making tough decisions and taking decisive action.

With federal government receipts growing double-digits during 2006, there is today little impetus to deal with uncertain deficits somewhere down the road. This is the case in Washington as well as in Sacramento, Albany and elsewhere. It is worth noting that federal receipts during fiscal 2007's first quarter were up 8.2% from comparable 2006, with the federal deficit rapidly shrinking a third to $80.4 billion (for the quarter). First-quarter receipts were actually 18% ahead of comparable 2005 - only two years ago. And to better ascertain the current tide of Washington consensus opinion, tune into Larry Kudlow and hear the clamor of economic miracles, evaporating deficits, and soon to reemerge budget surpluses. Today, bullish euphoria has the incredible U.S. economic engine handily coping with the burden of guns and butter - today, tomorrow and forever. Besides, if at some point the economic expansion were to prove not quite up to the task, the Bernanke Fed would be right there keen to make it right.

My frustration with Mr. Bernanke is simply a continuation of the issues I had with Mr. Greenspan. They talk an especially great game on Capitol Hill. Both are impressively capable of articulating some of the serious issues facing our economy - captivating our legislators and media in the process. Wall Street snickers.

As far as I am concerned, it is disingenuous for chairman Bernanke (as it was for Greenspan), to propound the necessity of Congress to deal forcefully with forthcoming problems, while ostentatiously cultivating faith in the capacity of monetary policy and the markets to cure all ailments. These ills include future Federal liabilities, the trade and Current Account Deficits and vulnerable household finances. So, why on earth would Washington fret when the Fed has for years conditioned Wall Street and global markets not to?

I hope readers will recognize that we today confront one of the Corrosive Consequences of Inflationism: Complacency and lack of resolve to deal with critical issues. Confidence in the Fed's capacity to cut rates, manipulate market behavior, and "reflate"/"reliquefy" has never been as unyielding as it today. If the power of the Fed was not made clear in the early nineties, it was in 1998, 1999, and 2000-2003. If the banking system needs recapitalized, there's no problem. Hedge fund and Y2K scares, the Fed's on the case. If a collapsing tech Bubble is weighing on growth, simply inflate home prices. If the corporate bond market suffers from bursting Bubbles, fraud, and problematic risk-aversion, well, just communicate to the marketplace that it's the Fed's policy to garnish outsized financial profits on the risk-takers and leveraged speculators. When the debt load - for individuals, businesses, governments, speculators - for the entire nation - becomes too onerous, just inflate system liquidity, asset prices, incomes, earnings and tax receipts.

There are apparently few problems that today's astute monetary policymakers can't resolve - fiscal, economic or financial. The days of hard decisions, (personal and national) sacrifice, and saving for a rainy day are, conveniently, a thing of the past. Activist central banking has somehow - over this protracted boom - relegated the structure of the real economy, our nation's balance sheet, and our financial system to peripheral issues.

One of our new Fed governors gave a speech this week that I won't let go unanswered. Dr. Frederic Mishkin, an academic partisan of Dr. Bernanke's, presented "The Role of House Prices in Formulating Monetary Policy." It received little media attention, though it will provide lush fodder for future financial and economic historians.

Excerpts from Dr. Mishkin's article:

"The issue here is the same one that applies to how central banks should respond to potential bubbles in asset prices in general: Because subsequent collapses of these asset prices might be highly damaging to the economy, as they were in Japan in the 1990s, should the monetary authority try to prick, or at least slow the growth of, developing bubbles? I view the answer as no."

"A special role for asset prices in the conduct of monetary policy requires three key assumptions. First, one must assume that a central bank can identify a bubble in progress. I find this assumption highly dubious...Indeed, the view that government officials know better than the markets has been proved wrong over and over again. If the central bank has no informational advantage, and if it knows that a bubble has developed, the market will know this too, and the bubble will burst. Thus, any bubble that could be identified with certainty by the central bank would be unlikely ever to develop much further."

"A second assumption needed to justify a special role for asset prices is that monetary policy cannot appropriately deal with the consequences of a burst bubble, and so preemptive actions against a bubble are needed. Asset price crashes can sometimes lead to severe episodes of financial instability, with the most recent notable example among industrial countries being that of Japan. In principal, in the event of such a crash, monetary policy might become less effective in restoring the economy's health. Yet there are several reasons to believe that this concern about burst bubbles may be overstated.

"To begin with, the bursting of asset price bubbles often does not lead to financial instability. In research that I conducted with Eugene White on fifteen stock market crashes in the twentieth century, we found that most of the crashes were not associated with any evidence of distress in financial institutions or the widening of credit spreads that would indicate heightened concerns about default. The bursting of the recent stock market bubble in the United States provides one example. The stock market drop in 2000-01 did not substantially damage the balance sheets of financial institutions, which were quite healthy before the crash, nor did it lead to wider credit spreads. At least partly as a result, the recession that followed the stock market drop was very mild despite some severely negative shocks to the U.S. economy..."

"There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability. House prices are far less volatile than stock prices, outright declines after a run-up are not the norm, and declines that do occur are typically relatively small. The loan-to-value ratio for residential mortgages is usually substantially below 1... Hence, declines in home prices are far less likely to cause losses to financial institutions... Not surprisingly, declines in home prices generally have not led to financial instability. The financial instability that many countries experienced in the 1990s, including Japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices. In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble."

"Many have learned the wrong lesson from the Japanese experience. The problem in Japan was not so much the bursting of the bubble but rather the policies that followed. The problems in Japan's banking sector were not resolved, so they continued to get worse well after the bubble had burst. In addition, with the benefit of hindsight, it seems clear that the Bank of Japan did not ease monetary policy sufficiently or rapidly enough in the aftermath of the crisis.

"A lesson that I draw from Japan's experience is that the serious mistake for a central bank that is confronting a bubble is not failing to stop it but rather failing to respond fast enough after it has burst. Deflation in Japan might never have set in had the Bank of Japan responded more rapidly after the asset price crash, which was substantially weakening demand in the economy. If deflation had not gotten started, Japan would not have experienced what has been referred to by economist Irving Fisher as debt deflation, in which the deflation increased the real indebtedness of business firms, which in turn further weakened the balance sheets of the financial sector.

"Another lesson from Japan is that if a burst bubble harms the balance sheets of the financial sector, the government needs to take immediate steps to restore the health of the financial system. This should involve structural improvements in the way banks operate, not bailing out insolvent institutions. The prolonged problems in the banking sector are a key reason that the Japanese economy did so poorly after the bubble burst."

Certainly not atypically, Dr. Mishkin's article fails to even use the word "Credit," let alone analyze the prevailing role of the Credit system in fostering destabilizing asset Bubbles. Not engendering credibility, the issues of liquidity and speculation go similarly neglected.

"Home prices, like other asset prices, have important effects on output and inflation. Home prices affect the economy in two primary ways. First, when they begin rising, the expectation of further appreciation tends to become built into the market. That expectation boosts demand for homes, which stimulates new construction and aggregate demand... Second, higher home prices increase household wealth, thus stimulating consumer spending, another component of aggregate demand."

The crucial error in Dr. Mishkin's asset Bubble analysis is to disregard Financial Sphere Dynamics, certainly including the expansive repercussions historic mortgage Credit inflation imposed upon U.S. and global economies and global finance, generally. More insightful analysis would consider - should begin with - the prominent role of system Credit expansion, liquidity excess and speculative dynamics. Housing inflation was only one of myriad consequence of the Mortgage Finance Bubble (including a ballooning Wall Street, leveraged speculator community, derivatives market and "structure finance" arena). This powerful financial "evolution" unfolded after years of loose Financial Conditions, only to be inflated to dangerous extremes with the Fed's post-tech Bubble monetary "reflation." Instead of being chastened from the gross excesses that fostered myriad Bubbles and busts (MBS/bonds '94, Mexico, SE Asia, Russia, LTCM, Argentina, tech and telecom), Fed "activism" nurtured and emboldened an escalation of lending, leveraging, and speculation in housing, mortgage-related securities and instruments.

The Fed's policy of responding to asset price risk disregards the reality that behind the serial asset market Bubbles have operated a Credit system and Pool of Speculative Finance that, by its very nature, inflates only larger, more powerful, and increasingly destabilizing with each passing year of accommodation. Over time, as Bubble infrastructure and psychology become more entrenched, failure to "prick" the Bubble is to further accommodate it. As we have again witnessed during the past year, there are profound consequences to the Fed's policy of ignoring Credit excess and resulting asset Bubbles. Moreover, incorporating into policy the intention of "appropriately dealing with the consequences" of asset Bubbles openly invites the by now dominating leveraged speculating community to aggressively position to profit from prospective rate cuts and "reflations."

I am personally a little sick and tired of the cop out nonsense that Bubbles can't be identified until after the fact. If the focus were on Credit - where it should and must be -the analysis would become much less nebulous and the policy task much less ambiguous. When home mortgage debt growth accelerated from 1998's 8.0% to 1999's 9.4%, the Fed should have been on notice. When 2001's 9.3% growth jumped to 2002's 10.6%, they should have been on guard. When mortgage Credit then expanded 11.6% in both 2003 and 2004, there was no doubt that a problematic Bubble in Mortgage Credit had emerged and the Fed should have aggressively tightened policy. Yet the Fed sat idly by and watched mortgage debt expanded a further 20% in two years, with resulting unprecedented Current Account Deficits, leveraged speculation, and global liquidity excess inspiriting speculative Bubbles in asset, securities and commodities markets across the globe.

Dr. Mishkin's focus is misguided. The crucial question is not whether a bursting asset Bubble will lead to a severe episode of financial instability. Rather, the key issue is what impact a vulnerable or faltering asset Bubble has on the underlying Credit and economic systems. The extent to which stock market Bubbles have been fueled by underlying speculative leveraging and then exacerbated system Credit excess will dictate a major influence on the degree of financial instability one would expect in the event of a crash. At one extreme would be a stock market boom financed by minimal leveraged speculation within a generally sound Credit and economic backdrop. At the other end of the spectrum is the 1929 market, with its gross speculative leveraging, acute financial fragility, and a deeply maladjusted Credit-driven Bubble economy. Somewhere between the two extremes is Japan in the late-eighties.

As we witnessed here at home, the bursting technology Bubble was met with surging bond and real estate prices. It triggered little in the way of severe tumult. Speculative leveraging in bonds and mortgage Credit growth provided more than ample system Credit and liquidity to sustain that unfolding Credit Bubble. Indeed, the tech bust and the Fed's response only energized and emboldened the Credit system and leveraged speculator community. The ballooning Financial Sphere has been of late further empowered by the prospect of bursting housing Bubbles and the Fed's foreseeable response. Not unpredictably, unprecedented Bubble Propagation enveloped the world.

Devastating Credit system crashes - fortunately much rarer events than bursting asset Bubbles - are the consequence of protracted periods of Credit and speculative excess. I would argue strongly that the mandatory backdrop demands repeated, extended, and escalating policymaker intervention and marketplace manipulation. Only such a constructive environment for prolonged financial excess can create such acute system fragility - unadulterated markets with functioning self-adjustment and correction mechanisms and dynamics would not. Regrettably, the Fed's asymmetric strategy with respect to ignoring asset Bubble while they are inflating and then reflating aggressively when they falter is tantamount to flagrant market manipulation.

A Hippocratic Oath is in order: First of all, Federal Reserve monetary policy must do no severe harm. To live up to such an oath, monetary policy would strive to avoid fostering Credit and speculative excess, while being prepared to take all necessary measures to ensure that protracted booms - with their deleterious effects on the financial and economic structure - not be tolerated. To minimize the risk of cumulative excesses and imbalances, the policy tool kit should avoid aggressive rate cuts, marketplace assurances and commitments to respond to faltering asset markets. Monetary policy should not be used to stimulate the economy or asset prices - it should not be "activist." Absolutely never should the Fed use the leveraged speculating community as a reflationary and liquidity-creating policy mechanism. And never should the Fed pre-commit to inflationary policies in the event of bursting speculative Bubbles. Drs. Bernanke and Mishkin's views on asset Bubbles and monetary policy are so dangerously ludicrous I find it difficult to believe they don't provoke heated debate, some consternation, and at least a little outrage.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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