Bernanke on Subprime

By: Doug Noland | Fri, May 18, 2007
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For the week, the Dow jumped 1.7% (up 8.8% y-t-d), and the S&P500 gained 1.1% (up 7.4%). The Transports added 0.9% (14.3%), and the Utilities gained 1.2% (15.6%). The Morgan Stanley Cyclical index gained 1.2% (19.2%), and the Morgan Stanley Consumer index rose 1.0% (7.3%). The small cap Russell 2000 declined 0.7% (up 4.6%), while the S&P400 Mid-Cap index added 0.5% (11.7%). The NASDAQ100 (8.0%) and Morgan Stanley High Tech (7.3%) indices were about unchanged. The Semiconductors declined 2.6% (5.1%). The Internet Index gained 0.8% (7.7%), while the NASDAQ Telecommunications index slipped 0.6% (5.4%). The Biotechs fell 1.3%, reducing y-t-d gains to 7.2%. The Broker/Dealers declined 0.6% (5.4%), while the Banks gained 0.8% (0.5%). With Bullion down $9.40, the HUI Gold index dropped 2.8%.

Global bond yields lurched higher. Two-year U.S. government yields jumped 11 bps to 4.82% (high since 2/22). Five-year yields surged 14 bps to 4.73%. Ten-year Treasury yields rose 13 bps to 4.80%, the highest yield since mid-February. Long-bond yields increased 11 bps to 4.96%. The 2yr/10yr spread ended the week inverted 2 bps. The implied yield on 3-month December '07 Eurodollars jumped 9 bps to 5.205%, the highest level since the end of January. Benchmark Fannie Mae MBS yields rose 11 bps to 5.92%, this week outperforming Treasuries. The spread on Fannie's 5% 2017 note was little changed at 38, and the spread on Freddie's 5% 2017 note widened one to 38. The 10-year dollar swap spread increased 1.75 to 55.75. Corporate bond spreads were mostly narrower, with the spread on a junk index about 10 bps narrower.

May 17 - Securities Industry and Financial Markets Association: "Issuance of new securities in the U.S. capital markets rose 13.0% in the first quarter, to $1.8 trillion, with merger and acquisition and leveraged buyout financing driving corporate bond issuance to a record $308.0 billion, up 23.6% from the same period last year. In addition, as a result of increased bond refunding activity, municipal issuance rose 50.8% from year-ago levels to $112.8 billion, also setting a record in the first quarter. Total equity underwriting reached $61.4 billion on 202 deals in the quarter, 42.6% higher than the first quarter of 2006." (see below)

A solid $28.2bn of corporate bonds was issued this week. Investment grade issuers included Countrywide $4.0bn, Bank of America $2.25bn, Xerox $1.1bn, Ford Motor Credit $1.5bn, PepsiCo $1.0bn, Citigroup $1.0bn, Virginia E&P $600 million, Jersey Central P&L $550 million, Silicon Valley Bank $500 million, Genworth $525 million, Nationwide Life $400 million, Foundation Health Systems $300 million, Bank of Oklahoma $250 million, and Emerson Electric $250 million.

May 15 - Bloomberg (Caroline Salas): "Never have so many made so much money from junk bonds, and that worries Dan Fuss. Fuss, whose $10.7 billion Loomis Sayles Bond fund has been the best performer among its peers the last 10 years, says high-yield, high-risk securities are showing unmistakable signs of a bubble. Yields are near record lows relative to government securities even though sales of the riskiest bonds increased 39% from last year... 'I haven't felt this nervous about a market ever,' said Fuss, vice chairman of Loomis Sayles & Co."

Junk bond funds reported inflows of $15 million this week. Issuers included Ford Motor Credit $2.0bn, Dynegy $1.65bn, Rite Aid $1.22bn, US Steel $1.1bn, Mueller Water Products $425 million, Health Net $300 million, CBG Florida REIT $300 million, White Mountains RE $250 million, and Swift Energy $250 million.

This week's convert issuers included Micron $1.3bn, and Gold Reserve Inc $90 million.

International dollar bond issuers included Citic Resources $1.0bn, South Africa $1.0bn, Atlas Copco $800 million, Sadia Overseas $250 million, Kansas City Southern $165 million, and Autopistas $155 million.

German 10-year bund yields jumped 9 bps to 4.31%. Japanese 10-year "JGB" yields were little changed at 1.64%. The Nikkei 225 declined 0.9% (up 1.0% y-t-d). Emerging debt markets were on the defensive, while equities generally marched higher. Brazil's benchmark dollar bond yields rose 5 bps this week to 5.62%. Brazil's Bovespa equities index rose 2.3% (up 17.1% y-t-d). The Mexican Bolsa gained 2.1% (up 16% y-t-d). Mexico's 10-year $ yields jumped 9 bps to 5.51%. Russia's RTS equities index rallied 0.8% (down 3.2% y-t-d). India's Sensex equities index surged 3.7% (up 3.7% y-t-d). China's Shanghai Composite index added 0.2%, increasing y-t-d gains to 51% and 52-week gains to 149%.

Freddie Mac posted 30-year fixed mortgage rates jumped 6 bps to 6.21% (down 39bps y-o-y). Fifteen-year fixed rates gained 5 bps to 5.92% (down 28bps y-o-y). One-year adjustable rates were unchanged at 5.48% (down 14bps y-o-y). The Mortgage Bankers Association Purchase Applications Index slipped 1.4% for the week. Purchase Applications were up 1.4% from one year ago, while dollar volume was 4.7% higher. Refi applications were about unchanged for the week, with dollar volume up 42% from a year earlier. The average new Purchase mortgage increased to $239,600 (up 0.7% y-o-y), while the average ARM jumped to $403,800 (up 16.5% y-o-y).

Bank Credit jumped $29.1bn (week of 5/9) to a record $8.509 TN. For the week, Securities Credit increased $13.8bn. Loans & Leases jumped $15.3bn (3-wk gain of $53bn) to $6.232 TN. C&I loans increased $5.3bn, and Real Estate loans added $3.7bn. Consumer loans were little changed, while Securities loans surged $17.2bn. Other loans fell $10.7bn. On the liability side, (previous M3) Large Time Deposits gained $9.3bn.

M2 (narrow) "money" rose $17.8bn to $7.229 TN (week of 5/7). Narrow "money" has expanded $186bn y-t-d, or 7.2% annualized, and $464bn, or 6.9%, over the past year. For the week, Currency was about unchanged, while Demand & Checkable Deposits declined $10.4bn. Savings Deposits jumped $25.9bn, and Small Denominated Deposits gained $2.5bn. Retail Money Fund assets dipped $0.2bn.

Total Money Market Fund Assets (from Invest. Co Inst) rose $18.2bn last week to a record $2.485 TN. Money Fund Assets have increased $103bn y-t-d, an 11.2% rate, and $427bn over 52 weeks, or 20.7%.

Total Commercial Paper grew $4.5bn last week to a record $2.087 TN, with a y-t-d gain of $113bn (14.8% annualized). CP has increased $320n, or 18.1%, over the past 52 weeks.

Asset-backed Securities (ABS) issuance surged to $22bn. Year-to-date total US ABS issuance of $260bn (tallied by JPMorgan) is running slightly ahead of comparable 2006. At $137bn, y-t-d Home Equity ABS sales are 26% below last year's pace. Meanwhile, y-t-d US CDO issuance of $132 billion is running 20% ahead record 2006 sales.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 5/16) increased another $8.8bn to a record $1.940 TN, with a y-t-d gain of $188bn (28% annualized). "Custody" holdings expanded $316bn during the past year, or 19.4%. Federal Reserve Credit last week declined $5.7bn to $847.8bn. Fed Credit was down $4.4bn y-t-d, while increasing $23.2bn y-o-y (2.8%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $551bn y-t-d (30% annualized) and $977bn y-o-y (22%) to a record $5.362 TN.

May 17 - Bloomberg (Maria Levitov): "Russia's foreign currency and gold reserves jumped $14.2 billion in the week ended May 11, the biggest seven-day gain since the central bank began weekly reporting in June 1998. The reserves, the world's third largest, surged to a record $386.3 billion..."

Currency Watch:

The dollar index posted a fractional gain to 82.11. On the upside, the Brazilian real gained 3.0%, the Canadian dollar 2.0%, the Colombian peso 1.8%, the Iceland krona 1.3%, the Turkish lira 0.9% and the Indian rupee 0.9%. On the downside, the South African rand declined 1.1, the Hungarian forint 1.0%, the Australian dollar 1.0%, the Polish zloty 0.8%, and the South Korean won 0.8%.

Commodities Watch

May 15 - Bloomberg (Ying Lou): "China's crude oil imports rose 23% to a record for a second successive month in April as output from domestic fields failed to keep pace with consumption... Imports climbed to 14.82 million metric tons (about 3.6 million barrels a day) last month... From January to April, China's purchases rose 11%..."

May 14 - Bloomberg (Gavin Evans and Danielle Rossingh): "Milk prices worldwide are rising at the fastest rate ever and won't be falling anytime soon because of growing demand in China and Latin America and dwindling government supplies."

For the week, Gold declined 1.4% to $661.45, and Silver dropped 2.3% to $13.003. Copper sank 7.8%. June crude jumped $2.57 to $64.94. June gasoline gained another 2%, and June Natural Gas added 0.6%. For the week, the CRB index added 0.7% (up 1.9% y-t-d), and the Goldman Sachs Commodities Index (GSCI) jumped 3.0% (up 10.3% y-t-d).

Japan Watch:

May 14 - Bloomberg (Toru Fujioka): "Japan's current account surplus widened to a record in March, as exports to Asia and Europe helped counter slower growth in shipments to the U.S. The surplus expanded 36.9% to 3.32 trillion yen ($28 billion) from a year earlier..."

May 17 - Bloomberg (Lily Nonomiya): "Japan's economy, the world's second largest, cooled in the first quarter... Gross domestic product grew at an annual 2.4% rate..."

China Watch:

May 15 - Bloomberg (Nipa Piboontanasawat): "China's growth in spending on factories and real estate in 2007 has probably outpaced last year's increase, suggesting the central bank may need to raise interest rates to cool investment. Fixed-asset investment in urban areas increased 25.3% in the first four months from a year earlier..."

May 13 - Bloomberg (Luo Jun and Helen Yuan): "China's money supply grew by more than the central bank's target for a third month, making measures to slow lending and investment more likely. M2...increased 17.1% in April from a year earlier..."

May 15 - Bloomberg (Nipa Piboontanasawat): "China's retail sales growth accelerated in April, fueled by rising incomes and a stock market boom that has prompted warnings of a speculative bubble. Sales rose 15.5% from a year earlier..."

May 15 - Bloomberg (Luo Jun): "Sales of asset-backed bonds in China may surge to as much as 200 billion yuan ($26 billion) next year from less than 10 billion yuan in 2005, the China Securities Journal reported..."

May 14 - Bloomberg (William Bi): "China's wholesale prices for grains rose 9.9% April from a year earlier, the People's Bank of China said."

May 14 - Market News International: "China's enterprise commodity price index, which measures the wholesale price level, rose 4.6% year-on-year in April, up from 4.2% recorded in March..."

May 15 - Bloomberg (Ting Ting Ng): "Hong Kong home prices may surge 30% by year's end on abundant liquidity, strong demand and a low unemployment rate, said the co-head of Asia real estate research at UBS."

India Watch:

May 17 - Financial Times (Joe Leahy): "India's central bank last night released long-awaited draft guidelines for banks and dealers to begin trading credit default swaps in the country - derivatives that allow banks to hedge against the risk of default. The move will enable banks in India to step up lending to the corporate sector by allowing them to offload some of the risk to third-party investors."

Asia Boom Watch:

May 16 - Bloomberg (Kathleen Chu): "Office rents gained in Asia's biggest cities during the first quarter of this year as expanding financial services firms encountered a dearth of prime office space, CB Richard Ellis said. Prime office rents in Singapore gained at the fastest pace among Asia's three biggest business hubs, with a 10% increase..."

May 14 - Bloomberg (James Peng and Stephen Engle): "Taiwan's economy, Asia's fifth largest, may expand 4.6% this year, faster than the government previously predicted, Minister Chen Ruey-long said."

May 15 - Bloomberg (Aloysius Unditu and Shamim Adam): "Indonesia's economy expanded faster than analysts expected in the first quarter... Southeast Asia's largest economy grew 6% from a year earlier, more than the 5.8% predicted..."

Unbalanced Global Economy Watch:

May 14 - Bloomberg (Simon Kennedy and Bill Faries): "Emerging markets from the Baltic states to Latin America, awash in overseas capital, are paying a price for their popularity. Vietnam's stock market, among the world's top performers this year, is triggering concerns that shares may be in for a fall. Brazilian and Colombian exporters are struggling to compete as the value of their currencies mounts. Residents of Latvia's capital, Riga, have seen house prices jump 67% in a year. Overseas investment will flood emerging markets with $469 billion this year, according to the Institute of International Finance in Washington. That will bring the total since 2005 to almost $1.5 trillion, twice as much as in the prior three years. While fueling growth, all that cash is bringing side effects that threaten to turn booms into busts."

May 17 - Bloomberg (Theophilos Argitis): "Canadian inflation, minus volatile components such as energy, accelerated in April to its highest in more than four years, more evidence that labor and housing shortages in western Canada may push interest rates higher. The so-called core rate...rose to 2.5% from a year ago..."

May 16 - Bloomberg (Theophilos Argitis): "Canadian home sales and prices rose to records in April, the nation's realtor association said, suggesting the housing market in the world's eighth-biggest economy remains buoyant."

May 15 - Bloomberg (Ben Sills): "Europe's economy expanded more than forecast in the first quarter as corporate investment offset the effects of higher euro-area interest rates and a German sales-tax increase. The economy of the 13 nations that share the euro expanded 0.6% from the fourth quarter, when it grew 0.9%..."

May 14 - Market News International: "UK house prices rose by 1.1% in March from February and climbed 10.9% from March 2006, the Department of Communities and Local Government said Monday."

May 16- Market News International: "French private-sector employment expanded at the fastest pace in six years in 1Q, driven by temporary jobs in the service sector, according to preliminary data... Non-farm private sector jobs rose by 93,600 in 1Q after +23,700 in 4Q (revised down from +28,900), and +44,600 in 3Q."

May 14 - Bloomberg (Ben Sills): "Spain's economy, Europe's fifth-largest, weathered a slump in the housing market to maintain the fastest expansion in more than five years in the first quarter as exports added to growth. The Spanish economy expanded 4% from a year earlier..."

May 16 - Bloomberg (Harry Papachristou): "Greek economic growth in the first quarter accelerated at the fastest pace in more than two the economy entered its 14th consecutive year of expansion. GDP increased 4.6%, from a revised 4.4%..."

May 16 - Bloomberg (Nasreen Seria): "South African retail sales growth accelerated to an annual 10% in March as consumer confidence jumped to a record and employment gained."

Latin American Boom Watch:

May 15 - Bloomberg (Telma Marotto): "Banco do Brasil SA, Latin America's largest bank by assets, said first-quarter profit rose 50% as falling interest rates encouraged consumers to borrow more and higher crop prices spurred demand for farm loans."

May 15 - Bloomberg (Fabio Alves): "Brazilian retail sales in March surged the most since July 2004 after 15 straight cuts in the benchmark lending rate prompted consumers to step up purchases of goods such as cars, furniture, and appliances. Retail, supermarket and grocery store sales, as measured by units sold, rose 11.5% in March from a year earlier..."

May 17 - Bloomberg (Patrick Harrington): "Mexico's economy grew at the slowest pace in more than a year in the first quarter... Gross domestic product...grew 2.6% from a year earlier..."

May 17 - Bloomberg (Bill Faries): "Argentina's economy, the second largest in South America, expanded 7.6% in March from a year earlier..."

Central Banker Watch:

May 15- Market News International (Mark Hemingway): "The increased fluidity of international capital flows is having a number of effects on the global economy, Federal Reserve Governor Randall Kroszner said... 'First, the scale of gross capital flows throughout the world is expanding, reflecting financial innovation, lowered barriers to capital movements, and a decline in what economists refer to as 'home bias... Second, increased capital mobility is making it possible to finance ever larger current account deficits, and, indeed, these deficits have grown in recent years relative to the size of the global economy... Finally, in the aggregate, we see that capital has been flowing, on net, from emerging-market economies to industrial countries in recent years, the reverse of the pattern in previous decades'"

May 16 - Bloomberg (Ryan Flinn and Scott Lanman): "Alan Greenspan...who recently said the U.S. economy may stagnate, will advise the world's biggest bond fund in his first role since leaving his position overseeing monetary policy. He will advise Allianz SE's Pacific Investment Management Co [PIMCO]...."

Bubble Economy Watch:

May 17 - Bloomberg (Lindsay Pollock and Philip Boroff): "Andy Warhol's acid-green painting of a gruesome car wreck sold for $71.7 million last night, as Christie's international sped past rival Sotheby's to chalk up the biggest-ever auction of postwar and contemporary art. The sale in New York raised $384.7 million, beating the previous high set on Tuesday at Sotheby's by more than 50%..."

Financial Sphere Bubble Watch:

May 16 - Financial Times (Richard Milne and John Reed): "Cerberus will be able to draw on $17bn as it battles to turn round Chrysler, the US carmaker it bought on Monday for $7.4bn, after raising the biggest financing package yet for a private equity deal. A group of five banks has committed more than $60bn in financing for the US private equity firm. About $50bn of that will be needed to refinance assets that will constitute Chrysler's financial services arm, Chrysler Financial Services."

May 16 - Bloomberg (Christine Harper): "Dow Kim, the second-highest-paid executive at Merrill Lynch & Co., is resigning to form a hedge fund, the latest top manager to leave an investment bank for the higher pay of running an independent trading firm. Kim, 44, is stepping down after 13 years... While Kim's $37 million pay package last year was second at Merrill only to CEO Stanley O'Neal's, hedge-fund managers can earn as much as $1 billion..."

May 14 - Bloomberg (Elisa Martinuzzi and Todd Prince): "Within a mile of the tomb of Vladimir Lenin, who vowed to destroy capitalists, investment bankers in Moscow are now earning double the pay of their counterparts anywhere else. Dealmakers...are offered $7 million and more a year, industry recruiters said. In New York, managing directors who arrange corporate mergers and stock and bond sales typically get $2 million to $3 million... 'This market is hot, hot, hot, and if you want to keep top talent, you have to pay big,' said Peter Necarsulmer, chief executive officer of PBN Co...."

Mortgage Finance Bubble Watch:

May 15 - The Wall Street Journal (Michael Corkery): "In what could be a crippling blow to downpayment-assistance programs, the Department of Housing and Urban Development is proposing that home buyers using certain government-insured loans be prohibited from accepting down-payment gifts that are indirectly funded by the home seller. HUD's proposed rule threatens dozens of nonprofit groups, including Nehemiah Corp...that have doled out hundreds of millions of dollars of payment assistance to mostly low-income home buyers across the country. Such groups have been controversial because many provide down-payment gifts to buyers and are then reimbursed by individual home sellers and home builders. Critics say some builders have included the cost of the gift into the price of the house, which inflates values. Critics also say these gifts lead to higher than normal foreclosure rates."

Foreclosure Watch:

May 15 - Bloomberg (Hui-yong Yu): "U.S. foreclosure filings jumped 62% in April from a year earlier... California, Florida and Ohio led the U.S. in filings."

May 15 - The Wall Street Journal (James R. Hagerty): "An auction of nearly 100 foreclosed homes here [San Diego] Saturday showed that mortgage lenders are having to accept huge discounts in some cases to unload such properties. A surge of foreclosures over the past year or so has left lenders struggling to sell a growing backlog of homes. Rather than relying on real-estate agents, the usual practice, some are turning to large-scale auctions to speed up the sale process... At the San Diego sale, houses and condos typically sold for about 30% below the previous sale or appraisal prices. In a few cases, the discounts were around 50%."

MBS/ABS/CDO/Derivatives Watch:

May 16 - Reuters: "Credit derivatives are a powerful tool with a dangerously sharp edge and individuals who say they have them all figured out are crazy, central bankers were warned... 'Anyone who thinks they understand this stuff is living in lala land' former New York Federal Reserve President Gerald Corrigan told policy-makers and financiers here examining the implications of the market's explosive growth. Federal Reserve Vice Chairman Donald Kohn enjoyed the joke and advocated special fire-drills for the handful of big institutions who dominate this market, to prepare for what he called the inevitable financial shock."

May 16 - Financial Times (Saskia Scholtes): "In today's shifting credit markets, banks on the whole distribute credit exposure rather than hold on to it as they once did. This is more efficient for their balance sheets and credit derivatives help them pass the risk on. But who, then, can be left holding the other side of the derivative contracts? One answer is a new breed of financial firm, the credit derivative product company. This nascent industry is still very small, with only four groups in operation. But this year could see a raft of new CDPCs hit the market, all hoping to take a slice of this credit derivatives business and make more of it than banks can. More than a dozen hopeful firms are in the works, backed by a mixture of private equity, hedge fund and investment bank sponsors... CDPCs are triple-A rated sellers of credit default protection on highly rated corporate borrowers. That means in exchange for quarterly premiums, they provide counterparties with a kind of insurance against the bankruptcy of designated issuers of debt."

Real Estate Bubbles Watch:

May 15 - Bloomberg (Kathleen M. Howley): "U.S. home prices tumbled to a two-year low in the first quarter, with declines in almost half of U.S. cities, the National Association of Realtors said. The median price for houses and condominiums slid 1.8% to $212,300 in the first three months of this year, the lowest since the first quarter of 2005..."

May 15 - Florida Association of Realtors: "In first quarter 2007, Florida's housing sector continued to mirror the national pattern, with higher inventory levels of homes for sale, median prices edging down and soft sales reflecting a buyer's market in many areas. Statewide, sales of single-family existing homes totaled 33,748 during the three-month period, a decrease of 26%... The statewide existing-home median sales price was $237,000 in the first quarter...a decrease of 3%..."

May 16 - Bloomberg (Daniel Taub): "The number of houses and condominiums sold in the San Francisco Bay Area dropped 18% last month to the lowest level in 12 years as prices in the region rose to a record, DataQuick...said."

M&A and Private-Equity Bubble Watch:

May 15 - Bloomberg (Ambereen Choudhury): "Mergers and acquisitions, fueled by corporate deals in Europe and U.S. buyouts, reached the $2 trillion mark today, 60% ahead of last year's record pace."

May 16 - Bloomberg (Steve Matthews and Shannon D. Harrington): "Gerald Corrigan, a managing director at Goldman Sachs Group Inc., said the proliferation of loans that banks make to finance leveraged buyouts warrants a review by banking regulators. Banks are helping fund a record pace of mergers and acquisitions this year, with the value of announced leveraged buyouts soaring 40% to $188 billion in the first quarter. In some of the past year's biggest deals, including the LBO of TXU Corp., banks made short-term investments alongside the buyers in a new type of financing called 'equity bridges.'"

May 17 - CNW: "Canadian M&A activity is nearly double what it was at this point last year and has accounted for an impressive 44% of the increase in the TSX Composite over the last 12 months, finds a new report by CIBC World Markets. Canadian M&A deals have topped $175 billion so far in 2007, including $82 billion in announced transactions in the month of May alone. This comes on the heels of an 80% jump in the value of M&A transactions in 2006."

Energy Boom and Crude Liquidity Watch:

May 17 - Dow Jones (David Bird): "The U.S. imported 54.9% of its crude oil imports in March from OPEC members, the highest level of dependence since April 1993, when OPEC supplied 57.7% of imports, latest U.S. government data show. The volume of crude imported from members of the OPEC averaged 6.184 million barrels a day in the month, the most in nearly 30 years..."

May 15 - Bloomberg (Maria Ermakova and James Brooke): "Russia's real estate market is the country's 'new oil' and will fuel economic growth as property and construction companies, Cushman & Wakefield's director in Moscow said."

Fiscal Watch:

May 15 - Bloomberg (Michael B. Marois): "California's budget gap may swell to $5 billion in two years because Governor Arnold Schwarzenegger used a number of one-time fixes to balance the budget for the coming fiscal year, the state's fiscal analyst said. Under Schwarzenegger's proposed budget...state spending will outpace revenue by more than $3 billion... That gap will climb to $5 billion by the end of the following fiscal year, she said."

Speculator Watch:

May 17 - FINalternatives: "Hedge fund assets, by most measures, shattered record growth numbers last year, and the pace continued in the first quarter of 2007, according to Hedge funds manage more than $2.4 trillion, adding an estimated $250 billion -- 11.5% -- in the first three months of the year, the largest quarterly increase on record. Most of the inflow, $168.6 billion, is new money, with the remaining $78.9 billion coming from fund performance."

Bernanke on Subprime:

Chairman Bernanke yesterday provided a rather broad review of the subprime issue. Below are a few selected excerpts:

"Having emerged more than two decades ago, subprime mortgage lending began to expand in earnest in the mid-1990s, the expansion spurred in large part by innovations that reduced the costs for lenders of assessing and pricing risks. In particular, technological advances facilitated credit scoring by making it easier for lenders to collect and disseminate information on the creditworthiness of prospective borrowers. In addition, lenders developed new techniques for using this information to determine underwriting standards, set interest rates, and manage their risks."

"The ongoing growth and development of the secondary mortgage market has reinforced the effect of these innovations. Whereas once most lenders held mortgages on their books until the loans were repaid, regulatory changes and other developments have permitted lenders to more easily sell mortgages to financial intermediaries, who in turn pool mortgages and sell the cash flows as structured securities... The growth of the secondary market has thus given mortgage lenders greater access to the capital markets, lowered transaction costs, and spread risk more broadly, thereby increasing the supply of mortgage credit to all types of households."

"The practices of some mortgage originators have also contributed to the problems in the subprime sector. As the underlying pace of mortgage originations began to slow, but with investor demand for securities with high yields still strong, some lenders evidently loosened underwriting standards.

"...Incentive structures that tied originator revenue to the number of loans closed made increasing loan volume, rather than ensuring quality, the objective of some lenders."

"Intense competition for subprime mortgage business--in part the result of the excess capacity in the lending industry left over from the refinancing boom earlier in the decade--may also have led to a weakening of standards. In sum, some misalignment of incentives, together with a highly competitive lending environment and, perhaps, the fact that industry experience with subprime mortgage lending is relatively short, likely compromised the quality of underwriting."

And from Mr. Bernanke's conclusion:

"Credit market innovations have expanded opportunities for many households. Markets can overshoot, but, ultimately, market forces also work to rein in excesses. For some, the self-correcting pullback may seem too late and too severe. But I believe that, in the long run, markets are better than regulators at allocating credit."

I appreciate Mr. Bernanke's broad approach in his discussion of the subprime debacle - the interplay of "technological advancement", "financial innovation", "the secondary mortgage market", "investor demand for securities", "incentive structures", "intense competition", and "excess capacity in the lending industry." At the same time, his analysis avoids the critical issue with respect to the principal responsibility borne by unfettered "contemporary finance." Fundamentally, the proliferation of securitizations, derivatives, leveraged speculation, and, in general, "structured finance" radically distorted both the Availability of Credit and the perception and pricing of risk throughout the marketplace. This mis-pricing fostered a recursive cycle of Credit and speculative excess in the financial arena, concurrently fueling asset inflation, destabilizing speculation, and maladjustment in the real economy. Moreover, the most damaging excesses occurred in a final period of "blow-off" excesses (2005/6). This is elemental Macro Credit Analysis that the Fed shuns at our peril.

And while the chairman's analysis is in some aspects on the right track, his conclusion misses badly. As such, critical lessons were, once again, somehow not learned. For one, the issue is definitely not one of "market overshooting". And while an argument can be made today that market forces are finally reining in subprime excesses, I view this development in anything but a positive light. Unfortunately, rather than correcting or self-regulating (in response to an "overshoot"), it is much more a case of highly-adaptable Wall Street "structured finance" simply abandoning subprime for greener pastures. Today, the insatiable appetite for yield is more readily satisfied by ("subprime") loans to support private-equity, LBOs, and The Global M&A Mania.

It should be obvious that over-liquefied and speculative global markets are these days doing an especially poor job of regulating and allocating Credit. And from a systemic perspective, it is also clear that the amount and character of Credit creation and financial flows deteriorate by the month.

Elsewhere this week, I found Bill Gross's "PIMCO secular forum" article fascinating. I've never been a fan of the word "capitulation," yet the unrelenting global Credit Bubble is today forcing even the more circumspect investment professionals to fancy the glass half full; to presume that glass will hold liquid for the foreseeable future; and to concede that there is little alternative than to participate semi-blindly in the runaway boom.

In this performance-based financial world in which we now operate, one can only sit gingerly on the sideline for so long before the strain of underperformance becomes too much to bear. To be sure, we are witnessing in real time the propensity for Credit Bubbles to (more than) sustain themselves for significantly longer than discerning analysts ever imagined - and how the resulting interplay of endless liquidity, embedded asset inflation, and speculative market dynamics inherently fosters "blow-off" excess. These dynamics were at play in the U.S. bond market back in 1993, various emerging markets throughout the nineties, tech/telecom in 1999/early-2000, and more recently in U.S. subprime and global M&A. The Fed has apparently learned little.

Curiously, Mr. Gross and others continue to use the terminology "stable disequilibrium" to describe the global backdrop. Such commentary is detached from the reality of ongoing Credit Bubble excess. There is today ample evidence that each year brings with it only greater Credit excess - and with it only more dramatic inflationary effects - most notably today's gargantuan global financial flows. A semblance of "stability" is maintained only because, first of all, the global Credit infrastructure has thus far succeeded in generally channeling global flows to the securities markets, while creating the requisite ever-increasing quantities of Credit and marketplace liquidity.

The greatest Credit, speculation, and prices effects remain largely contained in global asset markets, with speculators content for now to be crowded tightly together on the long side. Financial crisis it is not, but it does conspicuously fly in the face of claims of "price stability." Indeed, global asset inflation has "gone parabolic". It is worth noting that in just the past two years China's Shanghai Composite index has surged 265%, India's Sensex 122%, Russia's RTS 187%, Mexico's Bolsa 142%, and Brazil's Bovespa 108%.

The gentlemen at Pimco (and elsewhere) also cling to the fanciful notion that that the global financial apparatus and economies are buttressed by a "Bretton Woods II" "monetary regime." I'll cling to the view that this perspective is also not conducive to sound analysis. Please recognize that monetary regimes are disciplining frameworks accepted by participants to ensure the promotion of stable Credit, financial flows, currencies, trade and economic performance. The so-called "Bretton Woods II" - the ad hoc mechanism that evolved in the global central bank community for the purpose of recycling excess dollar liquidity back to U.S. securities markets - is in reality the Anti-Monetary Regime. Its purpose - the only reason for existence - is to accommodate Credit and liquidity excess, destabilizing financial flows, unprecedented trade imbalances, and unparalleled global financial and economic imbalances. And, as we've witnessed, to accommodate is to only invite greater excess. Financial scheme, perhaps, but this is no monetary regime.

May 17 - Financial Times (Saskia Scholtes and Richard Beales): "Booming structured finance markets are pumping out huge volumes of triple-A rated debt securities even as companies find increasingly that maintaining the top credit rating is financially inefficient. Structured products now account for around 99% of the triple-A credit market, suggesting investors are eager for the higher yields such products can offer relative to triple-A corporate debt. The dominance of structured finance also marks the dramatic ascendance of a market that is heavily reliant on the rating agencies' stamp of approval... The number of US non-financial companies rated triple-A by Moody's has declined to just five...This select group has a little less than $20bn of debt. Meanwhile, the number of different US structured finance issues with the top rating has mushroomed to more than 37,000, worth almost $5,000bn in total."

These days, the numbers all seem to grow exponentially. On the one hand, there is the incredible infrastructure necessary to create sufficient U.S. Credit growth required to sustain the U.S. Credit and Economic Bubbles - to transform/"intermediate" ever-increasing quantities of riskier Credits into sufficiently precious "money"-like debt instruments. Here we see the ongoing issuance explosion of "structured" debt instruments. There is, as well, the ballooning Wall Street balance sheets and derivatives markets, along with the almost $600 y-t-d growth in primary dealer "repo" positions. Hedge fund assets were estimated to have increased by a record $250bn during the first quarter. And, importantly, debt issuance is on record pace. And, on the other hand, there is the massive expansion of foreign reserves necessary to mop up the flood of dollar liquidity inundating the global financial system. Reserves expanded about $980bn over the past year (22%) and have only accelerated of late. The U.S. Bubble is sustained, but at an escalating cost of increasingly unwieldy global flows and asset Bubbles.

And this week providing detail that illuminates ongoing Credit Bubble excess, I've excerpted from the Securities Industry and Financial Markets Association's (formerly the Bond Market Association) Quarterly Research Report:

"Capital market issuance rose to $1.78 trillion in the first quarter of 2007, a 13.0% increase over the first quarter of 2006. The pace of mergers and acquisitions (M&A) and leveraged buy-out (LBO) transaction growth drove corporate financing volumes higher. Equity underwriting increased in the quarter, boosted by higher stock prices..."

"Total net issuance of U.S. Treasury securities, including bills and coupons, was $125.7 billion in the first quarter of 2007, 20.4% lower than the $158.0 billion issued in the first quarter of 2006... The year-over-year net issuance decline is the result of reduced Treasury funding requirements as tax revenue growth lowered the federal budget deficit."

"Issuance of federal agency long-term debt totaled $262.6 billion in the first quarter of 2007, 39.8% higher than the $187.9 billion issued in the first quarter last year... The Federal Home Loan Banks increased issuance by more than 60% in the first quarter to $120.7 billion..."

"Total short- and long-term municipal securities issuance totaled $112.8 billion in the first quarter of 2007, a record for a first quarter, and 50.8% higher than the $74.8 billion issued during the first quarter of 2006."

"The corporate bond issuance machine was moving on all cylinders in the first quarter, setting another record fueled by investor risk tolerance, ample liquidity and rising setting mergers and acquisitions (M&A) and leveraged buyouts (LBOs) transaction volumes. Gross corporate bond issuance surged to a record $308.0 billion during the first quarter of 2007, a 23.6% increase over...a year ago and a 4.3% increase over the...level in the fourth quarter... M&A and LBO financed deals accounted for 43.0% of total high-yield issuance, on pace to be the highest percentage in 18 years.

"New issue volume of non-convertible investment-grade debt rose 22.3% to $269.4 billion, in the first quarter of 2007... New issue volume of non-convertible high-yield corporate debt (rated below BBB) increased 33.1% to $38.6 billion in the first quarter, up from the $29.0 billion issued in the first quarter of 2006... First quarter 2007 registered the highest first quarter volume ever... Issuance of convertible bonds -- including investment-grade and high-yield issues -- totaled $20.8 billion in the first quarter of 2007, more than double the volume during the same period last year."

"Asset-backed securities (ABS) issuance totaled $297.3 billion in the first quarter, up 3.3% from the $287.9 billion issued in the first three months of 2006... The volume growth is all the more impressive considering the decline (down 27%) in home equity loan securitization in the wake of the continued housing slowdown... Student loan ABS issuance reached a quarterly record of $26.6 billion, 64.2% higher than the $16.2 billion volume in the first quarter a year ago and 77.3% higher than fourth quarter... Credit card ABS issuance totaled $24.8 billion in the first quarter of the year, an increase over the $20.5 billion issued in the same period last year..."

"Global CDO funded issuance reached $158.4 billion in the first quarter of 2007, up 46.8% from the $107.9 billion issued in the same period last year, but nearly 11% less than the fourth quarter..."

"Issuance of mortgage-related securities, including agency and non-agency pass-throughs and CMOs, totaled $552.1 billion in the first quarter... (11%) higher than the $497.2 billion issued in the first quarter of 2006 and the $493.2 billion issued last quarter. First quarter volume was the highest since the second quarter of 2005 and March issuance of $208.0 billion was the highest monthly total since September of 2005... Issuance of agency mortgage-backed pass-throughs totaled $287.8 billion in the first quarter, an increase of 27.8% from the same period last year... Non-agency MBS issuance, including jumbo and higher-quality residential and commercial mortgage-backed securities, increased to a quarterly record of $205.3 billion in the first quarter, 5.4% higher (y-o-y)... Commercial mortgage-backed securities (CMBS) issuance totaled $52.5 billion in the first quarter of the year, up 29.9%..."

"The average daily volume of total outstanding repurchase (repo) and reverse repo agreement contracts increased 2.5% in the first quarter to $5.81 trillion... Over $114.3 trillion in repo trades were submitted by GSD (The Fixed Income Clearing Corporation's Government Securities Division) participants in the first quarter of 2007, with an average daily volume of approximately $1.8 trillion."

"The outstanding volume of total money market instruments, including commercial paper (CP) and large time deposits, totaled more than $4.11 trillion at the end of March 2007, a 2.5% increase from the end of the fourth quarter... CP outstanding rose to $2.0 trillion...a 17.6% (y-o-y) increase..."

"The average daily value of trading on both the NYSE and NASDAQ hit record highs in the first quarter, at $80.9 billion and $54.1 billion, up 18.1% and 15.7%, respectively, from the previous quarter... Total equity underwriting of common and preferred stock topped $60 billion for the second consecutive quarter at $61.4 billion issued on 202 deals. First quarter volume was 42.6% higher than in the first quarter of 2006... This marked the first time $60 billion of equity was raised in consecutive quarters in nearly seven years..."

"US M&A activity, including LBOs, maintained its elevated pace into the first quarter following the strong fourth quarter of 2006. First quarter announcements totaled $449.9 billion on 2,670 deals... First quarter volume beat that of the same year-earlier period by 34.8%... S&P share repurchase dollar volume hit $95 billion, on track to beat 2006 by a wide margin..."



Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin

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