For the Twenty-First Century

By: Doug Noland | Fri, Jun 15, 2007
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For the week, the Dow gained 1.6% (up 9.4% y-t-d) and the S&P500 1.7% (up 8.1%). The Transports gained 1.1% (up 13.5%), and the Utilities jumped 3.4% (up 9.4%). The Morgan Stanley Cyclical index rose 1.8% (up 22%), and the Morgan Stanley Consumer index added 0.6% (up 6.3%). The small cap Russell 2000 gained 1.5% (up 7.7%) and the S&P400 Mid-Cap index 1.4% (up 13.4%). Technology stocks were strong. The NASDAQ100 jumped 1.9% (up 10.6%) and the Morgan Stanley High Tech index 1.8% (9.7%). The Semiconductors rose 2.9% (up 7.4%). The Street.com Internet Index gained 1.0% (up 9.7%), and the NASDAQ Telecommunications index surged 2.9% (up 8.8%). The Biotechs increased 2.1% (up 7.1%). The volatile Broker/Dealers managed a rise of 0.7% (up 9.7%), while the Banks rallied 1.2% (down 0.8%). With Bullion rallying $6.30, the HUI Gold index recovered 3.1%.

June 13 - Dow Jones (Emily Barrett): "In the last few decades, overseas investors used to get up in the middle of the night to check the news on the U.S. economy. These days, it may be the other way around. In today's financial market environment, with Treasurys testing their weakest levels in more than five years, U.S. investors can hardly afford to be parochial. Stock and bond trading in Asia and Europe is increasingly setting the scene for the U.S. market, and international growth and inflation indicators have become compelling reading for investors sweating the global trend toward higher interest rates."

Two-year U.S. government yields increased 2 bps to 5.01%. Five-year yields gained 3 bps to 5.08%. Ten-year Treasury yields rose 4.5 bps to 5.15% after trading above 5.30% Tuesday. Long-bond yields ended the week up 4 bps to 5.25%. The 2yr/10yr spread ended the week at 14 bps. The implied yield on 3-month December '07 Eurodollars rose another 2.5 bps to 5.38%. Benchmark Fannie Mae MBS yields added 2 bps to 6.29%, this week recovering some of last week's underperformance to Treasuries. The spread on Fannie's 5% 2017 note narrowed 2 to 41, and the spread on Freddie's 5% 2017 note narrowed 2 to 40. The 10-year dollar swap spread declined 0.75 to 59.25. Corporate bond spreads were mixed this week, with the spread on a junk index 8 bps wider.

Investment grade issuers included Hewlett-Packard $2.0bn, Weatherford $1.5bn, HSBC $1.0bn, National Semiconductor $1.0bn, Mellon Capital $500 million, Union Electric $425 million, Cooper $300 million, Mackinaw Power $290 million, Atmos Energy $250 million, Webster Capital $200 million, and Indianapolis P&L $165 million.

Junk issuers included El Paso Corp $1.25bn, Plains Exploration $600 million, and Algoma Acquisition $450 million.

This week's convert issuers included Molson Coors $500 million, Iconix Brand $250 million, Sunstone Hotel $220 million, Northstar Realty $150 million, Blackboard $150 million, Aspect Medical $110 million, and Trex $85 million.

International dollar bond issuers included Clondalkin $150 million, and Banco Hipotecario $150 million.

June 11- Bloomberg (Tony Barrett): "Emerging markets received $341 billion of new credit inflows in 2006, up 47% from a year earlier as borrowing increased to a record in developing Europe, according to the Bank for International Settlements. Investment and lending have boomed in eastern Europe, pushing up wages and spurring consumer spending, as eight nations joined the European Union in 2004 and a further two followed this year. More than 60% of new credit to emerging markets went to European countries in the last three months of 2006, the BIS said..."

German 10-year bund yields jumped 8.5 bps to 4.65%, while the DAX equities index increased y-t-d gains to 21.7%. Japanese 10-year "JGB" yields rose 4.5 bps to 1.93%. The Nikkei 225 rallied 1.1%, increasing y-t-d gains to 4.3%. Many emerging equities markets traded to new record highs, as debt markets regained their composure. Brazil's benchmark dollar bond yields declined 6 bps this week to 6.06%. Brazil's Bovespa equities index surged 4.2% to a new record, in the process increasing y-t-d gains to 22.6%. The Mexican Bolsa rose 2.1%, increasing 2007 gains to 21.5%. Mexico's 10-year $ yields added 3 bps to 5.93%. Russia's RTS equities index jumped 4.4% (down 2.0% y-t-d). India's Sensex equities index added 0.7% (up 2.7% y-t-d). China's Shanghai Composite index rose 5.6%, increasing y-t-d gains to 54% and 52-week gains to 169%.

Freddie Mac posted 30-year fixed mortgage rates surged 21 bps to 6.74% (up 11bps y-o-y), a jump of 59 bps in five weeks to the highest borrowing rate since last July. Fifteen-year fixed rates jumped 21 bps to 6.43% (up 18bps y-o-y). One-year adjustable rates rose 10 bps to 5.75% (up 9bps y-o-y). Curiously, the Mortgage Bankers Association Purchase Applications Index jumped 7.2% this week to the highest level since the first week of January. Purchase Applications were up 11.9% from one year ago, with dollar volume 19.6% higher. Refi applications gained 5.6% for the week, with dollar volume up 27.7% from a year earlier. The average new Purchase mortgage jumped to $242,500 (up 6.9% y-o-y), while the average ARM rose to $407,600 (up 19.5% y-o-y).

Bank Credit declined $18.5bn (week of 6/6) to $8.56 TN. For the week, Securities Credit declined $7.9bn. Loans & Leases dropped $10.5bn to $6.270 TN. C&I loans actually jumped $12.2bn, and Real Estate loans gained $5.0bn. Consumer loans were virtually unchanged. Securities loans sank $17.7bn, and Other loans fell $10.1bn. On the liability side, (previous M3) Large Time Deposits rose $2.8bn.

M2 (narrow) "money" dipped $1.6bn to $7.240 TN (week of 6/4). Narrow "money" has expanded $197bn y-t-d, or 6.3% annualized, and $448bn, or 6.6%, over the past year. For the week, Currency added $0.3bn, and Demand & Checkable Deposits jumped $27.8bn. Savings Deposits dropped $32.2bn, and Small Denominated Deposits slipped $0.5bn. Retail Money Fund assets gained $3.1bn.

Total Money Market Fund Assets (from Invest. Co Inst) rose $4.1bn last week to a record $2.530 TN. Money Fund Assets have increased $148bn y-t-d, a 13.5% rate, and $424bn over 52 weeks, or 20.1%.

Total Commercial Paper rose $5.7bn last week to a record $2.121 TN, with a y-t-d gain of $146bn (16.1% annualized). CP has increased $344bn, or 19.3%, over the past 52 weeks.

Asset-backed Securities (ABS) issuance slowed to $11bn. Year-to-date total US ABS issuance of $326bn (tallied by JPMorgan) is running about 1% behind comparable 2006. At $155bn, y-t-d Home Equity ABS sales are 34% below last year's pace. Meanwhile, y-t-d US CDO issuance of $167 billion is running 19% ahead of record 2006 sales.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 6/13) were about unchanged at $1.955 TN. "Custody holdings" were up $203bn y-t-d (25% annualized) and $323bn during the past year, or 19.8%. Federal Reserve Credit last week dropped $7.9bn to $850bn. Fed Credit has declined $2.2bn y-t-d, or 0.6% annualized, with one-year growth of $25.2bn (3.1%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $607bn y-t-d (27% annualized) and $962bn y-o-y (22%) to a record $5.417 TN.

Currency Watch:

The dollar index added 0.2% to 82.60. On the upside, the Iceland krona gained 2.3%, the Brazilian real 1.9%, the Turkish lira 1.9%, the Hungarian forint 1.6%, and the Bolivian boliviano 1.5%. On the downside, the Japanese yen declined 1.4%, the Canadian dollar 0.7%, the Swedish krona 0.6%, and the Taiwan dollar 0.5%.

Commodities Watch

June 14 - Bloomberg (Tony C. Dreibus): "Wheat rose in Chicago and Kansas City, extending its rally to the highest price since 1996, as overnight storms delayed the harvest of U.S. crops already diminished by an earlier cold spell."

For the week, Gold gained 1.0% to $655.15 and Silver 1.7% to $13.26. Copper rallied 5.0%. July crude surged $3.24 to a 9-month high $68.00. July gasoline jumped 6.3%, and July Natural Gas advanced 3.3%. For the week, the CRB index rose 3.8% (up 3.9% y-t-d), and the Goldman Sachs Commodities Index (GSCI) jumped 5.2% (up 14.2% y-t-d).

Japan Watch:

June 11- Bloomberg (Lily Nonomiya): "Japan's economy expanded more than the government initially reported in the first quarter after higher-than-expected spending by companies. The world's second-largest economy grew at an annual 3.3% rate in the three months ended March 31..."

June 13 - Bloomberg (Toru Fujioka): "Japan's current account surplus widened in April as exports to Asia and Europe helped counter slower growth in shipments to the U.S. The surplus expanded 50.3% to 1.99 trillion yen ($16 billion) from a year earlier..."

June 12 - Market News International (Yoji Inata): "The La Nina effect is expected to hit Japan with heat waves this summer, boosting sales of air conditioners, beverages and clothing and spending on leisure, but a water shortage would stifle production of steel, semiconductors and paper, analysts said..."

China Watch:

June 14 - Bloomberg (Zhang Dingmin): "China's economy will grow 10.6% this year, boosted by consumption, and its trade surplus may widen 48% to $260 billion, the Bank of Communications said in a report published in the China Securities Journal."

June 11- Bloomberg (Nipa Piboontanasawat): "China's trade surplus swelled a bigger-than-estimated 73% in May, increasing pressure on the government to allow faster currency gains. The gap widened to $22.45 billion..."

June 12 - Market News International: "Chinese broad money supply decelarated slightly last month following a slew of recent monetary tightening measures... M2 rose 16.7% year-over-year at the end of May compared with April's 17.1% rate."

June 13 - Financial Times (Jamil Anderlini and Sky Canaves): "China's banks are laden with cash and ready to take on the world - just as the Japanese banks were half a generation ago. The parallels are not lost on regulators in China or those in the developed world, who are wary about allowing banks that were insolvent just a few years ago into their domestic markets. Beijing issues regular warnings to Chinese lenders to improve their risk management and has so far only approved a handful of small offshore acquisitions."

June 12 - Bloomberg (Nipa Piboontanasawat): "China's inflation accelerated at the fastest pace in more than two years in May as pork prices soared, increasing the likelihood that interest rates will be raised. Consumer prices rose 3.4% from a year earlier..."

June 14 - Bloomberg (Nipa Piboontanasawat and Li Yanping): "China's government reported industrial production growth unexpectedly accelerated in May, hours after Premier Wen Jiabao said further steps are needed to cool the world's fastest-growing major economy. Production by factories, mines and utilities rose 18.1% in May from a year earlier..."

June 13 - Bloomberg (Li Yanping and William Bi): "The soaring pork prices that pushed China's inflation rate to the highest in more than two years aren't all bad news: Farmers' incomes are getting a boost and that may increase consumer spending and lower dependence on exports. Meat prices surged 26.5% in May from a year earlier because of a pig shortage linked to increased grain prices."

June 13 - Bloomberg (Nipa Piboontanasawat): "China's retail sales unexpectedly accelerated at the fastest pace in three years, buoyed by rising incomes and a stock market that's doubled this year. Sales rose 15.9% from a year earlier to 715.8 billion yuan ($94 billion) after gaining 15.5% in April..."

India Watch:

June 12 - Bloomberg (Cherian Thomas): "India's industrial production growth beat expectations in April, suggesting the central bank may need to raise borrowing costs further to contain inflation stoked by consumer demand. Output gained 13.6% from a year earlier..."

Asia Boom Watch:

June 14 - Bloomberg (Chen Shiyin): "An apartment unit at City Developments Ltd.'s downtown St. Regis Residences in Singapore was sold at a record price as demand for luxury homes rises... The two-floor penthouse was sold for S$28 million ($18 million), or S$4,653.50 a square foot, to a foreign buyer last month..."

Unbalanced Global Economy Watch:

June 14 - Bloomberg (Simon Packard): "Luxury home prices in London, the world's most expensive city, may increase at a slower pace this year as more properties come onto a market with fewer buyers, real estate broker Knight Frank LLC said. The average price of London's costliest houses and apartments probably will climb about 20% this year after an almost 29% gain in 2006..."

June 14 - Bloomberg (Brian Parkin): "Germany's IfW Kiel institute, one of five that advise the government, said it expects Europe's biggest economy to expand this year at the fastest pace since 2000, spurred on by exports and growing consumer demand at home. The IfW raised its economic-growth forecast for 2007 to 3.2%..."

June 12 - Bloomberg (Rainer Buergin): "German business confidence rose in April and May to the highest level since the country's re-unification in 1990 as managers stepped up investment and hiring plans, a survey of more than 20,000 companies showed..."

June 14 - Bloomberg (Beate Evensen and Vibeke Laroi): "Norway's global pension fund, the largest savings plan in Europe, increased its assets by 2.9% in May, the country's central bank said. The fund held 1.96 trillion kroner ($322 billion) at the end of May..."

June 13 - Bloomberg (Diana ben-Aaron): "Finland's economy grew an annual 5.5% in the first three months of the year, more than expected and the fifth consecutive quarter above 4%. Growth accelerated from 4.5% in the fourth quarter..."

June 14 - Bloomberg (Adam Brown): "Romania's unemployment rate fell to a 15-year low in May... Unemployment fell to 4.1% in May from 4.5% in April..."

June 14 - Bloomberg (Maria Levitov): "Russia's economy expanded in the first quarter at the fastest pace in six years as production of building materials and electronics increased. Gross domestic product grew an annual 7.9% in the first quarter..."

June 14 - Bloomberg (Maria Levitov): "Russia increased imports from countries outside of the former Soviet Union by 53% in the first five months of this year from the year-earlier period, the Federal Customs Service said... Imports totaled $56.54 billion from January through May..."

Latin American Boom Watch:

June 13 - Bloomberg (Katia Cortes): "Brazil's economy expanded in the first quarter as 16 straight cuts to the benchmark lending rate spurred consumer demand and encouraged companies to boost local production. Brazil's economy grew 4.3% in the first quarter from the same period a year earlier..."

June 14 - Bloomberg (Bill Faries): "Argentina's economy slowed in the first quarter of the year as construction, financial services and the production of manufactured goods moderated. Argentina's gross domestic product, the broadest measure of a country's output of goods and services, grew 8% in the first quarter of 2007..."

Central Banker Watch:

June 14 - Bloomberg (Simone Meier): "The Swiss central bank raised its benchmark interest rate to a six-year high today and said more increases are likely to prevent an expanding economy and a weaker franc from stoking inflation. The Swiss National Bank increased the three-month Libor target rate by a quarter-point to 2.5 percent, the highest since September 2001."

Bubble Economy Watch:

At 4.1%, May's stronger-than-expected y-o-y increase in Producer Prices is the highest since June '06. May Retail Sales were up a stronger-than-expected 1.4%, with y-o-y sales up 5.4%. May Consumer Prices were up 2.7% from one year ago.

June 13 - Bloomberg (Alan Bjerga and Carol Massar): "U.S. consumers are paying 8% to 10% more for breakfast foods than a year ago because of rising prices for corn, wheat, milk and other commodities, a Department of Agriculture economist said. Commodity inflation 'is starting to work its way through the system,' Ephraim Leibtag of the USDA's Economic Research Service said... 'The last few months we've seen it rise.'"

June 14 - BusinessWire: "While confidence in the U.S. economy continues to fluctuate, affluent consumers remain committed to maintaining their luxury lifestyles. In 2006 American affluent consumers continued to spend significant amounts of money indulging in luxury goods and services. The typical luxury consumer's spending on luxuries rose 6.6% to reach $56,065, following an increase of 3.8% in spending in 2005..."

Mortgage Finance Bubble Watch:

June 14 - Bloomberg (Jody Shenn and Yalman Onaran): "Bear Stearns Cos., the second-biggest U.S. underwriter of mortgage bonds, is liquidating holdings from one of its hedge funds after making money-losing bets on subprime home loans, said three people with knowledge of the decision."

Foreclosure Watch:

June 12 - Bloomberg (Kathleen M. Howley): "U.S. foreclosure filings surged 90% in May from a year earlier as more homeowners fell behind on their monthly mortgage payments, RealtyTrac Inc. said. There were 176,137 notices of default, scheduled auctions and bank repossessions last month, led by California, Florida and Ohio..."

June 14 - Bloomberg (Kathleen M. Howley): "The number of U.S. homeowners who face possible eviction because of late mortgage payments rose to an all-time high in the first quarter, led by subprime borrowers, as the economy grew at the slowest pace in four years. The share of mortgages entering foreclosure rose to 0.58%, including so-called prime loans made to the most credit-worthy borrowers, from 0.54% in the fourth quarter, the Mortgage Bankers Association said... Subprime loans entering foreclosure rose to a record 2.43%, up from 2% in the prior quarter..."

MBS/ABS/CDO/Derivatives Watch:

June 11- Bloomberg (Darrell Hassler): "Derivatives traded on global exchanges rose 24% in the first quarter to a record $533 trillion on growing use of interest rate futures, currency futures and stock index options, the Bank for International Settlements said..."

June 14 - Market News International: "The latest BIS quarterly report...has shown strong ongoing growth in the CDO market, with the overall global issuance for 1Q 2007 standing at $251bn, another record level. Issuance in CDS backed by ABS rose to $58bln from $48bln in the last quarter of 2006. Significantly though the growth in synthetic CDO's or CDO's which are backed by CDS, grew to $121bln, up from $92bln in the previous quarter. The BIS cited the strong growth in synthetic CDO issuance as being behind the divergence of spreads and premia of CDS to comparable corporate bonds..."

June 12 - Bloomberg (Jody Shenn): "The perceived risk of owning low-rated subprime-mortgage bonds created in the second half of 2006 rose to a near record today as loan delinquencies and mortgage rates climb, according to an index of credit derivatives."

June 12 - Bloomberg (Jody Shenn): "Moody's...so far this year has cut or considered lowering ratings on 139 classes of securitizations in 2006 of U.S. subprime second mortgages. The ratings actions, which compares with 29 for 2005 issues, comprise 14% of the classes of subprime second-mortgage bonds sold last year..."

June 12 - Financial Times (Stacy-Marie Ishmael ): "Investors should demand more transparency and accountability from managers of collateralised loan obligations, according to...Standard & Poor's. The rating agency said the rising popularity of so-called covenant-lite loans imposed significant risks on investors in the opaque CLO market. Demand for CLOs, complex financial instruments which repackage portfolios of loans, has surged recently... In the first quarter of 2007, global covenant-lite loan volume reached $48bn, compared with $24bn recorded for the whole of last year. The use of these loans to fund buy-outs is already well-established in the US and becoming more accepted in Europe."

June 12 - Bloomberg (Darrell Hassler): "Goldman Sachs Group Inc. sold the first security backed by so-called catastrophe bonds as more insurance companies seek to spread the risk of potential losses from hurricanes, earthquakes and other natural disasters. The $310 million collateralized debt obligation was sold on May 29 and will be managed by Bermuda-based Nephila Capital Ltd...."

Real Estate Bubbles Watch:

June 13 - Bloomberg (Daniel Taub): "The number of homes sold in Southern California fell 34 percent last month to the lowest level in 12 years even as prices matched a record, DataQuick...said. A total of 19,874 new and existing single-family homes and condominium units were sold in Los Angeles, Riverside, San Diego, Ventura, San Bernardino and Orange counties last month, down from 30,303 a year earlier... It was the lowest sales count for any May since 1995, when 17,712 homes changed owners."

June 13 - Bloomberg (Daniel Taub): "U.S. commercial real estate investment reached a record $157 billion in the first four months of 2007, up 62% from a year earlier, due to a surge in office purchases, the National Association of Realtors said. Office-building transactions from January through April totaled $95 billion, a record for the period..."

M&A and Private-Equity Bubble Watch:

June 12 - Financial Times (James Politi, Ben White and Francesco Guerrera): "Blackstone co-founders Pete Peterson and Steve Schwarzman will together reap as much as $2.5bn from the US buy-out group's initial public offering... The sum highlights the extraordinary wealth private equity executives have created for themselves during the industry's recent boom years. This has both elevated their status and influence in global business and attracted increasing scrutiny from politicians and regulators. Mr Peterson...will be selling 59.9% of his stake in the company, for a sum of $1.88bn... He will only own 4% of Blackstone after the stock market listing... Mr Schwarzman...will be selling a 5.7% stake for $677m. After the IPO, Mr Schwarzman will be by far the biggest shareholder in Blackstone, with a stake of 23% worth more than $7bn."

Energy Boom and Crude Liquidity Watch:

June 12 - The Wall Street Journal (Ana Campoy and Russell Gold): "The cost of building or expanding oil refineries is rising rapidly, contributing to delays in increasing the U.S. gasoline supply at a time of near-record prices. The oil industry is blaming cost escalation -- driven by shortages of skilled labor and construction services, along with higher materials prices -- for a spate of pushed-back or scrapped expansion projects. Valero Energy Corp., the U.S.'s largest refiner in terms of the amount of crude it can refine, has delayed expansions in Quebec, Canada, and in Texas. ConocoPhillips has put off projects at refineries in Texas and in Louisiana, while Tesoro Corp. canceled the installation of new equipment to process cheaper crude at a facility in Anacortes, Wash."

June 12 - Bloomberg (A. Craig Copetas): "It's molting season in the Kingdom of Saudi Arabia and change is in the air... Tabouk Regional Governor Prince Fahd bin Sultan, this year will begin construction on what is intended as a showcase for a new Saudi Arabia: a $300 billion multicultural metropolis designed to lure 700,000 inhabitants from around the globe. The construction of this and five other megacities scheduled for completion by 2020 will be funded by oil revenue."

June 11- Bloomberg (Ian McKinnon and Reg Curren): "Alberta's oil-based economy is forecast to expand almost twice as fast as the rest of Canada's this year, pushing unemployment to a 30-year low. The growth is bringing surging housing costs, a shortage of hospital beds, and a lack of schools and recreation facilities for a population that has gained 10% in five years."

June 14 - Bloomberg (Matthew Brown): "Increased lending to Kuwaiti residents by commercial banks' may increase inflation in the oil rich Gulf state, HSBC Holdings Plc. said. Commercial banks in Kuwait increased lending to residents by 4.3% in May from a month earlier to 17 billion dinars ($59 billion), an annual increase of 29%, the Central Bank of Kuwait said..."

Climate Watch:

June 12 - Bloomberg (Demian McLean): "A key weather satellite could fail soon, leaving U.S. hurricane forecasters blinded and coastal cities in danger, the Associated Press said, citing scientists including the head of the National Oceanographic and Atmospheric Administration. The QuikScat satellite, which isn't scheduled for replacement till 2016, lost its main transmitter last year and is using a backup, the news service said."

Fiscal Watch:

June 11 - New York Times (Jennifer Steinhauer): "State lawmakers across the country, their coffers unexpectedly full of cash, have been handing out tax cuts, spending money on fixing roads, schools and public buildings, and socking something away for less fruitful years. Budget surpluses have largely stemmed from higher than expected tax collections -- corporate tax revenues alone were 11% higher than budget estimates -- and booming local economies... More than 40 states have found themselves with more money than they planned as they wound down their regular sessions. Governors in 23 of those states proposed tax cuts, and a majority of states with surpluses chose to shore up their roads, schools and rainy day funds... The extra cash over the last two budget sessions (many states work on a two-year cycle) is at the highest level since 2000, state budget experts say."

Speculator Watch:

June 12 - Financial Times (Martin Arnold): "Europe's venture capital market recovered sharply last year, as money raised by funds investing in start-ups and early-stage companies rose 60% to the highest level since the peak of the internet bubble in 2000. The findings, published in a report by the European Venture Capital Association today, suggest investors are regaining their appetite for the riskier end of the private equity market."

Financial Sphere Earnings Watch:

Lehman Brothers reported fiscal 2nd quarter earnings of $1.3bn, up 27% from Q2 2006. Net Revenues were up 25% y-o-y to $5.512bn. Capital Markets net revenues were up 17% from Q2 '06 to $3.6bn. "Equities Capital Markets reported net revenues of $1.7 billion, nearly double the $878 million reported" in Q2 '06. "Investment Banking reported record revenues of $1.2bn, an increase of 55%... This increase was driven by record debt origination revenues, which rose 87% to $540 million... Investment Management reported record net revenues of $768 million, an increase of 30%..." The company's M&A pipeline ended the quarter at an astounding $584bn, with record pipelines in all major businesses. "Fixed Income Capital Markets reported net revenues of $1.9 billion, a decrease of 14%..., as strong client demand across most products and increased real estate and credit product revenue were more than offset by continued weakness in the U.S. residential mortgage business..." While U.S. mortgage finance struggled, international finance boomed. "Non-U.S. net revenues represented 48% of the Firm's quarterly net revenues..." Combined Europe and Asia revenues were up 62% y-o-y to a record $2.6bn. Lehman's Total Assets jumped $44.3bn during the quarter to $605bn (36% pace). This increased first-half growth to $101bn, or 40% annualized. The company repurchased 7.2 million shares during the quarter.

Macro comments from Lehman's earnings conference call: "Global equity trading volumes rose approximately 13% in dollar value terms... High grade credit spreads widened very slightly during the quarter, while high yield and emerging market credit spreads tightened significantly to their all time narrowest levels... The volume of announced M&A transactions was a record $1.7 TN for the period, rising 69% sequentially and surpassing the prior record set in year 2000. In equity underwriting, volumes increased 23% versus the prior period, driven by an increase in IPO and convertible activity. Debt underwriting volumes grew by 8% compared to the sequential period." "...Global liquidity remained strong with considerable corporate cash on hand, large pools of un-invested capital from financial sponsors, a growing allocation of assets to hedge funds, cash consideration from M&A, proceeds from share buybacks that need to be invested, and continued inflows from regions such as Asian and the Middle East. If anything, these trends are accelerating... This pool of liquidity continues to provide a strong underpinning for the global capital markets and for our own client-focused business model."

Goldman Sachs reported Net Revenues of $10.18bn for the second quarter, about in line with the year ago period. Earnings were flat y-o-y at $2.287bn. Compensation expense was down 4% to $4.887bn. "Net revenues in Investment Banking were $1.72bn, 13% higher than the second quarter of 2006...as mergers and acquisitions and financing activity remained strong." "Underwriting revenues were $1.0bn, 18% above the first quarter. Debt underwriting revenues grew 11%...and equity underwriting revenues grew 35%..." The investment banking backlog reached a new record during the quarter. At the same time, "Net revenues in Fixed Income, Currency and Commodities (FICC) were $3.37bn, 24% lower than the second quarter of 2006, primarily reflecting lower net revenues in commodities and weak results in mortgages, principally attributable to continued weakness in the subprime sector... Net revenues in Equities were $2.50bn, 6% higher..." "Asset under management increased 28% from a year ago to a record $758bn, with net asset inflows of $18bn during the quarter." International accounted for approximately 52% of revenues. The company repurchased 5.4 million shares during the quarter, at a cost of $1.13bn. Goldman does not release balance sheet data with its earnings release.

For the Twenty-First Century:

Today, Chairman Bernanke presented a paper, The Financial Accelerator and the Credit Channel, at the Federal Reserve of Atlanta's conference on The Credit Channel of Monetary Policy in the Twenty-First Century. It is a technical discussion of issues near and dear to my analytical heart - and worth plodding through. I'll excerpt and attempt an argument against conventional doctrine.

From Dr. Bernanke:

"Economic growth and prosperity are created primarily by what economists call 'real' factors--the productivity of the workforce, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers. But extensive practical experience as well as much formal research highlights the crucial supporting role that financial factors play in the economy... In the United States, a deep and liquid financial system has promoted growth by effectively allocating capital and has increased economic resilience by increasing our ability to share and diversify risks both domestically and globally."

My comment: The dilemma today is that current forces supporting "economic growth and prosperity" are primarily of a financial nature. Credit growth and resulting asset inflation and financial flows dictate the nature of economic activity to a greater degree each passing year. The pricing mechanism and incentive structure have been debauched. To be sure, financial "profits" have come to command system behavior. Yet as long as sufficient system Credit creation is maintained - readily providing ample new purchasing power throughout - the "services"-based U.S. economy plows right along, emboldening the New Era crowd and aggressive risk-takers in the process. Traditional frameworks and conventional thinking are in large part worthless, at best.

And it is certainly not, as Greenspan and Bernanke insist, a case of "effectively allocating capital." Instead, today's (global) prosperity is the upshot of an unrelenting boom in new Credit powering myriad Bubble processes and dynamics. As such, Dr. Bernanke's analysis is hopelessly archaic. Today, New Credit is so readily available that the "effectiveness" of its allocation is beside the point. So far, contemporary Credit systems have proved remarkably resilient. This dynamic is misinterpreted as economic "resiliency," when in fact economic systems have become precariously dependent upon (addicted to) uninterrupted rampant Credit creation and flows of speculative-based liquidity. We delude ourselves with fanciful notions of our newfound "ability to share and diversity risks," when the issue is actually the postponement of the day of reckoning through ever greater risk-taking.

It is curious how Dr. Bernanke can offer an extensive discussion - where he highlights academic work related to "financial accelerators" and "Credit channels" - without addressing Wall Street broker/dealers, hedge funds, private equity, securitizations, "repos," derivatives and foreign financial flows (certainly including the central banks). His approach remains little tweaks to the traditional bank centric analytical approach, conveniently chucking the heart of contemporary finance into the nondescript category "non-banks." Old paradigm frameworks won't suffice for the New Credit Paradigm; clearly, the research community has decades of catching up to do.

"Just as a healthy financial system promotes growth, adverse financial conditions may prevent an economy from reaching its potential. A weak banking system grappling with nonperforming loans and insufficient capital or firms whose creditworthiness has eroded because of high leverage or declining asset values are examples of financial conditions that could undermine growth. Japan faced just this kind of challenge when the financial problems of banks and corporations contributed substantially to sub-par growth during the so-called 'lost decade.'"

The critical flaws in Dr. Bernanke's framework at times shine through in this presentation. He instinctively sees the boom period as sound and, apparently with astute policymaking, sustainable. There is no recognition that a so-called "healthy financial system" may over time sow the seeds of boom/bust dynamics and inevitable financial and economic impairment. The primary role of activist policymaking revolves around rectifying "adverse financial conditions" that occasionally hold prosperity at bay. A "weak banking system" can and should be avoided by manipulating the inflationary process. Post-Bubble policy errors were to blame for Japan's "lost decade" - not spectacular inflationary Bubble excesses. More grievous policy blunders - and not a more reckless boom - were to blame for the Great Depression.

"Putting the issue in the context of U.S. economic history, I laid out, in a 1983 article, two channels by which the financial problems of the 1930s may have worsened the Great Depression).

The first channel worked through the banking system. As emphasized by the information-theoretic approach to finance, a central function of banks is to screen and monitor borrowers, thereby overcoming information and incentive problems. By developing expertise in gathering relevant information, as well as by maintaining ongoing relationships with customers, banks and similar intermediaries develop 'informational capital.' The widespread banking panics of the 1930s caused many banks to shut their doors; facing the risk of runs by depositors, even those who remained open were forced to constrain lending to keep their balance sheets as liquid as possible. Banks were thus prevented from making use of their informational capital in normal lending activities. The resulting reduction in the availability of bank credit inhibited consumer spending and capital investment, worsening the contraction."

My comment: Banks were "prevented from making use of their informational capital" because the "marketplace" had lost faith in their (deposits) and others' liabilities. Boom-time Credit and speculative excess and resulting Monetary Disorder had precariously distorted asset prices, earnings, incomes and the flow of finance throughout the U.S. and global economies. The scope of the preceding Bubble excesses ensured Credit system impairment, "runs" from risky assets, and rather deep-seated disillusionment. The inflationary boom had severely corrupted the financial intermediation process.

"The second channel through which financial crises affected the real economy in the 1930s operated through the creditworthiness of borrowers. In general, the availability of collateral facilitates credit extension. The ability of a financially healthy borrower to post collateral reduces the lender's risks and aligns the borrower's incentives with those of the lender. However, in the 1930s, declining output and falling prices (which increased real debt burdens) led to widespread financial distress among borrowers, lessening their capacity to pledge collateral or to otherwise retain significant equity interests in their proposed investments. Borrowers' cash flows and liquidity were also impaired, which likewise increased the risks to lenders. Overall, the decline in the financial health of potential borrowers during the Depression decade further impeded the efficient allocation of credit. Incidentally, this information-based explanation of how the sharp deflation in prices in the 1930s may have had real effects was closely related to, and provided a formal rationale for, the idea of 'debt-deflation,' advanced by Irving Fisher in the early 1930s (Fisher, 1933)."

It is fundamental Macro Credit Theory that "the availability of collateral facilitates Credit extension." Surely, an increase in Credit Availability and the flow of marketplace liquidity will tend to support asset inflation. Higher asset ("collateral") prices, then, foster further augmented Credit expansion and, almost certainly, greater speculative activity. "Collateral" can actually be a bigger issue during the boom, and I disagree with Dr. Bernanke's contention that "The ability of a financially healthy borrower to post collateral reduces the lender's risks and aligns the borrower's incentives with those of the lender."

In reality, Credit booms inherently inflate asset prices, incomes and business "cash flows", in the process creating a steady flow of so-called "healthy borrowers" willing to perpetuate an increasingly unwieldy Bubble - surreptitiously increasing lender risk throughout the life of the boom. Moreover, it is the nature of Credit "blow-offs" that lender risk grows exponentially as collateral values inflate most spectacularly. Only careful analysis of the underlying Credit process will provide an informed view of the true health of most borrowers. And, as far as the alignment of incentives, the further into Bubble excess the greater the incentive for the financing community to loosen lending standards sufficiently in order to perpetuate the boom (think telecom '99 or subprime '06). Seemingly robust "borrowers' cash flows and liquidity" abruptly turn suspect with the arrival of the inevitable bust.

"The ideas I have been discussing today have also been useful in understanding the nature of the monetary policy transmission process. Some evidence suggests that the influence of monetary policy on real variables is greater than can be explained by the traditional 'cost-of-capital' channel, which holds that monetary policy affects borrowing, investment, and spending decisions solely through its effect on the level of market interest rates. This finding has led researchers to look for supplementary channels through which monetary policy may affect the economy. One such supplementary channel, the so-called credit channel, holds that monetary policy has additional effects because interest-rate decisions affect the cost and availability of credit by more than would be implied by the associated movement in risk-free interest rates... The credit channel, in turn, has traditionally been broken down into two components or channels of policy influence: the balance-sheet channel and the bank-lending channel (Bernanke and Gertler, 1995). The balance-sheet channel of monetary policy is closely related to the idea of the financial accelerator that I have already discussed. That theory builds from the premise that changes in interest rates engineered by the central bank affect the values of the assets and the cash flows of potential borrowers and thus their creditworthiness, which in turn affects the external finance premium that borrowers face...

Historically, monetary policy did appear to affect the supply of bank loans... In the 1960s and 1970s, when reserve requirements were higher and more comprehensive than they are today, Federal Reserve open market operations that drained reserves from the banking system tended to force a contraction in deposits. Regulation Q, which capped interest rates payable on deposits, prevented banks from offsetting the decline in deposits by offering higher interest rates. Moreover, banks had limited alternatives to deposits as a funding source. Thus, monetary tightening typically resulted in a shrinking of banks' balance sheets and a diversion of funds away from the banking system... The extension of credit to bank-dependent borrowers, which included many firms as well as households, was consequently reduced, with implications for spending and economic activity.

Of course, much has changed in U.S. banking and financial markets since the 1960s and 1970s. Reserve requirements are lower and apply to a smaller share of deposits than in the past. Regulation Q is gone. And the capital markets have become deep, liquid, and easily accessible, either directly or indirectly, to almost all depository institutions.

This is not to say, however, that financial intermediation no longer matters for monetary policy and the transmission of economic shocks. For example, although banks and other intermediaries no longer depend exclusively on insured deposits for funding, nondeposit sources of funding are likely to be relatively more expensive than deposits, reflecting the credit risks associated with uninsured lending. Moreover, the cost and availability of nondeposit funds for any given bank will depend on the perceived creditworthiness of the institution...

Like banks, nonbank lenders have to raise funds in order to lend, and the cost at which they raise those funds will depend on their financial condition--their net worth, their leverage, and their liquidity, for example. Thus, nonbank lenders also face an external finance premium that presumably can be influenced by economic developments or monetary policy. The level of the premium they pay will in turn affect the rates that they can offer borrowers. Thus, the ideas underlying the bank-lending channel might reasonably extend to all private providers of credit."

In the case of both the Credit system and monetary policy, developments since the 1960s and 1970s are nothing short of momentous and historic. Today, asset-based lending (as opposed to financing business investment) and sophisticated (market-based) financial intermediation completely dominate the Credit creation process. Myriad intermediaries issue basically unlimited quantities of myriad Credit instruments - in the unbridled extension of new Credit. Bank deposits are today but a sideshow. As for policy, the Federal Reserve has gone to a system of openly transparent fixed short-term interest rates. Credit growth and asset prices are largely disregarded, while a narrow inflationary focus on core consumer prices holds sway over policy. The interplay of these two dynamics - marketable securities-based Credit and highly accommodating monetary policy - has created powerful inflationary dynamics that policymakers are ill-equipped to manage. Conventional doctrine is completely oblivious to prevailing inflation.

In reference to today's financial intermediation, Dr. Bernanke stated that "nondeposit sources of funding are likely to be relatively more expensive than deposits, reflecting the credit risks associated with uninsured lending. Moreover, the cost and availability of nondeposit funds for any given bank will depend on the perceived creditworthiness of the institution."

Well, this seemingly innocuous comment approaches the heart of today's flawed central banking. First of all, it implies that the marketplace accurately assesses and prices risk, an assumption directly at odds with a backdrop of unfettered Credit, marketplace liquidity, and speculation. Importantly, over liquefied and high speculative environments inherently under-price and over-extend risk, and this dynamic tends to only escalate over time. Instead of blind faith in the marketplace's faculty for accurately pricing and regulating risk, the focus should be on the major systemic risks associated with a Credit apparatus that will by its nature foster reinforcing Credit and speculative excess.

Secondly, today's securities-based finance juggernaut has evolved into the prevailing source of system Credit and liquidity creation. As such, the creditworthiness of Bernanke's "borrowing institution" is a minor issue in comparison to the market values (and liquidity) of the securities collateral supporting the borrowing. The booming "repo" market, for example, is dictated by the perceived safety and liquidity of the underlying securities - and not the credit standing of the borrower. And I will suggest that it is a dire predicament when "creditworthiness" for a large part of the Credit system is dependent upon Bubble-induced inflated securities and asset prices, incomes, cash flows and over-liquefied markets generally.

With respect to "financial accelerators" and "Credit channels," there are some very serious shortcomings inherent to the current regulatory framework. I'll note a few. First, today's securities-based Credit knows no bounds (no reserve or capital requirements or natural constraints). Second, the Federal Reserve and global bankers "peg" short-term interest rates and forewarn on policy adjustments. Third, the incentives are simply too enticing for aggressive borrowing at the lower pegged rates (wherever they may be found) to speculate in higher yielding securities and instruments. For one thing, this creates a remarkably powerful inflationary bias in the securities markets overall. And, fourth, the prevailing central banking doctrine disregards asset prices and speculative leveraging.

Dr. Bernanke concludes:

"The critical idea is that the cost of funds to borrowers depends inversely on their creditworthiness, as measured by indicators such as net worth and liquidity. Endogenous changes in creditworthiness may increase the persistence and amplitude of business cycles (the financial accelerator) and strengthen the influence of monetary policy (the credit channel). As I have noted today, what has been called the bank-lending channel--the idea that banks play a special role in the transmission of monetary policy--can be integrated into this same broad logical framework, if we focus on the link between the bank's financial condition and its cost of capital. Nonbank lenders may well be subject to the same forces."

I'll conclude by proffering that securitization and asset-based finance have been a radical departure from the traditional Credit mechanism. The proliferation of agency and asset-backed securities, leveraged speculation, derivatives, CDOs and "structured finance" in general has acted as one momentous "financial accelerator." Developments in monetary policy have aided and abetted the rise of "Wall Street finance" and the empowerment of Credit Bubble dynamics. Monetary "management" has been reduced to telegraphed "baby-step" adjustments to the interest rate "peg." The Fed allowed itself to become hamstrung by Bubble Fragility and the inoperability of imposing actual system monetary tightening. And when it comes to a working framework for "financial accelerators" and Credit Channels, I suggest that Dr. Bernanke scrap his previous research and have his staff begin anew.

The bottom line is that the Fed is content to let Bubbles run their course, while being ready to implement aggressive "mopping up" strategies. But the potent inherent "financial accelerator" attributes of contemporary asset-based "speculative" finance beckon for a radically different policy approach For the Twenty-First Century.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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