Credit Crunch

By: Doug Noland | Sat, Nov 17, 2007
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For another unsettled and volatile week, the Dow added 1.0% (up 5.7% y-t-d) and the S&P500 0.3% (up 2.9%). Economically-sensitive issues underperformed. The Transports declined 0.9% (up 0.1%), and the Morgan Stanley Cyclical index fell 2.0% (up 9.2%). The "defensive" Morgan Stanley Consumer index gained 1.9% (up 6.9%), while the Utilities dipped 0.6% (up 12.9%). The broader market was weaker. The small cap Russell 2000 declined 0.4% (down 2.3%), and the S&P400 Mid-Caps fell 1.1% (up 6.0%). Technology stocks rallied somewhat. The NASDAQ100 gained 0.7% (up 16.6%), and the Morgan Stanley High Tech index added 0.5% (up 9.0%). The Semiconductors fell 2.3% (down 8.9%). The Street.com Internet Index increased 0.5% (up 14.3%), and the NASDAQ Telecommunications index jumped 2.6% (up 14.5%). The Biotechs gained 1.3% (up 7.9%). The Broker/Dealers added 0.3% (down 13.6%), while the Banks declined 0.2% (down 20.5%). With Bullion sinking $45, the HUI Gold index dropped 6.8% (up 21.8%).

Three-month Treasury bill rates recovered 12 bps this week to 3.42%. Two-year government yields fell 7 bps to 3.33%. Five-year T-Note yields declined 6 bps to 3.69%, and ten-year yields dropped 5 bps to 4.16%. Long-bond yields fell 7 bps to 4.535%. The 2yr/10yr spread ended the week at 83. The implied yield on 3-month December '08 Eurodollars dropped 11.5 bps to 3.785%. Benchmark Fannie Mae MBS yields dipped only one basis point to 5.70%, again this week markedly under-performing Treasuries to the point of pushing agency MBS spreads to the widest levels in five years. The spread on Fannie's 5% 2017 note widened 2 to 65, and the spread on Freddie's 5% 2017 note also widened 2 to 65. The 10-year dollar swap spread declined 1.7 to 74.3. Corporate bond spreads widened - especially throughout the financial sector, as the spread on an index of junk bonds ended the week 4 bps wider to the widest level since September.

November 15 - Bloomberg (Fabio Alves): "Citigroup Inc., the largest U.S. bank by assets, was punished by investors in its first bond sale since disclosing almost $17 billion in credit-market losses. Citigroup yesterday sold $4 billion of 10-year notes at the highest yield relative to benchmark interest rates in the bank's history... The 6.125 percent securities yield 190 basis points more than Treasuries of similar maturity, up from 118 bps...in a similar offering by New York-based Citigroup three months ago."

Investment grade debt issuers included Citigroup $4.0bn, Fiserv $1.75bn, United Healthcare $1.6bn, Nstar Electric $300 million, Potomac Electric $250 million, and Wisconsin Public Service $125 million.

November 16 - New York Times (Fabio Alves): "High-yield corporate bond funds reported their biggest weekly outflow in two years, according to AMG... Investors pulled $632 million from high-yield bond funds..."

Junk issuers included Key Energy Services $425 million, Windstream Regetta $210 million and Gastar Exploration $100 million.

Convert issuers included Prologis $1.2bn, and Affymetrix $275 million.

Foreign dollar bond issuance included Connacher Oil $600 million, Xstrata Finance $500 million.

German 10-year bund yields rose 2 bps to 4.105%, while the DAX equities index declined 2.6% for the week (up 15.4% y-t-d). Japanese "JGB" yields dropped 5.5 bps to 1.47%. The Nikkei 225 dropped 2.8%, increasing 2007 losses to 12.0%. Emerging debt and equities markets were curiously mixed. Brazil's benchmark dollar bond yields dropped 11 bps to 5.73%. Brazil's Bovespa equities index gained 1.6% (up 45.3% y-t-d). The Mexican Bolsa also gained 1.6% (up 12% y-t-d). Mexico's 10-year $ yields rose 5 bps to 5.51%. Russia's RTS equities index fell 3.2% (up 13.9% y-t-d). India's Sensex equities index jumped 4.2% (up 42.9% y-t-d). China's Shanghai Exchange was little changed, sustaining y-t-d gains to 98.7% and 52-week gains to 174%.

Freddie Mac posted 30-year fixed mortgage rates were unchanged this week to 6.24% (and unchanged y-o-y). Fifteen-year fixed rates declined 2 bps to 5.88% (down 6bps y-o-y). One-year adjustable rates were unchanged at 5.50% (down 3bps y-o-y).

Ominously, Bank Credit surged another $73.8bn during the week (11/7) to a record $9.192 TN. Bank Credit has now posted a 16-week gain of $548bn (20.6% annualized) and y-t-d rise of $896bn, a 12.5% pace. For the week, Securities Credit jumped 62.7$bn (3-wk gain $102.7bn). Loans & Leases rose $11.1bn to a record $6.694 TN (16-wk gain of $381bn). C&I loans dipped $1.1bn (2007 growth rate 20.2%). Real Estate loans increased $2.4bn. Consumer loans rose $4.5bn. Securities loans jumped $29.3bn, while Other loans fell $23.8bn. On the liability side, (previous M3) Large Time Deposits dipped $2.0bn (5-wk gain of $134bn).

M2 (narrow) "money" declined $20.3bn to $7.407 TN (week of 11/5). Narrow "money" has expanded $363bn y-t-d, or 6.0% annualized, and $454bn, or 6.5%, over the past year. For the week, Currency dipped $0.6bn, while Demand & Checkable Deposits increased $28.6bn. Savings Deposits sank $54bn, while Small Denominated Deposits added $1.9bn. Retail Money Fund assets increased $3.4bn.

Total Money Market Fund Assets (from Invest. Co Inst) jumped $24.3bn last week to a record $3.025 TN. Money Fund Assets have now posted an unprecedented 16-week gain of $442bn (59% annualized) and a y-t-d increase of $643bn (30.5% annualized). Money fund assets have posted a 52-week gain of $738bn, or 32.2%.

Total Commercial Paper declined $4.2bn to $1.862 TN. CP is down $361bn over the past 14 weeks. Asset-backed CP added $3.4bn (14-wk drop of $301bn) last week to $882bn. Year-to-date, total CP has shrunk $112bn, with ABCP down $212bn. Over the past year, Total CP has declined $68bn, or 3.5%.

Asset-Backed Securities (ABS) issuance increased somewhat to $5.0bn this week. Year-to-date total US ABS issuance of $514bn (tallied by JPMorgan) is running 35% behind comparable 2006. At $219bn, y-t-d Home Equity ABS sales are 56% off last year's pace. Year-to-date US CDO issuance of $285 billion is now 11% below comparable 2006.

Fed Foreign Holdings of Treasury, Agency Debt last week (ended 11/14) fell $3.8bn to $2.029 TN. "Custody holdings" were up $277bn y-t-d (17.8% annualized) and $325bn during the past year, or 19.1%. Federal Reserve Credit expanded $1.4bn to $866bn. Fed Credit has increased $13.6bn y-t-d and $30.9bn over the past year (3.7%).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $1.149 TN y-t-d (27% annualized) and $1.249 TN year-over-year (26.5%) to a record $5.960TN.

Credit Market Dislocation Watch:

November 13 - Bloomberg (Carol Massar and Fabio Alves): "There's a greater than 50% probability that the financial system 'will come to a grinding halt' because of losses from mortgages, Gregory Peters, head of credit strategy at Morgan Stanley, said. The world's biggest banks and securities firms have written down at least $45 billion in the value of assets linked to subprime mortgages for the third quarter after borrowers with poor credit histories failed to keep up with payments. Structured investment vehicles have defaulted on debt, forcing lenders including Legg Mason Inc. and SunTrust Banks Inc. to prop up their money-market funds to cushion them from possible losses. 'You have the SIVs, you have the conduits, you have the money-market funds, you have future losses still in the dealer's balance sheet in the banks,' Peters said... 'That's all toppling at once.' The risk of systemic shock from the current subprime meltdown is quite large in the near term, Peters said. 'It's an overarching concern that we have,' he said."

November 15 - Bloomberg (Christine Richard and Cecile Gutscher): "The crisis of confidence in bond insurers that bestow top credit ratings on debt sold by borrowers from the New York Yankees to Citigroup Inc. may cost investors as much as $200 billion. The AAA ratings of MBIA Inc., Ambac Financial Group Inc. and their five smaller competitors are being reviewed by Moody's... and Fitch Ratings. Without guarantees, $2.4 trillion of bonds may fall in value and some issuers would get shut out of the capital markets. 'We shudder to think of the ramifications,' said Greg Peters, head of credit strategy at...Morgan Stanley... 'You have politicians, taxpayers, municipalities, states. It just opens up a Pandora's box. That is a huge destabilizing force.' For more than 20 years, the safety of insurance has eased the way for elementary schools, Wall Street banks and thousands of municipalities to sell debt with unquestioned credit quality. Now, mounting downgrades on insured bonds backed by assets such as mortgages are raising doubts about the stability of the guarantors. ...MBIA, the world's largest, has a 27% probability of default, and Ambac's is 39%, prices of derivatives show."

November 16 - New York Post (Robby Boyd): "Investment banks, hammered by massive write-downs and trading losses since the summer, are radically shifting business plans of their mortgage-backed securities departments - and it's leaving hedge funds out in the cold. Key asset- and mortgage-backed securities brokers like UBS and RBS Greenwich Capital have sharply curtailed their financing activities to hedge fund clients over the past several months. When hedge funds can't get such financing - also known as leverage - the attractiveness of doing trades for the funds dims. As these major brokers pull back, the mortgage market's liquidity dries up, driving bond prices lower. In turn, hedge funds are forced to cut the value of their holdings. In the case of illiquid securities like subprime bonds or collateralized debt obligations, the funds are unable to value them and have to suspend redemptions, or the return of an investor's principal in a security."

November 13 - Dow Jones (Anusha Shrivastava): "Fitch Ratings downgraded... the credit ratings of $37.2 billion of global collateralized debt, with more than $14 billion worth of transactions falling from the highest-rated AAA perch to speculative-grade, or junk, status... The rating agency said more than 60 CDO transactions are still on watch for potential downgrade... On Monday, nearly $20 billion worth of transactions was cut from investment-grade to junk, said Kevin Kendra, managing director at Derivative Fitch."

November 12 - Bloomberg (John Glover): "Losses stemming from falling values of subprime mortgage assets may reach $300 billion to $400 billion worldwide, Deutsche Bank AG analysts said. Banks and brokers will be forced to write down as much as $130 billion because of the slump in subprime-related debt...Mike Mayo, a New York-based analyst at the bank, wrote... Banks may have to write off $60 billion to $70 billion this year, he wrote."

November 16 - Bloomberg (Bryan Keogh and Shannon D. Harrington): "For the first time in at least a decade, the world's biggest financial institutions are paying more to borrow in the corporate bond market than the average company. Bonds of banks, brokerages and insurance companies yield 1.49 percentage points more than U.S. Treasuries, matching a record high set in October 2002... The average industrial company bond trades at a yield premium of 1.34 percentage points."

November 14 - Financial Times (Deborah Brewster and Saskia Scholtes): "Banks and mutual fund managers are being forced to prop up their money market funds to prevent ratings agencies from downgrading the funds, as the credit crisis spreads further through the financial system. Bank of America yesterday said it would spend $600m on supporting its money market funds... Legg Mason and SEI Corporation have also provided capital support to their money market funds in order to protect the funds' credit ratings. A drop in the credit rating would not itself cause the fund to lose money, but it would result in many investors pulling their money out, creating an immediate liquidity drain and a dent in the funds' reputation as a safe harbour."

November 14 - Financial Times: "There's motherhood and apple pie. And then there is the pledge by money market funds not to 'break the buck' - or allow net asset value to fall below face value, meaning losses for investors. Asset managers would rather have teeth pulled than suffer the hit to their reputation such a breach would involve. Regulators, too, would have reason to fear the investor panic this might cause. With so much at stake, it is probably not surprising that a few sponsors of money market funds have stepped in to provide capital support if needed... The issue is the funds' exposure to commercial paper issued by structured investment vehicles - which are rapidly losing their raison d'etre. SIVs, it turns out, are exposed to a whole lot more refinancing risk than anyone supposed. And the unravelling of the SIV sector is hard to contain neatly. That is made worse because, since SIVs do not benefit from vast back-up lines of credit, they have to move fast to sell assets if their troubles become too pronounced."

November 15 - Bloomberg (Christopher Condon and Rachel Layne): "A short-term bond fund run by General Electric Co.'s GE Asset Management returned money to investors at 96 cents on the dollar after losing about $200 million, mostly on mortgage-backed securities. The GEAM Trust Enhanced Cash Trust, a short-term bond fund with about $5 billion in assets, told non-GE investors on Nov. 8 that they could withdraw their money before losses mounted. Enhanced cash funds usually offer higher yields than money-market funds by investing in riskier assets. All outside investors, who together held 'several hundreds of millions of dollars' in the fund, pulled their money, Chris Linehan, a GE Asset Management spokesman...said... Most of the fund's money before the redemptions came from GE's corporate pension plan and remains invested. Enhanced cash funds 'never promised to be stable value, though investors may have believed that,' said Peter Crane, founder of Crane Data LLC...publisher of the Money Fund Intelligence Newsletter. There are a number these funds 'under duress,' he said."

November 14 - Bloomberg (William Selway and David Evans): "The Florida agency that manages about $50 billion of short-term investments for the state, school districts and local governments holds $2.2 billion of debt cut to junk status. The downgrades affect more than 4% of what the Florida State Board of Administration has purchased for the funds... Some $3.6 billion, or 7.3%, of the securities may be downgraded by credit-rating companies, according to the document, provided to Bloomberg by the state board. Florida rules require the state's short-term investments to only be top-rated, liquid securities, so taxpayer funds aren't placed at risk. The data from Florida shows how far the effects of the bursting of the housing bubble are being felt as complex investment vehicles once marketed as high-yielding safe havens are now backed by collateral shunned by investors... Florida's state funds were affected by bad investments in asset-backed commercial paper, short-term debt sold by financial institutions that is secured by collateral such as mortgage securities and credit-card receivables... Florida's short-term holdings include $400 million of Axon Financial Funding LLC debt, which was cut to junk status... The others rated below investment grade are $850 million of KKR Atlantic Funding Trust...$577 million of KKR Pacific Funding Trust debt...and $319 million of debt issued by Ottimo Funding Ltd.... Joseph Mason, a finance professor at Drexel University...said that the nearly 1,000 school districts, cities and counties invested in the fund, now informed of its downgraded debt, will be tempted to pull money out. 'This sets up the danger for a run on the bank,' said Mason, a former economist at the U.S. Treasury Department. Commercial money-market funds, established as a high-yielding alternative to savings accounts, have also invested securities battered by the...subprime mortgage crisis. Money market funds with total assets of $300 billion have invested in securities related to mortgages extended to borrowers with poor...credit histories..."

November 14 - Financial Times (Peter Garnham): "The yen carry trade is in trouble again. On Monday, the Japanese currency rose through Y110 against the dollar for the first time in 18 months, and climbed 2% against the euro, 2.4% against sterling and an eye-watering 4.4% against the Australian dollar... The success of a given carry trade requires two elements: a funding currency with a low yield, such as the yen, and stability in asset markets... Clearly, low Japanese yields are still in place. However, it is the asset side of the equation that has been called into question amid increasing worries over the health of the financial sector. Benedikt Germanier at UBS says the bank's FX Risk index suggests the market is once again close to fear levels last seen in mid-August at the start of the recent turmoil. 'Financial stocks in the US and Europe have weakened substantially... Spillover into other sectors and ultimately into the real economy is looming. This doesn't bode well for carry trades, which typically perform in an environment of stable or rising growth expectations and low market volatility.'"

November 14 - Bloomberg (Edward Evans): "British financier Guy Hands said large leveraged buyouts are close to impossible and returns will drop as bankers slash funding for new deals. 'Bankers are like dogs,' said Hands, the CEO of London-based Terra Firma Capital Partners Ltd., at the industry's SuperInvestor conference... 'They hunt in a pack and go into a feeding frenzy. When hit, they whimper, and hide in their baskets. The bankers have been hit very hard, and they're not going to come out of their baskets.'"

November 16 - Financial Times (Paul J Davies): "Bankers and investors in Europe's leveraged, or high-yield, loan markets do not expect to see a significant recovery from the summer's liquidity crunch until the middle of next year at the earliest. Furthermore, banks that underwrote the most aggressively structured deals for their private equity clients could be stuck with them through the economic downturn that may be on its way, unless they are prepared to seriously adjust the prices they will accept for them. These downbeat messages were repeated a number of times at a packed industry conference in London yesterday... The global market for high-yield debt, which provides the majority of the funding for private equity backed buy-out deals, still has a roughly $350bn backlog of underwritten debt to clear before banks can start writing significant amounts of new business."

November 15 - Bloomberg (Neil Unmack): "The net asset value of structured investment vehicles, companies that borrow short term to buy higher yielding securities, has fallen to 69.7% as the credit slump erodes their holdings, Fitch Ratings reported. The amount that would be left after selling SIV assets and repaying debt dropped from 71% on Oct. 19 and above 100% in July, data compiled by Fitch show."

November 15 - Bloomberg (Ben Livesey and Jon Menon): "Barclays Plc, the U.K.'s third-biggest bank, wrote down about 1.3 billion pounds ($2.7 billion) on credit-related securities tied to the U.S. subprime-mortgage market collapse."

Currency Watch:

November 14 - Bloomberg (James G. Neuger and Simon Kennedy): "'It may be our currency, but it's your problem' was Treasury Secretary John Connally's taunt when the U.S. unhooked the dollar from the gold standard in 1971, unilaterally rewriting the rules of world business in America's favor. Now the world is taunting back. Almost four decades after the U.S. tore up the monetary arrangements that governed the post-World War II international economy, the dollar's fall from grace amounts to a tectonic shift in the global hierarchy. This time, the U.S. currency is on the losing side. After declining in five of the last six years, the weakest dollar in the era of floating currencies reflects a period of diminished U.S. political and economic hegemony. Whoever wins the White House next year will confront two unpopular choices: Accept the fall in U.S. clout and the rise of new rivals, or rein in record public and consumer debt that the rest of the world no longer wants to bankroll. 'What we're seeing is a very broad rebalancing of economic and political power in the world,' says Jeffrey Garten, a Yale School of Business professor who was the Commerce Department's undersecretary for international trade in the Clinton administration. 'The scales are moving, and they're moving quite fast.'"

November 15 - Bloomberg (Seyoon Kim and Matthew Brown): "The United Arab Emirates may consider pegging its dirham to a basket of currencies, consisting mostly of dollars, said central bank Governor Sultan Bin Nasser al-Suwaidi. The falling dollar will trigger a 'review' of the U.A.E.'s dollar peg, al-Suwaidi said..., signaling for the first time that the U.A.E. may drop the dirham's link to the U.S. currency in the near future."

November 12 - Bloomberg (Joshua Gallu): "The Swiss franc is more of a 'safe haven' than other major currencies in times of economic stress, according to a working paper by the Swiss National Bank. While the yen and the euro have also been used as refuge currencies, 'the Swiss franc carries the strongest safe-haven attributes,' the paper said. So-called 'safe-haven' currencies tend to be stable in times of economic volatility."

The dollar index gained 0.6% to 75.83. For the week on the upside, the Brazilian real increased 2.7%, the Australian dollar 2.0%, the South African rand 1.9%, the New Zealand dollar 1.8%, the Swedish krona 1.3%, the Euro 0.9%, and the Danish Krone 0.9%. On the downside, the Japanese yen declined 1.5%, the Norwegian krone 0.5%, the South Korean won 0.4%, and the Canadian dollar 0.3%.

Commodities Watch:

November 14 - Bloomberg (Pham-Duy Nguyen): "Gold demand rose 19% in the third quarter, led by a sevenfold increase in investment in exchange-traded funds backed by bullion, the producer-funded World Gold Council said. Global demand increased to 947 metric tons from 796 tons a year earlier... Purchases of so-called ETFs and similar products rose to 138 tons from 19 tons as investors sought a haven from turmoil in financial markets. 'Gold demand benefited from the flight to quality that has accompanied the growing financial problems sparked by the subprime mortgage crisis,' George Milling-Stanley, the council's manager of investment and market analysis, said..."

For the week, Gold dropped 5.4% to $787, and Silver 6.7% to $14.51. March Copper added 0.6%. January Crude declined $1.46 to $93.84. December gasoline returned 3.3%, while December Natural Gas increased 1.3%. December Wheat fell 1.6%. For the week, the CRB index declined 1.4% (up 13.7% y-t-d). The Goldman Sachs Commodities Index (GSCI) fell 1.3%, reducing 2007 gains to 38.1%.

Japan Watch:

November 13 - Bloomberg (Lily Nonomiya): "Japan's economy grew faster than economists forecast in the third quarter as an unexpected increase in consumer spending countered a drop in housing construction. The world's second-largest economy expanded an annualized 2.6% in the three months ended Sept. 30 after a revised 1.6% contraction in the previous period..."

November 12 - Bloomberg (Jason Clenfield): "Japanese household sentiment fell in October to a three-year low as wages slumped, the job market weakened and gas prices surged. An index that measures confidence among households with two or more people slid to 42.8 points last month from 44.1 in September... A reading below 50 means that pessimists outnumber optimists. Japan's labor market is faltering as unemployment rises and wages slump. Slower consumer spending, which accounts for more than half of the economy, puts growth at risk at a time when overseas demand may wane because of the U.S. housing recession."

China Watch:

November 13 - Financial Times: "When inflation starts to kill people then it is a serious problem. Three people died and 31 were injured on Saturday in a stampede to buy cut-price cooking oil in the western Chinese city of Chongqing. China can no longer explain away inflation as a short-term result of floods and epidemics of animal disease - nor can it ignore the strains its macroeconomic policies are producing. Cooking oil is a special case - its price influenced by demand from China's glut of new biofuel refineries - but the broader price of food has risen in recent months by more than 15% compared with a year earlier. Floods and other acts of God have had their effect, as has the global rise in wheat prices, but there are structural forces at work as well. Nor is inflation confined to food any longer: producer prices are creeping up. The PPI for manufactured goods was up 3.2% cent in October - many steel products rose by more than 10% - and the PPI is likely to go even higher when the recent 10% hike in the controlled pump price of diesel feeds through...That is a worry for the rest of the world, used to enjoying the 'China price', a seemingly open-ended deflationary pressure on the world economy."

November 13 - Bloomberg (Nipa Piboontanasawat): "Inflation in China, the world's fastest-growing major economy, accelerated in October as food prices jumped, increasing pressure on the central bank to raise interest rates for a sixth time this year. Consumer prices rose 6.5% from a year earlier, matching the decade high in August, the National Bureau of Statistics said today, after gaining 6.2 percent in September... Pork prices jumped 55%, vegetable costs were up almost 30%... Rising food costs threaten to fan unrest, spur wage demands and undermine the stability of an economy that grew 11.5% in the third quarter. 'Food inflation has expanded into other categories -- energy, labor and asset prices,' said Chris Leung, senior economist at DBS Bank Ltd. in Hong Kong. 'Everyone in China is feeling inflation, especially the poor.'"

November 12 - Bloomberg (Nipa Piboontanasawat): "China' money-supply growth in October exceeded the central bank's annual target for a ninth straight month as a swelling trade surplus injected cash into the world's fastest-growing major economy. M2...rose 18.47% from a year earlier to 39.42 trillion yuan ($5.3 trillion)..."

November 12 - Bloomberg (Nipa Piboontanasawat): "China's trade surplus rose to a record $27.05 billion in October, adding fuel to U.S. and European complaints the yuan is undervalued. The gap increased 13.5% from a year earlier...imports surged 25.5%, exceeding export growth for the first time since March."

November 12 - Bloomberg (Winnie Zhu): "China's economy is likely to expand 11.2% in the fourth quarter, slightly slower than in the first nine months of the year, Xinhua News Agency said..."

November 14 - Bloomberg (Nipa Piboontanasawat): "China's house prices rose in October at the fastest pace since 2005 as inflation outpaced returns on bank deposits, encouraging households to speculate on property. Prices in 70 major cities jumped 9.5% from a year earlier after gaining 8.9% in September..."

November 14 - Bloomberg (Nipa Piboontanasawat): "China's retail sales rose at the fastest pace in eight years as consumers in the world's fastest-growing major economy got richer and inflation accelerated. The 18.1% increase in October from a year earlier to 826.3 billion yuan ($111 billion) topped 17% growth in September... It was the biggest gain since 1999... Sales of clothes, electronics and automobiles jumped more than 30%..."

India Watch:

November 12 - Bloomberg (Cherian Thomas): "India's industrial production grew at the slowest pace in 11 months in September as decade-high interest rates crimped consumer demand and a stronger currency made exports less competitive. Production at factories, utilities and mines rose 6.4% from a year earlier after gaining 10.7% in August..."

November 13 - Bloomberg (Anil Varma): "India's central bank bought a record $11.9 billion of foreign currency in September, its 11th straight month of purchases. The Reserve Bank of India's currency purchases in September jumped almost sevenfold from the previous month... The bank had bought $1.82 billion in August."

Asia Boom Watch:

November 15 - Bloomberg (Shamim Adam): "East Asia's economies will expand at the fastest pace in more than a decade in 2007 as China's accelerating growth offsets a slowdown in U.S. demand for the region's exports, the World Bank said. East Asia, which excludes Japan and the Indian subcontinent, will grow 8.4% this year, faster than the 7.3% rate the World Bank predicted in April."

November 12 - Bloomberg (Jean Chua and Shamim Adam): "Singapore's inflation rate may accelerate to as much as 5% in the first quarter of 2008 amid record oil prices and higher food and transportation costs, Minister of Trade and Industry Lim Hng Kiang said."

November 15 - Bloomberg (Aloysius Unditu and Arijit Ghosh): "Indonesia's economy expanded 6.5% in the third quarter, the fastest pace since the 1997 Asian financial crisis, spurred by bumper harvests and rising sales of cars, motorcycles and homes."

Unbalanced Global Economy Watch:

November 15 - Bloomberg (Fergal O'Brien): "Inflation in Europe accelerated in October to the fastest in two years, rising further above the European Central Bank's 2% ceiling on higher prices for energy and food. Consumer prices in the 13-nation euro region increased an annual 2.6%, the highest since September 2005, up from 2.1% in the prior month..."

November 13 - Financial Times (Chris Giles): "Fear of a slowing economy has led to a big fall in business confidence across Europe... The confidence in the European business outlook of earlier this year has given way to much weaker expectations for business activity, revenues, profits, capital spending and employment."

November 15 - Bloomberg (Jennifer Ryan): "U.K. retail sales unexpectedly fell for the first time in nine months in October as shoppers bought less food and clothing, a sign higher borrowing costs are squeezing consumer spending. Retail sales declined 0.1%, compared with an increase of 0.3% in September..."

November 13 - Bloomberg (Brian Swint): "The Royal Institution of Chartered Surveyors index of U.K. house prices dropped to the lowest level in more than two years in October after rising mortgage rates deterred buyers."

November 13 - Bloomberg (Christian Vits): "Investor confidence in Germany, Europe's largest economy, dropped to the lowest in almost 15 years in November after the euro reached a record and the price of oil neared $100 a barrel. The ZEW Center for European Economic Research in Mannheim said its index of investor and analyst expectations fell to minus 32.5, the lowest since February 1993, from minus 18.1 in October."

November 13 - Bloomberg (Helene Fouquet): "French consumer prices rose in October at the fastest rate since August 2006 as oil and fresh-food costs climbed. French annual inflation accelerated to 2.1% from 1.6% in September..."

November 12 - Bloomberg (Maria Levitov): "The Russian government's budget surplus probably reached 2.09 trillion rubles ($90 billion), or 8% of gross domestic product, in the first 10 months of the year, the Finance Ministry said."

November 12 - Bloomberg (Victoria Batchelor and Jacob Greber): "The Reserve Bank of Australia raised its inflation forecasts and said the economy's expansion shows 'considerable momentum,' reinforcing speculation the bank will increase interest rates by March."

November 13 - Bloomberg (Farhan Sharif): "Pakistan's inflation accelerated to a 29-month high in October due to rising food prices... Consumer prices jumped 9.3% from a year earlier, after gaining 8.4 percent in September..."

Bubble Economy Watch:

November 13 - Financial Times (Andrew Edgecliffe-Johnson): "Too many new media companies are chasing too few advertising dollars, one of the advertising industry's most senior executives has warned, as fresh questions were raised about the fast-rising valuations of prominent online groups. 'Everyone is seeing advertising as the manna,' said Maurice Lévy, chairman and chief executive of Publicis, one of the world's largest marketing groups. 'Far too many people are building plans based on advertising and they may well be disappointed because there is not enough money for everyone.' Speaking at this weekend's Monaco Media Forum, Mr Lévy likened the boom in businesses whose revenue models depend on the continued growth of online advertising to the dotcom boom and bust that began a decade ago."

November 13 - Financial Times (Aline van Duyn): "Shares in Echostar, the second-biggest US satellite operator, fell nearly 14 per cent after weakness in the economy and tougher competition led to a slowdown in subscriber growth. Charles Ergen, co-founder and chief executive, warned that US economic conditions were expected to get worse. The economy is going to be a bigger drag than people expected on all kinds of services,' Mr Ergen said, adding that the economy was either already "in a recession or shortly headed for a recession'. Echostar said it added 110,000 net subscribers in the third quarter, down from 295,000 a year earlier. A number of analysts had predicted an increase of 260,000 or more."

Central Banker Watch:

November 14 - Bloomberg (John Fraher): "Bank of England Governor Mervyn King said he's increasingly concerned over currency market 'tensions' and a potential drop in global stock prices. King cited the refusal of China and other countries to allow their currencies to trade freely as 'a major concern and all of us will want to discuss it at the Group of 20 meeting this weekend,' King told reporters... King said he left last month's meeting of the International Monetary Fund in Washington 'more concerned about the implications of these tensions precisely because the unwinding of imbalances is not a hypothetical prospect. It's happening.'"

GSE Watch:

November 15 - Bloomberg (Jody Shenn): "Freddie Mac...joined Fannie Mae in introducing or raising fees on mortgages the company buys from lenders because of the increased risks in slumping housing and mortgage markets. Freddie Mac is primarily setting new fees for mortgages made to borrowers with credit scores below 680, whose loans exceed 70% of their property's value. The new charges range from 0.75% to 2% depending on credit scores, according to a bulletin by the company... Freddie Mac's changes are 'in response to continuing volatility and turmoil in the mortgage market, including the deteriorating performance of higher-risk mortgage products...' It also said mortgages from markets with falling prices must now have loan-to-value ratios at least five percentage points below normal requirements for mortgages with the same attributes."

California Watch:

November 16 - Market News International (Chris H. Sieroty): "In less than three months since lawmakers in Sacramento passed the last budget with a projected reserve of $4.1 billion, the state has been plunged into the red by a troubled housing market and high-energy prices. Nonpartisan legislative analyst Elizabeth Hill has called on lawmakers to begin cutting government programs or raising taxes to deal with a shortfall that is expected to grow to $10 billion by July."

November 15 - Associated Press (Alex Veiga): "Reluctant buyers and tightened mortgage lending combined to drag down California home sales last month to the lowest level for October in more than 20 years... A total of 24,832 homes were sold in October, down 40.9% from 43,720 in the year-ago month, according to DataQuick... 'We're on the downslope in the housing cycle,' said John Karevoll, a DataQuick analyst... Home sales financed by jumbo loans declined in October by more than half in several of the state's biggest housing markets, compared to July, DataQuick said. The statewide median home price for October slipped to $424,000, down 1.4% from September and 9.2% from October 2006. Median home values peaked last spring at $484,000... Price declines were particularly concentrated in inland areas such as the Central Valley and the inland counties in Southern California, which experienced sharp increases in property turnover during the last stages of the housing boom. 'The areas that had a lot of buying and refinancing activity during that period, those are the areas now that prices have come down, that are feeling the heat,' Karevoll said."

November 14 - Reuters (Jim Christie): "Housing prices in Southern California fell to a two-and-a-half-year low in October and the region's home sales slumped 45% from a year earlier as lenders issued fewer 'jumbo' mortgages... The median price paid for a home in Southern California in October fell to $444,000, down 8% from a year earlier and the lowest level since April 2005, according to...DataQuick... The median price was down 3.9% from September... A total of 12,999 new and resale houses and condominiums were sold last month in Southern California -- which includes Los Angeles, Orange, San Diego, Riverside, San Bernardino and Ventura counties... 'Last month's sales were the slowest for any October in DataQuick's statistics, which go back to 1988,' the report said."

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

November 13 - Financial Times (Daniel Pimlott): "Global credit turmoil has spilled over into the market for bonds backed by US commercial mortgages, threatening to push down property prices and scuttle deals. Issuance of US commercial mortgage-backed securities fell to $6.3bn in October, a drop of 84% from record levels of $38.5bn in March, according to Commercial Mortgage Alert... The decline in CMBS issuance is crucial because such securities have provided an estimated 40 to 60% of financing for new commercial property purchases in recent years... RBS Greenwich Capital predicts US commercial property prices will fall 10-15% next year. Market turbulence is also raising the cost of commercial mortgage borrowing. The difference in rates on AAA-rated CMBS and the so-called risk-free rate has more than doubled since June, reaching its highest level since October 1998. Investors have fled the CMBS market, in part, because of worries that riskier lending practices in commercial real estate would lead to higher defaults, industry executives say... The total value of outstanding securitised commercial property loans was $804bn at the end of the first quarter of 2007."

November 13 - Financial Times (Daniel Pimlott): "'In the US we've spent 15 years building the concept of securitisation into real estate,' said Eric Schwartz, joint head of Deutsche Bank's commercial property arm. 'I don't think anybody is prepared to believe that the events of the last three months have changed everything.' In spite of Wall Street's hopes, the signs at the moment are not good in commercial real estate, as fears rise that a flight from commercial mortgage backed securities could be pushing commercial real estate prices lower... The fears come after a phenomenal rise in the importance and value of securitisation of commercial mortgages in the US. CMBS now makes up 27% of the $3,000bn in commercial and multifamily development mortgage loans still outstanding, according to the Federal Reserve. That is up from 4% in 1990. Securitisation has allowed riskier, more leveraged purchases because the lenders originating the loans did not have to carry them on their balance sheets."

November 13 - Financial Times (Paul J Davies): "The dramatic rise in the cost of protecting financial company debt against default in the credit derivatives markets has led Moody's to put almost $500m of complex investments based on these instruments on review for downgrade. The agency said on Monday that eight financial-company focused constant proportion debt obligations (CPDOs)...had been put on review after their net asset values had been hurt by credit-market volatility. CPDOs are a leveraged bet on a portfolio of credit default swaps - the derivatives that provide a kind of insurance against non-payment of corporate debt - mainly using the US and European investment-grade indices... All the deals on review for downgrade have exposure only to financial companies, such as banks and insurers, rather than to the broader and more diverse indices. The idea when they were created was that highly rated banks would not see their cost of protection fluctuate widely and none would ever be allowed to go bust. However, the cost of protection for banks and so-called bond insurers in particular has risen dramatically over recent months..."

November 16 - New York Times (Gretchen Morgenson): "A federal judge in Ohio has ruled against a longstanding foreclosure practice, potentially creating an obstacle for lenders trying to reclaim properties from troubled borrowers and raising questions about the legal standing of investors in mortgage securities pools. Judge Christopher A. Boyko of Federal District Court in Cleveland dismissed 14 foreclosure cases brought on behalf of mortgage investors, ruling that they had failed to prove that they owned the properties they were trying to seize. ...as foreclosures have surged, the complex structure and disparate ownership of mortgage securities have made it harder for borrowers to work out troubled loans, in part because they cannot identify who holds the mortgage notes, consumer advocates say... The ruling was issued Oct. 31 by Judge Boyko, and relates to 14 foreclosure cases brought by Deutsche Bank National Trust Company. The bank is trustee for securitization pools, issued as recently as June 2006, claiming to hold mortgages underlying the foreclosed properties. On Oct. 10, Judge Boyko...ordered the lenders' representative to file copies of loan assignments showing that the lender was indeed the owner of the note and mortgage on each property when the foreclosure was filed. But lawyers for Deutsche Bank supplied documents showing only an intent to convey the rights in the mortgages rather than proof of ownership as of the foreclosure date. Saying that Deutsche Bank's arguments of legal standing fell woefully short, the judge wrote: 'The institutions seem to adopt the attitude that since they have been doing this for so long, unchallenged, this practice equates with legal compliance. Finally put to the test, their weak legal arguments compel the court to stop them at the gate...' 'This is the miracle of not having securities mapped to the underlying loans,' said Josh Rosner, a specialist in mortgage securities at Graham-Fisher, an independent research firm... 'There is no industry repository for mortgage loans. I have heard of instances where the same loan is in two or three pools.'"

November 15 - Bloomberg (David Evans): "Hal Wilson smiles at the blue numbers on his desktop screen. His money is yielding 5.77%. For the chief financial officer of Florida's Jefferson County school board, that means the $2.7 million of taxpayer funds he's placed in the state's Local Government Investment Pool is earning more on this October day than it would get in a money market fund. And Wilson says he knows the Florida officials who manage the funds of the 1,559-student district have invested them wisely. 'We're such a small school district... We don't have the time or staff for professional money management. They have lots of investment advisers. It's risk free and easy.' It may be easy, but it's not risk free. What Wilson didn't know in October -- and what thousands of municipal finance managers like him across the country still haven't been told -- is that state-run pools have parked taxpayers' money in some of the most confusing, opaque and illiquid debt investments ever devised. These include so-called structured investment vehicles, or SIVs, which are among the subprime mortgage debt-filled contrivances that have blown up at the biggest banks in the world."

Mortgage Finance Bust Watch:

November 13 - Financial Times (Andrea Felsted): "The cost to insurers of claims brought against directors of companies caught up in the US subprime mortgage crisis could be more than $2bn, according to Guy Carpenter, the reinsurance broker... 'There was never any doubt that the subprime mortgage market collapse would have an insurance impact. The question was one of extent. While estimates vary from $1bn to $3bn, it looks like the reality may settle at the upper end of the scale. The final answer will not come until 2008 or maybe even 2009, but history, litigation tendencies and capital markets point toward the worst case scenario,' Guy Carpenter said..."

Real Estate Bubbles Watch:

November 15 - Associated Press: "Evoking Depression-era memories, Wells Fargo... President and Chief Executive John Stumpf...became the latest banker to predict continuing difficulties in the U.S. housing market as risky mortgages made to overextended borrowers disintegrate into large loan losses. Speaking at an investment conference in New York, Stumpf said the current real-estate conditions are the worst he has experienced during his 30-year career. He then punctuated his gloomy assessment by harking back to the deepest downturn of the 20th century. 'We have not seen a nationwide decline in housing like this since the Great Depression,' he said."

Crude Liquidity Watch:

November 12 - Bloomberg (Anthony DiPaola and Fred Pals): "Exxon Mobil Corp., the world's largest oil company, said resource nationalism is 'counterproductive' and may pose a threat to achieving secure energy supplies. 'Isolation and resource nationalism is counterproductive and undermines the goal of supply security,' Rex Tillerson, chief executive officer...said in a speech today... Resource-rich countries like Iran, Russia, Venezuela and Bolivia are implementing policies that give them a higher share of revenue through an increased role in national oil companies. This has forced some international oil companies to renegotiate with governments led by Venezuelan President Hugo Chavez and Russian President Vladimir Putin. The drive by some oil exporting countries to become 'energy superpowers' and make unilateral changes to existing contracts will have 'detrimental impacts' Tillerson said."

November 14 - Financial Times (Andrew England and Roula Khalaf): "For the past two decades Saudis have enjoyed a period of extremely low inflation as the economy had stood virtually still after the heady days of the oil boom of the 1970s and early 1980s. But as the kingdom reaps the benefits of record oil prices once again, it is having to come to terms with rising food and rent prices that risk widening the gap between rich and poor and taking the shine off economic expansion. Inflation, which crept up to 4.9% in September after averaging 2.2% last year, is raising anxiety among the authorities, so much so that King Abdullah felt compelled to summon officials last month to explain the phenomenon. 'That's a source of worry for us; more worrying are the factors behind this inflation, which are still at play,' Hamad al-Sayari, governor of the Saudi Arabian Monetary Agency, told the Financial Times. 'The high global food prices, commodity prices and domestic housing costs, these are the major sources of inflation.'"

Credit Crunch:

November 16 - Financial Times (Gillian Tett): "Another week, another memorable encounter with a nervous financial beast. This time, however, the animal in question is Royal Bank of Scotland...Last week, RBS raised eyebrows when it was widely reported that one of its highly respected credit analysts had predicted that subprime losses could eventually rise to between $250bn and $500bn - or twice previous estimates... behind the scenes - and occasionally in public view - the credit analyst community remains distinctly divided about just how big the final hit might be... Thus while some observers project a $100bn hit, others talk about $500bn... A decade ago, I covered the Japanese bank crisis and became embroiled in a bad-loan guessing game that continued for many years. The tally of Japanese bad loans was estimated to be about $100m at the start of the 1990s, but by 1999 had risen to 1,000 times that size. I am told that a similar game occurred during the Latin American debt crisis in the 1980s and the Savings and Loans crisis - or indeed in almost every other recent banking shock."

November 16 - Bloomberg (Kabir Chibber): "The slump in global credit markets will force banks, brokerages and hedge funds to cut lending by $2 trillion, triggering the risk of a 'substantial recession' in the U.S., according to Goldman Sachs Group Inc. Losses related to record U.S. home foreclosures using a 'back-of-the-envelope' calculation may be as high as $400 billion for financial companies, Jan Hatzius, chief economist at Goldman...wrote... The effects may be amplified tenfold as companies that borrowed to finance their investments scale back lending, the report said. 'The likely mortgage credit losses pose a significantly bigger macroeconomic risk than generally recognized,' Hatzius wrote. 'It is easy to see how such a shock could produce a substantial recession' or 'a long period of very sluggish growth,' he wrote."

I commend Mr. Hatzius for his informed and forthright analysis, and certainly appreciate Ms. Tett's insight. The adept and well-informed are coming to recognize the gravity of the situation. Meanwhile, most analysts and economists remain steadfast in the "economic fundamentals are sound and the risk of recession low" camp. Listening to commentators on CNBC, one might be tempted to believe that things are bound to quickly return to normal after traversing the subprime speed bump ("a bit of a Credit problem," according to one analyst). Goldman's Hatzius recognizes both the fundamental role that Credit plays in economic development and that we are in the midst of an extraordinary Credit Crunch.

Mr. Hatzius throws out a $2.0 TN number in an attempt to quantify the scope of curtailed lending. He goes on to suggest that a "substantial recession" is in order if this Crunch unfolds quickly, or a period of protracted stagnation if it materializes over time. I'll let Mr. Hatzius speak for himself, but my observations and analysis make it patently clear that this historic Credit Crunch has passed the point of no return and will now escalate hastily.

The general economy has reacted only moderately thus far. Most analysts mistake this as further indication of the resiliency of the U.S. economy and additional confirmation of "sound" underpinnings. I take exceptions on both counts, and see the general economy's fortitude in an altogether different light.

Central to the bull case today is the strength of the U.S. corporate balance sheet. Granted, the non-financial corporate balance sheet is today heavier on cash and lighter on short-term debt (perhaps significantly) than would typically be the case at this stage of the cycle. In stark contrast to the technology sector's ("Ponzi") vulnerability to the abrupt change in financial conditions back in 2000, much of our (non-financial) corporate sector can these days contemplate Credit market tumult with assured poise and, practically, indifference. Outside of housing, few face an immediate cash-Crunch that would necessitate terminating projects and firing workers. I believe this general invulnerability to short-term market liquidity issues helps to explain today's complacency in the face of a momentous deterioration in Financial Conditions. I believe this complacency is not only unjustified, but also creates the "hook" that has corporate managements and stock market bulls alike confidently staying the course in the face of terribly ominous developments.

Importantly, the other side of the ostensibly robust non-financial corporate balance sheet is the troubled financial sector's. Keep in mind that since the beginning of 2001, financial sector borrowings (from the Fed's Z.1 report) have inflated 83% to $14.9 TN. Moreover, during this six and one-half year period Total Mortgage Debt jumped 106% to $14.0 TN. It was, after all, the massive expansion of household and financial balance sheets that created the "cash-flows" that accumulated in unusual quantities in the non-financial corporate sector. The bulls are wont to fixate on the wherewithal of corporate America, yet the source of this seeming financial health is at the root of Acute Systemic Fragilities.

November 16 - Bloomberg (Bryan Keogh and Shannon D. Harrington): "For the first time in at least a decade, the world's biggest financial institutions are paying more to borrow in the corporate bond market than the average company. Bonds of banks, brokerages and insurance companies yield 1.49 percentage points more than U.S. Treasuries, matching a record high set in October 2002... The average industrial company bond trades at a yield premium of 1.34 percentage points."

The widening spread differential between the financial and industrial sectors is telling and it's not bullish. And financial sector spreads widened notably this week. Residential Capital LLC ("Rescap"), the residential lending arm of GMAC, saw its spreads widen an astounding 2,800 basis points this week (see Market Dislocation Watch above) to 4,500. The market is now pricing Rescap Credit insurance for likely default. Its bonds are trading at 55 cents on the dollar.

Rescap ended September 30th with a $114bn balance sheet. Total Liabilities of $107bn included $38.2bn "Collateralized Borrowings in Securitization Trusts", $14.5bn deposit liabilities, $10.5bn FHLB Advances, almost $7.0bn in repurchase agreements, $15.5bn in senior notes, $1.0bn in subordinated notes, $1.8bn in "third party Credit facilities" and another $10bn or so of other liabilities. A Rescap default would have far-reaching ramifications and would be a major blow for the mortgage finance overall.

According to their website, Rescap is the "7th largest originator of residential mortgage loans in the U.S., producing $161.6 billion in loan origination volume; the 7th largest servicer of residential mortgage loans in the U.S., with a primary portfolio covering 3.2 million loans valued at $412.4 billion; No. 1 warehouse lender in the U.S. with $13.2 billion in commitments; 3rd largest non-agency issuer of mortgage-backed and mortgage related asset-backed securities in the U.S. with issuance of $71.1 billion." Rescap has been a leading subprime lender, and we're all familiar with the silly commercials from their Ditech lending unit. Rescap, a unit of GMAC, is owned jointly by GM and Cerberus Capital Management, and the markets now fear that the parent companies will be forced to choose bankruptcy over funding a potential financial black hole.

GMAC (one-year) Credit Default Swap prices widened about 240 bps this week to 975 basis points. GM and Ford CDS widened notably as well. Clearly, a Rescap default would be a major event for the troubled Credit Default Swap marketplace. Whether it would prove catastrophic, I just don't know. But I will assume that Rescap, GMAC, GM and related risk exposures are a meaningful component in various structures, including synthetic collateralized debt obligations (CDOs of CDS).

Between the CDS market and heightened GSE angst, it was another rough week for "structured finance." Expect it to get only worse. Freddie tightened lending standards this week, and with a tidal wave of Credit losses building, I don't see how the GSEs don't implement meaningfully tighter lending standards throughout the "conventional" mortgage arena. And with major lenders such as Wells Fargo, Countrywide, and Rescap moving to tighter lending, it appears we are at the brink of only worsening Credit Availability and resulting housing market pressure.

And in regard to mortgage Credit tightening, it is worth noting recent operational data history from Countrywide. Despite the subprime crisis from earlier in the year, Purchase Mortgage Fundings actually remained quite strong at $18.7bn through the month of July. Purchase Fundings were down only marginally to $17.2bn during August. But these fundings then shank to $9.6bn in September and to $9.3bn in October. By October, Purchase Fundings were down 55% from July's levels. Other categories were even worse. Countrywide's ARM fundings were down 75% in three months; Home Equity Fundings were down 64%; and Subprime Fundings were down 98% to $42 million.

The point I'm drawing from the data is that we are now only two to three months into the general mortgage Credit Crunch - and Credit is about to get even tighter. Housing markets, especially in California, are at the brink of some very serious trouble. Moreover, a severe Credit crunch is just now taking hold in commercial real estate, a sector notorious for punishing boom and bust cycles. While not commonly appreciated, commercial real estate is today acute vulnerable to the downside of "Ponzi Finance" dynamics. And through Rescap, GMAC, the CDS and CDO markets, "leveraged lending," M&A finance, and the securitization market in general, we are today at the brink of an historic Credit Crunch.

With the securitization market severely impaired and Wall Street reeling, the Banking sector balance sheet has now ballooned $550bn (21% annualized) over the past 16 weeks. How can this not be a disaster? How can it be sustainable?

The bottom line is that we have now entered a financial environment prone to serious accidents. The financial sector generally is under heightened strain, and I expect this predicament to increasingly feed into the rest of the (finance-driven) real economy. For one, expect huge finance-related job cuts over the coming weeks and months. Second, expect more broad-based tightening of Credit and Financial Conditions. Third, expect the severity of the unfolding housing bust to negatively impact holiday spending and consumer confidence more generally. In short, expect intensifying recessionary forces. And, importantly, expect all of the above to worsen markedly when the stock market Bubble succumbs.

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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