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April 15, 2005

The Greatest Ever Speculative Bubble in Risk
by Doug Noland

HIGHLY UNEDITED!

The developing financial crisis took a major leap forward this week, with equity and risk markets in sharp retreat across the globe. Here at home, the Dow was hit for 3.5% and the S&P500 for 3%. Economically sensitive issues were in liquidation. The Transports were clobbered for 6% and the Morgan Stanley Cyclical index for 7%. Even the Utilities were hit for 1%, about the same as the Morgan Stanley Consumer index. The broader market was under heavy selling pressure. The small cap Russell 2000 dropped 5%, and the S&P400 Mid-cap index was down 4%. The NASDAQ100 sank 4% and the Morgan Stanley High Tech index fell 6%. The Semiconductors were hit for 8%. The Street.com Internet index fell 5%, and the NASDAQ Telecommunications index declined 4%. Led by Genentech, the Biotechs gained 1%. The Broker/Dealers dropped 4%, and the Banks declined 2%. While bullion declined only $2.20, the HUI gold index sank 9%.

The specter of unfolding financial crisis incited panic buying of Treasuries. Two-year Treasury yields ended the week down 24 basis points to 3.49%. Five government yields declined 27 basis points to 3.87%, and 10-year Treasury yields sank 24 basis points 4.23%. Long-bond yields dropped 17 basis points to 4.59%. The spread between 2 and 30-year government yields narrowed two basis points to 100. Benchmark Fannie Mae MBS yields dropped 22 basis points. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note were about unchanged at 36, while the spread on Freddie's 5% 2014 note narrowed one basis point to 35. The 10-year dollar swap spread declined 2 to 45.5. The corporate bond market could not keep pace with Treasuries, with junk spreads in particular widening again this week. Auto and auto-related bonds were hammered. The implied yield on 3-month December Eurodollars sank 28.5 basis points to 3.89%.

April 15 - Bloomberg (John Glover): "General Motors Corp. bonds in euros plunged in London trading. The extra yield, or spread, over government debt of similar maturity that investors require to hold GM's 5 3/8 percent bond maturing in June 2011 widened to 7.99 percentage points from 6.02 percentage points yesterday, according to Merrill Lynch prices... The yield...soared to 11.05 percent from 9.13 percent.

Corporate debt issuance increased to $12 billion. Investment grade issuers included HSBC $1.5 billion, ABN Amro $1.5 billion, ERAC Finance $500 million, Istar Financial $500 million, GATX $330 million, Greater Bay $150 million, Georgia Power $125 million, and Northern Natural Gas $100 million.

Junk bond funds saw outflows of $ million. Issuers included Chesapeake Energy $600 million, Amerigas $415 million, Whiting Petro $220 million, and Parker Drilling $50 million.

Convert issuers included Nabi Pharmaceuticals $100 million.

Foreign dollar debt issuers included Royal Bank of Scotland $4.0 billion, KFW $2.0 billion, Indonesia $1.0 billion, TFM $450 million, Nordea Bank $600 million, and Celulosa Arauco $400 million.

Japanese 10-year JGB yields declined 6 basis points to 1.30%. Emerging debt spreads to Treasuries widened significantly. For the week, Brazilian benchmark dollar bond yields rose 10 basis points to 8.71%. Mexican govt. yields ended the week up 5 basis points to 6.09%. Russian 10-year dollar Eurobond yields dipped one basis point to 6.24%.

Freddie Mac posted 30-year fixed mortgage rates declined 2 basis points to 5.91%, the lowest level in five weeks. Fifteen-year fixed mortgage rates dipped 2 basis points to 5.46%. One-year adjustable rates rose 7 basis points to 4.30%. It does not, these days, take long for mortgage applications to respond to lower rates. The Mortgage Bankers Association Purchase Applications Index jumped 6.4% this past week to the highest level since December. Purchase applications were up almost 10% from one year ago, with dollar volume increasing 22%. Refi applications gained 5.6%. The average new Purchase mortgage jumped to $239,200. The average ARM increased to $330,500. The percentage of ARMs rose to 35.8% of total applications.

Broad money supply (M3) declined $16.1 billion to $9.545 Trillion (week of April 4). Year-to-date, M3 has expanded at a 2.9% rate, with M3-less Money Funds growing at a 5.2% pace. For the week, Currency dipped $1.3 billion. Demand & Checkable Deposits fell $21 billion, and Savings Deposits declined $18.2 billion. Small Denominated Deposits added $2.5 billion. Retail Money Fund deposits gained $1.2 billion, while Institutional Money Fund deposits jumped $12.3 billion. Large Denominated Deposits gained $9.7 billion. Repurchase Agreements declined $1.8 billion, while Eurodollar deposits added $0.6 billion.

Bank Credit jumped $27.6 billion, increasing the year-to-date expansion to $290.7 billion, or 16% annualized. Securities Credit is up $93.6 billion, or 18% annualized, year-to-date. Loans & Leases have expanded at a 19% pace so far during 2005. For the week, Commercial & Industrial (C&I) loans increased $4.1 billion. Real Estate loans jumped $17.6 billion. Real Estate loans have expanded at an 18% rate during the first 14 weeks of 2005 to $2.664 Trillion. Real Estate loans are up $332 billion, or 14.2%, over the past 52 weeks. For the week, consumer loans dipped $2.2 billion, while Securities loans expanded $8.7 billion. Other loans declined $4.4 billion.

Total Commercial Paper rose $8.1 billion last week ($39.8bn in 2 wks) to $1.469 Trillion. Total CP has expanded at a 13.6% rate y-t-d (up 11.2% over the past 52 weeks). Financial CP rose $5.2 billion last week to $1.3 Trillion (up 9.7% ann. y-t-d). Non-financial CP increased $3.0 billion to $149.2 billion (up 30.5% in 52 wks), the highest level since the first week of May 2003.

Fed Foreign Holdings of Treasury, Agency Debt declined $0.7 billion to $1.389 Trillion for the week ended April 13. "Custody holdings are up $53.5 billion, or 13.9% annualized, year-to-date (up $209bn, or 17.7%, over 52 weeks). Federal Reserve Credit declined $2.0 billion for the week to $781.4 billion. Fed Credit is down 4.0% annualized y-t-d (up $41.2bn, or 5.6%, over 52 weeks).

ABS issuance increased to a robust $17 billion (from JPMorgan). Year-to-date issuance of $173 billion is now slightly ahead of comparable 2004. At $113 billion, y-t-d home equity ABS issuance is 13% above the year ago level.

Currency Watch:

The dollar index mustered a slight gain this week. The British pound and Japanese yen were up slightly against the greenback. On the downside, the South African rand and Iceland krona declined about 2%, the Chilean peso 1.7%, and the Polish zloty 1.6%.

Commodities Watch:

April 14 - Bloomberg (Claire Leow and Grace Nirang): "Indonesia, Southeast Asia's only OPEC member, may become a net oil importer this year as projects led by ConocoPhillips, Unocal Corp. and PetroChina Co. fail to stem falling output, helping to boost fuel prices to records. The country may turn to importing a net 61,000 barrels a day this year from net exports of 27,000 barrels a day in 2004...

April 11 - Bloomberg (Xiao Yu and Helen Yuan): "China's steel imports may rise 15 percent this year to 240 million metric tons to feed expansion by Chinese steelmakers, said Qi Xiangdong, deputy secretary general of the China Iron and Steel Industry Association.

April 13 - Bloomberg (Christopher Donville and Darrell Hassler): "China, the world's second-biggest consumer of aluminum, may become a net importer of the metal this year because of increasing demand and limited ability to produce more, Alcan Inc. Chief Executive Travis Engen said.

April 13 - AFX: "China's oil demand is estimated at 6.88 mln barrels per day (bpd) in 2005, up 7.9 pct over 2004, the International Energy Agency said.

May crude oil sank $2.83 to $50.49. For the week, the CRB index declined 1.8%, reducing y-t-d gains to 5.2%. The Goldman Sachs Commodities fell 2.2%, with 2005 gains down to 16.3%.

China Watch:

April 14 - XFN: "China's gross domestic product probably grew by about 9% year-on-year in the first three months of this year, compared with 9.7% in the same period last year, the China Daily reported.

April 11 - Bloomberg (Koh Chin Ling): "China expects to face shortages in more than two-fifths of production materials, including iron ore and crude oil, in the first half of this year because of rising industrial production. China's production won't meet demand for 43 percent of 300 types of materials surveyed by the trade ministry, the Beijing-based Ministry of Commerce said...

April 14 - Bloomberg (Nerys Avery): "China's money supply growth in March stayed within the central bank's 15 percent target for the ninth straight month after banks were ordered to limit lending to industries including real estate, steel and cement. M2, which includes cash and all deposits, expanded 14 percent from a year earlier to 26.5 trillion yuan ($3.2 trillion) after 13.9 percent growth in February...

April 15 - Bloomberg (Janet Ong): "Property prices in China rose an average of 9.8 percent in the first quarter from a year earlier, as government measures failed to curb real estate speculators. The fastest price property price increase were in Shanghai, where buyers paid prices that were an average 19 percent higher in the first quarter...

April 12 - Bloomberg (Nerys Avery): "China's trade balance widened last month as manufacturers shipped more clothes, electronics and machinery to the U.S. and Europe. The surplus reached $5.7 billion, up from $4.4 billion in February and rebounding from a $630 million deficit in March 2004... Exports rose 33 percent from a year earlier to $60.9 billion after rising 37 percent in the first two months.

April 13 - XFN: "China's Premier Wen Jiabao said he does not want so-called 'hot money' in China and vowed that speculators who park money in the country hoping to profit from a currency appreciation will not gain, Xinhua news agency reported. 'I don't want hot money to flow into China and I promise people who are doing this that such speculation won't benefit them,' the Chinese premier said...

April 12 - Bloomberg (Nerys Avery): "China's tax revenue rose 20.4 percent to 756 billion yuan ($91 billion) in the first quarter from a year earlier, state-run Xinhua New Agency reported...

April 11 - Bloomberg (Rob Delaney): "China's textile exports rose 29 percent in the first three months of this year, with sales to the U.S. almost quadrupling in the period, according to the commerce ministry.

Asia Boom Watch:

April 12 - Bloomberg (Cherian Thomas): "India's industrial production had its smallest gain in almost two years in February as exports slowed and a shortage of coal curbed steel and energy output. Output at factories, utilities and mines rose 4.9 percent from a year earlier compared with growth of 7.5 percent in January...

April 15 - Bloomberg (Anand Krishnamoorthy): "India's automobile sales rose 14 percent in March after Hero Honda Motors Ltd., the nation's biggest motorcycle maker, and Maruti Udyog Ltd., the biggest carmaker, boosted sales.

April 13 - AFX: "The (Indonesia) government is expecting the country's Gross Domestic Product (GDP) to grow by 6.1 pct in 2006 against a target of 5.5 pct this year, said Finance Minister Jusuf Anwar.

Global Reflation Watch:

April 15 - International Herald Tribune (Carter Dougherty): "The European Central Bank said Thursday that rising asset prices could lead it to raise interest rates even if growth in the 12-nation euro zone remained sluggish this year and inflation stayed under control. The statement, made in an article in the bank's monthly bulletin, marked the clearest indication yet that the ECB might respond to soaring real estate prices in some euro-zone countries by tightening credit - a controversial step in central banking circles.

April 13 - Bloomberg (Mayumi Otsuma): "Japan's producer prices rose for a 13th month in March, eroding profits at companies struggling to pass on costs after almost seven years of consumer price deflation. An index of prices of energy and raw materials in the world's second-largest economy rose 1.4 percent from a year earlier...

April 14 - XFN: "Japanese corporate bankruptcies in March declined 18.1% from a year earlier to 1,100, the 27th straight month of decline, Teikoku Databank Ltd reported. Total liabilities left by failed companies dropped 57.2%...

Latin America Watch:

April 13 - Bloomberg (Andrew J. Barden): "The International Monetary Fund raised its growth forecasts this year for Mexico and Brazil, Latin America's two biggest economies, saying they will expand faster on growing demand in domestic and export markets. Both countries' economies will expand 3.7 percent in 2005, more than the previous 3.2 percent forecast for Mexico and 3.5 percent outlook for Brazil... 'The favorable external environment continues to support economic activity, but it is now domestic demand that is leading growth, with private consumption and business investment growing briskly,' the...IMF said...

April 13 - Bloomberg (Alex Kennedy): "Venezuela's economy probably grew between 7 percent and 11 percent in the first quarter as surging oil exports generated more tax revenue for government spending, Central Bank Director Domingo Maza said.

Dollar Consternation Watch:

April 12 - MarketNews (Steven K. Beckner): "Atlanta Federal Reserve Bank President Jack Guynn warned Monday that the costs of a breakdown of confidence in the U.S. financial system due to renewed corporate scandals would be 'huge...' He warned that a repetition of such scandals could be even more damaging than before. 'We're a long way from a complete collapse of our economic system, but you can't multiply that kind of lack of trust and so forth very much before you really begin to get worried about the damage done to the larger financial system and the larger economy... If it happens enough, the effect on the larger system is just potentially huge...'

April 14 - MarketNews: "The growth of China's foreign exchange reserves this year is expected to easily outpace 2004's $206.6 bln jump as a booming export sector sees an increasing number of dollars flowing into the country, creating yet more headaches for the country's policy makers... Economists expect China's foreign exchange reserves to grow at least another 25% over the $609.9 bln that the country sat on at the end of last year. The People's Bank of China said today that its foreign exchange reserves grew 49.9% year-on-year in the first quarter to $659.1 bln...

April 14 - Bloomberg (Heejin Koo): "The South Korean government lost about 3 trillion won ($3 billion) trading in currency derivatives while intervening to stabilize the currency market, the Korea Herald reported, citing Finance Minister Han Duck Soo... South Korea's foreign exchange stabilization fund, used by the government to control volatility in the won, lost 10.2 trillion won ($10 billion) last year because of the currency's appreciation against the dollar, the Bank of Korea said...

Bubble Economy Watch:

As was widely reported, the February Trade Deficit was reported at a record $61 billion, up 33% from the year ago level. Goods Exports were up 9% from February 2004 to $71.2 billion. Over the same period, Goods Imports were up 18% to $135.9 billion. And while the weak dollar has helped Goods Exports jump 23% over the past two years, the U.S. Bubble Economy has consumed an amazing 32% increase in Goods Imports.

With half of the fiscal year now in the history books, it is examining our federal government's finances. At $294.6 billion, the fiscal y-t-d federal deficit is running only slightly (2.2%) below comparable (record) 2004. Yet, this is with y-t-d revenues running up 10.4% to $939 billion. Individual Income Tax receipts are running up 8.5% to $398.8 billion, while Corporate Income Tax receipts are 48.3% ahead to $99.8 billion. At the same time, Spending is up 7.1% to $1.234 Trillion. By major category, National Defense is up 7.3% to $238 billion. Social Security is up 5.4% to $256 billion. Income Security is up 2.4% to $188.5 billion. Medicare is up 9.5% to $142.2 billion. Health is up 4.8% to $124.6 billion. Education & Social Welfare is up 9.9% to $48.5 billion. Transportation is up 7.9% to $31.3 billion. Veterans Benefits are up 17.4% to $33.3 billion. Interest Expense is up 9.1% to $87.4 billion.

April 14 - The New York Times (Tim Weiner): "The battle over the Pentagon's billions has traditionally been fought between two forces - those who want more new planes and ships and tanks, and those who want more money for troops. Now there is a third: military health care. The cost of the main military health care plan, Tricare, has doubled since 2001 and will soon reach $50 billion a year, more than a tenth of the Pentagon's budget. At least 75 percent of the benefits will go to veterans and retirees. Over the next decade, a new plan for military retirees, Tricare for Life, will cost at least $100 billion...rivaling the costs of the biggest weapons systems the Pentagon is building... The Pentagon, said William Winkenwerder Jr., the assistant secretary of defense for health affairs, faces 'a growing, serious, long-term problem.'

April 15 - The New York Times (Paul Krugman): "In 2002, the latest year for which comparable data are available, the United States spent $5,267 on health care for each man, woman and child in the population. Of this, $2,364, or 45 percent, was government spending, mainly on Medicare and Medicaid. Canada spent $2,931 per person, of which $2,048 came from the government. France spent $2,736 per person, of which $2,080 was government spending. Amazing, isn't it? U.S. health care is so expensive that our government spends more on health care than the governments of other advanced countries, even though the private sector pays a far higher share of the bills than anywhere else.

April 14 - Dow Jones (John Connor): "Most U.S. states collected more taxes than originally expected in the first eight months of their 2005 fiscal year, but most also face heavy spending pressures. Those are among the findings in a new 'State Budget Update' report released Thursday by the National Conference of State Legislatures. 'Fiscal directors in about half the states indicated that their state does face a structural deficit,' the report said... Most of these states use tactics such as spending deferrals, borrowing, or tapping rainy day funds to balance the books. On the tax side, the report said corporate income taxes, the strongest performing tax category this year, are running above projections in 37 states...below estimates in only two... At the same time, the report said 31 states report spending overruns for some portion of their budget... The report said personal income tax collections are exceeding forecasts in 29 states... and below forecast in just two, and that sales and use tax receipts are running above forecast in 21 states.

Speculative Bubble Watch:

April 12 - Bloomberg (Samantha Lafferty): "Liechtenstein's Prince Hans-Adam II made his first foray into hedge funds by investing in Long-Term Capital Management LP. Instead of retreating when LTCM collapsed in 1998, his family firm, LGT Capital Partners, put $2.5 billion more into such funds -- including money from outside investors. In all, LGT Capital has swept in $6 billion for investment in buyout firms and hedge funds...

Mortgage Finance Bubble Watch:

"The FHLBanks Office of Finance announced today that it will delay publication of the FHLBanks 2004 Combined Financial Report and Combined Quarterly Financial Report for the Nine Months Ended September 30, 2004. This decision is due to the ongoing reviews of accounting matters being considered by the FHLBanks in preparation for SEC registration later this year. These matters are primarily related to accounting for derivative transactions dating back to adoption at January 1, 2001 under FAS 133.

April 13 - Dow Jones: "The average price for a residential apartment in Manhattan hit a record high in March, boosted by tightening supply and high-priced new developments, according to a recent report from real-estate brokerage firm Halstead Property. At $1.27 million, the average price for an apartment in the borough swelled 14% from February and 32% from the same time last year... The popularity of cooperative apartments is still strong and drove the median price of prewar units up 31%... As for condominiums, the median price jumped 33% in March from the year-earlier period

April 15 - Los Angeles Times (Annette Haddad ): "Southern California home prices in March failed to rise more than 20% for the first time in a year...more evidence that the region's sizzling housing market is cooling down a notch. The 18.6% gain over prices a year earlier ended a 14-month streak of 20%-plus increases and was the smallest rise since June 2003, according to DataQuick... Price gains in one of the region's hottest markets, San Diego, showed more modest increases, while sales fell. Regionwide, total sales were virtually unchanged from the year-earlier level... The median price in March hit a record $439,000 for all houses and condominiums sold in the six-county region. The number of sales was near a record, with 32,674 property transactions closed, 43 short of the year-earlier results, which were the strongest March sales on record...

April 12 - Bloomberg (James Tyson): "Fannie Mae spent $87 million for an advertising campaign that helped thwart efforts by Congress in 2003 and 2004 to create a tougher regulator for the government-chartered company, a University of Pennsylvania study says. Fannie Mae...paid for 10,797 print and television ads during the period...

Earnings Watch:

It was an unimpressive first quarter for Citigroup. While Revenues were up 6%, Expenses jumped 12%. Company Net Income was up only 3% from Q1 2005. By product group, Global Wealth Management Net Income was down 23% from the year ago quarter, with Smith Barney earnings down 22%. Total Corporate and Investment Banking Net Income was down 2%. While much smaller, Asset Management Net Income shrank 25%. Global Consumer Net Income was up 9%. In North America Cards, "managed revenues declined 5% from the prior year, as a 6% increase in sales was offset by net interest margin compression... International Cards "Revenue and income growth reflects a 31% increase in accounts and 23% growth in average managed loans. North America Consumer Finance "revenues increased slightly as an 8% increase in average loans was offset by a 46 basis point declined in net interest margin.

The Greatest Ever Speculative Bubble in Risk

It was a week of significantly heightened global financial instability. Global equity prices broke down. Treasury bond prices broke upward. GM and Ford bonds broke down. Some important Credit default swap prices blew out. Crude and some commodities prices broke downward. Emerging market bonds were unsettled. The dollar's attempted strong upward thrust was for now largely rebuffed in wild currency trading. In short, Risk markets are under increasing stress, the goliath leveraged speculating community is not making money - at best - and the derivative players must now be studying their risk exposure and questioning their risk assumptions and models. The Speculative Bubble in Risk has been pierced.

The Greenspan/Bernanke Reflationary Bubble Period (the fall of 2002 to present) will go down as the most unsound boom in history. That it has been so misinterpreted by many only undermines already tenuous system underpinnings. Somehow the optimists were willing to ignore the explosion of non-productive Credit, unprecedented leveraged speculation, a conspicuous Mortgage Finance Bubble, and unparalleled Current Account Deficits. They instead put their trust in asset prices and abundant liquidity.

It has always been a case of when this unhealthy boom would face the reality of a faltering Financial Sphere. Credit and speculative excess fostered a widening gap between market valuations and true underlying sustainable (post liquidity boom) economic value. And while I do appreciate that there have been some significant economic developments of late, I nonetheless believe financial developments are paramount these days.

Back in 2002 the Fed cloaked its reflationary policies in clever Friedmanite "determined to thwart deflation talk. As Dr. Bernanke proclaimed, "We'll never let 'it' (deflation) happen again. I have always believed that the top Fed officials were keenly cognizant that they were in reality fighting systemic debt market dislocation - a problem with key differences to outright deflation. If the Credit system was incapable of generating sufficient finance and liquidity to avoid a general debt collapse and downward price (including assets) spiral - in a general environment of extreme risk aversion - then the Fed's effort to "reflate would at least have not been reckless. But the circumstances were diametrically different, and the Fed succeeded only in inflating Bubbles.

Throughout 2002, the U.S. financial system was extending significant Credit, although it was extraordinarily unbalanced ("Financial Arbitrage Capitalism). While corporate debt growth slowed to 1.3%, Household Mortgage Credit expanded by 12.4% during 2002. This was the strongest growth since 1987. The Federal Government increased borrowings by 5.5%, while State & Local government debt surged 14.1%. Total Non-financial Debt expanded at a 7.1% rate during 2002, the strongest expansion since 1989. Financial sector Credit market borrowings expanded at a 9.8% rate. And in regards to the general risk environment, at the time the speculating community, leveraged trading, and the derivatives markets were all mushrooming. Similar to the strong inflationary bias throughout technology/telecom that was stoked into a "blow-off excess post-LTCM reliquefication, powerful expansionary and speculative forces in "risk were poised for wild excesses with the assistance of the Fed's "fight against deflation.

There were some very serious financial issues back in 2002. The technology and telecom debt Bubble had burst, and the corporate debt market was in tatters. The empowered speculators certainly preferred aggressively leveraging in agency securities, while shorting soiled corporate America (including Ford and GM bonds). The Fed's determination to inflate signaled that the corporate bond bears had best reverse positions and go long. The ballooning speculating community went aggressively long corporate debt, junk bonds and equities, along with upping leveraged bets in agencies and MBS. The resulting liquidity inundation stoked U.S. and global equities, emerging markets, and the rapidly expanding market in Credit default swaps (CDS). An historic Housing Mania took hold throughout the U.S. (and the U.K., Australia, and China, to name only a few), while the U.S. Credit Bubbled morphed into the Global Credit Bubble. It all evolved into The Greatest Ever Speculative Bubble in Risk.

I believe it is very important analytically to appreciate that it has always been a case of from what degree of excess this Risk Bubble would eventually burst. The Key Issues Have Been Financial Sphere Issues, and at the top of the list is that the Fed used the leveraged speculating community as a fundamental reflating mechanism. Fed reflationary policies incited systemic Monetary Disorder - speculative and liquidity excesses that completely distorted the demand and pricing for Risk (securities, derivatives, lending, housing, etc.). Writing insurance (Credit Default Swaps) on GM, Ford and other risky Credits became virtually free money - month after month, quarter after quarter. And declining risk premiums - lower cost of funds - encouraged debt issuance. Credit Availability made a phenomenal comeback. The return of liquidity to the corporate bond market then fueled a "virtuous cycle of narrower spreads, a more robust business environment, higher equity prices, improved confidence and only greater speculative interest in risk-taking (including fueling a Bubble in Credit default swaps). Risk premiums narrowed dramatically, while those on the wrong side of trades were forced to take (leveraged) long positions in the underlying bonds and stocks - which only further stoked the self-reinforcing asset inflation and boom cycle.

Bull markets create their own liquidity - and always nurture the perception of endless liquidity. The Bubble in Risk has been no exception. And as long as the crowd hankered to play risk - including writing Credit and market insurance - there was going to be continued downward pressure on risk premiums, upward pressure on bond and stock prices, greater liquidity excesses, increasingly robust economic conditions, and only more emboldened speculators. There was going to be escalating leverage in the system (stocks, bonds and aggressive lending), along with an ambiguous leveraging of speculative risk-taking (CDS and other derivatives).

For example, let's say the price for writing insurance against default at GM was 300 basis points a year. And while GM may have "only a few hundred billion of debt, the speculative interest in pocketing those 300 basis points of premium ("free money) was significantly larger. Aggressive hedge funds had an appetite to write, say, $500 billion "notional, intending to pocket $15 billion of annual premiums. "Street derivative players gladly accommodate the trade, hedging their exposure by acquiring a partial position in the underlying bonds. And as premiums declined and market liquidity flourished, the demand for easy profits from writing CDS became intense. The self-reinforcing demand for CDS, the underlying bonds, and resulting marketplace liquidity also supported a high GM stock price, which then supported only lower bond and CDS risk premiums. But perceived "virtuous cycle was in reality a Bubble of Risk.

There is just no way around some things. The speculation and liquidity induced collapse in risk premiums must eventually face the true reality of GM's dismal financial condition and prospects (certainly made worse by the concurrent inflationary spike in healthcare and energy prices!). The speculative Bubble in GM Risk - a historic mis-pricing of risk in the marketplace - was pierced when the company announced a major earnings shortfall. This immediately incited a move to unwind bets and liquidity evaporated. The huge crowd that had so handsomely profited by writing GM Credit insurance rushed to unwind and/or hedge their trades. Many speculators would attempt to short GM bonds to offset their risk to widening spreads, but the size ("notional) of the bets placed during the Bubble ended up at multiples of the underlying tradable bonds. With derivatives and hedging, the size of the trade didn't matter - that is, liquidity was no issue when trades were being put on.

Meanwhile, the derivative players - dynamically trading their exposure using hedging models - dump their bond holding and attempt to get positioned short. Other opportunistic speculators, appreciating the unfolding train wreck, begin aggressively shorting GM bonds and stocks. Selling pressure leads to a spike in risk premiums and more aggressive efforts to unwind, hedge and place bear bets against GM risk. And with Credit Availability quickly disappearing for GM, the company's prospects take a decided turn for the worst. Liquidity quickly disappears for GM bonds, and speculators and hedgers are quickly forced to sell GM stock as a means shorting GM "risk. When liquidity disappears in the stock, sellers must then turn to shorting related companies or simply the more liquid market futures contracts. GM bond market illiquidity feeds GM stock market illiquidity, quickly spilling over into the general market. Simultaneously, similar dynamics are leading to contagious dislocations, first in Ford, then the auto supply companies, and increasingly throughout the leveraged industrials, and other companies impacted by the expanding financial dislocation. How long until the storm hits the financials?

With some of the major CDS markets in tatters, the bloom is now off the rose. The piercing of this Bubble of Risk has important ramifications for both Credit Availability and Marketplace Liquidity. It is also clear that risk aversion is quickly taking hold and that the leveraged speculating community is taking some blows. CDS and auto bonds have been painful. Major losses are quickly adding up in global equities. And the poor bond market bears have been battered - once again. The volatile currencies have been tough and the dollar short a recent loser. Emerging bond markets have been treacherous. Crude spiked up and broke hard. Even the Old Faithful "reflation trade is now a war zone. For now, I will assume that the leveraged players are hoping to off-load risk, a dynamic that will, these days, have negative ramifications for liquidity in various markets.

But I sense that we are only kidding ourselves if we believe that the analysis is getting much easier. I specifically did not use "Credit Bubble in the title of this evening's piece; I conjecture about the piercing of the Bubble of Risk, not the Great Credit Bubble. After all, the sharp drop in Treasury yields plays right into the hands of the thriving Mortgage Finance Bubble. Barring outright financial crisis, I will assume lower yields throw a bit more gas on the housing finance fire. And while the bond market bulls are breathing a loud sigh of relief, I can envisage how this respite could be but part of The Unfolding Worst Case Scenario - the path of a collapse in Treasury yields and a blow-out in spreads; the path of continued mortgage Credit excess, over-consumption, Current Account Deficits and dollar crisis.

I still believe it is a case of dollar stability requiring higher U.S. yields, although this analysis is somewhat muddied by recent developments in U.S. and global markets. Surging Treasury prices are dollar unfriendly, not to mention spread trade unfriendly. Spread trade unfriendly is leveraged speculator unfriendly. I will confess that it is difficult for me to judge how short-term economy unfriendly a sinking stock market would be if the equity bear market equates to significantly lower market yields. And as important as the Credit default market has become, the dollar and "spread trades" are the Achilles heal of financial stability. In regard to both, there remains significant uncertainty. But with air now flowing out of the speculative Bubble in Risk, financial dislocation dynamics are in play. We'll come in Monday morning with lots to watch and ponder, including contagion effects and the potential for financial crisis.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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