UNEDITED!

Global equity markets remain under pressure. For the week, the Dow declined almost 2% and the S&P500 dipped more than 1%. The Transports declined 1.5% and the Utilities dropped 2%. Selling was broad-based, with the Morgan Stanley Cyclical index down 2% and the Morgan Stanley Consumer index sinking 3%. The small cap Russell 2000 declined 3%, and the S&P400 Mid-cap index fell 2%. The NASDAQ100 dipped 1%, and the Morgan Stanley High Tech index sank 2.5%. The Semiconductors and NASDAQ Telecom indices both were down 1%. The Street.com Internet Index dropped 2%. The Biotechs were hammered for 4%. The financial stocks bucked the trend, with the Broker/Dealers gaining 1.5% and the Banks up 0.5%. With bullion pounded for $16.50, the HUI gold index sank 7%.

Chairman Greenspan threw some ice water on the Treasury market (and the corporate market, the emerging markets, mortgages...). For the week, 2-year Treasury yields jumped 15 basis points to 2.65%. Five-year Treasury yields rose 13 basis points to 3.67%. Ten-year yields increased 8 basis points to 4.43%. Long-bond yields ended the week at 5.17%, up 5 basis points on the week. Benchmark Fannie Mae MBS yields jumped 8 basis points, in line with Treasuries. The spread (to 10-year Treasuries) on Fannie's 4 3/8% 2013 note was about unchanged at 38, and the spread on Freddie's 4 ½ 2013 note was unchanged at 37. The 10-year dollar swap spread increased 0.5 to 48.25. Corporate bond spreads were generally little changed for the week. The implied yield on 3-month December Eurodollars rose 9 basis points to 2.395%.

Corporate debt issuance totaled a strong $14.4 billion (from Bloomberg). Investment grade issuers included Wachovia $5.0 billion, Morgan Stanley $1.5 billion, Metlife $1.6 billion, Citigroup $1.0 billion, Nationwide Building $400 million, Allstate Life $300 million, Fisher Scientific $300 million, Union Pacific $190 million, and First American Corp $150 million.

Junk bond funds reported inflows of $196.6 million for the week (from AMG), the second straight week of decent positive flows. Junk issuance included Refco $600 million, LCE Acquisition Corp $315 million, Building Materials Corp $200 million, and Duane Reade $195 million.

Convert Issuance included Ocwen Financial $150 million, Titan International $100 million, and Empire Resorts $65 million.

Foreign dollar debt issuers included Gazprom $1.25 billion, Export-Import Bank of China $750 million, and Jean Coutu $350 million.

Japanese 10-year JGB yields gained 3.5 basis points for the week to 1.80%. Brazilian benchmark bond yields rose 27 basis points to 10.26%. Mexican govt. yields actually declined 4 basis points this week to 5.80%. Russian 10-year Eurobond yields rose 13 basis points to 6.54%.

Freddie Mac posted 30-year fixed mortgage rates dipped two basis points this week to 5.98% (down 34bps in five weeks). Fifteen-year fixed mortgage rates declined 3 basis points to 5.39%. One-year adjustable-rate mortgages could be had at 4.12%, up 10 basis points. The Mortgage Bankers Association Purchase application index declined 6.1% last week. Purchase applications were flat compared to the strong year ago period, with dollar volume up almost 8%. Refi applications were about unchanged. The average Purchase mortgage was $215,600, and the average ARM was $285,200. ARMs accounted for 31.3% of applications last week.

Broad money supply (M3) dipped $5.3 billion (week of July 12). Year-to-date (28 weeks), broad money is up $448.9 billion, or 9.5% annualized. For the week, Currency added $2.0 billion. Demand & Checkable Deposits dropped $26.1 billion. Savings Deposits jumped $26.9 billion. Saving Deposits have expanded $279 billion so far this year (16.4% annualized). Small Denominated Deposits were unchanged. Retail Money Fund deposits declined $1.7 billion. Institutional Money Fund deposits dropped $6.0 billion, while Large Denominated Deposits gained $8.7 billion. Repurchase Agreements declined $9.5 billion. Eurodollar deposits added $0.6 billion.

Bank Credit expanded $8.0 billon for the week of July 14. Bank Credit has expanded $298.6 billion during the first 28 weeks of the year, or 8.8% annualized. Securities holdings added $2.5 billion. Commercial & Industrial loans gained $1.8 billion, and Real Estate loans jumped $13.8 billion. Real Estate loans are up $184.8 billion y-t-d, or 15.4% annualized. Consumer loans dipped $0.7 billion for the week, while Securities loans dropped $9.9 billion. Other loans rose $0.4 billion. Elsewhere, Total Commercial Paper jumped $8.8 billion (up $23.2 billion in two weeks) to $1.345 Trillion. Financial CP added $5.1 billion, with Non-financial CP up $3.7 billion (up $12.8 billion in three weeks). Year-to-date, Total CP is up $76.3 billion, or 10.8% annualized. It is worth noting that non-financial CP is up $22.5 billion y-t-d (37% ann.) to $130.5 billion, the highest level since November.

ABS issuance jumped to a noteworthy $18.5 billion (from JPMorgan) this week, with y-t-d issuance of $333.8 billion 38% ahead of comparable 2003. Year-to-date Home Equity ABS issuance of $201.3 billion is running 80% above a year ago.

Fed Foreign "Custody" Holdings of Treasury, Agency Debt rose $4.7 billion to $1.239 Trillion. Year-to-date, Custody Holdings are up $172.0 billion, or 29% annualized.

Currency Watch:

"Hawkish" testimony from Chairman Greenspan sparked a fervent dollar rally. The dollar index jumped 2.5%, with the "commodity currencies" generally suffering the steepest declines. For the week, the South African rand dropped 4.6%, the New Zealand and Australian dollars 3.1%, and the Swiss franc 3.1%.

Commodities Watch:

July 19 - UPI (Christine Heath): "China is now the world's largest consumer of many
industrial commodities, and its robust economic growth may enact geopolitical transformations and force China to engage in stronger foreign and military policy, according to a recent article [in The National Interest]. According to global economist David Hale, the current economic status in China 'is likely to be as transforming an event in geopolitics as America's arrival as a world power during the early decades of the 20th century.' The United States has now fallen behind China in many commodity markets. China is now the price setter for many commodities, including copper, iron ore, aluminum, and platinum. 'China's economic takeoff and new role in the global-commodity markets has occurred so quickly that the United States and other countries have not yet fully come to terms with it,' Hale asserted."

For the week, the CRB index dipped 0.8%, with y-t-d gains of 5.8%. With September crude up 41 cents to $41.71, the Goldman Sachs Commodities index added 0.5% (up 15.6% y-t-d).

China Watch:

July 22 - Bloomberg (Allen T. Cheng): "China's economic growth will probably slow to 8.5 percent this year because of government efforts to cool industrial expansion, the 21st Century Business Herald newspaper reported... 'We set an original growth target of 7 percent initially,' Yao Jingyuan, chief economist at the National Statistics Bureau. 'But realistically speaking, growth will be between 8 percent and 9 percent, possibly 8.5 percent.'"

July 21 - Bloomberg (Janet Ong): "China's shortages of coal, electricity and oil will persist for 'some time' because supplies are tight and demand is still growing, the China Daily said, citing Ma Liqiang, director of the economic operation bureau at the National Development and Reform Commission. Energy and transport demand won't decline significantly before the end of the year... Railway companies can meet only 35 percent of demand even with all trains working at full speed..."

July 21 - XFN: "China' property prices rose 11.6% year-on-year to an average of 2,701 yuan per square meter in the first half, with the growth up 4.9 percentage points from the first quarter, the National Bureau of Statistics (NBS) said... The NBS said average residential housing prices increased 9.8% year-on-year...in the first six months. Average first half commercial real estate prices were up 23.1% and average industrial property prices were up 15.6%."

July 20 - Bloomberg (Jianguo Jiang): "China's passenger car production growth slowed for a second month in June after as lending and investment curbs imposed to cool the world's fastest-expanding major economy started dimmed demand for new vehicles. Output rose 20 percent to 216,100 cars last month...following a 32 percent expansion in May and almost 44 percent in April."

July 20 - Bloomberg (Alan Patterson): "Taiwan's corporate investment in China more than doubled in June as companies such as AU Optronics Corp. and Taiwan Semiconductor Manufacturing Co. expanded in the world's seventh-largest economy. Approved investment surged to $632 million from $295 million..."

Asia Inflation Watch:

July 21 - Bloomberg (Jennifer Itzenson): "Japan's Cabinet Office plans to increase its official forecast for the current fiscal year's economic growth to 3.5 percent from 1.8 percent, Kyodo News said, citing unidentified people in government."

July 21 - Bloomberg (Issei Morita): "Summer bonus payments to Japanese salaried workers rose 2.9 percent from a year earlier to a record, a survey by the country's biggest business lobby shows. Summer bonuses, which are usually paid in June and can amount to several months of a workers' salary..."

July 21 - Bloomberg (Cherian Thomas): "India's exports last month rose 34 percent as Ford India Ltd. and rival automobile companies sold more overseas and steelmakers increased sales to China. Exports reached $5.6 billion in June... Imports rose 43 percent to $7.9 billion, while the trade deficit widened to $2.2 billion from $1.3 billion in June last year."

July 21 - Bloomberg (Philip Lagerkranser): "Hong Kong's economy is expected to have achieved 'double-digit' growth in the second quarter as unemployment fell, property prices rebounded and tourism boomed, Chief Executive Tung Chee-hwa said. 'Our economy is showing signs of a strong rebound,' Tung said..."

July 23 - Bloomberg (Philip Lagerkranser): "Hong Kong's consumer prices fell last month at their slowest pace since deflation began more than five years ago as rising household spending and booming tourism enabled businesses to slash discounts. Consumer prices declined 0.1 percent from a year earlier after sliding 0.9 percent in May, the government said in a statement. That's the smallest decline since October 1998..."

July 23 - Bloomberg (George Hsu and Theresa Tang): "Taiwan's export orders picked up in June as electronics makers sent more parts to Chinese factories, which are boosting production of cell phones, flat-panel displays and computers as spending rises in the U.S., Europe and Japan. Export orders -- indicative of shipments in one to three months - increased 28 percent from a year earlier to $17.7 billion after climbing 26 percent in May..."

July 21 - Bloomberg (Seyoon Kim): "South Korean exports rose 32 percent from a year earlier in the first 20 days of this month, the Ministry of Commerce, Industry and Energy said... Exports climbed to $11.5 billion in the July 1-20 period... Imports rose 28 percent to $11.8 billion..."

July 23 - Bloomberg (Jason Folkmanis): "Vietnamese inflation accelerated for a ninth month in July to its fastest pace in more than five years as food costs climbed. Consumer prices climbed 9.1 percent from a year ago, the biggest gain since January 1999..."

Global Reflation Watch:

July 20 - Bloomberg (Walden Siew): "The global default rate for high-yield, high-risk and investment-grade debt is on a pace to fall to the lowest since 1997, according to Standard & Poor's. The rate of recorded defaults declined in the second quarter to an annualized rate of 0.62 percent from 1.84 percent for all of 2003, the New York-based ratings company said."

July 20 - Bloomberg (Duncan Hooper): "U.K. mortgage lending accelerated in June at a record pace after slowing in May, the British Bankers' Association said, suggesting the Bank of England may need to boost interest rates again to cool consumers appetite for debt.... The Council of Mortgage Lenders said gross mortgage lending rose 15 percent to 27.8 billion pounds."

July 23 - Bloomberg (Sam Fleming): "U.K. economic growth accelerated in the second quarter as four interest rate increases since November failed to damp consumer spending and manufacturing pulled out of a decline, reinforcing expectations for higher borrowing costs... The economy grew an annual 3.7 percent, the fastest since the third quarter of 2000. The U.K. has had 48 quarters of uninterrupted growth, pushing unemployment to a 29-year low and prompting the Bank of England to increase rates from the lowest in almost half a century in November."

July 22 - Bloomberg (Francois de Beaupuy): "Consumer spending in France, Europe's third-biggest economy, surged in June at the fastest pace in almost eight years as government-regulated seasonal discounts lifted sales of cars, home appliances and clothing. Spending on manufactured goods, which accounts for a quarter of total household consumption, climbed 4.2 percent from May..."

July 21 - Bloomberg (Jonas Bergman): "Danish second-quarter mortgage lending was the highest since the first three months of 2003 as low interest rates continued to support demand for refinancing, the Association of Danish Mortgage Banks said."

July 22 - Bloomberg (Carlos Caminada): "Brazil had a record current account surplus in June as exports surged. The surplus in the current account, the broadest measure of a country's trade in goods and services, rose to $2.06 billion from $1.48 billion in May..."

California Bubble Watch:

July 20 - Associated Press: "California's real estate market showed no signs of slowing in June as buyers scooped up houses and condos at a record clip and helped drive the median price for a home to an all-time high of $382,000. The median price for June represents a 23.2% increase over $310,000 in the same period last year and a 3.8% jump over the $368,000 recorded in May, according to data released by DataQuick... In all, 66,850 homes were sold during the month, up 21.7% from 54,930 in June 2003 and up 18% from 56,650 in May. 'We're still not seeing any turn in the market,' DataQuick analyst John Karevoll said."

July 17 - San Francisco Chronicle (Kelli Zito): "Bay Area home buyers went on a binge in June, pushing prices and sales counts -- not to mention monthly payments -- to their highest levels in at least 16 years. A total of 14,104 houses and condominiums changed hands in June in the nine-county region, blasting past the previous monthly record of 12,488 set in August 2003 and representing a 34 percent jump over the June 2003 total of 10,492, according to DataQuick... The median price for a single-family home hit $545,000, a record for the fifth consecutive month and nearly 18 percent higher than the year-ago figure of $464,000. June's median was also about 3 percent higher than May's median of $530,000. 'It's astonishing,' DataQuick researcher John Karevoll said about the sales volume. 'You never break records by that much. It's like Bob Beamon's long jump record,' Karevoll said, referring to the legendary track star whose 1968 record stood untouched for 23 years."

July 20 - (Sonoma, CA) Press Democrat (Michael Coit): "The median price for Sonoma County resale homes pushed past the half-million-dollar mark in June for the first time... The median was $503,000 in June, a month when sales increased more than 22 percent...

Sonoma County has been rapidly surpassing real estate milestones in recent years, as have much of the Bay Area and state. The county's median price hit $100,000 in 1982 and topped $200,000 in 1991 and $300,000 in 2000. It surpassed $400,000 last year."

July 17 - San Jose Mercury News (Sue McAllister): "Another month, another record broken by Bay Area home prices. The median price of houses sold in Santa Clara County climbed to $599,000 in June, the fifth consecutive month of record-high prices, racking up a 15.2 percent increase from a year earlier. And if those figures don't stun you, consider the huge jump -- 49 percent -- in the number of houses sold in the county last month..." Condo sales in the county surged also, increasing 64.8 percent from June 2003. The median price of the condos sold was $385,000, up 6.9 percent."

Mortgage Finance Bubble Watch:

July 21 - South Florida Business Journal: "The average sales prices for existing, single-family homes and condominiums in the Fort Lauderdale area are up an average 15 percent in the first six months of the year, the Realtor Association of Greater Fort Lauderdale said. The group said average price for an existing single-family home in the greater Fort Lauderdale area topped $363,019 for June 2004, a 14 percent increase from the January 2004 average of $317,455. Existing condominiums reached $175,628 for June 2004...up almost 16 percent from the January... Total units sold during the first half of 2004 totaled 31,199...a 20 percent jump from the 2003 first-half total... The dollar value of the first six months of sales reached $3.6 billion...18 percent ahead of last year's first-half total..."

GSE growth was strong during June. Freddie Mac's Book of Business expanded at a 16.4% rate to $1.46 Trillion, the strongest growth since October. The company's Retained Portfolio expanded $1.03 billion, or 19.4% annualized to $645.2 billion, the strongest growth since October. And Fannie Mae finally stepped up to the plate. The company's Book of Business expanded $18.7 billion during June, or 10.1% annualized, to $2.251 Trillion. This was the largest gain since December, and increased y-t-d growth to 4.8% annualized. Fannie's Retained Portfolio jumped $12.8 billion, or 17.5% annualized. This was the strongest expansion since last September. Fannie and Freddie's combined Book of Business expanded $38.4 billion for the month (13% ann.) to $3.7 Trillion. Combined Retained Portfolios expanded $23.1 billion (18% ann.) to $1.54 Trillion, the strongest growth since last September.

Fannie's 2^nd quarter was uninspiring, with Net Income about flat from Q2 2003 at $1.112 billion. Total Assets contracted at a 2.4% annualized rate during the quarter to $989.3 billion. Year-over-year, Total Assets were up only 7.1%. "(CFO Tim) Howard said that opportunities for portfolio growth for the next several months were likely to continue to be affected by an unusually high market share of adjustable-rate mortgages and spirited competition for mortgage assets among a variety of investor types... Howard said that as homeowners reacted to rising interest rates over a third of Fannie Mae's purchase commitments during the first half of 2004 were for hybrid ARMs and floating-rate mortgage-backed securities, compared with less than a 10 percent share of such products in 2002 and 2003." Fannie repurchased 2.8 million shares during the quarter.

Financial Sphere Watch:

Credit card behemoth Capital One reported Net Income of $407.4 million, up 34% from second quarter 2003. Average Managed loans expanded at a 12% rate during the quarter, the slowest expansion in one year. Total Assets increased $924 million, or 8% annualized, the weakest growth since the first quarter of 2003. Still, Total Assets were up 24% y-o-y. On the liabilities side, Interest-bearing Deposits increased 22% y-o-y to $24.2 billion.

Highlights from Wells Fargo: "Average loans up 30 percent from prior year. Average commercial and commercial real estate loans up 6 percent from prior year and up 11 percent (annualized) linked-quarter." "Commercial loan growth this quarter was broad-based across virtually all of our segments..." "Average consumer loans, including home equity and home mortgage, credit card and revolving credit and installment loans products, increased $56 billion, or 48 percent, from second quarter 2003, and $7.3 billion, or 18 percent (annualized), on a linked-quarter basis." For the quarter, ending Total Assets expanded $23.0 billion, or 23% annualized, to $420.3 billion. This was the strongest gain since the fourth quarter of 1999. By category, Real Estate Construction loans expanded at a 19% rate and Home Equity loans 39.8%. "Residential real estate originations for the quarter were $96 billion, up $31 billion from the first quarter." Year-over-year, Commercial loans increased 5% to $50.0 billion and Consumer loans were up 23.3% to $86.4 billion.

The Great Mortgage Spread Trade

From Countrywide Financial: "Consolidated net earnings reached $700 million, advancing 83 percent over net earnings of $383 million in the second quarter of 2003." "Purchase fundings rose 40 percent from the second quarter of 2003 to a record $46 billion... The servicing portfolio rose to a record $726 billion, up $81 billion from the beginning of the year." Total Assets expanded at a 14% rate during the quarter to $103.8 billion. On the liabilities side, Deposits were up 66% y-o-y to $15.5 billion

Thornburg Mortgage is a REIT that originates and invests in adjustable-rate mortgages. Total Assets expanded $2.1 billion during the quarter (38% ann.) to $24.5 billion. Total Assets were up 62% year-on-year, and are up from $4.4 billion outstanding three years ago. Examining the company's second-quarter balance sheet, $23.1 billion of "ARM Assets" are financed by "Reverse Repurchase Agreements" of $17.5 billion, "Collateralized Debt Obligations/CDOs" of $4.8 billion, other liabilities of approximately $700 million, and Shareholders' Equity of $1.56 billion. Assets are leveraged 15.8 times to equity.

New Century - "One of the nation's largest non-prime mortgage finance companies" that has opted for REIT status - reported quarterly earnings of $102.4 million. This was a 68% increase from last year's comparable quarter. Mortgage Originations increased 45% during the quarter to $12.26 billion and were more than double the year ago level. Total Assets surged 50% (not annualized!) during the quarter to $14.7 billion, and were up from the year ago $3.8 billion. It is worth noting that assets surpassed $1 billion for the first time during the third quarter of 2001.

"Non-conforming residential mortgage" REIT Impac Holdings enjoyed record originations ($5.5 billion) and balance sheet growth (about $4 billion) during the quarter. Total Assets more than doubled over the past 12 months to surpass $17 billion. Total Assets are up from $2.2 billion over the past three years. Impac ended the first quarter with Shareholders' Equity of $608 million.

While second quarter data are not yet available, it is worth noting that mortgage REIT Redwood Trust's Total Assets had increased 140% y-o-y to end the first quarter at $19.5 billion (up from March 2002's $2.7bn). Redwood Trust ended the quarter with Shareholders' Equity of $608 million. Annaly Mortgage Total Assets were up 45% y-o-y to end the first quarter at $18.3 billion (up from March 2001's $3.5bn). Annaly ended the quarter with Shareholders' Equity of $1.7 billion. Friedman Billings Total Assets were up 115% y-o-y to end the first quarter at $11.8 billion. Friedman Billings ended the quarter with Shareholders' Equity of $1.7 billion.

Chairman Greenspan's testimony Tuesday before the Senate Banking Committee and Wednesday before the House Financial Services Committee proved surprisingly interesting. The message was clear: the Fed is prepared to "normalize" short-term interest-rates, and the economy hitting a bit of a "soft-spot" has not altered the Fed's agenda. My read is that Mr. Greenspan is seeking to affect two markets. First, he has been satisfied with the orderly rise in market yields and wants to avoid another big yield decline, one that would again destabilize the mortgage and interest-rate hedging markets. Second - and this is a continuation of what I believe is a significant but unspoken policy shift - the Fed recognizes the vulnerability of the dollar. The Fed must signal to the marketplace that U.S. rates are going higher, weak data or not. Only time will tell as to the true degree of Fed resolve - as opposed to "hawkish" talk to comfortably manipulate markets. For now, bond yields backed-up somewhat, while currency traders bought dollars as if our Fed chairman was speaking to them directly.

One of the more interesting exchanges during Greenspan's testimony was provided courtesy of an astute question from California Congressman Edward Royce: "Chairman Greenspan, in preparing for your visit here I read an economic research note from a very respected economist, in which he called the Federal Reserve, in his view, the world's biggest hedge fund. And his rationale for making that claim is that the Fed has encouraged the financial markets to participate, in his view, in the carry trade, where one can borrow cheaply on the short end of the yield curve and invest those borrowings in a longer-dated security. So, according to this economist, the Fed encouraged the carry trade in 1993 when they took the Fed funds rate down to where it equaled the rate of inflation. And the current period is cited as another era, in his view, of the carry trade, since the Fed funds rate is negative or below the rate of inflation. The risk cited in this paper of his is that these Fed-encouraged carry trades can encourage artificial bubbles in asset prices. This claim is applied to the housing bubble today, but could, you know, the equity bubble in the 1990s could also be explained from that perspective. And I just wanted to get your thoughts on this critique of Fed policy."

Chairman Greenspan: "Well, Congressman, so long as the normal tendency is for long-term rates to be higher than short-term rates, there'll always be some carry trade. And indeed, one can even argue that commercial banks are largely carry trade organizations. But, as I point out in my prepared remarks, the awareness currently of the risks in taking extended positions in the carry trade markets is clearly being unwound, and our judgment is that while there is some, and there always will be some, it's not been a problem. Certainly, if you have an extended period and you lock-in these differences, you can create great distortions. But when we move rates down, as we have on several different occasions, we are acutely aware that in that process we will increase the carry trade. The more important question is, what the significance is if we do that? And if we perceived that that was creating bubbles or distortions, obviously we wouldn't do that. And I must say that our history of dealing with that problem, and it is a problem, as indeed there are huge numbers of related sorts of problems - we're aware of what happens when we move, but we try to adjust our policies in a manner as to significantly minimize any secondary consequences of such actions, and indeed, I think the recent history suggests that so far, at least, we've been successful in doing that."

Where do I begin? Traditionally, banks have been thought of as primarily lenders to finance sound investment and profitable business enterprise. In the process, "safe" deposits were created that yielded less than the return on riskier bank assets (loans). As long as these assets were expanded judiciously - nurturing a stable return on business investment that exceeded the cost of borrowing - bank assets remained sound and the banking system profitable. It was only when bank assets became largely detached from economic investment/returns - as they have evolved to be with the explosion in consumption and asset-based lending - that the notion of "carry trade organizations" became applicable.

All the same, Mr. Greenspan asserts that "positions in the carry trade market [are] clearly being unwound." He is either uniformed or disingenuous. It is true that the Fed has dedicated the past year's ultra-accommodation to the process of unwinding interest-rate speculations. Less appreciated, this process has been immeasurably facilitated by unprecedented foreign central bank Treasury purchases. Those endeavoring to off-load interest-rate risk - commonly accomplished by shorting Treasury bonds - enjoyed the luxury/anomaly of intemperate central bank buying.

The (too clever) Greenspan Fed has toddled patiently, carefully communicating its intensions to the leveraged speculating community. And this has surely spurred a significant unwind of the traditional borrow short/lend long "carry trades," as well as accommodated hedging programs for those exposed (including the derivative players themselves). But there has been no rectify of systemic distortions - anything but.

Importantly, I would argue that Mr. Greenspan's strategy has only incited a major reconstitution of the traditional interest-rate carry trade to a more problematic predicament I will refer to as "The Great Mortgage Spread Trade." With the Fed signaling tranquil rising yields ("Transparent Tightening Lite"), the hot speculation quickly shifted from profiting from the steep yield curve (borrow short, lend long) to playing credit spreads (some variation of shorting Treasuries and buying higher-yielding debt).

It is briefly worth contemplating the notion of a "neutral" Fed funds rate, a topical subject these days. But what does this mean? Some would suggest a neutral rate would (magically) produce a 2.5% "core CPI." Others would argue for a rate consistent with 4% GDP or general economic equilibrium. However, I think this line of thinking completely misses the point. Any concept of a "neutral" interest-rate must at least recognize the predominant mechanism (Monetary Process) for Credit expansion - today this is clearly the mortgage finance arena. What rate would have been "neutral" over the past couple of years, in respect to not inciting excessive mortgage borrowings and attendant distortions?

The momentous flaw in Mr. Greenspan's strategy is that 1% Fed funds has been a fraction of what would have been necessary ("neutral") over the past 18 months to rein in a runaway mortgage finance system. On the one hand, there has been a momentous Inflationary Bias throughout the financial system, with ballooning hedge fund and proprietary trading communities; scores of aggressive GSEs, REITS, banks, S&Ls, insurance companies, finance companies; and many others clamoring to participate in the mortgage spread game (and enterprising investment bankers creating sophisticated instruments). On the other hand, an overly liquefied mortgage finance super-system has been creating new mortgage Credit at an unprecedented pace of $1 Trillion annually - with the underlying quality of these loans deteriorating commensurate with manic borrowing excesses. The upshot has been insatiable demand for high-yielding instruments matched by explosive growth in the supply of subprime and less-than-prime mortgage lending. The situation beckoned for aggressive tightening but got aggressive accommodation.

Keeping in mind that it took the Japanese banking system only a few short years of reckless lending to virtually destroy itself with bad loans, the Fed's notion that it can dilly-dally for a couple of years to ensure the placid unwind of carry trades is one more example of failed (negligent) central banking. Indeed, it is becoming increasingly clear in my mind that problem mortgage Credits will likely pose the paramount risk to the U.S. financial system and economy, as opposed to interest-rate risk.

The Great Mortgage Spread Trade - and the resulting torrent of cheap liquidity flowing to housing finance - has fostered a price Bubble in California and, generally, at the "upper end," along with excessive construction throughout. The surge in no-downpayment, adjustable-rate (with teasers!), negative amortization and subprime lending has incited millions of buyers to bid up prices on properties to unsustainable levels. Perhaps most will be able to afford their monthly payments, but the odds of millions becoming underwater on their mortgages when the Mortgage Finance Bubble bursts is alarmingly high and growing.

And while the Greenspan Fed is succeeding (by dilly-dallying) in shifting interest-rate risk from the financial sector to the unsuspecting household sector, the cost will be enormous future loan problems. Prices are being artificially bid up and imputed equity extracted, while the amount of mortgage fraud is surely massive. The Fed may hold sway over interest rates going forward (mitigating the systemic risk attendant with surging ARM borrowings), but the unfolding Monetary Disorder throughout mortgage finance guarantees the Fed will have little power over Credit losses. Recall the telecom debt debacle?

Interestingly, Fannie Mae is understandably troubled by financial sector developments. From opening comments of the company's earnings conference call:

"In the last two quarters of 2003, one of the main factors supporting the sustained accumulation of mortgage assets by depositories showed signs of weakening, with core deposit growth slowing significantly in each quarter. That slowing turned around dramatically in the first quarter of 2004, with banks adding over $160 billion in core deposits. While growth slowed to $80 billion in the second quarter, that remains nearly three times the levels of growth recorded in both the third and fourth quarters of 2003. At the same time, we have seen no sustained pick-up in the level of C&I loan demand, with loan levels at the end of June exactly where they finished last year. As a result of these dynamics, depositories have continued to add to their mortgage holdings, albeit at a more moderate pace. Total mortgage holdings at commercial banks rose by 26 percent in the first quarter, but decelerated to 8 percent in the second quarter...

The second environmental factor that I would like to address is the increased ARM share we've seen during the past 18 months, and the proportion of that increase that has recently been driven by interest-only ARM hybrids. As interest rates have turned upward, and home price appreciation has remained strong, borrowers have turned to alternative mortgage products to maintain affordability. And as refinance-driven volume has disappeared, lenders have turned increasingly to these products, often extending into the Alt-A and sub-prime markets, to keep up volumes in their pipelines. In the first quarter of this year, first-lien ARMs grew by an estimated 34 percent on an annualized basis compared to only 5 percent for conventional fixed rate loans. On a loan count basis, the ARM share of conventional mortgage applications in May averaged over 36 percent -- the highest monthly rate since the survey began in 1990... A record percentage of ARM originations in the first quarter were interest-only hybrids. And an increasing proportion of these interest-only hybrids are being made to borrowers with blemished credit. In addition, so-called 'sub-prime' mortgage debt grew at an annualized rate of nearly 23 percent in the first quarter, nearly double the growth rate for conventional prime. And at the end of the quarter, the sub-prime share of residential mortgage debt reached an all-time high of 9.3 percent. We believe that interest-only loans, when used appropriately, are a valuable tool to help homeowners qualify for mortgages. But we view the combination of these factors with some concern, because adjustable rate, interest only loans leave consumers vulnerable to severe payment shock in a rising rate environment. Our analyses indicate that in some instances, as rates rise homeowners could see payment increases of up to 150 percent.

The third trend that I will address is the recent growth in share of private label MBS. With the spread between private label and our own MBS contracting modestly, and spreads on riskier subordinated tranches contracting considerably, private label share of new MBS issuance actually exceeded that of both Fannie Mae and Freddie Mac. When you take a closer look, you see that aggressive lending practices are driving the growth of private label issuance. An increasing proportion of the growing sub-prime and alt-A volume that I referenced earlier is being swept into private label MBS. In fact, these loans now account for over half of private label dollar volume. And in the Alt-A market, there has been a sizable increase in the investor loan share and the interest-only share of originations. The fact is that we do not believe the level of credit risk in private label securities has been adequately reflected in the current pricing."

As industry kingpins and Mortgage Finance Bubble Instigators, Fannie and fellow GSEs have good reason to be alarmed by the nature of current Credit excesses and general disorder. They surely were much more comfortable back when they dominated the mortgage lending process - when they controlled the monetary spigot. But financial excess and resulting Bubbles, by their very nature, become increasingly unwieldy over time. The masters of inflationary processes eventually loose control - in this case to an unparalleled pool of global speculative finance. I see this loss of control today for the GSEs and their Mortgage Finance Bubble, and this will be followed more generally with respect to the Fed and its market manipulations.

Ironically, the Fed has, of late, succeeded in stemming GSE growth. But what a Pyrrhic victory. Leaving rates at such artificially low levels - accommodating the interest-rate speculators and derivative players - incited manic "blow-off" excesses throughout non-GSE mortgage finance. The problem with such a development is that an unsound boom - and this one is of historic proportions - is inevitably vulnerable to devastating bust at any point that lending excesses subside. The All Too Clever Greenspan Fed will, at such time, have met its match. The Fed has committed a grave error in mobilizing speculative finance to accomplish its monetary policy objectives. The Great Mortgage Spread Trade will eventually unwind and there won't be a bigger leveraged trade to take its place.